The world economy.

Barrell, R. Anderton ; Caporale, G.

The US, the UK and Canada all experienced recessions in 1991, whilst in Germany and Japan activity began to slow markedly. Most commentators, including the Institute, underestimated the length and severity of the recessions being experienced by the UK and the US. Data for the third and fourth quarters, along with recent information on expectations and on consumer confidence, have caused us to revise down both our estimate of growth experienced in 1991 and our forecast for growth in 1992. The summary details of our forecast are given in table 1.

We are projecting that growth in the major four will average under 2 per cent in 1992, well below the average of around 3 per cent between 1982 and 1989. This rate of growth represents some recovery from 1991 but is well below capacity. Chart 1 plots past data and our forecast of the quarterly path for the rate of change in output in the major economies between 1988 and the end of 1993. The continued recession in the US is likely to make the path of growth more sychronised over the year ahead than it has been over the last two years.

We anticipate that capacity utilisation will continue to fall over the next year, after peaking in recent years in all of the major economies. Chart 2 plots survey based capacity utilisation indices for the major four. The capacity ceiling was reached first in the US in late 1988, but utilisation has fallen sharply recently. The US monetary authorities have responded very sharply to the fall in output, and the discount rate was cut to 3/2 per cent in December 1991, its lowest rate for some decades. Despite these strong moves we expect only a slow recovery from the depths of the recession.

The sharp reduction in interest rates ill the US should help recovery, but prospects for the world economy as a whole are somewhat weakened by the Bundesbank decision to increase interest rates at the end of 1991. The German authorities are seriously concerned about the emergence of inflationary pressures as a consequence of the increase in demand associated with the process of unification. Wage settlements have risen to around 6 1/2 percent, and consumer price inflation in 1991 has been almost 4 per cent. This does not seem high by international standards, especially as indirect tax increases have added to inflation. Chart 3 plots recent and prospective inflation in the major four economies.

The increase in German interest rates has been slowing growth and recovery in the rest of Europe. This is reflected in the low forecast growth rate for the major seven economies in table 1. We argued in the February 1991 Review that the expansion of demand as a consequence of unification in Germany could lead to a slowdown of activity in the rest of Europe. Box 1 sets out a simple analysis of the problem. If the European economies are committed to the Exchange Rate Mechanism then when German interest rates rise other countries have to react. Interest rates have risen in France, italy, the Netherlands and Belgium, and anticipated cuts have not materialised in the UK. The ERM is a coalition with a leader, and the German authorities are still reacting to German problems. In a monetary union the reaction to a German fiscal expansion of this scale might not be so severe.

German inflation has been pushed up both by tax increases and a high level of demand and we expect it to remain around 3Y2 per cent in 1992 before declining somewhat in the mid 1990s. Inflation elsewhere in the ERM system is likely to moderate somewhat, although the recent and anticipated (small) depreciation of the ECU may raise it by half a point in 1992. In the longer term we forecast that French inflation will remain slightly below that in Germany. Monetary Union in Europe is likely to be in place by the end of the decade, and policy will be run on the basis of Community wide targets. The Bundesbank will have lost its control of the German inflation rate, and we expect that the new European Central Bank will put a slightly greater weight on output. As a result German inflation may settle at around 3 1/2 per cent a year, which is around the average of the last 20 years.

World trade growth in 1991 and 1992 reflects the slowdown in activity. Total world trade in all goods (but excluding trade between the former centrally planned economies) grew by around 5/2per cent a year between 1982 and 1989. It slowed a little in 1990, and we estimate that it only grew by about 1 per cent in 1991. This partly reflects the disruption caused by the war in the Gulf in the early part of the year, but it is mainly the consequence of the decline in OECD industrial production. Output growth in the major seven was probably less than 1 per cent in 1991, and although we are expecting it to rise somewhat in 1992 all of the major economies will be operating below capacity for several years. We expect world trade growth to recover gradually in 1992 and 1993. There will be little support from imports into the formerly centrally planned economies, at least in the near future.

Interest rates, exchange rates and commodity prices Interest rates have risen in France and Germany in recent months whilst they have fallen in the US and Japan. Chart 4 plots recent 3-month interest rates on a weekly basis over the last year. The interest rate differential between the US and the ERM countries is now very considerable, reflecting the very different worries of the officials in the Federal Reserve and the Bundesbank. The US authorities are concerned about a continued recession, whilst the Bundesbank fears an acceleration in inflation. German fears have led to interest rate increases throughout Europe, despite the very poor prospects for output growth. These different fears have influenced recent exchange rate developments. Recent data and our forecast for exchange rates are set out in table 2.

The interest differential discussed above is also reflected in long rates, and German long rates have risen sharply in the last two years, whilst those in the US, and more recently japan, have been falling. Chart 5 plots recent long rate developments. The sharp rise in German long rates in 1990 was associated with the 8 per cent appreciation of the D-Mark (and of the other ERM currencies) in that year. Chart 6 plots recent exchange rate developments. The sharp appreciation of the D-Mark has now been reversed a little, but we would judge that the US is now undervalued in real terms. This belief is strengthened by the implications of the rebased national accounts data in the US. This new data, which is discussed in box 2 below, has led us to revise down our estimate of US trade demand elasticities, and hence as shown in Barrell and in't Veld (1991) our estimate of the US FEER will have been revised.

