2010 Global Economic Outlook

2010 Global Economic Outlook
NOMURA GLOBAL ECONOMICS
A Tale of Two Recoveries

The aftermath of the crisis should constrain the developed world recovery,
but, led by a booming China, emerging markets look set for strong growth.
Please see analyst certifications and important disclosures on the last page of this report.
Contents
GLOBAL
Forecast summary 3
Our view on 2010 in a nutshell 4
Outlook 2010: A tale of two recoveries 5
Fiscal forces 6
GEMaRI: Vulnerability remains 8
QE: Back to basics 10
Key political issues for 2010 11
UNITED STATES
Outlook 2010: The slow road from recession 12
Financial stress 14
Constrained by debt 16
The Fed’s balance sheet 17
Economic outlook: Strong finish to 2009, but cooler growth ahead 18
EURO AREA
Outlook 2010: Headwinds 19
Good work 20
Euro strength may prolong euro-area weakness 22
Liquidity withdrawal roadmap 24
Economic outlook: Constrained recovery 25
UNITED KINGDOM
Outlook 2010: Walking the policy tightrope 26
Q&A on MPC quantitative easing 27
Economic outlook: Better prospects, but risks persist on both sides 29
JAPAN
Outlook 2010: Shift to steady export-led growth in H2 30
Stimulus measures boost consumer spending 31
A policy mix to overcome deflation 33
Capacity and personnel cost adjustments 35
Economic outlook: More aggressive policy in store 36
ASIA
Outlook 2010: China-led paradigm shift 37
China: Dispelling some myths 39
Asian monetary policy: A fear of the exit 40
Asia rebalancing 42
Australia economic outlook: A two-speed recovery 43
China economic outlook: One of the best years in decades 44
Hong Kong economic outlook: Twin engines of China and the HKD peg 45
India economic outlook: Heading back to 8% 46
Indonesia economic outlook: Domestic demand to lead robust growth 47
Malaysia economic outlook: Private sector to lead the recovery 48
Philippines economic outlook: Too much fiscal hype 49
Singapore economic outlook: Tourism to drive momentum 50
South Korea economic outlook: Inflationary recovery 51
Taiwan economic outlook: Cross-straits moves to raise business confidence 52
Thailand economic outlook: Political uncertainty 53
Vietnam economic outlook: An overheated economy 54
Nomura Global Economics 1 16 December 2009

EMERGING EUROPE, MIDDLE EAST AND AFRICA

Outlook 2010: Differentiated growth woes 55
Towards EMU: New convergence anchor 56
Debt (un)sustainability 58
Election fever 60
Russia economic outlook: Animated by oil 61
South Africa economic outlook: Conflicting signals on growth, mandate change 62
Turkey economic outlook: The comeback king 63
Central and Eastern Europe economic outlook: Hungary, Czech Republic, Poland 64
Rest of Emerging Europe economic outlook: Ukraine, Kazakhstan, Romania 65
Middle East economic outlook: Egypt, Israel, Saudi Arabia 66
LATIN AMERICA
Outlook 2010: An uneven recovery 67
Brazil 2010 election outlook 69
Brazil economic outlook: Growth set to accelerate 71
Mexico economic outlook: A recovery burdened by long-term worries 72
Rest of Latin America economic outlook: Argentina, Chile, Columbia 73
FOREIGN EXCHANGE
Outlook 2010: Beyond peak performance 74
EQUITY MARKET
Outlook 2010: Still bullish 77

Forecast Summary
The World at a Glance

Real GDP Consumer Prices Policy Rate
% over a year ago % over a year ago % end of period
2009 2010 2011 2009 2010 2011 2009 2010 2011
Global -0.9 4.2 4.2 1.4 2.8 2.9 2.68 3.28 4.12
Developed -3.4 2.0 2.2 0.0 1.3 1.1 0.52 0.65 1.45
Emerging Markets 2.0 6.6 6.4 3.1 4.6 4.8 5.23 6.24 7.02
BRICs 4.7 8.4 8.0 2.3 4.5 4.9 6.15 7.03 7.88
Americas -2.5 3.1 2.8 1.0 2.5 2.1 1.73 2.28 3.08
United States* -2.5 2.7 2.6 -0.3 1.9 1.0 0.13 0.13 1.00
Canada -2.6 2.0 2.9 0.4 1.5 1.8 0.25 0.75 1.75
Latin America -2.6 4.6 3.4 4.8 4.4 5.1 6.84 8.84 9.31
Argentina -2.3 2.5 3.0 5.5 8.0 8.0 11.50 13.00 13.00
Brazil 0.1 5.4 3.1 4.9 4.2 5.3 8.75 11.75 12.50
Chile -1.5 4.7 4.0 1.5 2.1 3.0 0.50 4.00 5.00
Colombia 0.1 3.3 4.0 4.1 3.2 4.0 3.50 5.00 5.50
Mexico -7.0 4.6 3.9 5.3 3.9 4.5 4.50 5.25 5.50
Asia/Pacific 3.2 6.9 6.8 0.3 2.8 3.3 3.59 4.40 5.25
Japan -5.4 1.3 1.7 -1.3 -1.3 -0.5 0.10 0.10 0.25
Australia 1.0 2.8 3.2 1.8 2.4 2.6 3.75 4.25 4.50
Asia ex Japan, Aust. 5.5 8.4 8.2 0.6 3.9 4.2 4.47 5.45 6.42
China 8.5 10.5 9.8 -0.7 2.5 3.5 5.31 6.12 7.20
Hong Kong*** -2.6 5.6 4.4 0.5 3.2 2.9 0.30 0.40 1.15
India** 6.5 8.0 8.2 1.9 7.0 6.2 4.75 6.00 7.00
Indonesia 4.6 5.9 6.2 4.9 6.1 6.3 6.50 7.50 7.50
Malaysia -2.2 4.5 5.2 0.6 2.7 3.6 2.00 2.50 3.00
Philippines 1.0 5.5 6.0 3.2 5.4 5.7 4.00 5.00 6.00
Singapore*** -2.0 5.5 5.5 0.3 3.0 2.7 0.70 1.25 1.75
South Korea 0.0 5.5 4.0 2.8 3.3 3.2 2.00 3.50 4.50
Taiwan -3.0 4.8 5.2 -0.8 1.5 1.8 1.25 1.75 2.25
Thailand -3.0 3.0 5.0 -0.9 2.7 3.3 1.25 1.75 3.00
Vietnam 5.1 6.5 6.6 6.7 12.4 11.2 8.00 11.00 12.00
Western Europe -4.1 1.2 1.8 0.6 1.3 1.4 0.92 1.16 2.12
Euro area -3.9 1.1 1.7 0.3 1.2 1.5 1.00 1.25 2.25
France -2.3 1.2 1.7 0.1 1.2 1.4 1.00 1.25 2.25
Germany -4.8 1.6 2.0 0.3 0.9 1.4 1.00 1.25 2.25
Italy -4.8 1.1 1.5 0.8 1.3 1.6 1.00 1.25 2.25
Netherlands -4.0 1.2 1.5 1.0 0.4 1.2 1.00 1.25 2.25
Spain -3.6 -0.2 1.4 -0.2 1.3 1.6 1.00 1.25 2.25
United Kingdom -4.6 1.4 2.4 2.1 2.0 1.2 0.50 0.75 1.50
EEMEA -3.2 3.7 3.9 7.3 6.3 6.0 5.56 6.04 6.59
Czech Republic -4.0 0.8 1.8 1.0 2.0 2.0 1.00 3.00 3.50
Egypt 4.8 5.2 5.5 12.2 12.5 8.1 8.25 9.00 10.00
GCC 1.7 7.9 5.4 5.8 6.8 7.4 0.13 0.13 1.00
Hungary -6.9 -1.5 2.0 4.2 3.7 3.0 6.00 5.50 7.50
Israel 0.3 2.7 3.8 2.7 3.0 2.9 1.00 2.50 3.50
Kazakhstan -1.5 3.5 5.0 7.1 6.1 6.0 7.00 7.00 7.25
Poland 1.6 2.1 3.5 3.5 3.1 2.5 3.50 4.50 5.00
Romania -7.0 2.8 3.1 5.8 4.0 3.6 8.00 7.00 6.50
Russia -7.5 3.5 4.4 11.7 8.9 8.0 9.00 8.00 8.00
South Africa -1.6 3.0 3.5 7.2 6.1 6.6 7.00 7.50 9.00
Turkey -5.8 4.4 4.5 6.2 6.4 5.4 6.50 7.75 8.75
Ukraine -14.0 3.6 4.0 16.7 10.3 8.7 10.25 9.00 9.00
Note: Aggregates calculated using purchasing power parity (PPP) adjusted shares of world GDP; Real GDP and CPI are reported as
annual average growth rates; Developed countries comprise the United States, Canada, Japan, Australia, Hong Kong, Singapore, the
Euro area, and the United Kingdom - all other countries are considered Emerging Markets; BRICS: Brazil, Russia, India and China;
EEMEA: Emerging Europe, Middle East and Africa; Gulf Cooperation Council (GCC): Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and
the United Arab Emirates; all values are forecasts. * 2009 policy rate forecast is midpoint of 0–0.25% target federal funds rate range; **
Inflation refers to wholesale prices. ***For Hong Kong and Singapore, the policy rate refers to 3M Hibor and 3M Sibor, respectively.
Source: Nomura Global Economics.

Our View on 2010 in a Nutshell
Global
• The developed-world recovery looks set to be weak given de-leveraging forces and other legacies of the crisis.
• With good fundamentals and a lack of aftermath issues, the emerging world, particularly Asia, is set to grow strongly.
• Developed-world inflation should stay low amid ample spare capacity, but exchange-rate-targeting central banks risk bubbles.
• The main downside risks include a re-eruption of financial distress, a commodity price bubble and premature fiscal tightening.
• A possible upside surprise: animal spirits stir and, with monetary conditions super-loose, help release pent-up demand.
• We forecast an average Brent oil price of $72 in 2010 and $75 in 2011, after $62 in 2009.
• We expect further dollar weakness, especially vs EM, but the yen should gradually trade weaker on MOF intervention.
United States
• The “Great Recession” has ended, but the after-effects of the financial crisis are likely to weigh on the recovery.
• Job market conditions are improving, but business uncertainty should limit job growth and keep the unemployment rate high.
• Typical of the first phase of recovery, ample capacity is likely to put downward pressure on inflation.
• We expect the Fed to focus on an orderly exit from credit easing, but not to hike rates until early 2011.
• Proposals for a jobs-focused fiscal policy must overcome resistance from those worried about adding more to a record deficit.
Europe
• We expect sub-par growth given household de-leveraging in the UK and feeble domestic momentum in the euro area.
• The fiscal policy challenge: deliver short-term stimulus within a credible framework of medium-term consolidation.
• Headline inflation is set to rise in the UK and euro area, but underlying inflation is likely to stay very weak.
• We expect the ECB to start gradually removing exceptional liquidity measures but not to start hiking rates until October 2010.
• The BoE MPC faces uncertainties on both sides and we do not expect rate hikes until November 2010.
Japan
• We expect the Japanese economy to slow again through H1 2010 but for growth to pick up again in the second half.
• Faster-than-expected excess supply corrections and expanding exports, particularly to Asia, should drive a recovery in H2.
• Given a wider negative output gap, we expect CPI deflation to persist for the foreseeable future.
• The BOJ is likely to adopt additional easing measures, such as increasing long-term JGB purchases, in H1 2010.
Asia
• Things look ripe for a paradigm shift – domestic demand is replacing exports as the main growth driver, led by China.
• China: The investment and consumption booms are set to continue and to deliver double-digit growth.
• Korea: We see an inflationary economic recovery in 2010, driven by a prolonged macro stimulus and strong China demand.
• India: With both growth and inflation headed towards 8%, we expect the RBI to lead Asia in tightening monetary policy.
• Australia: Despite less expansionary policies, we see GDP growth quickening on stronger capex, exports and housing.
• SE Asia: Bullish on Indonesia, Singapore and the Philippines; less so on Thailand and Malaysia; concerned about Vietnam.
EEMEA (Emerging Europe, Middle East and Africa) and Latin America
• Key themes in 2010 are the removal of supranational support, fiscal sustainability and the effects of exit strategies on rates.
• CEE will likely be the slowest region to recover. Vulnerabilities persist, especially with banks’ NPLs set to peak in Q2 2010.
• Elections in CEE are a risk, with knock-on effects for fiscal policy sustainability. We see Poland entering ERM-II in Q4 2010.
• South Africa: World Cup and restocking will mask a weak recovery in consumption; we see a change in the SARB mandate.
• Russia should return to stable, if subdued, growth in 2010, supported by oil prices and pent-up domestic demand.
• Turkey should show a strong rebound in 2010, allowing some policy normalisation. Inflation should remain in check.
• Middle East: The Dubai story is a key test of investor confidence in the region; growth momentum should be maintained.
• LatAm: Strong growth in Asia and expansive monetary and fiscal policy are leading to a cyclical recovery.

Global ⏐ Outlook 2010 Paul Sheard
A tale of two recoveries

We expect a strong recovery in most of EM but a shallow one in the developed world.
EM weathered the Two key features of the global economy evident since the financial crisis of 2008 inform our
crisis well... global economic forecast for 2010. The first is that the developed economies, particularly the US
and Europe, experienced their worst financial crisis since the Great Depression. The aftermath
will cast a long shadow on their recovery. The second is that emerging markets (EM),
particularly emerging Asia, after absorbing the initial hit to exports from the crisis-induced
collapse in developed-world domestic demand, have performed remarkably well. Continuing this
trend, EM economies are likely to post strong domestic demand-driven growth in 2010 (Figure 1).
... particularly Looking back, the growth numbers that we expect for the full year of 2009 speak for themselves.
emerging Asia The global economy overall likely contracted by almost 1% in 2009, but developed-world GDP
likely fell by 3.4% while EM economies expanded by 2.0%. Within EM, there was notable
differentiation: EEMEA (Emerging Europe, Middle East and Africa) and Latin America likely
contracted by 3.2% and 2.8%, respectively, while Asia looks likely to hit 5.5% growth.
China and India stand China’s expected 8.5% growth in 2009, in such a challenging global environment, stands out. As
out well as benefiting from strong domestic growth momentum associated with a 30-year economic
development take-off, China, at the outset of the crisis, moved quickly to re-peg its currency
against the US dollar and engineer a fiscally and credit-driven investment boom. But India’s
expected 6.5% growth in 2009 also merits attention. The world’s two most populous economies
were the fastest growing in 2009 and together look like contributing 1.5 percentage points (pp) to
likely global growth of -0.9% (put another way, and a bit too simply, had these two economies
stood still rather than grown, global growth would have been -2.4% in 2009) (Figure 2).
The recession is over Looking to 2010, the first point to note is that the global recession is over – the quarter-on-
– and we expect it to quarter contractions in global GDP having ended in Q2 2009 (for the G10, Q3) – and we think
stay over will stay over. Recessions are not the natural state for an economy and tend to self-correct over
time, with counter-cyclical macro policy hastening the process. This recession threatened to
throw the developed world economy in particular into a great depression and deflation, but
concerted and unprecedented monetary, fiscal and financial-system policy action headed that
prospect off at the pass. Absent another major shock, which we do not expect, the global
economy should continue on its recovery path. We forecast global growth of 4.2% in 2010.
Developed world recovery weak

We expect the But developed world growth stands to be much weaker (2.0%) than growth in emerging
developed world to economies (6.6%). The recovery we forecast will not even make up the output lost in the
grow 2% in 2010 recession (Figure 3). This is not just a matter of emerging economies having much higher
potential growth rates than developed ones, which is the case. Coming out of such a severe
recession, growth rates can be well above potential for a sustained period until the spare
Figure 1. GDP growth forecasts: 2010, key countries/regions Figure 2. GDP path: 2008-2011, key countries/regions
% y-o-y 2009 2010 2011
12 Global growth (% y-o-y) -0.9 4.2 4.2
10
Contributions to growth (pp):
Developed -1.8 1.1 1.1
8
United States -0.6 0.6 0.6
Western Europe -0.8 0.2 0.3
6
Japan -0.4 0.1 0.1
4 Emerging Markets 0.9 3.1 3.1
China 1.1 1.5 1.5
2 India 0.4 0.5 0.5
0
WE Japan US EEMEA LatAm ROA India China
Note: WE is Western Europe; ROA is Rest of Asia. See note to “The World at a Glance” table on p2 for definitions of
Source: Nomura Global Economics. Developed and EM. Source: Nomura Global Economics.

Fiscal forces Paul Sheard

The deterioration in fiscal positions is necessary as governments dis-save to absorb private sector surplus savings.
One of the big casualties of the recent financial crisis and global recession has been the fiscal positions of governments
around the world (Figure 1). Fiscal deficits ballooned as tax revenues fell because of the recession and expenditures
rose because “automatic stabilizers” kicked in (notably rising unemployment benefits and social welfare payments) and
governments implemented large-scale fiscal stimulus packages and bank-bailout schemes.
The numbers are startling. The US fiscal deficit went from 3.2% of GDP in 2008 (FY basis) to 10.0% in 2009; in the euro
area, from 1.9% of GDP in 2008 to 6.9% in 2009; in the UK from 5.5% to 11.9%; and in Japan from 6.9% to 9.1% (FY
basis). We forecast budget deficits to worsen in the euro area in 2010 and to stay very high in the US, UK and Japan
(Figure 1). Despite some improvement, except in Japan, we expect fiscal deficits in 2011 to remain gaping.
This deterioration in fiscal finances is a (longer-term) concern to be sure, but it is important to put it in context. In our view,
and in the view of most economists, an aggressive fiscal policy response, on top of relying on automatic stabilizers, is a
necessary part of the policy response in a financial crisis or serious recession. Keynes would be smiling from his grave.
In a recession, particularly a very serious one which risks morphing into a great depression, private sector net savings go
up as households save more and corporations reign in capital investment. This spike in net savings of the private sector
threatens to throw the economy into a tail-spin unless another sector of the economy – the government sector or the
external sector (the rest of the world) – absorbs those surplus savings. There are limits to the rest of the world’s ability to
absorb the surplus savings, particularly if the recessed economy in question is large and if the recession is happening on
a global scale. The way that those surplus savings can be absorbed is by the government increasing its budget deficit, or
going from a budget surplus to deficit – that is, by dis-saving.
All of this follows from the basic macro identity, the workhorse of macroeconomics, which states that private (household,
corporate and financial) sector net savings plus government net savings must equal the current account balance (which
in turn is the change in the net claim of the country on foreigners). Being an identity, this relationship must always be true,
although, equally, it is not possible to ascribe direct causality between changes in the components.
That the huge rise in government deficits is largely just the counterpart to the surge in private net savings can be seen by
looking at what is happening to current account balances around the world. By and large, these are narrowing. We
forecast the current account deficit in the US to narrow by 1.2pp between 2008 and 2010, from 4.6% of GDP to 3.4%.
Likewise we expect the euro area current account deficit to improve by 1.4pp in the same period, from 1.6% of GDP to
0.2%, and the UK current account deficit to improve by 0.5pp from 1.9% of GDP to 1.4%.
If current account deficits are narrowing while fiscal deficits are worsening, from the macro identity it must be that private
sector net savings have rocketed, which indeed is the case (Figure 2). The exception in Figure 2 is China, where a
decline in private net savings and an increase in the government deficit are combining to reduce the current account
surplus from 9.8% in 2008 to 5.0% in 2010, on our forecasts.
Japan provides an instructive application of the macro identity. Japan has been running huge fiscal deficits for years but
it has been running big current account surpluses for even longer, meaning that Japanese are saving so much that they
can finance large government deficits and still have a lot left over to lend to the rest of the world.
Figure 1. Fiscal deficits of major developed economies Figure 2. Change in private sector net savings, 2008 to 2010
% GDP % GDP
0 8
-2
6
-4
4
-6
-8 2
-10
0
-12
-2
-14
US Euro area UK Japan
-4
2008 2009 2010 2011 US Euro area UK Japan China
Note: Japan and US budget balances for fiscal years; Note: Private sector net savings is measured as current account
Source: Nomura Global Economics. balance minus fiscal balance. Japan and US fiscal balance is FY
basis; Source: Nomura Global Economics.

capacity created by the recession is fully used up. But demand, not supply, is the constraint on
growth and we expect demand growth in the crisis-hit developed economies, notably the US,
Europe and (for somewhat different reasons) Japan, to be muted for some time.
We see five We identify five main reasons to expect weak demand growth in developed economies:
headwinds
“De-leveraging” forces: Households, particularly in the US, took on too much debt in the run-
up to the crisis on the premise that they were richer than they turned out to be – and now need
to reduce debt levels and rebuild savings. Some parts of the financial and corporate sectors are
in the same boat. This makes monetary policy less effective than it would normally be.
Constraints on credit availability: While much progress has been made in quelling financial
distress and in dealing with the underlying asset and potential insolvency problems, financial
balance sheets in much of the developed world are still impaired and the flow of credit impeded.
Not all potential borrowers are willing to borrow, but not all willing borrowers are able to.
Continued high uncertainty: The financial crisis led to a spike in uncertainty about the future,
as “tail risk” events became front-page news, dealing a blow to confidence. A year on from the
crisis, uncertainty about the future remains unusually high and is likely to keep putting a damper
on big-ticket consumer durable goods purchases and business investment decisions.
Potential fiscal drag: The recession would have been much worse had it not been for
governments using fiscal policy aggressively to fill the void in private sector demand created by
the spike in net savings (see Box: Fiscal forces). But with fiscal deficits ballooning as a result,
and concerns escalating about mounting public debt levels, fiscal drag looms as a medium-term
check on growth as governments turn their attention to repairing public sector balance sheets.
Constraints on exchange rate adjustments: The global economy needs to “rebalance”

domestic demand growth away from the developed to the developing world; this is taking place,
and is being reflected in narrowing current account balances. This rebalancing needs facilitating
movements of currencies: those of deficit countries weakening, those of surplus countries
appreciating. Some EM monetary authorities are resisting upward pressure on their currencies
by intervening in the FX market, so this “external adjustment” is impeded and the contribution of
net exports to developed world growth stands to be less than it would otherwise be.
Emerging world recovery strong

EM does not have The picture is very different in the emerging world. Emerging economies were hit by the financial
crisis-aftermath crisis and global recession but, by and large, they suffered collateral not intrinsic damage. They
issues to deal with... are not left with the same aftermath issues to deal with that the economies at the “epicenter” of
the financial crisis are. Many of these economies, having absorbed the demand shock, or having
offset it with stimulatory macro policy, can return more or less to pre-crisis growth rates.
... plus domestic Of course, the external environment for emerging economies has changed, perhaps
demand is strong permanently. The “more or less” above relates to the fact that emerging economies like China
will need to rely more on domestic demand growth and less on export growth. And that is exactly
Figure 3. GDP path: 2008-2011, key countries/regions Figure 4. Estimated bank losses by region: 2007-2010
Index, Q1 2008 = 100 $bn

135 1,200 Expected losses
US Forecast
130 Realized losses
Euro area 1,000
125
Japan 800
120
India
115 600
Korea
110 400
105 200
100
0
95 United Euro area United Other Asia
90 States Kingdom mature
Mar-08 Mar-09 Mar-10 Mar-11 Europe
Source: Nomura Global Economics. Source: IMF, Global Financial Stability Report, Oct 2009, p.12.

GEMaRI: Vulnerability remains Peter Attard Montalto ⏐ Rob Subbaraman

A wide range of vulnerabilities in Emerging Markets after this crisis should make 2010 a year of country comparisons.
With investors currently very attuned to risk, we think there is a need to step back to assess macro risks in Emerging
Markets (EM) objectively and quantitatively. Our early-warning system, the Nomura Global Emerging Markets Risk Index,
or GEMaRI, is intended to do just that. GEMaRI is based on 16 macroeconomic and financial indicators across 35
countries that, in back tests, have performed well in predicting past financial crises, especially exchange-rate crises, in
Asia, Europe and Latin America. GEMaRI would have rung alarm bells before previous major financial crises in Chile,
Iceland, Korea, Malaysia, the Philippines, Poland, Russia, Thailand, Turkey and Ukraine.
We think GEMaRI will prove useful as the focus shifts back to sovereign risk, given recent events in Dubai, Greece and
Vietnam. Helped by unprecedented macro policy easing, the performances of economies and asset classes were highly
correlated in 2009; in 2010, these correlations are likely to weaken as investors search for alpha through macro and
relative value trades. GEMaRI could help in this search. Indeed, despite strong capital inflows to EM in 2009, and the
outperformance of its equity markets vis-à-vis advanced economies, the latest GEMaRI scores diverge widely (Figure 1).
The top ranked country for risks is Iceland, showing the degree of stress underneath its current exchange rate controls.
Scores are also high for Bulgaria, Lithuania, Latvia and Hungary, which have been hard hit by the crisis and where, in the
case of those with IMF programmes, many private-sector vulnerabilities have been transferred to the government. At the
other end of the scale, scores are zero for Peru and very low for Colombia, Argentina, Taiwan, Indonesia, Russia,
Mexico, Kazakhstan and Hong Kong. The scores for several countries – Ukraine, Poland, Peru, Bulgaria, Serbia, Turkey,
Vietnam and the Czech Republic – have fallen sharply in recent quarters. This partly reflects a kind of cleansing process
from the global financial crisis and recession. Large contractions in GDP and depreciating currencies have helped reduce,
and in some cases eliminate, sizeable current account deficits, while policy responses have reduced risk in banking
sectors (albeit at the cost of worsening fiscal positions). With a slow recovery in the EEMEA region from this crisis, any
move back to imbalances on this front should be slower than elsewhere.
Scores for a few countries have risen significantly in 2009 or remained sticky at high levels. This is true for Croatia, owing
to its exposed nature but no IMF programme. Other countries such as India and Malaysia are experiencing recoveries
helped by large fiscal stimulus, which has worsened already weak fiscal positions, contributing to a rise in their GEMaRI
scores. In the case of the Baltics, the large falls in GEMaRI scores give some idea of the level of internal adjustment that
has taken place to reduce external imbalances. By contrast, most Asian countries have current account surpluses and
the region’s sound fundamentals are attracting strong net capital inflows, putting upward pressure on currencies. Rising
GDP growth, excess liquidity and central banks slow to raise rates are ideal conditions for asset price bubbles, which
could eventually lead to financial crises. Hong Kong and China, with highly rigid exchange rates, seem most at risk.
Some countries, notably China, Brazil and South Africa, have suffered less than others, missing the banking crisis and
enjoying government-led investment programmes to boost demand. Each has remained higher and more stable in the
GEMaRI index across this cycle than other countries without recession to aid the cleansing of vulnerabilities. One
example is China’s domestic credit boom which could create a prolonged asset price bubble. Another key theme in this
crisis has been the nationalisation of risk and vulnerabilities. There have been bail-outs, as previously private balance-
sheet risks and vulnerabilities have shifted to the state, resulting in higher budget deficits. A flurry of external debt
issuance through Q2 and Q3 2009 to fund these vulnerabilities has caused some stickiness in country risk scores.
Figure 1. GEMaRI scores for Q3 2009
Scores
1-in-2 chance of a
100
currency crisis
79
75 67 64 1-in-3 chance of a
62 60
58 currency crisis
54
48 46 45
50 44
37 36
31 30 30
27 25 25 25 25
23 23
25 19 19 19 16 16
15 14 13 13
3 3 0
0
Ukraine
Romania
Colombia
Turkey
Israel
Iceland
Malaysia
Croatia
India
Mexico
Indonesia
Peru
Estonia
Chile
Thailand
Poland
China
Hong Kong
Kazakhstan
Russia
Egypt
Philippines
Hungary
Brazil
Vietnam
Bulgaria
Lithuania
Latvia
South
Singapore
South
Serbia
Taiwan
Argentina
Czech
Source: Nomura Global Economics. Note: The key levels on the graph are 100 = 1-in-2 chance of a crisis, and 73= 1-in 3 chance. See
the appendix of GEMaRI: Vulnerability remains 10 December 2009 for full details.

what they seem to be doing, particularly in Asia. Of the 4.2% growth that we forecast for 2010,
3.1pp is attributable to emerging markets and a full 2.0pp to just China and India (Figure 2).
Emerging Asia leads Just as there was marked differentiation in Asian and EM growth in the crisis, we expect similar
the rest of EM in the recovery. We forecast very strong growth in Asia, of 8.4% in 2010 and 8.2% in 2011, led
by China (10.5% and 9.8%, respectively) but less impressive growth in LatAm (4.6% and 3.5%)
and EEMEA (3.7% and 3.9%). Our Global Emerging Markets Risk Index, GEMaRI, which
measures the risk of currency or balance-of-payments crises in EM, points to some vulnerable
spots in the EM landscape, particularly in EEMEA (see Box: GEMaRI: Vulnerability remains).
Inflation and monetary policy

We see inflation Given our forecast and interpretation of quantitative easing (QE) as being consistent with central
remaining low in the banks’ price stability mandates, we continue to see little inflation risk in the developed world (see
developed world Box: QE: Back to basics). We forecast annual consumer price inflation in the developed world to
be 1.3% y-o-y in 2010 and 1.1% in 2011, after being flat in 2009. Given persistent large output
gaps, a benign inflation outlook and still-weak financial systems, we see major central banks
being very slow to start to hike rates (our weighted average policy rate forecast for end-2010 is
0.65%, up only slightly from end-2009’s expected 0.52%). Notably, we forecast the European
Central Bank to make its first rate hike in October 2010 and the Bank of the England in
November. We do not expect the Fed to move until Q1 2011 and the Bank of Japan even later.
Exchange rate The monetary landscape looks different in EM. Many countries, particularly in emerging Asia,
targeting risks continue to manage their exchange rates against the US dollar, intervening heavily at times
bubbles in Asia against currency appreciation. The combination of the resulting very loose monetary policy
conditions and strong domestic demand growth set the stage for potential asset price bubbles.
Risks to the forecast

Financial distress We continue to see the main downside risk to our forecast being another breakout of financial
re-erupting is the system distress, which in turn exerts negative feedback onto the real economy and pushes the
main downside risk developed world economy back into recession. The Japanese experience of there being many
false dawns as financial distress periodically re-erupted over more than a decade provides some
caution against over-confidence in calling the financial crisis all-clear.
Write-offs eroding There are a number of potential triggers: latent banking system problems resurfacing in the US
bank capital could be as commercial real estate prices continue to fall, or home prices start to again; the withdrawal of
a trigger policy support exposing weak underlying private sector demand growth and that weakness
feeding back into financial system distress; or continued write-offs exposing banking system
undercapitalization and, in the US case, showing that the big repayment of TARP funds was too
hasty by half (Figure 4). A re-eruption of financial distress would likely clobber domestic demand
via confidence effects and ricochet around the global economy again, shades of Q4 2008. Policy
credibility would take a few knocks too, undermining its subsequent efficacy.
But we think That said, we do not expect a financial crisis to re-erupt. The reason is that the US and Europe
aggressive policy has in the late 2000s is not Japan in the mid-1990s. The lessons from Japan, that is, the lessons
done the job from what Japan did not do – when faced with a financial crisis, act quickly, forcefully and across
the board – were learned and applied in this crisis. Japan’s financial crisis re-erupted many
times because the balance sheet problems were not tackled, but rather kicked down the road
either for time to heal (which it did not) or to land in someone else’s in-tray (which they did).
A commodity price Another downside risk is a possible commodity price shock, including oil, given strong growth in
shock is another commodity-hungry China and loose global monetary conditions. This could start to un-anchor
downside risk inflation expectations and put developed world central banks in the uncomfortable situation of
having to tighten monetary policy faster than they would otherwise like.
Beware geopolitics There are also political risks, amid a busy election calendar, and geopolitical risks, which by their
nature tend to be to the downside (see Box: Key political issues for 2010).
The main upside risk The main risk on the upside is that developed world growth turns out to be much stronger
hinges on animal because confidence and animal spirits – the hardest part of any economy to forecast – return
spirits faster than we expect. Then, with monetary policy very accommodative, households might go on
a spending spree to close the demand gap between the current depressed levels of housing and
consumer durables, and long-term average levels.

QE: back to basics Paul Sheard

If, when and how major central banks exit from quantitative easing (QE) in 2010 will be a key focus of investor attention.
But a good deal of mystery – and, we would submit, misunderstanding – surrounds QE. Here, we try to demystify.
To understand QE, it is important to go back to the basics of how a central bank balance sheet works and how central
banks normally operate. Precise details of components and operations differ from country to country, but a simplified
central bank balance sheet is composed of assets acquired (eg, government debt) or credit provided (lending) on the
asset side and three components on the liability side: bank reserves (banks’ deposits with the central bank); government
deposits (the central bank is usually the government’s banker); and banknotes in circulation (the money in your wallet or
under the mattress). Being a balance sheet, the following identity must hold:
Central bank assets/credit provided (CBA/C) = bank reserves (BR) + government deposits (GD) + banknotes (BC).
This identity immediately yields a few insights:
- 1) if CBA/C and GD do not change, BR goes down when BC goes up, and vice versa;
- 2) if GD and BC do not change, BR goes up when CBA/C goes up, and vice versa;
- 3) if CBA/C and BC do not change, BR goes down when GD goes up, and vice versa;
- 4) if BR and BC do not change, CBA/C goes up when GD goes up, and vice versa.
Point 1 highlights the pivotal role that bank reserves play in a money economy: when people take money out of the bank,
bank reserves fall; it is by topping up the depleted bank reserves (operation 2) that central banks supply cash to the
economy. Point 3 highlights the key fact that government transactions with the private sector (e.g., taxes and welfare
payments) either drain or add to bank reserves. Point 4 occurs when the government issues debt directly to the central
bank. Points 1 and 3 are, in central bank jargon, called “autonomous factors”: they influence the level of reserves but are
beyond the central bank’s direct control. Together, these balance sheet relationships show that, conditional on the
observable autonomous factors, the central bank, by adjusting its provision of credit, can determine aggregate reserves
in the banking system. This point bears repeating: the central bank, not banks, controls the overall level of bank reserves.
How does a central bank normally use its balance sheet to achieve its objective of maintaining price stability? It sets an
overnight interest rate (in the inter-bank market for lending and borrowing reserves), doing so by adjusting the aggregate
level of reserves: withdrawing reserves if there are too many (thus removing downward pressure on the overnight rate),
adding reserves if there are too few (thus exerting downward pressure). But what is the level of reserves that achieves
that balance? In a nutshell, the level of reserves that the banks want to hold, either because minimum reserve
requirements (linked to the amount of deposits in the banking system) require them to or because of precautionary
demand for central bank “liquidity”. Because reserves (an asset for the banks) either pay no interest or a very low rate
(up to the policy rate), banks typically want to hold as few reserves as possible. So, in normal times, when the central
bank is setting a positive interest rate, reserves are relatively low, the central bank does not target or directly control the
size of its balance sheet, and the size of the balance sheet tends to be quite stable (grow only slowly) over time.
All of this changes under QE. Exploiting Point 2 above, the central bank can unilaterally expand the size of its balance
sheet by creating more reserves. Indeed, targeting a higher than usual level of reserves or of the overall balance sheet is
the definition of QE. Note two things. One, because a balance sheet has two sides, and they must balance, it is possible
to characterize QE in terms of the central bank expanding reserves (as the Bank of Japan did in 2001-06) or in terms of it
increasing the asset side of its balance sheet (as the Fed has done with its “credit easing”) or both (as the Bank of
England has done with its asset purchases, where it has emphasized that these will be financed by the creation of
reserves). Second, because interest was not usually paid on reserves, QE implied a zero interest rate policy. But now,
with more of them paying interest on reserves, central banks are able to divorce the QE decision from the interest-rate-
setting decision, giving the Fed, for example, the flexibility to raise interest rates before shrinking its balance sheet.
So how does QE work? Essentially via two mechanisms (on top of the lender-of-last resort aspect of preventing a
collapse of the financial system): by changing relative asset supplies and creating “portfolio rebalancing effects”, and by
working positively on confidence and (anchoring inflation) expectations. Under QE, rather than just target a single
interest rate (the overnight rate), a central bank can leverage its balance sheet (both its size and its composition) to try to
influence a range of interest rates and asset prices. Because banks in aggregate end up with a very liquid balance sheet
under QE, having swapped risk assets for reserves, they may endeavor to rebalance their portfolios back toward higher-
yielding assets, thereby helping to buoy asset prices and create positive wealth effects. But, contrary to much common
commentary, QE does not work through a mechanical credit multiplier process: banks cannot “take” their reserves and
“lend them out”, as if reserves were money waiting to flow through the economy. Banks create credit by simultaneously
creating loans and deposits, not by re-directing reserves (it is only subsequently, via Point 1, that reserves are depleted).

Key political issues for 2010 Alastair Newton

We judge that political/geopolitical risk has continued to subside during the second half of 2009. However, major
downside (and some upside) risks – “local”, regional and global – persist, which stand to impact financial markets.
Set out below is a checklist of our “Top 10” political and geopolitical issues for 2010 (which we intend to cover in more
detail in our geopolitical risk forecast for 2010 due for publication in early January). The order reflects our subjective
judgment of the importance of each of the issues to market participants.
1. United States: The economy – especially unemployment (which we expect to amplify protectionist pressures and
therefore trade frictions with China) and the fiscal deficit – looks set to be the dominant issue in the 2 November
Mid-Term elections. We expect the Democrats to be able to manage to retain a majority in both houses of Congress,
but judge it likely that they will lose their super-majority in the Senate. Assuming healthcare reform is passed (by no
means certain), congressional attention will then turn to financial regulation (see Issue 4 below) and climate change
legislation (Issue 7). USD-focused market attention will also be directed to the Administration’s budget proposals,
due in February, and in particular, plans for reining-in the fiscal deficit.
2. The Middle East: A further round of UN sanctions is likely to result from Iran’s intransigence over its nuclear
programme, but we doubt that these will deflect Tehran from its aspirations, in which case military intervention is
likely to remain firmly on the table in Israel. More widely in the region, significant progress looks unlikely with the
Middle East Peace Process; the US is committed to withdrawing all its combat troops from Iraq by August; Egypt
prepares for legislative elections in October amid rising speculation over the presidential succession; and al Qa’ida,
now established in troubled Yemen, poses a real terrorist threat across the region.
3. Afghanistan/Pakistan: Despite President Barack Obama’s decision to commit additional troops to Afghanistan, we
judge the political will in the West to continue the struggle there to be slowly draining. This has potentially significant
implications for the future stability of Pakistan which, although it appears to have improved somewhat both
economically and politically since early 2009, remains fragile. Further terrorist attacks in India backed by elements
in Pakistan cannot be ruled out, although for now at least markets seem to be judging India purely on its own merits.
4. G20: With G20 leaders now not due to consider recommendations on regulatory and institutional reform until
November, we are concerned that the process will lose political momentum to the point where agreements in
principle fail to translate into practice. Nevertheless, we expect the EU largely to implement its de Larosière reform
agenda by mid-2010. We are less sanguine about reform prospects in the US, however, which stand to be
gridlocked and/or diverted by the contentious issue of political oversight of the Federal Reserve.
5. United Kingdom: Opinion polls suggest that the general election (which must be held by early June) will return the
main opposition Conservative Party to power. But a hung parliament (which we would see as negative for market
sentiment and likely to lead quickly to a further election) cannot be ruled out. The main election issue is set to be
the “right” balance between sustaining economic growth and reining-in the UK’s fiscal deficit though, in practice,
there may be less between the two main parties than they try to suggest.
6. Turkey/EU: Failure to achieve real progress towards reuniting Cyprus by April stands to throw up a major hurdle in
Turkey’s already troubled path to EU membership. We judge that the accession process will not be derailed entirely
but will probably be frozen if the Cyprus negotiations fail.
7. Climate change: Assuming a political-level agreement does emerge from the December 2009 climate change
summit, attention will then focus in 2010 on turning this into a binding successor treaty to the Kyoto Protocol (to
come into force in 2012). Absent such a treaty, experts agree that the private sector will continue to lack the
framework needed to drive up investment commensurate with moving to a low-carbon economy.
8. Thailand: Markets appear to have factored in continued political sclerosis in Thailand but could still to be moved by
domestic developments (as happened in October 2009) or by an “out-of-left-field” event such as deepening
tensions with Cambodia exploding again into border skirmishes.
9. Ukraine: We see little likelihood of Russia engineering a gas crisis in the run-up to the 17 January Ukrainian
presidential election, which looks like heading to a run-off between Prime Minister Yuliya Tymoshenko and main
opposition leader Viktor Yanukovych. But a domestic political and/or economic crisis cannot be discounted. The
incoming president will face major economic challenges but can expect improved relations with Moscow.
10. Russia: President Dmitry Medvedev has recently begun setting out a vision for Russia’s economic development
which we believe stands to differ significantly from that of Prime Minister Vladimir Putin, and which would stand
ultimately to boost Russia’s economy. But it remains to be seen whether he can push ahead with his agenda in
2010 – and, if he can, what that may imply for the presidential election in 2012.

