The world economy.

Barrell, R. ; Anderton, R. ; Morgan, J. 等

Growth in the OECD as a whole has been well below trend in the last three years, and the EU as a whole appears to have experienced a fall in output in 1993. Prospects for 1994 look better, and we are forecasting OECD growth of over 2 per cent in 1994, with only slightly slower growth in the EU as a whole. Inflation has been falling in the EU since 1991, and because these economies are likely to be operating below capacity we are projecting that it will continue to fall, albeit slowly, for the next two years. Inflation in the US will probably reach the end of four years of decline in 1994, and we are forecasting that it will edge up only slowly over the next few years. The Federal Reserve has responded to the prospect of higher inflation, and short rates have been pushed up. Long rates, both in the US and elsewhere have, partly as a consequence, risen sharply in the last few months.

Inflation pressures have been low for several years because there has been a considerable degree of excess capacity available in the world economy. This has helped reduce inflation in the US despite the robust growth that has been experienced for several years. The existence of spare capacity in Europe, along with increasing competition from producers in the Asia Pacific rim, has kept up pressure on US producers' margins. However, both of these phenomena must be seen as temporary. The European economies are emerging from recession, and their spare capacity will gradually be absorbed. The pricing policies of newly emergent producers are in part designed to gain entry into the market, and hence the effect on inflation, rather than the price level, is likely to be temporary.

We are forecasting that inflation in the OECD will settle down around 3 per cent in the medium term, with EC inflation averaging around 4 per cent. The forecast is set out in Table 1. In the February Review we warned of a potential rise in commodity prices, and we now have more evidence to support this worry. This has led us to raise our short-term inflation forecast, as has the slightly higher level of growth that we are now projecting. However, since February, there has been a marked rise in long-term interest rates, and this has caused us to revise upward our projections for short-term interest rates over the medium term. This projected tightening of the monetary stance in the future has led to downward revision to our medium-term growth forecast.

The prospects for growth and inflation in the year ahead look relatively good for most OECD countries, but Japan stands out as an exception. The 20 per cent appreciation of the yen in the last two years has put that economy under considerable strain. Output growth fell to almost zero in 1993, and the stimulatory fiscal package that we assumed in November would be implemented has so far failed to materialise. We are projecting growth of around half a per cent in 1994 in Japan, and although we are then forecasting a slow recovery inflation is liable to be kept very low because of pressures from import prices. In the longer term we expect Japanese growth to fall from its high level of the 1980s to around 3 per cent or less as the slowdown in population growth feeds through into potential output growth. The aging of the population is also projected to reduce the current account surplus as the assets accumulated for the retiring generation are used up.

Interest rates and exchange rates

The strength of the upturn in the US in 1993 has induced the Federal Reserve to tighten monetary policy more rapidly than we had previously anticipated, and short-term interest rates have been rising strongly in recent months. However, as Chart 1 shows, short-term rates have continued to fall in Germany (and Japan) in recent months. Long-term interest rates have risen rather more than short rates in the US in the last few months, although they reached their trough in the Autumn of 1994 and have been rising since then. Canadian and Japanese long rates have also been rising over the last six months, as can be seen from Chart 2. These increases are larger than can be justified by the rise in short rates, and they suggest that in the future short rates will be higher than had previously been anticipated.

The long-term rates on equivalent securities in Chart 3 are now very similar in France and Germany, and both began rising at the start of the year. In the longer term it appears that the markets are expecting short rates to be very similar in the US and in Germany, whilst they will be higher in the UK and Canada, and lower in Japan. It is a little harder to read such a strong signal into long-rate TABULAR DATA OMITTED developments in Spain and Italy because bond markets are relatively thin. However, as can be seen from Chart 4 these rates have fallen significantly in the last two years, and are now only slightly above levels in the rest of Europe.

We set our forecast for exchange rates and interest rates together, with the path for the exchange rate depending on observed interest differentials and any projected risk premia. Our forecasts are set out in Tables 2 and 3. Our interest-rate projections are set in line with our analysis of the implications of observed long rates. We are expecting German short-term interest rates to continue to fall to around 5 per cent by the middle of the year and then start to rise in early-1995, with French and German rates converging by the middle of 1995. US rates are expected to continue to rise during the next two years and then to settle at around 6 1/2 per cent. With inflation of around 3 per cent at the end of the decade this gives real rates of 3 1/2 per cent in the US and Germany.

Table 2. Exchange-rate forecasts for the major six

 Percentage change in effective rate

 US Japan Germany France Italy Canada

1990 -4.2 -8.4 4.2 4.0 1.5 0.2
1991 -1.5 8.2 -0.5 -1.4 -1.2 1.7
1992 -1.0 5.7 3.2 3.3 -2.9 -5.8
1993 3.7 19.3 5.0 4.3 -15.1 -5.6
1994 2.9 5.0 -0.8 0.7 -2.9 -6.2
1995 0.2 0.5 0.4 0.2 -2.2 -0.5
1996 -0.8 2.6 0.2 0.3 -1.7 0.5

 Yen D-Mark Franc Lira Franc Lira
 per Dollar per D-Mark

Nominal cross rates, year average

1990 144.8 1.62 5.44 1197.8 3.37 741.7
1991 134.5 1.66 5.64 1240.0 3.40 747.7
1992 126.7 1.56 5.29 1231.1 3.39 789.4
1993 111.2 1.65 5.67 1570.7 3.43 950.0
1994 107.5 1.73 5.86 1676.0 3.39 970.3
1995 107.1 1.73 5.88 1716.8 3.40 993.7
1996 104.3 1.72 5.87 1745.2 3.40 1011.8
Table 3. Short-term interest rates

 Per cent

 US Japan Germany France Italy

1990 8.1 7.7 8.4 10.2 12.4
1991 5.8 7.4 9.2 9.7 12.2
1992 3.7 4.5 9.5 10.5 14.0
1993 3.2 3.0 7.2 8.4 10.2
1994 4.5 2.4 5.3 5.8 8.7
1995 6.0 3.3 5.6 5.7 9.0
1996 6.3 3.7 6.4 6.4 9.0
1997-2001 6.5 4.0 6.5 6.5 9.0

