Risks to the Global Outlook: Insights from the Oxford Global Economic Model

rnewton-smith@oxfordeconomics.com

Rain Newton-Smith

October 2010

Co

rpo

rate

rec

ove

ry

Financial sector recovery

Outlook still highly uncertain

Co

rpo

rate

rec

ove

ry

Financial sector recovery

Outlook still highly uncertain

Oxford forecast■ Gradual rise in business confidence

encourages corporates to invest ■ But weak banks combined with excess

capacity limit scale of investment recovery

■ Consumer spending recovery limited by pace of job growth and fiscal retrenchment

■ But recovery strong enough that fiscal crisis remains contained

Co

rpo

rate

rec

ove

ry

Financial sector recovery

Outlook still highly uncertain

Renewed global boom■ Strong corporate liquidity feeds into new

investment boom■ Faster growth boosts business and

consumer confidence, and trade multiplier magnifies upturn

■ Bank balance sheets improve quickly and credit growth resumes

■ Strong growth boosts tax revenues/cuts social security payments, helping fiscal consolidation

Oxford forecast■ Gradual rise in business confidence

encourages corporates to invest ■ But weak banks combined with excess

capacity limit scale of investment recovery

■ Consumer spending recovery limited by pace of job growth and fiscal retrenchment

■ But recovery strong enough that fiscal crisis remains contained

Co

rpo

rate

rec

ove

ry

Sub-par recovery■ Business optimism remains low and

corporates continue to hoard cash■ Investment and job growth is modest as

capacity is underutilised■ Monetary policy supports banking sector

but fiscal coffers are empty■ Easier credit conditions mean benefits of

loose monetary policy feeds through to a stronger housing and consumer recovery

Financial sector recovery

Outlook still highly uncertain

Renewed global boom■ Strong corporate liquidity feeds into new

investment boom■ Faster growth boosts business and

consumer confidence, and trade multiplier magnifies upturn

■ Bank balance sheets improve quickly and credit growth resumes

■ Strong growth boosts tax revenues/cuts social security payments, helping fiscal consolidation

Oxford forecast■ Gradual rise in business confidence

encourages corporates to invest ■ But weak banks combined with excess

capacity limit scale of investment recovery

■ Consumer spending recovery limited by pace of job growth and fiscal retrenchment

■ But recovery strong enough that fiscal crisis remains contained

The Oxford Global Economic Model – Overview

The Oxford Global Economic Model is the most widely used commercial International Macro Model, with clients including international institutions, Ministries of Finance and central banks around the word, and a large number of blue-chip companies.

It provides a rigorous and consistent structure for forecasting and scenario analysis.

The Model covers 46 economies in detail, including many emerging markets, and provides headline forecasts for another 30 countries.

Forecasts 5, 10 and 25 years ahead are updated each month.

Oxford Economics’ powerful user-friendly software is very easy to use.

Oxford Economics provides telephone and e-mail support, and runs regular training workshops for clients.

Linkages between country models

Trade

Competitiveness

Interest rates and exchange rates

Equity markets

Oil & commodity prices

World price of manufactured goods

Capital flows

Extensions following the global financial crisis Despite the good performance of the Oxford Global Economic Model,

the global financial crisis did highlight areas for enhancements:

■ Interest rates – expanded coverage to include key corporate and consumer lending rates, as well as interbank rates and bond yields

■ Credit conditions – introducing levers to account for tightness/looseness of bank lending that are not reflected in interest rates. This analysis is based on research by Prof. John Muellbauer of Oxford University

■ Balance sheet coverage – expanded to cover financial and non-financial corporates as well as households and governments

■ Credit ratings – Reflecting the impact of sovereign debt ratings on interest rate spreads for government bonds

