credit suisse, jan 7, 2014, european economics. " 14 points for 2014"

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DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES AND

ANALYST CERTIFICATIONS.

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European Economics

14 points for 2014

The euro area should continue its modest recovery this year. Abating

financial and fiscal headwinds should support domestic demand and stronger

global growth spur exports. It's possible corporate spending provides an upside

surprise as firms resume investment after a five-year dearth.

Perhaps the key theme of the euro area in 2013 was its resilience . Both the

financial system and the economy absorbed several political and financial

shocks remarkably well compared to previous years. We think that was a

consequence of the move of most of the periphery into current account surplus.

That theme should continue this year.

But the European Parliament elections in May should continue the theme

of political volatilityas populist parties are likely to perform well. There's also

a small, but real risk, of elections in Greece and Italy. And the ECB's Asset

Quality Review and continued negotiations over banking union could provide

further financial uncertainty.

And those current account surpluses could provide their own risks. Given

the inability of core Europe to generate stronger domestic demand, the euro

area's surplus is now at a record high. That should keep upwards pressure on

the currency and leave markets extremely concerned about deflation risks.

Although we think it'll take another recession for the euro area to slip into

deflation, there'll be a number of months this year when inflation could print

low enough to spook markets.Aggressively easier monetary policy from theECB would help address these risks, and there are several tools it could use.

But in the absence of a new slowdown, we don't expect the ECB to use them.

Monetary conservatismwith its associated risksis likely to prevail.

The countries that could garner interest are France, Germany and the UK.

France's relative economic underperformance has become more apparent,

but investors shorting its fixed income have been consistently disappointed.

That may remain the case.

At the same time, the new German government will bed down this year. The

thrust of its policies appear to be in the opposite direction to those it has

prescribed for other euro area economies. Over the next few years, that may

be constructive for addressing some of the euro area's imbalances, especially if

the introduction of a minimum wage boosts labour incomes and consumption.

But, in the longer-run it may hinder economic performance.

The vigour of the UK's recovery has taken many by surprise , not least

Governor Carney. We think the strength of the upswing can be sustained,

meaning there's likely to be tension between the desire of most of the MPC

to signal that rates will be on hold for some time and markets watching a

burgeoning recovery mature and spare capacity diminish.

Research Analysts

Christel Aranda-Hassel

+44 20 7888 1383

[email protected]

Steven Bryce

+44 20 7883 7360

[email protected]

Mirco Bulega

+44 20 7883 9315

[email protected]

Violante Di Canossa

+44 20 7883 4192

[email protected]

Neville Hill

+44 20 7888 1334

[email protected]

Axel Lang

+44 20 7883 3738

[email protected]

Giovanni Zanni

+44 20 7888 6827

[email protected]

07 January 2014Economics Research

http://www.credit-suisse.com/researchandanalytics


2/17

07 January 2014

European Economics 2

2014: The year of doing better, but not well

This year should be one of positive growth in the euro area. The recovery that began

early in 2013 looks set to continue at a modest pace. Surveys such as the PMIs that

track growth well are consistent with the economy growing at an annualized rate of

around 1%. The recovery is made in Europe, like the recession before it. The tight

monetary, financial and fiscal conditions that pushed the economy into recession in 2011-

12 have abated sufficiently for the economy to grow. For example, the fiscal tighteningacross the euro area this year should amount to no more than half a percentage point of

GDP, compared to 2pp of GDP in 2011 and 2012.

The main driver of the recession was the collapse in domestic demand(Exhibit 1). That

has now stabilized and started to grow. And the external environment looks more

promising: the improvement in global cyclical indicators that accompanied the end of the

euro crisis should support an acceleration in export growth (Exhibit 2). In all, then, there's

scope for the pace of euro area growth to pick up further from the limited pace it put in in

the second half of last year. The upswing should be apparent across all the euro area .

We expect GDP across the stressed periphery to register a rise this year, as domestic

demand in these economies also stabilizes and their net trade moves further into surplus.

So the euro area should do better than it has done in recent years this should be

the third year in six in which GDP has not shrunk but it is unlikely to do well. A

recovery predicated on conditions becoming less challenging, rather than a dose of

stimulus, is unlikely to be vigorous. The contrast with the UK, which saw significant

monetary and credit easing ahead of last year, is striking. We expect euro area growth of

just 1.3% this year, compared to 2.8% in the UK. That's hardly impressive given the

cumulative loss in output relative to potential in the last few years.

The euro area economy needs more stimulus, but recovery has reduced the urgency of

policymakers to respond. As we discuss below (page 10), we don't expect the ECB to

ease further. The major problem with this outcome is that the growth we forecast should

do little to meaningfully lower the high levels of unemployment in the periphery, especially

amongst young people, that will continue to pose a risk to political stability (page 14).

Exhibit 1: Euro area domestic demand has troughed Exhibit 2: And export growth should pick up

Q1 2008=100 Euro area exports and global PMI new orders

94

96

98

100

102

104

2008 2009 2010 2011 2012 2013

Euro area

US

Japan

30

35

40

45

50

55

60

-25

-20

-15

-10

-5

0

5

10

15

20

1999 2001 2003 2005 2007 2009 2011 2013

Global PMI new orders, 6m lead, rhs

Real exports, y/y%, 3mma, lhs

Source: Credit Suisse, Thompson Reuters Datastream Source: Credit Suisse, ECB, Markit


3/17

07 January 2014


The not so jobless recovery to come

Last year saw the start of a recovery in GDP in the euro area. This year should see the

start of a recovery in the euro area labour market. That shouldn't be the case. By most

estimates the pace of growth at which the euro area is currently running around 1%pa

should still be consistent with rising, not falling, unemployment.

