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Slow Slog, No Growth Spurt

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									                                                              MORGAN                 STANLEY                RESEARCH

                                                              Morgan Stanley & Co. International        Elga Bartsch
                                                                                                        +44 (0)20 7425 5434

                                                                                                        Daniele Antonucci
                                                                                                        +44 (0)20 7425 8943

                                                                                                        Olivier Bizimana
September 3, 2013                                                                             
                                                                                                        +44 (0)20 7425 6290

European Economics                                                                                      Tomasz Pietrzak
                                                                                                        Samar Kazranian

Slow Slog, No Growth Spurt
Reiterating our forecast for sub-par growth: Despite
                                                              Staying Below Official Forecasts for 2014
the long-awaited recovery now coming through in the
                                                                                               Real GDP Forecast (YoY%)
data, we stay cautious on the euro area growth outlook.                                Morgan Stanley        Consensus
                                                                                       EC                    Official govt.
In our view, the growth momentum will lag behind that of        2.0
past recoveries and other major economies and also              1.0

stay below the historical trend. After an upwardly revised      0.5
contraction of 0.5%Y this year, we continue to expect           -0.5
GDP to expand by a sub-par 0.9%Y next year. As such,            -1.5
euro area growth remains vulnerable to external shocks          -2.0
and domestic policy mistakes.                                          2013e   2014e   2013e   2014e    2013e   2014e   2013e     2014e   2013e   2014e

                                                                         Euro Area        Germany          France             Italy          Spain

More core countries struggle; periphery stabilises:           Source: IMF, EC, ECB for the Euro Area govt estimate, Morgan Stanley Research
We note that several core countries, notably France, the      forecasts

Netherlands and Belgium, are still struggling to recover
meaningfully. For now only Germany and Austria show           European GDP Growth Forecasts at a Glance
clear signs of recovery. More encouragingly, there are                                          2012            2013e            2014e            2015e
some signs of a stabilisation in the southern periphery,      EU-15                              -0.4             -0.1              1.2              1.4
                                                              EMU                                -0.5             -0.5              0.9              1.2
which we expect to pave the way for positive growth
                                                              Austria                             0.8              0.5              1.6              1.6
later this year in Italy and Spain, and in the smaller
                                                              Belgium                            -0.3              0.1             1.2              1.7
countries next year.                                          Denmark                            -0.4              0.0             1.2               1.6
                                                              Finland                            -0.8             -0.2              0.8              1.2
At most, we see one more ECB rate cut: Contrary to            France                              0.0              0.0              0.6              1.2
our previous call for aggressive monetary easing by the       Germany                             0.7              0.4              1.8              1.8
ECB, we only see scope for one more refi rate reduction       Greece                             -6.6             -4.0              0.0              0.4
                                                              Ireland                             0.1              0.4              2.1              2.5
after the German election. But the ECB’s inaction over
                                                              Italy                              -2.4             -1.7              0.4              0.7
the summer has dented our conviction on additional            Netherlands                        -1.3             -1.2              0.5              0.8
ECB easing. When it comes to OMT, we can only see             Portugal                           -3.2             -2.0              0.2              0.5
Ireland requesting an ESM credit line that would make it      Spain                              -1.6             -1.3              0.8              1.1
eligible for OMT support. But we are concerned about          Sweden                              0.7              1.1              2.2              3.0
the legal and political hurdles to OMT activation – some      UK                                  0.2              1.4              2.4              2.1
                                                              Source: National Statistics, Morgan Stanley Research forecasts
of which might also apply to QE.

Plenty of risks to the baseline: The risks to our
baseline forecast remain tilted to the downside due to a
combination of potential external shocks, possible euro
area-wide policy mistakes and a range of country-specific
risk factors. Even though it is not our base case, we
would not rule out a re-escalation of the euro crisis after
the German election, when unresolved issues such as
Greek debt sustainability, Portuguese programme
targets and Irish bank support are likely to resurface. In
addition, the euro area needs to complete several key
steps towards a banking union.                                For important disclosures, refer to the
                                                              Disclosures Section, located at the end of
                                                              this report.
                                                                                   MORGAN            STANLEY             RESEARCH

                                                                                   September 3, 2013
                                                                                   European Economics

Euroland – Slow Slog, No Growth Spurt
Morgan Stanley & Co.             Elga Bartsch                                      •    A policy coordination system that shows serious signs of
International plc      
                                                                                        crisis fatigue, having already spent much political capital
Key Points                                                                              on austerity measures, structural reforms, bail-out
Despite signs of a timid recovery, euro area growth remains                             packages and limited institutional reforms of euro area
vulnerable to external shocks and domestic policy mistakes.                             governance;

Even though it is not our base case, we cannot rule out a
                                                                                   •    An ECB that so far has not delivered significant additional
re-escalation of the euro crisis after the German election.
                                                                                        easing and instead continues to allow its balance sheet to
The ECB is unlikely to act aggressively despite low inflationary                        shrink materially. Hence, we are concerned that the ECB
pressures, we think, in the face of legal and political debates.                        might not be able to fend off spillovers from Fed tapering.

Despite the recovery arriving one quarter earlier than expected,                   To these domestic policy concerns at the euro area level, we
we stay cautious and reiterate our long-standing call for a                        would add a list of worries about the global economy, which is
sub-par recovery in the euro area. We continue to expect
                                                                                   preparing to digest monetary policy normalisation in the US,
that this timid recovery will eventually also extend to the
                                                                                   the financial market dislocations this might cause (e.g., in EM)
periphery. After a stronger-than-expected 2Q GDP outturn of a
                                                                                   and potential flare-ups in individual euro area countries (please
non-annualised 0.3%Q, we expect a slight moderation in
                                                                                   see our bull-bear scenarios on page 6 for details). Over the
momentum in 2H as the only large economy that shows some
                                                                                   next 12 months, the euro area needs to complete key steps
clear signs of recovery at the moment is Germany. Away from
                                                                                   towards a banking union. Some of these steps have the
the core, where a number of countries including France, the
                                                                                   potential to create a rise in uncertainty, we think.
Netherlands and Belgium are struggling, the stabilisation in the
periphery is encouraging. It should pave the way to a return to                    Exhibit 2
positive growth rates in Spain and Italy later this year.                          Most Euro Economies Have Troughed Now
Exhibit 1                                                                           108                      Real GDP (1Q 2008 = 100)
Euro Area Recovery to Stay Below Historical Trend                                                GER          FRA         ITA            SPA      IRE    POR
    1.5                                                                     6.0

    1.0                                                                     4.0


    0.5                                                                     2.0

                                                                            1.0        96
    0.0                                                                     0.0

                Quarterly GDP (QoQ%)                                                   92
 -0.5                                                                       -2.0
                IP-based GDP Indicator (QoQ%)                               -3.0
                                                           Morgan Stanley              88
 -1.0           Full Year GDP estimate (YoY%- RHS)                          -4.0
                                                             estimates                  2008      2009      2010     2011       2012       2013   2014   2015
                                                                                   Source: Eurostat, Morgan Stanley Research forecasts
 -1.5                                                                       -6.0
     1999 2000 2001 2002 2004 2005 2006 2007 2009 2010 2011 2012 2014
                                                                                   Euro area growth to be at or a touch below its potential, at
Source: Eurostat, EC, Morgan Stanley Research forecasts
                                                                                   an unchanged forecast of 0.9%Y for next year, following an
The main reason for us to remain cautious is that we fail to                       upwardly revised -0.5%Y for this year, from -0.7%Y before,
see a sustainable engine for growth in the euro area.                              brining us back to where we were before our spring outlook
Instead, we see multiple homemade headwinds in the quarters                        (see Cutting GDP Forecasts Due to Concerns on Italy &
ahead from:                                                                        France, March 13, 2013). As a result of such tepid growth
•         An undercapitalised banking system that still needs to                   momentum, we think that the rate of capacity utilisation will
          deleverage further (echoing similar deleveraging needs                   stay rather subdued and the rate of unemployment high by
          across most sectors in most of the euro area economies)                  historical standards, and there will likely be no meaningful
          and that faces several key stress tests in 1H14 as well as a             improvement in pricing power. Hence, if anything,
          change in its resolution regime;                                         disinflationary, if not deflationary, pressures should still

                                                                               MORGAN              STANLEY              RESEARCH

                                                                               September 3, 2013
                                                                               European Economics

dominate, especially once one-off effects from indirect taxes                  Exhibit 4

and administrative prices are taken into account, as well as                   Indirect Taxes Boost HICP Inflation by 0.5pp
food and, possibly soon, energy prices.                                         5.0
                                                                                                                   Euro Area                         F'cast

Exhibit 3                                                                       4.0

Capacity Utilisation Still Subdued, Unemployment
Rate Elevated                                                                   3.0

 88         Capacity Utilisation Rate, LHS      Unemployment Rate, RHS   13%
 84                                                                             1.0
 82                                                                      11%
                                                                                            HICP at Constant Tax Rates
 80   LT averages                                                        10%
                                                                         9%         2003 2004 2005 2006 2007 2008 2008 2009 2010 2011 2012 2013 2013 2014 2015

 74                                                                      8%    Source: Eurostat, Morgan Stanley Research forecasts

                                                                         7%    At most, we expect the ECB to cut rates one more time:
 70                                                                            Contrary to our previous call for aggressive monetary easing
 68                                                            6%              by the ECB up to and including a deposit rate cut (see
 1985Q1 1988Q4 1992Q3 1996Q2 2000Q1 2003Q4 2007Q3 2011Q2 2015Q1
                                                                               EuroTower Insights: Another Dose of Draghinomics? May 22,
Source: European Commission, Eurostat, Morgan Stanley Research                 2013), we now only see scope for one more refi rate reduction
                                                                               after the German election – in line with the ECB’s forward
In terms of the different demand components, domestic
                                                                               guidance. Afterwards, we expect the bank to leave interest
demand will likely stabilise next year and begin to expand
                                                                               rates unchanged over the whole forecast horizon. We would
the year after, following a marked contraction this year. The
                                                                               expect the bank to use forward guidance to keep the money
stabilisation in domestic demand is supported by investment
                                                                               and bond markets anchored. However, our conviction
spending (largely on the back of maintenance spend). At the
                                                                               regarding the ECB’s willingness to ease has taken a hit due to
same time, consumer spending should also move from a
                                                                               inactivity over the summer. The main reason why we continue
further fall in expenditure this year to timid growth in the
                                                                               to expect some easing is that otherwise financial conditions
remainder of the forecast horizon. Rebuilding of inventories
                                                                               would tighten materially, not just because the balance sheet is
should also support overall growth – albeit not permanently –
                                                                               shrinking but also because EONIA would rise back to the refi
thus helping to counterbalance a temporary decline in the
                                                                               rate. Our composite financing cost indicators lie consistently
growth contribution coming from net foreign trade.
                                                                               above nominal GDP growth, suggesting that private sector
                                                                               financing conditions are still relatively restrictive and are only
On our projections, HICP inflation will likely fall further
                                                                               easing slowly.
over the forecast horizon as one-off effects stemming from
rises in indirect taxes and administrative prices fall out of the              Exhibit 5
year-on-year comparisons. With no meaningful job creation                      Financing Cost Indices Are Above Nominal Growth
and subdued wage growth, we believe that unit labour costs will                  8.0                       EMU: Financing Cost Indicators                            8.0

barely rise and could even fall outright – a phenomenon not
                                                                                 7.0                                                                                 7.0
uncommon in the early stages of a recovery. Hence, core
                                                                                 6.0                                                                                 6.0
inflation should ease gradually over the forecast horizon,
reflecting the limited pricing power of companies and workers.                   5.0                                                                                 5.0

Headline inflation should hold steady around 1.5%Y, helped by                    4.0                                                                                 4.0
a weaker EUR on our FX team’s forecasts and above-average
                                                                                 3.0                                                                                 3.0
food price inflation. Recent geopolitical events would point to
potential upside risks to the oil price assumptions underlying our               2.0                                                                                 2.0

                                                                                               Non-Financial Corporates
forecasts. Any oil price spike would have a deflationary impact in               1.0           Households                                                            1.0
                                                                                               Refi Rate
an economy such as the euro area where capacity is so
                                                                                 0.0                                                                                 0.0
severely underutilised. Initially, this deflationary impact would                  2003    2004    2005   2006   2007    2008   2009   2010   2011   2012     2013

be masked by the first-round impact on headline inflation.                     Source: ECB, Morgan Stanley Research

                                                                      MORGAN            STANLEY                    RESEARCH

                                                                      September 3, 2013
                                                                      European Economics

Forward guidance alone won’t prevent a rise in the EONIA              extend to QE purchases. The BoE, for instance, gets
rate once excess liquidity falls below a threshold of                 authorisation from the Chancellor each time the MPC decides
€150-200 billion, which based on the current pace of banks            to embark on a new round of QE. For the German finance
paying back VLTRO funds could happen early next year. For us,         minister to sign such a document, he would most likely need to
a potential sharp rise in the EONIA rate is one of the key reasons    obtain the parliament’s approval, we think.
why the ECB needs to lower its policy rate again. Without a refi      Exhibit 6
rate cut, it is difficult to see why banks, which consistently keep   Pace of Austerity Slows Materially, Especially in
paying back their VLTRO funds, would be keen to load the              Periphery
liquidity boat again if offered another VLTRO at the same terms
                                                                                        Structural Primary Balance (Chg., % GDP)
as the outstanding operations. Once the ECB has decided that it        3
has reached the bottom of the interest rate cycle and won’t be
cutting anymore, it could consider offering a VLTRO at a fixed,
rather than a tracker, rate. This would be a powerful way to           1
reinforce the ECB’s forward guidance.
We see serious obstacles in terms of the ECB’s OMT
programme and potential QE action. At this stage, we can
see Ireland requesting an ECCL after the end of its current            -2
programme that would make it eligible for OMT support.                             Eurozone             Core              Periphery
However, we don’t see any other viable candidates for OMT.
This is because Portugal’s recent political turbulence will likely     -4
                                                                            2004    2005      2006     2007      2008      2009      2010      2011      2012      2013       2014
have negatively affected the ECB’s assessment of the extent to
                                                                      Source: Eurostat, European Commission, Morgan Stanley Research forecasts
which the country has regained full market access. The
Portuguese government itself has started to talk about the
                                                                      Fiscal policy should remain contractionary in most
need for a second programme. Before the German
                                                                      countries, with Germany being a notable exception next year.
Constitutional Court has ruled on OMT, which will likely happen
                                                                      But the pace of austerity will likely slow materially (see Death of
only after a new German government has been formed,
                                                                      Austerity? May 21, 2013). As a result, we expect debt/GDP
probably in late 2013, we do not expect any OMT purchases to
                                                                      ratios to keep rising. However, to let austerity slip further or to
be made by the ECB.
                                                                      consider outright fiscal stimulus would be unlikely to be
In fact, we are concerned that the German Constitutional              successful in boosting overall demand because the debt crisis
Court ruling on OMT might erect additional hurdles to QE.             has raised the public awareness about the unsustainable
This is because the key point the Constitutional Court has            nature of many fiscal policy trajectories. Only where the fiscal
made in all euro-related cases is that the German parliament          easing is essential to overcome credit constraints in the private
cannot be sidelined by the decision-making process moving to          sector can it prove to be effective, we think. However, here,
the European level, e.g., to the Ecofin or the European Council.      direct bank recapitalisations might prove to be more effective.
But, as long as parliament has been adequately involved, the          Exhibit 7
Court so far has been satisfied that there was no violation of        Still Plenty of Risks to Baseline Forecast
the German Grundgesetz. In our view, the set-up of OMT takes           3
                                                                                       Base     Bull     Bear Case                                    Our estimates
this concern into account as the ESM credit line that is a
precondition for OMT eligibility (and equally a full programme)        2

will have to be approved by the Bundestag. At that point, when
the country applying and the time period the credit line is            1

granted for are known, it is straightforward to calculate the
maximum amount of bonds the Eurosystem could buy and
what the Bundesbank’s share would be. But there is a potential
                                                                      -1                                      Bear case
problem in insisting that the Bundestag needs to pre-approve                                                  - Sharp rise in UST yields, spills into Bunds, widens periph spreads
                                                                                                              - ECB action constrained by constitutional and political concerns
OMT. For one, it could become more difficult to obtain political      -2
                                                                                                              - Export demand dented, negative spillovers into domestic demand
                                                                                                              Bull case
approval in parliament once it is obvious that it would also give                                             - Decline in UST yields, spills into core mkts, compresses spreads
                                                                                                              - ECB able to raise rates gradually in 2015, anchors bond markets
a green light to ECB bond purchases. What’s more, if the Court        -3                                      - Export demand recovery spills into domestic demand (esp. capex)