1992 I 4.1 5.2 9.6 10.2 12.2
II 3.9 4.7 9.7 10.3 12.7
III 3.3 4.1 9.7 10.6 16.3
IV 3.4 3.8 9.1 10.7 14.7

1993 I 3.1 3.4 8.3 11.6 11.9
II 3.1 3.2 7.6 8.1 10.8
III 3.1 3.0 6.8 7.3 9.3
IV 3.3 2.3 6.3 6.6 8.8

1994 I 3.5 2.1 5.8 6.3 8.5
II 4.3 2.3 5.4 5.8 8.5
III 5.0 2.4 5.0 5.5 8.7
IV 5.3 2.7 5.0 5.5 9.0

1995 I 5.8 3.1 5.3 5.5 9.0
II 6.0 3.2 5.5 5.5 9.0
III 6.1 3.3 5.8 5.8 9.0
IV 6.2 3.4 6.0 6.0 9.0

We are expecting no major change in the pattern of exchange rates over the next few years. This reflects both our projections for interest rates and our calculation that real exchange rates are much nearer to sustainable levels than they have been in the recent past. We have on a number of occasions analysed FEERs, the real effective exchange rates that would produce 'sustainable' current accounts if all economies were producing their trend level of output. In November 1992 we undertook some calculations of the FEERs (Fundamental Equilibrium Exchange Rates) implied by our model NiGEM, and there have been no major developments since then that would persuade us to change our estimates. However, real exchange rates have moved, as can be seen from Table 4. We would now estimate that real effective exchange rates (on a trade weighted basis) differ from FEERs within the ranges (a plus gives the per cent overvaluation):-

 US Japan Germany France Italy UK
[+1,-4] [+17,+12] [+1,-4] [5,+0] [-3,-8] [+5,0]

The ERM realignments in 1992 and 1993 may have produced a more sustainable set of exchange rates, with only the Italians having overshot the FEER, perhaps in anticipation of higher inflation in the future. Both the UK and France appear overvalued, and this helps slow growth in France, and, along with the recession in Europe, it helps explain the projected current account deficit in the UK. However, our calculations suggest that the yen may have appreciated rather more than can be justified by fundamentals.

World trade and commodity prices

The disjunction of the cycle in output between North America and Europe has helped to keep world trade relatively buoyant over the last three years. However, the strength of growth in China and the Far East has also supported trade growth and imports into Latin America have been rising strongly over the last year or so. As a result of all these factors we estimate that overall world trade (excluding that between the formerly Centrally Planned Economies) grew by almost 4 per cent in 1993, and the growth rate is likely to rise to over 6 per cent this year.

Table 4. Real effective exchange rates

year average US Japan Germany France Italy

1990 95.4 87.3 96.9 97.6 106.0
1991 94.0 92.6 95.1 94.3 107.0
1992 93.8 96.8 98.5 95.7 105.9
1993 97.6 113.5 103.5 98.5 91.7
1994 101.3 116.5 102.8 97.9 89.8
1995 102.8 114.1 102.7 97.0 89.2
1996 103.2 114.4 101.9 96.5 89.3

The strength of world trade, and especially import growth from outside the OECD area, is likely to support output in Europe and North America. In our model based forecast all imports have to be somebody else's exports, and hence when some countries gain market share others must lose it. The US and to a greater extent Japan, have appreciated against the rest of the OECD over the last year or so, and both have lost market share, and as can be seen from Chart 5, they are expected to continue to do so over the next two years. The US has been losing market share in part because the Canadian dollar has been depreciating against the US dollar by 6 per cent or so for three years whilst inflation has been a point or so below that in the US. Around a quarter of US exports go to Canada, and hence the impact has been significant. This bilateral loss of competitiveness also helps explain the growth of import penetration in the US.

These significant losses of market share have to be matched elsewhere, and after some years of significant decline we expect Germany to regain some ground in its export markets. This is in part the consequence of the moderate growth rate of wages over the recent past and the near future, which feed through to competitiveness. Producer prices have fallen in the recent past, and this has affected export price competitiveness. This gain in competitiveness particularly affects French trade, and as can be seen from Chart 6 we expect the French will not gain market share over the next few years.

The strength of world trade is a partial cause of the recent rise in world commodity prices. Strong demand for metals and minerals on the Asia Pacific rim has helped hold up copper and nickel prices in recent months, and cartel driven output cut backs in aluminium production have put extra pressure on the metals market. Stocks of these metals on the London Metal Exchange are high, but up to half of the stocks are currently in the hands of banks as collateral, and hence they are not being released onto the market as quickly as might have been expected. Our forecast for commodity prices is given in Table 5, and recent price developments are plotted in Chart 7.

There is some inflationary message in commodity price increases, although there are also special factors to consider. Poor harvests and strong local demand have been putting upward pressure on coffee prices, and sugar prices have also risen as corn starch-based substitutes have become scarce. As a result of these movements we expect less developed country food prices to rise strongly this year. The increase in revenue received, especially in Latin America, will help support import growth. Developed country food prices rose sharply at the end of last year. This was in part because a poor Japanese rice harvest has raised demand for other grains, but also because the flooding in the US in the summer of 1993 had a larger effect on maize and soya output, and especially quality, than had at first been estimated. As a result shortages of feed grains emerged, but these have eased somewhat with the approach of the Southern Hemisphere harvest. We expect all food prices to fall in real terms in the medium TABULAR DATA OMITTED term as output continues to rise, with a strong reversal of high developing country food prices towards the end of this year.

However, in the short term the systematic movement of all commodity prices cannot be ignored, and we believe that it is an early warning of a rise in inflation, albeit a small one. This message seems to have been accepted by the large oil companies, who appear to be raising their stock holdings in anticipation of higher prices. As a result crude prices rose to 16 dollars a barrel in early-May despite the considerable level of over supply which had driven prices to under 14 dollars a barrel just a month previously.

United States

The pace of the US recovery decelerated during the first quarter of 1994. Real GDP increased by around 0.7 per cent compared with 1.75 per cent in the fourth quarter. Gross private sector investment rose by 4.25 per cent compared with 6.5 per cent in the previous quarter. Although investment in producers' durable equipment only grew at half the rate of the fourth quarter, the largest deceleration occurred in building investment which was adversely affected by severe weather conditions. Government expenditure and net external trade also contributed to the first quarter slowdown. Public expenditure fell rather erratically by more than 1 per cent whereas export volumes of goods declined by 3 1/2 per cent and import volumes rose a further 1 per cent. In contrast, consumer spending growth slowed only slightly to almost 1 per cent in the first quarter.

News of the slower growth resulted in an immediate increase in US bond prices as the financial markets expected interest rates to decline given that the outlook for inflation seemed more optimistic. However, bond prices later declined sharply as attention focused on the 2.6 per cent annual increase in the GDP deflator. However, the uncertain reaction of the financial markets probably reflected the fact that the underlying strength of the US recovery may have been disguised by special factors which depressed the first quarter figures. Severe weather conditions in January, the erratic decline in public expenditure and the robustness of consumers' expenditure indicate that output may well grow more rapidly in the second quarter. For example, housing starts fell by over 21 per cent in January but rose in the following two months. In the 3 months to March, industrial output rose by almost 2 per cent but the monthly profile was erratic.