United States ⏐ Outlook 2010 David Resler
The slow road from recession

The US economy is growing again, but it will take a long time for activity to return to pre-
recession levels.
This has been a In terms of depth and duration, the recession of 2007-09 has no precedent in the post-war US
downturn like no experience but in its first phase – through the first three quarters of 2008 – the downturn did not
other differ markedly from previous post-war recessions. The recession took on an entirely different
character when the financial system seized up after the fall of Lehman Brothers in September
2008. The ensuing decline in real GDP from Q4 2008 to Q2 2009 was the sharpest since the
Great Depression, leaving the financial system itself profoundly damaged and incapable of
playing its usual supportive role in any prospective recovery. Aggressive and innovative policy
actions have mitigated the damage, but the corrective forces required to set the economy right
must still run their course – a course that is likely to be long and arduous (Figure 1).
The “Great Recession” has ended

Nonetheless, it now seems likely that the ”Great Recession” probably ended in the third quarter,
The NBER will when real GDP grew at a 2.8% rate after four straight quarters of decline. Of course, growth in
determine the
real GDP is not the only – or even the decisive – metric of business-cycle turning points.
recession’s end
Ultimately, the National Bureau of Economic Research will determine when the economy hit its
nadir. Amid persistent weakness in the jobs market and the feeble 0.1% net advance from the
June low in the Conference Board’s index of coincident indicators, the NBER is unlikely to make
that determination anytime soon. But with most recent data pointing to an advance of nearly 3%
in real GDP in the current quarter, we suspect the NBER will eventually confirm that the longest
and deepest slump since the Great Depression did indeed end sometime in the third quarter.
Q3 growth sets the The moderate rate of Q3 growth also seems likely to be a signal of things to come. Accordingly,
standard for coming after a Q4 2009 growth spurt of 3.5%, we forecast that real GDP growth over the four quarters of
quarters next year will match the 2.8% pace of Q3 2009. Instead of the snap-back, V-shaped rebound
that has been typical after previous deep recessions, we think a much shallower growth
trajectory lies ahead (Figure 1).
In a slow recovery, The shallow recovery that we envision rests on a different precedent than the rebounds that
key metrics will have followed other post-war US recessions. Namely, the more relevant antecedents of the
remain below normal current slump – the deep contractions experienced in other economies that have weathered
crippling financial crises – suggest a much slower and more drawn-out recovery. In short, we
believe that, although the economy will no longer be contracting, activity in such key sectors as
housing and motor vehicles will be far below the levels typical of previous expansions. Similarly,
the unemployment rate looks likely to remain well above 9% in the year ahead, not falling below
9% until late in 2011. Maintaining the accommodative mix of fiscal and monetary policy should
prevent a reversion into economic decline but cannot, in our opinion, fully counter the effects of
the financial rebalancing that lies ahead.
Figure 1. This recession compared to previous ones Figure 2. Forecast sector contributions to recovery
GDP Index, Peak = 100 pp

108 2.0
1973-75
1st 6 qtrs.
1981-82 1.5
106 1990-91 First quarter 2011
2001 of expansion 1.0

104 2008- ???
0.5
Peak level
102 0.0
-0.5
100
-1.0
Government
Consumption
Equipment
Housing
Trade
Inventories
Structures
98
96
0 1 2 3 4 5 6 7 8 9 10 11
Quarters after GDP Peak
Source: Bureau of Economic Analysis; Nomura Global Economics. Source: BEA; Nomura Global Economics.

As is typical of most recoveries, a rebound in consumer spending, residential investment and

inventory investment will likely provide the main impetus to recovery. Together, these three
segments should contribute about three percentage points to forecast real GDP growth during
the first six quarters of the economic recovery (Figure 2). However, we expect the deepening
downturn in non-residential construction, which was buoyant during the first third of the overall
recession, to offset about 0.5pp of the boost from the aforementioned sectors. In contrast to cuts
in spending for structures, forecast growth in business investment in equipment and software
provides progressively greater support for the expansion. Despite the weaker dollar and
improving economic conditions overseas (especially in China and other Asian economies), the
US trade balance should provide only limited support for the recovery in 2010 and H1 2011. It
was not enough to counter the net drag on growth in Q3 2009 and looks unlikely to do so in Q4.
The upside of the In one important respect, the first phase of the forecast upturn resembles the early stages of
inventory cycle is previous recoveries. Although the inventory liquidations during this recession have been large,
under way they have accounted for only about one-fourth of the 3.8% drop in real GDP from its Q2 2008
peak – a much smaller impact on overall economic activity than in most post-war contractions.
However, we expect the reversal of the inventory cycle to follow the patterns of the past and to
largely reverse their six-quarter drag on growth with offsetting contributions to the recovery over
the year ahead. From Q1 2008 through Q2 2009, falling inventories subtracted an average of
about 0.9pp from quarterly GDP growth and we expect a rebound in inventory investment,
already under way, to contribute a like amount to real GDP through the end of 2010.
Debt unwind to limit pace of recovery

While most economic downturns rectify imbalances that emanate from the markets for goods
and services, this recession was simply the first step toward correcting the imbalances that
developed during the debt-financed housing boom. Until financial institutions have strengthened
their balance sheets, they are likely to limit new lending to the business and household sector
(See Box: Financial stress). The modest improvement in those imbalances during the recession
itself represents merely the down-payment of a corrective process of deleveraging, particularly
in the financial and household sectors, that is likely to play out over a period of several years.
Wealth losses The recession took a devastating toll on consumer balance sheets and the greatest impediment
undercut spending to a quick, V-shaped recovery will be the household sector’s need to strengthen its finances.
options From the Q3 2007 peak to the Q2 2009 trough, household net worth declined by about $14.2
trillion, with declines in financial assets accounting for about $10.7tr (more than 75%) of the total.
More than half the drop in financial asset valuations occurred in Q4 2008 and Q1 2009 but the
implosion of household wealth appears to have ended in Q1 2009. With the steep slide in real
estate values apparently arrested and the stock market rebound that began in the spring
boosting equity market values, households had recovered nearly $5tr of their net wealth losses
by the end of Q3 2009. Nonetheless, the two-year wealth losses still totalling about $9tr will
likely continue to exert a drag on consumer spending. Conventional estimates of the “wealth
effect” suggest that these losses will reduce long-run consumer spending by about $300bn to
$700bn, enough to erase more than a year’s worth of average spending growth.
Figure 3. Housing starts: Actual and forecast path Figure 4. Inflation declines in early phase of recoveries
m saar Change in % y-o-y rate, pp

2.5 1.5
1.0 All items
2.0 0.5 Core
0.0
1.5
-0.5
-1.0
1.0 Lowest of past recessions
-1.5
0.5 -2.0
-2.5
t-6 Trough t+6 t+12 t+18 t+24
0.0
Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Months from recession trough
Source: Census Bureau; Nomura Global Economics. Note: Average of past eight recessions; Source: BLS; Nomura
Global Economics.

Financial stress David Resler

The worst of the financial crisis has likely passed, but worries about hidden dangers persist.
The worst financial crisis since the Great Depression has understandably left a legacy of worry that the “too big to fail”
doctrine will not be able to head off a new systemic threat. Some observers have criticized the “stress tests” as too
narrowly focused on just 19 large financial institutions. They also contend that the stress tests were not sufficiently
rigorous to assess systemic risks accurately. Others note with alarm the fragile state of smaller banks and worry that a
failure of one that is deemed not quite big enough to rate as system-critical could again set off a chain reaction that
brings the system to its knees.
Unfortunately, none of these concerns can be dismissed out of hand. After all, they reflect the new-found appreciation of
the “tail risks” embedded in a highly complex and interconnected financial system. Indeed, many of the worries are
grounded in inescapable facts. Despite the extraordinary measures by the Federal Reserve, Treasury and Federal
Deposit Insurance Corporation (FDIC), the authorities so far this year have closed or assisted in the takeover of some
141 institutions. With another 552 insured depository institutions housing $346 billion in assets currently classified as
“problem institutions,” more failures seem likely before the end of 2009 (Figure 1). Although this is far fewer than the
number of bank resolutions in 1985-1992, the 2009 failed depositories housed almost $2.1trn in assets, representing
about 15.6% of all assets at insured depositories, about 4 1/2 times the proportion in the worst year of the earlier crisis.
Most of the bank failures cited above have been among banks with less than $1bn in assets and the deepening
recession in the commercial property market aggravates the financial stress for these institutions. With commercial real
estate prices still falling – precipitously in some markets – memories of how real estate loan problems at smaller
institutions in Japan spread to larger ones during the 1990s has kept markets fearful. The real estate risk exposure of
small banks is considerable. In contrast to the 16.6% share at the nation’s 25 largest banks, commercial real estate loans
comprise about 41.7% of loans at all other US chartered banks. As Figure 2 shows, banks in this size category have not
raised their loss provisions as much or as rapidly as their larger counterparts. But hundreds of the smaller institutions
have shored up their capital base with funds from the Troubled Asset Relief Program (TARP). Moreover, the FDIC has a
permanent credit line from the Treasury of $100bn and, in an emergency, is able to tap up to another $400bn. With none
of this used yet, the FDIC has ample capacity to deal with a much larger increase in bank failures than we believe to be
likely in the year ahead. That extra capacity for assistance from the FDIC should also mitigate the risks of contagion.
The increased FDIC Treasury credit line, along with other policy innovations, such as the Term Asset Lending Facility
(TALF), make it less likely that the US will see a replay of the Japan-style contagion that spread much more slowly than
the crisis in the US. For instance, more than two years elapsed between the first Japanese bank failure in the post-war
era (August 1995) and the collapse of Yamaichi Securities (November 1997). Although the Japanese authorities tapped
public funds to capitalize banks shortly after the Yamaichi collapse, they failed to evaluate the systemic stress that
contagion might pose. While the US crisis developed much more quickly – just six months between the forced absorption
of Bear-Stearns into JPMorgan-Chase and the Lehman Brothers bankruptcy – authorities responded quickly and more
forcefully. Moreover, the “stress tests” conducted by Fed last spring have helped restore confidence in the banking
system. Despite the criticism that the tests were not sufficiently rigorous, the fact that some of the, presumptively, most
troubled large banks have repaid or petitioned the Treasury to repay TARP funds supports our belief that the US will
avoid the mistakes that magnified and prolonged Japan’s financial crisis. Nonetheless, the financial fall-out that followed
Lehman’s bankruptcy underscores the uncertainties inherent in today’s complex, interconnected financial system.
Figure 1. Failed and “problem” banks Figure 2. Credit loss provisions by bank size
Number %
1,600 2.5
>$10bn
1,400 Failed
2.0 $1bn to $10bn
1,200 "Problem Institutions"
$100mn to $1bn
1,000 1.5 <$100m
800
600 1.0
400
0.5
200
0 0.0
1980 1987 1994 2001 2008 Mar-00 Mar-03 Mar-06 Mar-09
Source: FDIC: Nomura Global Economics. Note: Insured commercial banks (excludes savings banks)
Source: FDIC, Nomura Global Economics.

Corrective forces The wealth losses alone would exert a potent drag on spending, but even if asset valuations
require household continue to recover, the legacy of the massive debt incurred during the past decade will limit
debt reduction household spending. As real estate prices soared during the early part of this decade,
innovations in housing finance made it ever easier to draw on the rapidly rising equity in their
homes (see Box: Constrained by debt). Consequently, households spent a much larger share of
current income than ever before. At the height of the housing-finance boom and well before the
first leaks in the bubble, the saving rate hit a record low of just 1.4% of disposable income in
2005. The debt incurred during this period has left households too weak to support the sort of
spending rebound that has typically followed past recoveries.
A weak jobs market With the jobless rate forecast to remain above 9% until late in 2011 – an unprecedented stretch
will slow income at such a high level – sluggish growth in wage and salary income are also set to curb spending.
growth The high unemployment rate will also likely remain a source of political angst and stir debate
about the eventual return to a “new normal.” The prospect of another “jobless recovery” seems
likely to spawn debate about whether or not the recession and the de-leveraging that lies ahead
has raised the unemployment rate that defines “full employment” and, if so, how this might affect
monetary policy during the recovery.
The strained financial condition of the household sector is also likely to retard the pace of
Problem debt will recovery in home-building. Though the production cuts of the past year and a modest rebound in
also restrain housing
sales have depleted the inventory of unsold new homes, the record number of unoccupied rental
recovery
property and the threat of rising foreclosures should swell further the inventory of existing homes
for sale. The likely result will be a grudging recovery that will keep housing starts at levels below
those of previous recessions. For instance, housing starts at our forecast Q4 2011 peak are
nearly 13% below the average of all past downturns. Indeed, we do not expect starts to surpass
the lowest level of all past recessions until Q3 2011 (Figure 3).
Subdued inflation but daunting challenges for the Fed

While many seem to believe that inflation pressures develop quickly in a recovery, past
experience proves otherwise. Twelve months into recovery, the 12-month rate of CPI inflation
has been lower than at the business cycle trough by an average of 1.9pp (Figure 4). In the only
exception to that pattern (after the 2001 downturn), core inflation fell by about 0.4pp. With the
unemployment rate likely to remain stubbornly high, indicating persistent excess capacity, it
seems unlikely that these historical tendencies will be violated. Embracing the implications of
excess supply in the early phase of recovery, we expect inflation to continue its cyclical retreat,
with the four-quarter growth in the core CPI continuing its slide from a recession high of 2.4%
(Q1 2008) to a low of 0.9% by mid-2011.
Though understandable, fears that the Fed’s massive balance sheet expansion will inevitably
spawn uncontrollable inflation seem ill-grounded. For that to occur, two conditions would need to
be met. First, the excess reserves (Fed liabilities) associated with the increased Fed assets
would need to be quickly transformed into a rapid expansion of bank credit and into a
transactional – rather than a precautionary – demand for money balances. Second, some
impediment must prevent the translation of that monetary-induced demand from beckoning forth
more goods and services. We see no evidence of such an impediment and we believe the Fed
stands ready to forestall any rapid expansion of bank lending if some barrier prevented an
increase in production in response to a rise in demand supported by greater bank lending.
We do not see the Nonetheless, the Fed faces daunting policy challenges. The FOMC has declared that “low rates
Fed starting to hike of resource utilization” combined with “subdued inflation trends, and stable inflation
until Q1 2011 expectations” justify an “exceptionally low” federal funds rate for an “extended period.” We
expect that period to extend through 2010 and into the first quarter of 2011; only then is the
FOMC likely to begin raising interest rates above current emergency levels. But even though we
see no imminent threat to price stability, fears of inflation lie just under the surface and are likely
to percolate into the markets well before any evidence of inflation pressures emerges. We
believe that the Fed will strive (successfully) to contain those fears by diligently and
transparently implementing the “exit strategy” from quantitative easing that it has been carefully
outlining in recent months (see Box: The Fed’s balance sheet). To succeed, however, the Fed
must navigate a perilous path between nervous markets on one side and a vengeful political
establishment increasingly suspicious of it on the other. We note only that the conduct of
monetary policy is an art and that beauty is always in the eye of the beholder.

Constrained by debt David Resler

The heavy burden of debt, a legacy of the housing boom, will likely limit consumer spending.
Decades of excessive borrowing have left the household sector with an onerous debt burden that must be reduced. The
need to reduce that debt – and to restore a level of savings that provides the foundation for lifetime wealth accumulation
– should restrain spending growth even as employment and incomes begin to rise again.
Since the mid-1980s, household debt has consistently grown faster than disposable income. From a decades-long range
of 0.6 to 0.7 times prior to 1980, the ratio of household debt to disposable income (DYR) rose steadily and, by mid-2001,
exceeded unity for the first time (Figure 1). With innovations in mortgage and other consumer-debt financing making
access to debt more convenient and readily available than ever before, household debt grew rapidly, pushing the ratio to
a record 1.36 times in Q4 2007. In contrast to previous recessions when this ratio has risen slightly, throughout this
recent downturn it has fallen sharply. With consumer debt (including mortgages) down about 3.2% from its Q3 2008 peak
and disposable income up about 1.4% over the same period, the DYR fell to a four-year low in Q3 2009. To reduce the
debt-to-income ratio to unity – a value first breached less than eight years ago – by the end of 2011, household debt
would need to contract at nearly twice the rate that disposable income grows.
The burden of household debt has paralleled the rise in overall debt. The household debt-service ratio (DSR) compares
the principal repayments and interest payments required on currently outstanding mortgage and consumer debt to
disposable personal income. As shown in Figure 2 (in percentage terms), the DSR peaked in Q4 2007 and has retreated
slightly since then, reflecting the contraction of household credit outstanding as well as the decline in interest rates since
the recession began. At its most recent (Q2 2009) reading of 13.1%, the DSR remains well above its 30-year average of
12.1%, primarily the result of the high level of mortgage debt. However, as a result of the sharp drop in interest rates and
the consumer credit contraction, the share of disposable income devoted to interest payments on non-mortgage debt fell
below 2% for the first time in 30 years in the second quarter of 2009 and is continuing to decline, albeit at a slower rate.
The secular downtrend in interest rates on consumer and mortgage debt has partly mitigated the impact of growing
indebtedness on household finances. Consequently, the ratio of debt service costs to household debt, which serves as a
proxy for average overall household borrowing costs, has declined to a new historical low (also shown in Figure 2). With
lending rates on new debt, including refinanced mortgages, generally lower than the rates on existing debt, average
borrowing costs are likely to continue their long-running downtrend, but unless households further reduce their overall
indebtedness, debt servicing payments should continue to absorb a relatively high share of disposable income.
While caution and risk aversion underpin much of this debt contraction, foreclosures or forced debt restructuring under
bankruptcy proceedings should also play a role. Debt write-downs by lenders are at record levels and look likely to
increase further. For instance, the delinquency rate on consumer (non-mortgage) loans at US commercial banks reached
a record 4.0% in Q2 2009 while the delinquency rate on residential real estate loans has risen from 7% in Q3 2008 to
9.6% in Q3 2009. With a record 4.5% of all mortgages currently in foreclosure proceedings, further increases seem all
but certain.
Whether voluntary or forced, the imperative to reduce debt should remain a significant constraint on aggregate spending
for a long time. We believe this pattern of debt reduction reflects an important legacy of the financial crisis – a marked
increase in risk aversion – that will continue for the foreseeable future.
Figure 1. Ratio of household debt to annual income Figure 2. The household debt burden
Ratio Ratio
Ratio
1.4 14 18
1.3
13 16
1.2
1.1
12 14
1.0
0.9
11 12
0.8
0.7 10 10
Mar-80 Feb-85 Jan-90 Dec-94 Nov-99 Oct-04
0.6
Debt service/income (lhs) Debt service/debt (rhs)
Mar-80 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05
Source: Federal Reserve; BEA; Nomura Global Economics. Note: Debt service/debt ratio calculated by dividing DSR by DYR.
Source: Federal Reserve; BEA; Nomura Global Economics.

The Fed’s balance sheet Zach Pandl

The Fed’s balance sheet will continue to evolve in 2010 but we think a complete exit from credit easing remains far off.
In an effort to stem the financial crisis, the Federal Reserve augmented its interest rate cuts over the past two years with
aggressive use of its balance sheet – a policy Chairman Bernanke termed “credit easing”. The Fed purchased securities
outright in order to raise prices and lower interest rates (particularly mortgage rates) and created targeted lending
programs to ease the strains in distressed markets. These efforts made monetary policy looser than it would have been
otherwise, and as the economy recovers, the Fed will need to decide how and when to withdraw this additional stimulus.
Although the composition of the Fed’s balance sheet will change in 2010, we expect its overall size to remain very large
at around $2.5trn, and for the stimulus to the economy from credit easing to remain largely in place. We expect the Fed
to shrink its balance sheet in earnest only in 2011 and beyond, well after it has begun raising interest rates.
Over the near term, the Fed’s assets are likely to continue to grow as it completes its mortgage-related buying programs
(Figure 1). To date, the Fed has purchased $156bn in agency debt and $1,071bn in agency MBS. It plans to purchase a
total of $175bn and $1,250bn respectively by the end of Q1 2010. It is difficult to overstate the significance of these
programs. If the Fed concludes its purchases as scheduled, its holdings of agency MBS alone will be 60% greater than
the total size of its balance sheet before September 2008. Once it reaches the purchase targets, we expect the Fed’s
security portfolios to be little changed throughout 2010, although it may reintroduce MBS purchases if growth disappoints.
After 2010, the Fed’s holdings will gradually mature or pre-pay and it may even choose to sell assets at some point.
We expect borrowing through the Fed’s short-term liquidity programs – the other major component of its assets – to
continue to decline. However, this should primarily be a demand-driven phenomenon, not a concerted policy tightening.
The lending programs are designed in such a way as to make them unattractive in a normal market environment. As
market conditions have healed over the last year, for example, borrowing has fallen from about $1.5trn to just $136bn.
With limited borrowing, the Fed is likely to begin winding down many of its emergency facilities. Lending through the
programs authorized by section 13(3) of the Federal Reserve Act is already quite low, and we expect these facilities to
close as scheduled on 1 February 2010. Section 13(3) requires that the Fed demonstrate “unusual and exigent
circumstances” before lending to non-standard counterparties, so as long as money market conditions remain normal it
will be difficult for the Fed to continue making this claim. We look for the Term Auction Facility (TAF) to remain in place
but for its use to gradually decline. The Term ABS Loan Facility (TALF) should remain open through Q2 2010, but it is
unlikely to grow to as a large a scale as originally envisioned (for more, see “The Fed’s bulging balance sheet”, Global
Weekly Economic Monitor, 30 October 2009).
The Fed is also likely to change the composition of its liabilities in 2010, but from the perspective of the broader economy
we judge this is not particularly important (Figure 2). The Fed’s authority to pay interest on reserves allows it to influence
short-term interest rates even if reserves remain well above minimum required levels. Hiking interest rates while excess
reserves remain high would be unusual, but other central banks (e.g., in Norway and New Zealand) have operated under
this type of system for some time. Changing the composition of the Fed’s liabilities is also unlikely to constrain credit
creation. Instead of holding overnight deposits with the Fed, banks will own repurchase agreements (repos), Treasury
Supplementary Financing Program (SFP) bills, and/or term deposits. Substituting one short-term, low-yielding, risk-free
asset on banks’ balance sheets for another should not make banks any less willing to lend, or customers less willing to
borrow. The Fed’s reserve draining operation could help control the spread between the fed funds rate and the excess
reserves rate, but would accomplish little more, in our view.
Figure 1. The Federal Reserve’s assets Figure 2. The Federal Reserve’s liabilities
$bn $bn
2,750 Forecast 2,750 Forecast
All other All other
2,500 2,500
assets liabilities
2,250 2,250
2,000 2,000 Treasury
deposits Term
1,750 Liquidity programs, 1,750 deposits
1,500 TALF and
emergency aid
Agency debt 1,500
and MBS Overnight bank
1,250 1,250 deposits
1,000 1,000
750 750
500 500 Reverse repos
Treasuries Notes in circulation
250 250
0 0
Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
Source: Federal Reserve, Nomura Global Economics. Source: Federal Reserve, Nomura Global Economics.

United States ⏐ Economic Outlook David Resler ⏐ Zach Pandl ⏐ Aichi Amemiya
Strong finish to 2009, but cooler growth ahead

The US economy is ending 2009 on an upbeat, but persistent debt woes in the household and
finance sectors are likely to prevent further acceleration.
Activity: A revival of consumer spending, a rebound in residential investment, and a slower

drawdown of inventories lifted the economy out of recession in Q3 2009. Although the revised
2.8% growth was slightly less than first estimated, subsequent developments suggest the overall
pace of growth will accelerate in Q4 before moderating to a sustainable pace averaging about
2.8% in 2010. Key to this more confident outlook has been the improvement in the job market.
Payrolls have not risen in two years, but staffing cutbacks have subsided and more firms have
resumed hiring. We expect continuing improvement – and finally, gains in employment – to form
the foundation of a sustained expansion. In the first few months of the year, hiring of upwards of
1 1/4 million workers for the 2010 Decennial Census is likely obscure the sustainable recovery of
permanent jobs. While the economy is no longer contracting overall, activity, especially in such
key sectors as housing and autos, is likely to remain far below the levels that have been
customary for the past two decades. Consequently, the unemployment rate looks likely to
remain well above 9% in the year ahead, not falling below this until Q3 2011.
Inflation: The excess productive capacity evident in the stubbornly high jobless rate is likely to
exert persistent downward pressure on wages and prices. Under conditions of persistent excess
capacity, the massive expansion of the Fed’s balance sheet poses little imminent inflation threat.
Consequently, we expect core inflation to continue its cyclical slide, reaching 1% by the end of
2010 and edging still lower during 2011
Policy: We believe the Fed will maintain an “exceptionally low” set of interest rate targets into
early 2011. With financial market conditions improving steadily, we believe the Fed will not need
to undertake any further expansion of its credit easing programs and will be able to manage an
orderly exit strategy as conditions warrant. Proponents of further fiscal stimulus face a difficult
challenge of persuading those fearful of the long-run implications of large budget deficits. The
evolution of labor market conditions in the early months of 2010 could prove decisive in the
debate over fiscal policy.
Risks: Rising unemployment could undermine the expected recovery in housing and consumer
spending. Additionally, if long-run inflation expectations shift downward or potential output
proves resilient, a deflation problem more serious than we currently expect could develop.
Details of the forecast

% 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP 2.8 3.5 2.9 2.6 2.8 2.7 2.4 2.4 -2.5 2.7 2.6
Personal consumption 2.9 2.3 2.7 2.4 2.1 2.1 1.4 2.2 -0.5 2.3 2.1
Non residential fixed invest -4.1 -6.1 -5.0 -3.1 0.7 3.2 5.0 5.3 -18.1 -3.9 4.1
Residential fixed invest 19.5 13.6 12.5 17.7 15.2 9.3 8.7 8.4 -20.0 12.0 10.7
Government expenditure 3.1 0.1 0.1 0.8 0.2 0.3 -0.4 -0.6 2.0 1.0 -0.2
Exports 17.0 17.0 7.8 6.1 8.7 9.1 8.1 6.2 -10.0 9.6 7.2
Imports 20.8 14.5 4.8 5.2 6.9 5.0 4.1 4.6 -14.0 7.4 5.1
Contributions to GDP:
Domestic final sales 2.8 1.4 1.8 2.0 2.0 2.1 1.6 2.2 -2.8 1.8 2.1
Inventories 0.8 2.2 0.9 0.6 0.8 0.3 0.4 0.2 -0.7 0.9 0.3
Net trade -0.8 -0.1 0.2 -0.1 0.0 0.3 0.4 0.1 1.0 0.0 0.1
Unemployment rate 9.6 10.1 10.1 9.9 9.6 9.3 9.2 9.0 9.3 9.7 8.8
Non-farm payrolls, 000 -199 -57 163 286 -5 250 250 250 -344 174 238
Housing starts, 000 saar 589 585 642 722 763 794 833 863 561 730 900
Consumer prices -1.6 1.5 2.5 2.3 1.6 1.0 0.9 1.0 -0.3 1.9 1.0
Core CPI 1.5 1.8 1.6 1.3 1.2 1.0 1.0 0.9 1.7 1.3 0.9
Federal deficit (% GDP) -10.0 -9.5 -7.3
Current account deficit (% GDP) -3.1 -3.4 -3.4
Fed funds 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0-0.25 0.50 0.75 0-0.25 0-0.25 1.00
3-month LIBOR 0.29 0.25 0.25 0.25 0.30 0.45 0.70 0.90 0.25 0.45 1.20
TSY 2-year note 0.95 0.80 0.95 1.10 1.20 1.40 1.70 1.80 0.80 1.40 2.10
TSY 5-year note 2.31 2.25 2.40 2.50 2.60 2.80 2.95 3.05 2.25 2.80 3.25
TSY 10-year note 3.31 3.50 3.55 3.60 3.65 3.80 3.95 4.00 3.50 3.80 4.10
30-year mortgage 5.04 4.95 5.00 5.05 5.05 5.20 5.35 5.40 4.95 5.20 5.50
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates (saar). Unemployment rate is a quarterly
average as a percentage of the labor force. Nonfarm payrolls are average monthly change during the period. Inflation measures and
calendar year GDP are year-over-year percent changes. Interest rate forecasts are end of period. Housing starts are period averages.
Numbers in bold are actual values, others forecast. Forecasts reflect data as of 16 December.

Euro area ⏐ Outlook 2010 Laurent Bilke ⏐ Maxime Alimi
Headwinds
The headwinds that we expected to sow the seeds of a very sluggish recovery have proven less
forceful than anticipated – but the recovery will still be a long haul through 2010.
We paint a fairly balanced picture of the euro-area economy in 2010. Among the developed
economies, the euro area as a whole is not where the deleveraging burden will be the strongest,
and a soft recovery seems already underway. But a strong euro and the beginning of a
tightening of monetary conditions will prevent the economy from reaching cruising speed by the
end of 2011. Still, we revise up our GDP growth forecasts to -3.9% in 2009, to 1.1% in 2010 and
to 1.7% in 2011 (from -4.0%, 1.0% and 1.3%, respectively; Figure 1).
Positive momentum
The euro area officially pulled out of recession in Q3 2009, with GDP expanding by 0.4% q-o-q
(non-annualised). Since our last forecasts (see Long convalescence, 10 July 2009), surprises
have been to the upside. Short-term effects have pushed activity above trend and a slowdown is
likely in the coming quarters, but we see no reason to expect a relapse. In particular, automatic
stabilisers, which account for most of the fiscal response in the region, do not add volatility in the
same way that discretionary interventions would.
The economy is still The euro area is well positioned to benefit from recovering emerging economies and this will
driven by exports play an important role in jumpstarting the economy, despite the strength of the euro (Figure 2).
While the strong rebound in foreign demand in Q3 2009 was probably due to trade disruptions in
the first half, the euro area remains geared to benefit from a pick-up in infrastructure-led
investment, especially in Asia. According to Bundesbank data, the share of German exports to
Asia has risen from 10% in 1999 to 14% in 2009. Looking ahead, we expect the trade surplus to
continue expanding in the short term and net trade to add 0.8pp to GDP growth in 2010.
Hours worked, rather On the domestic side, recent labour market developments have clearly been better than
than the number of anticipated, largely because of proactive government measures (see Box: Good work). A larger-
jobs, have fallen than-usual share of the burden of the adjustment in the workforce has relied on hours worked
rather than headcount. Moreover, the rise between the low-point in March 2008 (7.2%) and the
latest print (9.8% in October 2009) is sizable, but reflects mostly events in Spain; labour markets
in the other economies have held up remarkably well (Figure 3). These revisions in employment
as well as the general improvement in economic conditions lead us to revise our forecast for the
unemployment rate drastically: we believe the unemployment rate is now topping out, peaking at
10.1% in H1 2010, before a very gradual decline to 9.4% by the end of our forecast horizon.
More balanced investment

A specific reason to be more positive (or more precisely, less negative) on the investment
outlook is credit conditions. We previously were negative on investment growth due to concerns
that credit supply might be restricted. Our baseline scenario also incorporated a spread on bank
interest rates. A few months on, it is difficult to find any compelling evidence of the
materialisation of either. By most measures, the credit slowdown did not seem to go beyond a
Figure 1. Main forecast changes Figure 2. Foreign demand
% July December % y-o-y
2009 2010 2011 2009 2010 2011
15
Real GDP growth -4.5 0.6 1.3 -3.9 1.1 1.7 10

HICP inflation 0.4 1.1 1.5 0.3 1.2 1.5
5
Unemployment rate 10.4 11.4 11.6 9.4 10.0 9.6
ECB policy rate 1.00 1.25 1.75 1.00 1.25 2.25 0
10-y Bund yield 3.10 3.50 3.75 3.20 3.60 3.80
Fiscal balance -5.9 -6.9 -5.9 -6.4 -6.9 -6.4 -5
Annual averages, except unemployment rate and interest rates -10 July
which are end of period. Unemployment rate is % labour force December
-15
and fiscal balance is % of GDP.
-20
1Q06 4Q06 3Q07 2Q08 1Q09 4Q09 3Q10 2Q11
Source: Eurostat, ECB, Bloomberg, Nomura Global Economics. Source: Nomura Global Economics.

Good work Laurent Bilke ⏐ Maxime Alimi

European governments have reacted swiftly to the global downturn by adopting measures that have helped damp the
rise in unemployment. We have therefore revised our labour market outlook significantly.
Recent labour market developments have been clearly better than anticipated. Back in July, we were expecting the
unemployment rate for the euro area as a whole to rise from 8.7% in Q1 2009 to 10.4% in Q4 2009 and to peak at 11.6%
in mid-2011. But the outcome has been much better than we expected, with unemployment at 9.8% in October. Apart
from Spain, labour markets in the largest economies have held up remarkably well.
Cutting hours, not headcount

Some might argue that the adjustment has just been postponed, that further deterioration of the labour market lies ahead.
But we see good reason for the resilience of the labour market: policies. Proactive government measures, exemplified by
Germany’s short-shift scheme, have helped avert a sharp rise in layoffs. The German scheme has allowed firms to keep
workers in employment on reduced hours (700,000 workers were participating in the scheme at the peak, in February
2009, according to the German labour agency), curbing the rise of outright unemployment. Italy has taken a similar
approach: the “Wage Supplemental Fund” (CIG), a government scheme that compensates workers for part of the loss of
income stemming from reduced hours, has been extended to additional categories of workers.
In France, too, employment policies have been key to capping the rise in unemployment. One scheme provides
subsidies to firms to allow them to make temporary cuts in working hours without major income losses on employees
(90% of net compensation is maintained). About 157,000 people benefited from the scheme in Q1 2009, rising to
320,000 people in Q2. Labour costs have been targeted as well: all new hiring (or extension of temporary work) by small
firms has been largely exempted from social security contributions – with full-exemption at the minimum wage level. The
measure has benefited more than 600,000 people and is scheduled to remain in place until June 2010. A number of
other schemes have also been deployed, including support for job reconversion or business creation.
Conversely, Spain has registered very heavy job destruction since early 2008, boosting the unemployment rate to close
to 20% (Figure 1). This stems from the collapse of labour-intensive sectors such as construction, where most workers
were employed on a temporary basis and their contracts not renewed. The reallocation of these workers towards growing
sectors will likely be a slow process.
So, the smaller-than-expected rise in the unemployment rate does not mean that labour adjustment has not occurred.
Rather, it has occurred in a different way: less through a reduction of headcount (layoffs) and more through a reduction
of hours (short shifts). This is confirmed by Eurostat data on average weekly hours worked (Figure 2).
This is probably a better balance for the economy as less work is better for confidence than no work at all. We see this
extraordinary policy reaction as the main reason why the rise in unemployment has been relatively contained in the euro
area and looks likely to remain so. We would expect the reversal of these schemes to be very gradual, if at all, and we
acknowledge that our negative view on labour market developments a few months ago may not have been entirely
warranted. Adding this factor to the general improvement in economic conditions leads us to revise significantly our
forecast for unemployment: we now expect the rate to peak at 10.1% in the first half of 2010, followed by a very gradual
decline to 9.4% by the end of our forecast horizon.
Figure 1. Unemployment in the euro area Figure 2. Average weekly hours worked
Contribution to % change y-o-y Hours / week

30 38.5
Other
25
Spain
20 38.0
Italy
15
France 37.5
10
Germany
5
37.0
0
-5 36.5
-10
-15 36.0
Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09 2Q99 1Q01 4Q02 3Q04 2Q06 1Q08
Source: Eurostat and Nomura Global Economics. Source: Eurostat and Nomura Global Economics.

normal, albeit severe, cyclical downturn. A very detailed survey conducted by the ECB in
September 2009 on the access to financing provided some interesting evidence previously
missing from the picture (Figure 4). Risk premia on bank loan interest rates (or margins) have
also come in much lower than we previously anticipated.
Investment growth is That said, we are not yet ready to declare the corporate sector all-clear. There are balance-
likely to stay muted sheet adjustments to be made by non-financials in some countries, notably France and Spain
(see “Europe Inc: Protracted belt-tightening” in Long convalescence, 10 July 2009). The
persistence of spare capacity in the productive sector will not accelerate the recovery either.
Overall, we forecast investment growth to recover only slowly, declining by 1.3% in 2010 and
growing again by 1.5% in 2011.
Euro problem
Exports have been the motor of the euro-area economy in recent years, making the current
recovery crucially dependent on foreign demand. Since 2003, wage moderation has contained
private consumption but improved competitiveness and fuelled export performance, positively
looping back on investment and employment. We see no real reason for more domestically
driven momentum today and we expect exports, not consumption, to kick-start the economy. For
this reason, the current euro appreciation comes at an inopportune time: just as foreign demand
is needed to help put the economy on a proper recovery path.
The euro is a Our FX strategy team forecasts the euro to stay at its current elevated level in trade-weighted
powerful negative terms for another year, as its appreciation against the US dollar (which would reach 1.60 in Q4
drag 2010) would offset any depreciation against other currencies (see Box: Euro strength may
prolong euro-area weakness). The currency effect is likely to take its toll on economic activity in
both 2010 and 2011, given the usual transmission lags. It is reinforced by the other lag between
import and export growth in an externally driven recovery, as exports rise first and imports catch
up later when domestic demand improves. Hence the contribution of net trade to growth is
significantly reduced in our model in 2011.
Muted inflation in 2010

We see inflationary The inflation outlook is likely to remain benign for most of 2010, especially on the assumption
pressures emerging that the oil price would stay stable at the current level until the end of our forecast horizon. We
only in 2011 do not expect external inflationary pressures to contribute positively to inflation before the start
of EUR depreciation, in early 2011. On domestic inflationary pressures, the process by which a
weak economy translates into low inflation is a very protracted one. Hence, we forecast core
inflation (excluding food, energy, alcohol and tobacco) to bottom only late in 2010 and start to
accelerate only very gradually in 2011 as wage pressures and margins improve. As such, we
see core inflation decelerating further from 1.4% in 2009 to 1.1% in 2010 and accelerating
modestly to 1.2% in 2011. In our forecasts, headline inflation reaches 0.3% in 2009, 1.2% in
2010 and 1.5% in 2011 (Figure 5).
Undeclared monetary policy tightening...

At a time when most central banks are gradually becoming more concrete about their exit
strategies, the ECB stands out as the central bank that has started to withdraw some of its
Figure 3. Unemployment rate forecasts Figure 4. Limited mismatch between loan demand and supply
Euro area Euro area Germany France Italy Spain %, obtained loan
July December
2008 7.6 7.6 7.8 7.4 6.8 11.4 50 IT

GE
2009 10.4 9.4 8.3 9.2 7.6 18.3 SP
40 Oth.
2010 11.4 10.0 8.9 9.8 8.4 20.0 GE IT

30 SP
2011 11.6 9.6 8.5 9.4 8.0 19.3 FR
20
% of labour force, annual average
FR %, needed loan
10
10 20 30 40 50
Source: Eurostat, ILO, Nomura Global Economics. Note: Diamonds signify large firms; circles signify SMEs.
Source: ECB, Nomura Global Economics.

