Global Barrel Bill (2012 Edition) March 16, 2012 By Spyros Andreopoulos & Sung Woen Kang | London

The renewed oil price run-up makes us revisit our barrel bill framework, first introduced last year (see Global Economics: Barrel Bill, April 13, 2011). Barrel Bill: The Update We define the barrel bill as the value of aggregate oil imports by net oil importing economies as a share of these countries' combined GDP (for more details, see Box 3 below). At around US$2.3 trillion, the (first stage) wealth transfer from oil importers to oil exporters in 2011 reached all-time highs in dollar terms. As a share of aggregate oil importers' GDP, the barrel bill has surpassed the 2008 level of 3.2%. Put differently, over 2010 and 2011, the barrel bill has more than fully recovered the 1.2% of oil importers' GDP drop that it suffered between 2008 and 2009. In terms of aggregate oil exporters' GDP, the value of global oil trade last year was around 23.3% - compared to the all-time high of 23.7% in 2008. To put these levels into historical perspective, they are still meaningfully lower than in the early 1980s, when the oil wealth transfer was 5.9% (34.3%) of oil importers' (oil exporters') combined GDP for 1980 and 4.2% (28.4%) for 1981. As we will see below, however, realistic scenarios for the oil price could bring the barrel bill to 1981 levels this year. What happens to this oil revenue? It gets recycled' into goods and assets (see Box 1 below for more details). Oil revenue recycling 1: Goods: Of the US$2.3 trillion barrel bill, around 50% will, over time, return to oil-importing economies in the form of export revenue: oil exporters spend around half their oil revenue on goods imports from oil importers (the average propensity to import out of oil revenue'). Indeed, we think it is likely that this share will increase as oil exporters bid to maintain social stability (that is, the marginal propensity to import out of oil revenue may soon rise). In any case, the net wealth transfer - i.e., after accounting for this (second stage) wealth transfer back to oil importers - is thus much smaller than the gross (first stage) transfer. Oil revenue recycling 2: Assets: This leaves around US$1.1 trillion unspent. While some of this will no doubt be spent on domestic goods and services (or on goods and services from other oilproducing economies), it is fair to assume that the lion's share will be saved, that is, invested mainly in assets from the oil-importing economies. If this flow of saving is US$1 trillion, it would be equivalent to 1.8% of global equity market capitalisation. What Does it Mean for Growth? Unfortunately, there is no consensus in economics regarding the consequences of oil shocks for real GDP. We sidestep this problem by using the barrel bill concept to look at the potential implications of the current oil price surge for global growth. As we explain in Box 2, we prefer to look at the change in the barrel bill rather than the level. Further, the underlying drivers of the barrel bill matter, i.e., shocks to oil demand or supply, whether the shock is permanent or transitory, and of course whether it is large or small. Beginning from this reasoning, we note: The current oil price surge is not (yet) very persistent: in real, domestic currency terms, the sixmonth trailing average of the price of oil for some economies - namely the US, China, Japan and the UK - has not yet reclaimed last year's highs.

 In fact, in the US the share of energy in total household expenditure has actually declined lately, courtesy of a mild winter (which reduced the volume of demand) and lower gas price quotes (which reduced the price of energy for some households). Further, the barrel bill concept can help us to gauge the impact of oil on the global economy. Scenario analysis: Using assumptions about oil prices for the rest of the year and the responsiveness of demand to prices (price elasticity of demand'), we can construct different scenarios for the 2012 barrel bill - and its change over the 2011 barrel bill. At current oil prices (around US$125 for Brent), our scenarios indicate an increase in the barrel bill of about 0.2-0.4pp of oil importers' combined GDP compared to last year. This is roughly in line with the average increase in the barrel bill over the last ten years (0.3% of GDP). That, in general, has not been recessionary in the past. In addition, we take heart from the fact that despite a sizeable increase in the barrel bill between 2010 and 2011 (of 0.9% of GDP), 2011 was not a recession year for the global economy (although it did weaken the US economy in the first half). This despite: i) general DM sluggishness induced by deleveraging; ii) the global shock from the Japanese catastrophe; and iii) the European sovereign and banking crisis. An oil price at US$150 per barrel would, depending on the demand responsiveness, add at least 0.7% of GDP to the barrel bill of oil importers. It is likely - although not certain - that this would tip some of the more fragile parts of the global economy into recession, particularly in DM. It would also bring the share of GDP importers' spend on oil to well above 4%, levels we haven't seen since the early 1980s (the barrel bill declined from 5.9% of oil importers' GDP in 1980 to 3.5% in 1982). In short: Oil prices at current levels are a drag, but should not be too much of a problem for oil importers and the global economy as a whole. A meaningful further rise in oil prices from current levels, say to US$150, could tip the more fragile parts of the global economy into recession, particularly in DM. A final worry: It is always worth bearing in mind that it is difficult to draw conclusions about the future path of the economy from correlations; all else' is rarely equal'. One of the ways in which this oil price surge could impact the economy is indirect: by rendering global monetary policy less accommodative. This may already be happening: The Fed seems to be favouring sterilised asset purchases (Operation Twist 2) to another round of unsterilised purchases (QE3) - not least because we think it would not want to be seen to be fanning inflation expectations when energy quotes are likely to climb. Our ECB watcher, Elga Bartsch, is flagging upside risks to her call for another 25bp cut in 2Q as the oil price surge exerts upward pressure on the inflation outlook. And of course, last year the ECB hiked in response to the oil price rally then. Our Asia ex-Japan economist, Chetan Ahya, thinks that the rally in oil prices will delay repo rate cuts by the Reserve Bank of India, initially expected to commence in March; an April move would depend on the trajectory of oil and commodity prices, in his view. Our Bank of Korea watcher, Sharon Lam, sees risks to her call for a cut if inflation rises in the coming months. Conclusions: We estimate the global wealth transfer from oil importers to oil exporters at current oil prices at around US$2.5 trillion for 2012 - 4.2% of oil importers' GDP or 3.6% of global GDP. This will likely be a drag on global growth, but would on its own not be sufficient to derail the

recovery. Oil prices at US$150 could well tip the more fragile parts of the global economy into recession, however. We also worry that higher oil prices will act as a constraint on central bank easing, thereby resulting in less monetary support for the economy. Box 1: The Global Effect of Oil Price Shocks Higher oil prices first and foremost constitute a redistribution of wealth - and therefore demand from net importers to net exporters (demand redistribution effect). This income transfer occurs because, in the short run, there is no escape for net importers: the responsiveness of energy demand to price (the price elasticity') is low, since much of energy-consuming economic activity is essential' (people have to drive to work, factories need to run, and so on). As a consequence, consumer spending on other items gets squeezed, as do corporate profits and therefore spending by firms. Net exporters, the recipients of the income transfer from the net importers, are likely to save a substantial part of the income transfer. How much is saved and how much is spent depends crucially on whether the oil price increase is (perceived to be) permanent or transitory - the more transitory, the more is saved. In any case, the fact that at least some of the transfer is saved means that higher oil prices also, on net, take out demand from the global economy (demand destruction effect). What happens to those savings? Part of it will be invested domestically. The other part will be invested abroad - oil producers' persistent current account surpluses are evidence of this. Some of these funds will be invested in other oil-exporting countries. But a substantial part of them will be invested in net oil-importing countries. In short, some of the initial income transfer is recycled into the purchase of assets of net importing economies - naturally, oil exporters obtain claims on net oil importers. So, the oil shock results in a reshuffling of the global ownership of assets - the asset market counterpart of the global wealth redistribution (asset recycling effect). What happens to the part of the income transfer that is consumed? Again, a part of it will be consumed on domestic goods, and a part on imported goods. And once more, some of these goods will be imported from other oil producers, but most will be imported from net oil-importing countries. That is, part of the initial income transfer is reversed through goods imports from net oil importers (goods recycling effect). So, from a high-level perspective, the oil bill is not a net negative for the global economy. The resources spent on purchasing more expensive energy do not disappear into outer space. Rather, a redistribution takes place - and as with every redistribution, it creates winners and losers. And even within the group of the losers, some will be relatively better off and some will be relatively worse off. Box 2: The Barrel Bill and GDP Growth How do oil prices and the barrel bill relate to GDP growth? Level versus change: We think that it is usually more helpful to look at the change in the barrel bill rather than the level. Why? The level of the oil import bill most of the time matters for the level of income available to an economy, not real GDP growth. Think of an economy that transfers a constant share of its income abroad every year. The consumption and investment decisions that determine GDP growth are then made on the basis of the post-transfer income. It is only when the share of income that goes abroad changes that spending plans have to be changed. If the share of the income transfer changes meaningfully, the resulting adjustment in spending can be disruptive to the economy. In particular, since spending on energy is essential', other spending usually has to be reduced when energy becomes more expensive. (Of course, the level matters in

the sense that, for a given change, the level determines the percentage - i.e., the relative - change in the bill.) Large versus small; permanent versus transitory: This is why large, permanent increases in the barrel bill matter more. Small increases only generate minor changes in level and pattern of spending; temporary increases can be absorbed by reducing saving. Supply versus demand: Last but not least, the driver of the (change in the) barrel bill matters. A strong world economy will boost oil demand, prices and hence the barrel bill; and vice versa when the global economy is weak. At the same time, an oil price and barrel bill driven by demand will act as an automatic stabiliser: they will slow the economy when it's strong and boost it when it's weak. On the other hand, a supply shock will increase the price of oil, decrease demand and increase the value of oil importers' imports, the barrel bill. (The latter increases because the response of demand to higher prices is muted - the price elasticity of demand' for energy is low - hence the percentage price increase in the price outweighs the percentage decrease in demand.) The higher barrel bill has an impact on spending and hence reduces growth. In short, it follows that while demand shocks increase prices and the barrel bill, the impact on GDP growth will be to slow it down gradually. Metaphorically speaking, in this case the price of oil acts like an elastic leash on the dog that is the global economy. If the dog surges ahead too quickly, the constricting effect of the leash will make sure it slows down - but it will not stop. Between 2003 and 2007, the real price of oil roughly doubled, with little evident harm to the global economy. A supplyinduced increase in the price of oil (and barrel bill) would tend to have more serious effects. In the dog metaphor, an oil supply shock could act as a jerk on the leash, which could bring the dog to a halt. The upshot: the most dangerous oil shocks are - you guessed it - large, permanent supply shocks. How large is large' and how long-lasting is permanent'? Here's an indirect answer. The current supply change is certainly large' (Brent is up 17.5% year to date). And December 2013 oil futures trade at around US$113 (implying an average price of US$120 between April 2012 and December 2013) - long lasting but not permanent'. Box 3: Measuring the Oil Bill The metric one uses depends on the purposes of the investigation. Here, we focus on the wealth redistribution that takes place in the global economy due to oil shipments from exporters to importers. Hence, we look at oil imports (equivalently: trade), rather than total oil consumption. It is only imports (exports) that imply a transfer (receipt) of resources abroad (from abroad). Correspondingly, to scale the global income transfer, we divide by the aggregate GDP of the oilimporting economies only. The difference between imports and consumption is meaningful, both on a global and individual country level. Globally, consumption of oil for 2010 was around 87 mbd; imports on the other hand were around 54 mbd. This implies that out of the total consumption of oil, only around 59% crosses borders. The remaining 41% is nearly equally split between what oil exporters consume domestically (19% of global consumption) and what oil importers produce - and consume domestically (22% of global consumption). In terms of individual countries, some net exporters are important consumers, and some net importers are important producers. Russia and Saudi Arabia, the two biggest producers, together account for almost 7% of global consumption. Similarly, the US and China - both in the top three of global oil consumers - produce a substantial part of their total consumption domestically (in 2010, the US produced 39% or 7.5 mbd of its total 19.1 mbd consumption while China covered 45% of its 9.1 mbd crude oil needs from its domestic production of 4.1 mbd).

For full details and accompanying exhibits, see Global Economics: Barrel Bill (2012 Edition), March 14, 2012.

Latin America Oil Risk to Abundance March 16, 2012 By Gray Newman & team | New York No sooner have the tail risks in Europe begun to subside, than a new threat has appeared on the horizon - the rising price of oil threatening the global recovery. After arguing in recent years that there were three risks to abundance in Latin America - the pace of the US recovery, the sovereign debt crisis in Europe and the magnitude and effectiveness of China's policy response - it looks like we have to add a fourth. But it is not clear that an oil shock belongs in our risks to abundance in Latin America. The region is, after all, a net exporter of oil. While the latest data from Argentina and Brazil show that the two countries are beginning to trade places - Brazil is becoming a net exporter even as Argentina is becoming a net importer - the differences are presently modest. (There are some discrepancies between the widely used oil balance as measured by BP and the US Energy Information Administration, which define the oil balance as the difference between production and consumption, and some of the national statistical measures, which compare imports and exports. For the sake of consistency across the region we are using the BP and EIA series.) Indeed, only Chile is a significant oil importer in the region. Indeed, a simple exercise that tries to measure the impact of an oil shock concludes that Latin America is one of the three regions in the world that actually gain from higher oil prices. The World Bank exercise suggests that even with a large shock to oil prices - defined here as a US$50 per barrel increase (roughly twice the magnitude of the average oil shock over the past 40 years), Latin America would see a boost to GDP of 0.7% in the calendar year following a mid-year price jump. The other winners would be sub-Saharan Africa and the Middle East, even as global GDP and emerging market GDP would suffer a hit to growth. Gaining, Before Losing I am a bit sceptical of such exercises. Most of the episodes of stronger oil prices during the past 40 years (the experience of developed economies during the 1970s being the most important exception) have found that higher oil prices are associated with rising demand and stronger global GDP. I am concerned that the positive relationship between higher oil prices and stronger growth has it limits; the risk is that the relationship is non-linear. Up to some threshold, higher oil prices should benefit Latin America. But if prices climb far enough and fast enough to send the global economy into a downturn, the benefits to the region begin to diminish and may be overwhelmed by the global downturn. The difficulty is that most studies have had a hard time measuring the damage on overall growth, and those that do find it to be modest. Indeed, the IMF study cited above suggests that an increase in oil prices of 25% (close to the average for shocks in the past 40 years) led to a loss in real GDP in oil-importing countries of less than half of one percent, spread out over two to three years. Meanwhile, our commodity analyst Hussein Allidina argues that even with a supply disruption from a conflict with Iran, he still sees limited upside to oil prices (see Crude Oil: Pricing for a Disruption, February 10, 2012). Confused? You can understand why we leave the oil call to our global and commodity teams.

