Outlook 2014 - Recovery on a shaky footing
The Dutch economy will not grow in 2014. Unemployment will rise further, and the slight boost provided by the global growth spurt will not be vigorous enough for the country to overcome its domestic woes. US economic performance and the modest eurozone recovery account for more than half the global growth spurt.
We are pleased to present the 25th edition of our Outlook. Since 1988, we have been sharing our macroeconomic vision with our clients towards the end of the year. A lot has changed in these 25 years. At the same time, many of today’s themes have regularly reoccurred. In our 1989 publication, for instance, we wrote about the economic uncertainties regarding actions taken by the US politicians and the Federal Reserve. The first edition of our Outlook presented two scenarios for the development of the global economy that was largely dependent on the conduct of fiscal and monetary policy in the US. And 1988 was also the year in which the Dutch business community raised many questions about the fulfilment of the European Single Market. Naturally, our economists devoted much attention to this topic by listing the possible consequences for the various business sectors.
In the Outlook 2014 as well, US economic policy as well as developments associated with the European integration play an important role. However, both the political impasse in the US and the ‘tapering’ of the Fed’s extremely accommodative monetary policy would appear to involve greater uncertainties than the situation at the time of President Bush senior and the then Fed Chairman Alan Greenspan. As regards European integration, the situation today features scepticism about the European project and uncertainty regarding the progress of the still ongoing crisis, while the arrival of the Single Market at that time created business opportunities. One thing that has not changed is our desire to approach this uncertain world with an open mind, and to identify the most relevant financial and economic developments for our clients as far as possible.
Looking at the global economy, we can see that growth in 2013 was slightly lower than we expected last year, mainly because the recovery in the eurozone is taking longer to materialise. We are, however, on the right track, and combined with the expectation of growth acceleration in the US, our economists are forecasting a further pick-up in global activity in 2014.
The improved external environment can provide some minor support to the Dutch economy. Unfortunately, this will not be sufficient to outweigh our domestic problems. The weak balance sheets of the government, consumers and banks is an obstacle to any powerful recovery. In the opinion of our economists, government policy is geared too much towards reducing the budget deficit in the short term instead of focusing on structural reforms. Overall, we do expect the contraction of the Dutch economy to come to an end in 2014.
As in every year, all these forecasts are subject to great uncertainties. Indeed, these uncertainties have only become more acute since the financial crisis. Uncertain outcomes of political decision-making processes in the US, Europe and the Netherlands could significantly affect our forecasts. The weak financial position of European banks could derail the recovery. There is also the possibility that the Fed’s monetary policy will surprise us going forward. This could lead to a different scenario for interest rate movements, and also significantly affect exchange rates around the world.
All these uncertainties affect the growth of the Dutch economy. The internal situation in the Netherlands could work out more favourably than we expect. A stronger upward movement in the housing market than currently expected would strengthen households’ balance sheets, and would thereby result in higher domestic consumption.
Policymakers continue to bear a heavy responsibility. If they have the courage to take the right decisions, we can look forward to a better economy next year. It could even be a year in which the downside risks can be converted into upside potential around the world.
For now, I hope you enjoy reading this year’s Outlook and that it will provide some inspiration, and I wish you and those close to you much health, happiness and success in 2014.
Chairman of the Executive Board
Global economic outlook: Policy decisions are key
The global economy is expected to grow by 3¼% in 2013 – slightly less than the 3¾% forecast by Rabobank last year (figure 1). The pace of recovery in the eurozone, in particular, again has disappointed. Meanwhile, Japan’s economy has surprised on the upside, where ‘Abenomics’ (the term referring to the radical approach introduced by Prime Minister Abe) buoyed growth. Looking at the bigger picture, we note that growth is slowly shifting from the emerging markets (EMs) to the industrialised world (figure 2). This is due to several factors, including the decision of the new Chinese leadership to prioritise reforms over unsustainably high growth, causing a slowing demand for raw materials, which has softened growth in the commodity-producing countries. The announcement of tapering of the asset purchase programme by the US Federal Reserve only reinforces this trend, and serves as a powerful reminder that quantitative easing is not here to stay. This has prompted investors worldwide to re-focus on the underlying economic fundamentals, and with capital being withdrawn from some of the weaker EMs. The bubbles created as a result of surging capital inflows in the past few years are starting to deflate.
Global GDP growth – on the back of a stronger growth momentum in the US and the long-expected return to a moderate pace of growth in the eurozone – could well reach 3¾% in 2014. And here, in essence, are the main risks currently facing the economy. The euro crisis did not return to its acute phase in 2013 but in order to keep it at bay over the longer term, Europe’s political leaders will need to take radical and forceful measures to further strengthen European integration. This would include further progress on the banking union and finding a solution to the current (hidden) bad debt on banks’ balance sheets. This would allow the Southern European banking system, in particular, to start contributing positively to the recovery. As for the growth forecast in the US, the political crisis in October 2013 over the Budget and the debt ceiling drove home the fact that the main risks here, also, are policy-related; the doom scenario being an actual default by the US government. If this scenario pans out, the impact of the recent government shutdown following failure to reach a compromise on the government Budget will seem like child’s play by comparison. While we consider default by the US as unlikely as we did a collapse of the euro in recent years, if the risk rises – which it may well do on more than one occasion – it could end up stifling US growth, which would have a significant impact on the global economy.
The dynamics of the major economic experiments
US: political deadlock eclipses successful policies
Highly stimulative fiscal and monetary policies – including three major rounds of quantitative easing  and only very gradual fiscal consolidation – have provided a relatively solid basis for the US economic recovery. The housing market has been on an upward trajectory for some time, spurred by very low interest rates and supportive fiscal measures. Where we identified the first real signs of a recovery in our Outlook 2013 report (published at the end of 2012), property values have actually been rising for more than 18 months now (figure 3). As a result, households have been better able to repair their balance sheets, which has also improved economic sentiment. Investments in property are also visibly boosting construction activity.
Figure 3: Housing market recovery
Source: Reuters EcoWin, Rabobank
These positive factors enabled the economy to absorb the fallout from the partial fiscal cliff  and the steep automatic cuts implemented this spring (a direct result of the political polarisation that prevented Republicans and Democrats from reaching agreement on alternative austerity measures). Although tax increases and automatic spending cuts implemented in 2013 amounted to approximately 2.5% of GDP, the economy still managed to grow steadily during the first six months of the year (1½% y-o-y in real terms). This actually had a positive effect on the US’s twin deficits – defined as the combined deficit in both the current account balance and the government budget balance (figure 4) – particularly in conjunction with the impact of the ‘shale gas revolution’ (box 1).
Figure 4: Narrowing Twin Deficits
Source: IMF, Rabobank
Nevertheless, additional, structural measures will be required when it comes to both pensions plans and the healthcare system in order to ensure the long-term sustainability of public finances.
Box 1: Shale gas on a macroeconomic scale
New, advanced drilling techniques are now being used that facilitate deeper horizontal drilling in vertical drilling wells. Combined with hydraulic fracturing (a process also known as ‘fracking’), this has made it possible to extract large quantities of shale gas and shale oil from the deep layers of sedimentary rock in which they are stored. In order to release the energy, the rock is fractured through the high-pressure injection of chemicals and water. Due to the environmental risks involved in this process, the United States is currently the only country engaged in large-scale shale-gas extraction. This form of energy generation has already reduced US gas prices to 20% and 25% of the Japanese and European price levels, respectively. In addition, it is estimated that the US will eventually be able to extract roughly three million barrels of shale oil a day – more than 3% of the daily global oil production (IMF, 2013e).
The macroeconomic impact of this development can roughly be divided into three channels. The first of these is the availability of affordable shale energy –particularly gas– which has provided the US industrial sector (most notably the petrochemical industry) with a price-competitive advantage (Marey and Koopman, 2013). Second, shale-energy extraction requires substantial investments, also to expand the associated industrial activity and –on a limited scale– build export facilities for liquefied shale gas. Third, shale-oil extraction in the United States –all other things being equal– will slow down the increase in global oil prices more significantly than we would have anticipated otherwise. A case in point: US net imports of raw oil have halved in the past five years alone. Shale-gas extraction obviously also drives down global energy prices, even though, due to the limited marketability of the gas (at least in the short term), this translates mainly into a lower US demand for coal.
We have attempted to quantify the macroeconomic effects of shale-gas extraction using the NiGEM macro-econometric model (Bruinshoofd, Smolders and Weernink, 2013). For US energy prices, we’re counting on a drop in gas prices of almost 50 percent and a slight decline in oil and electricity prices. Additionally, we expect that these dips in price on a national level will be fully passed on to export prices. The decline in the overall US price level (by 0.2%) is nevertheless limited due to the modest share of energy costs in total production costs (≈2%) When it comes to US investment, we expect a one-off boost (equivalent to approximately 0.5% of GDP) in order to facilitate the extraction of shale gas and shale oil and build more industrial processing facilities. Furthermore, we expect ongoing investment (of approx. 0.6% of GDP) to be required for shale-gas extraction; this investment will increase over time. Finally, global oil prices are expected to be approximately 8% lower than in the baseline projection without shale gas.
Despite this being a broad-strokes picture, we can say that the first two channels mainly affect US macroeconomic values and that the rest of the world will be able to benefit from US-based shale-energy extraction mainly through the third channel (figure Box 1). For oil-exporting countries – including Russia, as pictured – the impact is negative due to the deteriorated terms of trade. Essentially, the macroeconomic impact of the shale revolution represents a welcome economic boost at a time of otherwise relatively tepid economic recovery. At the same time, these effects can be considered modest, given that the impact of the shale-gas revolution extends beyond macroeconomic aspects alone to include the environmental risks noted above, but certainly also the resulting geopolitical shift, which could potentially be substantial. For one, a reduced US dependence on oil imports would give the country more freedom in its foreign policy, including in its relations with the Middle East. Shale-gas exports to Japan are affecting Russia’s position as a gas exporter, and lower oil revenues may also put pressure on social spending in oil-producing countries in the Middle East and North Africa.
Figure Box 1: Simulated impact of ‘shale shock’
The continued growth in the US economy has boosted employment, with an average of approximately 180,000 new jobs being added on a monthly basis in the year to date. Since a large portion of the unemployed population had become discouraged, this generated a sharper-than-expected decline in registered unemployment (figure 5), backing the Federal Reserve in its announced intention to taper its monetary stimulus programme. According to the Fed, the economy is strong enough to continue its recovery without further support. The impact on the financial markets of both this announcement and the surprising news, in September, that tapering would be postponed is discussed in detail in our Financial market outlook, while the economic impact on the rest of the world is addressed elsewhere in this report.
Figure 5: Labour market recovery, with scars
Source: Reuters EcoWin, Rabobank
While fiscal and monetary policies have played a key role in the modest but persistent economic recovery from the Great Recession, the current political gridlock has emerged as the single largest threat to America’s growth momentum which – based on the economic fundamentals – could appear in the coming year (table 1). The October 2013 US government shutdown may have been extremely inconvenient, particularly for those directly affected, but its impact on the economy as a whole has been manageable (Marey, 2013). However, the ongoing political disagreements about raising the debt ceiling – which is periodically necessary – could nip the growth momentum in the bud due to the rise in economic uncertainty that weighs on sentiment (Marey and Van Geffen, 2013).
Table 1: Forecast summary US economy
Source: Reuters EcoWin, IMF, Rabobank
Japan: Consensus belies cracks in Abenomics
Japan has also been successful in boosting its economy through a combination of fiscal and monetary policies, particularly since Prime Minister Abe announced his three ‘policy arrows’. The first of these arrows entails a substantial fiscal stimulus programme equal to approximately 1.4% of GDP, the main focus of which is infrastructure investment. The second arrow is a further easing of monetary policy, which – by doubling the monetary base, among other measures – is designed to structurally increase inflation to 2%. The first two arrows have hit their target in that the yen has dropped sharply since late 2012, while the Nikkei index – due to increased confidence and other factors – rose (figure 6). The Japanese economy is expected to grow by 1¾% in 2013 – a full percentage point more than we projected at the end of 2012, before the introduction of Abenomics. The crucial third arrow consists of structural reforms to improve economic growth potential and thus ensure the initial success of the first two arrows is maintained in the long run. It is on this crucial point – the acid test for Abenomics as a reform programme – that the Japanese government has largely fallen short of expectations.