In response to the possibility of rising inflation the Federal Reserve increased the Federal Funds target rate by 0.25 per cent to 3.75 per cent in mid-April following similar increases in late March and early February. The yield on ten year government bonds has increased by about 1 1/2 percentage points since the beginning of the year. The forward markets expect three month interest rates to increase to around 6 per cent in twelve months time, and we have adopted this profile in our forecast. This is a more rapid increase than we had previously expected, and it is consistent with the recent rise in US long rates. Higher borrowing costs have caused equity prices to fall and the Dow-Jones industrial index is now 7.5 per cent lower than its all-time high at the end of January. However, recent data are giving mixed signals about inflation. Average weekly earnings at the end of the first quarter were almost 4 per cent higher than a year ago, but strong productivity growth kept unit labour cost growth subdued. Consumer price inflation remained low at approximately 2 1/2 per cent over the same period. Money supply growth, as measured by M2, grew at an annual rate of 2.5 per cent in March which is 0.5 per cent higher than in January, but well within the target range of 1-5 per cent.

The renewal of stronger growth in the latter part of the first quarter is confirmed by the figures for employment. After falling in January because of the severe weather, non-farm payrolls grew by more than 650,000 over the next two months. However, only service-sector jobs were badly affected by the cold weather in January and manufacturing employment has now risen for 6 consecutive months. Both average weekly working hours and overtime working have now reached a new peak.

In March, at the halfway point of the 93/94 fiscal year, the budget deficit was around $150bn compared to over $180bn a year earlier. The deficit has benefited from lower interest rates, cuts in defence spending and the extra tax revenue and lower benefits associated with the recovery. The budget proposals for the fiscal year beginning in October aim to bring the fiscal deficit down to around $175bn (2.5 per cent of GDP) from an estimated $235bn this fiscal year. Discretionary outlays are to be reduced by around 4 per cent in real terms; half of the cuts will be in defence and the rest is accounted for by reduced expenditure on transport subsidies, agriculture and low-income energy assistance programmes. Some savings will also be made by reducing administrative costs of government by, for example, personnel reductions of 100,000 in the next fiscal year. Overall, government spending is planned to rise by only 2.3 per cent in the 1995 fiscal year. In the longer term the authorities expect the deficit to rise to $200bn by the end of the century which should be just above 2 per cent of GDP.

As Table 6 shows, our forecast for US GDP is similar to that in the February Review. We expect growth to be above trend this year at around 3 1/2 per cent followed by a deceleration to approximately 2 1/2 per cent next year. By the end of next year we believe that US short-term interest rates will be approximately 2 percentage points higher than their current level. Growth in the components of GDP that are more responsive to higher short-term borrowing costs--such as consumer's expenditure and housing investment--is expected to slow down rapidly. In contrast, we are forecasting that long-term interest rates will only be half a percentage point higher than they are now, as they already reflect the expected rise in short rates, and hence we do not expect to see much of a fall in the growth of business investment in 1995.

In general, movements in prices tend to lag behind output. Our predicted higher activity this year should allow unemployment to fall by an extra half a percentage point to around 6 1/4 per cent, but most of the resulting upward pressure on wages will not feed into prices until 1995. However, this only partially explains why we expect consumer price inflation to continue falling in 1994. Some of the downward pressure on prices originates from falling import prices in response to the recent appreciation of the dollar in effective terms. However, the dollar has depreciated against the yen but it seems that this has yet to be passed fully through into import prices. Furthermore, the very low inflation rates prevalent among the major exporters to the US, especially Canada, have further depressed the price of imported goods.

Table 6. United States GDP

 Percentage
change

 1990 1991 1992 1993 1994 1995
1996-2000

Consumption 1.5 -0.4 2.6 3.3 3.4 2.0
2.1 Investment: housing -9.2 -12.8 16.3 8.7 8.5 3.5
 7.2 business 1.2 -5.9 2.9 11.8 8.9 6.2
 3.6 Government expenditure 3.1 1.5 -0.1 -0.7 0.6 2.8
 2.4 Stockbuilding(a) -0.5 -0.3 0.3 0.2 0.2 0.0
 0.0 Total domestic demand 0.8 -1.4 2.9 3.8 3.9
2.7 2.6

Net export(a) 0.4 0.7 -0.3 -0.8 -0.5 -0.3
-0.1 GDP 1.2 -0.7 2.6 3.0 3.4 2.4
 2.5

Savings ratio 7.1 7.7 8.0 6.7 6.9 6.8
6.6 Average earnings 5.6 3.5 5.0 2.1 3.8 4.7
 4.2 Consumer prices(b) 5.2 4.3 3.3 2.7 2.5 3.5
 3.0 RPDI 1.8 0.1 3.0 1.8 3.5 1.8
 1.8 Unemployment, % 5.5 6.7 7.4 6.8 6.3 6.3
 6.3

(a) Change as a percentage GDP.

(b) Consumers' expenditure deflator.

The deterioration in US competitiveness is reflected in Table 7 which reports our forecast for the trade position of the US. We expect the price of US traded goods to grow more rapidly than her major competitors as the dollar appreciates in line with the positive US interest-rate differential. Hence exports will grow more slowly than major markets and the US will lose market share. Import volumes of goods will grow particularly strongly this year partly because of the robust increase in the import-intensive expenditure categories such as business investment and consumption. The recent appreciation of the dollar against the European currencies will also encourage US tourism abroad, whereas the opposite is true for tourism to the US. Hence, we expect no improvement in the services balance in the short term. The appreciation will also add to the deterioration in net IPD revenues which is primarily caused by the growing net external debt of the US. All of these factors tend to push the current balance further into deficit. We are now expecting the deficit to exceed 2 per cent of GDP this year and deteriorate further during 1995.

Several factors, working in different directions, are influencing the government budget deficit. The strong recovery from recession and the aforementioned measures to cut spending will reduce the deficit whereas the increase in short and long-term borrowing costs will increase the payments on debt (US government debt is currently around 60 per cent of GDP). Table 8 shows the US deficit and the figures for 1993 reflect the impact of TABULAR DATA OMITTED the recovery and government efforts to reduce the deficit; the growth of transfers declined last year; growth in tax revenues has increased from 4.5 per cent to 7 per cent; government purchases have declined by more than I percent. We believe that the Omnibus Budget Reconciliation Act of 1993 will lead to more restrictive fiscal policy and bring the deficit down towards the 2.5 per cent of GDP forecast by the authorities for the 1995 fiscal year.