But the labour market has recently performed better than GDP growth wouldsuggest, as Exhibit 3 shows. Unemployment barely rose last year and employment looks

to have stabilized in Q3. The employment component of the composite PMI survey is

almost at 50. So the labour market looks to be turning. At the country level there's some

dispersion in performance, but even in Spain it appears that unemployment is falling.

Although that may reflect a slowdown in productivity, it does mean that the modest

acceleration in growth we expect this year should bring about a further improvement in

labour dynamics. That's important for a number of reasons. For a start, as Exhibit 4 shows,

falling unemployment should support a further rise in consumer confidence. In turn,

that should help the nascent recovery in domestic demand.

But as well as providing fundamental support to the recovery, the turn in the labour

market should also go some way to help address some of the "stock problems"

legacies of the crisis that we discussed in the 2014 Global Outlook. One of our keyconcerns remains the sharp increase in support for radical political parties in many euro

area economies (see page 14). We think some of that increase in support reflects the high

level of unemployment, especially among young people. So to the extent to which

unemployment rates start to fall, so should current and expected levels of political risk.

The other stock problem is the high (and still rising) level of impaired and bad loans. As we

discuss below (page 9), the ECB's Asset Quality Review should go some way to more

clearly reveal and address the scale of the problem. But, to the extent to which bad

loans are a lagging function of the cycle, falling unemployment should both

correlate with and cause this stock problem to stabilize and possibly improve.

Exhibit 3: Growth and unemployment Exhibit 4: Unemployment and consumer confidence

Euro area GDP growth and changes in the unemployment rate

-6

-4

-2

0

2

4

6-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

90 91 92 93 94 96 97 98 99 00 01 03 04 05 06 07 08 10 11 12 13

12m change inunemployment rate, pp, lhs

GDP, y/y%, 3qma, rhs, inv

-0.6

-0.2

0.2

0.6

1.0

1.4

-40

-35

-30

-25

-20

-15

-10

-5

0

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

Consumer confidence, lhs

6 months change inunemployment rate, rhs,inverted

Source: Credit Suisse, Thompson Reuters Datastream Source: Credit Suisse, Thompson Reuters Datastream
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07 January 2014


Can corporate spending make a difference this year?

Investment has finally stabilized in the last couple of quarters, having fallen by 8% in

the 2011-13 recession after a 16% drop in the 2008-09 recession. Given investment's

capacity to contribute significantly to any volatility in output, it is important for this upswing

to continue and strengthen.

We don't think corporates lack the means to invest.Although bank deleveraging andthe associated decline in lending to corporates should present a stiff headwind against a

strong recovery in investment, we note that the "credit impulse", which matters most for

growth, has turned (European Economics Peripheral Data Monitor: Credit where Credit

is Due). And corporates across the euro area are relatively cash-rich. Over the last few

years the corporate sector has been running a much higher financial balance than usual,

meaning there's capacity for firms to boost spending on investment from existing

cashflows rather than needing to borrow.

Corporates may have a growing need to invest, as well . Net investment has been

especially weak in the euro area in the last few years, meaning that the capital stock is

becoming increasingly obsolete. Investment has fallen back to the end of the 90s levels.

Our view has been that the euro area financial crisis of 2010-12 was a powerful brake on

corporate spending. Given the high levels of uncertainty and the tail risk of a

catastrophic financial collapseit's unsurprising that corporate behavior was cautious.

Uncertainty has abated, though. The European policy uncertainty index, which has fallen

steadily over the past 12 months. It is also evident in the improvement in business

confidence, especially the forward-looking components, from the lows.

These three factors corporates having the financial wherewithal and the need to

invest and reduced uncertaintyshould all make for stronger corporate spending.

There is evidence for that from the latest European Commission surveys or our latest

proprietary survey of European corporates (see here). Given that investment has been

growing at an annualized pace of around 1% since the spring, this suggests that corporate

spending should make a stronger contribution to euro area demand growth in the coming

six to twelve months.

Exhibit 5: Uncertainty abates Exhibit 6: Investment intentions for 2014

European policy uncertainty index Survey taken in October-November of the prior year (%)

50

70

90

110

130

150

170

190

210

1999 2001 2003 2005 2007 2009 2011 2013

-8

-6

-4

-2

0

2

4

1999 2001 2003 2005 2007 2009 2011 2013 Source: Scott Baker, Nicholas Bloom and Steven J. Davis at www.PolicyUncertainty.com,Credit Suisse

Source: European Commission, Credit Suisse
https://plus.credit-suisse.com/r/vQgOUhhttps://plus.credit-suisse.com/r/vQgOUhhttps://plus.credit-suisse.com/r/vQgOUhhttps://plus.credit-suisse.com/r/vQgOUhhttps://plus.credit-suisse.com/r/vQgOUhhttps://plus.credit-suisse.com/r/vQgOUhhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=1025081451&serialid=RIB4jpBbh4KIjPsbir8kR7pMoZpuL0PINBEq9JvWfv8%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=1025081451&serialid=RIB4jpBbh4KIjPsbir8kR7pMoZpuL0PINBEq9JvWfv8%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=1025081451&serialid=RIB4jpBbh4KIjPsbir8kR7pMoZpuL0PINBEq9JvWfv8%3dhttps://doc.research-and-analytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=1025081451&serialid=RIB4jpBbh4KIjPsbir8kR7pMoZpuL0PINBEq9JvWfv8%3dhttps://plus.credit-suisse.com/r/vQgOUhhttps://plus.credit-suisse.com/r/vQgOUh


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07 January 2014


Could global growth be more supportive than expected?