                                                                            2007      2008       2009         2010        2011         2012         2013        2014         2015
insists on OMT being pre-approved by parliament, as a
corollary, the need for parliamentary approval might also             Source: Eurostat, Morgan Stanley Research forecasts

                                                                                                        MORGAN               STANLEY                  RESEARCH

                                                                                                        September 3, 2013
                                                                                                        European Economics

Exhibit 8
Euroland – Detailed Macroeconomic Forecasts, 2010-15E
Growth rates, %                                                2012                       2013E                              2014E
                                                   1Q        2Q    3Q      4Q     1Q     2Q 3QE         4QE     1QE        2QE 3QE           4QE      2010     2011        2012 2013E 2014E 2015E
GDP Eurostat (qoq)                                  -0.1     -0.2   -0.1   -0.6 -0.3      0.3     0.1     0.2     0.2        0.3      0.3      0.3
GDP Eurostat (qoq, annualised)                      -0.2     -0.7   -0.4   -2.4 -1.1      1.2     0.4     0.9     0.9        1.0      1.2      1.2
GDP (yoy)                                           -0.1     -0.5   -0.7   -0.9 -1.1     -0.7    -0.5     0.3     0.8        0.8      1.0      1.1     1.9       1.5        -0.5    -0.5           0.9       1.2
Private Consumption (qoq, ann.)                     -0.7     -2.0   -0.6   -2.5   0.1     0.4     0.4     0.0     0.0        0.4      0.4      0.4     1.0       0.2        -1.3    -0.5           0.2       0.5
Government Consumption (qoq, ann.)                  -0.5     -1.1   -0.5    0.2 -0.6      0.4    -0.4    -0.4     0.6        0.4      0.4      0.4     0.8      -0.1        -0.4    -0.3           0.2       0.5
Gross Fixed Investment (qoq, ann.)                  -5.1     -7.1   -3.2   -5.8 -7.4      1.5    -2.8    -1.2    -0.1        0.3      0.6      0.9    -0.4       1.5        -4.2    -4.0          -0.3       1.3
  Machinery & Equipment (qoq, ann.)                 -5.9     -7.3   -5.3   -6.6 -10.5     2.0    -3.9    -1.6    -0.4        0.0      0.4      1.0     5.6       4.5        -4.3    -5.3          -0.7       1.5
  Construction (qoq, ann.)                          -5.7     -7.7   -2.2   -5.8 -7.0      0.8    -2.8    -1.6    -0.4        0.0      0.4      0.4    -4.3      -0.4        -4.8    -4.0          -0.6       0.9
  Other (qoq, ann)                                   4.3     -1.7   -0.6   -2.8   4.9     4.1     2.4     3.2     3.0        3.0      3.0      3.0     3.6       2.2         1.1     1.7           3.1       3.0
Contribution to Growth
Inventories (qoq, ann.)                             -0.1     -0.2   -0.6   -0.2   -0.1   -0.2     0.3     0.9        0.7     0.4      0.3      0.1     0.6       0.2        -0.5    -0.1           0.5       0.0
Net Exports (qoq, ann.)                              1.4      2.2    1.2    0.3    0.4    0.8     0.4     0.3        0.1     0.2      0.4      0.6     0.7       1.0         1.6     0.7           0.3       0.6
Final Domestic Demand (qoq, ann.)                   -1.5     -2.7   -1.0   -2.4   -1.4    0.6    -0.4    -0.3        0.1     0.4      0.4      0.5     0.7       0.3        -1.6    -1.1           0.1       0.6
GDP Gap (actual versus potential)                                                                                                                     -2.2      -1.6        -2.9    -4.1          -4.0      -3.5
Main Euro Area Countries
  Germany (qoq, ann.)                                2.7     -0.3    0.8   -1.8    0.0    2.9     1.0     1.6        2.0     1.8      1.6      1.6     4.2          3.0      0.7     0.4          1.8        1.8
  France (qoq, ann.)                                 0.1     -1.3    0.6   -0.7   -0.6    1.9    -0.5     0.3        0.7     0.9      0.9      0.9     1.6          2.0      0.0     0.0          0.6        1.2
  Italy (qoq, ann.)                                 -4.0     -2.5   -1.0   -3.6   -2.6   -0.8     0.2     0.4        0.4     0.4      0.8      0.8     1.7          0.5     -2.4    -1.7          0.4        0.7
  Spain (qoq, ann.)                                 -1.7     -2.0   -1.5   -3.1   -1.5   -0.4     0.2     0.6        1.0     1.0      1.1      1.4    -0.2          0.1     -1.6    -1.3          0.8        1.1

Employment, Income, Profits
Employment (qoq)                                    -0.4      0.0   -0.1   -0.3   -0.5   -0.2    -0.1    -0.1    0.0        0.0       0.1      0.1    -0.5       0.4        -0.7    -0.9      -0.1           0.2
Unemployment Rate, % of labour force                10.9     11.3   11.5   11.8   11.9   12.0    12.1    12.2   12.3       12.3      12.3     12.3    10.1      10.2        11.4    12.1      12.3          12.4
Compensation per Employee (qoq)                      0.6      0.3    0.3    0.3    0.9    0.5     0.3     0.3    0.3        0.3       0.3      0.3     1.8       2.1         1.8     1.9       1.3           1.2
Real Disposable Income (qoq)                                                                                                                          -0.7      -0.4        -1.0     0.4       0.4           0.9
Savings Ratio (% of disposable income)                                                                                                                13.8      13.4        13.7    14.5      14.6          14.9
Gross Operating Surplus (qoq)                                                                                                                          4.2       2.6        -0.4     2.0       2.1           3.2

Productivity, Costs, Inflation
Labour Productivity per capita (qoq)                 0.3     -0.2    0.0   -0.3    0.2    0.5     0.2     0.3        0.2     0.3      0.3      0.3     2.5          1.1      0.2     0.5          1.0        1.0
Unit Labour Costs (yoy)                              1.7      1.4    1.8    1.5    2.0    1.5     1.3     0.8        0.2     0.2      0.2      0.2    -0.7          1.0      1.6     1.4          0.2        0.2
Inflation (HICP), yoy                                2.7      2.5    2.5    2.3    1.9    1.4     1.4     1.5        1.6     1.7      1.5      1.4     1.6          2.7      2.5     1.5          1.6        1.4
Core inflation, yoy                                  1.6      1.6    1.5    1.5    1.5    1.2     1.1     1.1        1.1     1.1      1.0      0.9     1.0          1.4      1.5     1.2          1.1        0.9

Balance Sheets
Current Account (% of GDP)                                                                                                                             0.0       0.1         1.3     2.4       2.3           2.4
General Government Balance (% of GDP)                                                                                                                 -6.2      -4.1        -3.7    -3.1      -2.9          -2.7
General Government Gross Debt (% of GDP)                                                                                                              85.6      88.1        91.4    94.5      96.5          96.2

Source: National Statistics, Eurostat, Morgan Stanley Research forecasts   QoQ = Quarter on Quarter, YoY = Year on Year

Exhibit 9
European Interest Rate Forecasts at a Glance, 2013-15E
                                                   Current      Sep 13E      Dec 13E      Mar 14E        Jun 14E           Sep 14E          Dec 14E    Mar 15E            Jun 15E   Sep 15E              Dec 15E
Euro Area
ECB Deposit (Floor) Rate                              0.00          0.00          0.00          0.00          0.00            0.00             0.00          0.00            0.00          0.00             0.00
ECB Refi Rate (EoP)                                   0.50          0.50          0.25          0.25          0.25            0.25             0.25          0.25            0.25          0.25             0.25
ECB Marginal Lending (Ceiling) Rate                   1.00          1.00          0.50          0.50          0.50            0.50             0.50          0.50            0.50          0.50             0.50
3M Money market futures                               0.22          0.24          0.31          0.41          0.49            0.57             0.66          0.75            0.86          0.99             1.13
United Kingdom
BoE repo rate (EoP)                                   0.50          0.50          0.50          0.50          0.50            0.50             0.50          0.50            0.75          0.75             1.00
3M Money market futures                               0.50          0.53          0.55          0.61          0.69            0.78             0.88          1.00            1.15          1.33             1.55
Riksbank Repo (EoP)                                   1.00          1.00          1.00          1.00          1.00            1.00             1.25          1.25            1.50          1.50             1.75
3M Money market futures                               1.21          1.23          1.28          1.43          1.58            1.73             1.89          2.04            2.18          2.31             2.44
Riksbank's Own Repo Forecast (Avg)                                  0.99          0.94          0.94          0.94            1.00             1.25          1.50            1.75          2.00             2.25
Source: Reuters, Bloomberg, Morgan Stanley Research forecasts

                                                                                     MORGAN       STANLEY        RESEARCH

                                                                                     September 3, 2013
                                                                                     European Economics

Still Plenty of Risks to Our Baseline Scenario
Morgan Stanley & Co.                                                                    EM markets to varying degrees, and would likely be
                               Elga Bartsch
International plc
                                                accompanied by a rally in risk markets, thus easing financial
                               Daniele Antonucci                                        conditions; and ii) A Chinese soft take-off in growth, with
                                           confidence being enhanced by successful sector-specific
Key Points                                                                              stimulus and bold structural reforms that promote
Given the uncertainty around major policy decisions both in                             rebalancing. All this, and the reversal of capital flows back
the region and elsewhere, and the fragile state of the euro                             into EM as a consequence, would be quite supportive of an
area economy, single-point forecasts seem even less useful                              export-led recovery in the euro area.
than usual. We therefore encourage our readers to think
about a range of outcomes, reflecting a range of different                            Equally, recent geopolitical events suggest caution on the
assumptions along three dimensions: global, European and                              price of oil. The same applies to FX: While the baseline
national                                                                              assumes a gradual weakening of EUR, any meaningful
                                                                                      deviation from that forecast would have an impact on growth
Exhibit 10
Bull and Bear Scenarios – GDP Growth
                        Base Case                 Bear Case           Bull Case
                   2013e 2014e 2015e             2014e   2015e       2014e   2015e    2. Europe – EU Policy and the ECB
Subjective Prob.    60%                            20%                20%             The global context is by no means the only – or even main –
EU-15                  -0.1     1.2       1.4       0.2     0.0        1.9     2.0
EMU                    -0.5     0.9       1.2      -0.1    -0.2        1.6     1.8    risk to the euro area economic outlook, for several reasons:
Austria                 0.5     1.6       1.6       0.6     0.2        2.2     2.2
Belgium                 0.1     1.2       1.7       0.3     0.3        2.1     2.4
Finland                -0.2     0.8       1.2      -0.2    -0.2        1.5     1.8
                                                                                      • First, not only will the banking system, which remains short
France                  0.0     0.6       1.2      -0.4    -0.1        1.6     2.1      of capital, have to continue with its balance sheet repair. We
Germany                 0.4     1.8       1.8       0.8     0.4        2.4     2.4
Greece                 -4.0     0.0       0.4      -1.0    -1.0        0.6     1.0
                                                                                        also believe that there are some key challenges ahead:
Ireland                 0.4     2.1       2.5       0.1     1.1        2.8     3.1
Italy                  -1.7     0.4       0.7      -0.6    -0.7        1.0     1.3     i.   In the short term: We think that the Asset Quality
Netherlands            -1.2     0.5       0.8      -0.5    -0.6        1.1     1.1
Portugal               -2.0     0.2       0.5      -0.7    -0.8        0.9     1.1          Review and the bank stress test in 1H14 are
Spain                  -1.3     0.8       1.1      -0.2    -0.3        1.4     1.7          potentially important events that could eventually
Sweden                  1.1     2.2       3.0       1.2     1.7        2.9     3.6
                                                                                            refocus market participants on the lack of a full
Source: National data, Morgan Stanley Research forecasts
                                                                                            circuit-breaker between banks and sovereigns (see
1. Global – All Eyes on US Rates, EM Markets and China                                      European Banks: Don’t Underestimate the AQR, August
In our global outlook, the baseline scenario assumes that DM                                29, 2013).
bond markets stabilise and China slows down in a controlled
fashion. By contrast:                                                                 ii.   In the medium term: We think that a fully fledged
                                                                                            banking union is the minimal solution to fix the flawed
• Our bear case explores the impact of: i) US bond yields                                   institutional set-up of the euro area. While a new
  surging to 4% in the next few months on fears of earlier Fed                              resolution regime is in the making, prospects of a Single
  rate hikes. The rise in bond yields is then transmitted to                                Resolution Mechanism, a common bank rescue fund
  other DM and EM markets to varying degrees. It would likely                               and a deposit guarantee appear remote.
  be accompanied by a sell-off in risk markets, thus tightening
  financial conditions; and ii) Chinese growth rolling over to                        • Second, the political situation remains quite fragile and
  5-6%Y quickly. This alone, and the severe disruption to EM                            vulnerable to setbacks. There’s as much support fatigue in
  capital flows, would be enough to put the euro area – and                             core Europe as there’s austerity fatigue in peripheral
  indeed the global economy – back in recession.                                        Europe. This is not to say that no reforms have happened.
                                                                                        To some degree, and in selected areas, they actually have.
• Our bull case explores the impact of: i) US data in the                               But the key point is that even the limited progress we’ve
  sweet spot of continued expansion and the Fed                                         seen has resulted in overstretched political promises, along
  successfully accomplishing the separation. It does begin                              with voters’ disillusion, on belt-tightening and reforming the
  tapering, but combines it with a strong signal of its intent to                       economy, pushing through further EU coordination
  keep rates low for a very long time. The accompanying                                 mechanisms and rescuing the weakest members of the
  decline in bond yields would be transmitted to other DM and                           currency union.