TABULAR DATA OMITTED

Japan

The Japanese economy stagnated last year and GDP grew by only 0.1 per cent. In the previous year output grew by 1.2 per cent, which was the lowest growth rate since 1974. Capital investment has been most hit in the current downturn, and it fell by 8.5 per cent in 1993, the second consecutive year that investment has fallen. In addition, exports have been affected by the recent 20 per cent appreciation of the yen. A modest growth in consumption of 1.1 per cent and various stimulatory fiscal packages in 1993 could only prevent the economy from contracting even further. Current trends suggest that this pattern could well be repeated this year with further reductions in exports and investment and more buoyant growth in government spending and consumption.

Industrial production fell by 4.5 per cent in 1993. This was the second consecutive year that production was reduced, as in 1992 it had fallen by over 6 per cent. Profits have plummeted over the last year and recent surveys show no improvement in business confidence, which remains at a 20 year low. Retail sales have also continued to fall and in the first quarter of 1994 were 1 per cent lower than a year ago. Lower wage rises and reduced bonus payments, less overtime working and rising unemployment reduced consumer confidence and depressed consumer spending.

The annual inflation rate edged up slightly in March to 1.3 per cent despite slack labour markets and the strong yen. Consumer price inflation averaged 1.1 per cent in 1993, and it is generally on a downward trend. The appreciation of the yen has reduced import prices, which were around 11 per cent lower in the first quarter than a year ago, whilst wholesale prices were around 3 per cent lower. In addition, lower growth in labour costs has put further downward pressure on prices. The only inflationary pressure is coming from the public sector with various increases in administered prices and public tariffs as the government attempts to raise revenues to stop the widening of the public sector deficit.

The annual spring wage negotiations (the 'shunto') have once again led to lower wage rises than in previous years. The agreed wage increase had fallen to 3.9 per cent in 1993, from 4.9 per cent the year before, but this year the outcome is closer to 3.0 per cent. As overtime pay and bonuses, traditionally a large share of total wages, have fallen sharply, total labour costs are projected to rise by much less than 3 per cent in 1994. Over 2 million people, or less than 3 per cent of the workforce, are now classified as unemployed. This may look low by international standards, but that is partly due to the Japanese definition of unemployment, which, for instance does not include people who work for only one hour per week. The proportionate change in the official rate of unemployment is more informative, with an increase from 2.2 per cent in the first quarter of 1993 to 2.9 per cent in March 1994. There are indications that the Japanese tradition of guaranteed 'life time' employment in a firm has become too costly for some companies in difficulties and many firms are encouraging early retirement or even laying off staff. The current trend of rising unemployment may therefore persist and the rate of unemployment could remain well above its historical average in the medium term.

Our forecast for Japanese GDP is set out in Table 9. We expect no strong recovery this year despite the stimulatory fiscal packages that have been announced. A modest recovery in consumers' expenditure is unlikely to offset the effects of the projected sharp fall in business investment for the third consecutive year. Although we forecast domestic demand to rise by about 1 per cent this year, we expect this to be partly offset by a negative contribution of net exports to GDP. Details of our trade forecast can be found in Table 10. Exports are projected to fall more than last year, as the lagged effect of the loss in competitiveness, due to the appreciation of the yen, works through. This will dampen GDP growth significantly and will also slightly reduce the surplus on the current account. We expect inflation to fall further and foresee no significant change in the consumer price level in the next two years. With unemployment at a much higher level than its historical average, there will not be much wage pressure and nor will there be much growth in bonus payments and overtime working with the economy stagnating. However, if the labour market has changed, and equilibrium unemployment risen then there may be less downward pressure on wages than past relationships might suggest. We have attempted to take account of this in our forecasting by making a small upward adjustment to the residual on our wage equation.

Our forecast has a high degree of uncertainty due to the political situation in Japan. The coalition government of reform parties announced a fiscal package to boost the economy in February. This package amounted to a Y 15-3 trillion stimulus and included a widely demanded Y5.9 trillion tax cut for 1994, which mainly involved reductions in personal income taxes. These will be given in the form of two rebates in June and October this year. In addition a Y4 trillion increase in public investment was announced. The rest of the stimulatory package included additional expenditure on land purchases, loans for housing and enterprises and various subsidies. It was agreed that this package would be financed by an increase in sales tax in 1997, but the socialists, which were the largest party in that coalition, opposed this planned increase in indirect taxation. In April, Prime Minister Hosokawa had to resign after allegations of TABULAR DATA OMITTED financial improprieties. He was succeeded by Prime Minister Hata, but the socialist party left the coalition in the same week. Prime Minister Hata's first objective will be to get the budget for the fiscal year 1994/5, which started on April 1st, through parliament. The socialists have agreed to support the new minority government on this legislation, but have warned that after that they could withhold their support. New elections later this year are now increasingly likely and this increases the uncertainty surrounding our forecast.

We expect some boost to output coming from the planned increases in government investment, but past TABULAR DATA OMITTED experience has shown that announced plans are often watered down by the Finance Ministry. We assume indirect taxes will be raised in 1997, but despite this increase in revenues we foresee no return to government surpluses in the near future.

Germany

In 1993 the German economy experienced the sharpest downturn in real GDP since the war and both inflation and unemployment rose to historically high levels. The latest estimates suggest that pan-German GDP fell by 1.3 per cent last year following a 2.1 per cent increase in 1992. Unemployment has now risen to almost 3.8 million and the annual average rate of inflation reached an eleven year high of 4.1 per cent in 1993. The picture emerging for the first few months of 1994 is somewhat better. Production appears to be stabilising, inflation is falling but unemployment is still rising.

Within the pan-German figures the former west and east German economies experienced sharply contrasting economic fortunes. Provisional data suggest that whilst real GDP fell 1-9 per cent in west Germany it rose by 7.1 per cent in the east. Consumption was stagnant in the west but rose by 1.5 per cent in the eastern Lander. However this divergence in economic performance, which takes place against the background of the sharp decline in east German GDP following reunification, can largely be explained by continuing public sector transfers and investment (particularly construction). Government consumption fell by 1.3 per cent in the west in 1993 following a rise of 3.2 per cent the previous year. This compares with rises in government consumption in the east of 2.6 per cent and 7.2 per cent in 1993 and 1992 respectively. Whilst investment fell sharply in the west, it was again the fastest growing component in the east. Construction investment fell slightly in west Germany but rose by 21 per cent in east Germany (following a 36 per cent rise in 1992).

