The world economy.

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

A comprehensive model manual lists individual equations and describes the theoretical basis of the model's relationships. A full data listing gives the definition and source for each model variable, allowing the user to update the forecast in between quarterly releases.

Hardware requirements

The package requires a 80386 based PC, such as the IBM P/S2 Model 70 or 80, wit 8 megabytes of memory. A maths co-processor (80387) is also necessary. The computer should also have at least 20 megabytes of hard disk and a VGA graphics board. The World economy appears to be entering a period of sustained and widespread output growth after some years of recession in Europe and recovery in North America. Output actually fell in the EC as a whole in 1993. We are forecasting that OECD output will grow by around 2 1/2 per cent in 1994, with output growth around 2 per cent in the EC and above 3 per cent in North America. The recovery in Europe is relatively widespread and we expect positive growth in all the major continental economies.

The existence of spare capacity in Europe along with competitive pressures from producers in the Far East and Mexico has helped to keep inflation low in the US and Canada. However, inflationary pressures are beginning to build up. Commodit prices have recovered somewhat from the trough they reached during the recessio and oil prices have risen markedly. These developments may be driven partly by special factors, which we discuss below, but they have been taken as a signal o emerging inflationary pressures. The monetary authorities in the US have responded to these pressures, albeit slowly, and interest rates in North Americ began to rise at the end of 1993. Short rates in the US are now around 5 1/4 pe cent, more than 2 percentage points above their minimum in 1993.

The US is clearly approaching full capacity, and this, along with the effects o previously announced fiscal policies, is likely to restrain growth in 1995. The US Federal Reserve may have reacted rather slowly to recent developments and US inflation is expected to rise in 1995. We are forecasting that consumer prices will rise by 3.9 per cent in 1995 after rises of only 2 1/2 per cent in 1993 an 1994. Table 1 contains our forecast for the major five economies and for the major groupings as well as for world trade. We expect that OECD wide inflation will reach a trough in 1994 and it will rise from 2 1/2 per cent in 1994 to 3 per cent in 1995. Although the US response has so far been muted we are expecting that the dominant monetary players, the Federal Reserve, the Bundesbank and the Bank of Japan will continue to be successful in their strategy of pursuing low inflation, and we do not expect OECD wide inflation to rise much above 3 per cent over the next six to eight years with output growth settling down on trend.

The prospects for growth in the OECD area over the next three years generally look good. Although long-term interest rates have risen this in part reflects anticipations of stronger demand and higher inflation. Inflation has been very low in the OECD as a whole over the last two years. This could have been the result of a considerable amount of spare capacity in the World economy. However recent estimates of output gaps by the OECD, which are discussed in Box A, suggest that spare capacity may not be excessive. The unification boom in Germany pushed the economy well above normal output, and the fall in output in 1993 has probably returned that economy to around capacity. In late-1993 both the OECD and the IMF seemed to believe that France, Italy and the UK had output gaps of between 3 1/2 to 5 1/2 per cent of GDP but our own work, and more recen OECD estimates, suggest that these estimates were in some sense too optimistic. If output gaps in Europe are no more than 2 per cent, then prospects for sustained strong growth with low inflation cannot be good. Prospects for 1995 and 1996 look fair, but not outstanding, as we expect that fiscal and monetary authorities will have to react to restrain demand. We believe that revisions to estimates of output gaps have been one of the reasons for rising bond rates and we discuss these below.

The medium-term prospects for the Japanese economy look less good, however. The 20 per cent appreciation of the yen over the last 18 months has reduced output growth somewhat and its effects are likely to continue into 1996. In addition, around the end of the decade the Japanese working population is likely to reach its peak after some years of strong growth, and this is likely to reduce the growth of potential output.

Interest Rates and Exchange Rates

The combination of a strong upturn and a perception that the Federal Reserve ha acted rather slowly in response to emerging inflationary pressures has led to a weakening of the dollar over the last three months. However, it is something of a moot point as to whether it is the dollar that has depreciated or the yen tha has appreciated. In the first six months of 1994 the dollar depreciated by around 5 per cent against the yen. However, over the same period it appreciated by over 3 per cent against the Canadian dollar and 6.5 per cent against the Mexican peso. Based on the weights derived from trade with other OECD countries the effective exchange rate for the dollar depreciated by 0.8 per cent over the first six months of 1994. Some of the United States' most important trading partners--such as those in South East Asia--are not in the OECD. We have also calculated an effective exchange rate based on the ten most important trading nations for the US. On this basis the effective exchange rate was virtually unchanged over the first half TABULAR DATA OMITTED of 1994. The dollar/yen exchange rate has fluctuated around 100 for some time, and we expect that in th third quarter, the yen will on average have appreciated by 7 per cent more than we forecast in May. As a result, our estimate of the Japanese effective exchang rate in the third quarter is 4 per cent higher than in our May forecast.

These movements in exchange rates have had much less impact on Europe, even though the D-Mark/dollar rate has moved by almost as much as the yen/dollar rate. Europe has become increasingly integrated over the last decade and intra-European trade has risen more rapidly than has overall trade. This means that the weight on the US as a potential competitor has been declining. Intra-European exchange rates have also been relatively stable in the last thre months, and hence effective exchange rates have been relatively stable. Table 2 gives our forecast for exchange rates for the major six economies. We believe that monetary policy in France and Germany will be reasonably well co-ordinated over the next few years, and hence the franc is unlikely to move outside its notional narrow band. We do not see the Italian lira following the same course, as monetary developments in Italy are likely to be more directed to domestic problems than they were in the 1980s. As can be seen from Table 3 we are expecting Italian interest rates to remain significantly above those in Germany and as a result we expect the lira to continue to depreciate.

Short-term interest rates in the US have risen somewhat more rapidly than we or the short-term money markets had anticipated in May. The same is true for Italy and Spain, but short rates in Germany have remained low, as can be seen from Chart 1, and we are no longer expecting any increase this financial year. US long-term rates, which are plotted in Chart 2, have continued to rise. Long rates have been rising in Germany, as can be seen from Chart 3. However, the forward markets are projecting only moderate increases in German short rates over the next twelve months.

Long rates are the average of expected future short rates, and inspection of th whole yield curve is necessary to explain why long rates rise. We would judge that recent increases in long rates reflect revisions to both the anticipated short-term inflation profile and to estimates of the real interest rates that may prevail toward the end of the decade. Output gap estimates are being revised, with lower estimates of spare capacity and hence either the prospects for inflation must be seen as slightly worse, or alternatively interest rates are expected to rise earlier than previously anticipated in order to keep inflation on target. Smaller output gaps imply revision to estimates of government structural budget deficits, and hence current budget deficits look much more serious than they did a year ago. This should lead either to a revision of estimates of real interest rates or to a clear set of plans for fiscal consolidation. We believe that recent rises in long rates reflect, at least in part, the revision of estimates of structural savings flows and hence of projections of real interest rates over the next decade.

