Subject: David Hale Global Forecast: Will the US Avert the Fiscal Cliff?
From: "David Hale" <[email-masked]>
To: "R. Hunter Biden" <[email-masked]>
Date: Sat, 1 Dec 2012 15:40:38 -0800 (PST)

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Dear R. Hunter,

As we approach 2013, major uncertainties persist in the global economy. 
President Obama and Republican leaders in Congress need to make tough 
choices in order to prevent the US economy from falling off the fiscal 
cliff. Although there are some signs of stabilization in Europe, the 
economic situation in the periphery is dire. China's new leadership 
teams need to implement dramatic reforms to meet their ten-year goals, 
but the increasing ossification of the political system may prove to be 
an insurmountable barrier. Japan could face a period of monetary turmoil 
unprecedented among G-7 countries in the modern era, depending on the 
results of the upcoming election.

Attached you will find our latest comprehensive global forecast, "Will 
the US Avert the Fiscal Cliff?" Key conclusions:

US consumer confidence could soon follow the same downward trajectory as 
business confidence until the fiscal cliff issue is resolved

Corporate profits will likely be weaker than expected over the next year 
because of the negative impact on US growth on fiscal drag

The eurozone economy should contract again this quarter as weakness is 
expected in both Germany and France and the periphery remains in 
recession

The mid-December Japanese election could result in the LDP returning to 
power, and usher in an era of an even more expansionary Bank of Japan

Chinese GDP growth is accelerating as a result of an upturn in both 
manufacturing and the housing market

Developing Asia has been experiencing more robust growth rates this year 
than developed Asia as a result of stronger domestic demand

Additionally, I will be travelling to Asia this coming week, where I 
will be speaking at the ASEAN 100 Leadership Forum in Myanmar—my first 
trip to that country.  I will also be visiting China where I will be 
meeting with local economists and officials in Beijing. I will share my 
findings from this trip later this month.

As always, we welcome any questions or comments.

Best regards,

David Hale 

Chairman

David Hale Global Economics, Inc.

546 Lincoln Avenue, 2 nd  Floor

Winnetka, Illinois 60093 USA

847-386-6009 (tel)

847-386-6011 (fax)

[email-masked]

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Will the US Avert the Fiscal Cliff?

By David Hale 

KEY CONCLUSIONS

• The US election produced a status quo outcome which will do little to 
ease concerns about resolving the fiscal cliff brinksmanship

• US consumer confidence could soon follow the same downward trajectory 
as business confidence until the fiscal cliff issue is resolved

• The US housing sector is becoming one of the US economy's biggest 
growth drivers

• The Federal Reserve's balance sheet could expand by over $1 trillion 
over the course of the next year

• Corporate profits will likely be weaker than expected over the next 
year because of the negative impact on US growth of fiscal drag

• The eurozone economy should contract again this quarter as weakness is 
expected in both Germany and France and the periphery remains in 
recession

• Improving euro area Target-2 balances could be indicative that the 
period of financial panic has passed in Europe

• Japanese GDP contracted sharply in the third quarter on the back of a 
nearly 20% annualized decline in exports as a result of a strong yen and 
weak global economy

• The mid-December Japanese election could result in the LDP returning 
to power and usher in an era of an even more expansionary Bank of Japan

• Chinese GDP growth is accelerating as a result of an upturn in both 
manufacturing and the housing market

• Developing Asia has been experiencing more robust growth rates this 
year than developed Asia as a result of stronger domestic demand

• Indian growth and inflation results continue to disappoint the markets

• Latin American growth this year will be less than half the growth 
achieved in 2010 as a result of ongoing weakness in Brazil and commodity 
exports

• Emerging market central banks continue to buy gold in order to 
diversify reserves

THE FOUR LARGEST ECONOMIES FACE DIVERSE CHALLENGES

The immediate question confronting the US economy is whether there will 
have to be a large stock market decline to resolve the disagreements 
between the White House and Congress over pending tax increases and 
spending cuts. There is a broad consensus that the tax hikes should be 
deferred in order to lessen the risk of the economy sliding back into 
recession, but there is a deep philosophical disagreement about the tax 
status of high income people. The president wants to return the top 
marginal income tax rate on Americans earning over $250,000 per annum to 
39.6% while the Republicans want to leave it unchanged. There is now 
discussion about curtailing the value of tax allowances rather than 
hiking marginal tax rates, but such proposals will face fierce 
resistance from vulnerable constituencies such as home builders and 
charities. As a result, there is no way of predicting how Washington 
will achieve a fiscal compromise in time to prevent large tax increases 
on January 1, 2013.

The European economy continues to suffer from recession while Spain has 
so far declined to pursue a rescue program which would allow the 
European Central Bank to purchase its debt. As Spain has large funding 
needs in the new year, the markets expect Spain to seek a program in the 
near future, but it is unclear if it will act before year end. The issue 
of monetary policy has suddenly become prominent in the Japanese 
election campaign. The LDP leader, Mr. Shinzo Abe, has been calling for 
a more expansionary policy and the central bank governor, Mr. Masaaki 
Shirakawa, has said that Mr. Abe's proposals could jeopardize the 
Japanese bond market. Such a confrontation between politicians and the 
BOJ is unprecedented, but as Mr. Abe is likely to emerge as prime 
minister in mid-December he will have the power to change monetary 
policy by appointing a successor to Mr. Shirakawa in April. The odds are 
high that this new monetary policy will weaken the yen. China has 
completed the first stage of its leadership transition by appointing Mr. 
Xi Jinping as Communist Party leader. He will become president in March. 
As China's economy is showing signs of recovery, there are unlikely to 
be any radical policy changes in the short term, but there will have to 
be major structural changes during the next two or three years to 
sustain a high growth rate.

US GROWTH TO WEAKEN THIS QUARTER

The Commerce Department's first estimate of third quarter real GDP 
growth was 2.0%. Newly published data for foreign trade and inventory 
indicate that the third quarter growth rate was 2.7%. There were large 
upward adjustments in inventories and inventory-to-sales ratios rose to 
high levels, suggesting there will be a correction during the fourth 
quarter. The growth rate of final domestic demand was also reduced to 
1.7% from 2.3% because of weaker estimates for both consumption and 
investment.

The economy's growth rate during the fourth quarter will probably ease 
back to 1.0% or less. Several factors could depress growth in the fourth 
quarter. There was a large increase in defense expenditures during the 
third quarter which is unlikely to be repeated. The uptick in exports 
during the third quarter will be vulnerable to weakness in the global 
economy. Capital spending is likely to remain weak because of 
uncertainty about federal fiscal policy. Hurricane Sandy will depress 
job gains during November, and thus weaken personal income growth. The 
one potential offset to this weaker income growth could be the decision 
of many households to reap capital gains this year in order to avoid the 
risk of higher capital gains taxes next year. Over one hundred companies 
are boosting dividends in December or moving dividends scheduled for 
January to December (Wal-Mart) in order to lessen the risk of higher 
dividend taxes penalizing their shareholders. There is no precise way to 
quantify how large the capital gains will be during December, but 
historical precedent suggests the number could be significant. In 1986 
the knowledge that capital gains taxes would increase from 20% to 28% 
caused investors to increase their capital gains from $172 billion to 
$328 billion. This figure declined back to $148 billion in 1987. If the 
experience of 1986 is repeated this year, households could use some of 
their windfall capital gains or enhanced divided income to boost their 
Christmas spending.

