The world economy.

Barrell, R. ; Anderton, R. ; Caporale, G.M. 等

part of the renewed commitment of the Italian government to curtail the country's budget deficit and reduce the level of debt. The stock of outstanding debt has reached the record level of L1,700,000bn (over 110 per cent of GDP), rising 1.8 per TABULAR DATA OMITTED cent from February to March and 13.5 per cent in a year. Only around 4 per cent of public debt is held by foreign investors.

Shortly after the appointment of Mr Antonio Fazio as the new governor of the Bank of Italy, a plan made by the central bank to modify the banking system has been approved by the cabinet. It will allow commercial banks to own up to 15 per cent of The short-term outlook

The deepening recession in Europe during the first half of 1993 has resulted in increasing pressure on the stability of exchange rates. The Exchange Rate Mechanism went through a crisis in late-July/early-August, and very wide fluctuation bands were adopted on the 2nd of August. Table 1 presents our forecast for output and inflation, which helps put the turmoil on the exchanges in context. Output is expected to fall in Germany and France in 1993, but the causes and consequences differ considerably. The recession in the former country may just take output back to a little below capacity whereas in France there has been a good deal of spare capacity for some time.

We are expecting the West German economy to contract by around 2 per cent this year, the largest fall since the war. This is in part a reflection of the slow growth in activity elsewhere, but it is mainly driven by domestic events. German unification in 1990 was accompanied by a loosening of fiscal policy and a sharp increase in investment spending. Both factors increased demand and put upward pressure on inflation. The Bundesbank kept to its monetary targets, and interest rates rose sharply in Germany. As a result the D-Mark appreciated against the dollar. The commitment to the ERM on the part of France, Italy, Belgium and (for a time) the UK meant that interest rates in those countries were higher than they otherwise would have been.

There was a strong case for an upward revaluation of the D-Mark as early as 1990. The Institute believed in 1990(1) that the Bundesbank's policy would cut growth throughout Europe, and might well lead to a recession. In the August 1991 Review John Williamson(2) argued that unification was a once and for all shock and should have been accompanied by a revaluation of the D-Mark, and we calculated that sterling and the lira were 10-15 per cent overvalued.(3) We have seen little reason to change our judgment over the last few years, except that the success of the anti-inflation strategy in France, at least when compared to Germany, has probably reduced the potential overvaluation to at most 5 per cent.(4)

Our central forecast suggests that growth will continue to be slow in Germany for some time, but that this is in part a reflection of the rapid growth experienced through until 1991. Output was above normal levels of capacity utilisation for several years, and is probably not much below it even now. The difference between the French and German positions is clear from Chart 1. We have argued elsewhere that(5) the sustainable level of unemployment is around 7 to 8 per cent in France, and just below this in Germany. Unemployment has been held above the sustainable level in France throughout the 1980s, and as a result inflation has come down, albeit slowly. In the upturn around 1989 French unemployment stayed above the sustainable rate and inflation did not rise very much. On the other hand Germany was clearly operating above capacity and inflationary pressures emerged. Our research suggests that there is a considerable degree of nominal inertia in the process of adjustment in the labour markets of Europe.(6)

The franc was overvalued for much of the early ERM period. Such overvaluations in the real exchange rate can be dealt with either by depreciation or by deflation, that is a reduction in the rate of inflation brought about by a period of low pressure of demand. However, a real depreciation through deflation can be costly, as can be seen from the French example in the 1980s. The deflation TABULAR DATA OMITTED was driven by high real interest rates and by a tight fiscal policy. Real interest rates stayed high as Europe moved into recession. It would have been in the interest of the French to see lower rates two years ago, as this would have helped alleviate a recession now. In a fixed exchange rate system even a 3 per cent overvaluation can be difficult to deal with. It requires, for instance, that the inflation rate of the overvalued country is 1 per cent below that in its competitors for three years and when there is a great deal of nominal inertia in wage bargaining this can be expensive to achieve, with sustained high unemployment being the obvious consequence of the policy. The combination of the continuing effects of high real interest rates and a possible overvaluation of the franc made the survival of the ERM problematic. An orderly realignment in 1992 might well have preserved the system, reduced uncertainty, and helped alleviate the recession in Europe and the inflation problem in Germany.(7) It would have also reduced the problems faced by the French authorities, as the Italian and UK devaluations had put some competitive pressure on French industry, but much of this problem is likely to be removed by even the small depreciation we have recently seen.

Budget deficits tend to increase in recessions as falling output cuts revenue and raises expenditure. Prospects for German output and the budget deficit look bleak for several years to come. Fiscal policy has been loose, and a set of plans to reduce the deficit has been announced. If all consumers and workers were fully forward looking and were able to adjust their present expenditure accordingly this package would have been anticipated, and we would not see any negative effect on output. However, we would also not have seen the effects of a loose fiscal policy in 1990-1 adding to the expansionary effects of high investment. Although the scale of the German deficit is at least in part driven by structural factors, it is perhaps unfortunate that a fiscal tightening has to take place in the midst of a recession. The fiscal position in France has deteriorated more recently, as the growing recession has cut tax revenues. The new government has announced a fiscal package that is designed to curb the growing deficit, but it will also reduce the speed of recovery from the recession. The fiscally prudent French are clearly worried about the scale of the deficit. However, a fiscal tightening during a recession is not necessarily the quickest way to recovery.

The recovery in North America does not appear particularly robust, but it is clearly under way. Output is rising in both the US and Canada, and we expect it to continue to do so. The slow pace of recovery is helping to keep down the rate of inflation, and in neither country do we expect to see much of an increase. The floods in the Mid West of the US are likely to depress output and stockbuilding in the short run, but will provide a boost to the depressed construction sector over the next year. A slow recovery is a good time for fiscal consolidation, and the Clinton fiscal package discussed in our May Review looks set to be passed by Congress. The Canadian government also seems set to reverse a long period of large and growing public sector deficits.

Growth in Japan is likely to be slow this year and next, and unemployment is expected to rise. The sharp rise in the stock market since the early months of this year appears to have reduced the liquidity squeeze on banks and has raised consumer wealth. Both seem to have helped improve prospects since our last forecast, whilst the further appreciation of the yen has kept down our forecast of inflation. The Japanese government has been running surpluses for some years, and there is room for a further fiscal expansion to help overcome the slowdown in activity. The Japanese have run a tight fiscal policy and have adopted a relatively loose monetary stance for some years. The rest of the G7 economies appear to be moving towards this position. Fiscal policy is generally being tightened, whilst the monetary stance has been loosened, especially in Europe.

