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Editorial Europe’s resilience As 2016 begins, Europe’s economy is holding up fairly well in the face of a slowdown in emerging markets. Cheap money, credit and oil are providing it with support, while trade and capital flows are shifting in directions that are favourable for the single market. After working very hard to improve their fiscal and trade position, southern European countries continue to make up ground.

p.3

UNITED STATES Zero no more

EUROZONE Once more unto the breach!

GERMANY A mild winter

FRANCE 2016, the year unemployment finally levels off

ITALY A gradual recovery

SPAIN Dynamic economy, log-jammed politics

BRAZIL Downfall!

RUSSIA Low oil prices threaten fragile stabilisation

INDIA Public banks under scrutiny

CHINA The year starts off badly

JAPAN Slow but steady

IRELAND Wind in its sails

DETAILED FORECASTS

p.10 p.12 p.14

p.22 p.24 p.26

ECONOMIC RESEARCH DEPARTMENT

p.18 p.20

p.28

p.16

p.4 p.6 p.8

economic-research.bnpparibas.com Eco Perspectives 1st quarter 2016

The bank for a changing

world

Editorial Europe’s resilience As 2016 begins, Europe’s economy is holding up fairly well in the face of a slowdown in emerging markets. Cheap money, credit and oil are providing it with support, while trade and capital flows are shifting in directions that are favourable for the single market. After working very hard to improve their fiscal and trade position, southern European countries continue to make up ground.

Lower interest rates, weaker oil prices and depreciation in the euro were forces that combined throughout 2015 to underpin the recovery. Had it not been for them, France’s growth performance, though meagre (at barely over 1%), would no doubt have been only half as strong 1 . From a European perspective, the “planetary alignment” remains favourable as 2016 begins. With oil prices below USD 30 per barrel, households’ and businesses’ energy bill continues to decline. Borrowing costs are moving steadily lower, even in real terms. The single currency may have clawed back some of its losses, but at less than USD 1.10, it remains competitive in relation to its purchasing power parity (USD 1.30). All told, the business climate indices are holding up. Even though they came after the terrorist attacks that struck France so deeply, December’s sentiment surveys remained fairly optimistic in the euro zone. They improved in the manufacturing sector – a strange paradox considering that industry in China and the United States is stalling.

■ Swing of the pendulum Economic activity has obviously maintained some impetus, just as emerging markets – and global trade with them – have started slowing down. According to figures compiled by the Centraal Planbureau, developing countries cut their volume of purchases in 2015, a first since the Great Recession of 2009. The latest data available, for the period to October, does not really indicate a reversal of this trend. While European countries’ exports are nonetheless growing at a rate of 4% to 5% p.a., this is because they are trading more with each other. With global currents now less supportive, the European Union (EU) stands out given the strength of its internal trade (chart). It has also recorded more direct investments, especially in the form of the repatriation of profits, which soared to a record level in 2015.

The tide appears to be turning. Given the decline in the price of commodities and erosion in the profitability of investments in heavy industry and infrastructure, capital is returning to Europe. Globalisation, at least the kind that is constantly rolling back frontiers, has paused, which is not in itself exceptional. The phenomenon has always proceeded in waves and experienced cycles. The one now drawing to a close has in barely ten years turned China into one of the planet’s leading economic powers and seen commodity prices triple. The one beginning now will bring other transformations – in energy and transport owing to the urgent

1The fall in oil prices cut France’s bill for imported energy by EUR 18 bn in 2015 compared with 2014. The impact on growth derives from the marginal propensity of households and businesses to spend this amount. It would have been around 0.3 points of GDP in 2015. In its most recent Note de conjoncture (December 2015), Insee estimates the impact on economic activity of the combined fall in interest rates and the euro at 0.4 points.

need for action to stop climate change, in services with the digital revolution and the boom in the “sharing economy”, and in robotics and artificial intelligence owing to population ageing.

The stronger trade and financial flows in the single market are, at last, helping to make up for a demand shortfall. That applies primarily in the euro zone – one of the few places where activity has not yet reverted to its pre-crisis level. According to the OECD’s estimates, the GDP of the 19 euro-zone member countries lagged 2.7 points below its potential in 2015, with capacity in southern Europe still largely under-utilised. Italy, Spain and Portugal are now making up for lost time, and monetary policy is no longer the only factor spurring them on. In 2016, most of the governments will allow the “automatic stabilisers” to operate. In other words, they will refrain from stepping up their fiscal effort. This will coincide with the ramp-up in the so-called Junker investment plan for Europe, after a fairly timid start.

The European Union – a free-trade area unrivalled in size – and its 508 million consumers will remain as much as ever in 2016 the main engine powering its member countries’ economies. That should give pause for thought to those who dismiss it.

Jean-Luc Proutat jean-luc.proutat@bnpparibas.com

Internal momentum EU exports in volume terms (2013=100), seasonally-adjusted, smoothed)

Sources: Eurostat; Estimates: BNP Paribas Economic Research.

▬ Intra EU 28 ▬ Extra EU 28

60

80

100

120

140

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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United States Zero no more Growth was disappointing in 2015 as oil industry investment was scaled back due to low energy prices. In 2016, exports are likely to be the biggest damper on growth due to the strong dollar and slowing world trade. Although recession seems inevitable in the industrial sector, the rest of the US economy should benefit from the very factors squeezing manufacturing (low oil prices and the strong dollar). Consumer spending could surprise on the upside, buoyed by an unfalteringly dynamic job market. The Fed’s target of full employment has now been met, and it is likely to meet its price stability target in the medium term. The US economy no longer needs the exceptional support of zero interest rates, and the Fed has begun to normalise its monetary policy… At first glance, US growth was disappointing at only 2% in Q3 (annualised quarterly rate). Yet the breakdown from national accounts points to a dynamic performance, excluding the highly negative contributions of inventory changes and oil-extraction related investment. Weakened by the strong dollar and severe slowdowns by its main trading partners, exports will certainly place a more powerful damper on growth this year. The manufacturing sector is already feeling the first tremors. Other sectors, in contrast, which are more focused on the domestic market, are more resilient, bolstered by consumer spending, which is hard to imagine slumping with such a dynamic job market.

■ A unanimous decision: Yes, but… As the year 2015 ended, the Fed began normalising monetary policy with its decision to raise the key Fed funds target rate by 25 basis points. The Fed also announced technical instruments that it will use to steer the effective Fed funds rate within its new target range of 0.25% -0.50%1. As Fed Vice-Chair Stanley Fischer pointed out in early January, the first assessment is positive: the colossal amount of excess reserves did not prevent rates from effectively rising.

According to the minutes of this historical meeting – the first time the Fed has increased its key rates in nearly 10 years, after holding them just above zero for seven full years – it was a unanimous decision by all the voting members of the FOMC. Yet some members do not seem to be as certain as others, expressing fears that it is taking too long for inflation to accelerate.

In theory, the currently dynamic job market should fuel an upturn in wages and prices: the unemployment rate reached 5% in December, which is the estimated level of the NAIRU2. It is even more likely that prices will accelerate, as the impact of the drop-off in energy prices and the surging dollar winds down in the months ahead. Yet be warned: in the periods during and after the 2007-2009 recession, the models were never really able to explain pricing trends.

The FOMC members do not all share the same degree of certainty concerning their inflation forecasts. The vast majority (15-16 out of a total of 17) esteem that the degree of uncertainty is more or less “normal”, i.e. similar to that in the past. The nature of these risks – whether on the downside or upside – is balanced concerning

1 For more information on these instruments, see: Alexandra Estiot, “Up with the rate!!”, BNP Paribas Eco Flash, 16 December 2015. 2 Non-Accelerating Inflation Rate of Unemployment, a proxy for the equilibrium unemployment rate. The FOMC estimates referred to herein fluctuate between 4.7% and 5.8% with a median of 5%, which matches the estimates of the Congressional Budget Office.

economic activity and unemployment, but clearly on the downside when it comes to both headline and core inflation. Thirteen members deemed that the risks pertaining to their growth and unemployment forecasts were “balanced”, only 10 felt that way for headline inflation (and 9 for core inflation). As to the latter two, none of the members saw any upside risks: 7 foresaw downside risks for their headline inflation estimates and 8 for their core inflation estimates.

1- Summary of forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- The normalisation just begun %

▬ Fed Fund Target rate

Sources: Federal Reserve

Annual growth, % 2015 e 2016 e 2017 eGDP 2,3 1,7 1,9Priv ate consuption 3,0 2,3 2,0Business Inv estment 3,0 2,9 3,4Ex ports 1,0 1,0 3,0Consumer Price Index (CPI) 0,1 1,4 2,3CPI ex food and energy 1,8 2,1 2,1Unemploy ment rate 5,3 4,8 5,1Current account balance -2,6 -2,8 -3,2 Fed. Gov t. Budget Balance (% of GDP) -2,5 -2,4 -2,5 Gross Fed. Gov t. Debt (% GDP) 73,7 74,7 75,0

0

3

6

9

12

15

1965 1975 1985 1995 2005 2015

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This uncertainty alone justifies the caution the Fed intends to use during the interest rate tightening phase. Additional arguments are based mainly on the temporal lag separating monetary policy decisions from their full impact on the economy. There is also uncertainty concerning estimates of the equilibrium interest rate3.

■ Industrial recession As there should be, numerous voices criticise the Fed for acting too late or too early. There are also those who think the Fed’s reaction function is too muddled: they want the Fed to follow precise rules and not a discretionary policy. Others are worried about manufacturing trends. With regard to employment prospects and the outlook for inflation, the Fed’s decision seems as fully justified as possible, but if we look solely at the industrial sector, there are indeed room for doubt.

The ISM manufacturing index is indicating an industrial recession after two consecutive months below 50 points, the level that separates contraction from expansion. Details are hardly any more reassuring: of the five components, “delivery time” was the only one in positive territory. Although activity data are not all that bad, it is certainly only a matter of time. Manufacturing output is slowing and order books look weak. The only reassuring factor is the limited level of inventories relative to shipments. If the inventory adjustment were to continue4, it would only have a mild and short-lived impact on activity, thereby reducing the time that industry idles, and the risk of contagion to the rest of the economy.

The sharp divergence between the eurozone and the United States in late 2015, supports the idea that the slowdown in the US manufacturing sector is attributable to low oil prices and the strong dollar. Both are support factors for eurozone growth, but are having a negative impact on the US, which has become the world’s largest hydrocarbon producer in recent years. The strong dollar erodes the external competitiveness of American producers while boosting the competitiveness of their European counterparts. The durable goods sector has been hit hardest by the drop off in investment spending in the oil industry and by higher international exposure compared to other sectors. The durable goods industry is also hit by slowdowns observed in several big countries (Brazil, Canada and China).

Though not very encouraging, these manufacturing trends must be kept in perspective. The sector only accounts for 12% of US value added, and less than 9% of payroll employment. Even so, its economic clout is effectively much bigger than these figures suggest. Manufacturing accounts for a much bigger share of investment spending, estimated at between 20% and 25% 5 . Similarly, the impressive productivity gains reported by the sector in recent decades (which have averaged 5.5% since 1990) illustrate the non-negligible outsourcing of certain functions. Consequently, the impact of a slowdown in manufacturing is spread out over all of these suppliers and sub-contractors.

3 See Alexandra Estiot, “The Queen’s speech”, BNP Paribas Eco Perspectives, Fourth Quarter 2015. 4 Stock building has already slowed in recent months and inventory change has had a negative impact on growth of 0.7 points (annualised quarterly rate) 5 In foreign trade, the weight of manufacturing goods is estimated at about 60%.

In the past, the overall economy rarely managed to grow while the industrial sector was experiencing a recession. Still, the socks of the past were very different from today’s: oil shock (with prices skyrocketing, not plunging) or too tight a monetary policy.

In fact, in the non-manufacturing sector, business is still going strong, as illustrated by an ISM reading of 55.3 in December, with particularly strong showings for the “production” and “new orders” components (58.7 and 58.2, respectively). Indeed, sector activity does not face the same headwinds: services are relatively sheltered from dollar trends and profitability is buoyed by low prices for commodities and other imported inputs.

■ May the force be with them As always, US growth prospects still depend on the outlook for consumer spending. Clearly, the strong dollar and low oil prices will support household purchasing power, at least in the short term. Since summer 2014 – when the dollar bottomed out and oil prices peaked – American households have not spent all of their purchasing power gains, as illustrated by the roughly 1-point increase in the savings rate. This period was also marked by relative sluggish wage growth, which may have fuelled precautionary savings. Assuming that the unemployment rate is near or below the natural unemployment rate, which would naturally fuel an acceleration in wage inflation, US households should enjoy major purchasing power gains which they are more likely to spend rather than to save. This, in any case, is what the Fed is counting on.

Alexandra Estiot alexandra.estiot@bnpparibas.com

3- Sectorial divergences Purchasing Managers Indices

▬ Manufacturing — Non-manufacturing

Source : ISM

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Eurozone Once more unto the breach! Because the European recovery is partly delayed from that of the other major economic zones, growth in the eurozone remains sluggish. The slowdown in external trade is an obstacle to any marked acceleration in business activity, but it is partly compensated for by the weakness of the euro, while the latest fall in oil prices is boosting households’ purchasing power and companies’ margins. The recovery continues, but on its own it is too slow to have a decisive impact on inflation. The European Central Bank therefore decided to step up its support in December and could do so again in future if the need is confirmed.