Our medium term forecast for exchange rates in table 2 is based on the open arbitrage relationship. It is therefore dependent on our interest rate forecast which is set out in table 3. Short rates are eventually expected to converge in Europe, but they will remain higher than in the US or Japan. In the longer term we believe that nominal rates will be determined by the real return to capital and the inflation objectives of the authorities. The real interest rate appears to have risen, at least in Europe, as a consequence of developments in the east. Inflation in Europe is forecast to settle down to around 3 1/2 per cent a year by the end of the decade, and we are forecasting real interest rates of around 3 1/4 per cent by then. The US and Japan are likely to have lower real interest rates of around 2 1/2to 2 1/4 per cent in the longer run, and we are therefore expecting their currencies to appreciate in real terms.

The slow growth of demand in the industrialised countries has led to rather weak commodity prices. Chart 7 plots recent commodity price developments. Minerals and metals prices have been weak, with aluminium and especially copper prices falling sharply in the last few months. Less developed country food prices have also been weak, with falling sugar prices more than offsetting the recent strength in the cocoa market. Sharp declines in cotton prices have also influenced our non-food index. The developed country food index has been supported by very high wheat prices. These reflect anticipated falls in US output and strong demand for exports to the former Soviet Union. Forward markets are exhibiting larger than usual falls in wheat prices after the next harvest, and these are built into our forecast. Past data and our forecast for commodity prices is given in table 4. We expect real commodity prices to remain generally weak, following the pattern of the last decade plotted in chart 8.

Oil prices were weaker in the fourth quarter than forward markets anticipated. This in part reflects the fact that oil exports from the former Soviet Union have been maintained at relatively high levels. We anticipate that oil prices will stay around $19 per barrel in 1992. Demand is expected to be low, and although the Iraqis have not yet resumed their exports they will eventually do so, and this will put downward pressure on prices. In an attempt to prevent prices from falling OPEC has recently agreed to cuts in production of just over 1 million barrels a day.

United States

The uncertainty dominating the world economy is particularly apparent in the U.S. After showing signs of recovery in the middle of last year, poor fourth quarter GDP growth renewed fears of a 'double-dip' recession. After having already reduced the discount rate by 72 a per cent in November, the Federal Reserve implemented a further 1 per cent cut to 31/2 per cent in December. This prompt action was a direct response to the reversal of recovery signaled by the fourth quarter figures. Real GDP only rose by 0.3 per cent (at an annual rate) in the final quarter of 1991 compared to 1-4 per cent and 1.8 per cent in the second and third quarters respectively. The main forces depressing growth were weak consumers' expenditure and slower investment growth. Although real consumption began growing in the second and third quarters, reversing the declines of late 1990 and early 1991, the trend of falling consumption resumed in the fourth quarter despite a rise in personal disposable income. This probably accounts for some of the rise in stockbuilding in the fourth quarter which is in direct contrast to the destocking experienced in the first half of last year. After rising by almost 20 per cent (at an annual rate) in the third quarter, total investment growth slowed down to around 272 per cent in the final quarter of 1991. Even so, this was largely accounted for by house building whereas investment in producers' durable equipment remained flat. Steady export growth provided some stimulus to the economy but the fourth quarter fall in imports is consistent with a further weakening of the economy.

Capacity utilisation in most sectors declined slightly in the fourth quarter as industrial output fell by 0.2 per cent compared to a 1-7 per cent rise in the previous quarter. The degree of uncertainty over future output growth is highlighted by the recent simultaneous increase in the unemployment rate combined with an increase in the number of overtime hours worked. It may be the case that firms are increasing output by increasing working hours rather than employing more workers because they are uncertain about the sustainability of the current recovery.

Obviously the Federal Reserve was aware of the poor outturn during the last quarter of 1991 and responded by reducing the discount rate by 1 per cent. The two most subdued categories of expenditure, business investment and consumers' expenditure, should benefit as a consequence. Economic activity could recover strongly. However, confidence remains the key to recovery and this is difficult to gauge. Obviously confidence is dependent upon expectations of the future. Given that 1992 is a presidential election year, there remains some uncertainty regarding both future economic strategy and the permanence of recent policy responses. As personal debt rose in response to financial liberalisation consumers must now be acutely aware that the costs of borrowing are both volatile and unpredictable. This should act as a restraint upon further borrowing especially as long- term interest rates suggest that the discount rate will begin rising again in the future. The persistent and growing US public sector deficit, the need to increase US savings in the medium term and the historically low current level of the discount rate all suggest that the recent fall in real interest rates will not be permanent. Furthermore, it should be emphasised that recent spending was probably undertaken when expectations about the future were more optimistic. Therefore, it is highly possible that consumers now perceive debt/income ratios as too high and the timing and magnitude of their response to cheaper credit is uncertain.