That doesn't mean we cannot say anything about the region. This note looks at three metrics to determine sensitivity of economic activity in each country in the region to an oil shock. And we provide an update on our thinking of how oil could impact both inflation as well as the fiscal dynamic in the region's largest economies. But keep in mind that while the greatest near-term risk to the region is one of the three (or possibly four) risks to abundance, we still think that the greatest medium-term challenge for the region is the risk of abundance - a period of strong inflows pressuring currencies ever stronger (see "Latin America in 2012: The Risks to Abundance Return", This Week in Latin America, November, 28, 2011). What happens to the cycle in 2012 matters a great deal to us, but we suspect that the risks in the near term are the exact opposite of the region's medium-term risks. Oil: The New Grease? We've looked at three metrics to determine sensitivity of economic activity in each country in the region to an oil shock. The first and seemingly most straightforward is to measure the oil balance: what is the magnitude of an economy's status as a net importer or exporter of oil. The second metric - an oil reliance measure - looks at what percentage of energy requirements in a country is met by oil. The third is an oil efficiency or intensity measure, comparing how many barrels of oil are necessary to produce a unit of GDP and then comparing each country in the region to the global average. First, from an oil balance perspective, Chile seems most exposed to a sudden spike in oil prices as the region's largest net importer of oil - running near 4% as measured by BP and EIA data. In contrast, Venezuela and Colombia are the largest net exporters. While there are significant differences on the precise magnitude of Venezuela's oil surplus, recent estimates place it anywhere from 18-26% of GDP, with Colombia's oil balance running from 6-8% of GDP. Of course, this metric fails to take into account the sizeable stabilisation funds that Chile has built to withstand such a shock. Chile's vulnerability is likely to be much more limited than its exposure. Second, it is worth noting that not only is Chile the region's largest net importer of oil, but it also has the greatest reliance on oil for its total energy needs of any of the major economies. One might think that, given Chile's net oil importer status, it may have had greater success in weaning itself off its overreliance on oil, but no economy in the region relies more heavily on oil than Chile as a share of total energy needs. In contrast, Colombia and Argentina have the lowest reliance on oil relative to other sources of energy in the region. Third and finally, Venezuela and Mexico appear to be the least efficient in their use of oil: They have the highest oil consumption requirement to produce US$1 million of output. Once again, Colombia is by far the most energy-efficient, requiring the least oil per unit of output - a surprising feat, given that Colombia is an important net exporter of oil. Country Details: Inflation and Fiscal Impact We see a limited inflation impact in the region from the current increase in oil prices. It is worth remembering that the prices that consumers see at the pump do not necessarily move oneto-one with global oil prices, and that the potential inflation impact is complicated by fiscal subsidies. Even in Brazil, where Arthur Carvalho has repeatedly warned that there is very little manoeuvering room on the inflation front and that any shock in prices of foodstuffs could push inflation well above 6%, he sees little room for an oil price shock to feed through to inflation in 2012 in a significant way. While it normally takes on average about six months before higher oil prices feed through to the consumer in Brazil, this scenario seems unlikely in 2012. A

move upward in consumer fuel prices would coincide with municipal elections and with the beginning of headline inflation's year-on-year rise, according to our forecasts. One possible outcome in Brazil would be to raise gasoline and lower taxes in order to have a limited impact on the final consumer price. Unfortunately, Arthur believes that there is not much more room to reduce this tax (CIDE). Currently, if the administration raises gasoline prices by 10%, which is only half of what would be compatible with the current oil prices, it would be able to offset 5% by cutting taxes. In turn, a 5% price increase for consumers would add roughly 20bp to headline inflation. In Mexico, direct subsidies on gasoline - which are unlikely to be lifted ahead of the July presidential elections - limit the fiscal gains from higher oil prices, but also likely limit the inflation impact in 2012. With the government deriving nearly a third of total revenues from oil, rising crude quotes translate into greater tax receipts which, given a fiscal regime that deemphasises saving, are for the most part spent. If the Mexican oil basket were to remain at the early March level of around US$115 per barrel - well above the budget projection of US$84.9 per barrel - Luis Arcentales estimates that the oil-revenue windfall could reach near 1.2% of GDP in 2012 (In 2011, above-budget oil receipts reached M$95.1 billion or 0.6% of GDP). The problem of course is that, by controlling gasoline prices, a heavy fiscal burden emerges when crude prices rise. By end-February, domestic regular gasoline was some 30% lower than US retail prices. Among the largest economies in the region, the greatest risk to inflation (and growth) appears to be in Chile. As the experience of 2007 and 1H08 showed, the country is still vulnerable to pressure from oil prices via rising costs, expectations and inflation. On the inflation front, Luis Arcentales notes, gasoline prices are adjusted on a weekly basis to reflect swings in international benchmarks, and thus the impact on consumer pockets is almost immediate, even without considering potential second-round effects from higher input costs. Today's backdrop, moreover, bears some resemblance to 2007, because dry weather conditions have the potential to disrupt hydroelectric generation, which would force companies to switch to more expensive thermal sources at a time of high crude prices. While electricity tariffs plunged in January, the risk of higher tariffs is something we are monitoring closely. After all, Chile watchers likely remember the one-two punch of soaring fuels and electricity prices in the last cycle: by the time annual inflation peaked in October of 2008 at 9.9%, higher fuels and electricity were adding nearly two full percentage points to headline inflation. In addition, Luis suspects that persistent pressure from fuel prices could make Chile's central bank more cautious - particularly given today's backdrop of tight labour markets - and thus reduce its incentive to ease policy in coming months (see "Chile: Dj vu 2007?", This Week in Latin America, February 27, 2012). On the fiscal front, higher oil hurts the government coffers via several ways, including from the drag on economic activity as well as from weaker tax receipts from miners whose margins are squeezed by steeper energy costs, unless metal prices compensate for this. Last, in the recent past when faced with soaring energy prices, the government has resorted to cutting gasoline taxes or adding resources to the fuel stabilisation fund. Given Chile's strong fiscal position, with some 8pp of GDP in its main stabilisation funds, we suspect that the fiscal drag won't become a major issue for Chile watchers. After decades of being a net energy exporter, Argentina appears to have become an energy importer in 2011 as measured by the INDEC: The energy trade balance slipped to a deficit of US$3.2 billion in 2011 from a surplusof US$2.0 billion in 2010. To put this in perspective, the overall trade surplus in Argentina in 2011 was US$10.3 billion, suggesting that if last year's pace of deterioration in oil trade continues, Argentina's trade balance would be wiped out within two years. Higher oil prices would only shorten that timeline, heightening concerns regarding the viability of the current managed floating exchange rate regime.

Further, Daniel Volberg is concerned about the negative impact on Argentina's fiscal accounts. With regulated prices of energy largely frozen over the past decade, the impact of rising energy prices has had a serious impact on the fiscal accounts, as last year energy subsidies hit 2% of GDP and rising. Indeed, with the domestic oil price in Argentina at just under US$75 per barrel in December 2011, upside to international prices would likely force either a more rapid increase in domestic prices or a larger fiscal effort to maintain subsidies in place. Given lack of direct access to international capital markets, a higher burden of energy subsidies may not be fiscally sustainable. If there is a positive story in the oil shock scenario, Colombia may be the region's biggest beneficiary, up to a point. With a positive oil balance estimated at 6-8% of GDP in 2011 and oil production expected to continue rising over the next few years, higher prices - absent a global downturn - would likely boost Colombia's GDP, trade and current account. Finally, while Venezuela is normally seen as the biggest beneficiary of higher oil prices, Daniel argues that there are two issues that likely limit the benefits. First, we suspect that official oil production and export numbers are overstated. Officially, Venezuela's oil trade surplus in 2011 reached 26% of GDP, boosting the overall trade surplus to nearly 15% of GDP. However, data on production and consumption by other sources suggest that Venezuela's oil balance may be widely overstated. Second, a decade of policy heterodoxy has impaired domestic production of goods and services, so export proceeds are increasingly used to pay for imports. Therefore, we suspect that upside in oil prices is likely to have a positive but limited impact on Venezuela's trade balance and GDP growth. Bottom Line As an oil exporter, Latin America likely gains from rising oil prices...up to a point. But we suspect that the rise in oil prices has a limit: crossing that threshold could damage global activity, and it is not difficult to see that Latin America's oil gains could be tempered or offset. While Chile's exposure is well known, we would argue that Mexico is also at risk. Although Mexico is a modest exporter, if an abrupt rise in oil prices called into question the recovery of the US - and presumably the threshold that could cause the US to stumble is lower today - the link with the US would likely overwhelm the gains associated from higher oil revenues. An oil shock per se might not be enough to make it to our trio of the risks to abundance, but nor would Latin America be immune to oil's impact on the rest of the globe. United States Fed Thoughts: QE or Not QE? March 06, 2012 By Vincent Reinhart | New York For some time, our call has been that the Federal Reserve will undertake additional balance-sheet action in 1H12. This view has been in and out of consensus thus far this year, even though the Fed appears to have been adhering to a consistent storyline throughout. Three observations support our assessment that there is a three-in-four chance of unconventional action by June. First, the political calendar makes it likely that the Fed will want to keep a low profile in the second half of the year's campaign season. If the window for a policy move closes by June, the hurdle for action is lower before then. Second, economic slack persists and inflation is running below the Fed goalin its mediumterm projection. The dual shortfall from its mandate provides both justification and political cover for action.

Third, the decision-makers at the core of the FOMC have consistently pointed to reasons why the performance of the economy will be subpar and at significant risk in the near term. Here, too, at Morgan Stanley, we share the view that the fillip to economic growth associated with a restocking of inventories is fading and that real GDP growth will slow notably in the current quarter. Anxiety-inducing headlines that the economy is losing steam would be conducive to Fed action. The most likely form of that action is open market purchases of Treasury and mortgagebacked securities funded through the creation of reserves - Quantitative Easing 3 (QE3) - at the April or June meetings. We expect it to total around $500 billion to $700 billion. Such a program would dovetail with the expiration of the ongoing Operation Twist at the end of June. An attractive alternative to the Fed would be to expand the scale and scope of that existing program - that is, announce Operation Twist 2 (OT2). It could stretch purchases out until the end of the year, implying total new purchases of about $400 billion, and include MBS as well as Treasuries. Moreover, the Fed would use the tools of monetary policy to sterilize the effects on the balance sheet. Those tools include continuing to sell shorter-term Treasuries and arranging temporary reserve-draining operations. OT2 would allow the Fed to act sooner, say at the March or April meeting, and frame the initiative as support for the ongoing economic expansion. It would also buy some insurance from criticism by keeping the overall size of the balance sheet unchanged. We made this Fed call late last year (see Fed Thoughts for 2012: Into the Heart of Darkness, December 27, 2011), and the first order of business is to mark it to market in light of what we've since learned. In the event, data, particularly those describing labor markets, have come in stronger than we expected. The Fed's core policy-makers, however, have sounded dovish in almost every public utterance. On balance, the logic for additional Fed action still seems compelling. Why, then, has the expectation of action fallen out of the consensus? The answer hinges on an assessment of the economy's momentum, a careful reading of the latest FOMC minutes, and an understanding of the Fed's conduct in anticipation of an adverse turn of events. Of course, there is the possibility that we could be wrong, which is why we end with some discussion of the one-infour chance that the Fed stays on hold in 2012. What Have We Learned? The Morgan Stanley outlook is that the US economy will expand this year and next at around a 2% rate, about that of potential output growth. Unfinished business from the financial crisis leaves the mortgage market impaired and households needing to improve their balance sheets. This balance-sheet improvement is likely to come the hard way - by increased saving - rather than through significant capital gains on equity and real estate holdings. This is because the forward calendar is chock-full of events in the US and Europe that may set back global financial markets and the economy. As a consequence, we think investors will not retain a durable-enough conviction about fundamentals to support an extended market rally. Without a continuing boost from wealth creation, the economy grows at trend. If so, resource slack and inflation would move sideways. This was our outlook in December and is still so in March. The data have been better, of course. Readings on the labor market, including initial claims for unemployment insurance, have been decidedly more upbeat. We know now that real GDP expanded at a 3% annual rate in 4Q11. However, about 2 percentage points of that growth owed to inventory stock-building. This is not the basis for sustained robust expansion, and as inventory levels settle down, we expect real GDP to slow appreciably. Indeed, our tracking estimate of growth this quarter clocks in at only 1%.

The Federal Reserve has seen these data and seems to share a similarly cautious assessment of the outlook, at least judging by the summary of the economic projections of FOMC participants that accompanied the January meeting. Thus, it has a medium-term forecast in which it falls short of both parts of its dual mandate of maximum employment and stable prices, a ready justification for additional policy action. In other aspects of its communications, the Fed has been transparent in its intent. It apparently does not want market participants to get too enthusiastic about the outlook. Three specific aspects of its message deserve more attention. Stronger incoming data have mostly been ignored by the Fed. There was almost no mention of favorable readings on activity and the labor market in the Fed's public statements earlier this year. Only late in the game, with the semiannual testimony to Congress, did Chairman Bernanke devote much attention to employment gains. No doubt, it would have been awkward otherwise to review economic developments over the past year without noting that the unemployment rate has fallen by 0.75 percentage points. Even so, the Chairman's reminder that "the job market remains far from normal" seemed to be the main takeaway. The Fed either does not accept that the pickup in growth will be sustained or does not want market participants to get carried away in connecting the last few data points. The emphasis is on the dark clouds, not the silver lining. Every Fed statement frets that "strains in global financial markets posed significant downside risk to the economic outlook". Deep down to their free-market bones, Fed officials are mostly euroskeptics who have trouble convincing themselves that a flawed currency union will survive. A general piece of advice from Fed economists working on the policy challenges posed by the zero bound to the nominal funds rate is that it is best to front-load policy accommodation if there is a significant risk of an adverse event. That way, the economy is on a stronger footing if the blow does strike. The political calendar makes this insurance motive more important: Since the Fed likely wants to keep a low profile during the height of the campaign season, it should be quicker to act in the first half in anticipation of adverse shocks. Follow the Fed and do not worry about inflation. The Fed has signaled in multiple ways that it doubts that a pick-up in inflation is a material risk to the outlook. It excised the sentence referring to monitoring inflation and inflation expectations from the January FOMC statement. In the summary of economic projections for that meeting, it forecasts inflation to run below its goal in the medium term. This is not surprising, because the basic determinant of inflation in Fed-style models is resource slack, which it asserts is considerable. After all, policy-makers have not raised their assessment of the natural rate of unemployment or lowered their estimate of the rate of growth of potential output. For good measure, the Fed's inflation goal was raised a touch, to 2%, just to be sure that there was white space between desired and actual inflation. Reasons We Are Not Wrong Our three-in-four expectation of Fed action has moved out of consensus in the past few weeks. Some of the objections are easy to understand. After all, we also see a one-in-four chance that nothing happens. If the economy surges or equity investors continue to embrace risk, the Fed would cheerfully keep its plans on the shelf. Therefore, if we are undercounting the resilience of the US economy, we are also overestimating the likelihood of Fed action. Some of the objections, though, seem off kilter. In particular, we push back against three leading questions whenever we are asked them. Doesn't the Fed Need to See a Fall in Economic Activity before it Acts?

No. That notion is based on a misreading of the minutes of the January meeting. In the discussion of the views of all FOMC participants about whether additional balance-sheet changes were appropriate, we learned that a few preferred to act in 2012 and a number remained open to that possibility "if the economic outlook deteriorated". This phrase just means that their forecast of economic growth has to soften, not that the level of activity has to drop. Even more to the point, this characterization was in the back of the book, which discussed the views of all those who are surveyed - the five governors and the 12 bank presidents. What matters is the explanation earlier in the minutes that is limited to the ten voters. There we learned that a few members thought current and prospective economic conditions could warrant action "before long". Other members would support this if "the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate". In minutes math, a "few" plus "others" is likely a majority. Note that the first trigger only requires a slowing in economic expansion and that the second is already met in their published forecast. Doesn't the Recent Run-Up in Oil Prices Take Fed Action Off the Table? The Fed does have a problem because oil prices are 35% above their local bottom of October 2011. Such a run-up creates an uncomfortable tension for a central bank, in that headline inflation rises but spending gets hit because the US is a net importer of energy. However, Chairman Bernanke's academic work on the strong post-WWII association between energy price spikes and subsequent recessions puts part of the blame on the Fed's historical response. As long as inflation expectations are well anchored, the strong conclusion is that the central bank should ease policy to counter the blow to aggregate demand. Thus, the recent rise in oil prices and the risk that they go higher likely inclines the Fed to do more, not less. How Can Fed Officials Believe That Further Balance-Sheet Manipulation Would Work? It is their job. Fed officials do not have outsized expectations for the efficacy of their policy instrument. Rather, they feel a responsibility to use an instrument that most likely works in furthering their mission, even if those benefits may be small. Moreover, while the basis point consequences of asset purchases might be modest, the Fed wants to be seen by the private and public sectors as willing to act when there is a need. For households and firms, QE3 or OT2 might boost confidence. For the rest of officialdom, the Fed would show that at least one institution in Washington DC retained a sense of purpose. Reasons We May Be Wrong We see a three-out-of-four chance that the Fed acts as the data on growth soften and the rally in the equity market fades. If the Fed is in a hurry or feels no need to push up inflation expectations, the action likely takes the form of sterilized asset purchases, i.e., the one-in-four chance of Operation Twist 2. Recent public comments by Fed officials, along with press comments, make it more likely we are underestimating, not overestimating, their willingness to execute OT2. If the Fed needs to see some slowing in the economic expansion either to get internal agreement or external insurance, the policy initiative waits until the April or May meeting and more likely entails asset purchases that are funded with reserve creation. This policy, Quantitative Easing 3, which we peg at a one-in-two chance, would also be favored if the Fed desired more significant currency depreciation. The remaining one-in-four probability of no action hinges mostly on a happy outcome for the Fed. It would not ease if it sees no reason to do so as payrolls expand robustly and equity markets extend their rally. This requires, of course, that politics at home and the ongoing sovereign and banking crisis abroad do not intrude.

