No solidarity without conditionality

European Economics Jacques Cailloux Chief European Economist

+44 (0)20 7102 2734 jacques.cailloux@nomura.com
See Disclosure Appendix A1 for the analyst certification and other important disclosures.

January 2013

Nomura Securities International plc

Key views

1.

Fiscal consolidation, financial deleveraging and tight real economy funding conditions should lead to a deeper-than-expected recession Spain to continue free riding the OMT thus delaying call for ECCL, our baseline remains an ECCL will be called during the course of the year Italy remains very exposed and might require ECCL too. Given ECBs credibility, none of the countrys risk is likely to trigger an imminent call for help

2.

3.

4.
5. 6.

GDP contraction and higher NPLs remain the key policy challenge in the short term
Debt trajectory to continue rising faster than expected Pressures could build around weak banks and sovereigns in H1, but also around negotiations for Fiscal and Banking Union creation which could show lower level of solidarity than currently priced. Absent a growth strategy, Europe will experience very low growth over next decade

7.

Sovereign bond market tensions are easing but the economic and social crisis in the euro area is deepening. Financial market stress could come back absent a sustained return to growth
1

Global demand environment

The great divide post crisis

Industrial production by key regions, levels, 100 = Jan 2008 (Last obs = Oct 2012)

140 130 120 110 100

% increase in Industrial output Since Trough Since Jan 05 World 19.0 16.7 US 15.6 1.8 Asia 48.0 72.6 Euro 7.1 -1.7

World IP US IP Euro area IP Asia IP

90
80 70 Jan-05
. Source: CPB

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12
3

Contraction in global trade showing signs of stabilisation

But strong recovery needed to provide some offset to weak euro area domestic demand
World manufacturing export orders, PMI index (Last Obs Jan) Euro area GDP lags global trade cycle by one quarter

Last Obs: 48.9, avg pre crisis 51.3, avg inc crisis 50.6

57

52

47

-1

42

-3

37

Global export orders

-5

Euro area GDP (%, y/y, rhs) Dot is average of Q4 32 Mar-02 Mar-04 Mar-06 -7 Mar-08 Mar-10 Mar-12

Source: Markit, CPB

German apparent rebalancing hides EA/non EA split

Germany
German current account surplus widening vs non euro area
(last obs. Q3 2012, seasonally adjusted using Eviews)

... And current a/c improvement inside EA due to weak demand

(last obs. Q3 2012)

% GDP 6 5 4 3 2

% GDP 7 6 5 4 3

Exports to China Imports from periphery

Exports to Periphery

1 0 -1
-2 -3 -4 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q12
Periphery: Italy, Spain, Greece, Ireland and Portugal Source: Datastream, Nomura

EA

Non EA

2 1 0 1Q00

1Q02

1Q04

1Q06

1Q08

1Q10

1Q12
5

As Germany looks outside the euro area for sources of growth

German exports outside EA are taking off

(last obs. Q3 2012)

Foreign demand not key driver of periphery performance Results come from our recently published estimations

% GDP
30

25

20

15

GDP impact from different assumptions Non EA GDP Ger & FR domestic 2ppts stronger demand 1 ppts relative to baseline higher Germany +1.0 France +0.4 Italy +0.7 +0.3 Spain +0.2 +0.2 Portugal +0.3 +0.2
Exports to EA Exports to non EA

10

0 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q12

Source: Datastream, Nomura, Periphery: Italy, Spain, Greece, Ireland and Portugal

Watch out for the big fiscal multipliers

Fiscal multipliers are larger in stressed EMU countries Estimates of short term fiscal multipliers in normal circumstances
Expenditure Transfers Public C to h/h Investment Revenue Indirect Personal tax inc. tax

1. 2. 3. 4. 5.

Currency adjustment is more modest Zero bound for interest rates Broken monetary policy transmission channel Liquidity constraints in the private sector Starting point has large output gaps *

Germany France Italy UK US

Source: OECD

0.6 0.8 0.8 0.7 0.9

0.5 0.6 0.6 0.6 0.7

1 1 1 1 1.1

-0.3 -0.3 -0.3 -0.3 -0.4

-0.5 -0.6 -0.6 -0.6 -0.7

Recent research suggests that the above multipliers might be underestimated in the case of Italy & Spain

With already high debt ratios, the impact of fiscal consolidation plans on debt ratios is likely to be more than offset by the indirect effect of lower GDP (IMF, 2012)

Easier financing conditions required

Should lending rates fail to decline, we think responses at a decentralised level will be soon required, especially for Italy and Spain
Euro-area rate band suggested by Taylor rules Euro area lending rate spreads (vs ECB policy rates)

% 7 6
5 4

Band ECB

HH spread

NFC spread 3

3
2

1
0 -1

-2
-3 1Q99 1Q01 1Q03 1Q05 1Q07 1Q09 1Q11 1Q13

0 Jan-03 Jun-04 Nov-05 Apr-07 Sep-08 Feb-10 Jul-11

Source: Datastream, ECB, EC and Nomura Global Economics. Note: HH stands for houshold and NFC stands for non financial corporations.

