Outlook 2015

Europe: future leader or eternal laggard?

> Content Preface 03

chapter I Global economic outlook 1 Introduction 06

2 United States: : balanced growth in a lower growth trend 08

3 Japan: ‘Abenomics’ not yet convincing 12

4 Eurozone 14

5 Emerging markets 23

6 Global balance of payments imbalances are declining 26

7 Risks and policy challenges 29

8 Conclusion 31

chapter II Financial markets outlook 1 Walking a tightrope… 33

2 Will the ECB take over the baton from the Fed? 37

3 The implications of quantitative easing by the ECB 45

4 High Yield under pressure 51

5 The euro-dollar exchange rate in the middle of a tug of war 54

chapter III Dutch economic outlook 1 Recovery continues but remains fragile 62

2 Export growth limited by European problems 67

3 Housing market recovery continues 69

4 The consumer is still the weak link 71

5 Government policy: good for the long term, not so good for recovery in the short term 78

References 85

Appendix 87

Disclaimer & colophon 90

In any case, it seems very likely that the growth figures seen in the years preceding the crisis are now very utopian. Accordingly, this Outlook 2015 does not offer any jubilant story, but stresses that there is certainly no reason for exuberant optimism. The prospects for the global economy are far from spectacular, with the eurozone as the main problem, and a significant number of downside risks that could completely disrupt global growth. While the Dutch economy will perform substantially better in 2015 than it did in the year behind us, we will have to be satisfied with very modest growth that still falls far short of the GDP

growth figures we were used to before the onset of the crisis.

There are still substantial underlying imbalances in the global economy. The accommodative monetary policy pursued by the central banks has opened up a gap between the valuations of various financial instruments on the one hand, and economic growth and corporate profits on the other. Certain important trends that threaten to pressure potential growth require a robust approach and will not permit policymakers to rest on their laurels. For instance, there is the high level of unemployment in Europe, especially among young people, that is crying out for a policy agenda to achieve economic growth. The design flaws in the EMU have also still not been fully addressed, although the banking union represents good progress on the way to the necessary further European integration.

> Preface

WIM BOONSTRA

“ Like the rest of the eurozone, the Dutch economy will grow faster in 2015 than it did in the year just past.”

Like the rest of the eurozone, the Dutch economy will grow faster in 2015 than it did in the year just past. But growth will remain low, and unemployment high. There is still no consensus among economists regarding the structural growth path we have embarked upon since the eruption of the financial crisis in 2008 and the Great Recession that followed.

Outlook 2015 04

In our humble opinion, growth has to be encouraged by a combination of a stimulative budgetary policy and an accommodative monetary policy. Take for instance the United States, where an expansive budgetary policy is accompanied by a very sizeable package of quantitative easing. Or the UK, where while there has been significant austerity, the central bank is exerting every effort to kick start the economic recovery. Both these economies are currently doing substantially better than the countries in the eurozone, where a one-sided fixation on budgetary austerity and a cautious central bank have been standing in the way of a real recovery in growth.

To address trends such as the ageing of the population and technological developments, we need a more flexible labour market, investment in good education and a programme focused on lifelong learning to prepare society for the increasingly rapid changes that characterise today’s world.There are still necessary policy gains to be realised in our own country as well. While both Prime Minister Rutte’s cabinets have introduced substantial reforms in recent years, there is now a unique opportunity to bring the Netherlands out of the crisis in a stronger position through a reform of the tax system. There is broad political support for simplification of the system of allowances and reducing taxation on employment. Reducing the taxation on employment could strengthen the policy to increase the labour potential that has already been introduced. This Outlook 2015 addresses this in more detail.

It remains only for me to say that I hope you enjoy reading this edition of Outlook and that it will offer you some inspiration, despite its message of moderate optimism. And of course, I wish you and those close to you a healthy, happy and successful year in 2015.

Wim BoonstraChief economistRabobank

WIM BOONSTRA

“ The eurozone is expected to show economic growth in 2015. Nonetheless, Europe continues to be the problem child of the global economy.”

chapter I > Global economic outlook

Recovery, but no reason for over-optimism

Outlook 2015 06

Since the financial crisis in 2008 and the Great Recession that followed, the global economy has clearly entered a lower growth trend. This applies especially to the richer and so-called industrialised countries. The aftermath of the recession features high unemployment and high levels of public and private debt. The global economy is now growing at a rate of around 4% a year, but growth rates in different areas vary widely.

Among the industrialised countries, the United States and the United Kingdom are generating relatively high rates of growth. In the eurozone however, the recovery is still far from convincing. Economic growth is also slowing in Japan, despite all the policy initiatives designed to combat this. And unemployment has yet to fall to pre-crisis levels almost everywhere in the industrialised world, with Germany as the important exception. In some of the emerging markets as well, growth in 2015 will fall short of the rates we have become accustomed to in these regions.

There is a danger that low economic growth will become permanent. In large parts of the world, economic growth is already under pressure due to flattening growth or even contraction of the labour force. More or less all the economies are suffering from a relatively high output gap, meaning that their actual Gross Domestic Product (GDP) is lower than their potential GDP. This suggests in

1 > Introduction

Outlook 2015 07

theory that there is potential for higher growth in order to catch up. This catch-up growth can however only occur through a boost to spending. If this does not occur, the output gap in individual countries can close through a decline in potential GDP. The long-term unemployed may lose their skills, highly educated people with no job may leave to try their luck elsewhere and low business investment could lead to an obsolete capital stock, resulting in a decline in capital productivity. So a return to a higher growth rate is of great importance. This article gives a general account of the expected development of the global economy in 2015, after which we address the situation in the eurozone in more detail. This is because firstly, the challenges there are still the greatest and the recovery is the least convincing, and secondly of course because the fortunes of the Netherlands are closely linked to those of the rest of the eurozone. We then describe the risks to economic growth in 2015.

This article deals with economic growth in the traditional definition of the term. We therefore discuss the increase in GDP and employment. Work is important because it generates income and offers people opportunities for development. The excessive level of unemployment mainly in southern Europe illustrates the urgent necessity of changing policy to a more growth-oriented stance. This article also ignores what is perhaps an even greater challenge, which is the equally urgent need to move to an ecologically and socially sustainable growth model. This raises questions about our definition of prosperity, which in turn exposes the limitations of GDP as a growth indicator. Especially in the rich countries, which for years have been able to amply provide for the material needs of their populations, there will be an increasing need to measure prosperity and wellbeing in a different way than GDP per capita. The solution to this question will require a radical change of policy based on a paradigm shift. The study by Hans Stegeman deals with these questions in more depth.

1 > Introduction

Outlook 2015 08

2 > United States: balanced growth in a lower growth trend

The US economy is one of the best-performing economies among the industrialised countries. At first glance, it would seem that the country has shaken off the effects of the crisis. Economic growth will amount to 2½% in 2015, after 2¼% in 2014. The budget deficit has returned to approximately 3% of GDP and government debt has stabilised at around 105% of GDP. The US current account deficit has been significantly reduced (figure 1). Initially, this was due to a sharp contraction in imports in the recession year of 2009. More recently, the deficit has increased again somewhat, but as a percentage of GDP it has more than halved since the years preceding the crisis.

exports of goods imports of goods

trade balance balance on current account

Figure 1: Signi�cant reduction of US current account de�cit

US balance of payments (1980-2013)

USD billion

-3000

-1000

-2000

0

1000

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Source: US Bureau of Economic Analysis

Outlook 2015 092 > United States: balanced growth in a lower growth trend

Shale gas has played an increasingly important role in recent years. The large-scale extraction of shale energy has led to lower energy costs for US industry. The gap in the US energy balance is also falling fast (figure 2). In 2008, the year of the crisis, net US imports of energy amounted to more than USD 400 billion. In 2009 this fell by more than USD 200 billion due to the recession, which contributed to a decline in both the price and the volume of energy imports. Since then we have seen a gradual increase in US energy exports and, since 2011, declining energy imports. If this trend continues, one may expect the United States – traditionally one of the largest net importers of energy – to become a net exporter within the foreseeable future.

Figure 2: The gap in the US energy balance is falling fast

-600

USD billion

200

100

0

-100

-200

-300

-400

-500

2001

energy imports energy exports net energy balance US

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Source: US Bureau of Economic Analysis

The consequences of this are numerous and diverse. The price of energy for US industry is one third of that in Germany, where the so-called Energiewende (Energy Change) has actually led to much higher energy prices. This strengthens the competitive position of US companies. One can already see that US exports of energy-intensive products are growing rapidly. This and the sharply falling energy bill are supporting the US trade balance and therefore also the exchange rate of the US dollar. The sharp fall in US dependence on foreign energy may also have geopolitical consequences, if the country has less reason to be concerned about the Middle East, for instance. The other side of this of course is that shale gas makes very little contribution to sustainability. The price of this energy turnaround consists of greater environmental pollution and higher CO2 emissions.

Outlook 2015 10

The US economy started slowly in 2014, due to one-off factors such as an extremely severe winter. After this the recovery in growth was robust, with economic growth in real terms this year amounting to more than 2%. As mentioned already, we expect to see the US economy grow in volume by around 2½% in 2015. Unemployment will fall further and inflationary pressure remains limited.

This apparently rosy picture obscures the fact that the US economy, too, appears to have entered a lower structural growth trend. The rise in labour productivity has slowed and labour participation has also fallen. The lower level of unemployment must therefore to some extent be attributed to a smaller labour force. In the longer term, there will be pressure on potential growth from demographic factors. This means that the long-term outlook for US government finances is also less rosy. The results of the mid-term elections mean that the Republicans now have a majority in both the House of Representatives and the Senate. This could lead to a policy impasse, whereby the final years of President Obama’s tenure could be lost years. This is not a good thing. Lower economic growth, higher interest costs (especially if monetary policy is normalised) and rising costs for the ageing population in the form of retirement provisions and health care costs will, in the absence of a change in policy, lead to an increasing government deficit in the medium to longer term. It is true that just as in the past, the Americans can fund their deficits fully in dollars and that as a country the shale gas revolution is a significant windfall profit. As long as the dollar continues to have its special status in the world order, it is unlikely that the Americans will encounter difficulties in funding their budget deficit. The fact that the United States as a ‘deficit country’ is better positioned in many respects than Japan, a ‘surplus country’ (see below), is mainly due to the dollar’s special status.

One important question is when the US central bank, the Federal Reserve Board (Fed), will start to tighten policy (see also the article by Elwin de Groot on the financial markets). A tighter monetary policy will entail a higher policy interest rate, a reduction in the monetary base and rising bond yields, and will definitely affect the real economy. Financial bubbles, to the extent they have occurred, will collapse. The effects will be felt around the world, also in emerging markets. We do not expect the Fed to take this step before the end of 2015, if at that time it is sure that the US economy is strong enough to withstand the shock. It is a balancing act, because premature monetary tightening could damage economic growth, while leaving it too late could cause higher inflation, or expectations thereof.

2 > United States: balanced growth in a lower growth trend

Outlook 2015 11

ConclusionThe United States will also be one of the best-performing industrial countries in 2015 in terms of economic growth, the labour market and government finances. In the longer term, growth will subside and the state of government finances will deteriorate as a result of this. We do not however see this as causing serious financial problems.

2 > United States: balanced growth in a lower growth trend

Outlook 2015 12

3 > Japan: ‘Abenomics’ not yet convincing

Japan has experienced low economic growth for decades, with a deflationary environment and systematically deteriorating government finances. However one has to say that adjusted for demographic developments, Japan is not performing as badly as at first sight it would appear. Japanese stagnation is occurring at a high level of prosperity, measured by GDP per capita.

Japan has traditionally featured high savings surpluses, as measured by the balance of the current account of the trade balance (figure 3). The extremely poor state of government finances in an international perspective, with a deficit of 7% of GDP in 2014 and government debt of 245% of GDP, are for the time being thus mainly an internal problem. The Japanese private sector has such a large savings surplus that the country can amply fund the government deficit on its own. But one cannot conclude therefore that Japan is doing well. The Japanese savings surplus is melting away, growth is still low and while the danger of a reversion to deflation has moved to the background, underlying inflation remains stubbornly low. In 2007 Japan had the world’s third-largest savings surplus, but in 2014 it fell out of the top ten. The underlying cause is a large turnaround in the trade balance, which is now showing a deficit. This is mainly due to higher energy imports as a result of the cessation of production of nuclear energy since the tsunami in March 2011. Indeed, Japan intends to restart nuclear energy production again to some extent. In the longer term, the Japanese demographic contraction will lead to a decline in the savings surplus, which over time will turn into a savings deficit.

Outlook 2015 133 > Japan: ‘Abenomics’ not yet convincing

Japanese government finances are sustainable for as long as the country has a savings surplus and the government can finance its debt at a low rate of interest. Were Japan to become dependent on the financial markets for the funding of its government debt, one would have to fear that problems would occur. The interest costs would quickly become unsustainable at a market interest rate, certainly in a situation of very low nominal economic growth. Fortunately, we are not anywhere near such an outcome. Japan has built up very sizeable foreign investments in the past which it could possibly liquidate if the savings surplus turns into a savings deficit. Japan also has a strong economic base with a powerful and internationally operating industry. However this does not change the fact that the state of Japanese government finances is not sustainable in the long term without a change in policy. If the Bank of Japan continues its massive purchases of Japanese government debt while the country has a savings deficit, a sharp downward correction to the yen cannot be ruled out. This could lead to the long hoped-for substantial rise in the inflation rate through import prices.

It is disappointing that Japan has not yet succeeded in bringing its economy up to speed. Its very aggressive monetary policy has indeed succeeded in pushing inflation slightly higher and increasing growth to some extent, although the latter measure has fallen away again in response to the large increase in VAT imposed earlier this year. Underlying inflation is also still too low. We expect growth to slow further in 2015, with the possibility that a substantial (2%) increase in VAT will again undermine growth. Government finances remain as weak as ever, inflation is too low and structural reforms are faltering. Reforms are needed to increase the potential for growth, but very difficult to realise in political terms.

Conclusion2015 will not deliver any decisive evidence that ‘Abenomics’ can achieve success. In the event of failure, this will inevitably raise concerns regarding the sustainability of Japanese government finances over time.

Outlook 2015 14

In some countries the crisis has left deep social scars in the form of extremely high unemployment, especially among young people. Southern Europe in particular is in a socially unsustainable situation, with youth unemployment in some countries rising to around 50% . This outlook of hopelessness is causing many mainly well-educated people to seek their fortunes elsewhere, leading to a brain drain that is undermining the growth potential of countries such as Portugal, Greece and Spain. While the news that growth will recover in these countries as well is welcome, it cannot disguise the fact that it will take a long time before the unemployment figures return to more tolerable levels. Parliamentary elections will be held in most of the countries in the southern eurozone in the coming years. It is difficult to imagine in this context that the current parties in government will remain in power. There is a good chance that the policy consensus will be debated, and that this will lead to serious political tensions between the eurozone countries.

4 > Eurozone still a problem

The eurozone is also expected to show economic growth in 2015. The recovery will be supported, or to put it more accurately, less hindered by budgetary policy, which overall will be less restrictive than it has been in recent years. Nonetheless, Europe continues to be the problem child of the global economy. Not only because the cyclical recovery in the eurozone is more hesitant and uneven than anywhere else, but also because there are serious underlying imbalances.