Our forecast for US GNP and its components is set out in Table 5. Our model of the US economy has been re-estimated on the rebased national accounts data, and the major revisions are set out in Box 2. We expect a rather muted recovery in the US this year with GNP growth of around 1.8 per cent. This is largely accounted for by increased consumers' expenditure combined with a small increase in net exports. Although confidence among US consumers has been subdued in recent months we believe that the obvious determination of the monetary authorities to prevent the recovery from faltering, apparent from official statements and recent substantial easing of monetary conditions in the US, should gradually engender more consumer optimism and prevent the savings ratio from rising further. Rising real incomes and upward revaluations of net financial wealth should provide the impetus for a significant increase in consumption this year. Real disposable incomes should benefit from both the rise in nominal incomes caused by the recovery in activity and a further fall in inflation. Subdued import prices, low levels of capacity utilisation and decelerating unit labour costs growth should all contribute to continued downward pressure on prices in 1992. Depressed activity in the US should encourage importers to restrain prices, and hence squeeze profit margins in order to maintain market share, while US unit labour costs will also be restrained as employment growth usually lags output at this stage of the cycle.

Although we do not forecast any significant growth in either US housing or business investment this year, the interest rate declines of last year should prevent these expenditure categories from falling any further in 1992. In fact, given our inflation and interest rate profile, expost real interest rates will be approximately zero in the US this year. Next year we predict that GNP will grow by around 2-5 per cent as the full impact of lower real interest rates feeds through to all the expenditure categories.

The US balance of payments forecast is given in Table 6. The visible trade balance deteriorates in line with the increase in US demand this year and next but remains fairly stable as a per cent of GDP. However, the current account will register a more severe deterioration over this period as the Gulf War transfers of 1991 drop out of the surplus on invisibles. In the medium-term we expect the current account deficit to stabilise at around 1 per cent of GDP. This is somewhat more optimistic than previous forecasts. The depressed level of activity in the US, combined with the one-off Gulf War payments, have reduced the decline in US net overseas assets which, in turn, has decelerated the deterioration in US net revenue from interest, profits and dividends. As box 2 shows, the new national accounts data have caused us to revise our estimates of demand elasticities downward. This revision implies that for any given US GNP growth rate the current balance deficit will be lower than previously anticipated. This also partly explains our less optimistic forecast for world trade growth.

In his state of the Union address to Congress, President Bush outlined plans for a small short-term fiscal stimulus comprising temporary tax credits for first time homebuyers, increases in personal allowances for each child and a cut in capital gains tax. Given the current depressed state of the US economy and the expectation of a stronger fiscal expansion these measures were perceived as somewhat disappointing. But the government view seems to be that the discount rate cuts are sufficient to promote recovery and adding a substantial fiscal stimulus on top of these expansionary forces would be unwise. Furthermore, an expansionary fiscal package of tax cuts could drive the deteriorating public sector deficit to levels beyond the tolerance of the financial markets, perhaps prompting a reversal of the recent easing of monetary conditions.

In the medium-term, President Bush has stated his intention of further increasing the "peace-dividend". An extra $50 bn of defence cuts are now projected in addition to the current plans to reduce the US armed forces by 25 per cent over the next five years. Nevertheless, even after accounting for these expenditure reductions, in contrast to previous forecasts, the administration is not projecting a balanced budget in the medium-term. It is the expected growth of mandatory expenditure on pensions, welfare payments and other social entitlements which sustains a large federal deficit into the longer-term. Our US public sector forecast is given in table 7. Our figures for the deficit use equations based on data from the national income and product accounts. The projected deficit therefore excludes any temporary or permanent additional borrowing directly related to the collapse of the Savings and Loans institutions. This would add $115 billion to our deficit projection in fiscal 1992 and $58 billion in 1993. We have, however, made an allowance for increased interest payments on this stock of debt.

We expect the recent recession and subdued growth in 1992 to cause a deterioration in the deficit as tax revenues will be lower and expenditure on unemployment insurance benefit will remain at a high level.

Consequently we are forecasting that the Federal and total Public Sector deficit on a NIPA basis will worsen in 1992 to $231 billion and $204 billion respectively. Renewed trend GDP growth after 1993 should create the conditions for a sustained downward trajectory for the deficit/GDP ratio to around 1 per cent by the end of the decade. Our medium-term projection of substantially lower nominal interest rates compared to the 1980s will expedite the process of deficit reduction by lowering debt interest payments.

Japan

The Bank of Japan has followed a tight monetary policy in recent years in response to inflationary pressures. A discount rate of 2.5 per cent in early 1989 was successively increased to 6-0 per cent by the second half of 1990 and, as money supply growth decelerated, the rate was gradually reduced to 4.5 per cent with the latest V2 per cent cut in December of last year. This recent cut was in response to both decelerating inflation (accompanied by weak monetary growth) and a slowing economy. Although labour market pressures have eased in recent months the underlying rate of inflation is still high by Japanese standards particularly now that import prices are not failing so rapidly in response to a stronger Yen.

GNP growth reached 5.3 per cent in 1990 but decelerated to approximately 4.5 per cent in 1991 as both consumer spending and particularly investment reacted to higher interest rates. Real GNP growth fell successively in the first three quarters of last year with the result that unplanned stockbuilding occurred. Figures for the 4th quarter suggest that housing starts may now be responding to lower interest rates (although they are 20 per cent lower than a year ago) but business investment is still subdued. The outlook for the latter category for 1992 is poor. A MITI survey reveals that for this fiscal year manufacturers expect to reduce investment by 7-5 per cent although some growth is expected in non-manufacturing investment. This recent, and expected future, poor performance in business investment is due to weak demand and poor company profits combined with high interest rates. Furthermore, difficulties with equity financing resulting from both the fall in the stock market in 1991 and new rules concerning banks' reserve ratios will not make raising capital any easier.