Important Disclosure Information at the end of this Forum

China Downside Risks to Growth Capped; More Policy Easing to Come March 06, 2012 By Helen Qiao, Ernest Ho, Yuande Zhu | Hong Kong Silver lining starts to shine... On a recent field trip to China, we noticed evidence of rising export growth momentum as well as a substantial increase in property transactions in major cities in the last few weeks, which we believe will help to cap the downside risks to growth in the near term. In addition, policy-makers indicated that existing projects of government-driven infrastructure investment have been prioritised, most likely lifting infrastructure investment growth in the near term from the low level seen in 4Q11. ...but a bigger push from monetary policy easing is needed. We highlighted an early start in policy loosening since the end of 2011, but we believe that monetary easing will have to step up to provide sufficient credit to the growth recovery. In particular, we noted that liquidity in the interbank market does not seem to have translated into notably looser financial conditions for the corporate sector, not least because of binding constraints such as the loan-to-deposit ratio and the direct control on loan drawdown. More tolerance for property policy easing by stealth to come. The central government hesitates to withdraw property tightening policies, but we maintain our view that local governments will likely loosen the implementation of such measures after the NPC and CPPPCC towards the end of 1Q and early 2Q. Initial relaxation will likely benefit first-time property buyers, while leaving leveraged purchase for upgrade demand still constrained. 1. Downside Risks to Growth Capped... We believe that some positive evidence has started to emerge of trends that could cap the downside risks to growth we have highlighted since 4Q11 (namely soft external demand, property market weakness and infrastructure investment deceleration caused by funding difficulties with local government investment vehicles). If we see further support from official data in these areas in the next one or two months as well as effective delivery of policy easing in implementation, the risks would likely be biased towards the upside with regard to our baseline forecast of real GDP at 8.4%Y this year. I. Exports Although January export growth seemed weak due to the Lunar New Year effect, we witnessed some positive developments in support of a small rebound in export recovery. These included: (i) better sentiment from exporters, as seen in the manufacturing PMI sub-index on new export orders; (ii) improvement in Korean exports, which tend to lead Chinese exports, especially the processing trade component; and (iii) improvement in US consumer demand in certain markets, e.g., furniture. II. Property In the last three weeks, both developers and property agents reported a strong pick-up in residential housing transaction volume in first-tier cities, despite the lack of policy change or price cuts by developers. It is possible that the better availability and lower costs of mortgage loans for first-time buyers compared to 4Q11 have stimulated some release of pent-up demand.

However, we admit that it may be too early to call for a property market recovery at this stage. We cite three factors: (i) the Lunar New Year effect prevents us from gauging such growth momentum with precision; (ii) the significant acceleration in sequential growth was amplified by a particularly low base at the end of 2011; and (iii) second-tier cities have yet to see a similar recovery in transaction volume. Nonetheless, we believe that this is worth watching closely - a broad-based increase in both firsthand and second-hand housing transaction volumes in top-tier cities has often been a prelude to changes elsewhere in the past. III. Infrastructure There is likely to be an uplift to infrastructure investment growth in the near term from the recent low levels of 4Q11. The official release on government-driven project approvals confirms our earlier prediction that infrastructure investment has shifted more towards utilities (especially under the umbrella of CDM - clean development mechanism) and rural development (e.g., irrigation and water conservation and rural infrastructure construction). In addition, funding support to key projects and existing projects has also been extended and verified by banks. 2. ...but a Bigger Push from Monetary Policy Easing Is Needed Liquidity in the interbank market does not seem to have translated into notably looser financial conditions for the corporate sector. We highlighted that policy loosening has been under way since the end of 2011 (see China Economics: Policy Easing Limits the Downside Risks to Growth, January 17, 2012). The market has also been expecting a strong rebound in bank loan extension after the Chinese New Year. Still, domestic media reported a possible disappointment of less than Rmb700 billion of loans made in February. If bank loans in February indeed turn out to be less than Rmb750 billion, as we forecast in our preview, it would confirm our suspicion that the liquidity released by the recent RRR cut has yet to be channeled to the real economy. Supply-side constraints on loans, rather than demand-side weakness, should take the blame. On our field trip, we observed firm demand for bank loans and informal lending, but banks' responses were lackluster because of binding loan-to-deposit ratios (especially outside of the Big Five banks). In addition, the macro-prudential measures introduced in 2010 (such as the direct control on loan drawdown) have also hurt banks' capability in deposit creation and thus loan extension. We believe that monetary easing will have to step up to provide sufficient credit to growth stabilization. As CPI inflation continues to trend downwards, policy-makers will likely see fewer obstacles in promoting a more effective relaxation through multiple policy tools. The central government's Rainy Day Fund' (Budget Adjustment Fund) could provide some cushion to a few existing government-driven investment projects, but further monetary easing is indispensable to a cash-strapped economy in the near term. We expect top decision-makers to promote the usage of multiple tools to ensure easing in financial conditions by the PBoC and CBRC, including window guidance and fine-tuning of the existing macro-prudential measures. 3. More Tolerance for Property Policy Easing by Stealth to Come We maintain our view that local governments will likely loosen the implementation of policytightening measures after the NPC and CPPCC towards the end of 1Q and early 2Q (see China Economics: Policy Easing Limits the Downside Risks to Growth, January 17, 2012). The central government has overruled local governments' recent attempts to relax the purchase restrictions; we don't think it will take long before some forms of policy loosening take place.

1) Local governments need to revive their fiscal revenue resources from property-related sectors (especially land sales) to support ambitious plans for social housing as well as new investment projects under the 12th Five Year Plan. 2) With notable declines in new residential housing prices (especially in city suburbs), the central government may not think it is too far from reaching the implicit targets set in April 2010. In our view, initial relaxation will likely benefit first-time property buyers, while leaving demand still constrained for leveraged purchases of upgrade properties. We expect positive catalysts to come from follow-up measures of the Hukou system reform and the requirement by MOHURD to lower the requirement for non-local resident purchases. However, relaxation in top-tier cities and on mortgages for purchases of third (and above) housing would be more difficult to realize in the immediate term.

Important Disclosure Information at the end of this Forum China NPC Preview: Domestic Demand Promotion with Focus on 'Stability' and 'Livelihood' March 06, 2012 By Helen Qiao, Yuande Zhu, Ernest Ho | Hong Kong

China will hold the Fifth Session of the 11th National People's Congress (NPC) on March 5: The Chinese People's Political Consultative Conference (CPPCC) began on March 3. We expect stability, structural adjustment and people's livelihood to be keystones of the agenda. The policy stance should adhere to the combination of "proactive fiscal policy and prudent monetary policy" set at the central economic working conference in December. We expect the following key issues to be featured prominently during the two sessions (Liang Hui) this year. Fiscal Policy Outlook The proactive fiscal policy stance remains unchanged. We expect the 2012 fiscal budget deficit target to be set at around Rmb800 billion or about 1.5% of GDP, lower than the budgeted Rmb900 billion (2% of GDP) in 2011. On a cash basis, the actual fiscal deficit was Rmb519 billion in 2011, equivalent to 1.1% of GDP. Therefore, if compared to the pre-2008 deficit of below 1% of GDP or the cash-basis deficit of 1.1% in 2011, a budget deficit of 1.5% is consistent with the proactive fiscal policy stance. Meanwhile, we expect that overall fiscal revenue and expenditure growth rates will grow at around 15% in 2012, in line with a modest expansionary stance. In addition to the deficit figure, we think it is of more interest to see how proactive fiscal policy will be deployed to support economic growth in the context of anemic global recovery. Structural tax adjustment is a policy focus. The potential tax reform topics may involve VAT for business tax, preferential tax treatments for SMEs, personal tax cut, resource tax, property tax, etc. The tax burden for some categories will be lowered, but will be increased for others.

Government spending will be more targeted. We expect budget priorities will be placed on social housing, agriculture infrastructure (e.g., water projects), urban transportation (e.g., subways), industrial upgrading, R&D, education and initiatives to boost consumption - pension and health, etc. Social housing remains as a policy priority. The central government will likely increase its financial support for social housing projects, since more units are scheduled to be completed this year than last year. By our estimate, social housing under construction will increase to 13 million units, with 5 million units expected to be completed in 2012. Local government financing: After the clean-up of local government financing platforms in 201011, the central government will likely loosen platform financing modestly this year. Possible options may include loan restructuring and rollover, issuing local bonds to replace bank loans, etc. In this light, local government bond issuance may be slightly expanded from Rmb200 billion to under Rmb300 billion. Monetary and Financial Issues Monetary policy stance remains prudent. In particular, the PBoC has set the target for M2 growth at 14.0% in 2012, lower than the 16% target in 2011, but slightly higher than the actual growth of 13.6% at end-2011. Provided that RMB position for foreign exchange purchase will register lower growth in 2012, we estimate that the implicit new loans target should be at least Rmb8 trillion (versus Rmb7.5 trillion in 2011), so the overall liquidity conditions will be more accommodative in 2012 than 2011. In particular, new credit will be more targeted, with emphasis on SME financing, social housing, selective infrastructure projects, etc., in our view. People's Livelihood We expect people's livelihood' to remain a buzzword. Some old questions will be put on the table again, such as how to keep household income growth at the same pace as economic growth, and how to boost households' consumption. This would entail improvement of the income distribution by raising the minimum wages continuously, more policy measures to tackle housing affordability, and improving social safety net coverage. On this front, more fiscal budget funds may be allocated to support education, healthcare and pension system, especially in rural areas. Other Topics We think the discussions/debates during the two sessions will also touch the following issues: openness for private sector, relaxation of property market tightening, urbanization and farmers' land, and utility pricing mechanism.

France 2012 Elections Series - Addressing Structural Issues March 06, 2012 By Olivier Bizimana | London Addressing Structural Issues Investors seem to be concerned about the upcoming elections in France. This report outlines the main structural weaknesses of the French economy, evaluates the candidates' economic programmes proposed, and assesses possible market implications.

France's economic performance has declined over the recent decade and, more importantly, the competitiveness gap with its main trading partners has widened. Given the steepness of the trend, we believe that bold reforms would be necessary to address the underlying structural problems. This stresses the importance of the upcoming elections, as the economic programmes presented by the candidates are expected to outline the reforms that are needed to foster competitiveness and potential growth in the longer term. The question is whether the economic proposals are proportionate to adequately address French economic imbalances. Yet, this early in the presidential race, the outcome of the elections is still open. The latest polls indicate that Franois Hollande and Nicolas Sarkozy are the frontrunners for the second round of the presidential election, with a victory implied for the former. In addition, the platforms of the candidates are still evolving, so it is too early to establish with certainty what economic policy may be implemented post-elections. What is certain, however, is that the winning candidate will have to undertake bold reforms to tackle the structural issues of the French economy, under a tight budget constraint. The Reform Strategy The key challenge for France's new government is to implement reforms that would address the main structural problems of the economy, while pursuing the adjustment in the public sector at the same time. In the longer term, these supply-side reforms would contribute to restoring the soundness of public finances as well. Indeed, fiscal consolidation in the medium term would require stronger potential growth, which would necessitate a larger contribution from external demand. Hence, reducing labour market rigidities and fostering productivity should boost competitiveness, reduce external imbalances and help to restore public finance soundness. In the near term, the persistence of the eurozone sovereign debt crisis is a hurdle. Market participants seem to have some concerns over public finances in general, and France's fiscal position in particular. At the moment, the interest rates on French government debt remain at relatively low levels. A spike in the costs of borrowing cannot be ruled out though, especially if one or more other rating agencies lower France's credit rating (S&P has already cut France's long-term credit rating to AA+, from AAA, with a negative outlook, while Fitch and Moody's have affirmed the AAA rating but revised the outlook to negative'). This, in turn, might further increase the financial constraint, making it more difficult to push through reforms. Overall, we believe that a successful reform strategy would need to focus on the labour market, by increasing the flexibility of the labour force, easing the high employment protection and enhancing the efficiency of job placements. In addition, the priority should be on promoting reforms aimed at creating a favourable environment for businesses, notably SMEs, by facilitating the expansion of their capacity of financing, and their size and investment in R&D, as well as innovation. The fiscal consolidation strategy would need to focus on further control of spending in all the sub-sectors of the general government. Moreover, given the challenges posed by population ageing in the medium term, pension and healthcare reforms would need to be pushed further. On the revenue side, fiscal reform should focus on reducing ineffective tax loopholes and a more pro-growth tax system for corporates, and additional progressivity for households. Finally, in the longer term, the adoption of a binding fiscal rule would enhance the sustainability of public finances. Why French Elections Matter for Financial Markets French elections seem to be a source of concern for financial markets this time round, mainly because of the context of the eurozone sovereign debt crisis. Indeed, political uncertainty in the eurozone's second-largest economy is clearly unwelcome, given that confidence in financial markets remains fragile.