Figure 6: The first impact of Abenomics
Source: Reuters EcoWin, Rabobank
Even if the administration does manage to define this third arrow more clearly, the path towards growth and inflation is narrow with limited margins for error. Just like Odysseus successfully sailed his ship past Scylla and Charybdis, Japan has (at least) two major risks to overcome. The first of these consists in the inevitable medium-term fiscal consolidation necessary to maintain debt sustainability. As yet, the consolidation plan does not extend beyond an increase in the national consumption tax (VAT) from 5% to 10%, to be implemented in two stages by 2015. The first stage (from 5% to 8%) will take effect in April 2014 and poses a major risk to economic growth. Although the government has also suggested tax cuts and additional spending to reduce the fiscal impact by more than half, we nevertheless anticipate growth to fall to approximately 1% in 2014 (table 2). This, however, also means that fiscal consolidation will not reduce the deficit from 9½% in 2013 to 6¾% in 2014, but only to 8¼% (figure 7). This has increased the need for a clear and credible consolidation strategy with a clearly defined timetable. In order to stabilise the gross public debt-to-GDP ratio (which currently stands at 245%) when the deficit is 8¼% of GDP, a nominal GDP growth of 3.4% is required, assuming no change in interest rates.
However, the growth target is unachievable even if the long-term inflation target of 2% is met and GDP volume grows by 1% (which would have to be considered a positive outcome, taking into account historical data and Japan’s shrinking population). The second risk has to do with Japan’s interest-rate profile. Inflation may rise if Abenomics proves successful; however, the resulting upwards pressure on long-term interest rate represents a substantial financial and economic risk. This applies both to the government – which thus far is able to finance its very high debt level at an extremely low interest rate – and to banks and pension funds, which will then have to absorb a massive loss of value in their government-bond portfolios. Even if Abenomics does not succeed in raising inflation in the long term, lower investor confidence may still push up interest rates and compel the Bank of Japan to implement even more aggressive measures. It should be clear from the above analysis that it is much too early at this stage to determine whether the Abenomics experiment will be successful in the long run, despite the early gains achieved in the form of temporarily higher growth.
Gradual rebound in Europe
UK: The success of ‘Plan A’?
Like the United States, the United Kingdom also bolstered economic recovery in the wake of the crisis with large-scale monetary and fiscal stimulus programmes. However, unlike in the US, the policy implemented by Prime Minister David Cameron and Chancellor of the Exchequer George Osborne in recent years has had a single-minded focus on getting the country’s public finances back in order. The Bank of England facilitated this through large doses of quantitative easing - massive purchases of government bonds. The budget deficit was reduced from 11.3% in 2009 to 6% in 2013 and adjusted for the weak economic activity (partly as a result of the ambitious fiscal- consolidation strategy), the pace of retrenchment even turned out slightly higher still.
From the outset, many economists urged the government to implement a ‘Plan B’, which would involve easing up on austerity in order to give recovery a chance to gather steam – a strategy that had proved successful in the US. Yet the British government ignored these calls time and again and even compensated for shortfalls by implementing additional cuts. Economic recovery therefore remained sluggish up to early 2013, as British exports failed to show any consistent signs of recovery despite the weak pound (which was not very surprising given that the majority of the eurozone countries were in recession at the time). Additionally, the fiscal tightening combined with private sector deleveraging resulted in weak domestic spending (table 3; Kamalodin, 2013).
Table 3: Forecast summary UK economy
Source: Reuters EcoWin, IMF, Rabobank
However, economic sentiment has taken a turn for the better since 2013. GDP growth has picked up in the past few quarters suggesting that the recovery is more robust this time around than had previously been the case (figure 8). Clearly, business and consumer sentiment improved with a rise in employment, which has been remarkably strong given the depth and duration of the recession. UK property values are also on the rise, and British consumers are more confident about the economic outlook. The government regards this economic revival as proof of the effectiveness of its ‘Plan A’, but, since the pace of fiscal consolidation has been rolled back somewhat this year, it is clear that the government essentially borrowed elements from ‘Plan B’.
At the same time, we should underline the strong monetary and fiscal basis of the recovery. The Bank of England introduced its Funding for Lending  programme to stimulate credit growth, and recently the government also launched a scheme named Help-to-Buy in an effort to further bolster the housing market recovery. These are potentially fragile and credit-driven pillars of growth – which also characterised the British economy during the pre-crisis years and have shown themselves to be unsustainable back then. At the same time, economic boosts notwithstanding, UK’s recovery can be considered weak both from an international and an historical perspective. As regards the latter, the economy is recovering at an even slower pace than during the years immediately following the Great Depression in the 1930s. The fact that growth is forecast to continue into 2014 partly on the back of the brighter outlook in both the US and the eurozone also highlights the most substantial downside risks. Interest rates were up sharply after the US Federal Reserve announced its intention to taper its asset purchase programme, and the Bank of England did not manage to mitigate this effect through its forward- guidance policy (‘forward guidance’ essentially represents no more than an uncommitted [i.e. basically idle] promise to keep interest rates low) – figure 9. There is a risk that British interest rates will increase further once the Fed actually begins tapering. Meanwhile, recovery in the eurozone remains very fragile.
Eurozone: Long-awaited recovery
The majority of eurozone member states have also taken the austerity route. To some extent, this was out of necessity, since the euro countries were unable to make binding agreements with each other regarding a more gradual pace of consolidation, and the monetary union lacked a central bank with the mandate to support fiscal policy directly through quantitative easing. Nevertheless, the long-awaited – and often- announced – return of growth in the eurozone finally materialised in the second quarter of 2013. Based on leading indicators, it is likely that this growth will continue into 2014 (table 4; Verduijn and Wijffelaars, 2013). Nevertheless, the growth rate will remain exceptionally low and will remain vulnerable to a lack of crucial progress in European political decision-making (box 2).
Box 2: Thorough investigation and recapitalisation of banking industry is crucial
Substantial economic risks relate to the capacity of the banking sectors, especially those in the peripheral European countries, to fund a stronger recovery. Through the Asset Quality Review (AQR) of the European Central Bank (ECB) – a crucial step towards the establishment of the European banking union (Rabobank, 2013) – the European Union has created an opportunity to restore trust in the banking industry. To achieve this, it is necessary that bank balance sheets are investigated using a standardised system and reliable methods. Recapitalisations of the relevant institutions must eliminate the weaknesses identified. This was done in the United States in 2009, and by now, the US banking industry is contributing to growth. However, when it comes to the European AQR, a number of credibility concerns have risen even before the review has taken place. These concerns are mainly related to the fact that the bailout funds established to provide financial aid to countries will be inadequate. There is a general fear that the AQR’s level of ambition will be adapted to the available resources .
The European Commission’s objective is to facilitate as many transactions through private recapitalisation as possible (with investor bail-ins for banks representing a key element). The central government can then chip in, followed by the European Stability Mechanism (ESM) through loans to central governments; and finally, at the European level, there may be a EUR 60 billion fund provided by the ESM for direct recapitalisations.
One problem is that there is currently no standardised European bail-in framework in place; the parties have reached agreement only on the framework that will be applicable in the future banking union. The use of the bail-in in the AQR will, therefore, be implemented by different countries in different ways, which will only increase uncertainty among investors in European banks. A second problem is that the governments of the weakest member states cannot support their banking industries without feeding concerns about their own solvency, and the European backstop seems completely inadequate to address this issue.
This will undermine the credibility of the AQR – a setback that Europe really cannot afford following two previous less-thansuccessful stress tests (which many banks passed with flying colours only to then collapse afterwards). The fragile economic recovery is simply too dependent on trust in a well-capitalised European banking industry. It is, consequently, essential to create both a substantially larger European bailout fund and to accelerate a standardised bail-in framework. Time is running out, and there is very little political willingness to pay for national problems from the past at the European level.
The fact that the recovery has persisted this time around is mainly because the euro crisis did not escalate this past summer. In previous years, the crisis would flare up every summer and the already fragile business and consumer sentiment would invariably plummet as a result (figure 10). The second half of the year, therefore, never brought the anticipated recovery, destroying the foundation for the growth estimate for the following year instead. The commitment made by the ECB to do ”whatever it takes” to keep the monetary union intact and the announ- cement of its Outright Monetary Transactions (OMT) programme in September 2012 would appear to have broken this pattern. However, when we look at how an otherwise inconsequential country like Cyprus managed to destabilise European politics in spring 2013, we can conclude that the additional EUR 10-15 billion in aid to Greece and an increasingly likely rescue package for Slovenia could end up causing some tension yet.
With all that being said, the weaker member states have made significant strides in recent years in terms of structural economic reforms (OECD, 2013), reducing their current-account deficits (figure 11), and fiscal consolidation (figure 12). This latter element, in particular, has seriously undermined economic activity, also due to the collective efforts in this area across virtually the entire European continent. However, the austerity effort required in the eurozone decreases with each passing year (IMF, 2013d), although it should be noted that several countries have to implement a number of additional measures.
Despite this underlying progress, however, we have not yet fully recovered from the crisis. For one, the eurozone output growth remains sluggish amid high unemployment, which has increased dramatically in the peripheral member states and among young people.
The modest growth recovery is not nearly strong enough to change this in any significant way in 2014 . Secondly, the European banking system would appear unequipped, in the immediate future, to facilitate a stronger recovery: credit supply in the periphery is still contracting and interest rates remain too high. This once again underlines the necessity of (quickly) taking appropriate steps towards far-reaching European integration. This would initially involve the establishment of the banking union (Verduijn, 2013a, 2013b) in order to strengthen the banks, but also, eventually, a system for central debt financing such as Eurobonds (Boonstra, 2011) to eliminate high interest rates based on national sovereign risks. Thirdly, European long-term interest rates increased as a result of the Fed’s tapering announcement (see US section). A sharp increase in rates was harmful to the fragile eurozone economy in 2013 and may be more harmful than we now anticipate for 2014 as well. In 2013 Portugal wound up getting hit particularly badly, since the rise in interest-rates coincided and augmented sovereign risk; it polarised its political community and coincided with the rejection of a number of necessary austerity measures by the Portuguese Constitutional Court. The 10-year Portuguese government interest rate increased from less than 6% in May 2013 to well above 7% in September .
Emerging world catches up
The emerging economies continue to grow at a fast pace relative to the industrialised world, despite the recent growth slowdown. This means they contribute the most to global economic growth (figure 13). However, their growth momentum is visibly weakening due to a combination of factors, with the impact on individual countries being different.
First of all, recovery from the Great Recession is taking longer than expected, and secondly, growth has turned out lower in a number of countries due to the government policies pursued. For example, China, under the new leadership, is focusing specifically on slower growth that is more desirable in terms of the expenditure breakdown (see below). A lower trend growth rate is also anticipated for Russia (figure 13), but, unlike in China, this is due to the country’s infrastructure bottlenecks and lacklustre business climate – two weaknesses that for a long time were concealed by the country’s growing energy production and exports. Neither China nor Russia will, therefore, be able to fully counter 2013’s growth slowdown over time.
Thirdly, the Fed’s announcement of its tapering programme served as a wake-up call for investors worldwide (figure 14). Investors in emerging markets began to look beyond liquidity and instead turned their attention to the actual fundamentals of these economies.
The vulnerable EMs were hit hard by capital flow reversals, particularly countries with substantial current-account deficits, including India, Turkey, South Africa and Indonesia. The strong response to tapering illustrates how quantitative easing has resulted in overvaluation of assets in parts of the emerging world. The reversal of unorthodox monetary policy measures generally involves a number of difficult adjustments. Since this only concerns the response to the Fed’s reduction in its additional monthly bond purchases, it is likely that the actual monetary policy normalisation – i.e. reversing monetary stimulus – will end up creating extra volatility. And this is only one of the four major central banks that have implemented unprecedented stimulus policies. At the same time, supporting or further driving this kind of overvaluation through delayed monetary normalisation would obviously provide much greater cause for concern in the medium term.
Finally, the general growth slowdown leads to more moderate growth in raw-material prices. This, in turn, will reinforce the growth slowdown in the commodity-producing parts of the emerging world, including Russia and – to a lesser extent – Brazil. Naturally, this trend will also affect industrialised countries that are highly dependent on the production and export of raw materials, including Australia (e.g. IMF, 2013b). The growing competition created by shale-oil extraction in the United States mainly affects countries that produce lighter types of oil with a lower sulphur content (including Nigeria), since these can easily be replaced by shale oil.