Policy rates more appropriate for core than peripheral countries

Change in policy rate required in 2013 in percentage points

Additional easing / tightening required on average (excluding changes in bank lending rates spreads) Euro area Germany France Italy Spain Netherlands Ireland Portugal Greece 1.3 0.9 0.7 2.3 2.4 1.5 1.3 1.4 1.7

Average spread of bank lending rates to ECB before crisis 1.7 2.1 1.6 1.6 1.6 1.5 1.9 2.2 4.0

Current spreads 2.4 2.1 2.4 3.1 2.7 2.3 3.0 4.1 5.2

Additional easing / tightening required controlling for changes in bank lending rate spreads 2.0 0.9 1.5 3.8 3.5 2.3 2.4 3.3 3.0

Source: ECB and Nomura Global Economics. Note: 1. The additional easing required is measured as the difference between the average of our five Taylor rule implied policy rates in Q4 2013 and that predicated by the average of the five rules in Q4 2012. It is not computed as the difference between the predicated rate in Q4 2013 and the current actual policy rate. 2. The average spread before the crisis is computed over the 2003-end 2007 period.

Bank Lending Survey (1): Tighter from already tight conditions

Our composite credit standard index (based on the ECB bank

lending survey (BLS) assuming a 50/50 split between households and corporates), rose from 11% to 13% in Q3, suggesting most banks tightened credit standards more in Q3 2012 than in Q2. Survey conducted between 20 September and 9 October 2012, so the accelerating deterioration in credit standards seems to suggest only a limited positive impact from OMT announcement, at least so far

However, most of the deterioration in credit standards led by a deteriorating economic cycle (eg. general economic activity or industry-specfiic risks) rather than balance-sheet constraints Despite the very significant improvement in market conditions credit standards continued to tighten

Aggregate credit conditions in the euro area

% balance, net tightening 60 50 40 30 Supply: present Supply: future

Bank lending conditions for enterprises

% balance, net tightening 70 Cyclical factors 60 50 Competition Balance sheet constraint

Tighter credit conditions 40 30

Overall

Tighter conditions

20 20 10 10 0

0
-10 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 -10 1Q07

1Q08

1Q09

1Q10

1Q11

1Q12 10

Source: ECB and Nomura Global Economics. Note: Balance-sheet constraints include capital, access to financing, and liquidity position. Cyclical factors include general economic activity, industry outlook, and collateral risks. The sum of the bars has been adjusted to equal the corresponding overall value.

Bank Lending Survey (2): Germany the only country seeing demand
Demand conditions remain weak across the euro area as a whole, but

mainly concentrated in the periphery, with business cycle considerations the key driver of the deterioration in both supply and demand

Easing credit conditions in countries under most stress is complicated by the breakdown in the transmission mechanism and the deepening recession in those countries.

Despite the very significant improvement in market conditions, credit standards continued to tighten. This begs the question as to whether the bailout mechanisms, as they have been devised, will successfully reach the end-users in those economies or whether other tools should be used to generate a more direct easing in credit conditions.

Aggregate demand conditions in the euro area

% balance 40 30 20 10 0 -10 -20 -30 Demand: present Demand: future

Demand conditions across countries

% balance 60 40 20 0 -20 -40 -60 Euro area Germany Italy Spain

-40 -50 -60 1Q07 1Q08 1Q09

Weaker demand -80 -100 1Q10 1Q11 1Q12 4Q02 3Q04 2Q06 1Q08 4Q09 3Q11 11

Source: ECB and Nomura Global Economics

ECB still at the centre of the policy response: from SMP to OMTs (i)
ECB Outright Monetary Transactions (OMTs) i. Secondary market bond purchases that aim at safeguarding an appropriate monetary policy transmission and singleness of monetary policy ii. Necessary condition is strict and effective conditionality attached to appropriate EFSF/ESM programme: Full macroeconomic adjustment programme Precautionary programme Enhanced Conditions Credit Line (ECCL) Both must include the possibility of EFSF/ESM primary market purchases Involvement of IMF sought for country-specific conditionality design and monitoring iii. Focused on short end of yield curve and in particular on sov bonds with maturity between 1-3 yrs iv. No ex-ante quantitative limits set on the size But purchases will be limited by maturity and free float constraints ECB could buy an average of Eur 5bn SPGB a week and be in the market for 5 months without hitting free float limits (SPGB secondary mkt up to 3yrs: Eur 200bn) Might be difficult for the ECB to buy more than Eur 100bn, on top of the Eur 44bn we estimate the ECB already holds of SPGBs v. ECB to stop purchases during quarterly review and full market access required No intervention for countries that have lost market access could be very concerning for Ita/Spa Short-term issuance monitored very closely While ECB says amounts involved might be unlimited, they will de facto be constrained by maturities target and free float available
12

ECB still at the centre of the policy response: from SMP to OMTs (ii)
1. OMT is a tail risk instrument and not aiming to reduce bond yields aggressively Yield-capping, not yield-crushing could become the biggest bone of contention with the Spanish govt.
Draghi 7 Nov 2012: The ECB has produced the OMT. The OMT is a fully effective backstop mechanism that is devised to remove the tail risk while at the same time not removing the incentive for fiscal discipline and delivering price stability thats there - and the conditions for accessing that are also very very clear. The ball is completely in the courts of the government, not with the ECB.

