INTERNATIONAL ECONOMIC OUTLOOK QUARTERLY MARCH 2016 RISKS CONTINUE TO CLOUD GLOBAL OUTLOOK CONTENTS

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1 INTERNATIONAL ECONOMIC OUTLOOK QUARTERLY MARCH 2016 RISKS CONTINUE TO CLOUD GLOBAL OUTLOOK Global growth prospects have diminished over the start of 2016, following turmoil in financial markets as the year opened. Although the market reaction to news on growth prospects has been somewhat overblown, it reinforces the risks to global growth. With advanced economies also showing a generalised slowing in momentum, global growth could well disappoint this year. Advanced economies slowed in the second half of 2015, with Japan showing negligible growth over the year amidst falling consumer spending and stagnant investment. With the Yen on the up once more, fiscal and monetary policy are likely to remain accommodative. News on US growth has been a little more promising recently, despite the low oil price continuing to drag on the oil sector. For both the US and the UK, a strong labour market should support overall growth this year and next, with monetary policy gradually tightening in both countries. But in the UK, growth in activity has eased off and interest rates are now unlikely to move before the end of the year. Meanwhile, weakening growth and inflation in the Eurozone have pushed the ECB into another programme of monetary easing. Although China continues to slow, growth should reach a little under 6% over the next couple of years. Meanwhile, India will remain the EM growth leader, helping fuel a surge in FDI with strong consumer income and low oil CONTENTS prices supporting overall growth. Brazil s murky politics will continue to impede a Page 2-3 EUROZONE meaningful improvement in prospects, while Russia remains caught by high inflation and weak oil prices, with geopolitical Page 4-6 UK developments a further drag on growth. CBI international forecasts US Eurozone Germany France Italy Spain UK Japan China India World (purchasing power parity) Subdued growth to continue after ECB easing A bright light amid gathering darkness PAGE 7-8 US Growth rests on solid foundations PAGE 9 JAPAN More policy stimulus is likely PAGE 10 CHINA Rebalancing efforts prove tricky PAGE 11 INDIA Domestic strength to offset external headwinds PAGE 12 BRAZIL Weak currency to do little to alleviate woes PAGE 12 RUSSIA Prospects hampered by low oil prices

2 EUROZONE GDP growth slowed during 2015 and February PMIs point to a further softening at the start of Against this backdrop, the ECB announced a broad package of monetary stimulus measures at its mid- March meeting, with a particular focus on easing credit conditions for companies. Going forward, domestic demand is expected to hold up reasonably well, but weaker exports could offset this strength driven by a sharper slowdown in demand from China. Overall, real GDP growth is likely to remain subdued, with continued financial market volatility and political risks posing additional downside risks. Concerns rise over vulnerability of Eurozone economy In 2015, the Eurozone expanded by 1.6%, which although subdued in comparison with some other developed markets, was still its best performance since However, growth slowed during 2015: the Eurozone economy grew by 0.3% in the fourth quarter of 2015, unchanged from the previous quarter, but down from 0.4% in Q2 and 0.6% in Q1. Encouragingly, domestic demand has remained solid. Consumers have continued to benefit from falling oil prices which have allowed real wages to continue to grow. Retail sales volumes in January bounced back following a soft patch in September-October 2015, while passenger car registrations also surged in the final months of 2015, and rose further in January. Industrial production rose markedly in January, by 2.1% month on month, a significant rebound for the sector following two months of contraction. And record low interest rates continue to support a recovery in lending. The ECB s banking lending survey reported a further easing in credit standards on loans to enterprises in Q4. Growth in the major Eurozone economies was unchanged Eurozone GDP growth (% yr/yr) 4% 3% 2% Germany France Italy Spain Eurozone CBI Eurozone forecast 12mth% unless otherwise stated Growth and consumption Real GDP, of which: Germany France Italy Spain Household consumption Fixed investment Government consumption External Trade Exports Imports CPI inflation Unemployment rate (%) Government balance (% of GDP) ECB refi rate (%)* *end year in Q4, relative to Q3, at 0.8% in Spain and 0.3% in France and Germany. The exception was Italy, where growth slowed from 0.2% in Q3 to 0.1% in Q4. Meanwhile, in the peripheral economies, Greece avoided recession in Q4, with growth of 0.1%, although the economy still shrunk slightly over the year as a whole. Recent business surveys signal that the Eurozone s recovery may be under threat from weak global demand. Concerns about a China slowdown, a reappraisal of the outlook for emerging markets.and further commodity price declines appear to be affecting a vulnerable Eurozone. The European Commission s consumer confidence and economic sentiment survey decreased sharply in February, suggesting that confidence is being affected by these global concerns. Additionally, the business climate indicator fell markedly, reflecting weakness in the industrial sector. Meanwhile, the February flash composite PMI dropped to 53.0 a 13 month low, with new orders falling to a one year low. Deflationary pressures also strengthened, as weaker commodity prices weighed on input prices. The flash March composite PMI surprised to the upside at 53.7, as both manufacturing and services regained momentum, however the details were more subdued. New orders picked up only slightly while employment slowed and price pressures remained weak. The ECB comes out all guns blazing The Eurozone s weakening growth outlook coupled with continued declines in commodities prices has raised concerns about downward risks to price stability. 1% 0% -1% -2% -3% Q1-13 Q2 Q3 Q4 Q1-14 Q2 Q3 Q4 Q1-15 Q2 Q3 Q4 Inflation had been improving since its decline into negative territory in September, although remaining far lower than the ECB s target of 2%. The headline reading for February of -0.2%, however, pointed towards further downside risks, with weakness broad-based across components. Core inflation (excluding globally-influenced energy and food prices) has slowed slightly into the second month of