Outlook 2015 15

Much work has been done on strengthening the institutional framework of the eurozone in recent years. An amended Stability and Growth Pact (SGP), the introduction of the European semester and the formation of the banking union, to name but a few examples, will lead to a stronger and more effectively managed eurozone. The completion of the Asset Quality Review in November 2014 is also an important step towards a better-functioning banking sector, even though this will not yet contribute to a clear recovery in bank lending in the near future (Verduijn 2014). The European Central Bank (ECB) has also made a significant contribution to strengthening confidence in the euro (see also the article by Elwin de Groot). The formation of the banking union and the Asset Quality Review that preceded it represent significant progress in strengthening confidence in the banking system. However, the ECB has not yet succeeded in coming up with targeted measures to return bank lending to a sound level. The ECB’s problem is that while it can buy time by intervening in the financial markets, it cannot do anything about the underlying structural problems in the eurozone. Only the politicians can do this.

This is why it is especially disappointing that national politicians in most of the large countries in many respects have failed to address this. Germany, the largest economy in the EMU, is seeing economic growth slow down. The country has a balanced government budget and a far too high current account surplus in its balance of payments, and therefore ample potential for stimulating economic growth, for example through useful investments in physical infrastructure. However it does not look as though this is on the cards at the moment. Germany is also not making much progress on structural reforms. The relatively favourable developments in recent years are mainly due to the reforms made by Gerhard Schröder (the predecessor of Chancellor Angela Merkel). Since that time, Germany has shown little or no policy leadership with regard to the economy. One exception to this is the radical, but expensive and so far not especially successful Energiewende (Energy Change).

The lack of policy leadership from Germany is a significant factor in the weak growth generated by the eurozone. The latest policy proposals from the German government actually point in the other direction: they want to reduce the retirement age for some groups of employees. For a country with one of the fastest-ageing populations in Europe, this is not a sensible policy. Unfortunately, Germany is not alone. France, Europe’s second largest economy, is also pursuing a very weak policy. The country has a budget deficit of more than 4% of GDP and a public debt of more than 95% of GDP, and is therefore not meeting the requirements of the SGP (figure 4). What is worse is that France is lagging far behind as regards economic reforms that are desperately needed. The country

4 > Eurozone still a problem

Outlook 2015 16

features weak government finances, a poorly functioning labour market and extensive bureaucracy. The effective retirement date is less than 59 years. As a result of this, the country is totally unprepared for the ageing of the population. The fact that France has a relatively high birth rate and is thus one of the countries with the least rapidly ageing populations offers only temporary comfort. It is only recently that the French government seems to have taken account of the seriousness of the situation. Unfortunately the years of policy failure mean that the country now has almost no possibility in its budget to ease the painful short-term effects of structural reforms with a somewhat easier fiscal policy. Furthermore, the manner in which the country is still attempting to evade the European rules offers little cause for optimism.

Figure 3: Global overview of public debt and de�cit, % of GDP

total public debt

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5

10

0

-5

0 50 100 150 200

eurozone members EMU

other countries

bubble size is proportional to 10y government bond yields (27 October 2014)

250

budg

et b

alan

ce

AT

BE

FI

FR

DE

GR IE IT

NL

PT

ES

EMU

GB

SE

DK

NO

CH

US JP

CA AU

NZ

Source: IMF, Macrobond

For years, Italy has featured minimal economic growth, very high government debt and high unemployment, but on the other hand it appears to be slowly awakening from its lethargy. The new Prime Minister Renzi seems to be cut from a different cloth than his predecessors. The country has a long way to go in dealing with its problems, since as in France much maintenance work is well overdue. Italy also still has a lot of bureaucracy, a poorly functioning labour market and a relatively rapidly ageing population. Much needs to change, and Italian politics are so sluggish that everything could still go wrong.

4 > Eurozone still a problem

Outlook 2015 17

Interest-rate differentials within the eurozone have fallen sharply since the middle of 2012 due to central bank intervention on various occasions. This indicates a return of confidence in the future of the euro. The other side is that the European currency has become relatively strong as a result of capital inflows from abroad. This has put a brake on European exports and also contributed to the increasingly deflationary tendencies in the eurozone. At the same time, a key weakness in the eurozone, the fragmentation of its government bond markets, has still not been addressed. This means that if the financial markets lose confidence in France or Italy for instance, interest-rate differentials within the eurozone could rise rapidly again. Even a large country like Italy or France indeed could then encounter difficulties in sustaining the level of its government debt. Of course, everyone expects the ECB to step in with massive purchase of Italian or French government paper to turn the tide in such a situation. But it should be clear that the situation is not really sustainable if these countries continue to make poor policy decisions. The fact that French politicians have learned nothing of the fate of Spain for example is not a good sign. This emphasises the fact that the eurozone’s institutional framework is incomplete. In practice, the European Commission has little or no influence on the way in which structural reforms are introduced in the individual Member States, while this is of decisive importance for the sustainability of government finances in the long term and far more important than budgetary policy in the short term.

Another important lesson from the last few years is that the eurozone Member States, and particularly the smaller ones, would be well advised to maintain a wide margin with regard to the maximum deficit ceiling of 3% under the SGP. Even before the introduction of the euro, there were warnings that the smaller Member States faced a risk that their economic cycles would be out of step with the European average. The ECB sets its monetary policy on the basis of the eurozone average, which in practice means that it focuses on price developments in the large Member States. So it is very possible that policy will not be appropriate to the economic development of the smaller countries. This means that the smaller countries need greater flexibility in their budgetary policy, while the SGP imposes strict budgetary norms. We also have to recognise that even countries that behaved properly with respect to budgetary policy in the run-up to the crisis like Spain and Ireland can still encounter serious problems due to large savings deficits building up in the private sector.

The eurozone is on the edge of deflation. Despite the application of numerous unconventional measures, the ECB is not succeeding in achieving its inflation target of around 2%. The ECB’s deposit facility now pays a negative rate of interest and short-term Dutch and German government bonds provide a yield

4 > Eurozone still a problem

Outlook 2015 18

of approximately 0%. The ECB’s task of achieving its inflation target has definitely not been made easier, mainly because other policymakers in the eurozone do not seemingly understand that policy needs to be directed more towards generating economic growth. The longer inflation remains low, the greater the risk that expectations with respect to future inflation will be adjusted downwards. If the expectation that prices will actually decline on a structural basis takes hold, the eurozone can expect difficult times (Boonstra & Verduijn, 2014). While this is not our base scenario, there is now a serious risk of deflation. Anyway, low inflation is a problem in itself. It makes nominal adjustments within and between countries difficult to realise. Moreover, slightly faster nominal growth would make it much easier to reduce debt levels.

The problem here is that it seems as though the ECB has more or less exhausted all the weapons in its armoury. With policy interest rates close to zero or even below zero, we have reached the lower limit. A further decline in interest rates is not really possible without risking unpredictable effects on the stability of the financial system. The special stimulation programmes (LTRO and TLTRO) have not yet had the desired effect on bank lending and this is not expected to happen in the near future. What the eurozone needs is a strong boost to spending in combination with monetary funding. Only then will the newly created money actually appear in the real economy in the form of real spending. For instance, this could take the form of an extensive EMU-wide package of reforms in transport infrastructure, clean energy, education and innovation. Things that in the short term will boost economic growth through the related spending and that will increase the growth potential of the eurozone in the longer term (see also IMF, 2014). Gradual work on the further deepening of the economic integration of the EMU is also needed. An important priority here is increasing the cross-border migration of labour within the eurozone. Based on demographic projections it is clear that some countries, especially Germany and Italy, face a contracting labour force while other countries will face high levels of unemployment for many years to come. Increased cross-border mobility of labour between the Member States will contribute to both higher growth potential for the eurozone as a whole and lower unemployment in southern Europe. From any point of view, this would be a win-win situation.

4 > Eurozone still a problem

Outlook 2015 19

United KingdomOutside the eurozone, the successful growth performance by the British economy is notable. Despite the serious political uncertainties that the Cameron government has evoked across the country, the economy is steadily growing, unemployment is falling and government finances are improving. Because it is not part of the eurozone, the UK has managed to avoid the too restrictive budgetary policy in the EMU and is now enjoying the benefits of this. The price is a still excessive government deficit and a level of government debt that has stabilised at above 90% of GDP. The current account balance is also deteriorating.

After the close call over the independence referendum in Scotland in September 2014, the United Kingdom is still looking forward to uncertain times. Not only will there be intense scrutiny of how the promises made to the Scots in the event of a ‘no’ vote are fulfilled, there is an even more important referendum on the UK’s membership of the European Union (EU) looming on the horizon. A ‘no’ vote by the UK with respect to the EU would be bad news for Europe, but without doubt for the UK as well.

ConclusionAfter a long and, especially in southern Europe, a deep recession, the eurozone economy is showing signs of recovery. In our base scenario, economic growth will continue in 2015. But it will take a long time before the damage caused by the crisis is repaired. The effects of the recession will be felt for a long time in the labour market, especially in the southern Member States. Europe therefore needs a strong boost to spending in combination with structural reforms in the lagging countries in order to get growth back on track. An immediate reduction in the taxation of labour, combined with a subsequent and gradual increase in VAT, could boost consumption and introduce new expectations for inflation.There are several risks to the recovery. Inflation is too low and the EMU is eerily close to deflation, a phenomenon that the ECB can do little to prevent. Poor policy especially in France and Italy is undermining these countries’ growth potential and forms a threat to stability in the European financial markets. The eurozone moreover has intrinsic vulnerabilities. Because, although much progress on broadening and deepening the political foundation for European integration has been made, the fragmentation of the government bond market is still a significant flaw that has not yet been addressed. Unless economic integration is strengthened and unless conditional euro bills or bonds are introduced to remove the fragmentation of the government bond market to some extent, the EMU will continue to be as vulnerable as ever to turns in market sentiment (Boonstra, 2012).

4 > Eurozone still a problem

Outlook 2015 204 > Eurozone still a problem

BOX 1 – The economic cycle in the eurozone

The eurozone has slowly struggled out of recession. The recovery of economic growth during

2013 has continued hesitantly in 2014. But the recovery is certainly not at all convincing, given

the average quarterly growth of 0.2 per cent achieved so far in 2014. We expect GDP volume to

have increased by ¾% in 2014. The good news is that the recovery is fairly broad-based, especially

since domestic consumption is also picking up. The growth is also broad-based in geographical

terms: with the exception of Italy (-¼%), all the large EMU Member States will show positive

growth figures in 2014. Looking ahead, this trend will continue in 2015. We expect economic

growth to accelerate slightly to 1¼%, with a further positive contribution to growth from

domestic spending. We also expect Italy to show positive (albeit modest) growth in 2015.

Government debt of the eurozone as a whole is stabilising, with the government deficit of on

average 2.5% of GDP below the maximum permitted level of 3% and unemployment is falling

again.

Table 1 Key figures eurozone, year-on-year change (%)

2013 2014 2015

Gross Domestic Product -0,7 ¾ 1¼

Private consumption -1,0 ½ 1

Government expenditure -0,1 ½ ½

Investment -3,9 1 1¾

Exports 1,2 3 3¾

Imports -0,4 3 3¾

Inflation 1,7 ½ ¾

Unemployment (%) 11,9 11¾ 11¼

Government balance (% GDP) -2,9 -2½ -2½

Government debt (% GDP) 93,3 95 95

Source: Rabobank

The at first sight reasonably favourable cyclical picture however obscures the familiar problems.

We look at the problems of structurally low inflation and the threat of deflation in more detail in

the main text, where we point out that despite the return of growth, the eurozone is still clearly

underperforming most other economic blocks. The developments also vary widely from one

country to another. For instance, Spain will be one of the best-performing economies in the

eurozone in 2014 and 2015, with economic volume growth estimated to reach 1¼% and 1¾%

respectively. This recovery is broad-based. Spain is outpacing the average growth in the EMU area

in both exports and domestic consumption. The nearly 4% fall in unemployment expected

between 2013 and 2015 is also impressive. The other side of this shining growth example is that

Outlook 2015 214 > Eurozone still a problem

the crisis has left deep scars. The absolute level of unemployment of 22½% of the labour force

estimated in 2015 will still be unacceptably high. Government finances are slowly but surely

recovering, but the country is not yet out of the danger zone in this respect.

Italy will show the weakest economic performance of the large economies in 2015 as well. The

forecast of ½% economic growth is in the margin of error of stagnation. Unemployment is rising

further and government finances are weak. The Italian deficit of 2.5% of GDP is indeed still below

the 3% norm, but the country’s already excessive government debt will rise further in 2015 to

around 140% of GDP.

At first sight, France is not doing that badly. The country avoided recession in 2013 and was one of

the better-performing economies in terms of growth. In 2014 and 2015 the country will show a

relatively somewhat weaker performance than the eurozone average, with economic growth of

½% and 1% respectively. Growth in France will however be mainly generated by private

consumption and government spending. It does not look as though 2015 will see any recovery in

business investment. Unemployment is stagnant at over 10% and government finances are

developing negatively, with a deficit of over 4% of GDP and government debt that is approaching

100% of GDP.

The economy with the best cyclical position is Germany. The country’s government budget is in

balance, its government debt is declining and unemployment is low and still falling further. This

last factor is partly due to a contraction in the potential labour force. In terms of growth however,

the country is not performing better than the eurozone average and the undertone is relatively

weak. A strong first quarter (+0.8%) was followed by weak second and third quarters, with growth

of -0.1% and 0.1%. In 2015 economic growth will slow slightly to 1¼% (2014: 1½%). The good

news is that growth in both consumption and government spending will accelerate to some

extent in 2015. The rate of growth in business investment on the other hand is falling slightly.

Foreign trade will also be a slightly negative factor for growth, since growth in the volume of

imports in 2015 will be somewhat higher than that of exports.

Outlook 2015 22

Table 2 Year-on-year change (%)

GDP volume 2013 2014 2015

Eurozone -0,7 ¾ 1¼

Germany 0,2 1½ 1¼

France 0,4 ½ 1

Italy -1,9 -¼ ½

Spain -1,2 1¼ 2

Inflation (%) 2013 2014 2015

Eurozone 1,7 ½ ¾

Germany 1,6 ¾ 1¼

France 1,0 ½ ¾

Italy 1,2 ¼ ½

Spain 1,4 -¼ ½

Unemployment(%) 2013 2014 2015

Eurozone 11,9 11¾ 11¼

Germany 5,3 5 4¾

France 10,3 10¼ 10¼

Italy 12,2 12½ 12½

Spain 26,1 24¼ 22½

Source: Rabobank

If we compare the eurozone with the other large industrialised countries, we see that the growth

rate in the eurozone is clearly lower than in the US or the UK, but slightly higher than in Japan. It is

notable that this is the picture not only with respect to the real increase in GDP, it also applies to

private consumption. The more successful policymakers are in getting private domestic

consumption (spending and investment) to grow, the higher economic growth will be and the

faster unemployment will fall. The focus of policy in the eurozone has been on reorganising

government finances at the expense of domestic spending, while it has in comparison with the

other blocks the strongest (or least weak) government finances. Growth has been expected to

come mainly from exports that has certainly contributed to the poor growth performance and

the stubbornly high level of the unemployment figures.