When it comes to risks, we think one should make a distinction between perception and implementation risks. In the near term, during the electoral campaign, market participants are likely to worry more about the main candidates' positions than what they may do once elected. The implementation risks, on the other hand, may arise after the elections. These are related to policies that are likely to be undertaken once the new government is sworn in. Based on the main candidates' current economic programmes, we see four factors that may be sources of concerns for market participants in the near term: 1. The orientation of fiscal policy post-elections: Some policy proposals may give the impression of increasing risks to the sustainability of public finances in the medium term. For example, the expenditure side of the main candidates' budgetary plans is not yet completely detailed, which could raise some doubts over fiscal consolidation going forward. Challenging the recent pension reform may also raise some concerns about a future increase in healthcare spending, especially given the future challenges posed by population ageing. As the French sovereign rating is under scrutiny by the credit rating agencies, further concern over the soundness of public finances could trigger a downgrade, which would have significant repercussions on other sovereigns, notably the EFSF credit rating, which could conceivably put the overall eurozone crisis management framework at risk. 2. Uncertainty about the resolution of the eurozone crisis: The upcoming elections present an additional source of uncertainty for the resolution of the sovereign debt crisis. For example, France is unlikely to be able to implement the intergovernmental treaty before the next parliament is sworn in. Moreover, major new initiatives from the French government to address the sovereign debt crisis also seem unlikely to be considered during the electoral campaign. Finally, candidates' new proposals to address the sovereign debt crisis (or amend or complement existing proposals) may increase uncertainty about the implementation of the decisions that have already been agreed upon by the current government. 3. Near-term growth risks: The political debate over how to achieve the deleveraging of the public sector could generate uncertainty about future economic policies. This policy uncertainty may, in turn, lead households and corporates to be more cautious in their spending decisions. This may ultimately aggravate the economic downturn and weigh on fiscal revenue. Given that France has committed to achieve a numerical budget deficit target, weaker growth would require further fiscal tightening to achieve the same target, which would lower further growth and ultimately lead to a fiscal austerity trap' (see Europe Economics: Breaking the Spell of the Euro Crisis, January 9, 2012). 4. Effectiveness of the reform agenda: The effectiveness of the economic reforms may raise some concerns. The question that may arise is whether the proposals will be able to adequately address the underlying structural problems of the French economy. This may especially be a source of concern for rating agencies questioning France's long-term growth outlook. A Glimpse of the Main Economic Imbalances France's economic performance has weakened over the past decade and reflects largely structural factors.External sector imbalances have gradually worsened since the late 1990s, and, though remaining modest at present, the trend seems persistent. Part of the downturn trend in the external sector reflects structural labour market rigidities, which are viewed as one of the most important hurdles to higher employment growth. What's more, public finances have deteriorated continuously, with a structural budget deficit in place since the 1970s and a very high debt-to-GDP ratio. 1. Gradual Deterioration of the External Sector

French export growth has declined since the start of the last decade. Export underperformance is also noticeable relative to most of its euro area peers. In addition, export market share has declined significantly over the same period.The downward trend in export market share partly reflects the rising share of large emerging economies in world markets. Still, French export performance lagged over the last decade compared with other developed competitors as well, which suggests that this phenomenon may be attributable to other factors. As a result, the current account balance has declined, essentially as a result of deterioration in the trade balance of goods. The trade balance of services is still in surplus, but it has retreated gradually over the recent period. Given the cumulative current account deficits, France's net foreign assets have declined, from a surplus of 1% of GDP in 1999 to a deficit of 11% in 2010. Several complementary factors may explain the worsening external sector performance: Declining price and cost competitiveness may be one among other reasons why French export growth was sluggish, especially compared to main trading partners. The euro has appreciated and was above its historical average during the first years of the decade, suggesting some overvaluation of the real effective exchange rate. However, that appreciation affected all euro area countries, and hence does not explain in itself the underperformance compared to eurozone peers. In addition, unit labour costs have increased in France since the beginning of 2000 from faster growth in wages, which has been only partially offset by productivity gains. However, the divergence in the development of unit labour costs in France is especially visible relative to Germany, while the upward trend is similar to the average euro area. Hence, non-price factors are likely to explain most exports' underperformance and the loss in competiveness. Structural features, including the following, are important factors that may explain the underperformance of French exports: inadequate industrial specialisation (focus on low and medium-high-technology, limited degree of product differentiation), which limits the flexibility to respond to changing global demand, and supply constraints (small size and number of SMEs limiting their export capacity; insufficient R&D leading to weak innovation). In addition, French exports are more oriented towards slow-growth regions (64% of exports are to EU countries) and less to the more dynamic regions (less than 20% of exports are to developing and emerging economies). This could also explain their moderate pace of growth. Finally, the weak performance of exports partly explains the erosion of non-financial companies' profit margins over recent years. Indeed, exporting companies have reduced their profit margins to compensate for the deterioration in cost competitiveness in order to limit losses in market share. Our view: The strengthening of the supply side should help to reduce external imbalances. The priority should be on promoting reforms that aim at creating a favourable environment for businesses, notably SMEs, by facilitating the expansion of their capacity for financing, their size, investment in R&D and innovation, but also taxation and other fiscal incentives. 2. Persistent Structural Rigidities in the Labour Market

The weaknesses of the French labour market are structural. The unemployment rate remains elevated, at just a touch below 10% in 2011. The unemployment rate of young workers (between 15-24) is particularly elevated, at an average of more than 20% since 1980. Most importantly, the structural unemployment rate in France is above the euro area average since the 1990s, at around 9%. In addition, it is likely to continue to rise, as long-term unemployment has worsened over the recent period. As a result, France has one of the lowest employment rates among developed countries, especially for seniors (19.1% versus 51.5% in OECD countries in 2010) and young workers (33.9% versus 42.5% in OECD countries in 2010).

The structural weaknesses of the labour market in France include: High labour tax wedges that push up labour costs (relative to productivity), which limits demand for labour; a high and increasing minimum wage that reduces employment opportunities, especially for the young and low-skilled workers; heavy legal restrictions in employment contracts (hiring, firing and working hours) that generate segmentation between employment contracts; poor quality of labour dialogue between trade unions and employers' organisations; and the inefficiency of public job placement. Despite governmental efforts to address some of these shortcomings over recent years, we think that policies to enhance the situation of the labour market must be stepped up in order to continue to ease structural rigidities. Our view: Labour market reforms should focus on raising the labour force participation of young people and older workers, by increasing the flexibility of the labour force (hours worked), easing the high employment protection, and enhancing the efficiency of job placement. More specifically, we believe that promoting a system of flexicurity', which combines contractual flexibility (hiring and dismissal) with enhanced income security for workers between jobs and active labour market policies, could improve employment conditions. In addition, policies aimed at supporting training programmes for unemployed people and low-skilled workers should enhance their reintegration into the labour market, in our view. Moreover, lowering labour tax wedges should reduce labour costs, which would boost employment and competitiveness. As labour taxes help to finance social security, their reduction would require, on the revenue side, alternative sources of financing (tax on capital or tax on consumption), and more importantly, on the expenditure side, a reform of social benefit. 3. Trend Deterioration in Public Finances

France has run a fiscal deficit almost continuously since the beginning of the 1970s. This deterioration of public finances reflects largely structural factors. The cyclically adjusted fiscal balance has remained in deficit over the entire period. Despite tentative improvements in the mid1990s, ahead of entering the EMU, the fiscal consolidation plans have not been sustained long enough to be able to bring the budget balance back into surplus. Even during periods of strong growth, the structural budget balance remained in deficit, which reveals the weakness of the institutional framework of budgetary policy. In terms of sectors, the main source of the budget deficit is the central government, though the balances of local government and social security have somewhat turned to deficits over the recent period as well. As a result of the cumulative budget deficits over the last three decades, the debt-to-GDP ratio rose to almost 90% in 2011, which is considered a level harmful to growth. In particular, the debt-to-GDP ratio has trended upwards from 20.7% in 1980 to 85.1% in 2011. The deterioration in public finances in France over the last 40 years is due to a sharp rise in spending.General government spending as a share of GDP has considerably increased over the last three decades, to 56.6% in 2010 from 46% in 1980. The continued rise in expenditure is mainly due to a sharp expansion in social spending - in particular, healthcare and pensions. The other components of government spending have risen over the recent decades as well, albeit at a slower pace. The interest payment rose sharply during the 1990s, on the back of higher government debt, but debt service eased afterwards, with the reduction in the costs of borrowing. The ratio of operating expenditures to GDP increased as well. By contrast, public investment as a share of GDP fell until the beginning of the 2000s. General government revenue has increased over the last three decades as well, at 49% of GDP in 2010, compared to 46% at the beginning of 1980. More specifically, the tax burden (tax revenue as a share of GDP) increased by around three percentage points over the period to 42.5% in 2010. However, it has been trending down since the beginning of the last decade. Despite the recent decline, the general government tax burden in France remains

one of the highest among developed countries. The average tax burden for OECD countries was at 33.8% of GDP in 2009, almost 10 percentage points lower than in France. The split of the tax burden by government sub-sectors shows divergent dynamics. While the share of the central government in the tax burden has tended to decline, the share of social security and local government has increased. The increase in the tax burden of social security reflects the upwards trend in social expenditures. Overall, the high level of tax burden, especially relative to other developed countries, suggests little scope to increase revenue in France. Nevertheless, there seems to be some room to manoeuvre, as tax expenditures (tax loopholes) are elevated. Hence, they may constitute a potential source for increasing fiscal revenue. According to the 2012 budget bill, there are 491 tax expenditures (versus 504 in 2011), including 449 that would cost public finances 65.9 billion in 2012 (around 3.3% of GDP). Our view: A successful fiscal consolidation strategy would need to focus on further control of spending in all the sub sectors of the general government. Moreover, given the challenges posed by an ageing population in the medium term, pension and health care reforms would need to be pushed further, by notably increasing the legal retirement age further in line with life expectancy. On the revenue side, we believe that fiscal reform should include a reduction in ineffective tax loopholes and a more pro-growth tax system for corporates, and additional progressivity for household taxation. Finally, longer term, the adoption of a binding fiscal rule would enhance the institutional framework of budgetary policy, and hence sustainability of public finances. To sum up, the French economy faces persistent structural challenges, including a worsening of the external sector, persistent labour market rigidities and deteriorating public finances. Hence, the main candidates at the upcoming elections would face the same problems and will have to tackle them once elected, under the same budgetary constraint. A Closer Look at Main Candidates' Platform on the Economy The presidential candidates who are leading in the polls - in particular Mr. Bayrou, Mr. Hollande and Mr. Sarkozy - seem to share a similar analysis of the source of structural challenges within the French economy. Their economic programmes presented so far intend to tackle the supply-side weaknesses of the economy, mainly by supporting SMEs and strengthening the labour market conditions, while pursuing fiscal consolidation. The economic programme of Ms. Le Pen distinguishes itself by envisioning an exit of the euro area and establishing protectionist measures. Our first assessment of the candidates' proposed programmes: Labour market reforms may prove insufficient and do not address the main structural rigidities: All the candidates envisage measures to stimulate employment for young people and older workers, by providing incentives, especially for SMEs. This would increase the participation rate of these categories of workers. Some measures are also designed to reduce the labour tax wedges. However, in our view, the envisaged reduction in payroll contributions remains too modest and wouldn't significantly increase employment. In addition, the proposals do not address some of the important constraints of the French labour market, notably the high employment protection and the low labour market flexibility. Candidates' proposed measures to strengthen the external sector underperformance point in the right direction: The measures proposed to reduce the underlying structural problems of the external sector are focused on strengthening the supply side, and more specifically on improving financing conditions for SMEs, promoting their research and development capacity, and hence innovation. These measures should improve firms' competitiveness in the medium term. Still, in order to address the deterioration in cost

competitiveness, these measures would need to be complemented by reforms of the labour market, healthcare and pensions. The candidates are aware of the need for fiscal consolidation, but the spending side remains unaddressed: Broadly, all the proposed economic programmes project to continue fiscal consolidation in the medium term, with a balanced budget by 2016 or 2017. We view this as a step in the right direction in order to stabilise the debt-to-GDP ratio in the medium term. The way to achieve fiscal consolidation differs only slightly among candidates, as all would rely on a reduction in tax loopholes. Also, they would implement tax reforms, which would result notably in a rise in taxes on the wealthiest households and large corporates. However, while the fiscal consolidation plans are relatively detailed on the revenue side, the spending side remains relatively vague. This could present a challenge, as a main source of the structural deterioration in public finances stems from expenditures, and more specifically social spending. How Do the Platforms Differ? Nicolas Sarkozy: Fiscal Consolidation and Enhancing Competitiveness President Sarkozy has officially announced his candidacy, but he has not yet unveiled a detailed economic programme. Still, on the fiscal side, he is likely to stick to the consolidation plan announced by the current government, which expects to balance the budget by 2016. In addition, he unveiled the latest economic reforms of his mandate at the end of January, most of which is likely to be implemented after the elections, even though parliament is expected to pass them before. Moreover, the 2012 Project' unveiled by his political party (UMP) provides the outlines of what his presidential platform would be. In particular, the project presents reforms on the supply side aimed at supporting SMEs and their expansion. The new measures announced at the end of January were designed to stimulate job creation and improve businesses' competitiveness. One of the key measures announced was a so-called Social VAT', in which a reduction in employer social contributions will be financed by a VAT, but also complemented by an increase in social welfare tax on investment income (see France Economics: 2012 Elections Series - Social VAT' - So What? February 1, 2012). In addition, businesses and labour unions would be encouraged to conclude the competitiveness-employment pact' aimed at saving jobs, by allowing for both working hours and compensation to vary in connection with demand. Finally, President Sarkozy announced that France would unilaterally impose a tax on financial transactions. Franois Hollande: Strengthening the Supply Side and Social Justice The Socialist Party candidate's economic programme is centered on measures to support SMEs and other supply-side reforms focused notably on the labour market, in particular, by lifting the participation rate of seniors and young people, in addition to support for research and innovation. Fiscal consolidation is also a priority, with a deficit target of 3% of GDP in 2013 and a balanced budget by 2017. This fiscal effort would be financed by cuts in tax loopholes and an increase in taxes for the wealthiest households and big corporates. A broad fiscal reform would complement the adjustment of public finances. Financial institutions would be subject to several regulatory measures and taxes. In addition, the socialist programme intends to repeal some of the policies that have been implemented by the current government. For example, the pension reform is to be partially reviewed according to the proposal. The intergovernmental treaty agreed at the December 9 Summit would be renegotiated by adding measures aimed at strengthening growth and governance. In addition, Mr. Hollande would propose the creation of euro bonds to the European partners and would call for more involvement of the European Parliament into these decisions. Franois Bayrou: Public Sector Deleveraging and Boosting the Supply of Output

The economic programme of MODEM's president outlines two key priorities: fiscal consolidation and restoring France's supply of output. More specifically, fiscal consolidation would be accelerated in 2013, with a budget deficit of 2.8% in 2013 and a balanced budget in 2016. To achieve these objectives, government spending would be frozen in the medium term. In addition, cuts in tax loopholes, as well as a rise in VAT, would contribute to increase government revenue. The tax system, especially on the wealthiest households, would be reformed. Finally, the economic plan calls for a fiscal rule (Golden Rule') enshrined in the constitution in order to maintain fiscal discipline in the medium term. Hence, Mr. Bayrou will support the implementation of the fiscal compact. In addition, to boost the production potential, his plan proposes measures to support SMEs by stimulating their capacity of financing and research and innovation. Finally, the employment proposals also focus on small businesses, by reducing tax wedges on new jobs for young people. Marine Le Pen: Exit from the Euro and Favouring National Production Ms. Le Pen's economic programme calls for a progressive and coordinated exit of France from the euro area, accompanied by capital control and a partial nationalisation of commercial banks. The supply side of the economy would be supported by protectionist measures favouring domestic products and SMEs. In addition, the central government would intervene directly in almost all sectors of the economy. On the fiscal side, Ms. Le Pen projects a balanced budget by 2017. The fiscal adjustment would be achieved essentially through an increase in government revenue (cut in tax loopholes, increase and creation of various taxes). The previous pension system would be almost restored and financed by new taxes. Moreover, the principle of debt sustainability would be set in framework laws. Finally, labour market conditions are expected to be improved by introducing binding laws on hiring policies, as well as reductions in tax wedges. What Are the Most Recent Polls Saying? Latest polls (as of February 29, 2012) indicate that Mr. Hollande is leading in the first round of the presidential election, followed by Mr. Sarkozy, Ms. Le Pen and Mr. Bayrou. In addition, Mr. Hollande is projected to win the second round over Mr. Sarkozy by 56% to 44%. Finally, the gap between the two front-runners in the second-round run-off has held fairly steady since the beginning of the year. However, at this stage of the campaign, it is difficult to assess which candidate is likely to emerge victorious out of the elections, as polls are only indicative. The Electoral Process at a Glance The fact that the electoral process in France involves two consecutive elections with two rounds is likely to generate a relatively long period of uncertainty. Indeed, the presidential elections will be followed by the legislative elections, and hence the electoral campaign will in fact end in mid-June. So, how will the electoral process work? Presidential Elections The presidential term is five years (since a referendum of September 24, 2000), renewable (versus a seven-year term previously). In addition, a president cannot serve more than two consecutive terms (since the constitutional law of July 23, 2008). Under the Fifth Republic and since the constitutional revision of November 6, 1962 (approved by a referendum of October 28, 1962), the President of the Republic has been elected by direct universal suffrage through a two-round majority system: To be elected in the first round of voting, a candidate must obtain an absolute majority of the total votes;

 If no candidate receives a majority of votes in the first round, a second round takes place two weeks later. As the elected candidate needs the majority of the votes in the second round, only two candidates may go forward to this second round (the two highest-scoring candidates in the first round). Only potential candidates who receive signed presentations from 500 elected officials are officially allowed to run for the presidential election. These officials must include different elected representatives from at least 30 dpartements or overseas collectivities and no more than 10% of them should be from the same dpartements or overseas collectivities. The Constitutional Council publishes the names and offices of the signatories. In addition, the candidates must submit to the Constitutional Council a declaration of their wealth and an undertaking to file a new declaration at the end of their term of office. After the election, the Constitutional Council publishes only the elected candidate's declaration. After checking all the admissibility requirements, the Constitutional Council draws up the list of candidates. Legislative Elections Members (deputies) of the National Assembly (the lower house of the bicameral parliament) are elected during the legislative elections. There are 577 deputies, who are elected by direct universal suffrage with a two-round system by constituency, for a five-year renewable term, unless the National Assembly is dissolved. To be elected in the first round of voting, a candidate must obtain the absolute majority of votes cast and a number of votes equal at least 25% of the registered voters; If no candidate is elected in the first round, those who obtained a number of votes equal to at least 12.5% of the registered voters enter the second round. In this round, the highest-scoring candidate is elected and, in the case of a tie, the older of the candidates is elected. How Markets Reacted to Elections in the Past? Given that French presidential elections take place in two rounds, and they are immediately followed by the legislatives elections, we think that uncertainty may persist throughout this period. A peak in uncertainty may occur between the first and the second round of the presidential elections, depending on the posture of the candidates. Moreover, the legislative election campaign is likely to generate some uncertainty, too, as it determines whether the newly elected president would have a majority in the lower house of parliament to govern. In particular, even though one would expect the parties supporting the newly elected president to benefit from the momentum from the victory at the presidential elections, there is still some uncertainty over the final results. The legislative campaign is on national and local issues, and the reaction of the electorate can be difficult to predict. Therefore, for this year, uncertainty could last until mid-June. Looking back at the most recent presidential elections (2002 and 2007), volatility in financial markets appears to have increased a few days before the first round and remained elevated before the second round. However, for the 2002 presidential election, volatility in financial markets spiked before the second round, presumably because of the unexpected elimination of the former Prime Minister, Lionel Jospin, from the presidential race at the first round, while Jean-Marie Le Pen, the FN candidate, had qualified. We do caution against reading too much into implications of past French elections for financial markets, as the overall economic and financial environment, as well as the candidates themselves and their positions at the time, may also have played a role. In addition, other elements outside of the elections may have contributed somewhat to the past increase in volatility.

