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HSBC -A long and winding road

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					  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                                                                                                    abc
   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.




                                                                                                                           1
    Macro
    European Economics                                                                                                        abc
    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




2
       Macro
       European Economics                                                                                                                                 abc
       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                       … as have 2013 growth forecasts but at a much lower rate
  worse …

       %                           2012 GDP forec ast                    % Year            % Year                                2013 GDP forecast                               % Year
   5                                                                           5           4                                                                                            4
   4                                                                           4
                                                                                           3                                                                                            3
   3                                                                           3
   2                                                                           2           2                                                                                            2
   1                                                                           1
                                                                                           1                                                                                            1
   0                                                                           0
  -1                                                                           -1          0                                                                                            0
           01-12
           01-11
           02-11
           03-11
           04-11
           05-11
           06-11
           07-11
           08-11
           09-11
           10-11
           11-11
           12-11

           02-12
           03-12
           04-12
           05-12
           06-12
           07-12
           08-12
           09-12




                                                                                                     01-12

                                                                                                             02-12

                                                                                                                       03-12

                                                                                                                                  04-12

                                                                                                                                          05-12

                                                                                                                                                  06-12

                                                                                                                                                            07-12

                                                                                                                                                                    08-12

                                                                                                                                                                               09-12




                         Western Europe                 Eastern Europe                                               Western Europe                       Eastern Europe
                         Eurozone                                                                                    Eurozone

  Source: Consensus economics                                                              Source: Consensus Economics




                                                                                                                                                                                            3
    Macro
    European Economics                                                   abc
    Q4 2012




Contents

                                               Budget balance              35
Key Forecasts                              3
                                               Debt                        36
A long and winding road                    5
Turning the corner?                        5
                                               Unemployment                37
The central bank task                      5   Demographics                38
Challenges for governments                 7   Economic infrastructure     39
Reforms, reforms                          13
                                               Eurozone                    40
Roadmap for integration                   16   Germany                     42
Life outside the euro isn’t easy either   20   France                      44
                                               Italy                       46
Emerging Europe is slowing too            21
                                               Spain                       48

Periphery at a glance                     23   UK                          50
                                               Norway                      52
Spain                                     25
                                               Sweden                      53
Italy                                     26   Switzerland                 54
                                               Hungary                     55
Ireland                                   27
                                               Poland                      56
Greece                                    28   Romania                     58

Portugal                                  29   Czech Republic              59
                                               Russia                      60
Rescue Packages                           30
                                               Turkey                      62
Key European forecasts and
statistics                                31   Disclosure appendix         67
GDP                                       32
                                               Disclaimer                  68
Consumer prices                           33
Consumer spending                         34


4
     Macro
     European Economics                                                                                                                 abc
     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?                                                       since led to a bond market rally on the scale that
                                                                          followed the ECB announcement of the unlimited
For much of the past three years, attempts to solve
                                                                          three-year LTROs (chart 1) and this is before the
the eurozone sovereign crisis appear to have been
                                                                          ECB has even bought a euro of bonds.
a case of ‘one step forward, one step back’. Over
the summer months we had a rare period of a                               The central bank task
couple of consecutive steps forward. The 28-29
                                                                          From SMP to OMT
June European Council summit, which in our
                                                                          The initial market impact was in response to Mr
view represented an important first step from
                                                                          Draghi’s 26 July speech but, as further details
coordination to genuine integration, did little to
                                                                          have become available, the ECB’s commitment
impress the markets. But the subsequent
                                                                          that, in exchange for countries meeting strict
commitment by the ECB president Mario Draghi
                                                                          conditions, it will undertake unlimited, but
to do “whatever it takes” to preserve the euro has


 1. The rollercoaster continues

 %                                                             2y r Bond Yields                                                     %
 8                                                                                                                                  8
                                       EC B starts                          EC B announces      Draghi commits to do
 7                                                                                                                                  7
                                  buy ing Spanis h                            3y r LTR Os        "w hatev er it takes "
 6                                                                                                                                  6
                                   and Italian debt
 5                                                                                                                                  5
 4                                                                                                                                  4
 3                                                                                                                                  3
 2                                                                                                                                  2
 1                                                                                                                                  1
 0                                                                                                                                  0
  Jan 11        M ar 11       May 11        Jul 11    Sep 11    N ov 11     Jan 12     Mar 12    May 12        Jul 12      Sep 12
                               Spanish 2y r Bond Yields                                         Italian 2y r Bond Yields

 Source: Bloomberg, Reuters




                                                                                                                                          5
    Macro
    European Economics                                                                                                                                 abc
    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                          What is the ECB trying to achieve?
it will not be a preferred creditor on its future                           By the ECB’s own admission, it can only provide
purchases (table 2), has caused most asset classes                          a backstop. It aims to address severe distortions in
to rally strongly. But we shouldn’t get too carried                         government bond markets which originate from
away. Ten-year yields on Spain and Italy are still                          euro break-up fears and to ensure the proper
only back where they were in May and, in the                                transmission of monetary policy to the real
final days of September were rising again. The                              economy throughout the monetary union. The fear
really strong performance has actually been in                              is that without such a policy there would be a risk
Ireland and Portugal, which, although they are                              of such “destructive scenarios” that the ECB
viewed as much less likely to pursue ECB support                            would not be able to deliver price stability.
via the OMT programme any time soon, have                                   Certainly, this does have the potential to be a
seen a continuation of the spread narrowing which                           much more genuine firewall than any of the
began earlier this year for Portugal and before                             rescue mechanisms put in place over the past few
that for Ireland.                                                           years because of the scale of the purchases that
The economic data has been much more                                        could be made. But this is not the first time that
disappointing. Admittedly it is still early days, but                       the ECB has found it necessary to step into
most sentiment indicators are still moving down                             government bond markets. Why should this
(charts 3 and 4). Both consumers and industry                               initiative be any more successful? From the
have yet to be convinced that the eurozone crisis                           markets’ perspective the key differences between
has genuinely taken a turn for the better.                                  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


6
   Macro
   European Economics                                                                                                                                                      abc
   Q4 2012




 3. Companies have been less impressed than financial                                  4. ...while consumers remain unimpressed
 markets....

  Index                                                                   Index        Index                     Consumer co nfidence                            Index
 115                                                                           60       20                                                                           20
 110                                                                           40       10                                                                           10
 105                                                                           20        0                                                                           0
 100                                                                           0
                                                                                       -10                                                                           -10
  95                                                                           -20
  90                                                                           -40     -20                                                                           -20
  85                                                                           -60     -30                                                                           -30
  80                                                                           -80     -40                                                                           -40
  75                                                                           -100    -50                                                                           -50

       08           09           10            11           12                               07          08          09          10           11        12
                       Ifo industry ex pec tations (LHS)                                              EMU                          F rance                   Italy
                       ZEW econom ic ex pec tations (R HS)                                            Germany                      Spain
 Source: Centre for European Economic Research (ZEW), Institute for Economic           Source: Directorate General for Economic and Financial Affairs
 Research (IFO)




scale) and the ECB will not be senior. In total, the                                  financial, fiscal and political integration. But the
SMP only purchased EUR220bn of five different                                         creditor nations within the monetary union will
governments’ bonds in the nearly two years that it                                    only be prepared to go down that route if all of the
was operational. To put this in perspective, it is                                    member states have shown that they can stabilise
less than one year of Italian bond issuance.                                          their debt burdens and restore their
                                                                                      creditworthiness without requiring indefinite
The other key difference, and the one that Mr
                                                                                      assistance from the ECB. Therefore the ECB has
Draghi tends to focus on, is that there will be
                                                                                      to try to provide incentives for governments to
explicit, rather than implicit, conditionality. A
                                                                                      continue the reform process.
commitment to fiscal and structural reforms,
through an actual EFSF/ESM programme, is a                                            Given that recent history has shown that the
necessary pre-requisite for ECB action and                                            urgency for reform has tended to fade whenever the
implementation of those reforms will be needed                                        pressure from the market has eased, the ECB has
for ongoing support. This also gives the ECB’s                                        said it will not only cease purchases of the bonds of
policy greater legitimacy than the SMP. Under                                         a country but potentially even sell them if its
the SMP, the Eurosystem was undertaking bond                                          government steps out of line with regards to the
purchases and therefore effectively mutualising                                       programme. Whether such a threat is credible we
the debt of eurozone member states but with no                                        will only discover over time. It should be borne in
legal mandate or democratic legitimacy to do so.                                      mind, however, that the ECB wasted no time in
Under the OMT the European Commission and                                             halting the SMP scheme for Italy when prime
IMF will set and monitor the conditions.                                              minister Silvio Berlosconi stepped out of line.

Will it work?                                                                         Challenges for governments
The ECB has now accepted its role as a credible                                       Waiting for Spain
lender of last resort but knows that it can’t single-
                                                                                      At the time of writing no country had actually
handedly provide a permanent solution to the
                                                                                      requested an EFSF/ESM programme, but Spain
crisis. It can merely buy time. For the market to
                                                                                      was widely expected to do so before long. On
remain stable at these levels, investors will have
                                                                                      27 September, the government announced a new
to make a leap of faith that governments will take
                                                                                      reform programme alongside the 2013 budget.
the necessary steps towards much greater


                                                                                                                                                                             7
    Macro
    European Economics                                                                                                                              abc
    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 Full macro economic adjustment programme
                     line or ECCL)
Eligibility          Activated when request made by country to Eurogroup           Activated only when a support request is made and a
                     members. Can be drawn by way of loan/primary market           country programme is negotiated with the EC, IMF and euro
                     purchase by non-programme countries with sound policies       area finance ministers and a MoU is signed. This would only
                     and fundamentals, but with some vulnerability. Aimed at       occur when the country is unable to borrow on markets at
                     overcoming external shocks and to prevent a crisis from       acceptable rates.
                     occurring.

Conditionality       Country to adopt corrective measures aimed at addressing      Linked to strict policy conditions which are set out in a MoU.
                     its weaknesses after consultation with EC and ECB.            The loan disbursement would be interrupted in case the
                     Remains under enhanced surveillance by the EC. Failure to     country fails to meet these conditions until the MoU is
                     meet these can result in closing of the credit line.          renegotiated.

Size                 No upfront cap, but the typical size could vary between 2-    Maximum amount of a loan, its margin and maturity, and the
                     10% of GDP of the member state.                               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.

Duration             One year with the possibility of renewing it for six months   A programme is typically for three years. Does not contain
                     twice.                                                        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.

Source: EFSF, HSBC




While the deficit projection for 2013 still looks                           has EUR20bn of bond redemptions falling due in
overly optimistic given the assumption that the                             the last week of October.
economy will only contract by 0.5% in 2013, the
                                                                            Even assuming Spain does go into a programme,
reform package and planned spending cuts were
                                                                            it still means that its adjustment is closer to the
generally perceived as paving the way for a
                                                                            beginning rather than the end. The eurozone
EFSF/ESM programme. It included nearly all of
                                                                            member states that have gone into Troika
the measures recommended by the Commission
                                                                            programmes have always seen their government
earlier this year. It also seems likely that it will be
                                                                            bond yields rise rather than fall after being
a precautionary programme rather than a full-
                                                                            granted external assistance (see chart 6). As long
blown macro-economic adjustment programme
                                                                            as the ECB clearly demonstrates its willingness to
(table 5) which would allow prime minister
                                                                            undertake unlimited purchases this time, yields
Mariano Rajoy to at least nominally stand by his
                                                                            should remain contained, which should help to
election promise of not allowing Spain to go the
                                                                            curb rising corporate borrowing costs at the same
same way as Ireland or Portugal.
                                                                            time. This should also have some positive
Nonetheless, Spain is still wary of relinquishing too                       confidence effects. Nonetheless, there would still
much sovereignty and is likely to resist any                                need to be a large amount of fiscal consolidation:
demands for further austerity, and Mr Rajoy would                           the primary surplus just doesn’t need to be quite
also prefer not to request assistance ahead of the                          as big as under a higher effective interest rate.
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


8
   Macro
   European Economics                                                                                                                                                abc
   Q4 2012




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

 %                 10y r Gov ernment bond spreads ov er German Bunds                          LTRO alt. EUR529bn                                              %
                                                                                                                              Draghi commits
 40                                                                                LTRO alt. EUR489bn                        to "do w hatev er it takes"      40
            IMF-EU Greek loan & EFSF                          Portugal bailout
 35                                                                                  LTRO                                                                     35
             announcement and ECB                                                    announcement                                                  OMT
 30          purchasing (SMP) begins                                                                                                                          30
                                                                         ECB restarts
 25                             Deauv ille                               SMP programme                                                                        25
 20                             agreement                                                                                                                     20
                                                 Ireland bailout
 15                                                                                                                                                           15
 10                                                                                                                                                           10
  5                                                                                                                                                           5
  0                                                                                                                                                           0
   Jan-10            May -10       Sep-10            Jan-11          May -11             Sep-11              Jan-12            May -12             Sep-12

                    Italy                    Spain                         Portugal                              Greece                            Ireland
 Source: Bloomberg, Reuters




Italy going it alone?                                                            No shortcuts for fiscal consolidation…
While Spain is currently centre stage, Italy is also                             As we have discussed before, when the IMF first
viewed as a potential candidate for requiring                                    signed a letter of intent with Greece in May 2010,
ECB/ESM assistance in the coming months. The                                     its projections showed that Greece would have
budget deficit is much smaller than that of Spain:                               one more year of recession in 2011, but would be
even with a deep contraction in GDP of about                                     roughly stable overall in 2011-2013, which would
2.5% in 2012, Italy’s budget deficit should come                                 allow the economy to return to primary surplus in
in below 3% of GDP. However, given the size of                                   2012 and the debt burden would peak at just under
its debt stock and low potential growth rate, a                                  150% of GDP in 2013.
renewed rise in borrowing costs would pose a big
                                                                                 The latest projections suggest that, far from being
challenge for Italy. Its annual bond issuance needs
                                                                                 stable over that three-year period, the Greek
are in the region of EUR200bn. The negative
                                                                                 economy will actually contract by nearly 17%
impact that austerity is already having on the
                                                                                 (chart 7). Greece is still struggling to come up with
economy means that the prime minister, Mario
                                                                                 additional austerity measures and has also been
Monti, will continue to resist any calls for more
                                                                                 seeking an extra two years (until 2016) to achieve
aggressive fiscal consolidation, and will therefore
                                                                                 the required fiscal consolidation.
remain very reluctant to submit to EFSF/ESM
conditionality. Besides, if Spain goes into a                                    7. Greece IMF GDP forecasts: the damage to the real economy
                                                                                 has been much worse than the programme ever envisaged
programme and the ECB starts to walk the talk,
                                                                                 %Yr                                      2011      2012   2013 Cumulative
then Italy would probably benefit. A continuation
                                                                                 May-10                                    -2.6      1.1     2.1               0.5
of Mr Monti’s various reforms to raise long-term                                 Dec-10                                    -3.0      1.1     2.1               0.1
potential growth should also help to reassure the                                Mar-11                                    -3.0      1.1     2.1               0.1
                                                                                 Jul-11                                    -3.9      0.6     2.1              -1.3
market. Nonetheless, the elections looming in                                    Dec-11                                    -6.0     -3.0     0.3              -8.5
                                                                                 Mar-12                                    -6.9     -4.8     0.0             -11.4
April 2013 could lead to political uncertainty and                               Sep-12 (Consensus                         -6.9     -6.3    -3.3             -16.5
concerns about the continuity of the reforms,                                    Economics)

meaning that some kind of precautionary                                          Source: IMF country reports, Consensus Economics

programme for Italy cannot be ruled out.




