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Central Bank of the Republic of Turkey 2. International Economic Developments Global growth forecasts for 2011 are slightly upgraded amid the global developments since the release of the October Inflation Report, while downside risks to the growth outlook remain vigorous. The growth discrepancy between advanced and emerging economies continued into the third quarter, with slowgrowing major advanced economies failing to reach pre-crisis GDP levels. Moreover, due to disappearing base effects and ebbing stimulus effects in many economies, the global growth rate is expected to slow down in 2011. The US economic growth in the third quarter has been close to its potential amid strong inventories, thus allaying concerns over the US growth outlook. This outlook is also buoyed by the stronger-than-expected data indicative of the final quarter of 2010. Furthermore, Fed's second round of quantitative easing and the fiscal package extending tax cuts and unemployment benefits have reinforced prospects for the US economy. In fact, the minutes of the latest FOMC meeting confirm that the Fed expects growth to pick up slightly further despite risk factors. High unemployment rates, the real estate market distress amid the renewed housing slump and weak credit expansion constitute downside risks. Although the US economy rebounded during the third quarter, the euro area growth slowed significantly owing to the decline in the demand for fixed investment following the tensions in the EU periphery. Expectations for a fiscal tightening across core euro area economies in 2011 create major uncertainty amid the weak growth outlook. The sovereign concerns in the peripheral countries are expected to shape the near-term growth outlook for the euro area (Box 2.1). Although the announced rescue packages have currently prevented the contagion of the Irish banking crisis, the prevailing high CDS rates for both government and commercial bonds indicate that the concerns have yet to be fully resolved. Moreover, struggling peripheral economies are facing a heavy debt redemption for the first half of 2011, aggravating concerns about sovereign debt sustainability. Despite low and fragile growth in advanced economies, emerging economies continued to grow rapidly in the fourth quarter. The most important element of uncertainty for emerging economies is the accelerated capital inflows fueled by the ongoing monetary expansion in advanced economies. Inflation Report 2011-I 17 Central Bank of the Republic of Turkey Accordingly, many emerging market central banks have more intensely adopted unconventional policy instruments in order to cushion their economies against loss of competitiveness and excessive credit expansion due to massive capital inflows. The period following the October Inflation Report was also marked by rising commodity prices, particularly of agricultural products. Since food accounts for a large proportion of the CPI basket in emerging economies, rising food prices would have a major impact on inflation. In addition, the recent depreciation of emerging market currencies adds an upside risk to inflation outlook in the short term. 2.1. Global Growth The global economic activity continues to recover slowly and gradually. Emerging economies, particularly Asian and Latin American economies, were the main drivers of global growth in the third quarter of 2010, while advanced economies remained fragile (Graph 2.1.1). The strong recovery in emerging economies brought production above pre-crisis levels. However, the global production index weighted by the share of each country in Turkish exports continued to hover below pre-crisis levels in the third quarter (Graph 2.1.2). The fact that Turkey's export destinations recover at a slower pace will continue to have a dampening effect on external demand in coming months. Graph 2.1.1. Aggregated Growth Rates (Percent) Graph 2.1.2. Export and GDP-Weighted Global Production Index* Advanced Economies Emerging Economies GDP-Weighted 10 148 8 146 Export-Weighted 144 6 142 4 140 2 138 0 136 -2 134 -4 132 130 -6 12341234123412341234123412341234123 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Bloomberg, CBRT. 