3 with a reading of 0.7% down from 1% in January. The ECB forecasts for HICP inflation in 2016 were sharply revised down in March to 0.1% from 0.7% in December. Inflation is then expected to recover to 1.3% in 2017 and 1.6% in As a result, Mario Draghi signalled in February that the ECB stands ready to do its part. True to its word, the ECB intervened in the March meeting with a package of measures across the monetary policy spectrum to tackle these concerns. Cuts were announced to all three of the ECB s rates: the main refinancing rate and marginal lending rate were each cut by 5bp each, to 0% and 0.25% respectively, while the deposit rate was cut by 10bp to - 0.4% (this took place after we published our last forecast). Additionally, a 20bn extension to the current quantitative easing programme was announced, taking the full amount to 80bn, with the range of assets also expanded to include investment-grade non-bank corporate bonds. Four new targeted long-term refinancing operations (TLTROs) were unveiled, starting in June 2016 to March 2017 (after the end of the current TLTRO programme). Loans will have a maturity of four years, with the cost of loans potentially falling as low as the interest rate on the deposit facility (- 0.4%), providing that banks meet certain conditions for lending to the private sector. The negative interest rate on these loans means that the ECB will effectively be paying banks to borrow, mitigating the penalty from the negative deposit rate, which has risked squeezing bank margins and profitability. Perhaps mindful of this, Draghi also stated that we do not anticipate that it will be necessary to reduce interest rates further. The remark was widely seen as a shift in focus from interest rates (and an effort to push down the euro s exchange rate) to quantitative and credit easing channels going forward. Forecast subdued growth likely to continue Advance survey indicators continue to support the view that domestic demand is driving Eurozone growth. But overall business confidence has fallen back sharply to an eight month low according to the European Commission s confidence indicator, possibly related to turbulence in financial markets. This may feed into lower domestic demand, ultimately impacting growth. Looking forward, political turmoil continues to dominate the key risks facing the euro area, with Irish and Spanish elections on the horizon. In Greece, the first review of the bailout has been delayed due to the implementation of reforms being behind schedule. In Portugal, a centre-left minority government has Eurozone consumer price inflation (% yr/yr) 5% 4% 3% 2% 1% Total Core (excl energy & food) Eurozone purchasing managers indices (50.0 = no change) Germany France Italy Spain Eurozone been formed and a budget approved containing some antiausterity measures while still managing to comply with EU fiscal rules. Meanwhile, the UK goes to the polls to vote on an EU referendum on June 23rd adding an extra layer of uncertainty to this backdrop. We forecast that the Eurozone economy will grow at a rate of around 0.4%-0.5% per quarter through to the end of 2017, with overall growth of 1.7% in 2016 creeping up to 1.9% in In 2015, GDP growth came in at 1.6% - the strongest growth rate since But there s still significant divergence within the Eurozone - Spain has been growing at the fastest pace since 2007, but Italy will still be below its peak at the end of the forecast period. Domestic demand (including trade between member states) is expected to continue to underpin the Eurozone s growth in both years, amidst of falling commodity prices and low inflation. With easier access to borrowing, businesses are likely to drive a continued recovery in investment, which is expected to grow 2.1% in 2016 and 3.5% in Household consumption, meanwhile, is forecast to rise to 1.8% in 2016 and 2017, from 1.6% this year. Industrial production is also set to accelerate to 1.1% in 2016 and to 2.3% in Sluggish external demand, however, is likely to persist, particularly in emerging economies - this could drag on growth and presents a downside risk to our forecast. Spain still seems to be the shining light in the Eurozone, as the fastest-growing of the big four economies in 2015 at 3.2%, and we expect that to continue into 2016 and 2017 we forecast strong growth of 2.9% and 2.4% respectively. We continue to expect Germany to grow at a decent pace of 2.1% in 2016 and 2.0% in 2017 from 1.4% in This is still faster than France or Italy. However, we expect to see gradual recoveries in both of these over the next couple of years, after weak overall GDP in In 2015, Italy grew just below our forecast expectations at 0.6% while France grew by 1.1% - in line with our forecast. Meanwhile, we expect France to grow 1.4% in 2016 and 1.9% in 2017, while Italy s growth rate is expected to be slightly weaker at 1.2% in 2016 and 1.3% in % -1%

4 UK UK economic growth has remained solid relative to our previous forecast in November, powered by sound domestic demand. While we expect this to continue ahead, we have downgraded our forecasts for both 2016 and 2017, key drivers of which are: downward revisions to historical GDP data; slower wage growth bearing down on household spending; and softer economic momentum taking the edge off of business investment. Meanwhile, risks to the outlook remain firmly skewed to the downside, with the EU referendum on the horizon and global growth softening against a background of greater financial market volatility. CBI UK forecast 12mth% unless otherwise stated Growth and consumption Real GDP Household consumption Fixed investment Government consumption External Trade Exports Imports CPI inflation Unemployment rate (%) Public sector net borrowing (% of GDP) Bank Rate (%) Q Data revisions reveal softer momentum over Overall, the UK economy grew solidly over the course of 2015 and the composition of growth remained similar to that in powered by domestic demand, with a negligible contribution from net trade. However, revisions to national accounts data show that momentum over last year was slightly softer than previously thought growth for the year came in