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 5.1 4.3 -15.1 -5.6
1994 -0.1 6.8 0.0 1.0 -3.6 -6.4
1995 -1.5 3.2 1.4 1.4 -2.8 -2.1
1996 -0.6 2.9 0.7 0.9 -2.9 -1.1

1993 I 2.4 3.9 1.4 1.4 -7.0 0.9
 II -2.9 9.5 -0.8 -0.3 1.4 -1.5
 III 1.6 5.9 0.5 -1.8 -1.2 -2.3
 IV 1.6 -2.0 0.7 0.9 -3.5 -1.4

1994 I 0.5 0.5 -1.9 0.6 -1.1 -1.2
 II -1.3 3.2 0.8 -0.1 2.1 -3.6
 III -1.7 0.1 1.4 1.5 -2.1 -0.2
 IV 0.0 0.7 0.1 0.2 -0.6 -0.3

1995 I -0.1 0.7 0.1 0.2 -0.7 -0.3
 II -0.1 0.7 0.2 0.2 -0.8 -0.4
 III -0.1 0.7 0.2 0.2 -0.8 -0.3
 IV -0.1 0.7 0.2 0.2 -0.8 -0.3

1996 I -0.5 0.7 0.2 0.2 -0.7 -0.3
 II -0.2 0.7 0.2 0.2 -0.7 -0.3
 III -0.2 0.7 0.2 0.2 -0.7 -0.2
 IV -0.2 0.7 0.2 0.2 -0.6 -0.2

 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 103.5 1.64 5.61 1615.2 3.42 984.8
1995 99.5 1.58 5.40 1615.2 3.42 1022.6
1996 96.6 1.56 5.34 1651.5 3.42 1057.2

1993 I 121.1 1.63 5.54 1543.9 3.39 944.9
 II 110.0 1.62 5.48 1503.1 3.39 929.0
 III 105.6 1.68 5.81 1584.7 3.47 944.9
 IV 108.2 1.68 5.83 1651.1 3.47 981.0

1994 I 107.6 1.72 5.86 1683.4 3.40 977.0
 II 103.3 1.66 5.69 1604.0 3.42 965.7
 III 102.0 1.59 5.44 1582.0 3.42 995.0
 IV 101.3 1.59 5.44 1591.6 3.42 1001.5

1995 I 100.6 1.59 5.43 1600.9 3.42 1009.3
 II 99.8 1.58 5.41 1610.3 3.42 1018.0
 III 99.1 1.58 5.40 1620.1 3.42 1027.1
 IV 98.4 1.57 5.38 1629.5 3.42 1036.1

1996 I 97.7 1.57 5.37 1638.6 3.42 1044.8
 II 96.9 1.56 5.35 1647.4 3.42 1053.4
 III 96.2 1.56 5.34 1655.8 3.42 1061.5
 IV 95.5 1.56 5.32 1663.9 3.42 1069.2
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 4.7 2.4 5.3 5.8 8.9
1995 6.3 3.3 5.2 5.9 9.9
1996 6.7 3.7 5.7 6.0 10.0

1997-2001 6.8 4.0 6.5 6.5 10.0

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 2.2 5.8 6.3 8.8
 II 4.4 2.3 5.4 5.8 8.5
 III 5.2 2.5 5.0 5.5 8.9
 IV 5.8 2.7 5.0 5.5 9.4

1995 I 6.2 3.1 5.0 5.7 9.8
 II 6.3 3.2 5.1 6.0 10.0
 III 6.4 3.3 5.2 6.0 10.0
 IV 6.5 3.4 5.3 6.0 10.0

1996 I 6.6 3.5 5.4 6.0 10.0
 II 6.7 3.6 5.6 6.0 10.0
 III 6.8 3.7 5.8 6.0 10.0
 IV 6.8 3.8 6.0 6.0 10.0

World Trade and Commodity Prices

The pattern of world trade in the next few years is likely to be strongly affected by recent developments in real exchange rates. Italy, Canada, the UK, Spain and the majority of EFTA countries have experienced large real depreciations over the last three years, whilst Germany, France, the US and Japan have all seen real appreciations. As can be seen from Table 4, the Japanese appreciation is both larger and more recent than that experienced elsewhere. As a result we expect that Japan will continue to lose trade share, despite some tightening of exporters' profit margins.

The real appreciation of the D-Mark has helped reduce the level of demand in Germany and resources have switched to servicing domestic demand. Much of this switching is now complete and Germany may regain some of its lost trade share. This in part reflects Germany's role as a price setter in its specialist markets, with other producers, of, say, specialist machine tools following German prices and raising profit margins rather than market share. The appreciation of the franc has been less beneficial and export competitiveness has not adjusted.

We are expecting overall world trade to rise strongly in 1994 as output grows throughout the OECD. Demand from China and the Asia Pacific rim is likely to be strong, boosting overall world trade growth to 8 per cent. The strength of recovery in the US and Canada, along with the continuing effects of the recent free trade agreement, is likely to raise their imports significantly. This is one of the factors behind the forecast rapid growth of world manufacturing trad (an OECD based measure) in 1994. The continuing effects of the new European system for collecting trade data may also have artificially boosted world trade this year. The registration system inevitably involved delays in document submission and data for the first quarter of 1994 may include a degree of late registration from 1993.

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 93.9 92.6 95.1 94.5 107.0
1992 93.5 96.9 98.5 96.0 105.6
1993 97.1 113.8 103.6 98.8 91.1
1994 97.6 119.3 104.1 98.7 89.0
1995 97.7 120.0 104.5 98.9 87.6
1996 98.4 120.2 103.9 98.8 87.0

1993 I 98.2 104.1 103.7 100.1 90.7
 II 95.3 113.6 102.9 99.4 92.6
 III 96.6 120.4 103.5 97.4 92.3
 IV 98.4 117.0 104.5 98.1 89.0

1994 I 98.8 117.6 102.7 98.3 88.3
 II 97.6 120.5 103.7 98.0 90.4
 III 96.6 119.7 105.0 99.3 88.7
 IV 97.3 119.3 104.9 99.1 88.3

1995 I 97.5 119.6 104.7 98.9 88.1
 II 97.6 120.2 104.6 98.9 87.7
 III 97.8 120.2 104.5 98.9 87.5
 IV 98.0 120.0 104.3 98.9 87.3

1996 I 98.1 120.1 104.1 98.8 87.1
 II 98.3 120.4 103.9 98.8 87.0
 III 98.5 120.3 103.8 98.8 87.0
 IV 98.8 120.1 103.7 98.8 87.0

Despite these measurement problems, it is clear that world trade and demand growth is currently very strong and this has been reflected in commodity prices Our forecasts for commodity prices are given in Table 5 and TABULAR DATA OMITTE recent developments are plotted in Chart 5. There are often special factors to take account of in commodity markets and the current conjuncture is no exception. Less developed countries' food prices have risen very sharply in recent months. Pressures on stocks were already evident at the start of the year, and we discussed them in the February Review. However, sharp frosts in Brazil have destroyed much of this year's coffee crop, and coffee (and cacao) bean prices have risen sharply. The London spot price for coffee rose threefold between March and the end of July 1994. Sugar prices have also been strong over the same period. We have fed these increases into our forecasts for 1994-95, bu because of the specific nature of the shock we have assumed that harvests will return to normal next year and prices will fall back to levels seen at the beginning of the year.

Our developed country food price index, which includes wheat, maize, cattle and pork, has been weaker, largely because maize and soya prices have been falling. The floods in the Midwest of the US in the summer of 1993 led to depletion of feed grain stocks and maize prices rose through the autumn. However, a reasonable southern hemisphere crop and good weather in the US has eased prices considerably. Overall developed country food prices are now stable or falling. Considerable pressure has built up in metals' markets and prices have risen. This may reflect speculation in copper markets, where prices rose by 40 per cen between January and the end of July. Aluminium and nickel prices have also rise and there is some evidence of rising demand, especially from the Far East and also from North American car producers.