Hurricane Sandy will make it difficult to use economic data for October 
and November. The storm struck the New York-New Jersey area in late 
October, but its effects lingered for several days. It is estimated that 
the storm could have done as much as $30-50 billion of damage. If these 
estimates are correct, Sandy will rank as the second most expensive 
hurricane during the past decade. The other high cost hurricanes using 
2011 dollars were Katrina in 2005 ($145 billion), Ike in 2008 ($28 
billion), Wilma in 2005 ($19 billion), and Rita in 2005 ($19 billion). 

Before the hurricane struck, the economy had experienced three months of 
robust retail sales and weaker capital goods orders. The University of 
Michigan Consumer Sentiment Index initially rose to 84.9 during November 
in the flash estimate, or the highest level since July 2007. Spending 
intentions for large household goods jumped to 137 from 128 after 
declining for two months. Buying conditions for houses rose to an 
eight-year high of 166. Auto purchase plans rose to 131 from 124.  The 
final index reading retreated to 82.7, however, which still represented 
an increase. Surveys of business confidence, by contrast, were far more 
subdued. Consumers were feeling more optimistic because of rising house 
prices and declining gasoline prices. Business executives were deeply 
concerned about the dangers posed by the fiscal cliff as well as signs 
of weakness in Europe and formerly high growth developing countries such 
as Brazil, India, and China. There also has been a slowdown of profit 
growth, but profit margins remain near record high levels in relation to 
national income.

THE HOUSING SECTOR IS DRIVING US GROWTH

The economy's new growth locomotive is housing. The number of housing 
starts during October rose 3.6% to 894,000. The uptick resulted from an 
11.9% gain in multifamily starts to 300,000, or a level 57.1% higher 
than one year ago. Single family starts declined 0.2% to 594,000, but 
are up 35.3% from one year ago. The National Association of Homebuilders 
also reported that its confidence index rose five points during November 
to 46 and is now more than twice as high as its level of 19 one year 
ago. The component gauging current sales conditions rose eight points to 
49—its highest mark in six years. The component measuring sales 
expectations going out six months held above 50 for the third 
consecutive month with a two point gain to 53. The housing upturn has 
resulted from three factors. First, homes are highly affordable because 
of low mortgage rates and the price declines since 2006. Secondly, the 
inventory of single family homes for sale has declined 17% during the 
past year to 1.76 million units. Thirdly, there has been an upturn in 
household formation after a sharp decline during the recession.  At the 
peak of the housing bubble during 2004-06, household formation soared to 
1.5 million from 1.1 million during the previous decade. During the 
period 2007-11, household formation fell to only 600,000 per annum. This 
decline resulted from slower immigration and a decline in the headship 
rate for young adults as many decided to live with their parents rather 
than establish new households. During the first nine months of 2012, the 
rate of household formation rose back over one million. If the economy 
can continue to produce jobs, the rate of household formation could rise 
to 1.2 million in 2013 and 1.3 million in 2014-16. Such an uptick in 
household formation should boost housing starts to 1.0 million next year 
and 1.5 million during 2016. Such a sustained recovery could generate 
many new jobs. During the recession, the economy lost 2.3 million 
construction jobs and has so far regained only about 83,000. One of the 
surprises in the employment data is that we have not produced more 
construction jobs since the housing upturn began last year. Developers 
have probably remained risk averse because of the severe downturn during 
2008 and 2009. The increasing confidence of homebuilders should produce 
larger gains in construction employment next year.

The recent uptick in home sales has been accompanied by an upturn in 
property values. Zillow estimates that home values rose 1.3% during the 
third quarter of 2012—the largest quarterly gain since 2006. Zillow also 
estimates that the price gains pushed negative equity levels down from 
30.9% to 28.2%, the first time that negative equity has fallen below 30% 
since Zillow began tracking such data in 2008. There are still 14 
million people with negative equity in their homes, and they owe $1.02 
trillion more than their houses are worth. Homeowners with negative 
equity are reluctant to put their properties on the market, so buyers 
have to bid for other homes and can create upward pressure on prices 
which reduces the negative equity in underwater homes. Zillow estimates 
that these price gains have reduced negative equity by 6.2% in Phoenix, 
5.5% in Las Vegas, 4.9% in Denver, 4.6% in Sacramento, and 4.2% in 
Orlando. The reduction of negative equity lessens the risk of homeowner 
defaults while boosting household balance sheets after large wealth 
losses during 2007-11.

One other factor which has been boosting the housing market is increased 
foreign purchases. In the twelve months through March, foreign purchases 
rose 24% and now account for 5% of all purchases. International buyers 
from Canada (24% of such purchases), China (11%), and Mexico (8%) are 
taking advantage of low US house prices and strong domestic currencies.

FISCAL DRAG IS INEVITABLE IN 2013

The White House and congressional Republicans have begun preliminary 
talks on how they will avoid large tax increases and spending cuts in 
January. The Democrats want to extend the income tax cuts for everyone 
earning less than $250,000 per annum. The Republicans want to extend the 
tax cuts for everyone. The Republicans are opposed to hiking marginal 
income tax rates because they say the impact would fall heavily on small 
businesses which pay the personal tax rates, and thus could retard job 
creation. There are 34.8 million small businesses in the US and 30 
million only employ their owner. Of the remaining 4.8 million firms 
which employ workers, 1.2 million have incomes above $200,000 per annum. 
These firms account for 54% of all private sector jobs (77.6 million). 
While they make up only 3% of all small businesses, they earn 91%—or 
$341 billion—of all profits reported by small firms with workers. They 
also pay 44% of all business taxes. The Republicans believe the 1.2 
million firms with income above $200,000 per annum are the most prolific 
job creators.

As the Republicans are opposed to hiking marginal income tax rates, 
there is discussion about instead curtailing tax allowances. One week 
after the election, Mitt Romney economic advisor Glenn Hubbard had an 
article in the Financial Times advocating curtailing tax allowances as a 
way to achieve deficit reduction. The Center for a Responsible Federal 
Budget has produced a report estimating the revenue potential from 
curtailing tax allowances. They first estimated the impact of curtailing 
the value of tax allowances to $25,000. Such a change would be 
progressive because only 11% of taxpayers have deductions worth $25,000 
and nearly three-quarters of these deductions belong to people with 
incomes above $200,000 per annum. The Center estimates the $25,000 cap 
would raise $94 billion of revenue during the first year. The Center 
also examined the feasibility of a proposal from Martin Feldstein to cap 
tax deductions at 2% of adjusted gross income and impose a $10,000 cap 
as well. The Center found this proposal could generate revenue of $317 
billion if applied to everyone and $86 billion if applied to those 
earning over $200,000 per annum. The Democrats have also spoken about 
possibly allowing high income people to subtract their tax deductions at 
a marginal income tax rate of 28% rather than the current top rate of 
35%. The administration estimates that such a change could raise $300 
billion of revenue.

There are powerful interest groups opposed to reducing the value of tax 
allowances. They include real estate interests who want to protect the 
mortgage deduction, charities who want to protect their gifts from high 
income people, and high tax states who want to protect the deductions 
for their state income and local property taxes. The fact that these 
groups' tax allowances would be reduced, but not eliminated, could help 
to lessen opposition, but they could still pose an obstacle to tax 
reform.

The Republicans have suggested they could be more flexible on the idea 
of raising revenue than they were in the past. Their tradeoff for such a 
change is that the White House offer substantive proposals for reducing 
spending on entitlement programs such as Medicare. The White House has 
flirted with ideas such as raising the eligibility age for Medicare or 
means testing Social Security, but it has not offered any concrete 
proposals in the current negotiations. The president's problem is that 
many congressional Democrats are opposed to any changes in the 
entitlement programs.