■ Feedback effects – from unemployment/insolvencies on credit conditions

Model extensions

Credit conditions

Interbank spreadsOfficial policy rates &

Government bond yields

Lending spreadsAvailability of

credit/other lending criteria

Lending rates

Household Corporate

Consumer spending

Housing investment/

prices

Business investment

GDP

Household wealth/ equities

Government finances

Corporates are key

200

250

300

350

400

450

500

550

600

650

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

Renewed boom

Sub-par recovery

Source: Oxford Economics

$2005 billions

US: Business investment

Scenarios for the global economy

2009 2010 2011 2012

Oxford Forecast (45%)US -2.6 2.7 2.6 3.5Eurozone -4.0 1.5 1.4 1.8China 9.1 9.7 9.0 9.2World -0.7 4.4 4.3 5.0

Renewed boom (20%)US -2.6 2.9 3.8 4.2Eurozone -4.0 1.7 2.5 2.9China 9.1 10.4 10.7 10.4World -0.7 4.7 5.6 6.0

Sub-par recovery (25%)US -2.6 2.5 1.9 2.2Eurozone -4.0 1.2 0.9 1.0China 9.1 8.8 7.2 7.5World -0.7 4.0 3.4 3.8

Alternative GDP growth forecasts

Co

rpo

rate

rec

ove

ry

Sub-par recovery■ Business optimism remains low and

corporates continue to hoard cash■ Investment and job growth is modest as

capacity is underutilised■ Monetary policy supports banking sector

but fiscal coffers are empty■ Easier credit conditions mean benefits of

loose monetary policy feeds through to a stronger housing and consumer recovery

Financial sector recovery

Outlook still highly uncertain

Renewed global boom■ Strong corporate liquidity feeds into new

investment boom■ Faster growth boosts business and

consumer confidence, and trade multiplier magnifies upturn

■ Bank balance sheets improve quickly and credit growth resumes

■ Strong growth boosts tax revenues/cuts social security payments, helping fiscal consolidation

Oxford forecast■ Gradual rise in business confidence

encourages corporates to invest ■ But weak banks combined with excess

capacity limit scale of investment recovery

■ Consumer spending recovery limited by pace of job growth and fiscal retrenchment

■ But recovery strong enough that fiscal crisis remains contained

Co

rpo

rate

rec

ove

ry

Renewed crisis■ Threat of double-dip means renewed

slump in asset prices as Eurozone sovereign debt crisis re-emerges

■ Pressure to cut budget deficits rapidly in all major economies

■ Rising unemployment and business failures feed back into banking

■ Limited scope for monetary policy offset

Sub-par recovery■ Business optimism remains low and

corporates continue to hoard cash■ Investment and job growth is modest as

capacity is underutilised■ Monetary policy supports banking sector

but fiscal coffers are empty■ Easier credit conditions mean benefits of

loose monetary policy feeds through to a stronger housing and consumer recovery

Financial sector recovery

Outlook still highly uncertain

Renewed global boom■ Strong corporate liquidity feeds into new

investment boom■ Faster growth boosts business and

consumer confidence, and trade multiplier magnifies upturn

■ Bank balance sheets improve quickly and credit growth resumes

■ Strong growth boosts tax revenues/cuts social security payments, helping fiscal consolidation

Oxford forecast■ Gradual rise in business confidence

encourages corporates to invest ■ But weak banks combined with excess

capacity limit scale of investment recovery

■ Consumer spending recovery limited by pace of job growth and fiscal retrenchment

