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Dear R. Hunter,

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


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


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

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

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

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

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

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


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


As always, we welcome any questions or comments.


Best regards,

David Hale

Chairman


David Hale Global Economics, Inc.

546 Lincoln Avenue, 2 nd Floor

Winnetka, Illinois 60093 USA


847-386-6009 (tel)

847-386-6011 (fax)

davidhale@davidhaleweb.com

LinkedIn Profile

http://www.linkedin.com/pub/david-hale/18/ba8/595

http://davidhaleweb.com

http://davidhaleweb.com/

http://whatsnextbook.com

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Will the US Avert the Fiscal Cliff?

By David Hale

KEY CONCLUSIONS

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

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

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

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

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

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

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

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

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

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

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

• Indian growth and inflation results continue to disappoint the markets

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

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


THE FOUR LARGEST ECONOMIES FACE DIVERSE CHALLENGES


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


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


US GROWTH TO WEAKEN THIS QUARTER


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


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


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


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


THE HOUSING SECTOR IS DRIVING US GROWTH


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


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


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


FISCAL DRAG IS INEVITABLE IN 2013


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


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


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


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


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


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


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


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


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


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


CORPORATE PROFITS WILL BE WEAKER THAN EXPECTED IN 2013


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


GROWTH OUTLOOK SUBDUED UNTIL BUSINESS CONFIDENCE RECOVERS


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


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


FURTHER CONTRACTION IS EXPECTED IN EUROPE IN THE FOURTH QUARTER


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


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


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


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


CAN FRANCE AVERT A CRISIS?


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


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


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


CHALLENGES REMAIN IN THE EU


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


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


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


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


THE UK SLOWLY EMERGES FROM RECESSION


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


TUMULTUOUS YEAR AHEAD FOR JAPAN


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


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


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


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


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


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


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


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


NEW LEADERSHIP IN CHINA


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


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


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


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


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


EAST ASIAN GROWTH DIVERGES


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


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


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


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


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


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


INDIA'S GROWTH POTENTIAL WEAKER THAN EXPECTATIONS


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


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


AUSTRALIAN AND CANADIAN MONETARY POLICY DEPEND ON EXOGENOUS FACTORS


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


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


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


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


BRAZILIAN GROWTH TO REBOUND STRONGLY IN 2013


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


The B