If the White House and Congress are unable to achieve a compromise on 
the pending tax increases and spending cuts, they could attempt to head 
off the risk of renewed recession by agreeing to defer the tax hikes for 
three months or six months in order to allow more time for negotiations. 
As the Treasury will once again hit the federal debt ceiling during the 
first quarter, there will have to be some kind of grand bargain on 
fiscal policy by next March. With this deadline looming, both Democrats 
and Republicans could decide there is inadequate time to achieve 
meaningful deficit reduction during December and opt for the deferral 
option. At the current time deferral appears to be the most likely 
option in order to head off the risk of renewed recession while leaving 
the door open to serious long-term deficit reduction.

While the Congress and White House should avoid a fiscal cliff in 
January, there will still be fiscal drag. It appears that Congress will 
allow the payroll tax cut first enacted two years ago to expire despite 
the president including an extension of the payroll tax cut and extended 
unemployment benefits in his initial fiscal cliff offer. This will 
impose a $108 billion tax on the household sector, or a sum equal to 
0.7% of GDP. Congress is also unlikely to continue extending 
unemployment benefits for the long-term unemployed. This action will 
reduce household income by $30 billion. These measures will be a drag on 
personal income during the first quarter, and thus will depress consumer 
spending.

WILL THE FED'S BALANCE SHEET INCREASE BY $1 TRILLION IN THE NEXT YEAR?

The Federal Reserve began a new program of buying $40 billion per month 
of mortgage-backed securities during September while continuing its 
Operation Twist program of converting short-term Treasury debt into 
longer term securities. The Operation Twist program will end in December 
when the government runs out of short-term securities. Some district 
presidents have expressed support for continuing the Treasury bond 
buying program after Operation Twist ends. If the Fed does as they 
suggest, it will purchase $85 billion per month of securities and expand 
its balance sheet by a further $1 trillion during the next twelve 
months. Fed Chairman Ben Bernanke will probably accept this proposal in 
order to help the economy offset the fiscal drag likely to occur in 
January as the payroll tax cut and extended unemployment benefits end. 
Mr. Bernanke has been publicly warning that the pending tax increases 
and spending cuts could drive the economy back into recession.

The Fed's Vice Chairwoman, Janet Yellen, gave a speech in November 
clarifying further how she thought monetary policy should evolve during 
the years ahead. She suggested the Fed should not use calendar dates to 
set monetary policy, but should instead use "guidance on the economic 
conditions that need to prevail before liftoff of the federal funds rate 
might be judged appropriate". As with Charles Evans, president of the 
Chicago Fed, she would favor holding the funds rate at its current low 
range until the unemployment rate falls below 7.0%. Ms. Yellen's 
opinions are important because she is probably the frontrunner to 
succeed Ben Bernanke if he leaves the Fed when his term ends in January 
2014.

The Fed can retain an accommodative stance because there are few signs 
of inflation accelerating. After registering gains of 0.6% during August 
and September, the CPI rose 0.15% during October and is now 2.2% above 
its level one year ago. The core CPI rose 0.18% last month and is now 
2.0% above its level one year ago. There was zero commodity inflation 
last month because energy prices fell 0.2%. Service inflation, by 
contrast, rose 0.27% because of upward pressure on residential living 
costs. The owner's equivalent rent measure rose 0.21% and has increased 
at a 2.8% annual rate during the past three months compared to 2.1% 
during the past year. The separate rent of primary residence also rose 
0.4% in October and has increased at a 3.6% annual rate during the past 
three months. Rents are rising because of a sharp decline in the 
apartment vacancy index. Producer prices fell 0.2% during October and 
are likely to weaken further during the next few months because of 
declines in the prices of crude goods. The weakness of the global 
economy is helping to restrain inflation everywhere. The risk in the US 
economy is that demand for rental property could generate further upward 
pressure on housing costs and help to hold the core inflation rate close 
to 2.0%.

CORPORATE PROFITS WILL BE WEAKER THAN EXPECTED IN 2013

The GDP measure of corporate profits rose 3.5% during the third quarter 
over the second quarter. Companies in the S&P 500 reported that their 
global sales fell 1.5% year on year during the third quarter despite a 
gain of 4.4% in domestic sales. Both Europe and Japan are now in 
recession. The growth rates of emerging market economies in Asia and 
Latin America have slowed.  The S&P 500 measure of profits eased to 
$24.37 during the third quarter from $25.43 during the second quarter. 
Analysts estimate that profits could rebound to $25.77 during the fourth 
quarter and rise steadily next year to $29.98 by the fourth quarter. If 
these forecasts are correct, profits will rise to $113.45 next year from 
$99.81 this year. As a result of the risks posed by fiscal drag to the 
US economy during early 2013, these profit estimates appear to extremely 
bold. The economy is more likely to produce single-digit profit gains 
during 2013 rather than double-digit gains. There is a possibility of 
more robust profit growth during 2014 if the US can resolve its fiscal 
problems and the global economy improves. The profit risks during the 
intermediate term are on the downside. The sectors facing the greatest 
profit vulnerabilities are materials, industrials, information 
technology, and consumer discretionary.

GROWTH OUTLOOK SUBDUED UNTIL BUSINESS CONFIDENCE RECOVERS

Hurricane Sandy could depress US output growth by 0.25-0.50% during the 
fourth quarter and boost it by nearly as much during the first quarter. 
The hurricane depressed industrial production by 1.0% during October and 
significantly boosted unemployment insurance claims. The Markit survey 
of US manufacturing suggests that the hurricane did not, however, 
fundamentally undermine the resilience of manufacturing during November. 
The Markit Flash US Manufacturing Purchasing Managers' Index rose to 
52.4 during November from 51.0 the previous month. Incoming new work at 
manufacturing firms rose for the thirty-ninth consecutive month in 
November as a result of both stronger domestic demand and stable 
exports. The US manufacturing sector lost momentum during the middle 
quarters of the year because of weaker domestic demand and exports. It 
has regained momentum during the past two months because of an upturn in 
both. This suggests that the US economy could achieve a growth rate in 
the 2.0-3.0% range during the first quarter of 2013 if there were not 
significant uncertainties about federal fiscal policy. The probable 
fiscal drag during early 2013 is likely to weaken domestic demand by at 
least 1.0%, and thus hold the growth rate closer to 2.0% or less. The 
magnitude of the upturn after the first quarter will depend upon whether 
firms regain the confidence to bolster capital spending and employment.

There has been a significant recovery of consumer confidence during the 
past three months, but business confidence is very subdued because of 
policy uncertainty. If business confidence does not rebound, the 
economy's growth rate could remain lackluster despite a housing recovery 
and further steady gains in the output of oil and gas.

FURTHER CONTRACTION IS EXPECTED IN EUROPE IN THE FOURTH QUARTER

The European economy contracted by 0.1% during the third quarter after a 
0.2% decline during the second quarter. The two biggest economies, 
Germany and France, sustained a growth rate of 0.2%. There were declines 
of 0.2% in Italy, 0.3% in Spain, 1.1% in the Netherlands, 0.8% in 
Portugal, and 0.1% in Austria.

