JPM Global Data Watch

Economic Research
April 1, 2011
Contents
Global Data Watch Economic Research note
Tracking the global economic
• Global industrial activity poised to slow sharply in coming months ... impact of Japan’s earthquake 11
EM food inflation to push higher
• ... led by a double-digit drop in Japan over March and April into midyear 13
US: first-half income growth and a
• Sustained US job growth is the key for this downshift to be temporary simple twist of fate 15
Euro area debt crisis: gauging the
• ECB to tighten next week while Fed still expected to stay on hold for 17
optimal exit path
more than a year Understanding the supply shock to
Japan’s economy 19
Fundamental lifts meet temporary drags Israel: BoI steps up tightening
21
pace into second half of cycle
The March data flow is validating our view of a building tension between Iceland: export-led growth holds
fundamental lifts and temporary drags. Releases thus far raise our comfort level the key 23
about the underlying health and resiliency of the global expansion. However, they Global Economic Outlook Summary 4
also are underscoring the impact of material drags this quarter—particularly on Global Central Bank Watch 6
industrial production and consumer spending. If we are right, these drags will be The J.P. Morgan View: Markets 7
narrowly based and short-lived. As such, the rocky road expected over the coming
Selected recent research from
months should be followed by a rebound in the second half of the year. J.P. Morgan Economics
10
This week’s key March releases lay to rest doubts about the fundamental support Data Watches
coming from business spending and hiring. Rebounding from a weak January, US United States 27
private payroll gains averaged 188,000 monthly gains last quarter. Alongside a Euro area 35
continued upward trajectory in the workweek, increases in hours and private Japan 41
sector labor income look set to be strong this quarter. Meanwhile, Euro area Canada 47
surveys slipped in March to still elevated levels and continue to signal a broaden- Mexico 49
Brazil 51
ing regional expansion—particularly in the core countries outside Germany. In
Andeans 53
Asia, a rise in China’s PMI survey and healthy Korean trade flows underscore the
United Kingdom 55
solid position of regional growth on the eve of the Japanese earthquake.
Sweden 59
Russia 61
However, in the aftermath of Japan’s tragic natural disasters, Asian regional
Turkey 63
performance is set to deteriorate. We are more downbeat this week about the size
of the economic shock hitting Japan and have further revised down our 1H11 Australia and New Zealand 65
growth forecast. The Japanese economy is expected to contract in both quarters China, Hong Kong, and Taiwan 69
with industrial activity dropping a huge 16% over March and April (see “Under- Korea 73
standing the supply shock to Japan’s economy” in this GDW). This week, two ASEAN 75
industry surveys covering the post-quake period collapsed. As negative as their India 79
results appear, they probably understated weakness due to the low reporting rate Regional Data Calendars 84
by the hardest-hit firms (see “Tracking the global economic impact of Japan’s
Our latest Special Report, “India: heading for an
earthquake” in this GDW).
accidental soft landing,” was
published on April 1, 2011 and is available on
The impact on the rest of the Asian region is likely to vary widely. This week’s
our website.
March trade report shows little immediate impact on the Korean economy. Korean
J.P. Morgan global PMI excluding Japan US: consumption and private payrolls Bruce Kasman
DI, sa %q/q, saar 000s, mo. avg. (1-212) 834-5515
Cons. bruce.c.kasman@jpmorgan.com
62 4 (with 1Q 400 JPMorgan Chase Bank NA
Output
60 forecast) David Hensley
2 200 (1-212) 834-5516
58 david.hensley@jpmorgan.com
New JPMorgan Chase Bank NA
56 0 0
orders
Joseph Lupton
54 Private payrolls (1-212) 834-5735
-2 -200
joseph.p.lupton@jpmorgan.com
52 JPMorgan Chase Bank NA
Jan 10 Apr 10 Jul 10 Oct 10 Jan 11 -4 -400
06 08 10 www.morganmarkets.com
JPMorgan Chase Bank NA, New York Economic Research
Bruce Kasman (1-212) 834-5515 Joseph Lupton (1-212) 834-5735 Global Data Watch
bruce.c.kasman@jpmorgan.com joseph.p.lupton@jpmorgan.com April 1, 2011
David Hensley (1-212) 834-5516
david.hensley@jpmorgan.com
Japan manufacturing PMI and industrial output covery in the affected areas, the financing of the fiscal
DI, sa %3m, saar stimulus measures is important for the outlook of the
PMI Mfg output
70 60
broader economy as well as for the impact on the JGB mar-
ket. While some portion of the supplementary budget will
40 be financed by a tax increase, it will take time before a tax
60
20 rate hike plan is decided. As a result, the stimulus will ini-
50 0 tially be financed by debt issuance—including short-term
bill financing—and will thus prove to be more stimulative
Adjusted -20
40 Mar PMI for economic activity in 2Q and 3Q.
-40
30 -60 EMU fiscal stress on slow simmer
2007 2008 2009 2010 2011
The EMU sovereign credit crisis continued to simmer but
non-oil imports rose smartly last month, while exports to Japan not boil over this week, with markets appearing to have
remained firm in the days after the shock. The impact of supply discounted much of the news out this week. According to
disruptions and weaker Japanese demand should be more the Central Bank of Ireland’s bank stress test, Ireland’s
apparent this month and felt most strongly in the ASEAN banking system will require €24 billion in additional capi-
manufacturing centers. Accordingly, we lowered growth esti- tal. Capital will be provided by the National Pensions Re-
mates for Taiwan, Malaysia, and Thailand this week. serve Fund, the EU/IMF facility, subordinated bond hold-
ers, and private capital markets. Some market stress was
The other temporary drag on global growth comes from rising relieved as it is now clear that senior bank creditors will not
oil prices, which are taking a bite out of global consumption be impacted by restructuring. However, it remains unclear
spending as we move through the first quarter. This is evident how Irish banks will be funded in the medium term. There
in the US where consumption gains slowed to about a 1.5% has been much speculation this week about the ECB creat-
annualized pace. Global auto sales also appear to be moving ing a medium-term facility for banks that have a chronic
lower at the end of the quarter. This consumption drag will be funding need. Nothing has been announced yet; we may
reinforced by Japan’s demand shock. Our forecast incorpo- get more information at next week’s ECB meeting. As ex-
rates a softening in global consumption into midyear but pected, the Portuguese debt and deficit numbers were re-
energy prices are threatening to move above forecast levels. vised up this week, and the president announced that the
There is growing concern that disappointment from consum- election will take place on June 5. With bond yields con-
ers will magnify a projected slowing in industrial activity. The tinuing to climb, it seems only a matter of time before the
March global PMI survey provides some hints of this vulner- Portuguese ask for external help. There is some uncertainty
ability as new orders appear to be weakening while output about whether this is possible during the interregnum. Our
gains remain strong. view is that if Portugal needs help, a bridge loan will be put
in place until a new government has the authority to re-
Japan ramping up fiscal stimulus quest a full bailout.
The forces currently depressing Japanese activity will
quickly turn to lift around the middle of the year. Just the ECB walks while the Fed will talk
restarting of temporarily shut down production will lead to The tension between lifts and drags on growth is also regis-
a sharp rise in economic activity from its depressed levels tering in the inflation environment. Food and energy prices
in the wake of the disaster. This rebound will be amplified are lifting headline inflation everywhere. However, in the
by the start of a major restoration and reconstruction effort. developed economies wage inflation remains subdued
These efforts will be partly initiated by the private sector nearly everywhere, and there are significant sectoral or re-
but also get a huge boost from government support. gional issues creating financial vulnerabilities. This envi-
ronment complicates monetary policy setting and is push-
Japan’s fiscal response to the earthquake and tsunami will ing policymakers in different directions.
ultimately amount to about ¥10 trillion, or 2% of GDP. The
first installment of this will come in April and amount to There is a sharp distinction at the ECB where the bank’s
about ¥2 trillion for the immediate costs of restoration, balance sheet is being geared toward fostering financial
such as disposal of rubble. A much larger supplementary stability while interest rates will be raised to contain infla-
budget is expected to be announced in July. While the size tion pressure. Next week, the ECB will likely begin nor-
of the spending increase is critical for the speed of the re- malizing policy rates with a 25bp hike. Such a move will
2
Brazil policy rate and core inflation LATAM monetary policy tightening
%p.a. %oya; IPCA trimmed mean smoothed
In the emerging markets, differences of opinion regarding
18 7 monetary policy tools are focused on whether
Selic rate Core inflation
macroprudential measures and other financial market con-
15 6 trols can substitute for traditional monetary policy rate
tightening. Underscoring market concerns about a lack of
12 5 vigilance toward inflation, this week’s release of Brazil’s
1Q11 Inflation Report signaled that the COPOM is inclined
9 4 to adopt a more gradualist approach in its tightening strat-
egy that involves a greater reliance on macroprudential
6 3 measures. The monetary authority has concluded that the
2006 2007 2008 2009 2010 2011
costs of bringing inflation down to 4.5% in 2011 may be
too high and has shifted its focus to fighting only the sec-
ond-order effects of the supply shocks and aiming to guar-
not be beneficial to the periphery, where rising rates will antee inflation convergence to the targeted level by 2012.
slow financial healing and damp growth. But ECB council Against the backdrop of elevated core inflation, rising in-
members have been adamant in highlighting that the central flation expectations, and overheating demand conditions,
bank only has one policy instrument and it thus has to re- this strategy may prove hard to sustain.
spond to conditions in the region as a whole. The central
bank is helping the periphery via enhanced credit support Brazil’s apparent gradualism is not shared throughout Latin
and the collateral requirements, as illustrated this week America. Indeed, during the IADB Annual Meetings in
when the ECB suspended the rating threshold for debt in- Calgary last weekend, the message from other central
struments of the Irish government. banks in the region was much more cautious. After surpris-
ingly stepping up the tightening pace to 50bp last month,
Although there is an active ongoing debate at the FOMC, Chile’s monetary authorities still see inflation risks on the
Fed officials are not likely to use its balance sheet and rate upside and, contrary to Brazil, stated clearly that they will
policy for different objectives. Rhetoric has shifted to em- continue to rely solely on policy rate hikes to tighten, in-
phasize the Fed’s commitment to its medium-term inflation stead of combining this strategy with macroprudential mea-
objectives, but officials are not willing to adjust policy in sures. Peru has been doing a mix of both, and Friday in-
the face of perceived temporary inflation shocks. In addi- creased reserve requirements once again as March CPI in-
tion, they are more likely to see near-term support for deflation exceeded expectations. Matters are more compli-
mand as critical in an environment in which they perceive cated in Mexico, where inflation has been on the decline
cyclical weakness in labor demand unemployment as a but a narrowing output gap and a likely hike in adminis-
threat to structural supply. Viewing the expansion of its tered gasoline prices next year are lifting inflation expecta-
balance sheets as an extension of traditional policy setting tions. Although we still look for a 4Q11 Banxico hike, the
when interest rate policy is constrained by a lower bound, risks are skewed to a later move.
NY Fed President Dudley reaffirmed today the Fed’s com-
mitment to complete its purchases of $600 billion and un- CBRT uneasy with robust growth
derscored that, while the economy is improving, there re- Economic activity in Turkey picked up at a faster pace than
main “several areas of vulnerability and weakness.” anticipated in the year ending 4Q10. Combined with signs
that domestic demand is expanding at a robust pace as the
The BoJ is facing a crisis and is responding to the earth- year begins, the CBRT hiked the reserve requirement ratios
quake and tsunami by easing monetary conditions through by an aggressive 400bp last week. Unless bank lending
several channels. In particular, the BoJ is supporting the slows, further RRR hikes are likely in the coming months.
government’s rescue and rebuilding operation by expanding Traditional policy rate hikes look in the offing following
its balance sheet ¥22.5 trillion ($280 billion). Asset pur- the elections. We see a total of 175bp in hikes in the second
chases will include JGBs, corporate bonds, and equities. Ad- half of the year.
ditionally, the government may examine the possibility of
BoJ debt monetization as one measure to finance the fiscal
package. The BoJ is expected to expand its asset purchase Editor
program at next week’s board meeting. Sandy Batten (1-212) 834-9645 sandy.batten@jpmorgan.com
3
JPMorgan Chase Bank, New York Economic Research
David Hensley (1-212) 834-5516 Joseph Lupton (1-212) 834-5735 Global Data Watch
david.hensley@jpmorgan.com joseph.p.lupton@jpmorgan.com April 1, 2011
Carlton Strong (1-212) 834-5612
carlton.m.strong@jpmorgan.com
Global economic outlook summary