Net trade has been the only engine of euro area GDP growth in recent years, despite a

lackluster performance of global trade growth. In 2014 and for the first time since 2010,

domestic demand will contribute more than net trade to GDP growth, reflecting a more

balanced composition of growth. Even so, the performance of the worlds first exporter

could surprise on the upside thanks to a global investment revival, improved

competitiveness and of course, the (slow) recovery of euro area domestic demand intraeuro area exports represent about half of total euro area exports.

Companies higher investment intentionsare the main reason for global trade to pick up

(remember that the import content of investment is high). In the US, where the net

investment-to-GDP ratio is historically low, firms are facing increased demand from

consumers whose saving effort is likely to ease as the large fiscal drag experienced in

2013 fades away and the job market continues to gradually improve.

In Japan, incentives to invest are high inasmuch as firms have delevered, face low

financing costs and enjoy high profits thanks the Abe/BoJ policies. Higher investment in

those two major countries would be positive for the euro area given its export

specialisation (machine equipment) and the second round effect on EM growth.

Indications that global trade is likely to support the euro area economy are alreadyevident in the surveys. The global manufacturing PMI is currently at robust level and the

new export components of the euro area PMI is also very well oriented. Exhibit 2 indicates

that export growth could accelerate quickly in the first half of the year

Exhibit 7: Global trade growth Exhibit 8: US net investment ratio (% of GDP)

-15

-10

-5

0

5

10

15

1992 1996 2000 2004 2008 2012

Long term average

2

3

4

5

6

7

8

1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Credit Suisse, Ameco Source: Credit Suisse

Negative shocks to the global economy are possible, though. Indeed, communicationchallenges lie ahead for the Fed despite a smooth start to reducing the size of QE3. A

bumpy road can certainly not be excluded and policy uncertainty would most likely derail

investment plans. Japans planned VAT hike in April could depress final demand if wages

dont increaseaccordingly. Chinas efforts to change the structure of its economy could be

hindered by fragility in credit markets while markets could test the strength of other key

and weaker EM countries such as Brazil, India, Indonesia, Turkey and South Africa in the

midst of the Fed tapering.


6/17

07 January 2014


Fiscal policy: Letting the cycle do some work

Pressure on euro area government bond markets has diminished during 2013,

driven by the OMT in the backdrop and by improving activity and external balances

indicators. Barring new political/policy turbulences in 2014, we expect euro area bond

markets, and in particular the periphery, to stabilize further this year.

Fiscal data available for 2013 suggests that most countries have broadly compliedwith their yearly targetswith some limited slippage still possible. Full-year data are

still not available general government figures, on a national account basis, will only be

available in March. However, the monthly indicators of fiscal developments suggest a

broad compliance with the official targets set in agreement with the European Commission

and generally slightly better than 2012 figures.

2014 budget balances should continue to improve.We anticipate a further fall in the

euro area aggregate deficit/GDP ratio next year, to 2.4% from 2.9% in 2013 (Exhibit 10).

Low interest rates and reduced indexation of government expenditures should help drive

deficits down, despite the still modest 2014 GDP growth projections. Peripheral countries

are still under some pressure to reduce their structural deficits although less than in

recent years, after an impressive overall structural consolidation achieved while

Germany is benefitting from favourable funding conditions and stronger domestic demand.

Both circumstances will drive net funding requirements lower, we believe.

The structural adjustment is largely completed for the euro area as a whole,

especially when compared to other major economic area around the world.

Estimates from the IMF put the 2013 structural deficit at around 1.4% of GDP, vs.

estimates of a 4% structural deficit for the UK and for the US (and 9% for Japan). Looking

ahead, this should allow the euro area cyclical recovery to proceed more smoothly, without

major fiscal headwinds.

Exhibit 9: General government balance and debt Exhibit 10: Change in euro area structural balances

Genera l government balance Debt

% GDP 2012 2013E 2014E 2013E

Austria -2.5 -2.5 -1.7 75Belgium -4.0 -2.8 -2.6 100

Finland -1.8 -2.0 -2.0 58

France -4.8 -4.1 -3.6 94

Germany 0.1 0.0 0.1 80

Greece -6.0 -4.0 -2.0 176

Ireland -7.6 -7.3 -4.5 124

Italy -3.0 -3.2 -2.7 133

Netherlands -4.1 -3.2 -3.3 75

Portugal -5.9 -5.5 -4.3 128

Spain -6.8 -6.5 -5.7 95

Euro area -3.2 -2.9 -2.4 96

-1

0

1

2

3

4

5

Ger Aust Fra Fin Bel Neth Ita Ire Spa Por Gre EA

2011 2012 2013 2014

Source: Credit Suisse estimates Source: Credit Suisse estimates


7/17

07 January 2014


The unbearable weight of a current account surplus

The euro area's large current account surplus will remain a perennial theme this

year. As Exhibit 11 shows, it is now running at close to 2.5% of the region's GDP. In large

part, this surplus is a consequence of the crisis and the severe external adjustment in the

periphery (Exhibit 12). But it has also been a consequence of continued high savings rates

in core Europe and the lack of any adjustment in their external surplus.