■ But recovery strong enough that fiscal crisis remains contained

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

Eurozone sovereign debt crisis

-3 -2 -1 0 1 2 3 4 5 6 7 8

Germany

Finland

Austria

Netherlands

France

Italy

Belgium

Portugal

Spain

Ireland

Greece

20102011

Fiscal plans for 2010 and 2011

Change in cyclically adjusted budget balance % GDP

Source : IMF/Oxford Economics

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

Eurozone sovereign debt crisis

0.0

2.0

4.0

6.0

8.0

10.0

12.0

Jan-2008 Jul-2008 Jan-2009 Jul-2009 Jan-2010 Jul-2010

Greece Spain

Portugal Ireland

Italy

Eurozone: Credit spreads% spread of 10-year bonds over German bunds

Source : Oxford Economics/Haver Analytics

Eurozone sovereign debt crisis

0

50

100

150

200

250

300

350

400

2007 2008 2009 2010

Ireland

Portugal

Spain

Greece

Eurozone: ECB lending to 'periphery'€ billion

Source : Oxford Economics/Haver Analytics

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

‘North’ Eurozone’s trade exposure

0%

2%

4%

6%

8%

10%

South* China UK US

North*

Germany

Trade spillovers% total exports, 2007-09

Source : IMF, Oxford Economics

* North = Ger, Fra, Neth, Bel* South= Spa, Gre, Por & Ire

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

Eurozone sovereign debt crisis

The Eurozone sovereign debt crisis will have a significant impact on economic growth over several years, with this impact operating through a number of channels –

■ Fiscal cutbacks – higher taxes and lower government spending and investment will tend to depress economic growth

■ Higher interest rates/restricted credit – bond yields in the weaker Eurozone states have been driven up by higher default risk and in some cases liquidity squeezes have also taken place in the banking sectors of weaker states as foreign funds have fled. These developments have driven up borrowing costs and limited the availability of credit to the wider economy.

■ Wealth effects – higher interest rates, lower capital inflows and dwindling growth prospects have also created negative wealth effects on business and consumers.

■ Trade effects – weaker growth in the ‘peripheral’ Eurozone countries will hit the exports of the stronger ‘core’ countries.

■ Confidence effects – on households and companies, as well as markets.

Set against these negative effects, there are also potential positives such a lower interest rates in the ‘core’ countries due to a ‘flight to quality’ by investors and a lower euro which should benefit exports.

Eurozone sovereign debt crisis

0

1

2

3

4

5

6

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

%

Eurozone: Interest rates

Bunds (10-year yields)

Euribor(3-month rates)

90

100

110

120

130

140

150

Dec-05

Jul-06 Jan-07

Jul-07 Jan-08

Jul-08 Jan-09

Jul-09 Jan-10

Jul-10

Nominal effective rate

Dollar/€

Dec 30 2005=100

Eurozone: Exchange rates

£/€

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Peripheral Eurozone Sovereign Debt Crisis

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Bank funding costs and lending

rates rise

Local banks cut lending

Markets continue to fear default and sovereign spreads surge

Other banks lose confidence in peripheral EZ

banks

Peripheral Eurozone Sovereign Debt Crisis

0

1

2

3

4

5

6

7

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base EZ Peripheral Crisis

Source: Oxford Economics

%

Eurozone-Med*: Government bond yields

*Greece, Portugal, Spain & Italy0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base EZ Peripheral Crisis

Source: Oxford Economics

%

Germany: Government bond yields

Peripheral Eurozone Sovereign Debt Crisis

-6

-5

-4

-3

-2

-1

0

1

2

3

4

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

Source: Oxford Economics

% year

Eurozone-Med*: GDP

*Greece, Portugal, Spain & Italy

-6

-5

-4

-3

-2

-1

0

1

2

3

4

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

Source: Oxford Economics

% year

Eurozone: GDP

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Peripheral Eurozone Sovereign Debt Crisis

Growth in peripheral EZ hit hard, limited contagion

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Bank funding costs and lending

rates rise

Local banks cut lending

Markets continue to fear default and sovereign spreads surge

Other banks lose confidence in peripheral EZ

banks

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Peripheral Eurozone Sovereign Debt Crisis

Growth in peripheral EZ hit hard, limited contagion

European Banking Crisis

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Bank funding costs and lending

rates rise

Local banks cut lending

Markets continue to fear default and sovereign spreads surge

Other banks lose confidence in peripheral EZ

banks

European banks face large losses

Banks sell assets and euro plummets

Credit conditions tighten across

Europe

Interbank rates rise

European Banking Crisis

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

EU Banking Crisis

Source: Oxford Economics

%

Eurozone: Government bond yields

European Banking Crisis

0.0

1.0

2.0

3.0

4.0

5.0

6.0

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

EU Banking Crisis

Source: Oxford Economics

%

Eurozone: Interbank rates

European Banking Crisis

-6

-5

-4

-3

-2

-1

0

1

2

3

4

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

EU Banking Crisis

Source: Oxford Economics

% year

Eurozone: GDP

European Banking Crisis

-5

-4

-3

-2

-1

0

1

2

3

4

5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

EU Banking Crisis

Source: Oxford Economics

% year

US: GDP

European Banking Crisis

-3

-2

-1

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Base

EZ Peripheral Crisis

EU Banking Crisis

Source: Oxford Economics

% year

World: GDP

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Peripheral Eurozone Sovereign Debt Crisis