at 2.2%, against our November forecast of 2.4%. But the drivers of these revisions were broad-based in both directions: the contribution from net trade was lower, but fixed investment was higher, and household and government spending were broadly unchanged....partly driving a downgrade to our forecast Despite softer momentum over 2015 than we previously expected, our broad view of the UK economic outlook remains unchanged: we still expect relatively resilient GDP growth ahead, supported by domestic demand. However, we have downgraded our forecasts for UK GDP growth: to 2.3% in 2016 (from 2.6% previously) and 2.1% in Contributions to GDP growth revisions over 2015 Q1-Q3 (ppts) 2017 (from 2.3%). Data revisions are a key driver of this downgrade in 2016, accounting for around two-thirds of the change to our forecast in that year. However the boost from household spending growth is also slightly smaller, reflecting both slower wage growth in recent months (see In focus) and in our forecast the latter in turn partly reflects a slower recovery in productivity. We also expect a larger drag from net trade, as the resilience in domestic demand fuels strong import growth, offsetting a pick-up in exports. In 2017, slower GDP growth weighs on business investment growth, while lower real household incomes bear down on housing investment. Risks remain skewed to the downside Downside risks to the UK s otherwise solid economic outlook have intensified since our last forecast. Perhaps the most immediate risk is that uncertainty ahead of the EU referendum delays plans for investment and expansion, tempering growth through the middle of the year. However, there is little sign of this happening so far, with investment intentions in both our surveys and others holding up well. GDP growth & forecast (y/y% and ppt contribution) Other Net trade Fixed investment Government spending Household spending Total revision to GDP growth (Q1-Q v a year ago) Private consumption Government consumption Total fixed investment Other Net trade GDP growth 4

5 CBOE VIX volatility index The UK also remains exposed to a number of global headwinds. Global growth momentum has weakened further since our last forecast, as China s economy continues to slow and the outlook for emerging markets has deteriorated. While the UK s direct links with the emerging world are relatively small, a further worsening in that region could dent global growth further, weighing on the UK s already weak trade position. Concerns over the health of China s economy in particular sparked a large deterioration in global financial markets early in 2016: the FTSE Global All-Cap index remains down by 7% on the start of the year. Looking forward, it is possible that we may see further market volatility one driver may be a divergence in global monetary policy, as the US seeks to raise interest rates further, against more expansionary policy in emerging markets, thus exacerbating capital outflows from EMs. Concerns over the global outlook may also push up risk premia, raising the price of more risky assets. At present, expectations of equity market volatility (as measured by the VIX volatility index) remain relatively low, but are creeping higher. The UK would obviously be exposed to further gyrations in financial markets, with greater uncertainty, lower confidence and negative wealth effects hitting business investment and spending. Domestic demand will be the keystone of growth... Domestic demand remains the key driver of growth in our forecast. In particular, household spending is expected to continue rising strongly, underpinned by strong consumer confidence and with low inflation boosting households purchasing power. Business investment will also see robust growth, especially in the near-term, with our business surveys showing that investment intentions for the year ahead remain solid. The North Sea industry remains the key exception to this, where the hit to profitability from low oil prices has put a real dent into plans for capital spending in that sector....but slower wage growth has taken the edge off But while we continue to expect decent growth in household spending 2.7% in 2016 and 1.8% in 2017 this is a slight downgrade from our last forecast (2.9% and 2.2%). Much of this stems from an easing off in wage growth over recent months, contrary to our (and other analysts ) expectations Investment intentions (standardised % balance) Swathe of non-cbi measures of investment intentions CBI investment intentions composite of a pick up as the labour market continued to tighten (we explore this further in the In focus section). Also pushing down on the outlook for wage growth is the impact that downward revisions to historic GDP growth data have had on productivity growth over the last couple of years, combined with the fact that output per worker is likely to have fallen sharply over Q (by close to 1%). Both lower outturn data on wage growth and the impact of lower productivity have pushed down our forecast for earnings growth (although with inflation lower in the near-term, real earnings should still rise strongly for a time before easing off). This has a modest bearing on our forecast for household spending....and investment growth is lower In 2017, slower growth in total fixed investment is also a driver of the downgrade to our forecast. This reflects both lower real incomes growth pushing down on housing investment, and slower GDP growth taking some of the momentum out of business investment. We nonetheless expect strong growth in capital spending over the first half of 2016 reflecting the strength in our investment intentions data for the year ahead before slowing to quarterly rates more in line with the pre-crisis average over 2017 (around 0.9% in each quarter). Furthermore, business investment still accounts for roughly a quarter of GDP growth in both 2016 and 2017, making a larger contribution than in our November forecast. Net trade to remain the missing ingredient In contrast to the relatively sound outlook for domestic demand, we still do not expect a material contribution to the economy from net trade continuing the theme of the recovery over the last few years. At present, survey data tends to provide a better steer on trade than the more volatile official data. Our Industrial Trends Survey has shown a small improvement in manufacturers export order books over recent months, coinciding with the decline in sterling against the euro. But overall orders remain subdued and only just in line with average levels. Looking ahead, the recent fall in Sterling (a decline of 8% since end-november 2015) may continue to provide some relief to exporters. However the decline is relatively small 5