In the year to December 1993 industrial production fell by 1.2 per cent in west Germany. However by February 1994 industrial production was beginning to rise again with a 1.1 per cent increase over the previous 12 months. Retail sales fell by 4.2 per cent in 1993 following a 1.8 per cent fall in 1992. However retail sales rose in the first two months of 1994 and were slightly up in the 12 months to February. Capacity utilisation in German manufacturing fell in the fourth quarter of 1993 to an eight year low of 78 per cent, some 12 per cent below the peak of 90 per cent in the final quarter of 1990.

Unemployment rose across Germany in 1993 and in March 1994 it stood at 9.3 per cent in the west and 17.7 per cent in the east, but these figures do not take account of the estimated 1.5 million east Germans who have retired early or are on job training schemes. To combat unemployment the government has announced proposals to deregulate the labour market. Under consideration are the ending of the state's monopoly on job placing; the promotion of part-time employment; aid to the unemployed to set up their own businesses; incentives for the long-term unemployed to undertake low-paid community work or seasonal jobs; and a reduction in wages for those on job-creation schemes.

The high level of unemployment has had a depressing effect on pay deals. Despite threats of industrial action the engineering union IG Metall has agreed to what amounts to a rise in pay of just 1 per cent in 1994. Similarly, after lengthy negotiations, the public sector union OTV accepted a pay rise of 2 per cent and the suspension of Christmas bonuses (of one month's pay) for the next three years. Overall earnings growth has continued to fall with hourly wage rates up 4-2 per cent in 1993 compared with 5.9 per cent in 1992.

The lower earnings growth and weak demand have led to lower inflationary pressures in the first three months of 1994. In spite of a sharp rise in consumer prices in January due to higher petrol taxes the annual inflation rate was 3.2 per cent in April 1994, down from the annual average of 4-1 per cent in 1993. Wholesale prices rose by just 0-2 per cent in the year to March 1994 whilst import prices fell by 0.4 per cent in the year to February 1994.

The fall in German GDP in 1993 has led to a rise in the budget deficit. A package of spending cuts and tax increases has been announced. These include reductions in social security and unemployment benefits, a public sector pay freeze and measures to combat social security fraud. The German government has also decided to increase expenditure in east Germany as part of the 'Solidarity Pact' agreed with the opposition, federal states, employers and the unions. To cover this expenditure there will be a 7.5 per cent increase in income tax and higher wealth taxes from January 1995 and a rise in public borrowing.

The Bundesbank gradually reduced interest rates throughout 1993 and 1994. The most recent relaxation of monetary policy came on the 11 May 1994 when both the Discount and Lombard rates were cut by 0.5 per cent to 4.5 per cent and 6.0 per cent respectively. Official rates have fallen by 1.25 percentage points since February this year and are currently at a 5 year low. The latest cuts took place despite the recent sharp growth in the money supply. M3 rose at an annualised rate of 15.2 per cent in March compared with a target range of 4-6 per cent for 1994. However the Bundesbank took the view that the growth of M3 was affected by special factors, such as the return of funds from Luxembourg following recent tax reforms, and there was no need for any policy response. This suggests a shift in emphasis away from M3 growth figures as an early indicator of inflationary pressures. In future the Bundesbank may rely more heavily on recent trends in factory gate and wholesale prices.

Details of our forecasts for west German GDP are given in Table 11. After last year's sharp recession we are predicting a return to growth in 1994. We expect growth of around 1 per cent in 1994 rising to 2 per cent in 1995 and the following year. Consumers' expenditure will be depressed by the low level of wage settlements and the introduction of the solidarity tax in 1995. As a result consumption is expected to be unchanged in 1994 and 1995. Investment is forecast to decline slightly in 1994 following a large fall in 1993. However as growth picks up in 1995 investment is predicted to rise sharply by between 3.5-4.0 per cent. Our forecast implies no overall change in domestic demand, excluding stockbuilding. However, we do not expect further destocking in 1994, and therefore, the change in stockbuilding will make a positive contribution to GDP growth of about a full percentage point.

Despite the rapid fall in earnings growth we remain pessimistic about unemployment. West German unemployment is expected to rise to about 9.5 per cent in 1994 and remain about this level in 1995. This in turn should maintain the downward pressure on earnings growth. Average earnings are predicted to rise by between 2-2.5 per cent in each of the next two years. With rising productivity this should help to constrain the growth in unit labour costs. As a result inflation is forecast to fall to around 3 per cent in 1994 with the prospect of a further fall to 2.5 per cent in 1995.

Details of our forecast for west German trade are given in Table 12. The slow growth in unit labour costs, combined with a modest depreciation in the D-Mark, should lead to an improvement in German competitiveness. However we expect net exports to be little changed in 1994 and to increase modestly in 1995. It is, however, difficult to draw many firm conclusions about recent developments in trade because of the uncertainties surrounding the statistics following the change in data collection from customs document to VAT based returns.

With growth remaining below capacity in 1994 it is likely that the government deficit will rise. Table 13 gives details of our forecasts for the German public sector on a national accounts basis, including the Social Security Fund. Using this measure we are expecting a deficit of around 5.5 per cent of GDP in 1994. The deficit should fall in 1995 as the economy picks up and the government receives additional revenues from the 'Solidarity Tax'. However in 1995 the government will be taking responsibility for the outstanding debts of of the Treuhandanstalt and the GDR debt fund. This means that there will be a step jump in the debt to GDP ratio to over 60 per cent, and the debt to GDP ratio will then be in breach of the Maastricht criteria for economic and monetary union.

Table 11. West German GDP

 Percentage change

 1990 1991 1992 1993 1994 1995 1996-2000

Consumption 5.0 4.4 1.5 0.0 0.0 0.0 1.4
Investment 9.0 6.2 0.4 -6.9 -0.4 3.6 3.0
Government consumption 2.2 0.3 3.2 -1.3 0.8 0.5 1.8
Stockbuilding(a) 0.1 -0.4 -0.3 -0.8 0.9 0.5 0.1
Total domestic demand 5.4 3.6 1.2 -2.6 1.0 1.4 1.9

Net exports(a) 0.5 1.0 0.0 0.7 0.1 0.4 0.6
GDP 5.9 4.6 1.2 -1.9 1.0 1.8 2.5

Average earnings 4.9 6.0 5.4 3.0 2.1 2.4 4.0
Consumer prices(b) 2.7 3.7 4.0 3.4 2.9 2.5 2.2
RPDI 6.9 4.2 1.0 -0.7 -0.4 -1.9 1.6
Savings ratio 14.7 14.5 14.1 13.5 13.1 11.5 12.2
Unemployment, % 7.1 6.3 6.7 8.3 9.4 9.5 8.7

(a) Change as a percentage of GDP.
(b) Consumers expenditure deflator.

