European Economic Quarterly-A long and winding road

EUROPEAN

ECONOMICS

Macro

European Economics

Q4 2012

A long and winding road

The promise of ECB intervention means fears of eurozone disaster have receded...

…but with the economy still slowing, unemployment rising and more austerity

ahead…

…there will be plenty more twists and turns on the road to genuine fiscal, financial

and political integration

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Macro

European Economics

Q4 2012

Summary

The eurozone crisis may have abated. But it is definitely not over.

ECB president Mario Draghi’s summer promise to do “whatever it takes” to preserve the euro has certainly led

to a sharp improvement in market sentiment, and the mood has been further helped by some significant

political events – the first hint of a roadmap at the end of June EU summit and the German constitutional court

ruling on the legality of the ESM in September, for example.

But investors, companies and consumers remain nervous. They still worry that the ECB’s actions will do all

too little to lift the eurozone economy out of recession, and the protests in Greece, Spain and Portugal, as well

as the secessionist drive in Catalonia, are adding to fears that the austerity is already reaching the limits of

acceptability.

We have had periods of relative stability and market rallies before in the past three years, including earlier this

year after the announcement of the Long-Term Refinancing Operations. It is still too early to say whether this

rally will prove more durable. And although the headlines have been big, the changes to our forecasts this

quarter are modest. The eurozone recession is set to persist in the coming months and we expect a gradual

upturn in world trade to deliver only a modest recovery next year: we have lowered our 2013 GDP forecast

from 0.3% to -0.1%. The outlook is only marginally better in the UK. We are now forecasting a small fall in

full year GDP in 2012 and have cut our 2013 forecast for growth sharply.

In this report we look at what ECB action has already achieved, what it is attempting to do over the medium

term and why its efforts to keep some kind of lid on sovereign bond yields might be more successful than

previously. But while the ECB backstop can prevent a catastrophe, it can’t single-handedly solve the crisis. By

its own admission it is trying to address the “convertibility” or euro break-up risk, but only governments can

improve their credit risk, both by delivering the required fiscal consolidation and structural reforms and by all

the member states taking much more far-reaching steps towards closer financial sector integration, a more

centralised fiscal framework and a new governance structure.

We look at progress so far on fiscal consolidation and structural reform in the most-affected countries and

conclude that heavy indebtedness will remain a drag on growth for the foreseeable future. There is some

evidence of improving competitiveness and successful export diversification in the periphery, but low potential

growth rates will make fiscal consolidation a long and arduous task. Even Ireland, which is ‘best in class’, has

at least another three years of austerity to follow the five it has already endured. Others are less advanced and in

deeper recessions. As recent strikes and unrest in Greece, Spain and Portugal show, austerity is becoming less

and less palatable to voters. The risk is of further upheaval, particularly as the public sector job losses still have

some way to run in many countries.

Macro

European Economics

Q4 2012

Any suggestion that governments are wavering on reform, or that populations’ acceptance of austerity (or the

euro) is starting to wane, will spell trouble for markets. While market pressure will no doubt incentivise

governments to continue with reform and fiscal consolidation, it is also likely to push more countries into

requesting external assistance. Spain looks likely to be the first, most likely in October. The fiscal consolidation

process is generally on track in Italy, but its financing needs are high, and with the elections looming in April

2013, some kind of precautionary programme, while no certainty, seems quite likely there by early 2013.

Meanwhile discussions about a further extension to the second Greek Troika programme will likely continue

through October and maybe November.

We have heard little recently on the required new institution-building, other than on plans for a single bank

supervisor. This was meant to be the most straightforward part, but has already amply demonstrated the

divergence of opinions between member states and is unlikely to be in place as soon as hoped. It is just a taster

of what lies ahead in terms of governments having to relinquish sovereignty to eurozone-wide institutions. The

rest of the building blocks, not just for the banking union, but for the fiscal union, have yet to be outlined, but

the European Council meeting in mid-October should present some preliminary ideas. Heads of government

will need to take decisions on what is achievable and then set out on the very long road to implementing them.

The ECB has bought time. Now governments need to do the rest. Our underlying assumption remains that the

eurozone will ultimately reach this destination, but not without further twists and turns along the way.

HSBC forecast revisions

_________________GDP (%Yr) __________________ _____________Consumer prices (%Yr) _____________

______ 2012f ________ ________ 2013f _________ ________ 2012f _________ ________ 2013f ________

Published in -> Previous Latest Previous Latest Previous Latest Previous Latest

Eurozone -0.6 -0.6 0.3 -0.1 2.3 2.5 1.6 1.8

Germany 0.8 0.9 1.5 0.9 2.0 2.1 1.6 2.1

France 0.3 0.2 1.3 0.9 2.2 2.3 1.7 1.8

Italy -2.0 -2.5 -0.3 -1.1 3.2 3.4 1.7 2.3

Spain -2.0 -1.5 -1.3 -2.0 2.0 2.4 1.9 2.5

Other Western Europe 0.6 0.5 1.8 1.4 2.0 1.9 1.7 2.0

UK 0.1 -0.1 1.8 1.1 2.7 2.7 1.9 2.5

Norway 3.0 3.6 3.1 3.0 0.8 0.7 1.8 1.6

Sweden 1.1 0.8 2.1 2.1 1.2 1.1 1.8 1.2

Switzerland 1.5 0.9 1.5 1.4 -0.4 -0.6 0.4 0.3

Other Europe

Hungary -0.5 -1.0 1.4 1.3 5.4 5.7 3.4 3.7

Poland 2.7 2.5 3.1 2.0 3.8 3.9 2.6 2.7

Romania 1.0 1.1 3.0 2.5 3.0 3.1 3.9 3.5

Turkey 2.0 2.7 3.5 3.8 9.3 9.0 7.9 7.3

Czech Republic -0.5 -0.9 1.5 1.0 3.5 3.3 2.1 2.0

Russia 3.0 3.0 2.5 2.5 5.0 5.2 7.5 7.4

Source: HSBC estimates

Macro

European Economics

Q4 2012

Key Forecasts

Key forecasts

___________GDP ___________ _________ Inflation___________ ______ Unemployment _______ ____ Consumer Spending _____

% Year 2011 2012f 2013f 2011 2012f 2013f 2011 2012f 2013f 2011 2012f 2013f

Eurozone 1.5 -0.6 -0.1 2.7 2.5 1.8 10.2 11.4 12.1 0.1 -0.8 -0.2

Germany 3.1 0.9 0.9 2.5 2.1 2.1 7.1 6.8 6.7 1.7 0.9 1.2

France 1.7 0.2 0.9 2.3 2.3 1.8 9.7 10.2 10.5 0.2 0.1 0.5

Italy 0.5 -2.5 -1.1 2.9 3.4 2.3 8.4 10.6 11.5 0.2 -3.4 -1.3

Spain 0.4 -1.5 -2.0 3.1 2.4 2.5 21.7 25.0 27.2 -1.0 -1.8 -1.8

Other Western Europe

UK 0.8 -0.1 1.1 4.5 2.7 2.5 10.2 11.4 12.1 -1.0 -0.1 1.3

Norway 2.5 3.6 3.0 1.3 0.7 1.6 0.0 0.0 0.0 2.4 3.7 4.5

Sweden 3.9 0.8 2.1 3.0 1.1 1.2 7.5 8.1 7.5 2.2 1.6 1.2

Switzerland 1.9 0.9 1.4 0.2 -0.6 0.3 2.8 2.9 3.1 1.2 2.3 1.6

Other Europe

Hungary 1.6 -1.0 1.3 3.9 5.7 3.7 10.7 11.1 10.9 0.2 -1.3 0.2

Poland 4.3 2.5 2.0 4.3 3.9 2.7 12.5 13.0 13.0 3.1 1.6 1.6

Romania 2.5 1.1 2.5 5.8 3.1 3.5 5.1 5.0 5.0 0.7 0.1 2.1

Turkey 8.5 2.7 3.8 6.5 9.0 7.3 9.8 10.0 9.0 7.7 0.0 3.0

Czech Republic 1.7 -0.9 1.0 1.9 3.3 2.0 9.8 10.0 9.0 -0.5 -2.8 0.3

Russia 4.3 3.0 2.5 8.5 5.2 7.4 15.4 13.8 12.7 6.8 5.5 4.5

Source: HSBC estimates

Consensus forecasts for 2012 GDP growth have been getting steadily

worse …

-1

% 2012 GDP forec ast

% Year

01-11

02-11

03-11

04-11

05-11

06-11

07-11

08-11

09-11

10-11

11-11

12-11

01-12

02-12

03-12

04-12

05-12

06-12

07-12

08-12

09-12

Western Europe Eastern Europe

Eurozone

Source: Consensus economics Source: Consensus Economics

-1

… as have 2013 growth forecasts but at a much lower rate

% Year 2013 GDP forecast

% Year

01-12

02-12

03-12

04-12

05-12

06-12

07-12

08-12

Western Europe Eastern Europe

Eurozone

09-12

Macro

European Economics

Q4 2012

Contents

Key Forecasts 3

A long and winding road 5

Turning the corner? 5

The central bank task 5

Challenges for governments 7

Reforms, reforms 13

Roadmap for integration 16

Life outside the euro isn’t easy either 20

Emerging Europe is slowing too 21

Periphery at a glance 23

Spain 25

Italy 26

Ireland 27

Greece 28

Portugal 29

Rescue Packages 30

Key European forecasts and

statistics 31

GDP 32

Consumer prices 33

Consumer spending 34

Budget balance 35

Debt 36

Unemployment 37

Demographics 38

Economic infrastructure 39

Eurozone 40

Germany 42

France 44

Italy 46

Spain 48

UK 50

Norway 52

Sweden 53

Switzerland 54

Hungary 55

Poland 56

Romania 58

Czech Republic 59

Russia 60

Turkey 62

Disclosure appendix 67

Disclaimer 68

Macro

European Economics

Q4 2012

A long and winding road

The promise of ECB intervention has pulled the eurozone back

from the brink once more …

… but with the economy still slowing, unemployment rising and

more austerity ahead …

… there will be plenty more twists and turns on the road to

genuine fiscal, financial and political integration

Turning the corner?

For much of the past three years, attempts to solve

the eurozone sovereign crisis appear to have been

a case of ‘one step forward, one step back’. Over

the summer months we had a rare period of a

couple of consecutive steps forward. The 28-29

June European Council summit, which in our

view represented an important first step from

coordination to genuine integration, did little to

impress the markets. But the subsequent

commitment by the ECB president Mario Draghi

to do “whatever it takes” to preserve the euro has

1. The rollercoaster continues

since led to a bond market rally on the scale that

followed the ECB announcement of the unlimited

three-year LTROs (chart 1) and this is before the

ECB has even bought a euro of bonds.

The central bank task

From SMP to OMT

% 2y r Bond Yields

EC B starts

buying Spanish

and Italian debt

EC B announces

3y r LTR Os

The initial market impact was in response to Mr

Draghi’s 26 July speech but, as further details

have become available, the ECB’s commitment

that, in exchange for countries meeting strict

conditions, it will undertake unlimited, but

Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12

Source: Bloomberg, Reuters

Draghi commits to do

"w hatev er it takes "

Spanish 2y r Bond Yields Italian 2y r Bond Yields

Macro

European Economics

Q4 2012

2. Outright monetary transactions (OMT): what we know and what we don’t

Measure OMT programme

Eligibility & Sequencing ECB will start purchasing a country’s bonds in the secondary market once:

1) the country has requested for assistance;

2) has reached an agreement on conditionality with the EFSF/ESM and signed a MoU – this can either be a full or a

precautionary programme but must include a primary market programme (PMP) as part of it; and

3) EFSF/ESM has started buying bonds in the primary market.

Bond purchases would be undertaken by the national central banks according to the ECB’s capital key.

Conditionality Strict conditionality will be imposed, ideally involving the IMF, and the ECB has said it will cease intervention in case

the member state does not fulfil these conditions. Part of the conditionality will be that the maturity structure of the

debt may not change so that governments do not put all new debt in the short end of the market to take advantage of

the new scheme.

Maturity Bond purchases would be focused on the short end of the curve, only bonds with three or fewer years until they

mature will be bought under the programme.

Size 1) No specific ceiling on spreads or yields. No outright limit on how many purchases the ECB can make of

government bonds.

2) Not restricted to only buy bonds that were issued before a government requested an OMT programme - ECB can

buy debt issued after the start of a programme with an implicit limit on it.

Seniority ECB will not have the preferred creditor status on its purchases.

Sterilisation Intervention will be sterilised with the ECB taking weekly deposits similar to the SMP.

Transparency ECB will publish the size of its purchases by bonds of each country bought every month.

Source: ECB, FT and HSBC

sterilised, purchases of government bonds and that

it will not be a preferred creditor on its future

purchases (table 2), has caused most asset classes

to rally strongly. But we shouldn’t get too carried

away. Ten-year yields on Spain and Italy are still

only back where they were in May and, in the

final days of September were rising again. The

really strong performance has actually been in

Ireland and Portugal, which, although they are

viewed as much less likely to pursue ECB support

via the OMT programme any time soon, have

seen a continuation of the spread narrowing which

began earlier this year for Portugal and before

that for Ireland.

The economic data has been much more

disappointing. Admittedly it is still early days, but

most sentiment indicators are still moving down

(charts 3 and 4). Both consumers and industry

have yet to be convinced that the eurozone crisis

has genuinely taken a turn for the better.

What is the ECB trying to achieve?

By the ECB’s own admission, it can only provide

a backstop. It aims to address severe distortions in

government bond markets which originate from

euro break-up fears and to ensure the proper

transmission of monetary policy to the real

economy throughout the monetary union. The fear

is that without such a policy there would be a risk

of such “destructive scenarios” that the ECB

would not be able to deliver price stability.

Certainly, this does have the potential to be a

much more genuine firewall than any of the

rescue mechanisms put in place over the past few

years because of the scale of the purchases that

could be made. But this is not the first time that

the ECB has found it necessary to step into

government bond markets. Why should this

initiative be any more successful? From the

markets’ perspective the key differences between

the OMT and the Securities Markets Programme

(SMP) is that the OMT is unlimited (the SMP was

always designed to be temporary and limited in

Macro

European Economics

Q4 2012

3. Companies have been less impressed than financial

markets....

Index

115

110

105

100

08 09 10 11 12

scale) and the ECB will not be senior. In total, the

SMP only purchased EUR220bn of five different

governments’ bonds in the nearly two years that it

was operational. To put this in perspective, it is

less than one year of Italian bond issuance.

The other key difference, and the one that Mr

Draghi tends to focus on, is that there will be

explicit, rather than implicit, conditionality. A

commitment to fiscal and structural reforms,

through an actual EFSF/ESM programme, is a

necessary pre-requisite for ECB action and

implementation of those reforms will be needed

for ongoing support. This also gives the ECB’s

policy greater legitimacy than the SMP. Under

the SMP, the Eurosystem was undertaking bond

purchases and therefore effectively mutualising

the debt of eurozone member states but with no

legal mandate or democratic legitimacy to do so.

Under the OMT the European Commission and

IMF will set and monitor the conditions.

Will it work?

Ifo industry e x pec tations (L HS)

ZEW econom ic ex pec tations (R HS)

Source: Centre for European Economic Research (ZEW), Institute for Economic

Research (IFO)

In dex

-20

-40

-60

-80

-100

The ECB has now accepted its role as a credible

lender of last resort but knows that it can’t singlehandedly

provide a permanent solution to the

crisis. It can merely buy time. For the market to

remain stable at these levels, investors will have

to make a leap of faith that governments will take

the necessary steps towards much greater

4. ...while consumers remain unimpressed

Index Consumer confidence

-10

-20

-30

-40

-50

07 08 09 10 11 12

EMU France Italy

Germany Spain

Source: Directorate General for Economic and Financial Affairs

financial, fiscal and political integration. But the

creditor nations within the monetary union will

only be prepared to go down that route if all of the

member states have shown that they can stabilise

their debt burdens and restore their

creditworthiness without requiring indefinite

assistance from the ECB. Therefore the ECB has

to try to provide incentives for governments to

continue the reform process.

Given that recent history has shown that the

urgency for reform has tended to fade whenever the

pressure from the market has eased, the ECB has

said it will not only cease purchases of the bonds of

a country but potentially even sell them if its

government steps out of line with regards to the

programme. Whether such a threat is credible we

will only discover over time. It should be borne in

mind, however, that the ECB wasted no time in

halting the SMP scheme for Italy when prime

minister Silvio Berlosconi stepped out of line.

Challenges for governments

Waiting for Spain

Index

-10

-20

-30

-40

-50

At the time of writing no country had actually

requested an EFSF/ESM programme, but Spain

was widely expected to do so before long. On

27 September, the government announced a new

reform programme alongside the 2013 budget.

Macro

European Economics

Q4 2012

5. EFSF/ESM Macro Economic Programmes: a precautionary, rather than a full-blown, programme would help a government to save face

Measure Precautionary Programme (enhanced conditions credit

line or ECCL)

Eligibility Activated when request made by country to Eurogroup

members. Can be drawn by way of loan/primary market

purchase by non-programme countries with sound policies

and fundamentals, but with some vulnerability. Aimed at

overcoming external shocks and to prevent a crisis from

occurring.

Conditionality Country to adopt corrective measures aimed at addressing

its weaknesses after consultation with EC and ECB.

Remains under enhanced surveillance by the EC. Failure to

meet these can result in closing of the credit line.

Size No upfront cap, but the typical size could vary between 2-

10% of GDP of the member state.

Duration One year with the possibility of renewing it for six months

twice.

Source: EFSF, HSBC

While the deficit projection for 2013 still looks

overly optimistic given the assumption that the

economy will only contract by 0.5% in 2013, the

reform package and planned spending cuts were

generally perceived as paving the way for a

EFSF/ESM programme. It included nearly all of

the measures recommended by the Commission

earlier this year. It also seems likely that it will be

a precautionary programme rather than a fullblown

macro-economic adjustment programme

(table 5) which would allow prime minister

Mariano Rajoy to at least nominally stand by his

election promise of not allowing Spain to go the

same way as Ireland or Portugal.

Nonetheless, Spain is still wary of relinquishing too

much sovereignty and is likely to resist any

demands for further austerity, and Mr Rajoy would

also prefer not to request assistance ahead of the

regional elections on 21 October. But the rise in

public protests in the final days of September and

the secessionist drive in Catalonia are already

pressuring markets, so Mr Rajoy may not be able to

wait that long before requesting assistance: Spain

Full macro economic adjustment programme

Activated only when a support request is made and a

country programme is negotiated with the EC, IMF and euro

area finance ministers and a MoU is signed. This would only

occur when the country is unable to borrow on markets at

acceptable rates.

Linked to strict policy conditions which are set out in a MoU.

The loan disbursement would be interrupted in case the

country fails to meet these conditions until the MoU is

renegotiated.

Maximum amount of a loan, its margin and maturity, and the

number of instalments to be disbursed are decided

unanimously by the euro area member states’ finance

ministers. Portugal’s EUR78bn package of EFSF/IMF

funding amounts to 45% of GDP.

A programme is typically for three years. Does not contain

any maturity limitations for the loans nor for the funding

instruments, to be defined case-by-case. Maturities to have a

minimum average of 15 years and up to 30 years.

has EUR20bn of bond redemptions falling due in

the last week of October.

Even assuming Spain does go into a programme,

it still means that its adjustment is closer to the

beginning rather than the end. The eurozone

member states that have gone into Troika

programmes have always seen their government

bond yields rise rather than fall after being

granted external assistance (see chart 6). As long

as the ECB clearly demonstrates its willingness to

undertake unlimited purchases this time, yields

should remain contained, which should help to

curb rising corporate borrowing costs at the same

time. This should also have some positive

confidence effects. Nonetheless, there would still

need to be a large amount of fiscal consolidation:

the primary surplus just doesn’t need to be quite

as big as under a higher effective interest rate.

Macro

European Economics

Q4 2012

6. A Troika programme has typically led to higher, not lower, yields – the ECB should mean it will be different for Spain

LTRO alt. EUR489bn

IMF-EU Greek loan & EFSF

Portugal bailout

LTRO

announcement and ECB

announcement

purchasing (SMP) begins ECB restarts

Jan-10 May -10 Sep-10 Jan-11 May -11 Sep-11 Jan-12 May -12 Sep-12

Source: Bloomberg, Reuters

10y r Gov ernme nt bond spreads ov er German Bunds

Italy going it alone?

Deauv ille

agreement

Ireland bailout

While Spain is currently centre stage, Italy is also

viewed as a potential candidate for requiring

ECB/ESM assistance in the coming months. The

budget deficit is much smaller than that of Spain:

even with a deep contraction in GDP of about

2.5% in 2012, Italy’s budget deficit should come

in below 3% of GDP. However, given the size of

its debt stock and low potential growth rate, a

renewed rise in borrowing costs would pose a big

challenge for Italy. Its annual bond issuance needs

are in the region of EUR200bn. The negative

impact that austerity is already having on the

economy means that the prime minister, Mario

Monti, will continue to resist any calls for more

aggressive fiscal consolidation, and will therefore

remain very reluctant to submit to EFSF/ESM

conditionality. Besides, if Spain goes into a

programme and the ECB starts to walk the talk,

then Italy would probably benefit. A continuation

of Mr Monti’s various reforms to raise long-term

potential growth should also help to reassure the

market. Nonetheless, the elections looming in

April 2013 could lead to political uncertainty and

concerns about the continuity of the reforms,

meaning that some kind of precautionary

programme for Italy cannot be ruled out.

SMP programme

LTRO alt. EUR529bn

Italy Spain Portugal Greece Ireland

No shortcuts for fiscal consolidation…

As we have discussed before, when the IMF first

signed a letter of intent with Greece in May 2010,

its projections showed that Greece would have

one more year of recession in 2011, but would be

roughly stable overall in 2011-2013, which would

allow the economy to return to primary surplus in

2012 and the debt burden would peak at just under

150% of GDP in 2013.

The latest projections suggest that, far from being

stable over that three-year period, the Greek

economy will actually contract by nearly 17%

(chart 7). Greece is still struggling to come up with

additional austerity measures and has also been

seeking an extra two years (until 2016) to achieve

the required fiscal consolidation.

7. Greece IMF GDP forecasts: the damage to the real economy

has been much worse than the programme ever envisaged

%Yr 2011 2012 2013 Cumulative

May-10 -2.6 1.1 2.1 0.5

Dec-10 -3.0 1.1 2.1 0.1

Mar-11 -3.0 1.1 2.1 0.1

Jul-11 -3.9 0.6 2.1 -1.3

Dec-11 -6.0 -3.0 0.3 -8.5

Mar-12 -6.9 -4.8 0.0 -11.4

Sep-12 (Consensus

Economics)

-6.9 -6.3 -3.3 -16.5

Source: IMF country reports, Consensus Economics

Draghi commits

to "do w hatev er it takes"

OMT

Macro

European Economics

Q4 2012

Greece may be an extreme example and no-one is

suggesting that any other member state is in such a

dire position. But the Greek projections show how

hard it was to appreciate in advance just how

damaging austerity on that scale would be for the

real economy when the private sector was not in a

position to compensate. Other countries have been

relatively successful, but even Ireland is a useful

reminder of the lengthy painful adjustment

associated with these kinds of programmes.

Ireland began its austerity programme very early – in

July 2008 when countries such as Spain (and most

other countries in the Western world, except Italy)

were providing a fiscal stimulus. It has delivered a

total cumulative fiscal consolidation between 2008

and 2012 of 13% of GDP, over half of which was

spending cuts. It also undertook a large internal

devaluation, returned to positive GDP growth and is

back in the market raising medium-to-long term

debt. Yet it will still have a budget deficit of about

8.3% of GDP this year. Hence it is projecting a

further 5% of GDP of fiscal consolidation over the

next three years (chart 8).

…which still has a long way to run

Nonetheless, Ireland is still further along in its

adjustment than the other most problematic member

states, particularly regarding shrinking the public

sector. Charts 10-15 speak for themselves. Not every

country provides a neat split between public and

private sector employment so, where it is not

available, we have used the IMF approach of

9. Official projections are still a little optimistic

8. Irish austerity: five years down; three to go

%GDP Ireland F iscal Consolidation

08 09 10 11 12f 13f 14f 15f

Ex penditure contribution R ev enue contribution

Source: IMF Ireland Country Report Seventh Review

aggregating the three sectors which are

predominantly public sector (public administration

& defence, education and health & social work). The

charts show that although Ireland had started to shed

public sector jobs by the end of 2008 and Greece

started in 2010, the Spanish public sector increased

public sector employment between 2008 and mid-

2011 by about 12%. Spain has only started to cut

jobs, largely through natural wastage over the past

year (see Spanish Labour Reforms: Protest or

Progress, 12 September 2012). Italy and Portugal do

not appear to have started yet. In contrast, the US

and, in particular the UK, have been consistently

shedding public sector jobs (charts 16 and 17). In

both of those countries the public sector job losses

have been offset by private sector job gains. In the

periphery the private sector is still shedding jobs

and unemployment rates are likely to continue

rising for at least the next year.

___ Budget Balance (% GDP) ____ __ Real GDP Growth (% Year) ___ ___ Government Debt (% GDP) ___

2011 2012f 2013f 2011 2012f 2013f 2011 2012f 2013f

Latest budgets

France -5.2 -4.5 -3.0 1.7 0.3 0.8 86.0 89.9 91.3

Spain

Peripheral projections

-8.5 -6.3 -4.5 0.7 -1.5 -0.5 68.5 … …

Spain (IMF) -8.5 -6.3 -4.7 0.7 -1.7 -1.2 68.5 89.6 94.3

Greece -9.1 -7.3 -8.4 -6.9 -4.7 0.0 165.3 160.6 168.0

Ireland -12.8* -8.3 -7.5 1.4 0.4 1.4 106.5 117.7 119.3

Italy -3.9 -2.6 -1.8 0.4 -2.4 -0.2 120.1 126.4 126.1

Portugal -4.2 -5.0 -4.5 -1.6 -3.0 -1.0 107.8 119.1 123.7

Source: IMF forecasts, country budgets.

Note: *=including bank support. IMF report for Ireland published on 10 September, Portugal Ministry of Finance published September, Italian Ministry of Finance projections published on 20

September, Spain budget on 27 September which kept the GDP forecasts and deficit projections unchanged from July forecasts, Spain IMF report published on 27 July

%GDP

Macro

European Economics

Q4 2012

10. In the eurozone, Ireland has shrunk public sector

employment the most...