Consumers' expenditure in Japan was temporarily boosted by a decrease in foreign travel by Japanese tourists during the Gulf war period. Nevertheless, the weakening of demand and a higher rate of price inflation depressed real incomes and resulted in a slightly smaller rise in consumers' expenditure last year. The fall in the stock market will also have reduced consumers' wealth and this in turn should reduce consumption growth. But inflationary pressures are now easing as the labour market has become weaker. The unemployment rate rose to 2.2 per cent in December of last year and labour shortages decreased. In particular, the ratio of unfilled vacancies to job seekers fell from a peak of 1.47 in March 1991 to 1-30 in December. Although inflation will not benefit so much from lower import prices as in 1991 the general inflationary trend should be downward this year as activity slows and wage increases become more subdued. The introduction of a land tax to dampen land and property prices should also add to this deflationary tendency. Fears of trade policy friction between the US and Japan were renewed as the Japanese current account surplus increased to $77 bn in 1991 from $36 bn in 1990. This is particularly surprising given the fall in demand due to the US recession. However, the surplus with SE Asia and the EEC rose faster than with the US. This is partly explained by the fact that many Japanese multinational companies export to the US via overseas production in the EEC. The trade surplus has benefitted from higher export growth due to strong demand growth in SE Asia slightly offset by weaker demand in the US, but import volume growth has recently turned negative due to the weaker activity in Japan. The invisibles deficit was also slightly lower in 1991 as Japanese tourism abroad was subdued due to the Gulf War.

Table 8 shows our GNP forecast for Japan. We expect GNP to grow by only 2 1/4 per cent this year which is virtually a recession in Japanese terms (by Japanese definitions this means growth below 2 per cent). Most of this slow-down in demand will probably originate from a deceleration in both consumption and business investment. Our global econometric model (NIGEM) now contains net financial wealth as a determinant of consumption. A persistent decline in Japanese equity prices has contributed to falls in real net financial wealth over the past two years. Consequently, a desire on the part of consumers to rebuild wealth stocks underlies much of our projected increase in the savings ratio this year. This is consistent with consumer surveys such as the Nikkel consumption forecast index which recently registered the largest fall since 1980 when the index first began. Business sentiment has also deteriorated and, its combination with falling capacity utilisation, will discourage capital expenditure in industry. We therefore expect business investment to grow at a rate of only 3 per cent this year. In contrast, housing investment has already shown signs of a recovery and will strengthen further during 1992 in response to the recent declines in the cost of borrowing. However, although NIGEM predicts that the Japanese economy responds strongly to an easing of monetary conditions it does take some time for the effects to work through completely. Most of the benefits from the recent loosening of monetary policy are more likely to occur in 1993. We therefore expect an expansion in most expenditure categories, particularly consumption, to push GNP growth towards 3-5 per cent next year.

Until recently the Japanese authorities have conducted a tight fiscal and monetary policy with the objective of dampening underlying inflationary pressure. Plans for a looser fiscal stance in 1992 and the recent easing of monetary conditions suggest that the official view is that inflationary tendencies are now weaker. We believe that this is indeed the case and expect the short, but sharp, slowdown in growth to bring the consumers' expenditure deflator down to a 2 per cent increase this year. Both the strength of the Yen (by suppressing import price growth) and the easing of labour market pressures should be major factors behind this projected fall in inflation. However, further significant reductions in the discount rate are unlikely this year. Renewed GNP growth next year will probably be associated with a small rise in inflation to around 2 1/4 per cent.

Although we foresee Japan's exports growing rapidly in 1992 this is again largely due to strong demand growth in markets such as the Far East rather than the US. In the longer term, we expect Japan's share of world trade to decline. This is partly due to Japanese companies locating production abroad and the growth of intra-European trade as integration within Europe progresses. Similarly, import penetration will increase as the Japanese economy continues to open up. Table 9 shows that in the medium term we are projecting that import volume growth will exceed that of exports. Consequently, we do not see the Japanese surplus as a medium term problem. We are projecting a trend decline in Japan's current account surplus to around 1 per cent of GDP in the latter half of this decade. In the short term, we expect the current account surplus to benefit from subdued domestic demand and probably expand to around $90 bn this year and to show only a marginal reduction in 1993.

Germany

The reunification boom of 1990 in Germany has been followed by a considerable downturn in economic activity in the second half of 1991. Real GNP was still rising strongly in the first quarter of last year but both the second and third quarters witnessed declines and preliminary figures indicate that real GDP only grew by 3-2 per cent in 1991 compared to 4-5 per cent in 1990. Declines in investment and exports were to blame for the initial fall but these have recovered slightly since then. However, the unification' indirect tax of 7-5 per cent implemented in July appears to have triggered the downturn in the third quarter as consumer spending fell by 1-9 per cent.