Industrial production in the OECD area has been falling for around two years, and we expect it to recover slowly during this year and more rapidly next year. Growth in the major seven economies as a whole is likely to be slow this year as the recovery in North America and the UK is offset by slow growth in Japan and Italy and a recession in Germany and France. As a consequence we expect inflation to remain at moderate levels for several years throughout the industrial world. The pace of recovery in the next two years should be relatively modest amongst the major seven as a whole, and any capacity shortages that emerge in particular countries should easily be covered by spare capacity elsewhere and inflationary pressures will be low. Our forecast embodies a return to trend, or capacity, growth in the latter half of the decade. However, the redesign of the ERM has clearly introduced a good deal more uncertainty into the prospects for exchange rates and for the pattern of output amongst the major economies. Hence our forecast must be seen as a central projection of the outturn for an increasingly uncertain future.

Interest Rates and Exchange Rates

Speculative pressure on the French franc has forced a redesign of the European Exchange Rate Mechanism, with considerably wider bands for fluctuation for most countries. The initial adjustment of exchange rates has been rather limited, with the franc falling only 3 per cent in its first few days of trading inside the wider bands. A further fall is possible, but this small depreciation is not out of line with fundamentals, and it should help reduce the upward pressure on French unemployment. The Dutch and Austrian currencies have been able to sustain the D-Mark parity, and interest rates in Holland have even dropped below those in Germany. Changes elsewhere have been larger, although less momentous. The lira has fallen by 25 per cent in effective terms since September 1992, and the yen has continued to strengthen, and has risen by almost 20 per cent in the last twelve months.

Our exchange rate forecast is set out in Table 2. Although we expect the franc to stay below its previous parity, the change to our central forecast is not particularly great. However, interest rates may fall much more sharply than is suggested either by the forward markets or by our forecast, and the exchange rate may move much further. Our interest rate forecast for France is set in line with the forward markets and long-term interest rates, and after the widening of bands they signalled an almost immediate fall in French short-term interest rates. Long rates in France fell by less than a half a point in early August, and the spread between five and ten year bonds indicated no revision to expectations for interest rates over that period.

Table 2. Exchange-rate forecasts for the major six

Percentage change in effective rate

 US Japan Germany France Italy Canada

1988 -5.5 11.2 -0.6 -1.9 -3.4 6.1
1989 4.8 -4.2 -2.1 -2.1 0.0 6.4
1990 -6.8 -10.7 8.1 7.9 4.7 -1.7
1991 -0.7 8.6 -2.1 -2.7 -2.5 1.9
1992 -2.9 4.0 3.0 3.4 -3.2 -6.7
1993 4.0 19.6 -1.3 -2.3 -18.7 -3.6
1994 2.3 5.7 -2.7 -3.5 -3.9 -0.5
1995 0.9 1.7 -0.3 0.1 -3.1 -0.3
1996 0.5 1.7 -0.1 0.0 -2.7 -0.2
 Yen D-Mark Franc Lira Franc Lira
 per Dollar per D-Mark

Nominal cross rates, year average

1988 128.1 1.76 5.96 1301.2 3.39 741.1
1989 137.9 1.88 6.37 1370.9 3.39 729.7
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 111.3 1.67 5.77 1567.8 3.45 937.5
1994 107.5 1.76 6.14 1678.7 3.48 952.4
1995 106.5 1.79 6.21 1744.3 3.48 976.5
1996 105.3 1.80 6.26 1800.0 3.48 999.7

The term structure of interest rates contains a considerable degree of information about expected future short rates, and we use this information in our forecast for all countries unless we have good reason not to. However, the forward markets sometimes make expectational errors, and in May they were indicating a fall in German short rates rather earlier than has actually been the case. German interest rates are now expected to fall to around 5.7 per cent next year. This is almost half a point lower than the projection we made in May, but the trough in rates is now expected to start later and last longer than we had anticipated. This reflects further downward revisions to forecasts of output growth in Germany. The reluctance of the Bundesbank to cut rates this Summer was not fully anticipated, and it was clearly a factor behind the wave of speculation in late July. The anticipated fall in German rates is one reason why the depreciation of the franc has been moderate. Our forecast for interest rates is set out in Table 3. We are expecting that French and German rates will converge early in 1994, and that monetary cooperation will continue in some form.

The franc--D-Mark axis was central to the stability of the ERM, and the political fall-out from the recent turmoil may well have caused a significant decline in the willingness of the authorities to cooperate. However, we expect that after the initial turmoil has subsided the French authorities will continue their low inflation, stable exchange rate strategy. The aversion of the Banque de France and the Ministry of Finance to floating exchange rates is both well known and long established. We anticipate little sustained change in the franc--D-Mark exchange rate in the next few years as both countries are certain to follow similar low inflation strategies. However, the parity may well be subject to much greater short-term fluctuations than have been seen for a decade or more, and this may well have deleterious effects on trade. The prospects for monetary union in Europe are now much more uncertain than they were even a month ago, and at best we may expect that it will probably be delayed until into the next century. Although our central forecast is consistent with our belief that monetary union is still possible, the future is hedged around with a great deal of uncertainty at present.