Index

115

110

105

100

Ireland Index

08 09 10 11 12

Public sector Private sector

115

110

105

100

11. ...while Greece is a close second

Index Greece

115

110

105

100

08 09 10 11 12

P ubli c se ctor* Priv ate s ector

Source: Central Statistics Office of Ireland Note: *With no national data reported, public sector employment includes Public

Administration, Defence, Compulsory Social Security, Education, Human health and

Social Work Activities from Eurostat, in line with IMF approximations made for Greece

Source: Eurostat

12. Spain has only started to cut public sector jobs

recently...

Index Spain

115

110

105

100

08 0 9 10 11 12

Public sector Priv ate s ector

Index

115

110

105

100

13. ...while Italy hasn’t really started...

Inde x Ita ly

115

110

105

100

08 09 10 11 12

Public sec tor* Priv ate s ector

Source: INE Note: *With no national data reported, public sector employment includes Public

Administration, Defence, Compulsory Social Security, Education, Human health and

Social Work Activities from Eurostat, in line with IMF approximations made for Greece

Source: Eurostat

14. ...and public sector employment is Portugal seems to

have grown steadily

Index Portugal

115

110

105

100

08 09 10 11 12

Public sector* Priv ate s ecto r

Index

11 5

11 0

10 5

10 0

Note: *With no national data reported, public sector employment includes Public

Administration, Defence, Compulsory Social Security, Education, Human health and

Social Work Activities from Eurostat, in line with IMF approximations made for Greece

Source: Eurostat

15. No public sector job cuts in Germany

Index Germ any

115

110

105

100

08 09 10 11

Source: Federal Statistic Office

Public sec tor Priv ate s ector

Index

115

110

105

100

Index

11 5

11 0

10 5

10 0

Index

115

110

105

100

Macro

European Economics

Q4 2012

16. More public sector job losses in the UK than in the

eurozone

Index U K

115

110

105

100

08 09 10 11 12

Public sector Priv ate s ector

High debt to constrain growth

Clearly the fiscal consolidation challenges are not

just confined to the periphery. Most European

countries, whether inside or outside the eurozone,

face a similar challenge in trying to stabilise their

debt burdens, just to varying degrees. With the

exception of Switzerland and parts of

Scandinavia, debt levels are historically high. Not

only will the austerity deliver a big dent to GDP

in the short term, the continued high debt burden

can reduce growth for many years through a

number of channels. Most obviously, higher taxes

can create unwelcome distortions that harm

growth, as can the need to cut back on longerterm

government investment. In addition, the

government financing need can ‘crowd out’

private borrowers, particularly if default risk has

driven government borrowing rates up, as has

been the case in the eurozone periphery. Finally,

so-called ‘financial repression’, where authorities

impose restrictions on finance to reduce

borrowing costs, can also impede growth (as

discussed in Stephen King’s report From

depression to repression, 23 April).

Index

A recent study by a trio of leading economists

examined 26 episodes where economies nursed

115

110

105

100

17. Even the US has shed more public sector workers than

most

Index U S

Source: ONS Source: Bureau of Labor Statistics

115

110

105

100

08 09 10 11 12

“exceptionally high” levels of debt 1 (gross public

debt exceeding 90% of GDP) and reached two

main conclusions: growth in highly indebted

economies is more than 1pp below average and

18. General government gross debt (%GDP)

1999 2007 2012f

Greece* 94.9 107.4 168.0

Italy* 113.0 103.1 126.1

Ireland* 48.0 24.8 119.3

Portugal* 49.4 68.3 123.7

Belgium 113.6 84.1 100.5

EU17 71.6 66.3 91.8

United Kingdom 43.7 44.4 91.2

France 58.9 64.2 90.5

EU27 65.7 59.0 86.2

Germany 61.3 65.2 82.2

Spain 62.4 36.2 80.9

Hungary 60.8 67.1 78.5

Cyprus 59.3 58.8 76.5

Malta 57.1 62.3 74.8

Austria 66.8 60.2 74.2

Netherlands 61.1 45.3 70.1

Poland 39.6 45.0 55.0

Slovenia 24.1 23.1 54.7

Finland 45.7 35.2 50.5

Slovakia 47.8 29.6 49.7

Czech Republic 15.8 27.9 43.9

Latvia 12.5 9.0 43.5

Denmark 58.1 27.5 40.9

Lithuania 22.6 16.8 40.4

Sweden 64.3 40.2 35.6

Romania 21.7 12.8 34.6

Luxembourg 6.4 6.7 20.3

Bulgaria 77.6 17.2 17.6

Estonia 6.5 3.7 10.4

*Official forecasts

Source: European Commission

Public sector Priv ate s ector

Index

115

110

105

100

See Reinhart, Reinhart and Rogoff (2012), ‘Debt overhangs: past and

present’, NBER WP 18015

Macro

European Economics

Q4 2012

debt overhangs are highly persistent, with an

average duration of more than two decades. So if

history is any guide, many indebted European

countries (table 18) could suffer from sub-par

growth for a decade or more. The consequences

are considerable. If eurozone growth averaged

1% rather than 2% over the next 20 years, output

at the end of this period would be more than a

fifth lower and debt-to-GDP ratios would remain

stubbornly high.

The example of Ireland makes the point neatly.

Under a base-case scenario, using the IMF’s

forecasts of 2.5% annual average GDP growth in

2013-2017 Ireland’s debt-to-GDP ratio would

gradually ease to 109% of GDP by 2017. If GDP

growth is 1pp higher in each of those five years it

would be 93% (chart 19). If, however, GDP

growth is 1pp lower in each year the debt burden

would still be more than 125% of GDP: further

fiscal consolidation would be required to lower

the deficit below the European Commission’s

threshold of 3% of GDP and the debt burden

would remain very high unless growth revives

more convincingly.

19. The importance of growth to debt stabilisation

%GDP

140

130

120

110

100

Source: IMF, HSBC

Ireland Debt-to-GDP ratio %GDP

10 11 12f 13f 14f 15f 16f 17f

140

130

120

110

100

GDP -1% GDP Bas e GDP +1%

Reforms, reforms

With the public sector likely to be a drag on

growth for the foreseeable future, the private

sector needs to be on the strongest possible

footing in order to generate jobs. Hence, there is

even greater need to undertake the structural

reforms required to raise the potential growth rate

in these increasingly demographically-challenged

countries. Of course many of the necessary

reforms were meant to have been undertaken even

before the inception of the euro but, with the main

exception of Germany, were put on the

backburner once the euro was formed and now,

under the guardianship of the Troika and/or

pressure from the markets, they have resumed.

Table 24 summarises the broad range of structural

reforms for which the sovereign crisis has been

the catalyst. Clearly much still needs to be done,

and not just in the periphery. Minimum wages are

high in many countries. A country such as

Belgium still has a much higher incidence of

wage indexation than Spain. And France, for

much of the population, still has a lower

retirement age than most member states. But even

France recently announced that it is establishing a

committee for competiveness in an attempt to

curb labour cost growth.

20. Periphery is starting to regain competitiveness

Index REER, Jan 2001=100 Index

140

130

120

110

100

01 02 03 04 05 06 07 08 09 10 11 12

140

130

120

110

100

Greece Ireland Portugal

Spain Italy

Source: European Commission

There are now firmer signals that the reforms are

starting to deliver some improvements in

competitiveness, particularly in Ireland, where the

real effective exchange rate has fallen most

rapidly thanks to wage cuts and job losses, but all

of the peripheral countries have seen some

improvement over the past year or so (chart 20).

Macro

European Economics

Q4 2012

21. The periphery seems to be diversifying its exports with Africa becoming increasingly important to Portugal and Spain

12mma % share _______ Greece ________ ________ Ireland _________ _______ Portugal_______ _________ Spain _________

of exports May-07 May-12 Jul-07 Jul-12 May-07 May-12 Jul-07 Jul-12

Eurozone 44.6 32.2 41.0 39.1 67.4 62.1 57.3 51.3

Germany 11.6 7.2 7.7 7.5 13.4 13.2 10.9 10.5

France 4.5 2.7 5.7 5.2 12.6 11.9 18.8 17.3

Italy 10.9 8.4 3.6 3.2 4.1 3.6 8.7 7.5

Portugal 0.6 0.5 0.5 0.5 - - 8.7 7.5

Spain 3.9 2.0 3.8 3.3 28.4 23.7 - -

UK 5.9 3.3 16.5 15.5 6.5 5.2 7.7 6.2

USA 4.4 4.7 18.4 21.2 5.5 3.6 4.3 3.7

China 0.8 1.4 2.0 2.6 0.6 1.5 1.0 1.7

Japan 0.7 0.1 2.1 2.1 0.6 0.4 0.8 1.0

Brazil 0.1 0.1 0.2 0.3 0.7 1.4 0.7 1.2

Africa 2.1 3.5 - - 6.1 10.5 4.2 6.2

Note: Spain eurozone figure calculated as a sum of exports to each eurozone country

Source: IMF Direction of Trade Statistics (Greece and Ireland), Central Statistics Office Ireland, Spanish Ministry of Economy and Competitiveness

Much of the sharp improvement in the current

account positions of the periphery (chart 22) is

attributable to a collapse in imports rather than an

export revival. The periphery still has a long way

to go to close the competitiveness gap with

Germany that widened steadily throughout the

first decade of the euro. But it is notable that some

peripheral countries are starting to narrow the gap,

and they also seem to be having considerable

success at diversifying their export markets (table

21). For instance, Portugal has doubled the share

of its exports going to Africa over the past five

years. Similarly, Germany’s current account

surplus is still huge (as a share of GDP it is much

bigger than China’s) but it is not an import

compression story. It has managed to offset much

of the loss of exports to the periphery with exports

22. Periphery current account deficits are narrowing

sharply...

% GDP Current ac count

-4

-8

-12

-16

00 02 04 06 08 10 12

% GDP

Portugal Ire land Greece

Italy Ge rmany Spain

-4

-8

-12

-16

elsewhere. Hence, the countries that it has a

bilateral surplus with have changed significantly

(chat 23). The surplus vis-à-vis the periphery has

shrunk markedly while it has eliminated the

deficit it used to run with China and its surplus

vis-à-vis both the US and the rest of Asia has

continued to grow.

That said, while an improvement in competitiveness

is essential to the long-term growth outlook, it won’t

revive growth quickly if external demand keeps

weakening. Worryingly, the biggest downward

forecast revisions in our latest global forecasting

round have been to the emerging world (see Why

pump priming isn’t working, 27 September).

23. ...while Germany’s surplus remains large as its balances

with non-eurozone trading partners improve

EURbn, 4Q sum

Source: National Sources Source: Deutsche Bundesbank

120

-30

German bilateral current account balances

EURbn, 4Q sum

00 02 04 06 08 10 12

120

-30

China Eurozone Asia US

Macro

European Economics

Q4 2012

24. Structural reforms catalysed by the euro area debt crisis

Tax reforms

Greece Ireland Portugal Spain Italy

Base broadening by rationalising personal income tax & eliminating some

deductions

Broadening VAT tax base

Budget-neutral tax shifting aiming to lower labour costs

Reforming property tax

Environmentally friendly taxation increases

Measures to combat tax evasion and enhancing tax compliance

Pension reforms

Increasing the legal and/or minimum retirement ages

Lengthening contribution periods required for a full pension

Reducing generosity of pension benefits

Abolished seniority pension, replacing it with an early-retirement pension

Reducing early retirement (via reducing benefits) *

Indexing the retirement age to life expectancy **

De-indexation of high-level pensions

Welfare and active labour market policies reforms

Reducing unemployment benefit rates

Reducing unemployment benefit duration

Introducing means tested benefits

Cutting other welfare payments

Strengthening active labour market policies

Increasing provision of training and internship

Enhancing efficiency in Public Employment Service

Strengthening the mutual obligations approach

Product market reforms

Privatisation programmes aimed at raising public revenues

Launch of public-private partnerships and concessions to develop some

state-owned immovable assets

Strengthening power, independence or effectiveness of competition authority

Enforcement of competition law

Easing formalities to start a new business

Reducing complexity of licensing procedures

Increasing competition in transport and network industries

Phasing out regulated tariffs in electricity and gas

Increasing competition in retail trade

Reducing barriers to entry in professional services

Increasing R&D tax incentives and improving business-academic research links

Public sector reforms

Efficiency enhancing measures

Reorganising local and central government

Rationalising the public remuneration system

Rationalising management and improving efficiency and governance

Cross public sector measures

Public healthcare measures

Labour market reforms

Reduction in severance pay for regular contracts and simplification of

dismissal procedures

Measures to boost temp employment by increasing maximum work time

Moves to reduce temp employment by making temp contracts restricted

Measures to boost flexibility by cutting overtime pay/earnings of part time

employees

Measures to enhance flexibility in wage setting, eg easing conditions for

firms to opt out from higher level collective bargaining agreements

Reforming sectoral wage agreements

Introducing a sub-minimum wage for young people

Financial sector reforms

Measures to help deleverage banking system

Enhancing prudential regulation by reinforcing banking supervision

Restructuring the banking system

Note: * and revising the list of arduous occupations. **2006 reduced pension by >3%

Source: OECD, IMF

Macro

European Economics

Q4 2012

Roadmap for integration

Given that both the fiscal consolidation and the

beneficial impact of the structural reforms on

growth will take several years, it is asking a great

deal of the markets to take the leap of faith that

the ECB will keep buying the debt indefinitely

without more rapid progress being made on future

eurozone integration. This requires new

institutions for financial and fiscal integration as

well as a new governance framework.

Financial integration

Since the broad plan was set out at the late June

summit (see EU Summit: First steps to banking

union, 29 June 2012), the only further details we

have so far been given have been the European

Commission’s proposals for the single banking

supervisor, published on 12 September (table 25).

It had been hoped that this would be the relatively

straightforward part of the integration process and

could be put in place fairly swiftly. Progress on

this issue is essential before the EFSF/ESM loan

to the Spanish banks can stop being a government

liability as it would allow the ESM to recapitalise

the banks directly. However, the European

Commission plan currently looks too ambitious to

be palatable to all of the eurozone member states.

It would eventually give the ECB broad

supervision powers over all 6,000 eurozone banks

rather than just the 20 or so large international

banks which could “pose a systemic risk at a

Europe level” that has been advocated by some.

The German government in particular has called

for national supervisors to retain control over

most of the smaller regional banks.

25. Supervisory powers given to the ECB in the single supervisory mechanism proposed by the European Commission

ECB National supervisory authorities EBA

Scope Banking supervision across the eurozone. EU countries

outside the eurozone that wish to participate will be able

to enter if they meet specific conditions. The ECB will be

the host supervisor for credit institutions established in

non-eurozone EU countries, which establish a branch or

Prudential

rules

provide cross-border services in the eurozone.

Assess qualifying holdings, ensure compliance with the

minimum capital requirements and with provisions on

leverage and liquidity, may impose additional capital

buffers, may carry out early intervention measures when

a bank is in breach of, or is about to breach, regulatory

capital requirements.

Authorisation Competent authority for authorisation of credit

/Licensing institutions/withdrawal of authorisation in participating

member states.

Investigatory

powers

Will be able to request all relevant information from

supervised entities.

Will also be empowered to conduct all necessary

investigations, including on-site inspections.

Sanctions In case of a breach of a requirement under directly

applicable Union acts, the ECB may impose

administrative pecuniary sanctions of up to twice the

amount of the profits gained or losses avoided because

of the breach, or up to 10% of the total annual turnover

Internal risk

model

Source: European Commission

of a legal person in the preceding business year.

All tasks not conferred on the ECB will remain

with national supervisors. Ex Consumer

protection, fight against money laundering,

supervision of third country credit institutions

establishing branches or providing crossborder

services within a member state.

Assess compliance with any conditions of

authorisation set out in national law and if

conditions are met/infringed, could propose to

the ECB to grant/withdraw the authorisation.

Carry out ongoing day-to-day assessment of a

bank’s situation and on site verifications,

implementing general guidance or regulations

issued by the ECB.

In the cases not covered, the ECB may require

national supervisory authorities to take action

in order to ensure that appropriate sanctions

are imposed.

Final validation of the model. The national supervisor could assess the

model and could propose to the ECB whether

and under which conditions to validate the

model. After validation, the national supervisor

could oversee the application of the model and

monitor its ongoing use.

Develop the rules at EU

level and ensure

convergence and

consistency of

supervisory practice.

Design rules at EU level.

Macro

European Economics

Q4 2012

26. Depth of Banking Unions : Eurozone and United States compared

Eurozone (European Commission proposals) United States

Bank Supervision The ECB would ultimately have responsibility for supervision

of all banks in the eurozone.

Deposit Insurance

Scheme

Bank Resolution

Scheme

Sources: HSBC, European Commission

The ECB would first be allowed to take over supervision of

any bank it wants in the eurozone (and in particular banks

receiving public support) as early as 1 January 2013. It would

then be granted supervisory powers on the most systemically

important European banks on 1 July, 2013. Finally, all banks

in the Eurozone would come under ECB supervision on

1 January 2014.

Coverage of national Deposit Guarantee Schemes has been

raised to a harmonised level of EUR100,000 since

31 December 2010. There is no common deposit insurance

scheme.

Existing Resolution schemes exist only at the national level.

However, the Commission indicated in its proposal on

integrated bank supervision that it envisages making a

proposal for a single resolution mechanism within the future

banking union.

No doubt some kind of compromise on the range

of banks that will be covered will be reached, but

it will take time. The European Commission

President, Jose Manuel Barroso, optimistically

hopes to have a consensus on the single banking

sector supervisor issue by the end of this year but

the plan cannot become law until passed by all EU

governments. Even once it is in place, the

common supervision will in itself be unable to

break the negative feedback loop between a

eurozone sovereign and its banks. Meeting that

goal will require much more controversial

elements such as a eurozone-wide deposit

guarantee scheme and bank resolution

mechanism. The current official proposals

therefore still fall short of the mechanisms

existing in the US, despite a very fragmented

supervisory network there (table 26).

On the other areas of integration, the plan is that

four building blocks will be put in place over the

next decade. The first block is the move towards

some kind of banking union discussed above

while the others are integrated frameworks for

fiscal matters and economic policy, accompanied

by increased democratic legitimacy and

Bank supervision remains very fragmented.

The Office of the Comptroller of the Currency (OCC) is the

primary regulator of National Banks. At the federal level, the

Federal Reserve Board regulates state-chartered banks that

are members of the Federal Reserve System and bank

holding companies. For other state-chartered banks, the

primary regulator is the Federal Deposit Insurance

Corporation. Finally, thrift holding companies and savings

banks are regulated by the Office of Thrift Supervision.

The FDIC provides deposit insurance for 7,246 financial

institutions (as of 30 June 2012) in the United States. Dodd-

Frank legislation temporarily put in place unlimited deposit

insurance for interest-bearing accounts until the end of this

year. For interest bearing (consumer) accounts the limit will

revert to USD250,000.

The FDIC has resolution powers on federally insured banks

and thrift institutions but also on systemically-important

financial institutions since the passage of the Dodd-Frank act.

Since the crisis began the FDIC has resolved, liquidated and

restructured more than 400 banks.

accountability. European Council President

Herman Van Rompuy said he will present an

interim report on at least some of the issues at the

next European Council meeting in October.

Fiscal integration

As with the banking union proposal, Mr Van

Rompuy’s report may be what he believes is

necessary, but will nonetheless probably be at the

more ambitious end of what is actually feasible.

Much of the focus will be on any new information

on what an integrated fiscal framework would

actually involve. As well as a swift

implementation of the existing governance

framework (table 27) it will also have to entail a

qualitative move towards a fiscal union. This

would involve a much greater pooling of decisionmaking

on budgets. EU institutions would have

much greater powers over the national budgets of

member states which breach debt and deficit

rules, and if a country needs to increase its

borrowing, it would be forced to go to other

eurozone governments to obtain prior approval.

Macro

European Economics

Q4 2012

27. The current governance framework

Measure Sanctions

Excessive Deficit

Procedure (6-pack)

Macroeconomic

Imbalance Procedure

(6-pack)

Once an Excessive Deficit Procedure is

initiated, the European Commission may

decide sanctions (up to 0.5% of GDP) if

no effective action has been taken.

These sanctions are only rejected if a

qualified majority of member states in the

Council votes against them.

Once a Macroeconomic Imbalance

Procedure is initiated, the European

Commission may decide sanctions (up

to 0.1% of GDP) in case of failure to

comply with the recommended corrective

action. These sanctions are only rejected

if a qualified majority of member states in

the Council votes against them.

Fiscal Compact (TSCG*) Fiscal Compact requires integration of

fiscal rules into national law, preferably

at a constitutional level. In case of failure

to comply with this integration, the

European Commission may ask the

European Court of Justice (CoJ) to rule.

The CoJ may then impose financial

sanctions (up to 0.1% of GDP).

* TSCG is the Treaty on Stability, Coordination, and Governance (TSCG)

Source : European Commission, HSBC

As we discussed in our last quarterly (A rocky

road ahead, 12 July 2012) progress towards this

kind of fiscal integration at the eurozone level is

only possible if both creditors and debtors agree

to relinquish more sovereignty to a supranational

institution. This will be difficult in any of the

member states and will require a much higher

degree of democratic legitimacy but it will be

particularly challenging for France. The budget

announced on 28 September by the prime

minister, Jean-Marc Ayrault, reiterated the

government’s commitment to reducing the budget

deficit to 3% of GDP in 2013, but this looks too

optimistic. With the market currently quite

forgiving about France, we fear that Mr Hollande

will be under little pressure to move closer to the

German position regarding the need for genuinely

coercive fiscal integration and oversight of

member states’ fiscal policy by European

institutions, unless the French bond market starts

to come under pressure too.

Timeline

Any clear timelines for steps towards common

bond issuance are unlikely to be in the report at

this early stage. The Van Rompuy report 2

published in the summer briefly mentioned the

prospect of partial common debt issuance “in a

medium-term perspective” citing bills or a

redemption fund, but plenty of other options such

as blue-red bonds or stability bonds have also

been proposed. Clearly Germany will continue to

resist being on the hook for further transfers of

funds or a further sharing of its credit rating

without a certain loss of sovereignty of the debtor

attached to it. Hence we expect any explicit

timelines to be glaringly absent in either of the

upcoming reports. Rather than coming up with

some kind of 2020 deadline, we expect the next

roadmap to be a building-block process with any

goals only being achieved if various conditions

are met along the way. By the end of this year, we

might also have an indication as to which

elements of the roadmap can be achieved within

existing treaties and what needs to be changed.

Germany has admitted a referendum will be

needed at some stage. Ultimately populations

across the eurozone will have to vote for it.

Towards a Genuine Economic and Monetary Union, Herman Van

Rompuy, European Council 26 June 2012

Macro

European Economics

Q4 2012

28. The collapse in consumer spending in the periphery… 29. …has been driven by big increases in taxation as well as

job losses

% Yr C ons umption Grow th

% Yr

-2

-4

-6

-8

07 08 09 10 11 12

Ge rma ny Portugal Italy

Will populations vote for it?

To keep populations on side over the coming

months and years there will need to be some signs

of light at the end of the tunnel. The stabilisation

in Italian consumer confidence in September,

which must be at least in part a response to the

ECB’s new policy, is therefore welcome. But for

the peripheral countries to continue to see the

benefits of remaining inside the monetary union

they will need to believe that there will ever be an

end to the deepening recession and ongoing rise in

unemployment. For the creditor nations within the

euro, they would feel more comfortable about

continuing to underwrite future rescue packages if

their governments were able to point to a success

story or a country successfully graduating from a

programme. Ireland is currently the relative

success story, but, as discussed above, others have

much farther still to go and the contraction in

GDP does not always give a fair representation of

the depth of the recession underway in some of

these countries. Italy is a case in point. In 2009

Italian GDP declined by 5.5%, but much of that

recession was driven by the collapse in the world

trade cycle. In some of the periphery countries the

rising unemployment and persistent tax rises and

spending cuts mean domestic recessions are much

deeper now. According to our forecasts, Italian

consumer spending will contract by 3.4% in 2012

-2

-4

-6

-8

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0

Source: Eurostat Source: Eurostat

pts Tax im pact on inflation pts

04 05 06 07 08 09 10 11 12

Eurozone Ita ly Portugal

compared with a 1.5% fall in 2009. The same

point holds for Portugal (charts 28 and 29). It is

perhaps hardly surprising that hundreds of

thousands of protestors participated in a peaceful

demonstration in Portugal in September when the

prime minister announced that he proposed to

raise workers’ social security contributions from

11% to 18%. The number of working days lost

due to industrial action in Portugal is typically

among the lowest in the eurozone.

The end of the road

2.5

2.0

1.5

1.0

0.5

0.0

-0. 5

-1. 0

No one ever said it would be easy, and things appear

set to get tougher still in the year ahead. Heads of

government will need to take decisions on exactly

what kind of financial, fiscal and political integration

is achievable and then set out on the very long road

to implementing them. The ECB has bought time.

Now governments need to do the rest, most likely in

the face of growing resistance from their

populations, some of which may start to think that

the answer to their problems lies outside the

eurozone (table 30). But the euro is not the sole

source of their problems and their structural rigidities

will have to be addressed and new institutions built.

Our underlying assumption remains that the

eurozone will ultimately reach this destination but

believe there will continue to be periods when it

takes the market to keep member states moving in

the right direction.

Macro

European Economics

Q4 2012

30. What is your opinion of a European economic and monetary

union with one single currency, the euro?

% For Against Don’t know

Cyprus 52 44 4

Italy 53 33 14

Spain 55 36 9

Portugal 58 33 9

Malta 63 32 5

Germany 65 30 5

Austria 65 30 5

France 69 28 3

Estonia 71 25 4

Netherlands 73 25 2

Finland 74 24 2

Belgium 75 23 2

Greece 75 21 4

Luxembourg 78 19 3

Slovenia 80 18 2

Slovakia 80 16 4

Ireland 79 13 8

Source: European Commission Eurobarometer survey July 2012 (Fieldwork May 2012)

Life outside the euro isn’t easy

either

Given the immense challenges that lie ahead for

the eurozone member states, one could be forgiven

for thinking that life is considerably easier for

countries not in the euro. Despite the size of its

budget deficit and debt burden, the UK has

benefited from being something of a safe haven.