Industrial production began to fall rapidly in December after previous increases, but capacity utilisation in manufacturing has been declining since the second quarter of 1991 (reaching 86.8 per cent in the fourth quarter of 1991 compared to 90 per cent a year earlier). Although investment in plant and machinery rose ill the third quarter this followed a substantial decline in the second quarter. After rising by 9-3 per cent in 1990, capital expenditure growth will probably decelerate to around 7 per cent in 1991 with a further slowdown in 1992 to around 3 per cent. Total orders (for the whole economy) in November and December were 11 per cent lower than the previous two months. This not only reflected a lower growth of domestic orders but indicated a substantial fall in export orders as recession overseas subdued foreign demand.

In this environment of rapidly declining demand and output the Bundesbank decided to increase the discount rate by 0.5 per cent on 19th December. The discount rate had previously been increased by 1 per cent and 0.5 per cent in August and February 1991 respectively, and a further rise came as a surprise. However, the Bundesbank was well aware that its anti-inflation resolve was under scrutiny given developments in the labour market and the increasing budget deficit. The weakening of the D-Mark and the breaking of the monetary growth target in December and November i.e. 5-7 per cent and 5.1 per cent respectively compared to the already downward revised target of 3-5 per cent) put further pressure on the authorities. Inflation reached 3.5 per cent at the end of 1991, the highest since 1982 and a substantial increase on 2-7 per cent of 1990. In contrast hourly wage rates increases were on a downward path; rising by 7-2 per cent in the summer, 6.9 per cent in October and 6-7 per cent in November. This reflected slower activity and a severe weakening of the labour market. The unemployment rate rose to 7-0 per cent in January 1992 from 6.5 per cent in December 1991. During 1991 the combination of a slowdown in the second half and an influx of East Europeans increased the unemployment rate. Given these factors, and the increased competition for jobs in West Germany from 1/2 million commuting East Germans, it seems that wage growth should continue to decline. However, the recent steelworkers' settlement of 6.4 per cent may provide a benchmark for other groups in more successful industries. Future settlements by public sector workers and others will determine whether the Bundesbank will find it necessary to increase interest rates further.

Reunification resulted in additional costs for the West German government in terms of unemployment and other social benefits. In addition, the cost of the Gulf war has added to the public debt. The original target for the total public sector deficit for 1991 was D-Mark 140 bn. But it is now generally expected to be considerably above this figure, but below the worst projections. Spending has been lower than expected and the strength of demand in West Germany has boosted tax revenues. Also taxes have been increased in 1991 in addition to the July indirect tax increase. Oil and petrol along with other consumer taxes have risen and an increase in unemployment benefit contributions is expected to raise D-Mark 18 bn.

GDP is expected to grow by 10 per cent in East Germany in 1992 after two successive years of decline. The volume of industrial output began growing in September 1991 of last year. But output is at a very low level; in September of last year it was 28 per cent below that of a year earlier. At one stage output had contracted by 40 per cent. Unemployment in East Germany has risen substantially. Low productivity and the removal of subsidies has resulted in the closing down of many firms. July saw a large increase in unemployment as the one year ban on redundancies in the engineering industry ended. However, up to 1/2 a million workers have found jobs in the west. job creation schemes and training programmes also helped alleviate unemployment by around 400,000 at the end of 1991. Consequently, the unemployment rate was roughly 11.8 per cent in December 1991 after peaking at 12-1 per cent in August 1991. The number of employees on shorttime working has also been reduced to just over 1 million at the end of 1991 compared with 2-0 million in April.

Table 10 contains our forecast for German national income. We expect a considerable slowdown in GNP growth this year to around 1 1/4 per cent followed by a sharp recovery in growth to around 3 per cent in 1993. Our projected interest rate profile and the downturn in consumer and producer confidence are the key factors influencing this projected path for GNP. We assume that the Bundesbank is worried about sustained wage inflation and will not reduce interest rates until the third quarter of this year. This also coincides with the expiry of the indirect tax levy. These two factors are likely to restrain consumers' expenditure in the first half of the year, outweighing the expenditure-inducing rise in real disposable income produced by robust wage inflation. We expect a considerable upturn in consumption from the second half of the year driven by falling interest rates.

Business investment growth is expected to slow down to around 2 per cent this year but housing investment will be fairly strong as East Germans who currently commute to work buy homes in the West. A sustained recovery in business investment next year, in response to continued declines in the discount rate and a return to a high level of capacity utilisation, will add to the recovery in 1993.

Table 11 gives our German balance of payments forecast and shows that we expect the German current account to move back into surplus this year. The severity of our projected shock to demand will considerably subdue import volume growth, whereas the output that was temporarily diverted to satisfy domestic demand during the unification boom will return to the overseas market and boost export growth. The invisibles balance will also improve this year as external transfers were temporarily boosted by Gulf War payments in 1991. In the medium term we expect the current balance surplus to increase gradually as a percentage of GDP.

High wage inflation this year will increase government tax revenue considerably in 1992. Combined with the extra indirect tax income, this will offset the increased government outlays on job creation schemes and unemployment benefit and the public sector deficit as a percent of GDP should fall this year. We expect this deficit to dwindle to a sustainable 1 1/2 per cent of GDP by 1995. Our forecast for the public sector is given in table 12.