China: Manoeuvring between growth and reforms
Due to its size and planned economy, China should theoretically be better equipped to continue to follow its own course in the global economy. However, doing so involves a number of restrictions. The Chinese government wants to avoid a major slowdown in activity while at the same time transforming its economy from a planned, investment-driven model to a more market-based, consumption-driven system (Blaauw, 2013). At the same time, it also wants to better protect the country from the impact of the rapid population ageing as evidenced by the shrinking workforce (Every, 2013b).
The IMF (2013a) correctly notes that China, since the Great Recession, has come to rely much less on exports as a growth driver. Domestic growth was driven mainly by investment (figure 15), which, in turn, was fuelled by credit managed by Beijing (figure 16). This led to a sharp increase in outstanding credit especially to (state- owned) businesses, which makes evident that this economic policy is unsustainable in the long run (Every, 2013a).
The strategy pursued by the new Chinese leadership – with a focus on sustainable, rather than merely strong, growth – is therefore not only desirable, but necessary. However, when, in mid-2013, it seemed like the growth rate might slip to below 7%, the limit for low-growth tolerance had been reached and the government opted for a solution that had proved its worth in the past: it launched new infrastructure projects, financed with business loans, and gave priority to state companies. There is a definite fear of a too-hard landing of the economy, but what is likely causing even greater anxiety is the fear of civil unrest that might arise during a growth slowdown.
While the Chinese government has no intention of abandoning its reforms, all this does drive home the importance of economic growth. In fact, all eyes are currently fixed on the Third Plenum, scheduled for November 2013 . In the past, Third Plenums formed the basis for major reforms – for example the one held in 1978, which marked the beginning of market reform and transparency. There are a large number of reforms to be implemented, albeit gradually. Given the conditions for growth, however, we can continue to count on further volume growth in the Chinese economy of 7% minimum (table 5), supported, if necessary, by additional policy measures prescribed by the central government.
Table 5: Forecast summary Chinese economy
Source: Reuters EcoWin, IMF, EIU, Rabobank
 Unlike conventional monetary policy – where central banks encourage private money creation by cutting interest rates – in the case of quantitative easing, they inject money into the economy directly, for example by purchasing government and mortgage bonds. In the current environment this has predominantly found its way into excess reserves held by the banking system.
 The original fiscal cliff entailed a number of tax cuts expiring at the same time, which, combined with previously agreed automatic spending cuts would result in a fiscal consolidation on 1 January 2013 representing roughly 4.5% of GDP.
 This scheme allows banks and building societies to borrow from the Bank of England at below-market rates to help them increase lending to (small) businesses.
 Against this background, the Trans-Pacific and – notably for Europe – Trans-Atlantic negotiations regarding further trade liberalisation are good news for long-term economic activity (Bruinshoofd and Talal-Azimi, 2013).
 This has made the envisaged unaided return of Portugal – and possibly also the full return of Ireland – to the financial markets after the expiry of the bailout agreements less likely – see our Financial market outlook.
 The Plenum is a plenary session of the Communist Party, where members discuss forthcoming policy changes.
Financial markets: Less liquidity, more attention to the fundamentals
The liquidity in the financial system that has been created by global central banks forms the central theme of our story. In recent years, this liquidity has had an almost all-powerful effect on the prices of many financial assets. The rate at which it is reduced again will be a key factor determining financial markets in 2014 and beyond.
The reduction of the liquidity measures will become an increasingly relevant theme. This is because a number of industrialised countries – with the US in the lead – is showing signs of recovery, as described in the first part of this Outlook. The new European framework is also slowly taking shape and with the systemic nature of the crisis moving to the background, there will be more attention to the fundamentals again.
Fed moves the markets
One of the main drivers of market sentiment this year for once did not originate from Europe. It was in May, when the Fed for the first time tinkered with the idea of tapering the purchases of securities under its third round of quantitative easing (QE3) . The reason for this was that the US economy seemed to have reached an advanced stage of recovery, and that a more accommodative monetary policy would over time entail risks for price stability and the stability of the financial system.
The speech by Fed Chairman Ben Bernanke on 22 May 2013 and the minutes of the preceding policy meeting that were published on the same day can be described as an important turning point for the financial markets. In a few months’ time, the yield on 10-year government paper rose by more than 70 basis points. Although various policymakers, Bernanke included, repeatedly stressed in the ensuing months that reducing the purchases did not in itself represent monetary tightening and was only a slowing of the easing, this had little effect. Even the pronouncement that the rate of reduction would be linked to the development of the US economy failed to really calm the markets, since the 10-year yield ultimately rose further, actually touching 3% on 5 September. The yield only eased substantially after the policy meeting on 18 September, at which the Fed surprised the market with its decision not to start tapering just yet.
Better too easy than too restrictive policy
With its decision, the Fed wanted to give a clear signal that it had been surprised by the sharp market reaction that it had itself caused, and especially the potentially negative effects of this on the real economy. However it also showed foresight, because political bickering over the US budget and the debt ceiling would soon culminate in a temporary shutdown of US government services. In any case, the announcement made clear that when it comes down to it, the Fed would prefer to ease too much rather than too little. Janet Yellen, Bernanke’s intended successor, is expected to continue this line of policy or possibly take an even more cautious approach regarding the economic recovery.
The recent political deal to postpone the deadlines for a real agreement on the budget and the debt ceiling to the beginning of next year (which brought the government shutdown to an end) has actually achieved very little apart from extra time. The Democrats and the Republicans are still diametrically opposed and therefore all we can look forward to is a resumption of the political game of chicken that was displayed this year. The economic recovery will be less robust in the coming months than previously estimated. While the negative effects of the temporary closure of government services are still difficult to assess at this point, the continuing political uncertainty will negatively affect business investment in the coming months.
Given the Fed’s recent statements, we expect the policy committee to wait until March 2014 before implementing the first step in the tapering of QE3. Assuming that the process of reducing the accommodative stance will take at least six months, we think that the Fed will not complete this operation until somewhere in the fourth quarter of 2014. After the end of QE3, attention will shift to the first increase in the interest-rate target . Currently, the Fed targets an interest rate of close to 0% (in fact, it uses a target zone of 0% to 0.25%). The central bank has stated that it will continue to use this target at least until the unemployment rate falls below 6.5% or inflation rises above 2.5%. If we compare these values with the economic forecasts of the policy committee, we can conclude that the first interest-rate hike is not likely until 2015.
Verbal intervention, the new modus operandi of the ECB
Already in the initial months of 2013, ECB President Mario Draghi threatened to introduce new measures to keep money-market rates stable and mitigate the effects of the strong euro. However it turned out that these were to a large extent only threats, and verbal intervention has become the new approach. The ECB lowered its main refinancing rate by 25 basis points in May, followed by another 25 basis points to 0.25% in their most recent November meeting. However, from now on, policy changes are likely to be even less tangible. In fact, there is little left in the ECB’s armoury. The measures still at its disposal (such as a further reduction in the refinancing rate) are less effective, would involve negative side-effects (such as the introduction of negative interest rates on deposits held by banks in the euro system), or are more difficult to implement. In July 2013, the ECB decided to formalise its verbal intervention with the introduction of ‘forward guidance’. With this, the Governing Council expresses its intention to keep its interest rates at current or even lower levels for a longer period, albeit without saying how long exactly.
The market will continue to test the ECB
This intention is however conditional, since the ECB explicitly stated that it is based on the moderate outlook for inflation and economic growth. Furthermore, ECB President Draghi has repeatedly emphasised that the ECB’s ‘reaction function’  has not changed. While we have our doubts with respect to this last point, the financial markets are continuing to look critically at the macroeconomic indicators, also in view of the ECB’s conduct in the past. The generally better macroeconomic figures in the eurozone countries in the period from May to August led to expectations of higher interest rates (reflected in Euribor forward contracts, for example). Figure 19 shows the remarkably close correlation between expectations for 3-month Euribor rates and our indicator of economic surprises for the eurozone. Moreover, the forward guidance during this period largely failed to stop the effect of higher US interest rates on interest rates in the eurozone countries.
However we do not think we will see actual interest-rate increases in the eurozone next year. As described in the first part of this Outlook, the economic outlook is still far from rosy, despite a burgeoning recovery. This suggests that the ECB will not find it so difficult to defend no change in interest rates with its new forward guidance policy. Keeping the interest-rate target low is justified, not only by the modest outlook for growth, but also because the strong euro and the tightening effect of higher capital market rates need to be compensated for by accommodative monetary conditions. In any case, the more recent macroeconomic figures show that the market is still reacting symmetrically, since expectations of future interest-rate hikes have receded somewhat since September. This effect has been amplified by the latest November rate cut.
But the markets will test whether the ECB means what it says in due course. If the figures for economic growth and/or inflation unexpectedly improve, expectations of higher interest rates will increase. If the ECB then again avails itself of verbal intervention (as we expect), this could be interpreted as a sign that its reaction function has indeed changed, and that US and European monetary policy has (more than previously) been decoupled.
Box 3: ECB liquidity keeps its key role
We expect the ECB to continue to use its liquidity policy to manage the markets in 2014. At the time of writing this Outlook, there is still a surplus of liquidity (of around EUR 175 billion) in the financial system to keep money-market rates at their current levels. If the banks in the peripheral countries continue to repay their loans from the ECB, money-market rates could rise suddenly, as we recently pointed out in a study of the non-linear relationship between the liquidity surplus in the money market and overnight (Eonia) interest rates (De Groot, 2013). One of the conclusions was that the repayment rate of LTRO funding by banks may proceed more slowly now because most banks in the core countries have already completed this process. Another conclusion was that the asymmetrical distribution of liquidity is in fact helping to keep money-market rates low and that the point where the liquidity situation in the money market will push rates significantly higher is still some way off (figure 20). From recent statements by Draghi, one can infer that the ECB wishes to anticipate this in order to avoid creating any unnecessary uncertainty. The November decision to extend its policy of full allotment in liquidity operations to mid-2015 underscores these comments. Furthermore, there is still a group of banks that are likely to be dependent on ECB funding for a longer period. As the final repayment date for the existing 3-year LTROs approaches (January and February 2015), volatility in the money market could rise. We should certainly also not fail to mention the European bank stress tests that will take place in the course of 2014. In order to achieve a smooth transition, we think there is a significant chance that the ECB will introduce a new LTRO in the first quarter of next year, most likely with a maturity of two years. This will effectively extend the support from ECB liquidity by one year. The central bank will thus ensure that the money market liquidity will not become a source of market stress, without losing its sights on the exit strategy. This is important because the LTROs also involve risks, such as the fact that they increase the unhealthy stranglehold between governments and banks in the periphery. Some banks have been using LTRO funds to purchase bonds from their own governments. These bonds can be used again for obtaining new liquidity. European regulators have recently expressed their disquiet about this behaviour.
Lending concerns remain
The biggest cause for concern remains the ill-functioning of the monetary transmission mechanism and thus also the provision of credit. Nonetheless, the ECB is likely to leave this up to the market as far as possible. The strengthening of balance sheets in both the financial and the private sector is a matter of urgency, but it is in everyone’s interest that this process is as orderly as possible. From this perspective, the ECB is continuing to look at specific measures that could remove any obstacles on the supply side of the credit provision process. It has recently raised a working group that should investigate initiatives to stimulate the market for ABS  paper based on European SME loans. The recent easing of the collateral requirements for ABS, such as the reduction of the haircuts, is in anticipation of this. However, as long as words continue to have the desired effect, the ECB may wish to refrain from taking action.
Systemic crisis recedes to the background
In the previous two editions of the Rabobank Outlook, we stressed the systemic nature of the financial crisis in the eurozone. This was partly due to the fact that while the 17 member states have a common monetary policy, they pursue very different economic and fiscal policies . The systemic nature of the crisis has however significantly receded, with the important turning points being the large-scale ECB liquidity operations at the end of 2011 and in early 2012 and, even more importantly, the commitment by ECB President Draghi in July 2012 to prevent the break-up of the eurozone ‘whatever it takes’. This turned the market’s attention more to the underlying fundamentals in the various member states. Although the job is far from over, there has been clear progress on structural reforms and the strengthening of the common fiscal and macro-prudential framework (Verduijn, 2013a, 2013b)).
Nevertheless, in our view it is liquidity that has been the main driver of the financial markets in recent years. In the eurozone, we saw this mainly reflected in a rally in peripheral government bonds inspired by the OMT programme, without any noticeable effect on yields and in particular the credit risk premiums on government bonds in the core countries. This is shown in figure 5, which plots the yield on German bonds against a composite index of credit spreads on peripheral government bonds. If there had been a fundamental solution instead of a liquidity-driven solution, such as a fiscal union whereby the credit risk was borne entirely or partly by the eurozone member states collectively, we would have seen a much clearer upward movement in German yields .