Oil prices sunk to exceptionally low levels between December 1993 and March 1994, but started to rise in April--Chart 6 plots spot prices for crude oil. By the end of July the price of light Brent crude from the North Sea had risen to 18 dollars per barrel, some 45 per cent above its level at the start of the year. Current demand and stockbuilding in anticipation of future demand increases have put upward pressure on prices, but they have only returned to levels seen at the end of 1992. In early-August 1994 the Brent/Dubai split widened and prices for Brent rose because of the effect of pro-democracy strike in Nigeria on production of light crudes. Recent oil prices rises give an indication of a robust recovery but, as with other commodity prices, they canno be read as a harbinger of a burst of inflation. However, the message they may contain should be borne in mind.

The United States

The recovery continued in the second quarter. Real GDP increased by over 0.9 pe cent. This compares with just over 0.8 per cent in the first and over 1 1/2 per cent in the fourth quarter of last year. Exports and investment accounted for most of the growth in the latest quarter: export volumes grew by 2 3/4 after declining by 1 per cent in the first quarter; non-residential investment increased by 2 1/2 per cent and residential investment by 1 3/4, both growing slightly slower than in the first quarter. However, consumers' expenditure showed the strongest deceleration, only growing by 0.3 per cent in comparison t more than 1 per cent in the first quarter. The growth rate of both consumer durables and non-durables purchases slowed down considerably. Stockbuilding has also accelerated in recent months, particularly in the second quarter.

Other recent data also reflect the continued strength of the recovery. Non-agricultural employment rose by over a million during the second quarter. However, this rapid increase partly reflects the weak employment growth during the bad weather of the first quarter, particularly in construction. Although th US economy must be approaching its sustainable level of employment--the unemployment rate is now 6 per cent--wage growth is still sluggish. Average weekly earnings are still only approximately 3 per cent higher than a year ago. The combination of strong GDP growth and low wage inflation has resulted in a decline in unit labour costs, but it is expected that recent rapid productivity growth will soon feed into wages. For the moment, inflation is low and stable, producer prices are either stagnant or declining and consumer price inflation remained at 2 1/2 per cent in the second quarter, which is the lowest since 1987.

Housing starts rose by 5 per cent in the last three months, encouraged by low mortgage rates and high consumer confidence. The Conference Board's index of consumer confidence reached 92 in June compared to around 58 a year ago. Consumption has moved in line with confidence, and the savings ratio has remained historically low, but savings are now rising due to the strength in real personal disposable income largely resulting from the increase in the number of people in employment.

Growth in production remained strong in the second quarter but was a little slower than the previous quarter. Industrial production in the three months to June rose by 1.1 per cent, half the growth rate of the first quarter. Similarly manufacturing output increased by 1.3 per cent compared to almost 2 per cent in the previous quarter. Capacity utilisation in manufacturing also continued to rise in June and is currently at its highest level for five years.

Table 6. United States GDP

 Percentage chang
 1990 1991 1992 1993 1994 1995 1996-200

Consumption 1.5 -0.4 2.8 3.3 3.0 1.5 2.1
Investment: housing -9.2 -12.9 16.2 8.2 8.6 5.0 6.8
business 1.2 -5.7 2.0 12.5 11.5 4.5 3.5
Government expenditure 3.1 1.2 -0.7 -0.8 -0.7 2.2 2.4
Stockbuilding(a) -0.5 -0.1 0.1 0.3 0.5 0.1 0.0
Total domestic demand 0.8 -1.3 2.5 3.9 4.1 2.3 2.5

Net exports(a) 0.4 0.7 -0.3 -0.8 -0.5 0.1 0.0
GDP 1.2 -0.6 2.3 3.1 3.5 2.3 2.5

Savings ratio 7.1 7.9 8.2 6.6 6.8 7.1 7.2
Average earnings 5.6 3.5 5.0 2.1 4.4 4.9 4.5
Consumer prices 5.2 4.2 3.2 2.5 2.5 3.9 3.2
RPDI 1.8 0.3 3.2 1.4 3.0 1.7 1.8
Unemployment, % 5.5 6.7 7.4 6.8 6.3 6.6 6.7

(a) Change as a percentage GDP.

(b) Consumers' expenditure deflator.

The Federal Reserve increased its Federal Funds target rate by 1/2 a percentage point to 4 1/4 per cent on 17th May which was obviously designed to dampen the inflationary pressures resulting from the strength of the recovery. The rate ha also been increased by a 1/4 per cent on each of 18th April, 22nd March and 4th February. However, the Federal Reserve has indicated that it believes that monetary policy is now virtually neutral--neither restrictive nor expansionary--which suggests that there are no strong pressures for further increases in the near future. In marked contrast the forward markets indicate that US three month rates will be above 6 per cent within 12 months. The recent declines in the US stock market also suggest that a further monetary tightening is expected. However, monetary growth is still weak, the annual growth in M2 wa 1 1/2 per cent in June which is close to the floor of the target range.

The yield on US 10-year government bonds is now 1 1/4 percentage points higher than a year ago. It appears that bond rates were at too low a level to be sustainable and that financial markets did not foresee either the recent tightening of short rates or revisions to expectations above real rates. The potential sustainability of low long rates may have been gradually weakened by growing public sector deficits in many advanced countries.

The dollar has been depreciating against the yen since the beginning of the year, but it has fallen a further 10 per cent during June and July. Many commentators agree that the movements of the dollar are not in line with 'fundamentals'. The fall of the dollar against the yen is largely due to the growing Japanese trade surplus and the poor prospects for any 'trade talks' success. But the weakness of the dollar seems to be partly due to the perceived weakness of the Federal Reserve. The financial markets have been expecting another rise in US short rates for some time in order to subdue strong underlying inflationary pressures and to defend the dollar. However, the weakness of the dollar/yen rate has not been fully reflected elsewhere.

The budget deficit is declining fairly rapidly. The first 8 months of the fisca year saw it narrow to around $165 bn compared to $212 bn a year earlier. Apart from the obvious impact of higher activity, the deficit has benefitted from a reduction in defence spending, lower interest payments and some revenue from th sale of the failed savings' and loans' associations. Long-term fiscal policy is guided by the Omnibus Reconciliation Act of 1993 which aims to reduce the deficit by a cumulated $500 bn by 1998. But the slow rate of increase in federa expenditure combined with high revenue growth, delivered a deficit for the last fiscal year of $255 bn, which is $30 bn below the administration's own projections The budget package for the 1995 fiscal year aims to reduce the deficit to 2 1/2 per cent of GDP by reducing expenditure on public housing and subsidies on mass transit and home heating.

We agree with the forward markets that US interest rates must rise in the near future, perhaps increasing to above 6 per cent over the next twelve months. The monetary tightening is reflected in our US forecast given in Table 6. Our projection of strong GDP growth this TABULAR DATA OMITTED year and decelerating next year is the 'consensus' view, but our profile of interest rates gives us a much more rapid slow-down in 1995. We expect GDP growth of around 3 1/2 per cen this year and 2 1/2 per cent next year. Much of the growth in 1994 comes from investment and from consumption, the latter growing in line with real personal disposable incomes. However, despite the dollar depreciation, net exports will not contribute to growth this year as import volumes are likely to react strongly to domestic demand. Without the assumed increase in interest rates, GD growth in 1994 would be above 4 per cent, but a fiscal tightening, in the form of negligible growth in government spending and limited tax increases, is also likely to dampen the recovery.

Average earnings should be growing strongly by the end of the year, responding to the fall in unemployment and the recent increases in productivity. Consumer price inflation will lag behind the increase in earnings and be more rapid in 1995. The high level of activity should restrain growth in unit labour costs this year with the result that inflation will remain below 3 per cent in 1994, but rising to almost 4 per cent next year.