2015 finally kept its promise and proved to be a year of recovery for the eurozone. Although, after a strong start last winter (+0.5% q/q in Q1 2015), quarterly GDP growth remained moderate, the rebound in activity proved to be resilient and durable and, on a y/y basis, GDP growth remained well above 1% throughout the year, its highest level for more than three years. The impact of this recent recovery is modest but palpable: according to the latest available data, in 2015 the economies of the eurozone created more than 1.3 million jobs (at end-September), the unemployment rate fell by around 1pp of the active population (10.5% in November), and the fiscal deficit fell by just over half a point of GDP (to 2.0%), as did government debt (to 91.2%).

■ Under its own steam We expect these trends to continue this year, with GDP growth remaining at 1.6%, after 1.5% in 2015. With no change in sight, this forecast raises several questions, starting with the lack of acceleration: if the economy is indeed in a recovery phase, why shouldn’t growth accelerate in 2016? One reason is that the external economic environment is set to remain mildly favourable for the eurozone, while activity levels have probably peaked in the United States, and the difficulties affecting several large emerging economies look likely to continue. Despite support from the weak euro in terms of price competitiveness, extra-euro area exports have been sluggish since mid-2015. At the end of October, they even showed y/y growth of zero in value terms. Internal demand, particularly household consumption, is likely to remain the main driver of European growth in 2016, at least to the extent it was in 2015, including of course via the trade it generates between eurozone members (see editorial, p. 3).

Several factors are contributing to this. The first is obviously the recovery in the employment market virtually everywhere in Europe. As highlighted by a recent ECB study, European households’ income has been underpinned in recent quarters by dynamic job creation in the countries where employment was worst affected by the crisis (salaried employment was up by 2.0% to 2.5% a year in mid-2015 in Spain, Portugal and Ireland), as well as by a fairly strong increase in per-capita remuneration in some countries that are close to full employment, such as Germany (+2.5% in the same period). In addition to these “structural” factors, there is of course the weakness of oil prices, which released significant purchasing power among European households in 2015. Just a few months ago, the prospect of a stabilisation and then a recovery, albeit gradual, in oil prices regularly led us to predict that private consumption would probably lose one of its supports in 2016. Given the current

downturn in oil prices and our new inflation forecasts (see below), the assessment is now more favourable.

Activity levels in 2016 should also benefit from looser fiscal policies, which are likely to be neutral or even slightly expansionary in several major eurozone countries, mostly as a result of cuts to taxes and social security contributions, or refugee-related spending. As regards internal demand, the main uncertainty is the future development of investment trends. With the demand outlook strengthening, companies could step up their capex, given favourable financing conditions. The expected recovery in housing investment by households in some countries could also mean that

1- Summary of forecasts

e: BNP Paribas estimates and forecasts 2- Growth GDP growth, % ▌GDP (quarterly annualised rate, %, l.h.s.) ; ▬ PMI composite

Sources: Eurostat, BNP Paribas forecasts

Annual growth, % 2015 e 2016 e 2017 eGDP 1.5 1.6 1.8Priv ate consuption 1.7 1.5 1.5Gross Fix ed Capital Formation 2.3 2.5 3.1Ex ports 4.8 3.7 4.7Consumer Price Index (CPI) 0.0 0.5 1.5CPI ex food and energy 0.8 0.9 1.1Unemploy ment rate 11.0 10.4 10.0Current account balance 3.1 2.8 2.6Gen. Gov t. Balance (% of GDP) -2.0 -1.8 -1.3 Public Debt (% GDP) 91.2 90.2 88.5

35

40

45

50

55

60

-8%

-6%

-4%

-2%

0%

2%

4%

2009 2010 2011 2012 2013 2014 2015 2016

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investment will play a greater role in the composition of growth in 2016.

■ Inflation again weaker than expected After dipping to -0.6% a year ago in January 2015, inflation has generally been in positive territory since March, though without managing to rise significantly above zero. At 0.2% in December, it was once again at the lower end of expectations. On one hand, the renewed onset of weakness in oil prices has substantially reduced the recovery in the energy component of inflation, long expected in late 2015 / early 2016 1 . On the other, and more importantly, underlying inflation lacks vim, given that at 0.9% it is virtually unchanged since last May.

Indeed, although demand is slightly more resilient, companies are feeling little pressure on costs. In most member states, still high unemployment levels and continued efforts to boost competitiveness are significantly limiting wage pressures (except in Germany), while the fall in energy prices is reducing production costs. Little by little, the recovery in business activity, the absorption of excess production capacity and the strength of household demand, particularly in the service sectors, are likely to lead to somewhat stronger growth in consumer prices. Nevertheless, at this stage, the trend is too slow for comfort.

Tension in the Middle East and within OPEC on the supply side, and the extent of the uncertainty over Chinese growth on the demand side make the precise forecasting of oil prices even harder than usual for the months to come. While it is acknowledged that they look set to remain “low” in the next few months, it is difficult to say when and at what level the current decline might end and a process of stabilisation set in. At this stage, we have once again revised our inflation forecasts downwards, to 0.5% for 2016 (vs 1% forecast last October).

■ ECB: still calling the shots, as usual Even before this trend had gained momentum, the European Central Bank decided in early December to step up its support for the economy, by once again cutting the deposit facility rate by 10 basis points to -0.3%, and by extending the minimum duration of its quantitative easing programme by six months to March 2017. At the current rate of purchases (60 billion euros a month) this extension will boost the size of the programme by 360 billion euros. In addition, the ECB has committed to reinvesting the principal component of the securities, which will start to mature as from that date, thereby stabilising the volume of securities it will hold.

1 This recovery is automatic, given that the sharp oil price decline in late 2014 / early 2015 is gradually exiting from the y/y comparison of prices measured by the rate of inflation – the familiar “base effect”.

While it had already disappointed expectations in December by declining to increase the volume of securities purchased each month, could the ECB be moved to step up its intervention once again in response to the further deterioration in the inflation outlook? In the short term, it is more likely to point out that its objective is to evaluate the medium-term outlook for inflation, looking beyond the volatility caused by fluctuating energy prices. It will also emphasise that its policies are already having an effect on the cost and flow of credit to companies and households and that this effect should gain further momentum in the coming months. Moreover, the growing divergence between its policy and the approach being adopted in the United States should continue to exert downward pressure on the euro exchange rate.

In a context where inflation is already too low, the issue is to assess at what point this renewed energy price weakness risks having an indirect effect on the outlook for a recovery in underlying inflation. The ECB, which is to publish an update on its growth and inflation projections in March, and has already announced that it will review the “parameters” of its QE programme in the spring, is likely to emphasise that it stands ready to provide stronger support, if needed. Frédérique Cerisier frederique.cerisier@bnpparibas.com

3- Inflation outlook too weak Year-on-year, %

▬ Headline inflation — Underlying inflation (excl. energy, food & tobacco)

Source: ECB

-1

0

1

2

3

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5

2008 2009 2010 2011 2012 2013 2014 2015

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Germany A mild winter According to Destatis first annual estimate, GDP grew by 1.5% in 2015, from 1.6% in 2014, putting it slightly above German potential which is estimated at 1.25%. In 2016, the rebalancing of growth drivers towards internal demand looks set to continue, boosted by the labour market and purchasing power thanks to wage growth and low inflation. Meanwhile, the rapid integration of refugees of working age into the labour market will be the major challenge for this year, and represents a real opportunity to reverse the ageing of the population. Lastly, the good health of the public finances will help fund the integration of this new workforce and support economic activity. The latest available data confirmed that growth did not accelerate in the fourth quarter, having risen 0.3% q/q in Q3. In November, industrial production shrank slightly (dropping 0.3% m/m after gaining 0.5% in October) in line with manufacturing output, which represents 60% of the total (-0.8% from +0.6% in October). Thus industrial production growth carried over in the fourth quarter was negative (-0.7% q/q, from -0.2% in Q3 2015). This give a first, and fairly rough, estimate of GDP growth in Q4 (the first official estimate will be published on 12 February). In the past, a fall in the industrial sector on this scale has come alongside a virtual stagnation in GDP. However, the sharp rise in manufacturing orders in October (1.7% m/m) and November (1.5% m/m) suggest that industrial production may have bounced back in December. In addition, domestic orders were the main source of this rise, with an increase of 2.6% m/m following the 1.4% rise in October. This highlights the strength of internal demand, the components of which will be released along with Q4 second GDP estimate at the end of February.

■ No surprise as the year ended A number of trends that had already emerged in previous months were confirmed in the fourth quarter. Private consumption grew strongly in 2015 (around 2% y/y in real terms in the third quarter, the highest for nearly fifteen years). This was supported by particularly favourable conditions in the labour market, and gains in purchasing power due to the fall in oil prices and the introduction of a minimum wage on 1 January 2015 (see below). Nominal wages grew by 2.3% y/y over the first ten months of the year. In the fourth quarter consumer confidence surveys remained positive, and private consumption looks set to continue to support growth in 2016. Public sector consumption is also likely to have grown in Q4 and will also help support growth in 2016, thanks to the financing of the policy to integrate refugees. Having welcomed more than a million migrants in 2015, Germany is likely to take a further 600,000 this year, according to the country’s economic forecasting organisations. However, the slower growth in emerging economies, with China at the top of the list with a 9% fall in exports between May and October 2015, is likely to continue to hit international trade in 2016. Against this background, private sector investment will struggle to recover, despite a number of favourable factors (high capacity utilisation rates, full(ish) order books and historically low interest rates). An Ifo survey at the end of 2015 showed that manufacturing companies plan to increase investment by 7% in 2016, while they reported capacity utilisation rates of 84.4% in Q4. Nonetheless this optimism needs to be qualified: the 2014 survey showed a similar optimism but in the end investment was up by just 4% in 2015. Lastly, construction investment is likely to see a small increase, despite

positive interest rate conditions and the strong growth in the residential sector (+1.6% y/y over the first nine months of the year). Monthly surveys remained particularly positive at the end of the year, despite the slowdown in emerging markets. The December Ifo index remained virtually unchanged on its November level, when it reached its highest point since June 2014. Ifo’s President stated in his report that “the economic situation could hardly be better”. At 53.2 in December, the Manufacturing PMI index reached its highest level since April 2014. In addition in services, the activity index remained close to the 4-year high reached in November, reflecting the strength of private consumption. A slew of positive factors (lower

1- Summary of forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2 - GDP Growth and industrial production In %

█ GDP growth (q/q, lhs) ▬ growth in industrial production (q/q, rhs)

Source: Destatis

Annual growth, % 2015 e 2016 e 2017 eGDP 1.5 1.6 2.0Priv ate consuption 1.9 1.5 1.5Gross Fix ed Capital Formation 1.6 2.5 3.0Ex ports 5.1 4.6 5.7Consumer Price Index (CPI) 0.1 0.6 1.7CPI ex food and energy 1.1 1.4 1.4Unemploy ment rate 6.4 6.3 6.0Current account balance 8.1 8.3 8.4Gen. Gov t. Balance (% of GDP) 0.9 0.5 0.7Public Debt (% GDP) 71.5 68.8 65.8

-3-2-10123456

-1

0

1

2

2009 2011 2013 2015

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fuel bills, rising wages, fiscal easing) are supporting the rebalancing of sources of growth and this is likely to continue in 2016. Whilst not accelerating, German growth was roughly unchanged at 1.5% in 2015.

■ The minimum wage: a year on One year after the introduction of a minimum wage of EUR 8.50 per hour, the report is fairly positive. The fears expressed by some have not been borne out, as the strength of the labour market has not been damaged. Over the first ten months of 2015 nearly 350,000 jobs were created (+0.9% y/y), with particularly strong growth in business services (+2.4% y/y in Q3, the most recent figures available), construction (2.2%) and public services (1.3%). The introduction of the minimum wage on 1 January 2015 led to a fall in the number of ‘mini job’ contracts, paying EUR 450 per month. For the most part these were transformed into traditional part-time contracts, particularly in the catering sector – one of the stated aims of the reform. Conversely some sectors in the eastern regions, such as temporary work, as well as agriculture across the country, have opted to smooth the introduction of the minimum wage over two years, as they have until 1 January 2017 to come into line with the new regulations. At 6.3% the unemployment rate reached its lowest level since reunification in November 2015.

In 2016, the integration of refugees into the labour market will be the major challenge. On this point, employers’ organisations and the Council of Economic Experts (the ‘Five Wise Men’) have argued that new arrivals should benefit from the same conditions as the long-term unemployed in Germany for a period of 12 rather than 6 months. This would mean that they could be paid at below the minimum wage during this 12-month period. Furthermore, the commission which sets the minimum wage will meet in mid-2016. The Five Wise Men are firmly opposed to any increase of the minimum wage as of 1 January 2017, believing that such a move would create an additional barrier to the rapid integration of refugee labour. Political factors are also important in this area, especially as there will be five regional elections (Rhineland-Palatinate, Baden-Württemberg, Mecklenburg-West Pomerania, Berlin and Saxony-Anhalt) from March until September, followed by general elections in 2017. Angela Merkel’s popularity has fallen sharply in recent months, and her management of the refugee crisis has been criticised even by some in her own party. The CDU leads the coalition government in Saxony-Anhalt and is a coalition partner in Mecklenburg and Berlin. If it were to lose one of these three elections, Mrs Merkel’s position would be weakened and she could face challenges to her re-election as the head of the party in 2017.