Whereas many eurozone member states have seen

a gradual fall in the maturity of their debt stocks

(chart 31) the UK has managed to extend the

maturity of debt recently. But in public finance

terms, this is a rare bright spot in an otherwise

darkening picture: it is not only the eurozone

economies that face fiscal difficulties.

In 2010, the UK government set itself two tough

fiscal targets: to balance the cyclically-adjusted

current budget within a rolling five-year period

and to have net-debt-to-GDP falling in 2015/16.

The UK’s Office for Budgetary Responsibility

(OBR) has so far considered the UK government

to be on track to meet these aims – just. But this

is likely to change in its next assessment, largely

because growth has disappointed. In our view,

the OBR has consistently been too optimistic on

the strength of the recovery. In November 2010,

31. Average duration of debt stocks is shortening

Years Duration of Debt Stocks

Years

14.5

13.5

12.5

Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12

Source: Bloomberg

UK (LHS) Italy (RHS)

Spain (RHS) Portugal (RHS)

7.5

5.5

the OBR projected that growth in 2012 would be

2.6%, but even in March of this year it forecast

0.8% growth. We expect a 0.1% contraction.

So before new official forecasts are published on

5 December, the UK government faces a huge

dilemma: does it tighten fiscal policy and weaken

the economy further, or does it take the political

hit and admit its deficit reduction programme is

failing. Currently we think it will opt for the latter

and try to pin the blame on a global slowdown.

Whether or not markets will give the UK

government the benefit of the doubt remains to be

seen. So far, UK borrowing costs have been

helped by a supportive Bank of England, which

has bought huge amounts of debt under its QE

policy. But we think there is a good chance the

BoE may pause QE, at least for the rest of this

year, (see Time for caution, 30 August). This,

alongside a weak growth outlook and the fact that

the UK has done less actual deficit reduction than

several other European countries (chart 32), could

put the UK’s AAA rating under renewed pressure.

What’s more, the UK, like other governments, has

huge contingent liabilities that are hangovers from

support offered during the financial crisis. While

these are hard to quantify, the numbers are large.

The UK for example excludes the debt of publicly

owned banks from its benchmark measures of net

6.5

Macro

European Economics

Q4 2012

32. The UK is lagging behind others on the primary balance

adjustment

-2

-4

-6

-8

% Potential % Potential

2000 2002 2004 2006 2008 2010 2012

Source: OECD

debt as it assumes these institutions will eventually

be returned to the private sector. This is probably a

fair assumption, but more than three years after

bailing out two of its biggest banks, they are still in

public ownership (and even where ‘good’ parts have

been sold, the ‘bad’ assets have been retained). If

we look at total public debt including financial sector

support, net debt more than doubles from 66% to

136% of GDP (chart 33).

33. Including the debt of publicly-owned banks greatly

increases the net-public-debt-to-GDP ratio

% %

180

150

120

Source: ONS

United Kingdom France

Italy Spain

Portugal

06 07 08 09 10 11 12

Debt:GDP Debt:GDP (ex fin support)

Emerging Europe is slowing

too

The relatively less indebted part of the region is

not holding up particularly well either. Across

emerging Europe, economic activity stabilised in

the second quarter, but all indicators point to

renewed weakness in the second half. Even the

-2

-4

-6

-8

outperformer Russia is losing steam as oil prices

moderate, fiscal consolidation kicks in and

inflation picks up. The outlook for Central &

Eastern European (CEE) countries remains fairly

dire. Hungary has dipped into technical recession

and the Czech Republic is looking worse by the

day. Poland is losing traction at an astounding

pace. Turkey has so far held up better than we

feared, thanks to a very successful diversification

effort of export destinations, but even though

domestic demand tends to be resilient Turkey

cannot escape the global slowdown and

policymakers are gearing towards lower growth

targets for this year and the next.

Although activity has been losing steam since the

second half of last year, inflation has been simply

sticky, cruising above the target in many countries.

Nowadays, there is even further upside risk to

headline inflation given the ominous path of global

agricultural commodity prices. This is especially

true for the large economies with big domestic

markets, such as Russia and Turkey. Nonetheless,

wage inflation remains in check, broadly speaking,

although Russia is an exception.

Overall, the growth/inflation trade-off has

deteriorated in Emerging Europe since the global

crisis. We see policymakers shifting their focus

more towards growth and looking comfortable with

above-target inflation for longer. They are possibly

emboldened by ultra-loose monetary policy in the

developed world. As the developed world keeps its

fingers on the trigger for further pump-priming, the

developing countries would also likely tilt, on

balance, towards a higher tolerance for inflation

and other imbalances in order to use what scope

they have to support growth.

Macro

European Economics

Q4 2012

33. Policy rates forecasts

Q4 2011

Eurozone

Q1 2012 Q2 2012 Current rate Q4 2012f Q1 2013f Q2 2013f Q3 2013f Q4 2013f

Repo rate

1.00 1.00 0.75 0.75 0.50 0.50 0.50 0.50 0.50

Base rate

Norway

0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50

Sight deposit rate

Sweden

1.75 1.50 1.50 1.50 1.50 1.75 1.75 1.75 2.00

Repo rate

Switzerland

1.75 1.50 1.50 1.25 1.00 0.75 0.75 0.75 1.00

SNB target rate

Czech Republic

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Repo rate

Romania

0.75 0.75 0.25 0.25 0.25 0.25 0.25 0.25 0.25

Repo rate

Poland

6.00 5.50 5.25 5.25 5.25 5.25 5.25 5.25 5.50

Reference rate

Hungary

4.50 4.50 4.75 4.75 4.50 4.00 4.00 4.00 4.00

Base rate

Russia

7.00 7.00 6.50 6.50 6.50 6.00 5.50 5.50 5.50

Refinancing rate

Turkey

8.00 8.00 8.25 8.25 8.75 8.75 8.75 8.00 8.00

One week repo rate

5.75 5.75 5.75 5.75 5.75 5.75 5.75 5.75 5.75

Targeted Fed Funds

Japan

0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25

Overnight call rate 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10 0-0.10

Note: values are end-period

Source: National Central Bank and HSBC estimates

Macro

European Economics

Q4 2012

Periphery at a glance

Ireland, Portugal and Greece have made more progress on

primary balances this year than Spain and Italy

Capital spending is still easier to cut than current spending

Primary budget balances are improving generally Total revenues have grown in Ireland, Portugal and Spain

EURbn Primary Budget Balanc e

-5

-10

-15

-20

Greece Ireland Portugal Spain Italy

EURbn

Year-to-date* 2011 Year-to-date* 2012

Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and

Portugal. Countries should be compared on a year-to-date basis, as different timings of

payments or revenue collection can distort the comparisons.

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,

Spanish Government Office IGAE, DG Orçamento

-5

-10

-15

-20

% Year

-5

Total Rev e nue* % Year

Greece Italy Portuga l Ireland Spain

Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and

Portugal

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,

Spanish Government Office IGAE, DG Orçamento

Some improvement in direct tax revenues Interest expenditure surging as debt levels and interest rates rise

% Year

-5

-10

Tax Revenue* % Year

Spain Italy Portugal Greece Ireland

Direct Tax Indirect Tax

Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and

Portugal

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,

Spanish Government Office IGAE, DG Orçamento

-5

-10

% Year

-10

Interest Ex penditure* % Year

Greece Italy Spain Portugal Ireland

Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and

Portugal

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,

Spanish Government Office IGAE, DG Orçamento

-5

-10

Macro

European Economics

Q4 2012

Capital spending has borne the brunt of cuts … … while current spending has been harder to trim

% Year

-20

-40

-60

-80

Capital Ex penditure* % Year

Ireland Portugal Spain** Italy

Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and

Portugal

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,

Spanish Government Office IGAE, DG Orçamento

General government expenditure

-20

-40

-60

-80

% Year

Current Ex penditu re* % Year

Portugal Ireland Italy Spain**

Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and

Portugal. **Spanish current account based on a calculation of the sum of current

transfers, staff expenses and goods and services

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,

Spanish Government Office IGAE, DG Orçamento

EURbn 2007 2008 2009 2010 2011

Ireland

Total 50.9 55.7 60.0 55.0 64.2

Current 40.9 44.7 45.2 47.0 48.0

Capital 10.0 11.0 14.7 8.0 16.2

Interest 1.6 1.5 2.5 4.1 3.9

Italy

Total 740.3 765.5 788.4 788.4 788.7

Current 677.7 706.3 721.4 730.7 740.8

Capital 62.6 59.2 66.9 53.8 47.9

Interest 76.9 80.7 69.7 69.2 76.1

Greece

Total 67.2 74.9 86.4 80.7 81.4

Interest 9.8 11.2 12.3 13.2 16.4

Spain

Total 139.7 148.1 189.3 179.6 151.1

Current 77.7 82.8 112.4 104.7 79.9

Capital 9.2 8.9 17.4 14.9 10.4

Interest 14.5 15.9 17.7 19.6 22.2

Portugal

Total 75.1 77.1 83.8 88.5 83.6

Current 69.5 71.8 77.2 78.8 77.2

Capital 5.6 5.3 6.7 9.8 6.4

Interest 5.1 5.3 4.8 5.0 6.6

Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance, Spanish Government Office IGAE, DGOrçamento

Macro

European Economics

Q4 2012

Spain

Key information

Economy Spain’s GDP contracted 0.4% in the second quarter of 2012, pulling the economy further into recession, as tough austerity measures aimed at

tackling the budget crisis took their toll on both overall demand and the prices that consumers have to pay for goods. On 20 September 2012, the

Spanish government slashed its GDP forecasts to a contraction of 2.4% in 2012 and a further contraction of 0.2% in 2013, due to “a deterioration in

the international environment”.

Unemployment rates hit record highs in July at 25.1%, of which 52.2% are long-term unemployed according to AGETT, an association of temporary

employment.

Politics Spain’s centre-right opposition, Popular Party (PP) led by Mariano Rajoy, won the parliamentary election with an absolute majority on 20 November

2011, but did not take office formally until 22 December 2011. The next general election will be held no later than 13 December 2015.

Financing programme On 25 June, Spain became the fourth country to officially request aid from the eurozone’s bailout funds. It asked for up to EUR100bn to recapitalise a

number of regional banks that have been badly affected by the collapse of the real estate bubble, after stress tests revealed that Spanish banks’

recapitalisation needs could, in a worst-case scenario, reach EUR62bn. Detailed stress test results released 28 September showed that the country’s

lenders have capital needs of cEUR60bn. Markets are still waiting for Spain to formally request a support package for the government, a necessary

step to unlock the ‘conditional’ support that has been made available by the ECB.

Spain’s regions are facing fiscal and liquidity challenges: the 17 autonomous regions posted a 0.9% of GDP budget deficit in the first half of 2012 (the

target for 2012 is 1.5%), but three regions – Extremadura, Murcia and Navarra – are already reporting deficits above this target. Nonetheless, Spain’s

treasury minister said on 13 September that the country’s indebted regions will meet their 2012 deficit targets. In July, the Spanish central

government announced a new liquidity mechanism to help cash-strapped regions meet their funding requirements, which is able provide EUR18bn of

funding for the rest of this year. Regions can tap the fund on a voluntary basis but will be subject to strict conditionality in terms of central government

monitoring and austerity plans. Currently around EUR14bn is expected to be requested, and only Madrid, Galicia and La Rioja have ruled out the

option of using the fund. Five regions have so far requested aid: Catalonia (EUR5bn), Valencia (EUR4.5bn), Murcia (EUR0.3bn), Andalusia

(considering EUR4.9bn) and Castilla-La Mancha (EUR0.848bn). Despite this, Treasury Minister Cristobal Montoro said on 27 September that he saw

no need to increase the EUR18bn of funding available.

2013 Budget On 10 July, the European Council gave Spain an extra year to correct its deficit, on account of adverse economic circumstances. 2014 has been set as the new

deadline for bringing its deficit below the EU’s 3% of GDP threshold. Headline deficit targets of 6.3% of GDP for 2012, 4.5% for 2013 and 2.8% for 2014 have

been established. Spain’s economy minister Luis de Guindos said on 27 September that the 2012 budget deficit target would be met.

On 26 September, Spain announced a tough 2013 budget which focuses on cutting spending (by an additional 0.77% of GDP in 2013) over

increasing taxes (an additional 0.56% of GDP in 2013). It detailed 43 new reforms which will be implemented in the next six months to revive the

economy and rein in debt levels. The budget is based on unchanged economic forecasts (an optimistic -0.5% for 2013). Social spending will be the

focus of the budget cuts and government ministries will face spending reductions of 8.9%. Despite the austerity measures, though, total spending is

set to rise by 5.6% as pensions, school grants and interest payments are due to climb, with interest expenditure alone increasing by 33%. The

government is expecting tax revenue to be higher than originally budgeted in 2012; it plans a further increase of 3.8% in 2013 and forecasts total

revenue to increase by 2.7%. Spain is establishing an independent fiscal authority to oversee compliance with this new budget.

In January–August, Spanish expenditure increased by 8.9% compared with the same period last year. Despite overall revenue increasing 22.8% y-oy

in the eight-month period, tax revenue fell by 4.6%, although Spain’s deputy budget minister Marta Fernandez Curras said that she expects higher

tax revenues (mainly due to the increase in VAT from 18% to 21%, which was implemented on 1 September) and lower spending in the upcoming

months.

Structural reforms On 26 September, Spain announced a timetable of 43 new reforms which go beyond the European Commission’s demands for the country and are

thought to be pre-emptive of the conditions of a bailout. They will include the following:

Pension reforms: A pension reform will be presented by year-end which will limit individuals’ ability to retire before the mandated retirement age of

65 and ensure that the retirement age is tied to life expectancy.

Privatisation and liberalisation: Spain’s deputy prime minister announced that there will be further privatisations in the energy, services and

telecom sectors. Efforts will also be made to make markets more efficient by cutting down red tape.

Labour reforms: New measures will be adopted to further labour market reforms as well as to reform public administration.

Banking reforms On 31 August 2012, Spain unveiled a new set of financial reforms aimed at preventing capital flight from Spain caused by eroding investor

confidence and speeding up the clean-up of its banking sector. Previous measures adopted over the past three years have failed to put an end to the

financial crisis that has forced Madrid to take over four of its banks; however, deputy prime minister Soraya Saenz has said that these reforms will fix

Spain’s banking sector once and for all. She added that “the fundamental objective of this reform is to have credit flowing back into the country” to

remedy the fact that Spanish banks have been locked out of markets and left dependent on the ECB for funding after suffering a flight of deposits

(net outflows totalled EUR56.5bn in June). The centrepiece of the reform is the creation of an asset management company or “bad bank” which,

starting later this year, will buy property assets from banks at an average discount of 45-50% of original book value. The bank will receive unfinished

developments, unsold homes and building plots from developers that have gone bankrupt and will be expected to sell this stock on at a profit over the

next 10 to 15 years. Another key point of the reform is the creation of a new process for breaking up and winding down banks that will also ensure

that investors who invested in risky preference shares will bear some of the losses.

Source: Reuters, IMF, FT, National Ministries of Finance

Macro

European Economics

Q4 2012

Italy

Key information

Economy Italy’s economy shrank more than expected in Q2 2012, with GDP contracting 0.8% q-o-q, causing the recession to deepen further. The austerity

measures are weighing on the country, with both private and public investment and consumption the hardest hit. However, prime minister Mario

Monti emphasised that 2013 would be “a year of recovery” and would be followed by 1.1% growth in the economy in 2014 “as demand increases

both domestically and internationally, and the positive effects of a budget balance, a decreasing debt and structural reforms permeate through the

economy.”

Italy has been registering one of the highest inflation rates in the eurozone over the past year (3.6% in July 2012) due to methodological changes and

VAT increases.

Italian unemployment has reached its highest level since the euro was formed in 1999, at 10.7%.

Politics The current prime minister, Mario Monti, the head of a government of technocrats, took over from his predecessor, Silvio Berlusconi, who resigned

amid the mounting national debt crisis on 13 November 2011. The next set of parliamentary elections is due in April 2013 and the presidential

elections in May 2013. According to the most recent opinion poll carried out on 29 August 2012 by IPR, The Democratic Party, led by Pier Luigi

Bersani, is leading, with 26% of the vote.

2012 Budget Italy fell behind plan to meet the budget deficit target of 1.7% of GDP for 2012, down from 3.9% in 2011, raising its deficit projection to 2.6% of GDP

in late September. An emergency package of austerity measures involving EUR33bn of cuts was approved on 22 December 2011. Almost two-thirds

of the fiscal consolidation is to come from higher taxes and EUR10.5bn from spending cuts. Italy’s debt burden currently stands at 123.4% of GDP,

second only to Greece’s in the eurozone.

Revenue: Up from the same period last year

Italian tax revenues rose 4.7% y-o-y to EUR232bn in January-July 2012 after the introduction of several tax hikes and a crackdown on tax evasion as

part of a series of measures implemented to improve public finances. Italian economy minister Vittorio Grilli is expecting revenues from anti-taxevasion

measures to be over EUR10bn this year.

Expenditure: Higher than expected

In H1 2012, the budget deficit was reported as EUR47.7bn, EUR1.1bn higher than in H1 2011, largely due to increased spending on Italy’s share of

bailouts for other eurozone countries – up from EUR6.1bn in January-June 2011 to EUR16.6bn in the same period of 2012. However, prime minister

Mario Monti won a vote of confidence on 7 August 2012 to cut spending by a further EUR4.5bn during 2012 to help rein in the budget deficit, and to

postpone the planned 2pp hike in VAT from 21% to 23% until July 2013. The government estimates that savings from the cuts will amount to

EUR10.9bn in 2013 and EUR11.7bn in 2014, and will come from reductions in healthcare spending together with decreases of 10% in the number of

public sector workers and 20% in state managers. One major risk for the Italian budget at the moment is its debt-servicing cost. Despite 10-year bond

yields falling dramatically from their high of 6.5% in July, they are still currently showing high yields of around 5%. Italy is planning to spend

EUR84.2bn (5.3% of GDP) on servicing its debt in 2012.

Structural reforms Although the ECB plans detailed at its meeting on 6 September 2012 provoked widespread relief in Italy, Prime Minister Monti has said that reforms

must continue.

Deregulation package: A package involving the deregulation of some service sectors and professions in order to increase competition won

parliamentary approval on 21 March 2012, with the measures taking effect immediately. These include abolishing minimum tariffs among most

professions (except for lawyers), increasing the number of pharmacies nationwide, restricting cross membership of banking foundations and banks,

introducing free current account banking for pensioners earning less than EUR1,500 per month and simplifying procedures for starting up companies

by virtually eliminating the related costs for people under the age of 35.

Justice reforms: Justice minister Paola Severino has introduced reforms aimed at tackling Italy’s judicial inefficiency, which is helping stifle its

already weak economy. These reforms are expected to halve trial times, taking Italy to the average European level. The reforms include a ‘filter’ to

cut the number of cases that are allowed to proceed to the appeals level or are eligible for a second evaluation, and the creation of specialist

business tribunals.

Labour reforms: Italy’s highly controversial labour reform was passed by the Chamber of Deputies on 27 June 2012 despite provoking considerable

criticism, especially from trade unions. The reform, which aims to boost job creation and restore competitiveness, makes temporary contracts more

costly for employers by raising tax and welfare contributions, and eases firing restrictions in order to discourage firms from rotating temporary workers

rather than hiring them permanently, the aim being to prevent many young people from being stuck in dead-end, short-term jobs. It will also make it

easier for companies to fire workers by introducing a special legal procedure to speed up dismissal disputes. The intention is to reduce the

uncertainty of the current system in which workers can be reinstated after years of dispute. However, participation rates, especially among women,

are still extremely low at around 50%, compared to the 65% average across the EU.

Pension reforms: In late 2011, Italy introduced a pension reform including three key changes: the abolition of seniority pensions, a contribution

system for all pension schemes and an increase in the pension age for men and women. The current retirement age for men is 66 and, by 2018, the

retirement age for women will also rise to 66. Many workers in Italy retire before 60 under the system of seniority based on years of contribution paid,

but this scheme is to be phased out by 2018 and, with immediate effect, men and women must make one more year of contributions to retire. The

government estimates that this will cause 65,000 people who took early retirement to be left without a state pension; however, funds have been set

up to help them.

Source: Reuters, IMF, FT, National Ministries of Finance

Macro

European Economics

Q4 2012

Ireland

Key information

Economy The Irish economy has bucked the weakening trend evident in most eurozone economies. Industrial output has remained strong in the third quarter,

with manufacturing PMIs showing continued growth. The persistently high unemployment rate continues to be a source of uncertainty and, as an

export-led economy, Ireland is particularly vulnerable to the weak growth of its eurozone trading partners. This explains the IMF’s forecast of just

0.4% GDP growth for 2012, down from 1.4% in 2011.

Financing programme Officially requested on 21 November 2010. Approved on 16 December 2010

Amounts to EUR85bn supported by the IMF, EFSM, EFSF, bilateral loans from Demark, Sweden and the UK and Ireland’s own contributions

The IMF completed its seventh review and approved a EUR0.9bn disbursement on 5 September 2012. The Irish authorities have continued to

successfully implement their programme to meet the targets for end-June despite the weak global economic backdrop.

Ireland returned to the sovereign debt markets on 26 July 2012, raising EUR4.2bn of new funds in 5- and 8-year bonds, while financing needs for

2013 and 2014 were reduced by a further EUR1bn through a bond swap tailored to meet the needs of domestic pension funds. Irish bond yields have

fallen significantly, and are now below 5% for the first time since September 2010. At the euro area summit on 28-29 June, the need to break to

vicious circle between banks and sovereigns was recognised as a means of further improving Ireland’s debt sustainability and reducing its reliance

on official financial support. Euro area leaders and the IMF would like the ESM to be able to invest directly in key Irish banks to alleviate pressure on

government finances and allow more funds to be directed to the country’s restructuring programme.

2012 Budget Ireland is on track to meet its budget deficit target of 8.6% of GDP for 2012, down from 9.9% in 2011. Total fiscal consolidation measures, outlined on

6 December 2011, amount to EUR3.8bn, of which EUR2.2bn is to come from spending cuts and EUR1.6bn from increased revenue. A fiscal

responsibility bill, published in July 2012 and to be brought before parliament by end-September, will further support the necessary consolidation

measures through to 2013. Following the passage of the bill the government will be able to formally ratify the Fiscal Compact Treaty, which was

approved in a referendum on 31 May 2012.

Financial reforms

Revenue: Strong returns so far in 2012

Tax receipts were up 5.2% y-o-y at end-August, which is 1.7% ahead of target. The 2pp increase in the standard rate of VAT to 23% since the start

of 2012 has made significant contributions, and income and corporation tax continue to outperform.

Expenditure: Higher than expected

The social protection department has spent more than expected on unemployment benefits as a result of a persistently high unemployment rate.

Health spending has overrun significantly, with only 22% of planned savings achieved so far this year. Ireland’s Health Service Executive (HSE) has

already announced an emergency corrective package amounting to EUR130bn to be introduced in addition to other non-operational measures.

Measures include a 10% cut in overtime pay, a 6% reduction in the hours of those who care for the elderly at home and a halving in the use of staff

not directly employed by the HSE.

Reorganisation – creating a two-pillar banking system: The first stages have been implemented. Pillar one will be the Bank of Ireland and the

second will be created by merging Allied Irish Banks and EBS. The restructuring of Permanent TSB (PTSB) is proceeding with the establishment of

three separate business units (a core retail bank, an asset management unit and the UK mortgage loan book). As of 2012 the Department of Finance

has established a banking policy division to advise and support the government, helping to ensure a sustainable banking system that can drive

economic growth and job creation.

Recapitalisation – targeting Core Tier 1 capital ratios of 10.5% and 6% under base and stress cases, respectively: Aggregate recapitalisation

needs of EUR24bn were identified when banks forecast their financial statements through end-2013 in March 2011. The total cost to the state was

limited to EUR17.8bn through capital-raising from private investors and burden-sharing with subordinated debtholders. The exercise will run again

with the EBA’s euro area stress tests in 2013.

Deleveraging – a three-year framework to downsize the banking system, improve market funding prospects and reduce reliance on official financial

support: This is advancing faster than planned, in part due to front-loaded disposals by banks and the run-off of core asset portfolios, reflecting write-offs and

lacklustre credit demand. More than half of the EUR70bn worth of assets initially identified by banks has already been disposed of or amortised.

The authorities are continuing to work to improve the quality of banks’ assets and are attempting to resolve current household debt distress through

considerable efforts to reform the personal insolvency framework (see Box 2 IMF fifth review, March 2012).

Structural reforms European leaders have agreed to increase the EIB’s capacity to aid growth and investment. Ireland’s authorities propose to use EIB funds together

with other sources to supplement the exchequer’s capital investment in sectors including education, transport and healthcare.

Source: Reuters, IMF, FT, National Ministries of Finance

Addressing high unemployment: Under the Pathways to Work labour activation strategy, benefit and training services are being integrated to

provide a more streamlined approach, with four pilot programmes under way so far. The plan contains proposals to cut social welfare benefits where

claimants fail to co-operate with reasonable offers of education, training or employment. The resource and training needs of employment centres and

the involvement of private sector firms are being examined in a study that will be completed by end-September. The authorities are replacing rental

assistance with a new Housing Assistance Payment for those with long-term housing needs to reduce disincentives to work.

Macro

European Economics

Q4 2012

Greece

Key information

Economy The Greek economy has deteriorated sharply and is currently suffering its fifth consecutive year of recession, with the economy contracting 6.2% y-oy

in Q2 2012. GDP contracted by 6.9% in 2011, worse than expected; Consensus Economics is projecting contractions of 6.2% in 2012 and 3.3% in

2013. Prime minister Antonis Samaras was more pessimistic in his recent forecast, saying that he expected the Greek economy to contract by more

than 7% this year. In cumulative terms, this would be a contraction of 18.6% from 2008 to 2012.

Unemployment has continued to rise since May 2008, reaching a record high of 21.9% in March, but the IMF expects it to ease in 2014.

Politics The pro-bailout party, New Democracy, led by Antonis Samaras, formed a coalition with PASOK and the Democratic Left in the second round of

Greek elections on 17 June.

