Global Economic Research July 26, 2010

Tuuli McCully
1 (416) 863-2859
tuuli_mccully@scotiacapital.com

• European currency and debt markets maintain a strengthening tone

• UK and euro zone on robust growth trajectory for now
• Seven out of 91 banks fail EU banking sector stress tests

European currency and debt markets maintain a strengthening tone

The euro (EUR) and the British pound (GBP) continue in recovery mode following the release of Euro-
pean bank stress test results (please see commentary below) on Friday afternoon that allowed inves-
tors to digest the results over the weekend. While testing methodologies received plenty of criticism for
not being stressful enough, the results seem to have relieved some concerns vis-à-vis the health of
the European banking sector. Moreover, encouraging data regarding solid economic recovery in the
euro zone and the UK are further underpinning investor sentiment. The EUR is currently hovering near
the US$1.30 mark while the GBP reached US$1.55 this morning; the EUR has rebounded by 9%
against the USD since early June, while sterling is up by 8% since its recent low in mid-May. Never-
theless, uncertainty over global growth prospects will remain elevated in the near term while rapidly
changing investor sentiment continues to cause volatility in the financial markets; therefore, we expect
that both the EUR and the GBP may be subject to another bout of weakness this summer. Market
sentiment towards European debt assets continues to improve gradually, with bond yields in the highly
indebted euro zone countries lower from last week. European equity securities markets have started
the week on positive trajectory; the major European stock exchanges, the German DAX, British
FTSE100 and French CAC40, are up by 0.5%-0.8% on the day, led by the financial services industry.

UK and euro zone on robust growth trajectory for now

Economic recovery in the United Kingdom is proving stronger than previously anticipated – at least for
now – with the manufacturing sector being the driving force. The preliminary data show that real GDP
jumped by 1.1% q/q (1.6% y/y) in the second quarter of the year following a 0.3% q/q growth rate
(-0.2% y/y) in the January-March period. If output growth (in quarterly terms) were to remain flat for the
rest of the year, carry-over effects from the first two quarters would take real GDP expansion to 1.2%
this year; we expect the economy to reach near-1½% growth in 2010 as a whole. Output details show
a broad-based expansion across the services, manufacturing and construction sectors. Retails sales
depict a similar story, rising 0.7% m/m in June. Nevertheless, we expect that forthcoming fiscal con-
solidation, in the form of tax increases and reduced government spending, will dampen growth pros-
pects in the medium-term. Indeed, housing sector data are hinting that households are already be-
coming more cautious, with mortgage approvals declining in June from the month before and house
prices falling for the first time in fifteen months in July. Accordingly, British monetary policymakers will
likely keep the benchmark interest rate – the Bank Rate – unchanged at 0.5% until the second quarter
of 2011; minutes from the most recent Monetary Policy Committee meeting in early July reveal that
members voted 7-1 in favour of maintaining stable interest rates, with one member supporting higher
rates.

The euro zone economy continues to recover, with both manufacturing and the services sector moving
further into expansion mode in July, according to the ‘flash’ purchasing managers’ indices. Similarly,
new industrial orders in the euro zone jumped 3.8% m/m (and 22.7% y/y) in May, pointing to further
activity in the coming months. Germany continues to be the engine of growth in the region; the closely
followed IFO index on the country’s business conditions surged in July to the highest level since mid-
2007, proving that the German economy continues to benefit from euro weakness and strong demand
for the nation’s exports. Concerns regarding the impact from the turmoil in Greece and in other highly