Our forecast for the US balance of payments is given in Table 7. The table show that the depreciation does not change relative prices much for this year and next. The depreciation against the D-Mark and the yen has not influenced the effective exchange rate much, although it should be noted that the dollar has risen against the USA's largest trading partner, Canada.

Although 1992 and 1993 saw a downturn in Europe, growth in US export markets wa actually quite strong, particularly in the Far East which accounts for a larger proportion of US exports than do France, Italy and the UK together. Growth Outside of Europe, particularly in Canada, also accounts for the buoyant demand for US exports this year. The recent dollar depreciation also encouraged exports, but the strength of US demand is likely to cause import volume growth of above 10 per cent during 1994. If this occurs then import volumes will have grown by more than 30 per cent over three years. Hence we expect the visible balance to deteriorate this year, but this partly reflects a J-curve effect fro the dollar depreciation. Conversely, the fall of the dollar is likely to improv the IPD balance compared to our previous forecasts. In the longer term, the current balance deficit should stabilise at around 2 per cent of GDP, helped by the very competitive level of the dollar.

Our projections for the US fiscal deficit are given in Table 8. A combination o high activity, tax increases and stable government spending should cause a considerable decline in the deficit this year, probably to around 2 1/4 per cen of GDP. Deficit reduction will not proceed so rapidly next year as higher borrowing costs will boost debt interest payments and net revenue growth will slow down in line with the economy. However, we are quite optimistic about the sustainability of the deficit in the longer-term. We expect the deficit to decline to around 1 3/4 per cent by 1997, which is lower than for most of the 1980s.

TABULAR DATA OMITTED

Japan

After almost three years of stagnation, there are signs of a revival in the Japanese economy. GDP grew by 1.0 per cent in the first quarter of this year, compared to a fall of 0.7 per cent in the last quarter of 1993. GDP showed no growth in 1993 compared to 1.2 per cent growth in 1992. The recent upturn is mainly a reflection of higher consumer and government spending and in spite of weaker net exports as a result of the persistently strong yen.

Consumers' expenditure grew by 1.4 per cent in the first quarter, twice as much as in the fourth quarter. Gross fixed capital formation fell by 0.8 per cent, much less than in previous quarters, and there are signs that construction investment is picking up, boosted by low TABULAR DATA OMITTED interest rates on housing loans. The strongest contribution to growth is coming from government spending as existing expenditure plans have been brought forward and some additional public investment has been announced in the various stimulatory fiscal packages.

Industrial production rose by 0.8 per cent in the second quarter, compared with 1.5 per cent in the first. This is the first time since the beginning of the downturn almost three years ago that output has grown for two consecutive quarters. However, it is not clear whether the decline in production has really come to a halt. Balance sheets of the corporate sector have been severely weakened in recent years. Banks are reluctant to lend money and the burden of company debts forms an obstacle for financing new investments. Recent surveys show only mixed evidence of improved confidence and expectations seem to have improved only marginally. Many firms have seen their profit margins fall sharpl and are hit by the loss in competitiveness that has resulted from the continuin strength of the yen.

There are other indications that the recovery is not yet well established. The rate of unemployment has risen steadily and currently stands at 2.9 per cent. Although this may seem low by international standards, the Japanese definition of unemployment is not directly comparable to those of other countries and the current rate is close to the record level of 3.1 per cent. Most companies have so far been able to avoid compulsory redundancies and maintain their commitment to guaranteed life-time employment, but recruitment has fallen sharply and special schemes have been developed under which employees are encouraged to tak early retirement.

Rising unemployment has kept wage demands low. Wage increases in the annual Spring wage negotiations have fallen to the lowest since 1987 and overtime working and bonuses have also declined. Lower wage costs may help to offset the negative effect of the appreciation of the yen on competitiveness. They have also helped to put downward pressure on prices. The core inflation rate, excluding food prices, has fallen to 0.6 per cent. Wholesale prices were almost 2 per cent lower than a year ago in June and import prices 6 per cent lower.

Our forecast for the Japanese economy is set out in Table 9. We expect GDP to grow by around 1 per cent this year. Consumer spending is likely to be boosted by the tax cuts announced in the February fiscal package. These cuts, which amount to a total of Y5.5 trillion are given in the form of two tax rebates. Although it has been suggested that similar tax cuts could be given next year, this is highly uncertain in the current unstable political climate. We foresee modest recovery in housing investment, helped by lower interest rates on housin loans, but no strong recovery in business investment. We forecast a strong contribution of government spending to growth in 1994, but we expect much less impact from this source in 1995.

Our forecast for the Japanese economy is surrounded by a high degree of uncertainty due to the unstable political situation in Japan. The minority coalition government led by former Prime Minister Hata, which consisted of the small reform parties, but excluded the socialist party, was brought down after the budget for the new fiscal year, which started in April, was passed in late June. A new coalition government was then formed between the socialists and the Liberal Democrats with the support of one of the smaller reform parties. The ne coalition is led by Mr Murayama, leader of the socialist party, but the LDP, after a year in opposition, got most of the cabinet posts. In February, the coalition government of the former Prime Minister Hosokawa announced a stimulatory package of Y15.3 trillion, which included tax cuts of Y5.5 trillion This package was the fifth since April 1992, but previous promises of additiona public spending often failed to materialise due to opposition of officials within the Finance Ministry. It was initially agreed that this year's tax cuts would be financed by replacing the 3 per cent sales tax by a 7 per cent welfare tax in 1997, in order to overcome objections from the Finance Ministry. As the socialists opposed such an increase in indirect taxation, a final decision was delayed until later this year. It is not clear what will happen now that the socialists are back in government, but only as a junior partner to the LDP. We have assumed the tax cuts are not repeated next year and that the increase in indirect taxation goes ahead in 1997. Even with the additional revenue from thi increase, the government deficit is expected to persist in the medium term.

The main threat to a recovery is coming from the renewed strength of the yen. Earlier forecasts of a recovery last year proved premature as exports were hit by the appreciation of the yen. The recent appreciation of the yen threatens to lengthen the downturn. Chart 7 shows the appreciation of the yen over the last years. The yen appreciated by 20 per cent in 1993. Since 1990 the yen has risen by over 50 per cent against the dollar and by a similar amount in effective terms. In 1993 the current account surplus rose to $130 bn, or 3.1 per cent of GDP. Although the surplus is still rising in dollar terms this is TABULAR DATA OMITTED merely a reflection of a J-curve effect and the trade surplus is now falling in yen terms. Exports rose by 5.0 per cent in dollar terms in the secon quarter, but fell by 2 per cent in yen terms, while imports rose by 0.4 per cen in yen terms. Although there are now signs that the trade surplus is falling, this reversal of past trends comes remarkably late. There are several factors that can explain the relatively strong trade performance of Japan. First, exports are boosted by higher demand abroad. Table 10 shows that Japan's export markets have grown by around 10 per cent in the last two years. This higher demand, in particular from the US and East Asia, has helped to soften the impac of the appreciation of the yen on exports. Secondly, there is evidence that Japanese exporters are determined to sell their products even at loss-making prices in order to keep their market share. This has led to sharp falls in profit margins and is something that cannot persist for long. We forecast a smaller current account surplus for 1994 of around 3 per cent of GDP and expect the surplus to be further reduced in 1995. This worsening of Japanese net exports will dampen recovery.

Germany

After last year's sharp recession, a recovery in Germany began in the first quarter of 1994. GDP in the western Lander is estimated to have risen by 0.6 pe cent in the first three months of this year following a fall of 1.9 per cent in 1993. In recent months both inflation and unemployment appear to have stabilised. In June the annual rate of inflation stood at 3 per cent and west German unemployment was 9.4 per cent for the fourth month in a row.