France

French GDP rose 0.7 per cent in the third quarter of 1991, the same growth rate as in the second quarter and well above the 0.2 per cent rate recorded in the first quarter. Despite signs that an upturn has been under way for some time, however, the official forecast for 1991 has been revised downwards, from 2.8 to 1.4 per cent, mainly reflecting the adverse effects of the Gulf war on foreign trade. The outlook for 1992 is slightly brighter, as most components of GDP are expected to pick up, especially exports. Households' consumption of manufactured products (excluding food) in the last quarter of 1991 was up 0.8 per cent on the previous quarter and the year-on year increase was 0.4 per cent. After strong growth in October, there was a fall in November and December. Total consumption of manufactured goods fell 0.3 per cent in 1991, compared with an increase of 3.4 in 1990 and 4.5 in 1989. Sales of consumer durables also fell in December, but the January survey of retail trade by INSEE shows that non-food sales rose slightly in November/December.

Investment picked up 0.1 per cent in the third quarter of 1991, following a fall of 0.4 per cent in the second and first quarters of the same year and a sharper fall of 1.6 per cent in the last quarter of 1990. The recovery was mainly driven by household investment, which rose by 0.7 per cent in the third quarter, whereas business investment dropped by 0.4 per cent and government investment grew by a sluggish 0.4 per cent compared with 1.8 per cent in the previous quarter. For 1991 as a whole, a 0.9 per cent rise in investment is expected by INSEE. The official government forecast is that business investment will grow at a rate of 3.5 per cent in 1992. Industrial production fell by 0.6 per cent in November, with manufacturing output declining further as a result of a reduction in the production of capital goods and intermediate goods. There are, however, signs of a rebound, especially in construction activity, which should strengthen in the second half of this year.

Capacity utilisation, which had fallen to its lowest level for four years in the third quarter, picked up in the final quarter of 1991 to reach 82.1 per cent. Gains in competitiveness resulting from lower inflation and a weakening of the French Franc on the foreign exchange markets have boosted exports since March 1991. In particular, exports to Germany have increased since unification. The trade account showed a Fr 2.6 billion surplus in the three months to December, as exports rose by 0.3 per cent and imports fell by 4.0 per cent on the previous quarter. As for the current account, the surplus in the same period was Fr 6.9 bn. Price inflation increased by 0.1 per cent in December, down from 0.3 in November and 0.4 in October. The annual rate, which was 2-9 per cent in the last quarter of 1991, is running considerably below the German level. Wage inflation is also slowing down, as unemployment remains high (9-8 per cent in December) and vacancies are still lower than a year ago. The government's commitment to the ERM has resulted in tough anti-inflation policies and high real interest rates. Monetary policy remains tight: the target range for M3 growth, which was 5.7 per cent for 1991, has been lowered to 4.6 per cent for 1992, and the intervention rate of the Bank of France, after a cut in October by 0.25 per cent, was raised by 0.5 in November and then again in December by 0.35 per cent in response to the Bundesbank's decision to raise German official rates by 0.5 per cent. As a result, French short-rates and the three-month Euro-franc deposit rates have increased slightly. The future trend is, however, downward and interest rate spreads over Germany have been virtually eliminated, as foreign investors have confidence in the French government's resolve to pursue policies compatible with the ERM exchange rate constraint.

Fiscal consolidation is still being pursued, even though the 1991 central-government budget deficit is estimated to have reached Fr 100 billion, well above the target of Fr 81 billion. This is partly due to lower tax receipts, as the shifting of a number of products from a lower to a higher VAT rate has only partially offset the lower than expected corporation and income tax receipts which the slackening in activity has caused. The projected deficit for 1992 is Fr 89 billion, with overall spending growing by 3.1 per cent to Fr 1,330 billion, about the same as the forecast rate of inflation for this year. The tax burden is set to remain unchanged, the reduction in the rate of corporation tax being balanced by an Increase from 25 to 34 per cent in the tax on financial capital gains. Some revenue will accrue from the selling to the private sector of a minority stake in some state-controlled companies. The main worry continues to be the deficit on health and social security, set to widen in 1992, and the government is determined to come to grips with it by setting binding limits as well as increasing health-insurance and unemployment contributions. Overall, there is likely to be a slight rise in the ratio of government gross debt to GDP, especially when the top rate of VAT is abolished on the way to harmonising tax systems across Europe.

With inflation and public finances under control, the high rate of unemployment is now the foremost concern. The French government takes the view that supply-side policies are more appropriate to deal with increasing joblessness, because cyclical factors account for only a small percentage of the unemployed. More flexibility in the labour market, re-training schemes and lower taxation to reduce the tax wedge are deemed much more effective methods than a loosening of the fiscal or monetary stance. The latest measures adopted by the government include tax exemptions for firms employing young unqualified people and 18-month subsidised training programmes for youths who have been unemployed for over six months.

We are forecasting that economic growth in 1992 will not be much stronger than in 1991 (see table 13). Activity is expected to pick up only gradually, to approach potential growth not earlier than 1993, when GDP is forecast to grow by 2 1/2 per cent. One important factor accounting for the modest rate of output growth is the persistence of high real interest rates resulting from the commitment to the ERM and the stability of the exchange rate. Despite the increase in credibility, real rates are still above the German ones, and the present weakness of the Franc makes it unlikely that French rates will fall much before the end of the year. The trade balance is not expected to give a strong boost to growth either, as a slightly more buoyant demand starts feeding into imports, and exports do not grow at a brisk pace because of a weakening in the German growth rate. However, some small improvement in the current account balance is forecast for 1992 and 1993. Our forecast for the current account is contained in table 14.