Table 3. Short-term interest rates

Per cent
 US Japan Germany France Italy

1988 7.7 4.5 4.2 7.9 11.3
1989 9.1 5.4 7.1 9.3 12.7
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 3.2 7.3 8.2 10.6
1994 4.0 3.2 5.7 5.7 9.3
1995 5.1 3.9 6.1 6.1 9.6
1996 6.1 4.8 6.5 6.5 9.8
1997-2001 6.5 4.9 6.5 6.5 9.8

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 7.5 8.0 11.0
 III 3.2 3.2 6.8 7.0 9.8
 IV 3.4 3.1 6.5 6.0 9.6

1994 I 3.6 3.2 6.0 6.0 9.4
 II 4.0 3.2 5.6 5.6 9.2
 III 4.2 3.2 5.6 5.6 9.2
 IV 4.4 3.3 5.6 5.6 9.2

1995 I 4.7 3.5 5.8 5.8 9.4
 II 5.0 3.8 6.0 6.0 9.6
 III 5.2 4.0 6.2 6.2 9.6
 IV 5.4 4.3 6.4 6.4 9.8

The Italian lira has continued to be weak, and it has stayed at around 1600 lira to the dollar and 940 to the D-Mark. This devaluation of more than 20 per cent is likely to be prolonged by the recent fall in Italian short-term interest rates. These are now around 9 3/4 per cent, the lowest for two decades. This fall partly reflects the increased credibility of fiscal policy, and hence a reduction in the market risk premium, but it also follows from some relaxation of monetary policy on the part of the Bank of Italy. The realignment of September 1992 has not been followed by a burst of inflation. The final abandonment of the Scala Mobile wage indexation system appears to be helping to moderate wage increases, and hence the authorities have been able to cut interest rates without fuelling inflationary expectations. We are expecting that the Italian real exchange rate will stay at around current levels for the foreseeable future. Our forecast for the real exchange rates is set out in Table 4.

A number of European economies suffered from the effects of a real appreciation in 1992 as the dollar fell. However, competitive pressures on the European economies should begin to ease as the effects of the recent appreciation of the dollar begin to be felt. We expect that the US exchange rate will continue to rise as long as US interest rates remain below those in Europe. Japanese interest rates are significantly lower than elsewhere, in part in response to very low inflation rates, and we expect that the yen will also continue to appreciate as a result.

Table 4. Real effective exchange rates

year average US Japan Germany France Italy

1988 97.2 149.6 84.9 81.9 109.2
1989 102.9 138.8 80.9 78.7 111.7
1990 98.0 121.8 88.8 85.8 121.8
1991 97.4 130.3 85.8 81.6 122.0
1992 95.0 134.5 90.5 84.0 121.1
1993 98.8 158.6 89.3 80.1 99.2
1994 100.9 164.6 85.4 76.5 97.6
1995 101.3 164.4 83.9 76.3 97.7
1996 101.1 165.1 82.8 75.9 97.9

Long-term interest rates have fallen in most countries in the last 3 months by up to half a per cent and, as can be seen from Charts 2 and 3, we are expecting them to remain low. Information from the term structure of interest rates suggest that this reflects the revision to interest rate expectations in the short to medium term rather than a sea change in either inflation expectations or in expected future real interest rates in the longer term. Real interest rates have been very high in Europe during the early 1990s, whilst they have been low or zero in the US, Canada and Japan. We expect real rates to stay between 3 and 5 per cent in Europe even though many European countries have entered a recession in the last year. However, a further changes to the conduct of monetary policy in Europe could lead to larger cuts in nominal (and hence, at least in the short-term, real) interest rates.

World Trade and Commodity Prices

Total world trade growth has been slow for some time now, but the aggregate for all market economies has been buoyed up by developments outside of Europe, and to an extent outside of the OECD. We estimate that total world trade in all commodities grew by 4 1/2 to 5 per cent a year in 1991 and 1992, and we project that this growth will continue into 1993. Total trade in manufactured goods by the OECD has been growing more slowly at around 3 to 3 1/2 per cent over the same period. However, even this appears to be robust given that world industrial production has been falling for almost two years. We would indeed expect world trade to have been falling by now if the normal relationship, as plotted in Chart 4, still held between these variables.

There is a distinction to be drawn between developments in Europe and in North America. The two regions are at different points in the economic cycle, and we would expect trade growth to be slower in Europe, where overall a contraction in output is taking place, than in North America, where a moderate recovery is under way. However, import growth has been for stronger than we would have expected in both the US and Canada. Chart 5 plots the residuals on our main import equations for these countries, and it is clear that in both countries imports have been higher than would have been predicted by past relationships with demand and competitiveness. The European economies have not been experiencing a similar rise in import propensities. The differences stem in part at least from the recent North American Free Trade Agreement (NAFTA). There have been numerous trade barrier reduction treaties over the last twenty five years, and they have been an important factor behind the more rapid growth in world trade than in world output. The NAFTA agreement has had a larger impact in part because it has come into effect during an upturn, but mainly because it was clearly anticipated and led to a movement of production. There has been a good deal of movement of processing and manufacturing into the low wage Mexican border area, with cross border trade rising rapidly as a result.

The 1992 programme in Europe appears to have had a less immediate impact, although the removal of internal customs barriers in early 1993 has made this difficult to assess as data on trade between the European economies is less reliable now that customs statistics are not being collected for this part of overall trade. Effective tariff levels within Europe were already low, and patterns of manufacturing specialisation had already responded to this. Further developments were probably retarded by the cyclical downturn in Europe and by an increased degree of exchange rate and relative cost uncertainty. It is much easier to relocate marginal production in response to tariff changes when output is growing rapidly. The costs of adjustment will be lower in part because the process will not necessarily involve plant closures. In North America the low cost location is unique, obvious and very much cheaper than the core production area. The same is not true in Europe. Spain and, to a lesser extent, Portugal have clear cost advantages, but these have been eroded by a commitment to a fixed ERM parity that was both high on entry and did not change in relation to the adverse inflation differential. There had been a considerable flow of direct investment into Spain during the 1980s and early-1990s, but rising costs and the development of alternative locations have began to cause this to decline. German unification has opened up a new, still relatively low cost location for production, especially for German multinationals such as Volkswagen and Siemens. Some relocation of plant is already under way, and although the process is slow it will have been reducing recorded cross border trade because West German imports from the East have never been recorded in the trade statistics. The Spanish authorities are expressing worries for the medium-term about possible relocation of peripheral production to the newly opened up countries of Central Europe, and especially Slovakia and the Czech lands where there are large pools of underutilised skilled labour. Further developments here will in part be dependent on tariff reductions. It is also not clear that the Social Chapter of the Maastricht Treaty will be of advantage to the lower wage peripheral regions of Europe.