The odds are high that European GDP will contract further during the 
fourth quarter. Industrial production in September fell by 2.5%. There 
were declines in the core countries, not just the periphery. Industrial 
output fell 2.1% in Germany and 2.7% in France compared to 1.5% in 
Italy, 2.8% in Spain, 12.0% in Portugal, and 4.4% in Greece. In Germany, 
the ZEW confidence index fell 4.2 points in November to -15.7 compared 
to forecasts the index would rally to -9.8 from -11.5. The new pessimism 
in Germany reflects weaker exports to the eurozone and announcements by 
German companies of new cost cutting programs. These measures could 
depress investment as well as employment.

The euro area flash PMIs showed signs of stabilizing during November at 
depressed levels. The euro area composite index rose to 45.8 from 45.7. 
The euro area manufacturing PMI rallied to 46.2 from 45.4 led by gains 
in new orders and employment. The euro area service PMI, by contrast, 
fell from 46.0 to 45.7. In Germany the manufacturing PMI rose to 46.8 
from 46.0 while the service index fell to 48.0 from 48.4. In France the 
manufacturing PMI rose to its highest level in three months, 44.7, 
because of stronger export orders and employment. The depressed level of 
the PMIs suggests European output growth during the fourth quarter will 
remain negative, but the fact that the indices are showing signs of 
stabilizing could also set the stage for growth firming during the first 
quarter if the PMI indices rally further during the next three months.

The one positive feature of the European downturn has been an 
improvement in the region's current account. Ireland returned to a 
surplus two years ago. Spain and Greece went into surplus this summer. 
The deficits of Portugal and Italy have contracted sharply. As a result 
of these developments, Europe now has a current account surplus of €77.8 
billion, or 0.8% of GDP, compared to a deficit of €7.6 billion one year 
ago. During the 2008-09 downturn, there was a sharp decline in European 
exports that produced a current account deficit of 1.5% of GDP. This 
downturn has been driven by falling domestic demand, and thus has 
improved trade accounts.

CAN FRANCE AVERT A CRISIS?

Moody's has downgraded France's credit rating one notch to Aa1 from 
triple-A because of concerns about the country's growth potential and 
rising public debt. There is growing concern about the status of France 
as a pillar economy of Europe because of the new government's attempts 
to raise taxes on business and high income people. There has been a 
sharp increase in newspaper ads for sales of homes worth over €1 million 
as many wealthy French people make plans to leave the country. The 
Economist Magazine had a special feature section in November on the 
problems of the French economy. The challenges confronting France are 
both cyclical and structural. The government is committed to reducing 
its deficit to 3.0% of GDP next year, 2.2% in 2014, and 1.3% in 2015. 
These forecasts are based on the assumption that real GDP will grow by 
0.3% this year, 0.8% in 2013, and 2.0% in 2014. These numbers appear to 
be overly optimistic. The EU has just produced a new forecast which 
suggests real GDP will grow by 0.4% next year and 1.2% in 2014. A 
growing number of private analysts fear that France could have a modest 
recession next year and a GDP contraction of at least 0.1%. If growth 
falters, it will be difficult to reduce the fiscal deficit. The 
structural challenges center on the competitive position of the French 
economy. France has one of the largest public sectors in Europe and high 
labor costs. At the end of 2011, employee compensation amounted to 67.4% 
of value added in French industrial firms (up 6.7% since 1999) compared 
to 59.9% in Germany (down 9.7% since 1999). France has lost one-third of 
its share of global exports since 1999 while the country now runs a 
current account deficit of 3.1% of GDP compared to a surplus of 3.2% at 
the inception of the European currency.

The former CEO of EADS, Louis Gallois, produced a report on France's 
competitiveness problems during early November. The government responded 
by announcing a tax cut for business. It will lower social insurance 
contributions for firms on wages between 1.0 and 2.5 times the minimum 
by €10 billion in 2013 and €5 billion in 2014 and 2015. In total it will 
reduce labor costs by 6%. The government will finance the tax cuts by 
reducing public spending €10 billion and increasing the VAT as well as 
environmental taxes by €10 billion. Other European countries have 
attempted to reduce labor costs by increasing their reliance on 
value-added taxes and had some success bolstering employment growth. 
What remains unclear is whether France will be able to change wage 
bargaining in a way that helps to bolster the corporate sector's 
competitive position. 

Germany had major labor market reforms during the Schroder government 
which helped to reduce wage costs and strengthen the country's 
competitiveness. The Hartz labor market reforms of 2003-05 created a low 
wage sector in Germany by reducing benefits for the long-term unemployed 
and deregulating temporary employment. These reforms, coupled with the 
rising competitiveness of countries in Asia and Eastern Europe, 
encouraged firms to work with unions to enhance their competitive 
positions. The result was a prolonged period of subdued wage growth 
relative to productivity and Germany becoming the world's largest 
producer of tradable goods. The German government is so concerned about 
the erosion of France's competitive position that it has asked the 
council of economic advisors to prepare a report on what France can do 
to improve its economic performance. There will be no way that Germany 
can publicly give such a report to Mr. Hollande, but the very fact it is 
preparing the report underlines the deep concerns about France's 
problems among senior European officials. The new pessimism about France 
has not yet driven up French bond yields because Switzerland has buying 
a large volume of them to deploy its rapidly growing foreign exchange 
reserves. As France has one of the largest and most liquid bond markets 
in Europe it is a natural repository for central banks seeking to 
diversify out of low yielding German bonds.

CHALLENGES REMAIN IN THE EU

S&P downgraded Spanish debt from BBB+ to BBB- during mid-October. 
Multiple downgrade waves over the last year have driven Spain's 
sovereign rating from AA to the lowest ranking of investment grade. 
Spain is having a difficult time reducing its fiscal deficit because of 
the recession in the economy. It may only decline to 8% this year 
compared to previous targets in the 6-7% range. Spain has so far been 
reluctant to pursue an EU aid program in order to qualify for the ECB 
policy of outright monetary transactions to purchase its public debt. 
Spain has been cautious because the promise of ECB help has already led 
to a large decline in bond yields while the government is reluctant to 
be seen accepting any new austerity program from officials in Brussels. 
There have also been provincial elections which further reinforced this 
caution. The province of Catalonia held an election which produced a 
victory for parties which have been talking about holding an 
independence referendum. The Catalonians complain that fiscal transfers 
to Madrid are equal to 8% of provincial GDP and are unfair at a time of 
great fiscal austerity. Catalonia is Spain's richest province and 
accounts for about 20% of national GDP. As Spain will have €250 billion 
of funding requirements during the new year, the markets still expect 
the government to seek an aid program at some point. Spanish real GDP is 
likely to decline 1.5% next year because of further declines in 
consumption and investment, but exports are increasing and could reduce 
the current account deficit to 0.4% of GDP from 10% in 2007.

Italy's economy is likely to shrink by over 1.0% next year compared to 
2.1% this year. Both consumption and private investment are very weak. 
There will be less fiscal drag during 2013, but there will be new 
political risks because of national elections in March or April. As 
there is no clear front runner in the polls, it is unclear if a 
competent alternative government will emerge or whether Mr. Monti might 
be asked to spend another year as prime minister. Italy has the 
strongest fiscal position in Southern Europe. The primary budget surplus 
will be around 2.8% of GDP this year compared to deficits elsewhere in 
the region.