Growth in peripheral EZ hit hard, limited contagion

European Banking Crisis

Europe falls into recession and global growth slows

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Bank funding costs and lending

rates rise

Local banks cut lending

Markets continue to fear default and sovereign spreads surge

Other banks lose confidence in peripheral EZ

banks

European banks face large losses

Banks sell assets and euro plummets

Credit conditions tighten across

Europe

Interbank rates rise

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Peripheral Eurozone Sovereign Debt Crisis

Growth in peripheral EZ hit hard, limited contagion

Global Financial Crisis European Banking Crisis

Europe falls into recession and global growth slows

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Bank funding costs and lending

rates rise

Local banks cut lending

Markets continue to fear default and sovereign spreads surge

Other banks lose confidence in peripheral EZ

banks

European banks face large losses

Banks sell assets and euro plummets

Credit conditions tighten across

Europe

Interbank rates rise

Dramatic rise in financial market

stress

Global credit conditions

tighten

Asset prices fall further

Households and businesses

retrench sharply

Global Financial Crisis

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

%

Eurozone: Government bond yields

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

%

US: Government bond yields

Global Financial Crisis

-6

-5

-4

-3

-2

-1

0

1

2

3

4

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

% year

Eurozone: GDP

Global Financial Crisis

-6

-4

-2

0

2

4

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

% year

US: GDP

Global Financial Crisis

-3

-2

-1

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

% year

World: GDP

Scenarios on the sovereign debt crisis

Baseline

Eurozone muddles through

Peripheral Eurozone Sovereign Debt Crisis

Growth in peripheral EZ hit hard, limited contagion

Global Financial Crisis

All major economies slide into a deep recession

European Banking Crisis

Europe falls into recession and global growth slows

Government debt & deficits surge

in peripheral Eurozone

Rise in investor concerns about medium- term

creditworthiness

Rise in sovereign spreads

Fiscal consolidation & IMF/EU support

Bank funding costs and lending

rates rise

Local banks cut lending

Markets continue to fear default and sovereign spreads surge

Other banks lose confidence in peripheral EZ

banks

European banks face large losses

Banks sell assets and euro plummets

Credit conditions tighten across

Europe

Interbank rates rise

Dramatic rise in financial market

stress

Global credit conditions

tighten

Asset prices fall further

Households and businesses

retrench sharply

Eurozone debt crisis scenarios

2009 2010 2011 2012 2013

Oxford ForecastUS -2.6 2.7 2.6 3.5 3.8Eurozone -4.0 1.5 1.4 1.8 2.0China 9.1 9.7 9.0 9.2 8.8World -0.7 4.4 4.3 5.0 5.0

Peripheral Eurozone Sovereign Debt CrisisUS -2.6 2.7 2.5 3.6 3.9Eurozone -4.0 1.5 1.0 1.7 2.1China 9.1 9.7 8.9 9.2 9.0World -0.7 4.4 4.2 5.0 5.0

European Banking CrisisUS -2.6 2.6 1.7 2.9 3.9Eurozone -4.0 1.4 0.0 1.2 1.6China 9.1 9.7 7.9 8.6 9.4World -0.7 4.4 3.4 4.4 5.0

Global Financial CrisisUS -2.6 2.5 -0.9 0.0 3.4Eurozone -4.0 1.3 -1.2 -0.4 0.9China 9.1 9.6 5.4 5.8 9.5World -0.7 4.2 1.8 2.4 4.4