Euro strength may prolong euro-area weakness Maxime Alimi
With the euro appreciating and looking set to stay high throughout our forecast horizon, we expect a negative currency
impact on euro-area activity and prices in 2010 and 2011.
For an economy heavily reliant on exports to foster GDP growth, significant currency appreciation can seriously threaten
economic prospects, particularly in a fragile recovery phase. The euro has appreciated for several reasons over the past
few months (see Nomura FX Outlook 2010, Beyond peak performance) and we expect this strength to persist into 2010,
affecting activity through trade, prices through imports and, possibly, monetary policy.
From an economic point of view, what matters most is the effective, or trade-weighted, exchange rate of a currency,
rather than any individual bilateral rate. On this measure, the euro had appreciated by 8.6% y-o-y in November against a
basket of its 21 main trading partners’ currencies, reaching its highest level since the ECB series started in 1993.
Nomura FX strategists expect this trend to fade in 2010, but the euro should remain high throughout 2010 before
experiencing a gradual correction in 2011 (Figure 1). This would still leave the euro significantly above most structural
fair value measures until the end of our forecast horizon. When compared with our July forecast, the revision represents
a 10% appreciation in December 2010 and 3% as of Q4 2011.
In our Nomura Euro-area Economic Model (NEEM) model for the euro area, FX assumptions are exogenous and taken
into account through various channels: (i) on the activity side, a strong euro curbs exports and fosters imports as prices
do not adjust immediately; (ii) on the prices side, the currency affects import and export prices, including commodity
prices. Consequently, our new profile for the euro has a clear negative impact on both activity and inflation: Figure 2
shows the FX contribution to the revisions we make to GDP and inflation in the euro area compared to our July European
Economic Outlook. Given lags in the transmission of currency moves to prices, the impact that we expect in our inflation
forecast should be felt both in 2010 and 2011, despite the contemporaneous cooling of the euro.
For the growth outlook, euro strength dampens our baseline scenario of a largely export-led recovery: the model predicts
a 1.5pp negative impact from the currency on real exports in 2010, crucially looping back on investment and employment.
The net trade contribution to GDP is reduced from 1.2pp to 0.9pp in 2010. On the prices side, the euro appreciation is
slower but has even more of an impact on our forecast, trimming 0.2pp and 0.8pp from 2010 and 2011 inflation. This
magnitude is explained not only by the import prices channel, but also by our model’s assumption that second-round
effects allow wages to adjust to inflation shocks over two quarters – a somewhat extreme assumption that keeps the
model stable in the longer run. Because of exchange rate developments and very gradual rises in commodity prices (be
they for energy, food or metals), external price pressures remain limited in our forecast (import prices drop 5.2% in 2010
and rise 1.2% in 2011).
Exchange rate developments could also result in heightened divergences within the region, already driven by contrasting
economic outlooks. Because of differences in trade specialisation, competitiveness and mark-up flexibility, countries like
Germany could be less affected than others (e.g., Spain and Greece) that rely on price more than product
competitiveness. For instance, capital goods, which are less sensitive to currency developments, account for 28% of
German exports, but only 17% for Portugal, 14% for Spain and 11% for Greece. Against this backdrop, the euro burden
is unlikely to be shared equally.
Figure 1. Trade-weighted euro against 21 trading partners Figure 2. FX contribution to GDP and inflation revisions
Index 0.0
Baseline
120 -0.1
July forecast
-0.2
110 -0.3
-0.4
100 -0.5
-0.6
2010
90 -0.7
2011
-0.8
80 -0.9
Jan-93 Mar-96 May-99 Jul-02 Sep-05 Nov-08 pp GDP growth Inflation
Note: Lower is weaker. Source: Nomura Global Economics.

Source: ECB and Nomura FX Strategy.

exceptional support. We see a good chance that it will complete this process before the end of
2010. Albeit gradual, the removal of these measures (see Box: Liquidity withdrawal roadmap)
should have two sizeable effects: it will cause short-term interest rates to rise and it will tighten
European banks’ financing conditions. Indeed, the ECB’s liquidity policy has had two major,
largely inseparable consequences. First, it was the equivalent of about 75bp of rate cuts on the
overnight rate. Owing to the ECB’s liquidity provision policy, all money-market rates tended to
settle lower than they would normally have done relative to the ECB main refinancing rate. But it
is on the short end (overnight) that the strongest effect was felt. The second effect has been to
secure banks’ funding, as the ECB provided ample liquidity at unusually long maturities. While
the first effect was remarkable, it was actually just a by-product of the central bank’s intention to
secure banks’ funding, thereby contributing to financial stability at a time of extreme tension.
The normalization of The ECB now sees drawbacks in maintaining its generous liquidity provisions. There is a
ECB operations presumption that, if maintained for too long, these conditions would prevent some banks from
means higher rates doing what is required – writing-off losses, raising new capital and conducting the necessary
restructuring that the change in their business models should dictate. Therefore it ought to be
expected that the ECB normalizes the conditions under which it provides liquidity, even though
this is the (partial) equivalent of a rate hike. Such normalization is likely to be completed, in our
opinion, around the end of Q3 2010: in September 2010 the overnight rate would be above the
ECB main rate (1%), settling in somewhere between 1.05% and 1.15%.
We account for most of the interest rate effect on the economy as short-term interest rates move
up around mid-2010, causing banks’ interest rates to rise. Some of the tightening will likely come
by euro strength as well. The effect on banks financing conditions is more difficult to capture. We
have assumed little effect, presuming that the removal of ECB support will cause difficulties for
only minor, non-systemic banks – actors that would not have contributed to a peak in credit
anyway. But this is still a source of downside risk to our baseline.
... and declared tightening

We bring forward the Given the effect on money-market rates, such an unheralded tightening would leave only little
first rate hike from room for an announced tightening. But the ECB likes to keep liquidity policy separate from
December 2010 to monetary policy, viewing the two areas as distinct; a debatable stance, but we accept it as a
October given for our forecasting purposes. Thus, in the face of persistent rhetoric, the general
improvement in economic conditions and the ECB’s commitment to perform a timely exit, we
bring forward our expected date for the first rate hike from December 2010 to October 2010. We
do expect rising inflationary pressure toward the end of our forecast horizon as headline inflation
reaches 1.9% y-o-y in December 2011.
Interest rates can We have previously highlighted that an easing in the cost of financing would be an important
only go up force driving the economy out of recession. The assessment is straightforward this time around:
interest rates can only go up from here and the ECB is likely to make this a real prospect. Taking
into account exchange rates and interest rate developments, monetary conditions eased
continuously through 2009, despite the appreciation of the euro (Figure 6). Looking at 2010 and
2011, monetary conditions are likely to contribute negatively to growth in Europe.
Figure 5. Inflation forecast Figure 6. Monetary condition index
% y-o-y Index Exchange rate

5.0 Headline 160 Tighter
Corporate bond spreads
Core
Bank interest rates
4.0
120
3.0
2.0 80
1.0
40
0.0
-1.0 0
Jan-06 Dec-06 Nov-07 Oct-08 Sep-09 Aug-10 Jul-11 Dec-96 Jul-99 Feb-02 Sep-04 Apr-07 Nov-09
Source: Eurostat and Nomura Global Economics. Source: Nomura Global Economics.

Liquidity withdrawal roadmap Laurent Bilke

The ECB’s unwinding of liquidity support is set to have large effects on interest rates, even before the first main rate hike.
In the euro area, unconventional monetary policy has taken a very specific form and, we would argue, with some
success (in spite of a late start). The central bank has exploited a specific aspect of credit provision in Europe: it is
predominantly done by banks, rather than by capital markets, and off its own balance sheet structure; it mainly makes
loans to banks rather than purchases securities. The exceptional measures deployed by the ECB during the crisis have
targeted banks and relied on: 1) the provision of ample liquidity (through lending) in order to fully satisfy banks’
extraordinary demand (“full allotment”); 2) at longer maturities than usual (up to one year, as opposed to 3 months before
the crisis); and 3) against a wider range of collateral.
These policies have helped banks secure funding. But they also have had some sizeable effects on money-market
interest rates. The “full allotment” policy implied that the overnight market rate was actually pushed down towards the
level at which the ECB takes back liquidity, which is the deposit rate (0.25% as of December 2009), while longer term
money-market rates were anchored at the main rate (1%).
The ECB started the unwinding in December 2009 and will implement it in several steps, most likely finishing by the end
of 2010. As of December 2009, the ECB is committed to keeping the full allotment policy until at least mid-April 2010; to
lower, or stop altogether, the number of liquidity provision operations at the longest maturities (6 and 12 months); and to
conserve an extended collateral base until the end of 2010. We see this as preparatory work ahead of policy unwinding,
which is likely to be implemented in three steps:
In Q1 2010, liquidity conditions will be comparable to those prevailing at the end of 2009. Hence, the spread
between the overnight rate and the ECB main rate is likely to persist, while there is some possibility that the
Euribor 12M starts to de-anchor from the ECB rate (also incorporating some rate hike expectations);
In Q2 2010, we assume that the ECB will stop the 6M operations and reduce the 3M ones, but carry on with full
allotment at the 1-week maturity. As long as the last element is in place, the overnight rate should be
comfortably below the main rate, but the longer end would more clearly de-anchor.
From Q3 2010 on, excess liquidity would be gradually removed. As a result, the overnight rate would move
above the main rate, which presumably would still be 1% at that time.
There are two risks associated with this scenario. The first is that stage three starts earlier, in Q2 2010. One indicator
which is going to be decisive in that respect is the Libor-OIS spread: a return to pre-crisis levels (not our baseline) by
mid-2010 would likely trigger more forceful action. The second source of risk stems from uncertainty regarding the
transmission channel. There has not been a linear relationship between excess liquidity and the EONIA-ECB rate spread
under this regime in 2009 (Figure 1). We assume that the spread could be maintained as long as the ECB carries on with
the full allotment policy at 1-week operations, but a level shift as excess liquidity diminishes below a certain,
unpredictable, level cannot be ruled out. So the increase in the overnight rate may not be as smooth as we forecast.
All in all, we assume than the overnight will start a long and gradual march up, from Q2 2010 onwards (Figure 2),
reaching 1.30% by end-2010, up from 0.35% a year earlier. By the end of 2011, outright monetary policy would be
dominant, bringing the overnight rate up by another 100bp higher, to about 2.30%.
Figure 1. Excess liquidity and spread to main rate Figure 2. Interest rates forecasts
€ bn bp %
300 20 3.00
250 0 2.50
200 -20 2.00

150 -40
1.50
100 -60
1.00
50 -80
0.50
0 -100
02/01/09 02/04/09 02/07/09 02/10/09 0.00
Excess liquidity (lhs) 3Q09 1Q10 3Q10 1Q11 3Q11
EONIA- ECB main rate spread (rhs) ECB main rate EONIA 3mth Libor
Source: ECB, Bloomberg and Nomura Global Economics. Source: ECB, Bloomberg and Nomura Global Economics

Euro area ⏐ Economic Outlook Laurent Bilke ⏐ Maxime Alimi
Constrained recovery
We expect a constrained recovery in 2010, with modest growth driven mostly by external
demand. Nevertheless, and despite muted inflation, the ECB looks set to start tightening.
Activity: The recession ended in Q3 2009 and we are looking for positive, albeit modest, growth
in Q4 and throughout 2010. We expect a slowdown in the first quarter because of the payback of
expiring car-scrappage programmes in various countries and fading catch-up boosts. Trend
growth should settle at sub-potential levels as fixed investment remains weak, consumers
cautious and as governments rein in fiscal stimuli. Exports, set to remain the first motor of the
economy, may be impaired by a strong euro. An important theme for 2010 is divergence in the
region, as already illustrated in sovereign debt markets. While Germany may outperform, we
expect several countries, including Spain, to register falls in GDP for the whole year.
Inflation: Headline inflation is likely to remain subdued in 2010. Externally, we expect no
substantial commodity price inflation and a strong euro will push down import prices.
Domestically, limited room for mark-ups, still-large spare capacity in the manufacturing sector
and high unemployment should keep wages and inflation in check. We forecast HICP to average
1.2% in 2010 and core inflation to remain below that, at 1.1%.
Policy: On the monetary policy side, the ECB is initiating a withdrawal of its liquidity support,
which is a form of monetary policy tightening, though the central bank does not present it that
way. The exceptional provision of liquidity had sizeable effects on money-market interest rates.
Hence, when the ECB embarked on a withdrawal of liquidity support in December 2009, in a
slightly more aggressive way than expected, it did initiate a tightening. We expect the bulk of the
upside effect on money-market rates to appear in Q3 2010, though, and the first hike in the main
policy rate could take place in October 2010, on our forecasts. On the fiscal side, the withdrawal
of support is set to be smoother and slower than in the case of monetary policy because of the
significant role played by automatic stabilisers.
Risks: Risks look balanced: to the upside, inventory rebuilding and a lower euro than we
assume could boost activity further next year; to the downside, a larger-than-expected
commodity price recovery and further damage to the banking system are the main risks
(possibly in relation to a too prompt removal of the central bank liquidity facility).

% 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP 1.5 1.5 0.7 1.4 1.4 1.4 1.7 1.9 -3.9 1.1 1.7
Household consumption -0.9 0.0 -1.0 0.9 1.2 1.3 1.3 1.2 -1.0 0.0 1.2
Fixed investment -1.5 -1.5 -2.1 -0.2 0.7 1.3 1.8 2.0 -10.0 -1.3 1.5
Government consumption 2.1 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.4 2.1 2.0
Exports of goods and services 12.2 10.8 5.0 4.5 3.1 3.1 5.2 6.1 -13.4 5.8 4.9
Imports of goods and services 10.8 9.1 0.9 3.6 3.8 3.9 4.4 4.9 -11.2 3.8 4.3
Domestic final sales -0.4 0.1 -0.6 0.9 1.2 1.4 1.5 1.5 -2.2 0.3 1.4
Inventories 1.3 0.6 -0.4 0.1 0.4 0.3 -0.2 -0.1 -0.6 0.0 0.0
Net trade 0.6 0.7 1.7 0.4 -0.2 -0.3 0.4 0.6 -1.1 0.8 0.3
Compensation per employee -0.3 0.0 0.4 0.3 0.5 0.6 0.6 0.7 1.1 0.5 0.7
Labour productivity 0.8 0.7 0.4 0.5 0.4 0.4 0.4 0.5 -1.3 0.4 0.5
Unit labour costs -1.1 -0.7 0.0 -0.1 0.1 0.2 0.2 0.2 2.4 0.0 0.3
Fiscal deficit (% GDP) -6.4 -6.9 -6.4
Current account deficit (% GDP) -0.6 -0.2 0.0
Consumer prices -0.4 0.5 1.2 1.1 1.2 1.1 1.2 1.3 0.3 1.2 1.5
Core consumer prices 1.3 1.2 1.2 1.1 1.2 0.9 1.0 1.1 1.4 1.1 1.2
ECB main refi. rate 1.00 1.00 1.00 1.00 1.00 1.25 1.50 1.75 1.00 1.25 2.25
3-month rates 0.72 0.65 0.80 0.90 1.23 1.45 1.70 1.95 0.65 1.45 2.45
10-yr bund yields 3.22 3.20 3.30 3.50 3.60 3.70 3.70 3.75 3.20 3.70 3.80
$/euro 1.46 1.55 1.52 1.55 1.57 1.60 1.55 1.50 1.55 1.60 1.40
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemployment rate is a quarterly average as
a percentage of the labour force. Compensation per employee, labour productivity, unit labour costs and inflation are y-o-y percent
changes. Interest rate and exchange rate forecasts are end of period levels. Numbers in bold are actual values, others forecast.
Source: Eurostat, ECB, Datastream and Nomura Global Economics.

United Kingdom ⏐ Outlook 2010 Peter Westaway ⏐ Takuma Ikeda
Walking the policy tightrope

The UK economy should start growing in 4Q09 but the recovery looks fragile and uncertainties
around fiscal and monetary policy mean there is more scope for policy errors than usual.
The precarious path back to full capacity

We expect growth to Having fallen by nearly 6% we expect UK GDP to begin growing again in the final quarter of
be anaemic 2009. Many short-term forward-looking indicators have been positive and we expect net trade to
make an increasing contribution to growth as the influence of the recovering global economy is
reinforced by the depreciation of sterling’s real effective exchange rate by over 20% since mid-
2007 Even so, we still expect growth over the forecast period to be anaemic as the upward
impetus from the re-stocking cycle and the uplift from fiscal policy measures both fade.
Thereafter, the broad shape of the recovery is dominated by weak growth in consumption and
investment as firms and households deleverage and banks continue to restrict lending in an
effort to rebuild their balance sheets. By the end of the forecast period, the impact of the
beginning of an extended period of fiscal consolidation is also likely to be detracting from growth.
Inflation is set to fall As a consequence, we expect growth to remain well below potential in 2010 and only just up to
back in 2011 2.5% through 2011 (Figure 1). In fact, we estimate that the level of UK potential output has
suffered a 4% permanent loss from the recession, relative to where it would have been (we think
slightly less than the loss estimated by the Bank of England). We estimate that potential growth is
some 0.5% per annum lower for the rest of the forecast period; yet despite this the output gap is
set to persist and to remain above 3% at the end of 2011. As a result, there is underlying
deflationary pressure in the economy. So despite the sharp increase in headline CPI inflation to
2.7% in early 2010 as the VAT rate cut is reversed and as the oil price reaches its full effect,
inflation is then set to fall back to around 1% before rising gently to 1.5% through 2011 (Figure 2).
A stronger picture
We see three This outlook for activity and inflation is now somewhat stronger than we outlined in July,
positives although we have upgraded our forecasts by less than the MPC did in its November Inflation
Report. This has been driven by three main influences:
Higher asset Higher asset prices, driven by the continuing effects of extremely loose monetary conditions and
prices, … by the additional actual and potential asset purchases, have helped to drive down bond yields
and credit spreads and boost equity prices (up 27% since July) and house prices (up 3.4% since
July relative to an expectation they would fall by 0.4%). The resulting wealth effects are the main
transmission mechanism of the quantitative easing measures that the MPC has implemented
(see Box: Q&A on MPC quantitative easing). But we judge that historically estimated elasticities
exaggerate the strength of these effects at a time when the banking system is impaired.
Figure 1. GDP growth forecast Figure 2. CPI inflation forecast

% y-o-y %y-o-y
6 6
F CPI inflation F
4 5
BoE projection as of
Nov 09
2 4
0 3
-2 Nomura as of Jul 09 2
BoE's forecast as of Nov 09
-4 1
Nomura as of Dec 09
-6 0
2001 2003 2005 2007 2009 2011 2003 2005 2007 2009 2011
Source: ONS, BoE and Nomura Global Economics. Source: ONS, BoE and Nomura Global Economics.

Q&A on MPC quantitative easing Peter Westaway

Extraordinary monetary easing by the Bank of England has worked, although communication of the transmission
mechanism has sometimes confused. Looking forward, the exit strategy is just as challenging but the FSA may help out.
Why was QE necessary? By the beginning of 2009, it had become clear that unconventional monetary policies were
necessary to augment the already low level of Bank rate set by the Monetary Policy Committee (MPC). A simple Taylor
rule would have suggested that policy rates be cut to a negative rate of between -2% and -3% (Figure 1). So in March
2009, as well as cutting Bank rate to 0.5% (deemed to be the effective minimum rate), the MPC embarked upon a series
of asset purchases, initially of up to £75bn. By November 2009, the MPC had increased the amount deemed necessary
to provide the appropriate additional degree of monetary stimulus to £200bn, comprised almost entirely of gilts.
Importantly, these were financed by creating central bank reserves: the modern equivalent of printing money.
What is the transmission mechanism of QE? Broadly, there are two. The quantity channel, initially emphasised by the
BoE in its communications, is a straightforward monetarist one, positing that the additional reserves on the balance
sheets of banks induce them to lend more. But at a time when banks have strong incentives to build up their capital
bases and demand for credit is weak, this argument was unconvincing. Even so, its simplicity helped the MPC convey
the message that it would do whatever it took. The price channel, now emphasised more by the Bank, works via a
portfolio substitution effect driving down the yields of gilts in lower supply (see Figure 2) and driving up the prices of other
assets (e.g. equities or foreign assets). The resulting wealth effects drive up demand and stimulate the economy.
Isn’t printing money like this inflationary? Yes, but only in the sense of helping the BoE to achieve its inflation target.
In the context of a threat of deflation, the MPC wanted to generate some forces acting in an upward direction on prices to
help it to return inflation towards its target of 2%. If QE were to be continued indefinitely it would be inflationary, but that
is not what an inflation-targeting central bank like the BoE would do.
Is this monetising the fiscal deficit? In a way, but all in a good cause – to prevent deflation – and only for as long as
necessary. QE will be reversed once the need for extraordinary monetary accommodation is past.
Does QE work on monetary conditions as a stock or a flow? The price channel described above predicts that the
degree of monetary stimulus will be preserved at a constant level even if the flow of asset purchases is stopped (as we
expect it will be from February). So the stock matters. But if the price of gilts is also affected by the balance between
demand from the BoE and gilt issuance by the DMO, gilt yields may increase if the flow of QE is stopped, even if the
stock is maintained. This is an awkward source of uncertainty for the MPC in determining the start of its exit strategy.
When will asset purchases be reversed? The MPC has made it clear that it is in no hurry to sell the gilts back into the
market (a prospect that unsettles gilt market participants). We think policy tightening is most likely to take place via rate
hikes, partly because their effects are better understood. But when the stock of asset purchases is unwound, the asset
price effects described above can be expected to reverse, although the timing of those effects is highly uncertain.
Will the proposed new FSA liquidity regulations matter? They could. The proposal for pension funds to hold around
£100bn of additional gilts as part of new prudential liquidity regulations could provide a fortuitous way to avoid the Bank
having to force feed the gilt market with the gilts it has accumulated during the QE period. However, the timing and scale
of this is still uncertain so there is still scope for market indigestion and disruption.
Figure 1. Warranted UK policy rates are negative Figure 2. QE-induced relative fall in UK gilt yields
% Bank rate bp, change since 1 February 2009

10 Nomura forecast 40
8 Taylor rule 20
0
6
-20
4
-40
2
-60
0 -80
-2 -100
Intended QE effect Feb-09 Apr-09 Jun-09 Aug-09 Oct-09 Dec-09
-4
1997 2000 2003 2006 2009 Euro area UK US
Source: ONS and Nomura Economics. Note: 5-year government bond yield - 5-year OIS swap rate
Source: Bank of England and Nomura Global Economics.

… a lower exchange Another expansionary influence on activity growth has been the 5% depreciation of sterling’s
rate … effective exchange rate since July. This, together with the larger depreciation of some additional
15% since mid-2007 and the improving prospects for the global economy (forecast to grow by
about 1% per annum more strongly over the forecast period), has helped to boost the
contribution of net trade to growth by around 0.5% per annum (Figure 3).
… and a more benign The third positive influence has been the benign response of the labour market during the
labour market recession. Unemployment has risen to just below 8% but given the size of the drop in activity, it
might have been expected to rise more steeply given labour market performance in previous
downturns. This can partly be attributed to a reduction of hours worked rather than of employee
numbers. But there is also evidence that real wages per head have become more responsive to
the cycle, helping to mitigate rises in unemployment. Given the effect this has on consumer
confidence and associated effects, we estimate this may have boosted consumer spending by
around 0.5pp.
Risks on both sides

The MPC and the Chancellor face difficult judgements in balancing the considerable risks on
both sides of our central forecast.
How much There is considerable uncertainty about the output gap. If at one extreme, no capacity has been
inflationary pressure destroyed (as in the “no-loss assumption” in Figure 4) then the degree of deflationary pressure
exists is uncertain could be much larger and the risk is that tightening is premature. But if even more capacity has
been destroyed, for example through the scrapping of capital during the recession, then the
output gap may close more rapidly and inflation could re-emerge more quickly (for more, see
“Icebergs to port and starboard” in the Global Weekly Economic Monitor, 20 November 2009).
Managing fiscal There is also a delicate judgement to be taken on the stance of fiscal policy. By withdrawing
policy is tricky fiscal stimulus too soon, the nascent recovery may be snuffed out before private sector demand
growth has time to recover. On the other hand, in the absence of a credible commitment to
undertake future fiscal consolidation, the risk premium on UK gilts might rise and a loss of
confidence might lead to a sterling crisis. The updated plans set out by Chancellor Alistair
Darling in his recent pre-Budget report, largely unchanged from Budget 2009, have not resolved
this uncertainty.
Judging the exit strategy

Considerable risks The MPC has made it clear that it will begin its exit from the extraordinary monetary easing by
exist on either side of raising interest rates first and by selling the stock of gilts back into the market much later (see
our call Box: Q&A on MPC quantitative easing) The MPC forecasts inflation to be broadly on target at
the two- to three-year horizon, conditioned on a market interest rate curve factoring in rate rises
beginning around August 2010. Since our forecast is slightly softer, we see the first rate hike
coming later, probably at the time of the November 2010 Inflation Report and to raise rates
gradually thereafter to 1.5% by the second half of 2011. But there are considerable risks to that
call in both directions.
Figure 3. Net trade contribution vs GBP effective exchange rate Figure 4. Output gap under no-loss and 4%-loss assumptions
pp Index %
2
3 70
2 75 0
1 80
-2
0 85
-1 90 -4
-2 95 -6
Dec 09 No loss of potential
-3 100
Jul 09 -8 4% loss + slower
-4 105 potential growth
Dec 09 effective exchange rate (rhs)
-5 110 -10
1990 1993 1996 1999 2002 2005 2008 2011 2005 2006 2007 2008 2009 2010 2011
Source: ONS and Nomura Global Economics. Source: ONS, BoE and Nomura Global Economics.

United Kingdom ⏐ Economic Outlook Peter Westaway ⏐ Takuma Ikeda
Better prospects, but risks persist on both sides

We and the MPC have raised our forecasts for UK activity and inflation. But the MPC split vote
has emphasised the uncertainties facing fiscal and monetary policy.
Activity: Forward-looking PMI indicators are consistent with a return to positive growth in Q4.
We expect GDP to be around 1.5pp higher on average in 2010 relative to 2009. Activity is being
boosted by strong asset prices and an increasing contribution from net trade, driven by the
recovering global economy and sterling depreciation. But with no immediate prospect of a return
to potential growth, let alone above-potential growth, we expect the significant output gap to
persist. Consumption growth, once the main engine of growth, looks likely to remain weak amid
earnings deterioration and as households continue to deleverage.
Inflation: We expect CPI inflation to rise from October‘s 1.5% as the energy price base effect
pushes the numbers up on a year-on-year basis. We expect CPI to reach 2.8%, well above the
2% target, in January 2010 as the temporary VAT rate cut expires at end-December 2009. But
further out, a persistently negative output gap should cause CPI inflation to fall below target.
Policy: The BoE has left the Bank rate at 0.5% and intends to increase its programme of asset
buying by £25bn to £200bn by early 2010, though tapering off the rate at which these asset
purchases occur. The most recent MPC minutes revealed an unusual 1-7-1 split on the decision
emphasising the risks on both sides, with one member favouring a greater extension of £40bn to
insure against the continuing downside risks, and another voting for an outright pause, drawing
attention to the upside risks if policy were made more accommodating. The MPC is likely to
review its policy stance at the time of the February 2010 Inflation Report, when we expect it to
announce a pause in asset purchases. Comments in the minutes from Chief Economist Spencer
Dale suggest the MPC is becoming more alert to inflationary risks. But we think the Bank is too
optimistic about the pace of recovery. As such, we think interest rates will stay on hold until
November 2010, when we expect a 25bp hike, although there are risks on both sides to this call.
Risks: The risks to our upgraded forecasts are more balanced. It is possible that optimistic
official forecasts are right and consumption and investment could recover more strongly. But
uncertainty about the banking sector and households’ saving behaviour are likely to persist,
reinforced by worries about further fiscal tightening, so we see considerable downside risks, too.

% 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP -1.2 2.2 1.6 2.1 2.6 2.8 2.2 2.5 -4.6 1.4 2.4
Private consumption -0.1 1.4 -0.1 2.1 2.2 1.7 0.7 2.3 -2.9 0.8 1.7
Fixed investment -1.1 -6.6 -3.9 -3.2 1.2 6.1 7.4 5.7 -14.4 -3.8 4.9
Exports of goods and services 2.0 4.1 4.5 4.9 5.3 5.3 5.3 5.3 -10.7 3.7 5.3
Imports of goods and services 5.2 -0.2 -1.1 1.8 3.1 3.7 2.9 4.2 -12.6 0.7 3.4
Domestic final sales -0.2 -0.1 -0.6 1.0 1.7 2.0 1.6 2.3 -4.1 0.0 1.8
Inventories -0.1 1.2 0.8 0.4 0.4 0.4 0.0 0.0 -1.4 0.6 0.1
Net trade -0.9 1.1 1.4 0.7 0.5 0.4 0.6 0.2 0.9 0.7 0.4
Fiscal deficit (% GDP) -13.0 -11.9 -9.6
Consumer prices (CPI) 1.5 1.9 2.8 2.4 1.6 1.1 1.0 1.2 2.1 2.0 1.2
Retail prices (RPI) -1.4 -0.6 2.4 2.9 2.4 2.6 2.9 3.1 -0.8 2.6 3.0
Official Bank rate 0.50 0.50 0.50 0.50 0.50 0.75 1.00 1.25 0.50 0.75 1.50
10-year gilt 3.59 3.75 3.75 4.00 4.30 4.60 4.70 4.80 3.75 4.60 4.80
£ per euro 0.89 0.90 0.90 0.86 0.84 0.82 0.82 0.81 0.90 0.82 0.80
$ per £ 1.63 1.72 1.69 1.80 1.87 1.95 1.90 1.85 1.72 1.95 1.75
Notes: Quarterly figures are % q-o-q changes at a seasonally adjusted annualised rate. Annual figures are % y-o-y changes. Inventories
include statistical discrepancy. Inflation is % y-o-y. Interest rates and currencies are end-of-period levels. Fiscal deficit is based on the
European commission's definition. Numbers in bold are actual values, others forecast.
Source: ONS, Bank of England, Datastream and Nomura Global Economics.

Japan ⏐ Outlook 2010 Takahide Kiuchi
Shift to steady export-led growth in H2

We expect the growth in the Japanese economy to slow in H1 2010, but to then expand steadily
in H2, driven by increasing exports to Asia.
We expect steady In spring 2009, the Japanese economy emerged from the fallout from the global financial crisis and
growth in H2 after subsequently recovered more steadily than we had initially projected. Real GDP growth in Q3 2009
slowing in H1 was 1.3% annualized, after 2.7% in Q2. The deflationary trend, however, is gaining momentum as
the output gap widened sharply. The domestic demand deflator in Q3 hit -2.8% y-o-y – its sharpest
decline in 52 years, since Q3 1957. While Japan ends 2009 amid a distinctive mix of strong growth
and intensifying deflation, we expect growth to slow in H1 2010 as exports temporarily lose steam
owing partly to JPY appreciation and the adverse effects of stimulus measures. We expect
declining growth amid deflation to spur the government to adopt fiscal policies targeting economic
growth and the Bank of Japan (BOJ) to take further easing measures. We think these measures
will prepare the way for the economy to improve in H2 2010, supported partly by their influence on
financial markets, including stabilizing forex market. For Japan, we expect 2010 to be a year of
dynamic interplay between the three forces of economic conditions, policy responses and financial
markets. We believe that the economy, having been rocked more severely than some by the
global financial crisis, will finally move into steady, export-led growth in H2 2010.
Growth to slow in H1
Growth should be The CPI (excluding fresh food) has been declining year-on-year since March 2009, a trend we
strong amid deflation project will continue through to early 2012. Both the government and the BOJ have already
acknowledged officially that the economy is in deflation. Consumer confidence surveys also
point to expectations of renewed slippage in prices (Figure 1). Although falling prices could
support consumer spending by raising real incomes and increasing purchasing power, there was
no clear evidence of such benefits in the deflationary period from the end of the 1990s. Falling
prices depress corporate earnings, prompting companies to rein-in personnel expenses and
raising concerns that real wages will decline as wages fall faster than prices. Those concerns
mean that households are likely to reduce spending in times of deflation.
With deflation tending to weigh on domestic demand, and particularly consumer spending, the
economy’s ability to sustain strong growth hinges largely on two external factors: expanding
exports (driven by a global economic recovery) and economic stimulus measures. GDP statistics
for Q3 2009 show real exports at 6.5% q-o-q in annualized terms, maintaining the strong growth
momentum of the previous quarter, when they grew at the same pace. Trade statistics show
exports over the period expanding strongly to a broad range of regions, particularly Asia.
Figure 1. Household sector’s outlook on prices Figure 2. Real exports and the export orders index
DI, pp Price outlook (lhs) % y-o-y DI, pp % y-o-y

90 70 60 20
Oil price (rhs)
80 15
50 55 10
70 5
30 50
60 0
45 -5
50 10
-10
40
40 -10 -15
35 Manufacturing export order PMI -20
30
-30 (lagged 3-month) -25
20 30 -30
-50 Real exports -35
10 25 (3-month mov avg, rhs) -40
0 -70 20 -45
02 03 04 05 06 07 08 09 CY 02 03 04 05 06 07 08 09 CY
Notes: 1) Price outlook for all households one year from now. Figure Note: Seasonally adjusted values.
is the % of respondents expecting prices to rise minus the % Source: Nomura, based on Markit Economics’ materials.
expecting them to fall. 2) Figures from March 04 are estimates using
old-basis statistics. Source: Nomura, based on Consumer
Confidence Survey.

Stimulus measures boost consumer spending Mika Ikeda

Consumer spending has been firm thanks to the previous government’s stimulus measures. New measures by the DPJ
are expected to have a similar impact but the government’s hands could be tied by the poor state of public finances.
Real private-sector final consumption expenditure rose 0.9% q-o-q in Q3 2009, marking the second straight quarter of
relatively strong growth after the 1.2% increase in Q2. We think brisk consumption at a time when the employment
situation is unfavorable largely reflects the impact of government stimulus. Government cash handouts appear to have
been behind the sharp increase in consumer spending in Q2 and, with this impact dropping out in Q3, other measures
designed to stimulate spending such as the eco-point and eco-car schemes seem to have had some success.
Under the eco-point scheme, consumers can use points that come with purchases of energy-efficient consumer
electronics (including digital terrestrial TVs, air conditioners, and refrigerators) to buy other products and services. Based
on applications for eco-points, we estimate that purchases of qualifying consumer electronic appliances totaled around
¥340bn at end-September 2009 (equivalent to 0.12% of nominal private-sector final consumption expenditure), and
reached roughly ¥630bn (0.22%) at end-November.
Under the eco-car scheme, subsidies are available for the purchase of cars that meet certain environmental efficiency
criteria, and additional subsidies are available if the car is being purchased to replace a car used for longer than 13 years.
We estimate that the value of cars purchased using the eco-car scheme totaled around ¥1trn as of 28 September
(0.36%), and has continued to rise since, reaching an estimated ¥1.9trn (0.68%) as of 4 December. We think consumer
spending is again likely to be boosted by the eco-point and eco-car schemes in Q4. Both schemes are due to end in
March 2010, but the government extended the eco-point scheme until December and the eco-car scheme until
September. Thus a potential pull-back in consumer spending in Q2 2010, which has been a concern, could be avoided.
The new Democratic Party of Japan (DPJ) government has said it intends to implement various policies aimed at lifting
household incomes, under the slogan Putting People’s Lives First: a new childcare benefit scheme, the effective
elimination of public high school fees, and an end to provisional tariffs for gasoline. We have estimated the direct impact
of these measures on household incomes and the potential boost to consumer spending (Figure 1 has our assumptions).
Many of these new measures are due to be implemented in Q2 2010, and we forecast only a limited impact to start with.
However, we expect benefits to emerge from H2 2010 (Figure 2). Nevertheless, we think any policy effect will be
cancelled out in FY10 by the downward pressure on consumer spending from the eco-point and eco-car schemes being
scaled back and eliminated. We expect this negative impact to disappear in FY11, when we expect the new measures to
provide a noticeable boost to consumer spending. Many details of the new measures are also still undecided.
Tax revenues have fallen sharply in FY09 amid deteriorating corporate earnings, and new JGB issuance is projected to
climb past ¥50trn. The DPJ has therefore started looking at ways to save money, including revisiting the kind of
measures above that it pledged to implement in its pre-election manifesto. With the government also searching for new
sources of revenue, proposals for tax increases not included in the manifesto have emerged. The manifesto referred to
the abolition of tax deductions for spouses, only with respect to income tax, but the government now wants to extend this
to residence tax as well. Plans are also on the table to hike cigarette taxes. The debate will also probably focus on
reductions to specified dependent tax deductions and the creation of new green taxes.
The impact of these measures, if implemented, would depress our estimate for the boost to consumer spending shown in
Figure 2. Assuming the government implements new green taxes in FY11 equivalent to the amount of tax eliminated via
the abolition of provisional tariffs, we estimate the boost to consumer spending in FY11 would be halved. Against this
backdrop, we see a real concern that the parlous state of public finances could hamper the DPJ government’s ability to
implement new stimulus measures.
Figure 1. Assumptions underlying our estimates of policy Figure 2. Estimated boost to consumption from government
effects measures that will affect household income
DPJ polices aimed at stimulating consumption
50% of annual allowance to be paid in April 2010–March 2011 % y-o-y
Child allowances
Full amount paid from April 2011 1.5
Existing child benefits To be discontinued after March 2010 payment
Effectively free public 1.0
From FY10
high school tuition Est
Income tax deductions To be abolished from 2011
Cuts to public sector 0.5
Phased in gradually from FY10 and completed in FY13
personnel costs
Abolition of provisional tax on gasoline, etc, from April 2010. Whole 0.0
Abolition of provisional
amount factored in as the individual and corporate portions cannot
tax rates
be separated -0.5
Income support for
To start from FY11
agriculture -1.0 Other consum ption stim ulus policies
Not included in our calculations, as it is difficult to separate DPJ policy ef f ects
Elimination of highway
individual use from commercial use, and as the schedule for Cash handouts
tolls
implementation is not yet clear
-1.5
Total policy ef f ects
Other policies to stimulate consumption -2.0 Real priv ate consum ption expenditure
Eco-point scheme Extended to end-December 2010 08 09 10 11 12 CY
Eco-car subsidies Extended to end-September 2010
Source: Nomura, based on Ministry of Economy, Trade and Source: Nomura, based on Ministry of Economy, Trade and
Industry, Ministry of Internal Affairs and Communications, and Industry, Ministry of Internal Affairs and Communications, and
Cabinet Office data, and the DPJ manifesto. Cabinet Office data, and the DPJ manifesto.

Exports are set to We expect economic growth to slow apparently in H1 2010, as the underlying weakness of
lose steam domestic demand, eroded by deflation, temporarily emerges. We see the main factors likely to
temporarily weigh on growth as being a lull in exports after an extended robust expansion and the adverse
effects of stimulus measures. We expect economic rebounds in the developed countries to slow
from end-2009 through early 2010. Add to that the negative impact of yen appreciation, and we
expect a sharp drop in export momentum in H1 2010. That the Japanese manufacturing PMI
index’s export orders index, a roughly three-month leading indicator of real exports, declined in
October and November 2009 also suggests that export growth momentum will fade (Figure 2).
That, in turn, is likely to feed through to slowing growth momentum for industrial production,
which has been expanding rapidly.
We expect pay-back Real consumer spending in Q3 2009 was 0.9% q-o-q, followed by a second quarter of strong
in H1 from this year’s growth of 1.2% in Q3. We attribute firm consumer spending amid the depressed job environment
stimulus boost largely to benefits from stimulatory measures, with support from government cash handouts in
Q2, and from the eco-points system and subsidies to trade in old cars in Q3 (see Box: Stimulus
measures boost consumer spending). We expect the adverse effect from stimulus measures to
hit in H1 2010.
Stepping up the policy response

We expect joint With growth slowing in H1 2010 and the yen likely appreciating, we expect the Hatoyama
action from the government and the BOJ to work more closely to combat deflation and use fiscal and monetary
government and BOJ policy to that end (see Box: A policy mix to overcome deflation). At an unscheduled policy board
meeting on 1 December, the BOJ decided to adopt new fund supply measures (¥10trn at an
interest rate of 0.1% for three months). Meanwhile, the government announced a second
supplementary budget for FY09 including new spending of ¥7.2trn or 1.5% of nominal GDP.
Although the direct impact of both moves is likely to be limited, closer government-BOJ
coordination to fight deflation should boost confidence among companies and consumers and in
the financial markets, which in turn, should have a positive impact on the economy.
Manifesto pledges on a range of measures made by the DPJ (Democratic Party of Japan) in the
August 2009 Lower House election are due to move into the implementation stage, including an
increase in childcare benefits from April 2010. We expect this to provide a fillip to the economy
from H2 2010. If economic growth slows and the yen appreciates, we see a possibility that the
government, with an eye on July 2010 Upper House elections, will put together a large package
of economic stimulus measures in the form of a FY10 supplementary budget in Q2 2010.
Government finances have been deteriorating steadily amid a large shortfall in tax revenues (Figure
3). However, with the economy taking a stronger deflationary hue and fund surpluses growing in the
corporate sector, we expect the current account surplus to continue growing even if the fiscal deficit
keeps expanding. Assuming no change in Japan’s fund surplus position, therefore, we find it hard to
project a sharp increase in long-term interest rates solely on the deterioration in public finances.
There is a risk that looser fiscal discipline could have a serious impact on the economy over the
longer term, but we see benefits in the near term from government fiscal management that
emphasizes the macro economy but also allows deficits to expand.
Figure 4. Projected impact of the strong yen on real export

Figure 3. General account: JGB issuance (FY basis)
growth
¥trn JGB issuance (projected) (lhs) % pp impact on q-o-q grow th

50 JGB issuance (lhs) 1.0
45 As % of nominal GDP (projected) (rhs) 10

As % of nominal GDP (rhs) 0.5
40
35 8
0.0
30
6
25 -0.5
20
4
15 -1.0
10 2 CY
5 -1.5
Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
0 0
65 69 73 77 81 85 89 93 97 01 05 09 FY 09 10 11 12
Source: Nomura, based on Ministry of Finance. Source: Nomura.