1.

Contradictions in ECB intervention: i. Despite its intention, ECB is in no position to eradicate the cross-currency exchange rate risk premiums now embedded in the Monetary Union: - risk premium ultimately in the hands of the economy, populations and politicians ii. A tool designed to address failing monetary policy transmission should be unconditional and not have fiscal conditionality attached to it Buba concerned over lack of political and legitimacy of ECB actions: one can understand Buba Pdt Weidmanns worry about long term implications of the ECB becoming the institution that will decide on the fate of banks, sovereigns, governments and the Monetary Union itself While it is easy to blame the ECB for not going unlimited and unconditional in its support, its behaviour reflects the constraints under which it is operating politicians are to blame, not the ECB Policy response based on conditionality shifts the focus onto implementation risks

2.

3.

13

Our baseline scenario: ECB intervention buys time but no game changer

Spain & Italy: External support in focus

Spain and Italy to resist calling for help prompting renewed market deterioration Aggressive fiscal consolidation in Italy and Spain will likely lead to greater economic weakness than expected

EFSF/ESM

EFSF/ESM not credible to provide funding for Spain and Italy

ECB intervention insufficient

ECB intervention under strict conditionality & on short term maturities is not sufficient ECB not credible in defending irrevocability of the currency when membership is now revocable (due to politicians statements)

Exit risks remain high - various drivers

Banking/fiscal union discussion to precipitate decision on the ins and outs Exit risks, intra regional FX risks cant be tackled by central bank

After period of calm, renewed stress expected Timing: 3 months after activation of rescue
14

Spain

15

Spain: Conditions for call to be made (currently not met)

Spain has laid out 3 conditions to call for help which are currently not met. 1. Call should take place only if absolutely needed: Market conditions currently not seen by Spain bad enough especially when they have no clarity on how low yields would be post OMT. Rajoy (Nov 7th, COPE) said calling for help would make little sense if it does not help reduce the spread from the current 435bp to a much narrower 200bp. European countries should unanimously back the call: Press reports have reported that the Bundestag does not currently see the urgency of a sovereign bail out for Spain. Germany may want to bundle together the bail outs for Greece, Cyprus and Spain. Finnish PM also said in Madrid on Sep 11th The main thing is to try and avoid to request help.

2.

3.

Conditionality should be appropriate: This might be the least contentious item with most of the emphasis on structural reforms rather than on nominal deficit targets.

Delay in request for help should test markets patience

16

Spain: Conditions required for bail out to work (currently not met)

1. 2. 3. 4. 5. 6.

Cost of funding of households & Cies needs to drop to as close to 0 as possible Banking sector needs to regain market access at viable cost Assets should be transferred at credible clearing price to AMC Deleveraging of the economy needs to be mitigated by shock absorbers Fiscal consolidation should not be too front loaded Deposit and capital flights need to abate; availability of collateral needs to be ample

With nominal growth likely to remain around 0 at best for the next few years The cost of capital of the real economy needs to collapse, an unlikely scenario

17

Spain monetary conditions should ease by more than 300bps

Spain requires much easier monetary conditions due to economic contraction and wide lending rate spreads
Spains rate band suggested by Taylor rules Spain lending rate spreads (vs ECB policy rates)

% 9

Band

HH spread

7
5 3

ECB 3

NFC spread

1
-1 -3 1

-5 1Q01

1Q03

1Q05

1Q07

1Q09

1Q11

1Q13

0 Jan-03 Jun-04 Nov-05 Apr-07 Sep-08 Feb-10 Jul-11

Source: Datastream, ECB, EC and Nomura Global Economics. Note: HH stands for houshold and NFC stands for non financial corporations.

18

Backstop still too costly for Spain

Spain funding cost still too high even in best case scenario, %
Eur bn ECB rate Marginal cost of funding of the sovereign Marginal cost of funding of banks ECB Wholesale Household Deposits Corporate deposits Other deposits (FIs) Marginal cost of real economy Household real estate Household consumer credit Household other Corporates Memo items Compensation per employee Employment Consumption deflator Compensation of employees (nominal) Compensation of employees (real) Real consumption Real GDP Nominal GDP
Source: BdE and Nomura Global Economics.