Figure 21: No rise in German yields despite rally in the periphery
Source: Macrobond, Bloomberg, Rabobank
The Great Flotation
Whilst the ECB’s interventions mainly had repercussions for European markets, it was the Fed’s third quantitative easing programme, which took place against the background of a US economic recovery, that had the largest global spill-over effect, causing prices of financial assets to rise around the world and across the board. The continuing flow of liquidity in the financial markets ensured that yields on US (and indirectly also German) government paper remained unnaturally low and investors therefore felt forced to take on higher risk in an attempt to maintain their returns . From the many conversations we have had with investment managers in the Netherlands and abroad, it appears that they have returned (at least to some extent) to investing in the European periphery. This was certainly not because they were universally positive regarding the fundamental situation in these countries.
This Great Flotation (all asset prices rise) not only opened up a gap between the returns on government paper and more risky investments such as equities and corporate bonds, it also led to a discrepancy between the market valuation and the intrinsic value of securities, as suggested by figures 5 and 6. So in our view, the crucial question for the future development of the financial markets is how and how quickly exactly will this gap be closed. If liquidity dries up too fast, this could cause heavy price corrections in the financial markets, and what we have seen since the 22nd of May will be no more than an appetiser. The Fed is playing the leading role in all this, but we would also wish to stress that the decision by other central banks to emulate the Fed or not can either strengthen or weaken the spill-over effects of Fed policy. Box 2 below describes three scenarios that we can distinguish with respect to future market reaction to the tapering of liquidity provision.
Box 4: Three scenarios, with the Fed in the leading role
In order to get a good idea of how the markets will react to the rate of tapering by the Fed, we can distinguish three possible scenarios. It is important to note that these scenarios depend on the pace of the economic recovery, especially because the Fed itself has stated that the future rate at which tapering will be applied will depend on this. Indeed, the most crucial aspect will be the extent to which the market believes that the Fed is ahead of or behind the recovery curve. This is explained in more detail below.
We call the first scenario the Great Flotation scenario, and actually this is an extension of what has happened in the financial markets during the second half of 2012 and most of the first half of 2013. In this scenario, the Fed will maintain its accommodative policy because the rate of economic recovery is too slow. In other words, the Fed will remain behind the recovery curve. In that case capital market rates will decline again, but more risky financial assets will also benefit because market valuations will move further away from the fundamentals as a result of the continuing flow of liquidity. There will thus be a situation of asset price inflation. This scenario may also involve an increase in expectations regarding consumer price inflation at some point, but the effect of this on interest rates will be masked by the search for yield.
The second scenario we call the Great Rotation scenario. This describes the ideal situation in which the economic recovery continues to be strong and economic growth figures turn out better than the market expects. But this will mean that the Fed makes a start on reducing its bond purchase programme. However, it will do this with enough care to ensure that it does not nip the recovery in the bud. Once again, the Fed will remain behind the recovery curve. In this scenario, yields on government paper and related interest rates will rise, but at the same time the markets for more risky instruments will still be able to perform due to the economic recovery. Inflation expectations will also increase in this scenario, and in this case it will only reinforce the rise in interest rates as a result of reduced liquidity.
The third scenario, that we call the Great Slowtation, involves a moderate rate of economic recovery that is however not weak enough to prevent the Fed from reducing its bond purchase programme. In this scenario the Fed would be ahead of the recovery curve. The result would be higher capital market rates, as is the case in the Great Rotation scenario. However in contrast to this previous scenario, the prices of riskier assets will come under pressure because the rate of economic recovery, on which these assets depend (corporate earnings, for example), will no longer be in proportion to the increase in interest rates. If we consider the global spill-over effects, this is a high-risk scenario for those regions in which the economic recovery is still not sustainable, such as large parts of the eurozone. Inflation expectations will decline in this scenario, but nominal interest rates will nonetheless rise due to the reduction in liquidity (or the prospect thereof).
The financial markets have changed their preferred scenario several times during the past year. One of our preferred barometers for gauging which scenario is driving the markets is the rate of 10-year break-even inflation (figure Box 4). If the yield on 10-year government paper rises and inflation expectations rise at the same time, we are in the Great Rotation scenario; if both decline, we are in the Great Slowtation scenario. In the Great Flotation scenario interest rates will fall, but inflation expectations may rise. Table 1 presents the three scenarios together.
Regarding the likelihood of these three scenarios, we can say that the Fed has clearly signalled in September 2013 that it does not wish to move ahead of the recovery curve. In our opinion, this makes the Great Slowtation scenario less likely. In the short term, the Great Flotationscenario seems to have the upper hand, because the recovery in the US is being hindered by the continuing political deadlock between Democrats and Republicans. However since we are positive on the US economy from a medium-term perspective, we believe that the rate of recovery will ultimately be strong enough to justify a cautious reduction in the Fed’s bond purchase programme, which would bring us back to the Great Rotation scenario.
Figure Box 4: Inflation expectations as a barometer for the Fed’s position on the curve
Renewed interest-rate convergence in the eurozone…
In our base projection, we assume that the Great Rotation scenario with rising capital market interest rates is the most likely outcome. Although one could argue that the first blow in May 2013 already was half the battle, we think that both the actual tapering of QE3 and speculation regarding how the Fed will conduct its conventional monetary policy thereafter will be enough to push rates higher. We see the yield on 10-year US government paper rising by around 70 basis points during 2014, to around 3.3% by the end of the year. This will of course affect the European (or German) yield curve, which we also expect to move higher. However, with maximum deployment of verbal intervention by the ECB and a policy of additional liquidity, this move will be substantially less, with an increase of around 40 basis points to 2.1% at the end of 2014. The 10-year yield differential between the US and the eurozone will therefore widen further, from approximately 90 basis points at the time of writing to around 110 basis points by the end of next year. The last time we saw this kind of Trans-Atlantic yield differential was in 1999, and we think that this will have consequences for exchange rates as well (see below).
However in a European context, in the base scenario that we describe there will also be further convergence of government bond yields in Europe (and narrower spreads between government paper in the periphery and in the core countries). Under our base scenario, this will take the form of ‘bottom-up’ convergence, since yields on core paper (Germany) will rise while yields on peripheral government paper will remain stable as investors continue to have confidence in the economic recovery. We would also note that peripheral spreads will also narrow in the Great Flotation scenario. However in this case, it would happen as a result of absolute yield levels in the periphery declining due to investors’ search for return, while yields in the core countries fall by less or remain unchanged.
…but the risks are increasing
As we argue above, the perception of ample liquidity has meant that the European markets have been able to absorb various shocks quite well. Examples of this are Cyprus, and the political unrest in Italy and Portugal earlier this year. But the prospect of less abundant liquidity will make the markets more sensitive to any new shocks. Factors that we could add to the list of potential shocks include a weakening of the focus on structural reforms, and additional delay in or ineffective implementation of steps towards the banking union. We think that this additional sensitivity will lead to more volatility in markets in 2014.
Regarding the development of individual country spreads, the fundamentals in the various eurozone member states will become more important, however the issue of systemic risk could raise its head again as well. Peripheral bonds performed well in 2013 mainly due to absorption of this paper by the banks in these countries. However, the concentration of national government paper at national banks could initiate a new negative spiral if yields rise. Looking at the two elephants in the room – Spain and Italy, a further convergence of spreads could work out particularly positively in the short term for Spain and less so for Italy. This is partly because of the political uncertainties in Italy, but also because the size of Italian government debt is a negative factor in a scenario of rising market interest rates (even if spreads remain unchanged, absolute yields will rise). From a medium-term perspective, however, we are more concerned about the still weak fiscal position of Spain. An average primary deficit (before interest payments) of 5.4% over the period of 2011 to 2014 for the country stands in sharp contrast to an average primary surplus of 2.3% for Italy. As shown in figure 25, without structural improvement to the Spanish government deficit, the debt ratio will rapidly approach the level in Italy and the difference in sensitivity of the interest cost will quickly disappear.
Corporate bonds show resilience
Few financial assets have weathered the European financial markets crisis so well as corporate bonds. While the issuance of new corporate loans by banks has stagnated or actually significantly contracted in many countries, large and mainly higher rated companies have been able to maintain access to the corporate bond markets. Yields fell significantly in 2013 compared to 2012, when returns of 10% to 20% (depending on the risk category) were commonplace. This year, investors have to be satisfied with returns of between 1% and 5%. Against a backdrop of generally weaker corporate results and economic uncertainty, the European corporate bond market has been remarkably resilient in the face of bad news. With ups and downs, risk premiums have gradually subsided during the year, to around 25 basis points for investment grade paper and around 120 basis points for high yield (figure 21). In our view, the reason for this is once again to be found in central bank policy. The search for yield by investors has thus led to a relative outperformance by bonds in the high yield risk category. The relatively The relatively low liquidity/availability of corporate paper in the secondary markets and risk premiums on new issues have increased the importance of the primary markets for investors looking to obtain exposure to corporate bonds.
… but for how long?
The nascent economic recovery in the eurozone and the slightly higher growth rate of the global economy in 2014 are of course generally to be welcomed. However a lot of good news has already been discounted, implying that the market is now more sensitive to negative surprises and, of course, the rate at which the Fed will ‘taper’ its quantitative easing policy. The Great Rotation scenario, as described above, should at least cause a shift within this asset class, however it could also initiate a rotation out of fixed-income securities into equities, which in turn would lead to rising risk premiums (in addition to the already rising swap rates). In 2014, we expect slightly less issuance of paper than in 2013, partly because some of the planned redemptions for 2014 have already been pre-funded. An acceleration in mergers and acquisitions could support the primary markets. The risks that lie in wait relate to poorly executed acquisitions and share buybacks or high dividend distributions to shareholders. Here too, the fundamentals will become more important. The greatest risk however is still that there will be a serious upward move in global interest rates that will pressure both absolute and relative returns. Issuers could manage this risk by accelerating the refinancing of high coupon bonds; investors will most likely focus more on bonds that are more resilient to rising interest rates (such as floating rate notes, or FRNs).
The resilience of the euro
The euro has displayed considerably more resilience this year than in previous years . The famous ‘whatever it takes’ speech by ECB President Draghi in July 2012 was an important turning point with regard to the perceived risk of a breakup of the eurozone. Cross-currency basis swaps, which are a barometer of the risk premiums that European financial institutions have to pay for their dollar funding, have slowly declined over the last 18 months (figure 28). In the course of 2013, we noticed that foreign investors were showing more interest in the eurozone again. Macroeconomic developments in the eurozone have also contributed to the better sentiment, including the significantly improved current account balances and indications that reforms in the periphery are beginning to take effect. But ultimately it was the liquidity-driven lessening of fears that the periphery would kill off the eurozone altogether that proved the decisive factor.
Ground that has been won will not be given up easily
The fact that the euro has become better able to withstand temporary dips in general market sentiment was already apparent in the early months of 2013, during the Cyprus crisis and in the wake of the elections in Italy. The euro’s rise against many non-G10 currencies this summer was further evidence of this. Fears in relation to the Fed’s tapering of its quantitative easing policy then led to lower risk appetite among market participants, and investors abandoned emerging markets and sought safety mainly in the direction of the euro. Against the backdrop of a scenario in which the eurozone is slowly but surely emerging from recession, the US fiscal situation remains a source of uncertainty and the Fed is trying to stay behind the recovery curve, the euro will not easily give back ground to the US dollar in the months ahead.
Nevertheless, we think that the euro will ultimately change direction. Firstly, because we are more positive on the fundamental situation in the US. The economic recovery there is much more broad-based and more sustainable than the recovery in the eurozone. Secondly, the US economy is benefiting from the shale gas revolution, which will bring lower energy costs for industry and will reduce the current account deficit. Thirdly, we think that when the Fed actually begins to taper its quantitative easing programme in the course of 2014, with no change in ECB policy, this should ultimately lead to a wider yield differential between the US and the eurozone. This will also have a bearing on the exchange rate. We expect the euro-dollar rate to reach a level of around 1.27 by the end of 2014. In trade-weighted terms, the exchange rate is expected to weaken less, partly due to a weaker yen.