A policy mix to overcome deflation Shuichi Obata

The government and the BOJ are finally taking coordinated action to fight deflation.
In November, the government and the Bank of Japan (BOJ) finally admitted that deflation had taken hold again, and in
doing so acknowledged the concerns of the market. This acknowledgement was soon followed (on 1 December) by an
unscheduled policy meeting at which the BOJ decided to launch a new fund-supplying operation. The new facility is
aimed at increasing the supply of short-term funds and guiding longer-term interest rates (up to three months) on the
short-term money markets down toward the policy rate target (0.1%). While we expect the new facility to have some
effect in terms of lowering short-term interest rates, we think it is unlikely to have much impact on the economy,
consumer prices and exchange rate trends. In our opinion, the significance of the BOJ’s action is that it has now
positioned itself to implement further monetary easing, if it determines that business confidence could be negatively
affected by yen appreciation and falling prices, without revising its view of the economy and financial environment.
All eyes on coordinated action by the BOJ and the government

Of particular interest is whether the government will intervene in the forex (FX) market, and how the BOJ will respond if it
does. We forecast the exchange rate to be at USD/JPY 83 at end-March 2010; we think the government will intervene to
buy dollars and sell yen if the yen appreciates through the 85 level. In this situation, we would expect the BOJ to allow
intervention to go unsterilized (that is, release the intervention funds into the market without offsetting purchases, thereby
increasing bank reserves). In the earlier period of quantitative easing, the target for current account deposits rose
virtually in line with the cumulative amount of forex intervention. As a result, the increase in base money (current account
deposits plus cash-in-circulation) was consistent with the cumulative amount of funds used in FX intervention (Figure 1).
We thus think it is recognized within the BOJ that there is a close affinity between quantitative easing and forex
intervention. It remains unclear whether the BOJ this time will make an explicit shift to quantitative easing, as it did last
time, based on targets for current account balances. However, BOJ Governor Masaaki Shirakawa stated at his press
conference that the latest facility may also fall in the broad category of quantitative easing, and as such we think the
monetary policy of the BOJ is likely to be increasingly characterized by quantitative easing.
As of June 2009, the temporary borrowing ceiling for foreign exchange funds was ¥140trn, against which the outstanding
balance of foreign exchange fund bills was around ¥108.2trn, in theory leaving the government around ¥31.8trn in
ammunition for immediate intervention on the forex markets (Figure 2). On paper, therefore, the government has the
ability to intervene on a similar scale to that seen between January 2003 and March 2004. If the entire amount of such
intervention were unsterilized, then the BOJ’s balance sheet would expand by just under 30%.
Based on the statements of Governor Shirakawa, the BOJ seems reluctant to step up long-term JGB purchases as a means
of boosting the supply of funds. Mr Shirakawa appears to be concerned that increasing long-term JGB purchases would be
seen as holding up long-term interest rates or as fiscal financing (monetization). As well as its FY10 budget, the ruling
Democratic Party of Japan is currently compiling a second supplementary budget for FY09 to provide additional economic
stimulus. To end deflation it will be necessary to close the negative supply-demand gap, and this will be difficult to achieve
by monetary easing alone. This has prompted calls from some for additional economic stimulus measures, but there are
also concerns that fiscal deterioration could lead to a sharp rise in long-term interest rates.
In these circumstances, despite the BOJ’s reluctance, we see a strong possibility that it will increase its long-term JGB
purchases. The BOJ’s current policy is to lower interest rates from the front end of the yield curve. However, if policy is to
have a more direct impact on the economy and a greater easing effect, we think long-term interest rates will need to be
pushed down. Considering the likely overall impact, including the announcement effect, we still think it quite likely that the
BOJ will increase long-term JGB purchases in the first half of next year with the aim of gaining a duration-driven policy effect.
Figure 1. Forex intervention and quantitative easing Figure 2. Budgetary limits for forex intervention
Change in current acco unt balance End o f zero (¥trn) D if f e re nc e :
(¥trn) Change in base mo ney interest ¥3 1. 8 t rn
Cumulative fo rex interventio n amo unt
160 Upper limits o n fo reign exchange
rate po licy
70 fund bills and transfer fro m
140 natio nal treasury surplus
Intro ductio n o f quantitative easing
60
120
50
100
40 Outstanding balance o f fo reign exchange
80 fund bills and transfer fro m natio nal
30 treasury surplus
60
20
40
10
0 20 Outstanding balance
o f fo reign exchange fund bills
-10 0
99 00 01 02 03 04 05 06 (CY) 91 93 95 97 99 01 03 05 07 09 (CY)
Note: Amounts are cumulative amounts from January 1999. Source: Ministry of Finance and Nomura.
Source: Nomura, based on BOJ and MOF data.

The BOJ could step Our FX team projects a USD/JPY rate of 83 at end-March 2010. There are concerns that further
up quantitative yen gains could accelerate deflation by lowering the price of imported products and weighing on
easing exports (Figure 4). Some are therefore looking to the government to stabilize exchange rates as
part of a wider effort to combat deflation. The government could intervene to halt yen
appreciation, and this may be implemented in conjunction with unsterilized measures by the
BOJ, allowing its current account balance to rise as it halts the recovery of yen funds from banks.
We think this coordinated effort by the government and the BOJ would help to stabilize forex
markets and underline their joint commitment to combating deflation, contributing to improved
confidence in financial markets.
We also expect the BOJ to incrementally step up quantitative easing from H1 2010, including
increased purchases of long-term JGBs. In addition to the positive economic impact of these
coordinated fiscal and monetary measures, we think they will create an environment – via
greater stability in forex and stock markets – for stable export-led growth from H2 2010.
Stable growth amid deflation

Excess supply We see an easing in excess supply as one factor that should support stable growth from H2
problems are set to 2010. Companies have faced serious overcapacity and excess employment as a result of the
ease global financial crisis. Subsequent efforts to correct this by holding back investment and paring
headcount crimped domestic demand, and this has been one obstacle preventing the Japanese
economy from righting itself. However, the correction in production capacity and personnel
expenses is progressing at a faster pace than we initially projected. Our estimates now show
that the correction in both should largely be completed by mid-2010, providing another factor to
support stable growth (see Box: Capacity and personnel cost adjustments).
We expect exports to We look for exports to take an increasingly important role again in driving economic growth from
drive growth again H2 onwards, on the back of a sustained global recovery and as the negative impact of yen
from H2 onwards strength recedes. We also expect Japan to benefit strongly from expansion in Asia, in particular
China, with this acting as another driver for the domestic economy. In recent years there has
been a striking rise in the weighting of Japanese exports to Asia. Between the mid-1980s and
the late 1990s there was a sharp increase in the weighting of exports to NIEs3 (Korea, Taiwan,
Singapore) and Southeast Asia, while from the late 1990s until recently there has been a
considerable rise in the weighting of exports to China (including Hong Kong) (Figure 5).
Internationally, Japan also has one of the highest export exposures to Asia (Figure 6).
Deflation should not We expect the economy to expand even amid deflation, provided the export environment is
be overcome until healthy. However, we think it will be quite some time before there is a self-sustaining recovery in
2011 at the earliest domestic demand, particularly consumer spending. We doubt that in 2010 Japanese households
will feel that the economy is recovering. Signs of a self-sustaining recovery in consumer
spending, even amid deflation, as the benefits of export expansion feed through to the
household sector, are likely to come in 2011 at the earliest, in our opinion.
Figure 5. Breakdown of Japanese exports by country Figure 6. Asia export weightings
Asia (excluding China) Singapo re 33.0 25.3 58.3

% Japan 33.9 14.1 47.9
China (including Hong Kong) Ko rea 26.3 14.8
40 US 41.1
A ustralia 38.0 38.9
EU New Zealand 23.3 23.8
35 Resource-producing countries India 22.2 23.1
US 11.9 5.2 17.1 Other goods
Wo rldwide 12.5 4.5 17.0
30 B razil 15.0 15.2
Switzerland 8.4 9.7 Parts
25 Russia 7.3 7.4
UK 5.0 6.9
Germany 4.9 6.8
20 France 4.7 6.2
Finland 4.4 6.1
15 Sweden 3.6 5.2
Italy 3.8 5.0
Denmark 3.8 4.9
10 Canada 4.2 4.6
Netherlands 2.9 3.8
5 No rway 2.6 3.5
B elgium 2.6 2.9
CY Greece 1.7 %
0
85 87 89 91 93 95 97 99 01 03 05 07 09 0 5 10 15 20 25 30 35 40 45 50 55 60
Source: Nomura, based on Ministry of Finance statistics. Note: 1) Shows exports to Asia as % of total exports. 2) Asia is
total of China (inc HK), NIEs3 and Southeast Asia. 3) 2008 data
for all countries except Korea (2007 data). 4) Our classifications
for parts and other goods are based on BEC codes.
Source: Nomura, based on UN data.

Capacity and personnel cost adjustments Ryota Sakagami

Firms are likely complete the adjustments to their capacity and personnel costs in the first half of 2010.
Economic expansion in Japan since Q2 2009 has gone hand-in-hand with an increase in exports. However, there has
been no clear sign of recovery in domestic capital expenditure or household income.
In our view, one reason why the pickup in exports and production has not fed through to capex and consumer spending
to a greater extent is that companies have been adjusting their surplus production capacity and reducing personnel costs.
The production capacity DI and the employment conditions DI in the latest (September 2009) Tankan indicate that many
companies still think they have too much production capacity and too many employees.
Some people have compared the current situation, in which companies saddled with surplus production capacity and
excessive personnel costs are working to reduce them, thereby preventing the economic recovery from feeding through
to domestic demand, with Japan’s situation in the 1990s. These observers expect surplus production capacity and
excessive personnel costs to weigh down the economy for an extended period.
However, we see a major difference between the Japan of the 1990s and the Japan of today: the absence of a housing
bubble. Since 2002, a period not accompanied by a domestic asset price bubble, Japanese companies have been more
moderate in their expansion of production capacity and workforces than in the second half of the 1980s. Accordingly, we
think there has been less need for firms to adjust their capital stock in this recession.
To give a clearer view, we have estimated appropriate levels for companies’ production capacity and personnel costs,
enabling us to determine the potential for further adjustment. On our estimates, production capacity as of September
2009 was 3.4% in excess of the appropriate level in our standard scenario. Companies have been cutting their
production capacity by about 0.4% a month since January 2009. If they continue to do so, production capacity should
reach the appropriate level by April 2010 (Figure 1).
Similarly, we have calculated that personnel costs were 3.5% above the appropriate level (standard scenario) in Q2 2009.
Assuming the pace of adjustment to date is sustained, we calculate that personnel costs will reach the appropriate level
in Q2 2010 (Figure 2).
Accordingly, we project that capacity and personnel cost adjustments will run their course in Q2 2010. Hence, we think
pressure to adjust production capacity and personnel expenditure will ease in H2 2010 and beyond, paving the way for
the export-led economic recovery to feed through to domestic demand.
Figure 1. Estimates of appropriate production capacity Figure 2. Estimates of appropriate personnel expenses
2005 = 100 ¥trn, annualized

P erso nnel expenses
112.5 190 A ppro priate level o f perso nnel expenses
o ptimistic scenario : ¥175trn 09 Q2: ¥172trn
185
110.0 A ug 09: 104.5
180
107.5 A ppro priate pro ductio n Dec 09 175
105.0 capacity o ptimistic 170 3.5% 10 Q2
scenario : 102.9 1.5%
102.5 165 A ppro priate level o f perso nnel
3.4%
160 expenses standard scenario : ¥166trn 8.4%
100.0 A ppro priate pro ductio n capacity
standard scenario : 100.9
155 A ppro priate level o f perso nnel expenses
97.5 A pr 10 pessimistic scenario : ¥158trn 11Q2
16.3% 150
95.0 145
92.5 140 Simulatio n
A ppro priate pro ductio n capacity 135
90.0 Simulatio n
pessimistic scenario : 87.5 130
87.5 125
CY CY
85.0 120
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
Note: (1) Appropriate production capacity estimated by Nomura. Note: (1) Appropriate personnel expenses estimated by Nomura.
Our assumptions for industrial production are: optimistic Our assumptions for industrial production are: optimistic
scenario—FY10: +12.3%; FY11: +7.3%; standard scenario— scenario—FY10: +12.3%; FY11: +7.3%; standard scenario—
FY10: +8.7%; FY11: +9.2%; pessimistic scenario—FY10: +2.9%; FY10: +8.7%; FY11: +9.2%; pessimistic scenario—FY10: +2.9%;
FY11: 0.0%. (2) Our simulation assumes that production capacity FY11: 0.0%. (2) Our simulation assumes that personnel expenses
is cut by an average of 0.4%/month. continue to change at the same average q-o-q rate (–1.1%) as
Source: Nomura, based on Cabinet Office, BOJ and Ministry of from the most recent peak to Q2 2009.
Finance data. Source: Nomura, based on Cabinet Office, BOJ and Ministry of
Finance data.

Japan ⏐ Economic Outlook Takahide Kiuchi
More aggressive policy in store

We expect GDP growth to ease in H1 2010, but further fiscal and monetary action should help
growth rates pick up again in H2.
Activity: Real GDP growth was +1.3% q-o-q annualized in Q3 2009 (second preliminary
estimate), indicating that the economy has maintained the growth seen in Q2. We estimate that
GDP growth will ease markedly in H1 2010 as yen appreciation causes exports to temporarily
lose momentum after recent strong growth, and as the boost from government stimulus
measures drops out of the picture. We see a possibility that the economy could actually contract
slightly in H1. From H2, however, we think Japan will move to a phase of stable, sustainable
economic growth, driven by expanding exports, particularly to Asia.
Inflation: Deflation has made a full-fledged return in 2009, owing primarily to the wide supply-
demand gap that opened up following the global financial crisis. Not only do we think it will be
difficult to eliminate deflation, but we think that even a clear easing of deflationary pressures
may be unlikely during 2010.
Policy: In our opinion, declining economic growth and yen appreciation are likely to prompt the
authorities to take more aggressive fiscal and monetary policy action in 2010. Against a
backdrop of fiscal deterioration, we expect to see a fairly tight main budget for FY10. However, if
the economy were to deteriorate, the government could implement additional stimulus measures
from around spring, with an eye on the Upper House elections scheduled for July. We also see a
possibility that the Bank of Japan could push ahead with quantitative easing via unsterilized
intervention on the forex markets and increased purchasing of long-term JGBs.
Risks: If exports remain firmer than we currently envisage on the back of economic recovery in
emerging nations, particularly in Asia, then Japan’s GDP growth may not decline as much as we
expect in H1 2010. On the other hand, we see a risk that sharp yen appreciation could slow the
economy by more than we currently anticipate. A stronger yen would not only make for an
adverse export environment, but it could also exacerbate deflation by lowering import prices. We
also see a possibility that the adverse impact on the stock market could have a damping effect
on consumer spending.

% 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP 1.3 1.5 0.7 -0.2 2.2 1.9 1.8 1.3 -5.4 1.3 1.7
Private consumption 3.8 -0.8 0.3 -0.2 0.8 0.7 1.2 1.0 -1.1 0.8 0.9
Private non res fixed invest -10.6 9.3 4.5 -2.4 3.5 6.4 5.9 5.7 -19.1 0.3 5.2
Residential fixed invest -28.1 -3.6 1.9 1.7 2.1 3.3 3.6 3.9 -13.7 -5.9 3.5
Government consumption -0.5 1.2 0.8 0.8 0.8 0.8 0.8 1.0 1.4 0.8 0.9
Public investment -6.3 15.4 6.5 -1.8 -6.4 -9.0 -9.3 -15.1 7.6 3.0 -10.7
Exports 28.6 10.4 4.5 6.6 10.0 10.0 8.2 8.7 -24.8 10.9 9.3
Imports 13.9 13.9 6.4 2.7 -1.2 4.8 5.8 7.4 -16.4 5.4 5.1
Domestic final sales -0.7 1.7 1.2 -0.3 0.9 1.2 1.3 0.8 -3.1 0.8 1.0
Inventories 0.4 -0.2 -0.5 -0.5 -0.2 -0.2 -0.1 0.0 -0.2 -0.4 -0.1
Net trade 1.6 0.0 0.0 0.6 1.5 0.9 0.6 0.5 -2.1 0.9 0.8
Consumer prices -2.2 -2.0 -1.2 -1.5 -1.4 -1.0 -1.0 -0.4 -1.3 -1.3 -0.5
Core CPI -2.3 -1.6 -1.1 -1.4 -1.2 -1.1 -1.0 -0.4 -1.2 -1.2 -0.5
Fiscal balance (fiscal yr, % GDP) -11.3 -9.1 -9.4
Current account balance (% GDP) 2.7 3.4 4.2
Unsecured overnight call rate 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.25
JGB 5-year yield 0.60 0.70 0.65 0.80 0.90 1.00 1.05 1.05 0.70 1.00 1.10
JGB 10-year yield 1.30 1.25 1.20 1.35 1.45 1.55 1.60 1.60 1.25 1.55 1.65
JPY/USD 89.7 86.0 83.0 85.0 87.0 87.0 89.0 91.0 86.0 87.0 93.0
Notes: Quarterly real GDP and its contributions are seasonally adjusted annualized rates. Unemp. rate is as a percentage of the labor
force. Inflation measures and CY GDP are y-o-y percent changes. Interest rate forecasts are end of period. Fiscal balances are for fiscal
year and based on general account. Table last revised 11 Dec. All forecasts are modal forecasts (i.e., the single most likely outcome).
Numbers in bold are actual values, others forecast.
Source: Cabinet Office, Ministry of Finance, Statistics Bureau, BOJ, and Nomura Global Economics.

Asia ⏐ Outlook 2010 Rob Subbaraman
China-led paradigm shift

For the first time in more than a decade, things look ripe for a strong, internally led expansion.
Asia’s economies Asia ex-Japan is recovering faster than other regions, but even more encouraging, 2009 marked
have bounced back the discovery by Asian policymakers that the region has outgrown its export-led growth model.
strongly We expect a paradigm shift wherein, for the first time since the Asian crisis, regional domestic
demand, led by China, becomes the main driver of Asian growth. In the next two years, we
forecast average annual GDP growth of 8.3% in Asia ex-Japan, led by 10.2% growth in China.
This time is different

The largest-ever Asia’s policy response to this global crisis was the opposite of its response to the 1997-98 Asian
collective easing of crisis. Back then, the currency crisis forced central banks to raise rates and the IMF prescribed
Asia’s policies ... tighter fiscal policies. Domestic policies became so tight that most of Asia had little choice but to
depend on undervalued currencies and exports for growth. They stuck to an export-led growth
model for the next decade, with the region’s export-to-GDP ratio rising from 30% in 1997 to 47%
in 2007 as a result. This goes a long way to explaining why the economies were initially hit so
hard by the global financial crisis. This, we think, was a big wake-up call for Asian policymakers,
prompting them to implement the largest-ever collective loosening of macro policies. From peak
to trough, Asia’s GDP-weighted average policy interest rate has fallen by nearly 300bp, while, on
our estimates, the aggregate fiscal deficit widened by 3.6 percentage points of GDP in 2007-09.
... and sound The other big difference relative to 1998 is that this crisis did not originate in Asia: after more
fundamentals are a than a decade of reform, Asia’s fundamentals – ranging from external vulnerability indicators to
powerful combination the health of the corporate and banking sectors – are in much better shape than those of other
regions. Lean inventories, rising asset prices, falling unemployment and closing output gaps are
all contributing, but we judge that the main reason for Asia’s quick bounce-back is the powerful
combination of sound fundamentals and record loose macro policies. A quarterly GDP
expenditure breakdown is not available for China, but for the rest of the region it is encouraging
that the recovery is being led by domestic final demand, notably consumption (Figure 1).
We are optimistic that However, bouncing back from recession is relatively easy; sustaining expansion more difficult.
Asia can sustain its Inventory rebuilding and fiscal stimulus are temporary supports that will fade, while higher oil
robust growth prices are eroding producers’ profit margins. And the official leading economic indexes for
countries such as Taiwan and Malaysia, after rising sharply, are rolling over. Reflecting these
factors and other ones, our global FX strategy team is expecting a temporary rise in global risk
aversion in Q1. However, while financial markets may swoon, we do not expect a major relapse
in the global economy, given that policymakers have pledged to do whatever it takes to avoid
such an outcome. For Asia, we are particularly sanguine because of a new structural force that
we expect to have a bigger positive impact on the rest of the region than many realize: China.
Figure 1. Contributions to aggregate real GDP growth in Asia Figure 2. Nomura’s forecasts of consumption versus gross
(excluding Japan and China) fixed capital formation in 2010; circles = size of nominal GDP
Percentage points contribution to year-on-year grow th 25

25 Brazil
20
20
15 Philippines China
Growth of GFCF
15 Australia Korea
10 India
10 Vietnam
Russia
5 5 Indonesia
0 Poland
0
-5 US
-5
-10 UK
Gross exports Consumption Euro area Japan
-10
-15
Inventories Investment -5 0 5 10 15 20
-20 Grow th of private consumption
Sep-97 Sep-00 Sep-03 Sep-06 Sep-09
Note: Asia includes Korea, Taiwan, HK, India, Singapore, Note: The bubbles represent the size of nominal GDP for each
Malaysia, Indonesia, Thailand and the Philippines. country in 2008 measured in USD at current exchange rates.
Source: CEIC and Nomura Global Economics. Source: World Bank, CEIC and Nomura Global Economics.

China’s re-emergence
China’s investment We are bullish on China, forecasting GDP growth of 10.5% in 2010 and 9.8% in 2011 (for details
boom is far from over see China Economic Outlook: “One of the best years in decades”, in this issue). Our
assessment is that after adding on the investments being implemented by local governments
and state-owned enterprises, which are largely financed by the banks, the true size of the public
investment stimulus is roughly double the RMB4tr that Beijing announced in November 2008.
Being mostly multi-year infrastructure projects, more rounds of bank financing will be needed to
complete them. Indeed, as of November 2009, the funds needed to complete ongoing urban
fixed-asset investment projects reached RMB22tr, or 73% of China’s 2008 GDP. We doubt that
China will tighten monetary policy aggressively in 2010, as CPI inflation is so low and if ongoing
public projects are starved of ongoing financing, non-performing loans could quickly rise;
alternatively, if banks give priority to public projects, private investment could be crowded out.
It is being joined by a Unlike the consensus, we think a major overcapacity problem in 2010-11 is unlikely; rather, we
consumption boom see a major asset price bubble forming from too loose monetary policy. Most of the investment
is directed at China’s poorer inland regions, where there is still plenty of room for development.
Consumption and property booms are also under way. Personal incomes are at the point where
demand for durable goods is taking off. Policymakers are promoting consumption by spending
more on welfare, easing restrictions on urbanization, and reducing bottlenecks for rural spending.
If our 2010 consumption and investment forecasts are right, China will be the outlier (Figure 2).
China’s rapid re- China’s burgeoning demand is starting to have a big impact on the rest of Asia. Put simply,
emergence is helping China’s economy is now so big that its high compound growth rates really matter (see Box:
the rest of Asia China: Dispelling some myths). To illustrate, consider China’s so-called “ordinary” imports
(goods catering to China’s own demand, rather than exports). They are on track to total
USD0.5tr this year, whereas US goods imports are set to be three times larger (USD1.5tr). But
in 2006-08, China’s ordinary imports grew at an average annual rate of 27% versus 8% for US
imports. At this pace, China’s ordinary imports will double to USD1.0tr, equal to more than half
of forecast US imports (USD1.9tr) by 2012. They should exceed US imports by 2016 (Figure 3).
Policy dilemma
Asia could face a Policy rates in Asia being raised only slowly is also bullish for domestic demand (see Box: Asian
tsunami of capital monetary policy: A fear of the exit). Our base case is for shallow recoveries in the G3 economies,
inflows in 2010 with the Fed not raising rates until early 2011. This alone could fuel strong capital inflows to Asia,
but with the region being the stellar growth performer in the world, 2010 inflows could be more
like a tsunami. Asia has already experienced a turnaround in foreign capital, from net outflows
totaling USD262bn in July 2008-March 2009, to net inflows of USD241bn in April-September
2009, putting upward pressure on Asian currencies (Figure 4). Policymakers in most Asian
countries seem unwilling to tolerate anything other than gradual currency appreciation because
they are concerned about a G3 relapse and know the region’s high export exposure cannot be
reduced quickly. But capital flows rarely trickle in – they come in waves. So Asian central banks
have intervened heavily, boosting FX reserves from USD3.3tr in March to USD3.9tr in October.
Figure 3. China’s ordinary imports and US good imports Figure 4. Asia ex-Japan’s aggregate balance of payments
USD trillion Projections US$bn

2.8 250
China's ordinary
2.4 200 Capital account
goods imports
+8% p.a.
150 Current account
2.0 US goods imports
BOP
100
1.6
50
1.2 +27% p.a.
0
0.8 -50
0.4 -100
0.0 -150
1994 1997 2000 2003 2006 2009e 2012 2015 Sep-97 Sep-00 Sep-03 Sep-06 Sep-09
Note: Ordinary imports cater to China’s own demand; i.e. they are Note: The capital account includes net foreign direct investment,
not inputs used to produce goods for export. debt and equity portfolio flows and international bank lending.
Source: CEIC and Nomura Global Economics. Source: CEIC and Nomura Global Economics.

China: Dispelling some myths Mingchun Sun

It is time to scrutinize some of the conventional wisdom and correct some misunderstandings about China’s economy.
In 2009, China, with its massive fiscal stimulus package and strong V-shaped economic recovery, became the focus of
the world. In 2010, we expect even more attention, as, based on our 2010 GDP growth and currency forecasts, China is
set to surpass Japan as the world’s second-largest economy at market exchange rates. The world needs to know China
better. We attempt a modest contribution by challenging some of the conventional wisdom:
1. China is a “small” economy. For years, policymakers and most observers, inside and outside of China, have
analyzed China using the “small open economy” framework – namely viewing China as a price taker with little impact on
world prices, interest rates or incomes. This wisdom was challenged in 2009 as China’s V-shaped recovery clearly
spilled over into other Asian economies, Australia, and the effects were felt even as far as Latin America, as orders from
China boosted production and commodity prices. Being the second-largest economy in the world in 2010, China’s impact
on the rest of the world should be even more obvious as the investment and consumption booms continue into 2010.
2. Exports are the main growth engine. Many observers draw this conclusion by looking at the ratio of exports to GDP,
which was 33% in 2008. However, often ignored is the fact that half of China’s exports are so-called processing and
assembly trade, which requires imports of raw materials and components before the finished goods are exported. The
GDP share of net exports – namely, the difference between exports and imports – is much smaller (8% in 2008). In terms
of contribution to real GDP growth, net exports have accounted for only 10% over the last 17 years (Figure 1) – much
smaller than in Japan (23.8%) and Germany (28.8%). In other words, domestic demand has long been the main growth
engine in China (see “China: Gauging the importance of exports”, Global Weekly Economic Monitor, 27 March 2009).
3. Private consumption is weak. Such an impression may come from the low share of household consumption in
China’s GDP (36.8% in 2008). But in actual fact, China’s real consumption growth has been one of the strongest in the
world over the last 13 years (7.2%) – stronger than in the US (3.3%), Japan (0.9%), Brazil (4.0%) and India (5.5%). It
was even stronger investment growth that drove down the consumption ratio. For developing economies, robust
investment growth is needed for urbanization and industrialization purposes and it can be justified theoretically and
empirically (see China consumption outlook: Surprises from consumers, 20 May 2009).
4. High money supply growth leads to high CPI inflation. While this sounds like a given, the conventional wisdom is
not supported by the data. Over the past 15 years, China’s M2 money supply growth averaged 18.8% per year, but CPI
inflation averaged only 2.0%. Why the large discrepancy? Rapid credit expansion has been mainly used to increase
production capacity in the manufacturing sector, which helped relieve supply bottlenecks. Abundant, or even excess
capacity, fuels price competition and prevents producers from raising prices, even in the face of rising costs. Fortunately,
rapidly rising labour productivity – about 20% growth pa during 1994-2008 – helps producers absorb cost increases and
stay profitable (see “CPI inflation outlook”, Global Weekly Economic Monitor, 11 September 2009).
5. The investment stimulus exacerbates overcapacity problems. This criticism is superficial as it ignores the
direction of the investment stimulus in 2009. Overcapacity has existed for many years, but mainly in the manufacturing
sector, due to strong investment growth in the sector over the past investment boom (Figure 2). However, 2009’s
investment boom was mainly driven by infrastructure projects – especially in central and western regions – and thus is
unlikely to exacerbate any overcapacity (see Not just an investment boom, Asia Special Report, 9 November 2009).
Figure 1. Contribution to real GDP growth in China Figure 2. Fixed-asset investment growth by sectors
Percentage point
% y-o-y
contribution
Infrastructure
20 Domestic demand 60
Property
Net exports Manufacturing
16 50
12 40
30
8
20
4
10
0
2005 2006 2007 2008 2009
1991 1993 1995 1997 1999 2001 2003 2005 2007 Jan-Nov
Source: CEIC and Nomura. Source: CEIC and Nomura.

Asian monetary policy: A fear of the exit Young Sun Kwon ⏐ Sonal Varma
Asian policymakers risk falling behind the curve in 2010 due to a fear of currency appreciation and a preference to
accelerate growth. A delayed exit would leave problems with the lack of credibility and late rapid tightening.
After an unprecedented policy stimulus, Asian growth and asset prices rebounded fast from the global recession. Asian
policymakers now face the difficult challenge of sustaining the recovery, while keeping inflation in check. So far,
governments have preferred to impose administrative measures, rather than use blunt rate hikes, to limit rapid asset
price reflation. For instance, mortgage loan-to-value ratios have been lowered in Hong Kong and Korea. We look for
more piecemeal measures – and do not rule out restrictions on capital flows – but judge that they will have only short-
lived effects. We also expect CPI inflation to rise and, apart from China, see a risk of output gaps closing faster than we
initially thought. As policymakers come to recognize that their exit policies have been too slow, we expect them to move
to eventually catch up by implementing more aggressive rate hikes.
Three reasons for fearing an exit

• Fear of currency appreciation: Policymakers are likely to prevent their currencies from appreciating too fast, given
their lack of confidence over the export outlook, risking competitive devaluation for an extended period.
• Political preference: Given that central bank independence is not well established in Asia, pressures to delay rate
hikes will likely remain due to political priorities to support weaker economic segments (such as small and medium-
sized enterprises), still-sluggish job markets and a risk of larger capital inflows associated with interest rate arbitrage.
• Self-insurance: Some Asian countries experienced sharp currency devaluation during the post-Lehman crisis as
they were unable to borrow overseas in their own currencies (often referred to as the “original sin”). In response,
Asian countries are likely to build up FX reserves further as “self-insurance” against future potential external shocks.
Three potential risks

In 2010, we expect a total of 100bp of nominal aggregate policy rate hikes in Asia ex-Japan. However, given our forecast
that aggregate CPI inflation will rise to 3.9% from 0.6% in 2009, real policy rates are estimated to fall to 1.3% from 3.9%
in 2009 (Figure 1). Such a delayed exit leaves room for potential problems in macro risk management, in our opinion.
• Asset price inflation (or bubbles): As firms, facing global overcapacity, hold investment in check, easy monetary
conditions, including lower real borrowing costs, and a strong recovery in incomes could prompt households to take
on excess debt. Given our view that the negative output gap closes in 1H10 and asset price inflation accelerates, we
expect central banks to quicken the pace of interest rate hikes in 2H10. The biggest concern is that this would lead
to bad loan problems and asset market corrections if it proves that Asian asset prices are substantially overvalued.
• Speculation: Keeping currencies undervalued by accumulating FX reserves could encourage speculative positions
amid ample global liquidity as the markets position for eventual Asian currency appreciation (Figure 2). On the other
hand, extraneous FX changes between USD and other major currencies (especially JPY) could trigger a sizable
unwinding of arbitrage positions given Asia’s de facto soft USD pegging.
• Capital controls: In an extreme scenario of too large capital inflows or outflows, we do not completely rule out the
imposition of capital controls given that regional currency swap agreements are relatively small (USD120bn).
Figure 1. Asia ex-Japan’s weighted-average policy rates Figure 2. NEER and FX reserves in Asia ex-Japan
% y-o-y US$tr Index (2005 = 100)

Real policy rates
8 4.5 112
Nominal policy rates FX reserves, lhs NEER, rhs
6
3.5 108
4
2.5 104
2
1.5 100
0
-2 0.5 96
Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-00 Oct-01 May-03 Dec-04 Jul-06 Feb-08 Sep-09
Note: Weighted by GDP (on a purchasing power parity basis). Note: Lower value of nominal effective exchange rate (NEER)
India inflation refers to wholesale price index. indicates nominal trade-weighted exchange rate depreciation.
Source: CEIC, IMF and Nomura Global Economics. Source: BIS, IMF and Nomura Global Economics.

Excessively low real Resisting currency appreciation is reviving the so-called “Impossible Trinity”, involving a fixed
rates could result, exchange rate, free-flowing capital and control over interest rates: a central bank can maintain
fueling asset bubbles only two of these at any given time. By managing the exchange rate, central banks risk keeping
rates too low for too long (raising them could provoke even stronger capital inflows), and with
our forecast of rising CPI inflation we see real policy rates turning negative in most countries.
This situation looks ripe to fuel asset price bubbles (most notably in Hong Kong and China). To
lean against bubbles more administrative measures are likely, but we doubt that they will be as
effective as rate hikes. Over time, we believe Asia will allow significant currency appreciation, as
reflected in our FX strategy team’s end-2011 forecasts; otherwise a protectionist backlash
seems likely given that the region’s slice of the global economic pie is growing fast (Figure 5).
Two downside risks

An oil price boom, or We see two major downside risks to bullish Asian growth forecasts: another oil price boom and a
a G3 relapse are two major relapse in the G3 economies. We try to quantify these under two scenarios (Figure 6). Our
key downside risks base case is that the price of Brent oil averages USD72/bbl in 2010 and USD75/bbl in 2011, but
if it were to average USD100/bbl instead (Scenario A), we estimate that the region’s total 2010
GDP growth would be 0.7 percentage point (pp) below our base case, with Korea, Thailand and
the Philippines hurt most; Australia and Malaysia would actually benefit. Alternatively, if growth
in the G3 economies were to be 0% in 2010 rather than our forecast 1.9%, and the recovery in
2011 shallow (Scenario B), Asian 2010 GDP growth could be 1.3pp below our base case.
Notably, under both scenarios the most resilient country by far is China.
Five key themes

Watch for upside We would highlight five big picture macro themes:
surprises from the
Asian consumer China’s goldilocks year. With strong GDP growth and low CPI inflation, 2010 should be one of
the best years in decades for China’s economy. We do not expect major overcapacity problems
because the poorer inland regions need more investment, and we forecast a consumption boom.
Korea and Taiwan switch. Korea’s central bank is falling behind the curve and household re-
leveraging should drive 2010 GDP growth higher than in Taiwan, where large excesses remain.
But we expect the reverse in 2011, as the Bank of Korea plays catch-up with aggressive rate
hikes and as Taiwan starts to reap the benefits of closer economic ties with China.
India and South-east Asia. Overall, we expect the rate of potential growth in the region to rise
on improved economic fundamentals, growing links with China, rapid urbanization and average
income per capita having risen to the point where demand for durable goods is taking off.
Emerging disparities. We are bullish overall, but there are some gaps. A balance of payments
crisis in Vietnam cannot be ruled out; the Thai economy is being held back by political
uncertainties, which could worsen; and Malaysia is struggling to keep export competitiveness.
Consumption surprises. Supportive policies, rising asset prices, a growing middle class and a
need for global rebalancing set the stage for a consumption boom (see Box: Asia rebalancing).
Figure 5. The sizes of the economies of Asia ex-Japan, the US Figure 6. Nomura’s baseline GDP forecasts and two other
and Japan (GDP in USD at current exchange rates) less rosy scenarios, % y-o-y growth
China India Korea Scenario A: Scenario B:
US$tr Base Case
Oil price boom G3 relapse
16 Rest of Asia US Japan
2009E 2010 2011 2010 2011 2010 2011
14 China 8.5 10.5 9.8 10.0 9.3 9.9 9.2
Hong Kong -2.6 5.6 4.4 4.9 4.2 2.9 3.6
12
India 6.5 8.0 8.2 7.2 7.4 6.5 7.2
10 Indonesia 4.6 5.9 6.2 5.6 6.2 4.9 5.0
Malaysia -2.2 4.5 5.2 4.7 5.4 2.0 3.8
8
Philippines 1.0 5.5 6.0 4.0 4.5 3.0 4.0
6 Singapore -2.0 5.5 5.5 4.7 5.2 2.2 4.0
4 Korea 0.0 5.5 4.0 4.0 3.0 2.5 4.5
Taiwan -3.0 4.8 5.2 4.0 5.1 2.3 4.1
2 Thailand -3.0 3.0 5.0 1.5 3.5 1.0 3.0
0 Vietnam 5.1 6.5 6.6 6.0 6.1 5.5 5.8
1995 1997 1999 2001 2003 2005 2007 2009E 2011F Asia ex Japan 5.5 8.4 8.2 7.7 7.5 7.1 7.3
Australia 1.0 2.8 3.2 3.3 3.9 0.8 2.5
Note: 2010 and 2011 are Nomura’s forecasts of GDP growth and Source: Nomura Global Economics.
exchange rates. Source: CEIC and Nomura Global Economics.