Increases in exports and construction investment seem to be leading the German economy out of recession. In the western Lander total investment rose by almost 4 per cent in the first three months of 1994, with construction investment up 6.2 per cent. Export volumes rose by 3 per cent in the first quarter and there was some run down in stock levels. However consumer spending remained unchanged and government consumption fell by 1.3 per cent. In the eastern Lander, strong growth in real GDP was maintained in 1993. GDP is estimated to have risen by around 7 per cent following almost 10 per cent in 1992. Total investment rose b 8.2 per cent in 1993, with construction investment up 21 per cent. Government consumption rose by 2.6 per cent and consumer spending by 1.5 per cent. However export volumes fell by 1 per cent in 1993.

In west Germany, industrial production has shown some modest increase in the early part of 1994. In the twelve months to May production was about 2 per cent higher. However the pace of recovery seems to have accelerated in June with a 1 per cent rise in that month. New orders suggest that the economic situation wil continue to improve. In May new orders from west German industry were 5.8 per cent higher than in the previous three months with export orders up 7 per cent. The trade surplus has risen significantly over the last year. The surplus in th three months to May totalled DM 17.8 bn up from DM 11.2 bn a year earlier. The total deficit for the first five months of 1994 was DM 17 bn.

Table 11. West German GDP

 Percentage change
 1990 1991 1992 1993 1994 1995 1996-2000

Consumption 5.0 4.4 1.5 0.0 0.4 -0.2 1.1
Investment 9.0 6.2 0.4 -6.8 3.0 3.9 2.2
Government consumption 2.2 0.3 3.2 -1.3 -0.8 0.9 2.0
Stockbuilding(a) 0.1 -0.4 -0.4 -0.8 0.6 0.7 0.1
Total domestic demand 5.4 3.6 1.2 -2.6 1.4 1.7 1.6
Net exports(a) 0.5 1.0 0.0 0.7 0.2 0.2 0.7
GDP 5.9 4.6 1.2 -1.9 1.5 2.0 2.3
Average earnings 4.9 6.0 5.4 2.9 3.0 2.3 3.4
Consumer prices(b) 2.7 3.7 4.0 3.4 2.9 1.8 1.7
RPDI 6.8 4.2 0.9 -0.7 -0.3 -1.6 1.3
Savings ratio 14.7 14.6 14.1 13.4 12.8 11.6 12.4
Unemployment, % 7.1 6.3 6.7 8.3 9.3 9.4 8.8

(a) Change as a percentage of GDP.

(b) Consumers expenditure deflator.

Whilst the unemployment rate in west Germany was unchanged in June at 9.4 per cent it was up from 8.2 per cent a year earlier. Also there are Still an estimated 500,000 people on job creation or training schemes and 267,000 on short-time working. In east Germany the rate of unemployment was 15.7 per cent in June up from 15.1 per cent a year ago. Short time working stands at just ove 100,000 and there are an estimated 1.5 million people who have either retired early or are on job creation or training schemes. Some estimates suggest that the true level of unemployment could be nearer 35 per cent in the east.

The level of unemployment in Germany is now having a substantial impact on pay deals. Hourly wage rates rose by just 1.2 per cent in the twelve months to May compared with 1.7 per cent in April and 4.2 per cent in 1993. The annual rate o inflation remained unchanged at 3 per cent in June compared with 4.1 per cent i 1993. Wholesale prices in the twelve months to June were up by 1.8 per cent, whilst producer prices were up just 0.4 per cent.

These figures suggest a weakening in inflationary pressures in the coming months. This should be reassuring for the Bundesbank which now seems to placing more weight on actual movements in prices and less emphasis on M3 in its assessment of inflationary prospects. M3 has been highly volatile in recent months showing an annualised growth of 10-15 per cent for much of 1994. The Bundesbank argues that this measure has been affected by special factors, such as the return of funds from Luxembourg, and has become a less reliable indicator. However Hans Tietmeyer, the Bundesbank's president, recently stresse that they would not be giving up using M3, but would now be taking more account of other factors. In the light of its increasingly sanguine view of the inflationary prospects the Bundesbank has continued its policy of steadily relaxing monetary policy. In May both the discount and lombard rates were cut b half a per cent to 4.5 per cent and 6 per cent respectively. This followed on from several small cuts in interest rates in the early part of 1994.

The general government deficit rose sharply in 1993. On a national accounts basis and including the social security fund, the deficit was estimated to have reached DM 101.8 bn (3.5 per cent of GDP) in 1993. In an attempt to steadily reduce the deficit in the coming years the government has planned a package of spending cuts and tax increases of DM 27 bn in 1995 and DM 29 bn in 1996. In order to keep the growth in nominal government spending to only 3 per cent in 1995 there are plans to reduce social benefits, particularly limiting benefits for the long-term unemployed to two years and cutting social assistance.

Our forecast for west German GDP is given in Table 11. We expect the modest recovery evident in the first quarter of 1994 to continue and that GDP will ris by about 1 1/2 per cent over the whole year. We then expect GDP growth to accelerate to around 2 per cent in 1995. The growth over these two years will stem from a combination of higher net exports, investment and stockbuilding. Consumers' expenditure is forecast to be little changed over the next two years Consumption is likely to be held back by falling real personal disposable incomes--down by a little under 1/2 per cent in 1994 and 1 1/2 per cent in 1995 Disposable incomes are in turn likely to be constrained by the slow growth in average earnings, increases in social security contributions (in 1994) and the reintroduction of the 7.5 per cent 'Solidarity Tax' (in 1995). After falling by almost 7 per cent in 1993 we expect investment will pick up in the next two years. We are forecasting total investment to grow by between around 3 per cent in 1994 and 4 per cent in 1995. The strongest growth is likely to be in housing investment which we predict will rise by around 4 per cent in 1994. Business investment is expected to rise by between 2 1/2-3 per cent in 1994.

We expect net export growth to make a very modest contribution to GDP growth in 1994 and 1995. Over these two years we anticipate that net exports will grow by a total of around 1/2 per cent of GDP. As indicated in our trade forecast, whic is given in Table 12, we expect that strong growth in export volumes will be largely balanced by strong growth in imports in 1994 and 1995. Imports are expected to grow rapidly as German GDP growth increases and because of the relatively high value of the D-Mark. The current account deficit is expected to widen slightly to around 2 per cent in 1994 and then to decline slightly in 1995. However there are still considerable uncertainties about these trade figures following the change in data collection method from customs documents t VAT returns.

Unemployment is expected to remain at its current TABULAR DATA OMITTED level of around 9 1/2 per cent in 1994 and 1995 before decreasing gradually in subsequen years. This high level of unemployment is likely to constrain the growth in average earnings to around 3 per cent in 1994 and 2-2 1/2 per cent in 1995. We expect inflation to average about 3 per cent in 1994. Slower earnings growth, combined with lower import prices from an appreciation of the D-Mark, should mean lower inflation in subsequent years. We forecast that consumer prices will rise by about 1 1/2-2 per cent in 1995 and around 1 1/2 per cent in 1996.

Our forecasts for German government finances are given in Table 13. We have become more optimistic about the prospects for the public sector finances in Germany. Higher social security contributions and taxes in 1994 and 1995, tighter control on public expenditure and increased GDP growth in the coming years should help the German authorities keep the general government deficit down to around 3 per cent of GDP. We expect the deficit to fall to around DM 95 bn (3 1/4 per cent of GDP) in 1994 and around DM 80 bn (2 1/2 per cent of GDP) in 1995. This is on the assumption that the target to keep the nominal growth i government consumption down to 3 per cent per annum is met. However this is unlikely to prevent the debt to GDP ratio exceeding 60 per cent when the government takes over the outstanding debts of Treuhandanstalt in 1995.