Tenacity by Japanese policymakers will ultimately weaken the yen further
The dollar-yen currency pair is obviously also highly dependent on the actions of the Fed. In the short term, dollar weakness will prevail. In addition, if PM Abe is successful in his aim to rid Japan of its deflationary shackles and persistent economic weakness of recent decades, new investment flows into the country could provide support for the yen. As we pointed out earlier in this Outlook, the Japanese government is unfortunately making slow progress with its structural reforms. ‘Abenomics’ represents a latest and best effort to get Japan out of the mire, and failure is not an option. This means ultimately that the Bank of Japan will have to save the day with further (maybe much further) expansion of its monetary easing policy. The prospects for the yen over the medium to longer term are therefore not positive. By the end of 2014, we expect to see dollar-yen trading around 106. On balance, this also implies a (slight) weakening of the yen against the euro. We also think a further decline of the yen after 2014 is quite likely.
Sterling: How much good news is already discounted?
With the exception of the New Zealand dollar, the British pound has appreciated against all other G10 currencies in the last three months. The good macroeconomic news from the UK has raised expectations that the next policy move by the Bank of England will be an interest-rate hike. In the eyes of the market, this may happen at least a year before the Bank of England has indicated on the basis of the conditional forward guidance strategy introduced by Governor Mark Carney. With so much good news already discounted, this suggests that the British pound could face setbacks in the short term. The economic headwind of falling real wages and austerity measures is far from over. This does not alter our assessment that the rhetoric adopted by the Bank of England is more suggestive of policy tightening in the medium to longer term than the tone adopted by the ECB. And, as the Bank of England has also pursued a much more aggressive quantitative easing policy, there could be a bigger impact when this policy is wound down. For this reason we expect the British pound to appreciate against the euro in 2014.
Box 5: Emerging markets: which are driven by liquidity, and which are supported by fundamentals?
|Perhaps one of the most notable developments in the financial markets last year was the volatility of emerging markets currencies, which since the middle of 2012 have been driven mainly by the effects of global liquidity. In what seemed at times to be a blind search for higher returns by investors, this led to upward pressure on many of these currencies. When Fed Chairman Bernanke reminded the market in May 2013 that the flow of liquidity would come to an end at some point, several emerging markets currencies suffered heavy falls. In the upward move, it seemed that the market made little distinction between the various currencies. However on the way down investors made a clear differentiation. Emerging countries with relatively sound economic fundamentals have been notably less hard hit than those for which the market has justifiable doubts. The Indian rupee and the South African rand were relatively hard hit, because both these countries have a large balance of payments deficit and a significant government deficit. Low foreign exchange reserves and political unrest (in the case of South Africa) and failure to enact structural reforms (in India) complete the picture. Since investors have a tendency to avoid what they most fear, the ebbing of the liquidity effect is clearly demonstrating which countries have decent fundamentals and which do not. To illustrate this effect, a heat map of various indicators of vulnerability has been compiled for a series of countries (Lawrence, 2013). These include the current account deficit, the budget balance, foreign exchange reserves and the currency’s historical volatility. We have condensed these indicators into a composite vulnerability index . A comparison of this index with the performance of a series of emerging markets currencies since 22 May 2013 clearly shows that countries with relatively low vulnerability have experienced less currency weakness.|
Fundamentals regain importance
Since September 2013, there has been a (temporary) postponement of tapering (and so the market has moved back to the Great Flotation scenario). Many emerging markets currencies have clearly reacted positively to this. In itself this is a cause for concern, as it suggests that investors are still trying to surf the liquidity wave, but that as soon as liquidity looks like drying up things will become more volatile again. Our base projection is that the Fed will taper its QE3 programme over the course of 2014 and thus (perceived) liquidity will gradually disappear. And this means that many emerging markets currencies will behave more according to their economic fundamentals than they have recently. This immediately makes it clear that deeper macroeconomic analysis of these countries will increase in importance in the coming period. It is beyond the scope of this Outlook to deal with all the currency pairs individually, but fortunately there are a number of similarities so that we can take a regional perspective. The Latin American currencies, and especially the Mexican peso, are suffering in the short term from the continuing political uncertainty in the US, which is associated with lower growth. Looking somewhat further forward, however, these countries stand to benefit from the burgeoning US economic recovery. If, for starters, the fundamentals are good, as is the case in Mexico, the currency has upside potential despite the removal of liquidity. The currencies of the Central European countries are less affected by the political risks in the US (indeed, they are benefiting more from the improved sentiment towards the eurozone), and are also less exposed to the liquidity effect. We therefore see upside potential for currencies from these countries in the second half of 2014, particularly if the central banks in countries such as Poland turn their attention to monetary tightening. Returning to our vulnerability index, we see further weakening of the South African rand, the Turkish lira and the Indian rupee as the greatest risks in 2014.
 The monthly purchase of USD 85 billion in government bonds and mortgage-backed securities.
 We are assuming that the Fed will not resell bonds, and that it will hold the bonds it has acquired until maturity.
 The reaction function describes the stance of the central bank: how it reacts to figures and forecasts for macroeconomic variables.
 Asset Backed Securities – negotiable securities based on underlying assets, such as existing loans.
 To some extent we have to describe the ECB’s OMT programme as a ‘backdoor solution’ to budgetary unity, since large-scale purchases of government paper by the euro system ultimately involves risks for all the eurozone countries. However since up to now not one euro cent has been used in the programme, we can describe this loosely as (potential) liquidity.
 The LTROs from the ECB also led to an abundance of liquidity in the financial system. On top of this, the fragmentation within the eurozone led to relatively high demand for Bunds.
 We should immediately note here that, generally speaking, it is remarkable how little the exchange rate has been affected by the deep eurozone crisis since 2011.
 We did this by converting individual scores into Z-scores (whereby the average is subtracted from the variable and then the result is divided by the standard deviation) and then adding the Z-scores (unweighted) together to create a composite vulnerability index.
25 years of Outlook reports: a quarter century of forecasts
Rabobank will be hosting its 25th Outlook Conference this year. Each year since 1988, we have published a report to coincide with this event containing our analysis of relevant aspects of the economy along with a GDP forecast for the upcoming year. Figure 34 shows the accuracy of our estimates by comparing past forecasts for the year ahead with the actual change in GDP that occurred.
Figure 34: Dutch GDP volume – forecast vs actual
Source: Rabobank, Statistics Netherlands
The diagram above clearly shows that the economy moves faster in either direction than we typically estimate. At the same time, we must also conclude that we are unable to forecast peaks and troughs in the right way. This is partly because the Outlook reports are published only once a year. It should be noted that the discrepancies between estimates and actual outcomes are not too large overall. The average prediction error is exactly zero, with overestimates and underestimates cancelling each other out. We can conclude from this that we have been neither consistently overly positive nor overly negative about expected economic trends over the past 25 years. Although the absolute prediction error is substantial at 1.1%-points, the forecasts included in these reports have added value; this can be calculated based on the principle of inequality – also known as the Theil coefficient  – which has a value of 0.7. This means that the estimate adds value compared previous period’s growth into the future. While the accuracy of our GDP estimates is very similar to those of, for example, the CPB (Kranendonk et al., 2009) this does not alter the fact that the precision of our Outlook forecasts leaves room for improvement.
Most economists use macroeconomic models for their forecasts, based on the most recent data available. However, Lanser en Kranendonk (2008) argue that this method comes with a number of uncertainties. For one, released data can be adjusted at a later stage, and amendments to National Accounts data, in particular, can be substantial and end up changing the basis of the forecast. A second source of uncertainty consists in the assumptions made for different variables that are not forecast by the model itself, including exchange rates, interest rates and oil prices. A third source of uncertainty is the estimated equations in the macroeconomic model. If these ratios turn out to be incorrect – or are no longer correct – any forecasts made using this model will be incorrect as well, even if the other assumptions are accurate (this is referred to as ‘model uncertainty’). A fourth, related source of uncertainty is the margin of error in estimating equations. Even if an economic equation is estimated correctly, the correlation can never be established with absolute certainty. A final source of uncertainty is ‘expert knowledge’, which refers to the process of adjusting model outcomes based on users’ economic expertise and insights, which are not included in the model.
Lanser en Kranendonk (2008) demonstrate for the Saffier model, developed by the CPB, that the main source of uncertainty consists in assumptions for variables that are not derived endogenously from the model. This is likely to also apply to the forecasts for the Dutch economy we have made over the past 25 years. In the period since 2008, it increasingly appears that model estimates based on the preceding period do not always produce the most plausible results. This is related to the nature of the economic situation – balance sheet problems for households, the financial industry and the government that are not factored into the ‘standard’ macroeconomic models. It is, therefore, unlikely that forecasting accuracy will improve in the immediate future. An effective way of dealing with these uncertainties is to identify upside and downside risks that could potentially result in a different outcome.
 Expressed as a formula, , in which Vi,t is forecast GDP growth for period t, and Ri,t is actual GDP growth. If all estimates are correct, the value is 0. As long as the value is lower than 1, the forecast adds value compared to the ‘naïve’ forecast.
The Netherlands: seven years of tribulation
In terms of its persistence – more so than in terms of hardship and unemployment rates – the current economic downturn in the Netherlands unfortunately makes previous post-war recessions look like mere blips by comparison. The country has never witnessed seven consecutive years without economic growth since World War II. The increasingly important question people keep asking is when we will begin to see signs of a recovery? The answer to that question is twofold. While the economy has been boosted slightly by foreign trade and investment, this has been insufficient for the country to fully overcome its myriad domestic woes. The balance sheet problems affecting the government, consumers and banks are undermining a lasting recovery. The debt overhang is hindering is preventing growth to gain momentum.
Unprecedented zero-growth period…
With gross domestic product (GDP) posting a contraction in eight of the past ten quarters, we can only conclude that the Dutch economy is in the doldrums. In the second quarter of 2013, the level of output was down by more than 4% from early 2008. This brings the size of the economy close to the record low reached in the second quarter of 2009 (figure 35), which means most of the progress made during the economic revival in 2010 has been undone. Actually, this is the first time in the post-war era that the Netherlands has experienced three recessions within a 5-year time frame.
Figure 35: GDP growth
Source: Statistics Netherlands, Rabobank
In our Special Rabobank Outlook 2010 we explored the question of how the Netherlands would recover from the Great Recession. The pundits involved in the debate at the time tended to refer to the economic trajectory in letter terms, speaking of ‘V-shaped recoveries’, ‘W-shaped double dips’ and ‘L-shaped, no-growth Japan-style scenarios’. One key question in the debate about the nature of a medium-term recovery was to what extent the economy would be able to bounce back to the trend or long-term growth trajectory, which analysts had forecast prior to the Great Recession. After a series of minor recessions, the economy was supposed to return to the old growth path relatively quickly.
Based on historical data, Reinhart and Rogoff (2010) conclude that this is not always true for recessions that occur in conjunction with a financial crisis. The question that needs to be answered is whether production levels in the Dutch economy will rebound and catch up to pre-2008 output levels. Most economists assume, based on economic models, that the economy will eventually return to its long-term growth path following a recession. In these models, the difference between actual output and potential output works as a – referred to as the ‘output gap’ – will be closed as the economy finds its equilibrium. After a period characterised by a negative output gap (i.e. where actual growth is lower than potential growth), the economy will start growing at a faster rate, according to standard economic theory . By way of illustration: the -3.5% output gap estimated by the Netherlands Bureau for Economic Policy Analysis (CPB) for 2014 means that the economy will start outpacing the trend again in the years beyond 2014 until this gap has been closed (figure 36). However, in recent years the Netherlands – along with many other countries – saw a negative output gap as well, and yet there has been no growth in the economy. How can this be explained?
Figure 36: Economic growth remains below potential
Keynes addressed this problem as early as 1935, challenging the dominant paradigm of his day – and well beyond – that economies eventually reach a new equilibrium. Interest rates are meant to play a vital role in this ability to self-correct. However, Keynes concluded that there is no sound theory backing up the notion that interest-rate fluctuations always help restore the equilibrium. If an interest rate has been hovering around 0% for some time without generating any new economic activity, the economic equilirbium will not be restored, as maximum production capacity is not being fully utilised. In Keynes’ magnum opus, General Theory of Employment, Interest and Money, published in 1936, he explains why disequilibrium interest-rate systems occur in some situations and presents solutions to this problem. With policy interest rates having hovered around 0% for more than four years now in much of the industrialised world, we appear to have just such a situation on our hands. The common consensus is that the damaged balance sheet of households, the government and the financial industry must be repaired relatively quickly. This has caused debt reduction to become an objective in and of itself, to the point where it is prioritised over investment returns. Yet the Netherlands – which shows major savings surpluses year after year – cannot be considered a ‘debt nation’ (see below) by any definition.