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 2006 2007 2008 2009 2010 * 1996=100. Source: Bloomberg, CBRT. Production and inventory changes provided the largest contributions to the US growth in the third quarter, while the contribution of fixed investments decreased significantly (Table 2.1.1). Recent data also indicate that both the 18 Inflation Report 2011-I Central Bank of the Republic of Turkey second round of quantitative easing and the ongoing fiscal stimulus measures spur economic growth, despite the gloomy outlook for real estates and the labor market. Consumption and net exports continued to be the key drivers of the euro area growth in the third quarter, whereas fixed investments created a drag on growth. The fiscal tightening in the euro area, the weak external demand, the mounting concerns about the sustainability of the export-led growth in core economies and the renewed financial distress in the peripheral Europe all feed into the clouded outlook for euro area growth in the upcoming period. Table 2.1.1. Growth Decomposition in US and the Euro Area in 2010 (Annualized, Percent) USA 2010-I 2010-II 2010-III 2010-I 1.3 1.5 1.7 0.8 -0.3 0.8 0,8 0.0 0.4 2.1 0.2 -0.4 2.6 0.8 1.6 2.8 -0.3 -3.5 -1.7 -2.0 3.7 1.7 2.6 1.2 Private Consumption Public Sector Fixed Investment Inventory Changes Net Exports Total Euro Area 2010-II 0.4 0.0 1.6 1.6 0.4 4.0 2010-III 0.4 0.4 -0.4 0.4 0.4 1.2 Source: Bloomberg. The negative outlook of the labor markets in advanced economies continues to dampen private consumption and hence economic growth. The US unemployment declined to 9.4 percent in December, while the euro area unemployment rose to 10.1 percent in November (Graph 2.1.3). Given that the average unemployment spell is about 34 weeks in the US and the recently announced fiscal package extends the length of the unemployment benefit, the negative impact of unemployment on aggregate demand remains limited. The JP Morgan Global PMI, the most recent data for the fourth quarter, indicate that the third-quarter downtrend has ended as of September, with manufacturing and services PMI posting gains in the fourth quarter (Graph 2.1.4). Graph 2.1.3. Unemployment in Advanced Economies Graph 2.1.4. JP Morgan Global PMI (Percent) USA Manufacturing Euro Area 11 65 10 60 9 Services 55 8 50 7 45 6 Source: Bloomberg. Inflation Report 2011-I 2010 2009 2008 2007 2005 2010 2009 2008 2007 2006 2005 2004 2003 30 2002 3 2001 35 2000 4 2006 40 5 Source: Bloomberg. 19 Central Bank of the Republic of Turkey Consensus Economics revised its end-2011 global growth forecast slightly upwards after the October Inflation Report (Table 2.1.2), mainly owing to an upgrade in end-2011 US growth forecasts due to signs of a more robust US economic recovery. Overall, the growth discrepancy between advanced and emerging economies is expected to continue into 2011, albeit at a more moderate pace. Furthermore, uncertainties regarding the growth outlook for advanced economies may slow down the external demand of export-oriented emerging economies over the upcoming period, hence making growth in those economies to depend more on domestic demand. Table 2.1.2. Growth Forecasts World USA Euro Area Eastern Europe Latin America Asia-Pasific (Annual Percentage Change) 2010 October December 3.7 3.9 2.7 2.8 1.6 1.7 4.0 3.9 5.,4 5.6 6.4 6.6 2011 October 3.1 2.4 1.4 3.9 4.0 5.1 December 3.2 2.7 1.5 3.9 4.0 5.0 Source: Consensus Forecasts. 2.2. Commodity Prices Commodity prices were on rise during the fourth quarter amid the ongoing global economic recovery (Graph 2.2.1). Unexpected weather conditions affected food supply and energy demand, putting an additional upward pressure on food and energy prices. Moreover, during the same period, prices of industrial and precious metals continued to increase. Prices of precious metals have especially risen on higher demand for these metals as a hedge against inflation and economic risks. Meanwhile, crude oil prices picked up as production quotas remained unchanged at the latest OPEC meeting despite ample idle capacity. Oil producers violating quota limits have also cut production in order to improve compliance with OPEC's output quotas. In addition, adverse weather conditions drove crude oil prices higher (Graph 2.2.2). In fact, historically trading below WTI, Brent crude oil prices floated higher on the apparently wintry weather conditions in Europe. 20 Inflation Report 2011-I Central Bank of the Republic of Turkey Graph 2.2.1. S&P Goldman Sachs Commodity Prices* 180 Headline Energy Industrial Metals Agriculture Graph 2.2.2. Crude Oil (Brent) Prices (USD/bbl) Spot Futures (1-15 October 2010) Precious Metals 100 Futures (1-4 January 2011) 150 120 80 90 60 60 30 0712 0112 0711 0111 0710 0110 0709 0111 0710 0110 0709 0109 0708 0108 * January 2008=100. Source: Goldman Sachs. 