6 CBI ITS: Manufacturing export order books (standardised % balance) 2.0 CPI inflation (y/y%) compared to the appreciation seen since 2013 (a 21% rise between March 2013 and November 2015), and firms will still be faced with the headwind of softer global momentum. Furthermore, to the extent that the depreciation in the pound reflects uncertainty ahead of the EU referendum, much of the near-term outlook is likely to depend on how this uncertainty evolves over the next few months. Fundamentals alone would otherwise suggest that Sterling should appreciate against the Euro (reflecting more stimulative monetary policy in the Eurozone), and fall slightly against the dollar (with monetary policy relatively looser in the UK). Nonetheless, we do expect some pick up in export growth over 2017 particularly, as world GDP growth gradually strengthens. However with domestic demand growing strongly, this will be matched by import growth, such that the contribution from net trade will be negligible. We expect the drag from net trade will be slightly larger in 2016 (-0.5ppts) compared to our last forecast (-0.3ppts), which accounts for some of the downgrade to our 2016 GDP growth forecast. Inflation will remain lower for longer... Alongside softer global growth and the deterioration in equity markets, the other key development in the world economy has been a further fall in commodity prices. In particular, oil prices have declined further since our last forecast (by 21%), now trading at close to $40 per barrel. With supply remaining abundant and global demand softening, futures prices point to only a gradual pick up ahead. Sterling effective exchange rate (12 March 2013=100) Nov 2015 forecast Feb 2016 forecast Renewed falls in commodity prices have led us to revise lower our near-term CPI inflation forecast: we now expect inflation to rise above 1% in late 2016, compared with the beginning of this year previously. Over the next couple of months, we re likely also to see some modest downward pressure from recently announced cuts to utility prices. We expect inflation to converge to the Bank of England s 2% target in mid with a rate rise now unlikely until end-2016 Alongside lower global commodity prices, domestic inflationary pressure has also softened, with inflation likely to be lower for longer, wage growth easing and economic momentum a tad slower. As a result, the impetus for an interest rate rise seems to have waned. At their February meeting, all members of the MPC voted to leave interest rates unchanged, marking the first show of unanimity in six months. Rhetoric from the MPC has also generally turned more dovish several members have pointed to the need to see a definitive pick up in wage growth/unit labour costs before considering a rate rise. As a result, we now expect the first rise in interest rates in Q (to 0.75%), two quarters later than in our last forecast. However, this is still earlier than when financial markets are pricing in the first rate rise (currently in early 2018), which the MPC continue to indicate is inconsistent with inflation stabilising at the 2% target in two years time. As a result, we now expect the first rise in interest rates in Q (to 0.75%), two quarters later than in our last forecast. However, this is still earlier than when financial markets are pricing in the first rate rise (currently in early 2018), which the MPC continue to indicate is inconsistent with inflation stabilising at the 2% target in two years time

7 UNITED STATES The US economy grew by 2.4% in 2015, unchanged on the previous year. However, the composition of growth shifted, with the upswing becoming more reliant on the household sector. A strong labour market should ensure that consumer spending remains firm. But the industrial sector will continue to struggle in the face of a stronger dollar and sluggish external demand, with low global oil prices hitting investment and output in the energy sector. We expect these factors to hold back GDP growth to around 2.3% in CBI US forecast 12mth% unless otherwise stated Growth and consumption Real GDP Household consumption Fixed investment Government consumption External Trade Exports Imports CPI inflation Unemployment rate (%)* Federal Balance (% of GDP)* Federal Funds Rate (%)* *annual average Down, but not out Uncertainty about the US outlook increased at the start of 2016, amid a sharp stockmarket sell-off, falling industrial production and a weak outturn for fourth quarter GDP. However, while risks to growth have increased, these developments should not be taken as a warning sign of an imminent downturn. Conditions in the labour market remain favourable, and economic fundamentals suggest the US still has room to grow, with little evidence of overheating or excess leverage that typically precede a recession. Rather than reflecting domestic concerns, stockmarket volatility was linked to weaker global conditions, notably uncertainty over China s outlook and the fall in oil prices to a 15-year low of $26 per barrel in mid-january. After falling by 12% between December and mid-february, the S&P500 had recovered much of this ground by mid-march, mirroring a rise in oil prices back towards $40 per barrel. More generally, market volatility may also be a consequence of the Fed s decision to raise interest rates in December 2015, the first step in a process of gradual monetary tightening and adjustment in global asset prices that could well be accompanied by further volatility in the years ahead. Contributions to US real GDP growth (pp. annualised) Consumption Investment Net Trade Government Consumption Inventories Total Growth Q1-14 Q2 Q3 Q4 Q1-15 Q2 Q3 Q4 Meanwhile, the recent weakness of some economic indicators can also be put down to external events. The slide in oil prices since mid-2014 and appreciation of the dollar has hit US manufacturing hard. Industrial production weakened steadily through 2015, with annual