Real GDP Real GDP Consumer prices
% over a year ago % over previous period, saar % over a year ago
2010 2011 2012 3Q10 4Q10 1Q11 2Q11 3Q11 4Q11 1Q12 4Q10 2Q11 4Q11 2Q12
The Americas
United States 2.9 2.9 2.9 2.6 3.1 2.5 3.5 3.5 3.0 2.0 1.2 2.8 2.5 1.6
Canada 3.1 3.3 3.0 1.8 3.3 4.0 3.6 3.5 3.3 2.7 2.3 2.4 1.9 2.0
Latin America 6.1 4.4 n 3.8 2.5 4.5 n 3.7 n 5.5 p 4.0 p 4.1 p 3.3 n 6.7 7.0 7.5 p 7.6
Argentina 9.2 6.5 n 4.8 p 2.7 10.5 6.5 n 5.0 p 6.0 p 3.0 p 4.0 n 11.0 11.0 11.0 p 12.0
Brazil 7.5 4.0 3.8 1.6 3.0 3.9 4.8 4.9 4.6 4.0 5.6 6.0 6.1 6.2
Chile 5.2 6.0 4.5 8.7 3.8 4.5 5.0 5.0 5.0 4.5 2.5 4.0 5.5 5.0
Colombia 4.3 4.5 4.0 -1.9 7.9 6.0 3.8 3.7 4.2 4.5 2.7 3.6 4.0 3.4
Ecuador 3.6 n 3.5 3.0 8.4 n 11.0 n 3.0 2.5 2.5 2.0 3.5 3.4 n 3.5 3.8 3.6
Mexico 5.5 4.5 3.5 3.2 5.1 2.0 8.0 2.5 3.6 1.5 4.2 3.6 3.7 3.6
Peru 8.8 7.3 6.0 7.2 8.6 6.8 7.0 4.5 6.7 6.5 2.1 2.9 2.8 2.8
Venezuela -1.4 1.5 3.0 0.6 -1.8 2.5 1.5 2.0 2.5 3.0 27.3 29.0 33.8 34.6
Asia/Pacific
Japan 4.0 0.8 p 3.2 n 3.3 -1.3 0.5 p -3.5 p 5.0 n 6.5 n 3.0 p 0.1 0.8 n 0.8 n 0.8 n
Australia 2.7 2.6 4.5 0.5 3.0 -0.3 4.8 4.1 5.2 5.1 2.7 3.4 3.6 3.2
New Zealand 1.5 0.6 4.4 -0.8 0.8 -1.9 1.2 4.4 3.4 5.7 4.0 5.8 3.9 3.1
Asia ex Japan 9.1 7.4 p 7.6 7.3 p 7.9 7.5 p 6.9 p 8.6 n 7.3 7.1 4.9 5.4 4.4 3.9
China 10.3 9.4 9.0 9.9 12.7 8.7 8.8 9.0 9.0 9.3 4.7 5.1 3.3 3.0
Hong Kong 6.8 4.7 4.7 3.6 6.1 4.1 4.2 4.8 5.0 4.8 2.8 4.3 4.6 3.6
India 8.5 8.0 8.7 13.5 0.9 7.9 8.4 13.2 5.8 5.0 9.2 8.5 8.5 8.0
Indonesia 6.1 6.0 6.7 6.7 7.5 6.0 5.0 4.5 5.0 7.0 6.3 7.2 6.3 5.5
Korea 6.2 n 4.2 4.7 n 2.6 p 2.0 p 5.0 3.4 p 6.5 n 5.8 4.0 3.6 4.7 3.5 2.8
Malaysia 7.2 4.7 p 4.8 n -0.6 8.9 5.2 2.0 p 6.5 n 5.0 5.5 2.0 3.4 3.7 3.0
Philippines 7.3 5.0 5.1 -3.1 12.7 4.9 3.6 5.3 4.5 5.3 2.9 4.9 p 5.1 3.5 p
Singapore 14.5 4.1 p 5.7 n -16.7 3.9 5.3 p 7.0 p 8.2 n 6.6 4.9 4.0 4.5 3.3 2.0
Taiwan 10.8 4.5 p 5.4 n 3.2 0.0 8.0 p 4.6 p 6.0 n 6.5 n 5.5 1.1 1.8 2.9 2.1
Thailand 7.8 3.6 p 4.8 -1.3 4.8 6.5 1.0 p 6.5 n 5.5 4.5 2.9 4.5 n 5.4 n 4.5
Africa/Middle East
Israel 4.6 4.5 4.0 4.6 7.7 4.5 4.5 4.5 4.5 4.5 2.5 4.9 3.8 3.5
South Africa 2.8 3.7 3.8 2.7 4.4 3.6 3.7 4.0 4.1 3.0 3.5 4.2 5.9 5.8
Europe
Euro area 1.7 2.2 2.2 1.4 1.1 3.0 2.0 2.0 2.5 2.3 2.0 2.5 n 2.4 n 1.8 p
Germany 3.5 3.3 2.2 2.8 1.5 4.5 2.5 2.5 2.5 2.0 1.6 2.3 2.3 1.8
France 1.5 2.3 2.4 1.0 1.4 3.5 2.0 2.5 3.0 2.3 1.9 2.1 n 2.2 n 1.8
Italy 1.2 1.4 2.1 1.3 0.5 1.5 1.5 2.0 2.5 2.5 2.0 2.5 n 2.5 n 2.2
Norway 2.2 2.9 2.9 4.4 1.3 3.3 3.3 3.0 3.0 3.0 2.2 1.1 0.9 0.9
Sweden 5.3 4.6 2.9 8.7 5.1 3.5 3.3 3.0 3.0 3.0 1.9 3.1 2.9 2.4
United Kingdom 1.3 1.8 n 2.7 2.9 n -1.9 n 2.8 2.0 2.5 3.0 2.5 3.4 4.4 4.5 3.1
Emerging Europe 4.5 n 4.3 n 4.5 p 0.6 n 7.1 p 3.9 n 3.0 p 4.0 n 5.2 n 4.9 p 6.6 7.3 p 6.8 p 6.0 p
Bulgaria 0.1 3.5 4.0 … … … … … … … … … … …
Czech Republic 2.3 3.0 3.5 3.6 1.4 1.5 3.0 3.5 4.0 3.5 2.1 2.2 2.9 2.7
Hungary 1.2 2.8 3.5 2.2 0.8 2.5 3.0 3.5 3.5 3.5 4.4 4.3 4.2 3.7
Poland 3.8 4.0 4.2 4.9 3.2 4.5 3.5 4.0 4.0 4.2 2.9 4.0 3.7 3.0
Romania -1.3 2.0 4.0 … … … … … … … 7.9 7.3 4.8 5.0
Russia 4.0 4.5 5.0 -1.1 n 10.8 p 4.5 n 2.8 p 4.2 n 6.0 n 5.5 p 8.2 10.1 p 8.9 p 7.6 p
Turkey 8.9 n 5.6 n 4.3 p … … … … … … … 7.4 6.3 6.8 6.5
Global 3.8 3.3 3.6 3.0 n 3.0 3.3 p 3.0 p 4.1 n 4.1 n 3.3 2.7 3.5 3.3 2.7
Developed markets 2.5 2.3 2.7 2.3 1.5 2.4 p 2.0 p 3.1 n 3.4 n 2.4 1.6 2.5 n 2.4 n 1.7
Emerging markets 7.3 n 6.0 6.0 4.9 n 6.9 p 5.9 n 5.9 p 6.6 n 6.1 5.7 5.6 6.1 p 5.6 p 5.2
Memo:
Global — PPP weighted 4.8 4.2 4.2 3.9 n 4.1 p 4.1 p 3.9 p 4.9 n 4.7 n 4.7 n 3.4 4.2 n 3.8 3.3
Note: For some emerging economies, 2010-2012 quarterly forecasts are not available and/or seasonally adjusted GDP data are estimated by J.P. Morgan.
Bold denotes changes from last edition of Global Data Watch, with arrows showing the direction of changes. Underline indicates beginning of J.P. Morgan forecasts.
4
Carlton Strong (1-212) 834-5612
carlton.m.strong@jpmorgan.com
G-3 economic outlook detail

Percent change over previous period; seasonally adjusted annual rate unless noted
2010 2011 2012

2010 2011 2012 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q
United States
Real GDP 2.9 2.9 2.9 3.1 2.5 3.5 3.5 3.0 2.0 3.0 3.5
Private consumption 1.7 2.9 2.7 4.0 1.5 3.5 4.0 3.0 1.5 2.5 3.0
Equipment investment 15.3 10.1 9.6 7.7 4.0 12.0 12.0 10.0 10.0 8.0 8.0
Non-residential construction -13.7 2.3 9.6 7.7 -5.0 5.0 9.0 10.0 10.0 10.0 10.0
Residential construction -3.0 1.4 12.5 3.3 -3.0 10.0 15.0 10.0 10.0 15.0 15.0
Inventory change ($ bn saar) 62.6 66.9 64.3 16.2 81.9 70.4 58.0 57.5 59.8 64.7 68.1
Government spending 1.0 -0.5 -0.6 -1.7 -2.0 -1.3 -1.3 -0.1 -0.4 -0.6 -0.6
Exports of goods and services 11.7 10.1 8.5 8.6 15.0 10.0 8.0 8.0 8.0 9.0 9.0
Imports of goods and services 12.6 7.3 8.1 -12.6 14.0 6.0 8.0 9.0 9.0 8.0 7.0
Domestic final sales contribution 1.9 2.7 3.1 3.3 0.8 3.4 4.0 3.3 2.3 2.9 3.3
Inventories contribution 1.4 0.0 0.0 -3.4 2.0 -0.4 -0.4 0.0 0.1 0.1 0.1
Net trade contribution -0.4 0.2 -0.1 3.3 -0.3 0.4 -0.1 -0.3 -0.3 0.0 0.2
Consumer prices (%oya) 1.6 2.6 1.5 1.2 2.1 2.8 2.9 2.5 1.6 1.5 1.4
Excluding food and energy (%oya) 1.0 1.1 1.0 0.6 1.1 1.1 1.1 1.1 0.9 0.9 1.0
Federal budget balance (% of GDP, FY) -8.8 -9.8 -6.9
Personal saving rate (%) 5.8 5.3 5.0 5.6 5.5 5.4 5.2 5.2 4.9 5.0 5.0
Unemployment rate (%) 9.6 8.7 8.4 9.6 8.9 8.8 8.7 8.6 8.5 8.5 8.4
Industrial production, manufacturing 6.0 5.6 3.7 3.5 8.4 5.0 4.5 3.5 3.5 3.0 3.5
Euro area
Real GDP 1.7 2.2 2.2 1.1 3.0 2.0 2.0 2.5 2.3 2.0 2.0
Private consumption 0.7 1.2 1.8 1.7 1.0 1.0 1.5 1.5 2.0 2.0 2.0
Capital investment -0.8 3.3 4.5 -2.4 7.0 4.0 4.0 5.0 4.5 4.5 4.5
Government consumption 0.7 0.1 -0.3 0.4 0.0 -0.5 -0.5 -0.5 -0.3 -0.3 0.0
Exports of goods and services 10.6 8.3 7.0 7.5 8.0 7.0 7.0 7.0 7.0 7.0 7.0
Imports of goods and services 8.7 6.8 6.8 4.4 7.0 6.5 7.0 6.5 7.0 6.5 7.0
Domestic final sales contribution 0.4 1.3 1.8 0.6 1.9 1.3 1.5 1.7 2.0 2.0 2.0
Inventories contribution 0.4 0.1 0.1 -0.9 0.5 0.4 0.3 0.4 0.1 -0.4 -0.2
Net trade contribution 0.9 0.7 0.3 1.4 0.6 0.4 0.2 0.4 0.2 0.4 0.2
Consumer prices (HICP, %oya) 1.6 2.4 1.6 2.0 2.4 2.5 2.5 2.4 1.8 1.5 1.5
ex unprocessed food and energy 1.0 1.5 1.5 1.1 1.3 1.5 1.5 1.6 1.6 1.5 1.5
General govt. budget balance (% of GDP, FY) -6.3 -4.6 -3.9
Industrial production 7.2 6.2 4.6 7.6 7.0 5.0 5.0 4.5 4.5 4.5 4.5
Japan
Real GDP 4.0 0.8 3.2 -1.3 0.5 -3.5 5.0 6.5 3.0 2.5 2.0
Private consumption 1.9 -0.4 1.3 -3.2 0.5 -4.0 2.0 2.5 1.3 1.5 1.5
Business investment 2.4 2.5 6.3 2.0 2.0 -5.0 7.0 5.0 8.0 8.0 7.0
Residential construction -6.5 8.1 3.2 12.3 15.0 5.0 2.0 2.0 4.0 4.0 3.0
Public investment -3.3 -0.5 9.3 -20.5 -5.0 15.0 30.0 20.0 5.0 5.0 0.0
Government consumption 2.3 2.4 1.7 1.2 1.0 4.0 6.0 0.5 1.0 1.0 1.0
Exports of goods and services 24.2 2.5 7.7 -3.0 -1.0 -4.0 10.0 15.0 8.0 6.0 5.0
Imports of goods and services 9.8 2.6 5.5 -0.5 -2.5 -2.5 7.0 9.0 5.0 5.0 5.0
Domestic final sales contribution 1.5 0.7 2.4 -2.8 0.2 -3.2 5.2 6.0 2.3 1.3 1.0
Inventories contribution 0.3 -0.1 0.2 0.7 0.0 -0.1 -0.3 0.0 0.1 0.4 0.4
Net trade contribution 2.2 0.1 0.6 0.9 0.2 -0.2 0.0 0.5 0.6 0.8 0.7
Consumer prices (%oya) -0.7 0.7 0.7 0.1 0.1 0.8 1.0 0.8 0.8 0.6 0.7
General govt. net lending (% of GDP, CY) -7.9 -7.8 -7.4
Industrial production 16.0 0.0 15.9 -6.1 -0.1 -18.2 24.8 50.9 17.9 6.2 3.2
Memo: Global industrial production 9.3 6.1 6.7 5.7 7.2 3.9 8.6 10.1 6.7 5.4 5.1
%oya 7.3 6.3 4.9 6.2 7.1 7.1 7.6 6.7
Note: More forecast details for the G-3 and other countries can be found on J.P. Morgan’s Morgan Markets client web site.
5
JPMorgan Chase Bank N.A., New York Economic Research
Michael Mulhall (1-212) 834-9123
michael.r.mulhall@jpmorgan.com
Central Bank Watch

Change from Forecast
Official interest rate Current 1 Jan 11 (bp) Last change Next meeting next change Jun 11 Sep 11 Dec 11 Mar 12 Jun 12
Global GDP-weighted average 1.92 8 2.09 2.24 2.38 2.48 2.60

excluding US GDP-weighted average 2.62 11 2.85 3.07 3.26 3.40 3.56
Developed GDP-weighted average 0.62 0 0.74 0.87 1.00 1.11 1.23
Emerging GDP-weighted average 5.50 33 5.81 6.03 6.20 6.28 6.37
Latin America GDP-weighted average 7.85 57 8.35 8.46 8.67 8.67 8.67
CEEMEA GDP-weighted average 4.11 15 4.42 4.72 5.15 5.48 5.70
EM Asia GDP-weighted average 5.19 31 5.44 5.66 5.71 5.71 5.79
The Americas GDP-weighted average 1.38 9 1.47 1.53 1.58 1.59 1.61
United States Federal funds rate 0.125 0 16 Dec 08 (-87.5bp) 27 Apr 11 On hold 0.125 0.125 0.125 0.125 0.125
Canada Overnight funding rate 1.00 0 8 Sep 10 (+25bp) 12 Apr 11 31 May 11 (+25bp) 1.25 1.75 2.00 2.25 2.50
Brazil SELIC overnight rate 11.75 100 2 Mar 11 (+50bp) 20 Apr 11 20 Apr 11 (+50bp) 12.50 12.50 12.50 12.50 12.50
Mexico Repo rate 4.50 0 17 Jul 09 (-25bp) 15 Apr 11 4Q 11 4.50 4.50 5.00 5.00 5.00
Chile Discount rate 4.00 75 17 Mar 11 (+50bp) 12 Apr 11 12 Apr 11 (+25bp) 5.00 6.00 6.50 6.50 6.50
Colombia Repo rate 3.50 25 18 Mar 11 (+25bp) 29 Apr 11 29 Apr 11 (+25bp) 4.25 5.00 5.00 5.00 5.00
Peru Reference rate 3.75 75 10 Mar 11 (+25bp) 7 Apr 11 7 Apr 11 (+25bp) 4.50 4.50 4.50 4.50 4.50
Europe/Africa GDP-weighted average 1.49 3 1.75 2.01 2.30 2.57 2.81

