The world economy.

Barrell, Andrew Gurney ; Dulake, Stephen

Prospects for the short term

Our last forecast, which was published in August, was moderately optimistic about prospects for the world economy, and especially for the United States. Since the summer the Yen has risen strongly, the US has begun to look like it is facing a recession, and it is now clear that the united Germany will face a very large Government budget deficit after monetary and political union. Meanwhile prospects for war in the Gulf remain high, and although EC farm ministers have managed to agree amongst themselves about cuts in agricultural subsidies it is not clear that these cuts are large enough either to prevent the GATT round stalling or stop the US erecting trade barriers in retaliation. As a result of all these factors our forecast is hedged around with rather more uncertainties than usual. Table 1 sets out our short-term forecast. We assume that oil prices will peak at $35 pb in the last quarter of 1990, and will then fall to $28 pb by the end of 1991.

There has been a downward revision of almost 2 per cent to our forecast of US growth in 1991, and we are now projecting GNP growth of under 1 per cent. We are also expecting that inflation in the US will peak at around 6 to 6 1/2 per cent next year. Both projections are more optimistic than the average of US commentators.(') Our US forecast is discussed further below, but the reasons for our relative optimism on the US reflect both recent developments in Europe and prospects for European growth. Monetary and political unification in Germany has been followed by a discovery that the budgetary costs of unification are much higher than had been anticipated. The Federal German budget will decline from a surplus in 1989 (and from a previously projected deficit of around a per cent of GNP in 1991) to a deficit of around 5 to 6 per cent of GNP in 1991. This massive increase in the demand for saving, and for extra resources, cannot all be met internally, and we are expecting an increase in German imports in 1991 that is large enough to add to % per cent to world trade. Chart 1 plots past and forecast levels of the current account and budget surplus for the Federal Republic. This unanticipated fiscal stimulus will in the short run raise growth in Europe and the US above what it would otherwise have been.

We are forecasting that growth in Europe will slow despite the impulse given by German demand. Events in Germany have strengthened the D-Mark, and the ERM currencies have risen with it. We have previously argued that the appreciation of the D-Mark has followed from the realisation that unification, with its attendant increase in the supply of labour, will reduce real wages and would improve German competitiveness if the exchange rate did not rise. This argument does not apply to either France or Italy, and they will in the short run lose competitiveness and as a result growth will slow a little. In our forecast this is compounded in the medium term by a rise in real interest rates in Germany. The opening up of the East will raise the real return to capital, and hence raise the real rate of interest. With integrated capital markets the rise in real rates will spread throughout Europe. Chart 2 plots past and forecast real interest rates in Europe. (2) in Germany this rise is the result of a rise in the demand for capital, and as a result capital will flow in (or less will flow out). The concomitant effect of the reduction of capital outflows from Germany is that the supply of capital is reduced in the rest of Europe, and the rise in the real rate of interest will in the medium term be accompanied by a further slowing of growth. However, in the longer term we expect that the expansion effects that will flow from developments in the East will offset the deleterious effects of higher real interest rates.

For some time we have been more optimistic then other commentators about the prospects for Japanese growth. It now begins to look as if growth in 1990 will exceed even our optimistic projection. Business investment has remained strong, and trade performance improved as a result of the sharp depreciation of the Yen that took place during the first half of the year. However, Japanese inflation has also been rising, and interest rates in Japan have followed. The exchange rate has also risen by around 20 per cent since its nadir in May. The combination of a sharp appreciation and a rise in interest rates is likely to slow the Japanese economy down.

The appreciation of the Yen and the European currencies implies a depreciation of the Dollar, and the resulting gain in competitiveness, along with the European led increase in world demand, gives strong external support for the US. We are projecting that domestic demand will fall into 1991, but will rise thereafter. Our US forecast is more dependent upon our oil price assumption than is that for any of the other major economies. The US has both more energy intensive output and consumption and has freer energy markets than have any of the other advanced economies. As a result a rise in oil prices will, we believe, add more to US prices than it does elsewhere. We presume that the rise in inflation next year will, as long as a recession is not imminent, lead to a slight rise in interest rates. This is counter to recent developments which have been influenced by the successful conclusion of the budget deal. (There has also been a divergence between commercial and Government long rates, with the former rising whilst the latter have fallen. This may reflect fears of recession which have increased the risk premium on commercial bonds.) As a result we are projecting that growth will be below capacity for several years. Part of this lower growth is driven by the recently agreed budget package. However, the budget agreement has not caused us to revise our forecast because we have been assuming a package of this scale (and this structure) for some time now.