The fragile coalition is making negotiation of an EUR11.5bn bailout package more difficult, as both the PASOK and Democratic Left leaders are

objecting to some of the measures outlined by the prime minister and finance minister. However, all agree that the main objective is for the country to

“move on to the next stage”.

Financing programme A second adjustment programme was approved by the IMF and euro area member states in mid-March 2012.

The new official assistance amounts to EUR172.6bn, to be disbursed between the start of the programme and end-2014, of which EUR109.1bn will

be contributed by the EFSF and EUR28bn by the IMF (including EUR8.2bn of disbursements in 2015). The disbursements under the first economic

programme totalled EUR73bn.

The Troika returned to Greece on 9 September to complete the first review of the second programme. A report will be published, also including an

updated debt sustainability analysis, which will provide information on whether Greece is on track to reduce its public debt burden to below 120%

before end-2020. To date discussions are still ongoing, although the report was originally due before the Eurogroup meeting on 8 October (see fiscal

consolidation measures below).

2012 Budget The 2012 budget was approved on 6 December 2011, with a supplementary budget adopted on 20 February 2012, allowing Greece to access the

second bailout fund. This supplementary budget contained additional measures worth EUR3.3bn (1.5% of GDP) on top of the measures outlined in

the 2012 budget. The additional package is heavily tilted towards revenue measures, in particular improving the taxation system. On the expenditure

side, the focus lies on pension spending, which is to be cut by 15% of GDP. However, preliminary findings by the Troika discovered that Greece is

currently facing a budget shortfall totalling EUR20bn – double its previous estimate.

Revenue: Not as good as targeted

Government revenue rose by only 1.6% y-o-y for the first eight months of the year, which is EUR2.1bn less than was targeted in an interim report

detailed under the bailout plan. This shortfall is due to the failure of thousands of Greeks to make their first income tax payments by the 31 August

deadline, leading to EUR270m of lost revenue. This prompted the finance minister to step up the crackdown on tax dodgers, with the government

seizing houses, cars, deposits and shares worth millions of euros in September.

Expenditure:

The Greek government managed to reduce its budget balance by 33.2% y-o-y in January–August thanks to the reductions in public spending and

investment set out in the 2012 budget.

Structural reforms Following the latest Troika review at the start of July, prime minister Antonis Samaras said Greece would step up the pace of reforms, acknowledging

that its austerity programme was off track. The government was scheduled to present a new set of reforms aimed at meeting the Troika’s demands at

the euro working group meeting on 28 September.

It has already committed to a selection of reforms including:

• Labour market reforms such as the reduction of private sector wages, including a 22% reduction in the minimum wage

• Product market reforms to promote competition and facilitate price flexibility

• Service market reforms with the priority of abolishing restrictions in 20 high-value or highly restricted professions

• Business environment improvements designed to improve the functioning of the fast-track investment framework and make the judicial system

more efficient.

Fiscal consolidation

measures

The economic adjustment programme, outlined in February, aims to achieve a primary deficit of 1% of GDP in 2012 and a primary surplus of 4.5% of

GDP in 2014. To achieve these targets, additional consolidation measures amounting to 1.5% of GDP (all on the expenditure side) were adopted in

the supplementary 2012 budget on top of those approved in the 2011 medium-term fiscal strategy and the 2012 budget. However, further measures

of around 5.5% of GDP must be identified to close the fiscal gap through to 2014. On 27 September, ministers reached an agreement on the “basic

framework” of the EUR13.6bn austerity package required by the Troika if Greece is to receive the next EUR31.5bn instalment of aid. This will

allegedly comprise EUR3bn of additional revenue and EUR10.6bn from additional expenditure savings. However, further details have yet to be

provided. Finance minister Yannis Stournaras said that Greece will attempt to insert a “symmetrical fiscal performance clause” which, in the case of

fiscal shortfalls, will trigger new measures and, in the case of fiscal outperformance, will allow measures to be clawed back. Measures amounting to

EUR7.5bn out of the EUR13.6bn package should be included in the draft 2013 budget.

Source: Reuters, IMF, FT, National Ministries of Finance, Consensus Economics

Macro

European Economics

Q4 2012

Portugal

Key information

Economy Portuguese GDP contracted 1.2% q-o-q in the second quarter of 2012 as the government’s austerity drive depressed domestic demand. This has

caused the economy to sink deeper into recession, as GDP has declined for the last seven consecutive quarters. The IMF is projecting economic

activity to decline by 3% in 2012 thanks to weaker import growth among the country’s main trade partners in the eurozone and additional austerity

measures. GDP is now expected to turn positive in the second quarter of 2013, causing a 1% decline in full-year GDP in 2013.

Weak domestic demand has combined with pressures on firms to reduce their debt levels to push up the unemployment rate on a year-on-year basis

since October 2008, and it hit a record high of 15% in Q2 2012. However, the IMF expects the rate to peak in early 2013 at 15.9%.

Politics The current government came to power in June 2011 and is a coalition led by the centre-right Social Democratic Party with the smaller conservative

Popular Party, led by Prime Minister Pedro Passos Coelho. The next Portuguese legislative election must take place by 2015 at the latest.

Financing Programme Portugal officially requested an EU-IMF bailout on 7 April 2011 and a EUR78bn bailout (to which EFSF, EFSM and IMF each contributed EUR26bn)

was unanimously approved on 17 May 2011. Of this EUR78bn, EUR51.5bn has been disbursed so far (EUR20.1bn from the EFSM, EUR17.4bn from

the EFSF and EUR13.5bn from the IMF).

After completing Portugal’s fifth review on 11 September 2012, the IMF stated that this “confirms that the programme is making progress, albeit

against strong headwinds”. Approval of the conclusion of this review by the IMF executive board and at the Eurogroup and Ecofin meetings on the 14

and 15 October will allow a further disbursement of EUR4.3bn, of which EUR2.8bn will be from the EU and EUR1.5bn from the IMF. The next

programme review is due to take place in November 2012.

2012 Budget On 11 September, after Portugal’s fifth Troika review, its deficit targets were revised upwards from 4.5% to 5% of GDP in 2012 and from 3% to 4.5%

in 2013. In 2014, Portugal’s target is to reduce its deficit to 2.5%, below the 3% threshold of the Stability and Growth pact. The IMF hopes that the

new targets will ease the short-term economic costs associated with fiscal adjustment while allowing the government to implement sound structural

fiscal measures.

Revenue: Lagging behind plans

First-half tax collection was weak. Despite overall revenue increasing thanks to one-off transfers of banks’ pension funds to the state, January–

August tax revenue fell 2.4% y-o-y, largely due to the continued rise in unemployment.

Expenditure: Performing better than budgeted

January–August primary expenditure fell 3.2% y-o-y largely thanks to cuts in benefits paid to public sector workers. However, increased debt

servicing costs caused total expenditure to fall only 0.7%. The majority of cuts came from capital expenditure, which was reduced by 21.5% y-o-y.

2013 Budget On 7 September prime minister Pedro Passos Coelho announced new measures that will be imposed next year, as part of the 2013 budget, to meet

budget deficit targets and curb Portugal’s high unemployment levels. These included a sharp cut in take-home pay for workers, with social security

contributions deducted from wages increasing from 11% to 18% while the rate companies pay will be cut from 23.75% to 18% to encourage hiring

and make Portuguese exports more competitive by cutting labour costs. In the face of widespread protests, the government is now renegotiating with

labour unions.

Financial Reforms Portugal’s banking system is still benefiting from Eurosystem support, and the authorities are finalising efforts to ensure that targets for bank’s capital

buffers will be met, while further progress has been made in strengthening the banking supervision and resolution frameworks. Deleveraging in the

banking system has continued at an acceptable pace, although in some parts of the economy, access to credit at reasonable rates is still difficult.

Portugal is still planning on returning to the bond markets by September 2013.

Structural Reforms Business environment: The Portuguese government is currently planning reforms which include an economy-wide overhaul of licensing intended to

increase competition, strengthen the business environment and improve efficiency as well as reducing rents in the services and network industries.

Source: Reuters, IMF, FT, National Ministries of Finance

Judicial: Portugal is making progress a number of reforms designed to improve the efficiency of the court system and to reduce the backlog of

enforcement cases that has slowed the judicial process, increasing costs across the economy.

Labour: On 1 August 2012 new labour reforms came into force aimed at increasing worker flexibility to improve productivity and job creation.

Reforms include abolishing four public holidays as well as reducing the number of paid days of holiday a worker is entitled to from 25 to 22 days. The

entitlement to extra holidays previously granted to workers who had not been absent in the preceding year has also been removed. The new law

introduces an “hours bank” which allows employers to increase the working day by up to two hours and decreases the pay received for overtime.

Dismissals have been made easier by abolishing the employer’s obligation to find a fired worker alternative employment, by making layoffs easier in

a situation where there is a “business crisis” and by decreasing redundancy pay.

Public sector: After the prime minister’s proposal to cut both Christmas and summer holiday bonuses (each equivalent to a month’s pay) for all

public sector workers was blocked by the constitutional court on 5 July 2012, the government will now only cut one of these bonuses in 2013 while

both will be cut in 2012. However, both will be abolished for state pensioners.

Privatisation: Thanks to a 2011 agreement with the EU, Portugal is currently in the process of privatising its national air carrier, TAP Portugal, and

its airport concession, Aeroportos de Portugal. The IMF had hoped that the sale of TAP would be possible by the end of 2011 but adverse market

conditions have meant that the sale has not yet materialised. The country’s comprehensive privatisation plan includes the energy and insurance

sectors, media industries and transport. On 31 May 2012 Fitch Ratings said it expected Portugal to exceed its privatisation revenue target of

EUR7bn.

Macro

European Economics

Q4 2012

Rescue Packages

Disbursements to Greece under first bailout package

EURbn EU IMF Total

1. May 2010 14.5 5.5 20.0

2. Sep 2010 6.5 2.6 9.1

3. Dec 2010/Jan 2011 6.5 2.5 9.0

4. Mar 2011 10.9 4.1 15.0

5. Jul 2011 8.7 3.2 11.9

6. Dec 2011 5.8 2.2 8.0

Total 52.9 20.1 73.0

Note: EUR34.3bn was rolled over from this package to the second package (EUR10bn from the IMF and

EUR24.4bn from the EFSF’s undisbursed Greek Loan Facility

Source: IMF, EFSF, ESM, ECB and European Commission

Disbursements to Ireland

EURbn EFSM EFSF IMF

Disbursements to Portugal

EURbn EFSM EFSF IMF

31 May 11 1.8 22 Jun 11 3.7 1st review (12 Sep 11) 4.0

01 Jun 11 4.8 29 Jun 11 2.2 2nd review (19 Dec 11) 2.9

21 Sep 11 5.0 20 Dec 11 1.0 3rd review (04 Apr 12) 5.2

29 Sep 11 2.0 12 Jan 12 1.7 4th review (16 Jul 12) 1.5

06 Oct 11 0.6 19 Jan 12 1.0

16 Jan 12 1.5 30 May 12 5.2

24 Apr 12 1.8 17 Jul 12 2.6

04 May 12 2.7

Already disbursed 20.2 17.4 13.5

Pending disbursement 5.8 8.6 12.5

Total 26.0 26.0 26.0

Source: IMF, EFSF, ESM and European Commission

12 Jan 11 5.0 01 Feb 11 3.6 1st review (18 Jan 11) 5.8

24 Mar 11 3.4 10 Nov 11 3 2nd review (16 May 11) 1.6

31 May 11 3.0 15 Dec 11 1 3rd review (02 Sep 11) 1.5

29 Sep 11 2.0 12 Jan 12 1.2 4th review (15 Dec 11) 3.9

06 Oct 11 0.5 19 Jan 12 0.5 5th review (27 Feb 12) 3.2

16 Jan 12 1.5 03 Apr 12 2.7 6th review (13 Jun 12) 1.4

05 Mar 12 3.0

03 Jul 12 2.3

Already disbursed 20.7 12.0 17.4

Pending disbursement 1.8 5.7 5.1

Total 22.5 17.7 22.5

Source: IMF, EFSF, ESM and European Commission

Disbursements to Greece under second bailout package

EURbn Total committed Disbursed

PSI 30.0 29.7*

Accrued interest 5.5 4.8*

IMF contribution 28.0

EFSF contribution 109.1 39.4

Total 2nd package 172.6 73.9

Note: *the residual amounts committed will not be used by Greece

This second package contains EUR130bn of “new” money to finance Greece until the end of 2014. A further

EUR34.4bn was rolled over from the second package and in 2015 the IMF will become the sole creditor and

disburse a further EUR8.2bn.

Note on ECB collateral: As a temporary operation, the EFSF provided the Eurosystem with bonds amounting to

EUR35bn as collateral during Greece’s selective default period due to the PSI operation. These bonds were

returned to the EFSF on 25 July 2012 and were cancelled on 3 August 2012

Source: IMF, EFSF, ESM, ECB and European Commission

Macro

European Economics

Q4 2012

Key European

forecasts and statistics

Macro

European Economics

Q4 2012

GDP

Real GDP growth

GDP growth continues to weaken in 2012 GDP growth divergence persists across Europe

%Yr

-2

-4

-6

-8

Germany

France

Italy

Spain

Greece

Ireland

2011 2012f 2013f

Portugal

%Yr

-2

-4

-6

-8

-2

-4

-6

-8

EM U

% Year 2005 2006 2007 2008 2009 2010 2011 2012f 2013f

Eurozone 1.8 3.3 3.0 0.3 -4.4 2.0 1.5 -0.6 -0.1

Germany 0.8 3.9 3.4 0.8 -5.1 4.0 3.1 0.9 0.9

France 1.8 2.6 2.2 -0.2 -3.1 1.6 1.7 0.2 0.9

Italy 1.1 2.3 1.5 -1.2 -5.5 1.8 0.5 -2.5 -1.1

Spain

Other eurozone*

3.6 4.1 3.6 0.9 -3.7 -0.3 0.4 -1.5 -2.0

Austria 2.4 3.7 3.7 1.4 -3.8 2.3 3.1 0.8 1.7

Belgium 1.7 2.7 2.9 1.0 -2.8 2.3 1.9 0.0 1.2

Cyprus 3.9 4.1 5.1 3.6 -1.9 1.1 0.5 -0.8 0.3

Estonia 8.9 10.1 7.5 -3.7 -14.3 2.3 7.6 1.6 3.8

Finland 2.9 4.4 5.3 0.3 -8.4 3.7 2.9 0.8 1.6

Greece 2.3 5.5 3.0 -0.2 -3.3 -3.5 -6.9 -4.7 0.0

Ireland 5.3 5.3 5.2 -3.0 -7.0 -0.4 0.7 0.5 1.9

Luxembourg 5.4 5.0 6.6 0.8 -5.3 2.7 1.6 1.1 2.1

Malta 3.7 2.9 4.3 4.1 -2.7 2.3 2.1 1.2 1.9

Netherlands 2.0 3.4 3.9 1.8 -3.5 1.7 1.2 -0.9 0.7

Portugal 0.8 1.4 2.4 0.0 -2.9 1.4 -1.6 -3.3 0.3

Slovakia 6.7 8.3 10.5 5.8 -4.9 4.2 3.3 1.8 2.9

Slovenia

Other Western Europe

4.0 5.8 6.9 3.6 -8.0 1.4 -0.2 -1.4 0.7

UK 2.0 2.6 3.4 -1.1 -4.4 1.8 0.8 -0.1 1.1

Norway** 4.4 5.0 5.3 1.4 -1.5 1.8 2.5 3.6 3.0

Sweden 3.2 4.6 3.4 -0.8 -5.0 6.3 3.9 0.8 2.1

Switzerland 2.7 3.8 3.8 2.2 -1.9 3.0 1.9 0.9 1.4

Denmark*

Other Europe

2.4 3.4 1.6 -0.8 -5.8 1.3 1.0 1.1 1.4

Hungary 4.0 3.9 0.1 0.9 -6.8 1.3 1.6 -1.0 1.3

Poland 3.6 6.2 6.8 5.1 1.6 3.9 4.3 2.5 2.0

Romania 4.1 7.9 6.3 7.2 -6.6 -1.7 2.5 1.1 2.5

Turkey 8.4 6.9 4.7 0.7 -4.8 9.2 8.5 2.7 3.8

Czech Republic 6.8 7.2 5.7 2.9 -4.5 2.6 1.7 -0.9 1.0

Bulgaria* 6.4 6.5 6.4 6.2 -5.5 0.4 1.7 0.5 1.9

Latvia* 10.1 11.2 9.6 -3.3 -17.7 -0.3 5.5 2.2 3.6

Lithuania* 7.8 7.8 9.8 2.9 -14.8 1.4 5.9 2.4 3.5

Russia 6.4 8.2 8.5 5.2 -7.8 4.3 4.3 3.0 2.5

Note: *European Commission Spring 2012 forecasts for 2011, 2012 and 2013, **mainland GDP

Source: HSBC estimates, European Commission Spring 2012 forecasts

Source: HSBC estimates, European Commission Spring 2012 forecasts Source: HSBC, European Commission

%Yr

2011

%Y r

-2

-4

-6

-8

Macro

European Economics

Q4 2012

Consumer prices

CPI

% Year 2005 2006 2007 2008 2009 2010 2011 2012f 2013f

Eurozone 2.2 2.2 2.1 3.3 0.3 1.6 2.7 2.5 1.8

Germany 1.9 1.8 2.3 2.7 0.2 1.2 2.5 2.1 2.1

France 1.9 1.9 1.6 3.2 0.1 1.7 2.3 2.3 1.8

Italy 2.2 2.2 2.0 3.5 0.8 1.6 2.9 3.4 2.3

Spain

Other eurozone*

3.4 3.6 2.8 4.1 -0.2 2.0 3.1 2.4 2.5

Austria 2.1 1.7 2.2 3.2 0.4 1.7 3.6 2.4 2.0

Belgium 2.5 2.3 1.8 4.5 0.0 2.3 3.5 2.9 1.8

Cyprus 2.0 2.2 2.2 4.4 0.2 2.6 3.5 3.4 2.5

Estonia 4.1 4.4 6.7 10.6 0.2 2.7 5.1 3.9 3.4

Finland 0.8 1.3 1.6 3.9 1.6 1.7 3.3 3.0 2.5

Greece 3.5 3.3 3.0 4.2 1.3 4.7 3.1 -0.5 -0.3

Ireland 2.2 2.7 2.9 3.1 -1.7 -1.6 1.2 1.7 1.2

Luxembourg 3.8 3.0 2.7 4.1 0.0 2.8 3.7 3.0 2.0

Malta 2.5 2.6 0.7 4.7 1.8 2.0 2.4 2.0 2.2

Netherlands 1.5 1.7 1.6 2.2 1.0 0.9 2.5 2.5 1.8

Portugal 2.1 3.0 2.4 2.7 -0.9 1.4 3.6 3.0 1.1

Slovakia 2.8 4.3 1.9 3.9 0.9 0.7 4.1 2.9 1.9

Slovenia

Other Western Europe

2.5 2.5 3.8 5.5 0.9 2.1 2.1 2.2 1.7

UK 2.0 2.3 2.3 3.6 2.2 3.3 4.5 2.7 2.5

Norway 1.5 2.3 0.7 3.8 2.2 2.4 1.3 0.7 1.6

Sweden 0.5 1.4 2.2 3.4 -0.5 1.2 3.0 1.1 1.2

Switzerland 1.2 1.1 0.7 2.4 -0.5 0.7 0.2 -0.6 0.3

Denmark*

Other Europe

1.7 1.9 1.7 3.6 1.1 2.2 2.7 2.6 1.5

Hungary 3.6 3.9 8.0 6.1 4.2 4.9 3.9 5.7 3.7

Poland 2.1 1.0 2.5 4.2 3.5 2.6 4.3 3.9 2.7

Romania 9.0 6.6 4.8 7.9 5.6 6.9 5.8 3.1 3.5

Turkey 8.2 9.6 8.8 10.4 6.3 8.6 6.5 9.0 7.3

Czech Republic 1.9 2.5 2.8 6.3 1.0 1.5 1.9 3.3 2.0

Bulgaria* 6.0 7.4 7.6 12.0 2.5 3.0 3.4 2.6 2.7

Latvia* 6.9 6.6 10.1 15.3 3.3 -1.2 4.2 2.6 2.1

Lithuania* 2.7 3.8 5.8 11.1 4.2 1.2 4.1 3.1 2.9

Russia 12.7 9.7 9.0 14.1 11.7 6.8 8.5 5.2 7.4

Note: *European Commission Spring 2012 forecasts for 2011, 2012 and 2013

Source: HSBC estimates, European Commission Spring 2012 forecasts

Inflation easing through to 2013 Inflation above 2% for most European countries in 2011

%Yr

-1

Germany

Franc e

Italy

Spain

Greece

Ireland

2011 2012f 2013f

Portugal

%Yr

-1

EM U

Source: HSBC estimates, European Commission Spring 2012 forecasts Source: HSBC, European Commission

%Yr

20 11

%Y r

Macro

European Economics

Q4 2012

Consumer spending

% Year 2005 2006 2007 2008 2009 2010 2011 2012f 2013f

Eurozone 1.8 2.2 1.7 0.4 -1.0 1.0 0.1 -0.8 -0.2

Germany 0.3 1.6 -0.2 0.6 0.3 0.8 1.7 0.9 1.2

France 2.5 2.5 2.2 0.2 0.2 1.4 0.2 0.1 0.5

Italy 1.2 1.3 1.1 -0.8 -1.6 1.2 0.2 -3.4 -1.3

Spain

Other eurozone*

4.1 4.0 3.6 -0.6 -3.8 0.7 -1.0 -1.8 -1.8

Austria 2.2 1.8 0.9 0.8 -0.3 2.2 0.6 0.8 1.0

Belgium 1.0 1.8 1.7 1.9 0.8 2.5 0.7 0.1 1.2

Cyprus 3.5 4.7 10.2 7.8 -7.5 1.3 0.2 -2.5 0.3

Estonia 9.5 13.5 8.8 -6.1 -15.6 -1.7 4.2 2.8 3.0

Finland 3.1 4.3 3.5 1.9 -2.7 3.0 3.3 1.7 1.0

Greece 4.5 4.3 3.7 4.0 -1.3 -3.6 -7.1 -5.7 -1.1

Ireland 6.8 6.6 6.3 -1.4 -7.2 -0.9 -2.7 -1.7 0.3

Luxembourg 2.6 3.2 3.3 3.4 1.1 2.1 1.8 0.7 2.0

Malta 1.7 3.5 0.6 5.1 -1.4 -1.7 3.1 0.3 1.0

Netherlands 1.0 -0.3 1.8 1.3 -2.6 0.4 -1.1 -1.5 0.0

Portugal 1.7 1.8 2.5 1.3 -2.3 2.1 -3.9 -6.1 -1.0

Slovakia 6.5 5.9 6.8 6.1 0.2 -0.7 -0.4 0.2 1.6

Slovenia

Other Western Europe

2.1 2.8 6.1 3.7 -0.1 -0.7 -0.3 -1.4 -0.4

UK** 2.1 1.8 2.7 -1.5 -3.5 1.3 -1.0 -0.1 1.3

Norway 4.9 5.1 5.4 2.0 -0.2 3.6 2.4 3.7 4.5

Sweden 2.8 2.8 3.8 -0.1 -0.2 3.9 2.2 1.6 1.2

Switzerland 1.7 1.6 2.2 1.2 1.8 1.6 1.2 2.3 1.6

Denmark*

Other Europe

3.8 3.6 3.0 -0.3 -4.2 1.9 -0.5 1.4 1.6

Hungary 2.9 1.7 -1.0 -0.2 -5.7 -2.7 0.2 -1.3 0.2

Poland 2.1 5.0 4.9 5.7 2.1 3.2 3.1 1.6 1.6

Romania 9.7 11.5 10.1 8.8 -9.1 -0.3 0.7 0.1 2.1

Turkey 7.9 4.6 5.5 -0.3 -2.3 6.7 7.7 0.0 3.0

Czech Republic 3.1 4.4 4.2 2.8 -0.3 0.5 -0.5 -2.8 0.3

Bulgaria* 6.7 8.6 9.0 3.4 -7.6 0.1 -0.6 0.6 1.9

Latvia* 11.6 21.4 14.3 -5.8 -22.6 0.4 4.4 2.2 3.3

Lithuania* 11.2 10.0 11.3 4.2 -17.5 -4.9 6.1 3.0 3.4

Russia 12.2 12.2 14.3 10.6 -5.1 5.1 6.8 5.5 4.5

Note: *European Commission Spring 2012 forecasts for 2011, 2012 and 2013, no estimates available for Greece, **fiscal year forecasts

Source: HSBC estimates, European Commission Spring 2012 forecasts

Weak consumer spending in 2012 for the largest member states Consumption particularly weak in periphery in 2011

%Yr

-2

-4

-6

-8

Germany France Italy Spain Ireland Portugal

2011 2012f 2013f

Source: HSBC estimates, European Commission Spring 2012 forecasts Source: HSBC, European Commission