In large part the rise in the current account surplus was due to a collapse in domestic

demand in the periphery and stagnant domestic demand in core Europe leading to a sharp

fall in imports. And at the same time, solid growth outside the euro area, along with

significant improvements in competitiveness and market share in some peripheral

economies, has supported exports. Given that the weakness in domestic demand is, in

large part, a consequence of the relatively restrictive stance of both monetary and fiscal

policy, it is not a surprise that the surplus was associated with a strong currency.

There's little to suggest a change in these fundamentals this year. Given their

improving competitiveness and domestic headwinds against demand, we expect surpluses

in the periphery to continue to rise. Recent data do suggest a marked improvement in

domestic demand in Germany. But given the unwillingness of fiscal or monetary

policymakers to ease policy further, it seems unlikely that demand will grow sufficiently to

bring about an equivalent decline in surpluses in core Europe.

But such a large current account surplus is likely to put growing pressure on those

policymakers to ease. Germany's persistent current account surplus came under

criticism from both the US government and the European Commission last year. We

should expect more of the same this year. And the strong euro will continue to add to

disinflationary pressures in the euro area. Indeed, a strong appreciation from here

would likely have a marked impact on inflation, potentially pushing headline inflation rates

closer to deflation (see page 8), and so raising the prospect of a more aggressive policy

response from the ECB.

Exhibit 11: An unsustainably high surplus Exhibit 12: Asymmetric adjustment

Euro area current account surplus, as % GDP Trade balances as % euro area GDP

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1980 1985 1990 1995 2000 2005 2010

-2.0

-1.5-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1999 2001 2003 2005 2007 2009 2011 2013

"Core"

"Periphery"

Source: Credit Suisse, ECB Source: Credit Suisse, Eurostat


8/17

07 January 2014


Deflation scares

Inflation is unlikely to move steadily above 1% until the end of the year. And our

projections show a new trough in March, when a combination of base effects and

subdued energy inflation should push it back to 0.7%. Given the low starting point and

the consequent concerns over deflation, downside risks to prices will be closely

watched by markets.We see short-term risks coming from some weakness in services

inflation, apparent in the December preliminary prints, a smaller than expected impactfrom French VAT on prices and a relapse of the euro area economy back into recession.

Also, a strong currency would heighten deflation scares.

December core inflation fell to an all-time low, partly because of one-off factors in

Germany affecting services inflation. Core HICP should not print lower inflation rates, but

risks remain on the downside. Furthermore, recent experiences showed that the pass

through from higher indirect taxes has been far more muted than in the past. Given the

tentative state of the household sector in France, we would expect this to be the case

there too and we pencil in only a mild (but with downside risks) impact of the change in

taxation on prices.

On the growth side, the mild recovery we are expecting should put a floor to

downside pressures on inflation.Different measures of capacity utilization are pointing

to relatively stronger inflationary pressures, rather than to a protracted period of disinflation

or even deflation. Against the argument of lower inflation ahead we also note that short-

term inflation expectation measures have turned the corner, while longer-term inflation

expectations remain well anchored. Exhibit 14 shows our proxy for euro area standardized

price expectations. These have troughed in April and have been grinding higher for the

last nine months.

To conclude, a broad range of factors impacting short- and long-term inflation

expectations are pointing to low, but not lower inflation in the euro area.We will

likely see a prolonged period of low inflation, to be followed by a gradual upward

movement towards inflation rates below, but close to, 2% later on. Other things being

equal,inflation should not push the hand of the ECB further.

Exhibit 13: Inflation projections Exhibit 14: Euro area price expectations

HICP and HICP ex energy, food, alcohol and tobacco, y/y% Standardised

0.9

0.80.7

1.1

1.0 0.9

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2012 2013 2014 2015

Headline inflation

Core inflation

1.41.5

1.4

-3

-2

-1

0

1

2

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: Credit Suisse estimates, Thomson Reuters DataStream Source: Credit Suisse, Thomson Reuters DataStream, Markit Economics


9/17

07 January 2014


Banking union and AQR: A risk and opportunity

The latest banking union deal has come in for considerable criticism, both for its

complexity and lack of significant backstop.Against the backdrop of the ECB's Asset

Quality Review this year, it's a common view that these polices will contribute to continued

bank deleveraging and possibly risk a relapse back into recession.

However, it's worth bearing in mind that the stress tests and asset reviews aretaking place at a time of relative financial calm.Capital markets are open. And given

that a key aim of the process is to ensure banks have properly valued the loans on their

books and provisioned and capitalized sufficiently against them, there's evidence that the

process is already under way. As Exhibit 15 shows, capital and reserves on banks'

balance sheets in the euro area has already risen significantly over the past year or so.

This is a process that should continue.

So although deleveraging is likely to continue this year, it's not clear its pace will

worsen.Indeed, as recovery becomes entrenched and banks become better capitalized,

bank lending could start to stabilize. Given that it's the second derivative of credit growth

that matters for GDP growth, there's scope for this headwind to ease.