Asia rebalancing Tomo Kinoshita ⏐ Tetsuji Sano

Asia’s rebalancing from reliance on export demand to domestic demand has finally started.
Although we maintain our view that Asia is still vulnerable to a decline in demand in G3 economies, we believe that
Asia’s long-overdue rebalancing has finally started to materialize. In fact, we forecast that Asia’s current account as a
percentage of GDP will decline by 1.8pp in 2010, which would be the largest decline in the past two decades, followed by
a further fall of 1.2pp in 2011. Although 0.7pp of the total 1.8pp decline in 2010 is directly due to higher fuel prices, the
rest should be contributed by a rise in Asia’s own demand, led by China. We expect China to grow 10.5% in 2010, even
while demand for exports remains relatively weak. In light of this, we expect Asia’s aggregate current account surplus as
a percentage of GDP to drop significantly from the peak level of 7.1% in 2007 to only 2.5% in 2011 (Figure 1).
Regional demand, led by China, to lead regional growth

In 2010, Asia’s move toward rebalancing should be driven by both short-term and structural factors, in our view. The
short-term factors are likely to play more important roles. Investment should accelerate in 2010 in most of the economies.
Although the output gap in the global economy should still be significant, the output gap in Asia is likely to close in 2010,
which should lead to sizable demand for investment in domestic markets. Despite the expected rate hikes across Asia,
monetary policy, when measured in terms of inflation-adjusted real interest rates, should remain relatively loose, which
would also support investment. We expect China’s investment boom to continue with fixed asset investment growing
rapidly in 2010, at 30.0%. Given the size of China’s economy, which is set to become the second largest in the world in
2010, high investment growth in China is also likely to stimulate demand in the rest of Asia.
Another important short-term catalyst for Asia’s rebalancing is an acceleration of private consumption growth as a result
of improving employment conditions and consumer sentiment. There have been growing signs of private consumption
across Asia accelerating, supported by both pent-up demand and wealth effects from higher prices of stocks and
property. Reflecting the recovery in consumer sentiment, the number of intra-regional travelers also appears to be
recovering quickly. This is particularly good news for the economies whose net travel receipts are high relative to GDP,
notably Thailand (5.5% in 2008) and Malaysia (3.8%).
Two major structural factors should also support Asia’s move towards rebalancing. First, tariff reductions for intra-
regional trade should spur homegrown demand in Asia. Although a tariff reduction does not directly increase regional
demand, a lower trade barrier is likely to induce additional final demand in Asia through multiplier effects, as increased
trade encourages firms to hire more workers and expand capacity. The most notable development among various trade
initiatives should be the tariff reduction set by the China-ASEAN (Association of Southeast Asian Nations) Free Trade
Agreement. According to the agreement, China and the six original ASEAN member countries are, in principle, obliged to
eliminate all tariffs for Normal Track tariff lines, which accounts for more than 90% of trade in 2010.
Second, a rise in the middle-class population is likely to support sustained consumption growth in Asia. Asia’s middle-
income population is on the rise especially in the relatively low-income economies such as China, India and Indonesia,
supported by robust economic growth, currency appreciation and urbanization. As middle-income consumers tend to
spend more on service items than do low-income consumers, a sustained rise in service-sector investment and
consumption can be expected over time. In fact, per capita GDP in low- to middle-income Asian economies has risen
sharply over the past five years (Figure 2).
Figure 2. Per capita GDP in low- to middle-income economies

Figure 1. Current account balance in Asia ex-Japan
in Asia
Per capita GDP Population
%, GDP Current account (rhs) USDbn
Average annual
8 Current account as % of GDP (lhs) 800 2003 2008 rate of growth 2008
from 2003 to 2008
7 F 700
USD USD % million
6 600 Low to middle income group 997 2,285 18.0 2,978
5 500 China 1,269 3,258 20.7 1,328
India 535 1,052 14.5 1,154
4 400 Indonesia 1,100 2,247 15.4 229
3 300 Philippines 973 1,845 13.7 90
Vietnam 489 1,051 16.6 86
2 200 Thailand 2,261 4,299 13.7 63
1 100 Malaysia 4,400 8,008 12.7 28
High income group 17,071 25,967 8.8 105
0 0 South Korea 13,451 19,111 7.3 49
-1 -100 Taiwan 13,546 17,060 4.7 23
Australia 26,371 46,651 12.1 22
-2 -200 Hong Kong 23,559 30,863 5.5 7
90 92 94 96 98 00 02 04 06 08 10 Singapore 22,651 37,597 10.7 5
Note: Asia ex-Japan includes China, India, Taiwan, Korea and Source: CEIC and Nomura Global Economics.
ASEAN6.
Source: Nomura Global Economics from CEIC and IMF.

Australia ⏐ Economic Outlook Stephen Roberts
A two-speed recovery
Less accommodating policy settings will limit the pace of growth in consumer spending in 2010,
while business investment and exports should grow strongly helped by Asia’s strong recovery.
Activity: Real GDP growth should accelerate more than we originally forecast in 2010, to 2.8%
y-o-y and to 3.2% in 2011, reflecting burgeoning Asian demand for commodities driving a V-
shaped recovery in exports and business investment, especially mining sector investment.
Housing construction activity is also likely to accelerate in 2010 in a lagged response to the
government incentives for first-time homebuyers that ran from October 2008 and through much
of 2009. However, we believe the economic recovery in 2010 and 2011 will be a two-speed
affair, with household consumption growing only modestly as the highly leveraged household
sector adjusts to increased debt-servicing payments on higher interest rates, while the end of
fiscal support payments in 2009 will sharply reduce growth in household income in 2010.
Inflation: We expect a slow rise in CPI inflation through 2010 and 2011 – and in the two RBA
underlying inflation measures from late 2010 – but moving comfortably within the RBA’s 2%-3%
target band through 2H10 and 2011. We forecast a stronger AUD through 2010 containing
import prices and offsetting scattered domestic inflation pressure points, mostly in utility charges.
Wages growth should remain low through 2010, with some acceleration in 2011 as the labour
market tightens to the point where the unemployment rate starts to fall more consistently.
Policy: Fiscal stimulus spending peaked in 2Q09 with the concentration in that quarter of the
biggest “cash splash” transfer payments to households. Although government infrastructure
spending will rise in 2010, the declining total stimulus will, on our estimate, subtract 1.3pp from
GDP growth in 2010, compared with 2009. We also see the RBA continuing to reduce monetary
policy accommodation in 2010, but at a slow pace given the lack of an inflation “smoking gun”
that might drive the need for a quicker return to a neutral cash rate setting. Also, with banks
starting to raise their home loan rates by more than the RBA’s cash rate hikes, there is less
need for the RBA to raise rates aggressively. We forecast two 25bp cash rate hikes in 2010; one
in 1Q10 and another in 4Q10, taking it to 4.25%.
Risks: In our view, greater deleveraging by the heavily indebted household sector is the biggest
downside growth risk. On positive risk, if the economic recovery in Asia ex-Japan accelerates
more than we forecast, it would drive stronger exports and business investment spending.

% y-o-y growth unless otherwise stated 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP - % q-o-q saar 2.6 2.5 2.9 2.9 2.8 2.8 3.2 3.2
- % q-o-q, sa 0.7 0.6 0.7 0.7 0.7 0.7 0.8 0.8
- % y-o-y 0.9 2.3 2.6 2.7 2.8 2.9 3.0 3.0 1.0 2.8 3.2
Household consumption 1.8 1.9 1.6 1.1 1.2 1.3 1.7 1.5 1.5 1.3 1.6
Government (total spending) 1.6 2.4 3.5 3.6 3.0 3.1 3.4 3.1 2.4 3.3 2.8
Investment (private) -3.0 -1.0 5.0 6.2 6.4 5.8 6.3 5.9 -2.0 5.8 5.9
Exports -0.2 3.9 5.8 6.6 10.8 9.4 7.6 8.1 1.3 8.1 8.3
imports -8.3 0.9 10.6 10.7 7.0 8.5 9.6 9.4 -7.8 9.2 9.1
Contributions to GDP growth (% points):
Domestic final sales 0.6 1.3 2.9 2.9 2.9 2.9 3.1 3.0 0.9 2.9 3.0
Inventories and statistical discrepancy -1.7 0.4 0.9 0.8 -0.3 0.0 0.5 0.5 -2.1 0.3 0.5
Net trade 2.0 0.6 -1.2 -1.0 0.2 0.0 -0.6 -0.5 2.2 -0.4 -0.3
Employment, 000 17.9 15.0 15.0 18.0 18.0 18.0 22.0 25.0 4.2 17.2 24.8
Consumer prices 1.3 2.0 2.4 2.5 2.4 2.3 2.3 2.5 1.8 2.4 2.6
Trimmed mean 3.2 3.1 2.7 2.4 2.3 2.4 2.5 2.7 3.5 2.5 2.8
Weighted median 3.8 3.5 2.9 2.6 2.5 2.5 2.6 2.8 4.0 2.6 2.7
Federal deficit (% of GDP) FY end-June -2.3 -3.4 -2.2
Cash rate 3.00 3.75 4.00 4.00 4.00 4.25 4.50 4.50 3.75 4.25 4.50
90-day bank bill 3.39 4.10 4.15 4.50 4.50 4.70 4.90 4.90 4.10 4.70 4.80
3-year bond 4.84 4.65 5.00 5.30 5.40 5.50 5.60 5.60 4.65 5.50 5.40
10-year bond 5.44 5.50 5.70 6.20 6.30 6.40 6.50 6.50 5.50 6.40 6.20
AUD/USD 0.88 0.94 0.90 0.96 0.98 1.00 1.00 1.00 0.94 1.00 1.00
Note: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are
period average. All forecasts are modal forecasts (i.e., the single most likely outcome). Table last revised 16 December 2009.
Source: Australian Bureau of Statistics, Reserve Bank and Nomura Global Economics.

China ⏐ Economic Outlook Mingchun Sun
One of the best years in decades

Barring an aggressive policy tightening, 2010 will likely prove one of the best years in decades
for the Chinese economy, characterized by strong GDP growth and mild CPI inflation.
Activity: Real GDP growth should rise to 10.5% in 2010 – peaking at 12.0% y-o-y in Q1 – from
an estimated 8.5% in 2009. Investment should continue to be the main driver – contributing 6.8
percentage points (pp) to real GDP growth – as public investment remains strong and private
investment picks up. The contribution from private consumption to GDP growth should rise to
4.6pp from 4.0pp in 2009, as the credit boom boosts households’ real purchasing power in a
low-inflation environment and the government strikes further to boost consumption through
income transfers and fiscal subsidies. Government consumption may contribute only 1.5pp as
the strong economic recovery reduces the need for fiscal stimulus. We expect exports to return
to double-digit growth (11%), on a low base created by massive global destocking in 2009. We
expect import growth to be even stronger (20%), due to strong domestic demand from the
investment and consumption booms. Net exports will again be a negative factor (-2.4pp) in 2010.
Inflation: We expect significant PPI inflation of 6.0% – mainly due to strong demand for raw
materials and capital goods from the investment boom – but mild CPI inflation of 2.5% in 2010.
In our view, the existence of overcapacity in the manufacturing sector and rapid growth in labour
productivity should prevent high PPI inflation from being transmitted into CPI inflation.
Policy: We expect tightening policies to be introduced gradually in early 2010, in response to

signs of economic overheating. While we only see a 5% chance of an aggressive tightening (if
the PBC employs loan quotas and limits them strictly to below RMB7-8trn), the damage low loan
quotas could do to the real economy may be extensive given the massive investment projects
started this year. That said, without a real CPI inflation threat, policy tightening will (95% chance)
be mild – we expect to see only 81bp of rate hikes, 100bp of reserve ratio requirement (RRR)
hikes and window guidance. With growth as less of a concern, we believe 2010 will allow
policymakers to conduct structural reforms aimed at improving the quality of growth.
Risks: In our view, the 5% chance of aggressive tightening is the main risk that could prevent
the economy from enjoying one of its best years in decades. There is a chance that, having
delayed tightening for too long, policymakers over-react to some signs of overheating in 2010. If
this happens, the economy could face a hard landing. The development of an asset price bubble
is another risk, as abundant liquidity could ignite inflation expectations and a benign economic
environment may boost investor confidence to unreasonable levels. That said, there is hope that
if the government can limit the use of leverage in asset purchases successfully, the damage of a
bubble to the real economy could be reduced significantly.

Real GDP 8.9 11.0 12.0 10.5 9.9 9.6 9.4 9.7 8.5 10.5 9.8
Consumer prices -1.2 0.6 1.6 2.5 3.0 2.9 3.4 3.5 -0.7 2.5 3.5
Core CPI -1.5 0.1 0.5 0.8 1.2 1.6 2.0 2.4 -0.9 1.0 2.0
Retail sales (nominal) 15.4 16.2 17.3 19.3 19.7 18.0 20.0 18.0 15.4 18.6 18.0
Fixed-asset investment (nominal, ytd) 33.4 34.0 36.0 38.0 32.0 30.0 26.0 24.0 34.0 30.0 25.0
Industrial production (real) 12.3 18.4 22.0 16.3 13.3 12.3 12.0 11.5 11.3 16.0 13.8
Exports (value) -20.3 -2.8 15.5 15.2 7.8 7.5 4.1 8.6 -15.6 11.0 8.3
Imports (value) -11.8 14.3 36.5 21.0 12.3 16.3 15.0 15.8 -9.5 20.0 15.0
Trade surplus (US$bn) 24.1 70.6 33.3 26.3 29.5 51.8 7.6 7.4 207 141 73
Current account (% of GDP) 7.2 5.0 3.5
Fiscal balance (% of GDP) -3.7 -2.5 -1.3
1-yr bank lending rate (%) 5.31 5.31 5.58 5.85 6.12 6.12 6.39 6.66 5.31 6.12 7.20
1-yr bank deposit rate (%) 2.25 2.25 2.52 2.79 3.06 3.06 3.33 3.60 2.25 3.06 4.14
Reserve requirement ratio (%) 15.50 15.50 16.00 16.50 16.50 16.50 17.00 17.00 15.50 16.50 17.00
Exchange rate (CNY/USD) 6.83 6.82 6.82 6.68 6.55 6.45 6.40 6.35 6.82 6.45 6.10
Notes: Numbers in bold are actual values; others forecast. Interest rate and currency forecasts are end of period; other measures are
Source: CEIC and Nomura Global Economics.

Hong Kong ⏐ Economic Outlook Tomo Kinoshita ⏐ Robert Subbaraman
Twin engines of China and the HKD peg

The economy should rebound strongly, and lack of monetary control could fuel an asset bubble.
Activity: The Hong Kong economy is gaining further traction. The wealth effects arising from
higher property and stock prices, the pent-up demand for durable goods and improving job and
income prospects appear to be driving consumption growth. Retail sales are recovering quickly
with October sales volumes having risen by 8.2% y-o-y. We expect retail sales to strengthen
further in the short run and now forecast private consumption growth to accelerate to 7.0% in
2010 from 0.6% in 2009. We also expect the growth in gross fixed capital formation (GFCF) to
rebound to 10.0% in 2010 from -4.3% in 2009. GFCF growth surprisingly turned positive at 1.4%
y-o-y in 3Q09 as business sentiment/activity improved and public investment (mainly on
infrastructure) increased. A rebound in visitor arrivals, led by visitors from the Mainland, looks
set to buoy Hong Kong’s exports of services. We believe that the acceleration of economic
growth in China and abundant liquidity conditions – because of the HKD peg, Hong Kong has
imported quantitative easing from the US – should further drive optimism in Hong Kong in 2010.
Inflation: We expect headline CPI inflation to rise but to a still subdued rate of 3.2% in 2010, as
imported food and oil/commodity prices rise, policy effects gradually wane, consumer demand
recovers and the housing component of the CPI adjusts to higher residential rents, with a lag.
Given that the economy is still operating below full capacity and our assumption that oil prices
will remain around current levels, we are not forecasting an inflation problem, although we would
highlight it as an upside risk given the surfeit of liquidity and the possibility of higher oil prices..
Policy: We expect the 2010 budget to focus on sustainable economic development strategies,
particularly via promoting new niche industries, cooperation with China/Guangdong and Taiwan,
and infrastructure projects, while providing assistance to the disadvantaged. We do not expect
any large fiscal stimulus, as the recovery gains traction and as the government strives for fiscal
prudence. On the monetary front, capital inflows under the HKD peg have resulted in ample
interbank liquidity and a surge in the monetary base to a growth rate of over 200% y-o-y. To
guard against the formation of property and equity price bubbles, the Hong Kong Monetary
Authority (HKMA) has required banks to comply with prudent lending practices, including raising
the down-payment for luxury properties costing over HKD20 million to 40% from 30%.
Risks: Given Hong Kong is a small, open economy, and a regional financial hub, a setback to
the global recovery remains a key risk. Until it bursts, an asset price bubble is an upside risk,
while sudden capital outflows would tighten interbank liquidity and could cause an interest rate
shock. The risk of a more virulent swine flu outbreak still hangs in the air.

[sa, % q-o-q; annualized] 1.6 15.6 4.6 2.9 0.9 1.7 6.0 7.8
Real GDP -2.4 3.3 8.7 6.2 5.5 2.4 2.9 4.0 -2.6 5.6 4.4
Private consumption 0.2 9.2 9.8 6.2 6.9 5.5 4.6 4.4 0.6 7.0 4.9
Gross fixed capital formation 1.4 10.9 11.9 13.4 8.8 6.4 4.4 8.7 -4.3 10.0 7.6
Exports (goods & services) -10.7 -2.0 14.8 6.3 4.8 3.9 7.2 8.0 -10.6 7.1 8.2
Imports (goods & services) -7.8 0.8 15.8 7.3 5.7 5.5 8.2 8.5 -9.6 8.1 8.7
Inventories 4.3 1.5 0.1 0.8 1.0 0.3 0.1 -0.4 0.9 0.6 0.0
Net trade (goods & services) -7.3 -5.7 0.1 -1.4 -1.4 -2.5 -0.9 -0.3 -3.2 -1.3 -0.3
Unemployment rate (sa, %) 5.3 5.2 5.1 5.0 4.8 4.6 4.4 4.0 5.3 4.9 4.0
Consumer prices -0.9 1.4 1.8 3.1 4.7 3.2 2.7 2.8 0.5 3.2 2.9
Exports -13.8 -3.7 16.8 6.7 6.1 4.2 8.2 8.9 -12.7 7.9 9.2
Imports -9.9 0.2 18.0 9.0 7.0 6.5 9.6 9.7 -11.4 9.6 9.9
Trade balance (US$bn) -9.4 -8.1 -5.9 -8.0 -10.8 -10.6 -7.6 -9.3 -27.5 -35.3 -41.2
Current account (US$bn) 24.9 19.9 17.5
Current account (% GDP) 11.7 8.6 7.1
3-month Hibor (%) 0.22 0.25 0.25 0.27 0.30 0.40 0.60 0.80 0.30 0.40 1.15
Exchange rate (HKD/USD) 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75 7.75

India ⏐ Economic Outlook Sonal Varma
Heading back to 8%
A rebound in private demand, rising inflationary pressures and a surge in capital inflows have
set the stage for policy reversal in 2010. But managing the fiscal deficit will remain a challenge.
Activity: India has weathered not just the global crisis, but also weak monsoons, and is likely to
post 6.5% y-o-y GDP growth in 2009. Buoyed by loose macro policies, we expect growth to
rebound to 8% in 2010 and 8.2% in 2011. Domestic private consumption is picking up due to
lower interest costs, rising confidence and better job prospects. As consumer demand rebounds
and the global economy stabilises, increased business confidence should propel greenfield
investments. We expect the economy to rebalance towards a more normalised growth path, with
the decline in government consumption easily offset by accelerating private demand.
Inflation: Food inflation is a concern. We believe that food prices could remain high in 2010 due
to hoarding ahead of the next monsoons. Non-food inflationary pressures are also building due
to higher oil prices, and the economic recovery could soon lead to demand-side price pressures.
High input prices and rising demand are likely to prompt firms to gradually pass on more of their
increased costs to consumers. Therefore, the fundamental driver of inflation is likely to shift from
the supply side to the demand side in coming quarters. We expect wholesale price inflation to
rebound to 7.0% y-o-y in 2010 from 1.9% in 2009.
Policy: With both growth and inflation heading towards 8%, we expect the Reserve Bank of
India (RBI) to start normalising its policy rates in January, and hike its repo and reverse repo
rates by 125bp each in 2010. We expect the rupee to appreciate due to rising net capital inflows
and the RBI’s inflationary concerns. However, weak external demand suggests that the RBI will
continue to intervene in order to prevent too sharp INR appreciation, and to mop up the resulting
excess liquidity through cash reserve ratio hikes and market stabilisation schemes. Stricter
prudential norms to prevent too rapid an increase in asset prices and select controls on debt
capital inflows are also likely. On the fiscal side, we are sceptical about any public expenditure
cuts and instead expect higher revenue buoyancy, a reversal of tax cuts and disinvestment to
lower the fiscal deficit. Still, gross borrowings are likely to be substantial and, combined with
higher inflation and rising policy rates, are likely to put upward pressure on long-term yields.
Risks: Higher oil prices, a double-dip and global financial instability are the key downside risks,
while strong net capital inflows and a sharp rebound in investment are the key upside risks.

Real GDP (sa, % q-o-q, annualized) 11.4 2.4 9.7 8.5 10.9 4.7 6.9 9.3
Real GDP 7.9 6.5 7.5 7.9 8.1 8.3 7.7 8.0 6.5 8.0 8.2
Fixed investment 7.3 6.0 8.0 7.8 8.2 9.2 9.5 8.0 6.0 8.3 10.1
Exports (goods & services) -15.0 3.0 6.0 14.5 14.9 9.5 9.0 10.2 -5.8 10.9 10.2
Imports (goods & services) -29.8 -2.0 9.0 14.0 8.4 11.5 10.5 10.0 -14.5 10.7 11.8
M3 money supply 19.8 18.6 18.1 18.0 18.5 18.4 17.3 17.5 19.6 18.3 17.8
Non-food credit 14.7 11.1 14.8 15.2 17.3 19.7 21.1 22.6 15.1 16.8 22.6
Wholesale price index -0.1 4.0 7.5 7.4 6.3 6.7 7.0 6.4 1.9 7.0 6.2
Consumer price index 11.8 11.5 11.3 10.4 5.8 5.3 5.5 5.6 10.4 8.0 5.8
Merchandise trade balance (% GDP) -7.7 -9.6 -7.0 -6.7 -6.6 -9.7 -5.5 -6.6 -6.9 -7.6 -7.1
Current account balance (% GDP) -0.8 -0.7 -1.3
Fiscal balance (% GDP) -6.8 -6.2 -4.9
Repo rate (%) 4.75 4.75 5.00 5.25 5.50 6.00 6.25 6.50 4.75 6.00 7.00
Reverse repo rate (%) 3.25 3.25 3.50 3.75 4.00 4.50 4.75 5.00 3.25 4.50 5.50
Cash reserve ratio (%) 5.00 5.25 5.50 5.75 6.00 6.25 6.50 6.75 5.25 6.25 7.25
10-year bond yield (%) 7.34 7.00 7.25 7.30 7.50 7.75 8.00 8.20 7.00 7.75 8.40
Exchange rate (INR/USD) 48.0 45.8 46.2 45.0 43.7 42.3 40.5 40.0 45.8 42.3 39.0
period average. CPI is for industrial workers. Fiscal deficit is for the central government and for fiscal year, eg, 2009 is for year ending
March 2010. Table last revised on 16 December 2009.

Indonesia ⏐ Economic Outlook Tomo Kinoshita
Domestic demand to lead robust growth

Private consumption and natural resources-related investment should help the economy to
achieve about 6% growth in 2010-11.
Activity: After sailing through 2009 relatively unharmed by the global financial crisis, the
resource-rich Indonesian economy is likely to maintain strong economic momentum in 2010. We
revise up our growth forecast for Indonesia in 2010 to 5.9% from the previous 5.1% on stronger
private consumption and investment. We expect private consumption to maintain its robust
growth rate of 5.1% in 2010, with the latest reading of the consumer sentiment index still
hovering around the highest level since 2004. Wage increases and moderate inflation, the
former being bolstered by minimum wage hikes, should support consumption strength. Now that
the ruling coalition controls 423 of the 560 seats in the House of Representatives (DPR) as a
result of elections held in 2009, President Yodoyono ought to be more capable of passing his
legislative agenda through the DPR. This ease of legislative passage should support economic
reform and encourage greater domestic and foreign investments, particularly in natural
resources. We forecast that growth in gross fixed capital formation will accelerate to 8.0% in
2010 from 4.4% in 2009.
Inflation and monetary policy: Headline CPI inflation is expected to rise from 4.6% in 2009 to
6.1% in 2010, a more normal level for Indonesia in the absence of favourable base effects. As
the economy is expected to gain further traction in 2010 with moderate inflationary pressures,
we expect Bank Indonesia to raise its policy interest rate by 25bp in 2Q, followed by three more
25bp hikes during 2H10.
Fiscal policy: After implementing a fiscal stimulus policy, in 2009, we expect the Indonesian
government to become more conservative on this front. The 2010 budget proposal agreed by
the government and the House of Representatives plans only a 4.2% y-o-y increase in fiscal
spending. We forecast the fiscal deficit-to-GDP ratio to fall to 1.9% in 2010 from 2.6% in 2009.
Risks: We remain cautious about the effects of a slower-than-expected recovery on external

demand. We also note that a substantial and unexpected rise in international oil prices could
trigger a gasoline price increase, which would likely lead to an inflation problem. The
government recently announced that it was considering measures to curb foreign ownership of
short-term SBI securities. Although the actual introduction of such a restriction may be negative
for the overall investment climate, we would not expect such a move to cause large fluctuations
in asset prices as long as it is implemented in a reasonable manner.

Real GDP 4.2 5.6 5.4 6.0 6.0 6.2 6.2 5.9 4.6 5.9 6.2
Gross fixed capital formation 4.0 7.4 8.3 8.2 7.9 7.8 7.8 7.6 4.4 8.0 7.8
Exports (goods & services) -8.2 -5.1 3.0 4.1 4.8 5.0 5.9 6.1 -11.9 4.3 6.4
Imports (goods & services) -18.3 -4.9 3.6 4.2 5.1 5.1 4.6 4.9 -18.6 4.5 5.0
Inventories 0.1 0.7 0.1 0.3 0.3 0.3 0.0 -0.3 0.0 0.3 -0.2
Net trade (goods & services) 3.4 -0.6 0.1 0.4 0.5 0.4 1.0 1.0 1.5 0.4 1.1
Consumer prices index 2.8 3.1 4.6 6.1 6.9 7.1 6.8 6.6 4.9 6.1 6.3
Exports -19.4 -2.7 13.8 9.3 6.6 5.2 7.2 8.6 -20.7 8.4 9.2
Imports -10.7 20.8 44.0 11.0 7.2 6.9 6.9 8.4 -17.6 14.2 8.9
Merchandise trade balance (US$bn) 3.1 1.7 4.1 4.8 3.2 1.3 4.4 5.3 17.2 13.3 14.8
Current account balance (% of GDP) 1.2 -4.3 -0.6 1.9 1.1 -4.0 -0.3 1.9 0.2 -0.4 -0.1
Fiscal Balance (% of GDP) -2.6 -1.9 -1.5
Bank Indonesia rate (%) 6.50 6.50 6.50 6.75 7.25 7.50 7.50 7.50 6.50 7.50 7.50
Exchange rate (IDR/USD) 9681 9300 9450 9200 9000 8750 8622 8528 9300 8750 8250

Malaysia ⏐ Economic Outlook Tetsuji Sano
Private sector to lead the recovery

Domestic demand, especially from the private sector, should lead the recovery, as the
government strives to rein-in the large fiscal deficit.
Activity: We expect real GDP growth to rise to 4.5% in 2010 led by domestic demand. The main
contributor to GDP growth should be private consumption, adding 2.4 percentage points (pp) as
labour markets improve. In addition, we expect a significant increase in the number of tourists,
which should further boost GDP growth via service receipts. In the balance of payments, travel
receipts accounted for 8.1% of GDP for the first three quarters of 2009. The year-to-date number
of tourists increased 7.2% y-o-y in October, while we expect tourist numbers to grow at a
double-digit pace in 2010. We expect a milder GDP contribution from investment, of 1.3pp, as
we assume negative growth in public investment, while still significant spare economic capacity
is likely to restrain the recovery in private investment. We expect government consumption to
contract following a tightening of fiscal policy. Overall, we expect the private sector to lead the
economy in 2010. In fact, of the MYR67bn stimulus package, the government had disbursed just
MYR8.2bn by end-September. This suggests that the economy has not been dependent on the
stimulus package, implying that the private sector has already started to lead the recovery. Net
exports should subtract 0.7pp from GDP growth due to higher growth of imports than that of
exports, following the recovery of domestic demand.
Inflation: We expect CPI inflation to pick-up to 2.7% in 2010 for three main reasons. The first is
an increase in food prices, as food is weighted at 31% of the CPI basket. Higher oil prices, with
the transport category weighted at 16% of CPI, will also put upside pressure on inflation. The
third is that we expect a narrower output gap in 2010. Although talk of a goods and services tax
(GST) tax has been mooted, the government is not expected to implement a GST until late 2011.
Policy: On fiscal policy, the government announced a tighter policy stance in its 2010 fiscal
budget, by cutting its expenditure budget for 2010. The growth rate of operating expenditure,
which accounts for 93% of total expenditure, will be lowered to -13.7% after a 4.3% increase in
2009. Development expenditure growth will be cut to -4.4% from a 25.0% increase in 2009. On
monetary policy, we expect Bank Negara Malaysia (BNM) to start to hike rates in 2Q10. BNM
should raise its policy interest rate cautiously by just 50bp in 2010, keeping real rates negative.
Risks: Unlike the rest of Asia, higher commodity prices have a positive direct effect on Malaysia,
since it is a large net exporter of crude oil, palm oil and natural gas. However, if commodity
prices increase too rapidly, particularly if driven by speculation of supply-side factors, GDP
growth may suffer indirectly through a decline in exports if there is a major relapse in global
demand. In addition, consumer sentiment may deteriorate through a decrease in household
purchasing power in real terms.

Real GDP -1.2 2.5 6.2 4.4 3.7 3.7 4.7 4.7 -2.2 4.5 5.2
Government consumption 10.9 2.5 -2.5 -3.0 -4.0 -3.7 7.0 7.0 4.1 -3.4 7.0
Gross fixed capital formation -7.9 12.0 8.0 6.0 6.0 4.0 8.0 8.0 -4.7 5.9 8.0
Inventories 0.7 0.5 4.6 1.5 0.7 1.6 1.0 1.0 -2.6 2.0 1.1
Net trade (goods & services) -2.3 -2.5 -2.7 -0.1 0.0 -0.3 -1.0 -1.2 0.2 -0.7 -0.9
Unemployment rate (%) 3.6 3.5 3.4 3.3 3.2 3.2 3.1 3.1 3.7 3.3 3.1
Consumer prices index -2.3 -0.1 2.0 2.8 3.0 3.0 3.2 3.5 0.6 2.7 3.6
Exports -25.6 9.4 17.7 17.0 18.5 9.0 9.2 10.2 -21.0 15.2 11.3
Imports -21.8 10.0 22.2 21.0 18.5 9.0 9.2 10.2 -21.2 17.0 10.9
Current account balance (% of GDP) 14.6 15.9 18.1 16.1 15.2 14.6 16.1 13.6 17.0 15.9 13.9
Overnight policy rate (%) 2.00 2.00 2.00 2.25 2.50 2.50 2.75 3.00 2.00 2.50 3.00
Exchange rate (MYR/USD) 3.45 3.35 3.38 3.31 3.24 3.15 3.09 3.04 3.35 3.15 2.92

Philippines ⏐ Economic Outlook Robert Subbaraman
Too much fiscal hype

The fiscal deficit should remain large in 2010, but otherwise the fundamentals are in good shape.
Activity: The Philippines weathered the global crisis relatively well, escaping recession. The
modest downturn means that the economy is not lumbered with large excesses of labour and
capital, and so should be able to bounce back strongly. We are forecasting GDP growth to rise
to 5.5% in 2010 and 6.0% in 2011. This may seem aggressive, but over 2004-07 average
annual GDP growth was 5.9%. There are four other reasons for our bullish outlook. First, we
expect macro policies to remain accommodative, especially fiscal policy ahead of the May 2010
election. Second, with the global economy recovering, remittances by the 8.7 million Filipino
overseas workers should strengthen, and they account for a hefty 10% of GDP. Also, as large
companies around the world strive to reduce costs, the business process outsourcing industry of
the Philippines should continue to blossom. Third, output of the agricultural sector, which makes
up 17% of GDP and employs one-third of all workers, was weak in 2009 due to low food prices
early in the year and natural disasters in the latter half. We expect agricultural output to rebound
in 2010. And fourth, there is an urgent need to upgrade the capital stock. The investment-GDP
ratio has fallen to just 15%, but with much-improved fundamentals we expect it to rebound.
Fundamentals: Concerns have been raised about the increased fiscal deficit, which will likely
remain around 4% of GDP in 2010. However, in the global scheme of things this is not large,
and Philippine public debt has fallen to 60% of GDP from 95% in 2004. If the economy quickly
returns to high growth – as we expect – the fiscal finances should not be a problem. Other
fundamental indicators are healthy: the loan-deposit ratio, at 66%, is among the lowest in Asia;
the current account is in surplus; external debt has fallen to 33% of GDP from 72% in 2003; and
FX reserves are at a record high of USD36bn, equal to ten months of import cover.
Inflation and monetary policy: After plunging to almost 0% in August 2009, CPI inflation rose
to 2.8% y-o-y in November, and we expect it to continue rising, to average 5.4% in 2010.
However, we do not expect Banko Sentral ng Pilipinas to start hiking rates until 2Q10, and only
by a total of 75bp by the end of 2010. We see a number of reasons for the slow policy response:
inflation is rising from a very low level and is partly driven by higher costs of food and energy;
the elections may delay rate hikes; commercial bank lending rates are already quite high; and
peso appreciation will do some of the tightening of overall monetary conditions.
Risks: A surge in commodity prices (the Philippines is a large net importer of oil and rice) and
social unrest around election time are downside risks. On the upside, if growth picks up in 2010
as we expect, the Philippines’ favourable interest rate differential and relatively sound economic
fundamentals could attract strong capital inflows and possibly a sovereign credit rating upgrade.

Real GDP [sa, % q-o-q, annualized] 4.1 4.8 7.8 8.3 0.3 2.1 8.0 15.5
Real GDP 0.8 1.7 5.9 6.2 5.2 4.6 4.6 6.3 1.0 5.5 6.0
Imports (goods & services) 0.3 5.0 8.0 7.0 9.0 9.0 9.0 10.0 -3.8 8.3 9.8
Contribution to GDP growth (% points):
Inventories -1.8 0.6 1.0 0.0 0.0 0.0 0.0 0.0 -1.0 0.2 0.0
Net trade (goods & services) -7.9 -2.2 -1.3 -0.4 -1.0 -1.7 -0.3 -0.9 -4.0 -1.1 -0.8
Exports -21.5 2.0 5.0 8.0 8.0 10.0 11.0 11.0 -22.5 7.9 11.0
Imports -28.5 13.0 13.0 15.0 16.0 17.0 17.0 17.0 -21.5 15.4 17.0
Merchandise trade balance (US$bn) -0.9 -2.5 -2.5 -2.3 -1.9 -3.6 -3.5 -3.3 -6.5 -10.3 -14.6
Current account balance (US$bn) 2.0 1.4 1.3 1.5 2.5 1.5 1.5 1.8 7.3 6.7 6.8
(% of GDP) 5.1 3.0 3.1 3.3 5.3 2.7 3.1 3.3 4.6 3.6 3.0
Consumer prices 0.3 2.9 3.0 5.0 7.0 6.5 6.0 6.0 3.2 5.4 5.7
Reverse repo rate (%) 4.00 4.00 4.00 4.25 4.50 5.00 5.50 6.00 4.00 5.00 6.00
91-day T-Bill yield (%) 4.40 4.40 4.50 4.75 5.00 5.25 5.75 6.00 4.40 5.25 6.50
Exchange rate (PHP/USD) 47.6 46.3 46.8 45.7 44.7 43.7 43.0 42.4 46.3 43.7 41.0

Singapore ⏐ Economic Outlook Tetsuji Sano
Tourism to drive momentum

Singapore’s economy should accelerate through 2010, supported by domestic demand. Tourism
is likely to help private consumption and improve the current account balance.
Activity: We expect real GDP growth to rise to 5.5% in 2010 led by domestic demand. The main
driver will be investment, contributing 2.7 percentage points (pp) to GDP growth in 2010, with
strong investment in the biomedical sector set against an accommodative fiscal policy backdrop.
The government will continue to strive to attract foreign direct investment and global talent,
especially to the biomedical sector. Private consumption looks set to contribute 1.9pp to growth
in 2010 as the labour market improves. In addition, we expect a large increase in the number of
tourists to improve consumer sentiment and boost service exports. In the balance of payments,
travel receipts made up 5.6% of GDP for the first three quarters of 2009. We expect the number
of tourists to increase at a double-digit pace in 2010 as the global economy recovers, although
the year-to-date number fell 6.9% y-o-y in October. The two integrated resorts (IRs) including
casinos, start operations in 2010 and should attract added tourist numbers. Furthermore, higher
asset prices should have positive wealth effects and improve consumer sentiment.
Inflation and monetary policy: We expect CPI inflation to rise to 3.0% in 2010 as we expect
the housing segment to rise, largely due to technicalities: the government will raise its expected
market rental prices of all Housing Development Board (HDB) flats, effective from 1 January
2010 to reflect prevailing HDB rentals. Excluding this technical issue we would expect a 1.8%
increase in CPI inflation. On the monetary policy front, we expect the Monetary Authority of
Singapore to shift to a tightening stance of its exchange rate policy in April 2010.
Fiscal policy: We expect the accommodative stance to continue through 2010 with ongoing
infrastructure development, although we do not assume an additional stimulus package. The
government has decided to extend the job credit scheme – under which employers receive a
12% cash grant on the first SGD2,500 of each month’s wages for each employee on their
Central Provident Fund payroll – until the end of June 2010. A cut in the corporate tax rate to
17% from 18% will take effect in FY10, giving the Lion City the second-lowest tax rate in Asia
next to Hong Kong, at 16.5%.
Risks: Given that Singapore is Asia’s most open economy, the most significant downside risk is
a renewed slump in the global economy. We also note that the historically volatile biomedical
sector, which showed strong growth in 2Q09 and 3Q09, offers both upside and downside risks
to economic momentum, although we expect biomedical production to increase annually in 2010.

Real GDP [sa, % q-o-q, annualized] 14.2 -2.9 4.9 5.5 4.6 5.9 4.7 6.5
Real GDP 0.6 4.3 9.1 5.2 3.0 5.2 5.2 5.4 -2.0 5.5 5.5
Private consumption -0.9 1.9 6.4 4.7 4.1 4.2 4.4 4.7 -1.7 4.8 5.0
Gross fixed capital formation 0.3 6.2 11.8 7.7 9.0 10.2 12.0 12.0 -4.6 9.6 12.0
Inventories -0.5 0.6 1.3 3.6 1.3 2.7 1.8 1.6 0.2 2.2 1.7
Net trade (goods & services) -1.6 0.2 0.1 -3.1 -3.2 -2.8 -3.0 -2.3 -2.2 -2.3 -2.5
Consumer prices index -0.4 -0.1 2.5 3.3 3.3 3.1 1.9 3.0 0.3 3.0 2.7
Exports -22.3 10.4 25.4 18.4 11.7 8.1 8.9 12.8 -20.5 15.1 12.1
Imports -25.0 12.3 29.5 23.0 13.8 8.3 10.5 14.3 -21.3 17.6 13.5
Current account balance (% of GDP) 13.0 10.2 12.6 14.4 13.0 8.2 11.1 13.1 12.3 12.0 11.0
3 month SIBOR (%) 0.68 0.70 0.70 0.75 1.00 1.25 1.25 1.50 0.70 1.25 1.75
Exchange rate (SGD/USD) 1.42 1.38 1.38 1.36 1.33 1.30 1.28 1.27 1.38 1.30 1.23

South Korea ⏐ Economic Outlook Young Sun Kwon
Inflationary recovery
We see an inflationary economic recovery in 2010, driven by a prolonged macro stimulus rather
than productivity gains. A large balance of payment surplus should boost asset prices in 2010.
Activity: Korea’s 3Q09 real GDP gained 3.2% (sa) q-o-q or 0.9% y-o-y, bringing the level higher
than the previous 3Q08 peak. As the production utilization rate fully recovers, sequential quarter-
on-quarter GDP growth rates will likely be smaller, but still positive, meaning the recovery
remains on track. In 2010, despite sluggish recoveries in the G3 we are positive on the export
outlook, because of strong emerging market demand, particularly from China. Long-term growth
for Korea’s oil, gas and power plant exports to the Gulf looks intact. A weaker KRW/JPY should
help maintain export price competitiveness. Domestically, we expect consumption to recover as
pent-up demand is unleashed, helped by positive wealth effects, negative real policy rates and
household re-leveraging. A large 2009 current account surplus (we estimate USD41bn or 5% of
GDP) should have multiplier effects on the domestic economy in 2010. In sum, we expect
delayed rate hikes, an undervalued KRW, strong China demand and consumer re-leveraging to
all support growth in 2010, but the Bank of Korea (BOK) eventually tightening aggressively to
get back ahead of the curve is likely to lower growth in 2011. We forecast above-the-consensus
5.5% GDP growth in 2010, but below-the-consensus 4.0% growth in 2011.
Inflation: We expect CPI inflation to rise to 3.3% in 2010 from 2.8% in 2009 as the negative
output gap closes and nominal wages increase. Inflation expectations are relatively elevated.
Deeply negative real interest rates in 1H10 and rising money supply should support asset prices.
Policy: Although impressive data suggest that a rate hike is possible any time soon, we expect
the BOK to move late, with a 25bp rate hike in June, given the central bank’s benign inflation
outlook, its new, wider inflation target and a political preference to accelerate growth. We then
expect an aggressive 125bp of catch-up hikes in 2H10 to 3.50%. After adjusting for the cyclical
upswing, we judge that structural fiscal tightening should be only modest. The government
decided to extend its financial support for small and medium sized enterprises until end-June.
Risks: Upside risks are stronger-than-expected recoveries in the G3, lower oil prices, and
higher productivity in Korea, which would help firms’ profitability and limit inflationary pressure.
Successful structural reforms and more prudent macro policy are long-term positives. Downside
risks include worse-than-expected G3 demand, higher oil prices or a weaker JPY, which would
worsen the balance of payments. Uncertainty surrounding North Korea is a wild card. Record-
high FX reserves (USD271bn in November) and unused currency swap lines with the Fed
(USD29bn) should help buttress the economy from any renewed global financial turmoil.