Euro area Refi rate 1.00 0 7 May 09 (-25bp) 7 Apr 11 7 Apr 11 (+25bp) 1.25 1.50 1.75 2.00 2.25
United Kingdom Bank rate 0.50 0 5 Mar 09 (-50bp) 7 Apr 11 May 11 (+25bp) 0.75 1.00 1.25 1.50 1.75
Sweden Repo rate 1.50 25 15 Feb 11 (+25bp) 20 Apr 11 20 Apr 11 (+25bp) 1.75 2.25 2.75 3.00 3.25
Norway Deposit rate 2.00 0 5 May 10 (+25bp) 12 May 11 12 May 11 (+25bp) 2.25 2.50 2.75 3.00 3.25
Czech Republic 2-week repo rate 0.75 0 6 May 10 (-25bp) 5 May 11 23 Jun 11 (+25bp) 1.00 1.25 1.75 2.25 2.75
Hungary 2-week deposit rate 6.00 25 24 Jan 11 (+25bp) 18 Apr 11 4Q 11 (+25bp) 6.00 6.00 6.25 6.50 6.50
Israel Base rate 3.00 100 28 Mar 11 (+50bp) 24 Apr 11 24 Apr 11 (+25bp) 3.75 4.25 4.50 4.75 5.00
Poland 7-day intervention rate 3.75 25 19 Jan 11 (+25bp) 5 Apr 11 5 Apr 11 (+25bp) 4.25 4.25 4.50 4.75 5.00
Romania Base rate 6.25 0 4 May 10 (-25bp) 3 May 11 3Q 11 (+25bp) 6.25 6.50 6.75 7.00 7.00
Russia 1-week deposit rate 3.00 25 24 Dec 10 (+25bp) Apr 11 2Q 11 (+25bp) 3.50 3.75 4.00 4.25 4.50
South Africa Repo rate 5.50 0 18 Nov 10 (-50bp) 12 May 11 Nov 11 (+50bp) 5.50 5.50 6.00 6.50 7.00
Turkey 1-week repo rate 6.25 -25 20 Jan 11 (-25bp) 21 Apr 11 Jul 11 (+50bp) 6.25 7.00 8.00 8.50 8.50
Asia/Pacific GDP-weighted average 3.27 15 3.41 3.55 3.59 3.60 3.66

Australia Cash rate 4.75 0 2 Nov 10 (+25bp) 5 Apr 11 Aug 11 (+25bp) 4.75 5.00 5.25 5.25 5.50
New Zealand Cash rate 2.50 -50 10 Mar 11 (-50bp) 28 Apr 11 2Q 12 (+25bp) 2.50 2.50 2.50 2.50 3.00
Japan Overnight call rate 0.05 -4 5 Oct 10 (-5bp) 7 Apr 11 On hold 0.05 0.05 0.05 0.05 0.05
Hong Kong Discount window base 0.50 0 17 Dec 08 (-100bp) 28 Apr 11 On hold 0.50 0.50 0.50 0.50 0.50
China 1-year working capital 6.06 25 9 Feb 11 (+25bp) - 2Q 11 (+25bp) 6.31 6.56 6.56 6.56 6.56
Korea Base rate 3.00 50 10 Mar 11 (+25bp) 12 Apr 11 2Q 11 (+25bp) 3.25 3.50 3.50 3.50 3.75
Indonesia BI rate 6.75 25 4 Feb 11 (+25bp) 12 Apr 11 3Q 11 (+25bp) 6.75 7.00 7.00 7.00 7.00
India Repo rate 6.75 50 17 Mar 11 (+25bp) 3 May 11 3 May 11 (+25bp) 7.00 7.25 7.50 7.50 7.75
Malaysia Overnight policy rate 2.75 0 8 Jul 10 (+25bp) 5 May 11 5 May 11 (+25bp) 3.00 3.00 3.00 3.00 3.00
Philippines Reverse repo rate 4.25 25 24 Mar 11 (+25bp) 5 May 11 5 May 11 (+25bp) 4.75 4.75 4.75 4.75 4.75
Thailand 1-day repo rate 2.50 50 9 Mar 11 (+25bp) 20 Apr 11 20 Apr 11 (+25bp) 3.00 3.50 3.50 3.50 3.50
Taiwan Official discount rate 1.75 13 31 Mar 11 (+12.5bp) 3Q 11 3Q 11 (+12.5bp) 1.875 2.00 2.125 2.25 2.375
Bold denotes move since last GDW and forecast changes. Underline denotes policy meeting during upcoming week.
6
JPMorgan Chase Bank, London Economic Research
Jan Loeys (1-212) 834-5874 Global Data Watch
jan.loeys@jpmorgan.com April 1, 2011
The J.P. Morgan View: Markets the signs are not encouraging as we have been lowering our
own growth forecasts in a similar fashion to then. Our six-
Can 2Q survive IP sticker week rolling US Economic Activity Surprise Index turned
negative two weeks ago, and our economists are confirming
shock? that US data are indeed tracking soft versus growth forecasts.
• Economics: Japan IP to contract at 18% pace in 2Q, but
should make up the loss in 2H. US data are tracking a bit Even as 2Q threatens to look ugly, there are sufficient dif-
soft versus forecasts. ferences to keep us net long equities versus bonds. Most
important, we are nearing the second anniversary of the re-
• Portfolio strategy: 2Q11 should not be a repeat of the covery, which is now clearly on more solid footing than a
sell-off in 2Q of last year. But growth data do raise a year ago. In addition, while history frequently repeats itself,
warning. We stay net long equities to bonds, but reduce it is equally so that we constantly learn from experience, in
from aggressive to significant. particular, recent experience. And this tells us that global
• Fixed income: Bonds have largely retraced the March risk markets are extremely robust, having survived car-
flight to safety. Cover shorts in the US, but look for a nage in the Middle East and Japan. Hence, we stay net long
modest further sell-off in Europe. equities versus bonds, but reduce the overweight in re-
sponse to the risk that markets may react negatively to the
• Equities: Move to an overweight in EM vs. DM equities. weaker IP and PMI data over the next two months.
• Credit: Reduction in bail-in risk in Irish senior bank
bonds supports European bank bonds. Very near term, market attention will focus on the start of
US 1Q earnings season. Do note our observation last week
• FX: Dollar and sterling remain our main shorts. that over the first 10 business days of US earnings an-
• Commodities: A considerable draw in US corn invento- nouncement months over the past six quarters, US equities
ries confirms our bullish view. Stay long. rallied at least 2.5%, but then were either flat or down over
the following 10 days. Hence, it is probably worthwhile
Global equities rallied this week to within touching dis- lightening up tactically by selling into further rallies.
tance of the cycle peak reached only a month ago, confirm-
ing that the sell-off was merely a correction. And that in a Asset managers closed on 1Q yesterday, and should be on
month in which global carnage and disaster struck, and average happy-ish with their results. Credit managers
economists had to seriously downgrade growth expecta- have been aggressively long, and that clearly worked. Bond
tions for 2011 (chart, next page). What is happening managers were trading from the short side, and if they held
here? Is complacency setting in, or are the rocks thrown at on through the quarter, they eked a small profit on that as
risk markets really that puny relative to the compelling major government bond markets underperformed cash by
value offered by stocks? 0.5%. FX managers have been consistently negative the US
dollar and bullish EM currencies, and the US dollar is down
As is usually the case, the answer is a bit of both. Every some 3%-4% against G-10 and EM currencies in 1Q. We
investor we see argues that the Japanese earthquake will believe equity managers were generally long Cyclicals
only cause a down-and-up V-shaped move in IP and GDP and underweight Financials and EM. Both Cyclicals and
and that within the year, the Japanese and world economy Financials were flat versus index, while EM net
will be back to where we thought they would be all along. underperformed almost 3%. Hence, unless managers had
And that is also our forecast. What makes us nervous, the timing right, they earned little from these positions.
though, is that in coming months, sticker shock from the Commodity managers are harder to judge, but they clearly
dramatic impact on global and Japanese IP and PMIs might gained from the rally and inflows in the asset class.
lead investors to question whether something more per-
sistent is at work. US consumption is running soft versus Fixed income
production, and oil prices keep rising. Bonds fell for the second week in a row, driven by an-
other upside surprise in Euro area inflation, and gener-
This raises the question whether the second quarter will ally more hawkish commentary from the Fed. Govern-
turn into a repeat of last year when weaker activity data ment yields have now largely retraced the March flight to
raised fears of a double dip and pushed global equities safety. Inflation risks and impending central bank tighten-
down 15%, punctuated by the flash crash in May. So far, ing are the main forces bearing down on bonds. Against
7
Nikolaos Panigirtzoglou (44-20) 7777-0386 The J.P. Morgan View: Markets
nikolaos.panigirtzoglou@jpmorgan.com April 1, 2011
that, the coming slowing in activity data as a result of the 2011 global GDP growth forecasts: J.P. Morgan versus consensus
Japanese earthquake may provide near-term support. We %
3.8
keep our shorts where central bank hikes are on the hori-
zon, in the UK and Euro area, looking for a modest further 3.6 J.P. Morgan
sell-off. But we cover our duration short in the US, with
yields toward the higher end of their recent range. 3.4
3.2
Another eventful week for Euro area peripherals saw Por- Consensus
tugal underperform heavily. Ireland’s decision not to seek 3.0
haircuts on senior bank debt bolsters the value argument
2.8
for short-dated peripherals: 1-year Greece yielding 13% is Jan 10 Mar 10 May 10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11
the pick here, though it is not a position for the faint-
hearted. Portugal’s short-dated issuance program postpones old. Mechanically, the gap between DM and EM IP growth
the day when it will need EU/IMF funding. That still seems is set to widen even further in future releases due to the
the most likely outcome, though, especially after Portugal’s collapse in Japanese IP in March. This suggests that this
upward deficit revision widened the credibility gap be- trading model will continue to recommend an overweight
tween Spain (which has been delivering on its fiscal tar- in EM equities for the months ahead.
gets) and the rest. We still look for the semi peripherals
(Spain and Italy) to outperform the high yielders Last week, we highlighted downside risks to equity mar-
(Greece, Ireland, and Portugal) for a little longer. kets beyond mid-April, once the good news in the reporting
season is priced in. These downside risks stem from eco-
Equities nomic data disappointments as captured by our US Eco-
nomic Activity Surprise Index, which moved to negative
EM equities continue to outperform their DM counterparts.
territory two weeks ago. Is this a problem for our EM eq-
They have now recaptured almost half of their previous
uity overweight? Not in our view. More likely, worse DM
13% underperformance between October and early Febru-
can be supportive of an EM overweight. One of the drivers
ary. We took profit on our EM vs. DM equity underweight
of EM underperformance from October to February was a
a month ago (see J.P. Morgan View, Mar 4). We now rec-
narrowing economic growth differential vs. DM. With
ommend investors move to an overweight position, i.e.,
growth indicators softening in DM this growth differen-
long MSCI EM$ vs. MSCI World$.
tial will turn even more supportive for EM equities.
First, the technical backdrop still favors EM equities.
Both survey data and the share of EM in equity mutual Credit
funds/ETFs AUM suggest that both real money and retail Credit markets continued to tighten this week. Retail inves-
investors are still underweight EM in their equity portfo- tors are returning to higher risk credits, with inflows into
lios. Second, signs that policy tightening is having an effect high yield and EM bond funds compared to outflows last
in slowing overheated EM economies is making investors week. The upcoming earnings season is expected to confirm
more comfortable with the idea of a soft landing. In- the strength in corporate fundamentals, keeping us long cor-
deed, today’s release in Chinese PMI boosted the domestic porate credit for the medium term. However, with many
equity market, despite coming out below economists’ ex- uncertainties lingering in the backdrop and a potential for
pectations. This is both a sign of underweight positions and economic data “sticker shock” in coming months, the path
supportive of the idea that modestly weaker economic data toward tighter year-end spreads is uncertain.
are good for EM equities as they boost confidence in the
soft landing scenario. This week’s release of the Irish bank stress test reduces
the likelihood of bail-ins of existing senior bank bond hold-
Third, our EM vs. DM trading model, which uses a com- ers. The announcement yesterday is supportive of senior
bination of two signals, two-month return momentum, and versus subordinated Irish bank bonds as the threat of bur-
relative IP growth, has moved to a positive stance in EM. den sharing remains off the table for senior bonds, but
The MSCI EM index has outperformed MSCI World over not for subordinated bonds. The announcement is also
the past two months. Relative IP growth (i.e., the difference positive for Euro area senior bank bonds more generally,
between the oya rates in EM IP and DM IP) moved to 4.8% which were under threat from a potential bail-in. Stay OW
in the most recent release for January, above the 4% thresh- bank bonds within European HG credit.
8
Jan Loeys (1-212) 834-5874 Global Data Watch
jan.loeys@jpmorgan.com April 1, 2011
In contrast, the US Municipal market has seen little im- Ten-year Government bond yields
provement in recent weeks. Although the yield on Munici- Current Jun 11 Sep 11 Dec 11 Mar 12
pal bonds has stabilized around 4% with spreads approach- United States 3.45 3.60 3.65 3.70 3.90
ing February lows, retail investors continued to withdraw Euro area 3.37 3.50 3.55 3.65 3.75
funds from their Muni bond funds for the fifth consecutive United Kingdom 3.72 3.90 4.00 4.15 4.20
month. Moreover, heavy expected supply remains the main Japan 1.28 1.15 1.30 1.35 1.40
threat. Overall, $17 billion was issued in March, much less GBI-EM 7.00 7.30
than the $30 billion anticipated. This means that funding Credit markets
needs and supply are pushed out to coming months, keep- Current YTD Return
ing investors wary of jumping in currently. We remain de- US high grade (bp over UST) 136 0.7%
fensive tax-exempt Municipal bonds. Euro high grade (bp over Euro gov) 156 -0.8%
USD high yield (bp vs. UST) 513 4.2%
Foreign exchange Euro high yield (bp over Euro gov) 522 2.9%
EMBIG (bp vs. UST) 292 1.0%
The secular bull market in bonds is clearly over as the
EM Corporates (bp vs. UST) 271 1.8%
world’s second-most important central bank (ECB) pre-
pares to tighten next week, and the most important one Foreign exchange
(Fed) sounds collectively less dovish. Although this bond Current Jun 11 Sep 11 Dec 11 Mar 12
sell-off has been tame by historical standards—global rates EUR/USD 1.42 1.43 1.45 1.48 1.48
have moved up only 20bp this quarter compared to +50bp USD/JPY 84.1 80 79 78 78
moves when the ECB and/or Fed is tightening—the trend GBP/USD 1.61 1.57 1.59 1.64 1.66
for the rest of the year seems negative. The path for curren- Commodities - quarterly average
cies is more debatable. As always occurs when the US Current 2Q11 3Q11 4Q11 1Q12
bond market has sold off during this decade-long bear mar- Brent ($/bbl) 119 118 108 108 110
ket in the dollar, hopes (or fears) of a trend change emerge.
Gold ($/oz) 1430 1450 1475 1500 1500
The rates fixation is legitimate, but it still looks premature.
Copper($/m ton) 9413 9450 9750 10000 9750
Even though the US money market is the fourth most
Corn ($/Bu) 7.34 7.00 6.75 6.10 6.20
dovishly priced in the world, US activity data are softening
Source: J.P. Morgan, Bloomberg, Datastream
and the Fed remains a few quarters from hiking. And since
actual rate spreads matter as much for deficit countries like
the US as shifts in rate expectations, the dollar is very far
lower-than-expected US inventories, further highlighting
from turning. At best today’s payrolls can correct some of
the extent of the tight supply picture resulting from last
the dollar’s recent, excessive weakness that the US fiscal
year’s extreme weather. The USDA also announced a
disarray has been driving. Dollar forecasts are still bear-
much-expected increase in the amount of land dedicated to
ish, and trades split across several regional themes.
growing corn and wheat for the next season. This balances
the more bullish inventory picture, and we thus keep our
On trades, exploit the yen collapse to take profits on a short
price forecasts unchanged and remain bullish grains
JPY/KRW put spread opened in the 2011 Outlook (Nov 23,
over the next few months.
2010) and a short 1-month USD/JPY put opened after BoJ
intervention on March 18. Also take profits on a short
Copper is down almost 5% this week as a further hike in
AUD vs. BRL vol swap now that USD/BRL is beginning to
China’s reserve ratio, a slightly weaker-than-expected Chi-
slip. Sell NZD/CAD to increase exposure to oil currencies
nese PMI, and uncertainty around the impact from the
and position for a possible bumper Canadian employment
Japanese earthquake raised fears of a slowdown in demand.
report next week, and stay short sterling within Europe
Our view remains that China will be able to bring its
(vs. EUR and NOK). There is no running theme among
economy under control without adversely effecting de-
these trades, but rarely this year have regional dynamics
mand. The impact of the Japanese earthquake is less clear
been so diverse.
but we believe that there is likely to be a significant near-
term negative impact on the supply chain, especially in
Commodities Asia. However, the rebound in growth, as reconstruction
Commodities are up around 2% this week as oil and ag- gets under way later this year, should bring us back at least
riculture produced strong gains, offsetting a 3% fall in base to where we were before the disaster. We thus remain
metals. Corn rallied sharply after the USDA reported bullish copper on a medium-term view.
9
Selected recent research1 from J.P. Morgan Economics