The diverse pattern of output developments in Europe and North America has meant that commodity prices have been weak in recent months. In the first quarter of 1993 commodity prices, and especially non food agricultural products prices, rose on the expectations of a recovery of world output, but they weakened into the second quarter. Chart 6 plots indices of recent commodity prices. Metals and minerals prices have risen in recent weeks, but this is almost entirely due to a speculative bubble in copper trading on the London Metal Exchange. Unless there is a large upturn in demand it is anticipated that there will be one million tonnes of excess copper production this year. No other metals or minerals price has moved with copper, and we expect that the bubble will be burst by profit taking in the near future. TABULAR DATA OMITTED There have been downward revisions to the forecast of US grain harvest. Floods

in the US (and in India) have caused the International Wheat Council to revise down its output forecasts, especially for course grains, and wheat and maize prices strengthened in July. Maize prices are higher than at any time since June 1992, reflecting a forecast of world coarse grain output falling to around 800 million tonnes compared with 860 million tonnes last year. However, the floods have had little effect on the forecast for world wheat output which is expected to equal last years 560 million tonnes. Wet weather in the US has reduced expected quality, softening the wheat and reducing protein content, and hence more will have to used as feedgrain. Wheat stocks are expected to rise, but the shortfall in coarse grain output is likely to reduce stocks by 25 million tonnes after a rise of 32 million tonnes last year. Stocks appear to be more than adequate, and we do not expect any particularly strong rise in food prices over the next year.

Oil prices have remained weak so far this year, with little sign that OPEC has been able to constrain output in order to make way for the recovery in Kuwaiti production. Demand has been weak in Europe, and the former Soviet Union has maintained is exports (although not its output), and it has also had high levels of steam coal exports, and this has put downward pressure on all fuels prices. The former CIS has also managed to produce high levels of metals exports, and as a result tin, zinc and aluminum prices fell in the second quarter of this year. However, some of these sales were from stocks, and in the medium term they cannot be expected to be held at such high levels.

United States

After declining by almost 1 1/4 per cent in 1991 US GDP grew by just over 2 per cent last year. The first half of 1993 could be described as the continuation of a reluctant recovery. The first provisional estimates suggest that real GDP rose by only 0.4 per cent in the second quarter of 1993, but this represents a growth rate that is twice as rapid as the previous quarter. Extrapolating the first half suggests that GDP will only grow by around 1 1/4 per cent this year. However, the first quarter was unusually depressed as construction, production and retail sales were all adversely affected by poor weather conditions. In addition, growth in the second quarter may not be particularly strong but seems to be built on solid foundations. The sluggish growth rate was largely the result of subdued inventory growth as most of the major expenditure categories grew fairly strongly. Personal consumption rose by around 1 per cent, investment in producers durable equipment increased by over 4 per cent and export volumes rose by almost 1 3/4 per cent. In contrast, residential investment registered a decline of 2 1/2 per cent and business inventories only increased by $8bn compared to $34 bn in the previous quarter. As a result, final TABULAR DATA OMITTED sales growth (which excludes the impact of inventories) in the second quarter was almost 1 per cent. Although this gives a more favourable interpretation of activity in the 3 months to June, the figures must be disappointing to the Federal Reserve, which had predicted second quarter GDP growth of around 2 1/2 to 3 per cent.

Consumers' expenditure has continued to grow faster than disposable incomes; hence the savings ratio has fallen to 4.3 per cent from almost 5 per cent in the first quarter. The robust growth in consumption has occurred despite the continued decline in consumer confidence and the prospect of tax rises in the future. The Conference Board's Index of consumer confidence declined further in July to 57.7 compared to a peak of 78.1 in December. The prospects for employment have been weakened by the withdrawal of the proposed temporary fiscal stimulus of $16 bn and this may have dented consumer confidence. Unemployment has stopped falling and rose slightly to 7 per cent in May and employment growth has decelerated. Non-farm payrolls increased by just above 10,000 in June compared to well over 200,000 in May. Furthermore, average weekly hours and over time hours in manufacturing declined in both May and June. The number of jobs in manufacturing is still declining as employment expansion is concentrated in the service sector.

Business investment seems to be responding to the low level of real interest rates. After falling by over 7 per cent in 1991 it grew by 3 per cent last year. Growth has also accelerated in the first half of this year. The Commerce Department survey of investment intentions suggests that capital expenditure prospects have recently improved. The April/May survey shows that industry now plans to increase capital expenditure by over 9 per cent in volume terms this year which compares to only 8 per cent in the previous survey. However, manufacturing capacity utilisation has since declined in both May and June and this may discourage capital expenditure, but the major stimulus to investment seems to be the strong rise in profitability. Post-tax corporate profits increased by 9 per cent in the first quarter compared with a year ago after declining by around 4 per cent in 1991. Strong productivity growth, which did not push up wages, accounts for some of the rise in profits. However, business sector productivity growth is now decelerating after growing strongly in the second half of last year.

The forward markets indicate that interest rates will increase by around 1 percentage point over the next 12 months. This expectation is difficult to understand given the recent weakness of inflation, which declined to 3 per cent in June. Average weekly earnings growth fell to 2 1/2 per cent in June and this was combined with subdued import prices resulting from the strengthening of the dollar in the same month. In the longer run real interest rates should approximate the real return on capital which has historically been approximately 3 to 4 per cent. Hence to achieve this target, under the assumption of a medium-term inflation rate of 3 per cent, nominal interest rates must rise to around 6 1/2 per cent in the longer-term. This is consistent with the latest figures for US 10-year bond yields.

We have embodied the implied rise in interest rates in our forecast of GDP which is shown in Table 6. We expect GDP to grow by 2 1/2 per cent this year and then decelerate to around 2 1/4 per cent next year as monetary policy is gradually tightened. Investment and consumption will probably provide the main stimulus to growth this year. Although we are predicting a decline in the growth rate of housing investment we expect that business investment will grow by a robust 10 per cent in 1993. However, our forecast for residential investment is rather uncertain as the impact of the recent floods in the US is not clear. Consumers' expenditure should register growth of approximately 3 per cent in 1993 broadly in line with real personal disposable income. The latter is fuelled by strong real earnings growth as we expect the strong productivity performance of 1992 to eventually feed through into wages. Consumer price inflation will be pushed downwards as import prices will remain subdued if the dollar appreciates in line with our assumed path for US interest rate differentials. Net exports should have a negative impact upon output as exports will decelerate in line with weaker demand in Europe whilst imports will respond to strong US domestic demand. During 1994 we expect both consumption and particularly business investment growth to decelerate as these are fairly interest rate sensitive categories of expenditure. In addition, the growth in real personal disposable income will be somewhat subdued by tax increases.