The process described above is referred to as a ‘balance- sheet recession’. In these types of recessions, monetary policy remains impotent in pushing the economy towards an equilibrium. And the longer a balance-sheet recession lasts, the greater the likelihood that pre-crisis potential output levels will no longer be attained or at least not in a short period. This means the reduction in output levels – which is theoretically temporary in nature – will partly become permanent, resulting in what economists call the hysteresis effect . This can be due to consistently lower (i) labour participation and (ii) investment. A survey of the literature (DeLong and Summers, 2012; IMF, 2009)indicates that the hysteresis effects of a financial crisis are generally greater than those caused by ‘normal’ recessions. While the Dutch labour market currently shows no hysteresis effects, the record unemployment rate projected for next year could well cause permanent damage to the economy. The investment outlook is even more alarming: private investment (excluding homebuilding) is 20% below its pre-crisis level. Coupled with record-low capacity utilisation, this could end up permanently undermining the Dutch economy’s growth potential.
The first stage of economic recovery in the Netherlands was not nearly strong enough to boost GDP growth even to the very moderate growth path of 1.4% (figure 37). Since the return of the recession in 2011, the discrepancy with this potential growth rate has only widened. According to our growth forecast for 2013 and 2014, this trend is set to continue. By the end of 2014, the difference between the trend growth path extrapolated from the 2008 peak onwards and projected GDP will be more than 20%. A return to the pre-crisis growth path is therefore not likely, not even in the longer term (Stegeman et al., 2012).
Also worth noting are the changes in the various expenditure components of GDP (figure 38). Whereas, during the first few years of the current crisis, government spending offset some of the resulting economic fallout, in the following years it was mainly (net) exports that supported activity. This is also evident from the ever-growing current account surplus in the Netherlands. While this is due in part to strong export growth, what is even more significant is the relatively weak growth in imports, which contributed to the surplus through lower domestic spending. It is expected that in 2014, the current account surplus to amount to 11% of GDP, representing a new record. This would put the country’s savings surplus at more than EUR 66 billion – a clear sign of underspending.
The economic outlook for 2014 is largely the same as for 2013, with a similarly bleak picture in the years to follow. This weak economic growth we are expecting is down to a combination of a domestic balance-sheet recession and relatively weak export growth. To be clear, the latter is not the result of weaker competitiveness position. Although the country’s key markets have seen modest growth, this growth is markedly lower than during the pre-crisis years (see the section on the global economic outlook). Exports have, therefore, not been able to offset low domestic spending, as a result of which we will again see no growth in overall economic activity next year (figure 39). With a quarterly growth rate hovering around the zero-percent mark, one or two quarters of economic contraction should not be ruled out either.
…in a country whose wealth continues to grow…
While there is no denying the problems affecting the Dutch economy, in focusing on these problems we tend to overlook the fact that the Dutch per-capita GDP (adjusted for inflation) remains very high compared to mostother countries, despite the decline in recent years. It is still higher, for example, than the per-capita GDPs of countries such as Germany, Belgium and Italy. The country’s wealth also continues to grow: in 2012, people residing in the Netherlands saved a total of EUR 57 billion – 9.4% of GDP. The Netherlands has had a national savings surplus every year since the early 1980s; in other words, the country’s foreign asset position is building. The private sector accounts for a large share of this surplus (figure 40). The public sector, which has had a savings surplus on only five occasions in the past 40 years, has been accumulating substantial debt, especially since 2008. Overall, household spending in the Netherlands has exceeded household income for many years, resulting in a negative household savings ratio. However, this does not mean that Dutch households are poor: the net financial asset position of households is positive and stands at 430% of GDP - which is very high compared with other advanced countries (figure 41).
On average, then, the household finances in the Netherlands are solid, even though there is a high degree of dispersion (see elsewhere in this report). It should be noted that many households – particularly homeowners – have relatively high earnings and expenses. While their debt (mostly mortgage debt) is relatively high, they have, on aggregate, far more assets, particularly in the form of home equity and pension funds. One disadvantage of these assets, however, is that they are fairly illiquid –meaning that declines in incomes are more likely to result in lower spending than is the case in countries where a larger portion of the capital consists of liquid assets (e.g. equities and cash). It also means that the current emphasis on debt repayment has made the Netherlands more vulnerable to economic swings, as assets do not become more liquid.
…with out-of-balance households…
‘Balance-sheet recession’, a term frequently used to describe the state of the Dutch economy (Council of State, 2013; CPB, 2013; Netherlands Ministry of Finance, 2013; IMF, 2013a; Jacobs, 2013), basically refers to a situation in which households, businesses and governments struggle to improve their deteriorated financial position and do not have the flexibility or possibility to invest or consume as long as there is no prospect of more stable asset prices. In a balance-sheet recession, monetary policy barely has an impact on the spending habits of economic agents.
Critical issues in the Netherlands include the balance sheets of Dutch households, the government and the financial sector. Households’ financial position represents the main obstacle to higher economic growth. The substantial assets of households with relatively high debt in combination with lower house prices and pension funds have had a major impact on household behaviour. This is partly the result of how the housing market and pension funds respond to economic fluctuations (Social and Economic Council of the Netherlands, 2013). Since the introduction of a variable actuarial interest rate in 2007, Dutch pension funds have become highly sensitive to interest-rate fluctuations, causing their coverage ratios to decline along with interest rates during economic downturns. In an already ailing economy, this results in higher pension contributions, pension cuts and/or lower pension entitlements, while the exact reverse trend sets in during economic upturns. This undesirable adjustment of the regulatory rules has made the Dutch pension system (which should have represented a source of stability) highly procyclical. A similar problem can be observed in the housing market, where the high level of debt financing results both in higher house prices and more consumption during boom times. The reverse trend is witnessed during downturns, as we are currently seeing in the Dutch economy.
Although households’ financial positions – including pension assets – have improved overall (figure 42), a large number of households are still facing financial difficulties. This is because the distribution of assets among generations is highly uneven (figure 43).
For example, while the homes owned by many younger families are their main asset, some of these families are also deep in negative equity (i.e. house is worth less than the mortgage). Nominal house prices in the Netherlands fell by nearly 20% between 2008 and 2013, and especially households that purchased a home after, roughly, 2004 and that have barely made any mortgage principal repayments are potentially in a tight spot.
Although these are mostly asset losses on ‘paper’, households tend to compensate a decline in their assets by saving more (Berben et al., 2006). It should be noted, however, that the problems faced by households are coupled with relatively few foreclosures and delinquencies compared with the other countries.
Lower property values combined with less disposable income – which has been in decline for some years now – has left many households in a bind, with no choice left but to consume even less. Households are currently caught in a liquidity trap – this is also evidenced by private consumption levels, which have fallen more sharply in the Netherlands in recent years than in many other industrialised countries. To a modest extent, this discrepancy is due to how healthcare expenses are funded in the Dutch system (see our Outlook 2013 for details). The decline in private consumption since the second quarter of 2008 (6.7% in real terms) affected purchases of durable goods more than any other type of expenses. At the same time, an increasingly large portion of consumption consists of fixed expenses (figure 44) – this is also the reason why Dutch retailers have seen a sharper fall in spending than the decline in private consumption would suggest.
Private consumption is not expected to increase to any significant degree in the coming years. Purchasing power will remain under pressure on account of declining real wages, increases in tax and social insurance contributions and, in some cases, the freezing of supplementary retirement schemes. Furthermore, people who are losing their jobs – and this number will increase again in 2014 – are faced with a substantial decline in their income levels. These trends will continue to chip away at disposable income in the coming years, and Dutch households – unlike their counterparts in other countries, including the United States – have not yet begun paying down their debt (figure 45).
The least painful way toward balance-sheet recovery ultimately entails a spike in property values combined with economic growth. A recovery of house prices will make it easier for people to sell their homes, repay their debt and adapt their spending patterns to any changes to their income levels. At least, the good news is that there are increasing signs the housing market has bottomed out and prices are set to stabilise in 2014 (Rabobank, 2013). Economic growth also support disposable incomes, and thus also serves to facilitate debt repayment. However, experience has shown that this is a long-term process, and growth will also need to translate into higher wages for debt repayment to increase. All in all, we do not expect private consumption to drive the economy in the years to come amid the ongoing deleveraging by households.
On the whole, company balance sheets in the Netherlands look decidedly healthier than those of households: average solvency has remained relatively stable in recent years. However, as with the household sector, there are significant differences within the corporate sector. Whereas household wealth is divided along generational lines and linked to homeownership, the financial health of companies varies depending on whether they operate in the Netherlands only or have international operations. In this context, we also distinguish between major companies and small and medium-sized enterprises (SMEs). This division based on company scope and size is also reflected in both added value (figure 46) and the number of bankruptcies broken down by industry (figure 47).
The only industries to have grown since early 2008 are not-for-profit services – notably the healthcare sector – and the agricultural and mineral industries. All other industries have yet to recover from the economic crisis in 2008. Nevertheless, as stated above, there is a distinct difference between the various industries. While the number of bankruptcies in the more internationally-focused industry and trade sectors has been below average, the situation is quite different for industries primarily focused on the domestic market. In the construction industry, in particular, the number of bankruptcies has been high both from a historical perspective and compared with the other industries. For company balance-sheet positions, what ultimately matters is not only the depth of the recession, but also – especially – the duration of the slump. The outlook for companies with international operations is more favourable in this regard.
One of the key questions in the coming years is how and when investment will get back on track. Business investment is currently roughly at the 2004 level, which means the investment-to-GDP ratio is below its long-term average (figure 48). At 77.4%, capacity utilisation rate remains 6%-points lower in the third quarter of 2013 than the historical average (figure 48).
Figure 48: Low capacity utilisation rate and investment/GDP ratio
Source: Statistics Netherlands, Rabobank
A sustained period of low investment affects economic growth potential. Reduced investment over an extended period of time also results in consistently lower potential output, which, in turn, affects long-term growth. These hysteresis effects based on production capacity cannot be ruled out if the current economic situation persists, as businesses, understandably, still have a number of reservations when it comes to investing in the Netherlands. The investment outlook for both the government and households is far from rosy – both are focusing on improving their own balance sheets and will, therefore, continue to keep their purse strings tight in the next few years. Particularly, companies operating internationally are likely to also make the majority of investments abroad. The risk associated with this strategy, of course, is that some of the assets invested overseas may evaporate (Boonstra, 2008). A more structural reason for the lower investment levels is the sectoral structure of the Dutch economy. Since the main growth industry in the Netherlands is the healthcare sector – with a lower investment ratio than other sectors, especially manufacturing industry – the capital intensity of GDP growth has decreased slightly.
Finally, it remains to be seen to what extent balance- sheet repair process in the financial industry will weigh on investment. The fact that, according to the IMF (IMF, 2013b), there is currently no credit crunch in the Netherlands does not in itself signify a strong Dutch banking industry. The low credit growth is currently mainly the result of a lack of demand. However, an increase in the demand for credit, for example due to an improving economy, could turn this situation around. If credit restrictions really occur, this will, in the first instance, particularly impose restrictions on SMEs, since they are much more dependent on bank loans than larger companies (Van de Belt and Piljic, 2012).
The overall outlook for the Dutch business sector is mixed. Companies with international operations will benefit from the slight rise in global trade next year, but businesses primarily serving the domestic market will continue to struggle in the coming years – they will need to consider cost savings, corporate restructuring and new opportunities as part of their strategy. The good news is that Dutch companies on average are doing relatively well.