Global Central Europe, Middle East, and Africa
Offsetting crosscurrents for developed market consumers, Mar 18, 2011 Czech rate hikes: lagging ECB at first, but outrunning in 2012, Mar 11, 2011
Keep an eye on the global inventory cycle, Mar 18, 2011 Turkey: CBRT’s new policy mix slow to combat loan growth, Feb 25, 2011
Developed world capex poised to accelerate once again, Mar 4, 2011 Taking stock of Russian inflation expectations, Feb 25, 2011
Oil prices will take some steam out of near-term growth, Feb 25, 2011 Romania is ready for a long-awaited cyclical upswing, Feb 18, 2011
Easing G-4 bank lending standards reinforcing recovery, Feb 11, 2011 MENA region: 2011 a year of political turmoil, Feb 18, 2011
Surveys signal second wind for global recovery, Feb 4, 2011 South Africa: SARB faces delicate balancing act, Feb 4, 2011
Rising service sector will bolster DM economies, Jan 28, 2011 Russia: stronger economy and still elevated inflation in 2011, Jan 28, 2011
Return to sender: global recycling of Fed QE, Nov 26, 2010 Food inflation to climb higher in CIS countries in 1H11, Jan 28, 2011
Global IP slowdown appears to have reached bottom, Nov 5, 2010
Fault lines emerge amid global growth slowdown, Sept 10, 2010 Japan
G-4 banks begin to open the lending spigot, Aug 20, 2010 Japan to recover from the disaster, but will take time, Mar 18, 2011
Global potential growth slows, but much slack remains, Aug 6, 2010 Japan: core CPI deflation set to end in April, but temporarily, Mar 4, 2011
Euro FX depreciation widely spread but narrowly felt, Jul 9, 2010 Japan: private sector spending to get boost from confidence, Feb 18, 2011
Japan: service sector capex likely to expand in 2011, Jan 21, 2011
United States and Canada Japan 2011 outlook: toward growth with modest deflation, Jan 7, 2011
Import prices are pushing up US core inflation, Apr 1, 2011 Japan: no deficit reduction despite continued rise in debt, Dec 17, 2010
New Fed sequence is mostly the same as the old one, Mar 18, 2011
US data brings hints of stronger export growth ahead, Mar 11, 2011 Non-Japan Asia and Pacific
Commodities will give only temporary lift to core inflation, Mar 4, 2011 China: narrowing of trade surplus to continue in 2011, Apr 1, 2011
US GDW growth slips on oil in 1Q, Feb 25, 2011 Korea’s consumer inflation due mostly to food and energy, Apr 1, 2011
Showdown at the not-OK Corral: battle over the US debt ceiling, Feb 25, 2011 Riding on the coattails of China’s rising labor costs, Apr 1, 2011
US: one cheer for the fall in the unemployment rate, Feb 11, 2011 RBNZ on hold until 2012—OCR changes more potent, Mar 18, 2011
It doesn’t take much to get a 25% rise in US housing starts, Jan 28, 2011 Aussies’ online shopping: under-stating retail sales, not GDP, Mar 11, 2011
US: one gathers what another man spills, Jan 28, 2011 Singapore: to maintain current tightening path or go further?, Mar 11, 2011
More austerity ahead for US state and local governments, Jan 21, 2011 China’s export sector copes with rising wages, Mar 4, 2011
US: turn on, tune in, drop out of the labor force, Jan 14, 2011 Figuring the drivers of Thailand’s inflation trajectory, Mar 4, 2011
US: mind the gap or obey the speed limit?, Jan 7, 2011 Vietnam: navigating the monetary maze, Mar 4, 2011
Stronger US job growth would help clear the housing market, Jan 7, 2011 Australia’s virtuous cycle of a rising terms of trade, Feb 25, 2011
Canada: sluggish 2011 despite brighter US outlook, Jan 7, 2011 Another earthquake in NZ puts rate hikes off agenda, Feb 25, 2011
US: blame the textbook, not the TA, for money multiplier confusion, Dec 17, 2010 Australia’s GDP/employment mix inflationary, Feb 18, 2011
US tax compromise: more growth, higher deficit, less QE, Dec 10, 2010 Rising food prices: putting Australia in the EM Asia basket, Feb 11, 2011
Strong and broad US business expansion, with tepid job growth, Dec 3, 2010 China: tracking inflation in 2011, Feb 4, 2011
A V-shaped recovery for US profits, Nov 26, 2010
US: the fiscal cost of central bank interventions, Nov 19, 2010 Latin America
Looming fiscal issues include more than just Bush tax cuts, Nov 5, 2010
Fiscal policy back in the spotlight in Brazil, Mar 4, 2011
Latin America: policymakers in need of tightening will innovate, Jan 28, 2011
Western Europe
Chile: unpleasant CPI math, Jan 21, 2011
UK: energy pressures to take inflation air balloon still higher, Apr 1, 2011 Brazil: BRL cyclically strong despite pricey valuation, Oct 1, 2010
Euro area data point to a drift higher in core inflation, Mar 18, 2011
Euro area delivers a good comprehensive policy package, Mar 18, 2011 Special Reports and Global Issues
UK growth: the good, the bad, and the ugly, Mar 18, 2011
UK: why inflation is so high, and why it will come back down, Feb 11, 2011
UK: Budget for 2011 will stay the final course, Mar 18, 2011
Strong global growth ahead: eleven themes for 2011, Jan 7, 2011
The role of the time horizon in Euro area debt sustainabilitly, Mar 11, 2011
US 2011 economic outlook: strength, breadth, jobs, and a rising fiscal
ECB about to begin a rate normalization cycle, Mar 4, 2011
deficit, Dec 30, 2010
The Euro area’s journey to a comprehensive policy package, Feb 25, 2011
A way out of the EMU fiscal crisis, Dec 16, 2010
The not-so-small role of the output gap at the ECB, Feb 25, 2011
Jobs vs. income smoothing: a comparison of US and German labor
UK: quantifying MPC credibility, Feb 25, 2011
markets, Nov 15, 2010
Euro area: more growth, more inflation, and higher rates, Feb 11, 2011
Stuck in a low inflation rut, Oct 27, 2010
Uncertainty to persist beyond Euro area policy changes, Feb 4, 2011
1. Research notes listed have been published in GDW; Special Reports and Global Issues are stand-alone features, but may also have appeared in some form in GDW.
10
David Hensley (1-212) 834-5516 Global Data Watch
david.hensley@jpmorgan.com April 1, 2011
Joseph Lupton (1-212) 834-5735
Economic Research Note Upcoming Asia data releases for March

Release date Country Report
Tracking the global economic March 31
April 1
Japan
Japan
Mfg PMI
Auto registrations
impact of Japan’s earthquake April 1
April 1
Korea
China
Imports
Mfg PMI
• We are uncertain about how far Japanese output fell April 1 Korea Mfg PMI
in March and the degree of spillover elsewhere April 5 Japan Services PMI
April 5 Singapore Mfg PMI
• Data reports for March will give crucial guidance on April 8 Japan Economy Watchers survey
the hit inside and outside of Japan April 10 China Imports
April 11 Taiwan Imports
April 14 Japan Reuters Tankan (April)
The Japanese economy was accelerating impressively in
April 15 China IP
advance of the tragic earthquake and tsunami that struck on
April 15 Singapore Imports
March 11. The twin disasters almost certainly generated a April 19 Japan Consumer sentiment
huge drop in economic activity in the latter half of the April 20 Japan Exports
month, although it is impossible to gauge the severity of April 28 Japan IP
the blow at this time. They also almost certainly will gener- April 28 Japan Capital goods shipments
ate spillover into the rest of the world. Tracking how these April 28 Hong Kong Imports
events unfold will be one of the central tasks of global data April 29 Japan Vehicle production
April 29 Thailand Imports
watching in coming days and weeks.
Late April Japan Retail sales
Late April/early May Japan Household spending
The Japanese economy suffered both a demand and a sup- Early May Japan Cabinet Office PCE index
ply shock. In terms of demand, many households and com-
panies have been unable or unwilling to carry on with busi-
ness as usual, resulting in a drop in spending. This will
mainly land on domestic producers, although Japanese im-
ports and tourism abroad also have been affected. The Japan activity indicators around Kobe earthquake in Jan 1995
economy also has been hit by a supply shock whereby %m/m, sa
firms are unable to produce due to damaged facilities, 10 Exports
transportation bottlenecks, power outages, and supply- 8
chain disruptions. This supply shock is the principal means 6 Consumption IP
by which the disasters will be transmitted to the rest of the 4
world. With production depressed, exports will be curtailed 2
sharply, disrupting production in the rest of the world. Our 0
analysis of this issue indicates that the spillover will be -2
greatest in the rest of Asia, where production and trade -4
linkages with Japan are the strongest (see “Global reper- -6
1994 1995
cussions from the Japanese earthquake,” Global Issues,
March 25, 2011).
The dimensions of these shocks inside and outside Japan EM Asian imports around the Kobe earthquake
will begin to come into focus with the arrival of key March %m/m, sa
data reports. The accompanying calendar highlights the Taiwan
24
most relevant indicators. For Japan, we will track indicators
of both demand and supply, consistent with the dual nature 18
of the shocks affecting the economy. Concerning demand, 12
we will look to data on auto registrations and the broader 6
Korea
measures of retail sales to gauge the hit to consumption. In
fact, the registrations data were reported Friday, showing 0
that vehicle sales plunged nearly 30%m/m to the lowest -6
level in the series dating back to 1980. Later, capital goods -12
shipments data will provide guidance on capex. 1994 1995
11
David Hensley (1-212) 834-5516 Tracking the global economic impact of
david.hensley@jpmorgan.com Japan’s earthquake
Joseph Lupton (1-212) 834-5735 April 1, 2011
Concerning the supply side of the Japanese economy, the Japan manufacturing PMI
monthly business surveys will provide the first clues about DI, sa
how badly output has been hit. This week we received two 55
surveys from Japan that cover the post-quake period. The sur-
50
vey window for the March manufacturing PMI was March 11
to March 25. QUICK conducted a flash manufacturing 45
Tankan on March 28. The PMI, which is a diffusion index, 40 Reported March
fell 6.5pts to 46.4, the lowest level since April 2009. The
35
Tankan, which is a percent balance index, fell 36pts to -20 Adjusted March
(this is equivalent to a decline from 58 to 40 on a DI basis). 30
25
As negative as these results are, they appear to have a posi- 2008 2009 2010 2011
tive bias. Markit received just two thirds the normal re-
sponses. If we assume the remaining one third registered at Japan manufacturing PMI and industrial output
least some decline in output, the adjusted PMI reading would DI, sa %3m, saar
PMI Mfg output
be 31.1, near the low during the 2008/09 recession. In con- 70 60
trast with this month’s experience, Markit says the response
rate for the PMI was relatively stable during the recession, so 40
60
that this bias was not present at that time. 20
50 0
Although they are operating with a great deal of uncer-
Adjusted -20
tainty, our Japan team tentatively is forecasting that indus-
40 Mar PMI
trial production plunged 12%m/m in March. This is ex- -40
pected to be followed by a further 4%m/m decline in April.
30 -60
(The average level of output is expected to be lower in 2007 2008 2009 2010 2011
April than March even though the level of output is as-
sumed to grow throughout the month.) Thereafter, monthly Asian manufacturing PMIs
gains are expected to lift the level of output above the pre- DI
vious (pre-quake) path by year-end. Note that the adjusted
62 Taiwan
March PMI value of 31.1 appears roughly consistent with Korea
our forecast that IP will plummet at a nearly 50% annual 58 China
rate in the three months through August, based on the re-
cent relationship between the PMI and IP growth. 54
The March IP report for Japan arrives in late April. Since 50