growth turning negative since November, for the first time since the recession. The sectors that have been hit the hardest have been those most exposed to the energy sector or weaker demand from emerging markets, as well as more price sensitive commodity-type sectors (such as clothing). Producers of consumer goods have fared better. That said, there was no getting away from the surprising weakness of consumer spending in the latest GDP data. Overall, the US grew by a feeble 1.0% (annualised) in Q4, down from 2.0% in Q3. Growth in personal consumption spending slowed to 2.0%, having averaged over 3.0% for the previous year-and-half. On the other hand, residential investment continued to grow strongly, expanding by 7.9%. The main drags on growth came from business investment and net trade. Business investment fell by 1.9%, weighed down lower investment in structures and equipment, driven in part by developments in the energy sector. With a steep decline in exports (-2.7%) outpacing a drop in imports (- 0.6%), the contribution of net trade was also negative (- 0.3% points). And slower inventory building weighed on activity too (subtracting 0.1% points from headline growth). Stripping out the impact of net trade and inventories, final domestic sales rose by just 1.2%, weak enough to raise some concerns over the strength of underlying demand. One question, therefore, is whether the weakness in manufacturing over the past year is finally spreading to the rest of the economy. While the ISM manufacturing index has shown some encouraging signs of stabilisation, rising to five-month high of 49.5 in February, the slide in the nonmanufacturing index to a two-year low of 53.4 in February does point to a fairly subdued start to

8 Household demand will continue to underpin growth In our view, domestic demand rests on solid foundations and should be enough to offset the drag from low energy investment, a strong dollar and sluggish global demand. In particular, healthy growth in labour income should support consumer spending growth, albeit at a slower pace than in The recovery in the US labour market has continued apace, with non-farm pay-rolls increasing by 242k in February, far above the level that the Fed believes will be sufficient to push down the unemployment rate further (a little below 100k per month). The rate of unemployment was unchanged at 4.9% in February, but this reflected a rise in the participation rate, as more marginally attached workers were drawn into the labour force. Overall the picture remains one of a steadily tightening labour market. Thus although we expect employment growth to slow through 2016, wage growth is likely to resume an upward trend, with a dip in hourly pay growth to an eight-month low of 2.2% in February likely to be a blip. Stronger income growth will be crucial to sustaining demand over the next couple of years, particularly as some of the tailwinds that have supported consumption in 2015 are fading. For example, falling energy prices kept the Fed s preferred inflation measure (PCE) close to zero through much of 2015, boosting real incomes. But with past declines in energy prices now falling out of annual comparisons, PCE inflation has rebounded, standing at 1.3% in January. Together with strengthening activity, base effects are likely to push inflation back towards 2% later in In the absence of stronger wage growth, purchasing power will be squeezed. Second, wealth effects are likely to be more limited than in recent years, in view of the recent stockmarket correction and more moderate house price growth. But at the same time, estimates of the household savings rate have been revised sharply higher, which suggests some potential for the savings rate to fall, providing additional support to consumer spending. The outlook for investment is mixed A stronger recovery in wages should also underpin residential investment, which is expected to provide another solid contribution to GDP growth in Mortgage lending standards continued to ease in early 2016 and rising household incomes, combined with still low interest rates and moderate house price inflation, should help ease affordability constraints and further reduce risk aversion among lenders. This should allow housing activity to rise more in line with underlying demand than has been the case in recent years (as implied by demographic trends), though higher interest rates may dampen activity by The outlook for business investment is more mixed. Declines in oil drilling activity (around 11% of total business investment) have weighed heavily on business investment, with annual growth slowing to 3.1% in 2015 from 7.2% in The shake-out in the US energy sector still has some way to go. By the end of February, the number of US oil rigs had fallen to its lowest level since 2009, down 75% since the peak in October With oil prices expected to stay low over the next two years, the sector is likely to remain a drag on growth the US Energy Information Agency predicts that US crude oil production could fall by 600k barrels per day and 200k in 2016 and 2017, respectively. But the decline is coming from a strong base, thanks to spectacular gains in productivity in recent years. Output of 8.5m b/d in 2017 would still be 70% higher than the level in Moreover, shale producers can ramp up production fairly quickly if prices rise faster. Outside the oil sector, US firms should be able to count on sustained growth in consumer demand, but a number of factors suggest business investment growth will remain moderate this year, picking up slightly in 2017 as the drag from the energy sector fades. High frequency indicators, such as durable goods orders and investment intentions, continue to tread water. And profit margins, although still high, have fallen from post-crisis peaks, reflecting higher labour costs and the hit to overseas earnings from the stronger dollar and slowdown in emerging markets. Overall, US firms get around one third of their revenues from overseas, and though less than 10% of foreign sales come from emerging markets, some sectors are more exposed than others (such as IT, materials, energy and industrials). The external sector will continue to struggle Net trade is likely to remain a weak spot in 2016, having subtracted 0.6 percentage points from GDP growth last