Alternative GDP growth forecasts

Policy response to Eurozone debt crisis

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

%

Eurozone: Refi rate

US rates in Eurozone debt crisis scenarios

0

1

2

3

4

5

6

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

BaseEZ Peripheral CrisisEU Banking CrisisGlobal financial crisis

Source: Oxford Economics

%

US: Fed Funds rate

Co

rpo

rate

rec

ove

ry

Renewed crisis (10%)■ Threat of double-dip means renewed

slump in asset prices as Eurozone sovereign debt crisis re-emerges

■ Pressure to cut budget deficits rapidly in all major economies

■ Rising unemployment and business failures feed back into banking

■ Limited scope for monetary policy offset

Sub-par recovery (25%)■ Business optimism remains low and

corporates continue to hoard cash■ Investment and job growth is modest as

capacity is underutilised■ Monetary policy supports banking sector

but fiscal coffers are empty■ Easier credit conditions mean benefits of

loose monetary policy feeds through to a stronger housing and consumer recovery

Financial sector recovery

Outlook still highly uncertain

Renewed global boom (20%)■ Strong corporate liquidity feeds into new

investment boom■ Faster growth boosts business and

consumer confidence, and trade multiplier magnifies upturn

■ Bank balance sheets improve quickly and credit growth resumes

■ Strong growth boosts tax revenues/cuts social security payments, helping fiscal consolidation

Oxford forecast (45%)■ Gradual rise in business confidence

encourages corporates to invest ■ But weak banks combined with excess

capacity limit scale of investment recovery

■ Consumer spending recovery limited by pace of job growth and fiscal retrenchment

■ But recovery strong enough that fiscal crisis remains contained

New Basel III rules

The new Basel III rules provide for tighter definitions of tier one capital, increased liquidity requirements for banks and ceilings on bank leverage.

■ Banks may only make up 15% of their tier one capital from ‘lower quality’ items such as deferred tax assets, stakes in related institutions and mortgage servicing rights

■ Liquidity – the rules propose the introduction of a ‘net stable funding ratio’ to reduce banks’ reliance on short-term funding and minimum liquidity levels specified based on a stress test involving a freezing of financial markets for a given period

■ Leverage – the minimum tier one capital/total assets ratio set at 3% (e.g. maximum leverage 33 times). Off balance sheet items and securitisations must also be included but banks can net out derivative positions

New Basel III rules

The Basel Committee also proposes to increase bank minimum capital requirements

■ Capital requirements for trading assets will roughly double by alteration of risk weightings.

■ Minimum requirement for common equity will rise from 2% of risk-weighted assets (RWA) to 4.5% by 2015. Minimum Tier 1 capital (which includes other qualifying instruments) to rise from 4% to 6%.

■ On top of this a ‘capital conservation buffer’ of a further 2.5% of RWA to be implemented by 2019 taking total common equity minimum to 7% and Tier 1 minimum to 8.5%

■ A countercyclical capital buffer of 0-2.5% made up of common equity also to be implemented for use as a macroprudential tool – this buffer to come into effect in periods of excess credit growth.

Modelling the impact of bank regulation

Credit conditions

Interbank spreadsOfficial policy rates &

Government bond yields

Lending spreadsAvailability of

credit/other lending criteria

Lending rates

Household Corporate

Consumer spending

Housing investment/

prices

Business investment

GDP

Household wealth/ equities

Government finances

Bank regulation

Capital requirement

s

Liquidity requirement

s

Bank levies

The costs of tighter bank regulation

The potential costs and benefits of new regulations for the global banking sector have been explored in a number of studies. Of critical importance is the impact of bank regulation on lending rates and estimate vary:

■ BIS: 1% rise in capital ratio raises loan spreads 13bp, new liquidity standards by 25bps.

■ The IIF claimed the Basel III rules outlined last December increase bank loan costs by 130 bp in the US.

■ University of Harvard & Chicago studies – even a 10% rise in capital ratios would only raise weighted cost of capital for banks by 25-35 basis points.

■ McKinsey estimates quite small rise in loan costs to the economy from the Basel III changes - mostly around10-20 basis points, up to 50-60 for short-term loans, covered bonds, illiquid securities.