On the banking union deal itself, we also maintain a more constructive view, for

now.While it still lacks important detailsnotably on the backstop during the fund's build-up phase (2015-25), as well as on the decision process to resolve a bank we consider

as positive the fact that the Single Resolution Fund will eventually become fully European

and mutualized ten years from now. We also believe that the steady state amounts

available in the fund (55bn) would be sufficient to deal with most banking crisis with the

ESM or other backstops having to deal only with the most acute systemic crises.

We would have liked more explicit commitments from European officials, but the banking

union framework is there to be improved possibly already in the coming months, thanks

to the intervention of the European Parliament.In the absence of further clarifications,

the risk is that confidence would not be sufficiently restored, maintaining an

unnecessary, too high, level of fragmentation in European financial markets.

Exhibit 15: A recapitalizing banking sector Exhibit 16: Credit growth still weakEuro area banks' capital and reserves as % liabilities Euro area private sector credit growth %

5.0

5.5

6.0

6.5

7.0

7.5

1999 2001 2003 2005 2007 2009 2011 2013

-2

0

2

4

6

8

10

12

14

1999 2001 2003 2005 2007 2009 2011 2013 Source: Credit Suisse, ECB Source: Credit Suisse, ECB


10/17

07 January 2014


Weapons but not the will? The ECBs options for 2014

Our 2014 forecast has an unchanged ECB monetary policy stance. This assumes that

economic activity will continue to recover at a modest pace accompanied by very subdued

price pressures. But the ECB is not asymmetric when it comes to inflation and is

likely to act if it falls further. InThe ECB's arsenalwe outlined an array of measures that

we believe are still in the toolbox and could be used if required.

The ECBsbazooka, outright asset purchases, requires a serious risk of deflation,in

our view. This is not our base scenario but the very subdued inflation backdrop provides

little buffer in the event of another shock to economic activity. The tools for pure money

creation in order to preserve the price stability objective have always been available

to the ECBand it is interesting to note that ECB members have not ruled asset purchases

out. Should the need arise asset purchases are likely to follow the Feds script: open

endedand not limited to sovereign bonds but also including corporate paper. And

since size and variety will be important it makes little sense to relate QE to the ECBs

capital key since it could amount to the entire outstanding debt of Greece and exceed it in

the case of a smaller economy such as Estonia.

Prior to using the bazookaand to start with we believe that the ECB would cut rates

further in the event of inflation falling to 0.5% or lower. A further cut in the key policy rate

would also entail anegative deposit rate, in our view.

Other options in the ECBs toolbox are unlikely to be related to inflation but will be more a

response to liquidity issues of the euro areas banking system. Another VLTRO, lower

reserve requirements and ending or setting a rate cap to sterilizing the SMP are often

mentioned in this category. At the December press conference President Draghi ruled out

more unconditional unlimited funding through another VLTRO ahead of the AQR. But

cutting reserve requirements further to help periphery banks that have problems fulfilling

these and/or suspending the SMP drain against the backdrop of shrinking excess liquidity

cannot be excluded.

Exhibit 17: Percentage of outstanding debt boughtunder 1 trn QE using ECB capital key

Exhibit 18: The ECB has to provide increasinglyhigher fine tuning rates as excess liquidity shrinks

% %

2725 25

18 17

13 13 13 13 12 12 119 9 8

0

5

10

15

20

25

30

35

40

EST

GRE

SLK

SLJ

LUX

MAL

FIN

SPA

NET

CYP

GER

POR

AUS

FRA

BEL

ITA

IRE

151 97

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

May-10 Mar-11 Jan-12 Nov-12 Sep-13

Average fine tuning rate

ECB deposit rate

Source: Credit Suisse Source: ECB, Credit Suisse
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11/17

07 January 2014


The UK: Carney's challenge

This year is likely to bring volatility to UK markets , driven by a tension between a

burgeoning recovery and a central bank keen to keep monetary policy expansionary.

The UK economy begins the year on a strong note. Business surveys, such as the PMIs,

are consistent with growth stronger than the 3% annualized rate that the economy saw in

the middle quarters of 2013. This strength can be sustained. Business optimism is at itshighest in years, suggesting a long-overdue rise in business spending . That could

be supported by the recent fall in the size of corporate pension deficits, in turn a

consequence of rising long-term real interest rates. And given there's a general election

next year, the tone of fiscal policy is also likely to become (temporarily) more stimulative.

These are pro-cyclical forces at workthat can generate a vigorous recovery.

This strength challenges the signal and intent of the Bank of England MPC's

forward guidance. As Exhibit 20 shows, unemployment is likely to hit the 7% threshold, at

which the MPC's current guidance to keep policy rates on hold becomes obsolete, at some

point in the next few months. Given that the aim of forward guidance was to signal to UK

economic agents that the MPC intended "to maintain the current exceptionally stimulative

stance of monetary policy until weve seen a sustained period of strong growth", as Chief

Economist Dale has put it, the MPC may have to rephrase its guidance language.

We expect the MPC to sign up to a statement similar to that above , possibly at the

February Inflation Report, or sooner. But it's also possible that while a majority of MPC

members pursue such guidance, othersmost notably Wealecould start voting for higher

rates soon after the threshold is met (seeUK Economics: Forward forward guidance).