■ 2016 budget Although the 2015 budget was expected to balance, the government could in fact show a surplus for the second year running, at around 1% of GDP. This would follow the 0.3% surplus in 2014 and seven years of deficit from 2007 to 2013. Despite optimistic growth forecasts (1.7% in 2015), better than expected tax revenue (mainly from income and wealth taxes) and lower spending (unemployment and other welfare benefits) are the reason for the difference between the 2015 budget and the actual out-turn. Finance Minister Wolfgang Schäuble also expects his 2016 budget to balance, which, given forecast growth of 1.8%, assumes that fiscal policy will be eased by the equivalent of 0.75% of GDP. Some spending has already been planned, such as increased public investment in transport, energy and climate protection (EUR 10 billion over three years) together with increases in certain family benefits and cuts in income tax (costing a total of EUR 5 billion). In addition, EUR 8 billion has been earmarked for welcoming refugees in 2016, but some suggest that twice this amount could be needed. The European Commission arrives at more or less the same conclusions. It puts the cost of refugee arrivals at 0.25 point of GDP in 2016, from 0.1 point in 2015, and expects a smaller negative effect on the public finances. The Commission believes that the budget surplus will still be 0.5% of GDP in 2016. In such circumstances, total debt will fall to less than 69% of GDP in 2016, from more than 71% in 2015, and is likely to continue its rapid fall, taking it below the 60% mark by 2020. Caroline Newhouse caroline.newhouse@bnpparibas.com

3- Nominal wages ▬ All sectors (%, 3 month moving average y/y)

Source: Destatis

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France 2016, the year unemployment finally levels off France is the only major eurozone country in which the unemployment rate continues to rise. In Q3 2015, it rose to 10.6% of the active population, up from 9.1% in early 2011 and 7.1% in early 2008, the previous low. Although this is nowhere near the spectacular increases that plagued Italy and, even more, Spain during the crisis years, the trend is nonetheless alarmingly persistent. With 2016 GDP growth estimated at 1.4%, we are unlikely to see an inversion of the unemployment rate curve, but the jobless rate could finally level off this year. The French economy should generate enough jobs to offset the increase in the active population, but hardly more. Several years of sluggish growth – due first to the financial crisis and then to the eurozone debt crisis – triggered a significant upturn in unemployment in France. Unlike Italy and Spain, however, which experienced major net job destructions, French employment remained broadly stable (see chart). After a decline in 2009, French employment recovered gradually, but only modestly, essentially thanks to subsidised contracts in the non-market sector (see below). In Q3 2015, employment barely surpassed the early 2008 level. Net job creations failed to absorb the new arrivals to the job market. Between January 2008 and November 2015, Pole Emploi, the French employment agency, reported a 1.6 million increase in the number of Category A jobseekers (i.e. those with no work for the past month) to 3.6 million.

An analysis of Pole Emploi unemployment registrations since 2010 shows certain stability in the inflow of jobseekers due to redundancies. In contrast, the number of mutually-agreed contractual terminations of permanent job contracts (ruptures conventionnelles) seems to have soared 1 . To a lesser extent, reversals of activity have also contributed to the upturn in the number of jobseekers. In the first 11 months of 2015, 28.5% of new jobless applicants with Pole Emploi were due to the expiration of temporary contracts (fixed term and interim), while 16.5% were due to mutually-agreed contractual terminations and 10.5% to redundancies. Activity reversal accounted for 8.5% of new registrations for jobless benefits.

The reasons for leaving the Pole Emploi’s unemployment list are harder to interpret. Apparently, the number who said they had returned to work trended downwards between 2010 and 2014, but this trend may have been exaggerated. Some jobseekers who find work again fail to report the new job to Pole Emploi, and are removed from the unemployment list because their situation was not updated. Since Q1 2015, the number returning to work has been increasing again, notably in the business sector, although this movement has not been strong enough to prevent the number of jobseekers from rising.

According to INSEE statistics, employment is fairly dynamic for temporary job contracts. This is the category that was hit hardest by the crisis, and today it is the one providing most of the job growth, which makes the improvement all the more precarious.

1 Contractual termination of permanent job contracts are not measured explicitly but counted as “other”. Yet the strong rise in the “other” category since 2009/2010 coincides with the introduction of contractual terminations of job contracts in mid-2008. Since the “other” category was extremely stable between 2000 and 2008, we can assume that the big increase since 2009 is essentially due to these ruptures conventionnelles.

■ Inversion of the unemployment curve?

In 2016, we are more likely to see a levelling off of the jobless rate rather than an inversion of the unemployment curve. With growth estimated at 1.4%, the French economy should generate enough jobs to keep pace with the increase in the active population, but not much more. The upturn in economic growth, which rose from 0.1% year-on-year in Q4 2014 to 1.1% in Q3 2015, has already helped slow the rise in unemployment. The monthly increase in the number of category A jobseekers slipped from an average of 0.6% in H2

1- Summary of forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Employment Q1 2008=100

▬ France ▬ Italy - - - Spain

Source: Eurostat

Annual growth, % 2015 e 2016 e 2017 eGDP 1.1 1.4 1.6Priv ate consuption 1.4 1.4 1.7Gross Fix ed Capital Formation -0.3 1.5 2.7Ex ports 5.8 3.2 4.1Consumer Price Index (HCPI) 0.1 0.6 1.3CPI ex food and energy 0.6 0.6 1.0Unemploy ment rate 10.5 10.4 10.1Current account balance 0.1 -0.3 -0.9 Gen. Gov t. Balance (% of GDP) -3.8 -3.4 -3.0 Public Debt (% GDP) 97.0 98.0 97.7

80

85

90

95

100

105

2008 2009 2010 2011 2012 2013 2014 2015

economic-research.bnpparibas.com France 1st quarter 2016 10

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2014 to 0.3% in H1 2015 and to 0.1% between June and November 2015.

Historically, France’s unemployment rate has been stable when GDP growth is about 1.5%. Yet this empirical relationship is not written in stone. Certain factors suggest that things could be different this time round. Various measures like the competitiveness and employment tax credit (CICE) and the Responsibility Pact, which the government introduced to reduce the cost of labour, could foster more job-rich growth. Similarly, government subsidised job contracts, including hiring subsidies and the exoneration of some social welfare contributions, should help lower the level of growth needed to stabilise unemployment. The rebound in construction, a very job-intensive sector, should also work along the same lines.

Yet there are also several headwinds. Labour productivity in the business sector is low for this phase in the cycle, which suggests there is still major underemployed production capacity. Some companies could decide to increase the efficiency of their production process before increasing staff. The low confidence of economic players and the downside risks to growth prospects (particularly the sharp slowdown in the emerging countries) could put a damper on hiring. Lastly, a cyclical rebound could be accompanied by an increase in the participation rate (some inactive might decide to begin searching for work again), reducing the moderating effect on the jobless rate.

On the whole, although the unemployment rate is expected to ease slightly in H2, we will probably have to wait until 2017 before seeing a veritable inversion of the unemployment curve. Even so, we expect the year that begins to mark a turning point for the business sector. The resilience of the French job market during the crisis years was essentially due to the non-market sector through subsidised contracts. This probably helps explain the slowdown in productivity. Without this sector, employment would have contracted by 1% between 2011 and 2014. After a timid turnaround in 2015, employment in the business sector is expected to accelerate this year.

■ High structural unemployment

The upturn in unemployment since 2008 is mainly cyclical, due to sub-par growth. Assuming the French economy had experienced growth in line with the trends of the early 2000s, today it would boast 1.5 million more jobs. All other factors being the same, the unemployment rate would be closer to 5.5%. Yet the jobs deficit is not that easy to measure. First, nothing says that the growth rates of 2000-2007 could have been sustained over such a long period of time, even in the absence of a crisis. Indeed, the structural fiscal deficits accumulated during the years of strong growth (which averaged 2% a year) suggest the opposite. Since the mid-1980s, the unemployment rate in France has very rarely dropped below 8%, even as the economy has churned through all phases of the cycle. The level of unemployment is above all a structural problem, a characteristic that could have been accentuated by the crisis with the potential negative impact on

human capital adding to the existing malfunctioning of the job market. As the average duration of unemployment rises, the employability of jobseekers tends to decline, especially since long-term unemployment hit seniors and low skilled workers first. The risk is that they lose touch with the job market or that returning to work becomes increasingly precarious. One of the main reasons for France’s high level of structural unemployment is the duality of the job market, which is divided between insiders (employees with permanent, full-time job contracts) and outsiders (employees with fixed term or temporary job contracts), who provide most of the job market flexibility. The large inflows and outflows from unemployment lists are not a sign of job market mobility, but quite the opposite. They signal a closed system in which workers with temporary contracts alternate between periods of employment and unemployment, without ever managing to get a lasting foothold in the job market.

Beyond its mechanical downward effect on jobseeker numbers, the government’s recent initiative to retrain the long-term unemployed is thus welcome news. By targeting 500,000 people in 2016, the training system concerns about a third of jobseekers out of work for more than a year. Yet, experience suggests that hiring subsidies in the business sectors are often more efficient than training to fight long term unemployment. As to the labour reform law, which parliament is expected to vote this year, it should be based on the recommendations of the Combrexelle report, which calls for collective bargaining to play a greater role in the establishment of labour standards, especially concerning working hours and wages. For the reform to succeed, an improvement in the quality of the social dialogue is needed though. This requires an appropriation by management and labour representatives of the new rules of the game. Thibault Mercier thibault.mercier@bnpparibas.com

3- The 8 floor

█ Unemployment rate ▬ Output gap (rhs)

Source: European Commission

-3

0

3

6

6

8

10

12

1985 1991 1997 2003 2009 2015

economic-research.bnpparibas.com France 1st quarter 2016 11

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Italy A gradual recovery The economic outlook has improved. Real GDP has further increased, mainly driven by domestic demand, despite disappointing investment. Although households remain extremely cautious, private consumption strengthened, supported by the improvement of labour market conditions. Real disposable income rose, benefiting from lower inflation. On top of that, the real estate sector shows signs of recovery, with home prices up again. The number of transactions of residential units increased by more than 5% in the first nine months of 2015. Recent indicators point to further expansion: while exports might lose some momentum, investment is expected to pick up, supported by recently approved tax incentives. ■ A domestic recovery In Q3 2015, the Italian economy has further recovered, despite at a slower pace than that recorded in the first half of the year. Real GDP rose by a quarterly 0.2% (following +0.4% in Q1 and +0.3% in Q2). The annual growth rate reached +0.8%, the highest since the beginning of 2011. The recovery continued to be driven by domestic demand, which, excluding stocks, added 0.2 percentage points to the overall growth, as in the previous two quarters. While both private and public consumption positively contributed to the GDP increase (respectively +0.2 pp and +0.1 pp), investment subtracted 0.1 pp.

Foreign demand showed signs of weakening. The negative contribution from net exports was 0.4 pp, as imports rose by 0.5% and exports declined by 0.8%. According to trade balance data, Italian firms suffered from worsening economic conditions in the emerging world. Sales stagnated in China and collapsed in Russia, Latin America and OPEC countries.

In Q3 2015, activity in the construction sector further declined, while that in service was virtually stable. Industrial value added increased by 0.4%, the third consecutive positive reading, despite the recovery continued to be uneven at a sectorial level. From January to October, production of transportation equipment rose by almost 20% and that of pharmaceutical products by more than 5%, while in the food and textile sectors activity declined.

■ The positive momentum of consumption In Q3 2015, the positive trend in households’ consumption was confirmed. Private expenditure rose by 0.4%, the same rate as in Q3. The ninth consecutive increase brought the annual growth rate above 1% for the first time in four years. The rise was mainly bolstered by purchases of durable goods, which recovered more than 10 percentage points since the second half of 2013.

Labour market conditions improved, benefiting from social contribution relief on new open-ended hires and, to a lesser extent, the new rules on individual dismissals introduced by the Jobs Act. The unemployment rate fell to 11.3% in November, from more than 13% in end-2014. Youth unemployment rate declined to 38%, down by more than 5 percentage points in a year. The number of persons in work soared near 22.5 million. Since the worst of the crisis, in the second part of 2013, almost 350 000 new jobs have been created. The growth was entirely due to payroll employment as self-employment contracted.

Despite consumer confidence continued to increase, with the Istat index at the highest level in more than ten years, households remain

extremely cautious, increasing consumption slower than disposable income. From January to September, Italians’ purchasing power rose by almost 2%, benefiting from lower inflation (+0.1% in 2015), while the cumulative growth of consumption remained below 1%, while the saving ratio was up to 9.5% from 8.6% in Q2 2015.