The consumer' expenditure deflator will keep rising at a rate below that of France's European trading partners (we forecast 3-4 per cent for 1992), and unit labour costs will grow only moderately, as high and rising unemployment has its impact on wage claims and the new measures to increase labour demand will take time to come into operation. We expect the unemployment rate to stabilise next year. A reduction in the number of unemployed in the short run will not result from the expected modest growth in industrial production and investment of 1.4 per cent and 1/2 per cent respectively in 1992. The combination of all the factors mentioned above, in particular a weak external demand and subdued investment and real disposable income growth, underlies our projection of only a modest pick-up in the current year.

Italy

The latest available data show that GDP growth in Italy is still sluggish and inflation is not yet fully under control. The year-on year fall in industrial production in October was 2.4 per cent, and in the first ten months of 1991 it equaled 2-3 per cent. The fall was particularly sharp for investment goods (-5.9 per cent) and intermediate goods (-2.4 per cent). In the final quarter of 1991 production was 0.9 per cent below its year-earlier level, although 1.4 per cent above its level in the previous quarter.

Despite the slowdown in activity in 1991, there has been no improvement in Italy's external position. The trade balance showed a deficit of Lit 1,393 billion in October, bringing the total deficit from the beginning of the year to Lit 15,519 billion (Lit 3,000 billion more than in 1990). Imports rose by 4-6 per cent in the same period, while exports grew by 3.1 per cent. The widening external deficit is primarily a consequence of lower exports to the US. More encouragingly, imports to, and exports from, the other EC countries have been growing at the same rate (5 per cent). However, the demand surge associated with German unification might have been expected to have been associated with an improvement in the trade account, and the fact that this has not happened suggests that deteriorating competitiveness is having an effect.

In spite of a deceleration from 6.2 to 6.0 per cent in December, the annual rate of inflation was 6-4 per cent in 1991, slightly up from 1990, and above the official target forth year. In January, the index picked up a little to 6-1 per cent. More marked is the deceleration in producer prices, which by the end of October were growing at an annual rate of 2.1 per cent. Labour cost developments are still a major concern. Despite the slackening in the industrial sector and the fact that the rate of decline of employment has reached 3-2 per cent in October, average earnings rose by 12-8 per cent in the first nine months of the year. No swift action is, however, going to be taken, as the government, employers and unions agreed in December not to tackle the renewal of the 'scala mobile' wage indexation system, due to expire at the end of the current year, until after the next general election. Wage settlements outstripping the rate of inflation partly explain why consumption is the most buoyant component of aggregate demand. The high level of public sector debt held by private households and the interest payments they receive have also contributed to moderating the slowdown in the growth in real personable disposable income and therefore consumption. Fixed investment is still stagnating as business confidence has yet to make a full recovery.

Last December Italy increased the official discount rate from 11.5 per cent to 12 per cent in response to the Bundesbank's decision to tighten its monetary policy. This rise in the cost of borrowing could lead to a further slowdown of the economy and renewed calls for a `final realignment' of the ERM currencies before they are irrevocably locked. The more immediate impact of this measure will be on the projected budget deficit for 1992, which fails to take into account the additional cost of servicing the debt, expected to be approximately Lit 6500 billion, and the lower tax receipts resulting from GDP growth in the current fiscal year likely to be below the 2.3 per cent originally forecast by the government. The budget finally approved alms for a public sector deficit of Lit 128,000 billion, equivalent to 10.5 per cent of GDP. To achieve this target, both spending cuts and new receipts are envisaged. New receipts accruing from privatisation are expected to be of the order of Lit 6000 billion, despite the fact that the necessary legislation has not been included in the budget and has yet to be approved by Parliament. Other measures include a tax amnesty allowing evaders to pay only 15-20 per cent of the unpaid taxes back to 1986, and an increase in income taxes by 1 per cent for incomes above Lit 14 million a year. Recently, there have been some signs that, at long last, Italy is trying to come to grips with some of its longstanding structural problems, which are a serious obstacle to meeting the targets for economic convergence on the way to EMU. Of particular significance is a new law passed in January which officially sanctions the divorce between the Treasury and the Bank of Italy in the setting of the discount rate, giving full independence, in this respect, to the Central Bank which in the past could only give advice to the Treasury who had final responsibility for the interest rate policy. The latter, however, is still entitled to overdrafts with the Central Bank. A stronger will to tackle the budget deficit appears to be behind the concomitant decision to reorganise the Treasury by creating a council of independent advisers on the conduct of fiscal policy. An additional measure adopted to bring Italy in line with its European partners is the abolition of the 30 per cent withholding tax on interest for interbank deposits, with the aim of liberalising capital markets.