Although strong growth is l ikely to be welcomed by the Bank, the recent changes made to

the FLS suggest that policymakers are likely to lean against any increase in

household debt accumulation. "Macroprudential" policy tools, such as increasing capital

charges for types of lending, are likely to be deployed by the Bank this year. We think

they're intended as a substitute to monetary tightening. But markets may judge that

the only way they're likely to be effective is if they're used as a complement to higher rates.

Exhibit 19: UK growth set to strengthen further Exhibit 20: Unemployment rate set to fall sharplyMarket sector GDP growth and composite PMI Fitted measure using claimant count rate and vacancy rate

30

35

40

45

50

55

60

65

-15

-10

-5

0

5

10

1998 2000 2002 2004 2006 2008 2010 2012 2014

Composite PMI, rhs

Market sector GDP, q/q% ann, lhs

4

5

6

7

8

2002 2004 2006 2008 2010 2012 2014

Actual unemployment rate

Average of fitted values

"7% threshold"

Source: Credit Suisse, Markit, ONS Source: Credit Suisse, ONS
https://plus.credit-suisse.com/u/WWCqddhttps://plus.credit-suisse.com/u/WWCqddhttps://plus.credit-suisse.com/u/WWCqddhttps://plus.credit-suisse.com/u/WWCqdd


12/17

07 January 2014


The French contrarian

After some improvement at the beginning of 2013, Frances PMIs weakened in 4Q

2013. National surveys paint a better picture of activity, but we still believe that

French GDP growth is likely to underperform the euro area in 2014.

We have been in the past more optimistic than the consensus on France and the

data have supported our view, in the sense that France has outperformed euro areaGDP growth for the past three years. The reasons for our more optimistic view have been

explained in previous works. We also stressed that, from a bond market perspective,

France could hardly be associated with the "periphery". France is, indeed, at the true core

of Europe, in terms of economic structure and politically, meaning that policies will in most

cases suit the needs of the country. The French economy has also a number of strengths,

its bond market is liquid, and seen as sufficiently stable by rating agencies. As a matter of

fact, bond rates have remained relatively close to the German Benchmark in 2013. We

believe that the French bond market should continue to be supported in 2014.

But complacency would be misplaced. Losses of competitiveness might dampen

the gains expected from a rebound in external demand. Although demand from

France's key trade-partners has been recovering and should continue to accelerate this

year, the new export orders component of Frances manufacturing PMI has been

weakening in recent months suggesting that France has not (yet) benefitted meaningfully

from the stronger external demand.

A more significant overhaul of the economy is necessary to lift potential growth in

France.Despite some timid reforms and some tentative signs of their impact on labour

costs, more needs to be done, notably on labour market flexibility and competitiveness.

We view as positive the fact that the first declarations of the government this year include

the intention to cut further labour costs before the end of 2014. Meanwhile, non-price

factors also remain a drag on competitiveness, in our view.

Timing is of the essence, though. In our view, France should reform, but only

progressively. Indeed, we have stressed on several occasions that risking killing one of the

few remaining engines of growth in the euro area French domestic demand is not a

good idea, especially if there is no other strong engine to take up the baton of growth.France needs to build a solid reform framework, applying those reforms in earnest

only once domestic demand in Germany takes off more robustly.This is, en passant,

the strategy deployed by Germany in the 2000s: reforms happened while the rest of the

euro area was enjoying strong domestic demand growth.

Fiscal consolidation appears to be on track so far, but additional steps will be

needed by 2015. The European Commission (EC)s forecasts published in November

envisaged that Frances general government budget deficit will be 4.1% of GDP in 2013

and 3.8% of GDP in 2014, and the EC concluded that France is compliant with European

rules so far. However, we concur with the ECs view that additional measures will have to

be taken to comply with the 3% of GDP deficit target for 2015.

Overall, recent data are consistent with our view that French GDP growth will pick

up this year relative to 2013 but also that it will likely underperform the euro areagrowth acceleration.The popularity of the government is currently very low. However, in

the context of improving euro area growth numbers, the relative underperformance of the

French economy should occur without causing too much additional collateral damage to

the French government.
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13/17

07 January 2014


German structural reforms? Nein danke!

The European crisis has been a major catalyst of reform action, but not in Germany .

From the start, the German economy was under less reform pressure thanks to

weathering the financial crisis with more resilience. In part, however, this was also due to

the economy harvesting labour market reforms implemented before the Merkel

governments by her centre-left predecessor in the first half of last decade. But the Merkel

years,which started in 2005,have not been characterized by any reform impulses athome.

This could be blamed on the fact that her first term in office was at the helm of a grand

coalition, but she led a centre-right coalition in her second term and as Exhibits 21 and 22

show, that time was not used to tweak and implement any furthering of the previous

reform effort. If anything, temporary labour contracts became marginally less flexible again,

although on that front Germany remains below the EU average. But it remains way above

that average when it comes to protection of permanent workers.

The rolling back of reforms is likely to be speeded up in coming years. Merkel has

started her third term in office leading a grand coalition once more and the coalition

agreement is a significant step-back from hard-won past economic reforms. This

applies not only to the labour market, where the introduction of a statutory minimum wage

will be accompanied by more regulation and restrictions on temporary work, but rent

controls and a lowering of the pension age is likely to put a brake on economic progress.