%Yr

-2

-4

-6

-8

%Yr

-2

EMU

2011

%Yr

-2

Macro

European Economics

Q4 2012

Budget balance

%GDP 2005 2006 2007 2008 2009 2010 2011 2012f 2013f

Eurozone -2.6 -1.3 -0.6 -2.0 -6.2 -6.3 -4.6 -3.9 -3.2

Germany -3.3 -1.6 0.2 -0.1 -3.1 -4.3 -1.0 -0.8 -0.6

France -2.9 -2.3 -2.7 -3.3 -7.5 -7.1 -5.2 -4.5 -3.5

Italy -4.4 -3.4 -1.6 -2.7 -5.4 -4.6 -3.9 -2.9 -2.3

Spain

Other eurozone*

1.3 2.4 1.9 -4.1 -11.2 -9.3 -8.9 -6.8 -5.0

Austria -1.8 -1.7 -1.0 -1.0 -4.1 -4.5 -2.6 -3.0 -1.9

Belgium -2.6 0.3 -0.1 -1.0 -5.7 -3.9 -3.9 -3.1 -3.3

Cyprus -2.4 -1.2 3.5 0.9 -6.1 -5.3 -6.3 -3.4 -2.5

Estonia 1.6 2.5 2.4 -2.9 -2.0 0.3 1.0 -2.4 -1.3

Finland 2.7 4.0 5.3 4.2 -2.7 -2.8 -0.9 -1.0 -0.6

Greece -5.6 -6.0 -6.8 -9.9 -15.6 -10.5 -9.2 -7.3 -8.4

Ireland 1.7 2.9 0.1 -7.3 -14.0 -31.2 -13.0 -8.3 -7.5

Luxembourg 0.0 1.4 3.7 3.0 -0.8 -0.9 -0.6 -1.8 -2.2

Malta -2.9 -2.8 -2.4 -4.6 -3.8 -3.7 -2.7 -2.6 -2.9

Netherlands -0.3 0.5 0.2 0.5 -5.6 -5.0 -4.6 -4.4 -4.6

Portugal -6.5 -4.6 -3.2 -3.7 -10.2 -9.8 -4.2 -4.7 -3.1

Slovakia -2.8 -3.2 -1.8 -2.1 -8.0 -7.7 -4.8 -4.8 -5.1

Slovenia

Other Western Europe

-1.5 -1.4 0.0 -1.9 -6.1 -6.0 -6.4 -4.3 -3.8

UK -2.9 -2.3 -2.4 -6.7 11.2 -9.5 -7.9 -6.6 -7.1

Norway 15.1 18.5 17.7 19.1 10.7 10.6 11.3 13.8 13.6

Sweden 2.2 2.3 3.6 2.2 -0.7 0.2 0.3 -0.4 -0.6

Switzerland* -0.7 0.8 1.7 2.3 1.0 0.6 0.6 0.5 0.4

Denmark*

Other Europe

5.0 5.0 4.8 3.3 -2.7 -2.7 -1.9 -4.2 -2.1

Hungary -7.9 -9.5 -5.1 -3.7 -4.5 -4.3 4.2 -3.0 -3.5

Poland -4.1 -3.6 -1.9 -3.7 -7.3 -7.8 -5.1 -3.4 -3.0

Romania -1.2 -2.2 -2.9 -5.7 -9.0 -6.8 -5.2 -2.8 -2.5

Turkey -1.3 -0.5 -1.6 -1.8 -5.5 -3.6 -1.4 -2.2 -1.5

Czech Republic -3.2 -2.4 -0.7 -2.2 -5.8 -4.8 -3.1 -2.9 -2.9

Bulgaria* 1.0 1.9 1.2 1.7 -4.3 -3.1 -2.1 -1.9 -1.7

Latvia* -0.4 -0.5 -0.4 -4.2 -9.7 -8.1 -3.5 -2.1 -2.1

Lithuania* -0.5 -0.4 -1.0 -3.3 -9.4 -7.3 -5.5 -3.2 -2.8

Russia 7.5 7.4 5.4 4.1 -6.0 -4.0 0.8 0.0 -1.1

Note: *European Commission Spring 2012 forecasts for 2011, 2012 and 2013

Source: HSBC estimates, European Commission Spring 2012 forecasts

Budget balances expected to improve as austerity measures kick in Worst deficits in Ireland and Greece in 2011

%GDP

-5

-10

-15

Germany

Franc e

Italy

Spain

Greece

Ireland

20 11 2012f 2013f

Portugal

%GDP

-5

-10

-15

%GDP

Source: HSBC estimates, European Commission Spring 2012 forecasts Source: HSBC, European Commission

-5

-10

-15

EMU

2011

%GDP

-5

-10

-15

Macro

European Economics

Q4 2012

Debt

General government gross debt

%GDP 2005 2006 2007 2008 2009 2010 2011 2012f 2013f

Eurozone 70.2 68.6 66.3 70.1 79.9 85.6 89.3 91.9 93.5

Germany 68.6 68.0 65.2 66.7 74.4 83.0 81.2 80.3 78.7

France 66.8 64.1 64.2 68.2 79.2 82.3 86.0 90.5 91.9

Italy 105.4 106.1 103.1 105.8 115.5 118.4 120.1 126.6 127.0

Spain

Other eurozone*

43.1 39.6 36.2 40.2 53.9 61.2 68.5 81.3 86.1

Austria 64.2 62.3 60.2 63.8 69.5 71.9 72.2 74.2 74.3

Belgium 92.0 88.0 84.1 89.3 95.8 96.0 98.0 100.5 100.8

Cyprus 69.4 64.7 58.8 48.9 58.5 61.5 71.6 76.5 78.1

Estonia 4.6 4.4 3.7 4.5 7.2 6.7 6.0 10.4 11.7

Finland 41.7 39.6 35.2 33.9 43.5 48.4 48.6 50.5 51.7

Greece 101.2 107.3 107.4 113.0 129.4 145.0 165.3 160.6 168.0

Ireland 27.2 24.7 24.8 44.2 65.1 92.5 108.2 116.1 120.2

Luxembourg 6.1 6.7 6.7 13.7 14.8 19.1 18.2 20.3 21.6

Malta 69.7 64.4 62.3 62.3 68.1 69.4 72.0 74.8 75.2

Netherlands 51.8 47.4 45.3 58.5 60.8 62.9 65.2 70.1 73.0

Portugal 62.5 63.7 68.3 71.6 83.1 93.3 107.8 113.9 117.1

Slovakia 34.2 30.5 29.6 27.9 35.6 41.1 43.3 49.7 53.5

Slovenia

Other Western Europe

26.7 26.4 23.1 21.9 35.3 38.8 47.6 54.7 58.1

United Kingdom** 42.5 43.4 44.4 54.8 69.6 79.6 85.7 91.2 94.6

Norway 44.5 55.4 51.5 48.2 43.5 43.7 39.7 36.6 33.2

Sweden 50.4 45.0 40.2 38.8 42.6 39.3 38.3 38.0 37.5

Switzerland 51.6 47.4 44.7 43.0 41.5 40.5 42.3 42.3 42.0

Denmark*

Other Europe

37.8 32.1 27.5 33.4 40.6 42.9 46.5 40.9 42.1

Hungary 61.7 65.9 67.1 72.9 79.7 81.3 80.6 76.0 75.0

Poland 47.1 47.7 45.0 47.1 50.9 54.9 56.0 55.0 54.0

Romania 15.8 12.4 12.8 13.4 23.6 31.0 33.0 36.0 36.0

Turkey 52.7 46.5 39.9 40.0 46.1 42.4 39.4 37.0 35.0

Czech Republic 28.4 28.3 27.9 28.7 34.4 38.1 41.2 44.0 45.0

Bulgaria* 27.5 21.6 17.2 13.7 14.6 16.3 16.3 17.6 18.5

Latvia* 12.5 10.7 9.0 19.8 36.7 44.7 42.6 43.5 44.7

Lithuania* 18.3 17.9 16.8 15.5 29.4 38.0 38.5 40.4 40.9

Russia 14.9 8.8 8.7 6.6 10.2 11.6 11.5 12.1 12.7

Note: *European Commission Spring 2012 forecasts for 2011, 2012 and 2013 **HSBC forecasts for the UK are calculated based on net debt, therefore for comparison purposes we have used European Commission forecasts

Source: HSBC estimates, European Commission Spring 2012 forecasts

Debt levels are way above the Maastricht threshold of 60% of GDP... ...in most EU countries

%GDP

200

150

100

Germany

France

Italy

Spain

Greece

Ireland

Portugal

2011 2012f 2013f

%GDP

200

150

100

%GDP

180

150

120

Source: HSBC estimates, European Commission Spring 2012 forecasts Source: HSBC, European Commission

EMU

2011

%GDP

180

150

120

Macro

European Economics

Q4 2012

Unemployment

Unemployment rate

% 2005 2006 2007 2008 2009 2010 2011 2012f 2013f

Eurozone 9.2 8.5 7.6 7.7 9.6 10.1 10.2 11.4 12.1

Germany 11.7 10.8 9.0 7.8 8.1 7.7 7.1 6.8 6.7

France 9.3 9.3 8.4 7.8 9.5 9.8 9.7 10.2 10.5

Italy 7.7 6.8 6.5 6.8 7.8 8.4 8.4 10.6 11.5

Spain

Other eurozone*

9.2 8.5 8.3 11.4 18.0 20.1 21.7 25.0 27.2

Austria 5.2 4.8 4.4 3.8 4.8 4.4 4.2 4.3 4.2

Belgium 8.5 8.3 7.5 7.0 7.9 8.3 7.2 7.6 7.9

Cyprus 5.3 4.6 3.9 3.7 5.3 6.2 7.8 9.8 9.9

Estonia 7.9 5.9 4.7 5.5 13.8 16.9 12.5 11.6 10.5

Finland 8.4 7.7 6.9 6.4 8.2 8.4 7.8 7.9 7.7

Greece 9.9 8.9 8.3 7.7 9.5 12.6 17.7 19.7 19.6

Ireland 4.4 4.5 4.6 6.3 11.9 13.7 14.4 14.3 13.6

Luxembourg 4.6 4.6 4.2 4.9 5.1 4.6 4.8 5.2 5.9

Malta 7.3 6.9 6.5 6.0 6.9 6.9 6.5 6.6 6.3

Netherlands 5.3 4.4 3.6 3.1 3.7 4.5 4.4 5.7 6.2

Portugal 8.6 8.6 8.9 8.5 10.6 12.0 12.9 15.5 15.1

Slovakia 16.3 13.4 11.1 9.5 12.0 14.4 13.5 13.2 12.7

Slovenia

Other Western Europe

6.5 6.0 4.9 4.4 5.9 7.3 8.2 9.1 9.4

UK 4.8 5.4 5.3 5.6 7.6 7.8 8.1 8.1 8.2

Norway 3.5 2.6 1.9 1.7 2.7 2.9 2.7 2.5 2.3

Sweden 7.6 6.6 6.1 6.7 8.7 7.9 7.5 8.1 7.5

Switzerland 3.8 3.3 2.8 2.6 3.7 3.5 2.8 2.9 3.1

Denmark*

Other Europe

4.8 3.9 3.8 3.4 6.0 7.5 7.6 7.7 7.6

Hungary 7.3 7.5 7.7 8.0 10.5 10.8 10.7 11.1 10.9

Poland 17.6 14.8 11.2 9.5 12.1 12.4 12.5 13.0 13.0

Romania 5.9 5.2 4.1 4.4 7.8 6.9 5.1 5.0 5.0

Turkey 10.3 9.9 9.9 13.6 13.7 11.4 9.8 10.0 9.0

Czech Republic 8.9 7.7 6.0 6.0 9.2 9.6 8.6 8.8 8.8

Bulgaria* 10.1 9.0 6.9 5.6 6.8 10.2 11.2 12.0 11.9

Latvia* 8.9 6.8 6.0 7.5 17.1 18.7 16.1 14.8 13.2

Lithuania* 8.3 5.6 4.3 5.8 13.7 17.8 15.4 13.8 12.7

Russia 7.6 6.9 6.1 7.8 8.2 7.2 6.1 5.8 5.7

Note: *European Commission Spring 2012 forecasts for 2011, 2012 and 2013

Source: HSBC estimates, European Commission Spring 2012 forecasts

Diverging unemployment between largest member states Spanish unemployment highest in Europe

05 06 07 08 09 10 11 12f 13f

Eurozone Germany France Ital y Spain

Source: HSBC estimates, European Commission Spring 2012 forecasts Source: HSBC, European Commission

EMU

2011

Macro

European Economics

Q4 2012

Demographics

Changes in population of working age in each decade

% 1990-00 2000-10 2010-20f 2020-30f 2030-40f 2040-50f

Eurozone 0.3 0.4 -1.9 -4.6 -5.8 -3.7

Germany 0.2 -0.3 -5.1 -10.6 -7.7 -4.3

France 0.3 0.7 -0.3 0.2 0.3 2.1

Italy -0.1 0.3 -2.3 -5.4 -9.8 -5.3

Spain

Other eurozone

0.7 1.4 1.8 -1.0 -7.2 -7.7

Austria 0.4 0.5 -0.4 -6.7 -6.8 -3.6

Belgium 0.1 0.5 -1.5 -2.7 -1.9 0.4

Cyprus 2.4 2.2 8.6 2.8 0.1 -6.8

Estonia -1.2 0.0 -7.0 -3.9 -3.6 -7.9

Finland 0.3 0.3 -5.5 -2.9 0.2 -1.3

Greece 0.9 0.2 -1.7 -2.4 -6.3 -6.3

Ireland 1.6 2.0 5.9 7.1 2.6 0.0

Luxembourg 1.0 1.6 12.7 5.1 2.4 0.2

Malta 1.0 1.3 -4.4 -4.9 -2.6 -7.6

Netherlands 0.5 0.3 -2.1 -5.4 -5.2 0.4

Portugal 0.5 0.4 -2.3 -7.2 -11.7 -12.4

Slovakia 0.7 0.7 -4.5 -5.2 -4.8 -11.0

Slovenia

Other Western Europe

0.3 0.3 -5.2 -5.5 -5.5 -7.8

UK 0.2 0.7 2.2 1.6 0.5 0.8

Norway 0.6 1.1 2.3 2.0 0.6 3.8

Sweden 0.4 0.7 -0.6 2.0 1.0 1.2

Switzerland 0.5 0.9 -0.9 -5.4 -7.5 -4.7

Denmark

Other Europe

0.3 0.2 -0.5 -1.9 -2.5 0.8

Hungary 0.0 -0.1 -6.4 -3.4 -5.3 -7.5

Poland 0.5 0.4 -7.5 -6.4 -3.7 -12.0

Romania 0.0 -0.2 -5.9 -4.6 -10.0 -12.2

Turkey 2.4 2.0 13.2 7.3 1.9 -3.3

Czech Republic 0.5 0.5 -7.1 -1.1 -3.3 -8.8

Bulgaria -0.7 -0.5 -12.1 -9.4 -12.1 -15.3

Latvia -1.1 -0.2 -8.4 -7.2 -5.5 -10.1

Lithuania -0.6 -0.1 -7.2 -9.2 -5.4 -7.6

Russia 0.1 0.2 -7.7 -6.8 -4.6 -10.6

Source: World Bank, UN population estimates

Significant declines in working population over the next two decades Ageing populations are an issue across the whole of Europe

% change

-3

-6

-9

-12

1990-00

2000-10

2010-20

2020-30

2030-40

2040-50

Germany France Italy Spain

% change

-3

-6

-9

-12

-10

-20

-30

-40

-50

-60

Source: UN population estimates Source: World Bank, UN population estimates

% change in w orking population betw een now and 2050

-10

-20

-30

-40

-50

-60

Macro

European Economics

Q4 2012

Economic infrastructure

Nominal GDP Population GDP per capita Average years

male schooling*

Life

expectancy*

Fertility*

(average child

per person)

Tax revenue* Government

spending

2011 EURbn Persons, million EUR Years Years Children % GDP % GDP

Eurozone 9410 333 28,258 10.5 81 1.6 24.5 21.5

Germany 2567 82 31,413 11.8 80 1.4 22.3 19.5

France 1995 65 30,494 10.5 81 2.0 25.8 24.5

Italy 1581 61 26,013 9.5 82 1.4 28.7 20.5

Spain

Other eurozone*

1073 46 23,216 10.4 82 1.4 20.2 20.3

Austria 300 8 35,673 9.5 80 1.4 27.2 18.8

Belgium 370 11 33,605 10.5 80 1.8 29.1 24.1

Cyprus 18 1 15,915 10.1 79 1.5 26.6 19.4

Estonia 16 1 11,918 11.8 75 1.6 20.7 19.5

Finland 189 5 35,133 10.0 80 1.9 29.4 24.3

Greece** 230 11 20,376 10.7 80 1.4 19.8 17.5

Ireland 159 4 35,436 11.6 80 2.1 22.1 18.3

Luxembourg 43 1 82,843 10.1 80 1.6 26.1 16.5

Malta 6 0 15,339 10.2 81 1.4 26.9 21

Netherlands 602 17 36,079 11.0 81 1.8 24.3 28.1

Portugal 171 11 16,069 8.0 79 1.3 22.2 20.1

Slovakia 69 5 12,695 11.2 75 1.4 15.5 18.1

Slovenia

Other Western Europe

36 2 17,349 11.7 79 1.6 22.6 20.6

UK 1747 63 27,895 9.8 80 1.9 28.6 22.4

Norway 349 5 70,485 12.3 81 2.0 33.3 21.5

Sweden 387 9 40,917 11.6 81 2.0 37.4 26.6

Switzerland 459 8 58,102 9.9 82 1.5 22.4 11

Denmark

Other Europe

239 6 42,919 10.1 79 1.9 46.5 28.6

Hungary 101 10 10,143 11.7 74 1.3 25.4 20.8

Poland 370 38 9,681 9.9 76 1.4 20.6 18.1

Romania 136 21 6,367 10.4 73 1.4 18.3 14.4

Turkey 554 74 7,519 7.0 74 2.1 20.5 14

Czech Republic 155 11 14,677 12.1 77 1.5 18.2 20.9

Bulgaria 38 7 5,148 9.9 74 1.5 20.1 15.5

Latvia 20 2 9,018 10.6 73 1.2 18.7 16.2

Lithuania 31 3 9,585 10.9 73 1.6 16.5 18.9

Russia 1343 142 9,460 11.5 69 1.5 17.0 17.9

Note: * 2010 data, **Greece 2010 Nominal GDP

Source: Eurostat, World Bank, www.barrolee.com, World in 2050: From the Top 30 to the Top 100, Karen Ward, HSBC, 11 January 2012, Russian Federal Tax Agency

Population (millions, 2011) GDP per capita (EUR thousands, 2011)

0 10 20 30 40 50 60 70 80 90

Persons, m n

EUR th

Source: World Bank Note: *Greece GDP 2010 data

Source: Eurostat, World Bank

EMU

GR*

2011

EURth

Macro

European Economics

Q4 2012

Eurozone

Breathing space

The ECB has announced a framework that

could provide a backstop for the eurozone as

long as governments deliver on their side of the

bargain. By committing to buy unlimited

amounts of government bonds through its OMT

(Outright Monetary Transactions) programme,

the ECB can try to address the "convertibility"

(euro break-up) risk while governments attempt

to lower their credit risk by undertaking

structural reforms and fiscal consolidation. But

the ECB can’t purchase any bonds until a

country requests an EFSF/ESM programme, and

with spreads having narrowed sharply, the

Spanish government appears in no hurry to ask.

Even once Spain goes into a programme (most

likely in October) and the ECB starts buying

bonds, the long-term sustainability of the euro

% Year

will hinge on the debtor countries’ ability to

meet the conditions of their programmes and the

willingness of all of the member states to make

further progress on the roadmap for future

financial sector integration and fiscal

centralisation. Already the likely timing for a

banking union appears set to be delayed.

Meanwhile the growth picture remains

worrying. The eurozone was a little more

resilient than we had expected in H1 2012,

thanks to net exports which offset a domestic

contraction, but our GDP forecast remains

unchanged at -0.6% for 2012 as we now expect

the external environment to be a little weaker in

H2. Our 2013 forecast has also edged down

further, with virtually all of the mild upturn

expected to come from a gradual export revival.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 0.1 -0.8 -0.2 -1.0 -0.6 -0.5 -0.2 -0.1 0.2

Government consumption -0.1 0.1 -0.8 0.2 0.0 -0.4 -0.8 -0.9 -0.9

Fixed investment 1.6 -3.3 -1.5 -3.7 -4.0 -2.9 -2.2 -0.9 0.1

Final domestic demand 0.3 -1.1 -0.6 -1.3 -1.1 -0.9 -0.8 -0.4 -0.1

Stockbuilding (% GDP) 0.1 -0.1 -0.3 -0.2 -0.3 -0.3 -0.3 -0.2 -0.3

Domestic demand 0.5 -1.3 -0.7 -1.5 -1.4 -1.3 -1.1 -0.5 -0.1

Exports 6.3 2.5 2.5 1.8 2.1 2.0 1.5 2.7 3.7

Imports 4.1 -0.3 1.5 -0.6 0.8 1.3 1.0 1.5 2.3

GDP 1.5 -0.6 -0.1 -0.9 -0.8 -0.8 -0.5 0.1 0.7

GDP (% quarter) - - - -0.3 -0.3 0.0 0.1 0.2 0.3

Industrial production 3.4 -2.0 1.1 -2.9 -1.0 -0.1 1.0 1.4 2.2

Unemployment (%) 10.2 11.4 12.1 11.7 11.8 12.0 12.1 12.2 12.3

Wages 2.5 2.1 2.1 2.4 2.3 2.2 2.1 2.0 1.9

Inflation 2.7 2.5 1.8 2.5 2.4 1.9 1.9 1.8 1.7

M3 2.1 3.4 3.0 3.2 3.9 3.5 3.3 2.6 2.8

Current account (% GDP) -0.0 0.5 0.5 - - - - - -

Budget balance (% GDP) -4.6 -3.9 -3.2 - - - - - -

Debt (% GDP) 89.3 91.9 93.5 - - - - - -

ECB refi rate* 1.00 0.50 0.50 0.75 0.50 0.50 0.50 0.50 0.50

3-month money (%) 1.3 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

10-year bond yield (%)** 3.7 3.0 2.6 3.1 3.0 2.9 2.7 2.6 2.6

USD/EUR 1.30 1.35 1.40 1.30 1.35 1.37 1.38 1.39 1.40

Note. * = Period-end; ** = Weighted average of big 4, period-end

Source: Thomson Reuters Datastream, HSBC estimates

Janet Henry

Economist

HSBC Bank plc

+44 20 7991 6711

janet.henry@hsbcib.com

Macro

European Economics

Q4 2012

Promise of ECB action has caused rates to converge... … but the ECB can only buy time

% 10yr Bond yields

07 08 09 10 11 12

Eurozone Germany Spain

Source: Thomson Reuters Datastream

Since ECB head, Mario Draghi committed to do

whatever it takes to preserve the euro there has been a

significant convergence of eurozone government bond

yields.

The ECB can provide a backstop for the eurozone as

long as governments deliver on their side of the bargain.

The ECB can try to address the "convertibility" (euro

break-up) risk, while governments attempt to lower their

credit risk by undertaking structural reforms and fiscal

consolidation.

Governments will also need to show convincing

progress in drawing up a credible roadmap and timeline

for future financial sector and fiscal integration.

Despite the LTRO, loan growth continues to weaken… … and country divergences persist

EURbn, 3m sum Eurozone EURbn, 3m sum

200

150

100

-50

-100

Source: ECB

04 05 06 07 08 09 10 11 12

Corporate loan flow Household loan flow

150

100

-50

-100

Recent monetary growth has revived a little, with M3

accelerating to 3.8% from 3.2% in June.

However, loan growth remains extremely weak with no

evidence that the three-year LTROs have found their way

into an improving availability of credit. Household loan

growth has slowed to 1.1% y-o-y and corporate sector

lending to -0.2%. The monthly flows were also still falling.

The positive financial market response to the ECB’s OMT

programme should help to improve confidence, but the

country divergence in lending activity is set to persist

given the recessions and banking sector restructurings in

the periphery. Spain’s loan growth slowed to -5% y-o-y in

July while Germany’s has revived to 1.8%.

The contraction in GDP... … does not fully reflect how weak the economy is

Index % Qtr

99 00 01 02 03 04 05 06 07 08 09 10 11 12

Eurozone composite PMI output (LHS)

Eurozone GDP (RHS)

Source: Markit, Eurostat

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5

-2.0

-2.5

-3.0

Despite the upside surprises to German and French

GDP, eurozone GDP contracted by 0.2% q-o-q in Q2 as

the recessions elsewhere in the eurozone intensified.

Growth was still supported in Q2 by exports, particularly

to non-eurozone countries, such as China, but the world

trade cycle is now showing a more marked weakening.

This is likely to take a greater toll on the German and

eurozone industrial sectors in the coming months.

Despite the ECB’s planned OMT we still expect a

continued contraction in H2 2012, and, with official

growth forecasts for 2012-13 likely to be revised down

further, more questions will be raised about whether

member states can realistically expect to meet their

fiscal targets.

Macro

European Economics

Q4 2012

Germany

Cracks beneath the surface

While hard German economic data, such as industrial

orders and production, have held up remarkably well

recently, there are some cracks beneath the surface.

The intensifying crisis in the eurozone has already

left its mark on ifo export expectations, which in

September fell to its lowest level since July 2009. Net

exports, a substantial driver of GDP growth in H1

2012, will, in our view, fail to support in H2. This

also has negative implications for business fixed

investment for which growth has already declined in

the last two quarters. The outlook for companies in

the capital goods sector has deteriorated substantially

as a result of falling capacity utilisation in the

manufacturing sector, hinting at lower capital

spending ahead, despite favourable financing

conditions. Consequently, the willingness to hire has

receded further, pointing towards slow or no growth

in employment in future.

% Year

Nonetheless, with employment marking a postreunification

record high, and wages and salaries

showing y-o-y growth rates of almost 4%,

consumption should continue to contribute positively

to growth. Buying intentions (a subcomponent of

GfK consumer climate) largely maintained their

elevated level over the last couple of months.

Disposable income should receive a further boost

from a cut in the contribution rates for pension

insurance from 19.6% to 19.0% to take place in

January 2013.