Europe Weekly Outlook is available on www.scotiabank.com, Bloomberg at SCOE

Global Economic Research
indebted euro zone countries are showing signs of eas-
ing with euro zone consumer confidence improving in
July. Nevertheless, with many of the euro zone econo-
mies starting to focus on fiscal consolidation, growth
prospects will likely ease in the second half of the year.
Moreover, regional growth dynamics – particularly in
the export sector – will be additionally affected by a
slowdown to more sustainable rates in the US and
China in 2011.
Seven out of 91 banks fail EU banking sector stress
tests
The process of financial stabilization in Europe is gath-
ering speed following Friday’s release of the European
bank stress test results by the Committee of European
Banking Supervisors (CEBS). While the results imply
that the banking sector in the European Union (EU) is
fairly resilient, they revealed some weaknesses as well.
The CEBS together with the European Central Bank
and national supervisory authorities conducted stress
tests on 91 European financial institutions that together
represent 65% of the EU’s banking sector. In addition to
testing major cross-border banking groups, the cover-
age also included many domestic credit institutions,
such as the Spanish cajas.
The objective of the exercise was to assess the banking
sector’s resilience in 2010 and 2011, and specifically its
capacity to weather possible credit shocks, such as
those stemming from sovereign risks related to highly-
indebted euro zone countries, and to assess the banks’
dependence on public support measures. If a bank’s
financial strength − i.e. its ability to sustain future losses
− is not adequate, as measured by a Tier 1 capital ratio
(core equity capital / total assets) of at least 6% (the
current regulatory minimum is 4%), it will need to raise
more capital. The tests included two macro-economic
scenarios: the benchmark scenario assumed a modest
economic recovery in the euro zone (GDP growth at
0.7% in 2010 and 1.5% in 2011) while an adverse sce-
nario was based on a double-dip recession (with real
GDP growth of -0.2% in 2010 and -0.6% in 2011). The
adverse scenario had two components: the first in-
cluded a global confidence shock affecting demand
worldwide, and the second added an EU-specific shock
stemming from a worsening of the sovereign debt crisis.
An upward shift was implemented for the yield curve at
both the short-end − to capture interbank liquidity prob-
lems − and the long end of the curve − to depict dete-
riorated perceptions regarding the countries’ sovereign
creditworthiness. The tests also included valuation hair-
cuts to sovereign bond holdings for each country, rang-
ing between 4.2% (Slovenia) and 23.1% (Greece), how-
ever an outright sovereign default was not considered.
July 26, 2010
In addition, sovereign-debt losses were mapped for
those bonds that banks trade, rather than those that are
held to maturity.
The impact of the sovereign debt shock varied by coun-
try, reflecting their respective international public sector
exposure. With the addition of the sovereign shock,
seven European banks saw their Tier 1 capital ratios
fall below 6% in 2011, up from five in the case with the
global demand shock only. Furthermore, there were 10
institutions with capital ratios that fell to the 6.0-6.9%
range under the initial adverse scenario, increasing to
17 with the inclusion of the sovereign debt shock. One
of the failed institutions is German, and is already
owned by the government, while one is a Greek bank,
and the remaining five are Spanish (one bank and four
cajas). To date, the Spanish government has already
promised sizable funds for recapitalization purposes.
Transparency of the testing mechanism is a key ele-
ment in building credibility and investor confidence; with
plenty of details published regarding testing proce-
dures, investors should be able to scrutinize the credi-
bility of the tests easily. Nevertheless, investor con-
cerns regarding the stringency of the tests will likely
remain in place; macro-economic assumptions fall short
of the economic contraction of more than 4% in 2009,
though two consecutive years of economic decline can
be considered a fairly pessimistic assumption.
Following a relatively neutral market reaction to the
stress test results, we expect that the European sover-
eign debt crisis has now passed one of the key hurdles
and signs of stabilization will start to emerge. Neverthe-
less, with the turmoil mainly driven by rapidly changing
investor confidence, uncertainty remains high at least in
the near term. While financing conditions for many of
the countries in the euro zone periphery remain tough
and achieving fiscal sustainability is vital in order to
maintain investor confidence, the stress test results
support our view that sovereign debt issues will not
cause any unprecedented difficulties for the European
banking sector. Nevertheless, potential for a Greek debt
restructuring remains in place. According to BIS data,
the French banking sector is the largest lender to
Greece, accounting for 35% of total international claims
(as of Q1 2010) on the country, though these claims on
Greece account for only 2% of the French banking sec-
tor’s international exposure. With the Greek public sec-
tor accounting for 46% of all international borrowing, a
debt restructuring would have an adverse – though lim-
ited – impact on French banks. Nevertheless, the re-
sults of the stress tests, that cover nearly 80% of the
French banking sector, indicate that the country’s finan-
cial institutions are among the most resilient in Europe.
2
 Global Economic Research July 26, 2010

INTERNATIONAL RESEARCH GROUP

Pablo F.G. Bréard, Head

1 (416) 862-3876
pablo_breard@scotiacapital.com

Tuuli McCully
1 (416) 863-2859
tuuli_mccully@scotiacapital.com

Estela Ramírez
1 (416) 862-3199
estela_ramirez@scotiacapital.com

Oscar Sánchez
1 (416) 862-3174
oscar_sanchez@scotiacapital.com

Scotia Economics
Scotia Plaza 40 King Street West, 63rd Floor
Toronto, Ontario Canada M5H 1H1
Tel: (416) 866-6253 Fax: (416) 866-2829
Email: scotia_economics@scotiacapital.com
This Report is prepared by Scotia Economics as a resource for the
clients of Scotiabank and Scotia Capital. While the information is from
sources believed reliable, neither the information nor the forecast shall
be taken as a representation for which The Bank of Nova Scotia or
Scotia Capital Inc. or any of their employees incur any responsibility.