4 > Eurozone still a problem

Outlook 2015 23

In 1990 60% of the Chinese population was living below the poverty line; today, this is just over 6%. A policy mix with a strong focus on economic growth, encouraging market forces and international trade has ultimately been responsible for the successful outcome. Brazil also did well in this respect until 2010, however since then it has encountered increasingly serious structural problems. Elsewhere, and particularly in sub-Saharan Africa, poverty is still a major problem. In more or less all emerging markets, it is the lack of infrastructure in the broadest sense of the word (transport, education, politics, legal system, financial system, health care) that forms a serious obstacle to continued and sustainable development. In this respect, Africa poses the greatest challenges. The tragedy of the Ebola outbreak in west Africa does not only concern the misery of those directly affected: the beginning of an economic recovery in the countries concerned has been nipped in the bud.

In 2015 the contribution of emerging markets to the global economy will be less convincing than it was in the first years after the crisis. Growth rates are falling virtually everywhere, and particularly in the larger emerging markets. Some countries are experiencing a sharp slowdown. Economic growth in China will be lower in 2015, mainly because the government is striving to keep growth at more sustainable levels. In recent years they have converted their very successful, mainly export-led growth model into a model more based on expansion of domestic demand, especially investment and real estate. Now they have to make

5 > Emerging markets

It was mainly the emerging markets that produced the best performance in the initial years after the crisis. They ensured that the global economy recovered swiftly. Virtually all of them have enjoyed a clearly higher level of prosperity than in 2008 for several years now. In China, hundreds of millions of people have experienced a significant increase in prosperity in recent decades. Above all, it is China we have to thank that the United Nations (UN) millennium target for the reduction of poverty will be achieved.

Outlook 2015 24

the transition to growth that is more consumption-driven. This requires reforms and more market forces, also in the financial sector where there has been a strong increase in bad loans. These frequently concern bad loans from government banks to government businesses, where losses are not properly recognised. Over time, this will lead to an unhealthy and therefore unsustainable situation. China’s foreign trade surplus has already substantially diminished. China has thus made a significant contribution to reducing imbalances in global international payments. With economic growth of approximately 7%, China is still doing relatively well compared to the other large countries. However, the high level of debt in the private sector, the cooling housing market and the point that achieving the same level of extra growth in GDP will require ever higher lending point to a significant downside risk, with all the deflationary consequences this would have for the world as a whole.

Economic activity seems to be picking up in India as well, towards 5% in 2015. The newly appointed prime minister Modi is working steadily on streamlining the bureaucracy and strengthening the operation of market forces. India is the world’s largest democracy and the second-largest country in terms of population, however in terms of income per capita it is also one of the poorest countries. GDP per capita in India amounted to USD 4,000 in 2013 (based on purchasing power parity), significantly lower than in China (USD 9,800), Brazil (USD 12,100) or Russia (18,100). This makes India the poorest of the so-called ‘BRIC’ countries (Source: CIA). The country’s wealth is moreover very unevenly distributed. India is a country of extremes, with on the one hand a huge number of highly educated people (many of whom go abroad), an advanced industry and armed forces with nuclear capability, but also an enormous number of people in extreme poverty. If Modi were to succeed in getting economic growth going properly and achieving Chinese-style growth figures of 10% over a longer period of time, the country could emerge as a new growth driver for the global economy. For the time being however, the country’s economic performance is not so spectacular.

The richest BRIC country is Russia. At the same time however, one could say that Russia does not really belong among the other BRIC countries. It is not really an emerging market. While Russia has impressive wealth in terms of energy resources, a growing SME sector and an emerging middle class are still lacking. Poor economic management and, more recently, economic sanctions in response to the crisis in Ukraine have led to weak economic development and very modest prospects. A political system that in many ways recalls that of the old Soviet Union offers little encouragement to entrepreneurial spirit and foreign investment. However, the country is not isolated in its dispute with the European Union and the United States. Other emerging markets, China and Brazil in

5 > Emerging markets

Outlook 2015 25

particular, are (for economic reasons) happy to assist Russia to circumvent the sanctions that have been imposed.

Latin America is performing poorly in relative terms. This is not surprising, given that two of the largest economies in the region are both performing less successfully. Brazil, which made significant progress in all respects under President Lula, has fallen back again under his successor Dilma Rousseff. Growth has fallen sharply, and the successes achieved by her government in the fight against poverty have been funded mainly out of the government budget and do not have a sound economic basis. Inflation is being kept artificially low and foreign investors are being discouraged. After Rousseff ’s recent re-election for a new term, one has to fear that the country will undergo little economic reform in the next few years.

Argentina has recently defaulted again on its foreign debt. The country has a miserable record in this respect. Poor economic policy and political nepotism have led to a structural decline over decades. 100 years ago, it was still one of the ten richest countries in the world. In 2014 it just about makes the top 80, with further contraction to come. Mexico, one of the richer and largest countries in Latin America, is doing relatively well in terms of economic growth. In this specific case however, the positive picture is unfortunately overshadowed by a rise in brutal, and to some extent political, violence.

5 > Emerging markets

Outlook 2015 26

6 > Global balance of payments imbalances are declining

Prior to the financial crisis, the global economy featured large and increasing balance of payments imbalances. There were countries with large current account surpluses in their balance of payments, against a small number of important deficit countries (figure 4). Especially the United States had for decades been piling one current account deficit on top of another, making it the world’s greatest debtor country.

However, until now the US debt can be more or less entirely funded in dollars. This is due to the special position of the dollar in the global financial order. The US debt is thus offset by the ‘secure’ investments of the surplus countries, which are mainly in dollars. This situation has turned out to be unstable, and it was no surprise that the 2008 financial crisis originated in the United States.

Asia Central & Eastern Europe

North America

Latin America

eurozone Middle East & Africa

-2.0

-0.5

-1.5

-1.0

0.0

0.5

1.0

1.5

2.0

Figure 4: Global current account imbalances, in % of world GDP

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

rest of world

Source: Macrobond

Outlook 2015 27

Global imbalances have significantly fallen since that time. The US current account deficit as a percentage of GDP has more than halved, while China’s and Japan’s trade surpluses have declined, quite sharply in the latter case. However, this means that the uneven distribution of international investment positions, which is mainly determined by current account balances, still remains and is increasing further, albeit at a slower pace (IMF, 2014).

Table 3 The ten largest debtor and creditor countries

2006 2013

USD billion In % of GDP USD billion In % of GDP

The largest debtor countries

United States -1973 -14.2 United States -5698 -34

Spain -862 -69.7 Spain -1400 -103.1

United Kingdom -762 -30.6 Brazil -750 -33.4

Australia -462 -59.2 Italy -739 -35.6

Italy -453 -24.1 Australia -746 -49.6

Brazil -349 -32.1 France -578 -20.6

Mexico -346 -35.8 India -479 -25.5

Greece -237 -90.4 Mexico -445 -35.3

Turkey -206 -39 Turkey -409 -49.8

India -178 -18.8 Poland -380 -73.5

The largest creditor countries

Japan 1793 41.2 Japan 3056 62.4

Germany 782 26.9 China 1686 17.8

Hong Kong 535 276.4 Germany 1678 46.2

Saudi Arabia 513 136.4 Saudi Arabia 1063 142.1

Taiwan 504 134 Switzerland 939 144.3

Switzerland 495 122.3 Taiwan 933 190.9

China 476 17 Hong Kong 767 280.1

Singapore 371 251 Norway 732 142.8

United Arab Emirates 312 140.4 Kuwait 652 353

Kuwait 210 206.7 Singapore 637 213.9

n.b. Netherlands 393 58.0 n.b. Netherlands 800 67.4

Source IMF, DNB

The picture in the eurozone is somewhat more complicated. Here too, surplus countries are offset by deficit countries. Germany is Europe’s largest surplus country and can actually claim to be today’s largest surplus country anywhere in the world. The Netherlands has also been in the top 10 countries with the largest current account surpluses for many years. The deficit countries in the eurozone are mainly in southern Europe.

6 > Global balance of payments imbalances are declining

Outlook 2015 28

As we know, international trade is not a zero sum game. It is an international variant of specialisation and labour sharing, and in principle benefits all the countries concerned. The situation is different when it comes to trade balances. Any trade or current account surplus is offset by a deficit elsewhere. The sum of all these balances worldwide in principle is nil. So it is not the case that by definition a current account deficit is ‘bad’, or a current account surplus is ‘good’. A logical conclusion from this situation would be that when balance of payments imbalances are experienced as a problem, both surplus and deficit countries have an equal obligation to commit to removing the imbalances. In practice however, most of the cost of this commitment falls on the deficit countries, which have little choice other than to work off their deficit even though this makes them more vulnerable. On balance this leads to weak economic development for everyone, since reducing a deficit is achieved mainly by reducing domestic demand, and particularly demand for imports. This is still a problem in the eurozone today. The deficit countries have made extreme efforts to achieve a situation of balance, however the surplus countries have not. Indeed, Germany’s Finance Minister Schaüble recently said that Germany should not adjust its policy toward accommodation, and that other countries should be more like Germany and have savings surpluses. This remark, which borders on the absurd, would be amusing if it were not for the fact that it comes from the finance minister of one of the world’s largest economies. It is a source of serious concern. This type of reasoning is an important cause of the weak and uneven economic situation which the eurozone has experienced for years. It has also led to the eurozone as a whole having a sizeable savings surplus (or current account surplus). The logical conclusion is that the surplus countries in the eurozone should be adopting a (much) more expansive economic policy. However, this conclusion has not yet been reached. If on the other hand this happened, we could look forward to far more robust economic growth in 2015 than we currently estimate.

ConclusionThe good news is that the global imbalances in international payments have declined, as a result of the success of the largest deficit country (the US) and some large surplus countries (China, Japan) in bringing their current accounts to more balanced levels. In Europe, the deficit countries have managed under the pressure of circumstances to reduce their external imbalances through draconian austerity measures, but the surplus countries of Germany and the Netherlands have failed to play their part.

6 > Global balance of payments imbalances are declining

Outlook 2015 29

7 > Risks and policy challenges

The general picture for 2015 is one of moderate growth and is overall moderately positive. Unfortunately, there are a number of downside risks to this at first sight relatively rosy picture. We have already described in some detail the danger that the eurozone will fall into deflation. In any case, the rate of inflation will remain low everywhere in the world. This makes it more difficult to change competitive positions and improve the levels of public and private debt, and, perhaps more importantly, it leaves little room for manoeuvre in monetary policy.

Energy prices have already fallen significantly in the last six months and will remain under slight downward pressure in 2015. However there is a chance that political problems and/or armed conflict in the Middle East will lead to sharp price increases or serious supply problems. In this case the heavy dependence of Europe on Russian gas imports will become a big problem, certainly in view of the strained relationship between Russia and the EU. It is high time for a common energy policy, aimed at reducing European dependence on energy from foreign suppliers. Perhaps the German Energiewende could be the beginning of such a policy agenda, despite the disadvantages this entails in the short term in the form of higher energy costs.

The eurozone is still vulnerable. It is still not an optimal currency area, and much work remains to be done on the better integration of labour markets, strengthening a common budgetary policy, the introduction of conditional euro bonds and further political integration. These processes take much time. In the meantime the ECB will have to keep the eurozone together, as it did in the period from 2010 to 2014. It is important that the politicians back the central bank adequately and at the same time take responsibility for achieving a stronger

Outlook 2015 307 > Risks and policy challenges

European economy in all respects. If there are no effective steps towards further economic and political integration in the EMU, a return to serious tensions in the eurozone cannot be ruled out.In China, there are tensions in Hong Kong. The Chinese response has so far been relatively cautious, but tougher action could occur at any time. The government fears that calls for more democracy will spill over to other cities. China is hugely successful in economic terms, but it is not a democracy. The question of how long fast-increasing wealth and an increasingly influential middle class will be able to co-exist with a one-party system remains open. The experience in Europe is that sooner or later this will no longer be acceptable, and a more democratic order will ensue, either gradually or through revolution. On the other hand, it should be recognised that the example of Singapore shows that this situation can be sustainable for a long period in a different, that is Asian, cultural context. But this remains an important background uncertainty for China in the longer term.

The final risk we would mention in this by no means exhaustive list concerns the outbreak of Ebola in western Africa. If the virus is not swiftly brought under control, this will have dramatic effects for the countries directly affected, and could also spill over into other areas. Compared to other recent epidemics like SARS and bird flu, Ebola appears to be much more dangerous.

Outlook 2015 31

8 > Conclusion

We expect to see reasonable but far from spectacular growth in the global economy in 2015. The underlying imbalances are however serious, and there are still important trends in the background that could undermine the potential for growth. There is therefore absolutely no reason for policymakers anywhere in the world to be complacent. The high level of unemployment, especially of young people, in Europe is crying out for a policy agenda aimed more at economic growth. The design faults of the EMU that were so mercilessly exposed during the euro crisis have only been partially addressed.

Growth has to be encouraged by a combination of a stimulative budgetary policy and an accommodative monetary policy. It is precisely countries like the United States and the United Kingdom, where an expansive monetary policy is combined with a very extensive package of quantitative easing, that are currently better positioned than the countries in the eurozone where a one-sided fixation on budgetary austerity is standing in the way of a return to growth. The actions needed to address the big trends in the background, such as the contraction of the population and new technologies, are to make the labour market more flexible, invest in good education and develop permanent (lifelong) education programmes to prepare people as adequately as possible for the far-reaching and ever-accelerating changes that increasingly characterise the world in which we live. In order to boost both the labour market and purchasing power, policymakers need to reduce taxation on employment and to shift the generation of tax revenue to consumption and capital. A shift from taxation on environmentally friendly activities to environmentally damaging activities is also of great importance. All this requires careful international coordination.

In summary, we can say the global economic growth is picking up to some extent, but that the risks are serious and to the downside, the options for monetary policy are becoming exhausted and the policy agenda is possibly lengthier than ever before. All in all, there is little reason for unqualified optimism.

ELWIN DE GROOT

“ Despite several easing measures and its forward guidance, the ECB is under increasing pressure to start large scale quantitative easing.”

chapter II > Financial markets outlook

On the way to quantitative easing in the eurozone

Outlook 2015 33

The expansionist monetary policy pursued by the central banks has led to a disparity between the valuations of financial instruments and the factors that underpin those valuations, such as economic growth and company profits. As Wim Boonstra argues in the first part of this Outlook, the outlook for the global economy in 2015 is moderately positive but far from robust. That gives rise to all kinds of new risks and problems. The acrobatics have now made way for a balancing act, a tightrope walk in which central banks still have the starring role.

…that is far from stableLast year, we argued that global economic conditions would become a more important factor in the financial markets again due to the tapering of the Fed’s bond purchase programme. This did indeed happen, but the impact it had was far from unidirectional. In particular, the fragility of the economic recovery in the eurozone and elsewhere has been exposed once again. Uncertainty concerning growth in China was a frequent source of market volatility. As a result, high-risk assets such as shares and high yield corporate bonds saw relatively sharp price declines in the second half of 2014, although this was followed by subsequent recoveries. Geopolitical tensions in Ukraine and the Middle East, and the Ebola outbreak in West Africa accentuated swings in market sentiment during 2014. The dollar, on balance, strengthened, in particular against a number of emerging market currencies.The most striking development was the steady, almost uninterrupted fall in global interest rates. The yield on 10-year German government bonds actually reached an all-time low in October at 0.72%. The global nature of the decline in interest rates reflects the increasing disinflationary pressure stemming, in part, from falling commodity prices. The background to these developments is the question of whether liquidity can continue to support the financial markets and

1 > Walking a tightrope…

Since the financial crisis erupted in 2008, market participants have seen some real acrobatics from policymakers. Although the eurozone crisis quietened down in the course of 2012 and the acrobats were able to maintain their balancing act throughout the various mini-crises of recent years, there is a downside to the relative calm.