year. This reflects a combination of the appreciation of the dollar since mid-2014, the slowdown in China and other emerging markets, as well as a hesitant recovery in the euro zone. Global monetary policy divergence is likely to put further upward pressure on the dollar in 2016, though the appreciation is forecast to be less marked than last year, with the dollar s value expected to be stable in With relatively strong domestic activity expected to continue pulling in imports, net exports are therefore likely to remain a drag on overall growth, although no more so than in The Fed will be cautious about raising rates further Market volatility in late 2015 and early 2016 has highlighted how a fairly moderate upswing in the US economy is vulnerable to external shocks. Providing the US can continue to withstand the headwinds blowing from overseas, economic fundamentals suggest the business cycle still has some way to run. Household debts and debtservice costs remains historically low, the housing market recovery is still in its early stages and government spending is expected to provide a positive impetus to growth. Monetary policy will also remain accommodative for a while yet, as the Fed adopts a cautious approach to normalising interest rates. Since the Fed raised rates in December, further progress has been made towards meeting its inflation and employment goals. At 4.9%, the unemployment rate now matches the Fed s estimate of the structural rate, and core PCE inflation has risen to 1.7%, already above its latest end-2016 forecast, lowering the bar for further hikes. But while some of the tightening of financial conditions at the start of 2016 has unwound (with equity prices rising and the dollar losing ground), the global outlook remains uncertain. We expect the Fed to tread carefully, holding off from further moves until mid-2016, with a total of two hikes expected in 2016, and three in

9 CBI INTERNATIONAL ECONOMIC OUTLOOK QUARTERLY SEPTEMBER MARCH JAPAN The Japanese economy contracted at the end of 2015, rounding off a dismal year. Consumer spending and exports were particularly weak. A solid labour market should underpin a continuing, albeit mild economic expansion in However, it would not take much to blow the recovery off course, given sluggish growth in household purchasing power, hesitant business investment and the prospect of a sharper than expected slowdown in China and the wider Asia region. CBI Japan forecast 12mth% unless otherwise stated Growth and consumption Real GDP Household consumption Fixed investment Government consumption External Trade Exports Imports CPI inflation Unemployment rate (%) Government balance (% of GDP) Overnight Call Rate (%)* *annual average Economy shrinks again in Q4 Japan s economy contracted by 0.3% q/q in Q4, leaving real GDP growth for 2015 as a whole at just 0.5%. The breakdown of the Q4 data paints a fairly discouraging picture of the strength of demand, even considering Japan s declining population. Private consumption was especially weak, falling by 0.8% q/q. The drop was sufficient to fully reverse the recovery seen since the consumption tax hike in April 2014, with the volume of consumer spending falling to its lowest level since Residential investment also declined in Q4 (-1.2%), after rising steadily earlier in More encouragingly, business investment remained on an upward trend (up 1.6%). Net trade also made a small positive contribution to headline growth (0.1% points), though this was only because the fall in imports (-1.4%) was steeper than the decline in exports (-0.8%). January data suggest that the weakness in both private consumption and real exports has persisted into the early part of this year. This lack of momentum going into 2016, combined with stockmarket volatility, the renewed appreciation of the Yen since December and the uncertainty over the extent of the slowdown in China (Japan s second largest export market), points to a fairly subdued outlook for the next two years. Indeed, these Contributions to US real GDP growth (pp. annualised) Consumption Government Investment Inventories Net Trade Total Growth Q1-14 Q2 Q3 Q4 Q1-15 Q2 Q3 Q4 developments threaten to weigh on corporate earnings, the lifeline of the government s Abenomics stimulus programme, which aims to end decades of intermittent deflation. Already, the fact that high profits at Japanese firms has not been translating into stronger wage growth, despite a tight labour market, has been taken as a sign of fragile corporate confidence. In recognition of the deteriorating outlook, on January 29th the Bank of Japan (BoJ) adopted a negative interest rate policy, applying a rate of -0.1% on small portion of reserves held at the BoJ by financial institutions (currently 10trn out of 260trn of reserves, though rising over time). The stated aim of the policy was to reassure consumers and businesses that the BoJ is committed to meeting its 2% inflation target over time. Actual CPI inflation (excluding fresh food) stood at zero in January, and low oil prices mean that it is likely to remain close to this level through much of Core inflation (excluding fresh food and energy) was a little higher, at 0.7%, but is unlikely to move higher in the near term. Indeed, the BoJ s recent move has so far failed to restrain the appreciation of the Yen, which continued to gain ground through mid-march. This will bear down on inflation further. Further policy stimulus appears likely The prospect of a stronger Yen, combined with slowing external demand, leaves the government and BoJ increasingly reliant on a turnaround in domestic conditions to sustain Abenomics. A move towards negative rates could in theory stimulate more consumer spending and investment, but in practice, credit growth may well be constrained by a number of factors, notably a limited appetite for borrowing among an ageing household sector and a corporate sector that has been deleveraging for years. The BoJ may well decide to push rates deeper into negative territory. The government may also consider further fiscal stimulus and/or postponing an increase in the consumption tax that is currently scheduled for April