Japan
manufacturing lies at the center of the disruptions in Japan,
46
the IP report will be crucial to determining how much the
Jan 10 Apr 10 Jul 10 Oct 10 Jan 11
economy contracted immediately after the disasters and, by
extension, how rapidly it will grow as conditions normal-
ize. In this vein, the IP report will include manufacturers’ activity. Today’s PMIs were first up in the batting order and
production plans for April and May. the results were encouraging. China’s PMI rose 0.1pt, while
Korea’s fell 0.6pt and Taiwan’s fell 0.2pt. It may be too
Rather than IP, the disruption in Japanese exports is the early to look for spillover in March. Some Japanese compa-
main channel of transmission to other economies. The nies are reported to be protecting foreign customers by di-
March report on international trade, which is due April 20, verting product or inventory overseas. In addition, EM Asian
will tell how far exports fell that month. We also will watch producers presumably have buffer stocks or some ability to
for early signs of spillover in activity reports from EM procure substitute goods outside of Japan to cushion the
Asia. Korea reported today that imports rose strongly in shock. These factors suggest that the brunt of the spillover
March, although the result is clouded by Lunar New Year may be delayed to April or even May, or it may be more
volatility. China, Taiwan, and Singapore will report March evenly distributed across all these months. The sharp drop in
imports by mid-month, well in advance of Japan. There the one-month outlook in this week’s Korea FKI business
also will be a set of reports on EM Asian manufacturing survey hinted that there may be difficulties ahead.
12
David Hensley (1-212) 834-5516 Global Data Watch
Economic Research Note J.P. Morgan Agricultural CCI and EM food inflation
%oya
EM food inflation to push 100
JPMACCI
16
higher into midyear 75 14

EM food CPI 12
50
• After stabilizing in recent months, EM food inflation 10
is likely to rise further, peaking at midyear 25
8
0
• How much relief occurs in 2H11 depends on path of 6
commodity prices and nature of the passthrough -25 4
-50 2
00 02 04 06 08 10
The prices of many global commodities softened in March,
along with prices of most risk assets. This included agricul- Model of EM consumer food inflation
tural commodity prices, which retreated about 2.5%m/m, All price changes are %oya; Sample Jan03-Feb11
Contemporaneous only With lags
their first decline since June 2010. Even so, the March av- Constant 6.05 5.48
erage stands 63% above the level in last June and the risks (13.5) (15.5)
are skewed toward additional gains through midyear. Any Agric. prices 0.07 0.06
(3.5) (4.4)
relief on agricultural prices is especially welcome in the Agric. prices, lag 6m 0.06
emerging economies. Raw commodities make up a signifi- (6.8)
cantly larger share of value-added in EM food prices com- Adj. R-sq. 0.35 0.61
Std. dev. of residual 2.1 1.7
pared to the developed economies. Moreover, food com-
prises about 30% of the average EM consumer basket. EM food inflation, stable agric. prices going forward
%oya; Actual thru Feb11, fcst thru Dec11 (model estimated Jan03-Feb11)
With this sort of pipeline pressure, it is not surprising that
EM food inflation has escalated since mid-2010. Our sea- 14 Model
Actual (incl. 6m lag)
sonally adjusted series shows aggregate EM food prices 12
increased at an average 1.1% monthly rate from July 10
through February. This lifted the year-ago rate of EM food
8
inflation from under 6% to 8.9% in February, adding about
1%-pt to headline EM inflation over the same period. 6
Model
4 (contemp. only)
Rising food prices have been a headache for EM govern-
2
ments, stirring social tensions. They also have been a head- 02 04 06 08 10
ache for central banks. Resource utilization is high in the
EM and core inflation is rising. The added pressure from EM food inflation, 3% monthly agric. price gains through June 2011
rising food prices has pushed headline inflation above tar- %oya; Actual thru Feb11, fcst thru Dec11 (model estimated Jan03-Feb11)
get in most EM countries, compelling reluctant central 14 Model
banks to tighten policy. Even so, policy rates remain quite Actual (incl. 6m lag)
12
low by historical standards, suggesting the overall mon-
etary policy stance is stimulative. Investors are well aware 10
of these tensions. In this light, the path of food inflation 8
going forward is immensely important. 6
4 Model
A closer look shows that EM food inflation has been rela- (contemp. only)
tively steady at about 9%oya for four months between No- 2
02 04 06 08 10
vember 2010 and February. This holds out the possibility
that the surge in EM food inflation is over, especially with passthrough over much of the past decade. Thus, even if
agricultural commodity prices having edged down (sequen- commodity prices were to hold steady—in which case their
tially) last month. What happens next depends on several %oya rate would not rise much more—EM food inflation
factors. The first consideration is possible lags in transmis- might continue rising into the middle of the year. The sec-
sion from commodity prices to consumer prices. Casual ond factor to consider is that commodity prices might rally
inspection of the accompanying chart points to delayed further from their current levels.
13
David Hensley (1-212) 834-5516 EM food inflation to push higher into midyear
No relief until midyear EM food inflation

%oya Dec 09 Jun 10 Nov 10 Dec 10 Jan 11 Feb 11
Our take on this issue is that EM food inflation will reach EM 5.3 5.6 9.0 8.8 9.1 8.9
new highs in coming months, rising anywhere from 1%-pt EM Asia 6.1 6.7 9.6 9.1 9.5 9.5
to 4%-pts (on a year-ago basis) before a retreat in 2H11. As China 5.3 5.7 11.7 9.6 10.3 11.0
shown on the previous page, EM food inflation has a fairly Hong Kong 0.3 2.2 3.8 4.3 5.4 5.0
robust relationship with raw agricultural prices. To explore Indonesia 3.9 10.3 12.3 15.6 16.2 14.8
this relationship further, we regress EM consumer food infla- Malaysia 1.1 3.1 3.0 2.9 3.7 4.8
Singapore 0.6 1.2 1.8 2.1 2.8 2.6
tion (%oya) on the %oya change in the J.P. Morgan com-
Taiwan -3.5 1.7 3.6 2.2 2.0 2.7
modity curve index for agricultural prices (JPMACCI). Ac- Thailand 2.2 6.1 5.8 5.6 6.0 5.1
cording to the simple univariate relationship, contemporane- LATAM 3.2 4.5 7.3 8.1 7.7 7.1
ous movements in agricultural price inflation alone explain Argentina 5.9 15.7 15.8 14.7 13.1 10.6
over one third of the variation in EM food inflation, with a Chile -1.8 1.8 4.8 5.6 5.5 5.6
standard error of 2.1%-pts. Over this period, a 10% move in Colombia -0.3 1.5 2.4 4.1 4.8 4.4
the %oya JPMACCI generated a 0.7%-pt move in EM con- Ecuador 4.5 4.1 5.9 5.4 4.9 5.3
sumer food inflation. Peru 0.6 2.6 3.0 2.5 2.3 2.6
Bulgaria -3.2 -2.6 4.7 4.0 4.6 6.2
Romania 0.4 -0.1 6.0 6.5 7.2 8.8
In addition to this contemporaneous effect, there appears to Turkey 9.3 5.6 12.4 7.0 7.1 4.5
be a complementary influence from lagged effects of ear-
EM consumer food inflation, model forecasts
lier movements in commodity inflation. The existence of Inflation rates are %oya; Feb11 rate is 8.9%
such lags presumably would reflect a more gradual trans- Peak month Peak rate Dec 11 rate
mission of cost pressures as well as government interven- Stable agricultural commodity prices
Model: Contemporaneous only May/Jun 11 10.9 6.8
tion in the setting of consumer prices. Although we ex- Model: Includes 6m lag Jun 11 11.6 10.5
plored a number of lag structures, a six-month lag in the Further commodity price gains
%oya change in agricultural prices was by far the most im- Model: Contemporaneous only Jun 11 12.4 7.7
Model: Includes 6m lag Jun 11 12.8 12.6
portant, boosting the explained share of movements in EM
food inflation to almost two thirds and nearly doubling the • Peak rate depends on 2Q11 agricultural prices: Even
impact of a 10% move in the %oya JPMACCI to 1.2%-pts. if the JPMACCI stabilizes at current levels, at least a
We emphasize that we are not confident in the validity of modest further rise in EM food inflation is in store, with
the lagged effect, however. The regression might be “over- our models projecting a peak of 10.9%oya to 11.6%oya.
fitting” the 2007-08 period, as suggested by the modest dif- However, our strategists think the JPMACCI will rally in
ference in the standard error of the two regressions. 2Q. Assuming 3% monthly gains from April to June, our
models would project EM food inflation to peak from
Applying these model results to the current situation sug- 12.4% to 12.8% in June. (One qualification: actual infla-
gests several conclusions: tion currently is tracking a bit below the models; if this
error persists, inflation could crest about 1%-pt below the
• EM food inflation to climb further: Short of a further figures cited above.)
retreat in the level of agricultural commodity prices, EM
food inflation still has further to rise. The %oya • Speed of 2H11 moderation depends on lags: The lag
JPMACCI will climb until June even under the assump- structure underlying the passthrough of agricultural
tion of stable sequential prices. The recent plateau in EM prices to EM food inflation is crucial in assessing the
food inflation is well within the standard error of the path of EM food inflation in 2H11, and thus the pressure
model projection, which points to further gains in 2Q. placed on policymakers in the region. Unfortunately, the
two models considered above yield very different con-
• EM food inflation to peak by midyear: Although our clusions. If the passthrough is contemporaneous only,
strategists believe the risks point to higher raw agricul- then the models suggest EM food inflation will fall
tural prices into midyear, they look for them to level off sharply in 2H11. By contrast, if there is lagged
or possibly decline thereafter. This 2H profile implies passthrough, EM food inflation will remain sticky
that both JPMACCI and EM food inflation will peak in throughout 2H11. These scenarios assume a stable
June (remember that the surge in the JPMACCI and EM JPMACCI; EM inflation would fall more significantly
food prices began in July 2010). under either model if the JPMACCI retreats in 2H11.
14
Michael Feroli (1-212) 834-5523 Global Data Watch
michael.e.feroli@jpmorgan.com April 1, 2011
Economic Research Note Personal income Forecast

%ch, saar 4Q $ bn 3Q10 4Q10 1Q11 2Q11
US: first-half income growth Compensation
Proprietors' income
8100.3
1080.2
3.4
3.8
3.2
8.0
3.6
5.0
4.0
4.0
and a simple twist of fate Rental income
Interest income
308.4
1190.9
6.9
-9.8
6.2
5.6
24.0
4.0
15.0
2.0
• Tax cuts have been a big boost for income in 1Q and Dividends 724.2 3.3 5.2 15.0 10.0
Transfer payments 2337.7 5.4 3.7 1.0 0.0
inflation has been a big drag
Personal income 12724.0 2.5 4.1 7.6 3.7
• In 2Q both those factors should return to a more nor- -Payroll taxes 1022.8 3.3 2.9 -32.5 4.4
mal pattern Income and other taxes 1205.1 10.5 9.5 22.4 3.7
=Disposable personal income 11518.9 1.7 3.6 6.2 3.7
• Further out, continued strength in the labor market Inflation (PCE) 0.8 1.8 3.7 1.8
needed to offset higher taxes, fewer transfers Real disposable personal income 1.0 1.8 2.5 1.9
Since the beginning of the year, first-quarter real GDP Income and prices
growth projections have been marked down, largely be- %ch, 3-mo annualized
cause real consumer spending growth looks to be expand-
ing at a weaker-than-anticipated pace, perhaps in the 1%- 10
Compensation
2% range. That disappointment in turn seems to be mostly 5
a result of real disposable income growing at an okay but
not stellar 2.5% pace. Nominal disposable income has 0
been growing at a more respectable pace of around 6% or PCE prices
-5
better, thanks in part to the January reduction in Social Se-
curity taxes. However, because headline inflation is being -10
pushed higher by rising food and energy prices, that expan-
-15
sion in nominal income is not translating into as much 2009 2010 2011
growth in real income. In 2Q, those forces should mostly
reverse themselves: although headline inflation should Household sector: taxes paid minus gov't payments received
ease, the boost to nominal income growth from the tax cuts
% of income
will have faded, leaving real income growth tracking in the
2% neighborhood. 12
10
8
Pushes and pulls
6
One reason expectations for growth picked up late last year 4
was because changes in fiscal policy promised more con- 2
sumer income growth in early 2011 and therefore hopefully 0
greater consumer spending growth. The change in fiscal -2
policy referred to is not the Bush-era 2001 and 2003 tax 59 64 69 74 79 84 89 94 99 04 09
cuts: the preservation of those cuts left personal income tax
rates unchanged in 2011 relative to 2010, and thus should wait for next year’s tax refund season. That reduction lifted
have had no major impact on income growth. What did nominal income growth by almost 2%-pts in the first quar-
change was the one-year 2%-pt reduction in Social Secu- ter. (Note, although the reduced Social Security tax rates
rity taxes, which should put $110 billion extra in the wal- hold for all of 2011, the lift to income growth is entirely in
lets of consumers this calendar year. the first quarter).
That boost to income was partly offset by the loss of the So far, the income story looks pretty good. Unfortunately, a
$50 billion lower-income Making Work Pay tax credit. strong increase in inflation means that much of that extra
Even so, households ended up with a $60 billion reduction nominal income growth is simply going into higher prices.
in tax burden. Because that cut in taxes was in payroll Headline PCE inflation is increasing at a 3.5% annual rate
withholding taxes it should immediately show up in con- in 1Q, even as ex.-food and energy core prices are rising at
sumers’ pockets beginning in January, rather than having to less than a 1.5% rate. That extra two percentage points of
15
Michael Feroli (1-212) 834-5523 US: first half income growth and a simple twist
michael.e.feroli@jpmorgan.com of fate
April 1, 2011
inflation due to surging food and energy prices almost ex- Rental income of persons
actly offsets the two-percentage-point lift to nominal in- $ bn
come growth from the tax cuts.
350
Looking forward to 2Q... 280
If, as the futures markets anticipate, energy prices settle 210