                                                                                                                                                                       9
     Macro
     European Economics                                                                                                                                                                              abc
     Q4 2012




Greece may be an extreme example and no-one is                                                          8. Irish austerity: five years down; three to go

suggesting that any other member state is in such a                                                     %GDP                    Ireland F iscal Consolidation                        %GDP
dire position. But the Greek projections show how                                                       4                                                                                      4

hard it was to appreciate in advance just how                                                           3                                                                                      3
damaging austerity on that scale would be for the
                                                                                                        2                                                                                      2
real economy when the private sector was not in a
                                                                                                        1                                                                                      1
position to compensate. Other countries have been
relatively successful, but even Ireland is a useful                                                     0                                                                                      0
reminder of the lengthy painful adjustment                                                                      08        09       10          11     12f       13f      14f       15f
associated with these kinds of programmes.                                                                      Ex penditure contribution                     R ev enue contribution

Ireland began its austerity programme very early – in                                                   Source: IMF Ireland Country Report Seventh Review

July 2008 when countries such as Spain (and most
other countries in the Western world, except Italy)                                                  aggregating the three sectors which are
were providing a fiscal stimulus. It has delivered a                                                 predominantly public sector (public administration
total cumulative fiscal consolidation between 2008                                                   & defence, education and health & social work). The
and 2012 of 13% of GDP, over half of which was                                                       charts show that although Ireland had started to shed
spending cuts. It also undertook a large internal                                                    public sector jobs by the end of 2008 and Greece
devaluation, returned to positive GDP growth and is                                                  started in 2010, the Spanish public sector increased
back in the market raising medium-to-long term                                                       public sector employment between 2008 and mid-
debt. Yet it will still have a budget deficit of about                                               2011 by about 12%. Spain has only started to cut
8.3% of GDP this year. Hence it is projecting a                                                      jobs, largely through natural wastage over the past
further 5% of GDP of fiscal consolidation over the                                                   year (see Spanish Labour Reforms: Protest or
next three years (chart 8).                                                                          Progress, 12 September 2012). Italy and Portugal do
                                                                                                     not appear to have started yet. In contrast, the US
…which still has a long way to run                                                                   and, in particular the UK, have been consistently
Nonetheless, Ireland is still further along in its                                                   shedding public sector jobs (charts 16 and 17). In
adjustment than the other most problematic member                                                    both of those countries the public sector job losses
states, particularly regarding shrinking the public                                                  have been offset by private sector job gains. In the
sector. Charts 10-15 speak for themselves. Not every                                                 periphery the private sector is still shedding jobs
country provides a neat split between public and                                                     and unemployment rates are likely to continue
private sector employment so, where it is not                                                        rising for at least the next year.
available, we have used the IMF approach of

9. Official projections are still a little optimistic
                                        ___ 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                                          -8.5              -6.3             -4.5               0.7             -1.5              -0.5            68.5                …                   …
Peripheral projections
 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



10
  Macro
  European Economics                                                                                                                                                            abc
  Q4 2012




10. In the eurozone, Ireland has shrunk public sector                                   11. ...while Greece is a close second
employment the most...

Index                                   Ireland                                 Index   Index                                   Greece                                 Index
115                                                                               115   115                                                                              115
110                                                                               110   110                                                                              110
105                                                                               105   105                                                                              105
100                                                                               100   100                                                                              100
 95                                                                               95     95                                                                              95
 90                                                                               90     90                                                                              90
 85                                                                               85     85                                                                              85
 80                                                                               80     80                                                                              80
       08                09                10             11               12                  08                09               10             11               12

                  Public sector                               Priv ate sector                            Public sector*                               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                                    13. ...while Italy hasn’t really started...
recently...

Index                                     Spain                                 Index   Index                                     Italy                                Index
115                                                                               115   115                                                                              115
110                                                                               110   110                                                                              110
105                                                                               105   105                                                                              105
100                                                                               100   100                                                                              100
 95                                                                               95     95                                                                              95
 90                                                                               90     90                                                                              90
 85                                                                               85     85                                                                              85
 80                                                                               80     80                                                                              80
       08               09               10           11              12                       08                09               10             11               12

                  Public sector                             Priv ate s ector                             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                                15. No public sector job cuts in Germany
have grown steadily

Index                                   Portugal                                Index   Index                                   Germ any                               Index

115                                                                               115   115                                                                              115
110                                                                               110   110                                                                              110
105                                                                               105   105                                                                              105
100                                                                               100   100                                                                              100
 95                                                                               95     95                                                                              95
 90                                                                               90     90                                                                              90
 85                                                                               85     85                                                                              85
 80                                                                               80     80                                                                              80
       08                09                10            11                12                          08                  09              10               11
                 Public sector*                                Priv ate s ector                           Public sec tor                              Priv ate s ector

Note: *With no national data reported, public sector employment includes Public         Source: Federal Statistic Office
Administration, Defence, Compulsory Social Security, Education, Human health and
Social Work Activities from Eurostat, in line with IMF approximations made for Greece
Source: Eurostat




                                                                                                                                                                                  11
     Macro
     European Economics                                                                                                                                   abc
     Q4 2012




 16. More public sector job losses in the UK than in the                 17. Even the US has shed more public sector workers than
 eurozone                                                                most

 Index                          UK                         Index         Index                                      US                       Index
 115                                                           115       115                                                                      115
 110                                                           110       110                                                                      110
 105                                                           105       105                                                                      105
 100                                                           100       100                                                                      100
  95                                                           95         95                                                                      95
  90                                                           90         90                                                                      90
  85                                                           85         85                                                                      85
  80                                                           80         80                                                                      80
       08         09           10     11          12                            08             09              10        11           12

               Public sector                Priv ate s ector                              Public sector                        Priv ate s ector

 Source: ONS                                                             Source: Bureau of Labor Statistics




High debt to constrain growth                                        “exceptionally high” levels of debt1 (gross public
Clearly the fiscal consolidation challenges are not                  debt exceeding 90% of GDP) and reached two
just confined to the periphery. Most European                        main conclusions: growth in highly indebted
countries, whether inside or outside the eurozone,                   economies is more than 1pp below average and
face a similar challenge in trying to stabilise their                18. General government gross debt (%GDP)
debt burdens, just to varying degrees. With the                                                               1999            2007                2012f
exception of Switzerland and parts of                                Greece*                                   94.9           107.4               168.0
Scandinavia, debt levels are historically high. Not                  Italy*                                   113.0           103.1               126.1
                                                                     Ireland*                                  48.0            24.8               119.3
only will the austerity deliver a big dent to GDP                    Portugal*                                 49.4            68.3               123.7
in the short term, the continued high debt burden                    Belgium                                  113.6            84.1               100.5
                                                                     EU17                                      71.6            66.3                91.8
can reduce growth for many years through a                           United Kingdom                            43.7            44.4                91.2
                                                                     France                                    58.9            64.2                90.5
number of channels. Most obviously, higher taxes                     EU27                                      65.7            59.0                86.2
can create unwelcome distortions that harm                           Germany                                   61.3            65.2                82.2
                                                                     Spain                                     62.4            36.2                80.9
growth, as can the need to cut back on longer-                       Hungary                                   60.8            67.1                78.5
                                                                     Cyprus                                    59.3            58.8                76.5
term government investment. In addition, the                         Malta                                     57.1            62.3                74.8
government financing need can ‘crowd out’                            Austria                                   66.8            60.2                74.2
                                                                     Netherlands                               61.1            45.3                70.1
private borrowers, particularly if default risk has                  Poland                                    39.6            45.0                55.0
                                                                     Slovenia                                  24.1            23.1                54.7
driven government borrowing rates up, as has                         Finland                                   45.7            35.2                50.5
been the case in the eurozone periphery. Finally,                    Slovakia                                  47.8            29.6                49.7
                                                                     Czech Republic                            15.8            27.9                43.9
so-called ‘financial repression’, where authorities                  Latvia                                    12.5             9.0                43.5
impose restrictions on finance to reduce                             Denmark                                   58.1            27.5                40.9
                                                                     Lithuania                                 22.6            16.8                40.4
borrowing costs, can also impede growth (as                          Sweden                                    64.3            40.2                35.6
                                                                     Romania                                   21.7            12.8                34.6
discussed in Stephen King’s report From                              Luxembourg                                 6.4             6.7                20.3
depression to repression, 23 April).                                 Bulgaria                                  77.6            17.2                17.6
                                                                     Estonia                                    6.5             3.7                10.4
A recent study by a trio of leading economists                       *Official forecasts
                                                                     Source: European Commission
examined 26 episodes where economies nursed

                                                                     1
                                                                       See Reinhart, Reinhart and Rogoff (2012), ‘Debt overhangs: past and
                                                                     present’, NBER WP 18015




12
   Macro
   European Economics                                                                                                                       abc
   Q4 2012




debt overhangs are highly persistent, with an                             even greater need to undertake the structural
average duration of more than two decades. So if                          reforms required to raise the potential growth rate
history is any guide, many indebted European                              in these increasingly demographically-challenged
countries (table 18) could suffer from sub-par                            countries. Of course many of the necessary
growth for a decade or more. The consequences                             reforms were meant to have been undertaken even
are considerable. If eurozone growth averaged                             before the inception of the euro but, with the main
1% rather than 2% over the next 20 years, output                          exception of Germany, were put on the
at the end of this period would be more than a                            backburner once the euro was formed and now,
fifth lower and debt-to-GDP ratios would remain                           under the guardianship of the Troika and/or
stubbornly high.                                                          pressure from the markets, they have resumed.
                                                                          Table 24 summarises the broad range of structural
The example of Ireland makes the point neatly.
                                                                          reforms for which the sovereign crisis has been
Under a base-case scenario, using the IMF’s
                                                                          the catalyst. Clearly much still needs to be done,
forecasts of 2.5% annual average GDP growth in
                                                                          and not just in the periphery. Minimum wages are
2013-2017 Ireland’s debt-to-GDP ratio would
                                                                          high in many countries. A country such as
gradually ease to 109% of GDP by 2017. If GDP
                                                                          Belgium still has a much higher incidence of
growth is 1pp higher in each of those five years it
                                                                          wage indexation than Spain. And France, for
would be 93% (chart 19). If, however, GDP
                                                                          much of the population, still has a lower
growth is 1pp lower in each year the debt burden
                                                                          retirement age than most member states. But even
would still be more than 125% of GDP: further
                                                                          France recently announced that it is establishing a
fiscal consolidation would be required to lower
                                                                          committee for competiveness in an attempt to
the deficit below the European Commission’s
                                                                          curb labour cost growth.
threshold of 3% of GDP and the debt burden
would remain very high unless growth revives                               20. Periphery is starting to regain competitiveness

more convincingly.                                                          Index                    REER, Jan 2001=100          Index
                                                                           140                                                       140
 19. The importance of growth to debt stabilisation
                                                                           130                                                       130
 %GDP                     Ireland Debt-to-GDP ratio                %GDP
                                                                           120                                                       120
 140                                                                140    110                                                       110
 130                                                                130
                                                                           100                                                       100
 120                                                                120
                                                                            90                                                       90
 110                                                                110
 100                                                                100          01 02 03 04 05 06 07 08 09 10 11 12
  90                                                                90                   Greece               Ireland            Portugal
  80                                                                80                   Spain                Italy

          10         11     12f    13f     14f   15f   16f   17f           Source: European Commission


            GDP -1%                      GDP Bas e           GDP +1%
                                                                          There are now firmer signals that the reforms are
 Source: IMF, HSBC
                                                                          starting to deliver some improvements in
                                                                          competitiveness, particularly in Ireland, where the
Reforms, reforms                                                          real effective exchange rate has fallen most
With the public sector likely to be a drag on                             rapidly thanks to wage cuts and job losses, but all
growth for the foreseeable future, the private                            of the peripheral countries have seen some
sector needs to be on the strongest possible                              improvement over the past year or so (chart 20).
footing in order to generate jobs. Hence, there is


                                                                                                                                              13
     Macro
     European Economics                                                                                                                                                             abc
     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                                                         elsewhere. Hence, the countries that it has a
account positions of the periphery (chart 22) is                                                     bilateral surplus with have changed significantly
attributable to a collapse in imports rather than an                                                 (chat 23). The surplus vis-à-vis the periphery has
export revival. The periphery still has a long way                                                   shrunk markedly while it has eliminated the
to go to close the competitiveness gap with                                                          deficit it used to run with China and its surplus
Germany that widened steadily throughout the                                                         vis-à-vis both the US and the rest of Asia has
first decade of the euro. But it is notable that some                                                continued to grow.
peripheral countries are starting to narrow the gap,
                                                                                                     That said, while an improvement in competitiveness
and they also seem to be having considerable
                                                                                                     is essential to the long-term growth outlook, it won’t
success at diversifying their export markets (table
                                                                                                     revive growth quickly if external demand keeps
21). For instance, Portugal has doubled the share
                                                                                                     weakening. Worryingly, the biggest downward
of its exports going to Africa over the past five
                                                                                                     forecast revisions in our latest global forecasting
years. Similarly, Germany’s current account
                                                                                                     round have been to the emerging world (see Why
surplus is still huge (as a share of GDP it is much
                                                                                                     pump priming isn’t working, 27 September).
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                                                  23. ...while Germany’s surplus remains large as its balances
   sharply...                                                                                            with non-eurozone trading partners improve

   % GDP                             Current ac count                           % GDP                                  German bilateral current account balances
     8                                                                                8                  EURbn, 4Q sum                                           EURbn, 4Q sum
     4                                                                                4                 120                                                                  120
     0                                                                                0                   90                                                                 90
     -4                                                                               -4
                                                                                                          60                                                                 60
     -8                                                                               -8
                                                                                                          30                                                                 30
  -12                                                                                 -12
                                                                                                            0                                                                0
  -16                                                                                 -16
                                                                                                         -30                                                                 -30
          00        02          04         06          08         10          12
                                                                                                                00        02          04         06         08   10     12
                  Portugal                      Ire land                     Greece
                  Italy                         Ge rmany                     Spain                                   China                 Eurozone              Asia        US
   Source: National Sources                                                                              Source: Deutsche Bundesbank




14
     Macro
     European Economics                                                                                                             abc
     Q4 2012




24. Structural reforms catalysed by the euro area debt crisis
                                                                                      Greece   Ireland   Portugal   Spain   Italy
Tax reforms
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




                                                                                                                                      15
     Macro
     European Economics                                                                                                                                      abc
     Q4 2012




Roadmap for integration                                                          straightforward part of the integration process and
                                                                                 could be put in place fairly swiftly. Progress on
Given that both the fiscal consolidation and the
                                                                                 this issue is essential before the EFSF/ESM loan
beneficial impact of the structural reforms on
                                                                                 to the Spanish banks can stop being a government
growth will take several years, it is asking a great
                                                                                 liability as it would allow the ESM to recapitalise
deal of the markets to take the leap of faith that
                                                                                 the banks directly. However, the European
the ECB will keep buying the debt indefinitely
                                                                                 Commission plan currently looks too ambitious to
without more rapid progress being made on future
                                                                                 be palatable to all of the eurozone member states.
eurozone integration. This requires new
                                                                                 It would eventually give the ECB broad
institutions for financial and fiscal integration as
                                                                                 supervision powers over all 6,000 eurozone banks
well as a new governance framework.
                                                                                 rather than just the 20 or so large international
Financial integration                                                            banks which could “pose a systemic risk at a
Since the broad plan was set out at the late June                                Europe level” that has been advocated by some.
summit (see EU Summit: First steps to banking                                    The German government in particular has called
union, 29 June 2012), the only further details we                                for national supervisors to retain control over
have so far been given have been the European                                    most of the smaller regional banks.
Commission’s proposals for the single banking
supervisor, published on 12 September (table 25).
It had been hoped that this would be the relatively

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        All tasks not conferred on the ECB will remain     Develop the rules at EU
                 outside the eurozone that wish to participate will be able   with national supervisors. Ex Consumer             level and ensure
                 to enter if they meet specific conditions. The ECB will be   protection, fight against money laundering,        convergence and
                 the host supervisor for credit institutions established in   supervision of third country credit institutions   consistency of
                 non-eurozone EU countries, which establish a branch or       establishing branches or providing cross-          supervisory practice.
                 provide cross-border services in the eurozone.               border services within a member state.
Prudential       Assess qualifying holdings, ensure compliance with the                                                          Design rules at EU level.
rules            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          Assess compliance with any conditions of
/Licensing    institutions/withdrawal of authorisation in participatingauthorisation set out in national law and if
              member states.                                           conditions are met/infringed, could propose to
                                                                       the ECB to grant/withdraw the authorisation.
Investigatory Will be able to request all relevant information from    Carry out ongoing day-to-day assessment of a
powers        supervised entities.                                     bank’s situation and on site verifications,
              Will also be empowered to conduct all necessary          implementing general guidance or regulations
              investigations, including on-site inspections.           issued by the ECB.
Sanctions     In case of a breach of a requirement under directly      In the cases not covered, the ECB may require
              applicable Union acts, the ECB may impose                national supervisory authorities to take action
              administrative pecuniary sanctions of up to twice the    in order to ensure that appropriate sanctions
              amount of the profits gained or losses avoided because are imposed.
              of the breach, or up to 10% of the total annual turnover
              of a legal person in the preceding business year.
Internal risk Final validation of the model.                           The national supervisor could assess the
model                                                                  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.
Source: European Commission




16
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    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 Bank supervision remains very fragmented.
                 of all banks in the eurozone.                                  The Office of the Comptroller of the Currency (OCC) is the
                 The ECB would first be allowed to take over supervision of primary regulator of National Banks. At the federal level, the
                 any bank it wants in the eurozone (and in particular banks     Federal Reserve Board regulates state-chartered banks that
                 receiving public support) as early as 1 January 2013. It would are members of the Federal Reserve System and bank
                 then be granted supervisory powers on the most systemically holding companies. For other state-chartered banks, the
                 important European banks on 1 July, 2013. Finally, all banks primary regulator is the Federal Deposit Insurance
                 in the Eurozone would come under ECB supervision on            Corporation. Finally, thrift holding companies and savings
                 1 January 2014.                                                banks are regulated by the Office of Thrift Supervision.