TABULAR DATA OMITTED

TABULAR DATA OMITTED

France

French GDP fell by 0.7 per cent in 1993 after growing by almost 1 1/2 per cent in the previous year. Inflation, at an average rate of around 2 per cent, was lower than the rate in Germany for the third year in a row. However, unemployment continued to rise and averaged 11.7 per cent in 1993. A slow and fragile recovery began in the middle of 1993. All of the fall in output recorded in that year occurred in the first quarter followed by GDP growth of approximately 0.25 per cent per quarter for the remainder of the year. The pace of the recovery now seems to be increasing as there have been signs of growing confidence in recent months. Lower short-term interest rates appear to have stimulated activity in the property market with housing starts rising at an annual rate of over 20 per cent in February. Furthermore, the number of job losses has rapidly decelerated to around 5000 per month at the start of this year compared to 30,000 per month at the end of 1993. Consumers' expenditure also rose slightly in the three months to February compared to almost a 2 per cent decline in the previous three months. Some of this recovery in consumption is accounted for by the increase in car sales resulting from government measures to help the car industry (such as cash payments to individuals purchasing cars to replace one at least 10 years old).

The latest INSEE survey suggests a strengthening of the recovery. The output of intermediate goods has shown a marked improvement and car production has been stimulated by government subsidies. However the signals are still somewhat mixed. The latest figures show that stock-building declined sharply at the end of last year, whereas recent surveys indicate that stocks have remained unchanged in recent months. In addition, capacity utilisation is still falling and at the end of last year it reached its lowest level since 1976.

The unemployment rate reached 12.2 per cent in February compared to 11.1 per cent a year earlier. In September 1993 the Government announced a five-year plan to reduce unemployment. This involved making working hours more flexible, encouraging part-time work and making it cheaper for firms to hire new workers. The plan met with stiff opposition from trade unions and opposition groups who saw it as an attack on workers' rights. Most controversial of all was the proposal to allow young workers to be paid only 80 per cent of the minimum wage whilst training. In the face of this rebellion the Government backed down at the end of March and abandoned the proposals. Wage settlements are being depressed by both the growth and high level of unemployment. Manufacturing wage rates have been particularly affected, showing a rise of only 2 1/4 per cent during 1993. However this is still in excess of consumer price inflation, which is currently 1.5 per cent, its lowest level for 20 years.

The recent decline in interest rates seems to be the major force generating the recovery. Short-term rates have fallen by almost 6 percentage points since reaching a peak of around 11.6 in the first quarter of last year. In contrast, over the same period, long rates have fallen by a mere 1 1/2 percentage points but have increased in the first three months of this year.

Although the French franc can now fluctuate within the wide 15 per cent ERM bands, the Bank of France has not used its new found freedom to pursue a monetary policy independent of that of Germany. It has generally been the case that interest rates have come down in line with those prevailing in Germany and there has not been any significant fluctuation in the DM/FFr exchange rate. The Bank of France, which became independent in early-1994 and is now directed by the new Monetary Policy Council, reduced the intervention rate from 6.0 per cent to 5.9 per cent at the end of March. Similar 0.1 per cent cuts occurred earlier in March and also in February. The yield curve suggests that financial markets are not expecting substantial further cuts in French interest rates in the near future. Furthermore, the yield on 10-year government bonds has risen by around 0.75 per cent since the beginning of the year, very much in line with developments in Germany. The relatively high level we are projecting for short rates may not seem to be the most appropriate policy setting given the low rate of price and wage inflation, the tentative nature of the recovery and the slow growth of the target measure of money supply (M3). However, given the continued coupling of French and German monetary policy, it is inflationary pressures in the latter country which are preventing lower interest rates in France. German inflation is currently twice that of France and hence the Bundesbank is reluctant to reduce interest rates much further.

The general government budget deficit rose sharply during the recession and was around FFr 400 billion last year, which is almost 6 per cent of GDP. Although some deficit-reduction measures have been announced, it seems that the government prefers to wait for higher activity to erode the deficit by pushing up tax revenue and depressing expenditure on benefits. The effects of expected higher activity this year, a planned increase in social security contributions and a decrease in interest payments on public debt should lead to a slight decrease in the deficit in 1994.

Our forecast for French GDP is given in Table 14. We expect the French recovery to continue with GDP growth of around 1.5-2.0 per cent in 1994 and 2-2.5 per cent in 1995. We are expecting this recovery to be primarily investment led, although there should be some contribution from modest growth in consumption and stock building. We do not anticipate net exports contributing much to growth in the short term. Imports should respond strongly to renewed growth given the high level of the franc relative to the currencies of major competitors.

We expect consumption to grow by around 1 per cent in 1994. Consumption growth will be constrained by near stagnation in real personal disposable income in 1994. Disposable incomes will be significantly affected by an increase in the social security contributions (CSG) which is expected to raise an extra FF50 billion. Business investment should increase as output increases and investment in housing should respond positively to the lower level of short-term interest rates. Overall we are expecting moderate investment growth in 1994 followed by stronger growth of up to 4 per cent in 1995.

We do not anticipate net exports offering much stimulus to growth over the next two years. This is partly because TABULAR DATA OMITTED French GDP growth is likely to be slightly higher than growth in most of her competitors. We expect net exports to be little changed in 1994 and to fall by up to 1 per cent of GDP in 1995. As Table 15 shows both export and import volumes were estimated to have contracted in 1993. With stronger growth at home and abroad we expect export and import volumes to increase in 1994 and 1995. We are not anticipating any significant change in the current account surplus which should stay at around 1 per cent of GDP in both 1994 and 1995.

Unemployment is forecast to remain at its current level of a little over 12 per cent in 1994 and 1995. We have been pessimistic about the impact of the proposed new job creation measure for young workers. This involves a monthly subsidy of FFr 1000 for nine months paid to companies giving young workers their first job. The subsidy will be doubled for companies taking on young people before October 1994 and is intended to provide 500,000 new jobs. However this measure, which emerged following the government's climb down on plans to make the labour market more flexible, is probably more an attempt to be seen to be doing something about unemployment than a coherent policy response.