The EU has not yet given Greece the financial aid which was promised 
several months ago in return for a pledge to pursue fiscal austerity. 
There has been a disagreement between the EU and IMF on the issue of 
targets for Greek public debt. When Greece embarked upon a private debt 
restructuring program in March, its goal was to reduce the public debt 
to 120% of GDP by 2020. As a result of Greece's severe recession, the 
public debt could peak at a staggering 190% of GDP in 2014. As most of 
Greece's debt now belongs to official institutions, the IMF wants them 
to explore possible debt forgiveness as a way to restore Greece's 
long-term solvency. Since the EU governments originally promised there 
would be no debt forgiveness, they are reluctant to accept any further 
restructuring of government-owned debt at the current time. The 
governments have instead offered to lower the interest rates on their 
Greek loans by 100 basis points and to extend the maturities by fifteen 
years. They will also return to Greece any profits the ECB earns on its 
holdings of Greek government debt (about €45 billion). There will be a 
further review of the Greek government's solvency in 2016 when 
governments might agree to debt write-offs. There cannot be any debt 
forgiveness before the German federal election in September 2013.

The level of Target-2 balances in Germany, Italy, and Spain are a useful 
proxy for measuring financial stress. When there is capital flight from 
a Southern European country, the local central bank finances it with 
borrowing from the Bundesbank. Italian Target-2 balances have stabilized 
at around €276 billion since March. In October, the balance narrowed to 
€267 billion from €281 billion previously. Spanish Target-2 balances 
narrowed to €380 billion in October from €400 billion in September and 
€434 billion in August. The decline in Target-2 balances probably 
reflects greater investor confidence that the ECB will take effective 
action to maintain the monetary union.

THE UK SLOWLY EMERGES FROM RECESSION

The UK economy rebounded by 1% during the third quarter, but forecasters 
do not expect growth to remain at such lofty levels during the next few 
quarters. There has been an increase in the inflation rate which could 
squeeze consumer income. Exports to Europe are declining. The weakness 
of demand is depressing business investment. The government is committed 
to a program of fiscal austerity which will reduce public sector 
expenditures. The Bank of England decided to leave monetary policy 
unchanged at its latest meeting, but it will return £37 billion of 
interest payments received on government debt to the Treasury. This 
transfer is a de facto form of quantitative easing. The Bank is also 
going ahead with a Funding-for-Lending scheme which offers incentives 
for banks and building societies to lend by lowering the funding costs 
of those which meet lending targets. This program is an attempt to lower 
business borrowing costs directly rather than relying on indirect 
channels such as government bond purchases.

TUMULTUOUS YEAR AHEAD FOR JAPAN

Japan's GDP fell 3.6% during the third quarter at annual rates because 
of a sharp contraction in the trade surplus and the end of subsidies for 
auto purchases. Exports fell 19%, the worst plunge since the 22% drop 
just after the March 2011 tsunami, and accounted for 2.9 percentage 
points of the GDP decline. Japan's exports are suffering from the weaker 
global economy and the upsurge of tensions with China because of the 
Japanese government's decision to purchase the Senkaku Islands. China is 
Japan's largest export market and takes 21% of its exports. Most of 
Japan's exports are capital goods and processed materials for re-export. 
Consumer goods account for 6% of Japanese exports to China led by autos 
and various electronic goods. Japanese auto sales in China are worth 
¥6.7 trillion. Sales at these affiliates are likely to fall by 40% 
during the fourth quarter. As a result, exports of autos and auto parts 
to China are likely to fall over 50% and reduce total exports by around 
4.5%. Japan is also a major investor in China. There are 14,400 Japanese 
firms with operations in China and they employ 1.5 million people. The 
recent tensions could cause Japanese investors to reconsider their 
strategies and pull back from investment in China. As a result of labor 
shortages in China, there has already been some diversion of investment 
to ASEAN. It now accounts for $72.4 billion of Japanese FDI stock 
compared to $83.4 billion for China. If Sino-Japanese tensions do not 
cool, Japan will shift more investment to ASEAN during 2013 and 2014.

Japanese exports are still 12% below their pre-recession peak while real 
imports are now 4% above their pre-recession peak. The weakness of 
exports has given Japan a trade deficit, and during September it 
incurred the first current account deficit since 1981. The other factor 
which has produced a trade deficit is a large increase in oil imports to 
compensate for the fact that most of the country's nuclear power plants 
are still closed. Japan has a large surplus in investment income which 
should restore a current account surplus, but the surplus may be equal 
to only 1.0-1.5% of GDP compared to previous estimates it would be at 
least 2.0% of GDP.

The Bank of Japan has responded to the downturn by further expanding its 
balance sheet. It announced ¥10 trillion of new asset purchases in late 
September and a further ¥11 trillion in late October. The late October 
move was also accompanied by a joint statement with the government 
entitled "Measures Aimed at Overcoming Deflation". The statement was 
signed by BOJ Governor Masaaki Shirakawa, State Minister in Charge of 
Economic and Fiscal Policy Seiji Maehara, and Finance Minister Koriki 
Jojima. The government wanted to demonstrate that it is concerned about 
deflation and is taking action to encourage the BOJ to pursue a more 
accommodative policy. Mr. Maehara also attended the last two BOJ 
Monetary Policy Board meetings, the first minister to do so since Heizo 
Takenaka in 2003. Prime Minister Yoshihiko Noda has traditionally had a 
good relationship with Mr. Shirakawa, but Mr. Maehara felt there would 
be political advantages in displaying more willingness to modify 
monetary policy.

Mr. Noda dissolved the Diet in late November and announced there will be 
a general election on December 16th. On the basis of current opinion 
polls, the ruling Democratic Party is likely to lose over 100 seats and 
be replaced as the largest party by the Liberal Democrats, the party 
which ruled Japan for most of the post-war years before 2009. There will 
be some new regional parties seeking seats this year, so it is not clear 
if the LDP will have a clear majority with its traditional ally the New 
Komeito Party. There are estimates that the new party of the mayor of 
Osaka, Toru Hashimoto, could win as many as 50-70 seats.

The LDP leader, Shinzo Abe, has been making some very provocative 
comments about monetary policy. He says the BOJ should attempt to weaken 
the yen and aim for an inflation target in the 2-3% range. He also 
suggested that the BOJ should finance the issuance of government 
construction bonds in order to promote more infrastructure spending. At 
a recent press conference BOJ Governor Shirakawa felt compelled to say 
that such policies would jeopardize the central bank's independence and 
could drive bond yields sharply higher.

If Mr. Abe wins, he will have an opportunity during the spring to 
appoint two new deputy governors and a new governor at the BOJ. The 
terms of the incumbents end in March and April. He is likely to seek 
candidates who will favor a more expansionary policy than Mr. Shirakawa 
has. The potential candidates could include Kazumasa Iwata, a former BOJ 
deputy governor and director of an economic research institute, Prof. 
Takatoshi Ito, an economics professor and former LDP candidate for the 
job of deputy governor, Mr. Haruhiko Kuroda, president of the Asian 
Development Bank and former senior MOF official, and Heizo Takenaka, 
former minister for economic policy under Prime Minister Junichiro 
Kouzumi. All of these candidates have been critical of BOJ policy for 
being insufficiently stimulative. Mr. Iwata has also called for the BOJ 
to create a ¥50 trillion fund to promote devaluation of the yen. This 
proposal has been controversial because the MOF has traditionally 
controlled Japanese exchange rate policy. It also has undertaken 
large-scale intervention programs which have failed to weaken the 
exchange rate. Mr. Iwata is very concerned about the exchange rate 
because he believes it is causing deflation and encouraging a hollowing 
out of Japanese industry.