Real GDP (sa, % q-o-q, annualized) 13.6 0.6 4.5 6.1 4.5 4.1 3.6 3.6
Real GDP (sa, % q-o-q) 3.2 0.2 1.1 1.5 1.1 1.0 0.9 0.9
Real GDP 0.9 6.3 7.3 6.1 3.9 4.8 4.6 4.0 0.0 5.5 4.0
Business investment -7.4 9.0 24.0 13.7 2.0 1.0 1.0 0.5 -10.1 9.4 2.4
Construction investment 2.7 3.8 -1.8 -2.5 -1.5 0.5 1.5 0.5 2.8 -1.3 1.4
Exports (goods & services) 1.2 12.3 19.7 9.5 6.1 8.2 7.7 8.2 -0.5 10.6 8.0
Contributions to GDP growth (% points):
Inventories -5.4 -0.7 1.4 4.4 2.7 2.7 1.7 0.4 -4.7 2.7 0.3
Net trade (goods & services) 5.3 2.1 0.3 -1.7 -1.3 -1.1 -0.7 0.4 3.3 -0.9 0.3
Consumer prices 2.0 2.5 3.4 3.3 3.3 3.4 3.2 3.2 2.8 3.3 3.2
Current account balance (% of GDP) 5.0 2.0 0.5
Fiscal balance (% of GDP) -2.1 -0.4 0.2
Fiscal balance ex-social security (% of GDP) -4.9 -2.9 -2.3
Money supply (M2) 10.0 10.5 11.0 12.0 14.0 12.0 11.0 11.0 10.8 12.3 11.0
House prices (% q-o-q) 1.3 0.5 0.5 0.7 0.8 1.0 0.5 0.5 1.2 3.0 2.0
BOK official base rate (%) 2.00 2.00 2.00 2.25 2.50 3.50 3.75 4.00 2.00 3.50 4.50
3-year T-bond yield (%) 4.39 4.20 4.35 4.50 4.90 5.00 5.00 5.00 4.20 5.00 4.70
5-year T-bond yield (%) 4.81 4.70 4.85 5.00 5.35 5.50 5.35 5.25 4.70 5.50 5.00
Exchange rate (KRW/USD) 1189 1140 1155 1120 1080 1050 1025 1000 1140 1050 950
Source: Bank of Korea, CEIC and Nomura Global Economics.

Taiwan ⏐ Economic Outlook Tomo Kinoshita ⏐ Robert Subbaraman
Cross-straits moves to raise business confidence

A rise in consumer and business sentiment should fuel growth.
Activity: We expect the Taiwan economy to be on a firm recovery trend in 2010. Private
consumption has been improving on the back of improving sentiment and rising wealth effects
with the consumer confidence index having recovered to 62.5 in November 2009, up from the
bottom of 48.4 recorded in February 2009. Wealth effects on consumption are powerful in
Taiwan, since portfolio investment (of which the share of stocks is substantially larger than
others, in our view) accounted for about 37% of household assets according to the most recent
government survey (as of end-2007). Another recent government survey revealed that
companies intend to hire around 48,000 people during December 2009-January 2010. As the
government separately intends to create 15,000 jobs during 1H10, the number of unemployed
people should decrease notably from the seasonally-adjusted level of 661,000 in October 2009,
which should further lift consumer sentiment. Investment also appears to be recovering as
business sentiment rises and the capacity utilisation rate in major industries appears to have
picked up substantially from the bottom. Business sentiment should improve thanks to the
Economic Cooperation Framework Agreement (ECFA) which Taiwan is trying to conclude with
the mainland some time in 1Q10. Given the above expectations, we have raised our growth
forecast for 2010 to 4.8% from the previous 4.4%.
Monetary policy: We expect headline CPI inflation to rise to 1.5% in 2010 from -0.8% in 2009,
reflecting a decent economic recovery. The central bank has been warning against the risk of a
housing bubble and nonperforming loans, fuelled by fierce competition in mortgage lending. To
curb hot money inflows, the authorities have banned foreign investors from placing funds in the
banking sector’s time deposits. We expect the central bank to scale up its open market
operations to drain excess bank liquidity and to start raising the policy interest rate in 2Q10.
Fiscal policy: In an effort to consolidate fiscal policy after an expansionary budget in 2009,
central government expenditure is budgeted to drop by 4.1% for 2010. However, including the
special budgets for public construction, flood control and reconstruction, actual underlying
government spending is likely to be close to 2009 levels.
Risks: Rising consumer confidence and the powerful asset price-driven wealth effects in Taiwan
pose risk of stronger-than-expected private consumption growth. The sustainability and strength
of the global recovery is still uncertain, with volatile capital flows posing challenges to FX policy.
A delay in cross-strait economic liberalisation may disappoint financial markets, while successful
integration could raise the potential rate of growth over the medium term.

Real GDP -1.3 5.1 9.0 4.9 3.2 2.7 3.8 4.7 -3.0 4.8 5.2
Government consumption 3.6 2.3 -1.3 0.4 -0.2 1.4 0.0 -0.1 3.4 0.2 0.1
Inventories -3.1 -0.5 2.6 0.0 0.5 -0.1 0.4 0.8 -2.3 0.7 0.6
Net trade (goods & services) 1.3 0.9 1.0 0.5 0.3 0.1 0.4 0.2 0.6 0.4 1.1
Exports -20.8 10.2 22.1 11.9 8.1 6.8 10.6 12.3 -21.7 11.5 13.2
Imports -29.5 15.2 33.5 18.9 11.7 8.4 13.0 14.2 -27.9 16.4 15.4
Current account balance (US$bn) 5.7 6.1 11.9 7.3 6.3 5.7 11.6 7.1 37.2 31.2 29.6
(% of GDP) 6.2 5.7 11.6 7.4 6.0 4.9 10.0 6.2 9.8 7.4 6.1
Consumer prices index -1.3 -0.8 1.0 1.3 1.6 2.0 1.9 1.8 -0.8 1.5 1.8
Unemployment rate (%) 6.1 6.0 5.7 5.5 5.4 5.3 5.1 4.9 5.9 5.7 4.4
Discount rate (%) 1.25 1.25 1.25 1.50 1.63 1.75 1.88 2.00 1.25 1.75 2.25
Overnight call rate (%) 0.10 0.10 0.15 0.30 0.40 0.50 0.60 0.70 0.10 0.50 1.00
10-year T-bond (%) 1.40 1.45 1.50 1.60 1.75 1.85 1.95 2.05 1.45 1.85 2.30
Exchange rate (NTD/USD) 32.20 32.10 32.30 31.70 31.10 30.50 29.91 29.43 32.10 30.50 28.50

Thailand ⏐ Economic Outlook Tetsuji Sano
Political uncertainty
The economy should continue to recover gradually, but economic sentiment may be dented by
political uncertainty. We expect loose macro policies to continue.
Activity: We expect real GDP growth to rise to 3% in 2010 led by domestic demand amid loose
macro polices. We expect domestic demand to contribute 2.6 percentage points (pp) to GDP
growth in 2010, mainly due to a low base in 2009. The pace of the Thailand’s recovery is
expected to be the mildest in Asia, largely because the political impasse between pro- and anti-
Thaksin factions is expected to continue to hurt sentiment. Private investment has also been
negatively affected by events surrounding the Map Ta Phut industrial area. On 29 September
2009 the Central Administrative Court ordered the suspension of operations at 76 projects in the
Map Ta Phut area. On 2 December, the Supreme Administrative Court ruled that 65 of the 76
projects should remain suspended. Following the ruling, we believe manufacturers will take a
cautious stance on investment in 2010. We expect overall investment to grow at only 3.7% y-o-y
as weak private investment is offset by strong public investment. We expect the contribution of
net exports to GDP growth to slow to 0.5pp in 2010, again mainly on a low base in 2009.
Inflation and monetary policy: We expect CPI inflation to rise to 2.7% in 2010 on higher crude
oil prices. Demand-pull inflationary pressure should remain weak due to the still-remaining
output gap. On monetary policy, we expect the Bank of Thailand (BOT) to start hiking rates in
2Q10 following a pick-up in CPI inflation. We expect the BOT to raise its policy interest rate by
only 50bp in 2010, as downside risks to economic growth will persist. As a result, we expect the
real interest rate to remain negative through 2010.
Fiscal policy: The government plans to cut the expenditure budget to THB1.7trn for FY10
(starting October 2009), compared to the final THB1.95trn budget for FY09. The government
has started its THB1.43trn fiscal stimulus package for FY10-12, aimed largely at developing
infrastructure. The package is to be financed mainly from non-budgetary accounts, such as
state-owned enterprises; THB431bn has been allotted for FY10. Overall, we expect
accommodative fiscal policy to support the economy in 2010.
Risks: We have already mentioned some of the political risks, and the general election, which
must take place before 23 December 2011, is another. Prime Minister Abhisit seems to believe
that an early election would calm political tensions between pro- and anti-Thaksin groups, but it
could backfire. Moreover, if the incumbent coalition parties do lose in the election, a new
government may review and alter the stimulus package. Another downside risk, is a sharp rise in
oil prices, given that Thailand is Asia’s largest net importer of oil once scaled by GDP. The main
upside risk is a quick resolution of the political impasse, which would allow investors to refocus
on the economy, whose fundamentals are in good shape.

Real GDP -2.8 3.1 5.3 3.3 2.2 1.5 2.3 4.1 -3.0 3.0 5.0
Private consumption -1.3 -0.3 3.0 2.4 1.5 0.8 1.0 2.5 -1.6 1.9 3.5
Public consumption 4.7 3.0 3.0 3.0 3.0 -1.0 -1.0 -1.0 5.3 2.1 -1.0
Contribution to GDP (%points):
Domestic final sales -1.6 0.9 2.3 2.4 2.0 1.4 2.4 4.0 -1.9 2.0 4.7
Inventories -4.5 1.5 2.3 0.0 0.0 0.0 0.3 1.0 -2.8 0.6 1.0
Net trade (goods & services) 3.2 0.7 0.7 0.9 0.2 0.1 -0.4 -0.9 1.9 0.5 -0.7
Exports -17.7 4.5 14.4 14.1 10.6 5.0 7.6 10.8 -15.8 10.7 10.6
Imports -28.0 4.2 23.2 20.7 13.2 8.1 10.2 15.5 -24.5 15.3 14.4
Merchandise trade balance (US$bn) 4.8 -1.4 5.7 2.5 4.3 -2.8 5.3 1.0 14.3 9.7 4.8
Current account balance (US$bn) 3.7 -0.8 8.9 1.3 3.2 -1.9 8.9 -0.1 15.3 11.5 7.6
(% of GDP) 5.6 -1.1 12.4 1.8 4.4 -2.5 11.2 -0.1 6.0 4.0 2.3
Fiscal balance (% of GDP, fiscal year basis) -5.7 -3.9 -3.6
Consumer prices -2.2 1.8 3.2 2.8 2.6 2.2 2.5 3.0 -0.9 2.7 3.3
Overnight repo rate (%) 1.25 1.25 1.25 1.50 1.75 1.75 2.00 2.50 1.25 1.75 3.00
Exchange rate (THB/USD) 33.5 33.1 33.3 32.6 32.0 31.5 31.1 30.8 33.1 31.5 30.0

Vietnam ⏐ Economic Outlook Sonal Varma
An overheated economy
Vietnam needs to correct the macro-economic imbalances of excess credit growth, high fiscal
and current account deficits and rising inflation to avoid another crisis.
Activity: An aggressive fiscal stimulus, spearheaded by the interest-rate subsidy scheme, has
underpinned a domestic-led economic recovery that looks to be gaining momentum. Domestic
demand indicators such as auto sales, industrial production and retail sales have accelerated.
However, Vietnam is at risk of having over-stimulated the economy. Credit growth has already
accelerated 36% y-o-y in November (year-to-date), which is even higher than that in China, and
we see a growing risk that some of these loans are being used for unproductive purposes, such
as investment in asset markets. Higher credit growth and loose fiscal policies are likely to
stimulate private demand and boost GDP growth from 5.1% y-o-y in 2009 to 6.5% in 2010.
However, with foreign investor confidence flagging as a result of the twin deficits, we expect
aggressive policy action to curtail these imbalances. This should anchor GDP growth at 6.6% in
2011, below Vietnam’s real potential.
Inflation: Both demand and supply side factors suggest that inflation is likely to revert to double-
digits in 2010. Rising global commodity prices are putting upward pressure on raw material costs.
Meanwhile, accelerating growth and credit off-take are fuelling demand-side inflationary
pressures. We expect CPI inflation to average 12.4% y-o-y in 2010, up from 6.7% in 2008,
shifting the policy focus to inflation.
Policy: External sector pressures are gradually building up as a result of the widening trade
deficit and a sharp decline in foreign direct investment commitments, which have eroded the
balance of payments position. Amid media reports of growing black-market speculation that the
dong will be devalued again, the State Bank of Vietnam (SBV) has depleted its FX reserves to
fewer than three months of import cover to defend the currency. We expect another round of
devaluation some time in 2010. This is likely to add to inflationary pressures and increase the
need for additional rate tightening. Therefore, we expect the SBV to hike policy rates by 300bp
in 2010. Administrative measures to curtail lending amid growing concerns about the health of
the banking system and measures to reduce imports also look likely in the coming months.
Risks: High inflation, rising credit growth, loose fiscal policy and a widening trade deficit – all
sings of economic overheating – are the key challenges facing policymakers. If confidence
continues to decline, a vicious spiral could develop, ultimately leading to a balance of payments
crisis. In our view, policies need to be tightened aggressively to reduce these risks.

Real GDP 5.8 6.4 8.0 6.6 6.3 5.7 5.4 6.0 5.1 6.5 6.6
Private consumption 7.0 8.0 8.2
Public consumption 10.0 8.0 6.0
Gross fixed capital formation 3.5 7.8 9.0
Contribution to GDP growth (% points):
Domestic final sales 6.8 9.1 9.6
Inventories -1.0 0.7 0.8
Net trade (goods & services) -0.7 -3.3 -4.0
Exports -21.7 -6.7 5.0 12.0 13.3 14.1 12.3 13.1 -12.5 11.1 13.3
Imports -4.5 18.6 5.0 10.0 29.2 19.2 11.0 15.5 -16.1 17.0 14.7
Merchandise trade balance (US$bn) -4.4 -5.9 1.7 -3.8 -8.0 -7.7 2.1 -4.8 -12.4 -17.8 -21.3
Current account balance (US$bn) -10.0 -10.7 -11.8
(% of GDP) -10.8 -10.1 -9.6
Consumer prices 2.6 4.7 8.9 12.6 14.2 13.2 12.2 11.6 6.7 12.4 11.2
Unemployment rate (%) 6.0 5.5 5.0
Base rate (%) 7.00 8.00 9.00 10.00 10.00 11.00 11.00 11.50 8.00 11.00 12.00
Refinance rate (%) 7.00 8.00 9.00 10.00 10.00 11.00 11.00 11.50 8.00 11.00 12.00
Exchange rate (VND/USD) 17,841 18,500 18,500 18,500 19,000 19,000 19,000 19,000 18,500 19,000 19,380
Source: General Statistics Office of Vietnam, State Bank of Vietnam, World Bank, CEIC and Nomura Global Economics.

EEMEA ⏐ Outlook 2010 Ivan Tchakarov ⏐ Peter Attard Montalto ⏐ Olgay Buyukkayali
Differentiated growth woes

EEMEA will continue to display many areas of vulnerability, including debt sustainability,
although we expect relative policy credibility to lead to differing growth levels across the region.
EEMEA will continue Cheap credit, strong capital inflows and financial sector liberalisation together with the prospects
be the weakest EM of EU convergence fuelled growth in the EEMEA (Emerging Europe, Middle East and Africa)
link in 2010 economies in the run-up to the financial crisis (Figure 1). However, the unravelling of the current
account and external imbalances, as well as exposure to Western Europe, meant EEMEA
suffered disproportionally in 2009 relative to other emerging market (EM) economies in Asia and
LatAm. Even though this weighed heavily on the investor psyche, leading to frequent predictions
that the EEMEA economies were on the road to perdition, an Armageddon-type scenario failed
to materialise, mainly because of the generous supranational cushion that these economies
have enjoyed. With its challenging domestic policy environment, EEMEA likely will continue to
be the most vulnerable region in EM, but we expect it to return to modest growth in 2010.
New supranational cover

The IMF and EU Despite being the weakest link in the EM universe, EEMEA was cushioned in 2009 by strong
provided key support and flexible support by the IMF and EU. Supranational institutions were open to negotiating
in 2009 ... significant revisions to support programmes where there was political resistance (Ukraine, Latvia,
Romania, Hungary). They were likely concerned that any slip-ups in these economies could spill
over to the rest of the region, jeopardizing economic stability and heightening the risk of a crisis.
... but they will However, now that the worst may be over, the risk/reward trade-off between the necessity to
become more provide country support and the desire to avoid moral hazard is shifting in favour of a more
exacting in 2010 ... individual approach to country circumstances. In that sense, we expect to see a transition from a
hard to soft supranational cover, defined as close monitoring of specific country situations with a
view to providing financial support while, at the same time, exacting stronger compliance with
the IMF/EU programmes. We have started to see this shift in Ukraine and Romania, where the
programmes have been delayed, and Latvia, where international institutions stood their ground
against the government’s attempt to loosen the strings of the 2010 budget.
... leading to new However, we expect that, while supranational cover provided by the IMF and EU may fade in
supranational cover importance, it will be replaced by a new supranational anchor: the ERM-II. As countries exit the crisis
provided by ERM-II we believe they will turn back towards euro adoption and that the EU Commission sees this as a key
way to stabilise its periphery. The EU and CEE countries need to learn the lessons of previous
troubled entries to EMU, especially given that policymaker credibility was easier to achieve before the
crisis when credit was easy. As countries exit the crisis, timetables and fiscal policy need to adjust
and be made more credible. Adoption dates may be some way off, but with Poland set to join ERM-II
next year, in our view, and Estonia possibly applying to the ECB in Q2 2010 for an assessment of its
compliance with the Maastricht criteria, we think this theme will be key in providing a floor for EEMEA
economic performance leading into 2010 (see Box: Towards EMU: New convergence anchor).
Figure 1. West European banking credit exposures to the East Figure 2. Potential growth across the crisis
USD bn % % y-o-y Hungary Poland

Amount of exposure
8 Czech Russia
1,600 7
Proportion of exposure as % of total SA Turkey
7
1,400 exposure (rhs) 6
6
1,200
5
5
1,000
4 4
800
3 3
600
2
2
400 Pre-crisis Our pre- Short run Medium Long run
average crisis potential run
200 1
growth potential (next 5 potential (in
(1999- estimate years) 10 years)
0 0 2007) (1999-2007
Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 average)
Source: Nomura Global Economics;. Source: Nomura Global Economics

Towards EMU: New convergence anchor Peter Attard Montalto

ERM-II and euro adoption is likely to be a key theme and important anchor for markets and policymakers in 2010.
The last wave of interest in euro convergence was during the boom of 2004-06, when easy credit was expected to lead
to accelerated convergence into the eurozone. The arrival of more credible policymakers and EU entry for much of
Emerging Europe in 2004 also looked set to help emerging Europe along the road to convergence. However, the global
economic downturn has made the Maastricht criteria look increasingly unattainable, and government timetables have
slipped. Supranational support took over as a key anchor for the region, markets and its policymakers. However, coming
out of the crisis as this support starts to be removed we expect ERM-II and euro-convergence to become the new anchor
for Europe’s periphery. We also believe that policymakers in Brussels see the euro as an important support for such
countries as they exit the crisis, and so we think this whole process should have strong political backing.
Our Maastricht scorecard assesses the economic positions of EMU aspirants. The global economic crisis has affected
government balances and long-end rates as well as inflation, making it difficult for many countries to meet the criteria.
Also, the criteria have changed (or rather, our view of how the ECB will assess the present situation) as a result of
changes in the euro-area economies and their interest and inflation rates on which the criteria are based. Poland and the
Czech Republic, for instance, need to bring budget deficits down – a task that looks uncertain in 2011 and beyond
without austerity measures designed specifically to meet EMU-entry criteria. Long-end rates should converge as
countries adopt credible timetables for entry, but given that absolute debt levels and external vulnerability metrics remain
high, such moves in rates will likely be gradual. Hungary, in particular, has a long way to go on the debt front and may
need to adopt a difficult policy of net debt repayment to set a sustainable trend towards target. All in all, the global crisis
means specific government policy and coordination will be required to set countries on the right path. In our view, a slow
recovery by emerging Europe will mean that countries will stay in ERM-II for more than two years as they strive to meet
the criteria. Markets will likely reward governments that put in the effort on this front with a convergence of long-run rates.
The scorecard also presents our forecast for ERM-II central parity rates (centre of the +/-15% band) and when we think
countries will join ERM-II and the euro. We expect Poland to join ERM-II at the very end of 2010 or start of 2011, after
the presidential election is out of the way and loose fiscal policy can be reined back in. For Hungary we believe the likely
new FIDESZ government in 2010 will want to join the euro at the end of its first term in office and so start talking early on
about convergence, entering ERM-II in 2011and the euro in 2015. In the Czech Republic, given political difficulties and
the fact that the euro is a much more divisive issue there, we expect the whole process to be significantly delayed until a
government with a strong political mandate emerges.
As for central parity levels, we see Hungary and Czech rates at around current spot levels at 280 and 26 vs the euro,
respectively. Given the zloty’s undervaluation relative to fundamentals, we think the EU council is unlikely to accept
Poland’s wish to join just below spot (it has recently posited EURPLN 4.0). Instead, we think 3.70, a less competitive
level, would be more acceptable to the rest of the eurozone. Things are a little more complex in the Baltics. The EU
appears to have a very strong political commitment to the region, but imbalances are large. Estonia looks most ready to
join; we think it could apply to the ECB in May 2010 for a Maastricht assessment and setting of the permanent lock-in
rate ready for euro adoption in January 2011. Its two neighbours could have more difficulty and may have to delay for a
year. However, a flexible ECB may be less strict if it judges that a country is on a strong path towards meeting the criteria.
Overall, we believe policymakers and markets should keep this theme in mind when analysing policy.
Figure 1. Nomura`s Maastricht scorecard

Convergence criteria Forecast dates Forecast FX
Government finances
HICP Long Obligation ERM II
Currency
Country Inflation annual gov gross gov Interest In ERM II to adopt ERM II Euro central Gap
spot rate
rate deficit to debt to rate parity rate
GDP GDP
Criteria <3.2% -3%< <60% <6.5% 2 years
Czech 0.2 -5.5 37.8 4.3 No Yes 2012 2017 26.00 26.25 1.0%
Hungary 5.2 -4.2 79.8 7.6 No Yes 2011 2015 280.00 276.69 -1.2%
Poland 3.8 -5.5 56.6 6.2 No Yes 2010/11 2013/4 3.70 4.17 11.3%
Estonia -2.1 -3.0 9.0 n.a. 5 years Yes 2004 2011 15.65 15.65 0%
Latvia -1.2 -9.0 44.8 7.5 4 years Yes 2005 2011/2 0.70 0.70 0%
Lithuania 1.5 -6.8 35.4 7.5 5 years Yes 2004 2011/2 3.45 3.45 0%
No, Soon after
Denmark 0.9 0.8 17.5 2.7 10 years 1999
Referendum referendum
After
Sweden 2.4 -5.2 49.2 1.3 No Yes Not set
referendum
UK 1.9 -12.7 67.9 4.1 No No Not set Not set
2010 2010
Last Last Current Forecasts Forecasts
forecast forecast
Source: Nomura Global Economics, EU Commission, IMF.

Growth woes…
We see muted growth On growth, we expect EEMEA to underperform its EM peers for three main reasons:
• Pre-crisis growth was fuelled by rapid credit expansion, financed from external sources.
While domestic credit has been maintained in many countries given EU agreements,
post-crisis growth is likely to remain constrained as parent banks continue to focus on
building up liquidity buffers and strengthening balance sheets. Equally, easy money
flowing into equity markets will discontinue, which will be another drag on growth.
• Exports will remain subdued as Western Europe will be slow to recover. While some
countries are trying to diversify their exports into Asia and other EM countries, this is
more likely to materialize in the more distant future.
• Domestic demand will also be subdued because of the slow recovery in the external
sector, in particular for the more open economies in the CEE. In addition, time lags
from 2009 such as unemployment and nonperforming loans not peaking until Q2 will
provide a continued source of stress for the region.
… but with a tinge of differentiation

However, some However, there is a lot of differentiation in terms of growth performance and we expect some
countries will do countries – Russia, Kazakhstan, Poland, Israel, Turkey, South Africa – to perform better than
better than others others: Czech, Hungary, Romania and Ukraine.
In CEE, Poland remains the outperformer, having avoided recession in 2009 due to the more
closed nature of its economy, the higher efficacy of interest rate cuts and an expansionary fiscal
policy. Hungary is set to be one of the few countries to contract in 2010 as it implements
HUF900bn of budget cuts to keep public sector debt in check. Czech remains in between,
although given the very open nature of its economy it will bear the brunt of the slow recovery in
Western Europe. In South Africa we see a large bounce-back in growth, supported by rising
exports to Asia and the soccer World Cup adding 0.7pp to GDP, although underlying
consumption growth should pick up only slowly. Turkey has the highest potential output in the
region, with a reasonable chance to attain investment grade status in the next two years, while
Israel may benefit from a global recovery due to its dependence on technology-intensive export
goods. As Turkey and Israel entered the crisis with strong initial conditions and were fairly
aggressive with their policy stimulus, their recoveries should also be swift. Russia and
Kazakhstan should gain substantially from the recent run-up in energy prices and from a
proactive policy response, where prudent fiscal policy in the upswing has allowed the pursuit of
countercyclical policy in the downswing. Romania will continue to be vulnerable because of an
uncertain political backdrop, although we expect a modest recovery once this stabilizes. Ukraine
is the most risky economy, but the gradual improvement in the economic environment, the
strengthening of its external position and, hopefully, a clearer political picture after January’s
presidential election should lead to modest growth in 2010.
Risks are slanted to Overall, the balance of risks is tilted slightly to the downside. On the one hand, a better-than-
the downside expected recovery in Western Europe may spur net exports, boosting growth. On the other,
another bout of global risk aversion could again focus market attention on underlying
Figure 3. Debt levels in 2009 Figure 4. End-2010 policy rates: Taylor rules vs forecasts
Public debt to GDP, % %, policy rate

90 10
80 End-2010 forecast
ILS HUF
8
70 End -2010 Taylor rule
60
6
50 TRY PLN
40 4
CZK
30 ZAR
20 RON 2
UAH
10 KZT
RUB
0 0
Czech Hungary Poland South Turkey Israel
0 50 100 150
Republic Africa
External debt to GDP, %
Source: Nomura Global Economics. Source: Nomura Global Economics.

Debt (un)sustainability Ivan Tchakarov

Public and external debt in EEMEA appears broadly sustainable, but shock scenarios reveal important vulnerabilities.
Global risk aversion began to decline in early March as the conviction of market participants strengthened that the world
should be able to avoid the gloom-laden scenario that loomed so large at the start of the year. EEMEA, usually cited as
the emerging market region with the most acute economic problems, has also benefited from this more benign global
backdrop. However, with fears of a full-scale financial crisis receding, attention has focused on the ability of these
economies to return to a more sustainable path of medium-term economic growth.
A significant impediment to achieving this goal could be the potential medium-term debt sustainability concerns arising
from the need for strong countercyclical fiscal policies to cushion the adverse impact of the global crisis on domestic
demand. In order to assess the sustainability of public and external debt, we develop a quantitative framework that can
account for the different factors that contribute to the changes in the level of debt-to-GDP ratios. In particular, we
consider the combined effect on that ratio of one standard deviation shocks to: the interest rate; GDP growth; and the
current account (fiscal balance in the case of public debt-to-GDP ratio). We call this scenario the “worst-case scenario”
as it studies the impact of all the shocks rather than considering the effect of each individual shock in isolation.
The public debt-to-GDP ratio is set to peak in 2010 in the baseline scenario (Figure 1), although under the worst-case
scenario the ratio rises sharply to 55% in 2013 compared with the baseline projection of 39%. The fact that the ratio is on
a distinct upward trajectory is worrying, suggesting that under the worst-case scenario public debt might be
unsustainable. Although even the worst-case scenario falls short of the Maastricht criterion of 60% that is usually cited as
the appropriate benchmark for public debt sustainability, the widening gap between the baseline and the most stressful
scenario is indicative of the possible risks associated with a long-drawn-out, sub-par recovery, characterised by severely
depressed economic activity, subdued fiscal revenues and higher interest rates. It is also comforting that, even in the
worst case, the ratio compares favourably with that in the aftermath of the Asian crisis.
Looking at the average level of public indebtedness in the region masks important differences in levels of public debt of
individual countries and their ability to withstand unfavourable macroeconomic conditions. We are less concerned about
Russia and South Africa. Even though Hungary’s debt is the highest, we think the straightjacket imposed by the IMF and
the government’s effort to rein in fiscal excesses should pay off over the medium term. We are more concerned about
the Czech Republic and Poland, where public debt levels are projected to rise over the medium term and where shock
scenarios reveal that public indebtedness may reach levels that are dangerously close to the 60% Maastricht criterion.
On the eve of the crisis, EEMEA, with its large current account deficits and bulging foreign borrowing, was heavily
exposed to a “sudden stop” phenomenon. However, current account balances and external financing conditions have
now improved. Nevertheless, the ability to service foreign debt remains impaired notwithstanding the projected decline in
the baseline external debt-to-GDP ratio beyond 2009. At the same time, the worst shock scenario suggests that by 2012
the ratio may rise to 61% relative to the baseline of 45% (Figure 2). It may also outstrip that during the Asia crisis.
Hungary stands out: its debt has almost doubled as a share of GDP and is projected to remain above 100% in the
medium term. Israel and Poland will likely continue to exhibit external debt levels of about 50% of GDP. In South Africa
and Russia, foreign debt should be less of a concern. However, under shock conditions, the 2012 debt ratio almost
doubles relative to baseline in South Africa and Russia, and rises a lot in Israel and Turkey. The Czech Republic and
Poland seem to be the most resilient to shocks, with relatively minor increases in debt even in the worst-case scenario.
Figure 1. Public debt across crises Figure 2. External debt across crises
% of GDP % of GDP Asian crisis countries 1997-02

60 80
EEMEA baseline 2007-12
EEMEA w orst scenario 2007-12
50 70
40 60
Asian crisis countries 1997-03

30 50
EEMEA baseline 2007-13
EEMEA w orst scenario 2007-13
20 40
1 2 3 4 5 6 7 1 2 3 4 5 6
Source: Nomura Global Economics; Note: Year 1 is 1997 in Asia, Source: Nomura Global Economics; Note: Year 1 is 1997 in Asia,
2007 in EEMEA; Asia is average of Thailand, Korea, Malaysia, 2007 in EEMEA; Asia is average of Thailand, Korea, Malaysia,
Philippines. Philippines.

weaknesses. In addition, policy mistakes, in particular on the fiscal side, may lead to a
reappraisal of risk perception. A turnaround in trade balances in 2010 from 2009’s large
surpluses will also be a drag, but much will depend on the ability of inventory rebuilding and
consumption to offset this. Potential growth may also be dented by decreasing labour force
growth, declining productivity and falling investment rates (Figure 2). A post-crisis credit-
constrained world will be another headwind, and overall we see potential as lower than it was
before. Hungary, however, stands as an important example of how a country can specifically
target potential growth, improving structural reforms in order to boost medium-term growth.
Debt (un)sustainability
Public debt Public debt sustainability. EEMEA has certainly benefited from the more benign global backdrop
sustainability is a key in recent months as fears of a full-scale financial crisis reoccurring have eased. However, new
vulnerability ... macroeconomic concerns are taking centre stage as investors become increasingly worried
about the return to more stable and sustainable medium-term growth. This is best exemplified in
public debt sustainability as the EEMEA economies try to balance the need for aggressive short-
term cyclical stimuli against concerns that such actions might lead to unsustainable levels of
public indebtedness, thus posing dangers for medium-term growth (Figure 3). Although the
majority of countries were able to reduce public sector debt over 2002-08 – with Russia, South
Africa and Czech standing out – deteriorating growth prospects have brought slumping revenues,
worsening fiscal positions and higher public sector service requirements. As a result, public
debt-to-GDP ratios are set to rise in the next few years, with shock scenarios revealing concerns
in Czech and Poland, where indebtedness may reach levels dangerously close to the 60%
Maastricht criterion (see Box: Debt (un)sustainability). In addition, a plethora of elections next
year may further complicate the debt sustainability picture (see Box: Election fever). In that
sense, policymaker credibility will constitute a key test for the ability of many EEMEA economies
to tackle fiscal sustainability issues.
… and external debt External debt sustainability. This seems to pose fewer dangers given significant turnarounds in
risks may re-emerge current accounts, as domestic demand has compressed, and sizable improvements in external
financing conditions. Nevertheless, external debt-to-GDP ratios will still be at risk given subdued
growth and limited export growth. Adverse shocks would affect Hungary the most, with
Kazakhstan, Ukraine and Poland likely to continue to have external debt levels of about 50% of
GDP. In South Africa and Russia, foreign debt should be less of a concern.
Different monetary policy cycle

Monetary policy exit EEMEA economies are, in general, at a different stage of the monetary policy cycle relative to
will be much slower Asia and Latam, with many countries still to cut rates (Russia, Romania, Hungary, Ukraine). This
than in other EMs ... is driven by still-muted inflationary pressure, reflecting subdued domestic demand and looser
capacity constraints. Even those countries that are tightening are doing less so than Asian and
LatAm peers. One important avenue through which interest rates may increase has more to do
with the aforementioned fears related to weak public sector balances. A number of monetary
policy committees (MPCs) have raised this, with Poland standing out in this regard.
... with a clear In reality, central banks in the region are broadly split into three separate groups. Some, such as
differentiation in the those in the Czech Republic, Poland and Turkey, which we see starting to hike rates in Q2 2010,
timing of the exit will be looking to normalise rates from historically low levels. Others, such as in South Africa, will
likely start hiking only from Q4, although we do not see this as a normalisation in the rates and
monetary policy cycle. Finally, others will likely continue the cutting cycle, with central banks in
Hungary and Romania reducing rates through to Q2 given a continued slowdown in their
domestic economies. Russia and Ukraine are also looking to cut rates from still very high levels.
On monetary policy, one of the biggest events to watch in 2010 will be South Africa’s shift to a
dual mandate, although we do not believe this will affect an already highly flexible MPC
(Monetary Policy Committee). For most of the countries that plan to hike, we see central banks
doing less than that implied by our Taylor rule-based interest rate forecasts (Figure 4).
Capital controls are Capital controls are unlikely to be important for EEMEA, although soft versions, including making
unlikely it more onerous for corporates to borrow abroad, are possible in Russia. The authorities seem
genuinely committed to elevating the status of the rouble internationally and, in that sense, any
harder capital controls (after Brazil’s example) would appear unlikely. In South Africa, some
relaxation of controls on capital outflows is also likely in a bid to curb rand appreciation.

Election fever Peter Attard Montalto ⏐ Ivan Tchakarov ⏐ Olgay Buyukkayali

Elections across EEMEA in 2010 are a key risk to the region’s exit from this crisis, particularly for the fiscal outlook.
There are key elections in all three CEE countries, which will likely have important implications for both short-run market
noise and longer-run policy direction for fiscal policy and structural reforms. With investors increasingly looking to
differentiate between countries and policy sustainability being an important issue, elections will be major focus for
markets.
Poland has a presidential election scheduled in November, which looks set to be a close race between incumbent Lech
Kaczyński and current Prime Minister Donald Tusk. However, having led Poland through this crisis without going into
recession, Mr Tusk looks to be ahead of his rival and this could improve as growth rebounds. The key impact on policy is
that Mr Tusk’s PO party has allowed the budget to slip in order to maintain spending into the election. It now risks
breaching the key 55% of GDP public debt rule which would mean implementing a painful (in growth and political terms)
austerity package just before the election. Hence, long-run structural reforms have recently been curtailed and other
spending cuts have been announced. The passing of the election and the possibility of a new prime minister (perhaps
former PM Jan Krzysztof Bielecki if Mr Tusk were to become president) should allow a fresh look at the fiscal situation
and a reduction in spending as well as entry into ERM-II. The election is also important because the current president is
opposed to many of Mr Tusk’s privatisation plans which are a key pillar for revenue next year.
In Hungary, the technocratic government should come to an end with parliamentary elections in May. Support for the
current majority holder of seats, the MSZP, has fallen to around 35% in recent polls and current opposition FIDESZ is
expected to take over under new Prime Minister Victor Orban. The MSZP will be a hard act to follow, given present
Prime Minister Bajnai’s strong relationship with markets. FIDESZ is expected to try to alter next year’s budget when it
takes office, testing or even breaking IMF deficit limits in order to cut taxes and stimulate the economy for a year. Such a
move risks damaging the positive sentiment Hungary now enjoys. However, we do not expect a budget blowout, simply a
deficit of around 4.5% of GDP and spending rotated to the FIDESZ priority areas of education and health. After the post-
election stimulus programme, the budget should come back. We are more concerned about a lack of long-run reforms
from FIDESZ. However, we do not think concerns about next year should be exaggerated, although FIDESZ needs to
communicate more with markets, who are still uncertain of the party’s full plans for office.
In the Czech Republic, elections are due in Q2 after an attempt to pull them forward to this year failed in the
constitutional court. The current interim administration is composed of both ODS and CSD opposing parties and they are
neck-and-neck in the polls. Other smaller parties will be key to the formation of a new government, but it is generally
difficult to form coalitions in the Czech Republic and we would not be surprised to see the current arrangement continue
– indeed markets should not underestimate the probability of this occurring. If a government does form a coalition, a
centre-left one is slightly more likely, in our view, which would result in slower budgetary adjustment. We are concerned
that the budget deficit may not be dealt with as the political deadlock in the cabinet and parliament means pre-crisis
spending levels are still in place. While the country certainly needs sharp spending controls given its large structural
budget deficit, we doubt such a move will be forthcoming until at least 2011. We think the Czech Republic can run this
dangerous course for now given its low level (stock) of vulnerabilities (debt levels) but it cannot continue forever.
Ukrainian presidential elections are scheduled for 17 January. There appears little likelihood that the incumbent Viktor
Yushchenko will win and the key battle is likely to be fought between the Prime Minister Yulia Tymoshenko and the
leader of the opposition Viktor Yanukovich. Although Ms Tymoshenko has traditionally been associated with a more pro-
European policy view while Mr Yanukovich has been a proponent of stronger ties with Moscow, the candidates have
recently moved much closer together, recognising the need for good policy relationships with both Europe and Russia. In
that sense, the differences between the two candidates seem to be much less pronounced as both will likely strive to
strike a conciliatory tone with Moscow while maintaining a pro-European bias in foreign policy. The key issue after the
elections will be resolving the difficult economic situation in Ukraine, which is still, in our view, the most vulnerable
economy in EEMEA. Non-compliance with key conditions in the IMF programme has led to the disbursement of a critical
tranche of funding being delayed in November, and the next leadership’s paramount objective should be to ensure a
resumption of negotiations with the IMF.
Elections in Latvia, due in October, will be a key test of both the popularity of the current five-party coalition and the
ability of the IMF and EU to accept further push-back from a new government on budget austerity conditions in its aid
package.
Turkish elections are not scheduled until 2011 but the deteriorating unemployment trends have encouraged the idea that
they may be brought forward to 2010. Early elections are not our base case and we doubt the current government will
bring them forward. Prime Minister Recep Tayyip Erdogan has so far dismissed this. Back in 2001 the AKP benefited
from a disgruntled voter-base which protested against early elections during the job market deterioration.