There are also benefits from reducing the risk of banking crises

Interest rate impact

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

US EZ UK

Lending spreadsPolicy rates

Impact on interest rates of tighter regulation%

Source : Oxford Economics

GDP impact

-1.4 -1.2 -1 -0.8 -0.6 -0.4 -0.2 0

UK

EZ

US

With monetary policyresponse

Without monetary policyresponse

World: Effect of bank regulations% difference in GDP from base

Source : Oxford Economics

Concluding remarks on bank regulation

There is a wide variation in costs of regulation found by different studies reflecting significant differences in underlying assumptions and model design.

Some studies may over-estimate the impact. It is more expensive to fund assets with equity than debt or deposits, so initially this implies higher bank funding costs and loan rates. But –

■ Equity only accounts for around a fifth of the cost of a loan.

■ Lower bank riskiness from higher equity levels ought to reduce the cost of both debt and equity

■ Competitive pressures from the non-bank sector might limit the pass-through from bank funding costs to loan rates

■ The length of the transition matters – a rapid phase-in of new standards could see balance sheet shrinkage by banks, longer one allows banks to accumulate earnings and issue equity. Brookings Institute estimates US banks could raise most of the extra capital needed by retaining two years’ earnings

■ Banks might settle for a lower ROE than previously, reducing the need to pass on higher funding costs

■ Banks could cut administrative and other costs to increase profits

China: Growth slows but risks of a bust after the boom?

We expect China to grow strongly as consumption picks up the slack from weaker investment and the impact yuan appreciation, while authorities successfully manage price pressures

However, significant risks remain that could lead to a sharp downturn:

■ Excessive monetary tightening

■ Housing market bubble

■ A rise in non-performing loans following the credit boom

■ Contingent liabilities from lending to local government investment vehicles

China: Growth slows but risks of a bust after the boom?

We expect China to grow strongly as consumption picks up the slack from weaker investment and the impact yuan appreciation, while authorities successfully manage price pressures

However, significant risks remain that could lead to a sharp downturn:

■ Excessive monetary tightening

■ Housing market bubble

■ A rise in non-performing loans following the credit boom

■ Contingent liabilities from lending to local government investment vehicles

Government is reining in credit…

-4

-2

0

2

4

6

8

10

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0

5

10

15

20

25

30

35

40

45

China: Inflation and money supply% year

Source : CEIC

M2: +6 months(RHS)Inflation

(LHS)

% year

M1: +6 months(RHS)

…leading to slowing investment growth

0

10

20

30

40

50

60

1998 2000 2002 2004 2006 2008 2010

% year

Source: Oxford Economics

China: Total RMB loans and investment

RMB loans

Investment in fixed assets

China: Growth slows but risks of a bust after the boom?

We expect China to grow strongly as consumption picks up the slack from weaker investment and the impact yuan appreciation, while authorities successfully manage price pressures

However, significant risks remain that could lead to a sharp downturn:

■ Excessive monetary tightening

■ Housing market bubble

■ A rise in non-performing loans following the credit boom

■ Contingent liabilities from lending to local government investment vehicles

And slowing price inflation but is it heating up again?

-10

-5

0

5

10

15

20

25

Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10

China: House price inflation%

Source : CEIC

Annual rate

Monthly rate (annualised)

China: Growth slows but risks of a bust after the boom?

We expect China to grow strongly as consumption picks up the slack from weaker investment and the impact yuan appreciation, while authorities successfully manage price pressures

However, significant risks remain that could lead to a sharp downturn:

■ Excessive monetary tightening

■ Housing market bubble

■ Accumulation of non-performing loans following the credit boom

■ Contingent liabilities from lending to local government investment vehicles

Official NPLs are low but vulnerabilities may lurk beneath

0

2

4

6

8

10

12

14

2005 2006 2007 2008 2009 2010

0

400

800

1200

1600

2000

China: Non performing loans

Source: CEIC

RMB bn%

% of loans (LHS )

Value(RHS )

China: Growth slows but risks of a bust after the boom?