                                                                      MORGAN       STANLEY        RESEARCH

                                                                      September 3, 2013
                                                                      European Economics

• Third, the ECB hasn’t embarked on any extra easing.                  implement significant institutional reforms (including new
  Conversely, it has allowed its balance sheet to shrink. In the       electoral rules), along with product and labour market reforms,
  context of Fed tapering, we are concerned that the ECB               is not impossible. Yet, a bear case of political procrastination,
  might find it difficult to counteract any adverse impact on          as well as domestic instability and EU reform blockage, might
  euro area markets. Thus, European core rates might well              challenge the consensus view that the worst is behind us.
  rise more than expected and, potentially, peripheral
                                                                       Spain: The Spanish economy might recover faster than
  spreads might re-widen to a meaningful extent. This is all           expected. In our view, investors have not caught up yet with
  the more complicated due to the upcoming ruling by the               Spain’s ability to grow rather than just stagnate. In our bull
  German Constitutional Court on OMT. Our bear case                    case, a structurally strong export engine, which is getting
  assumes an inactive ECB that is clearly restricted by                stronger as competitiveness improves, a more growth-friendly
  shifting political and legal boundaries as well as slow              fiscal policy, the sharp contraction in construction coming to
  decision-making in what seems to be a divided Governing              an end and visible disinflation might well trigger a decent,
  Council. A marked rise in funding costs would cause a                rather than sub-par recovery. But a bear case of a more
  full-blown credit crunch and, due to rising debt-service costs,      intense deleveraging than envisaged could cause fresh
  could lead to additional fiscal tightening. Our bull case, by        concerns about the sustainability of the improvement. Thus,
  contrast, assumes lower funding costs – also helped by               while the consensus might well start to revise up, we see little
  further political steps towards crisis resolution – and less         scope for extra upside to GDP growth from what we project
  aggressive fiscal tightening (which has already been                 currently.
  relaxed). In this case, the ECB should be able to start
                                                                       Portugal and Greece: With signs of adjustment stress having
  raising rates in late 2014.
                                                                       recently emerged in both countries, their ability to refocus on
3. Country-Level – Any Engines of Growth/Reforms Left?                 their programmes will be closely watched. In Greece, the
Germany: The main risk emanating from Europe’s largest                 focus is on public sector downsizing and on reviving the
economy is the September 22 elections. In our view, a major            privatisation process, on which we stay cautious. A bull case
shift in the stance on key issues such as debt relief, joint           of smooth execution on all fronts appears a stretch, but would
issuance and direct bank recaps is unlikely if the incumbents          comfort investors and make near-term OSI more likely. A bear
are re-elected or if Chancellor Merkel is forced into a Grand          case would envisage renewed tensions, both in domestic
Coalition. In fact, a narrow majority for the centre right could       politics and with the Troika, which might delay or complicate
reinforce a relatively tough stance on these issues. Only in the       upcoming reviews. In Portugal, devising a plan B of a
unlikely event of a Red-Green coalition would the chances of           precautionary credit line or a second bailout with the official
a European debt-redemption fund rise materially, we think.             lenders is likely to dominate the debate. A bull case of a
                                                                       stronger political commitment would make financial support
France: In our view, developments in France are key to the
                                                                       become clearer sooner. But domestic politics remains a
stability of the euro area, notably the core’s ability to contain
                                                                       hurdle, as does the recent decision of the Constitutional Court
the crisis in the periphery. With growth in slow motion, the
                                                                       to strike some spending cuts. In a bear case, austerity fatigue
French current account deficit, which is now the largest in the
                                                                       would aggravate and a resolution might only come after
euro area, both in absolute terms and as a percentage of GDP,
                                                                       significant damage to confidence, which could – in turn –
could be a potential tipping point. In the absence of a
                                                                       make a delayed market comeback more likely.
correction of the underlying structural issues, dependence on
foreign capital would grow, potentially causing the country to         Ireland: The finishing stretch for Ireland’s programme exit in
become more vulnerable to shifts in international investor             early 2014 could be more uphill than expected. The economy
sentiment (see Foreign Capital Dependence: Should                      slipped back into recession in mid-2012 and government
Investors Be Concerned? July 3, 2013). In our bull case, we            parties are debating an easing of austerity. Mortgage arrears
assume that the authorities tackle structural imbalances               are still rising and repossessions only starting. Debt at 125%
swiftly, particularly in the public sector, with a fiscal              of GDP is already high, chances to offload ~40pp of debt from
consolidation strategy focused on the spending side.                   bank rescues seem remote, and the deficit remains one of the
                                                                       highest this year. Also, the euro crisis could re-escalate, legal
Italy: Policy-makers struggle to strengthen Italy’s near-zero
                                                                       or political setbacks could hit the ECB’s OMT programme and
potential GDP growth. An uncertain political situation
                                                                       mishaps are possible in the run-up to the SSM. Equally,
complicates the picture further. Rising political volatility
                                                                       investors might find that none of these concerns materialise,
following the recent court verdict might test government
                                                                       the strong Irish fundamentals reassert themselves and Ireland
cohesion. While not very likely, conceiving a bull case where
                                                                       sails out of its rescue programme full steam ahead.
the authorities focus less on internal political issues and quickly

                                                                    MORGAN              STANLEY                RESEARCH

                                                                    September 3, 2013
                                                                    European Economics

Germany – Not Strong Enough as a Single Engine
Morgan Stanley & Co.                                                as proposed by all opposition parties do not seem to be
                       Elga Bartsch
International plc
                            conducive to this goal, we think. Hence, we would deem a
                                                                    complete change in government after the September 22
Key Points
                                                                    election as negative for German equities. To what extent a
Despite the recent stellar performance, the German economy
                                                                    government more open-minded towards pooling financial
alone is not strong enough to pull the euro area along.
                                                                    resources in the euro area, e.g., via a debt-redemption fund
Instead, we believe that the newly elected government faces         and a bank rescue fund, would be able to offset this negative
several key policy challenges after the September 22 ballot.        impact through improving the growth prospects in the rest of
                                                                    the euro area is an open question. The sharp rise in EUR that
We would not read too much into the spurt in German
                                                                    would likely result from such step towards pooled financial
GDP growth in the spring. Part of it is just a normalisation
                                                                    resources would likely undermine some of the near-term
after a very cold winter. As a result, we would expect a
                                                                    growth momentum (for a detailed analysis of the election, see
renewed moderation in growth in 3Q. At present, our GDP
                                                                    Merkel to Score a Hat-Trick, August 27, 2013).
indicator is tracking just 0.2%Q between July and September.
In 1H, growth was significantly boosted by domestic demand,         Exhibit 11
notably consumer spending and also government expenditure.          Massive Inventory Build Did Not Show in 2Q GDP
In addition, investment spending recovered noticeably, which         115         Mfg Output, LH                                                           110
is partly attributed to a catching-up in construction investment                 Industrial Sales, LH
                                                                     110         Inventories in Mfg, RH
after the unusually cold winter. As domestic orders of capital                                                                                            106
goods were rather weak in 2Q, we would not expect a massive          105                                                                                  104
contribution from capex itself. Finally, net exports also boosted                                                                                         102
headline GDP growth as export growth outpaced import growth.                                                                                              100
While the preliminary GDP report does not show any significant        95
inventory rebuilding, monthly industrial data we track would          90                                                                                  96
suggest a very sharp rise in manufacturing inventories over the                                                                                           94
summer.                                                               85
                                                                      80                                                                                  90
While Germany is the only large euro area country that shows           2003             2005         2007        2009             2011          2013

some clear signs of recovery at the moment, we remain               Source: Deutsche Bundesbank, Morgan Stanley Research
concerned about the longer-term challenges that                     Exhibit 12
Europe’s largest economy faces. These challenges include:           Germany – Main Macro Forecasts, 2011-15E
i) The increasingly tight labour market causing bottlenecks in                                                  2011A    2012A       2013E      2014E    2015E
                                                                    Real GDP                                       3.0      0.7         0.4        1.8      1.8
certain sectors and regions; ii) The increasingly expensive         Private Consumption                            1.7      0.6         1.7        1.3      1.4
push towards renewable energy sources; and iii) The                 Government Consumption                         1.0      1.4         0.2        1.4      1.2
                                                                    Gross Fixed Investment                         6.2     -2.6        -0.6        3.2      3.0
persistent underinvestment in terms of public infrastructure and        Machinery and Equipment                    7.0     -4.8        -3.4        3.9      4.1
corporate capex. In our view, the latter is the main problem        Exports                                        7.8      3.7           1.7     4.3      4.3
                                                                    Imports                                        7.4      1.8           2.4     4.3      4.3
behind the sizeable German current account surplus. Instead         Contribution to GDP Growth (%)
of investing in productive capacity at home, Germany has             Final Domestic Demand                         2.2      0.2           0.9      1.6      1.6
                                                                     Net Exports                                   0.7      1.1          -0.1      0.3      0.3
invested a large part of its domestic savings in financial assets    Inventories                                   0.1     -0.6          -0.4     -0.1     -0.1
abroad. Unfortunately, the track record for such investments is     Unemployment Rate (% of Labour Force)         6.0      5.5            5.5     5.5      5.4
                                                                    Real Disposable Income                       -0.5      0.9            1.1     1.1      1.3
very poor. On average, Germany has lost about 0.5% of GDP           Personal Saving Rate (% of Disp. Income)     10.2     10.3            9.8     9.6      9.5
per annum on its net foreign assets.                                Inflation (CPI)                                2.1      2.0           1.6     1.9      1.9
                                                                    GDP Deflator                                   1.2      1.5           2.4     1.9      1.6
                                                                    Unit Labour Costs                              3.9      3.2           2.1     0.6      1.2
To harness the domestic growth potential in full and divert         Current Account (% of GDP)                     6.2      7.0           6.7     6.6      6.6
domestic savings towards domestic investment, the next              General Government Balance (% of GDP)         -0.8      0.2           0.0     0.1      0.3
German government will need to address the labour market            Primary Government Balance (% of GDP)         1.8      2.6            2.2     2.2      2.4
                                                                    General Government Debt (% of GDP)           80.4     81.3           80.3    77.8     75.2
issue, the energy policy question and the degenerating public       Net Government Debt (% of GDP)               50.8     50.9           N/A     N/A      N/A
infrastructure. Marked tax increases and minimum wage hikes         Source: National Statistics, Deutsche Bundesbank, Morgan Stanley Research forecasts

                                                                   MORGAN                STANLEY              RESEARCH

                                                                   September 3, 2013
                                                                   European Economics

France – Slow-Motion Economic Recovery
Morgan Stanley & Co.                                               ultimately, limit any meaningful recovery going forward. Finally,
                       Olivier Bizimana
International plc
                       the contribution from net exports should be neutral, as we
                                                                   expect exports and imports to improve gradually.
Key Points
We expect a slow-motion economic recovery over the coming
                                                                   Fiscal policy set to remain restrictive. France has been
quarters, amid a still-restrictive fiscal policy.
                                                                   granted two more years to reduce its budget deficit to
Domestic demand should remain soft, as weak corporate              bellow 3% of GDP by 2015: Nevertheless, fiscal adjustment is
balance sheets should limit any meaningful recovery.               set to continue, with a reduction in the structural deficit
                                                                   expected to be about 1.8pp in 2013 and 1.0pp in 2014,
The general government deficit is projected to decline slightly
                                                                   according to the 2013-2017 Stability Programme. Under our
to 3.5% of GDP in 2014 and the debt/GDP ratio to keep rising.
                                                                   growth forecasts, the general government deficit should fall to
The economy continues to stabilise, but headwinds                  3.9% of GDP in 2013 and 3.5% in 2014. The debt/GDP ratio
remain: The economy is projected to grow at a sub-par pace         should continue to rise to 95.3% in 2014 (from 90.2% in 2012).
next year, after two consecutive years of stagnation. Growth is
                                                                   Exhibit 13
set to pick up pace slightly in 2015, though staying below its
historical trend. If anything, we expect a slow-motion recovery.
                                                                   France – Main Macro Forecasts, 2011-15E
                                                                                                                   2011A     2012A    2013E       2014E    2015E
Despite the extension of the deficit deadlines, fiscal policy      Real GDP                                           2.0       0.0      0.0         0.6      1.2
                                                                   Private Consumption                                0.5      -0.4      0.2         0.5      0.9
should remain restrictive and continue to have a significant       Government Consumption                             0.4       1.4      1.5         1.0      1.1
drag on growth. The risks to the outlook remain higher than        Gross Fixed Investment                             3.0      -1.2     -2.5         0.4      1.8

normal. In particular, uncertainty about the fiscal outlook is     Contribution to GDP Growth (%)
                                                                    Final Domestic Demand                             1.0      -0.1      0.0        0.6      1.1
likely to persist. What’s more, the weakness of balance sheets      Net Exports                                       0.0       1.0      0.0        0.0      0.1
                                                                    Inventories                                       1.1      -0.8      0.0        0.0      0.0
could also make it more difficult for firms to access external
                                                                   Unemployment Rate (% of Labour Force)             9.2       9.8      10.5       10.8     10.7
financing, which could weigh further on growth.                    Real Disposable Income                            0.6      -1.0       0.6        0.3      0.6
                                                                   Savings Rate (% of Disp. Income)                 16.1      15.6      16.0       15.8     15.7

Exit recession to enter stagnation: Real GDP growth                Inflation (CPI)                                    2.1       2.0      1.0        1.6      1.4
                                                                   Unit Labour Costs                                  0.6       1.8      1.4        1.3      1.2
rebounded in 2Q, after two consecutive quarters of contraction
                                                                   Current Account (% of GDP)                        -1.9      -2.3      -2.1       -2.2     -2.3
(technical recession). Several of the underlying components of
                                                                   General Government Balance (% of GDP)            -5.3      -4.8      -3.9       -3.5     -3.2
real GDP registered solid growth. In particular, consumer          Primary Government Balance (% of GDP)            -2.7      -2.3      -1.3       -0.9     -0.5
                                                                   General Government Debt (% of GDP)               85.8      90.2      93.6       95.3     95.8
spending bounced back, while public consumption remained           Net Government Debt (% of GDP)                   62.5      70.7      N/A        N/A      N/A
strong. Likewise, export growth expanded at a rapid clip and       Source: INSEE, Morgan Stanley Research forecasts
changes in inventories made a positive contribution to growth.
                                                                   Exhibit 14
By contrast, both corporate and residential investment
                                                                   Slow-Motion Expansion
continued to decline. In the near term, though, the momentum
swing in 2Q is not expected to carry into 3Q, as some of the               %,Q              France: GDP growth contributions
                                                                                       Domestic demand (excl. inventories)    Inventory changes
elements supporting growth in 2Q were one-off factors and are
                                                                                       Net exports                            GDP
not likely to persist. Heading into 3Q, key data flows point to     1.2
relatively weak momentum. We expect a small contraction in                                                              Forecasts

real GDP in 3Q, followed by sluggish growth in 4Q and               0.8

throughout 2014.