Due to the strong first half, our 2012 full-year GDP

growth forecast of 0.9% looks achievable. Even so,

the combination of weaker net exports and business

fixed investment should lead to stagnation in the

second half. Even if we pencil in a rebound in

activity starting in Q1, the lower than anticipated

base makes cutting our growth forecast for 2013

from 1.5% to 0.9% necessary.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 1.7 0.9 1.2 0.4 1.0 1.2 1.1 1.2 1.2

Government consumption 1.0 1.1 0.7 1.1 0.7 0.7 0.7 0.7 0.8

Investment 6.4 -1.4 -0.0 -2.1 -3.2 -2.1 -0.8 0.9 1.9

Machinery & equipment 7.2 -3.6 -2.1 -6.3 -7.5 -6.6 -4.0 -0.0 2.5

Construction 6.0 0.1 1.2 1.1 0.2 1.2 1.7 1.1 0.8

Stockbuilding (% GDP) 1.6 0.9 0.5 0.6 0.5 0.5 0.5 0.4 0.4

Domestic demand 2.8 -0.2 0.3 -0.9 -0.9 -0.5 -0.2 0.8 1.2

Exports 7.9 3.9 2.9 3.1 3.5 2.7 1.2 2.9 4.6

Imports 7.5 2.9 3.3 2.2 2.7 3.5 2.3 2.9 4.4

GDP 3.1 0.9 0.9 0.6 0.7 0.4 0.5 1.0 1.5

GDP (% quarter) - - - 0.0 -0.1 0.3 0.3 0.5 0.5

Industrial production 8.0 0.1 2.3 -0.9 1.1 2.1 2.7 2.2 2.4

Unemployment (%) 7.1 6.8 6.7 6.8 6.8 6.7 6.7 6.7 6.7

Average earnings 1.7 2.6 3.2 3.0 3.0 3.1 3.1 3.2 3.2

Producer prices 5.7 2.0 2.0 1.1 1.6 1.4 1.6 2.4 2.4

Consumer prices 2.5 2.1 2.1 2.1 1.9 1.8 2.1 2.2 2.1

Current account (EURbn) 146.6 150.9 144.0 27.0 45.2 39.0 35.0 28.0 42.0

Current account (% GDP) 5.7 5.7 5.3 4.1 6.8 5.8 5.1 4.1 6.1

Budget balance (% GDP) -1.0 -0.8 -0.6 - - - - - -

3-month money (%)* 1.3 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

10-year bond yield (%)* 1.9 1.5 1.2 1.5 1.5 1.4 1.3 1.2 1.2

Note: * = Period-end

Source: Thomson Reuters Datastream, HSBC estimates

Stefan Schilbe

Economist

HSBC Trinkaus & Burkhardt AG

+49 211910 3137

stefan.schilbe@hsbc.de

Rainer Sartoris

Economist

HSBC Trinkaus & Burkhardt AG

+49 211910 2470

rainer.sartoris@hsbc.de

Macro

European Economics

Q4 2012

Weakening global trade to undermine German exports Exports

-10

-20

-30

01 02 03 04 05 06 07 08 09 10 11 12

German ex ports (LHS)

Global manufacturing PM I - new ex port orders* (RHS)

Source: Macrobond, HSBC

Note: *After 3 months

Index

Capital goods sector feels the crisis Investment

-15

-30

-45

-60

95 97 99 01 03 05 07 09 11

-20

-40

IFO capital goods sector - ex pectations for production

acitiv ity in the nex t 3 mo nths

Business fix ed inv estme nt

Source: Macrobond, HSBC

Money is cheap Financing conditions

% Interest rates for new non-financial corporate loans*

03 04 05 06 07 08 09 10 11 12

Spain Germany Italy France

Source: Macrobond, HSBC

Note: *Loans over 5 years, up to EUR1mn

The outlook for German exports has clearly deteriorated: the

‘new exports orders’ component of the global manufacturing

PMI has fallen to its lowest level since April 2009. The main

culprit is the deep recession in some eurozone countries, but

demand from non-eurozone economies has also begun to

fade notably.

The current level is consistent with a falling annual export

growth rate, a view that is supported by the more pessimistic

export expectations of companies questioned by ifo.

Further progress in the labour market will be difficult to

achieve as a consequence – the unemployment rate clearly

shows signs of bottoming out.

The more negative export outlook is starting to filter through

into investment companies’ spending behaviour: Firms´

assessment of the next three months in the capital goods

sector has fallen sharply, indicating negative yearly business

fixed investment rates ahead.

Capacity utilisation rates fell from 84.5% to 83.2% in Q3

2012, undershooting the long-term average for the first time

since Q4 2010.

As leading indicators in manufacturing business show no

signs of stabilisation yet, companies will be reluctant to

expand capacity.

Financing conditions for German companies (and

households) as a result of a loose monetary policy are

extremely favourable on a nominal and real basis, especially

when compared to countries like Italy and Spain.

Despite an intensifying debt crisis in the eurozone, the

Bundesbank lending survey and the ifo credit hurdle do not

point to restrictive lending behaviour by banks in Germany.

Given that key interest rates in the eurozone are likely to stay

extremely low for a prolonged time, credit growth should pick

up sharply in Germany, if and when signs of a global

recovery emerge, thus supporting business fixed investment

as well as residential investment.

Macro

European Economics

Q4 2012

France

Neither recession nor growth?

GDP is likely to remain stable in H2 2012, as it

was in H1 2012. Indeed, we expect a rise in

consumer spending in Q3 and Q4 2012, boosted

by a 25% rise in the allowance for children going

back to school in August and by a 2% hike in the

minimum wage on 1 July. In addition, the savings

rate could drop slightly after the presidential

elections as after previous presidential elections.

That said, we forecast weak growth in consumer

spending in 2013 because income tax will hike

and because the unemployment rate should

continue to rise until the beginning of 2013.

Moreover, industrial production could continue to

fall in H2 2012, as business investment declines;

the recession in southern Europe is hitting

exports, and the fall in the capacity utilisation rate

to 77% in August, from an average of 80% in

2011, will weigh on business investment.

% Year

In 2013, the tax hikes to be introduced to meet the

target of a public deficit of 3% of GDP in 2013,

despite the downward revision in GDP growth

forecasts, will shave 0.3pp off growth in gross

disposable income on our calculations. But at the

same time, social benefits will continue to grow,

as there is no target of cutting public spending,

merely of restricting its real growth (to 0.8% in

2013 from 2.3% per year before the crisis).

We also assume that France will adjust its position

on fiscal integration and come to an agreement with

Germany on giving the European Commission the

power of prior approval of all budget proposals,

and not just in the case of excessive deficit

procedures. If such an agreement is reached, the

uncertainty created by the lack of institutional

clarification will be reduced, improving the

prospects for economic activity and investment.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 0.2 0.1 0.5 0.2 0.4 0.3 0.7 0.5 0.6

Government consumption 0.2 1.2 0.9 1.3 1.4 1.1 0.8 0.8 0.8

Investment 3.5 0.6 1.8 0.6 -0.8 0.7 0.9 2.3 3.4

Stockbuilding (% GDP) 0.4 -0.2 0.0 -0.1 -0.2 -0.1 -0.0 0.1 0.2

Domestic demand 1.7 -0.1 1.1 -0.0 0.8 0.9 0.9 1.1 1.5

Exports 5.5 2.6 3.2 2.1 1.4 2.2 3.0 3.5 4.1

Imports 5.2 1.4 3.6 1.7 3.9 4.1 3.2 3.3 3.9

GDP 1.7 0.2 0.9 0.0 0.1 0.4 0.8 1.1 1.5

GDP (% quarter) - - - 0.0 0.0 0.3 0.4 0.4 0.4

Manufacturing output 3.1 -2.4 0.5 -2.6 -1.4 -0.4 0.7 0.6 0.9

Unemployment (%) 9.7 10.2 10.5 10.4 10.4 10.5 10.5 10.4 10.4

Average earnings 2.2 2.3 2.5 2.4 2.5 2.3 2.5 2.5 2.5

Consumer prices 2.3 2.3 1.8 2.3 2.1 1.8 1.7 1.8 1.7

Trade account (EURbn) -72.2 -69.9 -68.5 -17.0 -17.2 -16.9 -17.0 -17.2 -17.4

Current account (% GDP) -2.0 -2.2 -2.1 -2.2 -2.2 -2.1 -2.1 -2.1 -2.2

Budget balance (% GDP) -5.2 -4.5 -3.5 - - - - - -

3-month money (%)* 1.3 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

10-year bond yield (%)* 3.1 2.0 1.6 2.2 2.0 1.9 1.7 1.6 1.6

Note: * = Period end

Source: Thomson Reuters Datastream, HSBC estimates

Mathilde Lemoine

Economist

HSBC France

+33 1 40 70 32 66

mathilde.lemoine@hsbc.fr

Macro

European Economics

Q4 2012

France’s small open economy and the scale of

economic stabilisers...

%Yr %Yr

-2

-4

-6

-8

00 01 02 03 04 05 06 07 08 09 10 11 12

Germany: GDP growth (LHS)

France: GDP growth (LHS)

Sources: Destatis, INSEE, HSBC

-2

-4

-6

-8

... should help avoid a fall in consumer spending in

2013, despite higher taxes

Exports account for only 27% of French GDP, compared

to 50% in Germany, limiting the impact of the slowdown

in world trade on final domestic demand.

Moreover, public spending represented 56% of GDP in

2012, and a third of household gross disposable income

(GDI) comes from redistribution. As a result, the impact

of rising unemployment on income is limited. Since the

1990s, during periods of rising unemployment, GDI has

risen by an average of 2.6% y-o-y, compared to an

average of 4% y-o-y during periods of falling

unemployment.

Thus in 2013, on our calculations, the rise in social

benefits could offset the negative impact of tax hikes

(new 45% and 75% income tax bands for incomes

greater than EUR150,000 and EUR1,000,000 a year

respectively).

But the restructuring of the French car industry… … could limit industrial production growth in 2013

Index, 100 = 2000 Index, 100 = 2000

130

120

110

100

00 01 02 03 04 05 06 07 08 09 10 11 12

Sources: INSEE, HSBC

French IP French car production

130

120

110

100

The recession in Italy and Spain will continue to hit exports

to these countries which currently represent 15% of French

exports.

In addition, the positive effect on exports of a 7% decline in

the euro against the dollar between February and July 2012

will start to diminish in Q2 2013.

Lastly, French car makers are involved in a period of

restructuring. According to the OECD, there is 20% excess

capacity in the French auto industry. Moreover, the negative

trade balance in this sector has reduced the need for

production capacity still further. As a result, we expect car

production, which amounts to 8% of industrial production, to

continue to decline by some 11% per year between 2013

and 2015 on our calculations.

France’s acceptance of deeper fiscal integration... ... could clarify the way in which Europe works and

reduce the systemic risk premium

Bps

Sovereign credit default swaps in France, Germany

and the US

Bps

200

150

100

08 09 10 11 12

France Germany US

Sources: Bloomberg, INSEE, HSBC

150

100

Since the beginning of the crisis, we consider that

institutional clarification is essential to allow the eurozone to

function properly. This clarification includes the acceptance

by Europeans of the existence of supra-national decisions

that are applicable at the national level for banking, fiscal

and economic topics.

However, the Spanish Prime Minister is prevaricating on a

clean-up in the banking industry, limiting the scope of any

agreement on banking union. And France, to date, has

resisted a transfer of sovereignty over fiscal policy.

Significant moves in these two countries could boost a

European desire to introduce the reforms that would allow

the eurozone to function. Therefore, the eurozone systemic

risk premium could decrease and drive business investment

and stockbuilding.

Macro

European Economics

Q4 2012

Italy

Going it alone

The Italian government bond market has already

benefited greatly from the ECB’s announcement

that it is willing to undertake unlimited bond

purchases. Ten-year yields are now hovering just

above 5.2%, well down from their late July peak of

6.6%. The market is currently waiting for Spain to

request a precautionary EFSF/ESM programme

and trigger the ESM programme, but Italy is also

viewed as a potential candidate for requiring such

assistance in the coming months.

The budget deficit is much smaller than that of

Spain: even with a deep contraction in GDP of

about 2.5% in 2012 Italy’s budget deficit should

come in below 3% of GDP. But, given the size of

its debt stock and low potential growth rate, this

level of borrowing costs means Italy still faces

enormous challenges. The negative impact that

austerity is already having on the economy means

that the Prime Minister, Mario Monti, will continue

% Year

to resist any calls for more aggressive fiscal

consolidation, and will therefore remain very

reluctant to submit to EFSF/ESM conditionality.

The various tax increases have lifted inflation

above 3.5% for much of this year, implying a

severe squeeze on real wages at a time when the

unemployment rate is rising to new highs (10.7% in

July). Hence the contraction in consumer spending

has deepened, and the latest indicators show little

sign that spending will see an upturn any time soon.

We expect Mr Monti to continue with the various

reforms to raise long-term potential growth, which

should help to reassure the market. Nonetheless,

the elections looming in April 2013 could lead to

some political uncertainty and mean that some kind

of precautionary programme for Italy cannot be

ruled out.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 0.2 -3.4 -1.3 -3.8 -3.3 -2.5 -1.6 -0.9 -0.4

Government consumption -0.9 -1.0 -1.5 -0.8 -0.6 -1.1 -1.7 -1.6 -1.6

Investment -1.2 -9.4 -4.8 -10.8 -10.0 -7.6 -6.2 -3.6 -1.6

Stockbuilding (% GDP) -0.6 -0.9 0.3 -0.8 -0.7 -0.6 -0.6 -0.5 -0.5

Domestic demand -0.8 -4.9 -1.7 -5.1 -4.3 -2.8 -2.0 -1.3 -0.7

Exports 6.3 0.5 1.4 -0.6 -0.5 0.5 0.9 1.7 2.5

Imports 1.0 -7.3 -0.8 -7.0 -4.8 -1.2 -1.0 -0.7 -0.3

GDP 0.5 -2.5 -1.1 -3.1 -2.9 -2.3 -1.4 -0.6 0.1

GDP (% quarter) - - - -0.7 -0.5 -0.2 0.0 0.1 0.2

Industrial production 0.3 -6.7 -1.5 -7.8 -5.7 -3.6 -2.0 -0.6 0.3

Unemployment (%) 8.4 10.6 11.5 10.8 11.1 11.3 11.4 11.5 11.6

Hourly wage rate 1.8 1.4 1.4 1.5 1.4 1.4 1.4 1.4 1.3

Consumer prices 2.9 3.4 2.3 3.3 3.1 2.5 1.8 2.5 2.3

Current account (EURbn) -51.5 -20.5 -17.0 -4.0 -2.0 -12.0 -1.0 -3.0 -1.0

Current account (% GDP) -3.3 -1.3 -1.1 -1.0 -0.5 -3.1 -0.3 -0.8 -0.3

Budget balance (% GDP)* -3.9 -2.9 -2.3 - - - - - -

3-month money (%)** 1.3 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

10-year bond yield (%)** 6.4 5.0 4.5 5.2 5.0 4.8 4.7 4.6 4.5

Note: * = National measure ** = Period-end

Source: Thomson Reuters Datastream and HSBC estimates

Janet Henry

Economist

HSBC Bank plc

+44 20 7991 6711

janet.henry@hsbcib.com

Macro

European Economics

Q4 2012

Sharp fall in yields... ...in response to ECB’s plans

% Italian 2y r Bond Yields

Source: Bloomberg

Italian bond yields have fallen sharply since ECB head,

Mario Draghi, committed to do “whatever it takes” to

preserve the euro.

Italy has given no indication that it intends to request an

EFSF/ESM programme which could be needed for the

ECB to start buying Italian government bonds. The rally

has allowed the government to tap the market at much

more reasonable rates. It raised EUR4bn of 10-year

bonds on 3 September at about 5% and around

EUR1.5bn of 3 and 9-year inflation linked bonds on 25

September at 2.46% and 3.68% respectively.

While the caretaker government of Mario Monti will be

very reluctant to submit to EFSF/ESM conditionality, the

elections due to be held in April 2013 could lead to some

political uncertainty and mean that some kind of

precautionary programme cannot be ruled out.

The recession is deepening... ...with consumption and investment falling sharply

% Contribution to % Yr Growth

-1

-2

-3

-4

-5

Q1 10 Q3 10 Q1 11 Q3 11 Q1 12

Priv con Govt cons Investment Net exports

Source: Bank of Italy, Thomson Reuters Datastream

The recession in Italy continues, with GDP contracting by

a further 0.8% q-o-q in Q2 following the 0.8% fall in Q1

and 0.7% q-o-q drop in Q4.

Overall GDP fell 2.6% y-o-y in Q2, but the domestic

situation is even weaker, with consumer spending falling

3.6% y-o-y and investment down 9.5% y-o-y.

The caretaker government of Mario Monti is pressing

ahead with implementing the required reforms to raise

long-term potential growth, but will resist any pressure to

deliver even more austerity. This is just one of the

reasons why he will wish to avoid requesting

EFSF/ESM/ECB assistance if he can.

Inflation has been very sticky... ...and further VAT rises will squeeze wages further

% Yr

-1

-2

-3

Italy

05 06 07 08 09 10 11 12

% Yr

-1

-2

-3

HICP (LHS) Nominal wages (RHS)

Real wages (RHS)

Source: Eurostat, Istat

3y r LTROs announced

SMP starts

Draghi commits

to do "w hatev er

it takes"

Jan 11 Jul 11 Jan 12 Jul 12

Italy has been registering one of the highest rates of

inflation in the eurozone over the past year, because of

methodological changes and VAT increases, as well as

the higher energy prices which have impacted on all of

the eurozone.

With rising unemployment keeping a lid on nominal wage

growth, this rise in inflation has contributed to a very

sharp squeeze on real wages and contracting consumer

spending.

Assuming stable energy prices, inflation has now peaked,

and should slow steadily, but, the further 2% rise in VAT

planned for July 2013 means inflation is unlikely to slow

below 2%, implying real wage growth will remain

negative.

Macro

European Economics

Q4 2012

Spain

A soft bailout

The ECB has opened the door for ‘conditional’

support to the Spanish sovereign, and it appears

only a matter of time before Spain formally

requests assistance. It is clear that the Spanish

government is trying to distinguish itself from

countries that have sought Troika assistance by

outlining a detailed and comprehensive

austerity/reform programme on 27 September (see

page X … Spanish periphery page). This, it hopes,

will be sufficient to appease European partners

who could then offer Spain a more concessionary

(precautionary) form of assistance than a fullscale

Troika programme, which would come with

much stricter conditionality (and loss of face).

While expectations of a soft bailout for Spain

helped calm market sentiment, the real side of the

economy continues to deteriorate. Spanish GDP

growth held up better than we had expected in H1

2012 as net exports grew strongly and the

government delivered less austerity than we had

forecast. This, together with some base effects

resulting from lower 2011 GDP growth, has

implied that the contraction in 2012 will be

shallower than we had previously forecast.

However, this only means that there is more pain

to come next year. The government will have to

step up the implementation of austerity plans once

it asks for assistance, implying a bigger drag from

government spending over the next few quarters.

At the same time, there are clear indications that

the world trade cycle has turned down, implying a

softer contribution to growth from net exports.

While tail risks relating to Spain have ebbed, the

focus over the coming quarters will increasingly turn

to how politicians and trade unions react to the

deepening recession and rising unemployment,

which in turn could call into question the

government’s commitment to reforms.

% Year

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending -1.0 -1.8 -1.8 -2.0 -1.7 -2.5 -1.9 -1.7 -1.2

Government consumption -0.5 -3.1 -4.6 -2.5 -3.4 -4.0 -4.7 -5.0 -4.8

Investment -5.5 -9.4 -7.5 -10.8 -10.1 -9.9 -8.2 -6.8 -4.9

Domestic demand -1.9 -3.7 -4.0 -4.0 -3.8 -4.8 -4.2 -3.8 -3.1

Exports 7.6 1.1 1.7 -0.6 -0.9 1.5 0.6 1.8 2.8

Imports -0.9 -6.2 -2.8 -7.5 -5.9 -4.4 -3.4 -2.1 -1.2

GDP 0.4 -1.5 -2.0 -1.8 -2.1 -2.4 -2.4 -2.0 -1.3

GDP (% quarter) - - - -0.5 -0.8 -0.6 -0.4 -0.2 -0.1

Industrial production -1.4 -5.6 -2.6 -5.9 -3.8 -2.9 -2.0 -2.5 -3.0

Unemployment (%) 21.7 25.0 27.2 25.3 26.0 26.6 27.0 27.3 27.8

Average earnings 2.5 1.0 0.6 0.6 0.6 0.6 0.6 0.6 0.6

Consumer prices 3.1 2.4 2.5 2.7 3.0 2.8 3.2 2.4 1.7

Trade account (EURbn) -46.3 -8.3 -8.3 -7.5 -7.0 -9.0 -8.5 -8.0 -7.5

Current account (EURbn) -37.5 -29.1 -7.1 -4.5 -7.5 -10.5 -7.0 -6.5 -4.5

Current account (% GDP) -3.5 -2.7 -2.7 - - - - - -

Budget balance (% GDP) -8.9 -6.8 -5.0 - - - - - -

3-month money (%)* 1.3 0.2 0.2 0.2 0.2 0.2 0.2 0.2 0.2

10-year bond yield (%)* 5.5 5.8 5.3 6.0 5.8 5.5 5.4 5.3 5.3

Note: * = Period-end

Source: Thomson Reuters Datastream, HSBC estimates

Madhur Jha

Economist

HSBC Bank plc

+44 20 7991 6755

madhur.jha@hsbcib.com

Macro

European Economics

Q4 2012

Net exports… … have been the only source of growth for Spain

%pts Contributio n to GDP

%qtr

1.8

1.2

0.6

0.0

-0.6

-1.2

Q2 11 Q3 11 Q4 11 Q1 12 Q2 12

Consp Gov t GFCF

net trade GDP (RHS)

Source: Thomson Reuters Datastream

0.2

0.0

-0.2

-0.4

-0.6

Government spending proved to be less of a drag in H1

2012 than in H2 2011. However, we expect the drag

from government spending to rise as the government

steps up austerity implementation.

Domestic demand overall remained very weak, though,

as consumer spending fell sharply, more than reversing

the gain seen in Q1 2012.

Net exports added a strong 1.0pp to Q2 2012 GDP, not

only because of a further collapse in imports but also a

recovery in exports. We expect net trade to provide less

support to growth over the next few quarters, with

exports likely to be much softer.

Regional budget performance remains a big concern… … despite the recent improvement

% GDP % GDP

-1

-2

-3

-4.25

Andalucia

Aragon

Asturias

Beleares

Canarias

Cantabria

C-L M

C y L

Cataluna

Ex tremad

Galicia

Madrid

Murcia

Navarra

La Rioja

Valencian

Pais

Total

H1 11 H1 12

Source: MHAP

Note: C-L M refers to Castialla y Leon, C y L refers to Castilla y Leon

-1

-2

-3

Regional governments managed to halve their

deficit/GDP ratios in H1 2012 (-0.8% of GDP) as

compared to H1 2011 (-1.7% of GDP).

While this suggests that regional governments are doing

more to tighten their belts, we hesitate to draw any

conclusions about the full-year fiscal performance as

changes in the way that regions receive transfers from

the central government reduce the comparability of

performance between H1 2011 and H1 2012.

Despite that, Murcia, Extremadura and Navarra face an

uphill battle improving budget positions, with the budget

deficit/GDP ratio already crossing 1.5%, the target for

the year as a whole.

Unemployment set to rise further… …as public sector jobs are cut back too

Index 2005 Q1 =100

120

115

110

105

100

Source: INE

Spain Employ ment

05 06 07 08 09 10 11 12

Public Sector Priv ate sector

120

110

100

Public sector employment continued to grow even up until

2011 even though the private sector has shed jobs rapidly

since the triple crisis hit Spain.

But austerity is forcing cutbacks in employment both at

the central and regional government levels. This is mainly

being achieved through the non-renewal/shedding of

temporary roles

We estimate that the unemployment rate could surpass

30% by end -2013 unless the government is able to push

through more reforms that allow for some of the

adjustment in personnel costs to come through wage

moderation (See Spanish labour reforms: protest or

progress)

Macro

European Economics

Q4 2012

Accepting limitations

GDP fell sharply in Q2 2012, largely due to an extra

Bank Holiday for the Queen’s Jubilee. This was the

third consecutive quarterly contraction, but it should

be the last for a while, and we expect a bounce

back in Q3. However, looking past erratic factors,

underlying growth remains weak. High uncertainty,

tight credit conditions, fiscal consolidation and an

increasingly challenging international

environment continue to restrain activity.

Trade surveys suggest the difficult export conditions

are set to continue, as the Asian and eurozone

markets slow. And with commodity prices putting

upward pressure on inflation and the labour

market remaining weak, there is likely to be little

growth in real wages during 2013. Therefore

consumption is unlikely to drive a strong recovery.

So it seems that 2013 will be another year of very

slow growth. The question is, what can policy do

% Year

about it? Monetary policy is already very loose,

and it will take time to assess the impact of new

credit easing schemes, particularly the untested

Funding for Lending Scheme.

Unfortunately, ever-looser monetary policy is not a

miracle cure for the UK’s economic ills. More QE

entails risks and possibly some negative side-effects.

It is also possible that the incremental benefit may

be waning. Given that policy is already ultraloose,

there may be practical constraints on what

more it can do. We expect no further QE this year.

Fiscal policy is also highly constrained. With low

growth also meaning the public finances may be

getting off-track, the government may find it hard

to meet its own targets without a further tightening

of policy, let alone some form of loosening. So

the UK is in a bind, and may need to accept that

this is still the hangover from the pre-crisis boom

years. There may be limits to what policy can do.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending -1.0 -0.1 1.3 0.6 0.5 0.9 1.5 1.2 1.3

Government consumption 0.1 2.9 0.0 3.3 2.6 0.7 0.5 -0.3 -0.8

Investment -1.3 1.1 4.7 0.6 3.0 2.4 6.7 5.2 4.6

Stockbuilding (%GDP) 0.3 -0.2 -0.2 -1.0 0.0 0.4 -0.8 -0.3 -0.2

Domestic demand -0.5 0.5 1.3 0.2 1.4 1.5 1.3 1.2 1.1

Exports 4.4 0.1 1.5 1.9 -0.8 0.9 2.6 0.9 1.5

Imports 0.5 2.4 1.9 3.5 2.4 3.0 1.7 1.4 1.5

GDP growth 0.8 -0.1 1.1 -0.3 0.4 0.9 1.6 1.0 1.1

GDP % Quarter - - - 0.9 0.3 0.2 0.2 0.3 0.4

Manufacturing output 2.0 -1.0 0.3 -0.6 -0.2 -0.3 0.7 -0.2 1.0

Unemployment rate end-year 8.1 8.1 8.2 8.0 8.3 8.3 8.3 8.2 8.1

Average earnings 2.0 2.0 2.5 2.8 2.1 2.2 2.7 2.5 2.6

RPI 5.2 3.1 2.9 2.9 2.8 2.8 3.0 3.0 2.9

CPI, average 4.5 2.7 2.5 2.4 2.4 2.3 2.6 2.6 2.5

Current account (%GDP) -1.9 -3.0 -3.3 - - - - - -

PSNB (%GDP)* -7.9 -6.6 -7.1 - - - - - -

USD/GBP 1.55 1.60 1.60 1.58 1.60 1.62 1.61 1.60 1.60

GBP/EUR 0.84 0.84 0.88 0.82 0.84 0.85 0.86 0.87 0.88

Base rate (%)** 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50

10-year bond yield 2.1 1.8 2.0 1.7 1.8 1.7 1.6 1.7 2.0

Notes: * = Public borrowing numbers are shown in fiscal years and exclude financial sector interventions ** = Period-end.

