1. Michael Spence January 2010

2. Outline I am going to start with the major developing countries And spend a bit more time on China Because that is where growth is going to come from in the short and medium run And the systemically important developing countries are now important players in the global economy and policy setting Then I will talk about the situation in the US Comment briefly on some issues in Europe Conclude with some thoughts on investment opportunities and strategy issues when there is periodic system risk

3. Developing Countries Hit hard in 2008 by the crisis – following a difficult commodity price spike Two main crisis transmission channels 1. Credit (rapid exit of capital) 2. Trade - shortly after The major developing countries are restoring growth quickly The issue is the medium term and its relation to Global Growth

4. Exchange Rate Movements Reflecting Capital Flows Indian Rupee Against the Dollar

5. India Rupee in Yuan

6. Chinese Yuan Against the Dollar

7. Trade Quarterly world merchandise export developments, 2005-09 (2005Q1=100, in current US dollars) WTO

8. Developing Countries Much higher than expected resilience No toxic assets Fiscal stability Reserves Domestic ownership of financial institutions Current account surplus or balance - hence financing domestic investment from domestic savings Rapid response to credit tightening and capital outflows

9. India Struggling Back

10. Brazil Hit But Fundamentals for a Recovery are Good

11. China is Moving Back to 10% Growth And May be Overheating

12. Lessons Learned from the Crisis in the Developing Countries Self-regulating model rejected Central banks (or some entity) needs to focus on system stability Low inflation is not a sufficient statistic Judgment will be needed and mistakes made Some version of the utility banking model Relation to the Volker Rule Domestic ownership Reserves Controlled growth of plane vanilla shadow banking Complex derivative securities Clear Limits on Financial Globalization with a fragmented governance structure Distributional issues

13. Global Aggregate Demand and Rebalancing US Savings Rate Up $1 trillion (+-) of aggregate demand missing New normal in advanced countries Deleveraging takes time Unemployment high Impact of government exit uncertainty Banks and commercial real estate Government “owns” the residential real estate financing market Financial re-regulation uncertain Fiscal stability in the US and political resolve The Global Economy needs the surplus countries to reduce excess savings

14. But There is a Problem The Cyclical, Mean-Reverting View Outside the advanced countries, there is a view that the world will return to pre-crisis conditions, with a stable US as borrower, lender, and consumer of last resort. This ignores is that pre-crisis growth in the US and the global economy was based in part on an unsustainable configuration. Returning to that model is neither likely nor wise. Waiting around for the advanced countries to right their ships so that we can all go back to the “old normal” is neither good policy nor a good bet.

15. Global Surplus and Deficit Patterns 15

16. China’s Balancing Act Three related structural issues 1. Microeconomic restructuring and the middle income transition 2. Demand side restructuring Household income up Household savings down 3. Elimination of excess savings and the current account surplus This is NOT mainly an exchange rate issue The west is wrong to obsess about the Renminbi There is an issue of the effect of the peg or slow appreciation on the eurozone, the pound and the yen

17. Very High Investment Rate More than Fully Funded From Domestic Savings 17

18. Evolution of China Current Account Balance 18

19. Disposable Income Declining as Percentage of GDP 19

20. Components of Savings: The Increase is in the Corporate Sector 20

21. Comparative International Income Data 21

22. China Rising Trade Exposure Even as domestic economy becomes larger 22

23. Moving to Increase Household Consumption 23

24. Demand Growth 24

25. China: Shifting Micro-Structure of the Economy 25

26. The US Outlook US recovery is important globally It is a difficult moment to be optimistic Financial sector bounced back Real economy in trouble Citizens and Congress angry Re-regulation Late Tax on bonuses and threat to Fed independence Volcker Rule No credible plan for restoration of fiscal balance Longer term growth and restructuring Hard and soft infrastructure

27. Implications for Global Agenda A US policy agenda overloaded, overwhelmingly domestically focused, and partially paralyzed Lack of attention to global issues Coordinated monetary policy and exits Rebalancing demand WTO Environmental issues Climate change Water security

28. European Issues Fiscal imbalances Absence of effective mechanisms to deal with them European influence is mitigated in global policy issues by multiple voices Copenhagen Reform of IFI’s is waiting on European decision to speak with one voice US willingness to abandon veto

29. Investment Thoughts Substantial macroeconomic risks A bumpy ride with significant unresolved uncertainty Opportunities greatest in countries where there is a continued focus on longer term growth Right now that means the major developing countries And the financial and business entities that engage with these markets Markets have not internalized the non-mean reverting “new normal” environment Asset prices will (perhaps are) resetting as the economic and political challenges become clearer

30. Periodic Systemic Risk Regulatory reform momentum Over-emphasis on regulatory failure Self-regulation failed too Internalization of risk and public liabilities

31. Implications for Investment Strategy Attention to early warnings Dynamic asset allocation Effective management of liquidity To limit losses from illiquidity To facilitate asset allocation shifts To profit from investment opportunities in periods of stress Relative performance and needed new benchmarks

32. Bill Gross Risk/growth-oriented assets (as well as currencies) should be directed towards Asian/developing countries less levered and less easily prone to bubbling and therefore the negative deleveraging aspects of bubble popping. When the price is right, go where the growth is, where the consumer sector is still in its infancy, where national debt levels are low, where reserves are high, and where trade surpluses promise to generate additional reserves for years to come. Look, in other words, for a savings-oriented economy which should gradually evolve into a consumer-focused economy. China, India, Brazil and more miniature-sized examples of each would be excellent examples. The old established G-7 and their lookalikes as they delever have lost their position as drivers of the global economy.