Deposit Insurance Coverage of national Deposit Guarantee Schemes has been               The FDIC provides deposit insurance for 7,246 financial
Scheme            raised to a harmonised level of EUR100,000 since                      institutions (as of 30 June 2012) in the United States. Dodd-
                  31 December 2010. There is no common deposit insurance                Frank legislation temporarily put in place unlimited deposit
                  scheme.                                                               insurance for interest-bearing accounts until the end of this
                                                                                        year. For interest bearing (consumer) accounts the limit will
                                                                                        revert to USD250,000.

Bank Resolution         Existing Resolution schemes exist only at the national level.   The FDIC has resolution powers on federally insured banks
Scheme                  However, the Commission indicated in its proposal on            and thrift institutions but also on systemically-important
                        integrated bank supervision that it envisages making a          financial institutions since the passage of the Dodd-Frank act.
                        proposal for a single resolution mechanism within the future    Since the crisis began the FDIC has resolved, liquidated and
                        banking union.                                                  restructured more than 400 banks.
Sources: HSBC, European Commission

No doubt some kind of compromise on the range                                   accountability. European Council President
of banks that will be covered will be reached, but                              Herman Van Rompuy said he will present an
it will take time. The European Commission                                      interim report on at least some of the issues at the
President, Jose Manuel Barroso, optimistically                                  next European Council meeting in October.
hopes to have a consensus on the single banking
                                                                                Fiscal integration
sector supervisor issue by the end of this year but
the plan cannot become law until passed by all EU                               As with the banking union proposal, Mr Van
governments. Even once it is in place, the                                      Rompuy’s report may be what he believes is
common supervision will in itself be unable to                                  necessary, but will nonetheless probably be at the
break the negative feedback loop between a                                      more ambitious end of what is actually feasible.
eurozone sovereign and its banks. Meeting that                                  Much of the focus will be on any new information
goal will require much more controversial                                       on what an integrated fiscal framework would
elements such as a eurozone-wide deposit                                        actually involve. As well as a swift
guarantee scheme and bank resolution                                            implementation of the existing governance
mechanism. The current official proposals                                       framework (table 27) it will also have to entail a
therefore still fall short of the mechanisms                                    qualitative move towards a fiscal union. This
existing in the US, despite a very fragmented                                   would involve a much greater pooling of decision-
supervisory network there (table 26).                                           making on budgets. EU institutions would have
                                                                                much greater powers over the national budgets of
On the other areas of integration, the plan is that                             member states which breach debt and deficit
four building blocks will be put in place over the                              rules, and if a country needs to increase its
next decade. The first block is the move towards                                borrowing, it would be forced to go to other
some kind of banking union discussed above                                      eurozone governments to obtain prior approval.
while the others are integrated frameworks for
fiscal matters and economic policy, accompanied
by increased democratic legitimacy and


                                                                                                                                                            17
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     Q4 2012




27. The current governance framework                                           Timeline
          Measure                                   Sanctions                  Any clear timelines for steps towards common
Excessive Deficit                Once an Excessive Deficit Procedure is        bond issuance are unlikely to be in the report at
Procedure (6-pack)               initiated, the European Commission may
                                 decide sanctions (up to 0.5% of GDP) if       this early stage. The Van Rompuy report2
                                 no effective action has been taken.
                                 These sanctions are only rejected if a
                                                                               published in the summer briefly mentioned the
                                 qualified majority of member states in the    prospect of partial common debt issuance “in a
                                 Council votes against them.
                                                                               medium-term perspective” citing bills or a
Macroeconomic                    Once a Macroeconomic Imbalance                redemption fund, but plenty of other options such
Imbalance Procedure              Procedure is initiated, the European
(6-pack)                         Commission may decide sanctions (up           as blue-red bonds or stability bonds have also
                                 to 0.1% of GDP) in case of failure to         been proposed. Clearly Germany will continue to
                                 comply with the recommended corrective
                                 action. These sanctions are only rejected     resist being on the hook for further transfers of
                                 if a qualified majority of member states in
                                 the Council votes against them.               funds or a further sharing of its credit rating
                                                                               without a certain loss of sovereignty of the debtor
Fiscal Compact (TSCG*) Fiscal Compact requires integration of
                       fiscal rules into national law, preferably              attached to it. Hence we expect any explicit
                       at a constitutional level. In case of failure
                       to comply with this integration, the                    timelines to be glaringly absent in either of the
                       European Commission may ask the                         upcoming reports. Rather than coming up with
                       European Court of Justice (CoJ) to rule.
                       The CoJ may then impose financial                       some kind of 2020 deadline, we expect the next
                       sanctions (up to 0.1% of GDP).
                                                                               roadmap to be a building-block process with any
* TSCG is the Treaty on Stability, Coordination, and Governance (TSCG)
Source : European Commission, HSBC
                                                                               goals only being achieved if various conditions
                                                                               are met along the way. By the end of this year, we
As we discussed in our last quarterly (A rocky                                 might also have an indication as to which
road ahead, 12 July 2012) progress towards this                                elements of the roadmap can be achieved within
kind of fiscal integration at the eurozone level is                            existing treaties and what needs to be changed.
only possible if both creditors and debtors agree                              Germany has admitted a referendum will be
to relinquish more sovereignty to a supranational                              needed at some stage. Ultimately populations
institution. This will be difficult in any of the                              across the eurozone will have to vote for it.
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.
                                                                               2
                                                                                Towards a Genuine Economic and Monetary Union, Herman Van
                                                                               Rompuy, European Council 26 June 2012




18
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      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        pts                     Tax im pact on inflation                pts
  4                                                            4      2.5                                                           2.5
  2                                                            2      2.0                                                           2.0
                                                                      1.5                                                           1.5
  0                                                            0
                                                                      1.0                                                           1.0
 -2                                                            -2
                                                                      0.5                                                           0.5
 -4                                                            -4     0.0                                                           0.0
 -6                                                            -6    -0.5                                                           -0. 5
 -8                                                            -8    -1.0                                                           -1. 0

       07           08    09       10        11   12                        04     05   06      07    08    09      10   11   12
              Germany                Portugal          Italy                      Eurozone                  Italy             Portugal

 Source: Eurostat                                                    Source: Eurostat



Will populations vote for it?                                       compared with a 1.5% fall in 2009. The same
To keep populations on side over the coming                         point holds for Portugal (charts 28 and 29). It is
months and years there will need to be some signs                   perhaps hardly surprising that hundreds of
of light at the end of the tunnel. The stabilisation                thousands of protestors participated in a peaceful
in Italian consumer confidence in September,                        demonstration in Portugal in September when the
which must be at least in part a response to the                    prime minister announced that he proposed to
ECB’s new policy, is therefore welcome. But for                     raise workers’ social security contributions from
the peripheral countries to continue to see the                     11% to 18%. The number of working days lost
benefits of remaining inside the monetary union                     due to industrial action in Portugal is typically
they will need to believe that there will ever be an                among the lowest in the eurozone.
end to the deepening recession and ongoing rise in                  The end of the road
unemployment. For the creditor nations within the
                                                                    No one ever said it would be easy, and things appear
euro, they would feel more comfortable about
                                                                    set to get tougher still in the year ahead. Heads of
continuing to underwrite future rescue packages if
                                                                    government will need to take decisions on exactly
their governments were able to point to a success
                                                                    what kind of financial, fiscal and political integration
story or a country successfully graduating from a
                                                                    is achievable and then set out on the very long road
programme. Ireland is currently the relative
                                                                    to implementing them. The ECB has bought time.
success story, but, as discussed above, others have
                                                                    Now governments need to do the rest, most likely in
much farther still to go and the contraction in
                                                                    the face of growing resistance from their
GDP does not always give a fair representation of
                                                                    populations, some of which may start to think that
the depth of the recession underway in some of
                                                                    the answer to their problems lies outside the
these countries. Italy is a case in point. In 2009
                                                                    eurozone (table 30). But the euro is not the sole
Italian GDP declined by 5.5%, but much of that
                                                                    source of their problems and their structural rigidities
recession was driven by the collapse in the world
                                                                    will have to be addressed and new institutions built.
trade cycle. In some of the periphery countries the
                                                                    Our underlying assumption remains that the
rising unemployment and persistent tax rises and
                                                                    eurozone will ultimately reach this destination but
spending cuts mean domestic recessions are much
                                                                    believe there will continue to be periods when it
deeper now. According to our forecasts, Italian
                                                                    takes the market to keep member states moving in
consumer spending will contract by 3.4% in 2012
                                                                    the right direction.


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     European Economics                                                                                                                                      abc
     Q4 2012




30. What is your opinion of a European economic and monetary                            31. Average duration of debt stocks is shortening
union with one single currency, the euro?
                                                                                        Years               Duration of Debt Stocks              Years
%                                    For            Against          Don’t know           15                                                           8
Cyprus                                52                   44                      4   14.5                                                            7.5
Italy                                 53                   33                     14     14                                                            7
Spain                                 55                   36                      9
Portugal                              58                   33                      9   13.5                                                            6.5
Malta                                 63                   32                      5     13                                                            6
Germany                               65                   30                      5   12.5                                                            5.5
Austria                               65                   30                      5
France                                69                   28                      3      12                                                           5
Estonia                               71                   25                      4
                                                                                            Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12
Netherlands                           73                   25                      2
Finland                               74                   24                      2                  UK (LHS)                        Italy (RHS)
Belgium                               75                   23                      2                  Spain (RHS)                     Portugal (RHS)
Greece                                75                   21                      4
Luxembourg                            78                   19                      3    Source: Bloomberg
Slovenia                              80                   18                      2
Slovakia                              80                   16                      4
Ireland                               79                   13                      8   the OBR projected that growth in 2012 would be
Source: European Commission Eurobarometer survey July 2012 (Fieldwork May 2012)        2.6%, but even in March of this year it forecast
                                                                                       0.8% growth. We expect a 0.1% contraction.
Life outside the euro isn’t easy
                                                                                       So before new official forecasts are published on
either
                                                                                       5 December, the UK government faces a huge
Given the immense challenges that lie ahead for                                        dilemma: does it tighten fiscal policy and weaken
the eurozone member states, one could be forgiven                                      the economy further, or does it take the political
for thinking that life is considerably easier for                                      hit and admit its deficit reduction programme is
countries not in the euro. Despite the size of its                                     failing. Currently we think it will opt for the latter
budget deficit and debt burden, the UK has                                             and try to pin the blame on a global slowdown.
benefited from being something of a safe haven.
                                                                                       Whether or not markets will give the UK
Whereas many eurozone member states have seen                                          government the benefit of the doubt remains to be
a gradual fall in the maturity of their debt stocks                                    seen. So far, UK borrowing costs have been
(chart 31) the UK has managed to extend the                                            helped by a supportive Bank of England, which
maturity of debt recently. But in public finance                                       has bought huge amounts of debt under its QE
terms, this is a rare bright spot in an otherwise                                      policy. But we think there is a good chance the
darkening picture: it is not only the eurozone                                         BoE may pause QE, at least for the rest of this
economies that face fiscal difficulties.                                               year, (see Time for caution, 30 August). This,
                                                                                       alongside a weak growth outlook and the fact that
In 2010, the UK government set itself two tough
                                                                                       the UK has done less actual deficit reduction than
fiscal targets: to balance the cyclically-adjusted
                                                                                       several other European countries (chart 32), could
current budget within a rolling five-year period
                                                                                       put the UK’s AAA rating under renewed pressure.
and to have net-debt-to-GDP falling in 2015/16.
The UK’s Office for Budgetary Responsibility                                           What’s more, the UK, like other governments, has
(OBR) has so far considered the UK government                                          huge contingent liabilities that are hangovers from
to be on track to meet these aims – just. But this                                      support offered during the financial crisis. While
is likely to change in its next assessment, largely                                     these are hard to quantify, the numbers are large.
because growth has disappointed. In our view,
                                                                                       The UK for example excludes the debt of publicly
the OBR has consistently been too optimistic on
                                                                                       owned banks from its benchmark measures of net
the strength of the recovery. In November 2010,


20
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      European Economics                                                                                                                abc
      Q4 2012




 32. The UK is lagging behind others on the primary balance                      outperformer Russia is losing steam as oil prices
 adjustment
                                                                                 moderate, fiscal consolidation kicks in and
      % Potential                                       % Potential
                                                                                 inflation picks up. The outlook for Central &
  6                                                                         6
  4                                                                         4    Eastern European (CEE) countries remains fairly
  2                                                                         2
  0                                                                         0
                                                                                 dire. Hungary has dipped into technical recession
 -2                                                                         -2   and the Czech Republic is looking worse by the
 -4                                                                         -4
 -6                                                                         -6   day. Poland is losing traction at an astounding
 -8                                                                         -8   pace. Turkey has so far held up better than we
          2000    2002      2004   2006     2008    2010         2012            feared, thanks to a very successful diversification
                 United Kingdom                    France                        effort of export destinations, but even though
                 Italy                             Spain
                 Portugal                                                        domestic demand tends to be resilient Turkey
 Source: OECD                                                                    cannot escape the global slowdown and
                                                                                 policymakers are gearing towards lower growth
debt as it assumes these institutions will eventually                            targets for this year and the next.
be returned to the private sector. This is probably a
fair assumption, but more than three years after                                 Although activity has been losing steam since the
bailing out two of its biggest banks, they are still in                          second half of last year, inflation has been simply
public ownership (and even where ‘good’ parts have                               sticky, cruising above the target in many countries.
been sold, the ‘bad’ assets have been retained). If                              Nowadays, there is even further upside risk to
we look at total public debt including financial sector                          headline inflation given the ominous path of global
support, net debt more than doubles from 66% to                                  agricultural commodity prices. This is especially
136% of GDP (chart 33).                                                          true for the large economies with big domestic
                                                                                 markets, such as Russia and Turkey. Nonetheless,
 33. Including the debt of publicly-owned banks greatly                          wage inflation remains in check, broadly speaking,
 increases the net-public-debt-to-GDP ratio
                                                                                 although Russia is an exception.
 %                                                                          %
 180                                                                    180      Overall, the growth/inflation trade-off has
 150                                                                    150
                                                                                 deteriorated in Emerging Europe since the global
 120                                                                    120
                                                                                 crisis. We see policymakers shifting their focus
  90                                                                    90
  60                                                                    60       more towards growth and looking comfortable with
  30                                                                    30       above-target inflation for longer. They are possibly
      0                                                                 0        emboldened by ultra-loose monetary policy in the
          06      07        08     09      10      11       12                   developed world. As the developed world keeps its
                 Debt:GDP                 Debt:GDP (ex fin support)              fingers on the trigger for further pump-priming, the
                                                                                 developing countries would also likely tilt, on
 Source: ONS
                                                                                 balance, towards a higher tolerance for inflation
Emerging Europe is slowing                                                       and other imbalances in order to use what scope
too                                                                              they have to support growth.