The high level of unemployment is likely to exert a moderating influence on earnings growth. We expect average earnings to rise by around 2 per cent in 1994 and 3 per cent in 1995. We also expect price inflation to remain subdued with consumer prices rising by around 1.5-2.0 per cent in 1994 and 2 per cent in 1995. With growth still below potential we do not expect any significant improvement in the fiscal deficit over the next two years. It is expected to remain at above 5 per cent of GDP which should result in a rise in the government debt ratio to around 60 per cent of GDP in 1995. However the French government is embarking on an ambitious privatisation programme which it is hoped will yield receipts of up to FF200 million between 1994-97. This should help prevent the debt to GDP ratio from rising much further and we have taken account of these revenues in our forecast.

Table 15. French trade

 Percentage change

 1990 1991 1992 1993 1994 1995 1996-2000

Export volume (goods) 5.3 3.9 5.2 -1.3 5.5 3.2 4.5
Market growth 6.8 5.1 5.2 0.1 3.8 4.8 5.7
Relative prices(a) 4.2 -2.4 0.3 -0.9 -0.2 0.7 0.5

Import volume (goods) 5.8 3.0 1.1 -3.5 5.5 6.8 5.4
TFE 3.3 1.2 1.7 -1.2 2.4 3.1 3.2
Relative prices(b) -4.7 0.2 -3.0 -2.6 -0.4 0.1 -0.2
Visible balance $bn -9.3 -5.3 6.0 15.0 15.6 9.5 -3.6
Current account as % GDP -0.8 -0.5 0.3 0.8 1.1 0.8 0.0

(a) A fall is a gain in competitiveness.
(b) A rise is a gain in competitiveness.

Italy

The new government in Italy faces a weak economic situation. The fourth quarter figures for GDP were slightly worse than expected, and GDP fell by 0.7 per cent in 1993. The major driving force behind this recession was an 11 per cent decline in investment, with consumption falling by around 2.1 per cent. However, a strong impulse to growth from the external sector prevented a much larger fall in GDP; exports grew by 10 per cent in 1993 while imports fell by 7 per cent, both, as a result of the continued real depreciation of the lira which initially began in 1992 after Italy suspended its membership of the Exchange Rate Mechanism (ERM). As a consequence, the balance of payments on the current account is showing a substantial improvement; we are forecasting current account surplus equivalent to 0.1 per cent of GDP in 1993 compared to a deficit equal to 2.3 per cent of GDP in 1992.

Inflation was, for Italy, a modest 4 per cent during 1993 and this is partly due to downward pressure on wages from a slack labour market. Unemployment reached 10.7 per cent in the last quarter of 1993. There has been a reduction in wage growth from 11 per cent in 1991 to an annual rate of 3 per cent in the fourth quarter of 1993. Real incomes have been reduced as wages have increased more slowly than prices over the past two years. The Bank of Italy estimates that this, along with high unemployment and higher taxes, reduced real personal disposable incomes by around 2.5 per cent in the first three quarters of 1993 compared with the same period a year earlier.

Inflation is at its lowest level for 20 years. Consumer prices rose by 0.75 per cent in 1993q4 and 1 per cent in 1994q1 and the lower annual inflation rate is reflected in recent falls in 3-month interest rates. In the first quarter of 1994 the 3-month interbank rate fell by a quarter of a per cent to around 8.5 per cent from a high in 1993 of around 14.5 per cent. Long-term interest rates rose by 0.5 per cent in the first quarter of 1994 which may reflect worries about the policies of the new government. A clear risk is that the coalition will cut taxes without reducing spending, thereby increasing the budget deficit.

Although the fourth quarter GDP growth was disappointing there were some encouraging signs for domestic demand. Consumer spending rose by almost 0.5 per cent on top of a slightly smaller rise in the third quarter, the first positive growth for consumption since the first half of 1992. The contraction in household spending was the most protracted in the post-war period and was particularly marked in the purchases of durable goods. Spending on cars fell by 20.4 per cent in 1993 but there are better prospects for 1994 as car sales are up by 1.6 per cent in the year to March. The consumer confidence index jumped by 8.1 per cent in December 1993.

It seems that the prolonged fall in investment may be finally coming to a halt. The new government is likely to adopt a more favourable attitude towards business which should help encourage investment. The low levels of both short and long-term nominal interest rates are likely to promote investment and alleviate the borrowing difficulties facing Italian firms. However, market rates reflect the cost of borrowing by the government, which may have fallen more that that facing firms.

Our forecast for Italian GDP is set out in Table 16. We expect GDP to grow by around 1.5 per cent in 1994 due to a modest improvement in domestic demand and a continued stong contribution from net exports. Consumption is expected to grow by around 0.7 per cent. Consumer spending will still remain weak in part because direct taxes increased by 15 per cent in 1993. Even after excluding the municipal property tax the increase was still a significant 8.6 per cent and the budget also raised social security contributions by 6.5 per cent.

We are forecasting that the climate of business confidence, improvement in domestic demand and lower interest rates will lead to a small pickup in investment to show around 0.5 per cent growth in 1994. With the continued low level of capacity utilisation there is some slack within production for domestic absorbtion and we expect investment to show stronger growth only towards the end of 1994. Unemployment is likely to rise slightly and remain high throughout 1994 with a gradual decline in the long term, and this will help depress real wages for the forseeable future. With high unemployment, weak domestic demand and only a modest effect from the depreciation of the lira inflation is set to fall further in 1994.

Our forecast for Italy's trade position is set out in Table 17. The contribution of net exports will continue to offset weaker domestic demand in 1994 and 1995. Export volume is expected to increase by almost 9 per cent in 1994 after a 5 per cent increase in 1993. Export growth has been aided by falls in relative prices, but the increase in 1994 should be helped by market growth of around 5 per cent. Import volumes are expected to continue to fall in 1994. We are projecting that the current account will continue to show a small surplus in 1994 and 1995.

TABULAR DATA OMITTED

Canada

The Canadian economy began to emerge from its recession in 1992, but growth was relatively slow in both 1992 and 1993, with relatively weak domestic demand being offset by an improving trade performance, driven by competitiveness gains against the US. These gains were the result of a depreciating exchange rate coupled with the lowest inflation in the G7 in 1992 and almost the lowest in 1993. First estimates suggest that GDP grew by around 2.4 per cent in 1993, after 0.7 per cent in 1992, whilst unemployment was above 11 per cent in both years.

We expect growth to pick up quite strongly in 1994, and signs of this acceleration were already evident in the fourth quarter of 1993. Real GDP grew by 1 per cent in the quarter, with a strong impulse from business investment and a good export performance. We expect this pattern to continue into next year, as can be seen from our forecast in Table 18. Net exports are likely to contribute more than a per cent to GDP in 1994, and we expect business investment to rise by 10 per cent during the year. Survey evidence from the Conference Board suggests that business confidence is back to its pre-recession levels, and two investment intentions surveys around the turn of the year indicated rising investment plans.

