Economic prospects: the challenges & opportunities

July 2008

BUSINESS UNIT IN HERE

Trevor Williams, Chief Economist

Lloyds TSB Corporate Markets

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There are two overriding global economic themes at present in my view, one is the credit crisis, the s econd is the return of price inflation. The key risk is t he latter.

• The first stems from a bursting of the first asset price bubble of the new century. It was caused by too low interest rate s from 2001 onwards, high liquidity and hence a ‘search for yie ld’, aided by complacency about risk

• The second stems from fast growth in the world econ omy, that is now pushing up demand for commodities to fuel that faster pace of growth and, as a result of rising living standards, greater demand for better food and more goods. This is showing up in higher oil prices and in rising prices for manufactured goods exports.

• The solution is tighter policy in the developed & d eveloping economies and more open markets, like in agricultur al goods. But will this be the outcome?

Setting the scene

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Assessing the impact of the credit crunch so far

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Liquidity has drained out of financial markets…

Source: Bank of England

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Credit risk has fallen but remains volatile and…

150

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09/0

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35Bps Index

Vix, rhs, stock market volatility

Itraxx, lhs, credit market riskiness

Source: Bloomberg

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….concern about liquidity has widened borrowing spreads…

Source: Bloomberg

UK corporate spreads over benchmark bond yields

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AAA AA A BBB

BB B C

Spread, Bps

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…raising the cost of funds

Source: DataStream & LTSB Corporate Markets

So mortgage spreads have risen for most borrowers

3.5

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99

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2yr - 95% LTV Tracker2yr - 75% LTV

%

bps spread, 3mth libor - base rates

J F M A M J J A S O N D J F M A M J-60

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2007 2008

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Financial markets remain volatile – the dollar conti nues to slide and equity markets are uncertain…

Source: DataStream & LTSB Corporate Markets

Index Jan 07 = 100

J F M A M J J A S O N D J F M A M J75

80

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105Yen

Euro

UK £

Brazilian real

Canadian $

Australian $

2007 2008

Index Jan 07 = 100

J F M A M J J A S O N D J F M A M J65

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DJ Stoxx

FTSE 100

Dow Jones

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2007 2008

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…fixed term rates are rising, short term interbank r ates are up

Source: DataStream & LTSB Corporate Markets

%, 10yr gov't bond yields

J F M A M J J A S O N D J F M A M J3.0

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UK, lhs

US, lhs

EU, lhs

Japan, rhs

%, 10yr gov't bond yields

2007 2008

%, 3mth interbank rate

J F M A M J J A S O N D J F M A M J2.0

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%, 3mth interbank rate

2007 2008

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What are some of the medium term implications of the crisis – for regulation?

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Lessons from the recent financial turmoilArea of weakness Specific issues raised

Liquidity management • Underinsurance against closures of key funding markets.

• Inadequate recognition of contingent liquidity obligations to off balance sheet entities.

• Scenarios used in the stress testing of funding insufficiently severe.

Valuation of complex structured products

• High dependency on models in valuation.

• Extent of investors’ reliance on a narrow ratings metric.

• Insufficient clarity in the composition and construction of instruments.

Opacity of structured credit exposures

• Inadequate disclosure of exposures and losses.

• Lack of transparency in off balance sheet exposures.

Crisis management arrangements

• Insolvency arrangements for banks.

• Deposit insurance regime.

• Improvements in tripartite arrangements.

• Underdeveloped practical arrangements for managing stress at an international institution.

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What are the likely results?

� Change in legislation as regulators try and catch u p with the markets.

� Greater transparency, for issuers, insurers, rating s, credit scoring methodologies, disclosure of who has debt, implications for balanc e sheets of exposure (confidential to regulator).

� Understanding and reporting of total leverage and so exposure of whole of firm risk is required in future, not just on balance sheet, but all products. Only then can proper analysis be taken of risk of defaults.

� Models have only be taking account of risk on balan ce sheet (i.e. regulated capital), totally missing overall risk. This is gross failure on an e pic scale.

� Scenarios / stress testing must be more varied and ‘blue sky’.

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What are the implications?

� Global economic growth is likely to slow to around 4.3%, but should still remain relatively robust, led by continuing solid e conomic performance from emerging markets.

� Financial strains are likely to remain until the fu ndamental questions of valuation and exposure are addressed – how much liab ilities have to be brought on to balance sheets?

� Corporate and individual insolvencies forecast to r ise, reflecting weaker economic growth, tighter credit conditions and high leverage.

� Risk of recession (receding fast) in those countrie s most affected by the ongoing turmoil in credit markets, notably the US.

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What are some of the medium term implications of the crisis – for the financial players in the market place?

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What are the implications for financial firms?� Those reliant on wholesale markets will see a sharp rise in the cost of

capital, lowering profits and leverage� The higher the credit rating, the lower the cost of finance so higher rated

will gain relative to lower rated companies� There will be a return to relationship banking and deposit taking

institutions will gain relative to wholesale borrow ers. That may make retail banks more competitive versus investment banks.

� Private equity to gain too, as those seeking higher returns turn from credit instruments to old fashioned value investments.

� Sovereign wealth funds to remain a key feature of t he future financial landscape

� Developing markets gain at expense of the developed markets, as crisis was in developed markets and made their assets chea per

� Mortgage banks to lose out compared to older retail institutions, as they have moved into these new markets with weaker balan ce sheets and less experience

� Firms with global presence in emerging markets to g ain relative to others

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So what’s in store for the world economy?

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Global growth 2008; fast in emerging markets, slow in developed markets

Real GDPNorth America 2007 2008 2009 2010 2011 2012United States 2.2 1.7 2.6 3.4 3.2 3.0Canada 2.6 1.4 2.4 3.1 2.8 3.0EuropeEurozone 2.6 1.7 2.0 2.0 1.9 1.9Germany 2.6 1.8 2.0 1.5 1.5 1.5France 1.9 1.7 2.0 2.1 2.0 2.0Italy 1.7 0.7 1.5 1.4 1.3 1.3UK 3.1 1.8 2.0 2.9 2.6 2.8EU27 2.9 1.7 2.2 2.3 2.3 2.3AsiaJapan 2.1 1.5 1.9 2.1 2.1 2.1Emerging Asia 9.2 8.6 7.5 7.3 7.2 7.2China 11.4 10.8 9.1 8.7 9.2 9.2India 8.9 7.9 7.6 7.6 7.6 7.6World 2000 PPPs 4.8 4.2 4.1 4.3 4.3 4.3

Despite the credit crisis, growth to remain positive – no recession

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Emerging markets continue to outperform…

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Advanced

F'cast

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…but inflation poses a serious risk to global econom y…

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…especially in the emerging markets

% increase in year, inflation

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China

Russia

Brazil

India

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Philippines

Argentina

Indonesia

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We project a weaker £, rate rise in the UK (2009), higher EU (2008) & hikes in US rates (2009)

So what does this all mean for the $, £, euro and their interest rates?

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End quarter exchange rates v UK £Forecasts

£ buys US$

£ buys euro

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Short term interest rates, %Forecasts

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Euro

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Possible triggers for a global economic crisis • Asian/World inflation builds up unexpectedly• Diversification away from US assets/fall in USD, due to housing market collapse, fiscal and external deficits• A further leg to the credit crisis could exacerbate economic slowdown, i.e. another credit crisis• Oil prices – have been rising to record highs recently. Iran a wildcard?• EU risk from over tightening and strong currency?• UK fiscal policy too loose, currency at risk of even sharper fall?• Commodity prices are rising, oil, metals, food, does this pose a bigger threat?• China slows sharply, derailing global economy

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