However, given the context of the sovereign debt crisis, we would expect more volatility in the financial markets this time round than in the previous elections. For full details, see France Economics: 2012 Elections Series - Addressing Structural Issues, March 2, 2012.

Important Disclosure Information at the end of this Forum Brazil The Rate Cut Debate Continues March 06, 2012 By Arthur Carvalho | Sao Paulo While there continues to be a debate regarding how far Brazil's central bank will go in reducing interest rates, until recently there was little disagreement about the pace of the cuts (see "Brazil: How Much Lower Can Rates Go?" This Week in Latin America, January 31, 2012). In recent days, however, local rates markets have begun to price in the possibility of an acceleration in the pace of the easing cycle, from the 50bp pace we have seen so far to 75bp or even 100bp. While we expect the central bank to continue with its 50bp pace at the upcoming meeting that concludes on Wednesday, March 7, there is a risk that the authorities may increase the pace of the easing cycle. We believe that such a move would risk damaging inflation expectations even further and could shorten the planned easing cycle. Accelerating the Pace? The argument in favor of accelerating the pace of rate cuts centers on the exchange rate. When the central bank began cutting interest rates by 50bp last August, it was focused on concerns over a deflationary global macro backdrop from very weak global growth. Indeed, the authorities expressed concern that there was a significant chance of a severe global accident. While global risks remain, the global economy appears to be posting better growth than Brazil's central bank and most global watchers expected just a few months ago. Instead of a more severe global downturn and its deflationary risks, Brazil now appears to be suffering from significant inflows, driving the Brazilian real stronger and prompting measures such as those announced at the end of February to try to limit capital inflows. We expect to see more controls and taxes imposed on inflows in an attempt to limit the appreciation of the Brazilian real. This is hardly surprising and is in line with the kind of measures that the authorities adopted in recent years when the currency was gaining ground. But what is more worrisome is the notion that the central bank's easing cycle could be driven by exchange rate concerns. There is a school of thought within Brazil that argues that moves to resist currency strength and, if possible, moves to induce currency weakness will help to address the damage that a strong currency has caused in Brazil's industrial sector. We believe that this past week's new round of IOF taxes and capital controls is precisely an attempt to avoid currency strengthening. The risk, however, is that the central bank could begin to use monetary policy to avoid inflows into the country. An abrupt lowering of interest rates might help ease some of the pressures on the Brazilian real to appreciate, but we are concerned that such measures would likely lead to an acceleration in inflation. What may be gained on the nominal exchange rate front would likely be lost as higher inflation would be reflected in a further appreciation of Brazil's real effective exchange rate.

The Growth Mismatch The authorities' concerns with the strength of the exchange rate are well understood. Brazil's real is near a multi-decade strong level and its most noticeable consequence has been its effects on industrial production, which has been stagnant for nearly two years now. While the strong currency serves as an extraordinary boost to consumers, it has also swamped domestic industries with import competition. Given that Brazil's industry represents roughly 22% of GDP, this has been a major drag on growth, and we believe is behind the administration's shift in economic policy from trying to curb inflation to boosting growth. We believe it is also behind the re-emergence of new uses of the IOF tax to limit inflows. It is hard not to be sympathetic with those who argue that Brazil's rates - whether measured in nominal or real terms - remain too high and that conducting monetary policy from these levels simply invites further inflows and currency strength. While lower interest rates are desirable, we believe that lower interest rates at this current juncture are set to produce a rebound in inflation that is likely to be seen more clearly in 2H12 after the base effect appearance of improved in inflation has dissipated. After all, although much has been made of the fact that GDP stagnated during 3Q - and we are likely to learn this week that 4Q GDP was also weak (nearly 0.3% pace of growth) - the monthly data suggest that the economy has begun to bounce back more strongly in the last two months of the year and continued to gain at the beginning of 2012. The ongoing recovery started to gain traction in November in both industrial output and GDP. The latest available PMI data available through February show improving conditions for five consecutive months in the industrial sector. These indicators are currently at the levels compatible with the 5.5% annualized rate of growth seen in the past. Also, although the slowdown in the second half of 2011 did hit Brazil's labor market, this was a shallow and short-lived slowdown. Formal hiring is back at strong levels, which should keep income growth and demand growth strong over the next few quarters. Meanwhile, although headline inflation measured on a year-over-year basis continues to fall (as we have highlighted), the improvement is largely a function of the base year. Sequential improvements, as seen in the month-over-month readings in January, and mid-February, were largely due to a drop in food prices from ideal weather conditions for fresh produce and passthrough from lower soft commodities. In contrast, the core measures of inflation have shown little improvement - core continues to run right above 6% compared to a year ago. And services inflation continues to climb, reaching 10% in January. Given the strength of Brazil's domestic demand and the recovery we are seeing in Brazilian output, the conditions for further inflationary pressures building up are present. Additional rate cuts - whether at the 50bp or faster - are not warranted, in our view. Unfortunately, as long as Brazil watchers choose to look at yearly headline inflation rather than core, and GDP rather than domestic demand and labor markets, this sense that there is room to cut rates more aggressively will likely persist. Indeed, we expect inflation to reach 5.6% in 2012 and show signs of acceleration to 5.9% in 2013, given the current policy mix. As of the first days of March, inflation expectations for 2012 were gravitating around 5%. While not a worrisome level, if faced with a more aggressive monetary policy we would most likely see further deterioration. Given the current inflation picture, expectations for 2013 and 2014 are already beginning to de-anchor. We are concerned that an increased pace of rate cuts would accelerate this de-anchoring and spread to 2012 expectations as well. A Fiscal Solution? In order to reduce interest rates further without jeopardizing an uptick in inflation, the authorities would need to tighten fiscal policy much more. Although Brazil's fiscal performance has improved

materially in the past 12 months, it cannot be considered contractionary. Even after the R$55 billion cut announced just a month ago, the authorities are still set to run a 2% overall fiscal deficit, even though revenues are growing above 15% in nominal terms. Despite important strides on fiscal policy, such as the approval of the public servants' new pension scheme, we believe that in 2012 policy will be at best neutral. Hence, we do expect to see a further acceleration in inflation in 2H12, once base effects are over. Bottom Line Last year, Brazil's central bank began to cut interest rates in response to concerns of a much weaker globe.Just a little over half a year later, this scenario did not materialize even as the rate-cutting cycle continues. We believe that the authorities are now concerned as well about the recent strength in the currency and strong inflows that Brazil is experiencing as risky assets have begun to rally. Indeed, this may be an important driver behind the current rate-cutting cycle. Once the focus has shifted to the currency, it is not hard to imagine pressure building on the central bank to pick up the pace of rate cuts in an attempt to limit inflows. Such a move, in our view, would jeopardize damaging inflation expectations further and indeed would likely set us up for higher inflation in 2012 and 2013. For this reason, we doubt that the central bank will increase in the pace of rate cuts at the upcoming meeting. Still, we will be watching carefully and are mindful that the risks of an accelerating rate-cutting pace cannot be ruled out. Global QE Q&A March 02, 2012 By Spyros Andreopoulos | London Q1: QE hasn't worked. Why do central banks keep doing it? First off, in our view QE has worked. What do we mean by "has worked"? QE, and monetary policy more generally, cannot deliver strong growth when the overhang of previous excesses still weighs on the economy. But it does support growth through supporting asset prices, increased inflation expectations and lower bond yields and spreads - and hence lower real interest rates (and weaker exchange rates). In addition, it satisfies the public's increased preference for safe and liquid assets (cash and central bank reserves). At the same time, it's probably true that there are diminishing returns to QE: the incremental easing achieved by each successive round declines, and so do the effects on the real economy. But to answer the question properly - to understand why central banks keep doing QE - it is important to put oneself in monetary authorities' shoes and perform the same cost-benefit calculations that they are doing. It turns out that in the absence of other - more potent - policy tools, large real effects of QE are not necessary to induce central banks to engage in (further) QE. Given the potentially very serious adverse effects of deflation and the fact that central banks themselves view upside risks to inflation stemming from QE as small and manageable, then even very modest effects of QE are sufficient to justify it. Put differently, from central banks' point of view, the risk/reward of further QE remains very favourable, indeed compelling, in the current economic environment. When there are few low-cost tools available, and as long as QE can reasonably be expected to make a positive contribution - however modest - to keeping the economy away from the danger zone, monetary authorities are likely to continue deploying this tool. Q2: QE has raised risks of high inflation, thus increasing inflation uncertainty. Has this not undermined investment and growth rather than supporting it?

There is no doubt that inflation uncertainty is harmful for investment and growth: inflation uncertainty creates uncertainty over the real return on investment projects; all else equal, this will crimp investment spending. We see three problems with this argument, however. First off, we question the premise: that QE has increased inflation uncertainty. We think it is even possible that QE haslowered, rather than increased, inflation uncertainty. As we have argued before, recent central bank policy, including QE, has mitigated - though of course not eliminated deflationary risks. That is, while it is true that thanks to QE higher future inflation is more likely, it is also true that negative inflation is less likely. But even if we grant that QE has increased inflation uncertainty, we think that the effects are more likely to be small - if not outright negligible. For inflation uncertainty to have meaningful harmful effects on spending requires much higher inflation rates than currently prevalent - empirical research suggests that inflation rates in the double-digits are required to produce meaningful effects on investment and growth. Now, it is conceivable that despite current inflation rates well below double-digit territory, expected price increases are very high - even though this is not what either market pricing or surveys of expectations suggest. But let's suppose for the sake of argument that this is true for a meaningful segment of corporates and households. The issue is that such a divergence between actual outcomes and expectations cannot last for long. If people learn, they will shift their expectations over time as the outcomes consistently prove their expectations wrong: a business person that expects 20% inflation but is confronted with outcomes in the 1-4% region year after year is likely to, sooner or later, change those expectations. Any uncertainty over future inflation is likely to be completely dwarfed by the uncertainty prevalent in the real economy. Whether compared to uncertainty over the future path of fiscal policy in some economies (e.g., US, Japan), elections and their outcomes (US, France) or geopolitical issues and the corresponding oil price volatility, the contribution of QE to overall macro uncertainty can only be very small. Q3: Won't the large amount of excess reserves inhibit rate hikes and policy normalisation? No. Technically, the level of the main policy rate and the amount of excess reserves (and hence the size of the central bank's balance sheet) can be kept separate. It is true that the prevailing level of the overnight rate is influenced by the amount of excess reserves; hence, too high a level of excess reserves in the overnight market would pressure the overnight rate down and away from the overnight rate target (which is the main policy rate). So, what the central bank needs to do is to make sure that there are not too many reserves in the overnight market. It can achieve this through a combination of draining operations and/or outright asset sales, and incentives for commercial banks to keep their excess reserves out of the overnight market. The latter can be accomplished by raising the interest rate at which the central bank remunerates excess reserves in tandem with the policy rate (indeed, the Fed for example anticipates that this interest-onreserves rate will be its most important policy tool when it comes to steering the overnight rate (see Manoj Pradhan, The Global Monetary Analyst: ER, RR, IOR and RRR, February 17, 2010). While for some central banks - notably the Fed - there may well exist a host of practical issues to be resolved in this context, we think that by and large central banks should be able to at the very least broadly steer the overnight rate to the desired level. Under this premise, central banks should be able to push borrowing costs and financial conditions in the right direction. Q4: Why then do you still see inflation risks from QE? As just explained, we think that central banks have the necessary tools to effect policy normalisation when they think the time is right. So, it's not the "tools" part that worries us, it's the

"when they think the time is right". In our view, given the fragility of the economy and the possible adverse consequences of deflation, a rational central bank will want to err on the side of caution and exit too late, rather than too early (see Arnaud Mars, The Global Monetary Analyst: Better the Devil You Know, August 18, 2010). There are enough cautionary tales of premature exits in economic history (for the Great Depression see Spyros Andreopoulos, The Global Monetary Analyst: Back to the Future? September 14, 2011, and for Japan see The Global Monetary Analyst: The Mistakes of Others, November 9, 2011). This insight applies to any kind of monetary policy tightening - QE or not. But in the case of QE, there is an added element. The large amount of excess reserves with the banking system provide an additional source of risk, as this is a variable over which central banks have incomplete control (see Manoj Pradhan, The Global Monetary Analyst: Reversing Excessive Excess Reserves, October 28, 2009). We have stated above that central bank control of the overnight rate requires incentives that commercial banks keep their reserves out of the overnight market. Yet, this does not guarantee that commercial banks will keep their reserves out of the real economy as well. Once the economy improves, commercial banks may find it profitable to use their excess reserves to lend to households or businesses (a risk that has been debated in the past by the FOMC for example). This would further increase the money supply, boost spending and raise inflation risks. That is, while central bank tools discussed above are likely sufficient to give them the necessary amount of control over the overnight market and hence the overnight rate, this, in isolation, is not enough. Unless, therefore, the Fed manages the timing of exit - including the reduction of excess reserves - perfectly, inflation could take hold. Q5: What happens when the public loses confidence in central bank liabilities? In response to the seismic shift in private sector risk-aversion the financial crisis brought about, central banks have deployed their balance sheets to cushion the blow to the economy. They have done so by taking the unwanted risk off the private sector balance sheet and replacing it with safe as well as liquid assets: central banks' own liabilities (see Spyros Andreopoulos, The Global Monetary Analyst: QE Coming of Age, February 1, 2012). This is, in essence, a confidence trick. It works for as long as the private sector is willing to hold these liabilities - i.e., for as long as they are considered safe, which in turn depends on them being considered safe by everyone else. A central bank will, of course, never default on its liabilities they can, after all, create unlimited amounts of it. But the safety' property also depends on whether this asset is seen as a store of value, i.e., likely to maintain its real value - its value in terms of goods and services. So, while there is no technical limit to the expansion of central bank balance sheets, there is a limit nonetheless: the public's confidence in the real value of such liabilities - and government liabilities more generally. The more such liabilities are created, the more we approach this point. How would such a loss of confidence unfold? If the supply of central bank liabilities - call it liquidity' - exceeds the public's liquidity preference, then the latter will seek to substitute away from it. The public will then buy goods and real assets. The result is self-fulfilling inflation - inflation will rise essentially because the public has lost confidence in the ability of central bank liabilities to maintain their real value. We are probably very far from such an outcome - far enough that it can be considered a tail risk. Yet, the risk in question is nothing less than a wholesale run on the fiat money system.