■ Tentative signs of recovery in the real estate market The real estate also shows signs of recovery. After some ups and downs during a prolonged period of adjustment, 105,000 residential units (new and existing) were sold in Q3 2015, i.e. 10.8% more than in Q3 2014. All in all, in the first nine months of 2015, the number of transactions of residential units increased by 5.3% with respect to the same period a year earlier. Despite this positive trend, the number of transactions remains well below the peak of 866,000 reached in 2006, i.e. during the pre-crisis expansionary period. The

1- Summary of forecasts

e: estimations et prévisions BNP Paribas Global Markets

2- Real GDP Quarterly growth, %

Source: Istat

Annual growth, % 2015 e 2016 e 2017 eGDP 0.7 1.3 1.2Priv ate consuption 0.9 1.1 0.9Gross Fix ed Capital Formation 0.7 3.4 3.2Ex ports 3.9 3.2 4.4Consumer Price Index (CPI) 0.1 0.4 1.3CPI ex food and energy 0.7 0.6 1.0Unemploy ment rate 12.1 11.5 11.1Current account balance 1.9 1.7 1.6Gen. Gov t. Balance (% of GDP) -2.6 -2.5 -1.6 Public Debt (% GDP) 132.9 132.1 130.4

-3

-2

-1

0

1

2008 2009 2010 2011 2012 2013 2014 2015

economic-research.bnpparibas.com Italy 1st quarter 2016 12

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increase in residential unit sales was widespread nationwide. Still, it was particularly marked in the North, where sales are up 13% since Q1 2014, versus +10.7% in the Centre and +7% in the South.

For the first time since Q2 2011, home prices recorded a slight quarterly increase (+0.2%) in Q3 2015, the result of a limited fall in the prices of existing homes (-0.1%) and a solid rebound in new ones (+1.4%). The latter increase is the highest since 2010. In the first nine months of 2015 residential real estate prices are still negatively oriented, falling by 2.9% (compared to -4.6% in the same period of 2014), and down by about 14% since 2010. According to some international institutions, the current level of home prices to income ratio is slightly below its long run average. This may be seen as an indicator of undervaluation of the market.

■ The housing sector is key The slight recovery of the real estate market in Italy follows a general rebound in the Eurozone housing market that has turned the corner after years in the doldrums. Given the weight of the real estate property on the Italian households’ real wealth, a strong recovery of the sector would have a positive impact on households’ confidence, stimulating their propensity to consume.

According to some data recently released by the Bank of Italy, residential wealth represents about 85% of total Italian households’ wealth ; furthermore, the ownership ratio is quite high in Italy, at 67.7%1. This percentage, however, changes dramatically according to the level of income, age, school attainment and the employment status. As for wealthier families, the ownership rate reaches 90%, compared to 50% for those with a median wealth and just 1% for the poorest ones. Only a small percentage of foreign-born households own their homes: about 22%.

The recovery of the real estate market would support the construction sector, one of the most severely hit by the long crisis that has been gripping the Italian economy in the last seven years. The construction sector, in a broad definition, includes about 550,000 firms, more than any other country in Europe: France has about 513,000 construction firms, Spain 321,000 and Germany 274,000. In the first nine months of 2015 the sector accounted for about 4.7% of the total economy’s value added; in 2008 it was 6.1%. From Q1 2008 to Q3 2015 the construction sector’s value added decreased by 32.1% compared to -8.4% for the overall value added.

According to estimates recently released by the Italian construction firms association (ANCE), from 2008 to the end of 2015, investment in the construction of new residential units fell by 27.6%, due to an increase for investment in renovation (+19.4%) and a dramatic decrease for those in new buildings (which, according to the ANCE’s estimations, decreased by 61.1%).

1 Bank of Italy, “Survey on Household Income and Wealth - 2014”, Supplements to the Statistical Bulletin - Sample Surveys, December 2015.

However, tentative signs of an upturn can be highlighted, as the employment trend in the construction sector. After falling for 19 months in a row, the total number of persons employed in this sector rose by 2.5% y/y in Q2 2015; additionally only permanent contract employees increased in Q3 2015. Despite this positive data, the decline in the sector’s overall employment is dramatic. In Q3 2015, construction employment was down by 502,000 people (-25,3%) from Q4 2008.

■ Investment: still in the doldrums Business investment continued to be disappointing, despite favourable financial conditions. Although, bank interest rates on loans to non-financial corporations fell below 2%, gross fixed capital formation declined by 0.4% in Q3, after -0.1% in Q2. According to the Bank of Italy’s estimates, economic conditions for Italian firms were stable but at historically low levels. From July to September, spending on structures fell to the lowest level in the last twenty years and that on machinery and equipment renewed with contraction, offsetting the Q2 increase.

Recent indicators point to further expansion in the coming quarters, despite greater global risks. In 2016, real GDP is expected to accelerate well above 1%, driven by domestic demand. Private consumption is set to continue rising, as households disposable income will be supported by easier fiscal stance and lower oil prices. While exports might lose some momentum, investment is expected to pick up. The Italian Government recently approved incentives for firms spending on machinery and equipment.

Paolo Ciocca and Simona Costagli paolo.ciocca@bnlmail.com simona.costagli@bnlmail.com

3- House prices Index, 2010 = 100

▬ Total ; — New ; — Existing

Source: Istat

80

85

90

95

100

105

2010 2011 2012 2013 2014 2015

economic-research.bnpparibas.com Italy 1st quarter 2016 13

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Spain Dynamic economy, log-jammed politics The Spanish economy is likely to suffer from slowing growth in certain emerging markets. However, it retains numerous strengths. Record corporate profitability, advantageous financial conditions and the need to renew the capital stock are likely to boost investment. Job creation and purchasing power gains are also likely to continue to help support consumer spending. The transformation of the Spanish political landscape after the general election of 20 December 2015 does, however, raise questions as to the direction of the country’s future economic policy.

Spanish growth is likely to lose some of its sparkle over the next few quarters. The country, which is highly export-orientated1 and which diversified its markets by increasing exports to Asia (9.2% of exports of goods in Q3 2015, from 6.3% in 2007) and Latin America, will suffer from slower growth in these regions.

■ A dynamic economy Spain nevertheless retains a number of strengths and is likely to see relatively strong growth, of 3.1% in 2015 and 2.2% in 2016. Companies are winning market share and thus reaping the rewards of many years’ efforts to increase competitiveness. They are also benefiting from the weak euro and the good resilience of eurozone demand, particularly in France and Germany, the country’s main trading partners (15.5% and 10.5% respectively of exports of goods, see Figure 1). According to a Markit survey, the index of foreign orders addressed to manufacturing companies rose slightly in the fourth quarter (to an average of 54.8, from 52 in Q3 2015).

More advantageous financial conditions, as a result of ECB monetary policy, and the need to renew the capital stock are likely to boost investment. The contraction of commodity prices is also likely to help boost the already strong margins of Spanish companies. These factors, coupled with a slight increase in real estate prices since the beginning of 2015, could also offer support to investment in construction, which is still far below the levels seen before the crisis in 2008 (Q3 2015 was nearly 45% down on Q2 2007).

Against this background, companies are likely to continue to hire new staff. European Commission surveys and the PMI indices suggest that the rate of job creation is likely to remain strong, particularly in the service sector. Employment in the construction sector, which collapsed by 1.8 million during the crisis and weighed heavily on the Spanish economy, is also likely to continue to show signs of improvement. This trend will support consumer spending, which will also benefit from the absence of inflation. In December 2015 prices even fell slightly (0.1% over a year) in response to the further fall in oil prices.

■ Political log-jam Spain has managed to achieve dynamic growth and remove the threat of a sovereign debt crisis, albeit at the cost of harsh austerity measures. The budget deficit was probably 4.6% of GDP in 2015, having peaked at 10.4% in 2012. It could fall to about 4% of GDP in 2016. However, these improvements have not been enough to

1 Between 2007 and 2015, the weight of exports in total Spanish GDP rose from 26% to nearly 33%.

dispel the discontent of the many Spaniards still suffering persistent difficulties. In the third quarter of 2015 GDP was still 4.5% below the previous peak in the second quarter of 2008, whilst unemployment was nearly 14 points higher than in the spring of 2007 (at 21.6% in October, from 26.2% in Q1 2013) despite the creation of nearly 550,000 jobs since the winter of 2014. Wage moderation and the deterioration in the quality of employment have also played their part. Nearly 15% of employees worked part-time in the third quarter (from 11.6% in 2007).

As a result, Spain finds itself in a political log-jam following the general election on 20 December 2015. The right-of-centre People’s Party (PP), which won most votes in the election, is unable to

1- Summary of forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Slowdown of exports to Asia and Latin America Exports (EUR billions, 12-month cumulative total)

▬ To Asia; — To Latin America; - - - To the eurozone (rhs)

Source: Banco de España

Annual growth, % 2015 e 2016 e 2017 eGDP 3.1 2.2 2.7Priv ate consuption 3.0 2.5 2.7Gross Fix ed Capital Formation 6.3 4.6 4.1Ex ports 5.9 3.8 4.1Consumer Price Index (CPI) -0.6 0.0 1.2CPI ex food and energy 0.3 0.5 0.7Unemploy ment rate 22.4 21.0 20.0Current account balance 0.6 0.3 0.4Gen. Gov t. Balance (% of GDP) -4.6 -3.7 -2.3 Public Debt (% GDP) 100.8 102.0 100.7

economic-research.bnpparibas.com Spain 1st quarter 2016 14

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govern alone. Despite winning 28.7% of the general vote, it has only 123 seats of the 350-seat Congress. However, no coalition has yet taken shape. The PP cannot count on Ciudadanos, which placed fourth in the election with 13.9% of the vote but only 40 seats. A grand coalition of the left also currently looks unlikely. The main left-of-centre parties, PSOE (Spanish Socialist Workers’ Party), with 22% of votes and 90 seats, and the radical left Podemos (12.7% and 42 seats) disagree about the policy to follow with regard to Catalonia. Without prejudging the outcome, Podemos favours an independence referendum, whilst PSOE is firmly committed to the continued unity of Spain. For a grand coalition of the left to have a majority (176 seats), PSOE would have to form alliances with a large number of smaller parties, including the Basque separatists.

A coalition between PP and PSOE would allow Spain to pursue the policies adopted so far. Such an alliance would, however, require both parties to overcome their reluctance. Spain’s Francoist past has left a deep fissure between the PP and PSOE. Moreover, the parties would be unlikely to draw any long-term benefits from such a coalition. The recent elections showed that Spaniards want to bring to an end the hegemony of the traditional parties. In particular, left-leaning voters could move to Podemos in greater numbers if PSOE propped up the PP.

Thus a minority government by the PP looks the most likely outcome. The outgoing Prime Minister could form a new government on the basis of a simple majority of votes in the second round investiture vote in Congress2. Only Ciudadanos has already indicated that it will abstain from the investiture vote, but the rise in support for Podemos shortly before the elections could lead PSOE to reconsider its support, albeit only implicit, for the PP. If no government is invested within two months of the first investiture vote, which is expected later in January, Spain will have to call new elections. If a minority government were to be elected it would certainly be unstable. The PP could only legislate with the votes of political opponents and would therefore have little room for manoeuvre in governing.

This national impasse comes at a time when independence parties, with the majority of seats in the Parliament, will be able to pursue the goal of independence for Catalonia, which represents nearly 20% of total Spanish GDP. The “Junts pel Sí” (Together for Yes) coalition, which combines several independence parties, topped the

2An absolute majority is required for the first round. A simple majority only requires a majority of votes cast.

regional elections on 27 September and managed to secure the backing of the extreme left independence party, Candidatura d’Unitat Popular (CUP), in exchange for agreement not to re-appoint Artur Mas, leader of Junts pel Sí, as the head of the Catalan government. This centre-right politician has been associated with the austerity measures introduced in Catalonia in recent years, as well as with corruption scandals that have damaged the reputation of his party. This process is only a first stage on the road to an independence referendum in Catalonia. It could lead various stakeholders to begin negotiations, and will certainly feed into the political debate over the coming months.

Spain will need to meet a number of challenges without imperilling the public finances of a government with a high level of debt (99.3% of GDP in 2014). All political parties will therefore be pushed to find compromise and ease austerity policies, without completely taking the foot off the brake. Catherine Stephan catherine.stephan@bnpparibas.com

3- Growth in household disposable income Four-quarter moving average (year-on-year, %)

▬ Wages; — Disposable income; - - - Consumer price deflator

Source: INE

economic-research.bnpparibas.com Spain 1st quarter 2016 15

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Brazil Downfall! After a nightmarish 2015, the year 2016 looks no better. A festering political and institutional crisis may still weigh on the confidence of economic agents, a vital ingredient for a hypothetical economic recovery in the midst of a tough international environment. The key figure is 10% (the French name of the “Downfall” game is “10 de chute”), which reflects the level of the President’s popularity rating, the inflation rate, the public deficit, the rise in public debt over the past year, and soon, the jobless rate, not to overlook the decline in industry since 2013 and the expected cumulative decline in real GDP. Following the failure of its rentier economy and demand-side stimulus policies, the path to salvation lies in openness to trade and a supply-side shock. ■ 2015-2016: copy-paste More than a year after the outbreak of Petrolão, Brazil’s mega-corruption scandal, ongoing legal investigations and criminal charges continue to send shock waves through Brazil’s political and economic establishment. Suspected in the scandal, Eduardo Cunha, lower house speaker and member of the centrist PMDB party, part of the ruling coalition, accepted a request to launch impeachment proceedings against President Dilma Rousseff on 2 December for the falsification of public accounts to minimise the size of the fiscal deficit. Until the new parliamentary session opens in early February, it is impossible to say whether the proceedings will go forward. In any case, President Rousseff’s resignation no longer seems to be on the agenda, despite a popularity rating holding stubbornly at 10%.