…resulting in higher unemployment
Unemployment will rise further during this new economic downturn. After a slight decline in the following the economic recovery of 2010, the jobless rate has been steadily increasing since June 2011, and there are currently more than 630,000 job seekers in the Netherlands. We expect unemployment to increase further to 7.5% of the workforce next year, bringing it close to the level of the early 1980s. Yet the country is not faced with the same problems in the labour market as during that decade. For one, the welfare system – including both disability and unemployment benefits – has been overhauled. With the early retirement scheme having been all but abolished as well, opportunities for older workers to exit the job market through ways other than regular retirement are more limited than in the early 1980s. As a result of this development – as well as due to demographic trends – the labour supply has been transformed in recent years (figure 49). For example, the supply of workers aged 25-45 has decreased by 600,000 over the past decade, despite a higher participation rate among this age bracket. At the same time, the supply of older workers in the labour market has increased, particularly as a result of the higher participation rate. However, this does not result in a more efficient labour market, as demonstrated by the UV curve, a graphical representation of the relationship between the unemployment rate and the job vacancy rate (i.e. the number of unfilled jobs expressed as a proportion of the labour force). This curve has shifted outwards, unlike what we saw in the 1980s (figure 50). Although this is because older workers, in particular, no longer have a number of different options available to exit the job market, the question remains as to what extent this cohort can be considered part of the effective labour supply. For example, the number of unemployed aged 45 and older has been steadily increasing in recent years, and the chances of these older workers finding new jobs have been slim for a long time, with approximately 35% of this group now having been unemployed for more than two years. Businesses are reluctant to hire older workers, and turnover among this group tends to be low because severance packages become more generous as workers acquire more experience and gain seniority in their positions. Combined with wages that increase with age, this has kept older workers locked inside the proverbial ‘gilded cage’. At the same time, the high level of job protection and the high wages earned by older employees also make it very challenging for them to find a way back into the job market once they have been made redundant.
The outlook for young people has not improved either, with the youth unemployment rate standing at 11.7% as of September 2013. If long-term demand for labour remains low, this – along with the position of older workers in the labour market – will potentially represent the biggest problem. While the youth unemployment rate in the Netherlands may be relatively low, young people cannot find a job right after leaving school are at risk of becoming unemployable – or at least of not being able to find work in the foreseeable future. A lasting impact on unemployment and employment is not uncommon in the wake of a financial crisis (IMF, 2009), and that risk is currently present in the Dutch economy. Both young and older people can become so far removed from the labour market that employers – even after the economy recovers – will not be interested in what they have to offer (e.g. due to skill attrition). This is another hysteresis effect that could end up undermining growth potential. The analysis above shows the importance of further reforms in the Dutch labour market.
Government policy focused on the wrong problem
Over the past years, government policy has been focused almost exclusively on short-term fiscal consolidation rather than on kick-starting the economy through reforms (Stegeman and Van de Belt, 2013). Based on the above analysis of the economic problems affecting the Netherlands, this is not the most advantageous policy from a macroeconomic perspective. For one, public debt is not the main economic problem facing the country (Kamalodin et al, 2013). Fear of a credit downgrade and the resulting downward spiral of higher interest charges and ballooning public debt is unfounded given the country’s decade-long current-account surplus (see above). In the Netherlands, net wealth in the private sector vastly exceeds net debt in the public sector. Thanks to the structural measures that have by now been implemented in the housing market, along with healthcare reforms and the higher retirement age, the sustainability of the government budget will increase by 5.5% of GDP in the coming years. Assuming that current policies will remain unchanged, this will bring the budget sustainability to a surplus of 1% of GDP by 2017 (Lukkezen and Suyker, 2013). Based on this ‘sustainability surplus’, future government revenues will be more than sufficient to cover future public expenditure, including interest on current public debt.
What may be even more significant is that the government’s (additional) cuts are interfering with private sector deleveraging and are unnecessarily curbing domestic spending even further, since private sector expenses constitute a large share of public-sector revenues. This is illustrated by the conclusion of the CPB (2011) that the Dutch economy would have declined more sharply in 2009, and that unemployment would have been higher as a result, if the response to the recession had been to implement additional austerity measures immediately afterwards.
Nevertheless, in his preface to the Macroeconomic Survey, (2013) – and also noted in the Budget Memorandum 2014 and by the Council of State (2013) – the Dutch Minister of Economic Affairs highlighted the importance of improving the balance sheets of households, financial institutions and the government. The Netherlands serves as a textbook example of Keynes’ paradox of thrift - a simultaneous restoration of balance sheets in the public and private sectors without a resulting loss of demand is possible only if a strong growth in exports can offset the lower domestic demand. In this scenario, the Netherlands – which, as a share of GDP, has roughly the highest savings surplus of any country in the world – would be entirely dependent on the economic recovery abroad, without having actually contributed to this growth itself. However, we consider this scenario unlikely, partly because of the record-high current-account surplus. In addition, other countries in the eurozone – the Netherlands’ main export market – are also in the process of reducing their budget deficits. The government must, as a result, accept a deficit in its own budget in order to facilitate a balance-sheet recovery in the private sector (Jacobs, 2013).
Furthermore, in the current situation, accelerated fiscal consolidation will cause unnecessary additional damage to the Dutch economy. As argued above, part of the future production capacity may be permanently lost and unemployment may continue to rise (in what might, to some extent, become a long-term trend) as a result of hysteresis effects. More than 20% of GDP has been lost since 2008 compared to the scenario in which the trend growth would have been 1.4%. This is harmful to growth potential in the Netherlands, as well as undermining the long-term sustainability of public finances. On the other hand, revenues from the deficit reduction are relatively low thanks to lower interest payments on government debt as a result of a 50% cut on interest rates on newly issued sovereign debt paper (figure 51) . Note that the government interest rate was already relatively low prior to the crisis and was at an all-time low at the time of writing. Any additional positive effects of fiscal consolidation on the government interest rate are limited. The IMF (2011) has also warned against ‘too much short-term fiscal consolidation’, particularly in countries with relatively low financing costs.
Figure 51: Dutch government: low interest rates
Source: CPB Netherlands Bureau for Economic Policy Analysis, Rabobank
The costs of deficit reduction rise as fiscal multipliers  increase and there is a risk of a large share of temporary production losses becoming permanent. Due to the zero lower bound of monetary policy in conjunction with the size and nature of the current recession, fiscal multipliers have turned out to be larger than in previous recessions (Auerbach and Gorodnichenko, 2012; Baum et al., 2012; Borio, 2012; Stegeman and Kamalodin, 2013). Furthermore, Holland and Portes (2012) argue that fiscal multipliers are currently higher because most developed economies are carrying austerity simultaneously. Based on an analysis by DeLong and Summers (2012), we calculate that, in the current economy with its ineffective monetary policy, hysteresis effects and high multipliers, the interest rate charges saved due to the lower public debt do not offset the lost tax revenues and higher public expenditure. In this case, a higher public deficit will not result in a permanently higher public debt if fiscal policy manages to prevent the loss of output resulting from the current crisis from becoming, to a large extent, permanent. It is economically justifiable to reduce the budget deficit at an accelerated rate only if fiscal multipliers are very low and if there are virtually no hysteresis effects, because in that case the income generated by the lower interest payments exceeds the losses in income resulting from lost tax revenue . Figure 52shows the government interest rate for different fiscal-multipliers and the hysteresis coefficient . These estimates show why the government, even if it steps up its austerity measures, will not manage to reduce the public debt as a percentage of GDP in the long term. The unfavourable ‘denominator effect’ (i.e. a lower GDP) is a key factor here. To illustrate the scope of this effect: during the period 2011-17, the government will cut costs to the tune of EUR 54 billion (9% of GDP). Nevertheless, the budget deficit will decline by only 1.9% of GDP during this same period, while public debt will continue to grow from 65.7% of GDP in 2011 to 76.6% of GDP in 2017. There is no better way to illustrate the ineffectiveness of the policy pursued by the government.
Figure 52: High multiplier cancels out gains from fiscal consolidation
Source: DeLong and Summers, Rabobank
We anticipate that a new set of austerity measures will be necessary next year in order to reduce the deficit to below 3% of GDP (Piljic, 2013). Policymakers would do well to be less preoccupied with reducing the actual budget deficit in the short term. After all, the agreements made by the Dutch government at the European level leave some scope to take more time to achieve fiscal consolidation. It would be preferable to both improve the economy and strengthen public finances through a combination of further economic reforms and smart cuts (as opposed to increases in tax and social insurance contributions and across-the-board cuts including government investment). This is the only way to prevent even more future production capacity from being permanently lost.
Ways to improve…
In 2009, the economic downturn was kept in check by the lack of cost-cutting measures, a substantial easing of monetary policy, and the various bank bailouts. Both Keynes and Friedman would have been satisfied by this approach. The issue preoccupying policymakers and economists at present is how to emerge from the current balance-sheet recession without causing too much permanent damage to the economic growth potential. It has become clear that this issue will continue to dominate growth expectations in years to come. Figure 53 shows that all the organisations issuing GDP growth forecasts for the Netherlands now assume that long-term economic growth potential will be lower than before the current crisis. Whereas modest catch-up growth was expected for 2009, this is no longer the case, which puts the Netherlands’ economic performance significantly below that of its neighbours. This would indicate that causes for the country’s weak economic growth are domestic (and endogenous) in nature.
Figure 53: Lower estimate of potential growth and output
Source: Consensus forecast, Rabobank
Again, we draw on Keynesian theory in answering the above question: government intervention is important in ensuring that domestic demand reaches a decent level again. This calls for a number of key policy decisions that must be prioritised over short-term fiscal consolidation: reforming the financial industry, giving priority to improving household balance sheets and implementing reforms that will reduce public expenditure on a long-term basis.
Healthy bank balance sheets are a prerequisite for economic recovery, given that adequate growth in credit to the private sector is required to support the recovery. Previous financial crises, including the Japanese recession of the 1990s, have demonstrated that a combination of weak bank balance sheets, a credit crunch and low economic growth can create a vicious circle (Dutch Central Bank, 2013). This risk is greater during the current crisis, since it is coupled with lower house prices and household deleveraging, which subsequently reduces consumer spending. In addition, household debt reduction should not be complicated by substantial increases in tax and social insurance and wage moderation. As noted above, the price- competitive position of the Netherlands does not represent a problem, but wage moderation does exacerbate household balance-sheet problems (Stegeman and Van de Belt, 2012).
Additionally, a long-term policy agenda should also contain measures to counter any current problems that we will only be able to solve in the long term. For example, the explicit tax relief on debt financing for both households and businesses must be gradually reduced on a budget-neutral basis, and more risk-management laws must be implemented. One such law might be a reduction in the level of debt financing if house prices, for example, increase by more than 10%.
At the same time, the government can incentivise businesses to increase their investments, for example, by temporarily introducing accelerated depreciation regimes for innovative and/or sustainable investments. It is also important that the government implements reforms that will reduce public expenditure in the long term. The above analysis shows that labour market reforms are important, including an amendment of the laws governing redundancy and the corporate pay structure. In recent years, the government has made great strides in a number of areas, including the housing market and the state retirement age, but additional measures are required. In the owner- occupied segment of the housing market, for instance, it will take more than lower debt financing alone to boost the housing market. Developing a private rental market as a solid alternative to buying a house remains crucial (Piljic and Stegeman, 2013).
…when there are significant uncertainties?
As in previous years, there are significant uncertainties surrounding the estimate contained in this Outlook report. As we have repeatedly stressed in recent years, these uncertainties are greater than during the period before 2008. However, whereas last year we identified only downside risks, we anticipate a number of positive scenarios as well this year, both in the Netherlands and internationally. The Dutch economy’s strong dependence on foreign markets means that growth prospects are highly sensitive to any changes in the global macro environment. For example, policy uncertainty in the eurozone and/or the United States, as described in the section on the global economic outlook, can deter international trade and, therefore, end up reducing growth in the Netherlands. However, a stronger recovery of the eurozone economy, in particular, also cannot be ruled out.
The Dutch economy itself may also show signs of a revival next year. Other countries – including the United Kingdom and the United States – have demonstrated in recent years how a housing market recovery can revitalise the domestic economy. A faster and stronger rise in house prices than we currently anticipate cannot be ruled out, particularly in urban areas. This, in turn, could end up improving the balance sheets of households and lead to higher domestic spending. One substantial downside risk facing the Dutch economy is the continued policy uncertainty, including in relation to the housing market – combined with the political instability that has characterised the Netherlands in recent years. In 2014 as in 2013, any government budget shortfalls may spark a renewed, ongoing debate on austerity. However, taking into account consumers’ dissatisfaction with government cuts in recent years, we can only hope this will not be the case.
After several years of contraction, the Dutch economy will stabilise again next year. The outlook for the years beyond 2014 is slightly more optimistic, although the country remains dependent on global economic environment. The government and many households will continue to focus on restoring their balance sheets in the next few years, which will weaken domestic demand. However, if policymakers start making the right decisions, this could accelerate the balance sheet recovery process and reduce economic losses.
If we neglect to liberalise policies, this will also lead to a new equilibrium, but not the equilibrium indicated in economic models. Instead of a higher growth rate that closes the output gap, potential output will be lower, to the point where the Netherlands will eventually no longer be among the wealthiest countries in the eurozone. However, this development is not necessary nor desirable and we must make an effort to prevent it.