2009 1.25 3.0 1.7

Before Draghi 0.75 7.0 2.8 9.0 1.5 1.1 1.3 3.9 3.3 8.5 6.0 3.8 1.5 -5.0 2.0 -3.5 -5.5 -2.5 -1.3 -1.0

Post OMT 0.75 3.5 2.0 1.0 5.5 1.5 1.1 1.3 3.5

350 550 757 229 1400 646 65 128 825 3.5 1.2 1.7 1.2 3.3 2.5 9.3 4.5 3.2 4.2 -6.0 -1.0 -1.8 -0.8 -4.0 -3.7 -3.6

After OMT starts assuming 2 year rate at 2% and 10 year rate at 4% (our best case scenario)

1.0 -5.0 2.0 -4.0 -6.0 -4.0 -3.0 -3.0

Cost of funding of the real economy unlikely to go below sovereign cost of funding

19

Banking sector deleveraging has a long way to go!

Eur bn

4000

3500
3000 2500 2000 1500

Annual changes in assets of Spanish banks Eur, bn Loans Sov bonds Other assets Dec-09 -59.3 61 35.7 Dec-10 -4.2 -7.7 36.1 Dec-11 -33.7 35 148.9 Nov-12 -64.8 54.2 -16.4

Total assets 37.4 24.2 150.2 -27

But this might free up space for sovereign bond purchases by banks

1000
Total Assets Banking Sector 500 Nominal GDP

0 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12
Source: ECB and Nomura Global Economics.

20

Decomposing the Spanish Target 2

Changes in Spanish Target 2 and balance of payment by sector , bn euros

60

40
20 0 -20 -40 -60 -80 Jan-07

Other Sectors General government Financial Institutions Target2 m/m Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12
21

Source: ECB and Nomura Global Economics.

External position improving as demand for imports has stalled

Spanish exports continue to do well but unclear if current account improvement is sustainable
Spanish exports and imports (Nominal, annualised Eur, bn) Import content of domestic production still high (shares as %)
130 120

380

330

110 100

280

90

80

230
70 60

180 Imports Exports 130 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-11
Source: Datastream, and Nomura Global Economics.

Intermediate & cap goods imports / Manuf & construction VA Intermediate goods imports / Manufacturing VA
Sep-03 Mar-05 Sep-06 Mar-08 Sep-09 Mar-11 Sep-12
22

50 40 Mar-02

Spain bail out: Conditionality and limited resources are key limitations

1. 2.

Call for help to take place later than expected Spain to request first ECCL but full bail out with strict conditionality needed eventually Combination of ECB and EFSF/ESM to support Spain initially Weak economy, ongoing worries about banking sector & capital flight to question credibility of backstop Debt trajectory to continue rising faster than expected

3. 4.

5.

For as long as there is no evidence of sustainable economic recovery & real estate asset price stabilisation, foreign investors will stay away from Spain

23

Italy

24

Italian and Spanish bond markets have been highly correlated

Back to post LTRO levels
Spanish and Italian bond yield spreads 2 year Spanish and Italian bond yield spreads 5 year

8 7

Italy

Spain

8 Italy 7 6 Spain

6
5 4 3

5
4 3 2

2 1
0 Jan-10
Source: Bloomberg

1
0 Jan-10

Jan-11

Jan-12

Jan-13

Jan-11

Jan-12

Jan-13
25

Sudden stop also happened in Italy

Target 2 imbalances

bn
200 100 0 -100 -200 -300 -400 -500 Jan-08

Italy

Spain

Sep-08

May-09

Jan-10

Sep-10

May-11

Jan-12

Sep-12

Source: National Central Banks and Nomura Global Economics.

26

Italy requires the largest additional monetary easing in the euro area
Average lending rates for households and companies higher than in Spain
Italys rate band suggested by Taylor rules Italy lending rate spreads (vs ECB policy rates)

% 8 6

Band

HH spread

ECB

NFC spread

4
3

2 0 -2
2

-4 1Q01

1Q03

1Q05

1Q07

1Q09

1Q11

1Q13

0 Jan-03 Jun-04 Nov-05 Apr-07 Sep-08 Feb-10 Jul-11

Source: Datastream, ECB, EC and Nomura Global Economics. Note: HH stands for houshold and NFC stands for non financial corporations.