Unemployment remained high during 1993, although it fell to 11.1 per cent in the fourth quarter, down from its peak of 11.3 per cent in the middle of the year. (First quarter data has been affected by severe weather, and TABULAR DATA OMITTED does not signal a sustained upturn in unemployment). Employment growth has been particularly slow recently, and unit costs have been falling as productivity growth has exceeded wage growth. This has been one of the factors behind the exceptionally low rate of inflation in 1993. We expect inflation will remain low in 1994 as annual wage growth at the end of 1993 was only around 1 per cent, and there have been significant reductions in tobacco taxes, which have reduced consumer prices by almost half a point.

High levels of unemployment may well help explain the slow growth of consumer spending that we are forecasting for 1994. However, low wage growth has meant that real incomes are expected to stagnate in 1994, and increases in provincial taxes in the second half of 1993 actually reduced real personal disposable incomes. The last quarter of 1993 saw some acceleration in the growth of consumption despite these factors, and as a result the savings ratio fell. We are projecting a continued fall in this ratio as consumption is forecast to rise more rapidly than real disposable incomes in 1994. In the medium term the increase in the growth rate of output to around 3.5 per cent should help to raise real personal income growth again, and we are expecting both consumption growth and the savings ratio to increase from 1995 onward.

In the longer term the combination of tax increases and a stronger economy should help reduce the general government deficit, which consolidates Federal and Provincial accounts, to around 3 per cent of GDP from the 6.5 per cent we have seen for the last three years. However, the debt stock has risen strongly, and because we are forecasting low inflation we do not expect it to be eroded quickly, and it is likely to be above 80 per cent of GDP by the end of the decade. The tightening of the fiscal position along with weak consumption growth should lead to a gradual improvement in the balance of payments, but although the visible balance will continue to rise, the existence of large foreign debts will keep the current account in deficit.

Spain

The decline in Spanish GDP came to a halt in the middle of last year. The end of the recession was entirely due to the rise in external demand resulting from the sustained devaluation of the peseta that began at the end of 1992. Net exports added around 2.5 per cent to GDP last year; export volumes of goods grew by just over 9 per cent while import volumes declined by about 6 per cent. In contrast, both consumers' expenditure and private sector investment continued to decline throughout 1993. The 2.25 per cent fall in consumption last year was only partly due to depressed incomes, because real personal disposable income did not actually fall. A combination of rising unemployment and high interest rates encouraged consumers to spend less of their income and the savings ratio increased. The dramatic fall in private sector investment explains much of the recession. Investment is still falling even though capacity utilisation and real GDP have been rising since the third quarter of 1993. Consecutive restrictive budgets have increased both direct and indirect taxes with the net result that a substantial fiscal tightening explains some of the recession.

The 1 per cent fall in GDP last year was accompanied by only a small reduction of consumer price inflation from around 6 1/2 per cent to about 5 1/4 per cent. Average earnings growth also fell by a similar magnitude. The decline in wage inflation has also been negligible given that the unemployment rate has risen by 8 percentage points in 2 years to approximately 24 per cent at the end of 1993. However, inflation has been adversely affected by the rise in import prices resulting from the 44 per cent depreciation of the peseta against the dollar since the third quarter of 1992, although the recession has put pressure on importers' margins and prices have not risen as much as could have been expected. Service sector inflation has fallen by about 2 percentage points in 1993, somewhat more than expected. Inflation has fallen to below 3 per cent for clothing and footwear and household goods, which probably reflects the depressed state of consumer demand.

The unemployment rate is currently around 24 per cent, but the rise in unemployment has varied across industries and workers. In 1993 the largest falls in employment occurred in industry and construction. Furthermore, TABULAR DATA OMITTED temporary workers experienced a far greater rate of job loss compared to permanent workers. This is obviously related to the ease of firing temporary employees relative to permanent staff. In addition to the depressed level of activity, unemployment has also risen because of strong growth of the labour force.

In March, the number of individuals registered as unemployed at INEM (The National Employment Office) fell by 15,000 compared with a rise of almost 60,000 in March 1993. The labour ministry claimed that this reflected a change in the employment trend due to an improvement in economic activity. However, our econometric model of Spain uses the survey based measure which indicates that Spanish unemployment is still rising. The survey measure of unemployment gives a more consistent profile over the recent past as the INEM measure has been subject to changes in definition.

The government has attempted to stimulate car production by following the scheme implemented in France, giving incentives to scrap cars that are more than 10 years old and exchange them for a new car. In addition to these temporary measures and the peseta devaluation, the other major stimulus to growth is the easing of monetary policy. Three-month interest rates fell by around 6 percentage points between the final quarter of 1992 and the first quarter of this year. The latest reduction occurred on April 22 and cut the intervention rate to 7.75 per cent.

As Table 19 shows, we expect growth to be slightly above 1 1/2 per cent in 1994. Most of the growth comes from net exports but we also expect domestic demand to stop falling by the end of this year. Consumption should move in line with real personal disposable income this year, but the latter will be subdued due to the rise in direct taxes and cuts in benefits outlined in the latest budget. The favourable performance of equities in 1993, which is expected to continue this year as the recovery strengthens, should add to consumer confidence and increase net wealth. This will encourage consumption but the savings ratio will probably not decline until next year.

Although the devaluation and the fall in unit labour costs have allowed profitability to increase, the high level of long-term borrowing costs and substantial spare capacity will continue to deter investment. Next year should witness a small rise in capital expenditure as utilisation increases and the outlook for activity becomes brighter. We are forecasting that GDP growth in 1995 will increase to around 2 per cent. Net exports will only make a small contribution to output as the benefits of devaluation will already have been realised.

The rapidly deteriorating government deficit will TABULAR DATA OMITTED probably be around 8 per cent of GDP this year. The 1994 Budget promised a public sector wage freeze, increased taxes and reductions in capital spending, but more severe measures are necessary in the medium term to tackle the large structural deficit. In the mean time the high level of unemployment will keep the deficit at around 7.5 per cent of GDP next year and the debt ratio will probably grow to around 65 per cent of GDP.

Table 20 gives our forecast for the Spanish balance of payments. We expect the dramatic improvement in the deficit last year to continue over the short to medium term. Spain should register a current account surplus this year that should extend into the medium term. Most of the improvement obviously comes from the sustained gain in competitiveness resulting from the recent substantial depreciation of the peseta.