The possibility of Mr. Abe becoming prime minister and appointing more 
radical people to the BOJ Monetary Policy Board has led to a decline in 
the yen to 81-82 vis-a-vis the dollar. There has not yet been any major 
uptick in JGB yields because Mr. Abe's proposed monetary policy would 
lead to the BOJ monetizing the government deficit. If the BOJ could end 
deflation and create an inflation rate in the 1-2% range, there might 
finally be a correction in the JGB market. If yields rise sharply, it 
could create a problem for Japanese banks because they now have 25% of 
their assets invested in government debt. The megabanks primarily own 
securities with a maturity under three years, but the regional banks own 
larger portfolios of bonds with a six-year maturity.

If the LDP forms a government in mid-December, it is virtually certain 
that there will be major changes in the leadership of the BOJ. The LDP 
was already successful in having two dovish candidates appointed to the 
Monetary Policy Board in July. With the three vacancies pending in March 
and April, it will have appointed a majority of five members to the nine 
member Monetary Policy Board. These changes make Japan one of the 
potential global wildcards for 2013. It could embark upon the most far 
reaching monetary policy changes of any G-7 country in living memory. 
Such policy changes are likely to weaken the yen and bolster the Tokyo 
equity market. The great risk for the Japanese markets will be bond 
yields. If they rise sharply, they will pose a problem for the banks and 
could increase the government deficit by boosting its borrowing costs. 
As a result of deflation, the Japanese government has been paying less 
than 1% for ten-year money for several years. If the inflation rate 
rises into the 1-2% range, investors will also want much higher yields 
on government debt.

NEW LEADERSHIP IN CHINA

There are increasing signs that the Chinese economy's growth rate is 
accelerating after several quarters in which it slowed. The HSBC Flash 
Manufacturing PMI for November came in at 50.4 compared to 49.5 in 
October. This is the first time that the reading moved above the 50 
threshold since October last year. The output component rose to 51.3 
from 48.2 in October. The export orders component rose sharply to 52.4 
from 46.7. The stock of finished goods index rose to 49.5 from 48.4. The 
upturn in the PMI has resulted from both new government infrastructure 
projects and an improvement in foreign trade. Export orders rose 11.6% 
in October as a result of strong demand for clothing, Christmas items, 
and smartphones. Wireless communication devices, which account for 6% of 
China's exports, grew by nearly 30% year on year in October compared to 
20% in September. There are signs of improvement in the real estate 
market as well. Monthly turnover of commercial floor space sold in the 
third quarter was 18% higher than during the first half of the year. 
There was a 25% jump in home sales as measured by floor space in October 
compared to a 1.6% decline in September. The government has almost 
completed 5.1 million units of social housing and has a further 2.1 
million units under construction. The government does not want to 
rekindle the property boom which occurred during 2010 and it continues 
to restrict investor demand for property lending, but it is quite 
content to allow a recovery in demand from first-time home buyers and 
others seeking to upgrade their residences.

The growth rate of bank lending in China slowed to 505 billion rmb in 
October from 623.2 billion rmb in September. Total social financing 
(TSF), which comprises both bank lending and all types of non-bank 
financing for the corporate sector, rose 95% year on year and reached 
3.95 billion rmb during the third quarter. The biggest contributor to 
the TSF growth was new corporate bond issuance. It rose 299% year on 
year and amounted to 734 billion rmb during the third quarter.  The 
central bank injected 1.1 trillion rmb of liquidity into the interbank 
lending market during October. These injections are designed to 
compensate for a sharp slowdown in the growth of China's foreign 
exchange reserves. The central bank's foreign assets grew under 1% year 
on year during August compared to 12% in December and an average of 40% 
during 2003-07. Before 2012, the central bank had to sterilize the 
growth of these reserves in order to control the growth of the money 
supply. Now its challenge is to provide liquidity in the face of reduced 
reserves and capital inflows. The central bank eased reserve 
requirements by 150 basis points during November 2011, February 2012, 
and May 2012 in order to help facilitate this process. During the third 
quarter, it decided to leave reserve requirements unchanged and to 
expand its reverse repos from 89 billion rmb in May to a record 1.1 
trillion rmb in October. The central bank has left reserve requirements 
unchanged in order to increase the reliance of the commercial banks on 
the interbank lending market. This change represents a shift in Chinese 
monetary policy from a reliance on quotas or administrative controls, 
such as reserve requirements, to interest rates. It is one of the steps 
necessary to liberalize China's financial system and create more 
market-driven interest and exchange rates.

The Chinese Communist Party has just completed its 18th Congress and 
confirmed the names of the country's new leadership. Xi Jinping will 
become president in March and Li Keqiang will become premier. The 
election of these individuals came from a consensus-driven process, so 
they are unlikely to pursue radical new policies in the short term.

The most important personality change in the new leadership is the role 
of Wang Qishan. As vice premier, he had played a major role shaping 
economic policy and reform of the financial system. He is being 
reassigned to a new job in charge of party discipline and fighting 
corruption.  Economic policy will now be driven by the premier and the 
new vice premier, Zhang Gaoli, who was most recently leader of the port 
city of Tianjin. In this job he has presided over a large increase in 
debt-financed investment. The new standing committee will have seven 
members rather than nine. All of the members except for Mr. Xi and Mr. 
Li are in their sixties, and thus will have to step down at the 2017 
Party Congress. This means there is no clear front runner for the 
leadership positions which will become vacant in 2022.

The economic goal of the new leadership is to double per capita income 
for urban and rural residents by 2020 from levels in 2010. This implies 
a target of 7% for real GDP growth. There will have to be many reforms 
in order to achieve this goal. There will have to be further 
liberalization of the financial system and a major expansion of the bond 
market. There will have to be an increase in the share of tax revenue 
going to local governments, so that they can finance their 
infrastructure projects without relying so heavily on land sales. There 
will be a need to reduce the tax burden on small companies which 
currently give nearly half of their profits to the government. The 
government will have to strengthen the social safety net in order to 
lessen the pressure on households to maintain a high savings rate. The 
government now spends 35% of GDP on social security, education, 
medicine, and public housing compared to 14% in 2000. It will have to 
expand this share in order to bolster consumption and cope with the 
aging of the country's population. Current government spending on health 
care, for example, is only 1.5% of GDP compared to 9-11% in most OECD 
countries. There will have to be further deregulation in order to 
bolster the role of the private sector and more awareness of how 
government spending affects the economic status of the private sector. 
The 4 trillion rmb stimulus program announced in 2008 primarily helped 
state-owned enterprises because they had easier access to bank lending 
and monopoly status in many sectors. There are currently experiments 
occurring in some provinces to give the private sector a larger share of 
some markets and to improve its access to credit. There has already been 
extensive discussion of these issues and reports from the World Bank and 
IMF on how to move forward. The new leadership will now have to 
challenge powerful interest groups, such as the state-owned enterprises, 
in order to pursue these reforms.

EAST ASIAN GROWTH DIVERGES

The other East Asian economies are following a diverse growth path 
because of differences in fiscal policy and dependence upon exports. 
South Korea's PMI fell to 45.7 in September because of a sharp decline 
in new orders, although it contracted at a slower rate of 47.4 in 
October. The economy's growth rate during the third quarter was less 
than 1.0%. Exports declined 1.8% year on year in September because of 
weakness in both Europe and China. The central bank cut interest rates 
to 2.75% from 3.00% in mid-October. The government has announced another 
package of tax cuts and increased government spending totaling 5.9 
trillion won ($5.3 billion) to support the economy. The household 
consumption share of GDP is only 53%, but it is constrained by a high 
level of household debt. The ratio of household debt to disposable 
personal income is 163%, one of the highest ratios in the OECD. Most 
forecasters are now projecting a growth rate this year of under 2.5%. 
The economy could improve next year on the back of stronger exports, but 
investment could be restrained by political uncertainty. There will be a 
presidential election in December, and it is unclear who will win. Both 
of the leading candidates are talking about curtailing the powers of the 
chaebols and increasing welfare spending. These proposals could inhibit 
business decision making and hurt investment.