Source: Thomson Reuters Datastream, HSBC estimates

Simon Wells

Chief UK Economist

HSBC Bank plc

+44 20 7991 6718

simon.wells@hsbcib.com

Macro

European Economics

Q4 2012

Despite the deficit reduction plan, government

consumption has grown as the economy has slowed …

% Yr Contributions to growth

% Yr

-1

-2

2010

2011 2011 2011 2011 2012 2012

Q1 Q2 Q3 Q4 Q1 Q2

Consumption Government Investment

Stocks Net Trade

Source: ONS, HSBC

The UK’s productivity performance has become more

puzzling as employment has held up …

Index Productivity in UK recessions Index

12 0

120

11 5

11 0

10 5

10 0

Source: ONS, BoE

t t+2 t+4 t+6 t+8 t+10 t+12 t+14 t+16

-1

-2

115

110

105

100

70 s 80s 90s 00s

The Bank of England is as puzzled as anyone, and it has

never before been this uncertain about growth outlook …

18%

15%

12%

Implied probability of growth below zero 2-years-ahead

04 05 06 07 08 09 10 11 12

Source: BoE, HSBC

18 %

15 %

12 %

… and with trade slowing, the composition of growth

remains worrying

Net trade has started to drag on growth as global activity

cools and the eurozone’s recession begins to bite. Trade

surveys point to a drop in export orders suggesting the drag

from trade will continue.

Consumption is yet to add to four-quarter growth. This

reflects a prolonged period of inflation outpacing wage

growth. But with commodity prices rising, inflation will not fall

as far or as fast as we had previously expected, so real

wages will barely grow and consumption will stay weak.

Growth in 2012 has been affected by a number of one-off or

erratic factors. Excluding these factors, growth appears to

have been slow but positive. We expect a big bounce back

in Q3, with slow growth resuming in Q4 and continuing into

2013.

… which increasingly suggests the crisis may have had a

larger negative impact on the UK’s supply potential

Lower output combined with a modest amount of job

creation through 2012 means the UK’s dismal productivity

performance has continued. If this simply reflects a large

amount of spare capacity in the economy, then demand can

be stoked without fear of fuelling inflation.

But the fact that UK productivity has flat-lined for three years

increasingly points to a period of weak growth in potential

productivity. Supply-side weakness is not something that

can be addressed by ever-looser monetary policy.

Weak productivity also implies a risk of unemployment rising

again if some firms have been hoarding labour in the hope

that demand will pick up. Another year of weak demand

could be the final straw, forcing firms to reduce headcount.

… although the MPC’s implied probability of deflation in

two years’ time is way below 2009 levels

The outlook remains highly uncertain. Indeed, the MPC’s

published forecast data show it has never been more

uncertain about the outlook. In turn, its implied probability of

a GDP contraction in two years’ time is at an all-time high.

High uncertainty calls for cautious policy-making. Looser

monetary policy is not a one-way bet, and there are risks to

piling ever-more risk onto the central banks’ balance sheet.

Now would be a good time to pause QE and make a

meaningful assessment of existing policy measures.

Only if the MPC fears a really bad outcome would

aggressive policy be needed. This was the case in 2009.

Currently, the probability of deflation appears considerably

lower, meaning less need to take risks with policy.

Macro

European Economics

Q4 2012

Norway

Bucking the trend

Domestic growth is allowing Norway to decouple

from European economic weakness. Thanks to its

domestic strength, we expect output to remain

solid through H2 2012. This health will also be

reflected in the continued strength of the krone.

Norway saw another quarter of strong growth,

registering 1.0 % q-o-q in Q2. This was backed by

strong investment and consumption. Employment

continued to grow at a solid pace, as did wages.

This is not to say that Norway has been

completely immune to the downfall of its major

trading partner. The effects of eurozone weakness

were felt in lower demand for Norwegian exports

in the second quarter. In addition, given the

uncertain global environment, deposits and loans

to and from Norway also saw a marked fall in Q2.

In the coming months, we do not expect these

challenges to abate, and rising labour costs and a

% Year

strong krone should all further limit export

growth. However, this should be offset by a

stronger domestic environment and low interest

rates, resulting in trend GDP growth in 2012.

The inflation rate remains low (at 0.5% y-o-y in

August) and we expect it to hover around 0.6% in

2012. In the housing sector, the house price index

rose to 6.7% y-o-y in Q2 while household

indebtedness continued to rise faster than income.

Thus strong consumption patterns, rising

household debts and housing prices speak in

favour of higher rates. However, the problems

stemming from the eurozone crisis are far from

resolved and continue to pose a risk for the

Norwegian economy. Balancing these risks, we

expect Norges Bank to keep rates on hold this

year and start its tightening bias in 2013.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 2.4 3.7 4.5 3.9 4.2 4.1 4.1 4.6 5.2

Government consumption 1.5 2.0 2.0 2.0 2.7 3.2 2.4 1.6 0.8

Mainland investment 8.0 4.8 5.5 5.8 5.6 8.7 6.5 4.6 2.5

Stockbuilding (% GDP) 2.8 2.1 1.5 1.5 1.5 1.5 1.5 1.5 1.5

Mainland domestic demand 3.2 3.4 4.0 3.8 4.0 4.7 4.1 3.8 3.5

Mainland exports* 0.2 1.8 2.8 0.8 0.5 2.0 2.5 3.0 3.5

Mainland imports* 3.0 4.2 4.5 4.3 4.3 4.0 4.6 4.7 4.8

Mainland GDP 2.5 3.6 3.0 3.5 3.0 2.6 2.5 3.3 3.7

Mainland GDP (% quarter) - - - 0.5 0.3 0.8 0.8 1.3 0.7

Manufacturing production 0.9 2.4 2.4 3.5 2.7 2.6 2.0 2.3 2.7

Unemployment (%)** 2.7 2.5 2.3 2.5 2.6 2.2 2.1 2.3 2.5

Average earnings 4.5 3.9 3.7 3.3 2.5 1.3 3.3 4.3 5.9

Consumer prices 1.3 0.7 1.6 0.5 0.9 1.1 1.4 1.9 2.0

Current account (% GDP) 14.5 14.7 12.0 13.0 13.0 12.0 12.0 12.0 12.0

Budget balance (% GDP) 11.3 13.8 13.6 - - - - - -

NOK/EUR 7.75 7.10 6.90 7.25 7.10 7.00 6.95 6.95 6.90

3-month money (%) ** 2.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9 1.9

10-year bond yield (%) ** 2.2 2.0 2.3 2.3 2.0 2.0 2.1 2.2 2.3

Note: * = Travel and non-oil related goods and services; ** = Period-end

Source: Statistics Norway and HSBC forecasts

Janet Henry

Economist

HSBC Bank plc

Sakshi Gupta

Economics Associate

Bangalore

Macro

European Economics

Q4 2012

Sweden

Miracle or mirage?

Sweden had been seen as something of a safe haven

in Europe this year, but the massive downward

revision to Q2 GDP (from 1.4% q-o-q to 0.7%)

indicates that while the Swedish economy is still one

of the best-performing in Europe since the financial

crisis, it does not seem to have decoupled. A trade

slowdown could lead to a recession in H2 2012.

Net exports were revised down in Q2 but still made

a positive contribution to growth. However, the

momentum is of a slowdown in imports rather than

stronger export growth. Latest survey data for export

orders point to a sharp contraction, and this is likely

to be the main drag on GDP in H2. Wages, retail

sales and house prices will be weighed down by

deteriorating labour market conditions. Recent

downside data surprises mean unemployment could

rise to 8% by the end of the year.

% Year

The Riksbank’s surprise 25bps repo rate cut in

September should mitigate the upward pressure on

the krona, which has risen sharply in 2012 and

neared all-time highs against the euro in August. But

given the weak external demand environment, rising

unemployment and low inflation, we think the

Riksbank will continue to ease, and expect the repo

rate to fall by another 25bps in Q4 to 1%. This

should help to lower the real interest rate, which is

still positive, and support investment.

Policymakers may not be able to stop a tradeinduced

slowdown, but Sweden still has relatively

strong government finances, low debt and a top

credit rating in its favour. The government’s new

budget announced cuts to corporation tax and

infrastructure investment (although projects start

from 2014). So although the government’s GDP

forecasts look optimistic, the fact that it is delivering

stimulus rather than austerity will soften the blow.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 2.2 1.6 1.2 2.2 1.8 0.9 1.1 1.3 1.6

Government consumption 1.9 1.2 2.4 1.1 1.5 2.3 2.5 2.5 2.2

Investment 6.9 4.6 3.1 2.7 3.4 1.2 2.5 3.2 5.5

Stockbuilding (%GDP) 1.0 0.1 0.0 0.1 -0.3 -0.1 -0.0 0.1 0.2

Domestic demand 3.4 1.1 1.8 1.4 0.8 1.0 1.3 2.0 3.1

Exports 7.4 -0.4 2.2 -3.1 -0.1 -0.1 0.4 2.8 5.6

Imports 6.3 0.1 1.6 -0.4 0.1 0.2 1.0 1.9 3.3

GDP growth 3.9 0.8 2.1 -0.1 0.6 0.8 0.9 2.4 4.2

GDP (% quarter, sa) - - - -0.4 -0.3 0.8 0.9 1.1 1.4

Industrial production 5.7 0.2 2.0 1.3 1.9 2.1 1.0 1.4 3.7

Unemployment rate* 7.5 8.1 7.5 7.9 8.1 8.0 7.9 7.7 7.5

Average earnings 2.3 2.8 2.8 2.8 2.6 2.7 2.7 2.8 2.9

CPI, average 3.0 1.1 1.2 0.7 0.8 0.9 1.1 1.2 1.5

Current account (%GDP) 6.4 6.2 6.0 5.6 5.6 6.9 5.6 6.2 5.6

Budget balance (% GDP) 0.3 -0.4 -0.6 - - - - - -

State debt (% GDP) 38.3 38.0 37.5 - - - - - -

SEK/USD 6.86 6.00 5.75 6.38 6.00 5.91 5.83 5.79 5.75

SEK/ EUR 8.90 8.10 8.05 8.30 8.10 8.10 8.05 8.05 8.05

3-month money (%) * 2.7 1.8 1.8 1.9 1.8 1.8 1.8 1.8 1.8

10-year bond yield * 1.5 1.5 1.7 1.6 1.5 1.4 1.5 1.6 1.7

Note: * = Period-end.

Source: Thomson Reuters Datastream, HSBC estimates

John Zhu

Economist

HSBC Bank PLC

+44 20 7991 2170

john.zhu@hsbcib.com

Macro

European Economics

Q4 2012

Switzerland

CHF to remain stable thanks

to the SNB

Growth is likely to remain hampered by weak

foreign demand for Swiss goods and services. In

Q2, GDP fell 0.1% q-o-q, because of a sharperthan-expected

drop in exports. The recession in

the eurozone periphery and meagre growth

elsewhere in Europe and in the US are expected to

prevent any rapid recovery in exports, at least

until a lasting solution to the eurozone crisis is

found. Equipment investment is likely to remain

depressed by those weak export prospects.

Households have benefited in recent quarters from

falling consumer prices allowing them to increase

consumption. But with weak exports, we expect

the unemployment rate to keep ticking upwards in

the last few months of 2012, and so consumer

spending growth will be slower in the coming

quarters. As a result, we anticipate that GDP will

be flat in Q3.

% Year

In 2013, we expect growth to pick up gradually as

exports should cease to be a drag and monetary

policy remains very accommodative. Indeed, the

SNB has used unsterilized interventions to defend

its 1.20 EUR-CHF floor, creating ample liquidity

within Switzerland. We anticipate that

appreciation pressure on the CHF will persist, and

that the central bank will defend this floor until at

least the end of 2013, to prevent further losses of

export competitiveness and combat deflation risks.

Furthermore, the 0-0.25% target range for 3-month

LIBOR should be increased only once the EUR-

CHF floor has been lifted. Overall, this should

provide a boost to investment. The upside potential

for housing investment should, however, remain

limited. Indeed, since a Federal Council decision

in June 2012, the SNB can force banks to build

countercyclical capital buffers if needed. This

measure is designed to limit credit growth without

forcing the SNB to tighten monetary policy and

abandon its currency management.

2011 2012f 2013f Q3 12f Q4 12f Q1 13f Q2 13f Q3 13f Q4 13f

Consumer spending 1.2 2.3 1.6 2.4 1.9 1.4 1.5 1.7 1.7

Government consumption 2.0 1.9 0.7 1.4 0.8 1.3 0.4 0.5 0.4

Investment 4.0 0.8 2.5 1.4 1.0 1.8 2.5 2.8 2.7

Stockbuilding (% GDP) -0.6 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5 -0.5

Final domestic demand 2.0 1.9 1.7 2.1 1.5 1.5 1.6 1.8 1.8

Exports 3.8 -0.6 2.4 -0.2 -0.1 0.9 1.5 2.9 4.3

Imports 4.2 1.3 3.1 0.3 1.1 1.8 2.6 3.4 4.5

GDP 1.9 0.9 1.4 0.9 0.8 0.8 1.3 1.7 1.9

GDP (% quarter) - - - 0.0 0.3 0.5 0.5 0.4 0.5

Industrial production 0.9 -0.6 2.2 0.2 -0.5 0.0 3.0 2.8 2.8

Unemployment (%) 2.8 2.9 3.1 2.9 3.0 3.1 3.1 3.1 3.1

Consumer prices 0.2 -0.6 0.3 -0.6 0.0 0.0 0.3 0.5 0.5

Current account (EURbn) 49.9 51.1 50.8 10.8 11.7 12.5 12.5 12.5 13.3

Current account (% GDP) 10.5 10.4 10.1 8.8 9.5 10.1 10.0 10.0 10.6

CHF/USD 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9 0.9

CHF/EUR 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2

3-month money (%)* 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1 0.1

10-year bond yield (%)* 0.7 0.5 0.7 0.6 0.5 0.5 0.6 0.6 0.7

Note: * = period-end

Source: Thomson Reuters Datastream, HSBC estimates

François Letondu

Economist

HSBC France

+33 1 40 70 39 33

francois.letondu@hsbc.fr

Macro

European Economics

Q4 2012

Hungary

Still waiting

Weak economic growth is a significant risk to the

debt stabilisation strategy. We still lack confidence

that Hungary will reach an agreement with the IMF,

even though markets seem to have mostly priced that

in following the opening of negotiations in July.

The 2013 budget is the main near-term risk. The

government is under increasing pressure to deliver

stimulus to a weakening economy. The opinion polls

show that the popularity of the ruling party, Fidesz,

is declining. The Prime Minister promised earlier

this year that fiscal consolidation would come to an

end; however, more measures are necessary to

secure the 3% budget deficit ceiling.

While the 2013 budget has apparently assumed some

savings from lower debt servicing costs resulting

from an IMF deal, it also includes more spending

(labour market support programme) financed by

special taxes (financial transaction tax), something

that the IMF has criticised.

% Year

We have lowered our GDP growth forecast for this

year and next, given the weaker-than-expected

economic performance to date, uncertainty over the

outcome of the IMF negotiations, and our reduced

forecast for growth in Germany in 2013. To date,

industrial production and exports growth has shown

a small positive impact from new export capacities.

The current account is recording a significant surplus

but this is still unlikely to offset the capital outflow

(deleveraging).

In this environment, the Monetary Council’s

decision to start cutting its policy rate in August was

a risky one. We expect the easing cycle to pause

after September until an IMF deal is secured. A high

wage growth rate is a sign of second round effects

from persistently high inflation and will likely limit

the scope of total policy easing even in the positive

scenario of an IMF deal in place. Having said that,

this will still be determined by the changes in CB

management due next year.

2008 2009 2010 2011 2012f 2013f

Private consumption -0.2 -5.7 -2.7 0.2 -1.3 0.2

Government consumption -0.2 2.6 1.1 -2.4 -1.0 0.0

Fixed Investment 2.9 -11.0 -9.7 -5.5 -7.0 -4.0

Exports 5.7 -10.2 14.3 8.4 2.9 5.0

Imports 5.5 -14.8 12.8 6.3 0.8 3.0

GDP 0.9 -6.8 1.3 1.6 -1.0 1.3

Industrial Production -0.2 -17.6 10.5 5.7 1.6 5.0

Unemployment rate* 8.0 10.5 10.8 10.7 11.1 10.9

Consumer prices 6.1 4.2 4.9 3.9 5.7 3.7

Budget balance (% GDP) -3.7 -4.5 -4.3 4.2 -3.0 -3.5

Public debt (% GDP) 72.9 79.7 81.3 80.6 76.0 75.0

Current account (% GDP) -7.3 -0.2 1.2 1.4 2.2 3.2

External debt (% GDP) 116.8 149.9 141.7 130.0 123.0 113.0

CB policy rate* 10.00 6.25 5.75 7.00 6.50 5.50

HUF/EUR 265.9 270.2 278.3 314.8 280.0 270.0

10-year bond yield (%)* 8.3 8.0 8.0 9.8 7.9 6.5

Note: * = period-end

Source: Thomson Reuters DataStream, HSBC estimates

Agata Urbanska

Economist

HSBC Bank plc

+44 20 7992 2774

agata.urbanska@hsbcib.com

Macro

European Economics

Q4 2012

Poland

Slowdown triggers policy

response

Monthly activity data show no indication of the

economic slowdown bottoming out, while the decline

in domestic demand in Q2 2012 highlights downside

risks. Policymakers have responded accordingly. In

May, the National Bank of Poland had raised rates; in

September, it adopted an easing policy bias. In April,

the government had adopted a medium-term fiscal

objective of reducing the budget deficit to 0.9% of

GDP by 2015. Currently, however, it is only

planning to make the minimum deficit reduction that

would allow it to exit the excessive deficit procedure

(EDP). Along with its medium-term target set in

April, the government aimed at a budget deficit at

2.2% of GDP in 2013. This has been raised to 3% of

GDP, the level required under the EDP. In January

this year the European Commission forecast Poland’s

2012 budget deficit at 3.3% of GDP, compared to the

government’s then target of 2.9%. It said, however,

that taking account of the cost of pension reform (the

annual transfers to private pension fund) at 0.6% of

% Year

GDP this was close enough to the threshold for

Poland to meet the 2012 EDP requirement.

We have made another cut to our 2012 growth

forecast from 2.7% to 2.5% but reduced 2013 more

significantly from 3.1% to 2.0%. Growth in H1 2012

was largely in line with expectations, but recent

monthly economic data show a stronger than

expected slowdown. Also the growth composition in

Q2 was significantly worse than expected, with

domestic demand declining. Destocking was the

main driver, in line with weakening consumer and

business sentiment indicators. Labour market data

has been weaker than expected. Finally, the outlook

for global and European growth has worsened. All

these factors contributed to our 2013 forecast change,

but downside risks remain as there are no signs of the

slowdown abating, and leading business and

consumer confidence indicators are unsupportive.

Monetary policy has room to respond with easing,

and we pencil in 75bp rate cuts to 4% in the coming

months.

2008 2009 2010 2011 2012f 2013f

Private consumption 5.7 2.1 3.2 3.1 1.6 1.6

Government consumption 7.7 1.8 4.6 -1.0 -0.2 0.4

Fixed Investment 9.6 -1.2 -0.2 8.1 1.6 0.3

GDP 5.1 1.6 3.9 4.3 2.5 2.0

Exports 7.1 -6.8 12.1 7.5 3.0 4.9

Imports 8.0 -12.4 13.9 5.8 -1.0 2.9

Industrial Production 3.0 -3.6 11.1 7.0 3.3 3.5

Unemployment rate* 9.5 12.1 12.4 12.5 13.0 13.0

Consumer prices 4.2 3.5 2.6 4.3 3.9 2.7

Budget balance (% GDP) -3.7 -7.3 -7.8 -5.1 -3.4 -3.0

Public debt (% GDP) 47.1 50.9 54.9 56.0 55.0 54.0

Current account (% GDP) -6.5 -3.9 -4.7 -4.2 -4.3 -4.2

External debt (% GDP) 56.9 59.6 65.8 72.5 67.0 63.0

CB policy rate* 5.00 3.50 3.50 4.50 4.50 4.00

PLN/EUR 4.1 4.1 4.0 4.5 4.1 3.8

10-year bond yield (%)* 5.6 6.2 6.0 5.9 4.8 4.8

Note: *= period-end

Source: Thomson Reuters DataStream, HSBC estimates

Agata Urbanska

Economist

HSBC Bank plc

+44 20 7992 2774

agata.urbanska@hsbcib.com

Macro

European Economics

Q4 2012

Destocking pushed domestic demand into contraction in Q2

2012

Contribution to GDP grow th (ppt) % y -o-y

-1

-3

-5

1Q08 3Q081Q09 3Q091Q10 3Q10 1Q11 3Q11 1Q12

Priv cons Gov cons

Investments In v entorie s

Net exports GDP (rhs)

Domestic demand (rhs)

Source: National sources, HSBC estimates

-1

-3

-5

GDP is not likely to bottom until early 2013

Following 4.3% expansion in 2011, GDP growth dropped to

3.5% in Q1 2012 and 2.4% y-o-y in Q2 2012.

Both private consumption and investment growth slowed, but

the main drag in Q2 2012 came from destocking. Domestic

demand growth turned sharply recording a 0.2% y-o-y

contraction compared to 2.7% growth in Q1 2012.

On the value added side the biggest drag on growth in Q2 2012

came from trade and construction. Construction growth slowed

from 11.8% y-o-y in 2011 and 9.6% in Q1 2012 to 1.4% in Q2

2012. It is most likely to turn negative in H2 2012. Growth of the

value added component in trade slowed to 0.3% y-o-y in Q2

2012 from 5.5% in Q1 2012 and 4.6% in 2011.

Given no bottoming out of the monthly activity data, we

continue to see downside risk to our new, lower growth

forecast.

Labour market still in a downward trend A risk of more slowdown in private consumption

% y-o-y, real % y-o-y, real

1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12

Source: National sources, HSBC estimates

Priv ate consumption

Wage bill, whole economy (rhs)

Wage bill, enterprices (rhs)

-5

Employment growth has been slowing since early 2011 (from

4% average in Q1 2011) to zero in July 2012.

The seasonal summer unemployment rate drop was smaller

than average. We forecast the unemployment rate at 13% in

December 2012, its highest in five years, and no improvement

in 2013.

July data showed wage bill growth in the corporate sector

slowing further from 0.1% y-o-y real growth in Q2 2012 to a

contraction of 1.5%.

Private consumption growth halved from 3.1% in 2011 to 1.5%

in Q2 2012. In q-o-q terms, however, private consumption

growth has stabilised at a 0.3% average rate in the last four

quarters, and we do not expect the slowdown to go much

further, but the developments in the labour market are a

downside risk.

Inflation to fall into a 2.5% +/-1 range in November MPC signals policy easing

% y -o-y % y -o-y

Having raised rates in May, and having upheld an unofficial

hawkish policy bias in July, the Monetary Policy Council has

signalled that there will be policy easing in September if

incoming data confirm further weakening of economic

conditions and limited inflationary pressure.

3 We expect the MPC to cut its policy rate by 50-75bp in the

-1

Forecast

-1

coming months. We marginally favour the easing starting in

November, when the new Inflation Report is published, followed

by two more cuts in the first months of 2013. However, we see

a risk that the MPC will continue to disappoint markets and cut

later and by less than is currently priced in.

The risk to this scenario is that the MPC waits until January, to

05 06

CPI

07 08 09 10

C B inflation target

11 12

Core CPI

see inflation at least back in the +/-1pp range around the 2.5%

target, before starting the easing.

Source: Thomson Reuters Datastream, HSBC estimates

Macro

European Economics

Q4 2012

Romania

Positive domestic demand

We forecast 1% GDP growth for Romania in

2012, which is good relative to forecasts for other

EU members. Domestic demand continues to be

the main growth driver in Romania, in contrast to

what is seen in other Central European EU

member countries. Wage bill growth is positive in

real terms, supported by public sector wage hikes.

Romania’s focus on spending the funds granted

by the European Union has lifted investment

activity in the last few quarters. Together, these

factors should continue to support the economy in

2013. Exports might well be slowing, but this is

less important for the economy in Romania than it

is for the Czech Republic or Hungary.

The banking sector remains weak. Labour market

conditions are better than in Romania’s Central

European peers, but this has not significantly

diminished the problem of non-performing loans.

Also, banks’ balance sheets are still unbalanced,

with loans to deposit ratios exceeding 100%.

% Year

Credit growth is therefore likely to remain weak,

and is unlikely to support economic recovery in

2013. The rush to spend EU money has produced

some irregularities, and the EC has suspended

some funds.

The approaching parliamentary elections should

not bring any surprises. The tentative promises of

a fiscal loosening are a risk though. Lower VAT

and personal taxes would boost consumption, not

necessarily investments, drive inflation higher and

probably fuel the current account deficit,

repeating the pattern of unbalanced growth seen in

Romania before the 2008 global financial crisis.

The key policy challenge is to support balanced

economic growth. Inflation is set to double in the

second half of 2012, breaching the central bank’s

3% +/-1pp target in December and generally

staying close to the upper ceiling in 2013.

2008 2009 2010 2011 2012f 2013f

Private consumption 8.8 -9.1 -0.3 0.7 0.1 2.1

Government consumption 5.9 9.5 -10.1 -3.4 -0.6 2.0

Fixed Investment 15.1 -28.1 -2.1 6.3 5.7 5.5

Exports 8.1 -6.4 14.0 9.9 -0.5 4.5

Imports 7.3 -20.5 11.9 10.5 -1.3 5.0

GDP 7.2 -6.6 -1.7 2.5 1.1 2.5

Industrial Production 2.8 -5.2 5.5 5.8 0.6 3.0

Unemployment rate* 4.4 7.8 6.9 5.1 5.0 5.0

Consumer prices 7.9 5.6 6.9 5.8 3.1 3.5

Budget balance (% GDP) -5.7 -9.0 -6.8 -5.2 -2.8 -2.5

Public debt (% GDP) 13.4 23.6 31.0 33.0 36.0 36.0

Current account (% GDP) -11.6 -4.2 -4.4 -4.4 -4.1 -4.9

External debt (% GDP) 51.8 68.7 74.7 74.0 72.0 71.0

CB policy rate* 10.25 8.00 6.25 6.00 5.25 5.50

RON/EUR 4.0 4.3 4.3 4.3 4.4 4.3

3-month money (%)* 15.5 10.7 6.2 6.1 5.2 5.3

Note: * = period-end

Source: HSBC estimates, Thomson Reuters Datastream

Agata Urbanska

Economist

HSBC Bank plc

+44 20 7992 2774

agata.urbanska@hsbcib.com

Macro

European Economics

Q4 2012

Czech Republic

Recession in 2012, shallow

recovery in 2013

GDP growth did not rebound in Q2 2012 despite a

very weak Q1 reading. That prompted us to reduce

our growth forecasts for this year as well as next.