down, then headline inflation in the second quarter should
probably run in the 2% range. Relative to the first quarter, 140
that should provide some relief to real income growth. How- 70
ever, unlike the first quarter, second-quarter income growth
will not get a lift from tax cuts. These two swing factors— 0
59 64 69 74 79 84 89 94 99 04 09
tax cuts and headline inflation—just about offset each other,
and all else equal we would expect real disposable income Rental income is booming, implicitly
growth in the second quarter to increase at around the same One income source that has been soaring in recent years is
pace as in the first quarter: around 2% annualized. rent. In February, rental income of persons increased 2.6%
on the month to $326 billion. After bottoming at $120 bil-
...and longer term lion in February of 2007, rental income has nearly tripled
in the subsequent four years. Even though rental income
After the inflation and tax cut dynamics sort themselves
accounts for less than 3% of personal income, over the past
out, the more fundamental issue for personal income will
four years it has accounted for over 16% of personal in-
be the labor compensation, which accounts for over 60% of
come growth. This rise has little to do with landlords get-
all personal income. Compensation growth can be divided
ting more from their tenants. In fact, it has very little to do
into average hourly wage growth plus growth in hours
with what would normally be considered “rent.” Instead, it
worked. Growth in average wages has been tepid and will
mostly reflects mortgage payments of the household sector
likely remain so as the abundance of unemployed workers
coming down, in part because of the aggregate decline in
will make it hard to demand wage increases. Not only does
household mortgage debt due to the net cancellation of
economic theory suggest limited wage growth, workers
mortgages associated with foreclosures.
themselves aren’t expecting much in the way of pay raises:
expected income growth over the next year remains well
About a quarter of rental income is what one would nor-
below 1%. While average hourly earnings growth has been
mally consider rent in the ordinary use of the word—the
slow, hours worked have increased about 2% over the past
income received by one person from another person to use
year—with a similar annualized rate in the first quarter—
a dwelling. The other three-quarters, however, is “owner-
reflecting both an increase in employment and an increase
occupied rent.” In one of the odder quirks of national in-
in the average hours worked per employee. The average
come accounting, the BEA assumes that homeowners are
workweek appears to be nearing a normal level, so further
essentially landlords who rent to themselves. (This adjust-
gains in hours worked will probably come through full-
ment insures that the measured output of housing services
time employment: average monthly employment gains of
is invariant whether dwellings are owned or rented.) Gross
200,000 per month would be about consistent with hours
imputed rent for these units is how much rent owner-occu-
worked increasing another 2% in the year ahead.
piers would have received had they rented their units in-
stead of owning them. Owner-occupied rental income is
Longer term, compensation should be the driving force be-
this gross imputed rent less the costs associated with
hind income growth, while the net influence of the govern-
homeownership, and the largest such cost is mortgage in-
ment sector will likely be the dragging force. In normal
terest. Gross imputed rent has been gradually trending up-
times, the household sector gives about 8%-pts more of its
ward, but cannot account for the surge in rental income.
income in taxes than it receives in direct transfers such as
Instead, mortgage payments have fallen off relative to
Social Security or unemployment benefits. In the past two
trend, boosting measured rental income. Most of this de-
years, the household sector has received more in direct
cline in mortgage interest is due to lower outstanding mort-
cash payments from the government than it has paid in
gage debt. Much of that decline in mortgage debt is due to
taxes. If this net flow even partly returns to normal it would
delinquent mortgage debt being charged-off by lenders.
represent a significant drag on incomes.
16
David Mackie (44-20) 7325-5040 Global Data Watch
david.mackie@jpmorgan.com April 1, 2011
Economic Research Note A very simple model of equilibrium configurations of primary

positions and outstanding debt
Euro area debt crisis: gauging % of GDP
the optimal exit path Debt to GDP

Primary position with no extra Primary position with extra
risk premium risk premium
• Assessing costs of different policy options is hard 60 0.5 0.5

80 1.7 2.2
• Fiscal consolidation plus fiscal transfers likely to be 100 3.0 4.0
the least disruptive 120 4.2 5.7
140 5.5 7.5
One day Greece and Ireland will return to the capital mar- 160 6.7 9.2
kets. This will occur when they are well on the way to The equilibrium configurations in the first column are based on a regression of Euro area
achieving a configuration of primary fiscal positions and countries excluding Finland, Greece, and Ireland over the period 1997-2007. During this
debt levels that convinces investors that they are solvent. estimation period, risk premia were very small. The second column adds a risk premium which
is zero at a debt-to-GDP ratio of 60% and 2.5% at a debt-to-GDP ratio of 160%.
Although that much is certain, three key uncertainties re-
main: first, what these equilibrium configurations of pri-
mary positions and debt levels are; second, whether the na- There are a number of ways that this equilibrium configu-
ture of the journey itself has an impact on these equilibrium ration could be achieved. One extreme path would be for a
configurations; and third, how policymakers will judge the very large primary surplus to be generated in the near term
relative costs of the various policy options. and sustained for as long as needed to drive the debt level
down to 80% of GDP. This would also require a long pe-
There are a variety of ways that deficits and debt can be riod of liquidity support because the sovereigns would not
adjusted: the generation of primary surpluses, liability man- have market access for much of the adjustment. This is es-
agement exercises (debt buybacks at market prices), asset sentially the path in the EU/IMF program for Greece,
sales, the restructuring of official debt (lower borrowing which anticipates a 6% primary surplus being sustained for
cost and maturity extensions which are essentially fiscal an extended period. The other extreme path would be for
transfers), or the restructuring of market debt (coupon re- the fiscal adjustment to come to an end when the primary
ductions, grace periods for coupon payments, maturity ex- surplus reaches 2% of GDP and for the debt-to-GDP ratio
tensions, and principal haircuts). to be reduced by debt restructuring. There are many inter-
mediate paths between these extremes, which could include
Financial markets think there is a high likelihood that the differing degrees of concessional liquidity support (lower
exit path will involve a restructuring of market debt. In borrowing costs and longer maturities on official loans,
contrast, we have argued that policymakers may choose to which are essentially a restructuring of official debt), asset
limit any restructuring to the official debt (bilateral and sales, and liability management exercises.
EFSF/EFSM loans) which would be equivalent to a fiscal
transfer. Our judgment of which policies will be chosen is One issue that is rarely discussed is whether the journey
driven by an assessment of the relative costs. itself affects the equilibrium configuration of primary posi-
tions and debt. It is certainly possible that sovereigns need
Where do deficits and debt need to go? to generate a larger primary surplus after a restructuring of
market debt in order to convince financial markets that it is
A sovereign loses access to capital markets when investors a one-off event. Academic research suggests that the
doubt that it is capable of achieving an equilibrium deficit market’s appetite for a sovereign’s debt—and thus the
and debt position without restructuring its market debt. Un- likely equilibrium configuration of primary positions and
fortunately, it is very difficult to say what a sovereign debt—is influenced by the sovereign’s history of default
needs to do in order to convince financial markets that it is and inflation. The reason for this is that there is a historical
solvent once doubts have been raised. Our view on this has record of serial defaults. In the words of Reinhart et al,
been informed by the observation that a sufficient condi- “Debt intolerant countries tend to have weak fiscal struc-
tion for the sovereign’s intertemporal budget constraint to tures and weak financial systems. Default often exacerbates
be met is a positive relationship between the primary posi- these problems, making these same countries more prone to
tion and the level of debt.1 A simple estimated relationship future default.”2
for the Euro area suggests that a reasonable equilibrium
configuration for Greece and Ireland would be a primary 1. See Henning Bohn, “The Behavior of US Public Debt and Deficits,” The Quarterly Journal
surplus of 2% of GDP and a debt level of 80% of GDP. of Economics, 1998.
17
David Mackie (44-20) 7325-5040 Euro area debt crisis: gauging the optimal
david.mackie@jpmorgan.com exit path
April 1, 2011
The challenge of assessing relative costs Recent sovereign debt restructurings

NPV Principal Principal
Policymakers in the region should choose the adjustment Debt
reduction reduction reduction
path that minimizes the political, financial, and economic % of GDP % % of GDP % of debt
costs. With fiscal consolidation, we are well aware of the Preemptive
political and economic costs: austerity measures are both Ukraine 1999 41.8 5 0.0 0.0
painful and unpopular. Unfortunately, we have very little Pakistan 1999/00 91.9 8 0.0 1.0
1
idea of the costs of debt restructuring. Although there is an Argentina 2001 50.8 10 0.9 2.9
extensive literature on the costs of debt restructuring and Moldova 2002 84.4 6 -0.2 -6.4
the various channels through which these costs work—re- Uruguay 2003 89.0 8 -0.5 -1.0
duced access to capital markets (for the sovereign, Dominican Republic 2005 53.9 1 0.0 0.0
corporates, exporters, and banks), the shock to the domestic Post default
financial system, capital flight, and a loss of confidence— Ecuador 2000 120.4 25 -18.4 -37.3
there is little clarity on the magnitude of the costs. This Russia 2000 93.3 44 -4.1 -17.2
should not really be that surprising. Sovereign debt Moldova 2004 60.6 58 -2.5 -57.9
2
Argentina 2005 129.4 75 -37.0 -56.0
restructurings can vary enormously, both in terms of the
magnitude of the reduction in NPVs and in how that reduc- 1. Megaswap and Phase 1. 2. Global Debt Exchange. Source: Cross-Country Experience with
tion is achieved (coupon reductions, grace periods for cou- Restructuring of Sovereign Debt and Restoring Debt Sustainability, IMF, August 29, 2006.
pon payments, maturity extensions, and principal haircuts).

It likely makes a significant difference for the financial sys- ruptive, and should be avoided except as a very last resort.
tem and the macroeconomy if a given NPV reduction is This increases the likelihood that fiscal transfers, in the
achieved by a principal haircut rather than a maturity ex- form of a restructuring of official loans, will be used to
tension. Moreover, in past debt restructurings it is not al- help sovereigns achieve their equilibrium configurations of
ways easy to tell how much of the sovereign’s debt is held primary positions and debt without disruptive
by domestic financial institutions and how much of the loss restructurings of market debt. By 2013, Greece and Ireland
associated with the debt restructuring had already been ab- will have significant financial obligations to the rest of the
sorbed by mark-to-market pricing at the time the restructur- region, either via the bilateral loan program for Greece or
ing occurred. These issues are important because the dis- via loans from the EFSF and EFSM. A significant restruc-
ruptions to the financial system are likely to generate the turing of these official loans, involving a considerable ex-
largest costs associated with debt restructuring, as a signifi- tension of the maturity at a low borrowing cost, would
cant shock to capital positions will cause a credit crunch. avoid the potential disruptions of a restructuring of market
debt. As long as the debtor sovereigns have put in a good
Given the difficulty in gauging the costs of debt restructur- faith effort in terms of fiscal consolidation and structural
ing, it is hard to know which path the region should reform, the main cost of these fiscal transfers would be the
choose. There is a popular notion of burden sharing which potential political objections in the creditor countries.
suggests that as long as a significant amount of the debt is
held abroad, it is more costly for the debtor sovereign to
achieve the equilibrium configuration of primary positions
Which path will be chosen?
and debt by fiscal adjustment than by debt restructuring. Financial markets are convinced that some restructuring of
However, this is not necessarily true if the nonlinearities market debt will occur, for a number of reasons: they don’t
created by the shock to the domestic financial system are believe that the debtor sovereigns can achieve sizable pri-
very large. Sovereign debt restructurings can cause the mary surpluses; they don’t believe that the macroeconomic
same kind of shock as a large bankruptcy in the financial backdrop will be sufficiently supportive; they don’t believe
sector, and such events look more like negative-sum games that creditor sovereigns will be willing to engage in fiscal
rather than zero-sum games. The Lehman bankruptcy was transfers; and they believe that sovereign debt restructurings
clearly not a burden-sharing exercise with its creditors. share the burden. We are inclined to disagree with these
judgments. In our view, a combination of significant fiscal
The European Commission and the ECB appear to take the consolidation in the periphery and fiscal transfers from the
view that sovereign debt restructurings will always be dis- core would be the least disruptive path out of the crisis.
2. Carmen Reinhart, Kenneth Rogoff, and Miguel Savastano, “Debt Intolerance,” NBER
Working Paper, August 2003.
18
JPMorgan Securities Japan Co., Ltd. Economic Research
Masaaki Kanno (81-3) 6736-1166 Global Data Watch
masaaki.kanno@jpmorgan.com April 1, 2011
Masamichi Adachi (81-3) 6736-1172
masamichi.x.adachi@jpmorgan.com
Economic Research Note IP forecasts before and after earthquake

Feb11=100
Understanding the supply 110
After earthquake
105 Before earthquake

shock to Japan’s economy 100
• Supply bottlenecks to be major drags on domestic 95
and global production of autos and electronics 90
• Power outages to depress production and consump- 85

tion until end-April and in summer 80
Jan 11 Apr 11 Jul 11 Oct 11 Jan 12
• V-shaped economic recovery is expected after Sep-
tember with ¥10tn fiscal package for infrastructure
GDP forecasts before and after earthquake
With three weeks having passed since the Tohoku earth- %q/q, saar
quake, the bad news is that the nuclear power plant acci- 8
Before earthquake After earthquake
dent has not yet been brought under control. But the good
6
news is that highway and other transportation systems are
gradually recovering, and the media report the reopening of 4
plants in Tohoku and its neighboring prefectures. That said, 2
as the details have unfolded, the full recovery of production 0
is expected to be delayed by supply-chain bottlenecks and
ongoing partial power outages. -2
-4
2010 2011 2012
Grimmer outlook for IP and GDP
As a result of the disaster, we revised down our IP forecast of the major auto companies have halted production opera-
to -0.1%q/q saar in 1Q and -18.2% in 2Q from the original tions since March 11 even though their plants in western
28% and 3%, respectively. While we revised down the Japan did not experience any electric power supply prob-
GDP forecast two weeks ago in the aftermath of the earth- lems. J.P. Morgan’s auto equity analyst says that auto pro-
quake, we revised it down further this week to 0.5% from duction is expected to fall 46%m/m sa (not annualized) in
1.2% in 1Q and to -3.5% from -2.0% in 2Q. However, March and another 63% in April (seasonally adjusted by
though IP and GDP are forecast to plunge in 1H11, they economic research), which means that the level of produc-
are expected to surge in 2H and in 2012. tion will be 80% lower in April than that in February.
While agriculture, fisheries, and forestry are the primary Supply-chain bottlenecks are expected to have global im-
industries in the Tohoku region, the area has recently at- plications as well. For example, some plants in the region,
tracted a growing number of manufacturing industries due which produce a special semiconductor in auto engines and
to the development of a highway and shinkansen (bullet have a 40% share of the global market, were damaged criti-
train) network. As a result, firms, employing new technolo- cally and are not expected to reopen until June. Our analyst
gies, have opened new plants in the region, in part to, ironi- says that it will be difficult to find a replacement for this
cally, diversify geographical risk. part in a short time period. It is estimated that auto compa-
nies have at maximum one month’s inventory of this prod-
Supply chain problem uct, but unless supply of the special semiconductors re-
sumes shortly, a part of auto production outside of Japan
The typical new entrants are the auto, electronics, and may be forced to be suspended.
chemical industries. While the relative share of those
manufacturing industries is still low in the region (see “Ja-
pan to recover from disaster, but to take time,” GDW,
Do not underestimate the drag from the
March 18, 2011), there are a number of manufacturing outages
firms that produce key parts or materials without which In addition, power outages have become a much larger
firms cannot produce autos and electronic final products, drag on economic activity, not only in the Tohoku region,
including tablet computers. That’s why almost all the plants but also in the Tokyo metropolitan area, which produces
19
JPMorgan Securities Japan Co., Ltd. Economic Research
Masaaki Kanno (81-3) 6736-1166 Understanding the supply
masaaki.kanno@jpmorgan.com shock to Japan’s economy
Masamichi Adachi (81-3) 6736-1172 April 1, 2011
masamichi.x.adachi@jpmorgan.com
40% of GDP. Although the outages are for a maximum of IP forecast: with and without power outages
three hours a day, they will cause significant damage to Feb11=100
manufacturing, as any disruption in power can cause the 110
shutdown of operations. Unless a stable power supply is No outages
105
assured, their operations will likely remain depressed. In 100
addition, the power company is giving only one day’s no- 95
tice for the planned outages. This has made production With outages in summer
90
planning even more difficult.
85
The impact of the outages on the service industry is also 80