Taiwan's exports increased 10.4% in September because of stronger demand 
from China and robust sales of wireless communication devices produced 
by Taiwanese firms in China. If the global economy improves and boosts 
Taiwan's exports, its growth rate could rise to 2-3% next year from only 
1.0% this year.

Malaysia has had two years of expansionary fiscal policy as the 
government prepares for elections in March 2013. The ratio of public 
debt to GDP has risen from 41.2% in 2008 to 51.0% in 2011. There will 
have to be a fiscal consolidation after the election. Exports are nearly 
100% of GDP, and their growth rate has slowed to 2%. The elections pose 
a political risk because many young voters have turned away from the 
Barisan Nasional coalition. The government should eke out a small 
majority, but it may not be enough to sustain the position of Prime 
Minister Najib Tun Razak. The danger is that his replacement could be 
more conservative, and thus lessen the possibility of new reforms.

The Philippines is experiencing a 6% growth rate because of robust 
consumption and increased infrastructure projects under a new 
public-private partnership scheme. The government's policies have 
boosted business confidence, and are thus encouraging more investment. 
The gross government debt burden has fallen to 41% of GDP from 68% in 
2003 and could decline further if the government can broaden the tax 
base and improve tax collections. The improvement in the government's 
fiscal position could ultimately lead to an upgrade of the credit rating 
to investment grade.

Indonesia is achieving a 6.0% growth rate because of steady gains in 
consumption and 10.5% growth in capital formation. It also has become a 
major exporter of coal to China. There is now a current account deficit 
equal to 2.2% of GDP, but there has been no problem financing it. 
Political risk will start to loom as an issue next year as the country 
approaches presidential elections in 2014. Some of the leading 
candidates have unsavory reputations for corruption and human rights 
violations. If they were to emerge as victorious, there could be a major 
slump in business confidence.

Thailand could achieve a growth rate of 5.5% this year because of large 
gains in investment following last year's floods and solid gains in 
consumption. The minimum wage was hiked by 40% this year and put upward 
pressure on other wages. The government plans to increase its deficit to 
2.4% of GDP next year to finance increased spending on infrastructure. 
Monetary policy is also accommodative after the central bank reduced 
interest rates 50 basis points following the floods.

INDIA'S GROWTH POTENTIAL WEAKER THAN EXPECTATIONS

India's growth continues to be constrained by high inflation and 
business caution on new investment, with growth declining further to 
5.3% in the third quarter. The persistence of high inflation is calling 
into question the size of India's output gap and potential growth rate 
of real GDP. Three years ago, India hoped to achieve a growth rate 
higher than China, or 10%-plus. These hopes were based on the fact that 
productivity growth had risen to 3.8% during 2003-07 because of 
restructuring in the manufacturing sector and maturing of the IT service 
sector. There also was an increase in the equipment investment share of 
GDP from 10% in 2000 to 16% in 2008. This number has slumped to 12% of 
GDP, and thus has contributed to the downturn in productivity growth.

As a result of the weakness of productivity and business investment, 
economists now believe that India's potential real GDP growth rate is 
only 6.0-6.5%. These new estimates suggest that any upturn from the 
economy's recent growth rate of 5.3% will be relatively shallow. The new 
caution on India's potential growth rate will also limit the ability of 
the Reserve Bank to reduce interest rates in response to the slowdown. 
The Reserve Bank may be able to respond to lower inflation during the 
first quarter with one more rate cut, but it will probably be only 50 
basis points. The government has tried to bolster confidence by 
announcing new policies to reduce fuel subsidies and the fiscal deficit 
while allowing more foreign direct investment. These policy changes are 
a positive development, but it will still be difficult to reduce the 
central government fiscal deficit below 5.8% of GDP unless there are 
larger cuts in subsidies. There will also be opposition in parliament to 
plans for liberalizing foreign direct investment in the retail sector. 
The government should be able to enact the legislation with the support 
of small regional parties, but the markets will remain apprehensive 
until the vote actually occurs.

AUSTRALIAN AND CANADIAN MONETARY POLICY DEPEND ON EXOGENOUS FACTORS

Australia is now preparing for a slowdown in its resource boom as a 
result of reduced demand from China and falling commodity prices. Export 
prices fell 6.4% during the third quarter and are now 13.4% below their 
level one year ago. China is the critical swing factor in the Aussie 
outlook because it now consumes 30% of Australia's exports compared to 
14% five years ago. The upsurge of exports to China has been driven by 
demand for iron ore and coal.  Iron ore now accounts for 23% of exports 
compared to 13% four years ago. The coal share of exports has risen to 
17% from 13% in 2008. Some large mining companies have recently deferred 
mining projects because of uncertainty about Chinese demand. The 
resource boom in Australia has not been limited to iron ore and coal. 
Currently, nine of the ten largest projects in Australia's investment 
pipeline are LNG related. The resource boom has produced a larger 
current account deficit because of the need to import capital equipment. 
In 2014 there should be an upsurge of exports from the new projects 
while demand for equipment will decline. The Australian dollar has 
remained resilient despite falling export prices because of demand from 
central banks for an alternative to the US dollar and the euro. The IMF 
has announced it will now include the Australian dollar in its list of 
reserve currencies and attempt to measure central bank holdings. The 
strong dollar has had an adverse impact on the manufacturing, tourism, 
and education sectors. The Reserve Bank has recently intervened to 
stabilize the currency, but it does not plan to accumulate large foreign 
exchange reserves.

The Reserve Bank left interest rates unchanged at its latest policy 
meeting because of a perception that the global economy was improving 
and an upsurge of inflation during the third quarter because of the 
country's new carbon tax. The minutes of the meeting suggest that the 
committee is still open to further interest rate cuts, but it wants to 
see more evidence of how the commodity downturn is affecting investment 
and the risks in the global economy. If the US appears headed for large 
tax increases in the first quarter while Japan embarks upon further 
monetary easing, the odds would increase of a new interest rate cut in 
December.

The Canadian economy slowed to a growth rate of only 1.0% during the 
third quarter because of a large drag from net exports as a result of 
output disruptions in the oil industry and strong business demand for 
imported capital goods. The government has published new data on 
household debt which indicates that Canada's ratio of household debt to 
personal disposable income is 166% compared to 113% in the US and 145% 
in the UK. Canada has a high debt ratio because there has been no 
downturn in the housing market comparable to that which occurred in the 
US after 2006. As Canada has very low interest rates, mortgage credit 
grew by 7% in 2010 and 8% in 2011. The government became concerned about 
the dangers of property inflation and imposed tougher rules on mortgage 
insurance in June. The result has been a slowdown in housing inflation 
to 3.7% since July from 9% gains in 2010 and 5% in 2011. Canadian 
lenders are far more conservative than were US lenders five years ago. 
Canadian banks securitized only 29% of their mortgages in 2009 compared 
to 60% in the US. In Canada, all mortgages must be insured if the 
loan-to-value ratio is greater than 80%. This insurance can be obtained 
from the Canada Mortgage and Housing Corporation. Canadian mortgage 
loans are also full recourse, giving the lender the power to pursue the 
owners' other income and assets if they default.