Once again, we have lowered our GDP growth estimates for 2015-2017. We are now looking for a cumulative decline in real GDP of about 10% between mid-2014 and early 2017. An extremely deteriorated and uncertain political climate will continue to undermine the confidence of investors and households alike in the quarters ahead. In the short term, we do not foresee a recovery for several reasons: declining real wages (-3.5% y/y in the first 11 months of 2015), soaring unemployment (estimated at 10% in 2016, vs. 5% in 2014), the probable contraction in bank lending in the months ahead and the already sharp rise in lending rates (+700bp in a year). Nor can the Brazilian economy count on support from the international environment, characterised by China’s slowdown, advanced economies’ agonisingly slow recovery and rock-bottom commodity prices. Real GDP contracted another 1.7% q/q in Q3 on a seasonally-adjusted basis, the 7th consecutive decline (with the exception of a 0.1% increase in Q4 2014). In the first 9 months of 2015, GDP was down 3.2% compared to the same period in 2014. Investment (19% of real GDP) plunged 12.7% y/y in the first 9 months of the year, while household consumption (67% of real GDP) was down 3%.

In the midst of recession and a sharp depreciation in the real (-33% against the dollar in 2015), we are bound to see further adjustments in the external accounts. With rapid improvements in the trade balance and the resilience of foreign direct investment (FDI), the country should manage to preserve its solid external solvency and liquidity position in 2016-2017. Consequently, we see no real need to worry about the risks of a balance of payments crisis or destabilisation of the banking system, which seems to be solid, despite the expected deterioration in asset quality, which was already observed in 2015. What is alarming, however, is the vertiginous downturn in public finances.

■ Public finances spin out of control The central bank is determined to tighten monetary policy further to combat inflation, which rose to a 13-year high of 10.7% in 2015 (vs. an inflation target of 4.5% +/- 2 percentage points), driven up by the real’s depreciation. Yet it must weigh its efforts against the rapid increase in the interest burden on the public debt (+3.2 points of GDP in January-November 2015 compared to the year-earlier period, to 8.3% of GDP), 93% of which is denominated in the local currency. Since early 2015, the yield on 4-year bonds has gained 350 bp to 16.3%, and the 10-year yield spread on sovereign bonds

1- Summary of forecasts

f: BNP Paribas Group Economic Research estimates and forecasts 2- Public finances % GDP

— Central government primary balance (12 months) — Central government overall balance (12 months) — Gross general government debt (rhs)

Sources : Ministry of Finance, Central Bank, BNP Paribas

2015f 2016f 2017fReal GDP grow th (%) -3.8 -4.0 0.0Inflation (CPI, y ear av erage, %) 9.0 9.0 7.0Fiscal balance / GDP (%) -12.0 -10.9 -9.8Gross public debt / GDP (%) 66.9 75.6 80.3Current account balance / GDP (%) -3.4 -2.3 -3.0Ex ternal debt / GDP (%) 29.3 35.2 34.1Forex reserv es (USD bn) 349 350 355Forex reserv es, in months of imports 15.1 14.8 14.7Ex change rate USD/BRL (y ear end) 4.0 4.2 4.3

0

10

20

30

40

50

60

70

-10-8-6-4-202468

10

2007 2009 2011 2013 2015

economic-research.bnpparibas.com Brazil 1st quarter 2016 16

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in foreign currencies and those of 5-year CDS have more than doubled (to 510 bp and 480 bp, respectively).

Fiscal dominance, a theme dear to Olivier Blanchard, former IMF chief economist (NBER Working Paper 10389, March 2004), is once again the centre of debate in Brazil. Raising real interest rates to support the exchange rate would end up having the opposite effect, and would also drive up inflation: an interest rate increase would increase the probability of default on domestic public debt and fuel growing risk aversion among investors. In conclusion, monetary policy is seen as counterproductive, and fiscal policy would be the only effective instrument for reducing inflation.

Fiscal dominance or not, Finance Minister Joaquim Levy’s programme to clean up public finances launched by just over year ago has been a failure. The primary deficit of the consolidated public sector was 0.7% of GDP in the first 11 months of 2015, and the overall deficit has climbed to 9% of GDP. Taking into account the BRL 57 bn (2% of GDP) spent in December to repay pedaladas (spending allocated to the balance sheets of public banks in infraction of fiscal rule) reintegrated in the Federal government accounts, the overall deficit is expected to have exceeded 10% of GDP in 2015, and still in 2016. The direct consequence is the alarming increase in the gross public debt, which swelled by at least 8 points of GDP in 2015 (higher debt stock and drop-off in nominal GDP) and by an estimated 13 points of GDP in 2016-2017, to 80% in two years.

From a structural perspective, fiscal rigidity leaves the government very little manoeuvring room, with discretionary spending accounting for only about 10%, including public investment, which has already been slashed in recent months. Second, the comparatively high weighting of mandatory contributions (35% of GDP) relative to the average for the emerging countries further reduces the “tolerance for additional taxes”. From a cyclical perspective, the economic slump, accentuated by fiscal tightening, has triggered a major loss of tax revenue. Lastly, Dilma Rousseff was re-elected by a narrow margin in October 2014 based on a rather strong social welfare platform. The political shift dictated by events has also run up against hostility from Congress. Faced with the difficulty of passing painful reforms, the ongoing deterioration in the public accounts and the subsequent downgrade of Brazil’s sovereign rating to speculative grade by Fitch in December 2015 (after Standard & Poor’s downgrade in September), Joaquim Levy resigned. He was replaced by Nelson Barbosa, former minister of planning and a close associate of the president. There is reason to fear that the fiscal reins will be loosened, since some see the loss of Brazil’s sacrosanct “investment grade” status as a kind of liberation from the pressures of international investors: a godsend rather than a signal of alarm for launching a stimulus programme (subsidies, support for the construction sector, reactivation of lending via public banks?) and for trying to loosen monetary policy.

■ Exiting a rentier economy via a supply-side shock The expansionist policy to support demand (2011-2014) was guided by an erroneous economic analysis and political dogma. Although a cyclical rebound must inevitably include ongoing fiscal efforts and a

political clean up capable of regaining the confidence of economic agents, structural reforms designed to boost the supply side are also imperative to consolidate economic growth in the medium term.

Initiated in the 1930s, Brazil’s industrial take-off was sustained in the 1950s through an import substitution strategy. But the Custo Brasil – the high cost of conducting business in Brazil – ended up draining the industrial sector’s competitiveness: manufacturing output has dropped by nearly 10% since 2013, falling back to the 2005 level despite major adjustments to the exchange rate. According to the OECD (Brazil Economic Survey, November 2015), per capita productivity in the manufacturing sector has stagnated over the past decade (it has increased slightly after adjusting for the number of hours worked). In 2012, it was five times less than the average for a selection of 41 emerging and developed countries. At the same time, unit labour costs more than doubled. Brazilian industry now generates only 26% of value added, compared to an average of 36% in middle-income countries. Brazil’s economic structure is typical of a high-income country, with services generating more than 70% of value added.

All in all, despite the commodities windfall of the 2000s, Brazil is still not very open to trade. Dutch disease is no longer a problem and the country’s economic future now depends on an industrial strategy and greater openness. The regulatory framework must be simplified or overhauled (labour laws, the tax system, stronger contract law and judiciary system). Trade protections and entrance barriers hampering competition must be eased or eliminated (few free trade agreements; taxes on intermediate goods imports that hurt competitiveness; monopoly or oligopoly rent). Lastly, the country must deal with the unending problems of poor infrastructure, education/training and innovation, which must be placed at the heart of an ambitious industrial policy and investment programme. Sylvain Bellefontaine sylvain.bellefontaine@bnpparibas.com

3- Value added share of industry % GDP, current prices

— Brazil — East Asia & Pacific — Chile — Mexico

Sources: OECD calculations based on IBGE and IPEADATA for Brazil, World Bank for other countries.

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Russia Low oil prices threaten fragile stabilisation The economic situation has stopped deteriorating since July. But downside risks are very high due to the drop in international oil prices. Yet as long as oil prices hold at a very low level, any hopes of recovery are bound to lead to disappointment. Currently, a “slight improvement” can be seen, notably on the corporate side, while the household situation remains extremely fragile. The Russian economy should be able to meet its commitments in the short term. By 2017, however, it could become much harder to finance the budget deficit since the reserve fund will no longer suffice to fully cover the deficit, unless the government sharply cuts back spending, which risks placing a severe strain on growth. This problem could emerge before if oil prices remain below USD 50. ■ Fragile improvement in business climate The Russian recession seems to have bottomed out in Q2 2015. Although statistics concerning GDP growth trends can still be confusing from one quarter to the next (depending on the base year used), activity seems to have contracted less in Q3 than in the previous quarter (-0.6% q/q in Q3 2015 vs. -1.3% in Q2 2015) and the previous year (-4.1% y/y in Q3 2015 vs. -4.6% in Q2).

Increasing production in the agricultural sector was the main economic support factor as the consumption of local products replaced imported goods. Apparently this improvement continued in Q4, since farm production was up 3% y/y last October. On the whole, even though industrial production continued to contract (-3.5% y/y in October), the improvement first reported in June seems to be continuing.

Household consumption continues to be hard hit by persistently high inflation, despite a slight deceleration (+14.9% y/y in November vs. +15.8% in July), and by declining real wages, even though this trend eased slightly in November (-9% y/y). As a result, retail sales contracted again, down 13.1% y/y in November.

Inversely, the corporate situation has ceased to deteriorate, notably in industry. Business leaders are more confident, at least according to survey results in the manufacturing sector. Manufacturing PMI was above 50 in November, for the second consecutive month, even though it declined again in December. Corporate investment was up 3.1% in November compared to the year-earlier period. Although this upturn might seem a little premature, there has been a real change of pace since July (when the decline reached -8.5% y/y). Moreover, corporate earnings were generally higher in full-year 2015 than in 2014.

Yet despite this “slight improvement” in industry, growth prospects are hardly favourable in the short to medium term. Activity will continue to be squeezed tightly by several factors: 1) oil and basic metal prices are not expected to rise significantly over the next twelve months (even though the decline will be partially offset by the rouble’s depreciation against the dollar), which should affect investment decisions in these sectors, 2) lending conditions are not very favourable (the problem is not really with real interest rates, which are still negative, but the banks, which are reticent to lend), and 3) real wages are still declining, since inflation continues to outpace nominal wage growth.

In a nutshell, the situation remains extremely fragile, especially if oil prices hold at year-end levels.

■ Budget pressures The 2016 budget was accepted in the final reading by the Duma last December. The budget calls for a federal deficit of 3% of GDP entirely financed by drawing on the reserve fund. So far, the budget does not seem to be built on realistic assumptions. The government is anticipating full-year growth of 0.7%. It is also forecasting oil prices at USD 50/barrel (at RUB 63 per USD), which seems extremely optimistic with regard to current prices. Moreover, due to the drop in international oil prices, the government announced that the budget should be revised in Q1-16. Disregarding the size of the deficit, what is really alarming is the decline in the reserve fund. At 1 December, there was only USD 60 bn in the reserve fund,

1- Summary of forecasts

f : forecasts BNP Paribas Global Markets

2- Economic indicators (Year-on-Year, %)

▬ Retail sales, ▬ industrial output - - - investments

Source: Central Bank of Russia

2015f 2016f 2017fReal GDP grow th (%) -3.8 -2.0 0.5Inflation (CPI, y ear av erage, %) 15.6 8.5 7.0General Gov . balance / GDP (%) -5.0 -4.3 -3.0Public debt / GDP (%) 18.5 18.9 21.0Current account balance / GDP (%) 5.5 1.5 3.5Ex ternal debt / GDP (%) 32.4 37.2 34.8Forex reserv es (USD bn) 371 370 370Forex reserv es, in months of imports 10.9 14.6 13.6Ex change rate RUB/USD (y ear end) 73.0 70.5 69.0

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-5

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10

15

20

2011 2012 2013 2014 2015

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USD 30 bn less than in the previous year. Under these conditions, the reserve fund might not suffice to finance the entire deficit in 2017, which could become problematic if Russia’s political situation continues to prevent it from accessing financing on international markets. But, from 2016 onwards, this problem could surge if international oil prices stagnate at current level.

■ Investment shortfall: a key factor behind the decline in Russia’s growth potential

Looking beyond the crisis currently sweeping Russia, what is truly alarming is the erosion of potential growth. The consensus among economists estimates Russia’s potential growth at about 1% or even 1.5%, although some estimates are closer to 0. Prior to the 2008 crisis, in contrast, Russia’s growth potential was estimated at about 7%. This downward revision is only partially due to changes in the active population. The main cause is the lack of investment and the feeble diffusion of technical progress.

Investment in productive capital has fallen far short of what is needed to support growth, a problem that has persisted for several years. According to the US Conference Board, capital contributed only 1.7 percentage points (pp) to Russian growth over the period 2007-12, and only 0.5 pp in 2014, before the impact of sanctions. In the other emerging countries, in comparison, capital made an average contribution to growth of 4.3 pp in 2007-12 and 4.4 pp in 2014.

Moreover, unlike many other emerging countries, Russia did not benefit from major technological transfers via FDI, notably in the non-mining sectors. Consequently, the lack of productive investment (domestic and foreign) triggered a net slowdown in Total Factor Productivity (TFP), which rose by an average of only 0.8% over the period 2007-2012, down from 4.7% in 1996-2006. TFP made a negative contribution to growth of 0.2 pp in 2014.