We expect China to grow strongly as consumption picks up the slack from weaker investment and the impact yuan appreciation, while authorities successfully manage price pressures

However, significant risks remain that could lead to a sharp downturn:

■ Excessive monetary tightening

■ Housing market bubble

■ A rise in non-performing loans following the credit boom

■ Contingent liabilities from lending to local government investment vehicles

China: A loan crisis triggered by housing collapse

Authorities bring forward monetary tightening and introduce further measures to slow over-heating in the housing market

This bursts the bubble in the property market which leads to a rise in non-performing loans in the banking sector

Central government lowers current spending on health and education and scales back investment

Investment and consumption growth is weaker

Imports decline sharply

Emerging market premia rise and stockmarkets in Asia are particularly affected, and global growth hit

China: A loan crisis triggered by housing collapse

Authorities bring forward monetary tightening and introduce further measures to slow over-heating in the housing market

This bursts the bubble in the property market which leads to a rise in non-performing loans in the banking sector

Central government lowers current spending on health and education and scales back investment

Investment and consumption growth is weaker

Imports decline sharply

Emerging market premia rise and stockmarkets in Asia are particularly affected, and global growth hit

Sharp fall in house prices in 2010 Q4 and 2011 Q1

-20

-15

-10

-5

0

5

10

15

2007 2008 2009 2010 2011 2012 2013 2014

China: House prices% year

Source : Oxford Economics

China loan crisis

Base

China: A loan crisis triggered by housing collapse

Authorities bring forward monetary tightening and introduce further measures to slow over-heating in the housing market

This bursts the bubble in the property market which leads to a rise in non-performing loans in the banking sector

Central government lowers current spending on health and education and scales back investment

Investment and consumption growth is weaker

Imports decline sharply

Emerging market premia rise and stockmarkets in Asia are particularly affected, and global growth hit

China: A loan crisis triggered by housing collapse

Authorities bring forward monetary tightening and introduce further measures to slow over-heating in the housing market

This bursts the bubble in the property market which leads to a rise in non-performing loans in the banking sector

Central government lowers current spending on health and education and scales back investment

Investment and consumption growth is weaker

Imports decline sharply

Emerging market premia rise and stockmarkets in Asia are particularly affected, and global growth hit

Contributes to credit crunch & weaker investment

-5

0

5

10

15

20

25

2007 2008 2009 2010 2011 2012 2013 2014

China: Investment growth% year

Source : Oxford Economics

China loan crisis

Base

And subdued consumption growth

0

2

4

6

8

10

12

14

16

2007 2008 2009 2010 2011 2012 2013 2014

China: Consumption growth% year

Source : Oxford Economics

China loan crisis

Base

China: A loan crisis triggered by housing collapse

Authorities bring forward monetary tightening and introduce further measures to slow over-heating in the housing market

This bursts the bubble in the property market which leads to a rise in non-performing loans in the banking sector

Central government lowers current spending on health and education and scales back investment

Investment and consumption growth is weaker

Imports decline sharply

Emerging market premia rise and stockmarkets in Asia are particularly affected, and global growth hit

Weaker domestic demand lowers import growth

-7

-6

-5

-4

-3

-2

-1

0

1

2007 2008 2009 2010 2011 2012 2013 2014

China: Import Volumes% difference from base

Source : Oxford Economics

China loan crisis

China: A loan crisis triggered by housing collapse

Authorities bring forward monetary tightening and introduce further measures to slow over-heating in the housing market

This bursts the bubble in the property market which leads to a rise in non-performing loans in the banking sector

Central government lowers current spending on health and education and scales back investment

Investment and consumption growth is weaker

Imports decline sharply

Emerging market premia rise and stockmarkets in Asia are particularly affected, and global growth hit

…pulling down growth in Asia…

0

2

4

6

8

10

12

2007 2008 2009 2010 2011 2012 2013 2014

Asia: GDP growth% oya

Source : Oxford Economics

China Loan crisis

Base

…and in the US

-5

-4

-3

-2

-1

0

1

2

3

4

5

2007 2008 2009 2010 2011 2012 2013 2014

US: GDP growth% oya

Source : Oxford Economics

China Loan Crisis

Base