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The Global Economy Challenges to Recovery Prof. Jacob A. Frenkel Chairman, Merrill Lynch International The Global Economy Challenges to Recovery Prof. Jacob A. Frenkel Chairman, Merrill Lynch International Former Governor of the Bank of Israel 9 th Dubrovnik Economic Conference Dubrovnik June 26 – 28, 2003

Table of Contents n The US economy: Background and Challenges n A more sustainable Table of Contents n The US economy: Background and Challenges n A more sustainable growth outlook n Private sector reacts to challenges n A timely policy response n The path to economic recovery n Downside risks n Asset market vulnerability n Unwinding the current account deficit n Geo-political instability and oil shocks n Euroland economic outlook n Japan economic outlook n Emerging Asia and Latin America n Global Recessionary Deflation? June 18, 2003

US Economy Enjoys High Productivity % year-on-year 1998 -2002 average = 2. 7% Non-farm US Economy Enjoys High Productivity % year-on-year 1998 -2002 average = 2. 7% Non-farm Productivity, last data point: Q 1 03 Source: Bureau of Labour Statistics June 18, 2003

Background and Challenges n Non-sustainable rapid growth in the 1990 s led to a Background and Challenges n Non-sustainable rapid growth in the 1990 s led to a series of real and financial imbalances n Bubbles burst in tech sectors and telecoms with fallouts in financial and real markets n Profit crunch required cost reduction n Manufacturing sector declined, employment weakened n Terrorism (9/11) damaged economic confidence n Corporate governance crisis damaged financial integrity n Confidence crisis and recession required policy response n Iraq crisis: before and after June 18, 2003

Boom, Gloom and Modest US Recovery Quarterly Real GDP (4 Quarter percentage change) Actual Boom, Gloom and Modest US Recovery Quarterly Real GDP (4 Quarter percentage change) Actual Numbers ML Forecast Source: Bureau of Economic Analysis, last data point: Q 1 03 Average 1996 -2000: 4. 0% Average 2001 -2002: 1. 4% Average 2003 -2004: 2. 8% June 18, 2003

A More Sustainable US Growth Outlook n A flexible, competitive and deregulated economy enables: A More Sustainable US Growth Outlook n A flexible, competitive and deregulated economy enables: n A smooth response by corporates and households n A timely policy response n Real GDP growth forecast: 2. 2% in 2003, 3. 4% in 2004 n Capital spending starts to recover; limited overhang n Consumer spending less buoyant but still robust n High and rising productivity yields a jobless recovery n Housing market remains a solid pillar June 18, 2003

Quick Reaction of Economic Agents and Policies n A flexible and adaptable economy, with Quick Reaction of Economic Agents and Policies n A flexible and adaptable economy, with low inflation and moderate public debt has facilitated: n An effective private sector response: n A significant reduction in labor costs n A rapid adjustment of inventories n Mitigating the profit crunch n An effective policy response: n A decisive and timely monetary policy response n A series of fiscal stimulus packages June 18, 2003

Profit Crunch Requires Adjustment % 1992 -2002 average = 10. 1% Profits as Share Profit Crunch Requires Adjustment % 1992 -2002 average = 10. 1% Profits as Share of Non-Financial Corporate GDP Source: Bureau of Economic Analysis, last data point: Q 1 03 US Recession June 18, 2003

Companies Lay Off Workers to Cut Costs US Job Loss Jan 01 -Dec 02 Companies Lay Off Workers to Cut Costs US Job Loss Jan 01 -Dec 02 > 1. 9 m SA Unemployment Rate, as % of Total Civilian Labour Force Source: Bureau of Labour Statistics, last data point: May 03 June 18, 2003

Unit Labour Cost Pressures Have Declined % change US Recession Source: Bureau of Labour Unit Labour Cost Pressures Have Declined % change US Recession Source: Bureau of Labour Statistics; Unit Labour Costs, Non-farm Business Sector, last data point: Q 1 03 June 18, 2003

US Inventory Reflects Flexibility % change Inventories cut by $250 bn in one year US Inventory Reflects Flexibility % change Inventories cut by $250 bn in one year Manufacturing & Wholesale Inventories, 3 Month % Change, Annualised Source: Census Bureau, last data point: Apr 03 June 18, 2003

Decisive US Fed Rate Cuts Federal Funds Target Source: Federal Reserve Bank of New Decisive US Fed Rate Cuts Federal Funds Target Source: Federal Reserve Bank of New York June 18, 2003

In a Low Inflation Environment % year-on-year 10 year average = 2. 5% Source: In a Low Inflation Environment % year-on-year 10 year average = 2. 5% Source: Bureau of Labour Statistics, Merrill Lynch forecast June 18, 2003