Russia ⏐ Economic Outlook Ivan Tchakarov
Animated by oil
After the marked slowdown in 2009, Russia is poised to return to stable, if somewhat subdued,
growth in 2010, supported by the benign oil price outlook and pent-up domestic demand.
Activity: Years of strong economic growth were superseded by lacklustre performance in 2009.
The country was disproportionally affected by the global financial crisis because of a confluence
of adverse shocks – unwinding terms-of-trade gains, disappearing external demand and drying
up capital flows. However, the faster-than-expected recovery in oil prices and the very proactive
fiscal policy have paved the way for an improving output performance, starting from the second
half of 2009. We expect the growth momentum to continue through the next year, with GDP
recovering strongly from -7.5% in 2009 to 3.5% in 2010. Growth should be primarily driven by
domestic demand, with consumption and investment contributing 1.0% and 1.4% to growth,
respectively. Pent-up domestic demand and inventory re-stocking, underpinned by improving
confidence indices, should be the key supporting factors. However, in our view, the balance of
risks is slanted to the upside, as the potential for energy prices to outperform should provide an
important tailwind for growth.
Inflation: After the temporary bump in inflation in Q12009, reflecting the rouble devaluation,
price growth has been steadily decelerating ever since, falling to single y-o-y digits in October
2009. We see inflation continuing to drop over the next year from an average of 11.7% in 2009
to 8.9% in 2010 as subdued wage growth and loosening capacity constraints weigh on price
pressures.
Policy: Prudent fiscal policy in the upswing has allowed the pursuit of countercyclical policy in
the downswing. Fiscal policy will likely be consolidated, but should continue to support growth as
the federal budget should improve from a deficit of 6.8% of GDP in 2009 to a deficit of 5% in
2010. Part of the deficit would be financed by tapping the international financial market, although
the magnitude of the financing should be significantly less than originally envisioned (around
USD5-6bn vs USD18bn). The central bank navigated well the abrupt currency movements at the
start of 2009, although this was greatly facilitated by the loss of a third of foreign reserves.
Importantly, monetary policy seems to be on a transition course with regard to exchange rate
policy, with a gradual, yet arguably committed, move from exchange rate targeting to inflation
targeting. Our fair value currency calculations suggest that the rouble is now undervalued from a
fundamental perspective, and the upward pressures on the currency may intensify in 2010
should oil prices continue to rise and GDP surprise on the upside.
Politics: The strengthening signs of recovery have instilled fresh confidence in the Kremlin that
the economy is on the rise. We think any concerns about the possible souring of the relationship
between Prime Minister Putin and President Medvedev are premature. In our view, recent, and
any forthcoming, diverging policy messages emanating from them should rather be seen as a
reflection of a well-orchestrated campaign to address two different parts of the electorate, with
Putin appealing to older voters while Medvedev appealing to the younger population.
Figure 1. Details of the forecast Figure 2. GDP now vs 1998 crisis

2008 2009 2010 2011 % q-o-q saar forecast
Real GDP % y-o-y 5.6 -7.5 3.5 4.4 20 99q1 99q2 00q1
Contributions to GDP (pp) 07q4 99q4 00q2
08q1 00q3
Consumption 5.9 -3.5 1.0 2.7 10 98q4 09q2 99q3 00q4
08q2
Gross investment 3.4 -5.1 1.4 2.2 97q4 09q4 10q2
08q3 09q3
Net exports -3.7 1.0 1.1 -0.5 0 10q310q4
98q2 10q1
CPI % y-o-y ** 14.1 11.7 8.9 8.0 08q4
Federal budget % GDP 3.8 -6.8 -5.0 -4.1 -10
Current account % GDP 5.8 3.8 3.5 5.1
FX reserves, gross USD bn 431.3 426.0 484.2 574.8 98q1
-20
CRB policy rate %* 13.00 9.00 8.00 8.00
RUB Basket*** 35.30 35.20 33.00 31.00 98q3
-30 1997-2000
USDRUB* 25.0 28.2 26.0 26.3
09q1 2007-2010
USDRUB** 29.4 31.3 27.3 26.2
-40
*End of period, **Period average, Bold is actual data
***45% EURRUB and 55% USDRUB
Source: Nomura Global Economics. Source: Nomura Global Economics.

South Africa ⏐ Economic Outlook Peter Attard Montalto
Conflicting signals on growth, mandate change

Strong headline growth numbers driven by the World Cup and the inventory cycle are set to mask
weak consumption. We expect sticky deficits, noisy politics and a change in the SARB mandate.
Activity: Despite very poor sentiment locally, South Africa has come through the crisis with a
much shallower and not particularly long slowdown relative to its peers. The economy was
cushioned by public sector investment programmes, government spending (though it had no
specific stimulus package) and trade surpluses. Consumption, however, was hit hard as
unemployment increased and the credit supply contracted. Into 2010, South Africa is set to
bounce back strongly in headline-growth terms amid continuing infrastructure spending, a
contribution from net trade and restocking from low levels. On top of this, the World Cup will add
0.7pp to growth from short term consumption and investments, on our estimates. Consumption,
however, looks set to remain lacklustre (around 0.2% y-o-y ex World Cup, from -3.3% this year
and 2.4% in 2008) as households remain constrained by unemployment, debt and wealth effects,
though still-high real wage increases should provide a small buffer. We do not expect a full
recovery on this front until 2011, when employment should start rising again. Investment growth
should slow to 2.7% (compared with 11.7% in 2008 and 3.9% in 2009) because, although
public-sector investment volume remains very high, little new money will be available to fund the
same level of rapid growth. Given long-run structural rigidities on the supply side, we estimate
potential growth in the economy in the medium term at around 3.5%, a slight drop over this crisis.
Inflation and rates: We expect CPI to bob around the upper end of the target band (6%)
through 2010 as low demand pressures are offset by another large rise in electricity prices (we
expect the regulator to grant Eskom slightly less than its 35% tariff-hike application) as well as
the compounding second-round effects of wage growth and energy price rises into 2011. We
expect interest rates to remain unchanged until Q4 2010. The SARB’s monetary policy
committee sees inflation pressures remaining broadly under control until then, but we believe it
will be surprised by growth and inflation into end-2010 and revise its forecasts accordingly. Our
key call for next year is that, following a tri-partite alliance report in February, the SARB MPC’s
mandate will change to a dual mandate, with a clause on inflation-targeting and a clause on
promoting growth and employment. Given that the MPC is already so flexible, looking strongly at
growth, we do not expect this shift to affect the way the MPC decides interest rates. As such, it
looks like an easy political win for the ANC without fundamentally affecting policy credibility. That
said, there may well be a strong market reaction in the short term and a strong communication
strategy will be needed. We believe new Governor Gill Marcus will handle this with aplomb.
Politics: Since Jacob Zuma’s election as president in April 2009, there has been little new policy
and no shift to the left. That said, political debts will come due in 2010 and we see much of this
year’s political noise from the left continuing, with increasing in volume, into the New Year.
However, we still see no fundamental shift in policy. Budget plans look credible but are based on
no significant new legislation. Given new housing, education and national insurance bills as well
as a sluggish recovery in revenues, we look for the fiscal deficit to remain very sticky in 2010.
Figure 1. Details of our forecast Figure 2. Real GDP growth: Forecast with probability bands
2008 2009 2010 2011 Government
% y-o-y
Real GDP % y-o-y 3.1 -1.6 3.0 3.5 8 growth target
Current account % GDP -7.4 -4.6 -6.1 -5.5 7
PSCE % y-o-y* 13.6 0.1 9.7 10.0 6
Fiscal balance % GDP -1.2 -7.9 -6.2 -5.2 5
FX reserves, gross USD bn* 34.5 40.8 45.1 49.1 4
CPI(X) % y-o-y * 10.4 6.5 6.0 7.1 3
CPI(X) % y-o-y ** 11.3 7.2 6.1 6.6
2 Long run
1 potential
Manufacturing output % y-o-y 0.9 -12.7 3.2 5.5
0
Retail sales output % y-o-y 0.3 -4.7 1.2 2.2
-1
SARB policy rate %* 12.00 7.00 7.50 9.00
-2
EURZAR* 12.9 10.9 14.4 13.3
-3
USDZAR* 10.2 7.70 9.00 9.50
PSCE- Private sector credit extentions
Source: Nomura Global Economics. Source: Nomura Global Economics. Note: 10% probability per band.

Turkey ⏐ Economic Outlook Olgay Buyukkayali
The comeback king

2010 should bring a rapid recovery and a start of normalization in monetary policy. Fiscal
normalization will be key for upgrades of the sovereign ratings.
Activity: Turkey has one of the highest potential output rates in EEMEA. We see its potential
output as being 6% for the medium term. 2009’s growth slowdown of 5.8% y-o-y drove the
output gap as wide as 10% at its peak. In 2010, we see GDP growing at 4.4% y-o-y. Inventories
should contribute some 2.3pp to growth. Losses on the private investment side in 2009 (4.4pp)
should be recovered only by end-2011. We would expect to see domestic demand and lending
recover somewhat in 2010. Nevertheless, the nearly double-digit real wage decline in 2009, an
unemployment rate rising in the first half of 2010 and domestic roll-overs (likely around 105%)
are all likely to crowd out private investment, likely dragging on growth through 2010. The
relatively fragile state of the recovery, the output gap closing fairly slowly and the partly technical
recovery could still prompt the AKP government to resort to an IMF program. We project a
USD25bn stand-by to add 2.5pp to GDP in the next two years (to our base case), which is likely
to stop the deterioration in the labour market as early as the second quarter of 2010.
Inflation: Broad-based disinflation continued in 2009 despite a rise in the year-on-year headline
inflation rate at end-2009. We expect to see some volatility in inflation during H1 2010 and
project CPI to peak at 7.2% y-o-y in April (from a bottom of 5.1% in October 2009) before falling
back to 5.6% by end-2010, below the 6.5% target rate. Note that commodity prices, food and oil
prices are all big contributors to the rise, while administered prices should help the correction.
We do see some monthly declines in housing rent, which is important given the sticky nature of
double-digit rents. We expect core inflation to remain below 5% y-o-y throughout 2010.
Policy: The Central Bank of Turkey (TCMB) launched an aggressive monetary easing campaign,
cutting short-term interest rates from 16.75% in October 2008 to 6.50% in November 2009. The
deepening recession and disinflation justified lower interest rates and discretionary policy, in our
view, and we believe the TCMB did well to stay ahead of events. This resulted in a sharp closing
of the credibility gap between inflation expectations and inflation targets. We now expect a long
pause at 6.5% until June 2010. Then, following a period of normalisation and improving growth
prospects, we expect 125bp of hikes to 7.75% by end-2010 and a further 100bp to 8.75% by
end-2011. This is a gradual normalization effort and we expect rates in 2010 and 2011 to be
150bp and 75 bp below the Taylor rule level projection. Fiscal policy should also start to
normalize with a gradual tightening. We expect the pace of fiscal tightening to determine the
speed of convergence to investment grade ratings. If we are right about an IMF program, we
would expect this to occur within two years.
Risks: Commodity prices are always a risk for inflation and the current account – though the
post-crisis environment allows a lower current account trajectory. We find fiscal risks more
important for 2010. Also, there will likely be some speculation around early elections, although
this is not our base case as we continue to expect elections to be held in May 2011.
Figure 1. Details of the forecast Figure 2. CPI, Policy rate, Output gap
2008 2009 2010 2011 % %
Real GDP % y-o-y 0.9 -5.8 4.4 4.5 20 10
Consumption % y-o-y 0.3 -2.9 3.4 2.9 18
Gross investment % y-o-y -7.1 -22.5 7.7 11.0 5
16
Exports % y-o-y 2.6 -7.9 6.4 9.2
14 0
Imports % y-o-y -3.1 -16.1 10.4 13.0
CPI % y-o-y * 10.1 6.2 5.6 5.3 12 -5
CPI % y-o-y ** 10.4 6.2 6.4 5.4
10
Budget balance % GDP -2.0 -6.3 -4.5 -3.8
8 -10
Current account % GDP -5.6 -1.7 -2.5 -2.8
FX reserves, gross USD bn 72.1 71.5 73.5 76.0 6 -15
TCMB policy rate %* 15.00 6.50 7.75 8.75 CPI
4
USDTRY* 1.54 1.50 1.35 1.40 Policy rate -20
*End of period; **Period average; Bold is actual data 2 Output gap (monthly IP proxy, rhs)
0 -25
Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Source: Nomura Global Economics. Source: TCMB,TUIK, Nomura Global Economics.

Central and Eastern Europe ⏐ Economic Outlook Peter Attard Montalto
Hungary: Political uncertainty, second year of slowdown

The actions of the new government will be key to Hungary’s long-run prospects.
2008 2009 2010 2011 • The economy is set to contract for a second year
Real GDP % y-o-y 0.7 -6.9 -1.5 2.0 given the HUF900bn of government spending cuts.
Nominal GDP USD bn 158.6 120.5 126.8 141.2 The external sector should start to recover, however.
Current account % GDP -8.7 -0.7 -2.9 -4.5 We see a return to positive growth in Q4. Investment
Fiscal balance % GDP -3.4 -3.9 -4.1 -3.5 is likely to remain soft.
CPI % y-o-y * 3.5 5.7 3.0 3.0
CPI % y-o-y ** 6.1 4.2 3.7 3.0
• The fiscal policy outlook remains highly uncertain,
Population mn 9.93 9.91 9.88 9.85 given the likely switch to a FIDESZ government in the
Unemployment rate % 8.0 12.0 9.5 8.5 Q2 elections. The party currently wants tax cuts and a
Reserves USD bn *** 23.6 26.5 27.5 24.2 stimulus package which would conflict with the IMF
External debt % GDP*** 113.1 129.0 116.2 106.2 package. We expect a small increase in the budget
Public debt % GDP 72.6 78.1 79.9 73.7 deficit, but a stalling of long-run reforms would be of
MNB policy rate %* 10.00 6.00 5.50 7.50 greater concern.
EURHUF* 265.6 270 270 260
*End of period, **Period average, Bold is actual data • Inflation is likely to remain subdued with no demand-
***Includes IMF/EU funds side pressures to year-end. We see inflation rising
towards target. After a December cut we expect one
Source: HSCO, MNB, Nomura. more rate cut in Q1 and then rates on hold till a hiking
cycle starts in early 2011.
Czech Republic: Political deadlock continues

High risks of a “W”’ shape
2008 2009 2010 2011 • A slow recovery in the Eurozone should affect Czech
Real GDP % y-o-y 2.6 -4.0 0.8 1.8 Republic the most and we see continued spillover
Nominal GDP USD bn 216.5 182.0 185.6 193.7 effects from the external slowdown into the domestic
Current account % GDP -2.9 -1.1 -2.4 -3.2 economy. Full growth momentum is unlikely before
Fiscal balance % GDP -2.3 -8.8 -5.4 -5.0 2011 and much will depend on external investment.
CPI % y-o-y * 3.6 0.7 2.9 2.0
CPI % y-o-y ** 6.4 1.0 2.0 2.0
• We see inflation increasing back to target from near
Population mn 10.2 10.2 10.1 10.1 0% thanks to base effects from here but there are few
Unemployment rate % 5.4 9.5 10.0 9.0 underlying inflation pressures. Rate hikes could start
Reserves USD bn *** 37.0 39.5 40.8 42.3 in Q2 in a normalisation back to neutral rates.
External debt % GDP 37.5 39.0 39.4 41.2
• Ongoing political uncertainties lead us to be
Public debt % GDP 27.4 34.2 37.7 39.8
CNB policy rate %* 2.25 1.00 3.00 3.50
concerned about fiscal policy sustainability and the
EURCZK* 25.0 26.2 26.5 26.0 interim government. The budget deficit is likely to
*End of period, **Period average, Bold is actual data remain unsustainably wide until the political deadlock
ends. We see a high probability of the current interim
Source: CSO, CNB, Nomura. government continuing after spring elections.
Poland: Momentum-hidden risks

Politically induced fiscal slippage remains a big concern. Watch for ERM-II entry at the end of the year.
2008 2009 2010 2011 • Poland should be able to maintain its momentum
Real GDP % y-o-y 4.8 1.6 2.1 3.5 through 2010 as investment bounces back,
Nominal GDP USD bn 525.7 418.7 477.8 536.2 inventories are built up and consumption continues.
• As one of the only economies with residual demand
Fiscal balance % GDP -3.9 -6.5 -5.5 -4.5
pressures, inflation should remain sticky and fall to
CPI % y-o-y * 3.3 3.7 3.5 2.5
CPI % y-o-y ** 4.2 3.5 3.1 2.5
target. With the NBP surprised to the upside by
Population mn 38.0 38.1 38.0 38.0 growth we expect the new MPC to hike rates in a
Unemployment rate % 9.5 12.0 9.0 9.0 normalisation cycle from Q2.
Reserves USD bn *** 59.3 41.8 47.4 54.5
• The presidential election in Q4 is key. It has been
External debt % GDP 45.4 50.6 48.8 46.9
responsible for fiscal slippage through 2009. The 55%
Public debt % GDP 47.8 54.5 56.6 54.6
NBP policy rate %* 5.00 3.50 4.50 5.00
public debt limit risks being breached in 2010 and we
EURPLN* 4.15 4.10 3.80 3.75 expect a budget amendment package to be
*End of period, **Period average, Bold is actual data implemented in January otherwise we see a real risk
of an austerity package around election time.
Source: CSPO, NBP, Nomura.
• Should current PM Tusk become president, a new
prime minister would likely rein in the budget and set
Poland on the road to the euro by joining ERM-II.

Rest of Emerging Europe ⏐ Economic Outlook Ivan Tchakarov
Ukraine: Muddling through

Resumption of the IMF programme is the key to growth recovery
2008 2009 2010 2011 • Ukraine continues to be the most vulnerable economy
Real GDP % y-o-y 2.1 -14.0 3.6 4.0 in the EEMEA, still feeling the adverse impact of the
Contributions to GDP (pp) global financial crisis.
Consumption 8.8 -14.8 4.0 4.5
Gross investment 3.6 -6.5 1.8 1.9 • However, signs are emerging that the economy is not
Net exports -10.3 7.3 -2.1 -2.3 only stabilising, but returning to a positive, yet still
CPI % y-o-y ** 25.2 16.7 10.3 8.7 very subdued and fragile, growth.
Consolidated budget % GDP -1.0 -6.0 -4.0 -2.5
Current account % GDP -6.7 -0.6 -1.0 -1.5 • The outlook for 2010 hinges on the result of the
FX reserves, gross USD bn 31.5 29.1 26.7 25.1 January presidential elections and the resumption of
NBU discount rate %* 12.00 10.25 9.00 9.00 the IMF programme.
USDUAH* 7.9 8.3 8.0 7.0
*End of period, **Period average, Bold is actual data • Provided that these develop in a positive fashion, the
growth risks should be tilted to the upside in an
Source: Ministry of Statistics environment of pent-up domestic demand.
Kazakhstan: Looking up
Resolution of banking sector foreign debt problems should spur growth
2008 2009 2010 2011 • The resolution of the banking sector external debt
Real GDP % y-o-y 3.2 -1.5 3.5 5.0 problems should reduce external vulnerabilities and
Contributions to GDP (pp) provide a new impetus for stalled credit lending.
Consumption 2.9 1.4 2.8 3.0
Gross investment 2.5 1.0 2.1 2.8 • The revival in commodity prices should support the
Net exports -2.9 -3.9 -1.4 -0.8 balance of payments and replenish foreign reserves.
CPI % y-o-y ** 17.3 7.1 6.1 6.0
Republican budget % GDP -2.1 -3.4 -2.6 -1.1
• As a result, we think the economy should return to
Current account % GDP 6.8 -3.4 0.5 1.3 growth, with the balance of risks slanted to the upside
FX reserves, gross USD bn 19.4 22.1 30.1 38.5 should commodity prices outperform.
NBU official rate %* 10.0 7.00 7.00 7.25
USDKZT* 120.79 148 135 135 • The combination of stronger growth and commodity
*End of period, **Period average, Bold is actual data prices should put upward pressure on the currency,
increasing the likelihood of a tenge revaluation at the
Source: Ministry of Statistics. start of the year.
Romania: A challenging road ahead

Twin deficits leave little room for supporting growth
• The political background will remain testing at the

2008 2009 2010 2011 start of the year, increasing fiscal challenges and
Real GDP % y-o-y 7.1 -7.0 2.8 3.1 heightening risk perceptions.
Fiscal balance % GDP -5.2 -8.0 -7.4 -4.5 • However, the formation of a new government should
CPI % y-o-y * 6.3 4.7 3.6 3.2 pave the way for a re-establishment of the
CPI % y-o-y ** 7.8 5.8 4.0 3.6 relationship with the IMF.
NBR policy rate %* 10.25 8.00 7.00 6.50
EURRON* 4.0 4.2 4.0 3.8 • This should help bring growth into positive territory,
*End of period; **Period average; Bold is actual data although the recovery will likely be subdued by
historical standards.
Source: Ministry of Statistics.
• Inflation should continue to ease given excess
capacity and reduced wage pressures, creating more
room for interest rate cuts.

Middle East ⏐ Economic Outlook Peter Attard Montalto ⏐ Olgay Buyukkayali
Egypt: Bounce back

Economic and political imbalances remain a key concern
2008 2009 2010 2011 • The economy has fared well through the crisis,
Real GDP % y-o-y 6.5 4.8 5.2 5.5 supported by wider Middle East linkages. But growth
Unemployment rate % 8.9 9.5 10.0 9.0 will likely remain subdued in a credit-constrained post
CPI % y-o-y * 18.3 16.5 8.3 7.6 crisis-environment and is unlikely to reach the key
CPI % y-o-y ** 18.8 12.2 12.5 8.1
5.5% level needed to absorb new labour until 2011,
Budget balance % GDP 7.0 -9.5 -8.5 -8.5
potentially adding to social instability.
Current account % GDP 0.8 -3.0 -2.5 0.5
FX reserves, gross USD bn 34.5 30.0 28.5 30.0 • Inflation looks set to remain sticky given domestic
Policy rate %* 11.50 8.25 9.00 10.00
demand and oil moves, with large upside risks from
USDEGP* 5.54 5.44 5.30 5.30
any shift in commodity prices and removal of
subsidies. The CBE stopped cutting rates earlier than
we expected amid stronger growth and inflation. We
Source: Nomura Global Economics. think a hiking cycle will begin in Q1, with its pace
dependent on inflation.
• Parliamentary elections in October will be a key risk

event, with noise from the Muslim Brotherhood and a
resurgence of the Mubarak succession debate.
Israel: Stable recovery

Global recovery should allow policy normalization.
2008 2009 2010 2011
Real GDP % y-o-y 4.1 0.3 2.7 3.8 • Israel’s economy looks well placed to benefit from a
Consumption % y-o-y 4.2 -0.3 3.0 3.5 global recovery given the multi-pillared policy response
Gross investment % y-o-y 4.3 -6.5 2.5 3.2 and the stable conditions that prevailed ahead of the
Exports % y-o-y 3.7 -7.8 2.5 3.8 crisis.
Imports % y-o-y 3.2 -5.0 3.3 4.0
CPI % y-o-y * 3.8 2.8 2.9 3.0 • Inflationary pressures should be fairly high, stemming
CPI % y-o-y ** 4.6 2.7 3.0 2.9 from a domestic demand recovery, the housing market
Budget balance % GDP -0.6 -5.3 -4.3 -3.8 (which did not contraction much) and commodity
Current account % GDP 1.2 2.8 2.4 1.7 prices. We think the Bank of Israel is likely to hike by
Policy rate %* 2.50 1.00 2.50 3.50
150bp in 2010 to contain inflationary expectations.
USDILS* 3.80 3.70 3.45 3.75
*End of period, **Period average, Bold is actual data • Risks appear limited on the fiscal side as the external
backdrop remains healthy and employment conditions
seem stable.
Saudi Arabia: From oil bust to sustainable growth

The bursting of the oil bubble has brought an end to the country’s longest-ever stretch of growth.
2008 2009 2010 2011 • A slow recovery in the US should keep oil’s
Real GDP % y-o-y 4.6 -1.0 3.5 3.9 contribution to GDP, the current account and fiscal
Hydrocarbon % y-o-y 4.8 -8.8 3.0 3.8 balances muted over the next two years, though we
Nonhydrocarbon % y-o-y 4.3 2.5 3.7 4.0 do expect a recovery. This will be a key test of the
CPI % y-o-y * 9.8 5.0 5.4 5.6
nonhydrocarbon sector and we see its growth and
CPI % y-o-y ** 9.9 5.3 6.4 6.8
share of output continuing to increase over the next
Budget balance % GDP 33.3 -5.5 4.0 15.0
Current account % GDP 28.8 4.1 14.5 20.3
five years, driven by government-led infrastructure
Short-term interest rates % 0.50 0.13 0.25 1.00 spending. The Saudi economy should continue to be
USDSAR* 3.75 3.75 3.75 3.75 a growth engine for the region.
• The crisis has been a key test of the economy and it
Source: Nomura Global Economics. has pulled through on its large cash reserves.
Although Saudi Arabia is on a path to a more
sustainable economy, progress remains slow. It
should avoid the problems of Dubai, however, given
its more closed financial markets.

Latin America ⏐ Outlook 2010 Tony Volpon
An uneven recovery
We expect the region to continue the cyclical recovery begun in 2009. Stronger growth should
also lead to wider current account deficits, although inflation should remain tame.
Asian strength and Most Latin American (LatAm) economies have exceeded forecasts made at the beginning of
easy policy have 2009. Except for Mexico, which suffered from its close relationship with the crisis-hit US
helped LatAm economy and a swine flu outbreak, large economies in the region benefited from Asia’s strong
growth and the implementation of anti-cyclical fiscal and monetary policy to boost growth. Now
that cyclical recoveries seem to be firmly in place (Figure 1), the challenge for policymakers will
be to signal an orderly exit from the current policy stance to avoid higher inflation or a rapid
widening of current account deficits. We also see risks that the deterioration in fiscal policy in, for
example, Brazil, justified at the time of implementation as a temporary response to the economic
crisis, will become permanent, perhaps as an outcome of the 2010 presidential election.
Brazil
Brazil leads the way Brazil has posted the strongest recovery in the region but may face the trickiest exit from its
current policy stance, which remains very accommodative even as aggregate demand
accelerates strongly:
• Real policy rates (Selic) are at a low of 4.21%, compared with an average of 9.16% over
the past five years.
• The nominal budget balance has moved from a 1.25% of GDP deficit before the crisis to
3.34%, even as interest payments on the government’s debt fell from 5.6% of GDP in
October 2008 to 5.18% of GDP in June 2009.
• The government has taken a series of “capitalization” transactions to boost the lending
power of state-owned financial institutions. This has helped boost gross debt from 51% of
GDP in September 2008 to 65.5% in December 2009.
• Credit markets have been well supported during the crisis, with the total credit-to-GDP
ratio rising from 38.7% in October 2008 to 45.7% in December 2009.
• After briefly rising, unemployment is set to end 2009 lower than in October 2008 at 7.7%,
only 0.2pp off its all-time low.
Figure 1. Standardized measures of the output gap in four LatAm economies, using industrial production and retail sales
std dev std dev
2 Brazil 1.5 Mexico
1
1.0
0
0.5
-1
-2 Industrial 0.0
Production
-3 -0.5
Retail Sales Industrial
-4 Production
-1.0
-5 Retail Sales
-6 -1.5
Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09
std dev std dev

1.5 Chile 10 Colombia
1.0
8
0.5
6 Industrial
0.0 Production
-0.5 4
Retail Sales
-1.0 2
Industrial
-1.5
Production 0
-2.0
Retail Sales
-2
-2.5
-3.0 -4
Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09
Note: Data standardized (12-mth), seasonally adjusted and de-trended using HP filter.

These factors should ensure that the Brazilian economy performs strongly in 2010 – we forecast
5.4% – pushed higher by a strong recovery in investment spending. We expect that investment
spending fell by 10.6% in 2009, but we forecast it to rise by 18.5% in 2010.
The risk in Brazil is of We see the risks to our forecast as being to the upside. After claiming that greater government
overheating ... spending as a response to 2008’s crisis was cyclical in nature, the government is giving no
indication that it is considering tightening fiscal policy. This lack of an appropriate and timely
response means that inflation and interest rates will likely have to rise. We expect the central
bank of Brazil (BCB) to tighten rates in June 2010, taking the Selic policy rate from 8.75% to
11.75% by the end of the year. Inflation is also set to rise, from 4.34% in 2009 to 4.7% in 2010.
... due to loose Looser fiscal policy will very likely be driven by political considerations, as Brazil is set to hold a
fiscal policy heavily contested presidential election in October 2010 (see Box: Brazil 2010 election outlook).
This could delay a much-needed fiscal adjustment, which we expect to happen only in 2011,
when we forecast the government’s fiscal balance to be -2.8% of GDP, after -4.0% in 2010. This
late response should also generate an overshoot in growth that would widen out the current
account deficit from 1.5% of GDP in 2009 to 3.5% in 2011, even as growth decelerates.
Mexico
Mexico’s economic outlook is still closely tied to US economic performance. We think the
passing of the recent fiscal adjustment package, although criticized by some as not going far
enough, is still laudable given the 7.0% drop in GDP that we expect for 2009.
Mexico still needs We expect growth to rebound to 4.6% in 2010, but given the recession of 2009 this should not
to deal with structural be viewed as an exceptional performance. Longstanding structural problems still need to be
problems tackled to raise potential growth. For example, underinvestment by the state-owned Pemex
because of a restrictive legal framework has caused the production of petroleum to fall (Figure
2), helping lead to the current public finance crisis. Restrictive labor laws and lack of competition
in the economy are also widely seen as impediments to higher growth. Pension liabilities and
funds devoted to social spending are growing strongly. Pension liabilities, for example, are
projected by the Ministry of Finance to rise from around 2.25% of GDP in 2009 to 4% in 2010.
Mexico, unlike other Latin American economies, has suffered from Chinese competition in the
1
manufacturing of goods, losing jobs and markets in the process. A World Bank study estimates
that around 250,000 manufacturing jobs have been lost since 2000 because of the relocation of
manufacturing plants to Asia.
Recent fiscal reform law goes some way to addressing Mexico’s budget woes, but approved tax
hikes could add about 0.7pp to inflation. This should help take inflation from 3.62% in 2009 to
4.81% in 2010 and should also lead the monetary authorities to tighten interest rates from the
current 4.50% to 5.25% at the end of 2010 to keep inflationary expectations stable. Perhaps the
only positive is the current competitive level of the exchange rate, as Mexico, unlike most other
countries in the region, avoided the large appreciation seen in 2009. A permanent shift lower in
the real exchange rate now looks to be a necessary component of an eventual return to more
robust economic growth.
Figure 2. Mexican production of crude petroleum (12-mth ma) Figure 3. Chilean merchandise exports (3-mth ma)
Thous.Bbls $mn
3,600 /Day 7,000
6,000
3,400
5,000
3,200
4,000
3,000
3,000
2,800
2,000
2,600
1,000
2,400 0
Feb-02 Jun-03 Oct-04 Feb-06 Jun-07 Oct-08 Feb-02 Jun-03 Oct-04 Feb-06 Jun-07 Oct-08
Source: Haver Analytics, Nomura Global Economics. Source: Haver Analytics, Nomura Global Economics.

Brazil 2010 election outlook Tony Volpon

Brazil’s 2010 presidential election is set to be heavily contested. We look at how the election is shaping up, the history of
the main candidates, their policy preferences, and possible market impact.
On 3 October 2009, followed by a possible run-off second round on 31 October, Brazil will choose its next president.
Current opinion polls show this election promises to be heavily contested: although the main opposition candidate Jose
Serra currently holds a large lead, President Lula’s favored candidate Dilma Rousseff, his current chief of staff, is inching
closer on the back of Lula’s popularity and the strong economy. President Lula cannot run for a third term under current
law.
Lula’s choice of Ms Rousseff was seen as bold given her lack of political experience and lack of charisma. There is some
debate as to whether Lula can boost the level of support for her much more than the 20% or so of the vote that she has
already gained.
Jose Serra
Jose Serra, 67 years old, is the current governor of the state of Sao Paulo. He was president of the national student
union in the 1960s and left Brazil after the military coup of 1964. He has lived in numerous countries and completed his
PhD in economics at Cornell University in 1976. He returned to Brazil in 1978 and began a political career that
culminated in a successful term as health minister in the Fernando Henrique Cardoso government from 1998 to 2002.
Serra is seen as an efficient administrator who would likely run tighter fiscal policy than the current government. He has
criticized of current monetary and foreign exchange policy, although he has not as yet stated how he would change it.
Dilma Rousseff
Dilma Rousseff, 62 years old, is the chief of staff of Lula’s government. She was militant in urban guerilla groups during
the military regime and spent two years in jail from 1970 to 1972. She studied economics but due to her political career
has not completed her postgraduate studies. She occupied finance posts for the left-leaning PDT party in the southern
state of Rio Grande do Sul, and was chosen by Lula to head the Energy Ministry at the beginning of his government,
later being appointed chief of staff.
Ms Rousseff has become the key minister of the current government after the so-called “mensalao” and other scandals
brought down many key figures. During this period, after Finance Minister Antonio Palocci left office, government
spending rose substantially and the state began to act more aggressively on many economic fronts. In particular, the
government expanded state financing of consumption via public sector banks and of companies via the BNDES
development bank; these institutions are being capitalized by debt issuance, which is pushing up the level of federal
gross debt.
Electoral outlook
The main question in terms of the election outcome concerns the ability of President Lula, who enjoys personal favorable
poll ratings above the 80% mark, to transfer his popularity to Ms Rousseff, who is still unknown to much of the population.
The general view of political commentators is that this will happen if the population believes the chosen candidate will
continue the work of the current office holder. The government’s present strategy is to rely on popularity transfer, a
strong economy and a large lead in TV advertising time and campaign funds to win the election.
The opposition is still divided about how to fight an election against such a popular president who has made the election
of Ms Rousseff a personal priority. Although Mr Serra enjoys a large lead in the polls (the latest tally puts him at 38%
against approximately 22% for Ms Rousseff), support for his candidacy is not unanimous, with fellow Social Democrat,
governor of the state of Minas Gerais, Aecio Neves, making a run for the candidacy. Nonetheless, Mr Serra has the
advantage of being a very well known figure with real executive experience and accomplishments, unlike Ms Rousseff
whose main claim to fame is the management of the controversial “PAC” federal investment program these past few
years, something she herself has largely abandoned to make her early run for office.
In terms of political risk both main candidates present doubts. Ms Rousseff has been the government’s most powerful
figure after Lula during a period when the Brazilian government has greatly increased spending and interference in the
economy. Investors will want to know if a Rousseff government will continue on the current path, which would eventually
raise questions about the country’s credit risk.
In the case of Mr Serra, investors will want greater clarity as to how he wants to change the current monetary regime.
The tighter fiscal policy Mr Serra is likely to favor would naturally allow for lower rates and a less expensive currency, but
Mr Serra seems to want real changes in policy. Any attempts to force a regime of lower rates and a cheaper exchange
rate could have a rapid negative effect on inflation, as the unsuccessful policies of Argentina make clear.

Chile
Chile, a small, open economy that is very exposed to trade and has the most developed credit
market in the region, suffered more than most Latin American countries in the crisis. We expect
growth to fall 1.5% in 2009, and the economy also faces 1.4% deflation.
Nonetheless, while Chile may have suffered for its economic virtues, its stable policy framework
has allowed it to pursue very aggressive anti-cyclical policy. Policy rates fell to 0.5%, with the
Banco Central de Chile adopting a form of quantitative easing by providing term financing to the
market. Fiscal policy has also been aggressive, as can be seen in the deterioration of the public
sector balance from a vigorous 5.2% of GDP 2008 to an expected -3.4% in 2009.
Net exports are The current recovery scenario for Chile has one very positive component and one very negative
a plus ... one. First, exports have rebounded quite strongly already, providing a powerful boost to growth
(Figure 3). Copper, the country’s largest commodity export, is only about 15% below its pre-
crisis price, after having fallen as much as 60% in December 2008. On the negative side, the
labor-intensive construction sector has been hit hard and bank credit dried up with the crisis
(Figure 4). But the recent rise in business sentiment could lead to easier credit conditions and
… but the more demand to kick-start durable goods and housing demand. We expect growth to reach
construction sector is 4.7% in 2010, with inflation rising to 2.3%. This return to growth and inflation should allow the
a minus
Central Bank of Chile to normalize interest rates to 4.00% from 2Q 2010, as it has already
signaled.
Colombia
As a commodity exporter, Colombia, like Brazil, has done well in 2009 thanks to a combination
of Asia-led export demand and its ability to implement counter-cyclical policy. Policy rates fell to
3.5%, with the last rate cut taking the market by surprise, and the fiscal deficit at the end of 2009
is expected to be just 2.7%.
Political risks are Nonetheless the Colombian economy has been enduring something of a “hang-over” after a
affecting investor strong, investment-led boom that had lost steam even before the global economic crisis began
sentiment (Figure 5). This has led to a less pronounced cyclical recovery than the other economies in the
region (Figure 1) and better-than-expected inflation performance (we forecast 2.40% for 2009).
To this we have to add the political risks that have lately weighed on the outlook. Tensions with
Venezuela’s leftist regime are on the rise and are already affecting the country’s exports. The
undefined status of the 2010 presidential election – it is still not clear whether the very popular
President Uribe will run for a third term – should also add to the uncertainty.
We expect these factors to damp the current cyclical upturn, at least compared with the other
economies in the region, leading to GDP growth of 3.3% in 2010. Inflation should stay at a
subdued 3.5%, leading to only a modest adjustment in policy rates, to 5.00%.
1.
Lederman, Daniel, Olarrega, Marcelo and Soloaga, Isidro. “The growth of China and India in world trade:
Opportunity or threat for Latin America and the Caribbean?”, in China’s and India’s Challenge to Latin
America, The World Bank, 2009, p.103.
Figure 4. Chilean new building permits (12-mth ma) Figure 5. Gross investment in Colombia
units % y-o-y
15,000 80
70
14,000
60
13,000
50
12,000
40
11,000
30
10,000 20
9,000 10
8,000 0
Nov-02 Feb-04 May-05 Aug-06 Nov-07 Feb-09 Sep-04 Jul-05 May-06 Mar-07 Jan-08 Nov-08
Source: Haver Analytics, Nomura Global Economics. Source: Haver Analytics, Nomura Global Economics.

Brazil ⏐ Economic Outlook Tony Volpon
Growth set to accelerate

Strongly pro-cyclical monetary and fiscal policy, buoyant capital markets and strengthening labor
markets should make Brazil one of the strongest growth stories in LatAm in 2010.
Activity: The recession seems to have ended in Brazil. While the main drivers of growth have
so far been personal consumption and government spending, we expect business fixed-
investments to take up the slack, pushed higher by buoyant capital markets and an appreciating
currency. This powerful combination should put 2009 GDP just north of zero – at 0.1%. For 2010,
we forecast a return to very strong growth of 5.4%. However, we expect retrenchment in 2011
as interest rates rise and a newly elected government potentially reins in spending. Higher
consumption and investment by both the private and public sector should push the trade
balance into deficit in 2010 for the first time since 2000, with the current account deficit widening
further. Nonetheless, ample portfolio and investment flows should more than cover the growing
current account deficit, allowing BRL to appreciate.
Inflation: Inflation, as represented by the central-bank-targeted IPCA index, looks likely to close
below the central bank’s 4.5% target in 2009, but not in 2010. At the beginning of 2010, the
effects of currency appreciation and wholesale price deflation should provide a strong anchor for
inflation, but a rapidly closing output gap and electoral-year spending should drive inflation
higher, to 4.7% by end-2010, even if the Central Bank of Brazil (BCB) hikes rates.
Policy: Given concrete signs of a strong, broad-based growth in Brazil, we expect the BCB to
begin to tighten rates in June, though an earlier hike in April is also possible. An earlier start to
the tightening cycle is unlikely, as the near-term inflation outlook is positive even as the output
gap is set to close. Strong private-sector growth and loose fiscal policy in an election year will
likely push inflation expectations higher for the end of 2010 and 2011, eliciting tighter monetary
policy. We see rates rising by 375bp into March of 2011, taking the Selic policy rate to 12.50%.
We also expect that fiscal policy will be substantially tighter in 2011 after the recent deterioration.
Risks: We see the risks to our overall scenario as being to the upside. Very loose fiscal policy,
originally justified as a Keynesian-inspired “anti-cyclical” response to the crisis, looks set to
continue into the 2010 election year. This could lead to above-potential growth, putting steady
pressure on inflation and the current account deficit. We assume the BCB will be able to
execute monetary policy without overt intervention and political pressure to control demand. We
also assume that whoever wins the October 2010 presidential election will rein in spending at
the beginning of 2011 from the current unsustainable pace. Any disappointment on these fronts
could lead to higher inflation, a higher current account deficit and more volatile financial markets.