0109 40 0 Source: Bloomberg. Economic growth is likely to be the key driver of energy prices in coming months, once the effects of bad weather conditions taper off. The brisk demand in emerging economies as well as the newly fiscal stimulus packages in advanced economies are expected to spur energy demand. However, the outlook for industrial metal prices would continue to rely on the growth performance of emerging economies. 2.3. Global Inflation CPI inflation has been trending upward in both advanced and emerging economies since the end of the third quarter of 2010 amid rising commodity prices and the ongoing global recovery. Core inflation has also edged up, particularly in rapidly recovering emerging economies (Graphs 2.3.1 and 2.3.2). Graph 2.3.1. CPI Inflation in Advanced and Emerging Economies Graph 2.3.2. Core CPI Inflation in Advanced and Emerging Economies (Annual Percentage Change) (Annual Percentage Change) Advanced Economies Advanced Economies 9 Emerging Economies Emerging Economies 5 8 7 4 6 5 3 4 3 2 2 1 0 1 -1 Source: Bloomberg, CBRT. Inflation Report 2011-I 0810 0410 1209 0809 0409 1208 0808 0408 1207 0807 0407 1206 0806 0406 0 1205 0810 0410 1209 0809 0409 1208 0808 0408 1207 0807 0407 1206 0806 0406 1205 -2 Source: Bloomberg, Datastream, CBRT. 21 Central Bank of the Republic of Turkey The global inflation forecast for end-2011 was slightly revised upward in December from the previous reporting period on higher inflation expectations for the Eastern Europe and Asia-Pacific, while, inflation forecasts for the US and the euro area remained unchanged (Table 2.3.1). Table 2.3.1. Inflation Forecasts (Annual Percentage Change) 2011 World USA Euro Area Emerging Economies Eastern Europe Latin America Asia-Pasific October 2.6 1.5 1.6 December 2.7 1.5 1.6 5.7 7.1 2.3 6.0 7.0 2.7 Source: Consensus Forecasts. 2.4. Financial Conditions and Risk Indicators In the fourth quarter, financial markets were dominated by the renewed concerns about the sovereign debt sustainability in the European periphery and the consequent rescue package, and the Fed's second round of quantitative easing. As a result, the USD/euro parity has exhibited sharp volatility. On the other hand, additional monetary expansion measures adopted by advanced economies helped foster expectations of a prolonged environment of low interest rates and ample liquidity in advanced economies, thus improving the global risk sentiment. Accordingly, emerging economies have attracted more capital in the form of portfolio investments. Graph 2.4.1. OIS Spread (Percent) 0.4 3-month USD 3-month Euro 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0111 1110 0910 0710 0510 0310 0110 0.0 Source: Bloomberg. Across money markets, the OIS spread on both USD and the euro has widened. The euro OIS spread was particularly wider on euro area debt woes (Graph 2.4.1). 22 Inflation Report 2011-I Central Bank of the Republic of Turkey Although the risk perception about struggling euro area economies has eased in early fourth quarter, mounting fears of a worse-than-expected Irish banking crisis and concerns about counterparty risk have pushed the risk premiums for other peripheral euro area economies higher (Graphs 2.4.2 and 2.4.3). Graph 2.4.2. CDS Rates in Selected Countries Graph 2.4.3. Bond Spreads in Selected Countries over German Bonds (Basis Point) (10-Year, Percent) Greece Portugal Ireland Spain 1200 1000 Greece 1200 Portugal Ireland 1000 1210 0910 0610 1210 Source: Bloomberg. 0310 0 1209 0 0609 200 0910 200 0610 400 0310 400 1209 600 0909 600 0609 800 0909 Spain 800 Source: Bloomberg. Despite Europe's sovereign debt problem, the global risk appetite picked up in the fourth quarter amid signs of an improved US growth outlook, driving investors towards higher-risk assets and markets (Graph 2.4.4). Accordingly, the risk premiums for emerging economies declined quarter-onquarter. After having appreciated until the end of October, emerging market currencies began depreciating amid debt woes and adopted policy measures by central banks (Graph 2.4.5). Graph 2.4.5. Exchange Rate and Risk Premium Indicators for Emerging Economies* Graph 2.4.4. Global Risk Appetite Credit Suisse Risk Appetite Index VIX (right axis-reversed) 10 8 6 4 0 140 15 130 30 2 45 0 -2 60 Currency Basket EMBI (right axis) 1500 1350 1200 1050 900 750 600 450 300 150 0 120 110 100 90 80 Source: Credit Suisse, Bloomberg. 