Outlook 2015 34

whether the ECB is willing and able to take over from the Fed as the global liquidity provider. In this article of the Outlook, we answer these questions and look at the implications for the financial markets.

The Fed needs to get everything rightThe Federal Reserve’s programme for purchasing government bonds and MBS1 has now come to an end and attention has shifted to the possibility of an increase in interest rates. Our framework for understanding the Fed’s behaviour2 is based on the idea that the Federal Open Market Committee (the FOMC, the Fed’s policy committee) wants to make sure that the economic recovery is sufficiently robust to withstand higher interest rates. If it raises rates too quickly, it runs the risk of having to make a U-turn – not an appealing prospect for its reputation.

The situation in the labour market remains a key factor. In the past year, the FOMC started focusing on a broader measure for unemployment (U6) rather than the usual measure (U3) used up to that point. The broader measure includes people who are marginally attached to the labour force and involuntary part-time workers. The Fed thinks this is a more appropriate indicator of capacity utilization in the labour market. This should also be seen in the light of the relatively sharp decline in the labour force participation rate in recent years3. At present, U6 is 11.5% (figure 1).

Figure 1: Underutilisation US jobs are still not at the desired level

% labour force

0

15

10

5

U3 lower target (Fed) U3 upper target (Fed)

U6 lower target (Rabo estimate) U6 upper target (Rabo estimate)

unemployment (U3) underemployment (U6)

2008 2009 2010 2011 2012 2013 2014 2015

Source: Macrobond

1 Mortgage Backed Securities – bonds with mortgage loans as collateral.

2 Philip Marey, “The Fed’s checklist”, Financial Markets Research, 24 November 2014

3 To the extent that this lower labour force participation rate involves people who have withdrawn temporarily from the labour market, it signifies a greater potential increase in future employment levels than what could be deduced from the narrower definition of unemployment.

1 > Walking a tightrope…

Outlook 2015 35

We believe it could take quite a while before this indicator falls to a sufficiently low rate (9%). More direct measures of future inflationary pressure do not as yet suggest a need for immediate changes to monetary policy either. For instance, average hourly earnings have been expanding at an annual rate of only around 2% since 2009. We think the FOMC will see a significant acceleration in this rate as an additional precondition to be satisfied before it puts its foot on the brake.

Figure 2: Moderate core in�ation no reason for the Fed to quickly raise interest rates

% year-on-year

0.0

1.5

1.0

0.5

2.5

3.0

3.5

2.0

4.0

%

0.0

1.0

0.5

1.5

2.0

de�ator consumption expenditures excluding energy and food (l) 3M interbank rate (Libor) (r)

2008 2009 2010 2011 2012 2013 2014 2015

Source: Macrobond

Moderate inflationary pressure, weaker housing marketBut while the growth prospects for the USA in 2015 are still looking quite good, attention has now shifted to price developments. Earlier this year, accelerating inflation led to louder calls among the doves in the FOMC for an increase in interest rates, but the recent fall in inflation has silenced them. Meanwhile, the recovery in the housing market is also looking fragile. Since the Fed’s ‘taper talk’ in May 2013, institutional investors have had less incentive to seek higher returns by investing in the housing market. We already argued earlier this year that the transition to a market that is once again becoming dominated by new private buyers would not necessarily be smooth4. After all, these new entrants as a group are characterised as having relatively high levels of unemployment, limited access to credit and substantial student debts. The loss of momentum in the housing market is a threat to the more or less implicit linear recovery in the economy as embodied in the Fed’s dot plot, which has wrong-footed the financial markets several times last year.

4 Philip Marey and Stefan Koopman, ‘A sinkhole below the housing market?’, Financial Markets Research, 2 June 2014

1 > Walking a tightrope…

Outlook 2015 36

ConclusionUnder the working assumption that all signs really have to be flashing green, the Fed will only start to raise interest rates towards the end of 2015 at the earliest. We would also expect rates to be raised only very gradually. This is because the long-term growth prospects for the US economy are not as good as before the crisis and tightening monetary policy too quickly would entail risks for both the economy and the financial markets. This does not alter the fact that the next change in policy is likely to be a tightening move. The excess liquidity in the banking system as a result of the purchase programmes has resulted in money-market interest rates that are currently extremely low (3-month US Libor is close to its all-time low of 0.22%, see figure 2). However, once the Fed starts to mop up this liquidity as a consequence of the implementation of its exit strategy, this could potentially lead to fresh market volatility.

1 > Walking a tightrope…

Outlook 2015 37

At the start of 2014, the ECB refined its forward guidance, with ECB president Draghi stressing that interest rates would remain low for as long as capacity in the economy remains underutilised. This and a number of cuts in the main refinancing rate until it reached 0.05% in September were contributory factors in the substantial falls in interest rates in money and capital markets, even during the brief episodes in which economic indicators improved. This meant an end to the usual positive relationship between capital-market interest rates and surprises in economic indicators. This can be seen in figure 3. The introduction of a negative rate for excess reserves held in the central bank’s deposit facility and the suspension of the sterilisation of the SMP 5 bond portfolio in June were intended to reduce money market rates further and thus weaken the euro. In as far as these measures have prompted banks in the core countries to make new (short-term) loans to banks in the periphery, this has also accelerated the repayment of ECB loans by peripheral banks. This has undone part of the negative impact of these measures on overnight rates (see figure 4) by reducing excess liquidity in the system, an effect that we have already

In the past year, the ECB again broke various taboos in an effort to bolster the fragile economic recovery and stem disinflationary tendencies. So far, these measures have had little impact on the real economy but have had an effect on the financial markets. We consider this almost universal phenomenon in more detail in Box 2.

2 > Will the ECB take over the baton from the Fed?

5 Securities Markets Programme.

Outlook 2015 38

mentioned on numerous occasions6. In June, the ECB also announced new ‘targeted’ long-term refinancing operations for the banks (TLTROs7), the aim of which is to boost lending to the private sector.

Figure 3: ECB’s forward guidance has broken the relationship between interest rates and the economy

% Index

-25

-10

-5

-15

-20

5

10

15

0

0.4

0.8

1.0

0.6

1.2

1.4

5 year EUR swap rate (l) Rabobank economics surprise index (eurozone) (r)

jan-13 apr-13 jul-13 okt-13 jan-14 apr-14 jul-14 okt-14

Source: Macrobond, Rabobank

Figure 4: Despite negative deposit rate Eonia has not fallen far below zero

end of month observations have been deleted

0.00

0.35

0.40

0.30

0.45

0.25

0.10

0.05

0.15

0.20

8/5/2013 to 12/11/2013 (zero depo) 13/11/2013 to 10/06/2014 (zero depo)

11/06/2014 to 09/09/2014 (-0.1% depo) 10/09/2014 to now (-0.2% depo)

0 50 100 150 200 250 300 350

excess liquidity (EUR bn)

Eonia -/- deposit rate ECB (%-points)

Source: Macrobond, Bloomberg, Rabobank

6 See for example: Elwin de Groot, ‘Negative deposit rate or not?’, Financial Markets Research, 30 May 2013.

7 Targeted Long Term Refinancing Operations.

2 > Will the ECB take over the baton from the Fed?

Outlook 2015 39

Pressure on ECB has increased furtherDespite these interventions, the ECB came under increasing pressure in the second half of 2014 to take additional measures. In the past year, inflation has consistently been less than forecast while inflation expectations for the medium term, as reflected in inflation swaps, fell sharply, especially after the EU imposed sanctions against Russia. All this took place against a background of disappointing economic growth in a number of export markets and, in the second half of 2014, sharp falls in commodity prices. To some extent, we were seeing a scenario in which the risk of deflation in the eurozone came one step closer8. In September, ECB president Draghi announced a programme for purchasing ABS (asset-backed securities, i.e. bonds based on underlying loans) and covered bonds (covered bank bonds). Buying up these securities would give banks more room to provide new loans to the private sector and allow them to do so at lower rates. But the most striking aspect was that Draghi explicitly stated for the first time that the ECB expects the combined effect of these buying programmes and the TLTROs to be a considerable increase in the ECB’s balance sheet. A return to the level ‘at the beginning of 2012’, as suggested by Draghi, would mean a net increase of around one trillion euros. It seems as if the ECB is basing its approach on two lines of reasoning. It hopes its actions will nip the downward trend in long-term inflation expectations in the bud9 but it also sees the weaker euro that would result from this policy as a significant additional advantage. However we are sceptical about the expansionary impact on the balance sheet of these measures, as we argue in detail in Box 1. So why is so much emphasis being put on increasing the size of the balance sheet?

Genuine QE as the ECB’s last chance?It is not unthinkable that the ECB – and in particular its president, Draghi – has emphasised this so strongly in order to facilitate any future decision on the purchase of government bonds. After all, Draghi will be able to say that he has done everything in his power, but purchases of government bonds cannot be avoided if increasing the size of the balance sheet and the money supply is the ultimate goal. At the start of November, Draghi stressed that the entire Governing Council endorsed this expansion of the balance sheet and that it had given the relevant working groups within the ECB the task of working out the details of the implementation of additional measures, if these are needed. Moreover, the notion that the ECB can make purchases from an unlimited pool of government bonds helps create a weaker currency10. Given that real interest rates are undesirably high as a result of disinflationary tendencies, for the moment this seems to be the only channel through which the ECB can ease monetary conditions further in the short term.

8 Elwin de Groot, ‘Dallying with deflation’, Financial Markets Research, 24 February 2014.

9 The reasoning here would be that increasing the ECB’s balance sheet would eventually lead to an increase in the size of the balance sheet for the entire financial system and consequently the money supply. That would eventually have to lead to a rise in prices (assuming constant economic conditions) according to Fisher’s quantity theory of money. At the very least, expectations would incorporate that effect.

10 After all, the money supply (M) will eventually increase if the buying programmes are on a big enough scale, even though some factors will work against this.

2 > Will the ECB take over the baton from the Fed?

Outlook 2015 40

11 See for example Ruben van Leeuwen, Focus on ABS, ‘ECB Purchase Programmes: Our take on the details’, Financial Markets Research, 2 October 2014. The first steps in the purchasing programmes do suggest that the ECB has got off to a vigorous start. It purchased EUR 10.4 billion in securities in the first four weeks of the covered bonds programme. However, we wonder how long the ECB will be able to keep up this pace.

2 > Will the ECB take over the baton from the Fed?

BOX 1 – Expansion of the ECB balance sheet not as simple as it seems

We estimate that the ECB’s new purchasing programmes will not add more than about

EUR 100 billion to the balance sheet (EUR 50 billion per programme)11. This is because a

substantial proportion of the existing supply of ABS that meets the ECB’s criteria is illiquid

or is already being used by banks as collateral in the ECB’s liquidity operations. Therefore most

of the securities will have to be purchased in the primary market, which is developing only

slowly after years of contraction. In theory, the market for covered bonds is bigger and more

liquid, but this market can hardly be said to have excess supply. We are therefore somewhat

surprised at the ECB’s focus on this asset class. The fact that the ECB had to abandon its last

programme to purchase covered bonds, initiated in 2011, ahead of schedule (it stopped after

purchasing EUR 17 billion instead of the planned EUR 40 billion) due to a shortage of securities

speaks for itself. What is more, the ECB needs to take care in both programmes that its actions do

not distort prices too much.

Figure 5: Size of ECB balance sheet

1000

EUR billion

3000

2500

1500

2000

2007 2008 2009 2010 2011 2012 2013 2014

balance sizeMarch 2012well over EUR 3 trillion

Source: Macrobond

That would mean that most of the increase in the ECB’s balance sheet would have to come

from the TLTROs. This too seems quite implausible. To start with, these TLTROs (with a duration

of at least two and at most four years) have to compete with the standard 3-month LTROs,

which are unconditional and cheaper (by 10 basis points). It should also be noted that the

ECB has said that it will maintain its current liquidity allotment policy until the end of 2016.

Secondly, we believe that there will only be a limited requirement for additional liquidity in

Outlook 2015 41

12 See also Rabo Rate Directions, ‘Revisiting T-LTROs 1&2 take-up’, Financial Markets Research, 29 August 2014; and Rabo Rate Directions, ‘What does T-LTRO 1 take-up mean?’, Financial Markets Research, 19 September 2014.

13 A report by the news agency Reuters on 21 October mentioned this option and the ECB did not seem to deny the possibility categorically. This fits with the pattern of previous measures and is also in line with our view that the ECB is trying to delay the purchase of government paper for as long as possible.

14 Quantitative Easing.

15 See also Elwin de Groot, ‘Six reasons against QE (and why they may still do it)’, Financial Markets Research, 26 August 2014.

16 The ECB balance sheet actually becomes a kind of Eurobond because the credit risk is distributed in proportion to the economic weight of the affiliated Member States (in terms of population and GDP).

17 Of course this is far from ideal. For a detailed discussion of Eurobonds, see also Wim Boonstra et al., ‘Conditional Euro T-Bills as a transitional regime’, 11 June 2013.

2 > Will the ECB take over the baton from the Fed?

the banking system. Most banks are more concerned with scaling down rather than increasing

the size of their balance sheets. Nor is there robust demand for new loans. Even if bank lending

were to shift to a growth path in the course of 2015/2016, it is still debatable whether that

will necessitate large amounts of additional ECB liquidity. This is why we think that the main

motivation for subscribing to the TLTROs will be to replace existing ECB loans12. Finally it should

not be forgotten that the purchasing programmes in fact are already satisfying part of banks’

liquidity needs. All in all, we would therefore not be surprised if the net effect on the balance

sheet of the measures announced so far were to amount ultimately to no more than a few

hundred billion euros – far less than the intended ‘target’ of EUR 1 trillion.

It is not inconceivable that corporate bonds could be added to the list of purchasing programmes in the not-to-distant future13. The TLTROs and purchasing programmes are expected to contribute to a further gradual easing of financial conditions. This will lighten the burden in the peripheral member states in particular, where interest rates on bank loans to households and companies are still relatively high. But transmission of these lower interest rates to the private sector is an uphill process, in part because of stricter capital and liquidity requirements, and does not seem to be enough to bring about a definite turn for the better. That is why the scenario in which the ECB resorts to the large-scale expansion of its balance sheet through the purchase of government bonds (QE14) has now become almost inevitable – unless we experience a minor economic miracle in the next few months.

Of course, reaching that point will not be a smooth ride. QE is controversial, both in the eurozone context and in a broader context, as we argue in Box 215. The ECB’s Governing Council is very divided on the issue, although most of the resistance comes from several northern member states such as Germany and Austria. That is hardly surprising, as in the final analysis the large-scale purchase of European government bonds is tantamount to the forced introduction of Eurobonds16,17. But it still seems the most logical option given the lack of politically viable alternatives. It is with good reason that ECB president Draghi has made strong calls since his speech on 22 August in Jackson Hole for a more reflationary budgetary policy in those countries that can afford this. So far, this call has largely fallen on deaf ears, although it is not unthinkable that the introduction of a QE programme will be accompanied by a even stronger call for structural reforms and a more expansionary fiscal policy. After all, QE is much more effective when coupled with the issuance of new government bonds to finance projects that help offset the lack in aggregate demand.