We now expect close to 1% economic contraction

in 2012 and only weak recovery in 2013.

The very weak confidence indicators, both on the

consumer and business side, have continued to

gradually worsen in recent months. That has been

accompanied by a further weakening of activity

indicators. In particular, labour market data

deteriorated, as indicated by the poor level of the

consumer confidence index, and justifying an

earlier drop in consumer spending.

The near-term outlook for growth remains poor,

and despite reducing our forecasts we continue to

see the balance of risks tilted to the downside. The

downward revision to HSBC’s 2013 German

growth forecast has made a substantial recovery in

the Czech Republic less likely. Net exports have

% Year

been contributing positively to growth in the last

several quarters, mostly on weak imports. But in

the coming months exports will continue to

decelerate and net exports’ contribution to growth

will start to decline.

The policy makers have very limited scope for

responding to this deterioration. We cut our central

bank policy rate forecast to a record low of 0.25%

back in May, and we do not believe that there are

many other instruments at the central bank’s disposal

that could support the economy effectively.

The recession is creating stress in domestic

politics; the government is struggling to pass a

tight 2013 budget in the parliament, and the fall of

the government is a risk.

2008 2009 2010 2011 2012f 2013f

Private consumption 2.8 -0.3 0.5 -0.5 -2.8 0.3

Government consumption 1.2 3.8 0.6 -1.4 -1.1 -0.5

Fixed Investment 4.0 -11.3 0.0 -1.2 -1.9 0.6

Exports 3.6 -9.7 16.0 11.0 5.2 3.5

Imports 2.4 -11.4 15.7 7.5 2.5 3.0

GDP 2.9 -4.5 2.6 1.7 -0.9 1.0

Industrial Production -1.5 -13.2 10.2 7.1 0.3 4.0

Unemployment rate* 6.0 9.2 9.6 8.6 8.8 8.8

Consumer prices 6.3 1.0 1.5 1.9 3.3 2.0

Budget balance (% GDP) -2.2 -5.8 -4.8 -3.1 -2.9 -2.9

Public debt (% GDP) 28.7 34.4 38.1 41.2 44.0 45.0

Current account (% GDP) -2.1 -2.4 -3.9 -2.9 -1.3 -2.2

External debt (% GDP) 42.2 43.7 46.9 48.6 52.0 50.0

CB policy rate* 2.25 1.00 0.75 0.75 0.25 0.25

CZK/EUR 26.8 26.4 25.1 25.5 25.0 24.0

10-year bond yield (%)* 4.2 3.9 3.9 3.6 2.2 2.2

Note: * = period-end

Source: Thomson Reuters Datastream, HSBC estimates

Agata Urbanska

Economist

HSBC Bank plc

+44 20 7992 2774

agata.urbanska@hsbcib.com

Macro

European Economics

Q4 2012

Russia

A lonely hawk

GDP growth in Russia eased to less than 3% y-o-y

in July. The high base set by H2 2011 and a poor

harvest are likely to prompt further slowing of

economic activity in the coming months. Private

sector fixed investment growth has paused this

year, which could further restrain GDP growth in

the medium term.

In August 2012, Russia officially became a World

Trade Organisation member, finally ending its

long accession saga. Will this boost economic

growth? We think immediate material positive

implications for the economy from WTO

membership are unlikely. Apart from a few nonenergy

exporting sectors, the rest of the Russian

economy would only be able to reap the benefits

of WTO accession in the medium to long term if

the government uses it as an opportunity to

improve the business climate and the

competitiveness of the Russian economy.

Against the backdrop of slowing economic

growth, the Central Bank’s (CBR) decision to

hike its policy rates in September might appear

controversial, at a first glance. Indeed, the Russian

Central Bank is probably the only hawk these

% Year

days. Yet, loan growth stays high at about 20% yo-y

in real terms, which looks excessive for the

slowly growing Russian economy. If it continues,

such strong credit growth could trigger a spike in

NPL and a credit crunch. That would be

detrimental for the banking sector’s stability and

economic growth sustainability. Therefore, some

cooling of credit growth is warranted.

Even more important for the rate hike decision

was the fact that inflation had breached the CBR’s

6.0% ceiling for the year. All three broad CPI

components – food, non-food and services – have

made a U-turn, signalling broad-based inflation

acceleration. Moving towards inflation targeting,

the CBR has to provide an adequate policy

response to the surge in order to start building up

its credibility as an inflation fighter.

Finally, the CBR’s repo rates, which are the key

policy rates in Russia, are likely to remain

negative in real terms after the cumulative 75bp

policy rate hikes that we expect in the coming

months, as inflation is to gain more than the

policy rates. So, despite some notional monetary

tightening, the CBR’s policy will remain

accommodative.

2008 2009 2010 2011 2012f 2013f

Private consumption 10.6 -5.1 5.1 6.8 5.5 4.5

Government consumption 3.4 -0.6 -1.4 1.5 1.0 0.5

Fixed Investment 10.6 -14.4 5.8 8.0 5.0 4.5

GDP 5.2 -7.8 4.3 4.3 3.0 2.5

Exports 0.6 -4.7 7.0 0.4 1.0 2.0

Imports 14.8 -30.4 26.1 20.3 1.3 5.1

Industrial Production -1.0 -10.3 10.3 4.1 2.7 1.8

Unemployment rate 7.8 8.2 7.2 6.1 5.8 5.7

Consumer prices 14.1 11.7 6.8 8.5 5.2 7.4

Source: Rossat, MOF, CBR and Reuters, HSBC estimates

Alexander Morozov

Economist

HSBC Bank (RR), Moscow

+7 495 783 8855

alexander.morozov@hsbc.com

Macro

European Economics

Q4 2012

GDP growth (ex-crops sector) has been moderating Poor harvest weighs on GDP growth in H2 2012

%, y-o-y

-3

-6

-9

Real GDP

2008 2009 2010 2011 2012

Actual Counterfactual*

Note:*Counterfactual assumes crop harvest at 79 mln tns, average for 2001-2007

Source: Rosstat, Ministry of Agriculture, HSBC

%, y-o-y

-3

-6

-9

The official GDP growth rate has been steady at 4.3%

over past two years, which gave a (wrong) impression of

economic growth stability. Yet, the crops sector

performance, affected by weather conditions, has been

uneven: it was better than its historical average in 2011

but worse than its average in 2010 and 2012. We found

that Russia’s GDP growth rate adjusted for the crops

sector has been declining since 2010.

A weaker performance of the crops sector this year will

weigh on economic growth in H2 2012 and may result in

temporary economic stagnation in Q3 q-o-q sa, when

the crops sector contribution to GDP is highest.

Inflation breached the official target in September Repo rates matter, refinance rate does not

% (%, y-o-y)

Aug-09

Dec-09

Apr-10

Policy rates and CPI

Aug-10

Dec-10

Apr-11

Aug-11

Dec-11

Apr-12

% (%, y-o-y)

Aug-12

Dec-12

Refinancing rate Headline CPI

Fixed REPO CBR's inflation ceiling

Source: Rosstat, CBR, HSBC

HSBC CPI forecast

The CPI growth rate accelerated to 6.3% y-o-y in early

September, breaching the official inflation range of 5-

6%. Moreover, the continuing rise in food prices has the

potential to speed up headline inflation further to 7.5% yo-y

in December 2012 and 8.2% in March 2013, taking

into account the second-round effect.

In a similar situation in 2010, the CBR increased its

refinance rate only when inflation exceeded it by a wide

margin. Now, with the CBR caring much more about

inflation targeting than before, it made a rate hike

decision much earlier. It follows that, first, the CBR’s

response function has become more sensitive, and

second, it is the CBR’s (low) repo rates rather than

(high) refinance rate that serve as an inflation

benchmark.

Policy cross: exchange rate and interest rate bands More FX volatility, less interest rate volatility

RUB

Mar-10

Jun-10

Sep-10

Dec-10

Source: Reuters, CBR, HSBC

Mar-11

Jun-11

Sep-11

Dec-11

Mar-12

Jun-12

RUB band w idth (LHS)

CBR policy rates band w idth (RHS)

Sep-12

bps

500

400

300

200

Efficient inflation targeting in a country with an open

capital account requires a fairly flexible exchange rate

and low interest rate volatility. The CBR is moving

exactly in this direction; it has been steadily widening the

RUB band while reducing the interest rate band (defined

as the difference between the fixed repo rate and

deposit rates).

The CBR has not shrunk its interest rate band since last

year, while it has widened its RUB band twice this year.

This suggests the growing probability of a faster rise in

deposit policy rates than in repo rates in the coming

months. We think that the RUB staying in the middle or

upper part of the FX band is a pre-condition for that

happening.

Macro

European Economics

Q4 2012

Turkey

Rebalancing starts to hurt

Q2 GDP growth came in at 2.9% y-o-y, driven

exclusively by net foreign demand. In annual

terms, exports were up by 19.8% in Q2 (from

11.9% in Q1), adding 5.7pp to headline growth.

Meanwhile, the contribution from domestic

demand turned negative for the first time in 10

quarters, shaving 2pp off headline GDP.

With two quarters of actual data, we now raise our

whole-year growth forecast to 2.7%, from our

cautious expectation of 2.0%. For 2013, we only

make a minor revision, taking our forecast from

3.5% to 3.8%. Domestic demand growth is likely

to be nearly flat in both Q3 and Q4 this year, but

could pick up slightly in early 2013 as the impact

of looser monetary policy is felt. Export

performance was stronger than we expected in the

first half of 2012, and our increased GDP forecast

reflects this. Going forward, we expect exports to

remain resilient, but the pace of growth is likely to

slow, in line with the deterioration in global trade.

The main downside risk here is weaker demand

from the MENA region.

% Year

On the inflation front, food prices surprised

positively in the third quarter. Even as global

agricultural commodity prices spiked, processed

and unprocessed food prices in Turkey did not

rise much above their seasonal averages in the

June-August period. As a result, we nudge down

our year-end inflation forecast from 7.9% to

7.2%. Average CPI forecasts for 2012 and 2013,

which appear in the table below, are little

changed. But larger-than-expected administered

price and tax hikes, along with rising commodity

prices, could push CPI higher.

Aggressive monetary easing by the central bank is

a risk factor. In September, the CBRT started to

narrow the overnight interest rate corridor and

manage liquidity conditions using a new iteration

of its reserve requirement framework. This could

leave the lira vulnerable during bouts of risk

aversion. It could also interrupt the rebalancing

process that has been on track since the start of

the year.

2008 2009 2010 2011f 2012f 2013f

Consumer spending -0.3 -2.3 6.7 7.7 0.0 3.0

Government consumption 1.7 7.8 2.0 4.5 2.5 2.9

Fixed investment -6.2 -19.0 30.5 18.3 -1.9 5.2

Domestic demand -1.5 -5.1 10.8 10.2 -0.2 3.5

Exports 2.7 -5.0 3.4 6.5 13.6 10.8

Imports -4.1 -14.3 20.7 10.6 0.0 9.4

GDP 0.7 -4.8 9.2 8.5 2.7 3.8

Industrial production -0.9 -9.6 13.3 9.2 2.8 5.5

Consumer Prices* 10.4 6.3 8.6 6.5 9.0 7.3

Producer Prices* 12.7 1.4 8.5 11.1 6.2 6.5

Current account (% GDP) -5.7 -2.3 -6.5 -10.0 -7.6 -7.1

Budget deficit (% GDP) -1.8 -5.5 -3.6 -1.4 -2.2 -1.5

TRY/USD 1.54 1.50 1.54 1.89 1.80 1.65

3-month money (%)** 15.5 7.5 6.7 10.1 6.0 7.5

Note: * = Year average, ** = Average

Source: CEIC, National sources, HSBC estimates

Melis Metiner

Economist

HSBC Turkey

+90 212 376 4618

melismetiner@hsbc.com.tr

Macro

European Economics

Q4 2012

The rebalancing in the economy was on track in H1 2012 Growth was driven exclusively by net foreign demand

pp Contribution to growth

-5

-10

1Q10

Source: Turkstat

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

-5

-10

Domestic demand Net foreign demand

Change in inv entories Headline GDP (% Yr)

The CBRT’s priority has now shifted to supporting

growth

% %

CBRT's average funding rate

Sep-11

Oct-11

Source: CBRT

Nov-11

Dec-11

Jan-12

Feb-12

Mar-12

Apr-12

May-12

Jun-12

Jul-12

Aug-12

The shift in the growth outlook became more

pronounced in the second quarter: the contribution from

domestic demand turned negative as private

consumption contracted by 0.5% y-o-y, and private

investment by 7.9% y-o-y.

Consumer confidence, credit growth and durable goods

sales all suggest demand weakness continued in Q3.

This has prompted a policy response from the central

bank.

Monetary easing is in the pipeline

Between June and August, the central bank gradually

reduced the average cost of funding provided to the

banking sector by more than 400bp.

In its communication, the CBRT also made it clear that it

now prioritises supporting domestic demand growth.

In September, the CBRT cut the top end of the interest

rate corridor, the overnight lending rate, by 150bp to

10.0%. We expect more easing to follow, but its pace

will depend on the strength of risk appetite. Reduced

rate support could pose risks for the lira in case of risk

aversion.

Even though food prices behaved favourably in Q3 …there are signs that inflation is becoming sticky

% Yr % Yr

Consumer inflation breakdown

Source: CBRT

Goods Serv ices

Food inflation averaged 9.4% in the first eight months of

the year. While this is above the central bank’s 7%

average food inflation forecast for 2012, it was better

than HSBC’s expectations.

Even though processed and unprocessed food prices

did not rise sharply, there are signs that service prices

are becoming sticky. In August, service inflation rose to

6.9% y-o-y (from 5.7% in August 2011), while rent

inflation came in at 5.2%, its highest level in more than

two years.

Inflation expectations are also high at 6.6% for 12months

forward and 6.2% for 24-months forward. We

expect year-end inflation in 2012 to remain above the

CBRT’s 5% target.

Macro

European Economics

Q4 2012

Notes

Macro

European Economics

Q4 2012

Notes

Macro

European Economics

Q4 2012

Notes

Macro

European Economics

Q4 2012

Disclosure appendix

Analyst Certification

The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the

opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their

personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific

recommendation(s) or views contained in this research report: Janet Henry, Alexander Morozov, Mathilde Lemoine, Madhur

Jha, Simon Wells, John Zhu, Rainer Sartoris, Stefan Schilbe, Francois Letondu, Agata Urbanska and Melis Metiner

Important Disclosures

This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the

clients of HSBC and is not for publication to other persons, whether through the press or by other means.

This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer

to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this

document is general and should not be construed as personal advice, given it has been prepared without taking account of the

objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice,

consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek

professional investment and tax advice.

Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may

not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of

the investment products mentioned in this document and take into account their specific investment objectives, financial

situation or particular needs before making a commitment to purchase investment products.

The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an

investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls

in value that could equal or exceed the amount invested. Value and income from investment products may be adversely

affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative

of future results.

Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment

banking revenues.

For disclosures in respect of any company mentioned in this report, please see the most recently published report on that

company available at www.hsbcnet.com/research.

* HSBC Legal Entities are listed in the Disclaimer below.

Additional disclosures

1 This report is dated as at 1 October 2012.

2 All market data included in this report are dated as at close 28 September 2012, unless otherwise indicated in the report.

3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its

Research business. HSBC's analysts and its other staff who are involved in the preparation and dissemination of Research

operate and have a management reporting line independent of HSBC's Investment Banking business. Information Barrier

procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or

price sensitive information is handled in an appropriate manner.

Macro

European Economics

Q4 2012

Disclaimer

* Legal entities as at 8 August 2012

‘UAE’ HSBC Bank Middle East Limited, Dubai; ‘HK’ The Hongkong and Shanghai Banking Corporation

Limited, Hong Kong; ‘TW’ HSBC Securities (Taiwan) Corporation Limited; 'CA' HSBC Bank Canada, Toronto;

HSBC Bank, Paris Branch; HSBC France; ‘DE’ HSBC Trinkaus & Burkhardt AG, Düsseldorf; 000 HSBC Bank

(RR), Moscow; ‘IN’ HSBC Securities and Capital Markets (India) Private Limited, Mumbai; ‘JP’ HSBC

Securities (Japan) Limited, Tokyo; ‘EG’ HSBC Securities Egypt SAE, Cairo; ‘CN’ HSBC Investment Bank Asia

Limited, Beijing Representative Office; The Hongkong and Shanghai Banking Corporation Limited, Singapore

Branch; The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch; The Hongkong

and Shanghai Banking Corporation Limited, Seoul Branch; HSBC Securities (South Africa) (Pty) Ltd,

Johannesburg; HSBC Bank plc, London, Madrid, Milan, Stockholm, Tel Aviv; ‘US’ HSBC Securities (USA) Inc,

New York; HSBC Yatirim Menkul Degerler AS, Istanbul; HSBC México, SA, Institución de Banca Múltiple,

Grupo Financiero HSBC; HSBC Bank Brasil SA – Banco Múltiplo; HSBC Bank Australia Limited; HSBC Bank

Argentina SA; HSBC Saudi Arabia Limited; The Hongkong and Shanghai Banking Corporation Limited, New

Zealand Branch incorporated in Hong Kong SAR

Issuer of report

HSBC Bank plc

8 Canada Square, London

E14 5HQ, United Kingdom

Telephone: +44 20 7991 8888

Fax: +44 20 7992 4880

Website: www.research.hsbc.com

This document is issued and approved in the United Kingdom by HSBC Bank plc for the information of its Clients (as defined in the Rules of FSA) and those

of its affiliates only. If this research is received by a customer of an affiliate of HSBC, its provision to the recipient is subject to the terms of business in place

between the recipient and such affiliate. In Australia, this publication has been distributed by The Hongkong and Shanghai Banking Corporation Limited (ABN

65 117 925 970, AFSL 301737) for the general information of its “wholesale” customers (as defined in the Corporations Act 2001). Where distributed to retail

customers, this research is distributed by HSBC Bank Australia Limited (AFSL No. 232595). These respective entities make no representations that the

products or services mentioned in this document are available to persons in Australia or are necessarily suitable for any particular person or appropriate in

accordance with local law. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient.

The document is distributed in Hong Kong by The Hongkong and Shanghai Banking Corporation Limited and in Japan by HSBC Securities (Japan) Limited.

Each of the companies listed above (the “Participating Companies”) is a member of the HSBC Group of Companies, any member of which may trade for its

own account as Principal, may have underwritten an issue within the last 36 months or, together with its Directors, officers and employees, may have a long or

short position in securities or instruments or in any related instrument mentioned in the document. Brokerage or fees may be earned by the Participating

Companies or persons associated with them in respect of any business transacted by them in all or any of the securities or instruments referred to in this

document. In Korea, this publication is distributed by either The Hongkong and Shanghai Banking Corporation Limited, Seoul Securities Branch ("HBAP

SLS") or The Hongkong and Shanghai Banking Corporation Limited, Seoul Branch ("HBAP SEL") for the general information of professional investors

specified in Article 9 of the Financial Investment Services and Capital Markets Act (“FSCMA”). This publication is not a prospectus as defined in the FSCMA.

It may not be further distributed in whole or in part for any purpose. Both HBAP SLS and HBAP SEL are regulated by the Financial Services Commission and

the Financial Supervisory Service of Korea. This publication is distributed in New Zealand by The Hongkong and Shanghai Banking Corporation Limited, New

Zealand Branch incorporated in Hong Kong SAR.

The information in this document is derived from sources the Participating Companies believe to be reliable but which have not been independently verified. The

Participating Companies make no guarantee of its accuracy and completeness and are not responsible for errors of transmission of factual or analytical data, nor shall the

Participating Companies be liable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly available sources or

proprietary data. The opinions in this document constitute the present judgement of the Participating Companies, which is subject to change without notice.

This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. HSBC Securities (USA) Inc. accepts responsibility

for the content of this research report prepared by its non-US foreign affiliate. All US persons receiving and/or accessing this report and intending to effect transactions in

any security discussed herein should do so with HSBC Securities (USA) Inc. in the United States and not with its non-US foreign affiliate, the issuer of this report. In

Singapore, this publication is distributed by The Hongkong and Shanghai Banking Corporation Limited, Singapore Branch for the general information of institutional

investors or other persons specified in Sections 274 and 304 of the Securities and Futures Act (Chapter 289) (“SFA”) and accredited investors and other persons in

accordance with the conditions specified in Sections 275 and 305 of the SFA. This publication is not a prospectus as defined in the SFA. It may not be further distributed

in whole or in part for any purpose. The Hongkong and Shanghai Banking Corporation Limited Singapore Branch is regulated by the Monetary Authority of Singapore.

Recipients in Singapore should contact a "Hongkong and Shanghai Banking Corporation Limited, Singapore Branch" representative in respect of any matters arising

from, or in connection with this report. HSBC México, S.A., Institución de Banca Múltiple, Grupo Financiero HSBC is authorized and regulated by Secretaría de

Hacienda y Crédito Público and Comisión Nacional Bancaria y de Valores (CNBV). HSBC Bank (Panama) S.A. is regulated by Superintendencia de Bancos de Panama.

Banco HSBC Honduras S.A. is regulated by Comisión Nacional de Bancos y Seguros (CNBS). Banco HSBC Salvadoreño, S.A. is regulated by Superintendencia del

Sistema Financiero (SSF). HSBC Colombia S.A. is regulated by Superintendencia Financiera de Colombia. Banco HSBC Costa Rica S.A. is supervised by

Superintendencia General de Entidades Financieras (SUGEF). Banistmo Nicaragua, S.A. is authorized and regulated by Superintendencia de Bancos y de Otras

Instituciones Financieras (SIBOIF).

The document is intended to be distributed in its entirety. Unless governing law permits otherwise, you must contact a HSBC Group member in your home

jurisdiction if you wish to use HSBC Group services in effecting a transaction in any investment mentioned in this document. HSBC Bank plc is registered in

England No 14259, is authorised and regulated by the Financial Services Authority and is a member of the London Stock Exchange. (070905)

In Canada, this document has been distributed by HSBC Bank Canada and/or its affiliates. Where this document contains market updates/overviews, or similar

materials (collectively deemed “Commentary” in Canada although other affiliate jurisdictions may term “Commentary” as either “macro-research” or

“research”), the Commentary is not an offer to sell, or a solicitation of an offer to sell or subscribe for, any financial product or instrument (including, without

limitation, any currencies, securities, commodities or other financial instruments).

any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Bank plc. MICA (P)

038/04/2012, MICA (P) 063/04/2012 and MICA (P) 206/01/2012

[344682]

Principal contributors

Janet Henry

Economist

HSBC Bank plc

+44 20 7991 6711

janet.henry@hsbcib.com

Janet Henry was appointed as HSBC’s Chief European Economist in April 2007. She joined HSBC in 1996 in Hong Kong where she

worked as an Asian Economist in the run-up to, and aftermath of, the Asian crisis before moving back to London in 1999 where

she was a Global Economist for eight years. Janet’s career began at the Economist Intelligence Unit where she worked as an Asian

economist for over four years in London and Hong Kong after graduating with an Economics degree from University College London.

Mathilde Lemoine

Economist

HSBC France

+33 1 40 70 32 66

mathilde.lemoine@hsbcib.com

Mathilde Lemoine joined HSBC in 2006 as economist. After working as a macroeconomic researcher, Mathilde has served as economic

adviser to the French Minister of Trade and Economy and then assisted the French prime minister from 2002 to 2006. She obtained a

PhD in economics from the Paris Institut d'Etudes Politiques and a master’s degree from the University of Paris Dauphine.

Simon Wells

Economist

HSBC Bank plc

+44 20 7991 6718

simon.wells@hsbcib.com

Before joining HSBC as Chief UK economist in December 2011, Simon worked as an economist and senior manager at the Bank of

England. Over a twelve-year period, he held a number of roles in the Monetary Policy, Financial Stability and Markets areas of the

Bank. For several years he was responsible for briefing the Monetary Policy Committee on financial market developments, although

immediately before joining HSBC he headed the team analysing the outlook for UK demand and output. Simon also worked for two

years at the Monetary Authority of Singapore, heading a team in the Macroeconomic Surveillance Department.

Madhur Jha

Economist

HSBC Bank plc

+44 20 7991 6755

madhur.jha@hsbcib.com

Madhur is HSBC's Global Economist. She joined HSBC London in 2007 as an ABS generalist to cover the EMEA markets. She has

gained experience in emerging markets economics research from her stints as Fixed income/FX strategist at a leading research

consultancy in London and at the largest private sector bank in India, where she also worked in FX derivative sales.

Stefan Schilbe

Economist

HSBC Trinkaus & Burkhardt AG

+49 21 1910 3137

stefan.schilbe@hsbc.de

Stefan Schilbe is Chief Economist at HSBC Trinkaus & Burkhardt, where he has been working since 1996. Since 2001, he has served

as Head of the Treasury Research department, which is responsible for interest and currency forecasts as well as technical and relative

value analysis. Stefan is member of the Committee for Economic and Monetary Policy of the Association of German Banks. After being

trained as a banker, he studied economics at the University of Cologne.

Agata Urbanska

Economist

HSBC Bank plc

+44 20 7992 2774

agata.urbanska@hsbcib.com

Agata joined HSBC in 2011 as an economist for Central and Eastern Europe. She has been covering this region for 10 years. Before

joining HSBC, Agata worked as a senior Emerging Europe economist for one of the international investment banks. She has an

MA economics from Sussex University, UK and also from Warsaw University, Poland.

European Economic Quarterly-A long and winding road

products

Resources

Company

European Economic Quarterly-A long and winding road

Delete template?

Save as template?

products

Resources

Company