TABULAR DATA OMITTED

France

The modest recovery in the French economy, which began in the second quarter of 1993, has accelerated somewhat in the first quarter of 1994. Real GDP is estimated to have risen by 0.5 per cent in the first three months of this year, following smaller rises in each of the three previous quarters. Whilst inflationary pressures remain subdued, the annual rate of inflation has risen slightly to 1.8 per cent. However the economic recovery has not been sufficient to reduce the high level of unemployment. In June the jobless total was 3.33 million, or 12.6 per cent of the workforce.

The pick up in GDP growth in the first quarter of 1994 appears to be due to a combination of slower destocking and slightly higher government spending. Investment has TABULAR DATA OMITTED continued to decline in France, albeit at a slower rate. Total investment fell by 0.4 per cent in the first three months of this year following a sharp fall of 5.1 per cent in 1993. Business investment fell by only 0.2 per cent in the first quarter, but residential investment fell by 1.7 per cent after increasing in the latter half of 1993. The latest INSEE survey of investment intentions suggests a 3 per cent recovery in investment in 1994. The idea that the decline in investment may now be bottoming out is given some support by the capacity utilisation levels which appear to have stopped falling. French industry is estimated to have been operating at 80.6 per cent capacity in the first quarter of 1994 up from the eighteen year low of 80.2 per cent in the last quarter of 1993.

The rate of increase in wages has continued to decline in France. In the first quarter, hourly wage rates in manufacturing were up 2 per cent on the previous year. This compares with respective increases of 2.2 per cent and 2.3 per cent in the previous two quarters. Annual consumer price inflation has risen slightl from 1.5 per cent in March to 1.8 per cent in May. However this is still in accordance with the Banque de France's new stated objective of achieving price stability--defined as a rate of inflation below 2 per cent in 1994. The intermediate targets which the Banque proposes to use to meet its price stability objective are a stable currency within the ERM and to keep the growth of M3 and 'total indebtedness' to around 5 per cent over the medium term (representing 3 per cent growth in potential GDP and 2 per cent inflation).

The Banque de France has thus far been successful in maintaining a stable value for the franc in the ERM despite the greater freedom allowed by the 15 per cent bands. Its value against the D-Mark actually moved back in to the old narrow bands in late-1993 and has subsequently been trading just above its old floor. To achieve this French interest rates have had to remain closely tied to German rates. The intervention rate was cut from 5.2 per cent to 5.1 per cent at the end of June following a number of similar 0.1 per cent cuts earlier in the year There are also no signs of the Banque's money supply target being exceeded. In the twelve months to May 1994, both M3 and M4 actually fell by 4 1/2-5 per cent Special factors, cited by the Banque to explain these falls, include privatisation receipts and tax changes on 'mutual funds'. The growth of 'total indebtedness' (total domestic debt held by the government, companies and households) may prove more troublesome to target given that government borrowin will not be controlled by the Banque. Last year total indebtedness rose by 4 pe cent but this was almost entirely due to rapid growth in public sector debt.

As economic activity has begun to pick up, the trade surplus has begun to decline. From a record high of Fr. 13.3 bn in December 1993 the trade surplus has steadily shrunk and preliminary figures for May show a surplus of Fr. 7.6 bn. Whilst both export and import volumes have been rising in 1994, the latter appear to have risen more quickly. However there is still considerable uncertainty about these trade figures following the change in data collection under the EU's single market. The French stockmarket has not been immune from the world-wide decline in equity prices. French equity prices started falling i February, and by July they had declined by 9.5 per cent since the end of 1993.

Table 15. French trade

Percentage change
 1990 1991 1992 1993 1994 1995 1996-2000

Export volume (goods) 5.3 3.9 4.9 -1.1 5.2 6.1 4.4
Market growth 6.8 5.2 5.3 0.5 5.8 4.4 5.0
Relative prices(a) 4.1 -2.5 0.3 -0.9 -0.4 1.5 0.7
Import volume (goods) 5.7 2.7 0.7 -4.2 6.6 9.6 5.1
TFE 3.3 1.2 1.5 -1.5 2.2 4.0 3.1
Relative prices(b) -4.7 0.6 -2.5 -2.1 -0.7 -1.6 -0.5
Visible balance $bn -9.3 -5.3 6.0 16.1 6.2 4.9 1.7
Current account as % GDP -0.8 -0.5 0.3 0.8 0.1 0.0 -0.2

(a) A fall is a gain in competitiveness.

(b) A rise is a gain in competitiveness.

The French government aims to cut the budget deficit by Fr. 16.5 bn in 1994. This is to be achieved through increased privatisation revenues (up by Fr. 12 b since 1993) and a freeze on real expenditure. Tax reforms to benefit middle income earners and to increase investment in housing are also planned. The government wants to reduce the deficit by a further Fr. 26 bn in 1995.

Details of our forecast for French GDP are given in Table 14. We expect that French GDP growth will be around 1 1/2 per cent in 1994 and 2 1/2 per cent in 1995. The modest recovery in 1994 should be fairly broadly based with some contribution from investment, consumption and stockbuilding. However we anticipate that a sharp increase in investment growth will be a significant factor in the faster growth projected for 1995. We still do not expect that net exports will offer any contribution to growth over the next two years, due to stronger import growth and the high value of the franc.

Consumption is predicted to rise by only around 1 per cent in 1994 despite an expected rise in average earnings of between 2-2 1/2 per cent. The French government is attempting to raise some Fr. 50 bn extra in social security contributions (CSG) in 1994. For this reason we are expecting that real persona disposable income will remain little changed in 1994 despite the rise in averag earnings. However we are predicting that real personal disposable income will rise by 1 1/2-2 per cent in 1995 and this should be consistent with consumption growth of between 2 1/2-3 per cent. After falling by around 7 per cent we are expecting a moderate recovery in investment in 1994 of around 1 per cent. This should be followed by much stronger investment growth of around 4 1/2-5 per cen in 1995. Housing investment should respond positively to lower short-term interest rates, whilst business investment should rise as output increases. After last year's sharp decline, the stock level of French firms is likely to stop falling in 1994 and show some increase in 1995. For this reason we expect that stockbuilding will be a significant factor behind the improvement in growt in 1994 and 1995.

We expect that both export and import volumes will rise significantly over the next couple of years. However faster growth and a strong franc are likely to mean that import growth will exceed export growth. As a result we expect net exports to fall in both 1994 and 1995--reducing GDP growth by around 1/2 per cent or 1 per cent respectively. The current account surplus is also expected t decline from around 1 per cent in 1993 to around zero in 1995.

We expect French unemployment to remain high, and hence the growth in average earnings is likely to remain fairly modest. We expect average earnings to grow by 2-2 1/2 per cent in 1994 and 2 1/2-3 per cent in 1995. Consumer price inflation should also remain subdued at around 1 1/1-2 per cent in 1994 and 1 1/2 per cent in 1995. With growth recovering we expect that the government deficit will stabilise at around 6 per cent of GDP in 1994 and to fall to 5-5 1/2 per cent in 1995. However this will not be sufficient to prevent further rises in the government debt to GDP ratio. Once revenues from the privatisation programme have been taken into account we TABULAR DATA OMITTED expect the debt ratio to rise to a little over 54 per cent in 1994 and 56 1/2 per cent in 1995. On current trends it is then likely to exceed 60 per cent of GDP in subsequent years.