Domestic demand is soft, and consumption spending is                0.0
expected to remain rather tepid: A continuation of the bleak
labour market conditions, with rising unemployment, will likely     -0.4
keep consumer spending growing at a moderate pace.
Moreover, consumers should maintain a high saving rate,             -0.8
                                                                           Q1-11 Q3-11 Q1-12 Q3-12 Q1-13 Q3-13 Q1-14 Q3-14 Q1-15 Q3-15
partly reflecting uncertainty about the medium-term outlook for
                                                                   Source: INSEE, Morgan Stanley Research forecasts
fiscal policy. Business investment should stabilise somewhat.
More fundamentally, the weak corporate balance sheets and
low level of profit margins should hamper capital spending and,

                                                                     MORGAN               STANLEY                 RESEARCH

                                                                     September 3, 2013
                                                                     European Economics

Italy – Another ‘Political Year’
Morgan Stanley & Co.                                                 Yet, Italy has struggled to deliver on key structural
                       Daniele Antonucci
International plc
                        reforms to strengthen its economic fabric and bring back
                                                                     some decent growth – at least so far. While there’s
Key Points                                                           consensus on the need of some key institutional changes,
The economy should stabilise soon, but we see nothing more           including a new electoral law capable of generating stronger
than near-stagnation in 2014, and modest growth thereafter.          majorities, they haven’t materialised yet, and deep economic
Fiscal policy is giving some respite to the economy. But key         changes still seem unlikely for now.
institutional and structural reforms are not happening for now.
                                                                     Apart from potentially more difficult market and broad macro
The political situation remains very fragile, in terms of both       conditions on the external side, the picture is further
near-term government stability and medium-term prospects of          complicated by an uncertain political situation, with several
a less volatile environment. It’s Italy’s biggest risk.              tests still ahead of us. At a minimum, we’d expect rising political
The Italian economy might well have stabilised in 3Q, after          volatility following the recent court verdict, which might possibly
a two-year recession – the longest since records began.              test government cohesion and stability, both on the centre-right
Industrial production looks set for a better quarter, and hard       and on the centre-left of the political spectrum. With very low
data more broadly have become less bad, even though they             visibility yet on the rules of the game and its main actors, it
haven’t really turned visibly at this stage. Most business           looks like Italy is set to go through another ‘political year’.
surveys are showing a lifting of pessimism, certainly on the
                                                                     Exhibit 15
manufacturing side (where the corresponding PMI is now
                                                                     Italy – Main Macro Forecasts, 2011-15E
above the threshold of 50 separating expansions from                                                                     2011A    2012A     2013E      2014E         2015E
recessions) but also, lately, on the services side (where the        Real GDP
                                                                      Private Consumption
corresponding PMI has picked up notably, but it’s still pointing      Government Consumption                               -1.2     -2.9      -1.4       -0.8           0.7
                                                                      Gross Fixed Investment                               -1.4     -8.0      -5.0        1.9           2.2
to contracting activity).                                               Construction                                       -1.7     -7.2      -5.9        0.8           1.1

                                                                     Contribution to GDP Growth (%)
                                                                      Final Domestic Demand                                -0.5     -4.7      -2.5           0.0        0.6
These dynamics might be helped by a more growth-friendly              Net Exports                                           1.5      2.8       0.8           0.4        0.2
fiscal policy. The Italian government has started to pay a            Inventories                                          -0.5     -0.6       0.0          -0.1       -0.1

                                                                     Employment                                             0.8    -0.2      -1.4            0.3       0.5
substantial portion of its unpaid bills. Even assuming that just a   Unemployment Rate (% of Labour Force)                  8.4    10.7      11.6           12.4      13.0
small part will boost business investment, and that the bulk of      Inflation (CPI)                                        2.8      3.0      1.4            1.5       1.6

the cash injection is used to pay wage and salary arrears and        Current Account Balance (% of GDP)                   -3.1     -0.6       0.9         1.4          1.6
                                                                     General Government Balance (% of GDP)                -3.8     -3.0      -3.3        -2.4         -2.2
to build a cushion for precautionary purposes, this could lift       Primary Government Balance (% of GDP)                 1.2      2.5       2.2         3.4          3.8
                                                                     General Government Debt (% of GDP)                  120.8    127.0     131.6       131.6        130.8
GDP growth by half a percentage point over the next 12               Net Government Debt (% of GDP)                       97.5    112.9      N/A         N/A          N/A
months (see Paying the Bills, April 24, 2013).                       Source: ISTAT, Bank of Italy, Morgan Stanley Research forecasts

                                                                     Exhibit 16
The stimulus under way, together with an easing in the pace of
austerity (e.g., VAT tax hikes postponement and eventual             Near-Zero Potential Growth – Problem Yet to Solve
elimination, overhaul of IMU property tax) might give the             12                                  Real GDP (% Y/Y)
                                                                                                      1961-70 = 5.7% 1971-80 = 3.7%
corporate sector some respite, with a plan to pay an extra
                                                                                                      1981-90 = 2.4% 1991-00 = 1.5%
€20-25 billion of government arrears on top of €40 billion             8                                             2001-10 = 0.4%
already approved. As we suspected, apart from rising
confidence (partly due to European policy-makers’ actions),            4
extra time to reduce the budget deficit, less fiscal
retrenchment and a targeted stimulus programme are                     0
bringing some upside surprises in the data and have
made economic risks more balanced (see Death of                       -4
Austerity? May 21, 2013).
                                                                         1961      1966   1971    1976     1981   1986    1991    1996     2001      2006     2011

                                                                     Source: ISTAT, OECD, Morgan Stanley Research

                                                                    MORGAN              STANLEY             RESEARCH

                                                                    September 3, 2013
                                                                    European Economics

Spain – Bottoming Out and Rebalancing
Morgan Stanley & Co.                                                The current account is now in surplus: This is encouraging,
                       Daniele Antonucci
International plc
                       and should continue. Yet, Spain’s highly negative international
                                                                    investment position represents a key vulnerability, as it leaves
Key Points                                                          it subject to shifts in market sentiment and financial market
We expect a return to (fractional) growth later this year and       shocks. By summing up the net financial asset positions of all
expect the economy to expand, but just modestly, in 2014-15.        the domestic sectors (households, firms and the public sector),
Yet, high unemployment for longer, a sharper housing market         the international investment position is closely related to
adjustment and unfavourable financial conditions are key risks.     economy-wide deleveraging as much of it is foreign debt.

Fiscal and external imbalances are narrowing (e.g., current         The correction in the housing market might only be
account surplus, narrower budget deficit). However, external        slightly more than halfway through: So, prices will likely fall
debt remains high, and government debt keeps rising.                further, and for quite a while. But (residential) construction
There are signs that GDP might have stabilised – or even            investment, as a share of GDP, is now lower than the eurozone
expanded – in 3Q: We expect a resumption of positive                average. Therefore, one major hindrance that was pulling the
sequential growth before year-end, and an above-consensus           Spanish economy down, i.e., sharp falls in construction
0.8%Y growth in 2014.                                               investment, will no longer be there.

After a credit-fuelled housing and consumer boom (now turned        Exhibit 17
bust), the drivers of growth are shifting away from                 Spain – Main Macro Forecasts, 2011-15E
                                                                                                              2011A     2012A       2013E       2014E       2015E
domestic demand and into exports – which are structurally           Real GDP                                     0.1      -1.6        -1.3         0.8         1.1
strong and getting stronger (and a bigger share of the GDP pie),     Private Consumption                        -1.2      -2.8        -2.6         0.1         0.4
                                                                     Government Consumption                     -0.5      -4.8        -1.3        -0.1         0.4
courtesy of improving competitiveness on the back of wage            Gross Fixed Investment                     -6.5      -8.0        -7.4        -3.0        -0.5
                                                                       Construction                            -10.9      -9.7       -10.5        -5.2        -2.0
moderation and labour market reforms. This is
                                                                    Contributions to GDP Growth (%)
underappreciated in the market, and it’s likely to be the (only)     Final Domestic Demand                       -2.2     -4.2        -3.2        -0.5           0.2
growth engine in Spain over the forecast horizon.                    Net Exports                                  2.1      2.4         1.8         1.3           0.9
                                                                     Inventories                                  0.1      0.2         0.1        -0.1           0.0

                                                                    Unemployment Rate (% of Labour Force)       21.7      25.1       26.5        25.6           24.5
A process of disinflation is now happening, in part courtesy        Inflation (CPI)                              3.2       2.4        1.7         0.8            1.4
of structural reforms, which make goods and services markets        Current Account Balance (% of GDP)          -3.7      -1.1        1.7         2.8            3.4
more flexible. And, with last year’s tax hikes now dropping out     General Government Balance (% of GDP)       -9.4     -10.6       -6.9        -6.0           -5.3
                                                                    Primary Government Balance (% of GDP)       -7.0      -7.7       -3.5        -2.3           -1.4
of the year-on-year comparison, the rate of increase of             General Government Debt (% of GDP)          69.3      84.2       91.4        96.2           99.1

consumer prices should decelerate visibly. This is positive for     Source: INE, Bank of Spain, Morgan Stanley Research forecasts
household disposable income – even though the key driver of
                                                                    Exhibit 18
aggregate private consumption is likely to be the labour market,
                                                                    International Investment Position (% of GDP)
which remains quite weak.
                                                                                 Direct investment                        Portfolio investment
                                                                                 Financial derivatives                    Other investment
Yet, economy-wide deleveraging means that a sustained pace                       Reserves                                 Net claims w/ Eurosystem
of growth is probably too much to hope for. We’re worried that         20        Other net assets of BdE                  Total
the unemployment rate will not come down quickly – as
positive job creation has only happened when GDP was
growing twice as fast as the rate we project.                         -20

Balance sheet repair has to progress further, and its pace
and intensity are key risks. Corporates seem further advanced
than households on this front. As long as this continues, GDP         -80
growth is likely to stay weak – even after exiting recession. The
budget deficit, slowly, is narrowing more or less according to                   2000      2002       2004       2006       2008         2010            2012
official projections, and important reforms are happening in this   Source: Bank of Spain, Morgan Stanley Research
area too. Yet, government debt is high and on an upward
trajectory, which points to limited room for manoeuvre.

                                                                    MORGAN             STANLEY              RESEARCH

                                                                    September 3, 2013
                                                                    European Economics

Netherlands – As Safe as Houses?
Morgan Stanley & Co.                                                gas due to the relatively cold weather conditions. Government
                       Elga Bartsch
International plc
                            spending also fell as a result of spending cuts. While
                                                                    investment rebounded, gross fixed capital formation still stands
Key Points
                                                                    9.5% lower than a year ago. In the construction sector,
The Netherlands continues to struggle with the aftermath of the
                                                                    investment is still declining, but less rapidly than before. Yet,
financial crisis and falling housing prices. On our downwardly
                                                                    with house prices likely to fall further and with some evidence
revised forecast, the Dutch economy is the weakest in the core.
                                                                    of overbuilding in the past, we would expect construction
If it wasn’t for a sizeable current account surplus, a strong       investment to keep shrinking. Exports of goods manufactured
competitive position and low and stable funding costs, the          in the Netherlands fell significantly in 2Q while re-exports
economy could be mistaken for inching towards the periphery.        growth slowed compared to 1Q. It was only because imports
                                                                    stagnated while exports expanded mildly that net foreign trade
The Dutch economy remains the weakest within the core
                                                                    made a positive contribution to GDP growth. Last but not least,
and, at the time of writing, was still mired in an extended
                                                                    a considerable boost also came from inventories.
recession (see Netherlands Economics: Dutch Economy Still in
the Doldrums, April 30, 2013). We had to revise down our            Companies are continuing to lay off staff, with payrolls
estimate for 2013 again, cutting it to -1.25%Y, from -0.8%Y         shrinking by 41K in 2Q, falling by 1.9%Y: Hiring intentions
before. For 2014, we are sticking to our forecast 0.5%Y.            suggest that this trend will continue. Unemployment has
Whether a return to growth can be realistically achieved next       already risen to 8.7% of the working-age population (on the
year will also depend on the 2014 budget, which the                 stricter national definition) and to 6.8% on the harmonised ILO
government will present to parliament on September 17, the          definition. Household confidence is near record lows, with
traditional Prinsjesdag when parliament reopens. The main risk      purchasing intentions hitting very low levels and anxiety about
to the outlook stems from the housing market and its                job losses extremely elevated. In addition, household
repercussions for the banking system (see Dutch Mortgages:          purchasing power has been dented by the government’s
Underwater but Not Washed Out, July 25, 2013).                      austerity policy, which has reduced government transfers,
                                                                    frozen pay for civil servants and hiked VAT by 2pp last October.
Unless additional austerity measures are taken, the                 A sharp upward adjustment in rents pushed CPI inflation to
budget deficit is likely to widen materially next year: The         3.1%Y in July. Only in October when the VAT hike is falling out
CPB, whose forecasts government policies are based on,              of the year-on-year comparison is inflation likely to fall
expects the deficit to widen to 3.9% of GDP in 2014, from an        materially. But even then it remains above the increase in
estimated 3% this year. Despite an extension to the SGP             contractual wages of 1.2%Y. Only next year will inflation likely
deadline by one year, local media report that the government is     fall meaningfully below 2%Y, in our view.
contemplating austerity measures of up €8 billion, almost twice
                                                                    Exhibit 19
the amount that was discussed in the spring (a package that
was eventually withdrawn after reaching an agreement with the
                                                                    Netherlands – Main Macro Forecasts, 2011-15E
                                                                                                               2011A     2012A       2013E    2014E    2015E
trade unions and the employer federation) to rein in the deficit.   Real GDP                                      1.0      -1.3        -1.2      0.5      0.8
                                                                    Private Consumption                          -1.1      -1.6        -1.9     -0.5      0.4
On balance, we would expect the government to ease its              Government Consumption                        0.2      -0.7        -0.7      0.0      0.4
austerity drive somewhat in line with the rest of the euro area     Fixed Gross Investment                        6.1      -4.0        -8.5      1.4      2.5
                                                                    Exports                                       4.1       3.2         1.5      3.8      4.5
(see Death of Austerity? May 21, 2013). The lack of a majority      Imports                                       4.2       3.3        -1.1      3.6      4.9

in the upper house of parliament for the VVD-Labour coalition       Contributions to Growth
                                                                     Domestic Final Demand                        0.6      -1.6        -2.5      0.0      0.7
might also limit the ability of the government to implement a        Net Exports                                  0.3       0.2         2.0      0.6      0.2
pro-cyclical austerity package in the current downturn.              Inventories                                  0.1       0.2        -0.7     -0.4     -0.1

                                                                    Employment                                    0.0      -0.3        -0.5     0.0      0.2
                                                                    Unemployment Rate (%, ILO Definition)         4.4       5.3         6.7     7.2      7.4
In 2Q, GDP fell by a non-annualised 0.2%Q on the back of            Real Household Disposable Income             -0.8      -0.5        -1.5     0.7      1.2

a marked contraction in consumption of 0.8%Q: Consumer              Inflation (CPI)                               2.3       2.5        2.8      1.5      1.5
                                                                    GDP Deflator                                  1.1       1.3        1.6      1.5      1.6
spending has been falling for more than two years now as            Compensation Per Employee                     1.5       2.3        1.8      2.2      2.5