While Canada's housing market is cooling off, there continues to be a 
construction boom in high rise towers. Toronto now has more than twice 
as many high rise buildings under construction as New York. The boom 
includes many new condominiums as well as offices and hotels. Montreal 
has more towers under construction than Chicago while Calgary is tied 
with Miami. The building boom could create excess capacity in the 
Toronto market by 2014. The Canadian central bank continues to have 
monetary policy on hold because of uncertainty about the US and European 
economies. Export growth to the US is still positive, but it has fallen 
sharply to Europe and Japan. The Canadian dollar has remained resilient 
because of a perception that Canada will sustain 2.0% output growth next 
year and that the prices of Canada's major exports (oil, natural gas, 
gold, lumber) will remain firm.

BRAZILIAN GROWTH TO REBOUND STRONGLY IN 2013

The growth rate of Latin America has slowed to 2.9% this year from 6.2% 
in 2010 and 4.1% in 2011 because of weakness in Brazil. The growth rate 
of Brazil dropped to only 1.5% this year from 7.5% in 2010. Latin 
America is vulnerable to the global economy because of its heavy 
dependence upon commodity exports. The ratio of exports to GDP is 31% in 
Mexico, 38% in Chile, 22 % in Venezuela, 27% in Peru, 22% in Argentina, 
and 18% in Colombia. Among these countries, only Mexico relies primarily 
on manufactured exports. The dominant markets for Latin American exports 
are Europe, the US, and China. Europe takes 18% of Brazil's exports, 16% 
of Chile's exports, and 18% of Peru's exports. China takes 17% of 
Brazil's exports, 23% of Chile's, 18% of Peru's exports, and 13% of 
Venezuela's. The US takes 10% of Brazil's exports, 11% of Chile's, 39% 
of Colombia's, 79% of Mexico's, 15% of Peru's, and 48% of Venezuela's.

The Brazilian central bank has slashed interest rates by 525 basis 
points since August 2011. The Brazilian economy had 3.3% growth in 
consumption during 2012, but investment fell. The central bank has 
signaled that it will keep interest rates constrained for a long time 
while the government appears to be targeting the exchange rate at about 
2.0 to the dollar. There should be a recovery in capital spending next 
year because of resilient consumer spending, declining idle capacity, 
greater business confidence, and increased government infrastructure 
spending. If investment rebounds, Brazil could have a growth rate as 
high as 4%.

Mexico achieved a growth rate of 3.7% this year because of 4.5% growth 
in consumption and 3.0% in fixed investment. Exports also grew by 4.1%. 
Mexico's export share of GDP is over 31%, so it remains very sensitive 
to developments in the US export market. Mexico has been a major 
beneficiary of the upturn in the US auto industry because it now 
produces over 2.6 million autos. The central bank has not changed policy 
in three years and appears to favor continued stability despite the 
inflation rate increasing to 4% because of food price shocks. The new 
president, Enrique Pena Nieto, was sworn in on December 1st. He has 
promised a variety of structural reforms to help improve the economy's 
performance and the markets will be carefully scrutinizing his plans 
going forward. He helped to bolster confidence by supporting legislation 
from President Calderon to introduce more flexible labor contracts and 
lower firing costs. There had been tension with the unions because Mr. 
Calderon had also wanted to increase union transparency. The major items 
on Mr. Pena Nieto's agenda for 2013 will be fiscal reform and 
liberalization of the energy market. Mexico needs to increase government 
revenue by imposing a value-added tax on food and medicine. If the 
government could impose an 8% tax on these items, it could raise 
revenues as large as 1.5% of GDP. Pemex has had several years of 
declining oil output and the government will need to introduce new 
reforms to reverse the decline. The most likely change will be to allow 
Pemex to enter into joint ventures or profit sharing agreements with the 
private sector. If this is not possible, the alternative would be to 
give Pemex greater fiscal autonomy and to open up downstream activities 
such as refining, transport, and petro chemicals to private investors. 
The issue of private energy investment has been a taboo since 1938, but 
because of Pemex's inability to sustain its oil production there is now 
no alternative to allowing a larger role for the private sector.

The Peruvian economy has slowed from 8.8% growth in 2010 to 6.1% this 
year, but investment remains robust and is producing a strong currency. 
The central bank has recently added $13 billion of reserves to hold it 
in check. Chile's economy is delivering a growth rate above 5% this year 
because of robust domestic demand. The economy has benefited from high 
employment growth, increasing real wages, dynamic credit expansion, and 
relatively easy monetary and fiscal policy. The robust growth is 
creating some signs of overheating, such as the current account deficit 
increasing to 4.4% of GDP next year from 3.5% in 2012. The central bank 
should tighten monetary policy, but it is concerned that this could 
encourage appreciation of the exchange rate at a time when monetary 
policy is easy in the G-7 countries. It may therefore have to intervene 
in order to restrain the exchange rate.

WILL ANC CONFERENCE RESOLVE INVESTOR CONCERNS ABOUT SOUTH AFRICA?

South Africa's growth rate slowed to only 1.2% during the third quarter 
from 3.2% during the second quarter. There were large output losses in 
the mining sector during the third quarter because of strikes in the 
platinum and gold sectors. Platinum and gold account for 50% of mining 
exports, so the strikes will increase the country's trade deficit. The 
trade deficit increased to 13.8 billion rand in September from 12.2 
billion rand during August. The output loss from the strikes could be as 
large as 12.5 billion rand, or $1.4 billion. Moody's downgraded South 
Africa credit rating from A3 to Baa1 during late September. Moody's 
acted because of a mixture of political and economic factors, including 
a decline in the government's institutional strength amidst increased 
socioeconomic stresses, shrinking headroom for countercyclical policy 
actions given the government's debt metrics, and challenges posed by a 
negative investment climate in light of infrastructure shortfalls, 
relatively high labor costs despite high unemployment, and increased 
concerns about South Africa's future political stability.

This was the first downgrade since the end of apartheid and therefore 
attracted widespread coverage in the South African press. The question 
which the Moody's report could not address is the pending leadership 
election for the ANC at Mangaung in December. President Jacob Zuma is 
seeking another term as president despite his inability to articulate 
effective policies for addressing South Africa's numerous problems. He 
has not faced a formal challenger, but there has been speculation that a 
movement might develop to nominate Vice President Kgalema Motlanthe who 
was also the interim president after Thabo Mbeki stepped down. The 
general consensus is that Mr. Zuma will retain the ANC leadership, but 
he might offer the compromise of stepping down early in his second term 
which would start after elections in 2014. There is no way of knowing 
what may be happening behind the scenes in Mangaung, but there can be 
little doubt that Mr. Zuma's reelection will leave many people 
dissatisfied with the ANC. His reelection will increase perceptions that 
South Africa faces significant political risks during the next several 
years.

DEVELOPING COUNTRIES CONTINUE TO INCREASE GOLD RESERVES

Central banks in emerging market countries bought 40 tons of gold during 
October. Brazil was the largest buyer, topping up its gold reserves by 
17.2 tons to 52.5 tons. Turkey and Kazakhstan purchased 17.5 and 7.5 
tons respectively. In the first nine months of this year, central banks 
worldwide purchased 373.9 tons of gold, or 9% more than in the previous 
year. According to estimates by the World Gold Council, this buying 
could exceed last year's record of 457 tons of central bank purchases. 
Central banks in the emerging market countries now have over $7 trillion 
of foreign exchange reserves and want to diversify away from the US 
dollar and the European currency. They are doing so by purchasing gold 
and the public debt of triple-A countries such as Australia and Canada.

©2012 David Hale Global Economics, Inc.

All rights reserved. This document may not be quoted, forwarded, 
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