Italy

The export-led recovery in Italy is becoming more broadly based with improvements in domestic demand, but a failure by the government to construct a credible fiscal policy is lowering expectations of future growth. Although GDP was virtually unchanged in the first quarter of 1994, more recent figures on industrial production are encouraging. Both industrial and total production wer up about 7 per cent in April and May respectively as compared to a year ago. Consumption growth slowed by 0.5 in the first quarter to 0.35 per cent but continues to recover from a fall of 2.1 per cent in 1993.

Exports of goods and services grew by 5.6 per cent in the first quarter compare with an annual rate of 10 per cent in 1993. Imports are now recovering and grew just under 4 per cent in the first quarter. The substantial gains that Italy reaped from its devaluation after leaving the Exchange Rate Mechanism are now much reduced. The fall in the contribution of net trade in the first quarter wa offset by a rise in investment of 1.7 per cent, the largest gain for nearly three years. However there are fears that this recovery in investment is likely to stall, unless the government moves quickly to allay fears about the budget deficit and debt stock.

Although the discount rate has been reduced from 7.5 per cent to 7 per cent currently, implied forward 3-month interest rates have risen sharply to reach about 10 per cent towards the end of 1995. The unity of the government coalitio is coming under strain as cuts in spending, especially a reform of the pension system, are negotiated. The position on pensions was made worse by a constitutional court ruling in June, which ordered the government to pay arrear on certain pensions dating back to 1983. These arrears will amount to around L 32000 bn which is roughly equal to the spending cuts and extra revenue measures in the proposed 1994 budget. It is proposed that the age of retirement be raise from 55 to 60 for women and 60 to 65 for men. Along with large cuts in social security and health spending, these measures would signal to the financial markets a commitment to tackle the deficit.

A three-year macro-economic programme was promised after a cabinet meeting on the 21st of July but no detailed measures have been announced as yet. The delay in taking unpopular measures and confronting union opposition has led to interest-rate rises and a continuing weakness of the lira. The recently appointed Treasury minister, Mr Dini, was formerly deputy governor at the Bank of Italy, faces the difficult task of reassuring the financial markets. He has announced that the 1995 budget would reduce the deficit to L 140,000 bn based o current interest rates. If this budget forecast is correct then there would be primary surplus equal to 2 per cent of GDP in 1995, double that of 1994, but after including interest payments the deficit will amount to just under 10 per cent of GDP. This budget would represent a fall in the cyclically adjusted deficit and represents, therefore, a tighter fiscal policy.

The hourly wage rate index has been flat since January and real wages have fallen over the past three years. There is a great deal of spare capacity withi the domestic economy, larger firms are continuing to reduce their number of staff, and while domestic demand remains TABULAR DATA OMITTED relatively weak, unemployment is unlikely to fall. With subdued wage pressure and domestic deman only beginning to recover inflation is unlikely to rise far above its present 2 year low of 3.7 per cent.

The underlying position of the economy remains little changed from our last forecast, but doubts about the ability of the government to take unpopular fiscal measures are a problem. The government would have to move quickly if it wanted to remove uncertainty and bring down interest rates. A sustained rise in interest rates could prove very damaging to the public finances with a percentage point rise adding around L 15000 bn to government interest payments, which is over 1 per cent of GDP.

Our forecast for Italian GDP is set out in Table 16. We expect GDP growth of 1. per cent in 1994 helped by a recovery in domestic demand. Investment growth wil be about 1/2 per cent in 1994 picking up only in the medium to long term. While capacity utilisation is at a low level and stocks are still being reduced, investment growth is likely to be weak. Consumer spending will recover to show growth of 1/2 per cent but remain at a low level in part because of the continuing impact of the significant tax increases in 1993 which lowered personal disposable income by 2.5 per cent.

Unemployment is forecast to remain at its current level of a just under 11 per cent, and this will continue to moderate earnings' growth. We forecast an inflation rate of between 3 1/2 and 4 per cent for 1994. Although the Italian lira was substantially devalued in 1992, the rise in import prices has not been fully reflected in retail prices. However the rise in import prices of 13 per cent in 1993 is likely to have some effect in preventing inflation falling further. We expect government debt to continue to rise until any definite fisca measures are taken by the government.

Our forecast for Italian trade is set out in Table 17. Net trade will continue to be the main driving force behind the recovery. We forecast growth of 11 1/2 per cent for Italian exports in 1994. The good Italian trade performance in our forecast follows from the depreciation of the lira and the recovery in the European demand for exports. Although import growth was strong in the first quarter, we do not expect this demand to be sustained and are forecasting imports to fall further by 1 per cent in 1994.

Canada

Several problems have emerged at the same time to create a minor financial crisis in Canada. The expected and actual increase in US bond yields and short-term interest rates have put downward pressure on the Canadian dollar. Meanwhile upward pressure on Canadian interest rates is continuing to increase as concerns grow regarding the sustainability of both the government deficit an the federation itself. Three-month rates are currently 6 1/4 per cent compared with 4 per cent in the first quarter, and the forward markets suggest that rate may rise to above 7 1/2 per cent during next year. Ten-year bond yields have also risen by more than a percentage point. At the same time, government debt grew to around 90 per cent of GDP by the end of last year. Political uncertaint also grew as the separatist Parti Quebecois became favourites to win the Quebec elections in September; the Parti Quebecois have TABULAR DATA OMITTED pledged t hold a referendum on independence within a year of taking power.

The Canadian public sector deficit has hovered around 5 per cent of GDP for som time and the recession pushed it to above 7 per cent during 1993. The deterioration is due to both provincial indebtedness and to federal government developments. Ontario and Quebec have large structural deficits and both provincial governments seem reluctant to take serious corrective action. Stronger growth will reduce the deficits somewhat but the debt burdens are projected to rise to 30.4 per cent and 33 per cent of Gross Provinical Product this year for Ontario and Quebec respectively. The large deficit and debt of Quebec is making the financial markets nervous as they are concerned about the question of responsibility for the debt if Quebec actually leaves the federation. The uncertainty has resulted in a wider differential between Quebec and other Canadian bond yields.

However, the federal government intends to reduce the national deficit to 3 per cent of GDP in three years. This is to be achieved by restricting public sector wages and additional cuts in unemployment benefits and defence spending. Unfortunately, the government targets now look increasingly unlikely to be met due to the recent hike in interest rates, which will slow growth and add to deb interest payments. It seems that every time US interest rates rise there is a bigger rise in Canadian rates. Given the high level of Canadian public sector debt, interest-rate rises cause the budgetary outlook to look worse and therefore investors require a higher risk premium on Canadian assets. As a result, interest rates rise and the currency depreciates.

However, the first quarter GDP figures were more encouraging as they showed strong growth combined with low inflation. Last year growth was stimulated by exports to the US, but consumer spending is now beginning to show signs of strength (although tax rebates have recently given expenditure a temporary boost). Retail sales and car purchases were particularly strong in the first quarter, and helped to push GDP growth to over 1 per cent. High unemployment, rising to more than 11 per cent, has subdued earnings. During the first quarter average earnings only increased by 0.1 per cent. resulting in an annual increas of only 0.8 per cent. At the same time, the GDP deflator actually declined, largely reflected a cut in tobacco excise taxes.