Outlook 2015 42

18 See also Emile Cardon and Elwin de Groot, ‘Kan 3-maands Euribor negatief?’, Financial Markets Research 2 October 2014.

19 For a background document, see Michael Every, ‘A look back at a way to look forward’, Financial Markets Research, 21 October 2014.

20 We saw this effect in particular in Japan in the period 2012 to 2013 and more recently in the eurozone.

2 > Will the ECB take over the baton from the Fed?

ConclusionAll in all, this means that we expect money market interest rates to barely increase at all next year. In fact, there is a strong likelihood of some interbank rates (Euribor) temporarily becoming negative if the ECB does decide to press ahead with full-scale quantitative easing. A limited QE programme on the other hand could cause money-market rates to rise slightly18. However, big swings in the money market do not seem likely in 2015. The high levels of unemployment in the eurozone and low level of capacity utilisation suggest that the ECB’s first (major) increase in interest rates is not likely to take place before 2017.

BOX 2 – Why are monetary policy measures so ineffective?

Several attempts by central banks in recent years to boost their economies have proved

remarkably ineffective, to the extent that it has become an almost universal phenomenon.

In our view, the principal reason for this is the persistently high propensity to save and the

limited demand for credit in both the private sector and the public sector. This, in turn, is

associated with the high level of debt in these sectors in many countries and/or poor

long-term growth prospects19.

The central banks’ re-flationary policy is aimed at creating money (via purchasing programmes

and other means of injecting liquidity) in the hope that this will increase lending and

consequently economic growth. But there are two problems here. The first is that while central

banks can control the supply of base or central bank money, they cannot control the total money

supply (‘M’). The second problem is that the direction of causality is from lending to the creation

of money rather than vice versa. The money aggregates are endogenous. If we were to conduct

a simple thought experiment in which we assume that the creation of money, lending and net

foreign assets are inextricably linked and that economic growth is not possible without new

lending, that would in fact mean that if lending does not ‘move in line’ (for the reasons

mentioned above, see figure 6), this policy will eventually result in an increase in net foreign

assets (the liquidity that has been created leaks abroad, as it were). This may have the associated

advantage of a weaker exchange rate20 but unfortunately this is a zero sum game, as it comes at

the expense of the external competitive position of trading partners and is likely to provoke a

counter response. This leads to the proverbial ‘race to the bottom’ or ‘currency wars’ that we have

witnessed in recent years.

However, the policy of quantitative easing has more far-reaching consequences. In the first place,

the continual exchange of central-bank money for securities (bonds in particular) pushes up the

prices of these instruments further, leading to exceptionally low bond yields worldwide. Investors

then drive up the price of shares and other relatively risky securities in their hunt for yield.

Outlook 2015 43

21 BIS (2014), IMF (2014).

2 > Will the ECB take over the baton from the Fed?

Policymakers are now increasingly admitting publicly that bubbles are forming in some markets21.

But given the lack of growth (hardly any money is ending up in the real economy), there is a fear

among policy makers that bursting the bubble would only take us even further from the goal of

bringing the global economy back on track. Perversely enough, then, the answer often is yet

more monetary easing! The second major effect of such a policy is that it widens rather than

narrows the gap between the rich and the poor. The wealthier members of society profit most

from higher asset prices, but they are also more likely to have a high propensity to save. An

increase in aggregate saving in turn hinders economic growth. The real disposable per capita

income among the middle classes in many industrialised countries has not budged for years

(figure 7). And, at the first sign of wage increases, central banks are likely to threaten to deploy the

interest-rate weapon.

Figure 6: Growth in real bank lending remains disappointing in Japan and the eurozone

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Of course this is a stylised and simplified analysis of a complex issue, but the collateral damage

from this monetary policy could well be greater than the economic textbooks would have us

believe. Unfortunately the real solutions to the above problem either take too much time, in the

case of structural reforms that boost growth, or are considered to be politically unacceptable,

in the case of large-scale debt restructuring. In the eurozone, monetary financing would be a

great deal simpler from a practical perspective and undoubtedly enjoys the support of many

countries, but the last time we looked at the EU Treaty it was still prohibited.

Outlook 2015 44

Figure 7: In real terms, the average worker did not gain much in the past decade

Index 2004 = 100

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2 > Will the ECB take over the baton from the Fed?

Outlook 2015 45

22 This is the expected 5-year inflation swap starting in 5 years’ time and is the average annual rate that the swap recipient receives in exchange for payment of the actual inflation rate. As such, it is seen as an indicator of inflation expectations in the medium term.

The underlying theme in our Outlook 2014 was the tapering of the Fed’s buying programme, in particular in relation to the development of the American economy. In the past year, it has been the ECB that has distinguished itself with an ever more aggressive monetary easing policy. In this section on fixed income markets, we delve deeper into the implications and practical implementation of the ECB’s quantitative easing.

3 > The implications of quantitative easing by the ECB

Risk of deflation now the determining factorIn his speech at the Jackson Hole symposium on 22 August, Draghi gave a great deal of attention to the 5-year/5-year inflation swap rate22 as a measure of inflation expectations in the medium term. Although this indicator rose after his speech due to a temporary boost of confidence, inflation expectations fell further after the ECB’s decision of 4 September (figure 8). Even if this is partly due to technical factors (such as the increase in market volatility), the ECB still cannot afford to maintain this situation for much longer as the policy interest rate has reached its lower limit. So our basic scenario is that the ECB will move closer and closer to a full-scale quantitative easing programme unless an economic miracle takes place in the next few months. It may first add some less politically sensitive assets to its shopping list (such as corporate bonds or, less likely, bonds issued by supranational institutions), but we believe the odds of government bonds being included in the purchasing programme in the course of 2015 are now significant.

Outlook 2015 46

Figure 8: Long-term in�ation expectations start to change

%

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5 year in�ation swap 5 year forward

6-10 year forward in�ation forecast Consensus

ECB Survey of Professional forecasters, in�ation expectations 5 year forward

2011 2012 2013 2014

Source: Bloomberg, Consensus Economics, ECB, Rabobank

The nitty-gritty of quantitative easing…What would quantitative easing look like in practice? In one of our earlier research specials23, we took the remarks made by the Federal Constitutional Court of Germany in Karlsruhe on the ECB’s OMT programme24 as our starting point. One of our conclusions was that the ECB is likely to start buying the government bonds of eurozone countries in proportion to their total outstanding value or an investment index in order to keep the distorting effect on the markets to a minimum. This could be ‘advantageous’ to countries with a relatively high national debt such as Italy and France. However an alternative option is to buy bonds in proportion to the paid-in capital of the ECB. This would be relatively advantageous for a country such as Germany. We also concluded that the ECB would soon be forced to target a wide range of maturities (including the 5-10 years segment) because there will simply not be enough securities available in the shorter maturities, especially if the ECB aims for a purchasing programme of EUR 1 trillion or more. These considerations may be given less weight if the ECB is able to achieve part of the expansion in its balance sheet using other instruments but, as said, we are sceptical about this. Incidentally, we think it is important to note that these purchasing programmes give an impetus to the economy. If there is no accompanying (reflationary) fiscal policy and/or structural reforms, this could easily end up with being exclusively focussed on weakening the exchange rate instead of the other transmission channels of monetary policy.

23 See Rabo Rate Directions, ‘A Eurozone QE template’, Financial Markets Research, 7 March 2014.

24 Outright Monetary Transactions, the successor to the Securities Markets Programme and the predecessor to any QE programme that might be introduced; however, the ECB has never actually made use of the OMT.

3 > The implications of quantitative easing by the ECB

Outlook 2015 47

…and the consequences for the marketsFurthermore, we note that the markets are still not fully factoring in QE. If we look at the difference between the average yield on European government bonds and the overnight index swap curve and then compare this spread with that for the United States – a country that has already completed QE – we see that there is still room for a greater compression of interest-rate differentials within the eurozone (figure 9). This implies that the credit risk premiums in the eurozone for government bonds have still not been fully normalised. If we assume that QE is actually a form of fiscal union through the back door (the ECB becomes a de facto Eurobond), this would asymptotically have to lead to full convergence (i.e. if the ECB buys everything).

Therefore we expect to see further compression in 2015, even though sovereign spreads have already contracted significantly in the eurozone since mid-2012. We expect to see this compression coming mainly ‘from above’, in other words mainly from lower nominal yields on Spanish and Italian government bonds. Incidentally, if the ECB achieves positive results quickly with its reflationary policy, this could also lead to narrower spreads as such a policy would benefit the periphery most. It is also not inconceivable that yields on the bonds of core and semi-core countries such as Germany, the Netherlands and France would eventually rise during the course of QE as sovereign credit risks are shared between all the Member States. Indeed, as we saw in the US and the UK, it is the run-up to QE and the effect of the announcement that are particularly relevant for the markets. This was followed in those countries by a period of consolidation/increase in capital-market interest rates. However, this depends in part on how successful the policy is for the economy. For the time being, we are assuming that a policy of quantitative easing will initially drive up all financial asset prices (and depress yields), including those of the core countries. More specifically, we expect a flatter yield curve for the core and semi-core countries. Since there is no longer much room left in the 2 to 5-year segment, that almost automatically means that the 5 to 10-year segment (figure 10) will profit most from the move to QE. We expect the 10-year swap rate in the eurozone to be about 20 basis points lower halfway through 2015 before rallying slightly to reach around 1.2% by the end of 2015.

3 > The implications of quantitative easing by the ECB

Outlook 2015 48

Figure 9: Still room for further reduction in ‘average’ bond yields in the eurozone at QE

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sep-08 sep-09 sep-10 sep-11 sep-12 sep-13 sep-14

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Source: Bloomberg, Macrobond

Figure 10: Flatter German yield curve possible especially at the longer segment (10/5 year)

spread between Germany’s 5 year en 2 year yield spread between Germany’s 10 year and 5 year yield

2007 2008 2009 2010 2011 2012 2013 2014

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Widening trans-Atlantic interest-rate differential not a givenOne reason for that pickup in yields is that we expect upward pressure eventually from the United States on global capital-market interest rates. However this is not quite so straightforward in the shorter term. After all, it is not only the

3 > The implications of quantitative easing by the ECB

Outlook 2015 49

eurozone that is facing disinflationary forces at the moment. If we look at the policy implications in a market situation where liquidity is the driving force, we see that this liquidity can only be removed once there are absolutely no doubts about the economic recovery. Against the backdrop of the recent decline in commodity prices, there is a risk that the Fed will also be forced to delay its first interest-rate increase. Emerging countries have had a more difficult time since former Fed chairman Bernanke started talking about tapering the purchasing programme on 22 May 2013. But now the US itself is running the risk of being affected in turn by slower growth in those same emerging countries25.

We therefore see room for a decrease in American capital-market interest rates over the next three to six months. And from this perspective, we believe a further widening of the Transatlantic interest rate differential is not self-evident, in particularly over that particular time frame. It is also important to mention here that we see a structural undercurrent of lower capital-market interest rates in the US anyway. We published an article on this development last summer26. On the supply side, a substantially smaller federal deficit is reducing supply, which is keeping the prices of government bonds high (and yields low). On the demand side, increasing demand for government bonds due to the big increase in pensioners as a proportion of the population has compensated for the tapering of the Fed’s buying programme, while more stringent legislation has increased demand from banks.

ConclusionThe downward pressure on interest rates will be the dominant factor in both the US and Europe in the first part of 2015. In the eurozone, this will be accompanied by a narrowing of sovereign spreads with the periphery. The driving forces are disinflationary tendencies and increasing pressure on the ECB to embark on quantitative easing. We expect to see a transition in the course of 2015, once QE is a reality and the economic tide has turned in a more favourable direction. Given their low starting level, it will be more difficult for German yields (and EUR swap rates) to fall further than the yield on US government bonds (and USD swap rates). We therefore conclude that the interest-rate differential between the US and Germany (figure 11) is more likely to be narrower than wider by mid-2015, only to widen again in the second half of 2015.

25 What we are saying here is that a combination of rising commodity prices and a weaker euro (which would push up inflation whatever) is extremely unlikely.

26 Philip Marey, ‘Undercurrents in the UST Market’, Financial Markets Research, 31 July 2014.

3 > The implications of quantitative easing by the ECB

Outlook 2015 50

Figure 11: Transatlantic spread (US minus Germany) already high

10 year 5 year

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3 > The implications of quantitative easing by the ECB

Outlook 2015 51

After a strong performance in the first half of 2014, sentiment reversed sharply since the summer and we saw a substantial increase in risk premiums in the market for HY bonds, which more than offset the gains in the first six months (figure 12). The uncertainty about the economic recovery in the eurozone was of course not exactly helpful. Incidentally, we see this nervousness not just in the European markets but also in the American markets, especially after the statement by the Fed chairman, Janet Yellen, in the summer that she thought that valuations in the HY market were ‘stretched’. Listening to the professional investors with whom we are in regular contact, we get the impression that some of them have moved from the HY market to the market for Investment Grade (IG) bonds. This is one factor explaining why the latter (much larger) market remained buoyant in the second half of 2014. At an average of about 80 bp, risk premiums in this market are still close to their all-time low whereas in the HY market risk premiums rose by almost 100 bp in a short period of time.

4 > High Yield under pressure

The increasing risk of bubbles developing, which we mentioned in the introduction to this Outlook on the financial markets, has been particularly evident in the High Yield segment of the market for corporate bonds (abbreviated to HY, defined as credit ratings less than BBB-)

Outlook 2015 52

Figure 12: Especially high yield market faced worsening sentiment in 2014

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Figure 13: Issue new business paper probably lower in 2015-16 than in 2013-14

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Risks but don’t forget the tightrope walkIt is clear that the risk of a recession in Europe and fears of stagnation and deflation in 2015 could also affect sentiment in the market for corporate bonds.

4 > High Yield under pressure

Outlook 2015 53

Company profits have lagged behind in recent years, in part because of the fragile economic recovery. Share buy-backs remain a recurring phenomenon, and reflect the picture of multinationals with ample cash positions that do not wish to invest, or do not see sufficient opportunities for investment. This is not helped by an unsettled economic climate and continuing geopolitical tensions. Should the eurozone indeed end up in a deflationary spiral, the possibility of a substantial correction in the corporate bond market cannot be ruled out. In such a scenario, limited liquidity in the secondary market could accentuate the effect on price movements. Of course, an early increase in US interest rates could also put a spanner in the works. Merger and acquisition activities remain at low levels, despite an increase in 2014.

However, we believe a one-sided emphasis on these downside risks is not correct. The issuance of corporate bonds in 2015 is likely to remain significanty below the levels in previous years, in part because of lower redemptions (figure 13). While the recent decline in commodity prices, and energy in particular, may be a sign of weak economic growth, it is a blessing for businesses that make intensive use of commodities, just as the weaker euro is a boon for the export sector. As we have noted above, we expect the eurozone economy to pick up steam eventually and the Fed to be very cautious as regards possible interest-rate increases. A situation with moderate economic growth and extremely low interest rates is relatively good for corporate bonds. Should the ECB decide to add this class of securities to its purchase programmes (whereby we stress the speculative nature of this possibility), this would constitute a significant boost for this market, where a lack of demand is far from being the biggest problem anyway. Without that sort of stimulus, we think the risk premiums in the market for corporate bonds are more likely to move sideways in 2015 or even widen slightly.