70 1210 0810 0410 1209 0809 0409 60 1208 1210 0810 0410 1209 0809 0409 1208 0808 90 0408 -8 0808 75 -6 0408 -4 * Arithmetical average of the exchange rates of emerging market currencies against the currency basket of 1 euro and 1 USD. Equals 100 on June 2007 and an upward movement denotes depreciation in emerging market currencies. Source: Bloomberg. The growing risk appetite and ample liquidity helped stock markets rebound in both advanced and emerging economies (Graph 2.4.6). Fed's Inflation Report 2011-I 23 Central Bank of the Republic of Turkey quantitative easing policy and promising growth figures increased prospects of a rate hike in the US. Consequently, FOMC policy rate hike is expected to come sooner and be more sizeable than envisioned in October (Graph 2.4.7). Yet, the first rate hike is expected to come not earlier than the final quarter of 2011. Graph 2.4.6. Global Stock Markets Graph 2.4.7. Expectations of FOMC Rate Changes MSCI - Emerging Economies MSCI - Advanced Economies 0412 0112 0710 Source: Bloomberg. 1011 0.0 0711 50 0111 0.5 0110 100 0709 1.0 0109 150 0708 1.5 0108 200 0707 2.0 0107 250 0411 2.5 1012 January 29 April 30 July 30 October 29 December 31 0712 300 Source: Bloomberg. US loans dropped further in the fourth quarter, albeit at a slower pace. Yet, year-on-year changes are increasing due to base effects (Graph 2.4.8). In the euro area, although loans remained broadly stable, housing loans continued to rise steadily (Graph 2.4.9). Graph 2.4.8. Credit Developments in the US* Graph 2.4.9. Credit Developments in the Euro Area* (Annual Percentage Change) Business Loans Housing Loans 30 Consumer Loans Other Loans (Annual Percentage Change) Business Loans Housing Loans 30 Consumer Loans Other Loans 25 20 20 10 15 0 10 -10 * Off-balance sheet items have been consolidated into consumer loans and adjusted accordingly as of April 2010. Source: Fed. 2010 2009 2008 2007 2006 2004 2010 2009 2008 2007 2006 -5 2005 -30 2004 0 2005 5 -20 * 2008Q4 figures for insurance corporations and pension funds have been revised. Source: ECB. 2.5. Global Monetary Policy Developments Both advanced and emerging economies have yet to normalize policy rates that were slashed extremely during the crisis. While advanced economies have maintained quantitative easing in the fourth quarter, the fast-growing 24 Inflation Report 2011-I Central Bank of the Republic of Turkey emerging economies facing inflationary pressures have engaged in quantitative tightening. The previous Report indicated that the sovereign debt problems in the EU periphery created a major element of uncertainty about global growth prospects, and therefore, suggested that central banks would postpone the policy normalization process. Accordingly, excluding some Asia-Pacific and Latin American economies facing inflationary pressures, neither advanced nor emerging economies have started normalizing policy rates in the fourth quarter (Graphs 2.5.1 and 2.5. 2). Indeed, in aggregated indices, global policy rates were flat over the fourth quarter, and the composite policy rate for both advanced and emerging economies remained largely unchanged quarter-onquarter (Graphs 2.5.3 and 2.5.4). Graph 2.5.1. Policy Rate Changes in Advanced Economies* Graph 2.5.2. Policy Rate Changes in Emerging Economies* (Basis Point) (Basis Point) 200 100 0 0 -100 -200 -400 -200 -600 -300 -800 October 2010 - December 2010 -500 -1200 Israel Japan Australia Sweden Czech Rep. Norway S. Korea Canada UK USA N. Zealand Euro Area September 2007 - September 2010 -600 October 2010 - December 2010 -1000 September 2007 - September 2010 -1400 Turkey Colombia Chile S. Africa Peru Mexico Hungary Russia India Indonesia Thailand Poland Malaysia Brazil Romania -400 * As of December 2010. Source: Bloomberg, CBRT. Graph 2.5.3. Policy Rates in Advanced Economies Graph 2.5.4. Policy Rates in Inflation-Targeting Emerging Economies (Percent) (Percent) 5 20 18 4 16 14 3 12 10 2 8 6 Emerging Economies 2 Turkey* 0910 0510 0110 0909 0509 0109 0908 0508 0108 0907 0507 0107 0906 0 0506 0910 0510 0110 0909 0509 0109 0908 0508 0108 0907 0507 0107 0906 0506 0106 0 4 0106 1 * CBRT's overnight borrowing rate at the Interbank Money Market. Source: Bloomberg, CBRT. The quantitative easing across G3 economies that started in 2008 continued into the final quarter of 2010. In fact, following the first round of Inflation Report 2011-I 25 Central Bank of the Republic of Turkey quantitative easing