Our forecast for the US balance of payments is given in Table 7. The current account deficit widened to around $66 bn in 1992 which is approximately 1 per cent of GNP. This comprised approximately a $20 bn deterioration in the visible trade deficit to almost $100 bn which offset the small increase in the combined surplus on services and interest profits and dividends. We expect the current balance deficit to deteriorate further in 1993 to TABULAR DATA OMITTED around 1 1/2 per cent of GDP. This is the result of a combination of high US relative demand and a deterioration in competitiveness arising from an appreciating dollar. Net interest profits and dividends will also be reduced by the appreciation but the lower relative interest rate on foreign assets in the US will probably prevent the surplus deteriorating both this year and next. Competitiveness effects will contribute to a worsening of the current account in 1994 but the deceleration in total final expenditure growth will mitigate the extent of the deterioration. In the longer term we expect the US external deficit to remain at around 2 per cent of GDP.

The Federal budget deficit is showing signs of diminishing as the recovery in GDP continues. In the first nine months of the 92/93 fiscal year the deficit amounted to around $200 bn compared with $228 billion a year ago. Table 8 gives details of the US budget deficit on a calendar year basis. The public sector deficit deteriorated by 2 1/2 percentage points of GDP between 1989 and 1992 reaching almost $300 bn last year. President Clinton will now be able to implement a 4-year deficit reduction package consisting of tax increases and spending cuts amounting to $496 bn. The plan is expected to cut the Federal budget deficit from an estimated 5 per cent of GDP in this fiscal year to $261 bn in fiscal 93/94. Full details of the fiscal package and simulated effects of the impact upon US GDP were given in the May Review. We are projecting that the budget targets will be met and that the fiscal package will be successfully implemented.

TABULAR DATA OMITTED

Japan

Real GNP grew by 0.6 per cent in the first quarter of the year. Although this compares favourably with the fourth quarter of 1992, when output remained unchanged, and the third quarter of the same year, when it fell by 0.6 per cent, doubt remains whether the current downturn has come to an end. The Japanese economy grew by only 1.5 per cent in 1992, which was the slowest growth rate since 1974. In the first quarter of this year both consumer spending and total investment grew by 1.2 and 1.0 per cent respectively. The boost to investment came primarily from the fiscal stimulus package announced last August. Some of the delayed effects of this Y10,700 bn package came through in the first quarter, and government investment rose by 6.5 per cent. However, business investment fell slightly by 0.2 per cent, while housing investment fell by 3.0 per cent.

Industrial production is in its longest ever downturn and output was 5.1 per cent down year-on-year in June. Output has fallen now for longer than during the recession of 1974. Business surveys and leading indicators give conflicting evidence about the prospects for a recovery. Several surveys suggest that the recession has bottomed out. Business confidence stopped falling in the second quarter of the year, and expectations for the third quarter improved slightly, although they remain very weak. The index of leading indicators hints towards a further contraction in the next half year. Doubts remain and a strong recovery in the second half of the year seems highly unlikely.

Sales in department stores continue to fall, as consumer spending has been depressed by lower incomes growth and higher unemployment. Wage increases agreed in the annual wage negotiations are expected to average 3.5-4.0 per cent this year, down from 4.9 per cent in 1992, which was the smallest increase for many years. Bonus payments, a significant component of total earnings, fell this summer for the first time in 10 years. The unemployment rate rose from 2.3 to 2.5 per cent, and is now at a 5 year high. Although this may seem low by international standards, the official definition of unemployment is not comparable to that in other countries. The rise in unemployment was primarily due to a fall in employment in manufacturing, while employment in construction was boosted by the government's public works programmes.

The Japanese government has been running a fiscal surplus for some years, although this declined from 2.4 per cent of GDP in 1991 to 1.9 per cent in 1992. In April 1993, the government announced a package of Y13,200 bn that was designed to boost the domestic economy. This package was seen as a gesture to its G-7 partners after heavy criticism for Japan's growing trade surplus. The package supplemented the 0.2 per cent increase in government expenditure announced in March for the fiscal year 1993/94, starting in April, which was the smallest planned increase for 6 years. What the actual stimulating effect of the extra spending will be on the economy remains to be seen. Of the total Y13,200 bn package, a large proportion is in the forms of loans or simply expenditure growth in line with inflation, and not really new spending.

It is still not clear how much the August 1992 stimulatory package amounted to. When it was announced by the politicians it was said to be Y10,700 bn, but it was subsequently trimmed heavily by the Ministry of Finance. The April package announced by the LDP government amounted to new measures worth Y13,200 bn, but it could amount to much less when the final figures are published. Considerable uncertainty exists TABULAR DATA OMITTED about the plans of the new coalition government which consists of a wide range of political parties that are primarily concerned with reform of the political system. It remains to be seen how the new government will respond as the pressures intensify from other countries to give a real boost to domestic demand by a significant tax cut.

Our forecast for output is set out in Table 9. We now forecast about 1 per cent growth in output this year. On the basis of the first quarter data we have slightly revised it upwards from our previous forecast. We expect consumers' spending to grow by only 1.8 per cent, similar to last year, whilst private sector investment is likely to fall. The Tokyo stockmarket rose by over 20 per cent in the first quarter of the year. Although this led to a large rise in the personal sector's financial wealth, wealth effects work very slowly and we do not expect a large rise in consumption this year as a result and anyway earnings growth is expected to remain very slow. We are rather pessimistic concerning total investment, with the admittedly large increase in government investment in this year offset by further falls in housing and business investment. As much of the boost to government investment is front loading of existing investment plans for the current fiscal year, we expect much less growth in this sector in 1994. Although consumers' spending and private investment will pick up again by then, the recent appreciation of the yen will have had an effect on net exports and we expect no strong recovery of GNP growth next year. We are forecasting that total domestic demand will grow by 3.8 per cent in 1994, with a particularly strong effect coming from the growth of business investment after two years of decline. Output growth is likely to be much lower at around 2 per cent. Exports of goods are likely to decline next year, and imports could well grow by 9 per cent.

The continuing rise in Japan's trade balance has become a major cause of concern. The current account surplus rose from $77 billion in 1991 to $116 billion in 1992. The trade surplus grew to $ 132 billion over the same period. The 10 per cent increase in value of the yen in the second quarter of this year inflated the value of exports in dollar terms, offsetting the reduced growth in export volumes, while the slump in domestic demand has weakened imports growth. The current account has continued to improve into this year, and it is feared that the growing surplus with the EC and in particular with the US will exacerbate trade friction, and lead to a tariff war.