As the panel of independent economic experts who advise Merkel, the so-called five wise

men, bluntly remarked in their annual report: economic policy measures [in the coalition

agreement] taken together threaten to ruin the reform progress Germany has achieved

This flies in the face of periphery euro area members which have seen much pressure

to reform coming from Germany. As the wise men put it: The German federal government

can only convince other European governments to assume national responsibility and

conduct necessary reforms, if it adheres to this advice in its own national area of

responsibility. We could not agree more.

Exhibit 21: Protection of temporary workers againstindividual and collective dismissals Exhibit 22: Regulation on temporary contracts

Scale from 0 (least restrictions) to 6 (most restrictions) Scale from 0 (least restrictions) to 6 (most restrictions)

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

USA UK IRL SPA GRE POR ITA FRA GER

2013

2008

EU average 2013

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

USA UK IRL SPA GRE POR ITA FRA GER

20132008

EU average 2013

Source: OECD, Credit Suisse Source: OECD, Credit Suisse


14/17

07 January 2014


Political risk 1: The (European) Parliament of Populists

One of the consequences of the euro area crisis has been an increase in social

tensions and a rise in non-mainstream parties in several countries . There are still

residual risks of destabilising early-elections in Greece or Italy, for example, this year, but

the main political event should be the European parliamentary elections, on May 25. The

risk is that a similar increase in "extremism" surfaces in the European elections.

Our view is that this is more than a risk it is almost a certainty. If we trust recent

polls, the European parliament will have 25%or even close to 30% in some scenarios

of Eurosceptic MEPs (from just under 20% currently).

However, we also believe that eurosceptic MEPs will not be enough to block

decisions also because they are, differently from the large European Parliament's

political parties, quite heterogeneous amongst themselves. A strong nationalist party like

the Front National, in France, has been hovering around 20% of national vote for many

months now, according to polls. The same is true for Italy's M5S. Both parties present

themselves as fundamentally eurosceptic, and given the proportional electoral system in

existence for the EP elections, those two parties will have a significant delegation in

Brussels. However, these Eurosceptic parties are very heterogeneous. Similar

considerations are valid for otherleft or rightnational Eurosceptic parties.

The most likely outcome is that "Grand coalition" majorities will form on major

decisions, as has been the case until now in the present Parliament.Although polls

are suggesting a fall in support from the traditional center-right parties, and potentially a

slight relative majority in favour of the center-left (thanks notably to a return to form of the

Labour party in the UK), it is highly unlikely that the latter will be able to reach an absolute

majority without support from centrists and/or centre-right parties.

Overall, the risk of a blockage of the European institutions due to the surge in anti-

euro sentiment seems very small. However, it is a risk that needs to be monitored

closely first, because we are still five months away from the European elections; and

second, because the risk would be amplified later this year and beyond if the European,

and in particular euro zone economy, does not improve more forcefully.

Exhibit 23: Actual and predicted percentage of seats held by each parliamentary group

Estimates based on current polls

Abbr.Group Name 2009 2014 (E)

Predominantly Pro-European (PP) orPredominantly Eurosceptic (PE)

EPP European People's Party 36.0% 27.8% PP

S&D Socialists & Democrats 25.0% 28.4% PP

ALDE Alliance of Liberals and Democrats for Europe 11.4% 8.3% PP

Greens-EFA The GreensEuropean Free Alliance 7.5% 5.1% PP

ECR European Conservatives and Reformists 7.3% 8.1% PE

GUE-NGL European United LeftNordic Green Left 4.8% 6.3% PE

EFD Europe of Freedom and Democracy 4.3% 4.3% PE

Non-Inscrits Non-Inscrits 3.7% 11.9% PE

Total 100.0% 100.0%

Source: www.notre-europe.eu, Credit Suisse


15/17

07 January 2014


Political risk 2: Independence days

On September 18 Scotland will hold a referendum on the question Should Scotland

be an independent country?Current polls suggest that a no vote is likely, with about

60% of those polled voting no (excluding undecided and dont know votes). Nonetheless,

there are still eight months to go before the vote, and a yes vote does appear to be a

distinct risk.

A yes vote would raise significant economic questions.The most significant probably

concerns Scotlands choice of currency. While the yes campaign has stated that its

intention is for an independent Scotland to keep sterling as its legal currency, issues

remain unresolved. For example, if the Bank of England were the lender of last resort for

Scottish banks, what would its role be in bank supervision? Would there be a Scottish

representative on the MPC? Is it sensible to enter into a monetary union in which fiscal

transfers are being explicitly dissolved? The manner in which the national debt would

be split is also of interest.It seems likely that the current stock of gilts would remain a

liability of the remaining UK (rUK), while Scotland would take on a portion of the debt,

incurring a liability to the rUK (probably weighted by population or GDP) and gradually

issue its own sovereign bonds. The Fitch ratings agency has recently commented that

Scottish independence would not have a material impact on the credit rating of the rUK,

though presumably it could increase gross debt to GDP for the rUK by around 10% (withnet debt unchanged in the scenario described above).

The transition process could also be challenging.The yes campaign has said that if

the referendum passes they expect Scotland to become a fully independent country by

March 2016, leaving a year and a half of transition period between the referendum and

actual independence. This creates a risk of cross-border capital flows out of Scotland,

particularly if investors fear redenomination risk (as we saw in peripheral Europe). Outside

of the UK, a yes vote for Scottish independence could also have an impact on other

separatist groups, most notably in Catalonia.

Spains government can and will block Catalonias referendum on independence.