Investment’s contribution to growth is structurally weak in Russia compared to the situations prevailing in the other emerging countries. This can be explained in part by an especially unfavourable institutional environment, at least until recently. According to the World Bank’s latest reports, the government seems to have managed to improve the business climate through a series of reforms. Yet the improvement in the business environment is not enough to offset the deterioration in corporate financial positions reported since 2012, which is the real source of the slowdown in investment.

Investment as a whole first began to slow in Q1 2012, before contracting very sharply as of Q3 2013. In other words, the slowdown began well before the 2014 crisis, the implementation of international financial sanctions and the drop-off in oil prices. An

unfavourable combination of events only worsened the economic situation, which began to deteriorate as of 2011. The decline in investment was even more pronounced if we excluding housing investment.

The significant slowdown in investment can be attributed to 1) smaller revenues due to the drop-off in commodity prices, and 2) the shift in the sharing of value added in favour of wages.

Corporate earnings slowed as of 2011 before declining as of mid-2012. This slowdown is due in part to the fall of commodity prices and to rising production costs, notably the cost of labour. Wages rose much faster than productivity gains in all sectors of activity through year-end 2013. Between 2003 and 2013, there has been a continuous increase in the gap between wage growth and productivity gains.

At the same time, banks have become more risk adverse, particularly towards small businesses.

Capital investment by the government depends mainly on fiscal revenues, which are highly correlated to oil pricing trends. Unfortunately, as the government pointed out in its 2016 budget presentation, however, this investment is not part of “essential” spending. It has declined since 2012, in keeping with the levelling off and then decline in oil prices. In 2014, investment accounted for only 0.2% of GDP vs. 0.5% of GDP in 2015. Johanna Melka johanna.melka@bnpparibas.com

3- Exchange rate and oil price —Brent (USD /Bbl, rhs, inv) ▬RUB/USD (lhs)

Source: Central Bank of Russia

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economic-research.bnpparibas.com Russia 1st quarter 2016 19

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India Public banks under scrutiny The economic picture in India continues to improve. Growth prospects look encouraging, and corporate earnings are starting to grow again. Even so, several areas of uncertainty should not be overlooked. Credit risks in the banking sector continue to increase, and public banks need capital to comply with capital adequacy ratios. The government will not be able to fully recapitalise them, and so it is essential for them to clean up their accounts before attempting to raise funds in the markets. At the same time, the government again failed to get reform of the goods and services tax through parliament in December’s final session.

In the first half of the 2015-16 fiscal year (FY), growth slowed slightly to 7.2% from 7.5% in the first six months of the previous fiscal year. Even so, since the second quarter, growth has accelerated significantly, and this is set to continue as businesses consolidate their finances.

■ Acceleration in growth In the second quarter of the 2015-16 fiscal year, the pace of economic growth in India picked up to 7.4% compared with the same period of the previous year (vs. 7% in the previous quarter) on the back of upbeat domestic consumption and a sharp acceleration in public-sector investments. That said, net exports made another negative contribution to growth (-0.4 percentage points) owing to the 4.7% year-on-year decline in exports in Q2 FY 2015-16.

The latest economic indicators suggest growth has maintained the momentum it had at the beginning of the third quarter of the fiscal year. Industrial output recorded a 9.8% year-on-year increase in October, with the impetus coming from a steep rise in production of consumer goods (up 18.4% y/y) and also capital goods (up 16.1% y/y). The increase in households’ purchasing power (as inflationary pressures have receded) underpinned personal consumption and vehicle sales (up 14% y/y in November).

Even so, the crucial issue is whether businesses have already started or will start to invest again. In the second quarter of the current fiscal year, investments grew by more than 6.8% year-on-year, contributing 2.1 percentage points to growth. Nonetheless, this increase apparently reflects the rise in government investment rather than an upturn in investments by businesses. According to the government’s budget figures, capital spending under its development programme rose by over 8% year-on-year in the first eight months of the fiscal year compared with the same period of the previous year. What’s more, infrastructure and construction were the main sectors in which bank lending picked up pace, with road construction the stand-out performer.

■ Pressures on businesses easing In Q3 2015, the state of businesses’ finances improved owing in particular to the steep decline in their commodity costs. As a result, their net earnings rose by 7% year-on-year in Q3 2015, after declining in the three previous quarters. In addition, businesses’ financial position is less stretched following their debt reduction drive. In Q3 2015, 30.3% of their revenues before tax was devoted to paying interest, down from close to 36% in late 2014. As a result, their pre-tax revenues covered their Q3 2015 interest expense by factor of 3.3x, compared with just 2.8

times interest expense in late 2014. At the same time, businesses’ profit margins have increased. Net earnings (after tax) rose to 7.7% of revenues in Q3 2015 from just 4.3% of revenues in late 2014.

To sum up, although businesses’ finances are in a fairly fragile state, they have improved since December 2014, paving the way for their investments to recover. Even so, several indicators tend to suggest that private investment has yet to pick up. Production capacity utilisation rates are declining, investment projects are on the

1- Summary of forecasts

f: BNP Paribas Economic Research estimates and forecasts 2- Industrial production Growth over two months (%)

▬ Industrial output ▬ Capital goods (LHS) - - - Consumer goods

Source: Reserve Bank of India

2014 2015f 2016f 2017fReal GDP grow th(1) (%) 6.9 7.3 7.3 8.0Real GDP grow th(2) (%) 6.4 7.1 7.1 7.5Inflation (CPI, y ear av erage, %) 6.6 4.9 5.9 5.4Central Gov . Balance(1) / GDP (%) -4.4 -4.1 -3.9 -3.5Central Gov . Debt(1)/ GDP (%) 46.8 46.2 46.2 44.9Current account balance(1) / GDP (%) -1.7 -1.3 -0.8 -0.9Ex ternal debt(1)/ GDP (%) 23.5 22.9 22.9 22.3Forex reserv es(1) (USD bn) 283 352 370 395Forex reserv es(1), in months of imports 5.9 6.7 7.6 7.6Ex change rate INR/USD (y ear end) 63.1 66.2 66.6 65.9(1): fiscal y ear from 1 April of y ear n-1 to 31 March of y ear n (2): Calendar y ear

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-25-20-15-10-505

10152025

11 12 13 14 15

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decrease and investments halted rose in the third and fourth quarters of 2015.

■ Higher risks in the banking sector Banks have not yet reaped any benefit from the improvement in businesses’ financial position. The Reserve Bank of India’s latest report points to a further rise in credit risk. Doubtful and restructured loans amounted to 11.3% of lending at end-September 2015, up from just 6% in 2011. Public-sector banks (which hold 75% of bank assets) account for the bulk of loans at risk. The ratio stood at 14.1% at end-September (vs. 8% in 2011), compared with just 4.6% for private-sector banks and 3.4% for foreign banks.

What’s more, loans at risk are concentrated in industry and in five sectors of activity in particular – mining, steel-making, textiles, infrastructure and aviation. These sectors of activity alone account for 53% of loans at risk, yet just 24.2% of total banking sector lending went to businesses operating in them. Infrastructure and aviation are the sectors with the highest exposure (with respectively 61% and 24% of lending to them classified as being at risk).

The RBI estimates in its latest financial stability report that public-sector banks’ provisions would not suffice to cover their losses (estimated at 3.8% of total loans) were the economic and financial environment to deteriorate significantly1. 19 of 60 banks are said to be concerned, and they hold 36.2% of bank loans (compared with just 16 in June 2015). What’s more, five banks (accounting for 2.4% of bank loans) would have losses exceeding their capital.

At the same time, banks’ profitability declined. ROA and ROE slipped to 0.7% and 8.5% in September 2015, down from 1.1% and 13.6% in 2011. Earnings after tax contracted by 4.4% in the first half of the FY 2015-16 – owing in particular to the steep rise in provisions (22.2%) – and the contraction worked out at 22.7% for public-sector banks.

By the end of September, the capital adequacy ratio for the banking sector as a whole was mere a 12.7%. Even so, the situation varies tremendously from one bank to another. It stood at 11% for public-sector banks, but many of them have a ratio of around 10%, while their private counterparts average 15.5%.

1 The stress test assumptions were as follows: GDP growth of 2.7%, budget deficit of 6.1%, inflation of 10%, current-account deficit of 5.5%.

To improve their capital adequacy ratio, especially after the deterioration in their asset quality, the government injected INR 200 bn in August and will pump in another INR 50 bn by March 2016 (representing a total of USD 3.5 bn). Yet these capital injections fall well short of banks’ actual needs, even taking into account the additional INR450bn (USD 6.4 bn) due to be injected by March 2019 (INR 250 bn in FY 2016-17 and INR 100 bn in FY 2018 and FY 2019). The government itself believes that it will need to come up with another INR1100bn (USD 16 bn). Fitch, the rating agency, estimates that Indian banks critically need around USD 140 bn to meet the latest regulatory standards laid down by India’s central bank and to cope with higher rates of payment default. Of this INR 140 bn, Fitch estimates that the top five public-sector banks will need to be given over USD 67 bn.

As things stand, it is impossible for the government to inject all the capital that public-sector banks need to meet the regulatory standards laid down by monetary authorities by the 31 March 2019 deadline2. Given the state of the public finances, it cannot afford to do so, especially against a backdrop of fiscal retrenchment. Banks will have to raise capital in the financial markets, and for the time being, that appears a big ask given their financial condition. Johanna Melka johanna.melka@bnpparibas.com

2 India’s capital adequacy ratio currently stands at 9% for the banking sector as a whole and is set to increase to 11.5% by 31 March 2019 (from 8% to 10.5% under the Basel III framework).

3- Loans at risk % of total lending

█ Banking sector █ Public-sector banks

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economic-research.bnpparibas.com India 1st quarter 2016 21

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China The year starts off badly Panic shook the Chinese stock markets in the first days of January, revealing persistently strong concerns about China’s slowing growth and the effectiveness of its economic policy measures. It also brings to light the troubles the authorities are encountering in pushing through structural reforms. With downside risks straining short-term growth prospects, the authorities are bound to launch more stimulus measures. Domestic credit growth is barely picking up despite monetary policy easing, and the government is counting on an upturn in public investment and tax relief to support domestic demand.

■ The authorities are put to the test The Chinese economy was hard hit in 2015. In the industry, problems due to weak domestic and external demand, overcapacities and dwindling corporate profits have worsened, and production growth slowed to an all-time low (+6%). This was only partially offset by a good performance in the services sector (+8.3%). Moreover, China has had to deal with unprecedented capital outflows, which have made it harder both to implement an expansionist monetary policy and drive through the reform of the foreign exchange regime. In 2015, the central bank lost 13% of its foreign reserves (which are still very comfortable at USD 3,330 bn) and the yuan lost 4.7% against the US dollar. In the equity markets, share prices collapsed over the summer after an euphoric year. Local governments saw their resources evaporate due to the economic slowdown and the correction in the real estate market, which severely eroded their financial situation and reduced any leeway to support activity. Corporate debt (including that of entities owned by local governments) continued to swell to almost 165% of GDP at year-end 2015, up from 100% at year-end 2008. In this context, corporates’ capacity to service their debt has continued to weaken, and the financial sector’s performance to deteriorate.

The year 2016 did not get off to a better start. The stock markets have already racked up major losses: the composite index of the Shanghai Stock Exchange dropped 7% on 4 January and again on 7 January (for a cumulative loss of 18% in the first 15 days of 2016). In both cases, the authorities triggered the circuit breaker system, which took effect on 1 January and is aimed at suspending trading for the rest of the day when the index declines by 7%. However, this mechanism has aggravated investors’ jitters.

The stock market corrections were triggered by: i) the publication of the PMI index for the manufacturing sector at the end of December, which held below 50, squashing hopes for a recovery in industrial growth in the very short term, and ii) the authorities’ decision to accelerate the yuan’s depreciation, which fell 1.6% against the USD between 1 and 8 January. The decision was a response to capital outflows, which worsened in the year-end period, as illustrated by the record decline in foreign reserves in December. It also reflects a new step in reforming the foreign exchange regime, which now gives greater consideration to fluctuations in the yuan’s effective exchange rate. The effective exchange rate appreciated by 2.9% between year-end 2014 and November 2015, based on the central bank’s new index 1 . Investors are worried about several factors,

1 The composite index of the China Foreign Exchange Trading System (CFETS) measures fluctuations in the yuan relative to a basket of 13 currencies, which

including: the lack of detailed explanation reported by the authorities, the possible reasons explaining the yuan’s recent depreciation (such as problems encountered by exporters and capital account deterioration), its potential consequences (on Chinese enterprises with foreign-currency debt, on foreign exchange markets in the region…), and increasing expectations of yuan depreciation in the short term.

In addition, stock market investors also anticipated a massive sell-off of securities by the largest shareholders by 8 January, when the

curiously excludes the currencies of some of China’s main Asian trading partners, notably South Korea.