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Europe ECB to Do Less Later March 02, 2012 By Elga Bartsch | London The risks to our ECB call for 50bp of further rate cuts and outright Quantitative Easing (QE) in 1H12 have increased markedly in recent weeks. Euro area money markets have essentially priced out all ECB easing this year. The monthly ECB press conferences have become increasingly upbeat. Financial markets for risky assets have experienced a sharp rally in early 2012, fuelled by actual and expected LTRO liquidity. Business sentiment, at least in the core countries, appears to be stabilising. Globally commodity prices are on the rise. As a result, we now expect only one more rate reduction of 25bp from the ECB in 2Q12 and view outright asset purchases, i.e., QE, as a backstop if the financial-cum-sovereign crisis unexpectedly worsens again. Previously, we had penciled in 50bp of rate cuts in 1Q and the start of QE in 2Q. At the end of the day, the course of policy action in Frankfurt will very much depend on whether the two three-year LTROs are able to stabilise the financial system sufficiently over the medium term. Hence, the market reaction once the second LTRO is out of the way and the new funds have trickled through the system will be key. In this context, we will be keeping a close eye on the availability of bank loans to the private sector, notably to non-financial corporates. Clearly, the first two ECB press conferences in 2012 were less dovish than expected (see ECB Watch: Waiting for Next LTRO, February 9, 2012). In January, the Governing Council spoke of a tentative stabilisation and in February it no longer saw substantial downside risks to the growth outlook. While we agree with this assessment, we feel that it only means that the marked downside risks that were present in late 2011 have declined. Alas, the euro area as a whole is still in a mild recession and the periphery is mired in a very deep one. At the upcoming meeting on March 8, we would expect the ECB staff projections to be revised down meaningfully from the December estimate, which showed an average GDP growth rate of 0.3% in 2012. The new ECB staff projections should put the midpoint of the forecast range close to our own 2012 forecast of -0.3%, we think. Normally such a downward revision to the growth estimate would shave about two-tenths off next year's inflation projection. However, at this point, a higher oil price trajectory - which should be almost 10% higher than in December even after accounting for the stronger EUR - is likely to partially offset the downward pressure on the 2013 inflation projection from its December forecast of an average 1.5%. True, there are signs of a tentative stabilisation in activity. But, so far, the stabilisation is only visible in the sentiment data, which seem to be stabilising at somewhat suppressed levels. Hard data such as industrial output, retail sales, car registrations, merchandise exports, credit growth or the labour market are not showing much of a stabilisation yet. And new risks to growth, including oil prices at new highs and a stronger-than-expected euro, seem to be building already. A closer look at business sentiment indicators shows that it is mostly the expectation components that have started to improve, reflecting a rebound from the very depressed level at the height of the confidence crisis triggered by last summer's policy errors, notably the Greek PSI. The most recent crop of euro area business surveys shows that our surprise gap moved into the acceleration camp and our business cycle compass into recovery mode in February. Closer inspection shows, however, that this is due to the increasingly gloomy expectations of manufacturers not coming to fruition. Company captains are revising their outlook for the next three to six months a bit higher, but still see the outlook below trend. Other key indicators such as order books, inventory levels and current output are at best hovering sideways at below their long-term averages. And, if it wasn't for the more upbeat mood among German manufacturers, the stabilisation for the euro area as whole would occur at a much more subdued

level. In addition, we have consistently seen over the past few months that actual industrial production dynamics are falling short of our manufacturing production indicator estimates. What's more, manufacturing is essentially the international part of the euro economy, which should be less affected by tightening fiscal policy and credit conditions - which alongside higher energy prices are squeezing domestic demand. (Note though that the manufacturing eurozone data also pick up intra-EMU trade.) As the fiscal policy stance for this year is largely set (with the exception of Spain, where the budget will only be presented in late March), the main swing factor for domestic demand is the availability of credit to the private sector, notably non-financial corporates. In this context, the last several sets of monetary data were rather disconcerting, given the sharply negative credit flows observed during December and the absence of any meaningful credit flows in January. While it is probably too early to expect the full impact of the LTRO and the wider collateral pool to be reflected in these data reports, it is worth bearing in mind that successful LTROs are only a necessary condition - and not a sufficient condition - to avoid a full-blown credit crunch in the euro area. As long as the two three-year LTROs do the trick, there does not seem to be a need for the ECB to contemplate outright asset purchases, i.e. QE, which would also be highly controversial on the ECB Governing Council, we think. It is important, though, that investors are aware of the different mechanics of the LTRO as a form of indirect QE via central bank lending operations and active QE via outright asset purchases. The two are somewhat similar at first sight, as both boost the central bank's balance sheet as well as excess reserves in the banking system. But there are two key differences: The first concerns the transfer of financial market risk. While under a QE programme the market risk is transferred from the financial sector to the public sector, this is not the case under a collateralised lending programme, such as the LTRO. Consequently, QE is a proper market backstop. An LTRO, by contrast, is not a circuit breaker. On the contrary, if we see the euro area banking system increase its sovereign exposure markedly on the back of the three-year LTROs, the circular connection between the banks and the sovereigns would become even closer than before. As a result, another policy mistake, such as a repetition of the PSI, say, in the case of Portugal, could have even worse consequences than the Greek PSI decision. Back in 2009, euro area banks also used the LTROs to fund carry trades, and between October 2008 and October 2010 they bought nearly 480 billion of government bonds. Some of these institutions may later have regretted getting into the carry trade, particularly when the EBA announced a special sovereign stress test last autumn and equity investors became concerned about the sovereign exposure of European banks in the second half of last year. The second important difference concerns the risk of potentially crowding out traditional bank lending channels. Given the attractiveness of the carry trades, notably in the sovereign space, and their powerful impact on bank earnings, we see a risk that the LTRO liquidity could be diverted away from lending to small and medium-sized enterprises and households. Admittedly, widening in the collateral rules regarding credit claims was intended to offset this tendency. But, it is important to bear in mind that, whereas under outright QE a bank would find itself with free cash sitting on its balance sheet that it can either deploy or give back to investors, this is not the same for central bank lending operations, which work via the liability side of balance sheet. Efficacy of QE is undermined because of the effective subordination of private sector bond investors in the SMP. While these concerns lead us to believe that the two three-year LTROs cannot be a substitute for QE by the ECB, we need to acknowledge that the decision by the Eurosystem to effectively adopt a senior status vis--vis private sector bond investors will likely also have undermined the effectiveness of any outright asset purchases in the future.

True, there are two mitigating factors: 1. The Eurosystem will disburse any potential profits from its Greek bond holdings to the respective national governments, which are then earmarking them to contribute to making Greece more sustainable. 2. The fear of subordination only matters materially in those cases where the sovereign debt burden is viewed by the market as being unsustainable. Given that we would expect any QE programme to involve pro rata purchases of all countries, the largest chunk of purchases would likely occur in the core countries where such considerations should not play a great role. But the fact that the Governing Council appears to have taken a decision to swap the ISIN codes for its Greek bond holdings and thus avoid being potentially hit by the CACs introduced by the Greek government last week suggests to us that a QE programme is not very high on the agenda for the ECB Governing Council at the moment. So, let's hope that the need for additional policy insurance against the risks of very deep recession and the resulting deflationary pressures in the euro area does not arise. Global The Rules of the Game February 24, 2012 By Manoj Pradhan | London "There are decades when nothing happens, and weeks when decades happen." Lenin It is rare and quite ironic, to say the least, that Lenin's words are used to address events in financial markets. His pithy phrase, however, undeniably captures the exhausting speed at which events have been unfolding around us over the past several years. These unprecedented events have elicited an unprecedented policy response. Rather unfortunately, not all policy actions in these exigent circumstances have been of the right' kind. In this note, I argue that a rather long list of the wrong' kind of policy decisions, including the recent bond swap by the ECB, have retroactively changed the rules of the game and introduced regulatory risk into financial markets. By subverting the rules and regulations that they themselves put in place, policy-makers have ensured that investors will demand to be paid yet another kind of risk premium in future crises, a premium for bearing the risk of retroactive changes in regulations. Why hasn't such a risk premium asserted itself already? Because the right' kind of policy response - QE and the related strategy of financial repression - has nullified the risk premia. QE, for example, has helped to push risky asset prices higher and bond yields lower, thereby acting in exactly the opposite direction to risk premia. The fact that the use of unconventional policies has been so aggressive has meant that the net impact on financial markets has been a benign one. Financial repression - a set of policies designed to keep bond yields or currency values lower than unconstrained market pricing would have generated - is part of the standard policy toolkit for extreme scenarios. QE or regulatory policies that push bond yields lower are one way that policymakers can financially repress investors. If one argues that financial repression does change the rules of the game, then the same argument would have to apply to QE. This is clearly a grey area, but on balance, both QE and financial repression are best viewed as aggressive extensions of standard policy tools employed under extreme economic conditions. Policy-makers may well use a similar combination of QE and financial repression in future crises and override a prospective rise in the risk premium by stimulating markets vigorously. However, if the willingness or the ability of policy-makers to be ber-aggressive wanes in future crises, perhaps because of policy-maker concern over forfeiting public confidence through issuing too

many central bank liabilities (see The Global Monetary Analyst: QE Coming of Age, February 1, 2012), the risk premium could well dominate asset markets. What are the implications? The implications are profound and manifold, but I point out only two of the important ones here. First, peripheral Europe and EM economies know full well that a rise in yields during downturns or crises (which would happen if the risk premium was the dominant force) inhibits the rolling over of liabilities, public and private. In turn, this dampens the economic activity that was being financed by these liabilities. Second, there are repercussions, away from economics, for the first principles of finance. If the market price in future crises also includes a premium for regulatory risk, it will give only a murky signal about how much of the macro and market uncertainty is in the price. Through their decisions, policy-makers would have made markets less efficient. This would hurt not just markets but policy effectiveness too, given how much more reliant policy has become on markets and investor sentiment. To better understand the interplay between the benign and malign effect of policy decisions on asset prices, it is necessary to first understand which policy actions themselves are of a benign or malign nature and why. Two kinds of policy actions - the right' and wrong' kind: In order to avoid grossly understating the grey area between what is right' and wrong', I prefer to make the distinction between the two using concrete examples. As a simple framework for classification, the right' kind of policy measure is one that extends (even aggressively) the existing realm of policy without retroactively bending or changing the rules that govern financial markets. The wrong' kind of policy violates this principle. It is easy to see why such a broad distinction will not do. Take the example of financial repression. It is easy to argue that distorting asset prices and almost forcing investors and economic agents to expand their activities is simply an aggressive extension of the standard tool of policy rate cuts. However, my colleagues remind me that keeping official institutions senior to private investors is also an integral part of financial repression. Arguably, this is what the ECB has done. How then do I classify financial repression? Precisely in order to avoid broad, sweeping statements, a nuanced discussion follows. A Laundry List of What I See as the Wrong' Kind of Policy Decisions The ECB's recent refusal to accept losses on its purchases of Greek government bonds via the SMP programme: The main objection to a wrong' tag is that official institutions, particularly those acting to safeguard the system, are always senior to private bond holders. The issue, however, is the timing and manner in which this seniority has been asserted. Had the ECB announced at the very outset of its SMP purchases that it would not accept any losses on its purchases in the event of a restructuring, investors returning to peripheral bonds would have been fully informed and could have decided to participate, keeping in mind that the bonds they acquire or hold would be subordinated to those purchased by the ECB. By announcing and exercising its seniority only after investors came back to peripheral bond markets, the ECB has effectively changed the rules in a way that I believe violates the spirit of the law. The introduction of the PSI: Deciding to use the PSI in July 2011 broke a prior promise to not involve the private sector before 2013. It sparked a major wave of contagion into other peripheral bond markets. Emphasising the voluntary' route for the PSI was an attempt to avoid triggering sovereign CDS contracts:Success in restructuring Greece's debt without triggering the CDS would amount

to the bypassing of an important instrument designed to insure investors against exactly such a risk. Efforts to restrict sovereign CDS trading to holders of sovereign debt: While such a policy would have been in line with the intent behind the initial design of sovereign CDS contracts, imposing such a restriction on investors retroactively would have disenfranchised a significant proportion of investors in the market. Bans on short-selling: Even though short positions were driving markets into a tailspin faster, policy-makers would have been better off addressing the root of the problem, weak balance sheets of private financial institutions. Policy measures have been of the right' kind as well: Not all uncertainty is bad. The use of unprecedented measures like QE and capital injections should make investors think twice before they test the willingness and ability of central banks to act. The fact that the zero lower bound is no longer a restriction and that the design of QE can be adjusted in size and scope to address the problem at hand provide central banks some relief by introducing the right' kind of uncertainty among investors. How? The threat of aggressive QE helps to keep bond yields low, spreads tight and risky assets buoyant. In other words, the possibility that central banks re-enact their aggressive easing in future crises could well serve to quell risk premia then. Similarly, the use of capital injections by governments to bolster balance sheets of private financial institutions was the right kind of policy response, in my view. By providing explicit and tangible assistance to financial institutions, policy-makers addressed the root cause of the lack of confidence in these institutions. The injections did not circumvent the rules of the game. Capital injections are and will likely continue to be an important tool in the crisis and an essential part of maintaining financial stability. Going beyond the past sins of emerging markets: On balance, DM policy-makers have gone a step further than their EM counterparts in the EM crises of the past through their actions. Why? Because EM economies could be chastised or avoided by global investors thanks to the presence of a safe haven in DM markets. By ensuring that there is no safe haven, DM policy-makers have troubled investors globally by giving them no place to hide. EM policy-makers were not able to use financial repression very effectively, though they may have wanted to. DM policy-makers, however, have willingly wielded their ability to financially repress investors with the skill of Parthian archers. Summary: Unless policy-makers aggressively use the right' kind of policies to support asset markets in the next crisis, the risk premium from the legacy of the wrong' kind of policies from this crisis could become the dominant force. Asset prices could stay subdued, credit spreads could widen and bond yields could stay high if this turns out to be the case. Aggressive action by policymakers in the next crisis would thus become even more of a necessity. I believe that policymakers have put themselves on a very slippery slope in the future.