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


                                                                                                                                          21
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     European Economics                                                                                                                     abc
     Q4 2012




33. Policy rates forecasts
                                Q4 2011             Q1 2012   Q2 2012 Current rate   Q4 2012f   Q1 2013f   Q2 2013f   Q3 2013f   Q4 2013f
Eurozone
Repo rate                             1.00             1.00      0.75         0.75       0.50       0.50       0.50       0.50       0.50
UK
Base rate                             0.50             0.50      0.50         0.50       0.50       0.50       0.50       0.50       0.50
Norway
Sight deposit rate                    1.75             1.50      1.50         1.50       1.50       1.75       1.75       1.75       2.00
Sweden
Repo rate                             1.75             1.50      1.50         1.25       1.00       0.75       0.75       0.75       1.00
Switzerland
SNB target rate                       0.00             0.00      0.00         0.00       0.00       0.00       0.00       0.00       0.00
Czech Republic
Repo rate                             0.75             0.75      0.25         0.25       0.25       0.25       0.25       0.25       0.25
Romania
Repo rate                             6.00             5.50      5.25         5.25       5.25       5.25       5.25       5.25       5.50
Poland
Reference rate                        4.50             4.50      4.75         4.75       4.50       4.00       4.00       4.00       4.00
Hungary
Base rate                             7.00             7.00      6.50         6.50       6.50       6.00       5.50       5.50       5.50
Russia
Refinancing rate                      8.00             8.00      8.25         8.25       8.75       8.75       8.75       8.00       8.00
Turkey
One week repo rate                    5.75             5.75      5.75         5.75       5.75       5.75       5.75       5.75       5.75
US
Targeted Fed Funds                 0-0.25            0-0.25    0-0.25       0-0.25     0-0.25     0-0.25     0-0.25     0-0.25     0-0.25
Japan
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




22
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   European Economics                                                                                                                                                                  abc
   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                          EURbn           % Year                            Total Rev e nue*                          % Year
   0                                                                                  0     25                                                                                   25

  -5                                                                                  -5    20                                                                                   20
                                                                                            15                                                                                   15
-10                                                                                   -10
                                                                                            10                                                                                   10
-15                                                                                   -15    5                                                                                   5
                                                                                             0                                                                                   0
-20                                                                                   -20
          Greece         Ireland       Portugal        Spain           Italy                -5                                                                                   -5

            Year-to-date* 2011                          Year-to-date* 2012                          Greece           Italy        Portuga l      Ireland         Spain

 Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and         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    Portugal
 payments or revenue collection can distort the comparisons.                                Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,
 Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,         Spanish Government Office IGAE, DG Orçamento
 Spanish Government Office IGAE, DG Orçamento




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

 % Year                            Tax Rev enue*                               % Year       % Year                      Interest Ex penditure*                          % Year
 15                                                                                   15    70                                                                                   70
 10                                                                                   10    60                                                                                   60
                                                                                            50                                                                                   50
   5                                                                                  5
                                                                                            40                                                                                   40
   0                                                                                  0     30                                                                                   30
  -5                                                                                  -5    20                                                                                   20
                                                                                            10                                                                                   10
-10                                                                                   -10
                                                                                              0                                                                                  0
            Spain          Italy       Portugal Greece               Ireland                -10                                                                                  -10

                Direct Tax                                  Indirect Tax                             Greece           Italy        Spain        Portugal       Ireland

 Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and         Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and
 Portugal                                                                                   Portugal
 Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,         Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,
 Spanish Government Office IGAE, DG Orçamento                                               Spanish Government Office IGAE, DG Orçamento




                                                                                                                                                                                         23
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     European Economics                                                                                                                                                                         abc
     Q4 2012




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

  % Year                       Capital Ex penditure*                          % Year                % Year                       Current Ex penditu re*                         % Year
     0                                                                                 20           18                                                                                   18

                                                                                       0            15                                                                                   15
  -20
                                                                                                    12                                                                                   12
                                                                                       -20
  -40                                                                                                9                                                                                   9
                                                                                       -40
                                                                                                     6                                                                                   6
  -60
                                                                                       -60           3                                                                                   3

  -80                                                                                  -80           0                                                                                   0
              Ireland         Portugal           Spain**             Italy                                    Portugal           Ireland             Italy           Spain**

  Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and                Note: *Year-to-date = Jan-Mar for Italy and Jan-Aug for Ireland, Greece, Spain and
  Portugal                                                                                          Portugal. **Spanish current account based on a calculation of the sum of current
  Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,                transfers, staff expenses and goods and services
  Spanish Government Office IGAE, DG Orçamento                                                      Source: ISTAT, Hellenic Republic Ministry of Finance, Irish Department of Finance,
                                                                                                    Spanish Government Office IGAE, DG Orçamento




General government expenditure
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




24
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     European Economics                                                                                                                            abc
     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-o-
                    y 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




                                                                                                                                                                             25
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     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-tax-
                                  evasion 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




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     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.
                                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.
Financial reforms               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.
                                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.
Source: Reuters, IMF, FT, National Ministries of Finance




                                                                                                                                                                                                 27
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     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-o-
                                 y 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             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
measures                         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




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




                                                                                                                                                                             29
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     Q4 2012




Rescue Packages
Disbursements to Greece under first bailout package                                                                Disbursements to Greece under second bailout package

EURbn                                      EU                 IMF                                   Total          EURbn                                 Total committed                                       Disbursed

1. May 2010                               14.5                5.5                                   20.0           PSI                                                   30.0                                          29.7*
2. Sep 2010                                6.5                2.6                                    9.1           Accrued interest                                       5.5                                           4.8*
3. Dec 2010/Jan 2011                       6.5                2.5                                    9.0           IMF contribution                                      28.0
4. Mar 2011                               10.9                4.1                                   15.0           EFSF contribution                                    109.1                                           39.4
5. Jul 2011                                8.7                3.2                                   11.9           Total 2nd package                                    172.6                                           73.9
6. Dec 2011                                5.8                2.2                                    8.0           Note: *the residual amounts committed will not be used by Greece
Total                                     52.9               20.1                                   73.0           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
Note: EUR34.3bn was rolled over from this package to the second package (EUR10bn from the IMF and                  disburse a further EUR8.2bn.
EUR24.4bn from the EFSF’s undisbursed Greek Loan Facility                                                          Note on ECB collateral: As a temporary operation, the EFSF provided the Eurosystem with bonds amounting to
Source: IMF, EFSF, ESM, ECB and European Commission                                                                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




Disbursements to Ireland
EURbn                                     EFSM                                                              EFSF                                                           IMF
                                                  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 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




30
Macro
European Economics   abc
Q4 2012




         Key European
 forecasts and statistics




                        31
       Macro
       European Economics                                                                                                                                                     abc
       Q4 2012




GDP
Real GDP growth
% 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                                              3.6                 4.1                       3.6         0.9             -3.7                  -0.3               0.4          -1.5           -2.0
Other eurozone*
 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                                           4.0                 5.8                   6.9             3.6             -8.0                   1.4               -0.2         -1.4            0.7
Other Western Europe
 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*                                           2.4                 3.4                       1.6        -0.8             -5.8                  1.3                1.0           1.1            1.4
Other Europe
 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




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

  %Yr                                                                                               %Yr         %Yr                                                                               %Yr
   4                                                                                                    4        6                                                                                 6
   2                                                                                                    2        4                                                                                 4
   0                                                                                                    0        2                                                                                 2
  -2                                                                                                    -2       0                                                                                 0
  -4                                                                                                    -4      -2                                                                                 -2
  -6                                                                                                    -6      -4                                                                                 -4
  -8                                                                                                    -8      -6                                                                                 -6
         Germany




                                                              Greece


                                                                           Ireland


                                                                                       Portugal




                                                                                                                -8                                                                                 -8
                                                  Spain
                          France


                                     Italy




                                                                                                                      GR
                                                                                                                           PT
                                                                                                                           IT
                                                                                                                                     UK
                                                                                                                                          IR
                                                                                                                                          ES
                                                                                                                                                     EMU
                                                                                                                                                           HU
                                                                                                                                                                CZ
                                                                                                                                                                     FR
                                                                                                                                                                     CH
                                                                                                                                                                              RO
                                                                                                                                                                              NO
                                                                                                                                                                                   DE
                                                                                                                                                                                        SE
                                                                                                                                                                                        PL
                                                                                                                                                                                             RU




                   2011                          2012f                               2013f                                                                      2011

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




32
       Macro
       European Economics                                                                                                                                                            abc
       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                                         3.4                      3.6                  2.8                4.1             -0.2                2.0                   3.1             2.4                   2.5
Other eurozone*
 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                                      2.5                      2.5                  3.8                5.5              0.9                2.1                   2.1              2.2                   1.7
Other Western Europe
 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*                                      1.7                      1.9                  1.7                3.6              1.1                2.2                   2.7              2.6                  1.5
Other Europe
 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                                                                                                  %Yr           %Yr                                                                                       %Yr
   4                                                                                                      4           10                                                                                          10
   3                                                                                                      3            8                                                                                          8
   2                                                                                                      2            6                                                                                          6
   1                                                                                                      1
                                                                                                                       4                                                                                          4
   0                                                                                                      0
                                                                                                                       2                                                                                          2
  -1                                                                                                      -1
                                                                                                                       0                                                                                          0
            Germany


                         Franc e


                                     I taly


                                                  Spain


                                                               Greece


                                                                              Ireland


                                                                                             Portugal




                                                                                                                            CH
                                                                                                                            IR
                                                                                                                                       NO
                                                                                                                                            CZ
                                                                                                                                                 FR
                                                                                                                                                 DE
                                                                                                                                                          EMU
                                                                                                                                                                IT
                                                                                                                                                                     SE
                                                                                                                                                                          ES
                                                                                                                                                                          GR
                                                                                                                                                                                PT
                                                                                                                                                                                     HU
                                                                                                                                                                                          PL
                                                                                                                                                                                                 UK
                                                                                                                                                                                                      RO
                                                                                                                                                                                                           RU




                       2011                       2012f                             2013f                                                                            2011

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




                                                                                                                                                                                                                       33
         Macro
         European Economics                                                                                                                                                                       abc
         Q4 2012




Consumer spending
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                                                4.1                  4.0                  3.6                  -0.6                   -3.8                   0.7                -1.0                  -1.8              -1.8
Other eurozone*
 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                                             2.1                 2.8                   6.1                   3.7                -0.1                  -0.7                   -0.3                  -1.4              -0.4
Other Western Europe
 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*                                             3.8                  3.6                  3.0                  -0.3                   -4.2                   1.9                -0.5                   1.4               1.6
Other Europe
 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                                                                                                %Yr                %Yr                                                                                                 %Yr
     2                                                                                                  2                 6                                                                                                   6

     0                                                                                                  0                 4                                                                                                   4
  -2                                                                                                    -2
                                                                                                                          2                                                                                                   2
  -4                                                                                                    -4
                                                                                                                          0                                                                                                   0
  -6                                                                                                    -6

  -8                                                                                                    -8
                                                                                                                         -2                                                                                                   -2
                                                                                                                                PT
                                                                                                                                       IT
                                                                                                                                            ES
                                                                                                                                                   IR
                                                                                                                                                        EMU
                                                                                                                                                              HU
                                                                                                                                                                     CZ
                                                                                                                                                                          FR
                                                                                                                                                                                DE
                                                                                                                                                                                      CH
                                                                                                                                                                                             UK
                                                                                                                                                                                                  SE
                                                                                                                                                                                                       PL
                                                                                                                                                                                                             RO
                                                                                                                                                                                                                   NO
                                                                                                                                                                                                                        RU




           Germany         France           Italy           Spain        Ireland       Portugal
                  2011                               2012f                              2013f                                                                                  2011

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




34
     Macro
     European Economics                                                                                                                                                        abc
     Q4 2012




Budget balance
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                                             1.3                  2.4                          1.9         -4.1            -11.2                  -9.3            -8.9    -6.8              -5.0
Other eurozone*
 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                                         -1.5                 -1.4                          0.0         -1.9             -6.1              -6.0              -6.4      -4.3              -3.8
Other Western Europe
 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*                                          5.0                  5.0                          4.8          3.3             -2.7              -2.7                -1.9    -4.2              -2.1
Other Europe
 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                                                                                               %GDP           %GDP                                                                     %GDP
    0                                                                                                      0        15                                                                           15
                                                                                                                    10                                                                           10
   -5                                                                                                      -5
                                                                                                                        5                                                                        5
                                                                                                                        0                                                                        0
  -10                                                                                                      -10
                                                                                                                        -5                                                                       -5
  -15                                                                                                      -15      -10                                                                          -10
             Germany


                         Franc e


                                      Italy


                                                  Spain


                                                              Greece


                                                                           Ireland


                                                                                         Portugal




                                                                                                                    -15                                                                          -15
                                                                                                                             IR
                                                                                                                             GR
                                                                                                                                    ES
                                                                                                                                    UK
                                                                                                                                    FR
                                                                                                                                                  RO
                                                                                                                                                  PL
                                                                                                                                                               EMU
                                                                                                                                                               PT
                                                                                                                                                                     IT
                                                                                                                                                                     CZ
                                                                                                                                                                     DE
                                                                                                                                                                               SE
                                                                                                                                                                               CH
                                                                                                                                                                               RU
                                                                                                                                                                                       HU
                                                                                                                                                                                            NO




                       2011                      2012f                           2013f                                                                           2011

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




                                                                                                                                                                                                      35
     Macro
     European Economics                                                                                                                                                                  abc
     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                                            43.1                   39.6              36.2               40.2                53.9                61.2                  68.5               81.3                86.1
Other eurozone*
 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                                         26.7                   26.4              23.1               21.9                35.3                38.8                  47.6               54.7                58.1
Other Western Europe
 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*                                         37.8                   32.1                 27.5            33.4                 40.6               42.9                  46.5               40.9                   42.1
Other Europe
 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                                                                                            %GDP               %GDP                                                                                         %GDP
  200                                                                                                200             180                                                                                               180

  150                                                                                                150             150                                                                                               150
                                                                                                                     120                                                                                               120
  100                                                                                                100
                                                                                                                      90                                                                                               90
     50                                                                                              50               60                                                                                               60
     0                                                                                               0                30                                                                                               30
                 Germany

                           France


                                       Italy


                                                   Spain


                                                               Greece


                                                                            Ireland


                                                                                       Portugal




                                                                                                                        0                                                                                              0
                                                                                                                              NO
                                                                                                                                    RO
                                                                                                                                          SE
                                                                                                                                               CZ
                                                                                                                                                     PL
                                                                                                                                                          ES
                                                                                                                                                                HU
                                                                                                                                                                      DE
                                                                                                                                                                            UK
                                                                                                                                                                                   FR
                                                                                                                                                                                        EMU
                                                                                                                                                                                              PT
                                                                                                                                                                                                   IR
                                                                                                                                                                                                        IT
                                                                                                                                                                                                             GR




                 2011                              2012f                              2013f                                                                           2011

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




36
      Macro
      European Economics                                                                                                                                                 abc
      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                                             9.2                   8.5               8.3         11.4             18.0                20.1             21.7                  25.0                 27.2
Other eurozone*
 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                                          6.5                   6.0               4.9          4.4              5.9                 7.3              8.2                   9.1                  9.4
Other Western Europe
 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*                                           4.8                    3.9             3.8          3.4               6.0                7.5              7.6                   7.7                  7.6
Other Europe
 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

    %                                                                                            %       %                                                                                          %
    30                                                                                           30      25                                                                                         25
    25                                                                                           25      20                                                                                         20
    20                                                                                           20      15                                                                                         15
    15                                                                                           15      10                                                                                         10
    10                                                                                           10       5                                                                                         5
     5                                                                                           5        0                                                                                         0
     0                                                                                           0
                                                                                                               NO
                                                                                                               CH
                                                                                                                        RO
                                                                                                                             RU
                                                                                                                                  DE
                                                                                                                                       SE
                                                                                                                                            UK
                                                                                                                                                 IT
                                                                                                                                                      CZ
                                                                                                                                                           FR
                                                                                                                                                           EMU
                                                                                                                                                                    HU
                                                                                                                                                                         PL
                                                                                                                                                                              PT
                                                                                                                                                                                   IR
                                                                                                                                                                                          GR
                                                                                                                                                                                               ES