that started in the last quarter of 2008 and ended in the first quarter of 2010, a second round was launched on November 3, 2010. The second package involving a purchase of 600 billion USD of securities by the end of the second quarter of 2011, is expected to put downward pressure on long-term interest rates and to reduce borrowing costs. However, the package has so far pushed long-term interest rates up rather than down (Box 2.2). Similarly, the Bank of Japan and the ECB continued to run an expansionary monetary policy in order to soothe markets in the last quarter of 2010 as well. Across emerging economies, central banks have resorted to quantitative tightening to control the potential effects of the additional easing packages implemented in advanced economies on their economies. Higher global liquidity fueled by the above policy measures in advanced economies has prompted a massive capital flow into emerging economies with higher yields, exposing these economies to various risks. This massive capital flow, by placing an upward pressure on exchange rates, may reduce the competitiveness, and thus, can adversely affect the economic activity. Moreover, the possibility of a sudden stop in capital flows warrants caution in terms of its potential threats to financial stability. In addition, an excessive capital inflow may put an additional pressure on the medium-term inflation outlook in emerging economies that are already facing inflationary pressures due to rapid growth. However, as raising policy rates to contain inflation will further accelerate capital inflows, emerging economies have adopted various restrictive capital controls to counteract any additional inflationary pressures (Table 2.5.1). Table 2.5.1 Quantitative Easing in Emerging Economies Changes in Required Reserve Ratio (Percent) Brazil Colombia Peru China Indonesia South Korea Philippines Taiwan Thailand India Poland South Africa Russia Turkey Capital Controls During the Crisis (-) After the Crisis (+) More Restrictions on Capital Inflow Less Restrictions on Capital Outflow 2 3 5 2 4 7 √ √ √ √ √ 3 3 3 √ √ Other Measures* √ √ √ √ 2.5 0.5 1.5 0.5 5 TL: 1 FX: 2 2 TL: 2.4** FX: 2 √ √ √ √ √ * Indonesia: Measures to encourage long-term investment. South Korea, Taiwan: Measures to control speculative flows. India: Measures to discourage external borrowing. Russia: Tax adjustments to discourage borrowing in foreign currency. ** As of January 7, 2011, required reserve ratio for TL has been diversified according to maturity of the deposits. The figure presented in the table is the weighted average. Source: Relevant Central Bank websites, CBRT Financial Stability Report December 2010. 26 Inflation Report 2011-I Central Bank of the Rep public of Turkey Asidde from cap pital controlls, required reserve ratios that weere lowered during thee crisis in order to helpp the lendin ng channel operate o effeectively are raised in most m emergiing economiies facing in nflationary pressures, p leeading to a tight monetary stancee. While m many emerg ging econom mies lowereed required d the exit from reserve raatios graduaally down to pre-crissis levels during expansionaary policies, Brazil andd China raised required d reserve raatios above pre-crisis levels to tame their skyrocketing inflation n. In sum,, emerging Pacific and Latin L Americca, opted foor monetary economiess, particularlly in Asia-P tightening in the previous quarter by using qu uantitative methods m (Tabble 2.5.1). Advvanced econo omies are eexpected to continue wiith quantitattive easing, while emeerging econ nomies are llikely to maintain m quaantitative tigghtening in coming months. m The sovereign debt crisis in the EU periphery sstill posing significantt downside risk to gloobal growth h confirms that policyy rates are unlikely too return to prre-crisis leveels in G3 ecconomies in the near futuure. Hence, a policy raate hike is not expecteed before th he last quartter of 2011.. However, many emerging econo omies, particcularly in Laatin America and Asia-PPacific, are t take a steep towards nnormalizing g monetary policies p by the second expected to quarter (Grraph 2.5.5). Graph 22.5.5. Expected Policy Rates (Basis Point) G3 1.6 Latin America Asia-Pacific A CEEM MEA 1.4 1.2 1 0.8 0.6 0.4 0.2 2011-IV 22011-III 2011 1-II Turkey Poland S. Africa Czech Rep. Thailand S. Korea India Philippines Indonesia China Peru Mexico Colombia Brazil Japan Euro Area USA 0 2011-I Source: Bloomberg. Inflation Repo ort 