Reinforced by Ample Fiscal Stimulus US Budget Balance as % of GDP Source: IMF Reinforced by Ample Fiscal Stimulus US Budget Balance as % of GDP Source: IMF World Economic Outlook, April 2003 US Gross Public Debt as % of GDP June 18, 2003

Capital Spending Leads the Recovery % change New Orders of Non-Defense Capital Goods, % Capital Spending Leads the Recovery % change New Orders of Non-Defense Capital Goods, % change year-on-year Source: Census Bureau, last data point: Apr 03 June 18, 2003

US Tech Spending Recovers % change Real Capital Spending on Tech Equipment & Software, US Tech Spending Recovers % change Real Capital Spending on Tech Equipment & Software, % change quarterly Yo. Y Source: Bureau of Economic Analysis, last data point: Q 1 03 June 18, 2003

Mortgage Refinancing Supports Consumption Mortgage Application Index for Refinancing Households “cash out” $150 -200 Mortgage Refinancing Supports Consumption Mortgage Application Index for Refinancing Households “cash out” $150 -200 bn in 2002 4 Week Moving Average US Recession Source: Mortgage Bankers Association, last data point: 3 rd June 03 June 18, 2003

US Retail Sales Rebound and Stabilise % year-on-year Source: Census Bureau, Retail Sales ex-autos, US Retail Sales Rebound and Stabilise % year-on-year Source: Census Bureau, Retail Sales ex-autos, last data point: May 03 June 18, 2003

Robust US Housing Starts 10 year average US Recession Source: Census Bureau; Single-Family Housing Robust US Housing Starts 10 year average US Recession Source: Census Bureau; Single-Family Housing Starts, 000 s, SAAR, last data point: May 03 June 18, 2003

The Recovery Remains Jobless % Yo. Y growth Source: BEA, BLS, last data point: The Recovery Remains Jobless % Yo. Y growth Source: BEA, BLS, last data point: Employment May 03, GDP Mar 03 June 18, 2003

Global Growth Outlook Merrill Lynch Forecasts, June 2003 (*) IMF forecasts June 18, 2003 Global Growth Outlook Merrill Lynch Forecasts, June 2003 (*) IMF forecasts June 18, 2003

Downside Risks n Vulnerable Asset Markets Could further Affect Confidence n The investment rebound Downside Risks n Vulnerable Asset Markets Could further Affect Confidence n The investment rebound could be short-lived n Household spending could retrench n Disorderly Unwinding of US Current Account Deficit if: n Foreign investors reduce holdings of US assets n US Dollar weakens and forex markets remain volatile n US savings recover too rapidly n US investment recovers too slowly n Geo-political Instability and Oil Shocks n Global recessionary deflation? June 18, 2003

Risk Aversion in US Markets Risk Aversion Index, 30 days moving average Accounting scandals Risk Aversion in US Markets Risk Aversion Index, 30 days moving average Accounting scandals Russia/LTCM collapse September 11 Fall of Baghdad Index composed of Equity Implied Volatility, Swap Spreads & Spread Ratio between BBB & BB Corps Source: Merrill Lynch, last data point: 17 June 03 June 18, 2003

High US Corporate Debt Ratio 10 year average = 75% Long-Term Debt/Income, all Manufacturing High US Corporate Debt Ratio 10 year average = 75% Long-Term Debt/Income, all Manufacturing Industries Source: Census Bureau, last data point: Q 4 02 June 18, 2003

US Corporate Debt Servicing Manageable % Current = 14. 3% 10 year average = US Corporate Debt Servicing Manageable % Current = 14. 3% 10 year average = 12. 8% Interest Expense/EBITDA Source: Bureau of Economic Analysis, last data point: Q 1 03 US Recession June 18, 2003

Corporate Bond Defaults Rise Globally US$ bn No. of issuers Amount defaulted No. of Corporate Bond Defaults Rise Globally US$ bn No. of issuers Amount defaulted No. of issuers Insert Footnote Text Source: Standard & Poor’s June 18, 2003

US Corporate Credit Ratings Worsen US$ bn US rating actions by value Source: Standard US Corporate Credit Ratings Worsen US$ bn US rating actions by value Source: Standard & Poor’s June 18, 2003

Are Residential Prices Sustainable? Residential Price Indices , 1992 =100, logarithmic scale UK USA Are Residential Prices Sustainable? Residential Price Indices , 1992 =100, logarithmic scale UK USA France Japan Italy Germany Source: Bank for International Settlements June 18, 2003