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Europe Till Debt Do Us Part February 24, 2012 By Arnaud Mars | London

Of the importance of unintended consequences. Our colleague Joachim Fels once described the current stage of the crisis in Europe with the acronym CCC, standing for a crisis of confidence, competency and credibility. One could add a fourth C' to this list, for consequences. A recurrent feature of the global crisis is the unintended consequences of policy actions. Perhaps the two most important milestones of the past four years were policy decisions, whose unanticipated consequences caused in each case a considerable degradation of the situation and extended the crisis both in scope and length. The first of these events was the decision by US authorities to let Lehman Brothers fail in September 2008, now widely acknowledged to have been a major policy error. The second was the decision by European governments to initiate restructuring of public debt in Greece without having first put in place a robust safety net for solvent governments. This is also now widely regarded as a policy error. In each case, we note that many in the market initially applauded these decisions (when not actively calling for them beforehand) without seemingly fully appreciating the consequences. A euro exit by Greece would be no small matter. We are struck by the apparent complacency with which many in the market and more worryingly in policy circles speak of the possibility that Greece exits the euro area. The PSI agreement on February 20 has postponed the issue, but we do not think it has resolved the Greek situation once and for all. Debt sustainability remains problematic. An economic recovery in Greece remains remote (on these points, we refer readers to upcoming publications by our colleagues Daniele Antonucci and Paolo Batori). Political tensions across Europe have not been put to rest. Questions that have been postponed will likely resurface. Far from considering a Greek exit from the euro a benign event, we think that should such an exit materialise, the unintended consequences would be unfathomable for Europe and the world, and would be immensely more difficult to counter than those of either the failure of Lehman Brothers or a sovereign default. We explain why below. The Lehman Brothers collapse caused a fundamental change in the perception of bank credit. The consequences were bad enough but could be mitigated to some extent because public authorities deployed two lines of defence. They substituted the (then) superior credit of governments for that of banks by extending funding guarantees to financial institutions or forcefully recapitalising them. They also deployed the full range of central bank instruments to support the economy. The Greek PSI in turn caused a fundamental change in the perception of sovereign credit in Europe, leaving only one line of defence, the central bank. This line of defence has proved resilient, indeed more resilient than we anticipated. Resolute action from the ECB to shelter banks and governments from liquidity risk has proved relatively effective at stabilising the market, so far. Should Greece leave the euro, what would change is the nature of money itself, potentially disabling even the central bank as a stabilising force. Who then would be able to step in to mitigate the consequences is, to say the least, unclear. As for what these consequences would be, this is clearer in our view: taking this route would likely trigger a wide-scale bank run and threaten the existence of the euro as a whole, and with it that of the European Union. We justify this assertion below. What is also clear is that the consequences would reach beyond Europe. The European Union, even with little growth, remains the largest economy in the world, accounting for 26% of global GDP. If it gets further destabilised, so would the global recovery. So bad it cannot happen? Prior to exploring the unintended consequences of a Greek exit from the euro area, we underline that what we are providing here is a demonstration ad absurdum. We do not expect Greece to leave the euro, precisely because the consequences would be so damaging. It is however impossible to quantify objectively the risk of such an event. If it happens at all, we think it will happen because a subset of policy-makers has not appreciated the

consequences. For our expectation to prove founded, therefore, the unintended consequences of a Greece exit have to beanticipated, meaning understood by all parties. Why would a Greek exit from the euro area be so damaging? The euro is irreversible. Is it? The starting point of the analysis is the simple yet immensely important observation that if Greece were to leave the euro, this would imply that the euro is reversible. Note that this is not currently the case. The adoption of the euro by a country is, according to the terms of the European Treaties, irrevocable. There exists no institutional mechanism for a country to exit the euro area, nor was such an exit ever intended to take place. The reasons for this are straightforward: Breaking down the fungibility of money. If the euro is reversible, it is not reversible in only one country. It is reversible in all. If Greece can leave the euro, then other countries may also leave the euro at a subsequent date. The implication is what we described in an earlier piece as a breakdown in the fungibility of money. To explain this point, one must consider that in a fiat money system, money is the liability of a bank. It is the liability of the central bank in the case of central money, i.e., banknotes and bank reserves held at the central bank. It is the liability of commercial banks for commercial money, i.e., deposits. As long as the euro and the Eurosystem exist in an irreversible form, these different forms of money are effectively fungible. Should the euro be reversible, however, these different forms of money are no longer completely fungible. Federal money versus national money. Which is which? The euro may be a federal currency, but a deposit in a bank is effectively national money. If a country were to leave the euro, it would most likely be redenominated in that country's new currency (most likely' as opposed to definitely' as there is no precedent and currently no legal reference that can be applied to such a scenario). Strong money versus weak money. Which is which? As long as the euro is irrevocable, the distinction made above between federal and national money is irrelevant. By contrast, if the euro were to become reversible, this distinction matters. A euro held in a country more likely to abandon the euro becomes a weaker form of money than a euro held in a country more likely to keep it, with banknotes the strongest form of money. Under the more extreme scenario where the euro breaks up altogether, the weaker forms of money would be deposits in countries more likely to see their new currency depreciate after breakup, the stronger forms of money being deposits in countries whose new currency would more probably appreciate. Where banknotes rank exactly under such a scenario is less clear (they are the liability of an institution - the Eurosystem - that would no longer exist as such). How a run on money would unfold. In a situation where different forms of money are no longer entirely fungible, what one ought to expect is a run away from the weaker forms of money towards the stronger forms. More explicitly, this would take the form of: Savers withdrawing deposits from the banks of countries deemed weaker, preferring to hold banknotes instead; and/or Savers withdrawing deposits from the banks of countries deemed weaker and transferring them to the banks of countries deemed stronger.

The erosion of deposits in Greece and Ireland provides but a glimpse of what would happen elsewhere if Greece exited the euro. This erosion of deposits has, it will be argued, already taken place partially in Greece, where banks have lost a quarter of their deposit base since the end of 2009. It has also already taken place partially in Ireland, where banks have equally lost approximately a quarter of their domestic deposits and a larger proportion of their foreign deposits. In both cases, what has taken place is consistent with a migration of money away from weaker forms towards stronger forms, meaning to deposits in German or Dutch banks. This is reflected in turn in the build-up of the infamous intra-Eurosystem claims. Our point, however, is not that an exit from the euro area by Greece would threaten the deposit base of Greek banks, which is a given. It is that such an exit would threaten the deposit base of most banks across Europe, at least the banks of any country for which, as a consequence of a Greek exit, the probability of leaving the euro and devaluing its currency becomes meaningfully different from zero. More explicitly, the partial run observed in Greece or Ireland would both assume larger proportions and more importantly occur across a larger number of countries. Contagion ought to be a familiar pattern by now. To illustrate this point, it suffices to recall that the failure of Lehman Brothers closed access to capital market and interbank funding to all banks, regardless of whether they were solvent or not. Similarly, the initiation of PSI for euro area sovereigns caused contagion not just to Ireland and Portugal but also to Spain, Italy, Cyprus, etc., and eventually France and Austria, regardless of whether the governments of these countries were objectively solvent or not. No line of defence? The precedent of deposit haemorrhage in Greece and Ireland is nonetheless relevant in that it highlights the tools necessary to counter a bank run. Paradoxically, the determined action of the Eurosystem in Greece and Ireland to counter this haemorrhage illustrates why a run of broader magnitude would be very difficult to control. In a situation of a bank run, what prevents catastrophic outcomes (widespread bank failure) is the ability and willingness of the central bank to replace deposits and fund banks directly itself. This is what happened in Greece and Ireland, where the Eurosystem increased its lending to domestic banks. Limits to the ability of the Eurosystem to intervene... The Eurosystem is however constitutionally constrained to only lending to banks against adequate' collateral. The meaning of adequate' is elastic, as evidenced by recurrent loosening of Eurosystem-wide eligibility criteria through the crisis and by the acceptance of weaker collateral in the context of Emergency Liquidity Assistance (ELA) in both Greece and Ireland. It remains the case that the central bank cannot fund banks unless they have unencumbered assets to provide as collateral. A first threat to the ability of the Eurosystem to replace deposits on a wide scale is the availability on the balance sheet of banks of sufficient amounts of unencumbered assets. ...and perhaps limits to its willingness. More fundamentally, if the euro were to become reversible, the nature of the risk taken by the central bank by replacing deposits would change substantially. It is one thing for the central bank to fund banks that are and will always remain in the euro area. These banks are within its jurisdiction and are its natural counterparties. By contrast, if a country can leave the euro, its banks may no longer be ECB counterparties in the future, are regulated by authorities whose interests may no longer be aligned with those of the ECB, and are active in a market that may no longer use the euro as a currency. If the ECB is sensitive to the market and credit risk that it takes in its operations (which it is, judging by its refusal to take losses on its holdings of Greek bonds purchased in the context of the Securities Markets Programme), then it might become more reluctant to perform its role of lender of last resort without reservation if the euro were made reversible.

If not the ECB itself, at least some components of the Eurosystem may become (even) more reluctant to support the banks subject to a run. The corollary of the migration of deposits referred to above is the rise in intra-Eurosystem claims, which are claims of the national central banks of the stronger' countries on the ECB, matched by claims of the ECB on the central banks of the weaker' countries. As long as the euro exists and is irrevocable, these claims have very little relevance, in our view. They are an accounting mirage, resulting from the disaggregation of the balance sheet of the central bank of the euro area (the Eurosystem) into 18 sub-balance sheets (that of the ECB and of the 17 national central banks). As long as the euro exists, the exposure that central banks have to each other within the system imply no risk, in our view. Should the euro become reversible, however, then these intra-Eurosystem claims would suddenly imply genuine risk, as the national central bank of a country exiting the euro might realistically default on its obligations towards the remainder of the Eurosystem. And the credit crunch would likely come back. Arguably, the points we have listed here are of secondary importance. More important is the fact that if banks lost their deposits, they are very unlikely to extend credit to the economy. This would push any country affected by the run back towards the credit crunch, which the ECB painstakingly managed to avoid and to turn into a less damaging credit squeeze through its long-term refinancing operations. Conclusion: if one country goes, it is monetary union that goes. Our conclusion at this stage is that Greece leaving the euro would not be a local event. It would change the nature of money everywhere across the euro area by making the euro reversible. It would turn most of money supply (commercial money) back into national money. It would hinder the ability (and possibly willingness) of the Eurosystem to act as a lender of last resort for the entire euro area banking system. For all practical purposes, it would be the end of the euro as a genuine single currency. It would also likely trigger an unstoppable run on banks, which would push large parts of the continent onto a depressionary and politically painful path. To preserve the euro if Greece left would require total federalism in the rest of the area. Is there a way to avoid the conclusion we outlined, meaning to have one country leaving the euro area without triggering a catastrophic run in other countries? We think the answer is yes, but only under conditions that are unrealistic to us in the near term. For a Greece exit from the euro to happen without triggering the chain of events we have described, it would need to be ensured that the euro remains irreversible for all countries other than Greece, and perceived as such. In other words, it would need to be credibly ensured that Greece is the only country that will ever leave the euro. Needless to say, in a context where policy credibility has been a major casualty of the crisis (as reflected in Joachim Fels' CCC acronym) the only way to assure that no other country would ever leave the euro would not be policy statements but institutional and constitutional reforms that bind countries together forever. We believe that this would need to include at least: Full federalisation of banking supervision and deposit insurance, so as to pre-empt a run on deposits; Full federalisation of fiscal policy (through federal control over national budgets) and sovereign debt (through joint issuance), to prevent a repeat of the Greek situation. Not a plausible scenario in the near term. While advances are being made that may eventually - mean that both conditions are met (the agreement of EU heads of state and government on December 9 is a very, very small step on a route that we believe will lead eventually to fiscal federalism), they are very far from being in place at the moment.

Further, the ability of European governments to initiate far-reaching institutional reforms is constrained in the short term, if only by the French electoral calendar. With presidential elections by early May and legislative elections taking place in June, France is in our view not in a position to co-lead or participate in any meaningful institutional reform before the summer. Yet, as the past four years have shown abundantly, without co-leadership by France and Germany, institutional reforms seem to be impossible to achieve in Europe. Therefore, we do not believe that contagion from a Greek exit from the euro can be stopped, at least not in any foreseeable future. The euro cannot be split in two either. The arguments presented here also suggest that the notion that the euro can be split between a strong or Northern euro and a weak or Southern euro makes little sense. If the euro can be split in two, then each of the two new single currency areas can be further split at some point. A run on deposits from the weaker to the stronger countries becomes likely within each half-euro', eventually resulting in a total break-up. More fundamentally, if the euro were made reversible, so would the European Union. At the risk of sounding like a modern-day Cassandra, we believe that if the euro were to be broken up in part or in whole, so would eventually be the EU. The notion that if the euro were to break up Europe would simply move back 14 years in time is misguided, in our view. This argument is based on the crucial distinction between a free trade area (such as NAFTA) and a single market (the European Union). A free trade area is an intergovernmental agreement that is both partial and temporary. It is partial because in a free trade area free circulation is typically granted to goods, some services not necessarily banking services - and not necessarily labour or capital either. It is intergovernmental and temporary in the sense that the opening of borders may be revoked at any time by any of the contracting parties. By contrast, a single market such as the European Union is a supranational arrangement that is both universal and permanent. It is universal because it assumes unrestricted circulation of goods, services, capital and labour. It is supranational and permanent because it is established forever by Treaties that have precedence over national law. This distinction has considerable implications. A single market is therefore a political construct. Here is why: A single market does not assume solely the right to take part in the market but the means to protect that freedom across borders. By protecting the freedom of the market, we refer to the rules of competition, but also and primarily to the protection of property rights and the enforcement of contracts. In a word, the Rule of Law. Because the freedom to take part in the market is unrestricted in a single market, the protection of participants cannot be ensured by their national governments or courts, since those cannot close their borders to unfair or unlawful competition from across borders. Protecting the freedom of the market thus requires the existence of a judiciary that has jurisdiction over the whole market (i.e., a federal judiciary, incarnated in the European Union by the European Court of Justice). The existence of a judiciary supposes in turn that there exist a set of laws enforceable at the level of the market, hence the existence of a legislative power (in Europe, represented by a combination of the European Council and the European Parliament). And since a judiciary and legislative power are only meaningful to the extent that there exists an executive body able to enforce their decision, a true single market requires the existence of such a body (in Europe, a combination of the European Commission, and the Council again).

What we have done here in one paragraph is to demonstrate that a true single market requires the existence of the three branches of governments at the level of the market. Unlike a free trade area, it is not merely a commercial arrangement. It is a political construct. As is money. Without the euro, the single market would be unlikely to survive. It is in this context that we think a reversal of the euro would not be compatible with the survival over time of the European Union. Inconsistent quartet. Through the history of the European Union, Europeans have systematically associated fixed exchange rate policies with an integrated market place. They perceived exchange rate volatility to infringe on fair competition and therefore to be inconsistent with a single market. It can be argued that the first project of a single currency in Europe, the Werner plan of 1970, failed not only because Europe was not then an integrated market place, but also because exchange rate volatility was less of a concern before the demise of the Bretton Woods system. The euro itself resulted from the acceptance, following a demonstration by Tommaso Padoa-Schioppa in 1982, that Europe could not aim simultaneously at totally free trade, genuine capital mobility, fixed exchange rates and independent monetary policies. Since the first two were implied by the project of a single market and the third was deemed indissociable from those first two, then the fourth had to go. Enter the single monetary policy and the euro. Summarising the history of the creation of the euro in one paragraph may be abridging it too much, but we do not think it is oversimplifying it. The crucial point here is that Tommaso PadoaSchioppa's inconsistent quartet is as valid today as it was 30 years ago, as is the notion that fixed exchange rates and the single market go hand in hand. Should the euro become reversible, therefore, we think that support for the single market would quickly unravel too among the very policy-makers who created it, but also among the economic groups (business leaders, for one) who consistently supported it. And without the single market, there is no European Union. The economic and political cost of undoing decades of integration cannot be estimated with any degree of precision. We believe that it would be astronomical. Who can take the responsibility for a Greek exit? This paper was not intended as a forecast of things to come. It was intended as a demonstration ad absurdum. Our purpose was to demonstrate our belief that an exit of the euro by Greece would have cataclysmic consequences for the euro as a whole by changing the nature of money and undermining its fungibility across Europe. It would also have eventually catastrophic consequences for the European Union by undermining the consistency of its fabric. Along the way, it would in our view likely trigger a widespread bank run across the continent, which we are not convinced could be stopped because the ECB's stabilising power would be undermined if the nature of money were tampered with. Our rational conclusions ought to be that no responsible politician will take the decision to remove or expel Greece from the euro, and that the rest of Europe would rather continue to support its government and banks if need be - at a cost. Indeed, this is our conclusion. The next conclusion ought to be that so as to avoid a repeat of the threat to the existence of the European Union that the Greek crisis represented (and still represents), Europe will - however slowly - move towards the form of fiscal federalism that we have described in the past. This is also our conclusion. Very low risk (we think). Very high impact. We recognise, however, that these conclusions are subject to uncertainty. Our point here was therefore to warn investors that if the probability of the tail risk implied by a Greek exit from the euro might not be as low as we think, the impact of such an event would be much, much higher than most realise. Argentina The Orthodoxy Debate