27

Reform implementation takes time

Only 25% of the reforms approved by the parliament were fully effective by the end of 2012
In vigour since 6 Dec-11
100%
80% 60% Pending 40% 20% 0% Save Italy 47% Enacted 40% 20% 26% 0% Grow Italy 0% Simplification

In vigour since 24 Jan-12

100%
80% 60% 74% Pending Enacted

In vigour since 10 Feb-12

100%
80% 60% 40% 20% 15% 85%

53%

Pending Enacted

In vigour since 18 Jul-2012

100%
80% 60% 40% 20% 15% 0% Labour Market
Source: Il Sole 24 Ore, 30 Dec 2012

In vigour since 9 May-12

100%
80%

In vigour since 26 Jun-2012

100%
80%

85%

60% Pending Enacted 40% 20%

83% Pending Enacted

60% 40% 20%

78% Pending Enacted

17% 0% Spending Review 0%

22% Development

Reforms in Italy: more needs to be done

Additional suggested reform priorities
IMF / European Council :
Product markets: Well-targeted and timely executed infrastructure projects in the area of main network bottlenecks could further increase productivity in the economy Labour Market: Additional measure to strengthen the recent reform: more firm-level arrangements that favour employment rather than wages and to bridge the gap between permanent and temporary workers Tax reform to lower the labour tax wedge and remove disincentives for labour supply, especially for second earners Fiscal space: Growth friendly fiscal reform, prioritising public expenditure away from general transfers toward more public spending towards targeted infrastructure Public sector: Liberalisations of the area where the central government is the major stake holder (for example the gas sector)

OECD:
Fiscal space: Broaden tax bases, in particular by cutting the number of tax expenditures

Incorporate a spending review process into the normal budget and expenditure control systems
Operationalise the rules for a balanced budget and fiscal council in a timely and appropriate manner Enhance the privatisation programme to contain growth in debt if fiscal targets are substantially overshot Public sector: Embed -including by the adoption of the Anticorruption Bill- integrity and anticorruption tools within current structures of the Italian public administration by clearly defining roles and responsibilities for implementation of integrity measures among complementary functions Financial system: Strengthen banks capital bases in relation to assets by raising equity, or by disposing noncore assets rather than restricting lending Sever the adverse feedback from the sovereign to the banking sector by continuing both fiscal consolidation and structural measures Use, as planned, the bank failure resolution instruments available when required, regardless of the size of the bank Encourage banks to adopt a ring-fenced non-operating holding company structure to strengthen the structural resilience of its banking system

Liberalisation and competition where the local government play major roles (public services)
Regional differentiation and more flexibility in the public sector employment and wages Other reforms: Improving the efficiency of the judicial system, streamline procedures for labour disputes, strengthening contract enforcement
Source: IMF, European Commission OECD

29

Impact of structural reforms on the Italian economy

Findings in the literature

Authors Italian Government (2012)

Result Key measures to improve competition, cut regulatory costs and improve public administration efficiency taken up to the spring of 2012, could increase GDP growth by around 0.3% per year until 2020.

OECD (2012)

OECD (2009)

Related to the government estimate, including some further measures taken after the NRP was published, might be slightly higher, 0.3-0.4% on the average growth potential until 2020. Italys labour productivity could increase by about 14 percent over 10 years if its product market (especially professional services) regulation is aligned to international best practice.
Product market reforms adopted in Italy over 200812 could potentially increase TFP by 23 percent in 2020 Under an ambitious and broad reform agenda to close the gap with the best practice or most liberal cases (labor market reforms), Italys GDP per capita could increase by about 7 percent after 5 years and close to 15 percent after a decade. Increasing competition in services sector in Italy could raise its real GDP by up to 11 percent in the long run, half of which comes in the first three years. All product and labour market reforms have a positive impact in the medium term, and together, could raise real GDP in Italy by 5.75 percent after 5 years and by 10.5 percent in the long run
30

OECD Bouis and Duval (2011) and OECD (2012)

Forni and others (2011)

IMF (2012)

Source: Nomura European Economics, IMF

Italian elections: mind the Senate

Lack of absolute majority in the Upper House is a tangible risk due to uncertainty over key regions

Plausible seats allocation in the Senate 1. IBC wins all regions 2. IBC wins all regions but Lombardia and Veneto 3. IBC wins all regions but Lombardia, Veneto, Campania and Sicily Possible seats Monti could win Seats of a possible Bersani & Monti alliance under scenario 3

Number of elected Senators in Italy 177 155 138 35 173

Total Senators including foreign and for life 182 160 143 38 181

The centre-left coalition led by Bersani is very likely to secure an absolute majority in the Lower House, but the lack of an absolute majority in the Upper House is a tangible risk for the next national elections. We continue to expect a centre-left coalition to lead the next parliament. Should it fail to achieve an absolute majority in the Upper House we expect a broad Bersani and Monti coalition to be forged rather than new elections. This is likely to be viewed positively by the market. The risk of ungovernability remains but at this stage, Italian politics in our scenarios is unlikely on their own to trigger a broad and severe return of stress in the region.

IBC is Italia.Bene Comune. Seats allocation assumes IBC gets majority premium in all the regions but in those indicated in each scenario as lost. Absolute majority in the Senate implies 160 seats. For the latter regions the number of seats allocated to the coalition is given by poll published by il Sole 24 ore on 8 January and based on IPSOS poll results. Numbers in green indicate absolute majority is achieved. Numbers in red indicate absolute majority not achieved. For regions where polls are not available we use our own assumptions based on Source: Nomura European Economics consensus of each party in the national polls.