% y-o-y change unless noted 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP -1.2 5.3 7.5 5.1 4.7 4.6 5.1 3.7 0.1 5.4 3.1
Personal consumption 3.9 7.7 10.9 8.2 6.2 6.3 5.6 5.2 4.0 7.8 4.7
Fixed investment -12.5 0.6 22.0 24.3 15.3 13.9 12.4 7.2 -10.6 18.5 6.3
Government expenditure 1.6 4.9 3.8 6.1 6.8 6.8 2.2 1.2 3.7 5.9 0.4
Exports -10.1 -3.3 13.8 0.5 2.6 1.5 4.8 4.8 -10.0 4.1 5.0
Imports -15.8 -5.4 26.3 23.1 22.2 21.6 13.2 12.2 -13.4 23.2 10.6
Contributions to GDP (pp):
Industry -6.9 4.2 6.1 3.7 6.0 6.1 7.3 3.3 -5.5 5.5 1.3
Agriculture -9.0 -0.3 4.9 -0.1 3.9 1.5 6.1 5.2 -4.4 2.4 2.7
Services 2.1 6.3 5.4 4.0 4.3 4.5 4.5 4.0 3.0 4.5 3.8
IPCA (consumer prices) 4.34 4.34 4.21 3.78 4.27 4.70 5.12 5.43 4.34 4.70 5.17
IGPM (w holesale prices) -0.40 -1.12 0.59 1.58 3.25 4.59 4.91 5.27 -1.12 4.59 5.32
Trade balance (US$ billion) 27 23 18 11 7 -3 -1 -4 23 -3 -8

Current account (% GDP) -1.5 -3.0 -3.5

Net public debt (% GDP) 45.1 47.0 46.0
Selic % 8.75 8.75 8.75 9.25 10.50 11.75 12.50 12.50 8.75 11.75 12.50
BRL/USD 1.77 1.75 1.83 1.71 1.64 1.60 1.60 1.55 1.75 1.60 1.55
Notes: Annual forecasts for GDP and its components are year-over-year average growth rates. Trade data are a 12-month sum. Interest
rate and currency forecasts are end of period. Contributions to GDP do not include taxes. Numbers in bold are actual values, others
forecast. Table last revised 11 December.

Mexico ⏐ Economic Outlook Tony Volpon
A recovery burdened by long-term worries

Mexico is set to recover from one of the worst recessions in Latin America, but the recovery will
be hampered by long-standing structural impediments to higher growth.
Activity: Mexico is set to have one of the worst growth performances in LatAm for 2009 of
-7.0% as its close ties with the underperforming US economy and the swine flu outbreak hit both
consumption and investment hard. We expect growth to bounce back to 4.6% in 2010, but this
would not be an exceptional rate given the size of the recession in 2009. We forecast investment
spending to grow a relatively low 5.6% in 2010 as long-standing structural impediments to higher
potential output hinder greater investment. The recently approved fiscal package should help to
close a serious revenue shortfall caused by, among other things, a drop in oil production by
state-owned Pemex. Nonetheless, the adoption of more permanent measures is being pushed
into 2010, and if questions of fiscal sustainability, labor market flexibility, opening up of the
petroleum sector, and higher productivity are not addressed potential growth should remain low
over the next few years compared with other economies in the region. One structural positive
has been the recent depreciation of the currency, especially against other LatAm currencies,
something that should help Mexico regain competitiveness.
Inflation: Inflation is set to rise in 2010 to 4.81% as the economy recovers and the inflationary
impact of recent tax hikes affect relative prices. The Mexican economy suffers from structural
downward price-rigidities which prevented inflation from falling substantially in 2009 even though
the economy faced one of the worst recessions in the region, making inflation more susceptible
to any positive supply or demand shock.
Policy: If our forecast is correct and Inflation in 2010 moves much higher than the Banco de
Mexico’s 3% target and 1% tolerance interval, we think the monetary authorities could hike
policy rates to 5.25% over 2010 even as the economy faces a tepid recovery.
Risks: We see the risks to Mexico’s economic outlook as being balanced. A faster-than-
expected recovery in the US economy could have an immediate effect on economic activity in
Mexico, although unfortunately so could any further problems in the US economy. The market
expects the reform process to be slow and tortuous, so any positive surprise on the political
front could help improve the current pessimistic views of Mexico’s potential growth rate.

% y-o-y change unless noted 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 2009 2010 2011
Real GDP -6.2 -3.9 4.2 6.2 3.8 4.4 3.5 3.3 -7.0 4.6 3.9
Personal consumption -8.0 -6.6 4.6 6.2 3.9 4.5 3.4 3.2 -8.2 4.8 3.9
Fixed investment -12.6 -8.6 2.2 8.5 5.3 6.2 6.2 6.4 -11.0 5.6 6.3
Government expenditure 1.8 -0.2 -1.3 3.2 0.1 1.8 2.8 0.4 1.5 0.9 2.1
Exports -7.0 -2.3 15.1 3.6 -1.1 -2.1 1.0 1.0 -8.8 3.2 3.9
Imports -18.7 -10.5 16.8 14.3 5.9 4.3 4.3 3.3 -15.5 10.0 8.4
Contributions to GDP (pp):
Industry -6.6 -3.5 3.2 6.3 4.7 5.2 4.1 3.0 -7.9 4.8 4.3
Agriculture -1.1 -1.3 6.6 -2.9 11.5 10.6 10.6 8.6 0.3 6.1 8.2
Mining -6.5 -3.8 4.7 7.8 3.8 4.5 3.6 3.7 -7.0 5.2 4.1
CPI 4.89 3.62 3.61 3.64 3.98 4.81 4.71 4.53 3.62 4.81 4.00
Trade balance (US$ billion) -12 -7 -6 -7 -8 -11 -12 -13 -7 -11 -14
Current account (% GDP) -1.0 -1.5 -2.0

Gross public debt (% GDP) 40.0 41.0 43.0
Overnight Rate % 4.50 4.50 4.50 4.75 5.00 5.25 5.50 5.50 4.50 5.25 5.50
MXN/USD 13.48 13.00 13.70 12.90 12.60 12.43 12.40 12.35 13.00 12.43 12.30
Notes: Annual forecasts for GDP and its components are year-over-year average growth rates. Trade data are a 12-month sum. Interest
rate and currency forecasts are end of period. Contributions to GDP do not include taxes. Numbers in bold are actual values, others
forecast. Table last revised 11 December.

Rest of Latin America ⏐ Economic Outlook Tony Volpon
Argentina: Riding Brazil’s coat-tails

Rapid recovery in Brazil is giving Argentina a boost, but political uncertainties could stunt investment.
2008 2009 2010 2011
Real GDP % y-o-y 7.0 -2.3 2.5 3.0 • Better growth in Brazil and a general easing of
Consumption % y-o-y 6.5 -5.0 3.0 4.0 liquidity conditions is helping Argentina recover from
Gross Investment % y-o-y 8.0 -8.0 6.0 7.0 one of the region’s most severe recessions.
Exports % y-o-y 1.6 -3.0 4.5 5.0 Nonetheless, continuing political and policy
Imports % y-o-y 16.5 -20.0 10.0 7.0 uncertainty will likely remain a drag on investment, so
CPI % y-o-y * 7.2 7.0 8.0 8.0 any rebound in growth is likely to be tepid.
CPI % y-o-y ** 8.1 5.5 8.0 8.0
Budget balance % GDP 1.5 -1.5 -2.0 -2.5 • Fiscal policy remains expansive, with a widening
Current account % GDP 1.2 3.2 2.5 2.0 deficit being driven by higher spending even as the
Policy Rate % * 15.10 11.50 13.00 13.00 recession hits revenues hard. We think serious fiscal
USDARS * 3.45 3.80 4.50 5.00 reform is a precondition for any return to higher
* End of period, ** Period average, Bold is actual data potential growth.
Source: Nomura Global Economics. • The government has signalled a willingness to

engage creditors and the IMF, and a new creditor
proposal is expected soon. However, concrete
success is still pending.
Chile: Exports lead, investments to follow

Rebounding export demand is leading to a strong recovery that looks set to gather strength.
2008 2009 2010 2011
Real GDP % y-o-y 3.2 -1.5 4.7 4.0 • Chile’s economic recovery is being led by strong
Consumption % y-o-y 4.3 1.0 6.5 4.0 export demand, especially from Asia. This is already
Gross Investment % y-o-y 19.5 -13.0 15.0 6.0 affecting business confidence positively and we
Exports % y-o-y -4.8 -4.5 6.0 6.0 expect investment demand to pick up soon, boosting
Imports % y-o-y 3.1 -16.0 14.0 10.0 overall growth. The labour-intensive construction
CPI % y-o-y * 7.1 -1.4 2.3 3.0 sector remains a drag on growth, but easier credit
CPI % y-o-y ** 8.7 1.5 2.1 3.0 conditions should help activity in this sector recover in
Budget balance % GDP 5.2 -3.4 -2.0 2.0
2010.
Current account % GDP -2.0 0.8 0.7 1.5
Policy Rate % * 0.50 0.50 4.00 5.00 • The Central Bank of Chile is determined that recovery
USDCLP * 524.00 495.00 458.00 450.00 should be on a sure footing before monetary
* End of period, ** Period average, Bold is actual data conditions are tightened. Nonetheless, it has already
announced a phasing-out of its term lending facility
and signalled that rates should begin to rise early next
year. We expect rates to rise to 4.00% by the end of
2010.
Colombia: Recovery dampened by politics

Rebounding export demand is helping growth but political uncertainties are taking their toll.
2008 2009 2010 2011
Real GDP % y-o-y 2.5 0.1 3.3 4.0 • Stronger export demand from Asia and the effects of
Consumption % y-o-y 2.3 -0.5 3.5 4.2 easier monetary policy are having a positive effect on
Gross Investment % y-o-y 8.8 -5.5 9.0 10.0 growth in Colombia. We expect a rebound to 3.3% in
Exports % y-o-y 7.0 -4.5 5.0 6.0 2010.
Imports % y-o-y 9.8 -10.0 12.0 8.0
CPI % y-o-y * 7.7 2.4 3.5 4.0 • Nonetheless, the pace of recovery has disappointed.
CPI % y-o-y ** 7.0 4.1 3.2 4.0 This, alongside lower inflation, has allowed the
Budget balance % GDP -0.1 -2.7 -3.0 -2.5 Central Bank to surprise the market and cut policy
Current account % GDP -2.8 -2.8 -2.5 -2.5 rates to 3.5%.
Policy Rate % * 9.50 3.50 5.00 5.50
USDCOP * 2000.00 2000.00 1860.00 1820.00 • One factor behind the high uncertainty is rising political
* End of period, ** Period average, Bold is actual data tension with Venezuela, which is already hurting
exports. There is also uncertainty over the political
Source: Nomura Global Economics. future of President Uribe, who is attempting a third term
in office.

Foreign Exchange ⏐ Outlook 2010 Ned Rumpeltin
Beyond peak performance

A summary of our main FX views follows below. Please see our 2010 Outlook piece, Beyond
peak performance published on 30 November 2009 for more details.
Investor risk appetite As in other asset classes, developments in investor sentiment and risk appetite have been
is driven by the crucial this year in understanding relative currency performance. We think this feature of the FX
economic cycle market is likely to continue into next year. Investor sentiment and risk appetite are conditioned
heavily by developments in the economic cycle. To help guide our assessment of these, we
have developed the Nomura Leading Indicators (NOLI) index, which has become an essential
component of our overall “risk call”. In general, NOLI is positively correlated with risky FX.
We see an early 2010 Our current risk assessment remains marginally positive. However, momentum seems to be
correction in risk fading and NOLI appears likely to peak as early as January 2010. Thus, we would expect risky
appetite currencies to suffer a setback following NOLI’s peak. That said, we do not expect this setback to
be too deep or prolonged. We view it more as a natural correction after a solid run for risky
assets. On top of weaker investor confidence providing a less-supportive backdrop, we think
next year will be marked by a shift back to individual country fundamentals as the primary driver
for currencies globally. Although the recent run-up in price and positioning suggests some short-
term vulnerability, neither seems especially stretched in our opinion. In addition, we expect the
policy stance in key economies to remain supportive of risky asset performance long into 2010.
One of the main casualties of the recovery in investor sentiment has been the US dollar (USD),
We expect the US
dollar to weaken which has weakened substantially against its major economy peers since equity markets
further in 2010 bottomed in March. Looking forward, we acknowledge that a near-term setback for risk may
provide some near-term support, but we expect USD to weaken further in 2010. In our view, the
combination of an extraordinarily stimulative monetary policy from the Fed and structural
headwinds are likely to keep the dollar on the defensive for the foreseeable future.
USD has lost a key Global capital markets are gradually healing, and many types of cross-border capital flows have
support: foreign normalized in the process. This is generally true in relation to capital flows in and out of the US
flows into MBS also. But there is an important exception: foreign inflows into mortgage-backed (and other asset-
backed securities) have dried up completely and are showing no signs of recovery. These
inflows had been an important source of USD support in recent years and their disappearance is
likely to keep the dollar on a weak footing well into 2010. In addition, while the US trade position
has improved on lower oil prices and lower import volumes, the underlying structural deficit is
still fairly high from a historical perspective and is unlikely to provide enough support to offset
other USD-negative factors. We therefore recommend selling USD versus a diversified global
basket of the Japanese yen (JPY), the euro (EUR), the Korean won (KRW), the Chilean peso
(CLP) and the Russian ruble (RUB) (with respective weights of 20%, 25%, 15%, 15% and 25%).
The euro looks set to The euro remains at elevated levels against many currencies in the region. During the crisis, the
give back some of its euro gained on the back of a reversal of cross-border bank lending flows. As part of the
strength deleveraging process, Eurozone banks cut back aggressively on lending into countries around
the Eurozone. The resulting capital flows (positive for the Eurozone, negative for the peripheral
countries) have pushed most European FX crosses higher. These flows helped amplify effects
from the euro’s function as a “regional” safe-haven currency during the financial crisis, investors
seeking refuge in the relative size and stability of the Eurozone. In our view, the euro looks set to
retrace versus other European currencies as the support from banking flows fades. We therefore
recommend selling EUR exposure versus an equal-weighted basket of the Norwegian krone
(NOK), the Swedish krona (SEK) and the Polish zloty (PLN).
We see value in In addition to the specific themes in relation to anchor currencies (both USD and EUR) it will be
sterling vs the Kiwi important to track the country-specific cyclical momentum within G10. In 2010 there is likely to
dollar be a period of further (if lackluster) recovery in the global economy and normalization of its
financial system. We think increasing macroeconomic differentiation is likely to emerge as an
increasingly important driver for G10 currencies. Accordingly, we believe relative value will play
a bigger role in 2010 as cross-asset correlations decline. We see value in the British pound
versus the New Zealand dollar: GBP/NZD is trading at multi-decade lows and may benefit from

the Bank of England’s likely move to gradually normalize policy from late 2010 and the
continued need for loose monetary policy in New Zealand.
A strengthening yen The Japanese yen is likely to remain under upward pressure in 2010 as global trade recovers,
is likely to prompt repatriation inflows increase and a decline in global risk appetite is not fully offset by a pickup in
MOF intervention domestic portfolio outflows. In addition, Japan’s monetary policy remains relatively tight by
international standards; the Bank of Japan has maintained a very low interest rate setting for
several years, but did not significantly expand its balance sheet in response to the financial crisis.
We think these pressures could push USD/JPY down to a low of 83 by the end of Q1 2010.
However, this would leave Japanese authorities little choice but to intervene in the FX market –
an option that policymakers have thus far been reluctant to employ. We believe that the Ministry
of Finance may have some success in putting a floor under USD/JPY and pushing it back to
around the 85 level before the cross gradually grinds back toward 87 by the end of next year.
We expect some Aside from some of the idiosyncrasies in parts of Asia, several broad themes are likely to
temporary weakness emerge in support of our broader regional outlook beyond Japan. First, less favourable global
in Asia FX ... risk conditions will, in our opinion, be the main driver of a temporary weakness in Asia FX. A
significant amount of foreign equity flows into the region in recent months has left Asia
somewhat vulnerable to a retrenchment in risk appetite and a resultant decline in global equity
markets. However, the region’s economies have grown less vulnerable overall to volatility in
external financing, repatriation flows have ebbed and we do not view positioning by global
investors as particularly stretched from a medium-term perspective. This leaves us confident
that that any sell-off in Asia FX is likely to be temporary and limited.
… but then for further Next, we see the cyclical recovery in Asia supporting our view of further Asia FX appreciation in
appreciation to occur 2010. We see this theme bolstered by base effects as global growth rebounds and exports in
particular continue to recover. Another support to our strengthening cyclical view is the region’s
inventory cycle: our economists expect the inventory contribution to GDP growth to be positive
across the region into the early part of next year. Generally loose monetary policies also should
provide a boost to local growth and help fuel FX appreciation. Finally, China’s growth surge is
also likely to support Asia and encourage regional currency strengthening. In our view, these
factors are likely to increase pressure on authorities to allow for greater FX flexibility in 2010, but
only in the wake of our forecast bout of risk aversion that we expect to occur around January-
February, and once capital inflows return.
We are bullish on the One of our preferred trade ideas is to be long the Korean won (KRW). We remain bullish on
Korean won KRW because its FX valuations (FEER/REER) are favourable, we see it as less vulnerable to
macroeconomic risks than other currencies, the Korean economy is set to recover strongly, and
we expect the monetary authorities to accommodate FX appreciation – and the implicit monetary
tightening that results from it.
We favour the Indian In keeping with our emphasis on relative value opportunities in 2010, we note that while
rupee over the Indonesia remains fundamentally sound, it is beginning to diverge from India on several levels.
Indonesian rupiah First, the Reserve Bank of India, one of the most hawkish central banks in the region, does not
appear to be overly concerned about foreign equity inflows – which constitute one of India’s
main sources of foreign capital. Next, positioning in India’s financial markets does not appear
particularly stretched versus heavy positioning by foreign investors in Indonesia’s SBI (central
bank bills) and bond markets. Finally, the Indian rupee (INR) remains undervalued while the
Indonesian rupiah (IDR) is overvalued, according to our FX valuation framework.
We are positive on Turning to the interest rate outlook for Asia, we retain a positive duration view on Asian interest
Asian interest rate rate markets into 2010. While the region’s economic recovery may be superior in relative terms,
duration in absolute terms it is unlikely to justify the degree of inflation, and by extension, the rate hikes,
priced into most regional curves. Moreover, because we expect a period of global risk aversion
over the coming months, net received positions in Asian rates markets are even more attractive.
Crucially, however, we do not believe a period of risk aversion will spark a recurrence of the
2007 to early 2009 Libor crisis. Hence, we do not expect received positions in front-end interest
rate swaps (IRS) to be undermined by a sharp widening of bond-swap spreads, or between
swap fixing rates and central bank policy rates.
We continue to like trades which benefit from extracting excessive term premium in near- to
medium-term interest rate futures contracts. In particular, we see the markets in Australia, New
Zealand, Korea, Singapore and Thailand as offering particular value in this regard. We favour

taking advantage of this excessive term premium via a mix of IRS received positions, front end
butterflies and forward-starting curve steepeners.
The return of the The key risk to our Asian rates outlook is a return of the “inflation trade” as base effects and high
“inflation trade” is a commodity prices are likely to push headline CPIs higher in several key economies in coming
risk months. We are skeptical on the ability of high headline inflation rates to pass meaningfully
through to actual core inflation, however, and expect the experience of 2008 to ensure that
central banks are reluctant to tighten monetary policy due to price rises in nondiscretionary
consumption items.
The worst is likely We believe the worst is over for Emerging Europe, Middle East and Africa (EEMEA). With the
over for EEMEA region through the worst of its business cycle and most of the financial deleveraging process
over, these economies are now showing signs of stability. A modest and gradual improvement in
the outlook is our over-riding theme, beyond any Q1 risk retracement, with many of the pre-crisis
excesses becoming less pronounced. Within this modest recovery in EEMEA, we expect plenty
of macro differentiation in terms of growth and fiscal and current account developments. In
particular, we see several compelling opportunities in currency and rate markets, which are set
to enjoy a favourable technical and valuation backdrop into 2010. While the current account and
inflation adjustments have reached a mature stage, the excesses of the period before the 2008
crash look like a story of the past.
Accordingly, we recommend investing in growth, current account and valuation outperformers. In

our view, this leads us to recommend buying the Turkish lira (TRY). Russian ruble, Kazakh
tenge, and Israeli shekel. Against this, we would sell the Czech koruna (CZK), Hungarian forint
(HUF) and South African rand (ZAR). We also recommend receiving 1yr swaps 1fwd in IRS
space (TRY, ZAR with a view to include HUF) to protect currency longs. We expect PLN to
outperform in a similar fashion to the Slovak koruna in 2008, as we expect Poland to enter ERM
II in 2010. Furthermore, the currency’s valuation, growth differentials and competitiveness are
favourable relative to EUR and CZK, and we recommend buying PLN against EUR and CZK.
LatAm is benefiting With respect to Latin America, we maintain a positive stance on the region’s major economies.
from ties to Asia and The medium-term economic outlook for Latin America (particularly the southern cone) is
commodity prices underpinned by two positive structural factors. First, the rising trade links with high-growth Asia
(especially China), and the impact that Asia has had on commodity prices explains both the
absolute and relative performance of the economies in the region – specifically, we think this
accounts for a meaningful degree of Brazil’s better economic performance compared with
Mexico. The positive terms-of-trade shock and greater volume of export demand represent a net
income transfer to these commodity producers, reducing the perception of risk in the region and
generating a virtuous cycle of greater investments and consumption.
We are positive on Although a strong case can be made that a form of economic “decoupling” from the G3 business
LatAm currencies cycle has taken place, we expect local markets to continue to show high correlation to G3
against USD markets. In addition, the outlook for 2010 looks much trickier than 2009, with the uncertain
global environment, higher valuations and rising political and policy risk in Brazil and Colombia
arguing in favour of lower-risk strategies. Still, we maintain a positive view of the region’s
currencies against USD for 2010. The risk wobble we foresee in Q1 should have only a
temporary impact on the region's currencies, and is not expected to derail the ongoing rally. That
said, higher valuations do complicate matters and upcoming elections in Brazil and Colombia
will heighten political and policy risk.
The Brazilian real We favour two medium-term positions: sell USD/BRL and sell USD/CLP. We expect the
leads the pack Brazilian real (BRL) to continue to lead the pack, but with much more volatility amid the impact
of capital-control measures and a potential equity market sell-off in Q1 2010. We also
recommend short USD/CLP as a way to diversify exposure to the region. In addition, the
BRL/CLP cross may be a good vehicle in times of higher risk aversion. The market has priced in
an aggressive expectation of policy rate hikes that we doubt will materialize; as a result, we also
see good value in receiving rates in Brazil and look at specific “event triggers” to add to the trade.

Equity Market ⏐ Outlook 2010 Ian Scott
Still bullish
We expect the global equity rally to continue but at a slower pace than the gains seen since
March 2009. We forecast a local currency total return for global equities of 17%.
Strong support for stocks from a number of factors

We would characterise the positive forces in 2010 as the following:
Current loose policy 1) Continued policy support: For several reasons, we think the authorities in the major
could remain in place developed economies will err on the side of caution when considering moving away from the
for a while yet very loose policy stance that is in place at the moment: (i) the existence of a very large output
gap, (ii) continued benign news on inflation, and (iii) lessons from Japan’s experience, where
many now argue that policy support was removed too early after recovery had begun to take
hold. In terms of unconventional measures too, Nomura’s Global Economics team expects
support for markets to continue to rise, albeit modestly, well into 2010.
Valuations are lower 2) Valuations: We continue to feel that equity valuations are below where the current
than fundamentals fundamentals suggest they ought to be. The debate regarding earnings multiples hinges on an
suggest assessment of where the mid-cycle earnings point is. Fitting a simple constant growth trend to
historical earnings data suggests that current earnings are 45% below the mid-cycle point when
treated in nominal terms (Figure 1). With the nominal trend, the current multiple is 19% below its
40-year average (Figure 2).
Relative to government bonds, we think equities are favourably valued with an imbedded equity
risk premium of about 5.5%, while relative to credit too, equity yields now look much more
appealing than they did 12 months ago. One of the striking features of this current equity cycle is
the continued very high free cash flow being generated by non-financial companies, well above
that required to sustain their dividends. All in all then whether based on book values, earnings,
free cash flows or dividends, we think that both absolute and relative equity valuations are
appealing.
Earnings should 3) Earnings: We think earnings will continue to grow in 2010 and 2011. Our forecasts suggest
continue to grow in EPS growth of 24% which is below the current consensus of bottom-up analyst forecasts of 30%
2010 and 2011 (Figure 3).
We expect GDP, at the global level, to continue to grow at an accelerating pace in 2010 and
2011 despite the waning of policy stimulus. Our expectation of continued earnings growth leads
us to expect a likely continuation of earning upgrades, although probably not at the same pace
as over the past 11 months.
Asset allocation still 4) Asset allocation: We believe that asset allocation remains skewed in favour of cash and
favours cash away from equities. The traditional owners of equity – institutions and households – have more
cash as a proportion of financial assets than at any time over the past ten years Although we
Figure 1. Global EPS (earnings per share) and trend Figure 2. Normalised global PE (price earnings) multiple
Index, Jan 1970 = 100 Ratio

1,800 35
1,600
30
1,400
25
1,200
1,000 20
800 15
600
10
400
5
200
0 0
1970 1974 1979 1983 1988 1992 1997 2001 2006 1970 1974 1979 1983 1988 1992 1997 2001 2006
Source: Nomura Strategy research. Source: Nomura Strategy research.

see no definitive reason why asset allocation ought to move back towards equities and away
from cash, it is clear that in major developed economies, one of the intentions of asset-purchase
programmes and quantitative easing is to encourage exactly such an asset allocation shift.
Nonetheless, until that happens we think the potential remains for equity markets to be
supported by asset allocation flows.
We also see a number of negative forces at work on the equity market in 2010, the main one
being the high levels of government borrowing, which will likely limit the scope for multiple
expansion in 2010. Other factors include equity issuance, possible subdued institutional demand
for equities and higher regulation.
Market forecasts
We expect a still In Figure 4 we detail our index targets and market forecasts for 2010. We believe the overall
healthy overall gain gain for global equities will be less strong than it was since March 2009, but still healthy. As
for equities discussed above, this should be driven by continued earnings growth, low valuations, positive
asset allocation and benign policy.
Regional outlook – a tactical shift to Japan

Unlike the position 12 months ago, when we began 2009 with some very large departures from
the benchmark regional weightings, as 2010 approaches things do not seem quite as dislocated.
Nevertheless, we think there are some opportunities to diverge from the benchmark (Figure 5).
We raise our Japan: We are taking the opportunity to raise our recommended weighting in the Japanese
weighting in equity market from a previous 7% to 16%, against a benchmark of 8%. There is undoubtedly a
Japanese equities need for policy action, in our view. The strength of the yen has become a major problem for the
market. By acting to stem the rise of the yen recently by increasing the amount of emergency
liquidity available to the banking system and passing a supplementary budget, the new
Japanese government has signaled an intention to respond to “excessive” yen strength, at
around ¥85 to the US dollar. While the policy response is important, we see other supports for
an Overweight position. Although the economy is weak, and once again in the grip of deflation,
the situation may not be quite as bad as the market appears to think.
Confidence, arguably the most important variable during times of crisis, has recovered more
quickly than has been the case in the US, for example. Japanese output has recovered rapidly
from a much larger decline as a sharper inventory adjustment combined with the strength of the
yen and a larger underlying cyclicality. Nomura’s Japanese Strategy Team forecasts a rise in
Topix earnings per share of 140% in 2010 and another 50% in 2011. If this transpires then the
market is trading on 13.4 times 2011 expected earnings.
The US market US: The US market should perform well again in 2010 as the extreme policy measures
should perform well implemented by the US administration bear fruit. The economy is expected to recover, and to
again in 2010 grow above the GDP growth rate expected in Japan and the euro area. Although earnings are
likely to continue to grow in 2010, we doubt that they will continue to surprise estimates in the
way that they have done recently. A key element of our optimistic view on the US market is the
Figure 3. Earnings (EPS) growth forecasts Figure 4. Index forecasts for major global indices, 2010
2009 2010 2011 Price indices Price Total Total
EPS* growth (% y-o-y) return return return
1 Current* End 2010 Local Local $ terms
US 21.0 30.0 25.0
1
US 1103 1300 18% 20% 20%
Europe ex-UK -15.0 18.5 14.1
2
Europe ex-UK 140 155 10% 14% 19%
UK -38.0 28.0 11.0
3
UK 5311 6000 13% 16% 25%
Asia ex-Japan 5.2 14.6 17.0
4
2 Japan 899 1100 22% 25% 28%
Japan -58.5 140.0 50.0
5
Asia ex-Jap 316 350 11% 14% 21%
Emerging Markets -6.7 23.7 19.0
6
3 EM 502 560 12% 14% 21%
Global -3.2 23.9 19.5
EPS forecasts
Global 316 363 15% 17% 21%
S&P Operating EPS ($) 60 78 97.5
Topix (yen) 18 44 66
Notes: * Earnings pre-extraordinary items. 1) S&P 500 Operating Notes: 1) S&P 500; 2) FTSE Europe ex UK; 3) FTSE 100;
Earnings; 2) Topix; 3) FTSE AW World Index, 4) Topix; 5) FTSE Asia ex Japan; 6) FTSE Emerging Markets.
Source: Nomura Strategy estimates. * As of 9 Dec 09
Source: Nomura Strategy research.

expectation that the authorities will maintain a very accommodative stance for an extended
period of time. In addition, the asset allocation position in the US is an extreme one, with both
households and institutions holding relatively large amounts of cash. In 2010 we would expect to
see a greater appetite for equities developing.
We recommend being Europe ex-UK: We are recommending an underweight stance in the Europe ex-UK market
underweight Europe going into 2010. Although the region remains relatively cheaply valued on 12.4x consensus 12-
ex-UK month forward earnings, we think there are some potential constraints. Earnings growth is likely
to be constrained by the ongoing strength of the euro and a less aggressive attitude towards
cost cutting than is evident elsewhere, especially in the US. As Figure 6 shows, unit labour cost
growth contrasts with unit labour cost declines in the US. We forecast US profit growth to be
30% in 2010, current consensus estimates being 23.5%. In Continental Europe we anticipate
18.5% compared with consensus estimates of 28%.
The UK market is UK: We continue to overweight the UK market. The UK market has not been a defensive market
attractively valued - in this equity cycle. The market has suffered disproportionally as a result of the financial crisis,
we stay overweight as has sterling. We think this leaves an opportunity for investors to buy relatively cheap assets in
a relatively cheap currency. Nomura’s Foreign Exchange research team anticipates an
appreciation of the pound in 2010 to 1.95 versus the dollar, 1.6 versus the euro and 170 versus
the yen. In addition, the UK market receives support from valuation – the estimated risk premium
embedded in the UK equity market at 6.1% is 230 basis points above the risk premium
embedded in the rest of the world.
We retain a modest Emerging markets: We retain our modest underweight position in global emerging markets
underweight in EM (EM). The region no longer offers investors a higher risk premium compared with developed
markets. Profitability favours the emerging markets now, but we expect developed market
earnings to rise more strongly in 2010 and 2011. Finally, there is the issue of fund flow and the
currently buoyant sentiment towards EM. Based on the past three months of inflows, around
$14.1bn of EM equity assets have been bought by mutual fund investors. Although such flows
do not necessarily point to negative returns for investors in EM equities ahead, or even
underperformance, they have been associated with less bullish performance than when
investors buy into emerging markets following an exit of capital.
We reduce our Asia-ex-Japan: The developed Asia region has performed well in 2009, rising by 60% in US
exposure to neutral dollar terms. However, we think the time has come to reduce our recommended exposure to
in Asia ex-Japan Neutral from Overweight. The region (as defined by FTSE) trades on 15.4x current consensus
earnings for 2010. This compares with a 13.2x multiple for emerging Asian markets. The
premium for developed Asian markets seems hard to justify.
1
Figure 5. Recommended global market allocation Figure 6. US and euro-area unit labour costs
Benchmark Recommend- Recommendation % y-o-y
ed weighting 7
North America 44 39 Underweight
6
Europe ex-UK 20 11 Underweight Euro area
5
UK 9 18 Overweight
4
Japan 8 16 Overweight
3
Asia ex-Japan 8 8 Neutral
2
Emerging Mkts 12 8 Underweight
1
Unit: % of index 0
-1
-2
-3 US
-4
1
Benchmark: FTSE All World index (USD). Note: Unit labour cost data for the US are for the non-farm sector
Source: Nomura Strategy research. while data for the euro area is for the entire economy.
Source: Datastream, Bureau of Labour Statistics, EuroStat,
Nomura Strategy research.

Contacts
Global
Paul Sheard Global Chief Economist paul.sheard@nomura.com 1-212-667-9306
North America
David Resler Chief Economist US david.resler@nomura.com 1-212-667-2415
Aichi Amemiya aichi.amemiya@nomura.com 1-212-667-9347
Zach Pandl zach.pandl@nomura.com 1-212-667-9668
Europe
Peter Westaway Chief Economist Europe peter.westaway@nomura.com 44-20-7102-3991
Laurent Bilke laurent.bilke@nomura.com 44-20-7102-2566
Takuma Ikeda takuma.ikeda@nomura.com 44-20-7102-1605
Maxime Alimi maxime.alimi@nomura.com 44-20-7102-5846
Japan
Takahide Kiuchi Chief Economist Japan t-kiuchi@frc.nomura.co.jp 81-3-5203-0445
Kenichi Kawasaki Senior Policy Analyst k-kawasaki@frc.nomura.co.jp 81-3-5255-0574
Mika Ikeda m-ikeda@frc.nomura.co.jp 81-3-5203-0415
Ei Kaku e-kaku@frc.nomura.co.jp 81-3-5255-1711
Naokazu Koshimizu n-koshimizu@frc.nomura.co.jp 81-3-5203-0427
Masaki Kuwahara m-kuwahara@frc.nomura.co.jp 81-3-5203-0629
Takashi Miwa t-miwa@frc.nomura.co.jp 81-3-5203-0421
Takashi Nishizawa t-nishizawa@frc.nomura.co.jp 81-3-5203-0414
Minoru Nogimori m-nogimori@frc.nomura.co.jp 81-3-5203-0451
Shuichi Obata s-obata@frc.nomura.co.jp 81-3-5203-3635
Kohei Okazaki k-okazaki@frc.nomura.co.jp 81-3-5203-0428
Ryota Sakagami r-sakagami@frc.nomura.co.jp 81-3-5203-0446
Takayuki Urade t-urade@frc.nomura.co.jp 81-3-5203-0425
Asia
Rob Subbaraman Chief Economist Asia rob.subbaraman@nomura.com 852-2536-7435
Tomo Kinoshita Deputy Head, Asia Economics tomo.kinoshita@nomura.com 852-2536-1858
Stephen Roberts Chief Economist Australia stephen.roberts@nomura.com 61-2-8062-8631
Mingchun Sun Chief Economist China mingchun.sun@nomura.com 852-2252-6248
Young Sun Kwon South Korea youngsun.kwon@nomura.com 852-2536-7430
Tetsuji Sano Philippines, Thailand tetsuji.sano@nomura.com 65-6433-6947
Sonal Varma India, Vietnam sonal.varma@nomura.com 91-22-4037-4087
Emerging Markets
Peter Attard Montalto SA, CEE, Middle East peter.am@nomura.com 44-20-7102-8440
Olgay Buyukkayali Turkey, Israel olgay.buyukkayali@nomura.com 44-20-7102-3242
Ivan Tchakarov Russia, Ukraine, Kazakhstan ivan.tchakarov@nomura.com 44-20-7102-9093
Tony Volpon Latin America tony.volpon@nomura.com 1-212-667-2182

Analyst Certifications
We, Paul Sheard, David Resler, Aichi Amemiya, Zach Pandl, Tony Volpon (Nomura Securities International), Peter Westaway, Laurent Bilke, Takuma Ikeda,
Maxime Alimi, Peter Attard Montalto, Ivan Tchakarov, Olgay Buyukkayali, Ian Scott, Ned Rumpeltin (Nomura International plc London), Takahide Kiuchi,
Naokazu Koshimizu, Masaki Kuwahara, Takashi Miwa, Takashi Nishizawa, Minoru Nogimori, Kogen Okada, Shuichi Obata, Ryota Sakagami, Takayuki Urade
(Nomura Securities Company), Tomo Kinoshita, Rob Subbaraman, Mingchun Sun, Young Sun Kwon (Nomura International (HK) Limited), Stephen Roberts
(Nomura Australia Limited), Tetsuji Sano (Nomura Singapore Limited), Sonal Varma (Nomura Financial Advisory and Securities (India) Pte Ltd), hereby
certify (1) that the views expressed in this report accurately reflect our personal views about any or all of the subject securities or issuers referred to in this
report, (2) no part of our compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3)
no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International
plc or any other Nomura Group company.
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2010 Global Economic Outlook

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NOMURA GLOBAL ECONOMICS

A Tale of Two Recoveries

Nomura Global Economics 1 16 December 2009

EMERGING EUROPE, MIDDLE EAST AND AFRICA

Nomura Global Economics 2 16 December 2009

The World at a Glance

Nomura Global Economics 3 16 December 2009

Our View on 2010 in a Nutshell

Nomura Global Economics 4 16 December 2009

Global ⏐ Outlook 2010 Paul Sheard

A tale of two recoveries

Developed world recovery weak

Nomura Global Economics 5 16 December 2009

Fiscal forces Paul Sheard

Nomura Global Economics 6 16 December 2009

Constraints on exchange rate adjustments: The global economy needs to “rebalance”

Emerging world recovery strong

Index, Q1 2008 = 100 $bn

Nomura Global Economics 7 16 December 2009

GEMaRI: Vulnerability remains Peter Attard Montalto ⏐ Rob Subbaraman

Figure 1. GEMaRI scores for Q3 2009

Nomura Global Economics 8 16 December 2009

Inflation and monetary policy

Risks to the forecast

Nomura Global Economics 9 16 December 2009

QE: back to basics Paul Sheard

This identity immediately yields a few insights:

Nomura Global Economics 10 16 December 2009

Key political issues for 2010 Alastair Newton

Nomura Global Economics 11 16 December 2009

United States ⏐ Outlook 2010 David Resler

The slow road from recession

The “Great Recession” has ended

GDP Index, Peak = 100 pp

2001 of expansion 1.0

Nomura Global Economics 12 16 December 2009

As is typical of most recoveries, a rebound in consumer spending, residential investment and

Debt unwind to limit pace of recovery

m saar Change in % y-o-y rate, pp

Nomura Global Economics 13 16 December 2009

Financial stress David Resler

Nomura Global Economics 14 16 December 2009

Subdued inflation but daunting challenges for the Fed

Nomura Global Economics 15 16 December 2009

Constrained by debt David Resler

Nomura Global Economics 16 16 December 2009

The Fed’s balance sheet Zach Pandl

Nomura Global Economics 17 16 December 2009

Strong finish to 2009, but cooler growth ahead

Activity: A revival of consumer spending, a rebound in residential investment, and a slower

Details of the forecast

Nomura Global Economics 18 16 December 2009

Euro area ⏐ Outlook 2010 Laurent Bilke ⏐ Maxime Alimi

More balanced investment

Real GDP growth -4.5 0.6 1.3 -3.9 1.1 1.7 10

Nomura Global Economics 19 16 December 2009

Good work Laurent Bilke ⏐ Maxime Alimi

Cutting hours, not headcount

Contribution to % change y-o-y Hours / week

Nomura Global Economics 20 16 December 2009

Muted inflation in 2010

Undeclared monetary policy tightening...