10 CHINA Concerns over Chinese growth have continued into this year and drove a marked increase in global financial market volatility in January. Chinese GDP growth is officially estimated to have come in at 6.9% in 2015, although we believe momentum to have been a little lower (6.3%) given some inconsistencies in Chinese price data. Rebalancing continues, with the industrial sector continuing to suffer and consumerfacing sectors remaining resilient, and high frequency indicators point to growth at 5-6%. CBI China forecast 12mth% unless otherwise stated Growth and consumption Real GDP Household consumption Fixed investment Government consumption External Trade Exports Imports CPI inflation Unemployment rate (%) Government balance (% of GDP) Policy rate (%)* *Q4 average 2016 kicked off with a sharp fall in Chinese equities Concerns about growth and financial stability in China, combined with mishandled communications and market interventions, prompted a bout of significant volatility in Chinese stock markets at the turn of the year. The Shanghai Composite is now trading more than 40% below its peak level in June 2015 following an unsustainable run up in asset prices. While machinations in the index have had little impact on the real economy, it has sparked a considerable increase in capital outflows which has in-turn caused downward pressure on the renminbi to intensify, prompting the People s Bank of China to burn through its FX reserves to put a floor under the currency. While the financial market volatility now appears to be behind us, there is the potential for it to flare up again given the uncertain outlook for the Chinese economy, particularly with regards to its ever growing indebtedness and whether the the slowdown in growth will initiate a sudden bout of deleveraging - potentially putting the brakes on growth. Growth continued to slow in 2015 Momentum slowed through 2015 as China continues to struggle to rebalance its economy while grappling with 10 China real GDP growth: Official and CBI estimates CBI indicative estimate Published data domestic financial market volatility and currency management. Questions remain over the relative resilience of headline GDP growth given the apparent disparity between prices used to deflate GDP and official inflation data. Waning global demand has taken its toll on the exportoriented industrial sector, with production growth slowing sharply to 6.0% in 2015 from 7.3% in On the other hand, services has benefitted from the rise of the Chinese middle-class, with growth in the sector accelerating to 8.3% in 2015 from 7.8% in 2014 and for the first time accounted for more than half of the economy. However it is evident that the rebalancing is lopsided given that the strengthening of the services sector is failing to offset the decline in industry, a trend which shows little sign of abating in the near-term. This divergence has significant implications for the wider economy given the second-round effects. Firstly, investment will likely be scaled back in the face of significant overcapacity in the industrial sector. Secondly, net trade will be less supportive of growth as exports suffer amid weaker external demand and as imports are lifted by wealthier households. Finally, the expected layoffs in industry will prove difficult to be picked up by the services sector given the differences in skill requirements. China s economy is rebalancing Chinese household consumption is expected to grow by 7.3% in 2016 and incomes continue to show strong growth (8.9% in 2015). In addition to these factors, fiscal policy measures to encourage consumption and the reduction in import duties are likely to support growth in household consumption. But in contrast, both manufacturing and housing sector investment will be held back by oversupply and we expect the process of economic rebalancing from investment to consumption to accelerate in 2016 as oversupply continues to drag on production and investment. While this will be offset somewhat by strong consumer spending growth, the combination of these factors means that we expect growth to slow a little further ahead.

11 INDIA India is expected to achieve strong, stable growth and achieve the highest rate of economic growth in the G20 through the forecast period. Consumer spending is likely to remain the dominant driver, while the relative weakness of foreign markets is likely to cause net trade to continue to drag on growth. Meanwhile, the commitment to fiscal discipline in the Budget opens the door to further rate cuts by the RBI which should help to support economic growth. India confirmed as emerging market star for 2015 India s GDP growth came in at 7.6% in 2015 cementing its position as the world s fastest growing major economy - with both the manufacturing and services sectors making a strong contribution to growth of over 9% apiece. However, the agricultural sector, which accounts for around a fifth of GDP and half of employment, was affected by a poor monsoon and expanded at only 1%. On the expenditure side, private and government consumption contributed 3.9ppts and 0.3ppt to growth respectively, whereas net exports added a paltry 0.1ppt. Domestic demand should support strong growth Earnings have risen at a strong pace in India with average nominal wage growth growing at over 10% last year, a trend which is expected to accelerate in 2016 as the government implements the recommendation of the pay commission to increase salaries, allowances and pensions of public sector workers by 22.55%. Employment is also expected to climb over the coming years in order to address India s ever growing capacity needs, whereas a continuation of low inflation as well as the increasing likelihood of rate cuts by the Reserve Bank of India should also provide households with greater purchasing power, underpinning domestic demand in the near-term. Budget 2016: Fiscal policy supportive to growth Government consumption and investment (infrastructure budget increased 22.5%) is expected to make a strong contribution to growth in Indian fiscal reform is also expected to support growth through increasing the efficiency of fiscal policy. The Modi government has continued to improve tax policy, reducing the headline rate of corporation tax (CT) from 30% to 25% for manufacturers from , and committing to reducing the CT rate to 25% for other firms by the end of the parliament. Import and export tariffs and income taxes which were subject to large scale