That is the big difference to Scotland. Catalonias president, Artur Mas, had to deliver on

his election promise and plans to hold a referendum on 9 November. But the Spanish

constitution requires approval from both the government and the lower house ofparliament and both the majority conservative government and the main opposition

socialist party oppose it.

The referendum might thus be a mere consultation which is not legally binding. But

this risks pushing the problem out into 2016. Mas has already warned that if Madrid

opposes the referendum he will turn the regional election due that year into a vote on

independence.

Much will depend on Spains economic recovery.Fiscal austerity has been at the root

of the more secessionist fervour as we wrote in Catalonia's choice.The region, Spains

wealthiest but also most indebted one, has long sought to re-negotiate intra-regional

transfers and to have more tax autonomy along the lines of Navarre and the Basque

country. A reform of the financing of the regions via a more federal system could appease

Catalonia, but although favoured by socialists, the conservative government continues to

oppose this path. But this might change after the 2015 national election if calls for

secession remain strong.
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16/17

GLOBAL FIXED INCOME AND ECONOMIC RESEARCHDr. Neal Soss

Global Head of Economics and Demographics Research(212) 325 3335

[email protected]

Eric MillerCo-Head, Securities Research & Analytics

(212) 538 [email protected]

ECONOMICS AND DEMOGRAPHICS RESEARCH

GLOBAL / US ECONOMICS

Dr. Neal Soss

(212) 325 3335

[email protected]

Jay Feldman

(212) 325 7634

[email protected]

Dana Saporta

(212) 538 3163

[email protected]

Isaac Lebwohl

(212) 538 1906

[email protected]

LATIN AMERICA (LATAM) ECONOMICS

Alonso Cervera

Head of Latam Economics

52 55 5283 3845

[email protected]

Mexico, Chile

Casey Reckman

(212) 325 5570

[email protected]

Argentina, Venezuela

Daniel Chodos

(212) 325 7708

[email protected]

Latam Strategy

Juan Lorenzo Maldonado

(212) 325 4245

[email protected]

Colombia, Peru

Di Fu

(212) 538 4125

[email protected]

BRAZIL ECONOMICS

Nilson Teixeira

Head of Brazil Economics

55 11 3701 6288

[email protected]

Daniel Lavarda

55 11 3701 6352

[email protected]

Iana Ferrao

55 11 3701 6345

[email protected]

Leonardo Fonseca

55 11 3701 6348

[email protected]

Paulo Coutinho

55 11 3701-6353

[email protected]

EURO AREA / UK ECONOMICS

Neville Hill

Head of European Economics

44 20 7888 1334

[email protected]

Christel Aranda-Hassel

44 20 7888 1383

[email protected]

Giovanni Zanni

44 20 7888 6827

[email protected]

Violante di Canossa

44 20 7883 4192

[email protected]

Axel Lang

44 20 7883 3738

[email protected]

Steven Bryce

44 20 7883 7360

[email protected]

Mirco Bulega

44 20 7883 9315

[email protected]

EASTERN EUROPE, MIDDLE EAST AND AFRICA (EEMEA)ECONOMICSBerna Bayazitoglu

Head of EEMEA Economics

44 20 7883 3431

[email protected]

Turkey

Sergei Voloboev

44 20 7888 3694

[email protected]

Russia, Ukraine, Kazakhstan

Carlos Teixeira

27 11 012 8054

[email protected]

South Africa

Gergely Hudecz

33 1 7039 0103

[email protected]

Czech Republic, Hungary, Poland

Alexey Pogorelov

7 495 967 8772

[email protected]

Russia, Ukraine, Kazakhstan

Natig Mustafayev

44 20 7888 1065

[email protected]

EM and EEMEA cross-country analysis

Nimrod Mevorach

44 20 7888 1257

[email protected]

EEMEA Strategy, Israel

JAPAN ECONOMICS NON-JAPAN (NJA) ECONOMICS

Hiromichi Shirakawa

Head of Japan Economics

81 3 4550 7117

[email protected]

Takashi Shiono

81 3 4550 7189

[email protected]

Dong Tao

Head of NJA Economics

852 2101 7469

[email protected]

China

Robert Prior-Wandesforde

65 6212 [email protected]

Regional, India, Indonesia, Australia

Christiaan Tuntono

852 2101 [email protected]

Hong Kong, Korea, Taiwan

Santitarn Sathirathai

65 6212 5675

[email protected]

Regional, Malaysia, Thailand

Michael Wan

65 6212 3418

[email protected]

Singapore, Philippines

Weishen Deng

852 2101 7162

[email protected]

China

GLOBAL DEMOGRAPHICS & PENSIONS RESEARCH

Dr. Amlan Roy

Head of Global Demographics

44 20 7888 1501

[email protected]

Sonali Punhani

44 20 7883 4297

[email protected]

Angela Hsieh

44 20 7883 9639

[email protected]
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


17/17

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Investment principal on bonds can be eroded depending on sale price or market price. In addition, there are bonds on which investment principalcan be eroded due to changes in redemption amounts. Care is required when investing in such instruments.When you purchase non-listed Japanese fixed income securities (Japanese government bonds, Japanese municipal bonds, Japanese government guaranteed bonds, Japanese corporate bonds) from CS as a seller, youwill be requested to pay the purchase price only.
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credit suisse, jan 7, 2014, european economics. " 14 points for 2014"

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