             05       06        07       08        09       10          11       12f     13f
                                                                                                                                                      2011
             Euroz one               Germany               F rance               Italy         Spain

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




                                                                                                                                                                                                         37
      Macro
      European Economics                                                                                                                                         abc
      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                                                     0.7                         1.4                  1.8                          -1.0                     -7.2                      -7.7
Other eurozone
 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                                                  0.3                         0.3                -5.2                             -5.5                   -5.5                      -7.8
Other Western Europe
 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                                                  0.3                          0.2                 -0.5                            -1.9                   -2.5                       0.8
Other Europe
 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                                                                        % change        %             change in w orking p opulation betw een now and 2050                  %
      3                                                                                      3        0                                                                                0
      0                                                                                      0
                                                                                                   -10                                                                                 -10
     -3                                                                                      -3
                                                                                                   -20                                                                                 -20
     -6                                                                                      -6
     -9                                                                                      -9    -30                                                                                 -30
  -12                                                                                        -12   -40                                                                                 -40
                                                                                                   -50                                                                                 -50
            0



                           0


                                          -20



                                                    -30



                                                                0



                                                                               0
          -0



                         -1




                                                              -4



                                                                             -5
        90



                       00



                                        10



                                                  20


                                                            30



                                                                           40




                                                                                                   -60                                                                                 -60
      19



                     20



                                      20



                                                20



                                                          20



                                                                         20




                                                                                                           PT
                                                                                                                  RO
                                                                                                                       DE
                                                                                                                       IT
                                                                                                                                 PL
                                                                                                                                      RU
                                                                                                                                            HU
                                                                                                                                                  CH
                                                                                                                                                       GR
                                                                                                                                                            CZ
                                                                                                                                                            ES
                                                                                                                                                                 FR
                                                                                                                                                                      SE
                                                                                                                                                                      UK
                                                                                                                                                                           NO
                                                                                                                                                                                IR




                       Germany                  France           Italy         Spain

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




38
     Macro
     European Economics                                                                                                                                                        abc
     Q4 2012




Economic infrastructure
Economic infrastructure
                                        Nominal GDP               Population GDP per capita               Average years                      Life              Fertility*   Tax revenue*   Government
                                                                                                         male schooling*             expectancy*         (average child                      spending
                                                                                                                                                            per person)
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                                                1073                   46                23,216                     10.4                     82                1.4            20.2         20.3
Other eurozone*
 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                                              36                      2               17,349                     11.7                     79                1.6            22.6         20.6
Other Western Europe
 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                                               239                     6               42,919                     10.1                     79                1.9            46.5         28.6
Other Europe
 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)
  DE                                                                                                                EUR th                                                                    EUR th
  FR
  UK                                                                                                                80                                                                           80
    IT
  ES
  PL                                                                                                                60                                                                           60
  RO
  GR
  PT                                                                                                                40                                                                           40
  CZ
  HU                                                                                                                20                                                                           20
  SE
  NO
   IR                                                                                                                0                                                                           0
                                                                                                                           RO
                                                                                                                           RU
                                                                                                                           PL
                                                                                                                           HU
                                                                                                                           CZ
                                                                                                                           PT
                                                                                                                                                        GR*
                                                                                                                                                        ES
                                                                                                                                                        IT
                                                                                                                                                        UK
                                                                                                                                                        EMU
                                                                                                                                                        FR
                                                                                                                                                                              DE
                                                                                                                                                                              IR
                                                                                                                                                                              NL
                                                                                                                                                                              SE
                                                                                                                                                                              CH
                                                                                                                                                                              NO




         0        10        20        30         40          50      60        70        80        90
                                                                                     Persons, m n                                                                 2011
  Source: World Bank                                                                                                Note: *Greece GDP 2010 data
                                                                                                                    Source: Eurostat, World Bank



                                                                                                                                                                                                     39
     Macro
     European Economics                                                                                                                    abc
     Q4 2012




Eurozone
Breathing space                                                                       will hinge on the debtor countries’ ability to       Janet Henry
                                                                                                                                           Economist
                                                                                      meet the conditions of their programmes and the      HSBC Bank plc
The ECB has announced a framework that
                                                                                      willingness of all of the member states to make      +44 20 7991 6711
could provide a backstop for the eurozone as                                                                                               janet.henry@hsbcib.com
                                                                                      further progress on the roadmap for future
long as governments deliver on their side of the
                                                                                      financial sector integration and fiscal
bargain. By committing to buy unlimited                                               centralisation. Already the likely timing for a
amounts of government bonds through its OMT
                                                                                      banking union appears set to be delayed.
(Outright Monetary Transactions) programme,
the ECB can try to address the "convertibility"                                       Meanwhile the growth picture remains
(euro break-up) risk while governments attempt                                        worrying. The eurozone was a little more
to lower their credit risk by undertaking                                             resilient than we had expected in H1 2012,
structural reforms and fiscal consolidation. But                                      thanks to net exports which offset a domestic
the ECB can’t purchase any bonds until a                                              contraction, but our GDP forecast remains
country requests an EFSF/ESM programme, and                                           unchanged at -0.6% for 2012 as we now expect
with spreads having narrowed sharply, the                                             the external environment to be a little weaker in
Spanish government appears in no hurry to ask.                                        H2. Our 2013 forecast has also edged down
                                                                                      further, with virtually all of the mild upturn
Even once Spain goes into a programme (most
                                                                                      expected to come from a gradual export revival.
likely in October) and the ECB starts buying
bonds, the long-term sustainability of the euro

% Year
                                                    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




40
     Macro
     European Economics                                                                                                                           abc
     Q4 2012




 Promise of ECB action has caused rates to converge...                            … but the ECB can only buy time
 %                            10yr Bond yields                              %     Since ECB head, Mario Draghi committed to do
 8                                                                           8
                                                                                   whatever it takes to preserve the euro there has been a
                                                                                   significant convergence of eurozone government bond
                                                                                   yields.
 6                                                                           6
                                                                                  The ECB can provide a backstop for the eurozone as
 4                                                                           4
                                                                                   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
 2                                                                           2
                                                                                   credit risk by undertaking structural reforms and fiscal
                                                                                   consolidation.
 0                                                                           0
                                                                                  Governments will also need to show convincing
     07          08          09            10        11        12
                                                                                   progress in drawing up a credible roadmap and timeline
                Eurozone                    Germany                 Spain          for future financial sector and fiscal integration.
 Source: Thomson Reuters Datastream




 Despite the LTRO, loan growth continues to weaken…                               … and country divergences persist
  EURbn, 3m sum                    Eurozone               EURbn, 3m sum           Recent monetary growth has revived a little, with M3
 200                                                                200            accelerating to 3.8% from 3.2% in June.
 150                                                                  150         However, loan growth remains extremely weak with no
                                                                                   evidence that the three-year LTROs have found their way
 100                                                                  100
                                                                                   into an improving availability of credit. Household loan
     50                                                               50           growth has slowed to 1.1% y-o-y and corporate sector
      0                                                               0            lending to -0.2%. The monthly flows were also still falling.
     -50                                                              -50         The positive financial market response to the ECB’s OMT
                                                                                   programme should help to improve confidence, but the
 -100                                                                 -100
                                                                                   country divergence in lending activity is set to persist
           04    05     06    07      08        09   10   11   12                  given the recessions and banking sector restructurings in
                Corporate loan flow                   Household loan flow          the periphery. Spain’s loan growth slowed to -5% y-o-y in
                                                                                   July while Germany’s has revived to 1.8%.
 Source: ECB




 The contraction in GDP...                                                        … does not fully reflect how weak the economy is
                                                                                  Despite the upside surprises to German and French
Index                                              % Qtr                           GDP, eurozone GDP contracted by 0.2% q-o-q in Q2 as
65                                                  1.5                            the recessions elsewhere in the eurozone intensified.
60                                                  1.0
55                                                  0.5                           Growth was still supported in Q2 by exports, particularly
50                                                  0.0                            to non-eurozone countries, such as China, but the world
45                                                  -0.5                           trade cycle is now showing a more marked weakening.
40                                                  -1.0                           This is likely to take a greater toll on the German and
35                                                  -1.5                           eurozone industrial sectors in the coming months.
30                                                  -2.0
25                                                  -2.5                          Despite the ECB’s planned OMT we still expect a
20                                                  -3.0                           continued contraction in H2 2012, and, with official
   99 00 01 02 03 04 05 06 07 08 09 10 11 12                                       growth forecasts for 2012-13 likely to be revised down
               Eurozone composite PMI output (LHS)                                 further, more questions will be raised about whether
               Eurozone GDP (RHS)                                                  member states can realistically expect to meet their
                                                                                   fiscal targets.
 Source: Markit, Eurostat
     Macro
     European Economics                                                                                                          abc
     Q4 2012




Germany
Cracks beneath the surface                                              Nonetheless, with employment marking a post-             Stefan Schilbe
                                                                                                                                 Economist
                                                                        reunification record high, and wages and salaries        HSBC Trinkaus & Burkhardt AG
While hard German economic data, such as industrial
                                                                        showing y-o-y growth rates of almost 4%,                 +49 211910 3137
orders and production, have held up remarkably well                                                                              stefan.schilbe@hsbc.de
                                                                        consumption should continue to contribute positively
recently, there are some cracks beneath the surface.                                                                             Rainer Sartoris
                                                                        to growth. Buying intentions (a subcomponent of          Economist
The intensifying crisis in the eurozone has already                                                                              HSBC Trinkaus & Burkhardt AG
                                                                        GfK consumer climate) largely maintained their           +49 211910 2470
left its mark on ifo export expectations, which in
                                                                        elevated level over the last couple of months.           rainer.sartoris@hsbc.de
September fell to its lowest level since July 2009. Net
                                                                        Disposable income should receive a further boost
exports, a substantial driver of GDP growth in H1
                                                                        from a cut in the contribution rates for pension
2012, will, in our view, fail to support in H2. This
                                                                        insurance from 19.6% to 19.0% to take place in
also has negative implications for business fixed
                                                                        January 2013.
investment for which growth has already declined in
the last two quarters. The outlook for companies in                     Due to the strong first half, our 2012 full-year GDP
the capital goods sector has deteriorated substantially                 growth forecast of 0.9% looks achievable. Even so,
as a result of falling capacity utilisation in the                      the combination of weaker net exports and business
manufacturing sector, hinting at lower capital                          fixed investment should lead to stagnation in the
spending ahead, despite favourable financing                            second half. Even if we pencil in a rebound in
conditions. Consequently, the willingness to hire has                   activity starting in Q1, the lower than anticipated
receded further, pointing towards slow or no growth                     base makes cutting our growth forecast for 2013
in employment in future.                                                from 1.5% to 0.9% necessary.


% Year
                                              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




42
    Macro
    European Economics                                                                                                                                                 abc
    Q4 2012




Weakening global trade to undermine German exports                                                 Exports
%                                                                                       Index      The outlook for German exports has clearly deteriorated: the
                                                                                                    ‘new exports orders’ component of the global manufacturing
 30                                                                                        70
                                                                                                    PMI has fallen to its lowest level since April 2009. The main
 20                                                                                                 culprit is the deep recession in some eurozone countries, but
                                                                                           60
 10                                                                                                 demand from non-eurozone economies has also begun to
  0                                                                                        50       fade notably.
-10                                                                                                The current level is consistent with a falling annual export
                                                                                           40
-20                                                                                                 growth rate, a view that is supported by the more pessimistic
-30                                                                                        30       export expectations of companies questioned by ifo.
      01 02 03 04 05 06 07 08 09 10 11 12                                                          Further progress in the labour market will be difficult to
                                                                                                    achieve as a consequence – the unemployment rate clearly
           German ex ports (LHS)                                                                    shows signs of bottoming out.
           Global manufacturing PM I - new ex port orders* (RHS)

Source: Macrobond, HSBC
Note: *After 3 months




Capital goods sector feels the crisis                                                              Investment
                                                                                                   The more negative export outlook is starting to filter through
%                                                                                          %        into investment companies’ spending behaviour: Firms´
 30                                                                                       20        assessment of the next three months in the capital goods
 15                                                                                                 sector has fallen sharply, indicating negative yearly business
  0                                                                                       0         fixed investment rates ahead.
-15                                                                                                Capacity utilisation rates fell from 84.5% to 83.2% in Q3
-30                                                                                       -20       2012, undershooting the long-term average for the first time
-45                                                                                                 since Q4 2010.
-60                                                                                       -40
                                                                                                   As leading indicators in manufacturing business show no
      95      97      99      01      03        05        07        09        11                    signs of stabilisation yet, companies will be reluctant to
                                                                                                    expand capacity.
            IFO capital goods sector - ex pectations for production
            acitiv ity in the nex t 3 months
            Business fix ed inv estment

Source: Macrobond, HSBC




Money is cheap                                                                                     Financing conditions
%        Interest rates for new non-financial corporate loans*                             %       Financing conditions for German companies (and
                                                                                                    households) as a result of a loose monetary policy are
7                                                                                             7
                                                                                                    extremely favourable on a nominal and real basis, especially
6                                                                                             6
                                                                                                    when compared to countries like Italy and Spain.
                                                                                                   Despite an intensifying debt crisis in the eurozone, the
5                                                                                             5     Bundesbank lending survey and the ifo credit hurdle do not
                                                                                                    point to restrictive lending behaviour by banks in Germany.
4                                                                                             4    Given that key interest rates in the eurozone are likely to stay
                                                                                                    extremely low for a prolonged time, credit growth should pick
3                                                                                             3     up sharply in Germany, if and when signs of a global
    03     04      05      06      07      08        09        10        11        12               recovery emerge, thus supporting business fixed investment
                                                                                                    as well as residential investment.
            Spain               Germany                        Italy                France

Source: Macrobond, HSBC
Note: *Loans over 5 years, up to EUR1mn




                                                                                                                                                                         43
     Macro
     European Economics                                                                                                        abc
     Q4 2012




France
Neither recession nor growth?                                           In 2013, the tax hikes to be introduced to meet the    Mathilde Lemoine
                                                                                                                               Economist
                                                                        target of a public deficit of 3% of GDP in 2013,       HSBC France
GDP is likely to remain stable in H2 2012, as it                                                                               +33 1 40 70 32 66
                                                                        despite the downward revision in GDP growth            mathilde.lemoine@hsbc.fr
was in H1 2012. Indeed, we expect a rise in
                                                                        forecasts, will shave 0.3pp off growth in gross
consumer spending in Q3 and Q4 2012, boosted
                                                                        disposable income on our calculations. But at the
by a 25% rise in the allowance for children going
                                                                        same time, social benefits will continue to grow,
back to school in August and by a 2% hike in the
                                                                        as there is no target of cutting public spending,
minimum wage on 1 July. In addition, the savings
                                                                        merely of restricting its real growth (to 0.8% in
rate could drop slightly after the presidential
                                                                        2013 from 2.3% per year before the crisis).
elections as after previous presidential elections.
                                                                        We also assume that France will adjust its position
That said, we forecast weak growth in consumer
                                                                        on fiscal integration and come to an agreement with
spending in 2013 because income tax will hike
                                                                        Germany on giving the European Commission the
and because the unemployment rate should
                                                                        power of prior approval of all budget proposals,
continue to rise until the beginning of 2013.
                                                                        and not just in the case of excessive deficit
Moreover, industrial production could continue to
                                                                        procedures. If such an agreement is reached, the
fall in H2 2012, as business investment declines;
                                                                        uncertainty created by the lack of institutional
the recession in southern Europe is hitting
                                                                        clarification will be reduced, improving the
exports, and the fall in the capacity utilisation rate
                                                                        prospects for economic activity and investment.
to 77% in August, from an average of 80% in
2011, will weigh on business investment.