4 > High Yield under pressure

Outlook 2015 54

In the final months of 2014, this development was fanned further as greater volatility in the financial markets forced traders to scale down ‘carry trade’ positions in the currencies of emerging economies, which supported the dollar. Furthermore, increasing concerns that the eurozone would slip back into recession due to a global slowdown in growth has led to a capital flight from the eurozone. This is most clearly visible in the portfolio flows in fixed-interest securities in the balance of payments, which were still exerting strong upward pressure on the euro at the end of 2013 and beginning of 2014 (figure 14). The outflow that has developed since then has resulted in (slightly) higher periphery spreads and a weaker euro. The net change in the euro-dollar exchange rate in the first nine months of 2014 was a fall of more than 7%, but this was concentrated in the second half of 2014.

Trend should continue into 2015…Given our economic forecasts, the outlook for the dollar remains positive in the medium term. The recovery in the US has gained further ground and is considerably less fragile than in the eurozone. The US budget deficit has fallen significantly in recent years and the country has become less dependent on imports thanks to shale gas and oil. As a result, the need for the Fed to pursue a reflationary policy is gradually receding. In the eurozone, on the other hand, budget consolidation is still in progress and further structural reforms are essential if systematically higher growth rates are to be achieved. The focus of the ECB’s accommodative policy is increasingly on a weaker euro as the ECB realises that this is the most effective way of curbing deflationary pressure in

5 > The euro-dollar exchange rate in the middle of a tug of war

As central banks walk the tightrope, their act sometimes seems to be turning more into a tug of war. In 2014 that was reflected in the value of the common currency. So far, the ECB seems to have had the best of the deal as it introduced increasingly aggressive monetary easing measures.

Outlook 2015 55

the short term. We expect a euro-dollar exchange rate of 1.20, or slighty below that level, at the end of 2015.

Figure 14: Balance of payments eurozone - net in�ow of investment in debt securities

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balance of payments eurozone - net in�ow of investment in debt

EUR/USD

2011 2012 2013 2014

Source: Macrobond

Figure 15: Market expectations on Eurodollar already very negative

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number of contracts (x1000) EUR/USD

Source: Macrobond

5 > The euro-dollar exchange rate in the middle of a tug of war

Outlook 2015 56

…but will not be linearEven so, it will not be a straightforward process. Only very recently, we have seen a substantial adjustment in the euro-dollar rate and now market participants are increasingly wondering whether the Fed might adopt a tighter policy as early as 2015. The volatility in exchange rates has been partly influenced by market participants’ speculative positions. The rise in the euro-dollar rate in October was relatively brutal because of the record volume of long positions in the dollar (forward contracts speculating on a rise in the value of the dollar, see figure 15). If there is then a threat of the opposite happening, market parties offload these positions quickly and that accentuates the movement in the currency pair. However, the size of the movements in October suggests that speculative positions have now been significantly reduced. Another factor that could temporarily support the euro is uncertainty about whether the ECB will indeed be able and/or willing to significantly increase the size of its balance sheet. This will require ECB president Mario Draghi to perform the necessary magic in the debates about the need for QE and what benefits it might bring. What is more, a new inflow of foreign capital looking to gain from the expected price appreciation of peripheral bonds could (temporarily) offset the fall in the euro.

Weaker yen the path of least resistanceA series of economic indicators in the final months of 2014 suggests that the Japanese economy is having difficulty recuperating from the effect of the increase in VAT in April 2014. So far, broad money supply and lending have refused to grow substantially (see figure 16). This underlines once again how ineffective a policy of quantitative easing can be (see Box 2). A further VAT increase in 2015 would put pressure once again on the Bank of Japan to ease its monetary policy even more, although the prime minister, Abe, recently hinted that he wants to delay it by eighteen months. But even without a tax rise, the Bank of Japan’s intense monetary easing policy – it is buying sizeable quantities of bonds every month – will remain intact for the time being. In this respect, it (like the ECB) differs from the Fed, which is merely looking for the right timing to exit its relaxed policy stance. We therefore assume that the yen will weaken further with respect to the dollar in 2015 and even with respect to the euro, although to a lesser extent. Furthermore, the Japanese central bank has every reason to ensure that Japanese capital-market interest rates do not rise. The Japanese bond market has not been functioning normally for a long time. The high national debt as a percentage of GDP in combination with a huge, structural shortfall in the budget means that any increase in capital-market interest rates could easily lead to a completely uncontrollable spiral of higher interest-rate payments, a weaker economy and an unsustainable national debt. The ECB still has a choice about whether to apply QE, the Japanese central bank can only choose between

5 > The euro-dollar exchange rate in the middle of a tug of war

Outlook 2015 57

continuing with its bond purchases or intensifying them. This was highlighted once again by the BoJ’s decision on 31 October to step up its purchase programme. We expect the dollar-yen and euro-yen currency pairs to appreciate by 6% and 2% respectively in 2015.

Figure 16: Yen continues to weaken against the dollar, but aggressive acquisition BoJ e�ect modest on money supply

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Figure 17: GDP growth di�erence eurozone - / - UK increases and leads to stronger pound

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5 > The euro-dollar exchange rate in the middle of a tug of war

Outlook 2015 58

Sterling: stronger but not without some resistanceThe relatively positive developments in the British economy caused the pound to strengthen somewhat against the euro over the past year (figure 17). The outlook of relatively positive economic developments in 2015 leads us to expect the pound to remain stronger in the medium term as well. But even in the United Kingdom, monetary policymakers have no reason to change course soon, if only because of the high level of dependency on economic developments in mainland Europe. Even though there have been differences of opinion in the Monetary Policy Committee since the summer of 2014, with two of the seven members voting for an immediate increase in interest rates, we believe this will not happen before August 2015 at the earliest. The significantly lower inflation figures in September reflect not just the effect of a relatively strong pound and lower commodity prices for energy and food, a price war among the supermarkets and the warm weather are other contributing factors. Indeed, there is now a greater risk that inflation will remain low in the early months of 2015 and that it will undershoot the Monetary Policy Committee’s medium-term target. If we also consider the fact that nominal wage increases are still minimal and that a cold wind is once again blowing from the other side of the Channel, we actually think that the first interest-rate hike could take even longer to materialise. We therefore expect the pound to consolidate against the euro in the short term. In contrast to market participants’ long dollar positions, most of the long positions in sterling seem to have already been offloaded. This limits the risk of a sudden sharp fall in the pound against the dollar and the euro in the event of disappointing economic figures.

Emerging market currencies remain vulnerableOne of the key themes in the Outlook 2014 was the vulnerability of foreign currencies – especially those of emerging economies – to the tapering of the Fed’s buying programme. To a certain extent, we have indeed seen such a scenario in 2014. But once again the situation was far from clear-cut. Although the Fed has now long cleared the hurdle of tapering, with the currencies of most emerging economies having settled down again as a result, we saw many currencies weaken further in the second half of 2014. This was partly due to the current adverse economic conditions in a number of countries. For example, the Turkish lira and the South African rand fell, as did many Latin American currencies such as the Brazilian real and the Mexican peso.

5 > The euro-dollar exchange rate in the middle of a tug of war

Outlook 2015 59

Figure 18: Especially Central and Eastern European currencies weakened in 2014

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Most Asian currencies however maintained their value, including countries where we saw elevated fundamental risks such as India and Indonesia. In these two countries, that is also because the markets have pinned their hopes on their new governments. The Chinese renminbi fell sharply in the first half of 2014 but this was followed by a reverse movement, partly helped by stronger balance of trade figures. However, we expect the renminbi to depreciate against the dollar again in 2015 because we believe the Chinese authorities will not tolerate much lower economic growth and will opt for the easy route of a temporary export stimulus.

Our expectation that the Fed will not increase interest rates before the end of 2015 at the earliest and that the ECB will increasingly focus on monetary easing measures could benefit the currencies of countries with relatively favourable economic conditions and/or reform-minded governments in 2015. We are thinking in particular of countries such as Mexico and India. But we think further currency weakness against the dollar is on the cards for most emerging economies.

Room for recovery in Central and Eastern European currenciesIn this brief publication it is impossible to give our currency forecasts full consideration, but we would like to discuss one particular group of countries for a moment. The geopolitical situation in Europe came sharply to the fore in

5 > The euro-dollar exchange rate in the middle of a tug of war

Outlook 2015 60

2014 with a substantial depreciation in the Russian rouble (-25% against the euro) and negative knock-on effects on the Hungarian forint, the Polish zloty and the Czech koruna. Assuming that the geopolitical crisis in Ukraine does not flare up again or actually become more serious, this creates room for recovery in a number of Central and Eastern European currencies. The new series of policy measures by the ECB is expected to lead to capital flowing east. That could cause these countries’ currencies to appreciate, particularly in the first half of 2015. To our mind, the Polish zloty is a good example of a currency that could benefit as yields on Polish government bonds are relatively attractive. If the Polish central bank also reduces its interest rate by 50 basis points, as we expect, that will make more risky Polish investments (such as shares) more attractive too. If the ECB’s final and vigorous attempt to get the European ship under way again fails, that will of course affect this region. A broad sell-off in financial markets seldom works out well for the currencies in this group of countries. And the risks of this will increase in the course of 2015, especially if the economic recovery in the eurozone again fails to excite investors.

5 > The euro-dollar exchange rate in the middle of a tug of war

TIM LEGIERSE

“ The prospects for economic growth for the Netherlands in our Outlook 2015 are the highest in the past four years. But remains fragile”.

chapter III > Dutch economic outlook

Better, but not good enough

Outlook 2015 62

The prospects for economic growth for the Netherlands in our Outlook 2015 are the highest in the past four years. After a faster-than-expected (but still cautious) recovery in Dutch GDP volume in 2014, we expect economic growth to double in 2015 (figure 1, table 1). Unemployment is falling, disposable household income is rising for the second year in a row and the recovery in the housing market is continuing.

Figure 1: Development and forecast of Dutch GDP volume

Dutch GDP volume, seasonally adjusted,

actual development and Rabobank forecast

-2.5

-1.5

0.5

100

105

110

index

%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

GDP quarter-on-quarter change GDP index 2004=100

Source: CBS, Rabobank

1 > Recovery continues but remains fragile

Outlook 2015 63

This will make economic growth in 2015 slightly less dependent on exports. While demand from abroad will continue to be the main driver of Dutch economic growth, we expect, in addition to higher business investment, to finally see a pick-up in private consumption and investment in housing. As a result, the economic recovery in 2015 will be felt more clearly in the domestically oriented sectors such as construction, retail and hospitality, and thus also in the labour market. This broader-based economic growth will moreover be noticeable in more or less all parts of the country.

Table 1 Key figures for the Netherlands, year-on-year change (%)

2013 2014 2015

Gross Domestic Product -0.7 ¾ 1½

Private consumption -1.6 0 1

Government spending -0.6 ½ -½

Private investment -4.1 1½ 5

Exports 2.2 4¼ 5

Imports 1.0 4¼ 5¼

Inflation 2.6 ¼ ¾

Unemployment (%) 6.7 6¾ 6¼

Government budget (% GDP) -2.2 -2¾ -2¼

Government debt (% GDP) 68.5 70 70

Current account balance (% GDP) 10.2 10 9½

Source: CBS, Rabobank

At some point we will have to stop looking back at the long period of crisis and recession that is behind us. The 1¼% growth we expect to see in 2015 is a very realistic growth trend for the Dutch economy over time. However, with the large labour potential that is currently unused, some catch-up growth would be most welcome. The economic Outlook 2015 is thus certainly no cause for complacency.

This unused labour potential is mainly visible in the high level of unemployment (figure 2). The unemployment rate of 6½% in 2015 will still be more than twice as high as it was in 2008. Among businesses, the damage caused by the crisis is especially visible in the sharp increase in the number of bankruptcies. Both unemployment and bankruptcies are now in a clear downtrend, although the number in 2014 is still significantly higher than it was in 2008. Of course, it is not necessary for all indicators to return to their 2008 levels before we can speak of positive economic conditions. The low level of unemployment of 3% that was reached then was not sustainable due to tightness in the labour market, even without the economic crisis that followed. But the unemployment rate we are forecasting for 2015 is in our view certainly 1½ to 2% too high.

1 > Recovery continues but remains fragile

Outlook 2015 64

Figure 2: Development of unemployment

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4

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

change in unemployment, 3-month average (r)

unemployment rate national de�nition (l) unemployment rate international de�nition (l)

2015

%

%-point

Dutch unemployment rate, seasonally adjusted,

national (CBS) and international (Eurostat/ILO) definition

change in the unemployment rate,

international definition

Source: CBS

Another point to mention regarding the still weak economic conditions in 2015 is the continuing low level of production in several sectors, not only in absolute terms compared to 2008 but also per hour worked. This means therefore that there is still relatively ample production capacity available in these sectors, despite the high number of bankruptcies and the fall in employment. The sectors in question are mainly those oriented towards the domestic market, such as construction, hospitality and retail. Since the growth in production will not be fast enough to absorb the surplus capacity, downward pressure on employment and profit margins in these sectors will continue. So while we expect to see growth in more or less all sectors of the economy in 2015, this certainly does not imply that market conditions will suddenly improve dramatically for all businesses and their employees.

The overall direction is the right one, but our economy is not yet really doing well. For an extra factor in the answer to the question of whether the Dutch economy is doing well or not, we discuss the high level of prosperity in our country in box 1. Taking everything into account and looking at the development of the economy, despite the relatively favourable outlook for economic growth 2015 will be yet another year of low economic activity. Higher growth allowing us to emerge more rapidly from economic weakness would thus be highly desirable. Unfortunately, neither the economic developments abroad nor the conditions at home favour a faster recovery in the Dutch economy. The Dutch

1 > Recovery continues but remains fragile

Outlook 2015 65

government has introduced important reforms in recent years that will strengthen the economy over time. However the restrictions imposed by the European budgetary rules prevents it from boosting the still weak recovery in the short term.

BOX 1 – The grass is always greener…

Our cautiousness with regard to being unreservedly optimistic regarding the economic Outlook 2015

does not take account of the high level of prosperity in the Netherlands.

There are only twelve countries in the world with a higher Gross Domestic Product per capita than

the Netherlands (figure 3). If we take out the countries with very high income from oil production,

the Netherlands is in sixth place. In Europe, only Luxembourg, Norway and Switzerland have a higher

GDP per capita. Our country moreover features the lowest number of hours worked per person per

year, and thus very high productivity per hour worked.

Figure 3: Global comparison of GDP per capita

0

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10

Netherlands

oil producing countries

other countries

Europe excl. eurozoneeurozone

x1000 USD (PPP) Qatar= 144

Source: Macrobond

The Netherlands has relatively free markets with little hindrance from regulation. Compliance

with regulation and contractual obligations is of a high standard. Relative to many other countries,

there is little need for improvement in our education, infrastructure and innovation (IMF, 2010).

1 > Recovery continues but remains fragile

Outlook 2015 661 > Recovery continues but remains fragile

The Netherlands has accordingly occupied a high ranking in the Global Competitiveness Index

for many years. Our most recent ranking is eighth out of 144 countries considered. Since the 1980s,

our strong export performance has contributed to an uninterrupted sequence of surpluses in the

current account of the balance of payments.

