Views on Sovereign Risk Nantes, 16 mars 2012 Natacha Valla March 2012 Goldman Sachs Global Economics, Commodities and Strategy Research 1

Sovereign risk is intertwined in an adverse feedback loop 4 3 1 2

PLAN I – THE MACRO / BANKING FEEDBACK LOOP AND IMPLICATIONS FOR SOVEREIGN RISH I I– THE ROLE OF THE CENTRAL BANK I II– THE 2012 FRENCH ELECTIONS AND SOVEREIGN RISK IN THE EURO AREA Source: ECB

PART I THE MACRO / BANKING FEEDBACK LOOP AND IMPLICATIONS FOR SOV. RISK Source: ECB

Bank loan flows are very modest … Source: ECB

... and credit conditions are tightening ... Source: ECB

... with loan rates increasing, especially in peripheral countries ... and credit conditions are tightening, especially for smaller firms ... ... with loan rates increasing, especially in peripheral countries Source: ECB

Government bond yields are diverging … Source: Datastream

... destabilising sovereign markets ... Source: GS Global ECS Research

… with a spillover into the area-wide banking sector … Source: GS Global ECS Research, Bloomberg, Haver Analytics

… in a context of high funding needs of both banks and sovereigns Governments Source: Dealogic

PART II THE ROLE OF THE CENTRAL BANK Source: ECB

The ECB has provided extensive financing to banks ... Source: ECB

ECB has also eased in the face of weakness, but less on interest rate dimension … Source: GS Global ECS Research

… and more via balance sheet measures As of end of January 2012 (using 2011 GDP figures) Source: GS Global ECS Research

Outstanding ECB monetary policy operations have increased Source: GS Global ECS Research

… building banks’ dependence on the ECB … Source: National Central Banks

… and resulting in growing intra-Eurosystem cross-country (im)balances Source: National Central Banks

Debt of programme countries is migrating onto public balance sheets … Note: Includes second Greek package Source: IMF, GS Global ECS Research

… as banks have sold government debt … Source: ECB

... in large part to the ECB Source: ECB

In principle there is remaining capacity at the euro area level to address fiscal issues … Source: GS Global ECS Research

... given the consolidated euro area fiscal position ... Source: GS Global ECS Research

... but cross-country diversity in the fiscal situation is great ... ) Note: Column for Ireland excludes impact of state support to banking sector (unadjusted figure = -32.4% of GDP Source: IMF, GS Global ECS Research

... and governance weaknesses make consolidation difficult Source: Eurostat

Case study for sovereign risk: the 2012 French elections takeaways Long term: no major difference on Fiscal consolidation: will get there (late) Europe (on safe grounds) Short term, a couple of challenges Headwinds: Cycle + « inertia » in policies will mean fiscal consolidation slower than thought Europe: Hollande insisting on Treaty renegotiation Overall Renewed episode of market discipline likely in H2:2012

PART III CASE STUDY: THE 2012 FRENCH ELECTIONS AND SOVEREIGN RISK IN THE EURO AREA Source: ECB

First-round polls suggest four candidates have a chance of winning

Second-round polls: in the event of a Sarkozy/Hollande run-off , Hollande more likely to win

Similar horizon for a balanced budget

Past: both right- and left-wing governments have consolidated budgets…

…but counter-cyclical consolidation has been rare in France (1978-2011)...

Required gov. primary balance from 2014 as a function of nominal interest rate and nominal growth

Short-term: tax policy will be a key ‘divider’

France uncompetitive on a number of taxes

But proposals on expenditure cuts are scarce

Transfers matter for households’ real disposable income - not a campaign theme

Macroeconomic outlook: we foresee weak domestic demand (Contributions to quarterly GDP growth)

Background slides Total government spending suggests larger public sector in France than in the Euro area, the US or Japan...

The same holds for government consumption…

…and for the share of government employment

Northern 'core' - southern 'periphery' duality in the quality of institutions...

...which is less evident in other key indicators

BACKGROUND SLIDES

Global growth momentum has turned … Source: GS Global ECS Research

… resulting in some upward revision to our global forecasts Source: GS Global ECS Research

But marked deterioration in Euro area data through the year … Source: GS Global ECS Research

… reflected also in PMI business surveys … Manufacturing Services Euro-zone previous in (): Man PMI:xx (xx), Service:xx (xx), Composite PMI: xx (xx). Man. PMI: Germany xx (xx), France xx (xx), Italy xx (xx), Spain xx (xx). Source: Markit 1

... has led us to revise real activity down, but with a recent uptick … Source: GS Global ECS Research

… resulting in a growth forecast for 2012 of -0.4%yoy… Source: GS Global ECS Research

… with the Euro area standing half way through a ‘lost decade’ by end-2013 Source: GS Global ECS Research

Headline inflation is expected to moderate … Source: GS Global ECS Research

… while money and credit have rebounded, but remain subdued Source: ECB

General government deficit, revenue and expenditure

General government debt-to-GDP ratios

Unit labour costs remain divergent … Source: Eurostat

Cross-country comparisons of recovery Source: Eurostat

Disclaimer I, Natacha Valla, hereby certify that all of the views expressed in this report accurately reflect personal views, which have not been influenced by considerations of the firm’s business or client relationships. 1