France

32

France's worrying labour market situation (i)

Unemp. rate in Germany and France (%, Eurostat definition)

French unemployed, millions

3.00

12.5
2.80

11.5
2.60

10.5
2.40

9.5 8.5 7.5 6.5 5.5 Germany 4.5 France

2.20
2.00

1.80
1.60

1.40 Job seekers benefits

1.20

Total unemployment benefits

3.5 Mar-83 Mar-87 Mar-91 Mar-95 Mar-99 Mar-03 Mar-07 Mar-11

.Source: Datastream and Nomura Global Economics.

1.00 Jan-88

Jan-91

Jan-94

Jan-97

Jan-00

Jan-03

Jan-06

Jan-09

Jan-12

33

France's worrying labour market situation (ii)

Days needed to find a job, average for total unemployed

450

Days needed to find a job, unemployed who have lost their job for economic reasons
600

550 400 500

350

450

400 300

350

300
250

250

200

200

.Source: Datastream and Nomura Global Economics.

34

Credit conditions confirm economy slowing down significantly

Loan growth to Households and Corporates

Corporate treasurers survey on operating cash position

% y-o-y

Balance
20 15

20 Household NFC 10

15

10 5 0 -5

-10 -15

-20 -25

Operating cash (sa) Operating cash (trend)

-5 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11

.Source: Datastream and Nomura Global Economics.

-30 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12

35

Shift from foreign to domestic holdings has not led to market turmoil

Foreign ownership of French sovereign bonds

72 70

Banks holdings of French sovereign bonds

140 French banks Other EU 120 Other foreign banks UK banks Japanese banks German banks

68
100

66 64 62 60 58
20 80

60

40

56
0

54
Jul-08 Jul-09 Jul-10 Mar-08 Mar-09 Mar-10 Mar-11 Jul-11 Mar-12 Nov-08 Nov-09 Nov-10 Nov-11

Q4-11

Q2-12

.Source: Datastream, BIS, AFT , BIS and Nomura Global Economics. Note: French banks holdings of French bonds is sourced from EBA and might not be completely consistent with BIS methodology

36

French and Japanese banks have been the largest buyers in 2012

Japanese buying and selling of sovereign bonds Eur bns

French banks' exposure to sovereigns Exposure to France Gross Net Dec-11 Jun-12 Dec-11 Jun-12 BNP 16.4 16.6 10.9 6.6 Credit Ag. 23 32 20 28 BPCE 36 44 28.9 32 Soc Gen 17.7 21.7 13.4 16.6 Big 4 93.1 114.3 73.2 83.2 Total exposure Gross Dec-11 Jun-12 92.7 90.2 38 55.6 54.6 71.8 49 52.6 234.3 270.2 Net Dec-11 69.5 30 34.5 28.7 162.7 Jun-12 61.1 37.6 42.6 31.6 172.9

15 Germany 10 France Oct/Nov

-5

BNP Credit Ag. BPCE Soc Gen Big 4

-10

-15

-20 Q1-11
. Source: EBA, Datastream , MOF and Nomura Global Economics.

Q4-11

Q3-12
37

France

Frances rate band suggested by Taylor rules

France lending rate spreads (vs ECB policy rates)

% 7 6 5 4 3 2 1 0 -1

Band

HH spread

ECB

NFC spread

-2 -3 1Q01 1Q03 1Q05 1Q07 1Q09 1Q11 1Q13

0 Jan-03 Jun-04 Nov-05 Apr-07 Sep-08 Feb-10 Jul-11

Source: Datastream, ECB, EC and Nomura Global Economics. Note: HH stands for houshold and NFC stands for non financial corporations.

Netherlands

39

Netherlands: Consumer facing increasingly significant headwinds

Uncertainty about future tax take, housing and labour market dampen current spending
Consumer confidence (Last obs: Dec 12) Business confidence in the construction sector (Last obs : Dec 12)

40
40

30
30

20
20 10 0 -10

10 0 -10 -20 -30

-20

-40
-30 -40 Jan-88

-50 -60 Jan-88

Jan-92

Jan-96

Jan-00

Jan-04

Jan-08

Jan-12

Jan-92

Jan-96

Jan-00

Jan-04

Jan-08

Jan-12
40

Source: Nomura Euroepan Economics, European Commission, National Statistics Institute

Netherlands: Housing Price and Demand Conditions

Uncertainty about the economy and future effect of policy changes discourages buyers
House prices fell 16% from peak, transactions more than 50%
58000 120

Intention to purchase a home over the next 12 months at historic low

22 -68

53000

110

17
-73 12

100 48000 90 43000 7 80 38000 70 33000 60

Number of sold dwellings

-78

-83

-3 -88 -8
House price inflation, % y/y Intention to buy a house over the next 12 months (rhs)