Dutch households cut back spending on consumer durables             Current Account Balance (% of GDP)          10.2       10.1        8.9      9.9      9.7
                                                                    General Government Balance (% of GDP)       -4.3       -4.0       -3.4     -3.5     -3.4
like cars, clothes and furniture, as well as spending less on       Primary Government Balance (% of GDP)       -2.3       -2.2       -1.8     -1.8     -1.7
                                                                    General Government Debt (% of GDP)          65.5       71.2       74.8     77.0     78.7
food, drinks and tobacco. The decline would have been even          Net Government Debt (% of GDP)              38.7       42.0       N/A      N/A      N/A
more pronounced had consumers not spent more on natural             Source: National Statistics, Morgan Stanley Research forecasts

                                                                   MORGAN              STANLEY              RESEARCH

                                                                   September 3, 2013
                                                                   European Economics

Belgium – Brighter External Outlook to Spur Recovery
Morgan Stanley & Co.                                               Business investment should rebound, amid better demand
                       Olivier Bizimana
International plc
                       prospects and favourable financing conditions.
Key Points
                                                                   Fiscal consolidation remains dependent on the economic
We expect real GDP in Belgium to recover gradually in 2014,
                                                                   cycle: We expect the general government deficit to continue to
thanks to brighter economic prospects in the core countries.
                                                                   decline to 2.7% of GDP in 2013 and 2.4% in 2014 (versus 3.9%
We also expect domestic demand to pick up pace.                    in 2012). According to the 2013-2016 Stability Programme
                                                                   (SP), the government expects to reduce the deficit to 2.5% of
Fiscal adjustment should continue, though remaining
                                                                   GDP in 2013 and 2.0% in 2014. In particular, the fiscal
dependent on the developments on business cycle.
                                                                   structural effort will remain significant – 1.1pp in 2013 and
After almost zero growth this year, we expect Belgium’s            0.6pp in 2014. However, the outlook for fiscal policy should
economy to recover gradually in the course of 2014, with           remains dependent on the cyclical developments. If growth
real GDP expanding by 1.2%Y. The economy should return             turns out to be weaker than expected, further fiscal effort might
gradually to its trend growth in 2015, thanks to robust exports.   be required. Meanwhile, we expect debt/GDP to peak at
The improvement in economic activity expected in the main          100.5% this year.
trading partners, particularly in Germany, should benefit
                                                                   Exhibit 20
Belgium, which is a small, open economy with a relatively
strong non-financial private sector. Still, the weakness of the
                                                                   Belgium – Main Macro Forecasts, 2011-15E
                                                                                                                  2011A    2012A        2013E          2014E        2015E
French and Dutch economies, which are also major                   Real GDP                                          1.9     -0.3          0.1            1.2          1.7
                                                                   Private Consumption                               0.2     -0.3          0.4            0.9          1.3
trading partners, remains the major wildcard for the               Government Consumption                            1.1      0.4          0.6            1.3          1.6
near-term outlook. A greater-than-expected cyclical                Fixed Gross Investment                            4.2     -0.6         -2.4            1.2          1.9

slowdown could jeopardise fiscal consolidation this year.          Contributions to Growth
                                                                    Domestic Final Demand                            1.2      -0.2           -0.2           1.0          1.4
What’s more, the federal elections that will be held in mid-2014    Net Exports                                     -0.1       0.2            0.4           0.2          0.1
                                                                    Inventories                                      0.7      -0.2           -0.1           0.0          0.2
could generate uncertainty, especially given the popularity of
                                                                   Unemployment Rate (%, ILO Definition)            7.2        7.6            8.6           8.6       8.2
the Flemish nationalist party.                                     Real Household Disposable Income                -1.6        0.7            0.6           0.9       1.3
                                                                   Savings Rate (% of Disp. Income)                14.2       15.2           15.4          15.4      15.5

                                                                   Inflation (CPI)                                   3.5       2.8            1.3           1.7          1.7
Economic activity in Belgium has been particularly weak
                                                                   GDP Deflator                                      2.0       2.0            1.8           1.6          1.7
over 1H13: Part of this stemmed from weak export                   Current Account Balance (% of GDP)              -1.2       -1.7           -0.5        -0.2         0.2
performance due to deteriorating economic activity in the rest     General Government Balance (% of GDP)           -3.7       -3.9           -2.7        -2.4        -1.1
                                                                   Primary Government Balance (% of GDP)           -0.4       -0.5            0.7         0.8         2.1
of the euro area, especially in the core countries. Moreover,      General Government Debt (% of GDP)              97.8       99.6          100.5       100.3        98.2
                                                                   Net Government Debt (% of GDP)                  81.1       82.0           N/A         N/A         N/A
domestic demand remained feeble, as high uncertainty further
                                                                   Source: BNB, Morgan Stanley Research forecasts
eroded business and consumer confidence. The key monthly
data indicate a noticeable improvement in business                 Exhibit 21
conditions in 3Q. In particular, the leading economic              Stronger German Growth to Spur Recovery
indicators rebounded in 3Q, although remaining below their                                                 Real GDP
long-term average, suggesting still-subdued economic activity.                                        (Percentage change)                           MS forecasts
In the near term, we forecast real GDP to expand at a modest        4
pace of 0.2%Q in 3Q, after a small 0.1%Q gain in 2Q.

We expect economic growth to accelerate in the quarters
ahead: In particular, exports should benefit from the recovery
in Germany and in global trade, as well as a stabilisation in       -2
France and, to a lesser extent, in the Netherlands. Domestic
demand should pick up pace as some of the uncertainties             -4
                                                                                     Belgium          Germany
and headwinds should lessen. A continuation of positive real
income growth should boost household consumption. We                     2001        2003      2005        2007        2009          2011           2013          2015
expect the labour market to improve in 2014, with further gains    Source: BNB, Destatis, Morgan Stanley Research forecasts
in private sector jobs and a gradual decline in unemployment.

                                                                      MORGAN             STANLEY              RESEARCH

                                                                      September 3, 2013
                                                                      European Economics

Greece – Going for Three?
Morgan Stanley & Co.                                                  budget surplus this year, as we predict – and to the extent
                       Daniele Antonucci
International plc
                         that the reforms have progressed further – an announcement
                                                                      on OSI in 1H14. But, whatever the final form of this extra relief
Key Points
                                                                      (which, at a minimum, will involve further reduction of the
Growth has not come back yet, but the data have improved,
                                                                      interest rates on the official loans, and additional ‘debt
and the many shocks that hit the economy are dissipating.
                                                                      equitisation’), from a European perspective the negotiations
Competitiveness has improved, but progress has been slower            are likely to be difficult, and partly driven by the political
on public sector downsizing, tax compliance and privatisations.       calendar. Tough talks have happened before, and
                                                                      workarounds have been found, but a lot of ‘political capital’ has
To close a funding gap, a third bailout encompassing lower
                                                                      already been spent – domestically and in Europe.
interest rates and ‘debt equitisation’ is likely to be announced in
2014, after Greece reaches a primary budget surplus.
                                                                      The risks have to do with the significant challenges of the
As in other eurozone countries, economic data have surprised          adjustment programme itself. There’s a large debt overhang,
on the upside in Greece too. A recovery hasn’t started yet,           a traumatised economy, a more difficult external environment
but activity data are becoming less bad, as many shocks               (Fed tapering, slowing EMs, no strong impetus towards
that hit the economy are getting re-absorbed, e.g., euro exit         European integration, etc.) and a smaller majority now
worries, heavy fiscal retrenchment and reforms creating               supporting the government – with the downsizing of the public
near-term uncertainty due to job and pension uncertainty, as          sector yet to gather pace, and the privatisation plan so far
we’ve suspected for a while (see From Shake-Up to                     lagging behind expectations. The Troika reviews and, more
Shape-Up? January 21, 2013). Yet, a severe credit crunch is           broadly, the government’s ability to stay the course – on what
still unfolding, and Greece’s 2Q GDP still was more than 4.5%         remains an ambitious agenda across the board – will continue
lower than a year ago – in what is the sixth year of recession.       to be widely watched by investors over time.

                                                                      Exhibit 22
Our GDP indicator points to an improvement in Greece’s
economic situation heading into year-end, taken at face
                                                                      Cyclical Stabilisation – Not Far Off
value and with a pinch of salt, which might even have stabilised       3%             Industrial Production & Retail Sales (2012-13)
or be close to it. This is mainly due to the effect of growing                                     Industrial production (% 3m/3m)
industrial production, together with the rise in several                                           Retail sales (% 3m/3m)
confidence measures, while consumer indicators – from retail
sales to car registrations – are still stagnant or falling.                                                                                              NA

On the structural front, Greece’s price competitiveness has
improved substantially: Even though this process has further           -3%
to go – given that Greece was uncompetitive even when it
joined the EMU – it’s worth noting that the Greek economy has
recovered virtually all the lost ground since the inception of the
monetary union, courtesy of sizeable wage cuts and more                -6%
                                                                               Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13
substantial labour market reforms than in the rest of southern
                                                                      Source: Eurostat, Morgan Stanley Research
Europe. In other areas, including tax compliance, results have
been more mixed (but not totally discouraging).                       Exhibit 23
                                                                      Greece – Main Macro Forecasts, 2011-15E
Based on current projections, there will be a €4.4 billion                                                        2011A     2012A      2013E    2014E     2015E
                                                                      Real GDP                                      -6.1      -6.6       -4.0      0.0       0.4
funding gap in 2014, rising to €6.5 billion in 2015. The                 Final Domestic Demand (% contr.)           -7.8      -9.0       -7.7     -2.3       0.1
                                                                      Unemployment Rate (% of Labour Force)         17.7      24.2       26.1     26.6      26.8
European lenders will have to close it, or this might have            Inflation (CPI)                                3.3       1.5       -0.6     -0.4       0.1
implications for IMF financing under its ‘12-month rule’.             Current Account Balance (% of GDP)           -9.9       -3.4      -1.1      0.9           1.5
Therefore, we think there will have to be a further official sector   General Government Balance (% of GDP)        -9.5      -10.0      -4.0     -3.6          -2.7
                                                                      Primary Government Balance (% of GDP)        -2.4       -1.3       0.1      1.2           2.6
involvement (OSI) and, probably, a third bailout with fresh           General Government Debt (% of GDP)          170.3      156.9     168.8    171.6         172.8
                                                                      Net Government Debt (% of GDP)              142.6      102.8      N/A      N/A           N/A
money. We’d expect a debate to start after the German
                                                                      Source: National Statistics, Morgan Stanley Research forecasts
elections, and provided that Greece achieves a primary

                                                                     MORGAN             STANLEY              RESEARCH

                                                                     September 3, 2013
                                                                     European Economics

Portugal – Going for Two?
Morgan Stanley & Co.                                                 Market access remains a critical issue: The Portuguese
                        Daniele Antonucci
International plc
                        debt agency plans to resume bond issuance only if conditions
                                                                     are conducive. Portugal is fully funded for this year, and the
Key Points
                                                                     government is now prefunding for 2014. But the latest official
The 2Q GDP gain is unlikely to be sustainable. We expect a
                                                                     loan disbursement is in June 2014, after which there will be no
payback, and only see a broad stabilisation at this stage.
                                                                     EU/IMF funding under the current programme. Should a
Rebalancing is progressing, and competitiveness is improving         market comeback be delayed, then Portugal would need extra
as well, along with other structural reforms.                        support by the official lenders in the form of a precautionary
                                                                     credit line or a full second bailout – and probably get it, rather
The political crisis might have increased risks of a delayed
                                                                     than debt restructuring.
market comeback. Should this happen, we’d expect a second
bailout with no PSI, but the process is unlikely to be smooth.
                                                                     A further issue, in a hypothetical scenario of delayed market
We remain cautions on the macro environment: We see                  comeback, is the negotiations needed in several countries for
tentative signs of economic stabilisation, but we think that a       extra official funding to materialise – if needed. The political
return to sustainable growth is far off. Portugal’s GDP              calendar might play an important role as well, just like the
expanded by 1.1%Q in 2Q – after having contracted outright for       verdict of the German Constitutional Court on OMT (probably
10 quarters in a row. This was the strongest performance in the      in 4Q13). We think that market participants will remain vigilant
eurozone, with a pace of growth nearly twice that of Germany.        and look at the domestic and European situations quite closely.
There’s the risk that the gains might well reflect the one-off       At this stage, a potentially negative impact from rising core
effect on growth from stock-building after the heavy negative        rates, and slowing EMs, are further risks to watch out for.
contribution in 1Q, refinery expansion and a short-lived boost
                                                                     Exhibit 24
to consumption given by the Constitutional Court’s cancellation
in April of legislated cuts in bonus payments.
                                                                     Portugal – Main Macro Forecasts, 2011-15E
                                                                                                                  2011A       2012A    2013E        2014E    2015E
                                                                     Real GDP                                       -1.6        -3.2     -2.0          0.2      0.5
                                                                      Private Consumption                           -3.8        -5.6     -3.9         -1.1      0.4
As such, it’s far too early to say that a sustainable recovery        Government Consumption                        -4.3        -4.4     -2.6         -2.7     -1.0
is under way, and a temporary fallback, i.e., a triple-dip, due to    Gross Fixed Investment                       -10.6       -14.5     -8.0          0.7      3.3
                                                                     Contribution to GDP Growth (%)
inventories might well take place. Yet, encouragingly, it looks       Final Domestic Demand                           -5.6      -7.2        -4.3      -1.1         0.6
like the pick-up is fairly broad-based, suggesting that some          Net Exports                                      4.7       3.8         1.7       1.3         0.1
                                                                      Inventories                                     -0.7       0.2         0.7       0.1        -0.1
underlying improvement is taking place too. What’s more,             Unemployment Rate (% of Labour Force)            14.2     17.1         19.2     20.6         19.0
structural measures continue to be implemented, with the             Inflation (CPI)                                   3.7      2.8          0.6      1.3          1.3
                                                                     Current Account Balance (% of GDP)             -7.0       -1.5       0.2         1.4       2.1
economy recovering competitiveness and also becoming more            General Government Balance (% of GDP)          -4.4       -6.4      -5.7        -4.3      -2.8
open, along with a significant improvement of the current            Primary Government Balance (% of GDP)          -0.4       -2.0      -1.3         0.2       1.6
                                                                     General Government Debt (% of GDP)            108.3      123.6     131.8       134.4     135.1
account, which is finally in surplus.                                Net Government Debt (% of GDP)                 78.5       88.5      N/A         N/A       N/A

                                                                     Source: Statistics Portugal, Bank of Portugal, Morgan Stanley Research forecasts
A crucial factor is the ‘buy in’ of the politicians and the
                                                                     Exhibit 25
population at large: A U-turn in policy doesn’t seem to be
                                                                     Shifting Towards Export-Led Model
forthcoming, and the recent agreement within the ruling
                                                                      110                          Exports (2012,% of GDP)
coalition – following the political crisis – is an attempt to work
out a compromise to continue to execute on the adjustment              90

programme. Yet, investors will be watching whether the                 70
deterioration in sentiment that has already happened or
difficulties with the Troika reviews delay market access (see
Portugal and the Austerity Fatigue, July 3, 2013).
A (much delayed) Troika mission is about to start: The
Portugal government has to approve €4.7 billion of austerity in               GR     FR      PT       IT   ES    PT      FI    DE      AT      BE     NL     IE
the 2014 budget (2.8% of GDP), and resume the privatisation                                 (avg
plan. The opposition in parliament opposes all this but, by and                            2007)

large, they don’t have the numbers to trigger a political crisis.    Source: Eurostat, Morgan Stanley Research