As regards fiscal consolidation, however, progress to date has been minimal and Italy's public finance problems continue unabated (the stock of outstanding gross debt has now reached 103 per cent of GDP). Notwithstanding the approval of the EC Commission for this budget, the first they have monitored, it is far from certain that Italy will be able to meet the debt/deficits criteria of the Maastricht treaty. In the short run, the implementation of spending cuts has been made even more difficult by the forthcoming general election, announced for April 5, as a plethora of new spending bills have been rushed through Parliament before its formal dissolution. The outcome of the elections looks highly uncertain, at least by the standards of a political system where electoral swings of 1 or 2 per cent are regarded as a major shake-up. Most analysts expect a further fragmentation of the vote and a decline of the traditional parties, which could mean that electoral support for the present four-party coalition government could fall below the necessary 50 per cent level. In that case, the Republican party, who withdrew from the coalition last year because of disagreements over the conduct of economic policy, would probably be invited to rejoin its former government partners. This is likely to be the last general election to be held under the present political rules, as virtually all parties have put forward proposals for radical reforms which are deemed necessary for Italy to be able to make any further moves towards economic and monetary integration. Presidential elections are also to be held when Cossiga's term in office ends next july.

Our forecast is set out in table 15, and shows only a small improvement in Italy's economic performance in 1992. We expect output growth to be around 2 per cent in the current year, reflecting the weak growth of the last quarter of 1991 and the downward revision in expectations which is apparent from most recent surveys. A rebound is, however, likely in the second half of the year, fueled by stronger demand in world export markets and a pick-up in consumption. Capital spending will remain sluggish, as profit margins are still small due to the fact that wage claims are still buoyant. The rate of price inflation should ease to 4 3/4 per cent this year, but only if wage inflation slows as a result of the introduction of a new indexation system combined with restraint in the public sector. More significant should be the deceleration in producer price rises, though their rate of increase will remain above the German one. As the inflation outlook is relatively unfavourable convergence of interest rates in the short term to German levels will be slow, with short rates declining to around 10 1/2 per cent by the end of 1993.

Canada

Although it seemed that Canada was experiencing a strong recovery when real GDP increased 5.7 per cent in the 2nd quarter of 1991 this was followed by a much smaller 0.9 per cent increase in the following quarter. This faltering recovery was largely due to a small increase of 0.8 per cent in consumer spending compared to 8-0 per cent in the previous quarter. But a continuing decline in business investment also added to the deceleration in growth. A small fall in real personal disposable income accompanied by a slight deterioration in consumer confidence (according to the Conference Board of Canada Index of Consumer Attitudes) accounts for this slowdown in consumer spending. This means that the savings ratio has remained stable for over a year, even though factors which caused a decline in the 1979-81 recession, declining interest rates and lower inflation, have already improved for some time. Furthermore, the net wealth/income ratio has reached a record level which should stimulate spending. However, unemployment has still to recover and may be one factor behind continued poor confidence. More worrying is the continued decline in business investment. Low capacity utilisation makes further investment inappropriate at this stage but profits have recovered somewhat and the outlook for growth is the strongest of the G7. Nevertheless profits are only 50 per cent of the level of a year ago and are largely responsible for the very poor corporate financial position which must be a major factor inhibiting investment. A more optimistic development in the third quarter was the continued strong growth of residential investment.

Exports also added some growth last year but were less strong than was hoped largely because the US, Canada's largest trading partner, was in the midst of recession. Unfortunately, imports surged in the third quarter resulting in the largest current account deficit ever ($28-8 bn at an annual rate). This may signal that the recovery in output is far more considerable than the official figures suggest. Secondly, it indicates that the previous deterioration in Canadian unit labour costs is now affecting the trade deficit. Another factor may be the effects of the Canada-USA free trade agreement which may encourage US multinational corporations to relocate back in the US thus increasing Canadian imports and subduing exports. However, unit labour costs may now be improving as price and wage inflation seem to be moderating. Underlying consumer price inflation is better represented by the three month annualised rate, as it avoids the distortion of the Goods and Sales Tax introduced in january 1991, which only grew by 1 per cent in the three months to November 1991. Private sector wage settlements have been falling for at least a year as wage negotiations respond to poor output expectations and lower expected future inflation. Wage restraint in the public sector has reduced settlements in this sector to around 2 per cent in October. If wage inflation can be contained in the future then international competitiveness may improve.

Our forecast for Canadian GDP and trade is given in Table 16. After falling by almost 1 per cent last year we expect that GDP growth will show a marked recovery to just above 3 per cent this year. Both consumers' expenditure and housing investment should respond to the easing of monetary conditions and provide the major stimulus to growth. But business investment will take longer to recover and will probably remain flat for most of this year and then grow again in 1993. In addition, a further rise in consumption should push GDP growth towards its trend rate of 3.5 to 4 per cent next year and continue into the medium-term. In our short-term forecast, the improved consumption growth is largely due to rising real disposable income as price inflation decelerates. This, in turn, is due in part to the GST falling out of the annual rate calculation, but continued wage moderation is also an important factor. The persistence of an unemployment rate around 10 per cent for this year and next indicates the weakness of the labour market.

Another factor generating future likely improvement in the growth in Canada is the performance of exports. Although partly due to a less rapid deterioration in relative unit labour costs, renewed growth in the US accounts for much of the improvement. Import penetration is high in Canada and may be further increased by the removal of trade restrictions with the US. Given the erosion of overseas net assets due to the cumulative effects of a persistent current account deficit, the balance on IPD will also prevent the trade deficit from improving substantially. Therefore, it is difficult to see a sustained reduction in the Canadian current balance deficit in the short or medium term.