% Year
                                        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




44
  Macro
  European Economics                                                                                                                          abc
  Q4 2012




France’s small open economy and the scale of                             ... should help avoid a fall in consumer spending in
economic stabilisers...                                                  2013, despite higher taxes
                                                                         Exports account for only 27% of French GDP, compared
                                                                          to 50% in Germany, limiting the impact of the slowdown
%Yr                                                             %Yr
                                                                          in world trade on final domestic demand.
 6                                                                6
                                                                         Moreover, public spending represented 56% of GDP in
 4                                                                4
                                                                          2012, and a third of household gross disposable income
 2                                                                2       (GDI) comes from redistribution. As a result, the impact
 0                                                                0       of rising unemployment on income is limited. Since the
-2                                                                -2      1990s, during periods of rising unemployment, GDI has
-4                                                                -4      risen by an average of 2.6% y-o-y, compared to an
-6                                                                -6      average of 4% y-o-y during periods of falling
-8                                                                -8      unemployment.
   00 01 02 03 04 05 06 07 08 09 10 11 12                                Thus in 2013, on our calculations, the rise in social
               Germany: GDP growth (LHS)                                  benefits could offset the negative impact of tax hikes
               France: GDP growth (LHS)                                   (new 45% and 75% income tax bands for incomes
                                                                          greater than EUR150,000 and EUR1,000,000 a year
                                                                          respectively).
Sources: Destatis, INSEE, HSBC




But the restructuring of the French car industry…                        … could limit industrial production growth in 2013
                                                                         The recession in Italy and Spain will continue to hit exports
Index, 100 = 2000                                Index, 100 = 2000
                                                                          to these countries which currently represent 15% of French
130                                                               130     exports.
120                                                               120    In addition, the positive effect on exports of a 7% decline in
110                                                               110     the euro against the dollar between February and July 2012
100                                                               100     will start to diminish in Q2 2013.
 90                                                               90
                                                                         Lastly, French car makers are involved in a period of
 80                                                               80
                                                                          restructuring. According to the OECD, there is 20% excess
 70                                                               70      capacity in the French auto industry. Moreover, the negative
 60                                                               60      trade balance in this sector has reduced the need for
 50                                                               50      production capacity still further. As a result, we expect car
      00 01 02 03 04 05 06 07 08 09 10 11 12                              production, which amounts to 8% of industrial production, to
               French IP                  French car production           continue to decline by some 11% per year between 2013
                                                                          and 2015 on our calculations.
Sources: INSEE, HSBC




France’s acceptance of deeper fiscal integration...                      ... could clarify the way in which Europe works and
                                                                         reduce the systemic risk premium
                                                                         Since the beginning of the crisis, we consider that
           Sovereign credit default swaps in France, Germany              institutional clarification is essential to allow the eurozone to
                               and the US                                 function properly. This clarification includes the acceptance
Bps                                                               Bps
200                                                               200
                                                                          by Europeans of the existence of supra-national decisions
                                                                          that are applicable at the national level for banking, fiscal
150                                                               150     and economic topics.
                                                                         However, the Spanish Prime Minister is prevaricating on a
100                                                               100     clean-up in the banking industry, limiting the scope of any
                                                                          agreement on banking union. And France, to date, has
 50                                                               50
                                                                          resisted a transfer of sovereignty over fiscal policy.
  0                                                               0       Significant moves in these two countries could boost a
      08           09             10      11         12
                                                                          European desire to introduce the reforms that would allow
                                                                          the eurozone to function. Therefore, the eurozone systemic
              France                   Germany                 US         risk premium could decrease and drive business investment
                                                                          and stockbuilding.
Sources: Bloomberg, INSEE, HSBC




                                                                                                                                                45
     Macro
     European Economics                                                                                                           abc
     Q4 2012




Italy
Going it alone                                                             to resist any calls for more aggressive fiscal         Janet Henry
                                                                                                                                  Economist
                                                                           consolidation, and will therefore remain very          HSBC Bank plc
The Italian government bond market has already                                                                                    +44 20 7991 6711
                                                                           reluctant to submit to EFSF/ESM conditionality.
benefited greatly from the ECB’s announcement                                                                                     janet.henry@hsbcib.com
                                                                           The various tax increases have lifted inflation
that it is willing to undertake unlimited bond
                                                                           above 3.5% for much of this year, implying a
purchases. Ten-year yields are now hovering just
                                                                           severe squeeze on real wages at a time when the
above 5.2%, well down from their late July peak of
                                                                           unemployment rate is rising to new highs (10.7% in
6.6%. The market is currently waiting for Spain to
                                                                           July). Hence the contraction in consumer spending
request a precautionary EFSF/ESM programme
                                                                           has deepened, and the latest indicators show little
and trigger the ESM programme, but Italy is also
                                                                           sign that spending will see an upturn any time soon.
viewed as a potential candidate for requiring such
assistance in the coming months.                                           We expect Mr Monti to continue with the various
                                                                           reforms to raise long-term potential growth, which
The budget deficit is much smaller than that of
                                                                           should help to reassure the market. Nonetheless,
Spain: even with a deep contraction in GDP of
                                                                           the elections looming in April 2013 could lead to
about 2.5% in 2012 Italy’s budget deficit should
                                                                           some political uncertainty and mean that some kind
come in below 3% of GDP. But, given the size of
                                                                           of precautionary programme for Italy cannot be
its debt stock and low potential growth rate, this
                                                                           ruled out.
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
                                        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




46
    Macro
    European Economics                                                                                                                          abc
    Q4 2012




Sharp fall in yields...                                                          ...in response to ECB’s plans
%                            Italian 2y r Bond Yields                   %        Italian bond yields have fallen sharply since ECB head,
                                                                                  Mario Draghi, committed to do “whatever it takes” to
8                                                                           8     preserve the euro.
             3y r LTROs announced               Draghi commits
                                                to do "w hatev er                Italy has given no indication that it intends to request an
6                  SMP starts                        it takes"              6
                                                                                  EFSF/ESM programme which could be needed for the
                                                                                  ECB to start buying Italian government bonds. The rally
4                                                                           4     has allowed the government to tap the market at much
                                                                                  more reasonable rates. It raised EUR4bn of 10-year
2                                                                           2     bonds on 3 September at about 5% and around
                                                                                  EUR1.5bn of 3 and 9-year inflation linked bonds on 25
0                                                                           0     September at 2.46% and 3.68% respectively.
Jan 11                    Jul 11          Jan 12             Jul 12              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.
Source: Bloomberg




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

%                          Contribution to % Yr Growth                 %         The recession in Italy continues, with GDP contracting by
 4                                                                      4
                                                                                  a further 0.8% q-o-q in Q2 following the 0.8% fall in Q1
 3                                                                      3         and 0.7% q-o-q drop in Q4.
 2                                                                      2        Overall GDP fell 2.6% y-o-y in Q2, but the domestic
 1                                                                      1         situation is even weaker, with consumer spending falling
 0                                                                      0         3.6% y-o-y and investment down 9.5% y-o-y.
-1                                                                      -1
                                                                                 The caretaker government of Mario Monti is pressing
-2                                                                      -2
-3                                                                      -3        ahead with implementing the required reforms to raise
-4                                                                      -4        long-term potential growth, but will resist any pressure to
-5                                                                      -5        deliver even more austerity. This is just one of the
     Q1 10          Q3 10     Q1 11    Q3 11                Q1 12                 reasons why he will wish to avoid requesting
                                                                                  EFSF/ESM/ECB assistance if he can.
     Priv con          Govt cons    Investment                Net exports


Source: Bank of Italy, Thomson Reuters Datastream




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

 % Yr                                  Italy                          % Yr       Italy has been registering one of the highest rates of
 5                                                                      5         inflation in the eurozone over the past year, because of
 4                                                                      4         methodological changes and VAT increases, as well as
 3                                                                      3         the higher energy prices which have impacted on all of
 2                                                                      2         the eurozone.
 1                                                                      1        With rising unemployment keeping a lid on nominal wage
 0                                                                      0         growth, this rise in inflation has contributed to a very
-1                                                                      -1        sharp squeeze on real wages and contracting consumer
-2                                                                      -2        spending.
-3                                                                      -3
                                                                                 Assuming stable energy prices, inflation has now peaked,
   05        06     07    08             09         10    11     12
                                                                                  and should slow steadily, but, the further 2% rise in VAT
            HICP (LHS)                                Nominal wages (RHS)         planned for July 2013 means inflation is unlikely to slow
            Real wages (RHS)                                                      below 2%, implying real wage growth will remain
                                                                                  negative.
Source: Eurostat, Istat




                                                                                                                                                  47
     Macro
     European Economics                                                                                                         abc
     Q4 2012




Spain
A soft bailout                                                          government delivered less austerity than we had         Madhur Jha
                                                                                                                                Economist
                                                                        forecast. This, together with some base effects         HSBC Bank plc
The ECB has opened the door for ‘conditional’
                                                                        resulting from lower 2011 GDP growth, has               +44 20 7991 6755
support to the Spanish sovereign, and it appears                                                                                madhur.jha@hsbcib.com
                                                                        implied that the contraction in 2012 will be
only a matter of time before Spain formally
                                                                        shallower than we had previously forecast.
requests assistance. It is clear that the Spanish
government is trying to distinguish itself from                         However, this only means that there is more pain
countries that have sought Troika assistance by                         to come next year. The government will have to
outlining a detailed and comprehensive                                  step up the implementation of austerity plans once
austerity/reform programme on 27 September (see                         it asks for assistance, implying a bigger drag from
page 25 of this report). This, it hopes, will be                        government spending over the next few quarters.
sufficient to appease European partners who could                       At the same time, there are clear indications that
then offer Spain a more concessionary                                   the world trade cycle has turned down, implying a
(precautionary) form of assistance than a full-                         softer contribution to growth from net exports.
scale Troika programme, which would come with
                                                                        While tail risks relating to Spain have ebbed, the
much stricter conditionality (and loss of face).
                                                                        focus over the coming quarters will increasingly turn
While expectations of a soft bailout for Spain                          to how politicians and trade unions react to the
helped calm market sentiment, the real side of the                      deepening recession and rising unemployment,
economy continues to deteriorate. Spanish GDP                           which in turn could call into question the
growth held up better than we had expected in H1                        government’s commitment to reforms.
2012 as net exports grew strongly and the


% 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




48
     Macro
     European Economics                                                                                                                                abc
     Q4 2012




Net exports…                                                                             … have been the only source of growth for Spain
%pts                            Contribution to GDP                              %qtr    Government spending proved to be less of a drag in H1
                                                                                          2012 than in H2 2011. However, we expect the drag
1.8                                                                              0.2      from government spending to rise as the government
1.2                                                                              0.0      steps up austerity implementation.
0.6                                                                                      Domestic demand overall remained very weak, though,
                                                                                 -0.2     as consumer spending fell sharply, more than reversing
0.0
                                                                                 -0.4     the gain seen in Q1 2012.
-0.6
                                                                                         Net exports added a strong 1.0pp to Q2 2012 GDP, not
-1.2                                                                             -0.6     only because of a further collapse in imports but also a
              Q2 11       Q3 11           Q4 11        Q1 12         Q2 12                recovery in exports. We expect net trade to provide less
                                                                                          support to growth over the next few quarters, with
            Consp                         Gov t                           GFCF            exports likely to be much softer.
            net trade                     GDP (RHS)

Source: Thomson Reuters Datastream




Regional budget performance remains a big concern…                                       … despite the recent improvement
% GDP                                                                        % GDP       Regional governments managed to halve their
0                                                                                  0      deficit/GDP ratios in H1 2012 (-0.8% of GDP) as
                                                                                          compared to H1 2011 (-1.7% of GDP).
-1                                                                                 -1    While this suggests that regional governments are doing
                                                                                          more to tighten their belts, we hesitate to draw any
-2                                                                                 -2     conclusions about the full-year fiscal performance as
                             -4.25
                                                                                          changes in the way that regions receive transfers from
-3                                                                                 -3     the central government reduce the comparability of
                                                                                          performance between H1 2011 and H1 2012.
        Cataluna
       Cantabria



       Ex tremad




            Total
        Asturias
       Andalucia
         Aragon




          Galicia
          Madrid
          Murcia

        La Rioja
       Valencian
           C-L M
        Beleares
       Canarias




             Pais
           CyL




        Navarra




                                                                                         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
                    H1 11                                         H1 12                   the year as a whole.
Source: MHAP
Note: C-L M refers to Castialla y Leon, C y L refers to Castilla y Leon




Unemployment set to rise further…                                                        …as public sector jobs are cut back too
                                                                                         Public sector employment continued to grow even up until
                                  Spain Employment                                        2011 even though the private sector has shed jobs rapidly
  Index 2005 Q1 =100
                                                                                          since the triple crisis hit Spain.
120                                                                               120
115                                                                                      But austerity is forcing cutbacks in employment both at
                                                                                          the central and regional government levels. This is mainly
110                                                                               110
                                                                                          being achieved through the non-renewal/shedding of
105                                                                                       temporary roles
100                                                                               100
                                                                                         We estimate that the unemployment rate could surpass
 95                                                                                       30% by end -2013 unless the government is able to push
 90                                                                               90      through more reforms that allow for some of the
       05        06        07        08        09        10        11      12             adjustment in personnel costs to come through wage
                                                                                          moderation (See Spanish labour reforms: protest or
               Public Sector                                   Priv ate sector            progress)

Source: INE




                                                                                                                                                         49
     Macro
     European Economics                                                                                                                                                  abc
     Q4 2012




UK
Accepting limitations                                                                                           about it? Monetary policy is already very loose,         Simon Wells
                                                                                                                                                                         Chief UK Economist
                                                                                                                and it will take time to assess the impact of new        HSBC Bank plc
GDP fell sharply in Q2 2012, largely due to an extra                                                                                                                     +44 20 7991 6718
                                                                                                                credit easing schemes, particularly the untested
Bank Holiday for the Queen’s Jubilee. This was the                                                                                                                       simon.wells@hsbcib.com
                                                                                                                Funding for Lending Scheme.
third consecutive quarterly contraction, but it should
be the last for a while, and we expect a bounce                                                                 Unfortunately, ever-looser monetary policy is not a
back in Q3. However, looking past erratic factors,                                                              miracle cure for the UK’s economic ills. More QE
underlying growth remains weak. High uncertainty,                                                               entails risks and possibly some negative side-effects.
tight credit conditions, fiscal consolidation and an                                                            It is also possible that the incremental benefit may
increasingly challenging international                                                                          be waning. Given that policy is already ultra-
environment continue to restrain activity.                                                                      loose, there may be practical constraints on what
                                                                                                                more it can do. We expect no further QE this year.
Trade surveys suggest the difficult export conditions
are set to continue, as the Asian and eurozone                                                                  Fiscal policy is also highly constrained. With low
markets slow. And with commodity prices putting                                                                 growth also meaning the public finances may be
upward pressure on inflation and the labour                                                                     getting off-track, the government may find it hard
market remaining weak, there is likely to be little                                                             to meet its own targets without a further tightening
growth in real wages during 2013. Therefore                                                                     of policy, let alone some form of loosening. So
consumption is unlikely to drive a strong recovery.                                                             the UK is in a bind, and may need to accept that
                                                                                                                this is still the hangover from the pre-crisis boom
So it seems that 2013 will be another year of very
                                                                                                                years. There may be limits to what policy can do.
slow growth. The question is, what can policy do

% Year
                                                           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




50
     Macro
     European Economics                                                                                                                       abc
     Q4 2012




Despite the deficit reduction plan, government                           … and with trade slowing, the composition of growth
consumption has grown as the economy has slowed …                        remains worrying
                                                                         Net trade has started to drag on growth as global activity
% Yr                       Contributions to growth             % Yr       cools and the eurozone’s recession begins to bite. Trade
4                                                                 4       surveys point to a drop in export orders suggesting the drag
3                                                                  3      from trade will continue.
2                                                                  2     Consumption is yet to add to four-quarter growth. This
1                                                                  1      reflects a prolonged period of inflation outpacing wage
0                                                                  0      growth. But with commodity prices rising, inflation will not fall
-1                                                                 -1     as far or as fast as we had previously expected, so real
-2                                                                 -2     wages will barely grow and consumption will stay weak.
      2010 2010 2010 2010 2011 2011 2011 2011 2012 2012                  Growth in 2012 has been affected by a number of one-off or
       Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2                                      erratic factors. Excluding these factors, growth appears to
       Consumption        Government         Investment                   have been slow but positive. We expect a big bounce back
       Stocks             Net Trade                                       in Q3, with slow growth resuming in Q4 and continuing into
                                                                          2013.
Source: ONS, HSBC




The UK’s productivity performance has become more                       … which increasingly suggests the crisis may have had a
puzzling as employment has held up …                                    larger negative impact on the UK’s supply potential
 Index               Productivity in UK recessions             Index     Lower output combined with a modest amount of job
120                                                               120     creation through 2012 means the UK’s dismal productivity
                                                                          performance has continued. If this simply reflects a large
115                                                              115      amount of spare capacity in the economy, then demand can
110                                                              110      be stoked without fear of fuelling inflation.
105                                                              105     But the fact that UK productivity has flat-lined for three years
                                                                          increasingly points to a period of weak growth in potential
100                                                              100
                                                                          productivity. Supply-side weakness is not something that
 95                                                              95       can be addressed by ever-looser monetary policy.
 90                                                           90         Weak productivity also implies a risk of unemployment rising
         t     t+2     t+4    t+6     t+8 t+10 t+12 t+14 t+16             again if some firms have been hoarding labour in the hope
                                                                          that demand will pick up. Another year of weak demand
              70s                   80s          90s          00s
                                                                          could be the final straw, forcing firms to reduce headcount.