Our projections for the Canadian economy are given in Table 18. Despite the anxieties of the financial markets, we expect the robust growth of the first part of this year to continue. Exports will benefit from strong US growth and the prolonged depreciation of the Canadian dollar over the past two years. Recent growth in employment will boost real personal disposable income and the rise in consumer confidence will provide a further impetus to consumers' expenditure. Consumption will probably grow by around 2 1/2 per cent this year resulting in a decline in the savings ratio. Business investment will only be slightly influenced by the increased cost of borrowing as so much uncertainty surrounds the permanence of the recent rise in short-term interest rates. Increased consumption and buoyant export growth should push up capacity utilisation and encourage business investment to grow by around 6 1/2 per cent in 1994. Residential investment may be less buoyant as house purchasers will remain cautious until the unemployment rate falls below 10 per cent, which we believe will not occur until after 1995.

Our forecast for next year reflects our assumption that short-term interest rates peak at 7 1/2 per cent in 1995. We believe that three-month rates were fa too low at 4 per cent at the beginning of 1994 and the return of attention to the sustainability of the fiscal deficit and so on has pushed borrowing costs back towards more sensible levels. Hence, the growth in the interest-rate sensitive categories of consumption and investment is expected to slow down nex year, although a fiscal tightening also accounts for some of the deceleration i GDP growth next year. The continued Canadian dollar depreciation, combined with higher activity, will push up both wages and prices. Inflationary pressures thi year will be limited due to substantial excess capacity, but inflation will probably rise to around 3 per cent next year as average earnings respond to continual falls in unemployment and increases in productivity. Improved competitiveness and buoyant growth in Canada's major export markets should mitigate the impact of stronger domestic demand on the visible trade balance. But higher Canadian interest rates will contribute to a deterioration in the balance on interest, profits and dividends. Therefore we expect the current balance deficit to remain at around 4 per cent of GDP this year and to improve only slightly next year as competitiveness effects continue to come through.

Higher interest rates and a persistently high level of unemployment will tend t exacerbate both the public sector deficit and debt. We expect the deficit to be more than 7 per cent of GDP this year and then decline in 1995 as higher activity boosts net government revenues. But government debt looks as though it will remain above 90 per cent of GDP throughout the medium term.

Spain

The 1993 recession was almost entirely driven by domestic demand whereas economic recovery in 1994 has been generated by the external sector. Both investment and consumption fell markedly during 1993 and restrictive budgets kept any stimulus from public spending to a minimum. High interest rates associated with maintaining the peseta ERM parity provoked a decline in investment in 1992 and 1993. Poor company profits and liquidity and the deteriorating outlook for GDP growth also encouraged firms to lay off workers a well as reduce capital expenditure. The resulting rise in unemployment to almos 25 per cent seems to be a major cause of the drop in consumption last year.

The recovery began in the third quarter of 1993. This was primarily the result of the effects of the substantial devaluation of the peseta after the latter part of 1992. As a result, net exports added more than 2 1/2 per cent to GDP in 1993. Interest rates also declined substantially after the restructuring of the ERM in 1992, falling by about 6 percentage points, but this has only tended to decelerate the decline in consumption and investment rather than add to growth. Although consumption is now fairly flat and set to grow, investment is still falling, largely because of substantial excess capacity in the Spanish economy.

The depressed state of activity has brought consumer price inflation to below 5 per cent in April of this year compared to more than 6 per cent a year earlier. This is good news considering that wage inflation averaged 6 per cent last year and import prices have been pushed up by the devaluation. However, unit labour costs have benefitted from strong productivity growth and only a limited pass-through of the depreciation to import prices TABULAR DATA OMITTED has so far occurred. Previous labour market reforms, the freezing of public sector wages and the substantial excess demand for labour should begin to push down wage growth in the near future.

The recession, interest rates and the peseta devaluation have had a considerabl influence on financial balances. The improvements in competitiveness, combined with the depressed state of demand, are likely to turn a current balance defici in excess of 3 per cent of GDP into a small surplus next year. The counterpart to this is the reduction in the investment-savings imbalance as high interest rates depressed capital expenditure and encouraged households to increase savings. In contrast, the public sector deficit has spiralled from 4 1/2 per cent of GDP in 1992 to 7 3/4 per cent by the end of last year. This has occurre in spite of substantial increases in both direct and indirect tax rates and owe much to the effects of the recession.

Once again, a stringent fiscal policy is promised for 1994; government employment will be reduced, public consumption will be cut and, as mentioned above, public sector wages will not be allowed to rise. But reality may well fall short of the promised reductions and, in any case, more severe measures ar required to bring the deficit down from the current 8 per cent of GDP to a more sustainable level.

Our forecast for Spanish GDP is given in Table 19. We expect output to grow by around 1 1/2 per cent this year. The recovery is generated entirely by the external sector as we expect domestic demand to continue declining. Consumers' expenditure will probably remain fairly flat, and government consumption should fall as a per cent of GDP due to a fiscal tightening and stockbuilding will add virtually nothing to demand. Our predicted rate of GDP growth for 1994 is below that which is sustainable in the long run, and hence the unemployment rate will continue to rise this year, further dampening wage and price inflation.

The lagged effect of the decline in interest rates, combined with the rise in confidence resulting from the higher activity resulting from net exports this year, should push up domestic demand in 1995. Both consumption and investment should rise, but net exports will probably contribute very little as the impact of the depreciation dies away. Consumer confidence may be helped by a slight fall in the unemployment rate and the savings' ratio will probably decline somewhat. However, the high degree of slack in the labour market will continue to push down wages and help bring consumer price inflation down to below 4 per cent.

TABULAR DATA OMITTED

NIGEM THE NATIONAL INSTITUTE'S GLOBAL ECONOMETRIC MODEL

NIGEM is a 1000 equation macroeconomic model covering the whole of the world economy, but focusing particularly on the 8 major industrial countries. The National Institute publishes the current version of NIGEM together with a user-friendly, menu-driven operating package designed to enable economists to produce their own forecasts and simulations.

Background

NIGEM is used by the National Institute to produce forecasts and analyse events and policy options in the world economy. In the last few years it has established itself as one of the leading world econometric models, participatin (as the only UK based model) in comparative exercises organised by the US Federal Reserve and the Brookings Institution in Washington and in the EC financed SPES model comparison exercise. It has been used in academic studies o international policy co-operation, and its research and development is financed by the Economic and Social Research Council. The Institute has sold the model t the Bank of England, HM Treasury, the Bank of France, the Bank of Italy, the Netherlands Central Bank, the LBS, the World Bank and a number of other bodies for use in their published forecasts and policy analyses.

Scope and coverage

NIGEM is divided into twenty sectors. Each of the G7 country sectors contains around 80 variables covering individual components of demand, price indices, exchange rates and interest rates, trade, the public sector and the current account. Smaller models exist for Spain, Belgium, Netherlands and the rest of OECD. The remaining sectors cover OPEC, Asia, Latin America, Africa, China, the Centrally Planned Economies and Miscellaneous developing countries. These sectors contain equations for trade volumes and prices, which depend on five commodity price indices. The model incorporates rational expectations in financial, foreign exchange and labour markets.

The model package

The published model package comes with a 'front end' specifically designed for NIGEM (by Bahram Pesaran who co-wrote the estimation package MICROFIT) to enabl economists with little or no previous experience to produce forecasts and polic analysis. A user's guide is provided, but this menu-driven programme is largely self-explanatory. A base forecast is provided each quarter with the latest version of the model, and the user can inspect numerically and graphically the judgements that lie behind this forecast. By changing these judgements, or by adding new data, the users can produce their own forecast. Alternatively by using the model in simulation mode the user can look at the global effects of events such as a US fiscal expansion or an oil price fall.