The average income in the Netherlands is not only high, it is also relatively equally distributed, both in

an international perspective and in comparison with decades ago. A strong inclination to build up

savings means that despite a high level of mortgage debt, Dutch households are on average very

wealthy. Private pension savings, which relative to the size of the economy are among the highest in

the world, are an important contributing factor.

Although we consider the level of unemployment to be too high, our unemployment rate is one of

the lowest in Europe. Labour participation is also high. As already mentioned, Dutch people work

relatively few hours, indeed we are world leaders in part-time working. While GDP volume could be

increased by increasing the number of hours worked, it is debatable whether more market production

and less (leisure) time at home would increase prosperity.

Besides the positive economic achievements, the Netherlands has also scored highly for many

years in the UN’s Human Development Index, which takes account of life expectancy and the

education level of the population as well as income. The OECD’s Better Life Index also ranks the

Netherlands generally among the high-scoring countries.

So while the economy may not be performing as well as we would like, our country’s strong

position gives little cause for complaint.

Outlook 2015 67

2 > Export growth limited by European problems

The euro area, to which the majority of Dutch exports still goes, is like the Netherlands expected to show higher economic growth in 2015 than it has this year. This is the main reason why we expect export growth to accelerate. However, compared to the good years before the crisis, this growth will not be exuberant. As shown in the section on international economic developments in this Outlook 2015, the cyclical recovery in the currency union will be slow and uneven, and the serious challenges to economic policy in the large Member States have not been addressed nearly effectively enough.

In two other important export destinations for the Netherlands, the United Kingdom and the United States, growth will be much more convincing. The depreciation of the euro against the dollar and the pound that we forecast (see the section on the financial markets in this Outlook 2015) will moreover boost the growth in Dutch exports to these countries.

Despite the slowdown compared to the initial years after the crisis, growth in emerging markets will remain reasonably strong, however this will provide only limited support due to the low proportion of Dutch exports going to these countries.

As in the past years, exports will be by far the most important contributing factor to Dutch economic growth in 2015. This support from higher export growth is of course welcome, but it is definitely not enough. Although the small and open Dutch economy significantly depends on exports, one should not overestimate their importance. Domestic consumption still accounts for around two thirds of Dutch economic activity. What happens if exports grow but domestic consumption falls is what we have experienced in the past few years.

Outlook 2015 682 > Export growth limited by European problems

The fact that export growth was frequently disappointing was mainly due to the global and European recession, and not to any weakening in the competitive position of the Netherlands. Apart from the weak economic development in the euro area already mentioned – over which the Dutch government and Dutch businesses have little influence – the main economic challenges for the Dutch economy lie in the development of domestic consumption rather than export growth.

Outlook 2015 69

3 > Housing market recovery continues

The slump in the housing market in recent years was an important factor in the weak development of the Dutch economy. However a recovery began in mid-2013. Transaction volumes in existing housing have increased rapidly since that time. House prices have increased more cautiously (figure 4).

Figure 4: Transactions and house prices

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-2

0

2

8

12

16

14

18

10

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

price development transactions

20152003

x1000

%

sales of existing homes, own seasonal

adjustment, 3-month average

price index of existing homes, change of 3-month average compared to the previous 3 months

Source: CBS, Rabobank

In 2015 we expect to see home sales increase further, albeit at a slower pace than in 2014. Confidence in the housing market is high, and real disposable household income will rise next year for the second year in a row. The limited increase in

Outlook 2015 703 > Housing market recovery continues

house prices and the low mortgage interest rate (which by the way will not rise sharply in our view – see the section on the financial markets in this Outlook 2015) mean that homes will remain relatively affordable in 2015. On the other hand, the non-recurring gift tax exemption and starter loans will be less available next year. These stimulative measures have accelerated the increased activity in the housing market this year. This has led to the faster release of pent-up demand from first-time buyers, who had been deferring purchases during the period of falling house prices, in 2014. This effect will disappear in 2015.

However, we expect subsequent buyers to be more active in 2015, since rising house prices and redemptions this and next year will mean that a significant group of households will see the value of their homes increase above the amount of their mortgage loans. The delivery of new-build homes sold in 2014 will also lead to sales of existing homes.

On balance, we expect a further increase in home sales in 2015, albeit at a significantly lower rate than the rapid recovery in 2014. House prices have risen much more slowly than the volume of sales. In 2015 we expect to see a slight acceleration in the rate of increase. There is no likelihood of a return to the rapid increase in prices before the crisis. A more detailed analysis of the housing market and our expectations for 2015 can be found in our Dutch Housing Market Quarterly. In a short publication we look at the impact of recently published norms that determine the maximum loan that households are allowed to take out relative to their income (Nibud-normen).

Outlook 2015 71

However this growth will not be spectacular. Consumers are currently restricted by the limited development of incomes. While growth in private consumption in the years before the crisis – especially in the second half of the 1990s – regularly outstripped the increase in incomes, Dutch households have become much more cautious since 2008. They use less of their household income for consumption and also use less of what remains for investment in housing.

This combination of higher savings and lower investment has led to a very high accumulation of net financial assets. While the savings surplus of households had become less and less since the middle of the 1990s and family households as a group actually borrowed more than they saved on balance in 2006-2008, the net accrual of financial assets (including pension accumulation) as a percentage of disposable income in 2013 was the highest level since 1996. The main reason for this was the fall in debt accumulation, and the absolute level of debt has actually fallen in 2013 (figure 5).

The strong increase in propensity to save by households in theory leaves room for a strong increase in private consumption. If savings decline, consumption can grow faster than disposable income. But we do not expect this to happen. We do however expect that family savings will show little or no increase in 2015 after a further increase in 2014 (figure 6). However, since the savings rate will also not decline, any rise in household consumption will be limited to the increase in disposable income.

4 > The consumer is still the weak link

Household consumption will remain the Achilles heel of the Dutch economy in 2015. The fall in domestic demand since 2008 has happened mainly in private consumption and investment in housing. We expect to see an increase of domestic demand in these areas due to the rise in real disposable household income in both 2014 and 2015 and the recovery in the housing market.

Outlook 2015 72

Figure 5: Development of assets and debt

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30

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10

5

0

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-10

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

net wealth assets liabilities

EUR billion

Source: CBS

Figure 6: Income, savings and consumption

%

6

5

4

3

2

1

0

-1

-2

-3

-4

-5

saving income consumption

Dutch household consumption volume, % change and contributions of real disposable income and changes in the saving rate, actual development and Rabobank forecast

96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Source: CBS, Rabobank

4 > The consumer is still the weak link

Outlook 2015 73

Older people have the capacity, but not the willIn principle one might expect older households to contribute the most towards an increase in consumer spending. The share of total income and assets of older households has risen strongly in the last 15 years as a result of the ageing population. Furthermore, new retirees more frequently have a supplementary pension in addition to their state retirement pension. The average income of older households has risen quite strongly since 2008, despite the crisis (figure 7). Pensioners also increasingly own a home with a low mortgage (and therefore a large amount of surplus equity). It is not surprising therefore that average consumption by people over 60 years of age has only increased. The main contraction in consumption occurred in households where the main earner is aged less than 45 years (CBS, 2014). Since the increase in savings by older households has been limited, it is by no means certain that they will now begin to spend much more just because they can.

Figure 7: Change in shares of income and assets and income growth by age

-6

4

2

0

-2

-4

< 30

income share wealth share income development

30-45 45-60 60-75 75+

%-point change of the income- and wealth share of age groups, 2008-2012

change of average nominal household incomeof age groups, 2008-2013

Source: CBS, Rabobank

Furthermore, the group of pensioners with a supplementary pension, despite the increase in average income (which is mainly due to a different group composition), has been confronted with the largest loss of purchasing power of all types of household over the past years. Given the still low coverage ratios of pension funds which are still under pressure and the new pension regulations in the pipeline, the prospect of higher pension benefits would appear to be increasingly remote. The reform of long-term health care that will take shape

4 > The consumer is still the weak link

Outlook 2015 74

in 2015 will probably also lead to extra cautiousness among older people for the time being.

Due to the limited decline in their spending in the past, the relatively wealthy part of the Dutch population therefore has little reason to now ramp up their consumption. There are also several reasons for this group to be concerned about the future, meaning that propensity to save is more likely to increase than decline in the near term. And if people are concerned about the financial situation of their children and grandchildren, further cautiousness would seem to be the more likely prospect.

Young people have the will, but not the capacityYounger households will continue to be relatively frugal in the coming years. One important reason for the continuing higher level of savings is the sharp decline in house prices between mid-2008 and mid-2013 and the new mortgage regulations. There is thus little possibility for funding consumer spending by increasing one’s mortgage. This had already become less attractive than in the 1990s, due to the removal of tax deductibility for loans used for consumer spending in 1997 and the rules governing increases to mortgage loans in case of positive equity when buying another house (bijleenregeling) introduced in 2004.

Furthermore, the significant group of households with mortgages that are higher than the value of their properties (see our study (in Dutch) on this for a more detailed description of the problem) and wishing to move house will try to reduce their potential residual debt by saving or making additional repayments. Even if the residual debt is included in the new mortgage, households will usually have to pay this down faster, leaving less income available for consumption purposes. The fact that from 2015 households will be able to deduct the interest on residual debt from their taxable income for 15 rather than 10 years will mitigate this effect to some extent.

From January 2013, households may only deduct mortgage interest from taxable income for new mortgages if they repay the debt fully in instalments. This means that the trend of reduction of outstanding mortgage debt will slowly but surely gain momentum. The maximum mortgage with respect to the value of the property will be further limited in the coming years, to 100% in 2018. This means that buyers will have to put up more of their own money to finance the costs of the transaction. It also means that first-time buyers will save more for the purchase of their homes than was the case in the past.

4 > The consumer is still the weak link

Outlook 2015 75

Although the negative effect of lower house prices on consumption will gradually be reduced by the recovery in the housing market, at the same time the effect of the new mortgage rules will gradually become stronger. Relatively large savings that are needed because households want or are obliged to carry less debt and have to pay off more than in the past means that consumption growth will mostly remain limited to the increase in disposable household income in the years to come.

Besides increasing their debt, households could in theory allow their consumer spending to increase faster by reducing their financial assets or accumulating less financial assets. Freely disposable financial assets however form only a small part of total household assets, especially in the case of younger households. Most of the assets are locked up in pensions, which people can only access gradually after they retire. Or, the assets are locked up in surplus equity of their homes. The compulsory nature of pension savings and the strong tax incentive to pay off one’s mortgage in full means that there is very limited potential for lowering the savings rate.

From borrowing too much to saving too muchMany Dutch households borrowed a relatively large amount in the years preceding the crisis. Although arrears on Dutch mortgages have traditionally been low (compared to other countries) in both absolute and relative terms, falling house prices combined with the high burden of debt have led to a sharp fall in domestic consumption. Over an entire lifetime, households still accumulate a large amount of assets. The net assets of Dutch households sector are therefore currently very high (figure 8). A large proportion of income is set aside for later, partly due to compulsory savings for pension. In itself this is a sensible choice, as it will enable consumption to remain at the same level after retirement.

4 > The consumer is still the weak link

Outlook 2015 76

Figure 8: Household balance sheets

0

EUR billion

3000

2500

2000

1500

500

1000

non �nancial assets pension reserves investmentscash and bank accounts

other assets loans net wealthother �nancial liabilities

assets liabilities

Source: CBS

However, older households continue to save and are not using the assets they accumulate in free investments (that is, other than pension funds) and property. Important questions are: why is this happening (for instance, because parents want to leave a legacy for their children), and whether with hindsight they did not save too much over their whole lifetime. If people do not actually need these assets at a more advanced age, they could have saved less when they were younger, in the years that expenditure is relatively high during their working lives with children in school.

Since pension savings for employees are mandatory, taking on debt is the only way to accumulate less assets at a younger age. This possibility is now being significantly reduced, while it is not being offset by more flexibility for instance in pension accumulation. The development in consumer spending described above is a consequence of this.

It would thus be useful if the current debate on the future of the pension system were to lead to households being given more freedom of choice in the distribution of their savings and consumption behaviour over their lifetimes. Reconsideration of the strong incentive now being given to pay off mortgage debt in full would be another possibility. Any further reduction of the maximum mortgage loan compared to the property value (LTV) should from this point of view also be treated with considerable caution. The maximum LTV will already

4 > The consumer is still the weak link

Outlook 2015 774 > The consumer is still the weak link

be reduced to 100% in 2018, from 104% in 2014. If it is decided to reduce this even further, this would lead to households having to save more at an even earlier stage than in the past.

It should be clear that excessive debt is not a good thing. However if both household debt and assets are seen over a whole lifetime, too much emphasis on asset accumulation can lead to loss of welfare, since it will be impossible for households to spread their consumer spending over their whole lifetime in the way that they wish. The accumulation of savings for later in life should not lead to an excessive (and mandatory) pressure on the quality of life before retirement.

Outlook 2015 78

5 > Government policy: good for the long term, not so good for recovery in the short term

In a world in which politicians are usually criticised for only focusing on the short term and ignoring the long term, in recent years the Dutch government has been an extraordinary exception. It is not providing enough stimulus to the economy in the short term, while at the same time it has taken very sensible measures for the longer term. Now a shift of focus in the right direction is to be encouraged, however this comes at a very unfortunate moment.

Significant reforms …In comparison to the largest economies in the euro area (see the section on international developments in this Outlook 2015) the Dutch government has implemented significant reforms in recent years. In a series of publications, we discuss these reforms. In 2015 it will be the turn of long-term health care and the labour market to undergo significant changes. With the abolition of the AOW partner supplement and the reform of the arrangements for children, the Cabinet will remove important limitations on the labour supply. These measures are an extension to the early retirement schemes that have already been phased out, the gradual raising of the age of entitlement to AOW (state retirement pension) to 67 years in 2023 and the phasing out of the transferable tax credit.

…are good for growth over time…As a result of the labour market reforms the participation rate (the proportion of the population of working age that is actually looking for work) has increased in recent years, despite the period of low economic activity and recession (figure 9). The increase of the age of AOW entitlement moreover ensures that the decline in the potential labour force as a result of retirement will be deferred for a number of years (figure 10). This is in principle positive for the economy’s production

Outlook 2015 79

capacity. If more people want to work, we can produce more goods and services. Even more so if this is accompanied by a policy to encourage employees and employers to invest in an active and flexible labour force.

Figure 9: Retirement age and participation

63

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71

60

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64

2000

average retirement age (l) participation rate (r)

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

age

Dutch participation rate (labour force as % of population aged 15-64) and average retirement age

%

Source: CBS

Figure 10: E�ect of increase in the age of AOW entitlement

10.4

11.2

11.0

10.8

10.6

1998

15-64 15-pension age

2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030

million

Dutch working-age population

Source: CBS, central government, processed by Rabobank

5 > Government policy

Outlook 2015 80

The choice of the timing of the reforms could however have been more fortunate. Increased participation by older people and the decline in employment has led to a rise in unemployment, mostly among young people. High unemployment also puts a brake on wage growth. The positive economic effects of the reforms initiated in the field of labour participation will become clear over a number of years. However in the short term, the reforms are negative rather than positive for the economic recovery.