The recent appreciation of the yen has made Japanese manufacturers less competitive abroad. Japanese firms could opt to accept lower profit margins rather than raising their export prices in the immediate future and attempt to hold on to their market share. Indeed in the past there is some evidence that they have adopted this strategy. However, in the long run the appreciation should to some extent help to correct the current account imbalance. Our forecast for Japanese trade is set out in Table 10. The recent appreciation will not have much effect this year on trade in volume terms. Export volumes are projected to grow by 1 3/4 per cent, as Japan's export markets in the Far East, and in particular China, continue to expand rapidly. The loss in competitiveness will only slowly have an effect in the next year. The growth in the TABULAR DATA OMITTED trade surplus that is likely to result from the initial effects of the appreciation will probably be accompanied by an improvement in the invisibles account, in part because of the continued accumulation of overseas assets. As a result the current account surplus is expected to grow to around $150 bn this year. In the medium term the appreciation of the yen is likely to lead to a significant loss of export market share and at least some increase in import penetration. We are projecting that the surplus will fall to around 1.5 per cent of GDP by the end of the decade.

Meanwhile, the pressure will be on Japan to open up its domestic market to foreign imports and remove some of its trade barriers. We expect imports to grow gradually as such barriers are slowly removed. But now the new reformist parties, which are in favour of a more forcible attitude towards the US, are likely to come to play a significant role in the next coalition government, this could lead to growing tension with Japan's major trading partners.

Germany

In the first quarter of 1993 output in west Germany fell by 1 1/2 per cent. This was the fourth consecutive quarterly fall. Real GDP grew by 1.5 per cent on an annual basis in 1992, but that was largely due to a relatively strong first quarter. Since then GDP has fallen and the prospect for the current year is one of the steepest falls in output since the war. Whilst the rest of the world is going through a 'normal' cyclical recession, Germany has the additional costs associated with the restructuring of the eastern lander. This has proved an enormous burden and all of Germany is paying the price.

Total private investment remained unchanged in the first quarter of the year, as the rise in construction investment was offset by a sharp fall in investment in machinery and equipment. Construction is the only category of output that remains strong, as it is boosted by building activity in the eastern lander and high demand for housing for new residents. On the other hand, low profit levels have depressed business investment, as have high borrowing costs, and it is projected to fall sharply this year. Prospects for an improvement in the economic climate are poor. As domestic demand has weakened, domestic orders have dropped to well below last year's levels, while export orders have been depressed by slower growth in Germany's export markets as well as by a loss of competitiveness after the realignment of the ERM in 1992. Capacity utilisation in manufacturing has fallen markedly and is now at an eight year low, although it is still above the levels experienced in 1981 and 1982.

In the first quarter of the year, consumer spending fell by 1.1 per cent. In the previous quarter it had risen by 1.4 per cent, as expenditure was brought forward in advance of the increase in VAT in January 1993. Real income growth has declined, due to lower wage increases and persistently high inflation. Unemployment rose to 2.26 TABULAR DATA OMITTED million, and the rate of unemployment is now, at 8-2 per cent, at a five year high. Employment in manufacturing has fallen markedly, while the labour force has grown more rapidly over the last few years because of the influx of new residents. The rise in unemployment has helped to keep wage pressure down, and wages increases are beginning to moderate.

So far, this has not had the long awaited effect of bringing inflation down. The headline figure for inflation remains persistently high and edged up to 4.3 per cent in July. Consumer price inflation remains high despite the appreciation of the D-Mark and the fall in import prices. Wholesale prices were 1-8 per cent lower than a year ago in June. Import prices were 3 per cent down on a year ago. There are several factors behind the stubbornly high inflation of consumer prices, of which price increases in sheltered sectors are the most important. Excess demand for housing, due to the large inflow of new residents, has led to sharp increases in rent and related costs. In addition, prices of public services have also risen markedly this year as the public sector, in particular local government, raised fees for many services in order to enhance revenues. These factors have kept inflation in consumer prices much higher than would have been expected given the fall in import and producer prices.

The current headline inflation rate is double the Bundesbank's target level. In April, the Bundesbank reduced its official lending rates by half a percentage points and in the beginning of July, the discount rate was cut by 0.5 percentage points from 7.25 to 6.75 per cent and the Lombard rate by 0.25 per cent to 8.25 per cent. Since then the Bank continued to cut the 'repo' rate, its main money market rate, to below 7 per cent by the end of July. By then the repo rate had declined by almost 3 percentage points since it reached its peak of 9.7 per cent in September last year.

On July 29th, the Bundesbank lowered the Lombard rate by a further 0.5 percentage point to 7.75 per cent, but, contrary to market expectations and despite significant pressure from its ERM partners, the Bank did not lower the discount rate that normally functions as the bottom of the money market rates. The refusal of the Bundesbank to bend to pressure led to the ERM crises the following weekend, when the fluctuation margins around all ERM parities, except for the D-Mark/Dutch guilder parity, were widened to 15 per cent.

The Bundesbank's refusal to lower the discount rate must be seen in the light of the new figures that were released during the preceding week. Preliminary inflation figures indicated that the headline figure would creep up from 4.2 per cent to 4.3 per cent in July, more than double the target rate of inflation of 2 per cent. In addition, money supply growth (M3) had picked up in June to 7.1 per cent, well above the target range of 4.5-6.5 per cent for 1993. As pressure on the French franc and other ERM currencies mounted during July, the Bundesbank had been obliged to intervene. These interventions could not immediately be sterilised and this led to an increase in liquidity in the market. Estimates of the speculative inflows in July suggest these were close to D-Mark 60 bn. The Bundesbank was clearly concerned about the sharp jump in M3 growth that would result from this. This must also have been in their mind when changes to the functioning of the ERM were discussed, and any solution that would either involve a forced cut in interest rates or carry with it the slightest risk of more massive interventions was ruled unacceptable.