Source: ONS, BoE




The Bank of England is as puzzled as anyone, and it has                  … although the MPC’s implied probability of deflation in
never before been this uncertain about growth outlook …                  two years’ time is way below 2009 levels

       Implied probability of growth below zero 2-years-ahead            The outlook remains highly uncertain. Indeed, the MPC’s
                                                                          published forecast data show it has never been more
18%                                                             18%
                                                                          uncertain about the outlook. In turn, its implied probability of
15%                                                             15%       a GDP contraction in two years’ time is at an all-time high.
                                                                         High uncertainty calls for cautious policy-making. Looser
12%                                                             12%
                                                                          monetary policy is not a one-way bet, and there are risks to
 9%                                                             9%        piling ever-more risk onto the central banks’ balance sheet.
                                                                          Now would be a good time to pause QE and make a
 6%                                                             6%
                                                                          meaningful assessment of existing policy measures.
 3%                                                             3%       Only if the MPC fears a really bad outcome would
 0%                                                             0%        aggressive policy be needed. This was the case in 2009.
                                                                          Currently, the probability of deflation appears considerably
       04     05      06     07     08   09   10     11   12
                                                                          lower, meaning less need to take risks with policy.

Source: BoE, HSBC




                                                                                                                                                51
     Macro
     European Economics                                                                                                                    abc
     Q4 2012




Norway
Bucking the trend                                                                    strong krone should all further limit export          Janet Henry
                                                                                                                                           Economist
                                                                                     growth. However, this should be offset by a           HSBC Bank plc
Domestic growth is allowing Norway to decouple
                                                                                     stronger domestic environment and low interest        Sakshi Gupta
from European economic weakness. Thanks to its                                                                                             Economics Associate
                                                                                     rates, resulting in trend GDP growth in 2012.         Bangalore
domestic strength, we expect output to remain
solid through H2 2012. This health will also be                                      The inflation rate remains low (at 0.5% y-o-y in
reflected in the continued strength of the krone.                                    August) and we expect it to hover around 0.6% in
                                                                                     2012. In the housing sector, the house price index
Norway saw another quarter of strong growth,
                                                                                     rose to 6.7% y-o-y in Q2 while household
registering 1.0 % q-o-q in Q2. This was backed by
                                                                                     indebtedness continued to rise faster than income.
strong investment and consumption. Employment
continued to grow at a solid pace, as did wages.                                     Thus strong consumption patterns, rising
                                                                                     household debts and housing prices speak in
This is not to say that Norway has been
                                                                                     favour of higher rates. However, the problems
completely immune to the downfall of its major
                                                                                     stemming from the eurozone crisis are far from
trading partner. The effects of eurozone weakness
                                                                                     resolved and continue to pose a risk for the
were felt in lower demand for Norwegian exports
                                                                                     Norwegian economy. Balancing these risks, we
in the second quarter. In addition, given the
                                                                                     expect Norges Bank to keep rates on hold this
uncertain global environment, deposits and loans
                                                                                     year and start its tightening bias in 2013.
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
                                                     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




52
     Macro
     European Economics                                                                                                             abc
     Q4 2012




Sweden
Miracle or mirage?                                                      The Riksbank’s surprise 25bps repo rate cut in              John Zhu
                                                                                                                                    Economist
                                                                        September should mitigate the upward pressure on            HSBC Bank PLC
Sweden had been seen as something of a safe haven
                                                                        the krona, which has risen sharply in 2012 and              +44 20 7991 2170
in Europe this year, but the massive downward                                                                                       john.zhu@hsbcib.com
                                                                        neared all-time highs against the euro in August. But
revision to Q2 GDP (from 1.4% q-o-q to 0.7%)
                                                                        given the weak external demand environment, rising
indicates that while the Swedish economy is still one
                                                                        unemployment and low inflation, we think the
of the best-performing in Europe since the financial
                                                                        Riksbank will continue to ease, and expect the repo
crisis, it does not seem to have decoupled. A trade
                                                                        rate to fall by another 25bps in Q4 to 1%. This
slowdown could lead to a recession in H2 2012.
                                                                        should help to lower the real interest rate, which is
Net exports were revised down in Q2 but still made                      still positive, and support investment.
a positive contribution to growth. However, the
                                                                        Policymakers may not be able to stop a trade-
momentum is of a slowdown in imports rather than
                                                                        induced slowdown, but Sweden still has relatively
stronger export growth. Latest survey data for export
                                                                        strong government finances, low debt and a top
orders point to a sharp contraction, and this is likely
                                                                        credit rating in its favour. The government’s new
to be the main drag on GDP in H2. Wages, retail
                                                                        budget announced cuts to corporation tax and
sales and house prices will be weighed down by
                                                                        infrastructure investment (although projects start
deteriorating labour market conditions. Recent
                                                                        from 2014). So although the government’s GDP
downside data surprises mean unemployment could
                                                                        forecasts look optimistic, the fact that it is delivering
rise to 8% by the end of the year.
                                                                        stimulus rather than austerity will soften the blow.



% Year
                                           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




                                                                                                                                                          53
     Macro
     European Economics                                                                                                         abc
     Q4 2012




Switzerland
CHF to remain stable thanks                                             In 2013, we expect growth to pick up gradually as       François Letondu
                                                                                                                                Economist
to the SNB                                                              exports should cease to be a drag and monetary          HSBC France
                                                                        policy remains very accommodative. Indeed, the          +33 1 40 70 39 33
Growth is likely to remain hampered by weak                                                                                     francois.letondu@hsbc.fr
                                                                        SNB has used unsterilized interventions to defend
foreign demand for Swiss goods and services. In
                                                                        its 1.20 EUR-CHF floor, creating ample liquidity
Q2, GDP fell 0.1% q-o-q, because of a sharper-
                                                                        within Switzerland. We anticipate that
than-expected drop in exports. The recession in
                                                                        appreciation pressure on the CHF will persist, and
the eurozone periphery and meagre growth
                                                                        that the central bank will defend this floor until at
elsewhere in Europe and in the US are expected to
                                                                        least the end of 2013, to prevent further losses of
prevent any rapid recovery in exports, at least
                                                                        export competitiveness and combat deflation risks.
until a lasting solution to the eurozone crisis is
                                                                        Furthermore, the 0-0.25% target range for 3-month
found. Equipment investment is likely to remain
                                                                        LIBOR should be increased only once the EUR-
depressed by those weak export prospects.
                                                                        CHF floor has been lifted. Overall, this should
Households have benefited in recent quarters from                       provide a boost to investment. The upside potential
falling consumer prices allowing them to increase                       for housing investment should, however, remain
consumption. But with weak exports, we expect                           limited. Indeed, since a Federal Council decision
the unemployment rate to keep ticking upwards in                        in June 2012, the SNB can force banks to build
the last few months of 2012, and so consumer                            countercyclical capital buffers if needed. This
spending growth will be slower in the coming                            measure is designed to limit credit growth without
quarters. As a result, we anticipate that GDP will                      forcing the SNB to tighten monetary policy and
be flat in Q3.                                                          abandon its currency management.


% Year
                                        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




54
    Macro
    European Economics                                                                                                          abc
    Q4 2012




Hungary
Still waiting                                                        We have lowered our GDP growth forecast for this           Agata Urbanska
                                                                                                                                Economist
                                                                     year and next, given the weaker-than-expected              HSBC Bank plc
Weak economic growth is a significant risk to the                                                                               +44 20 7992 2774
                                                                     economic performance to date, uncertainty over the
debt stabilisation strategy. We still lack confidence                                                                           agata.urbanska@hsbcib.com
                                                                     outcome of the IMF negotiations, and our reduced
that Hungary will reach an agreement with the IMF,
                                                                     forecast for growth in Germany in 2013. To date,
even though markets seem to have mostly priced that
                                                                     industrial production and exports growth has shown
in following the opening of negotiations in July.
                                                                     a small positive impact from new export capacities.
The 2013 budget is the main near-term risk. The                      The current account is recording a significant surplus
government is under increasing pressure to deliver                   but this is still unlikely to offset the capital outflow
stimulus to a weakening economy. The opinion polls                   (deleveraging).
show that the popularity of the ruling party, Fidesz,
                                                                     In this environment, the Monetary Council’s
is declining. The Prime Minister promised earlier
                                                                     decision to start cutting its policy rate in August was
this year that fiscal consolidation would come to an
                                                                     a risky one. We expect the easing cycle to pause
end; however, more measures are necessary to
                                                                     after September until an IMF deal is secured. A high
secure the 3% budget deficit ceiling.
                                                                     wage growth rate is a sign of second round effects
While the 2013 budget has apparently assumed some                    from persistently high inflation and will likely limit
savings from lower debt servicing costs resulting                    the scope of total policy easing even in the positive
from an IMF deal, it also includes more spending                     scenario of an IMF deal in place. Having said that,
(labour market support programme) financed by                        this will still be determined by the changes in CB
special taxes (financial transaction tax), something                 management due next year.
that the IMF has criticised.



% 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




                                                                                                                                                   55
     Macro
     European Economics                                                                                                      abc
     Q4 2012




Poland
Slowdown triggers policy                                            GDP this was close enough to the threshold for           Agata Urbanska
                                                                                                                             Economist
response                                                            Poland to meet the 2012 EDP requirement.                 HSBC Bank plc
                                                                                                                             +44 20 7992 2774
Monthly activity data show no indication of the                     We have made another cut to our 2012 growth              agata.urbanska@hsbcib.com

economic slowdown bottoming out, while the decline                  forecast from 2.7% to 2.5% but reduced 2013 more
in domestic demand in Q2 2012 highlights downside                   significantly from 3.1% to 2.0%. Growth in H1 2012
risks. Policymakers have responded accordingly. In                  was largely in line with expectations, but recent
May, the National Bank of Poland had raised rates; in               monthly economic data show a stronger than
September, it adopted an easing policy bias. In April,              expected slowdown. Also the growth composition in
the government had adopted a medium-term fiscal                     Q2 was significantly worse than expected, with
objective of reducing the budget deficit to 0.9% of                 domestic demand declining. Destocking was the
GDP by 2015. Currently, however, it is only                         main driver, in line with weakening consumer and
planning to make the minimum deficit reduction that                 business sentiment indicators. Labour market data
would allow it to exit the excessive deficit procedure              has been weaker than expected. Finally, the outlook
(EDP). Along with its medium-term target set in                     for global and European growth has worsened. All
April, the government aimed at a budget deficit at                  these factors contributed to our 2013 forecast change,
2.2% of GDP in 2013. This has been raised to 3% of                  but downside risks remain as there are no signs of the
GDP, the level required under the EDP. In January                   slowdown abating, and leading business and
this year the European Commission forecast Poland’s                 consumer confidence indicators are unsupportive.
2012 budget deficit at 3.3% of GDP, compared to the
                                                                    Monetary policy has room to respond with easing,
government’s then target of 2.9%. It said, however,
                                                                    and we pencil in 75bp rate cuts to 4% in the coming
that taking account of the cost of pension reform (the
                                                                    months.
annual transfers to private pension fund) at 0.6% of

% Year
                                                     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




56
     Macro
     European Economics                                                                                                                              abc
     Q4 2012




Destocking pushed domestic demand into contraction in Q2                       GDP is not likely to bottom until early 2013
2012
                                                                               Following 4.3% expansion in 2011, GDP growth dropped to
Contribution to GDP grow th (ppt)                                 % y -o-y      3.5% in Q1 2012 and 2.4% y-o-y in Q2 2012.
                                                                               Both private consumption and investment growth slowed, but
 5                                                                       5      the main drag in Q2 2012 came from destocking. Domestic
 3                                                                       3      demand growth turned sharply recording a 0.2% y-o-y
 1                                                                       1      contraction compared to 2.7% growth in Q1 2012.
-1                                                                       -1    On the value added side the biggest drag on growth in Q2 2012
-3                                                                       -3     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
-5                                                                       -5
                                                                                2012. It is most likely to turn negative in H2 2012. Growth of the
     1Q08 3Q08 1Q09 3Q09 1Q10 3Q10 1Q11 3Q11 1Q12                               value added component in trade slowed to 0.3% y-o-y in Q2
        Priv cons                   Gov cons                                    2012 from 5.5% in Q1 2012 and 4.6% in 2011.
        Investm ents                In v entories                              Given no bottoming out of the monthly activity data, we
        Net exports                 GDP (rhs)                                   continue to see downside risk to our new, lower growth
        Dom estic dem and (rhs)                                                 forecast.

Source: National sources, HSBC estimates




Labour market still in a downward trend                                       A risk of more slowdown in private consumption
                                                                               Employment growth has been slowing since early 2011 (from
% y -o-y , real                                             % y -o-y, real
                                                                                4% average in Q1 2011) to zero in July 2012.
8                                                                        15    The seasonal summer unemployment rate drop was smaller
                                                                                than average. We forecast the unemployment rate at 13% in
6                                                                        10     December 2012, its highest in five years, and no improvement
                                                                                in 2013.
4                                                                        5     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
2                                                                        0      contraction of 1.5%.
                                                                               Private consumption growth halved from 3.1% in 2011 to 1.5%
0                                                                        -5     in Q2 2012. In q-o-q terms, however, private consumption
    1Q05   1Q06      1Q07     1Q08         1Q09    1Q10 1Q11      1Q12          growth has stabilised at a 0.3% average rate in the last four
                                                                                quarters, and we do not expect the slowdown to go much
                     Priv ate consumption                                       further, but the developments in the labour market are a
                     Wage bill, whole economy (rhs)                             downside risk.
                     Wage bill, enterprices (rhs )

Source: National sources, HSBC estimates




Inflation to fall into a 2.5% +/-1 range in November                          MPC signals policy easing
                                                                               Having raised rates in May, and having upheld an unofficial
% y-o-y                                                           % y -o-y
                                                                                hawkish policy bias in July, the Monetary Policy Council has
5                                                                        5      signalled that there will be policy easing in September if
                                                                                incoming data confirm further weakening of economic
4                                                                        4      conditions and limited inflationary pressure.
3                                                                        3     We expect the MPC to cut its policy rate by 50-75bp in the
2                                                                        2      coming months. We marginally favour the easing starting in
                                                                                November, when the new Inflation Report is published, followed
1                                                                        1      by two more cuts in the first months of 2013. However, we see
                                                            Forecast
 0                                                                       0      a risk that the MPC will continue to disappoint markets and cut
                                                                                later and by less than is currently priced in.
-1                                                                       -1    The risk to this scenario is that the MPC waits until January, to
      05     06      07       08       09         10   11    12                 see inflation at least back in the +/-1pp range around the 2.5%
                                                                                target, before starting the easing.
           CPI                C B infla tion target            Core CPI

Source: Thomson Reuters Datastream, HSBC estimates




                                                                                                                                                       57
     Macro
     European Economics                                                                                                    abc
     Q4 2012




Romania
Positive domestic demand                                             Credit growth is therefore likely to remain weak,     Agata Urbanska
                                                                                                                           Economist
                                                                     and is unlikely to support economic recovery in       HSBC Bank plc
We forecast 1% GDP growth for Romania in                                                                                   +44 20 7992 2774
                                                                     2013. The rush to spend EU money has produced
2012, which is good relative to forecasts for other                                                                        agata.urbanska@hsbcib.com
                                                                     some irregularities, and the EC has suspended
EU members. Domestic demand continues to be
                                                                     some funds.
the main growth driver in Romania, in contrast to
what is seen in other Central European EU                            The approaching parliamentary elections should
member countries. Wage bill growth is positive in                    not bring any surprises. The tentative promises of
real terms, supported by public sector wage hikes.                   a fiscal loosening are a risk though. Lower VAT
Romania’s focus on spending the funds granted                        and personal taxes would boost consumption, not
by the European Union has lifted investment                          necessarily investments, drive inflation higher and
activity in the last few quarters. Together, these                   probably fuel the current account deficit,
factors should continue to support the economy in                    repeating the pattern of unbalanced growth seen in
2013. Exports might well be slowing, but this is                     Romania before the 2008 global financial crisis.
less important for the economy in Romania than it
                                                                     The key policy challenge is to support balanced
is for the Czech Republic or Hungary.
                                                                     economic growth. Inflation is set to double in the
The banking sector remains weak. Labour market                       second half of 2012, breaching the central bank’s
conditions are better than in Romania’s Central                      3% +/-1pp target in December and generally
European peers, but this has not significantly                       staying close to the upper ceiling in 2013.
diminished the problem of non-performing loans.
Also, banks’ balance sheets are still unbalanced,
with loans to deposit ratios exceeding 100%.