meaningful. With power supply capacity insufficient to Jan 11 Apr 11 Jul 11 Oct 11 Jan 12
meet demand, the government has asked all individuals and
companies to conserve energy. As a result, restaurants and
Power supply/demand outlook: Tokyo metropolitan area (2011)
bars are closing earlier. With train service only partially
MnKW
available, people leave work earlier than usual. Note that
although there are no official statistics, quite a large portion 78 Supply
of consumption value added in Japan is generated between 64
5:00 pm and midnight by people eating and drinking out.
57
East Japan Railway announced that the number of passen-
gers fell 30% after the earthquake. Many amusement parks 50
also have been closed since the quake, and are expected to 43
be closed again in the summer, if outages are reintroduced. Demand
Even outages for only a few hours each day compel them 36
to shut down their businesses. In addition, consumer senti- Jan Mar May Jul Sep Nov Jan
ment even in the western part of Japan appears to be de-
pressed, as tourist arrivals from abroad decline and planned between demand and supply is nearly 10 mnKW, and will
events are canceled. In all, the outages are likely to impact likely require partial outages until seasonal demand falls in
private consumption more severely than many had ex- mid/late September. If the planned partial outages are rein-
pected. While we revised down the private consumption troduced, which is likely, economic activity will again be
forecast to 0.5%q/q saar in 1Q and to -4.0% in 2Q, it is depressed. That’s the basis for our forecast that the quarter-
hard to estimate the damage from the outages at the mo- on-quarter gains in GDP will peak in 4Q rather than in
ment, given the unprecedented events. 3Q11. However, if summertime temperatures are lower
than expected and/or if supply capacity can be increased
Looking ahead, the outages will be lifted by end-April, as further, say to 60 mnKW, then outages will not be needed.
seasonal demand for heating will fall along with a gradual In that case, the economy would surge in 3Q.
recovery of the damaged thermal power plants. Given the
expected return of a consistent power supply and the recov-
ery of production facilities, IP is expected to surge in May
Fiscal package to boost GDP in 2H11
(10.2%) and June (3.0%). However, it is likely that outages
and 2012
will resume in July through the first half of September, as The basic problem that Japan now faces is a supply shock to
the seasonal demand for air conditioning will surge in the the economy, quite different from past shocks, which were
summer, causing demand to once again exceed supply. mostly to demand. Hence, the timing of an economic recov-
ery depends on how long the supply shock restrains the
According to the Tokyo Electric Power Company (TEPCO), economy. While it remains uncertain whether the strongest
the current demand for power is 41-42 mnKW, which ex- rebound occurs in 3Q or 4Q, it is likely that the economy
ceeds the supply capacity of 38.5 mnKW. To prevent an will surge in 2H11. Moreover, given an expected ¥10 trillion
unexpected overall blackout, nearly 8% of demand must be supplementary fiscal package, which should boost both pub-
cut through voluntary power saving and the partial outages. lic works and employment, the 2H11 momentum should ex-
During the summer, the demand is expected to rise to 55- tend into 2012. We revised up our forecast for 2012 GDP
60 mnKW, depending on the temperature, compared to growth to 3.2%, after downwardly revised 0.8% growth in
48.5 mnKW of supply capacity, which is expected to in- 2011. On net, the subsequent gain in GDP is expected to be
crease 10 mnKW from March. But the expected divergence larger than the initial loss of GDP in 1H11.
20
Miroslav Plojhar (44-20) 7325-0745 Global Data Watch
miroslav.x.plojhar@jpmorgan.com April 1, 2011
Economic Research Note Israeli real interest rate remains negative despite solid growth
%oya for GDP and %p.a. for BoI rate
Israel: BoI steps up tightening 10
pace into second half of cycle 8

Real GDP growth
6
• Bank of Israel will likely raise rates another 250bp by 4
end-2012 to defend inflation-targeting credibility
2
• BoI to prefer higher rates over faster FX appreciation 0
or reducing holdings of government bonds -2 BoI base rate, CPI-adjusted
• Higher rates likely more effective in anchoring infla- -4

00 02 04 06 08 10
tion expectations and reining in surging house prices
Israeli CPI to stay above the target in the coming months
We think the Bank of Israel (BoI) is midway through its
%oy a
current rate hiking cycle. We expect it to increase its base
rate by another 250bp by the end of 2012, after having 8 Inflation Inflation
hiked the rate to the current 3% from 0.5% in summer
6 target of
2009. Still negative real interest rates are not consistent
with above-potential economic growth, an already positive 4 1%-3%
output gap, inflation and inflation expectations above the 2
target, and double-digit growth in house prices. The accel- 0
eration of the pace of rate hikes over the past three months -2
(up 100bp) indicates that maintaining inflation-targeting -4
credibility has overshadowed concerns over excessive cur- 00 02 04 06 08 10 12
rency strength or the risk of a weaker global economy. We
believe that interest-rate normalization toward a real rate of growth this year. Israeli inflation has accelerated to above
1%-2% will dominate other policy options, such as letting 4% in February from a low of 1.8%oya last August. Conse-
the currency appreciate at a faster pace, reducing holdings quently, market inflation expectations have risen as well.
of government bonds, or prudential measures in mortgage The front end of the CPI-swap curve is above the target but
markets. A higher base rate is the most effective tool to an- even the usually stable back end of the curve is close to the
chor inflation expectations and rein in overheating in both top of the 1%-3% target band. We expect inflation to ease to
domestic demand and the housing market, in our view. 3.5%-4%oya over the next year on easing energy and food
prices. Yet, the risks to Israeli inflation are on the upside due
Risks to inflation-targeting credibility to a positive and widening output gap, accelerating wage
growth, and potential full passthrough from house prices
In the summer of 2009, the BoI was the first central bank to
into consumer housing prices. Moreover, inflation will likely
embark on a course of monetary tightening. However, the
be above the target for the longest period since the 1990s.
tightening was slow last year, only 75bp, mostly due to
fears of excessive shekel strengthening if the interest-rate
differential against the dollar and the euro were to widen House prices and consumer housing prices
markedly. Moreover, the risk of the global economy return- The Bank of Israel is targeting the CPI, not house prices or
ing to recession in the middle of the year engendered a cau- any other asset price. That said, the housing market is a very
tious approach. The BoI kept its base rate relatively low important variable for future financial stability, an important
despite a narrowing output gap and soaring house prices. driver of economic activity, and also a driver of the housing
The situation has changed recently because of both stron- component of the CPI. Housing constitutes almost a quarter
ger local macroeconomic data and the global shift up in of the CPI basket. In the past, both house and housing prices
inflation and interest rate expectations. have moved broadly together (first chart, next page). This
tight relationship broke down with the start of bull market in
The Israeli economy outperformed expectations in 2010, house prices and “shekelization” of the housing market in
after revisions of 1Q-3Q data (released in late December) 2007-09. At present, the evidence is too mixed on the return
and a very strong fourth quarter. Moreover, the negative of this relationship for it to be included in our CPI forecast.
output gap from a shallow recession of 4Q08-1Q09 has But a potential catch-up of consumer housing prices to
closed, by our estimation. We expect above-potential house prices is a clear inflation risk.
21
Miroslav Plojhar (44-20) 7325-0745 Israel: BoI steps up tightening pace into
miroslav.x.plojhar@jpmorgan.com second half of cycle
April 1, 2011
Housing market is not a bubble, yet Housing prices in CPI are lagging growth of house prices
%oya
Beside a potential spillover into CPI, the experience of sev-
25 House prices
eral developed and emerging market countries has showed Housing prices
that inflation targeters should pay close attention to devel- 20 (a quarter of CPI basket)
opments in the housing market. Housing prices and mort- 15
gage credit in Israel did not explode in the mid-2000s as in 10
other countries, thereby limiting the damage from the glo- 5
bal recession. Yet, prices did start to climb in late 2007 and 0
are up 60% since then. We agree with the BoI that the -5
housing market is not in a bubble yet. However, this may -10
change if the double-digit price growth continues. -15
00 02 04 06 08 10
Studying housing market bubbles abroad, the BoI is trying to Housing market reflation is working too well
avoid a mistake of too lax regulation. Last fall, the BoI intro- 2000=100 ILS bn
duced measures designed to reduce loan-to-value ratios. The
experience of housing market bubbles also shows that inter- 160 220
est rates held too low play an important role in the specula- Volume of mortgages 200
tive process, although they are not the most important driver. 140 180
We do not argue that the BoI should target house prices. We House prices 160
120
only think that any central bank behavior should not contrib- 140
ute to overvalued asset prices. Leaving interest rates too low 120
100
for too long is proverbially pouring fuel onto the fire (sec-
100
ond chart).
80 80
00 02 04 06 08 10
Higher rates preferred option...
First, a small FX strengthening is unlikely to have a mate-
Of the main policy options, we think that increasing inter-
rial impact on export performance. Second, a weaker ex-
est rates to neutral or even slightly above will be preferred
port performance, if achieved, may strengthen domestic
to letting the shekel appreciate at faster pace, more macro-
demand for nontradable goods and services, e.g., related to
prudential measures, or reducing government bond hold-
housing, as seen in several developed countries in the past.
ings. Normalizing the level of interest rates should not only
This would be counterproductive in the effort to tame infla-
help to maintain inflation-targeting credibility but also re-
tion pressures in both consumer and house prices. Finally,
strain the housing market boom. Rising interest rates are
theoretical monetary policy considerations meet hard real-
pushing up the currency but only to a limited extent. The
ity when special interest groups are taken into account.
shekel is being driven more by relative undervaluation, the
There is constant, strong pressure from exporters on the
current account surplus, and insufficient investment by Is-
central bank to prevent large shekel gains. As FX hedging
raelis abroad than by capital inflows seeking high carry
activity among exporters is underdeveloped, the BoI is per-
(see “Israel: C/A surplus and strong economy keep pushing
ceived to be the main FX hedger for the whole economy.
FX up” GDW, January 14, 2011).
We expect the Bank of Israel to let the shekel strengthen to
...to a faster rise in the shekel nearer its fundamental value but it is unlikely to let the cur-
A stronger currency would have limited direct impact on rency completely undo more than 10% undervaluation in
inflation. In the past, there was a strong, immediate FX the coming quarters. The strategy of occasional FX inter-
passthrough due to dollarization of services, especially ventions is likely to continue. Regulatory measures to dis-
rents. During 2007-09, however, the rate of passthrough courage nonresident activity in the shekel market, taken
diminished markedly. We do not think it will increase un- two months ago, have so far had only a small effect on the
less the country experiences hyperinflation as in the 1980s. shekel rate. But once the BoI crosses the Rubicon in using
We estimate the current FX passthrough of 10% over 12 capital flow restrictions, more regulatory measures may
months, which is smaller than in similarly sized EMEA EM follow. Finally, it will be easier for the BoI to tighten the
economies due to a less open economy. A stronger cur- interest rate part of monetary conditions within a global
rency should slow inflation also indirectly through its nega- rising rate environment, especially with the likely increase
tive impact on economic growth. There are several caveats. from the ECB next week.
22
Nora Szentivanyi (44-20) 7777-3981 Global Data Watch
nora.szentivanyi@jpmorgan.com April 1, 2011
Economic Research Note Iceland: main economic indicators