Now that the external pressure on the Bundesbank's Council to cut the discount rate has been reduced, interest rate reductions may be delayed, but it is generally expected that further cuts in official rates will follow in the coming months. Indeed, the repurchase rate was cut further, to 68 per cent, in the week after the ERM. The underlying rate of inflation is probably below 3 per cent and, with further massive interventions highly unlikely, the money supply growth could move closer to the target rate again. The Bundesbank has also expressed concern at the size of the government budget deficit. The government has announced significant cuts in spending and plans for drastic tax increases, and signalled that it is prepared to make a serious effort to curb the fiscal deficit. This should help persuade the Bank to cut interest rates. The money market seems already to have discounted further interest rate cuts and our forecast incorporates that.

Our forecast for (west) German GDP is set out in Table 11. We expect GDP to fall by 2 per cent this year. The sharpest fall of almost 3 per cent is in investment. Consumers' spending will also fall by almost 1/2 per cent. For 1994, we see some recovery with GDP growing by only 1 1/2 per cent. The government has announced sharp cuts in social spending and unemployment benefits in an effort to curb to rising deficit making a slightly stronger recovery highly unlikely. Growth next year will very much depend on the positive contribution of net exports. Inflation is expected to remain well above the Bundesbank's target of 2 per cent. Despite the appreciation of the D-Mark and the fall in import prices, consumer inflation has remained persistently higher primarily due TABULAR DATA OMITTED in part to special factors mentioned above. We expect no drastic change in these factors with inflation in consumer prices averaging around 4 per cent for this year and to come down only slowly in 1994 to an average of 3.0 per cent. Unemployment has risen sharply this year and we expect the rate of unemployment to average around 8.3 per cent. With the recession deepening it is unlikely that the rise in unemployment will come to a halt soon.

Table 12 shows our forecast for German trade. Before 1991 Germany had a large trade surplus, but this fell sharply after unification when higher demand from the east boosted imports. With the onset of the recession imports fell back again as domestic demand slowed. But the strengthening of the D-Mark in the fourth quarter of last year has made German exports less competitive and this has depressed exports. We expect export volumes to fall by almost 5 per cent this year, due to the appreciation of the D-Mark and the slowdown in Germany's export markets. Import volumes are projected to fall by 3 1/2 per cent this year, as domestic demand has weakened. The deficit on services deteriorated significantly last year and we expect no improvement. As a result, we forecast a widening of the current account deficit to around 2 per cent of GDP this year and only a small improvement next year.

The budget deficit of the federal government is expected to rise from DM 39 bn in 1992 to DM 70 bn in this year. The fiscal package discussed above includes cuts in social benefits and unemployment payments and a public sector pay freeze. The government expects the federal deficit will remain around DM 70 bn in 1994. TABULAR DATA OMITTED Our forecast, set out in Table 13, shows the total public sector deficit, on a national account basis and including the social security funds, widening to DM 140 bn in 1993, or 5 per cent of GDP. Despite the numerous spending cuts, we expect no improvement in the total deficit next year, as tax revenues are likely to remain low due to the recession.

In addition to the spending cuts mentioned above, tax increases have been proposed to prevent the deficit from rising even further. In March this year a 'solidarity pact' with employers and trade unions was agreed, and one of the measures included was the reintroduction of the solidarity surcharge of 7.5 per cent on income tax from January 1995. As this will to a large extent reduce purchasing power of consumers, it will reduce the growth prospects for the German economy even further. With transfers to the east mounting and the obligation to take on the debt of the Treuhandanstalt and the GDR Debt Fund by 1995, which will lead to higher interest payments, we foresee no rapid reduction in the public sector deficit in the medium term.

France

At the time of writing, the French franc was standing slightly below the original floor of the franc/D-Mark parity but well within the new 15 per cent bands agreed by the EC Finance Ministers at the beginning of August. Before August the previous realignment of the franc was a devaluation of 3 per cent in April 1986. The current bout of downward pressure on the franc began in September 1992 in the run up to the French referendum on Maastricht. Unlike Italy and the UK, the French authorities successfully resisted devaluation by raising interest rates and intervening in the currency markets. However, the franc and other ERM currencies have been in a state of intermittent crisis ever since. Although the original pressure on the franc was interpreted as the result of uncertainty over future monetary union it soon became clear that the financial markets were more concerned with the incompatibility of German monetary policy and French domestic conditions. German reunification required high interest rates which France adopted to maintain the ERM parity. Such a tight monetary policy exacerbated a worsening French recession. Although the French authorities displayed credibility in terms of willingness to defend the franc their policy did not seem feasible given the prospect of an unemployment rate of above 12 per cent persisting into the medium term. It seemed that the French economy needed a stimulus from either a devaluation or a loosening of monetary or fiscal policy. In terms of fundamentals--primarily the current balance and inflation--it did not make sense to devalue the franc substantially as it seemed that France was at or near its equilibrium exchange rate. But at the same time it was clearly not sensible for France to follow the high real interest policy adopted by Germany for quite different domestic reasons.

The widening of the ERM bands will allow currencies to find their market level. Given the fundamentals one would not expect the franc to depreciate by much. But the extent of any depreciation also depends upon the market's perception of the continued commitment of the French authorities to a high exchange rate policy. The extent to which the authorities allow interest rates to fall will provide the major signal of future intentions. This, in turn, will largely depend upon the feasibility and commitment to monetary union and the relative priorities of the French government in terms of containing inflation and stimulating growth.

According to our Global Econometric Model (NIGEM) any stimulus from a decline in interest rates will take a considerable time to affect the economy. A more immediate impact could be provided by a devaluation. However, this would have to be quite large in order to reap substantial competitiveness benefits as, unlike the September devaluations of the UK and Italy, several other countries have also devalued and most of the gains would only be vis-a-vis Germany. If the remaining currencies in the ERM depreciate substantially more than the franc the final outcome could be an appreciation of the French currency in effective terms. Fiscal policy is an alternative source of stimulus but this is unlikely given the large and growing French public sector deficit.

Any effective stimulus to the French economy needs to be fairly large given the scale of the slide into recession. French real GDP declined 0.6 per cent in the first quarter of 1993 after falling by 0.4 per cent in the fourth quarter of 1992 and 0.1 per cent in the third quarter of the same year. The fall in GDP in the first quarter is accounted for by a 0.6 per cent fall in consumption, a 2.2 per cent decline in total investment and an 8.3 per cent fall in export volumes. The latter obviously reflects a serious weakening of demand in several European countries, particularly Germany. French import volumes declined by over 8 per cent in the first quarter which indicates the extent of the deceleration in French domestic demand.