1- Summary of forecasts

f: BNP Paribas Group Economic Research estimates and forecasts 2- Foreign exchange reserves and exchange rate Downward adjustments reach record levels

█ Foreign reserves, USD bn (lhs) ▬ CNY / USD (rhs, inversed)

Sources: SAFE, Macrobond

2015f 2016f 2017fReal GDP grow th (%) 6.9 6.3 6.1Inflation (CPI, y ear av erage, %) 1.4 1.8 2.0General Gov . balance / GDP (%) -2.5 -3.1 -3.0Central Gov . debt / GDP (%) 18.2 20.0 21.4Current account balance / GDP (%) 3.5 3.5 3.3Ex ternal debt / GDP (%) 7.2 6.6 6.5Forex reserv es (USD bn) 3 330 3 200 3 300Forex reserv es, in months of imports 19.7 18.2 18.0Ex change rate CNY/USD (y ear end) 6.49 6.78 6.80

5,5

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7,0

7,5

8,00

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2 000

3 000

4 000

5 000

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ban on selling shares introduced last June had to expire. In response to the wave of panic, the authorities finally restricted large shareholders from selling more than 1% of a given stock over the next three months. They also abandoned the circuit breaker mechanism. Even so, the authorities’ interferences and their “trial and error” approach to market regulation may well have eroded investors’ confidence even further.

■ The growth slowdown continues The stock market crisis should have only limited contagion effects on the rest of the economy: equity financing accounted for only 5% of new financing flows to the economy in 2015, and wealth effects are not significant (less than 20% of households’ financial assets are invested in equities). Systemic risks are also relatively limited, although they have been growing over the past year due to the increasing interconnections between the stock market, banks and other financial institutions.

The stock market crisis is more alarming because it reveals the persistently strong fears about the Chinese growth slowdown. It seems to capture the challenges involved in the economy’s current transition towards a growth regime that is more moderate and less dependent on credit and investment. The authorities are finding it increasingly difficult to contain the risks arising from the adjustment in investment (i.e. to stimulate activity) while pursuing structural reforms (reduction in industrial overcapacity, streamlining of local government finances, fight against corruption, tighter financial sector regulation, capital account opening and liberalization of the foreign exchange regime…). These reforms are indispensable for the transition, but some of them risk having a recessionary impact in the short term. Consequently, in addition to the economic slowdown and rising vulnerabilities (industrial crisis, debt excess, capital outflows, asset market correction), investors are also becoming increasingly nervous about uncertainty over China’s economic policy.

In our central scenario, the authorities will continue to pursue structural reforms in the years ahead, and step up stimulus measures in the short term in order to help contain the growth slowdown. We expect real GDP growth to slow to 6.3% in 2016, from 6.9% in 2015. This scenario remains positive, but has a number of downside risks, given the troubles in the industry, the worsening efficiency of investment and credit, rising financial fragility of corporates, local governments and banks, and the risk of contagion of the industrial slowdown on the services sector.

■ Fiscal policy loosening to the rescue To address these risks, the authorities intend to further ease the policy mix. Since November 2014, the central bank has already lowered six times the reserve requirement ratio (from 20% for the large banks to 17.5% at year-end 2015) and the one-year benchmark lending rate (from 6% to 4.35%), in response to weakening domestic demand and lower inflation. This has also helped ease debt servicing costs for corporates and local governments. Nonetheless, the effectiveness of these measures

has been undermined by disinflation, which raises real rates, and by capital outflows, which have a restrictive impact on domestic liquidity conditions. Growth in the total stock of credit (including all financing flows to the economy) did not rebound in 2015. Yet, the structure of domestic financing sources has started to change, with a growing role of bond and equity financing. Going forward, further interest rate cuts are expected, along with new liquidity injections and measures to encourage lending in certain targeted sectors.

The authorities will also expand their scope of action on the fiscal policy front. i) Local governments are expected to step up investment in infrastructure projects (after a slowdown since Q2 2015) thanks to the improvement in their financial situation. Firstly, local government debt refinancing has been facilitated since May 2015 by the easing of certain restrictions that were previously introduced with the new budget law of late 2014 (which illustrates how difficult it is for the authorities to reform public finances in the midst of an economic growth slowdown) and by the debt swap program aimed at replacing some bank loans by bonds at lower rates. Secondly, with the stabilisation of the real estate market, land sales proceeds could pick up again after collapsing in 2015 (down 35% y/y in the first three quarters). ii) Additional solutions are being explored to fund public investment, such as the development of public-private partnerships and the rise in quasi-fiscal spending by the three policy banks. iii) The government plans to increase its budget deficit (to at least 3% of GDP in 2016) as a result of some tax cuts. These are part of a series of new measures recently announced, which aim to support corporates by lowering their costs (fiscal, administrative, financial and logistics), in order to improve the quality of supply and reduce financial risks. Christine Peltier christine.peltier@bnpparibas.com

3- Domestic investment growth High hopes for public investment in infrastructure projects

Nominal fixed-asset investment, year-to-date, y/y % ▬ Manufacturing sector - - - Real estate ▬ Infrastructure ▬ Total

Source: NBS

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Japan Slow but steady The Abe government has embarked on a three-arrow reform programme to revitalise the economy. The first arrow - an expansionary monetary policy - has been a boon for exporting firms. Concerning the structural reforms, their effects are likely to spread more widely in the coming years. Signs of a positive feedback loop between the increases in employment and wages and the moderate rise in inflation indicate that the economy is coming out of deflation. In 2016, growth is expected to remain at around 0.7%, but may slow to 0.4% in 2017 due to a 2-point hike in the VAT rate.

After the LDP’s landslide victory in the general election in December 2012, the incoming government headed by Shinzo Abe started to implement the so-called “Three arrows programme”. The first arrow is a very accommodative monetary policy. In April 2013, the Bank of Japan (BoJ) announced a quantitative and qualitative easing (QQE), to be conducted until inflation had reached 2%. The Bank started to buy assets, mainly government bonds (JGBs) at an annual pace of JPY 65 trillion. In October 2014, the asset buying programme was stepped up to an annual pace of JPY 80 trillion. By end 2015, the monetary base had increased by 160% to JPY 350 trillion (70% of GDP). The second arrow is the flexible use of fiscal policy. In the short-run fiscal policy was expansionary through the adoption of fiscal stimulus programmes. In the long-run, it should become restrictive, as the government aims at achieving a primary surplus by FY 2020. Finally, the third arrow is a wide-ranging structural reform agenda that aims at raising Japan’s potential growth rate to 2%. This is crucial for achieving the fiscal long-term objective. Shortly after his re-election as party leader in September 2015, Prime Minister Abe announced three more arrows without any specific timetable, boosting GDP to JPY 600 trillion (compared with JPY 500 trillion in 2015), raising the female fertility rate to 1.8 (from the current 1.42) and stepping up long-term care for the elderly. All these policies should remain in place in the coming two years.

■ Weaker yen boosted activity The most eye-catching policy is the BoJ’s asset purchase programme, which has led to a sharp weakening of the yen. Since November 2012, the currency has lost a third of its value against the US dollar. This has been a boon for exporting firms, allowing them to regain market share and, more importantly, improve profit margins. Business conditions have improved significantly and corporate profitability has reached historically high levels (chart 2).

However, firms mainly producing for the domestic market have experienced less marked improvements, affected by the substantial decline in purchasing power as a result of the 3 point VAT hike to 8% in April 2014 and losses in the terms of trade related to depreciation. Although the latter reversed in 2015 following the sharp fall in oil prices, private consumption is expected to have declined by 0.9% in 2015.

In addition, the record profits have not been translated in increased capital spending even though, according to our estimations, the output gap has disappeared. In 2015, private non-residential capital spending may have increased by less than 1%. Weak investment spending despite favourable financing conditions is observed in many OECD countries and could be related to the uncertainty about the future state of the economy and subdued profit expectations. In

the case of Japan, the sluggishness of the domestic market, the shrinking working age population and energy shortages are important contributing factors. Another element could be Japan’s poor corporate governance. Its enhancement, through the new Companies Act and Industrial Competitiveness Enhancement Act, is part the structural reform agenda. The policy is helped by the creation of the JPX-Nikkei 400 index in January 2014. The stocks for the index are selected on the basis of their return on equity and corporate governance standards. However, the effects of these policies are likely to be only felt in the medium term.

1- Summary of forecasts

e: estimations et prévisions BNP Paribas Global Markets * : FY, general government excluding social-security funds

2- Abe’s policies beneficial for business ▬ Profits to sales (non-financial) — Tankan business conditions (rhs)

Sources: Bank of Japan and Ministry of Finance (Japan)

Annual growth, % 2015 e 2016 e 2017 eGDP 0.6 0.7 0.4Priv ate consuption -0.9 0.7 -0.3 Gross Fix ed Capital Formation 0.9 0.7 1.4Ex ports 3.2 1.8 2.3Consumer Price Index (CPI) 0.8 0.5 1.9CPI ex food and energy 0.5 0.5 1.9Unemploy ment rate 3.4 3.1 2.9Current account balance 3.2 2.9 2.8Central Gov t. Balance (% of GDP)* -4.4 -3.9 -3.2 Public Debt (% GDP)* 205.0 206.0 205.0

-50

-40

-30

-20

-10

0

10

20

0

1

2

3

4

5

6

7

2008 2009 2010 2011 2012 2013 2014 2015

economic-research.bnpparibas.com Japan 1st quarter 2016 24

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■ Encouraging signs that deflation has ended Since end 2012, the economy has created 1 million jobs. Almost all these jobs were in health care and welfare and are related more to the greying of the population than a change in policy orientation. Nevertheless, the improvement in business conditions of the manufacturing sector has stopped the steady decline in employment in the manufacturing sector. The unemployment rate, at 3.3% in November, is historically low and labour shortages have appeared.

For the moment, the impact on wages has been limited. In the 2015 spring negotiations (shunto), monthly wages rose by 2.5%, but this only affects a limited number of workers. On average, wages have hardly moved. Since April 2015, contractual wages have been on average 0.3% higher from a year earlier, compared with a slight 0.1% decline in 2014. In line with rising labour market tensions, wages may steadily increase. For the shunto 2016, the employers’ organisation Keidanren already asked its members to raise wages at a higher rate than in 2015.

Besides, consumer prices have on average hardly changed except for the VAT hike in April 2014. Despite the expansionary monetary policy, inflation is currently close to zero, mainly due to the fall in energy prices. However, the UTokyo daily price index has recently strongly increased (chart 3). Since September, it has been even around 1.3% higher from a year earlier. This index uses scanner data from about 300 supermarkets across Japan. Its rise indicates that supermarkets have been raising prices aggressively. This is partly related to the depreciation of the yen, but may also be due to a recovery in consumer demand thanks to improved wages and bonuses. According to BoJ Governor Haruhiko Kuroda, “the simultaneous occurrence of base pay increases and price hikes should be regarded as evidence that a positive feedback loop between the increases in employment and wages and the moderate rise in inflation is now in place.” In our scenario, we expect inflation slowly to increase to around 1.1% in 2017, excluding the effect of tax hikes.

■ A balanced budget is still far away The government has made some progress in fiscal consolidation. In 2014, the VAT rate was hiked by 3 points to 8%, which has increased tax receipts by JPY 6.6 trillion or 1.3% of GDP. As a result, the government is expected to succeed in halving the primary deficit-to-GDP ratio from 6.6% in FY 2010 to 3.3% in FY 2015. The aim is to reduce this ratio to 1% in 2018 and to achieve a primary surplus by 2020. An important element in the medium-term fiscal strategy is to raise the VAT rate by 2 percentage points to 10% in April 2017. The measure is likely to provoke a recession. On the other hand, postponing the rate hike might cast doubt on the government’s determination to improve the fiscal position and result

in further downgrades of Japanese debt by the rating agencies. The effect of the latter is limited given strong demand for JGBs by Japanese financial institutions.

■ Subdued growth ahead If the government’s three arrow policy undoubtedly helped revitalising the Japanese economy, it still has fallen short of its targets. However, the effects of the structural reform programme are likely only to be noticeable in the medium term. In the coming years, the reforms are likely to spread well beyond the export sector and large enterprises, as the reform agenda will become more targeted at SMEs, agriculture, health care and the services sector.

This year growth is likely to remain at around 0.7% as in 2015. The slowdown in exports, largely related to slowing Asian demand growth is compensated by a strong pick up in domestic demand (close to 1%). In 2017, growth is expected to ease to only 0.4%, assuming that the government will indeed go ahead with hiking the VAT rate to 10%.

The major risk for our scenario is the floundering of the Chinese economy. Given the importance of China - in 2014, almost 25% of Japanese exports were shipped to the PRC (including Hong Kong) – a more rapid slowdown would also lower Japanese growth to zero or even below.

Raymond Van der Putten raymond.vanderputten@bnpparibas.com

3- Is Japan getting out of deflation? %, y/y

▬ UTokyo index — CPI excluding fresh food

Sources: Datastream and BNP Paribas

-3

-2

-1

0

1

2

3

4

2005 2007 2009 2011 2013 2015

economic-research.bnpparibas.com Japan 1st quarter 2016 25

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Ireland Wind in its sails Ireland has returned to a rate of growth close to that which preceded the economic and financial crisis beginning in 2008. However, the fundamentals now look more solid, even though private sector debt remains very high by international standards. The restructuring of the banking system is running its course, as is the clean-up of the public finances. As a small, very internationally open economy, the Irish economy depends mainly on conditions in its main trading partners. With this in mind, the decision to hold a referendum on Britain’s membership of the European Union represents a major uncertainty for 2016. Prime Minister Enda Kenny is likely to be a key figure for the EU in negotiations with David Cameron. The Irish economy has made a spectacular recovery since 2013 when it left the international support programme run jointly by the IMF and the European Union. In 2015 it is likely to have seen economic growth of more than 6%, a marked improvement on the 5.2% it notched up in 2014. The recovery has been driven by the activities of multinationals based in Ireland, which are major players in sectors such as chemicals and pharmaceuticals that traditionally have little sensitivity to fluctuations in the economic cycle. Nonetheless internal demand is picking up the running from exports as the main engine of growth. In 2015, real GDP is likely to have exceeded its pre-crisis level.