A Rising Current Account Deficit Current Account balance as % of GDP Source: Bureau A Rising Current Account Deficit Current Account balance as % of GDP Source: Bureau of Economic Analysis, Merrill Lynch June 18, 2003

Risks to External Financing of Deficits n US current account deficit projected to remain Risks to External Financing of Deficits n US current account deficit projected to remain above 4% of GDP, worsening net foreign liability position n A potentially disorderly unwinding of US current account deficit is possible if: n Loss of confidence or a shift in portfolio preferences reduces foreign investors appetite for US assets n US Savings recover too quickly n US Investments recover too slowly n Possible disruption of exchange rates and interest rates June 18, 2003

Foreign Investors Withdraw from US Markets US$ bn, 12 months moving average Foreign Purchases Foreign Investors Withdraw from US Markets US$ bn, 12 months moving average Foreign Purchases of US Corporate Bonds Foreign Purchases of US Stocks Source: Federal Reserve, last data point: Mar 03 June 18, 2003

US Dollar Weakens US$/Euro Source: Bloomberg June 18, 2003 US Dollar Weakens US$/Euro Source: Bloomberg June 18, 2003

Oil Price (WTI) $/bbl 01/17/91 - Operation Desert Storm begins 02/28/91 - Cessation of Oil Price (WTI) $/bbl 01/17/91 - Operation Desert Storm begins 02/28/91 - Cessation of war 08/01/90 - Iraq invades Kuwait Source: Bloomberg June 18, 2003

Fiscal Consolidation and Convergence Budget Balance as % of GDP Germany France Spain Italy Fiscal Consolidation and Convergence Budget Balance as % of GDP Germany France Spain Italy Source: IMF, April 2003 June 18, 2003

Euroland Economic Outlook n Euro strength & US weakness dampen growth prospects n Unemployment Euroland Economic Outlook n Euro strength & US weakness dampen growth prospects n Unemployment is rising again n Business & consumer confidence are falling n Controversies concerning the “stability and growth” pact n The German engine is lagging n Structural measures are essential for future growth European Recovery Lags Behind US June 18, 2003

Euroland Recovery Lags Behind US % Real GDP Growth Source: Merrill Lynch forecasts June Euroland Recovery Lags Behind US % Real GDP Growth Source: Merrill Lynch forecasts June 18, 2003

Long Term Recession in Japan Real GDP %, Yo. Y OECD 10 -year Avg Long Term Recession in Japan Real GDP %, Yo. Y OECD 10 -year Avg = 2. 4% Japan 10 -year Avg = 0. 5% Source: ESRI, Merrill Lynch forecasts June 18, 2003

Fiscal Laxity has Created Public Debt Problem Japan Budget Balance as % of GDP Fiscal Laxity has Created Public Debt Problem Japan Budget Balance as % of GDP Source: IMF World Economic Outlook, April 2003 Japan Gross Public Debt as % of GDP June 18, 2003

Slow Progress on Japanese Bank Restructuring n A few major banks start to deal Slow Progress on Japanese Bank Restructuring n A few major banks start to deal with bad loans and strengthen their capital base But… n Under-provisioning for bad loans persists n Weak capital base and low profitability of banks limit speed of bad loan disposal n Market confidence in financial sector is low June 18, 2003

Asian Economic Outlook n Growth remains strong across Asian region: n China and India Asian Economic Outlook n Growth remains strong across Asian region: n China and India insulated by strong local markets n Tech-dependent Asia pulled by policy easing n Countries with strong policy frameworks experience stronger growth n High level of foreign reserves and current account surpluses have reduced vulnerability n Incomplete corporate and bank restructuring Solid Recovery Continues In 2003 June 18, 2003

Latin America Economic Outlook n Smaller fiscal deficits and lower inflation are key n Latin America Economic Outlook n Smaller fiscal deficits and lower inflation are key n Corporate governance and political stability remain critical factors n Region dependent on capital inflows n Argentina: needs to be reborn Brazil: on the road to recovery and Chile: bright spots Venezuela, Ecuador and Peru: in trouble Mexico Outlook Reflects Domestic Policies and US Growth June 18, 2003

Global Recessionary Deflation? n US: Very unlikely n Flexible and competitive economy n High Global Recessionary Deflation? n US: Very unlikely n Flexible and competitive economy n High productivity growth n Decisive policy response n Euroland: Unlikely but watch for Germany n Benefits from single currency and convergence n Structural rigidities n Political and institutional challenges n Japan: In the midst of deflation n Rigid policy framework n Needs financial restructuring If US and Europe Stay the Course, Global Recessionary Deflation Will Be Avoided June 18, 2003

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