% Year
                                                     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




58
    Macro
    European Economics                                                                                                      abc
    Q4 2012




Czech Republic
Recession in 2012, shallow                                          been contributing positively to growth in the last      Agata Urbanska
                                                                                                                            Economist
recovery in 2013                                                    several quarters, mostly on weak imports. But in        HSBC Bank plc
                                                                    the coming months exports will continue to              +44 20 7992 2774
GDP growth did not rebound in Q2 2012 despite a                                                                             agata.urbanska@hsbcib.com
                                                                    decelerate and net exports’ contribution to growth
very weak Q1 reading. That prompted us to reduce
                                                                    will start to decline.
our growth forecasts for this year as well as next.
We now expect close to 1% economic contraction                      The policy makers have very limited scope for
in 2012 and only weak recovery in 2013.                             responding to this deterioration. We cut our central
                                                                    bank policy rate forecast to a record low of 0.25%
The very weak confidence indicators, both on the
                                                                    back in May, and we do not believe that there are
consumer and business side, have continued to
                                                                    many other instruments at the central bank’s disposal
gradually worsen in recent months. That has been
                                                                    that could support the economy effectively.
accompanied by a further weakening of activity
indicators. In particular, labour market data                       The recession is creating stress in domestic
deteriorated, as indicated by the poor level of the                 politics; the government is struggling to pass a
consumer confidence index, and justifying an                        tight 2013 budget in the parliament, and the fall of
earlier drop in consumer spending.                                  the government is a risk.

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
                                                     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




                                                                                                                                               59
     Macro
     European Economics                                                                                                        abc
     Q4 2012




Russia
A lonely hawk                                                         days. Yet, loan growth stays high at about 20% y-        Alexander Morozov
                                                                                                                               Economist
                                                                      o-y in real terms, which looks excessive for the         HSBC Bank (RR), Moscow
GDP growth in Russia eased to less than 3% y-o-y                                                                               +7 495 783 8855
                                                                      slowly growing Russian economy. If it continues,
in July. The high base set by H2 2011 and a poor                                                                               alexander.morozov@hsbc.com
                                                                      such strong credit growth could trigger a spike in
harvest are likely to prompt further slowing of
                                                                      NPL and a credit crunch. That would be
economic activity in the coming months. Private
                                                                      detrimental for the banking sector’s stability and
sector fixed investment growth has paused this
                                                                      economic growth sustainability. Therefore, some
year, which could further restrain GDP growth in
                                                                      cooling of credit growth is warranted.
the medium term.
                                                                      Even more important for the rate hike decision
In August 2012, Russia officially became a World
                                                                      was the fact that inflation had breached the CBR’s
Trade Organisation member, finally ending its
                                                                      6.0% ceiling for the year. All three broad CPI
long accession saga. Will this boost economic
                                                                      components – food, non-food and services – have
growth? We think immediate material positive
                                                                      made a U-turn, signalling broad-based inflation
implications for the economy from WTO
                                                                      acceleration. Moving towards inflation targeting,
membership are unlikely. Apart from a few non-
                                                                      the CBR has to provide an adequate policy
energy exporting sectors, the rest of the Russian
                                                                      response to the surge in order to start building up
economy would only be able to reap the benefits
                                                                      its credibility as an inflation fighter.
of WTO accession in the medium to long term if
the government uses it as an opportunity to                           Finally, the CBR’s repo rates, which are the key
improve the business climate and the                                  policy rates in Russia, are likely to remain
competitiveness of the Russian economy.                               negative in real terms after the cumulative 75bp
                                                                      policy rate hikes that we expect in the coming
Against the backdrop of slowing economic
                                                                      months, as inflation is to gain more than the
growth, the Central Bank’s (CBR) decision to
                                                                      policy rates. So, despite some notional monetary
hike its policy rates in September might appear
                                                                      tightening, the CBR’s policy will remain
controversial, at a first glance. Indeed, the Russian
                                                                      accommodative.
Central Bank is probably the only hawk these



% Year
                                                       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




60
     Macro
     European Economics                                                                                                                                                                             abc
     Q4 2012




GDP growth (ex-crops sector) has been moderating                                                                                   Poor harvest weighs on GDP growth in H2 2012

%, y-o-y                                                                                                    %, y-o-y                The official GDP growth rate has been steady at 4.3%
                                             Real GDP                                                                                over past two years, which gave a (wrong) impression of
6                                                                                                                 6
                                                                                                                                     economic growth stability. Yet, the crops sector
3                                                                                                                             3      performance, affected by weather conditions, has been
0                                                                                                                             0
                                                                                                                                     uneven: it was better than its historical average in 2011
                                                                                                                                     but worse than its average in 2010 and 2012. We found
-3                                                                                                                            -3     that Russia’s GDP growth rate adjusted for the crops
                                                                                                                                     sector has been declining since 2010.
-6                                                                                                                            -6
                                                                                                                                    A weaker performance of the crops sector this year will
-9                                                                                                                            -9     weigh on economic growth in H2 2012 and may result in
              2008              2009                2010                   2011                      2012                            temporary economic stagnation in Q3 q-o-q sa, when
                                                                                                                                     the crops sector contribution to GDP is highest.
                                    Actual              Counterfactual*

Note:*Counterfactual assumes crop harvest at 79 mln tns, average for 2001-2007
Source: Rosstat, Ministry of Agriculture, HSBC




Inflation breached the official target in September                                                                                Repo rates matter, refinance rate does not
                                                                                                                                    The CPI growth rate accelerated to 6.3% y-o-y in early
% (%, y-o-y)                     Policy rates and CPI                                               % (%, y-o-y)                     September, breaching the official inflation range of 5-
12                                                                                                                            12     6%. Moreover, the continuing rise in food prices has the
                                                               HSBC CPI f orecast                                                    potential to speed up headline inflation further to 7.5% y-
                                                                                                                                     o-y in December 2012 and 8.2% in March 2013, taking
 9                                                                                                                            9
                                                                                                                                     into account the second-round effect.
                                                                                                                                    In a similar situation in 2010, the CBR increased its
 6                                                                                                                            6
                                                                                                                                     refinance rate only when inflation exceeded it by a wide
                                                                                                                                     margin. Now, with the CBR caring much more about
 3                                                                                                                            3      inflation targeting than before, it made a rate hike
              Dec-09




                                           Dec-10




                                                                             Dec-11




                                                                                                                     Dec-12
                                                      Apr-11




                                                                                          Apr-12
     Aug-09



                       Apr-10

                                 Aug-10




                                                                 Aug-11




                                                                                                       Aug-12




                                                                                                                                     decision much earlier. It follows that, first, the CBR’s
                                                                                                                                     response function has become more sensitive, and
                   Refinancing rate                                                Headline CPI                                      second, it is the CBR’s (low) repo rates rather than
                   Fix ed REPO                                                     CBR's inflation ceiling                           (high) refinance rate that serve as an inflation
                                                                                                                                     benchmark.
Source: Rosstat, CBR, HSBC




Policy cross: exchange rate and interest rate bands                                                                                More FX volatility, less interest rate volatility
                                                                                                                                    Efficient inflation targeting in a country with an open
RUB                                                                                                                      bps         capital account requires a fairly flexible exchange rate
8                                                                                                                         500        and low interest rate volatility. The CBR is moving
                                                                                                                                     exactly in this direction; it has been steadily widening the
6                                                                                                                         400        RUB band while reducing the interest rate band (defined
                                                                                                                                     as the difference between the fixed repo rate and
4                                                                                                                         300        deposit rates).
                                                                                                                                    The CBR has not shrunk its interest rate band since last
2                                                                                                                         200
                                                                                                                                     year, while it has widened its RUB band twice this year.
                                Dec-10




                                                                          Dec-11
     Mar-10
              Jun-10
                       Sep-10


                                          Mar-11
                                                    Jun-11
                                                               Sep-11


                                                                                      Mar-12
                                                                                                   Jun-12
                                                                                                                Sep-12




                                                                                                                                     This suggests the growing probability of a faster rise in
                                                                                                                                     deposit policy rates than in repo rates in the coming
                                RUB band w idth (LHS)                                                                                months. We think that the RUB staying in the middle or
                                CBR policy rates band w idth (RHS)                                                                   upper part of the FX band is a pre-condition for that
                                                                                                                                     happening.
Source: Reuters, CBR, HSBC




                                                                                                                                                                                                      61
     Macro
     European Economics                                                                                              abc
     Q4 2012




Turkey
Rebalancing starts to hurt                                      On the inflation front, food prices surprised        Melis Metiner
                                                                                                                     Economist
                                                                positively in the third quarter. Even as global      HSBC Turkey
Q2 GDP growth came in at 2.9% y-o-y, driven                                                                          +90 212 376 4618
                                                                agricultural commodity prices spiked, processed
exclusively by net foreign demand. In annual                                                                         melismetiner@hsbc.com.tr
                                                                and unprocessed food prices in Turkey did not
terms, exports were up by 19.8% in Q2 (from
                                                                rise much above their seasonal averages in the
11.9% in Q1), adding 5.7pp to headline growth.
                                                                June-August period. As a result, we nudge down
Meanwhile, the contribution from domestic
                                                                our year-end inflation forecast from 7.9% to
demand turned negative for the first time in 10
                                                                7.2%. Average CPI forecasts for 2012 and 2013,
quarters, shaving 2pp off headline GDP.
                                                                which appear in the table below, are little
With two quarters of actual data, we now raise our              changed. But larger-than-expected administered
whole-year growth forecast to 2.7%, from our                    price and tax hikes, along with rising commodity
cautious expectation of 2.0%. For 2013, we only                 prices, could push CPI higher.
make a minor revision, taking our forecast from
                                                                Aggressive monetary easing by the central bank is
3.5% to 3.8%. Domestic demand growth is likely
                                                                a risk factor. In September, the CBRT started to
to be nearly flat in both Q3 and Q4 this year, but
                                                                narrow the overnight interest rate corridor and
could pick up slightly in early 2013 as the impact
                                                                manage liquidity conditions using a new iteration
of looser monetary policy is felt. Export
                                                                of its reserve requirement framework. This could
performance was stronger than we expected in the
                                                                leave the lira vulnerable during bouts of risk
first half of 2012, and our increased GDP forecast
                                                                aversion. It could also interrupt the rebalancing
reflects this. Going forward, we expect exports to
                                                                process that has been on track since the start of
remain resilient, but the pace of growth is likely to
                                                                the year.
slow, in line with the deterioration in global trade.
The main downside risk here is weaker demand
from the MENA region.

% 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




62
    Macro
    European Economics                                                                                                                                                                           abc
    Q4 2012




The rebalancing in the economy was on track in H1 2012                                                                             Growth was driven exclusively by net foreign demand
pp                                                                                                                           pp    The shift in the growth outlook became more
                                    Contribution to growth
                                                                                                                                    pronounced in the second quarter: the contribution from
 20                                                                                                                         20
 15                                                                                                                         15      domestic demand turned negative as private
 10                                                                                                                         10      consumption contracted by 0.5% y-o-y, and private
  5                                                                                                                         5       investment by 7.9% y-o-y.
  0                                                                                                                         0      Consumer confidence, credit growth and durable goods
 -5                                                                                                                         -5      sales all suggest demand weakness continued in Q3.
-10                                                                                                                         -10    This has prompted a policy response from the central
               1Q10
                          2Q10
                                    3Q10
                                                4Q10
                                                          1Q11

                                                                          2Q11
                                                                                     3Q11
                                                                                               4Q11
                                                                                                          1Q12
                                                                                                                    2Q12



                                                                                                                                    bank.

                 Domestic demand                                                         Net foreign demand
                 Change in inv entories                                                  Headline GDP (% Yr)

Source: Turkstat




The CBRT’s priority has now shifted to supporting                                                                                 Monetary easing is in the pipeline
growth
%                                                                                                                            %     Between June and August, the central bank gradually
                                   CBRT's average funding rate                                                                      reduced the average cost of funding provided to the
13                                                                                                                           13     banking sector by more than 400bp.
12
                                                                                                                                   In its communication, the CBRT also made it clear that it
11                                                                                                                           11
                                                                                                                                    now prioritises supporting domestic demand growth.
10
 9                                                                                                                           9     In September, the CBRT cut the top end of the interest
 8                                                                                                                                  rate corridor, the overnight lending rate, by 150bp to
 7                                                                                                                           7      10.0%. We expect more easing to follow, but its pace
 6                                                                                                                                  will depend on the strength of risk appetite. Reduced
 5                                                                                                                           5      rate support could pose risks for the lira in case of risk
                                                                                                                                    aversion.
                 Oct-11


                                    Dec-11
      Sep-11




                                              Jan-12
                                                       Feb-12
                                                                 Mar-12
                                                                            Apr-12


                                                                                               Jun-12
                                                                                                         Jul-12
                                                                                                                  Aug-12
                          Nov-11




                                                                                      May-12




Source: CBRT




Even though food prices behaved favourably in Q3                                                                                  …there are signs that inflation is becoming sticky
                                                                                                                                   Food inflation averaged 9.4% in the first eight months of
% Yr                                                                                                                       % Yr     the year. While this is above the central bank’s 7%
                             Consum er inflation breakdown                                                                          average food inflation forecast for 2012, it was better
13                                                                                                                           13     than HSBC’s expectations.
11                                                                                                                           11    Even though processed and unprocessed food prices
                                                                                                                                    did not rise sharply, there are signs that service prices
 9                                                                                                                           9      are becoming sticky. In August, service inflation rose to
 7                                                                                                                           7
                                                                                                                                    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
 5                                                                                                                           5      two years.
 3                                                                                                                           3     Inflation expectations are also high at 6.6% for 12-
                                                                                                                                    months forward and 6.2% for 24-months forward. We
      06


                          07

                                             08


                                                           09


                                                                                 10

                                                                                                11


                                                                                                                  12




                                                                                                                                    expect year-end inflation in 2012 to remain above the
                                   Goods                                                                Serv ices                   CBRT’s 5% target.

Source: CBRT




                                                                                                                                                                                                   63
     Macro
     European Economics   abc
     Q4 2012




Notes




64
Macro
European Economics   abc
Q4 2012




Notes




                       65
     Macro
     European Economics   abc
     Q4 2012




Notes




66
    Macro
    European Economics                                                                                         abc
    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

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                                                                                                                                  67
     Macro
     European Economics                                                                                                                          abc
     Q4 2012




Disclaimer
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                                                                                                                                                                [344682]


68
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.

				
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Description: 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