28000
Price index purchase prices (rhs)

50

23000 40 Mar-96 Mar-98 Mar-00 Mar-02 Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 -13 Jun-96 Jun-98 Jun-00 Jun-02 Jun-04 Jun-06 Jun-08 Jun-10 Jun-12
Source: Nomura Euroepan Economics, European Commission, National Statistics Institute

-93 41

Netherlands: Price decline hitting young segment of the population

Liquid household assets below outstanding mortgages
Young population in negative home equity Household deposits by age, main income earner (2011, Eurbn)

140

120

100

80

60

40

20

up to 25 yrs

between 25 and 45 yrs

between 45 and 65 yrs

Over 65yrs

Source: DnB

42

Netherlands

Dutch rate band suggested by Taylor rules

Dutch lending rate spreads (vs ECB policy rates)

% 10

Band

HH spread NFC spread

8
6 4

ECB

2
0 -2

-4 1Q01

1Q03

1Q05

1Q07

1Q09

1Q11

1Q13

0 Jan-03 Jun-04 Nov-05 Apr-07 Sep-08 Feb-10 Jul-11

Source: Datastream, ECB, EC and Nomura Global Economics. Note: HH stands for houshold and NFC stands for non financial corporations.

43

Medium term challenges The North / South divide in the euro area is getting wider

44

Core / Periphery divide (i)

Unemployment rate

Unemployment levels

% 20 18 16 14 12 10 8 6 4 2

Millions Core Periphery 12 10 8 6 4 2 0 Jan-91

Core

Periphery

0 Jan-93 Mar-96 May-99 Jul-02 Sep-05 Nov-08 Jan-12

Jan-95

Jan-99

Jan-03

Jan-07

Jan-11

Note: Core includes Germany, France, Austria, Finland, Luxembourg, Netherlands and Belgium. Periphery includes Spain, Italy, Portugal, Greece and Ireland. Source: Datastream and Nomura Global Economics.

45

Core / Periphery divide (ii)

Social expenditures in the periphery, % of GDP

Social expenditures in the periphery, level

% of GDP 19 18

bn 600 550 500

17
16 15 14 13 12 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 450 400 350 300 Mar-01

Mar-11

Mar-03

Mar-05

Mar-07

Mar-09

Mar-11

Note: Periphery includes Spain, Italy, Portugal, Greece, Ireland. Source: Eurostat and Nomura Global Economics.

46

Core / Periphery divide (iii)

Manufacturing production

GDP

Index (Jan 05=100) 120 Core 115 110 Periphery

Index (1Q05 = 100)

112 110
108 106

Core

Periphery

105
100

95
90 85

104
102 100

80 Jan-05

Jul-06

Jan-08

Jul-09

Jan-11

98 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10 1Q 11 1Q 12

Note: Core includes Germany, France, Austria, Finland, Luxembourg, Netherlands, Belgium. Periphery includes Spain, Italy, Portugal, Greece, Ireland, Slovakia, Slovenia, Cyprus, Estonia, Malta. Source: Datastream, Eurostat and Nomura Global Economics.

47

Core / Periphery divide (iv)

M3

M1

% y-o-y 14 12 10

% y-o-y

Core

Periphery

20 15 10 5 0 -5

Core

Periphery

8
6 4 2 0

-2
-4 Oct-02 Oct-04 Oct-06 Oct-08 Oct-10 -10 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12

Note: Core includes Germany, France, Austria, Finland, Luxembourg, Netherlands, Belgium. Periphery includes Spain, Italy, Portugal, Greece, Ireland, Slovakia, Slovenia, Estonia, Malta. Source: Datastream and Nomura Global Economics.

48

Core / Periphery divide (v)

Target 2 imbalances

bn 1,500 1,000 Core Periphery

500 0
-500 -1,000 -1,500 Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12
49

Note: Core includes Germany, France, Finland, Luxembourg, Netherlands, Belgium. Periphery includes Spain, Italy, Portugal, Greece, Ireland, Slovenia, Malta. Source: National Central Banks and Nomura Global Economics.

Key medium term challenges

1. 2. 3.

Banking union to fast forward debate on fiscal & political union Non euro area members to face immediate challenge on banking union Lack of deposit guarantee schemes & of resolution mechanisms key limits to banking union Further integration on banking, fiscal and political fronts to require consultation with population in next two years Lack of growth strategy risks turning population against the euro Exchange rate risk premium cannot be eradicated, a major systemic weakness

4.

5. 6.