…but the economy needs more support nowNow that the economic recovery has started somewhat earlier than expected in 2013, the government was able to ease the spending cuts and tax hikes planned for 2015 to some extent. However, on balance the Cabinet is still implementing deficit-reducing measures amounting of around EUR 6 billion. So the government is certainly not aiding the economic recovery in the short term, although the cuts in 2015 will be much less than the EUR 14 and 12 billion in measures that were implemented in 2013 and 2014 respectively. Furthermore, the measures in 2015 will mean that over 80% of the proposed cuts in the period 2011-2017 will be achieved (figure 11). Although austerity has not yet come to an end yet, the majority of it is now behind us.

Figure 11: Measures to reduce the budget de�cit

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other Rutte I Rutte II 6 billion packagebudget agreement 2013

2011 2012 2013 2014 2015 2016 2017

cumulative measures to reduce the budget de�cit

EUR billion

Source: CPB

5 > Government policy

Outlook 2015 81

As we have shown, the recovery in the Dutch economy is incomplete and slow. Although the economic prospects for 2015 are the most positive for several years, there is certainly no cause for celebration. From an economics point of view, the government’s continued emphasis on deficit reduction in the short term is not desirable in the current phase of cautious economic recovery. An active budgetary policy to support the economy would be advisable given the current period of low economic activity. The size of the budget deficit and government debt is at a level that allows the government to do this without risking a threat to its creditworthiness. Certainly also because the structural reforms that have been introduced have now ensured that there will be a significant improvement to government finances in the long term. The calculations of the CPB (in Dutch) actually indicate that there will be a sustainability surplus.

We had therefore hoped that the government would more actively support the fragile recovery in 2015 than is currently the case. For instance, by not raising the tax rate in the first bracket in box 1 of the tax system at all, instead of raising it by less than originally planned. This would have created more potential for growth in the volume of private consumption, which – as we have shown – will largely be determined by the increase in income for the time being. Furthermore, a spending boost in infrastructure could accelerate the recovery of production and employment in the construction industry. For instance, the necessary strengthening of the defences against rising water levels or making the housing stock more sustainable. In terms of production and employment, construction has been by far the hardest hit sector as a result of the years of recession and low economic activity. Although the recovery in the housing market in 2015 will lead to an increase in construction activity, the sector and its suppliers are still in a situation of excess capacity.

The ties that bind themWith a forecast of a budget deficit of 2.2% of GDP in 2015 (figure 12), there was in fact room for a larger spending impulse for that year, either directly or via household income. At the same time, such a larger boost would only have been sensible if the European rule of a maximum deficit of 3% of GDP was not binding. Given the high level of uncertainty surrounding the economic outlook, if economic growth were to disappoint, a planned deficit of close to 3% would rapidly rise above the limit (for an overview of the uncertainties facing the global economy, see the section on international economic developments in this Outlook 2015).

5 > Government policy

Outlook 2015 82

A new round of measures to again reduce the deficit would then be needed. This would significantly damage business and public confidence. Given the restrictions of the European budgetary rules (and the desire of the Dutch government to adhere to these rules as closely as possible) the stance that has currently been taken is sensible. Indeed, this reduces the likelihood that the Cabinet will have to introduce additional budgets in 2015, as it had to in 2012 and 2013. This is possibly all the more important in 2015, since elections to the Provincial Councils in March 2015 will lead to a new composition of the Senate. With changed political relationships the need to agree new deficit-cutting measures could lead to even greater uncertainty, not only among Dutch households and businesses, but also in the international financial markets.

Figure 12: Government budget balance

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actual development andRabobank forecast

EUR billion %

Source: CBS, CPB

Clarity and confusion on tax reformBoth the cabinets led by Prime Minister Rutte have been responsible for large-scale reforms, austerity measures and increases in the tax and insurance burden in the past few years. Rutte now has an excellent chance to achieve his stated ambition to lead the Netherlands out of the crisis in better shape by changing the tax system. There is broad political support for simplification of the system of allowances and for a reducing in taxation on employment. Reducing taxation on employment, both social security contributions paid by employers and the income tax on the wages of employees, can strengthen the policy already in place of increasing the potential labour force.

5 > Government policy

Outlook 2015 83

The crucial political question here is whether the lower tax on income from employment should be offset by other taxes or if the lower revenue should be accompanied by lower spending. Many facilities (health care, education and pensions) are currently to a large extent arranged collectively in the Netherlands, resulting in a high tax burden and a very low disposable income for Dutch households, both as a percentage of GDP in an international context and also in comparison with 15 years ago (figure 13). A reduction in both taxation and collective spending that increases freely disposable household income might seem to be a sensible option from this point of view. At the same time, the degree to which facilities are arranged collectively, including the freedom of choice that households in a country have, is of course first and foremost a political issue.

Figure 13: Disposable household income as a proportion of GDP

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including pension saving

disposable income including individual government consumption

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

household income as a share of GDP,di�erent measures, cumulated

%

Source: CBS, processed by Rabobank

Are the politicians able to continue the reforms?Whether there will be a reform of the tax system in 2015 largely depends on the outcome of the Provincial Council elections already mentioned. The parties on the right and the left of the political spectrum have different opinions with respect to the question of whether the Cabinet should offset lower tax revenue on employment with lower spending or by increasing other taxes. Recent polls (figure 14) indicate shifting power relationships within the governing coalition (VVD and PvdA) and the constructive opposition (D’66, CU, SGP) in the Senate, mainly due to the potential loss of PvdA and the gains of D’66. This may complicate negotiations regarding the future tax system. Another obstacle could

5 > Government policy

Outlook 2015 84

be that, although we will still be dealing with low economic activity in 2015, the acute phase of crisis and recession has passed. This could mean there is less pressure to push ahead with necessary reforms.

Whatever the outcome of the elections, it is very important for the economic future of the Netherlands that the Cabinet takes serious steps towards a new tax system in 2015. Together with the reforms already in place, this could increase the potential for growth in the Dutch economy. Only then can the growth rate of the economy that we expect to see in 2015 be maintained over time, and perhaps even exceeded.

Figure 14: Composition of the Eerste Kamer and recent polls

0

50

40

30

10

20

current October poll

5* VVD PvdA CDA PVV SP D66 GL CU SGP

% of seats/votes

current setup of the senate and setup based on a recent poll (5* is the governing coalition of VVD and PvdA along with the constructive opposition parties D'66, CU and SGP)

Source: the Senate, Ipsos

5 > Government policy

Outlook 2015 85

• Boonstra, W. (2012). Conditionele Eurobonds als overgangsregime. Economische Statistische Berichten, 97, 134-137.

• Boonstra, W. & Verduijn, M. (2014). Deflatie in de eurozone: is het waarschijnlijk? Rabobank Special, 17 July 2014.

• IMF (2014). Legacies, Clouds, Uncertainties. World Economic and Financial Surveys, October 2014.

• Verduijn, M. (2014). Asset Quality Review: is de ECB geslaagd? Rabobank Themabericht, 4 November 2014.

> References chapter I – Global economic outlook

> References

• Boonstra, W. and Bruinshoofd, A. (2013). Conditional Euro T-Bills as a transitional regime, Rabobank Special, 11 June 2013.

• Cardon, E and Groot, E. de (2014). Kan 3-maands Euribor negatief? Financial Markets Research, 2 October 2014.

• Every, M. (2014). A look back at a way to look forward. Financial Markets Research, 21 October 2014.

• Groot, E. de (2013). Negative deposit rate or not? Financial Markets Research, 30 May 2013.

• Groot, E. de (2014). Dallying with deflation. Financial Markets Research, 24 February 2014.

• Groot, E. de (2014). Six reasons against QE (and why they may still do it). Financial Markets Research, 26 August 2014.

• Marey, P. (2014). The Fed’s checklist. Financial Markets Research, 26 November 2014. • Marey, P. (2014). Undercurrents in the UST market. Financial Markets Research,

31 July 2014.• Marey, P and Koopman, S (2014). A sinkhole below the housing market? Financial

Markets Research, 2 June 2014.• Rabo Rate Directions (2014). Revisiting T-LTROs 1&2 take-up. Financial Markets Research,

29 August 2014.• Rabo Rate Directions (2014). A Eurozone QE template. Financial Markets Research,

7 March 2014.• Rabo Rate Directions (2014). What does T-LTRO 1 take-up mean? Financial Markets

Research, 19 September 2014.

> References chapter II – Financial markets outlook

Outlook 2015 86> References

> References chapter III – Dutch economic outlook

• Allard, C. and Everaert, L. (2010). Lifting euro area growth: Priorities for structural reforms and governance, IMF Staff Position Note, 22 November 2010.

• Legierse, T. et al. (2014). Prinsjesdag 2014: minder bezuinigen maar meer hervormen. Rabobank Special, 16 September 2014.

• Smid, B., Rele, H. ter, Boetes, S., Draper, N., Nibbelink, A. and Wouterse, B. (2014). Minder zorg om vergrijzen. Centraal Planbureau, July 2014.

• Vries, P. de (2014). Herstelvermogen van huishoudens die onder water staan. Rabobank Themabericht, 18 June 2014.

Outlook 2015 87> Appendix

United States

Table 1 Year-on-year change (%)

2013 2014 2015

Gross Domestic Product 2.2 2¼ 2½

Private consumption 2.4 2¼ 2

Government expenditure -2.0 -¼ ¼

Investment -4.7 5¼ 6¼

Exports 3.0 3¾ 5¼

Imports 1.1 3½ 5

Inflation 1.5 1¾ 1¼

Unemployment (%) 7.4 6¼ 5½

Government balance (% GDP) -3.6 -3 -2

Government debt (% GDP) 104.2 106 105

Source: Rabobank

Japan

Table 2 Year-on-year change (%)

2013 2014 2015

Gross Domestic Product 1.5 ¼ 1

Private consumption 2.0 -1 -¼

Government expenditure 2.0 ½ 1¾

Investment 2.4 4 2½

Exports 1.5 7¾ 5¾

Imports 3.3 7¼ 5¼

Inflation 0.5 2¾ 1¾

Unemployment (%) 3.9 4 4

Government balance (% GDP) -8.2 -7 -6

Government debt (% GDP) 243.2 245 245

Source: Rabobank

> Appendix

Outlook 2015 88> Appendix

United Kingdom

Table 3 Year-on-year change (%)

2013 2014 2015

Gross Domestic Product 1.7 3 2¾

Private consumption 2.1 2½ 2¾

Government expenditure -0.1 ¼ -½

Investment 4.5 10¼ 10¼

Exports 0.5 -1¼ 3½

Imports 0.5 -1¼ 4

Inflation 2.6 1½ 1¼

Unemployment (%) 7.8 6½ 6

Government balance (% GDP) -5.8 -5¼ -4¼

Government debt (% GDP) 90.6 92 93

Source: Rabobank

Outlook 2015 89

Tabel 4A Forecast table

real GDP-growth (%) inflation (%) unemployment (%)

2013 2014 2015 2013 2014 2015 2013 2014 2015

World 3.3 3¼ 3¾ 3.8 3¾ 4 - - -

United States 2.2 2¼ 2½ 1.5 1¾ 1¼ 7.4 6¼ 5½

Eurozone -0.7 ¾ 1¼ 1.7 ½ ¾ 11.9 11¾ 11¼

Germany 0.2 1½ 1¼ 1.6 ¾ 1¼ 5.3 5 4¾

France 0.4 ½ 1 1.0 ½ ¾ 10.3 10¼ 10¼

Italy -1.9 -¼ ½ 1.2 ¼ ½ 12.2 12½ 12½

The Netherlands -0.7 ¾ 1½ 2.6 ¼ ¾ 6.7 6¾ 6¼

Spain -1.2 1¼ 2 1.4 -¼ ½ 26.1 24¼ 22½

United Kingdom 1.7 3 2¾ 2.6 1½ 1¼ 7.8 6½ 6

China 7.6 7¼ 6¾ 2.6 2 2 - - -

Japan 1.5 ¼ 1 0.5 2¾ 1¾ 3.9 4 4

Tabel 4B Forecast table

exchange rates

21-11-2014 Q4-2014 Q1-2015 Q2-2015 Q3-2015 Q4-2015

EUR / USD 1.24 1.25 1.24 1.23 1.22 1.20

EUR / JPY 145.8 148 149 150 150 150

EUR / GBP 0.792 0.79 0.78 0.77 0.76 0.76

USD / CNY 6.12 6.15 6.30 6.40 6.30 6.25

rates

21-11-2014 Q4-2014 Q1-2015 Q2-2015 Q4-2015 Q4-2015

United States

Fed funds 0.25 0.25 0.25 0.25 0.25 0.50

3-months libor 0.23 0.23 0.22 0.21 0.38 0.62

2-year swap 0.72 0.65 0.65 0.70 0.95 1.30

10-year swap 2.44 2.40 2.40 2.30 2.55 2.85

Eurozone

ECB refi 0.05 0.05 0.05 0.05 0.05 0.05

3-months Euribor 0.08 0.06 0.04 0.03 0.04 0.06

2-year swap 0.21 0.22 0.20 0.15 0.20 0.25

10-year swap 0.98 0.95 0.90 0.85 0.95 1.20

Japan

Overnight 0.10 0.10 0.10 0.10 0.10 0.10

3-months interbank 0.11 0.12 0.12 0.13 0.14 0.15

2-year swap 0.15 0.15 0.15 0.15 0.16 0.16

10-year swap 0.62 0.65 0.65 0.65 0.65 0.70

United Kingdom

Base rate 0.50 0.50 0.50 0.50 0.75 0.75

3-month Libor 0.56 0.55 0.60 0.70 0.80 0.85

2-year swap 0.97 0.95 1.00 1.10 1.35 1.60

10-year swap 2.10 2.10 2.15 2.05 2.30 2.55

Source: Rabobank

> Appendix

Outlook 2015 90

Sources

BIS – Bank of International Settlements

CBS – Statistics Netherlands

CPB – Netherlands Bureau for

Economic Policy Analysis

DNB – Dutch Central Bank

ECB – European Central Bank

IMF – International Monetary Fund

Currencies

BRL – Brazilian real

EUR – euro

GBP – British pound

HUF – Hungarian forint

INR – Indian rupee

JPY – Japanese yen

PLN – Polish zloty

TRY – Turkish lira

USD – US dollar

Used country and region abbreviations

AT – Austria

AU – Australia

BE – Belgium

CA – Canada

CH – Switzerland

CIS – Commonwealth of Independent States

DE – Germany

DK – Denmark

EMU – European Monetary Union

ES – Spain

FI – Finland

FR – France

GB – Great Britain

GR – Greece

IE – Ireland

IT – Italy

JP – Japan

NL – Netherlands

NO – Norway

NZ – New Zealand

PT – Portugal

SE – Sweden

US – United States

> Abbreviations

Author: Wim Boonstra

Elwin de Groot

Tim Legierse

Projectmanagement: Carlijn Prins

Hans Stegeman

Editing: Wim Boonstra

Jan Lambregts

Hans Stegeman

Enrico Versteegh

Infographics: Reinier Meijer

Selma Heijnekamp

Productiecoördinatie: Christel Frentz

Photography: Scholsfotografie

Art direction and production: Volta_thinks_visual, Utrecht

Contact address: Rabobank Nederland

Economic Research Department

Telephone: + 31 30 216 2666

Email: economie@rn.rabobank.nl

www.rabobank.com/economics

www.rabobank.com/outlook2015

> Colophon

Outlook 2015 91

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