2007 2008 2009 2010 2011f 2012f
Iceland: export-led growth Nominal GDP, US$ bn
Real GDP, %oya
20.4
5.9
16.9
1.5
12.1
-6.9
12.6 14.5 16.0
-3.5 2.0 3.0
holds the key CPI, %oya 5.1 12.6 12.2 5.4 2.5 2.5
Current account, % of GDP -16.3 -24.5 -10.3 -7.8 -3.5 -3.0
1
• Capital controls to be lifted only gradually; initial Underlying current account, % of GDP n.a. n.a. 2.5 1.7 5.0 5.0
steps will not put pressure on the krona Trade balance, % of GDP -6.7 -0.4 6.0 7.7 8.0 7.5
FX reserves, US$ bn 2.6 3.5 3.9 5.8 6.5 7.0
• The real exchange rate is undervalued, but further 2
Gross external debt, % of GDP 606 565 308 333 267 253
investment is needed in export-oriented sectors Fiscal balance, % of GDP 5.4 -13.5 -10.0 -7.8 -5.3 -1.8
Primary balance, % of GDP 5.8 -13.5 -6.5 -4.0 -0.1 2.8
• April 9 Icesave vote key to reducing uncertainty 2
Public debt, % of GDP 28.0 69.3 92.6 96.3 100.5 93.9
1. Excluding accrued interest due to deposit institutions undergoing winding-up proceedings.
Iceland has made significant progress over the past two 2. IMF estimate as of January 2011 (fourth review).
years toward meeting preconditions for lifting capital con-
trols, which have been in place since the banking sector Iceland's recovery in international comparison
collapsed in the autumn of 2008. Significant trade and un- Real GDP, sa, 3Q08=100
derlying current account surpluses have developed, infla-
105
tion has declined, debt ratios are coming down, and foreign US
currency reserves have doubled. Yet, the slow pace of pri- 100
vate sector debt restructuring and repeated setbacks to reso- Hungary
95
lution of the Icesave dispute have held back the recovery. Ireland
The exchange rate is undervalued from a medium-term per- 90
spective, but capacity constraints will need to be addressed Iceland
via new investment to achieve export-led growth and thus 85 Baltics
sustain the improvement in debt dynamics. A “yes” vote in 80
4Q08 4Q09 4Q10
the Icesave referendum would help unlock remaining bilat-
eral financing and boost market confidence in Iceland.
Real GDP—dynamics
A delayed recovery % change Oya
Iceland’s twin banking and currency crises dealt a severe 15 6.0
blow to domestic private sector balance sheets, even Q/q, sa (2qma)
10 4.0
though the burden of the bank failures will be borne in
large part by foreign creditors. Going into the crisis, the 5 2.0
private sector was highly levered, with much of the debt
0 0.0
FX-linked. The krona’s sharp depreciation (45% in 2008),
coupled with falling asset prices (real house prices down -5 -2.0
35% from their peak) thus resulted in an enormous demand
adjustment. Although the economy appears to have reached -10 -4.0
04 06 08 10
its trough and domestic demand is recovering, GDP has yet
to post two consecutive quarters of growth, and the level of
Household balance sheets sensitive to FX
output is still 12% lower than it was before the onset of the
crisis. This is a much deeper recession than recorded in %oya, both scales
other crisis countries like Hungary or Ireland, although 20 -20
shallower than in the Baltics. Notably though, Iceland’s
10 0
recovery has been one of the slowest.
0 20
Fundamentals have improved 40
-10 Household consumption EUR/ISK
Despite the slow recovery, Iceland has made significant (reverse scale) 60
progress on a number of fronts and now meets most of the -20
80
preconditions for lifting capital controls that were set out in -30
the IMF-supported economic program: 00 02 04 06 08 10
23
Nora Szentivanyi (44-20) 7777-3981 Iceland: export-led growth holds the key
• The external trade balance has improved markedly. Trade balance and underlying current account in surplus
Iceland’s balance of trade in goods and services moved % of GDP, 12-month sum
to a surplus of 11% of GDP in 2010 from a similar-sized
deficit two years earlier. The improvement owed prima- 15 Underlying current account1
rily to a sharp contraction in imports in 2008-09, and im-
proving terms of trade, while export volumes have risen 0
only modestly. Higher prices for Iceland’s main exports Trade balance (g&s)
(aluminum and marine products) led to a sizable im-
-15
provement in the terms of trade, particularly in 1H10. Current account
• The underlying current account is also in surplus. -30
Iceland’s headline current account has improved signifi- 2005 2006 2007 2008 2009 2010
cantly from pre-crisis levels, but remains in deficit owing 1. C/A ex. accrued interest due to deposit institutions undergoing winding-up proceedings
entirely to a sizable income deficit. Importantly, the re-
Foreign currency reserves have risen
ported income deficit includes accrued interest expenses
due to deposit institutions undergoing winding-up pro- US$ mn
ceedings worth about 9.5% of GDP last year. Because this 6500
does not reflect actual currency flows, but rather accrued
interest on failed banks that will never be paid, it makes
sense to exclude them when analyzing the external bal- 5000
ance. Once the failed banks are settled, the current account
for last year would be in a surplus of nearly 2% of GDP. 3500
• FX reserves are at record highs. Foreign exchange re-
serves have doubled over the past two years on the back 2000
of loans from the IMF, Nordic countries, and Poland; the 2007 2008 2009 2010 2011
CBI’s FX purchases and transactions with commercial
banks, and recovery of loans associated with the banking • Financial stability. The recapitalization of Iceland’s
collapse. Gross FX reserves reached a record high of three major banks is complete, and private sector debt
US$6.2 billion (47% of GDP) at the end of February, relief measures have been finalized following a supreme
while FX reserves net of liabilities reached 20% of GDP. court ruling in November and new legislation. An earlier
The current size of reserves would be sufficient to pay ruling that questioned the legality of FX-linked loans has
interest and principal on external debt through 2015, and led to significant delays in private debt restructuring and
in months of imports is more than adequate. thus in meeting the financial stability condition.
• Inflation has fallen back to target. Disinflation has Capital controls to be relaxed in phases
been rapid, with the headline CPI rate falling from a peak
Icelandic authorities now appear comfortable beginning a
of 18.6%oya in early 2009 to 1.9% in early 2011. This
gradual relaxation of capital account controls, although
has allowed the CBI to cut interest rates to a historic low
only measures to reduce offshore krona positions will be
of 4.25%. Supply shocks should push inflation higher
undertaken in the near future. Further steps in the liberal-
from here, but underlying price pressures should remain
ization strategy will be subject to a number of precondi-
modest as sizable slack persists (we see the output gap
tions and success of the initial steps taken (box, next page).
closing only in late 2013). We see inflation hovering
It is likely that the period of liberalization will span several
close to the 2.5% target, but believe that further rate cuts
years. The revised strategy document targets 2015 for end-
are unlikely due to rising policy rates elsewhere and the
ing the process—a four-year delay from the previous date.
CBI’s interim objective of exchange rate stability.
• Fiscal sustainability is on track. The primary fiscal bal- Nonresidents hold a large share of highly liquid ISK assets
ance improved by 10%-points of GDP between 2008 and of about ISK465 billion or 30% of GDP. Of this, 60% is
2010. The budget foresees a primary balance close to held in government bonds and the remainder in bank de-
zero this year, while a surplus of around 3% is targeted posits. The central bank believes that about 70% of deposi-
for 2012 and 6% by 2015. This, along with the new tors will want to exit their holdings as soon as possible or
Icesave agreement (box, last page), should help to put the might be forced to sell due to Iceland’s low sovereign
public debt ratio on a declining path from next year. credit rating. The first phase of the strategy will thus begin
24
Nora Szentivanyi (44-20) 7777-3981 Global Data Watch
by trying to match investors wanting to sell their offshore

krona holdings with local pension funds wishing to reduce Capital account liberalization strategy
their foreign currency exposure and invest in long-term lo- Phase I: reduction in offshore krona positions
cal government bonds. This will be done through a series Step 1: FX auctions: i) Owners of offshore krona will be
of FX auctions that will allow authorities to gauge selling allowed to swap their holdings for foreign currency held
pressure and alter the size and frequency of the auctions by domestic pension funds. The CBI will act as an inter-
based on market and economic conditions. This initial step mediary. Local funds will then buy long-term Treasury
to relax capital controls should not be a strain on FX re- bonds for ISK and that investment will be locked in for a
serves. In particular, the rule requiring that new inflows of period of five years; ii) Nonresidents will be allowed to
FX constitute 50% of the value of new investments should buy offshore ISK, as above, for investment in Icelandic
prevent downward pressure on the krona. corporate equity or other long-term domestic assets; iii)
Nonresidents that have purchased offshore krona since the
Further, we are not convinced there will be quite as many crash will be permitted to place them in a closed fund for
forced sellers as the CBI anticipates and think that the ISK a period of five years, thus investing in the economy. (In-
overhang could be reduced relatively quickly. Iceland’s vestors under ii and iii must contribute the foreign cur-
credit rating at BBB- is at the bottom of investment grade rency equivalent of 50% of the full investment amount).
and is thus unlikely to pose problems for most investors,
particularly as upgrades are likely from here (for reasons Step 2: Exit levy and bond swaps: Remaining holders of
unrelated to its rating, Iceland is not included in major gov- offshore ISK will be offered two further exit routes: i) ex-
ernment bond indices). Further, it is likely that most inves- change deposits for FX, subject to an exit levy determined
tors wanting to sell ISK will wait for appreciation of the by the spread between the offshore and onshore rate, or ii)
offshore exchange rate, which is currently still more than swap ISK government bonds for eurobonds.
50% weaker than the onshore rate. For local pension funds
or real economy investors such as aluminum companies, Phase II: removal of controls on onshore krona
the auctions represent an attractive opportunity to buy off- Prerequisites
shore krona at a significant discount. As such we expect the i) Sufficiently strong balance of payments position
offshore and onshore rates to converge. ii) Access to foreign capital markets on acceptable terms
iii) Significant reduction of nonresident krona positions
Once the stock of offshore krona assets held by distressed iv) Convergence of offshore and onshore exchange rates
investors has been reduced to the level the CBI deems man- v) Prudential limits on banks’ FX risk
ageable, the removal of controls on onshore krona holdings
can begin. The timing of this second phase will also depend ISK looks undervalued
on meeting a set of conditions (box) and will, in our view, 1998=0, % change
not begin until next year. ISK-EU real GDP differential
40
Real exchange rate is undervalued... 20

The krona appreciated 10% in real trade-weighted terms
over the past year, but is still approximately 25% below the 0
average of the past 30 years. The real exchange rate ISK REER
broadly followed the real GDP differential between Iceland -20
and Europe (its main trading partner) until early 2007 but a
large gap opened during the recession. Admittedly, -40
98 00 02 04 06 08 10
Iceland’s recovery has lagged that in Europe but the growth
gap is now narrowing, suggesting scope for gradual trade surpluses will continue to be supported by rising
catchup in the real exchange rate in coming years. terms of trade, although the improvement will be much
slower owing to rising commodity and fuel imports. More
Iceland’s balance of payments position is set to remain advantageous interest terms under the new Icesave deal
strong, albeit helped by capital controls for now. The re- (box, next page) will also help the external balance. FX
ported current account deficit should narrow rapidly, to reserve accumulation should continue, helped also by the
around 2% of GDP this year, while we forecast the under- recovery of assets related to central bank claims on failed
lying current account surplus to reach 6% of GDP. External banks and access to the remaining IMF and bilateral loans.
25
Nora Szentivanyi (44-20) 7777-3981 Iceland: export-led growth holds the key
...but export growth faces constraints Icesave Q&A

Despite continued current account surpluses, Iceland cur- 1. What is Icesave? Icesave was an online retail bank
rently faces a number of constraints in achieving sustained operating in the UK and the Netherlands as a branch of
export-led growth. Its production and export base is rela- Landsbanki, a privately owned Icelandic bank that col-
tively narrow. Over 80% of goods exports are generated by lapsed in 2008. Iceland has agreed to repay €1.3 billion
three aluminum smelters and the marine products sector. in lost deposit guarantees to the Netherlands and €2.5
Similarly, Iceland’s degree of openness is low relative to billion to the UK. The new deal was referred to a public
the size of the economy, while its exports are also less so- vote, due to be held on April 9, by Iceland’s President.
phisticated than suggested by the economy’s level of devel-
opment. The aluminum smelters are producing at full ca- 2. What are the terms of repayment? The latest deal
pacity, and the marine industry’s export capacity is con- approved by Iceland’s parliament includes a fixed inter-
strained by fish stocks and quotas. As a result, competitive- est rate of 3.2% (3.0% on the Dutch portion and 3.3% on
ness of the tradables sector and hence growth in export vol- the UK portion) until mid-2016, when the 30-year repay-
umes has been limited despite the sharp depreciation of the ment period begins. This is much lower than the previ-
real exchange rate (although service sector exports, such as ously agreed 5.5% rate. No interest is due on obligations
tourism and transport, have been more buoyant). prior to October 1, 2009, which represents a nine-month
interest holiday compared to the previous agreement.
Inducing net inflows of foreign investment into export in-
dustries will thus be crucial, particularly as pent-up demand 3. How much will this cost the Icelandic government?
for foreign assets by residents might appear once the sec- The actual cost to the state will be a lot smaller than what
ond phase of the liberalization strategy begins to be imple- Iceland owes, as Landsbanki’s assets are expected to
mented. Untapped renewable energy resources do allow for cover 89% of the loan according to the latest official esti-
further expansion of energy-intensive exports, although mates. The cost to the government is unlikely to exceed
lead times are usually long. The latest GDP data show that ISK50 billion or 2.1% of 2010 GDP. In its fourth review,
the turnaround in investment growth thus far has been lack- the IMF estimated that lower interest rates will lead to a
luster, but should benefit from new investment in Alcoa’s 13%-pt reduction in Iceland’s public debt ratio by 2015
planned carbon anode manufacturing plant and associated relative to the earlier Icesave agreement.
power generation this year. Further, despite repeated de-
lays, we assume that construction of a new aluminum
smelter at Helguvik will go ahead in 2012, with activity
half of Iceland’s total loan package. Given significant exter-
peaking in 2013. Shelving of this project would cut GDP
nal debt amortizations falling due later this year and the need
growth by 1%-pt in 2012 and 0.5%-pt in 2013.
to continue to increase FX reserves, Icelandic authorities
will want to unlock the full amount of program financing.
The importance of Icesave
Another key remaining source of uncertainty is the so- Second, approval of Icesave would help to improve
called Icesave agreement under which Iceland will need to Iceland’s credit ratings. As previous rating agency down-
repay €3.8 billion (40% of Iceland’s GDP) to the UK and grades have been linked to failed votes on Icesave we be-
Netherlands. The first version of the bill was rejected by lieve upgrades could follow a positive vote relatively
93% of voters in a referendum in March 2010. A new deal quickly. This in turn would allow the government to access
negotiated late last year contains significantly improved international capital markets on more favorable terms. The
terms for Iceland (box) and thus has a better chance of sovereign’s access to foreign credit is a prerequisite for all
passing in the upcoming referendum on April 9. The out- steps of the liberalization strategy, with the exception of
come of the vote is nonetheless a close call, with the latest the first step in phase I (box, previous page).
opinion polls showing about 55% support for the new bill.
Finally, Iceland’s EU membership aspirations could be ham-
Approval of Icesave would mark a milestone in Iceland’s pered by a “no” vote. Iceland formally started accession ne-
emergence from its crisis and is crucial for a number of gotiations in July last year and is already a member of the
reasons in our view. First, while not a condition for IMF European Economic Area, although entry will also be sub-
loan disbursements, approval of Icesave is an implicit con- ject to a referendum. If both Icesave and EU membership are
dition for access to remaining bilateral loans from the Nor- approved by the public, we think Iceland could join the EU
dic countries (US$1.3 billion), which account for nearly in 2013 and adopt the euro several years thereafter.
26

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Economic Research

Global economic outlook summary

G-3 economic outlook detail

2010 2011 2012

Central Bank Watch

Global GDP-weighted average 1.92 8 2.09 2.24 2.38 2.48 2.60

Europe/Africa GDP-weighted average 1.49 3 1.75 2.01 2.30 2.57 2.81

Asia/Pacific GDP-weighted average 3.27 15 3.41 3.55 3.59 3.60 3.66

Selected recent research1 from J.P. Morgan Economics

Economic Research Note Upcoming Asia data releases for March

The March IP report for Japan arrives in late April. Since 50

higher into midyear 75 14

No relief until midyear EM food inflation

Economic Research Note Personal income Forecast

Looking forward to 2Q... 280

If, as the futures markets anticipate, energy prices settle 210

Economic Research Note A very simple model of equilibrium configurations of primary

the optimal exit path Debt to GDP

• Assessing costs of different policy options is hard 60 0.5 0.5

The challenge of assessing relative costs Recent sovereign debt restructurings

pon payments, maturity extensions, and principal haircuts).

Economic Research Note IP forecasts before and after earthquake

105 Before earthquake

• Power outages to depress production and consump- 85

The impact of the outages on the service industry is also 80

pace into second half of cycle 8

• Higher rates likely more effective in anchoring infla- -4

Economic Research Note Iceland: main economic indicators

by trying to match investors wanting to sell their offshore

Real exchange rate is undervalued... 20

...but export growth faces constraints Icesave Q&A

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