 Hysteresis here refers to the long-term downward effect a temporary underutilisation of production capacity has on the potential output. This can be caused by discouragement among the labour force, but also by low investment over a longer period of time.
 An important explanation for the downward pressure on interest rates is due to the search for safe assets by (inter)national investors.This is a much more crucial factor than the tight fiscal policy being pursued.
 The fiscal multiplier indicates the costs of austerity measures or benefits of economic stimulus in a given year.
 This is obviously only the case if credibility and financeability of government finances is not at stake.
 The hysteresis coefficient indicates what percentage of a temporary loss in production capacity becomes permanent. In other words, the coefficient indicates the damage to potential output as a result of a long-term effect on both employment and capital stock.
Literature Global economic outlook
Blaauw, E.R. (2013), China: balancing reforms and growth, Rabobank Economic Report 15, November 2013.
Bruinshoofd, W.A., Smolders, N.M.P. and Weernink, M. (2013), De schalierevolutie vanuit een macro-economische context, Rabobank Economic Report 11, November 2013.
Bruinshoofd, W.A. and Talal-Azimi, R. (2013), Verdere handelsliberalisering kan mondiaal economisch herstel steunen, Rabobank Economic Report 11, November 2013.
CEPR (2013), Reducing Transatlantic Barriers to Trade and Investment: An Economic Assessment, Final Project Report, Prepared under implementing Framework Contract TRADE10/A2/A16, March 2013.
Every, M. (2013a), China: Debt’s what they did, Financial Markets Research Special, 26 September 2013.
Every, M. (2013b), 50 Shades of grey, Financial Markets Research Special, 18 October 2013.
IMF (2013a), Mind the Gap: Narrowing Imbalances, while Maintaining Growth, IMF Survey Magazine, 13 September.
IMF (2013b), World Economic Outlook: Transitions and Tensions, October 2013.
IMF (2013c), Global Financial Stability Report: Transition Challenges to Stability, October 2013.
IMF (2013d), Fiscal Monitor: Taxing Times, October 2013.
IMF (2013e), United States 2012 Article IV Consultation, Selected Issues, IMF Country Report No. 13/237.
Kamalodin, S.A. (2013), Outlook 2014: United Kingdom, Rabobank Economic Report 14, November 2013.
Lloyd (2011), Free Trade and Growth in the World Economy, The Singapore Economic Review 56(3), pp. 291–306.
Marey, P. (2013), Economic impact of government shutdown, Financial Markets Research Special, 30 September.
Marey, P. and Van Geffen, B. (2013), Implied US default window, Financial Markets Research Special, 15 October.
Marey, P. and Koopman, S. (2013), The macro-economic effects of the shale gas revolution, Financial Markets Research Special, November 2013.
OECD (2013), Economic Policy Reforms: Going for Growth 2013, OECD Publishing.
Rabobank (2009), Outlook 2010: Globalisation at a crossroads, Rabobank Theme booklet, December 2009.
Rabobank (2013), AQR FAQs, Financial Markets Research.
Bank Bulletin, 20 September 2013.
Verduijn, M.P. (2013a), Eurozone instituties: werk in uitvoering, Themabericht 5, August 2013.
Verduijn, M.P. (2013b), Why the eurozone needs stronger institutions, Rabobank Special 12, August 2013.
Verduijn, M.P. and M. Wijffelaars (2013), Outlook 2014: eurozone, Rabobank Economic Report 13, November 2013.
Literature Financial market outlook
Verduijn, M.P. (2013a), Eurozone instituties: werk in uitvoering, Rabobank Economic Report, 13 augustus 2013.
Verduijn, M.P. (2013b), Institutionele herinrichting eurozone, Rabobank Special 8, augustus 2013.
Lawrence, C. (2013), Rabobank FX Heatmap, Rabobank Special, forthcoming.
De Groot, E. (2013), The ECB liquidity effect on overnight rates, Rabobank Financial Markets Research, 15-08-2013
Literature The Netherlands
Auerbach, A. and Gorodnichenko, Y. (2012), Measuring the output responses to fiscal policy, American Economic Journal: Economic Policy, 4(2), pp. 1-27.
Baum, A., Poplawski-Ribeiro, M. and Weber, A. (2012), Fiscal multipliers and the state of the economy, IMF working paper 12/286, Washington: IMF.
Berben, R.P., Bernoth, K. and Mastrogiacomo, M. (2006), Households’ Response to Wealth Changes: Do Gains or Losses make a Difference?, CPB Discussion Paper 63, Den Haag: CPB Netherlands Bureau for Economic Policy Analysis.
Boonstra, W.W. (2008), De betalingsbalans en de externe vermogenspositie, Amsterdam: VU Uitgeverij.
Borio, C. (2012), The financial cycle and macroeconomics: What have we learnt?, BIS working paper 395, Zürich: BIS.
CPB Netherlands bureau for Economic Policy Analysis (2013), Macro Economische Verkenning 2014, Den Haag: CPB.
CPB Netherlands bureau for Economic Policy Analysis (2011), Effecten stimuleringspakket, CPB Notitie 12 September 2011, Den Haag: CPB.
DeLong, B. and Summers, L. (2012), Fiscal policy in depressed economy, Brookings Papers on Economic Activity, Washington: Brookings Institution.
Dutch Central Bank/De Nederlandsche bank (2013), Overzicht Financiële Stabiliteit, Autumn 2013, Amsterdam: DNB.
Holland, D. and Portes, J. (2012), Self-defeating austerity?, National Institute Economic Review, vol. 222, pp. 4-10, Londen: NIESR.
IMF (2013a), Kingdom of the Netherlands – 2013 Article IV Consultation, IMF Country Report 13/115, Washington: IMF.
IMF (2013b), Global Financial Stability Report. Transition challenges to stability, Washington: IMF.
IMF (2011), World Economic Outlook, Update January, Washington: IMF.
IMF (2009), What’s the damage? Medium-term dynamics after financial crises, in: Word Economic Outlook, Washington: IMF.
Jacobs, B. (2013), Macro-economische politiek voor een uitweg uit de crisis, ESB, 98(4669), pp. 576-578.
Kamalodin, S.A., D. Piljic and H.W. Stegeman (2013), Vijf argumenten voor begrotingsrust, Mejudice, 26 February 2013.
Keynes, J.M. (1963), A self-adjusting economic system, Nebraska Journal of Economic Business, 2(2), pp. 11-15, [reprinted from The New Republic, 20 February 1935].
Keynes, J.M. (1936), General Theory of Interest, Employment and Money, Londen: Macmillan.
Kranendonk, H., De Jong, J. and Verbruggen, J. (2009), Trefzekerheid CPB-prognoses 1971-2007, CPB Netherlands Bureau for Economic Policy Analysis, Document 178, Den Haag: CPB.
Lanser D. and Kranendonk, H. (2008), Investigating uncertainty in macroeconomic forecasts by stochastic simulation, CPB Netherlands Bureau for Economic Policy Analysis Discussion Paper 112, Den Haag: CPB.
Lukkezen, J.H.J. and Suyker, W.B.C. (2013), De naakte feiten over de Nederlandse overheidsschuld, CPB Netherlands Bureau for Economic Policy Analysis Achtergronddocument, Den Haag: CPB.
Ministerie van Financiën (2013), Nota over de toestand van ’s Rijks financiën, Miljoenennota 2014, Tweede Kamer, vergaderjaar 2013-2014, 33 750 (nr.1), Den Haag: Ministerie van Financiën.
Perotti, R. (2011), The “austerity myth”: gain without pain?, NBER working paper 17551, Cambridge, MA: NBER.
Piljic, D. (2013), Budget day: A repetition of moves, Rabobank Economic Report 5, September 2013
Piljic, D. and Stegeman, H.W. (2013), Anders wonen. Naar een werkende woningmarkt, Rabobank Special 7, June 2013
Raad van State (2013), Advies over Miljoenennota 2014: twijfel of omvang en tempo van maatregelen voldoende zijn, Advies W06.13.0263/III/B, 17 September 2013, The Hague: Council of State.
Rabobank (2013), Dutch Housing Market Quarterly, September 2013.
Rabobank (2012), Outlook 2013: Lower growth is the new reality, November 2012.
Rabobank (2009), Outlook 2010: Hope of recovery, December 2009.
Reinhart, C. and Rogoff, K. (2010), Growth in a Time of Debt, NBER Working Paper 15639, Cambridge, MA: NBER.
SER (2013), Nederlandse economie in stabieler vaarwater: Een macro-economische verkenning, Rapport | April 2013, Den Haag: SER.
Stegeman, H.W. and Kamalodin, S.A. (2013), Mind the fiscal speed limit, Rabobank Special 4, February 2013.
Stegeman, H.W. and Van de Belt, R. (2013), 3%: Een beperkte sociaaleconomische agenda, Me Judice, 3 June 2013.
Stegeman, H.W., Van de Belt, R. and Piljic, D. (2012), Minder groei: van de Grote Recessie naar de Lange Stagnatie, Rabobank Special 12/20.
Stegeman, H.W. and Van de Belt, R. (2012), Loonmatiging gedateerd instrument, ESB, 97(4638), pp. 397-399.
Van de Belt, R. and Piljic, D. (2012), Funding for growth. Now and in the future, Rabobank Theme Booklet, November 2012.
Elwin de Groot
Special thanks to
Art direction and production
Click Communicatie, Utrecht
Economic Research Department
Telephone: +31 30 216 2666
BIS - Bank for International Settlements
CEPR - Centre for Economic Policy Research
CPB - Netherlands Bureau for Economic Policy Analysis
DNB - Dutch Central Bank
ECB - European Central Bank
EIU - Economist Intelligence Unit
IMF - International Monetary Fund
OECD - Organisation for Economic Co-operation and Development
SER - Social and Economic Council of the Netherlands
AT - Austria
BE - Belgium
CA - Canada
CH - Switzerland
CIS - Commonwealth of Independent States
CY - Cyprus
DE - Germany
DK - Denmark
ES - Spain
FI - Finland
FR - France
GB - Great Britain
GR - Greece
ID - Indonesia
IE - Ireland
IN - India
IR - Iran
IT - Italy
JP - Japan
LU - Luxembourg
KR - South Korea
MY - Malaysia
MT - Malta
NL - The Netherlands
NZ - New Zealand
PH - Philippines
PL - Poland
PT - Portugal
SE - Sweden
SL - Slovenia
SK - Slovakia
TH - Thailand
TW - Taiwan
US - United States
VN - Vietnam
BRL - Brazilian real
CLP - Chilean peso
COP - Colombian peso
CZK - Czech koruna
EUR - euro
HKD - Hong Kong dollar
HUF - Hungarian forint
IDR - Indonesian rupiah
INR - Indian rupee
KRW - Korean (South) won
MXN - Mexican peso
MYR - Malaysian ringgit
PEN - Peruvian nuevo sol
PHP - Philippine peso
PLN - Poland zloty
RON - Romanian new leu
SGD - Singapore dollar
THB - Thai baht
TRY - Turkish lira
TWD - Taiwan dollar
USD - US dollar
ZAR - South African rand
The text of this publication was completed on 8 November 2013. In creating the text, we used sources we consider reliable. These data were incorporated into our analyses with care. Rabobank Nederland accepts no liability whatsoever in the event that any data or forecasts contained in this publication contain any inaccuracies. Use of the contents, or part of the contents, of this publication is permitted only provided that the sources are listed.
The information provided by Rabobank* in the Outlook documents or through its websites does not constitute an offer, investment advice, or any other type of financial service. While the information provided by Rabobank is based on sources considered reliable, the accuracy or completeness of this information cannot be guaranteed; it represents general information that is subject to change.
No rights can be derived from the information provided. Past performance does not guarantee future results. Rabobank and any other parties providing information in this publication and on the websites listed therein accept no liability whatsoever for the contents thereof or of information provided on or through the websites. Rabobank accepts no liability whatsoever for the contents of this publication or of websites it does not maintain itself and to which this publication refers or that refer to Rabobank websites.
The user of the information is responsible for the choice of information and any use thereof. The information may only be used by the user personally. This user is prohibited from transferring, reproducing, editing or disseminating the information. The user is required to comply with the instructions provided by Rabobank regarding the use of the information. The laws of the Netherlands apply.
© November 2013 - *Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A., The Netherlands.