February 22, 2012 By Daniel Volberg | New York

There is an intense debate whether Argentina is about to embark on a more orthodox path or whether more interventionist measures are most likely. The debate can be seen both within the newly re-elected administration and among Argentina watchers around the globe. Many Argentina watchers are focusing on new controls on imports as well as recent rhetoric suggesting that more heterodox measures could be coming to the energy sector. But while we expect headlines to remain a source of noise in coming months, we suspect that an important ongoing macro adjustment - especially a fiscal tightening and an effort to limit labor cost inflation - is likely to emerge as the hallmark of the administration. This doesn't mean that we don't recognize the increased risks posed by the intensification of controls, especially controls on imports. But we suspect that much of the recent jitters, especially related to political rhetoric over the energy sector, has been overdone. Intensifying Intervention Many Argentina watchers have been focusing increasingly on the plethora of new controls and other signals of intensifying heterodoxy from the administration. After all, since the administration's re-election at the end of October, the list of newly introduced controls and heterodox measures appears to be getting longer every month. Some new measures include new restrictions - introduced in late October, just days after the election - requiring pre-approval from the tax agency (AFIP) for foreign currency purchases; additional restrictions and information requirements for foreign currency purchases introduced by the central bank in December; higher capital requirements for financial institutions that raise the hurdle for dividend payments (including in foreign currency) introduced by the central bank in late January; and new requirements for advanced declaration and pre-approval by the tax agency (AFIP) and Internal Commerce Secretariat of all imports - better known as the new import controls - that came into force starting February 1. And if those measures were not enough, the press has reported statements from the administration regarding the takeover of the largest oil company in Argentina as well as a discussion of new controls on the payment of dividends. The import controls, in our view, may end up posing the biggest risk to the macro outlook and raise the risk of an economic hard landing. After all, Argentina's economic activity is very much integrated with global trade and reliant on a global supply chain. Indeed, capital goods, intermediate goods and fuel accounted for just over 81% of all imports last year, suggesting that a meaningful disruption to imports could translate into a significant disruption in economic growth. In addition, an intensification in import controls could lead to scarcity of goods and the consequent upside inflation risk. Thus, we suspect that the import controls regime requires careful monitoring as it raises risks to confidence (downside), activity (downside) and inflation (upside). Most of the new restrictions appear aimed at limiting capital outflows and shoring up Argentina's falling current account and trade surpluses. Recall that by December last year Argentina had lost in excess of $6 billion in international reserves due to a sharp bout of capital flight during the second half of 2011, while the trade surplus slipped from a record high $16.9 billion in 2009 to just $10.3 billion in 2011, the lowest since 2001. On the back of the slipping trade surplus, we expect the current account to fall to just 0.3% of GDP in 2011 from a surplus of 3.5% in 2009.

The deterioration in the trade and current accounts presents an important challenge for Argentina, which has relied on its current account surplus to help anchor domestic confidence, build reserves and help pay public sector external debt obligations without relying on financing from international capital markets. Indeed, the rapid appreciation of the real exchange rate (via inflation) and the rapid erosion of the trade and current account surpluses appear to have been the key drivers underlying the loss of confidence in the ability of the authorities to maintain the present currency regime without resorting to a large devaluation and the consequent sharp bout of capital flight late last year (see "Argentina: What's Next?" This Week in Latin America, August 29, 2011). The rise in energy imports appears to be an important element in the deterioration of the trade and current account surpluses. Last year Argentina became a net energy importer for the first time in decades when the energy trade balance fell to a deficit of -$3.25 billion from a surplus of $2.0 billion the previous year, a swing of more than $5 billion in just 12 months. Looking ahead, continued deterioration in just the energy trade balance at the current pace could turn Argentina's trade surplus into a deficit within two years and the current account surplus into a deficit within the next 12 months. The realization of the severity of this issue may be driving some of the recent rhetoric from the authorities regarding the need for more domestic energy production and the threats of takeover of Argentina's largest oil company. Is Interventionism Effective? While the rise in controls is undeniable, their effectiveness in addressing the issues at hand is more suspect. There are two elements to this discussion - the near-term effects of recently imposed controls and their medium-term viability as effective policy tools. Evidence from around the world suggests that capital and trade controls alone are unlikely to be effective medium-term tools to counteract current account deterioration on the back of a real exchange rate appreciation that is resulting in Argentina's loss of competitiveness and an energy policy that has failed to provide an adequate incentive for developing energy resources as authorities have maintained artificially low prices for too long. Indeed, were the authorities to rely purely on such measures, we would be arguing - as some Argentina watchers are already doing - that the economy would be heading for a hard landing within a year. While we suspect that there is little debate about the failure of relying exclusively on an intensification in controls in the medium term, there is a lively debate regarding their effectiveness in the near term. We suspect that even in the near term it has been despite the controls, rather than a reliance on them, that Argentina's policy-makers have been able to control the fallout from recent jitters. Take for example the loss of reserves late last year - the most important recent challenge to date for the authorities' ability to manage economic policy. Some have argued that it was the imposition of the controls that helped to stem a run on Argentina's currency and restore a modicum of stability. We disagree. In our view, it was the relaxation in controls and a move towards a more orthodox policy mix that helped to end the crisis of confidence that hit Argentina last year. Due to a rapidly appreciating real exchange rate and slipping external surpluses, there was a gradual erosion of confidence and a growing expectation of an abrupt devaluation. This resulted in steady capital outflows, forcing the authorities to defend their policy of managed floating of the exchange rate by selling on average $1.5 billion per month in international reserves in August-October. Then, immediately following the elections, the authorities announced a severe tightening in capital controls, validating expectations of an imminent devaluation. This resulted in reserve losses of $1.5 billion in the first two weeks of November - double the pace of reserve losses in the previous three months when Argentina saw a pick-up in capital outflows. That is when the authorities began relaxing the restrictions on foreign currency purchases, made a public commitment to gradual exchange rate moves (thus denying any intention of devaluing the currency) and announced their intent to begin a more orthodox macro adjustment that would include fiscal tightening (by cutting subsidies in the energy and public transportation sectors) and an effort to

limit labor cost inflation. It was the combination of these more orthodox measures and the fact that fundamentally Argentina's external balances are by no means stretched (with a trade and current account balances still in surplus), that - in our view - calmed the markets and allowed the authorities to begin rebuilding international reserves (see "Argentina: Balance of Payments Crunch?" This Week in Latin America, November 14, 2011). Ongoing Macro Adjustment The debate over the effectiveness of controls may help to determine the underlying drivers for the macro outlook and policy direction in Argentina in coming quarters, but so far we suspect that the main focus of policy remains the more orthodox macro adjustment. While controls have intensified, in our view the more relevant driver has been the more orthodox, threepoint macro adjustment of monetary tightening, fiscal tightening and an effort to limit labor cost inflation (see "Argentina: A Return of Orthodoxy?" This Week in Latin America, December 5, 2011). After all, in our view, it was a move towards more orthodox policies that ended last year's run on the peso and it is the macro adjustment that provides the most hope for policy-makers to engineer a soft landing and begin to address some of the structural challenges - such as loss of competitiveness on the back of an appreciating real exchange rate, eroding fiscal and current account surpluses and the distortions in the energy and public transportation sectors - that must be resolved in order to avoid a hard landing. We suspect that authorities will continue to make progress in their fiscal tightening efforts. While there have been few announcements of subsidy cuts or reductions, we suspect that so far the authorities have already taken measures that are the equivalent of roughly 0.6% of GDP in subsidy cuts. Among the measures are reductions or elimination of the electricity and gas subsidies to residential customers, a 127% increase in the subway fare to Ar$2.50 (from Ar$1.10), elimination of electricity and gas subsidies to a whole host of companies and the suspension of the Petroleo Plus and Refineria Plus subsidies to oil firms. Of these, the oil subsidy cuts may be the only ones that prove counter-productive in that they eliminate the incentive for oil exporters to continue investing and developing Argentina's energy resources. The good news is that they represent a minor change as they account for just 0.1% of GDP, and we suspect that they are likely to be resurrected in some fashion. Looking ahead, we suspect that the authorities may be scaling down somewhat their ambitions for fiscal tightening this year - from our expectation of near 2% of GDP in subsidy cuts to a revised outlook of 1-1.5% this year. However, the good news is that the plan remains for a multi-year adjustment that should help normalize Argentina's domestic energy prices while restoring a fiscal surplus. However, execution risk - especially regarding efforts to limit labor cost inflation - is critical to the outlook. The wage negotiations between organized labor and the private sector are now underway, with most unions asking for salary hikes of 28% or higher. With our estimates showing that inflation ended last year at roughly 22%, these kinds of wage increases pose the risk of accelerating inflation, limiting the effectiveness of the fiscal tightening. So far, all indications suggest that the authorities remain committed to a harder line with the unions and are unlikely to allow wage hikes above 25%, while initially guiding for 18-20% wage hikes. While we suspect that the authorities are likely to prove successful in this policy objective, we will continue to monitor wage negotiations as they unfold over the coming months. Bottom Line In the debate on whether Argentina has shifted towards a more orthodox adjustment or is moving the way of greater intervention, we remain in the more orthodox adjustment camp. While controls have intensified, in our view the more relevant driver has been the more orthodox

macro adjustment of monetary and fiscal tightening combined with an effort to limit wage hikes. After all, it is the macro adjustment that provides the most hope for policy-makers to engineer a soft landing and begin to address some of the structural challenges that must be resolved in order to avoid a hard landing. Global Global Inflation: Merry-Go-Round Spinning Again? February 17, 2012 By Spyros Andreopoulos | London The Great Monetary Easing (Part 2), is in full swing... In response to a slowing global economy and further downside risks emanating from the possibility of an escalating Eurozone debt crisis, central banks all over the world - and across the DM-EM divide - have been deploying their arsenal for a while now, and should continue to do so. The result is aggressive monetary easing on a global scale - what we have dubbed the Great Monetary Easing, Part 2 (GME2; see Sunday Start: What Next in the Global Economy, January 22, 2012); this follows on from GME1 in 200910. The GME2 is now in full swing. Last week, the Bank of England announced a further 50 billion of gilts purchases, to take place over the next three months. On Tuesday, the Bank of Japan upped the target of its Asset Purchase Program by 50%, from JPY 20 trillion to JPY 30 trillion, with the increment concentrated exclusively on JGB purchases. We think Sweden's Riksbank will pick up the baton from the Bank of Japan on Thursday and cut the repo rate by 25bp. ...reaching its crescendo in 2Q, when the heavyweights should re-join in the action. Fed: Nurturing the green shoots. In contrast to previous cases where monetary stimulus was reactive to a weakening in the economy, we think the Fed will embark on a further round of asset purchases despite the recent data improvement (see US Economics: Fed Thoughts for 2012: Into the Heart of Darkness, December 27, 2011). The aim is to "nurture the green shoots" support the (weak) recovery as it unfolds rather than allow it to flag again. ECB: Activating the circuit breaker. Liquidity provision, past and forthcoming (there is one more 3-year LTRO on February 29), has so far turned the vicious circle of a run on banks and peripheral sovereigns into a virtuous one. However, we are not convinced that liquidity provision will be enough to act as a circuit breaker; hence, we think that the ECB will have to embark on broad based asset purchases of private and public sector assets - but only after taking the refi rate to a new historical low of 0.50%. Out of a total of 33 central banks under our coverage, 16 have eased policy in various ways since 4Q11; 7 out of 10 DM central banks and 9 out of 23 EM central banks. Many of these central banks will ease further, on our forecasts, while the central banks of Poland, Korea, Malaysia and Mexico, which have not cut so far, will also join in (and the National Bank of Hungary will likely reverse its 100bp of hikes over the course of the year). Meanwhile, in the real economy... The data of late have generally been characterised by regional divergence. The US had a relatively good 4Q11 (growth was at the upper end of the 1-3% channel that our US colleagues have identified), while the euro area contracted over the same period. Chinese data still look consistent with a soft landing. More broadly, high-frequency activity indicators such as the various Purchasing Managers Indices are consistent with some pick-up in activity across the globe. That is, the global economy may, on the whole, be continuing on the recovery path after what might prove a mid-cycle slowdown. Benign base case inflation forecast but upside risks... What does all this mean for the global inflation outlook? Our current inflation forecasts give no cause for concern - we expect inflation to

remain benign due to past economic weakness and favourable base effects from the previous commodity price run-up. So what's the issue? First, the Fed's "nurture the green shoots" maxim implies that the FOMC will be putting the pedal to the metal for almost any reasonable data outturn over the coming months. Other central banks may respond in the same way and press on regardless - or feel compelled to do so due to action by the Fed and the other major G10 central banks. If the current data upside proves sustainable in the sense of representing a genuine cyclical improvement, central banks may end up easing into an already strengthening economy - generating cyclical inflation pressures further down the line. In EM, these would be added to structural pressures which, rather than having gone away, have merely been masked by the softening economy (see QE - What's Different This Time? February 8, 2012). Second, if - contrary to our expectations - global growth shifts up a gear, say because of a sustained and vigorous improvement in the US labour market or favourable developments on the Eurozone crisis front (which would bring us closer to our bull case for global growth of 4.2% for this year), the global central bank may again have administered too large a dose of monetary stimulus. Third, our inflation forecasts are based on the assumption that oil prices follow the futures curve. However, if QE does push up the price of oil and other commodities from here, our current forecasts will turn out to be too low. 2013 like 2011? The risks to inflation thus look skewed to the upside. Throw commodity prices into the mix - already meaningfully higher recently and the script becomes familiar - reminiscent of the inflation run-up that materialised between 3Q10 and 3Q11: DM easing, EM overheating, higher commodity prices, and all round rising inflation pressures. Our AXJ economist Chetan Ahya is already flagging upside risks to Asian inflation emanating from the forthcoming DM monetary easing (see Asia Pacific ex-Japan Macro Dashboard, February 13, 2012). Indeed, we think the entire global economy could be headed for yet another run-up in inflation - probably becoming visible late this year but unfolding mostly in 2013. The Merry-Go-Round is alive and well... That's because conditions remain in place for yet another loop on the Global Inflation Merry-Go-Round - a mechanism we highlighted early last year (see The Inflation Merry-Go-Round, January 26, 2011). 1. Super-expansionary monetary policy in the major developed economies, particularly the US, a) contributes to commodity inflation, and b) is imported by EM central banks through (US dollar) soft and hard pegs. 2. Price pressures rise in EM due to domestic overheating and higher commodity prices. Inflation is then re-exported to DM through more expensive goods exports. 3. More expensive imports from EM and dearer commodities raise inflation in DM. In turn, DM central banks initiate the next round by maintaining - or increasing - monetary accommodation if the economy remains weak (possibly due to the double-whammy imported cost shock). ...as long as EM sticks to its US dollar quasi-pegs. Note that EM currency policy is crucial for the Merry-Go-Round. If, and to the extent that, EM economies allow their currencies to appreciate against the dollar - most likely in order to shield themselves from higher commodity prices in dollar terms - then the Merry-Go-Round is weakened. EM then ceases to import the Fed's superexpansionary stance and thus avoids overheating while also mitigating the commodity price shock. The US - or indeed any economy embarking on expansionary monetary policy - will still suffer:

 a commodity price increase in domestic currency terms, as commodity producers are inclined to maintain the value of their exports in real terms, an increase in import prices as their currencies weaken against EM.

Conclusions. If the risks to the inflation outlook we sketch here materialise, it will likely have implications for the monetary policy outlook presented earlier. If inflation rises uncomfortably, some central banks - we think mainly in EM - will be forced back to the drawing board. Less easing and/or earlier tightening would likely be the consequence, as some central banks may attempt to get off the Merry-Go-Round. Stay tuned.