2011-I 27 Central Bank of the Republic of Turkey Box 2.1 The The Sensitivity of the EU Periphery to the Debt Crisis sovereign debt crisis that erupted in the peripheral euro area during the second quarter of 2010 poses downside risk to global growth. A possible contagion to other countries due to EU's integrated markets warrants a close monitoring of peripheral economies. This Box analyzes the vulnerability of peripheral economies amid the sovereign debt crisis that caused Greece and Ireland to request assistance from the EU, and discusses cross-border banking exposures, a key channel of contagion. During the rapidly spreading sovereign debt crisis in the EU periphery, firstly, Greece asked the EU to activate a rescue package due to problems about its sovereign debt rollover in May, and a bailout plan was announced on May 10. The similar and integrated structure of peripheral economies fueled concerns about Ireland, Portugal, Spain, Italy and Belgium with already distressed public and banking sectors. Indeed, Ireland requested financial assistance for its troubled banking sector, and EU announced a bailout plan on November 28. This Box derives a "vulnerability index" for the above-mentioned countries. The index is based on Gros and Mayer (2010)1 and uses eight variables including main indicators on public finances and economic activity as well as variables on sovereign default and banking vulnerability. The stance of public finance is captured by debt-to-GDP and fiscal deficit-to-GDP ratios. Requirement for external finance is measured by current account-to-GDP ratio, while economic activity is measured by the unemployment rate. Sovereign default risk is measured by the CDS rate and bond spreads from 10-year German bonds. In order to identify banking sector vulnerabilities, banking sector CDS rates and ECB funding have been included to the analysis. To make these various measures comparable, each variable, calculated as of the fourth quarter of 2010, is standardized by subtracting the cross-country mean and dividing by the standard deviation. The overall vulnerability index is the sum of these standardized variables where fiscal balance and current account balance have a negative sign. 1 Gros, D. and Mayer, T. (2010), "How to Deal with Sovereign Default in Europe: Create the European Monetary Fund Now!", CEPS Policy Brief, No. 202. 28 Inflation Report 2011-I Central Bank of the Republic of Turkey CDS Banking CDS ECB Funding*** Vulnerability Index 0.27 -1.28 0.07 1.74 1.70 1.09 0.69 7.52 -0.02 -2.01 0.55 0.30 0.41 0.53 1.14 1.60 5.41 Portugal -0.65 0.37 -1.07 -0.35 0.09 0.03 0.41 -0.45 -0.21 Spain -1.50 0.19 0.00 1.78 -0.49 -0.56 -0.71 -0.03 -1.69 Italy 0.93 0.59 0.52 -0.86 -0.76 -0.74 -0.93 -0.65 -4.12 Belgium 0.03 0.60 1.28 Source: Bloomberg, CBRT. * IMF end-2010 forecasts for Ireland, Greece and Portugal. ** As of 2010Q3 for Greece. *** As of November 2010 for all countries except Belgium. -0.94 -0.99 -0.97 -0.99 -1.16 -6.91 Current Account/ GDP* 1.21 Ireland Budget Balance/GDP Greece Debt Stock/GDP Unemployment** Bond Spreads over 10-year German Bonds Table 1. Vulnerability Index in the Euro Area Periphery Countries The index shows that Greece is the most vulnerable country in the euro area as of end-2010, followed by Ireland, Portugal, Spain, Italy and Belgium, respectively (Table 1). Reaching 130 percent of GDP, a strikingly high ratio compared to other countries, the government debt has been the major component of Greece's vulnerability, while banking sector vulnerabilities are much higher in Ireland. In fact, while Greece has faced a fiscal crisis, Ireland has faced a banking crisis. Despite the less damaged public finance, Portugal is the third most vulnerable country due to the significantly higher current account deficit and very high banking sector risks. In Spain, economic activity is still well below pre-crisis levels and unemployment rate hovers around a dramatic 20 percent as of end-2010. In Italy and in Belgium, the weakening public finances is a major concern. The debt stock-to-GDP ratio is 120 percent in Italy, well above the average of countries, and increases the vulnerability of the Italian economy. In Belgium, although the debt stock-to-GDP ratio hovers around the average, considering that the average 98 percent is already quite high, the high debt stock-to-GDP ratio stands out as the primary driver of the Belgian economy’s vulnerability. The above table shows that one of the major factors that