                                                                     MORGAN              STANLEY           RESEARCH

                                                                     September 3, 2013
                                                                     European Economics

Ireland – A Steep Uphill Finish
Morgan Stanley & Co.                                                 the credit line to focus on the banking sector and no additional
                       Elga Bartsch
International plc
                             fiscal austerity measures (see Reuters, August 9, 2013).
Key Points
The focus for Ireland will be transitioning out of the bailout       …where Ireland still faces a number of hurdles: For starters,
programme at year-end, and securing sustained access to the          mortgage arrears continue to increase (especially long-term
bond markets in 2014. Disappointing growth, political disunity       arrears), which is a source of risk to banks’ asset quality.
about austerity and upcoming bank checks are risks to watch.         Recently several reforms have been implemented to deal with
                                                                     arrears, ranging from the Code of Conduct on Mortgage
We expect growth to pick up next year, on the back of                Arrears, the Personal Insolvency Act and the ‘Land and
stronger net exports and domestic demand: The start to               Conveyancing Law Reform Act’. Strict targets for resolving
2013 was disappointing as GDP contracted by 0.6%Q in 1Q.             mortgage arrears have also been set for banks. The impact of
We expect net exports to boost growth again in 2014, with            these reforms will likely only be felt later this year though.
export demand benefitting from stronger dynamics in Ireland’s        Furthermore, tracker mortgages constitute a drag on banks’
key trading partners the UK and US. We expect domestic               profitability, an issue that could be addressed, at least in part,
demand to return to growth, with investment spending and             by backing them with an ESM guarantee (see Independent,
private consumption both picking up. After a sharp decline in        August 24, 2013).
private consumption (of ~10% between 1Q08 to 1Q13), we
expect a gradual stabilisation followed by some tepid growth.        As elsewhere, the new Bank Recovery and Resolution
Even though there are signs that house prices are bottoming          Directive (BRRD), the Asset Quality Review (AQR) and the
out, we will be watching mortgage arrears closely for any            EBA bank stress test (BST) could unveil additional capital
potential risks to this baseline.                                    needs. Another potential hurdle is the patent cliff that is
                                                                     affecting Irish exports as a number of blockbuster drugs come
Mild fiscal slippage likely in 2013 due to a growth shortfall:       off patent (pharma accounts for 27% of Irish goods exports).
We expect the deficit to exceed the target level of 7.5% of GDP      Once a drug comes off patent, the pharmaceutical companies
marginally, reaching 7.8%. Assuming that the planned                 are less likely to continue production in Ireland. The potential
austerity measures worth €3.1 billion under the bailout              impact on value-added is expected to be limited though as
programme are implemented in October, when the budget is             these blockbuster drugs are usually associated with high
being presented, we see scope for the deficit to outperform the      royalty payments to the overseas parent company. Being
programme target of 5.1% of GDP in 2014, reaching 4.9%. The          recorded as services imports, these royalty fees reduce Irish
ruling two-party coalition government is still divided on the        GDP.
issue, with the larger party, Fine Gael, not in favour of easing
                                                                     We acknowledge the contribution of Gaura Sengupta.
the budget, while the junior coalition partner, Labour, is in
favour of easing austerity efforts. While in principle the           Exhibit 26

promissory note deal reached earlier this year would allow for       Ireland – Main Macro Forecasts, 2011-15E
                                                                                                                  2011A     2012A    2013E      2014E    2015E
some easing in austerity, we think it would make sense for           Real GDP                                        2.2       0.1      0.4        2.1      2.5
Ireland to build some budget buffers, especially given that the      Private Consumption                            -1.5      -0.3     -0.7        0.8      0.7
                                                                     Government Consumption                         -2.8      -3.8     -0.8       -1.1     -1.2
country will likely have the highest deficit in the euro area this   Investment Spending                            -9.6      -0.7     -8.1        2.2      3.4
                                                                     Exports                                         5.3       1.6      0.0        4.7      4.6
year. Budget implementation faces a number of risks, including       Imports                                        -0.4       0.0      0.4        3.4      4.0
                                                                     Contribution to Growth
a potential higher one-off cost from liquidating bad bank IBRC,      Domestic Demand                                -2.4      -0.8       -1.3      0.4      0.5
public sector pay agreements and overruns on healthcare.             Inventories                                    -1.1      -0.6        2.1     -0.4      0.4
                                                                     Net Foreign Trade                               5.6       1.6       -0.4      2.1      1.6
                                                                     Other Economic Indicators
                                                                     Employment                                     -1.8     -0.6         0.9     0.0      0.3
Focus is on transitioning out of the bailout programme…              Unemployment Rate (%)                          14.7     14.7        13.6    13.5     13.4
                                                                     Current Account (% of GDP)                      1.2      4.5         6.0     6.0      6.5
Detailed negotiations for an effective backstop to smooth            Inflation (YOY)
Ireland’s return to the bond markets will likely begin post the      Consumer Prices                                 1.2       1.9        1.0      2.1      1.6
                                                                     GDP Deflator                                    0.7       0.7       -1.1      1.0      1.0
German elections on September 22. The most likely option is a        Wages Per Employee                             -0.1       0.8       -1.3      0.3      0.1
                                                                     Unit Labour Costs (Total Economy)              -3.4       0.0       -1.5     -1.8     -1.9
precautionary credit line that would qualify Ireland for the         Budget
ECB’s OMT programme. According to press reports, the Irish           Primary Govt. Deficit (% of GDP)              -10.0     -4.6        -2.8     0.0      2.7
                                                                     General Govt. Deficit (% of GDP)              -13.3     -8.1        -7.8    -4.9     -2.2
government would like the (light) conditionality associated with     General Govt. Debt (% of GDP)                 106.4    120.2       127.2   125.4    119.3
                                                                     Source: Eurostat, CSO Ireland, Morgan Stanley Research forecasts

                                                                        MORGAN              STANLEY              RESEARCH

                                                                        September 3, 2013
                                                                        European Economics

Austria – At the Heart of the Core
Morgan Stanley & Co.                                                    Only in 2014 and 2015 do we see the small, open Austrian
                        Elga Bartsch
International plc
                                economy to expand a brisker pace again. As the global
Key Points                                                              economy recovers, we expect Austrian companies to bump up
On our forecast, economic activity will expand at a much faster         investment and eventually hiring. Hence, disposable income is
rate in 2014/2015, driven by domestic demand and exports.               likely to increase. With a stable savings rate and falling inflation,
                                                                        consumer spending should strengthen. To sum up, along with
But the general election will be key for economic policies next         Germany, Austria should be the strongest-growing country in
year. Our base case is that the new government will stick to            the core of the euro area this year and next, only to be outdone
fiscal plans submitted to European Commission.                          next year and the year after by export-driven Ireland.
A general election on September 29 will be key for
                                                                        Austrian inflation to stay above the euro area average:
economic policies in Austria next year, notably budget policies.
                                                                        HICP inflation peaked at 2.4%Y in May, way above the euro
While the 2008 election brought major losses for the governing
                                                                        area average of 1.6%Y, driven by a variety of factors. Going
Grand Coalition and sizeable gains for the populist right, the
                                                                        forward, inflation should moderate slightly and should average
coalition between the Social Democrats, SPO, and the Austrian
                                                                        2.0%Y over the remainder of the forecast horizon.
People’s Party, OVP, was continued for another five years. Polls
would suggest that both parties need to brace themselves for            Exhibit 27
further, albeit small losses. Thanks to the 4% hurdle for               Early Signs of a Sharp Austrian Growth Acceleration
parliamentary representation in Austria, they might just win             65
enough votes to continue to govern in the current formation. If                                        Manufacturing PMI
they fail to win a sufficient number of seats in the Nationalrat, the    60

two parties would likely extend an invitation to the Greens to join
them on the government benches. A participation of the Free              55

Democrats, FPO, is unlikely, we believe, because of their
anti-European policy stance and ongoing internal problems.
Our baseline forecast assumes that the next Austrian
government will broadly stick to the plans submitted to
                                                                         40                            EMU (ex. Germany)
European partners in the spring and sees the budget deficit                                            Germany
around the 2% mark for the remainder of the forecast horizon,            35
a level that should allow Austria to stabilise its debt/GDP level,        1998       2000       2002        2004      2006       2008          2010      2012

if not slight reduce it by the end of 2015. One source of               Source: Markit, Morgan Stanley Research
uncertainty about the (cash) deficit and the government debt
                                                                        Exhibit 28
dynamics stems from ongoing problems in the banking sector,
notably the need for additional state aid to the Hypo-Alpe Adria
                                                                        Austria – Macro Forecasts, 2011-15E
                                                                                                                   2011A     2012A      2013E         2014E     2015E
group, where the supervisory board has signalled the need for           Real GDP                                      2.7       0.8           0.5       1.6       1.6
additional government injections of up to €2.5 billion (~0.9% of        Private Consumption                           0.7       0.4           0.0       0.8       1.2
                                                                        Gross Fixed Investment                        7.3       1.3          -1.2       0.8       2.0
GDP) (see “Horrorverlust bei der Hypo”, Die Presse, August 28,          Exports                                       7.1       4.8           1.8       4.5       4.1
                                                                        Imports                                       7.2       0.8           0.8       3.7       4.7
2013). So far, the government has pumped nearly €3 billion              Contribution to GDP Growth
into the troubled institution.                                           Final Domestic Demand                         1.8      0.4           0.4       0.9       1.2
                                                                         Inventories                                  -0.1      0.1          -0.5       0.0       0.4
                                                                         Net Exports
                                                                            p y                                        0.4      0.6           0.6       0.7       0.0
Having stagnated in early 2013, the Austrian economy                    Unemployment Rate (% of LF)                   4.1       4.4           4.8       5.0       4.9
returned to positive growth in 2Q13 when overall activity               Consumer Prices                               3.6       2.6           2.1       2.0       2.0
                                                                        Current Account, EUR bn                       4.1       5.4           7.2       9.6       9.6
expanded by a meagre 0.2%Q, driven by consumer spending                 Current Account (%of GDP)                     1.4       1.8           2.3       3.0       2.9
and net foreign trade. Investment, by contrast, continued to            General Government Balance (% of GDP)        -2.4      -2.5          -2.3      -1.9      -1.9
                                                                        General Government Debt (% of GDP)           72.5      73.4          74.8      74.2      73.6
contract. For the full year, we forecast the Austrian economy to
                                                                        Source: Statistics Austria, BoA, Morgan Stanley Research forecasts
expand by only 0.5%Y. As a result, job creation, which has held
up surprisingly well so far, will likely slow and unemployment
which at ~5% is the lowest in the euro area, might inch higher.

                                                                      MORGAN             STANLEY                RESEARCH

                                                                      September 3, 2013
                                                                      European Economics

Finland – Crisis Takes its Toll Up North
Morgan Stanley & Co.                                                  we expect the overall budget deficit to stay a touch below 2.5%
                       Elga Bartsch
International plc
                              of GDP between 2013 and 2015.
Key Points
                                                                      We expect government debt to rise, ultimately breaking
In line with our Finnish fatigue call, we expect a weak recovery
                                                                      above the 60% of GDP ceiling in 2015: Finland is one of the
in 2014 on the back of domestic demand returning to growth.
                                                                      few euro area countries that currently still meets both the deficit
The government deficit should remain almost unchanged,                and debt criteria of the SGP. But the rise in debt from 33.9% of
causing debt/GDP to reach and breach 60% in 2015.                     GDP before the crisis to 60%+ in 2015 is worrying. In contrast,
                                                                      net government debt/GDP has almost gone back to pre-crisis
For Finland, we have pencilled in a weak recovery in 2014:
                                                                      levels. One of the reasons behind the recent diverging trends in
This call is consistent with our theme of Finnish growth fatigue
                                                                      net debt and gross debt is the guarantees granted to the EFSF.
(see European Economics: Crisis Contained, Not Resolved,
                                                                      Eurostat includes guarantees granted to the EFSF in
January 7, 2013). The recovery will largely be driven by
                                                                      government debt, which is reflected in the gross debt metric.
domestic demand returning to growth. This year, GDP should
                                                                      Meanwhile, for net debt it is cancelled out as similar entries are
still contract on average, even though the Finnish economy
                                                                      made on the assets and liabilities side. The amount included as
managed to shake off its recession in 2Q. After weak domestic
                                                                      guarantees in government debt rose to €2.7 billion in 2012 from
demand dampens overall GDP, with investment and
                                                                      €0.3 billion in 2011. In addition, weaker-than-expected growth
consumption contracting this year, we expect economic
                                                                      has forced the government to run rising deficits, having printed
conditions to improve next year. Investment should revive as
                                                                      a surplus until 2008.
overall demand conditions improve and as the corporate tax is
reduced from 24.5% to 20%. Private consumption is likely to
                                                                      We acknowledge the contribution of Gaura Sengupta.
benefit from better employment prospects. But the gains in
                                                                      Exhibit 29
private consumption will likely be muted, as a rise in income
taxes due to tax brackets not being adjusted for inflation and an
                                                                      Debt to Exceed 60% Due to Persistent Deficits
increase of indirect taxes will limit consumers’ purchasing power.      65%           Government debt                Budget balance ~rhs                     8%
New collective wage agreements for 2014 and 2015 will be set                                                                                                 6%
this autumn and are expected to be similar to the current
agreement that foresees wage increases of 1.8%Y. We expect              55%
export demand to pick up in 2014, as growth conditions improve
in the euro area and Russia. Restructuring in the electronics and       50%                                                                                  0%

forestry industries will limit the improvements, though, as a large     45%                                                                                  -2%
part of the loss in Finnish competitiveness can be traced to the                                                                                             -4%
telecom sector, which is dominated by Nokia.                            40%
We expect the budget deficit to remain unchanged over the                                                                                                    -8%

forecast horizon. Based on the government’s budget proposal             30%                                                                                  -10%
for 2014, the corporate tax rate will be reduced from 24.5%                   1995          1999              2003         2007           2011        2015

from 20%, reducing the corporate tax intake by €900 million           Source: Eurostat, Morgan Stanley Research
(~0.5% of GDP). A number of revenue-increasing measures
will likely offset this effect. These measures include tighter        Exhibit 30

capital income taxation and reduced support for businesses by         Finland – Main Macro Forecasts, 2011-15E
                                                                                                                      2011A    2012A      2013E    2014E     2015E
abolishing or limiting tax incentives. A rise in indirect taxes       Real GDP                                           2.7       -0.8     -0.2     0.8          1.2
(such as exercise duties on tobacco, alcohol, sweets and              Final Domestic Demand                              2.8        0.0     -0.6     0.4          1.5
                                                                      Unemployment Rate (% of Labour Force)              7.8        7.8      8.0     7.9          7.5
non-alcoholic beverages as well as electricity) will likely           Inflation (HICP)                                   3.4        2.8      1.7     1.9          1.8
increase revenue by 0.2% of GDP. In addition, the government          Current Account (% of GDP)                        -1.5       -1.8     -1.5    -1.2      -1.2
                                                                      General Government Balance (% of GDP)             -1.1       -2.2     -2.3    -2.4      -2.3
had earlier decided to raise duty on vehicle fuels from next year.    Primary Government Balance (% of GDP)              0.3       -0.8     -0.9    -1.0      -0.5
We expect the rise in indirect taxes to contribute 0.6pp to the       General Government Debt (% of GDP)                49.0       53.0     56.8    59.5      61.7
                                                                      Net Government Debt (% of GDP)                   -54.1      -54.6      N/A    N/A        N/A
overall inflation rate in 2014. In total, we expect these             ECB Policy Rate (%, EOP)                          1.00      0.75      0.25    0.25      0.25
measures to increase revenues by 0.5% of GDP. As a result,            Source: Bank of Finland, Morgan Stanley Research forecasts