■ Flamboyant growth At 1.4% q/q (7% y/y) in the third quarter, GDP growth was boosted mainly by private investment (+4.9%) and consumer spending (+0.7%). Conversely, public spending fell by 1%. In 2016, the fiscal stance is likely to be less restrictive. Lastly, the rate of growth in exports (2.2%) was more than counterbalanced by that in imports (5.4%) in the third quarter. Thus international trade trimmed 2.9 points from GDP growth in the third quarter. Exports are likely to remain strong in 2016, boosted by a weak euro and demand from the country’s three main trading partners: the eurozone (one-third of total exports), the USA (more than 20%) and the UK (over 10%).

Labour market conditions continue to improve. The unemployment rate, which was 9.1% in August 2015, has fallen steadily from its high of over 15% and is back below the eurozone average. Half of the jobs destroyed during the economic and financial crisis were in the construction sector which collapsed as the speculative real estate bubble burst in 2008. However, long-term unemployment remains high and wages are gradually recovering, having stagnated between 2008 and 2014 (-0.5% year-on-year on average). In Q3 they rose by more than 2% year-on-year. Thus household disposable income probably rose by around 1% in real terms in 2015, against a background of virtually stable consumer prices. Inflation continued to fall over the year and was slightly negative (-0.1% from +0.3% in 2014). Surveys of consumer confidence, published jointly by the Economic and Social Research Institute (ESRI) and KBC Bank, thus hit a ten-year high in November.

■ Private sector debt remains high Private non-financial agents (households and corporate) remain heavily indebted. At 290% of GDP, Irish private sector debt is significantly above the eurozone average of 165%. In addition, non-performing loans still represent nearly one-fifth of total bank loans (19.8% in mid-2015, having peaked at over 25% in 2013). Although it has fallen, this level is higher than the eurozone average, and the

share of payment arrears of over 720 days continues to rise, albeit more slowly.

■ The banking system is doing better The rescue of the Irish banking system is beginning to show results, as demonstrated by its smaller size – on the eve of the economic and financial crisis in 2008, the Irish banking system had total assets of EUR 800 billion, nearly seven times national GDP; its reduced dependence on Eurosystem financing (in November 2010, this, including Emergency Liquidity Assistance from the Irish central bank, represented EUR 140 billion, or 85% of Irish GDP); and the

1- Summary of forecasts

e: BNP Paribas Group Economic Research estimates and forecasts 2- Economic growth GDP Growth, %

█ year-on-year, annual average actual and forecast

Sources: Eurostat, BNP Paribas Group Economic Research

Variations annuelles, % 2015 e 2016 e 2017 ePIB G 6.1 4.8 3.7Consommation priv ée P 3.1 2.9 2.2Inv estissement G 17.9 7.1 5.0Ex portations E 12.6 7.7 4.4Indice des prix à la consommation (IPC) H 0.1 1.7 2.3IPCH hors alimentation et énergie H 1.3 1.9 2.3Taux de chômage (%) U 9.4 8.4 7.8Balance courante (% PIB) C 5.6 5.4 5.3Solde des Adm. Publiques (% PIB) G -2.0 -1.3 -0.9 Dette publique (% PIB) G 100.0 95.2 90.7

-8

-6

-4

-2

0

2

4

6

8

2009 2010 2011 2012 2013 2014 2015 2016

economic-research.bnpparibas.com Ireland 1st quarter 2016 26

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fall in the ratio of loans to deposits at the three main Irish banks (Allied Irish Banks, Bank of Ireland and Permanent TSB).

Lastly, regulatory supervision has been improved significantly. The Irish banking system now looks better capitalised by international standards. The aggregate CET1 ratio (excluding preference shares) of the country’s three leading banks was around 10% in the first half of 2015. Although it has improved significantly since the crisis, this remains low in comparison to the rest of the eurozone, particularly given the injection of public funds received by Irish banks in 2010. The full assessment (asset quality review and stress tests) carried out by the ECB and the European Banking Association in 2014 showed that only one establishment had a small recapitalisation requirement, which has since been addressed. Against this background, growth in bank lending has remained modest. However, trends in residential and commercial real estate prices, particularly the latter, remain under close supervision by regulatory authorities who have required banking establishments to change their rules for assessing the borrowing capacity of their clients, taking account of income rather than just the value of the property in question.

■ Challenges for 2016 Ireland has made substantial efforts to consolidate its public finances. As a result, the government deficit was reduced from 11.5% of GDP in 2009 to 4% in 2014. It was probably around 2% in 2015. Although the Irish Fiscal Advisory Council (IFAC) believes that the proposed budget for 2016 as presented in the updated 2015 stability programme is below the preventative requirements of the Stability and Growth Pact, the European Commission believes it to be in line with the Pact. As we approach the general elections this year (no date has yet been set, but they are likely to be held by the end of February), the government announced at the end of 2015 a fiscal stimulus package worth EUR 1.5 billion (less than 1% of GDP); half of which takes the form of tax cuts and increases in public spending. Under these conditions, the government deficit is likely to be slightly more than 1% in 2016. Having peaked at 120% of GDP in 2012-13, total government debt is continuing to fall and should slip back below 100% in 2016. This significant improvement masks some weaknesses. Indeed, two-thirds of this debt is held by foreign investors, which makes its financing all the more sensitive to trends in interest rates and, in particular, to the yield gap between the USA, where the Federal Reserve has begun the normalisation of monetary policy (see USA, page 3) and the eurozone.

Lastly, the possibility of the UK leaving the EU, a so-called Brexit, following a referendum, as promised by British Prime Minister David Cameron, by the end of 2017 would not be without consequences

for the Irish economy given the historic and economic ties between the two countries that reach back for centuries. ESRI is particularly pessimistic on this point. It believes that Brexit would reduce trade between the two nations; at present Ireland imports around 25% of products from the UK, ranking Britain second behind the eurozone, which provides more than a third of imports. In the event of even a temporary lack of a free trade agreement between the UK and EU, the price of British imports would rise, at least temporarily, as the result of the imposition of customs tariffs. A free trade deal on the lines of that between the EU and Switzerland would remove tariffs but would nevertheless slow the movement of goods across borders. Moreover, UK growth would suffer from the impact on the country’s attractiveness to foreign investors. More than 12% of Irish exports go to the UK, making it the third biggest export market after the eurozone (around one-third of exports) and the USA (more than 20%). At the moment there is nothing to suggest that any foreign direct investment leaving the UK following Brexit would flow to Ireland, given the already high presence of foreign companies in the economy. Lastly, Brexit could limit migrant flows between the UK and Ireland, particularly those linked to migration for work, if no free movement agreement was reached rapidly.

Caroline Newhouse caroline.newhouse@bnpparibas.com

3- Trade with the United Kingdom — % of total imports ▬% of total exports (lhs)

Source: CSO

10

11

12

13

14

15

16

17

18

22

24

26

28

30

32

34

2008 2009 2010 2011 2012 2013 2014 2015 2016

economic-research.bnpparibas.com Ireland 1st quarter 2016 27

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Economic forecasts

Financial forecasts

En % 2015 e 2016 e 2017 e 2015 e 2016 e 2017 e 2015 e 2016 e 2017 e 2015 e 2016 e 2017 e

United States 2.3 1.7 1.9 0.1 1.4 2.3 -2.6 -2.8 -3.2 -2.5 -2.4 -2.5 Japan 0.6 0.7 0.4 0.8 0.5 1.9 3.2 2.9 2.8 -4.4 -3.9 -3.2 United Kingdom 2.7 1.8 1.9 0.0 0.9 2.1 -4.8 -4.3 -3.4 -4.0 -2.9 -2.2 Euro Area 1.5 1.6 1.8 0.0 0.5 1.5 3.1 2.8 2.6 -2.0 -1.8 -1.3 Germany 1.5 1.6 2.0 0.1 0.6 1.7 8.1 8.3 8.4 0.9 0.5 0.7 France 1.1 1.4 1.6 0.1 0.6 1.3 0.1 -0.3 -0.9 -3.8 -3.4 -3.0 Italy 0.7 1.3 1.2 0.1 0.4 1.3 1.9 1.7 1.6 -2.6 -2.5 -1.6 Spain 3.1 2.2 2.7 -0.6 0.0 1.2 0.6 0.3 0.4 -4.6 -3.7 -2.3 Netherlands 1.8 1.8 1.9 0.3 1.0 1.3 10.7 9.9 9.3 -2.1 -1.8 -1.6 Belgium 1.2 1.3 1.5 0.6 1.5 1.5 0.4 0.6 0.0 -3.0 -2.7 -2.3 Portugal 1.5 1.5 1.4 0.6 1.0 1.2 1.3 1.5 1.8 -3.0 -2.3 -1.9 Emerging 3.7 3.8 4.5 China 6.9 6.3 6.1 1.4 1.8 2.0 3.5 3.5 3.3 -2.5 -3.1 -3.0 India 7.3 7.3 8.0 4.9 5.9 5.4 -1.3 -0.8 -0.9 -4.1 -3.9 -3.5 Brazil -3.8 -4.0 0.0 9.0 9.0 7.0 -3.4 -2.3 -3.0 -12.0 -10.9 -9.8 Russia -3.8 -2.0 0.5 15.6 8.5 7.0 5.5 1.5 3.5 -5.0 -4.3 -3.0 World 2.9 3.1 3.5Source : BNP Paribas Group Economic Research / GlobalMarkets (e: Estimates & forecasts)

GDP Growth Inflation Curr. account / GDP Fiscal balances / GDP

Interest rates ######## ######## ########

End period Q1 Q2 Q3 Q4 Q1e Q2e Q3e Q4e 2015 2016e 2017eUS Fed Funds 0.25 0.25 0.25 0.5 0.50-0.75 0.75-1.00 1.00-1.25 1.00-1.25 0.01 1.00-1.25 2.00-2.25

3-month Libor $ 0.27 0.28 0.33 0.61 0.88 1.13 1.25 1.38 0.61 1.38 2.2510-y ear T-notes 1.93 2.35 2.03 2.27 2.55 2.75 2.75 2.75 2.27 2.75 2.75

EMU Refinancing rate 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.05 0.053-month Euribor 0.02 -0.01 -0.04 -0.13 -0.20 -0.20 -0.20 -0.20 -0.13 -0.20 -0.2010-y ear Bund 0.18 0.77 0.59 0.63 0.40 0.45 0.50 0.70 0.63 0.70 1.2010-y ear OAT 0.42 1.20 0.90 0.98 0.65 0.70 0.75 1.00 0.98 1.00 1.4510-y ear BTP 1.29 2.31 1.73 1.60 1.20 1.25 1.35 1.60 1.60 1.60 2.30

UK Base rate 0.50 0.50 0.50 0.50 0.50 0.75 1.00 1.25 0.50 1.25 2.003-month Libor £ 0.57 0.58 0.58 0.59 0.75 1.00 1.25 1.50 0.59 1.50 2.2510-y ear Gilt 1.58 2.03 1.77 1.96 2.10 2.20 2.25 2.30 1.96 2.30 2.50

Japan Ov ernight call rate 0.02 0.01 0.01 0.04 0.10 0.10 0.10 0.10 0.04 0.10 0.103-month JPY Libor 0.17 0.17 0.17 0.17 0.17 0.17 0.17 0.17 0.17 0.17 0.2010-y ear JGB 0.40 0.44 0.35 0.25 0.50 0.60 0.65 0.70 0.25 0.70 0.90

Exchange rates End period Q1 Q2 Q3 Q4 Q1e Q2e Q3e Q4e 2015 2016e 2017eUSD EUR / USD 1.07 1.11 1.12 1.09 1.04 1.02 1.00 1.02 1.09 1.02 1.10

USD / JPY 120 122 120 120 128 130 134 134 120 134 135EUR EUR / GBP 0.72 0.71 0.74 0.74 0.69 0.69 0.67 0.67 0.74 0.67 0.73

EUR / CHF 1.04 1.04 1.09 1.09 1.12 1.14 1.14 1.16 1.09 1.16 0.01EUR/JPY 129 136 134 131 133 133 134 137 131 137 149

Source : BNP Paribas Group Economic Research / GlobalMarkets (e: Estimates & forecasts)

2015 2016

2015 2016

economic-research.bnpparibas.com Detailed forecasts 1st quarter 2016 28

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© BNP Paribas (2014). All rights reserved. Prepared by Economic Research – BNP PARIBAS Registered Office: 16 boulevard des Italiens – 75009 PARIS Tél : +33 (0) 1.42.98.12.34 Internet : www.bnpparibas.com - www.economic-research.bnpparibas.com Publisher: Jean Lemierre Editor: William De Vijlder