increase the vulnerability of these countries is the vulnerabilities in the banking sector. Given that the crisis in Ireland has erupted in the banking sector and in view of the integrated structure of the EU banking sector, a cross-border contagion among EU banking systems is very likely. Figure 1 shows the liabilities of peripheral banks to foreign banks. In this context, German and UK banks are Ireland's two biggest creditors, and therefore, a crisis in Irish banks would directly affect German and British banking systems. In Portugal, the third most vulnerable economy after Greece and Ireland, domestic banks are mostly debtor to Spanish banks. Thus, given the high banking sector vulnerability in Portugal, a potential problem in Portuguese banks may adversely affect Spain's large banking sector. As the biggest creditors of Spanish banks are German, British and French banks, a problem in the Spanish banking system may have a direct and significant impact on the banking systems of EU's core economies. Hence, a “default” risk in the peripheral banking systems carries the potential to significantly damage the banking sectors of core EU countries. Inflation Report 2011-I 29 Central Bank of o the Republic of o Turkey Figure 1. Euro Area Perihperaal Countries Cross-Borrder Banking Sector Liabilities L * (Billion USD, Gross) Ireland Greece Portugal 138.6 6 36.8 62 2.6 37.22 49.8 2283.9 50.1 14 48.5 53.5 1.0 2.0 41.9 12.0 222.4 68.7 144.0 7.5 78.3 2.1 27.3 Italy Spain 3.1 Belgium 35. 1 153.7 253.1 181.6 384.9 353 3.6 195.3 418.9 4 110.8 162.4 0.0 2 21.0 47.1 5.7 32.6 38.00 66.8 32.5 40.0 18 8.9 29.2 * As of June 2010. Source: BIS. In sum, vulnerabilities of the EU's pperiphery couuntries mainly originate frrom public and bank king sectors, and a any pro oblems in the ese countries would spill o over across core coun ntries, especiially via the b banking secttor. The sovereign debt c crisis should be closely y monitored given the pe eriphery's alre eady trouble ed public fina ances and high bank king sector rissks as well as the sizeable redemption payments d ue in 2011. It is critica al for periphe eral econom mies to take all necessary y measures iin order to alleviate concerns c abo out debt susttainability an nd ensure a healthy h bankking system over the upcoming u pe eriod. 30 Inflation Re eport 2011-I Central Bank of the Republic of Turkey Box 2.2 With Causes of the Increase in the US Long-Term Nominal Bond Returns Following the Second Round of Quantitative Easing short-term interest rates approaching the zero bound, central banks in advanced economies have resorted to unconventional monetary policies. One of these policies has been the Fed's recent announcement of a second round of "quantitative easing". This program which aims to purchase a total of 600 billion USD of long-term Treasury securities by the end of the second quarter of 2011, was first announced in Fed Chairman Bernanke's Jackson Hole speech on August 28, 2010 and put into effect on November 3, 2010. The above purchase may either lower real and nominal bond yields amid increased money supply or Graph 1. Yields on 10-Year US Bonds 4.5 Launch of the Second Quantitative Easing Bernanke's Jackson Hole Speech 4 push them up through increased prospects for growth and inflation. After the launch of the second quantitative easing program, long- 3.5 3 2.5 term (10-year) bond yields have arguments that the program has failed. Indeed, some call the 0111 1210 1110 1010 0910 0810 0710 0610 0510 0410 0310 0210 2 0110 trended upward (Graph 1), fueling Source: Bloomberg. program ineffective due to rising yields, while some argue that the program has a negative impact on inflation expectations. This Box suggests that the increase in yields may not be due to the failure of the program, but rather due to normalization of growth and inflation expectations. In order to better interpret this yield increase, the first factor to consider is the strong possibility that bond prices were affected in advance as the program was announced a few months before the launch date. The announcement of the launch date has merely served to inform about the size of the program. As the second round of purchases is not as high as, and in fact, smaller than expected, the announcement of the launch date is unlikely to cause bond yields to fall or inflation expectations to deteriorate. Inflation Report 2011-I 31 Central Bank of the Republic of Turkey Another factor to consider is the Table 