                                                                    MORGAN             STANLEY              RESEARCH

                                                                    September 3, 2013
                                                                    European Economics

Sweden – On the Road to Recovery
Morgan Stanley & Co.                                                Inflation to remain low and far below the 2%Y target: On
                       Tomasz Pietrzak
International plc
                         our forecasts, GDP growth remains below its trend until 2015.
                       Elga Bartsch                                 As a result, the degree of spare capacity is likely to remain
                            large, suggesting that underlying inflationary pressures should
                                                                    stay contained. CPIF inflation, which strips out changes in the
Key Points
                                                                    repo rate, will most likely reach the inflation target beyond our
We expect economic activity to gain momentum into year-end
                                                                    forecast horizon. That said, headline CPI inflation will probably
and GDP growth to reach 2.2%Y in 2014, returning to trend.
                                                                    reach the 2%Y target in 2015 as the Riksbank hikes the repo
On balance, we think that the Riksbank will leave the repo rate     rate.
unchanged, as inflation pressures develop gradually.
                                                                    We expect the Riksbank to leave the repo rate unchanged
Activity is likely to gain momentum into year-end: We
                                                                    for an extended period, as economic activity improves only
revise our 2013 GDP growth forecast down by 0.2pp. This
                                                                    gradually and the Executive Board continues to take high
mainly reflects weaker-than-expected economic activity in 2Q
                                                                    household debt and elevated house prices into account. We
and thus does not constitute a change in the outlook. All in all,
                                                                    expect the first hike in the repo rate in 4Q14, in line with the
we expect GDP to grow by 1.1%Y this year. Going forward, we
                                                                    Riksbank’s forecast but below the current market pricing.
foresee economic activity to gain momentum into year-end and
grow by 2.2%Y in 2014, a rate close to the historical trend. The
                                                                    Downside risks: A less favourable external environment could
output gap will likely only start closing in 2015, when growth
                                                                    weigh more than expected on economic activity as foreign
moves above trend, at 3.0%Y.
                                                                    demand weakens and uncertainty increases. A sharper-than-
                                                                    expected correction in house prices could negatively impact
Domestic demand the main driver of growth: Domestic
                                                                    household consumption and the financial sector.
demand should drive the economic recovery to a greater extent
than has been the case in the past. Household consumption is        Exhibit 31
likely to accelerate further to an average 2.7%Y next year,         Sweden – Macro Forecasts, 2011-15E
amid improving consumer confidence, a lower savings rate,                                                         2011A     2012A    2013E    2014E     2015E
                                                                    Real GDP                                         3.8       0.7      1.1      2.2       3.0
subdued inflation and low interest rates. Ahead of the 2014         Final Domestic Demand                            2.7       1.9      0.7      2.2       2.8
general elections, the government will likely announce another      Unemployment Rate (% of Labour Force)            7.5       7.9      8.3      8.2       7.6
                                                                    Inflation (CPI)                                  3.0       0.9      0.1      1.1       2.2
fiscal stimulus in September, which we would expect to be only      Inflation (CPIF)                                 1.4       1.0      0.9      1.2       1.8
slightly higher than the fiscal stimulus in 2013. That said, we     Current Account (% of GDP)                        7.0      6.9      6.3       6.5      6.6
                                                                    General Government Balance (% of GDP)             0.3     -0.4     -2.1      -1.5     -0.5
expect a much sharper recovery in investment spending.              Primary Government Balance (% of GDP)             1.2      0.2     -0.9       0.2      1.1
Investment spending, currently at ~18% of GDP, is below what        General Government Debt (% of GDP)               38.4     38.2     42.3      42.0     40.6
                                                                    Net Government Debt (% of GDP)                  -20.5    -23.3      N/A       N/A      N/A
we see as a long-term equilibrium of 20%. This suggests that
                                                                    Riksbank Repo Rate (%, EOP)                     1.75      1.00     1.00      1.25     1.75
there is pent-up demand for investment, supported by low            Source: Statistics Sweden, Riksbank, Morgan Stanley Research forecasts
interest rates, improving demand and falling uncertainty.
                                                                    Exhibit 32

Net exports should weigh on economic activity, but the              GDP Forecast and Composition
impact is likely to be small. On our forecasts, net exports will     10            Inventories      Net Exports        Domestic Demand              GDP
                                                                           % yoy
likely weigh on headline GDP growth to the tune of 0.2pp. This        8                                                                                    Our
is mainly due to relatively low external demand growth, notably       6

for capital goods, and a somewhat stronger SEK. Going                 4
forward, export growth is likely to accelerate somewhat, albeit       2
at a slower pace as global demand will likely recover gradually.      0
As strong growth in domestic demand is likely to support             -2
imports, we expect only a small positive contribution from net       -4
exports to GDP growth next year.                                     -6

                                                                      1Q-95      3Q-97    1Q-00   3Q-02     1Q-05    3Q-07     1Q-10     3Q-12    1Q-15

                                                                    Source: Statistics Sweden, Morgan Stanley Research forecasts

                                                                   MORGAN            STANLEY               RESEARCH

                                                                   September 3, 2013
                                                                   European Economics

Denmark – Sun Starts Shining Again
Morgan Stanley & Co.                                               All in all, we expect net exports to weigh on GDP growth this
                       Tomasz Pietrzak
International plc
                        year, but expect a positive contribution next year and in 2015.
Key Points
                                                                   Risks to the economic outlook still tilted to the downside:
Denmark should leave the recession behind in 2H13. The
                                                                   Weaker-than-expected foreign demand remains the biggest
positive growth momentum will likely continue next year, driven
                                                                   risk for economic activity this year, as exports account for
by domestic and foreign demand.
                                                                   around 50% of GDP. What’s more, domestic demand might
On balance, we think that the Danish National Bank (DNB) is        turn out to be weaker than expected if policies intended to
likely to cut the lending rate by another 10bp in 4Q13, as the     boost corporate investment show only muted results.
ECB cuts the refi rate.
                                                                   The Danish National Bank (DNB) is likely to postpone
After years of weak economic activity, we expect the Danish
                                                                   additional rate cuts until 4Q, but it will likely keep the depo
economy to start to recover slowly. While we are revising
                                                                   rate unchanged and in negative territory: As we continue to
our 2013 GDP growth outlook down, amid weaker-than-
                                                                   think that the ECB maintains its easing bias and is likely to cut
expected growth in 1H, we continue to expect that economic
                                                                   the refi rate by additional 25bp in 4Q13, we expect the DNB to
activity will start to recover in the remainder of this year and
                                                                   lower the lending rate as low as 0.1%. Our forecasts are
foresee this trend to continue next year. In 2014, we expect
                                                                   sensitive to developments in the euro area though Should the
GDP growth at 1.2%Y, followed by 1.6%Y in 2015. Although
                                                                   upward pressures on the exchange rate intensify, the DNB
still weak, we believe that growth will be broad-based, driven
                                                                   might decide to lower the depo rate once again.
by both domestic and foreign demand.
                                                                   Exhibit 33
Private consumption is likely to continue to grow, although        Denmark – Macro Forecasts, 2011-15E
at a slower pace than during past recoveries. Yet, our positive                                                  2011A    2012A    2013E       2014E    2015E
                                                                   Real GDP                                         1.1     -0.4      0.0         1.2      1.6
outlook for household consumption assumes that households          Final Domestic Demand                           -0.2      0.4      0.5         0.9      1.1
will start spending a greater share of their income after the      Unemployment Rate (% of Labour Force)            7.6      7.5      7.7         7.7      7.6
                                                                   Inflation (CPI)                                  2.8      2.4      1.0         1.5      1.7
savings rate grew close to all-time highs. What’s more, we
                                                                   Current Account (% of GDP)                       5.5     5.1      5.0         5.1        5.2
expect a further increase in consumer confidence, amid             General Government Balance (% of GDP)           -1.9    -4.0     -2.0        -0.8        0.3
                                                                   General Government Debt (% of GDP)              46.5    45.8     45.2        43.0       40.3
declining uncertainty related to developments abroad. The          Net Government Debt (% of GDP)                   3.1     7.0      N/A         N/A        N/A
housing market is also already stabilising, as house prices        Danmarks Nationalbank Lending Rate (%, EOP)     0.70     0.20     0.10        0.10     0.10
have been largely unchanged for a few months now, and              Danmarks Nationalbank Deposit Rate (%, EOP)     0.30    -0.20    -0.10       -0.10    -0.10
                                                                   Source: Statistics Denmark, DNB, Morgan Stanley Research forecasts
hence consumption should no longer be affected by negative
wealth effects.                                                    Exhibit 34
                                                                   DNB’s Rates and CITA Swaps
Investment growth is likely to pick up, thanks to pent-up            1.8

demand that built up over the recent years. As the economic          1.6

outlook improves, uncertainty declines and interest rates            1.4                                                                CITA

remain low, we expect investment growth to improve. What’s           1.2
                                                                                                                                        DNB Deposit Rate
                                                                                                                                        DND Lending Rate
more, the government introduced large tax breaks on business           1                                                                DNB Current Acc Rate

investment which are likely to support growth in investment in       0.8

2H13. Going forward, business investment will probably also          0.6
be lifted by various infrastructure and public housing               0.4
investment projects, which are a part of government’s growth         0.2

Net exports to start supporting GDP growth next year as
economic activity abroad starts to improve, especially in              2010                      2011                      2012                         2013
Sweden and Germany. However, we believe that stronger
                                                                   Source: Datastream, DNB, Morgan Stanley Research
growth in exports will be offset by solid import growth as
domestic demand improves, especially investment spending.

                                                                    MORGAN              STANLEY             RESEARCH

                                                                    September 3, 2013
                                                                    European Economics

Norway – Weaker but Still Solid Growth Ahead
Morgan Stanley & Co.                                                Given the high level of resource utilisation, inflation
                       Tomasz Pietrzak
International plc
                         pressures should continue to pick up. On our forecasts,
                                                                    headline inflation will accelerate, but remain below the inflation
Key points
                                                                    target of 2.5%Y in 2015. As a result, we expect Norges Bank
Mainland GDP growth should decelerate this year to 1.8%Y,
                                                                    to only gradually raise the sight rate, first by 25bp in 4Q14,
followed by somewhat stronger growth next year. Domestic
                                                                    followed by two more rate hikes in 2015 to bring the main policy
demand remains the main growth driver.
                                                                    rate to 2.25%. Our forecast is largely in line with the current
We think that Norges Bank will hike the sight rate in 4Q14,         Norges Bank projections, but below the current market pricing.
followed by two more rate hikes in 2015.
                                                                    September elections: If the current opinion polls are to be
Growth in Norwegian economy decelerates: Mainland GDP
                                                                    believed, the opposition led by the Conservatives is likely to
growth was weaker than expected in 1H, partly due to the
                                                                    win the parliamentary elections on September 9, ousting the
weather-related drop in electricity output, but also thanks to
                                                                    Labour-led incumbent. The centre-right is likely to form a
more lacklustre household consumption, weaker exports and a
                                                                    minority government consisting of the Conservatives, Christian
drag from inventory investment. As a result, we are revising
                                                                    Democrats and Liberals. We do not expect any meaningful
down our growth forecast for this year and now expect
                                                                    changes to the fiscal policy stance, but it is likely that the new
mainland GDP growth at 1.8%Y, somewhat below consensus
                                                                    coalition will cut the wealth tax, while maintaining welfare and
expectations. Going forward, we expect only slightly stronger
                                                                    education spending. In terms of structural reforms, we would
growth in mainland GDP as investment growth in the petroleum
                                                                    expect some tightening in sick leave compensation and the
sector and tighter credit conditions weigh on growth in
                                                                    introduction of more flexible working hours.
economic activity. But as the production outlook in the
petroleum sector is expected to improve, total GDP growth is        Exhibit 35
likely to accelerate more sharply.                                  Monetary Policy Expectations
Domestic demand will be the main driver of growth over
                                                                     6.0                                                       Sight Rate & MS F'cast
the forecast horizon: First, we expect household
                                                                                                                               Norges Bank F'cast
consumption to grow at healthy rate of 2.7%Y this year. This is      5.0

because, despite weaker-than-expected growth in 1H13, real
                                                                                                                                           MS F'cast
disposable income has continued to grow at the strong pace.
Going forward, however, growth in household consumption is           3.0

likely to be somewhat weaker as a result of higher inflation,        2.0
tighter credit conditions and a mild correction in house prices.
While non-oil business investment should be somewhat
stronger next year, the investment survey conducted by               0.0
                                                                           2005 2006 2006 2007 2008 2008 2009 2010 2010 2011 2012 2012 2013 2014 2014 2015
Statistics Norway suggests that petroleum investment is likely to
grow at a slower pace than before and hence total investment        Source: Norges Bank, Morgan Stanley Research forecasts

spending is likely to decelerate next year.                         Exhibit 36
                                                                    Norway – Macro Forecasts, 2011-15E
We expect export growth to accelerate in 2014, after a fall in                                                       2011    2012A    2013E     2014E        2015E
                                                                    Real GDP (Total)                                   1.2      3.0      0.6       1.8          2.4
2013. This year, weak economic activity abroad, especially in       Real GDP (Mainland)                                2.6      3.3      1.8       2.0          2.2
the euro area, is weighing on Norwegian non-petroleum               Private Consumption                                2.5      3.1      2.7       2.6          2.4
                                                                    Public Consumption                                 1.9      1.7      2.5       2.3          2.0
exports. As global growth outlook improves gradually, especially    Gross Fixed Investment                             7.5      8.1      6.4       4.3          3.1
in Sweden and in Germany, we expect non-petroleum exports to        Domestic Demand                                    2.9      3.3      3.1       2.6          2.2
                                                                    Exports of Goods and Services                     -1.8      1.8     -2.0       2.1          2.9
accelerate next year. That said, solid domestic demand should       Imports of Goods and Services                      3.9      2.3      0.2       2.9          3.8
support import growth and hence net exports are unlikely to
                                                                    Unemployment rate (% Labour Force)                 3.3      3.2      3.7           3.7      3.5
contribute significantly to GDP growth.                             Inflation (CPI)                                    1.3      0.7      2.0           2.1      2.2
                                                                    CPI-ATE                                            1.0      1.2      1.6           2.0      2.0