Our forecast for France is set out in Tables 14 and 15. The short-term outlook for France is much more pessimistic than that set out in our May Review. However, this is not directly the result of the recent changes forced upon the ERM, which should stimulate French activity, but largely reflects the recessionary 'news' contained in more recent data. Of course, it is difficult to judge the extent to which the uncertainty over both the ERM and TABULAR DATA OMITTED monetary union has adversely affected the French economy. Nevertheless the stimulus to the French economy resulting from the recent turmoil in the currency markets--lower short-term interest rates and a lower franc exchange rate against the D-Mark--are included in the forecast. The decline in short rates will probably affect consumption the most. Borrowing for consumer purchases will be cheaper but these effects will take time to come through and the greatest impact will probably be felt next year. Consumers will be cautious about increasing expenditure until unemployment stops rising. French long rates have only declined by around 1/2 a percentage point so far. Therefore, if this remains the case, the major stimulus to French investment will be higher activity rather than the lower cost of borrowing. Consequently, it seems that the short-term effects of the widening of the ERM bands will only serve to ease a little of the recessionary pressures that have emerged this year.

We now expect real GDP to decline by around 1/4 per cent this year. An anticipated fall in investment of more than 4 per cent provides the major reason for the downturn. It is not surprising that the currency markets questioned the sustainability of the high interest rate policy in France given that investment had already fallen by around 3 per cent in both 1991 and 1992. A further fall of a similar magnitude this year will damage the supply-side to an extent which is difficult to justify as a worthwhile trade-off for slightly lower inflation. Consumers' expenditure is also less buoyant compared to our previous forecast. We are predicting that consumption growth will fall below 1 per cent this year and the savings ratio is expected to rise. Net exports will also add to the fall in GDP this year reflecting mainly the severity of the German recession, and despite the small depreciation of the TABULAR DATA OMITTED franc. Because it is only a small depreciation, the deflationary effects of the decline in activity dominate any rise in import prices and inflation should fall to 2 per cent this year.

Next year we expect a recovery in French GDP as the monetary loosening begins to boost both consumption and investment. But the recovery will be fairly muted as it will be some time before uncertainty over future policy diminishes and confidence begins to recover. Most of Europe will also be in the early stages of recovery, and hence the contribution of net exports to activity will be minimal. Given all of these factors we anticipate that GDP growth in 1994 will be around 1 1/2-2 per cent. As a consequence of the subdued growth, the two other major problems facing French policy makers, the public sector deficit and the high rate of unemployment, persist into the medium-term. Both of these problems are largely structural rather than cyclical and require imaginative structural solutions rather than shocks to aggregate demand. Hence the departure of the franc from the original ERM bands will not provide a panacea for the French economy.

Table 15 gives our forecast for French trade. Export and import volumes for 1993 show the severity of the predicted downturn in both domestic and external demand. The small impact of the widening of the ERM bands is indicated by the changes in relative prices in 1993 and 1994 which are not large. The visible surplus in 1993 and 1994 is larger compared to our previous forecast primarily because French activity is lower. In the medium-term the French current balance should remain in surplus at around 1 1/2 per cent of GDP.

Italy

The Italian economy is still affected by the combined effects of the European slowdown and of tighter fiscal policy. Capacity utilisation declined to its lowest level for seven years at the end of last year, and domestic demand remains weak. Industrial production was slightly higher in the first quarter of 1993 compared to the last quarter of 1992 (+ 1.2 per cent), but well below the level it had reached a year earlier (-5.6 per cent). Preliminary estimates suggest that in July it increased by 0.6 per cent, but that it was still 4.7 per cent lower than a year before. The main positive contribution to growth still comes from the external sector, with strengthening export volumes and lower imports. The balance of payments deficit in May was only L100bn compared to L1,054bn in the same month of last year. In the first five months of 1993 the external deficit has decreased to L2,535bn from L6,300bn in the same period last year.

The annual rate of inflation rose in June to 4.2 per cent from 4.0 per cent in May. This is one of the first signs that the effects of the devaluation of the Italian lira since last September are feeding through to domestic prices. However, inflation should not rise sharply because of the weakness of domestic demand and of the abolition of the wage indexation system. Also, a further depreciation of the lira against the other major currencies, in particular the D-Mark, is not to be expected as the lira is probably below its real equilibrium level at present. The labour market has been adversely affected by the sluggish GDP growth, and the total out of work is now 9.5 per cent. (It should be noticed that the definition of unemployed in the Labour Force Survey has recently been changed by Istat to include only claimants who have been without a job for at least thirty days and we estimate that will have reduced to headline figure by 1 1/2 to 2 per cent.) In the period 1992-1994 approximately 300,000 jobs will have been lost in the manufacturing sector, and employment is now declining even in the services sector, which is undergoing a radical restructuring. Istat, the national statistics institute, reports a drop of 6.5 per cent in employment in large companies in the first three months of 1993 over a year earlier. In the course of 1992 they lost 5.5 per cent of their workforce. However, a labour agreement reached in July between the government, Confindustria, the Italian industrialists' association, and the unions is expected to have positive effects on employment. The Bank of Italy immediately cut its discount rate to 9 per cent, the lowest level since 1976. According to the new four-year pact wage increases will be kept within the projected inflation rate, and they will be linked to productivity increases. Other measures aimed at making Italy's labour system less rigid include the introduction of the principle of temporary employment, lower starting salaries, and simplified procedures for the hiring of trainees and apprentices.

The government has also announced an additional L13,000bn package to reduce the budget deficit in 1993 and comply with the target set by the EC as one of the conditions to a 2 billion ECU grant. The official target for the deficit in 1994 is L150,000bn to be achieved mainly through spending cuts rather than a bigger tax take. The projected deficit in the absence of these measures would be L180,000bn or around 10 1/4 per cent of our forecast of GDP. The emphasis, in contrast to last year's budget, is on containing both current expenditure and investment. Each ministry's spending will have to be reduced by 3.0 per cent, and additional savings will be sought in the health, welfare and education budgets. Revenues are to be increased with, the main efforts going into improving the efficiency of tax collection and simplifying the way taxes are paid. The budget has been presented much earlier than usual as