1. National Income and Inflation Forecasts for US National Income 2010 2011 3.3 3.1 3.1 3 2.9 2.8 2.7 2.4 2.7 2.4 2.7 2.4 2.8 2.7 difficulty to isolate the program's effects Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 from other influencing developments in the same period. The most important of these simultaneous developments are the favorable readings on the US economy during and after the launch Inflation 2010 2011 1.7 1.7 1.7 1.5 1.6 1.4 1.6 1.4 1.6 1.5 1.6 1.4 1.6 1.5 Source: Consensus Forecasts. of the program, and prospects of a robust growth replacing double dip fears. Table 1 shows the month-on-month Consensus Economics forecasts of 250 participants with strong expertise in producing financial and economic forecasts for the US economy. Growth forecasts were revised downward until the announcement of the program, remained flat between the announcement and the launch date, and have been upgraded following the launch date. The bond yields in Graph 1 are largely consistent with the growth forecasts in Table 1. Put differently, the announcement to 6 European sovereign debt crisis and 5 rising double dip concerns (Graph 4 quantitative easing coincides with the beginning of the period of 2 0111 0110 -6 0109 1 0108 hand, the launch date of the 0 0107 yields further down. On the other 3 0106 into safe-haven US bonds, pushing 0105 2). In this period, investors rushed 12 6 0104 due 0103 appetite 0102 risk EU Sovereign Debt Crisis Credit Suisse Risk Appetite Index (right axis) 0100 slumping 10-year US Bonds 7 0101 date coincides with a period of Graph 2. Risk Appetite and Nominal Yields on US Bonds Source: Bloomberg, Credit Suisse. growing risk appetite amid relatively eased concerns about European debt problems and a double dip recession, putting upward pressure on yields. It is difficult to single out the effects of the second quantitative easing program where the growing risk appetite is expected to push yields up. 32 Inflation Report 2011-I Central Bank of the Republic of Turkey The current nominal yields in the bond market can be explained by the increases in real interest rates and/or the rise in inflation expectations fueled by increased prospects of growth. The average 10-year real interest rates can be derived from the yields on inflation-indexed bonds. The real interest rates on inflation-indexed bonds are correlated with growth Nominal Yields on 10-year US Bonds Real Yields on 10-year US Bonds 10-year Inflation Compensation (right axis) remains unchanged, changes in nominal rapidly on November's positive labor force data and announcement of tax incentives in 1.5 1 1 0.5 0.5 0 0 0111 increased 2 1.5 1210 but first 2.5 2 1110 announcement, the 3 1010 after rates 0910 interest 3.5 2.5 0810 declined real 4 0710 Accordingly, 4.5 3 0210 changes in inflation expectations.2 4 Bernanke's Jackson Hole Speech 3.5 0110 minus real interest rates reflect 0610 premium Graph 3. Nominal and Real Yields on 10-Year US the 0510 risk that 0410 inflation Assuming 0310 prospects. Source: Bloomberg. December (Graph 3). Hovering around record lows during the first announcement in August, inflation expectations increased gradually back to more normal levels afterwards. To sum up, the recent upsurge in nominal US bond yields points to a normalization in growth and inflation expectations. The current levels of interest rates can be interpreted as a correction driven by expectations of a higher growth and the eased uncertainty about double dip concerns and the European debt crisis. Yet, the effects of quantitative easing cannot be clearly distinguished. The fact that the decline in inflation expectations has ended and even been reversed after the announcement of the second round of quantitative easing can be interpreted as the contribution of the program to normalization. However, the fact that the inflation compensation but not real interest rates has increased during both the announcement and the launch of the program (Graph 3), suggests that market participants expect the program to have a limited impact on economic growth in the long run. The main factors affecting near-term growth prospects are favorable economic data and announcements of fiscal incentives. 2 Assuming that inflation risk premium increases on heightened uncertainty, the increase in inflation compensation cannot be fully attributed to rising inflation expectations. Inflation Report 2011-I 33 Central Bank of the Republic of Turkey 34 Inflation Report 2011-I