                                                                    Norges Bank Policy Rate (%, EOP)                  1.75     1.50     1.50        1.75       2.25
                                                                    Source: Statistics Norway, Norges Bank, Morgan Stanley Research forecasts

                                                                                    MORGAN       STANLEY        RESEARCH

                                                                                    September 3, 2013
                                                                                    European Economics

Exhibit 37
European Main Macro Forecasts, 2011-15E
% YoY                                                       GDP                                                       CPI
                                 2011            2012        2013E    2014E    2015E             2011        2012      2013E     2014E    2015E
Euro Area                          1.5            -0.5         -0.5      0.9      1.2             2.7         2.5         1.5       1.6      1.4
Austria                            2.7             0.8          0.5      1.6      1.6             3.6         2.6         2.1       2.0      2.0
Belgium                            1.9            -0.3          0.1      1.2      1.7             3.5         2.8         1.3       1.7      1.7
Finland                            2.7            -0.8         -0.2      0.8      1.2             3.4         2.8         1.7       1.9      1.8
France                             2.0             0.0          0.0      0.6      1.2             2.1         2.0         1.0       1.6      1.4
Germany                            3.0             0.7          0.4      1.8      1.8             2.1         2.0         1.6       1.9      1.9
Greece                            -6.1            -6.6         -4.0      0.0      0.4             3.3         1.5        -0.6      -0.4      0.1
Ireland                            2.2             0.1          0.4      2.1      2.5             1.2         1.9         1.0       2.1      1.6
Italy                              0.5            -2.4         -1.7      0.4      0.7             2.8         3.0         1.4       1.5      1.6
Netherlands                        1.0            -1.3         -1.2      0.5      0.8             2.3         2.5         2.8       1.5      1.5
Portugal                          -1.6            -3.2         -2.0      0.2      0.5             3.7         2.8         0.6       1.3      1.3
Spain                              0.1            -1.6         -1.3      0.8      1.1             3.2         2.4         1.7       0.8      1.4
Denmark                            1.1            -0.4          0.0      1.2      1.6             2.8         2.4         1.0       1.5      1.7
Sweden                             3.8             0.7          1.1      2.2      3.0             3.0         0.9         0.1       1.0      2.1
Norway                             1.2             3.0          0.6      1.8      2.4             1.3         0.7         2.0       2.1      2.2
UK                                 1.1             0.2          1.4      2.4      2.1             4.5         2.8         2.7       2.7      2.3

% of GDP                                    General Government Balance                                   Gross General Government Debt
                                 2011          2012     2013E      2014E       2015E              2011        2012     2013E    2014E     2015E
Euro Area                         -4.1          -3.7      -3.1       -2.9        -2.7             88.1        91.4       94.5      96.5     96.2
Austria                           -2.4          -2.5      -2.3       -1.9        -1.9             72.5        73.4       74.8      74.2     73.6
Belgium                           -3.7          -3.9      -2.7       -2.4        -1.1             97.8        99.6      100.5     100.3     98.2
Finland                           -1.1          -2.2      -2.3       -2.4        -2.3             49.0        53.0       56.8      59.5     61.7
France                            -5.3          -4.8      -3.9       -3.5        -3.2             85.8        90.2       93.6      95.3     95.8
Germany                           -0.8           0.2       0.0        0.1         0.3             80.6        81.3       80.3      81.6     81.6
Greece                            -9.5         -10.0      -4.0       -3.6        -2.7            170.3       156.9      168.8     171.6    172.8
Ireland                          -13.3          -8.1      -7.8       -4.9        -2.2            106.4       120.2      127.2     125.4    119.3
Italy                             -3.8          -3.0      -3.3       -2.4        -2.2            120.8       127.0      131.6     131.6    130.8
Netherlands                       -4.3          -4.0      -3.4       -3.5        -3.4             65.5        71.2       74.8      77.0     78.7
Portugal                          -4.4          -6.4      -5.7       -4.3        -2.8            108.3       123.6      131.8     134.4    135.1
Spain                             -9.4         -10.6      -6.9       -6.0        -5.3             69.3        84.2       91.4      96.2     99.1
Denmark                           -1.9          -4.0      -2.0       -0.8         0.3             46.5        45.8       45.2      43.0     40.3
Sweden                             0.3          -0.4      -2.1       -1.5        -0.5             38.4        38.2       42.3      42.0     40.6
Norway                            13.4          13.8      13.3       12.6        11.7             34.1        34.6       33.3      33.2     32.0
UK                                -7.8          -5.5      -6.1       -5.2        -4.4             82.3        90.1       93.5      96.2     97.8
                                             Current Account (% of GDP)                                   Unemployment rate (% of LF)
                                 2011          2012      2013E      2014E      2015E             2011        2012   2013E        2014E    2015E
Euro Area                          0.1            1.3       2.4        2.3        2.4            10.2        11.4      12.1        12.3     12.4
Austria                            1.4            1.8       2.3        3.0        2.9             4.1         4.4       4.8         5.0      4.9
Belgium                           -1.2           -1.7      -0.5       -0.2        0.2             7.2         7.6       8.6         8.6      8.2
Finland                           -1.5           -1.8      -1.5       -1.2       -1.2             7.8         7.8       8.0         7.9      7.5
France                            -1.9           -2.3      -2.1       -2.2       -2.3             9.2         9.8      10.5        10.8     10.7
Germany                            6.2            7.0       6.7        6.6        6.6             6.0         5.5       5.5         5.5      5.4
Greece                            -9.9           -3.4      -1.1        0.9        1.5            17.7        24.2      26.1        26.6     26.8
Ireland                            1.2            4.5       6.0        6.0        6.5            14.7        14.7      13.6        13.5     13.4
Italy                             -3.1           -0.6       0.9        1.4        1.6              8.4       10.7      11.6        12.4     13.0
Netherlands                      10.2           10.1        8.9        9.9        9.7             4.4         5.3       6.7         7.2      7.4
Portugal                          -7.0           -1.5       0.2        1.4        2.1            14.2        17.1      19.2        20.6     19.0
Spain                             -3.7           -1.1       1.7        2.8        3.4            21.7        25.1      26.5        25.6     24.5
Denmark                            5.5            5.1       5.0        5.1        5.2             7.6         7.5       7.7         7.7      7.6
Sweden                             7.0            6.9       6.3        6.5        6.6             7.5         7.9       8.3         8.2      7.6
Norway                           12.1           13.5       10.3        7.6        7.3             3.3         3.2       3.7         3.7      3.5
UK                                -1.5           -3.8      -2.7       -2.5       -1.9             8.1         7.9       7.7         7.5      7.3
Source: National data, Eurostat, Morgan Stanley Research forecasts

                                                                                                     MORGAN          STANLEY             RESEARCH

                                                                                                     September 3, 2013
                                                                                                     European Economics

Exhibit 38
Risk Events for 2H13
Date      Country    Event                                                             London Time     Date      Country   Event                                              London Time
02-Sep    INT        G20 Finance Ministers' Deputies Meeting (4 days)                    uncertain     25-Oct    EMU       Money supply M3, sa                                    09:00
04-Sep    EMU        GDP, 1st estimate                                                    10:00        25-Oct    EU        European Council Meeting (2nd day)                   uncertain
05-Sep    EMU        ECB Council Meeting & Press Conference                               12:45        25-Oct    GER       Ifo Business climate, sa                               09:00
05-Sep    INT        G20 Leaders' Summit (2 days)                                        uncertain     25-Oct    UK        GDP (preliminary)                                      09:30
05-Sep    SWE        Riksbank Monetary Policy Decision                                    08:30        28-Oct    ITA       ISTAT Business confidence                              09:00
05-Sep    UK         MPC Meeting                                                          12:00        29-Oct    US        FOMC meeting                                           19:00
09-Sep    ITA        Senate committee on Court verdict and on vote                       uncertain     30-Oct    BEL       Real GDP, flash estimate                               14:00
10-Sep    EMU        European Parliament to finalise Single Supervisory Mechanism        uncertain     30-Oct    EMU       ECB Bank Lending Survey                                09:00
10-Sep    ITA        GDP, sa (details)                                                    10:00        30-Oct    SPA       Real GDP, flash estimate                               08:00
12-Sep    SWE        Consumer prices                                                      08:30        30-Oct    US        FOMC meeting (2nd day)                                 19:00
13-Sep    EMU        Informal Eurogroup Meeting                                           14:00        31-Oct    EMU       HICP flash, nsa                                        10:00
14-Sep    EMU        Informal Ecofin Council Meeting                                      08:00
15-Sep    GER        Regional Election in Bavaria                                        uncertain     07-Nov    EMU       ECB Council Meeting & Press Conference                 12:45
15-Sep    POR        Troika Review                                                       uncertain     07-Nov    UK        MPC Meeting                                            12:00
15-Sep    CYP        Troika Review                                                       uncertain     11-Nov    EMU       Ecofin Budget Meeting                                uncertain
17-Sep    GER        ZEW Economic Sentiment                                               10:00        12-Nov    SWE       Consumer prices                                        08:30
17-Sep    NET        Government to present the 2014 budget                               uncertain     13-Nov    UK        BOE Inflation report & press conference                10:30
17-Sep    US         FOMC meeting                                                         19:00        14-Nov    EMU       GDP, sa (flash estimate)                               10:00
18-Sep    UK         MPC minutes                                                          09:30        14-Nov    GER       Real GDP, sa (Flash estimate)                          07:00
18-Sep    US         FOMC meeting (2nd day)                                               19:00        14-Nov    ITA       GDP, sa (preliminary)                                  09:00
19-Sep    NOR        Norges Bank Monetary Policy Decision                                 13:00        14-Nov    NET       GDP release, sa (1st estimate)                         08:30
19-Sep    SWI        Monetary Policy Meeting                                              13:00        14-Nov    EMU       Eurogroup Meeting                                      14:00
20-Sep    ITA        Deadline to present government economic and fiscal forecast                       15-Nov    EMU       Ecofin Council Meeting                                 08:00
22-Sep    GER        General Election                                                   uncertain      19-Nov    GER       ZEW Economic Sentiment                                 10:00
22-Sep    GER        Regional Election in Hesse                                         uncertain      20-Nov    EMU       PMI manufacturing (flash)                              09:00
23-Sep    EMU        PMI manufacturing (flash)                                           09:00         20-Nov    EMU       PMI services (flash)                                   09:00
23-Sep    EMU        PMI services (flash)                                                09:00         20-Nov    UK        Autumn Statement                                     uncertain
24-Sep    GER        Ifo Business climate, sa                                            09:00         20-Nov    UK        MPC minutes                                            09:30
25-Sep    FRA        INSEE Mfg survey (synth. Index)                                     07:45         22-Nov    GER       Real GDP, sa (details)                                 07:00
26-Sep    EMU        Money supply M3, sa                                                 09:00         22-Nov    GER       Ifo Business climate, sa                               09:00
27-Sep    FRA        Real GDP, final estimate                                            06:30         28-Nov    EMU       Money supply M3, sa                                    09:00
27-Sep    ITA        ISTAT Business confidence                                           09:00         28-Nov    ITA       ISTAT Business confidence                              09:00
29-Sep    GRE        Troika Review                                                      uncertain      28-Nov    SWE       Riksbank Financial Stability Report                    08:30
29-Sep    AUT        General Elections                                                  uncertain      29-Nov    EMU       HICP flash, nsa                                        10:00
29-Sep    GER        Vote on the enhanced EFSF                                          uncertain      29-Nov    SWE       Real GDP, 1st estimate                                 08:30
30-Sep    EMU        HICP flash, nsa                                                     10:00         30-Nov    GRE       Troika Review                                        uncertain
End-Sep   ITA        Planned VAT rate hike to be postponed
                                                                                                       04-Dec    EMU       GDP, 1st estimate                                       10:00
Oct*      ITA      Vote in the Senate on implications of Court verdict                  uncertain      05-Dec    EMU       ECB Council Meeting & Press Conference                  12:45
01-Oct    EU       Deadline for countries to take corrective action under EDP           uncertain      05-Dec    NOR       Norges Bank Monetary Policy Decision                    13:00
02-Oct    EMU      ECB Council Meeting & Press Conference (Paris)                        12:45         05-Dec    UK        MPC Meeting                                             12:00
04-Oct    IRE      Referendums on abolition of Seanad & setting up of a Appeal Court     07:00         09-Dec    EMU       Eurogroup Meeting                                       14:00
10-Oct    INT      G20 Finance Ministers & Central Bank Governors Meeting (2 days)      uncertain      10-Dec    EMU       Ecofin Council Meeting                                  08:00
10-Oct    SWE      Consumer prices                                                       08:30         10-Dec    ITA       GDP, sa (details)                                       10:00
10-Oct    UK       MPC Meeting                                                           12:00         12-Dec    SWE       Consumer prices                                         08:30
11-Oct    INT      IMF/Worldbank Annual Meeting                                         uncertain      12-Dec    SWI       Monetary Policy Meeting                                 13:00
14-Oct    EMU      Eurogroup Meeting                                                     14:00         15-Dec    POR       Troika Review                                         uncertain
15-Oct    ITA      2014 budget (draft)                                                  uncertain      15-Dec    CYP       Troika Review                                         uncertain
15-Oct    EMU      Ecofin Council Meeting                                                08:00         17-Dec    GER       ZEW Economic Sentiment                                  10:00
15-Oct    GER      ZEW Economic Sentiment                                                10:00         17-Dec    SWE       Riksbank Monetary Policy Decision                       08:30
15-Oct    GER      Announcement of size renewable energy levy for 2014                  uncertain      17-Dec    US        FOMC meeting                                            19:00
15-Oct    IRE      Budget for 2014 will be presented                                    uncertain      18-Dec    GER       Ifo Business climate, sa                                09:00
15-Oct    IRE      Troika Review (final)                                                uncertain      18-Dec    UK        MPC minutes                                             09:30
20-Oct    EMU      PMI manufacturing (flash)                                             09:00         18-Dec    US        FOMC meeting (2nd day)                                  19:00
20-Oct    EMU      PMI services (flash)                                                  09:00         19-Dec    EU        European Council Meeting (1st day)                    uncertain
23-Oct    UK       MPC minutes                                                           09:30         20-Dec    EMU       European Council Meeting (2nd day)                    uncertain
24-Oct    EU       European Council Meeting (1st day)                                   uncertain      20-Dec    EMU       PMI manufacturing (flash)                               09:00
24-Oct    NOR      Norges Bank Monetary Policy Decision                                  13:00         20-Dec    EMU       PMI services (flash)                                    09:00
24-Oct    SWE      Riksbank Monetary Policy Decision                                     08:30         30-Dec    ITA       ISTAT Business confidence                               09:00
25-Oct    EU       European Council Meeting (2nd day)                                   uncertain      End-Dec   ITA       Deadline to approve 2014 budget                       uncertain
Source: ECB, Bloomberg, Morgan Stanley Research                                                                                                            *Indicates approximate date/time

                                                                                             MORGAN           STANLEY            RESEARCH

                                                                                             September 3, 2013
                                                                                             European Economics

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                                                                                         September 3, 2013
                                                                                         European Economics

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