avoidance and evasion CBI India forecast 12mth% unless otherwise stated Growth and consumption Real GDP Household consumption Fixed investment Government consumption External Trade Exports Imports CPI inflation Unemployment rate (%) Government balance (% of GDP) Policy rate (%)* *Q4 average have been reduced, and consumption taxes increased. Meanwhile, government subsidies which distorted prices and were not well targeted at alleviating poverty have been scaled back. More efficient supply side policies to improve agricultural output (the part of the Indian economy which underperformed in both 2014 and 2015) have been scaled up. But weaker global economy will drag on exports Despite strong domestic demand, we have reduced our 2016 economic growth forecast for the Indian economy from 7.7% in our November forecast to 7.2%, with the downgrade mainly explained by weakness in Indian exports which account for over a fifth of GDP - as a result of subdued global growth. Because the strength of the domestic economy is expected to lead to strong import growth, net trade is likely to subtract from overall Indian economic growth. Despite our downgrade, however, India s economy is still set to outperform both the developed and emerging world, presenting a great opportunity to UK businesses. Indian PMIs in early 2016 are consistent with solid growth Manufacturing Services Composite Source: Markit 11

12 BRAZIL Tough year ahead for Brazil Brazil is currently mired in its deepest recession since the 1930s, with the economy contracting by 3.9% in 2015 after managing to eke out growth of just 0.1% in In seasonally-adjusted terms, real GDP shrank 1.4% between Q4 and Q3 (prev. -1.7%). Domestic demand fell by 2.2% (prev. -1.8%), largely due to a sharp 4.9% drop in gross fixed capital formation (prev. -4.4%) and compounded by a 2.9% fall in public consumption (prev. +0.3%). A further narrowing in the trade deficit on the back of the real depreciation meant net exports made a +0.7pp (prev. +0.7pp) contribution to GDP growth. On the output side, the industrial sector contracted by 1.4% (prev. -1.9%) and services output was similarly down 1.4% (prev. -1.1%). More recent monthly data has indicated that the economy remains in poor shape. Consumers have been deterred from spending by the high rate of unemployment - 7.6% in January as well as the prohibitive rate of inflation - CPI inflation was 10.4% on the year in February (prev. 10.7%). This is reflected in core retail sales which declined 1.5% in January on a seasonally-adjusted monthly basis (prev %). Sovereign debt lost its investment-grade status around the turn of the year, which will have a knock-on effect on financing across the entire economy, with real credit growth down 4.1% year-on-year in January. And with inflation far above the Banco Central do Brasil s target of 2pp either side of 4.5%, policymakers are effectively unable to loosen monetary policy to help mitigate lending conditions. RUSSIA Industrial production declined by a seasonally-adjusted 0.7% on the month in December (prev. -2.3%). Some solace comes in the form of the weak Brazilian real which could increase companies international competitiveness. Brazil s economy is expected to contract further over the coming year as the ongoing headwinds to growth offset the currency s boost to exports. Further out, the eventual recovery is likely to be anaemic since the persistence of low commodity prices which account for 60% of exports will weigh on growth, as will the government s austerity measures. Impeachment proceedings against senior politicians, including President Rouseff, will also hamper Brazil s long-term prospects by discouraging investment as well as preventing a harmonised policy response to the economic crisis. Finally, excessive debt levels will prove difficult to service as the BCB finds its hands tied from cutting interest rates amid the stagflationary environment. Brazil and Russia GDP growth (% q/q) Brazil (LHS) Russia (RHS) Oil price slump hampers Russia s prospects While Russian GDP figures have yet to be provided for Q4, inferring from the full year figures for 2015 (-3.7%) suggests the recession intensified in Q4 after having moderated a little to -0.6% in Q3. As the world s second-largest exporter of oil, Russia has been particularly susceptible to the slump in commodities, making it little wonder that in 2015 the economy shrank at the quickest pace since the fallout from the global financial crisis in Domestic demand continues to exert a significant drag on growth as consumer purchasing power is eroded by the growing cost of living and falling incomes. CPI inflation remains elevated, despite having slowed in annual terms to 9.8% in January (prev %) owing mainly to base effects. Meanwhile, real wages (adjusted for inflation) fell 10% on the year in December (prev. -9%). Consequently, it is no surprise that retail sales were down 15.3% year-onyear in December (prev %). The corporate sector has fared a little better as it has benefited from an increased shift towards import substitution in the face of the rouble weakness and international sanctions. Still, only the agricultural sector has registered any notable growth, expanding 12.6% throughout Industrial production was 1.0% lower on the year in February (prev. -2.7%) as the decline in manufacturing output also moderated to 10.0% (prev. -5.6%). After having brought the key rate down 600bp to 11% in 2015, the Central Bank of Russia now finds its hands tied in the wake of the renewed pressure heaped on the rouble. In fact, Governor Nabiullina has refused to rule out a rate hike in the event that inflationary risks escalate. Fiscal spending is likely to remain under pressure as a consequence of low energy prices, whilst the CBR is likely to find little room to cut the key rate in the face of stubbornly high inflation expectations. International sanctions show little sign of being lifted anytime soon, weighing on investment prospects and in-turn limiting growth potential. Economists widely expect the recession to spill over into 2016, with estimates averaging around a 1.5% contraction. It is likely to be some years before the economy turns a corner as long as Russia s fortunes remain tied to the path of oil prices - which are expected to experience a very gradual recovery. 12