High unemployment in structurally challenged economies main risk to stability of the Union

50

Are you in favour or against EMU and the euro: Core

Germany
80% 70% 60% 50%
50% 45% 40% 30% 20% 10% 40% 36% 27% 24% 39% 26% For

Finland
69%
Against 72%

90%

For

Against

83%
76%

71%

79%
69% 80%

70% 60%

62% 49%

50% 40% 30% 33% 20% 10% 46%

26% 20%

19% 15%

22%

0% 0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12 Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

Austria
For 80% 70% 60% 50% 40% 30% 20% 20% 10% 0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12 23% 74% 73% 67% 66% Against

Netherlands
90% 80%
66%

For

Against

83% 75%

70%
60% 50% 57%

66%

71%
62% 39% 30%

44% 43%

48% 38%
27% 28%

40%

37%

30%
20% 10% 0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12 15% 25% 22%

Source: European Commission.

51

Are you in favour or against EMU and the euro: Semi Core
France
90% 80% 70% 60% 50% 40% 30% 19% 20% 10% 0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12
20% 10%

Spain
For 78% 72% 69% Against
90% 80% For 78% Against

75%
69% 61% 58% 55% 32% 30% 68% 63%

63%

63%

70% 60%

58% 36% 30% 25%

50%

31% 27%

40% 30%

23% 19%
13% 21%

0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

Italy
100% 90% 78% 80% 70% 60% 82% For Against

Belgium
100% 90% 80% 75% 78% 69% For 89% Against 85%

62%

64% 58%

70%

57%
60% 50% 40% 30% 32%

57%

50%
40% 30% 20% 28% 31% 24% 31%

29% 15% 15%

20% 10% 18%

10%

10% 12% 11% 0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

Source: European Commission.

52

Are you in favour or against EMU and the euro: Periphery

Portugal
80% 70% 59% 60% 50% 45% 40% 29% 61% 57% 55% For 69% Against

Greece
90% 78% 80% 75% 63% For Against 75% 65%

70%
60% 50% 40% 47% 27%

52%

36%

30% 20%

37%

30%
25%

32% 25%

30%
20% 10%

31% 16%

10%
0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

17%

21%

0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

Ireland
100% 90% 80% 67% 70% 60% 50% 40% 30% 18% 20% 10% 23% 12% 14% 8% 8% For 83% 87% Against

Cyprus
80% For Against 67% 59% 48% 48% 43% 30% 20% 10% 35% 59% 57%

86%
70% 60%

78%

75% 67%

50% 40%

40%

37%
31%

0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12
Source: European Commission.

0% Oct-04

Oct-05

Oct-06

Oct-07

Oct-08

Oct-09

Oct-10

Oct-11

Oct-12

53

Are you in favour or against EMU and the euro: Non euro countries
UK
90% 80% 70% 59% 60% 50% 40% 48% 65% 67% 65% For Against 80%

Denmark
80%
70% 62% 60% 50% 40% 30% 36% 32% 45% 56% 56% 50% 53% 67%

For

Against
69%

42%

29% 30%

30% 20% 10%

36%

29%
23% 24%

28% 14%

20%

10%
0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12

Sweden
80% 70% 60% 50% 56% 50% For Against 76%

Latvia
70%
59%
62% 53% 62%

For

Against
55% 47% 56%

60% 50% 40% 46%

54%

40%

43% 36% 31%

44% 36%

35%

44%

40%
30% 20% 10% 34% 29% 23% 34%

30% 20% 10% 0% Oct-04

0% Nov-97 May-99 Nov-00 May-02 Nov-03 May-05 Nov-06 May-08 Nov-09 May-11 Nov-12
Source: European Commission.

Apr-06

Oct-07

Apr-09

Oct-10

Apr-12

54

Appendix

55

Euro area forecast

Growth outlook significantly weak in peripheral countries

Real GDP (% y-o-y) Euro area Austria France Germany Greece Ireland Italy Netherlands Portugal Spain 2012 -0.5 0.8 0.1 0.9 -6.1 0.4 -2.1 -0.8 -3.0 -1.4 2013 -0.8 0.2 -0.5 0.2 -4.4 0.5 -2.5 -0.5 -2.8 -3.0 2014 0.0 0.8 0.5 0.7 -1.8 1.3 -1.5 0.1 -0.1 -1.5

Consumer Prices (% y-o-y) 2012 2.5 2.6 2.2 2.1 1.0 1.9 3.3 2.8 2.8 2.4 2013 2014 1.8 1.5 2.3 1.4 1.7 0.3 0.3 2.0 2.7 1.2 2.1 2.0 1.7 1.4 0.0 0.6 1.4 2.1 0.5 1.1

Policy Rate (% end of period) 2012 2013 0.75 0.50 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 2014 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50

Source: Nomura Global Economics

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DISCLOSURE APPENDIX A1 ANALYST CERTIFICATIONS We, Jacques Cailloux and Nick Matthews, hereby certify (1) that the views expressed in this report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this report and (3) no part of our compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company. Issuer Specific Regulatory Disclosures The term "Nomura Group Company" used herein refers to Nomura Holdings, Inc. or any affiliate or subsidiary of Nomura Holdings, Inc. Nomura Group Companies involved in the production of Research are detailed in the disclaimer below.

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