The world economy reached a cyclical peak during 1989, and capacity utilisation in the major economies reached a peak towards the end of the year. Output growth had exceeded that of capacity for three years, and by 1989/90 the level of output was probably close to capacity. The utilisation rates plotted in chart 3 reached their highest level for a decade. The consequent downturn in the rate of growth of output was accompanied by a tightening of monetary policy throughout the advanced world. However we feel that the subsequent cycle in output is likely to be more damped than those we have observed in the recent past. Chart 4 plots past and forecast output growth and inflation in the major seven. The forecast cycle is damped partly because we believe that the process of deregulation, especially in credit markets, that we have observed in the last decade has reduced the amplitude of fluctuations in consumption that accompany a cycle. Unrationed and cheaper borrowing allows consumers to iron out their consumption pattern and this will reduce the value of the multiplier and hence the amplitude of the business cycle.

Cycles are not only the result of endogenous dynamics, they often result from shocks. We argue below that the oil price shock we have recently observed is both smaller and less likely to be sustained than were those in 1974 and 1979. Meanwhile the unification of Germany and the opening up of the East are a countervailing positive shock of some magnitude. It should help offset the deflationary impact of any slowdown in the US.

The prospects for world trade growth in the medium term depends in part upon the successful conclusion of the Gatt round. We are forecasting that total world trade will grow by around 6 1/2 to 7 per cent a year at the end of the decade after a period of rather sluggish growth in the early 1990s. The upturn in the world economy in the second half of the 1980s led to world trade growth of around 10 per cent in 1988. Growth has decelerated since then as the world economy appears to have passed its cyclical peak. We are expecting total world trade growth to slow down further into 1991. This slowdown is largely the result of our projection of slower demand growth in the US and also in much of Europe. However budgetary developments in Germany will help sustain intraEuropean trade, and we expect world trade in manufactured goods among the OECD economies to grow more rapidly than total world trade. This differential growth also reflects the effects on total trade of the embargo on Iraqi imports. We have assumed that this will be in place for most of 1991.

Oil markets and commodity prices

The greatest uncertainty in our forecast lies in the short-term prospects for oil prices. We do not think that the longer-term prospects for oil prices have been radically changed by recent developments. There has been a chronic oversupply of oil to world markets for most of the last five years, and prices have been weak. This is in part because the demand for oil in the advanced world has hardly grown for the last decade. With such weak demand the prospects for the survival of the OPEC cartel were clearly low, and its collapse in 1985 led to a fall in oil prices. As in all cartels, there is always a temptation for members to free ride and produce above quota. The Iraqi invasion of Kuwait has reduced the number of sources of supply in the short term, but does not appear to change long-run prospeCtS(3).

There are other factors affecting the long-term prospects that also point to lower prices than we are currently observing. The growing pressure for more conservation in the West is likely to put further downward pressure on the oil intensity of output and hence on oil prices. The increase in US energy taxes is likely to reduce US consumption, and initial estimates suggest that this tax alone could reduce world oil prices by $1 to $2 pb. Also developments in the East will eventually put downward pressure on free market oil prices although they may in the short term help raise prices. From January the USSR will sell oil to the rest of the old Comecon at market prices. This will cause a quadrupling of prices from the equivalent of $7 pb. This in combination with intense environmental pressure should cause the economies of central Europe to increase considerably their energy efficiency. In the short term Russian oil exports are projected to drop by a third as supply difficulties associated with the collapse of the economy reduce output. However we would expect that in the longer term a combination of greater energy efficiency and higher output will allow a substantial increase in Russian output and hence exports and this will put further downward pressure on oil prices.

In the short term there are also considerable pressures that should moderate prices. The loss of output from Kuwait and Iraq is around 4 1/2 million barrels per day and this is around 8 per cent of total world demand. However in September Saudi output was 2 million barrels per day above its level in the first half of the year, and other OPEC members such as Libya, Iran, Nigeria and especially Venezuela had between them raised output by one 1 million barrels per day. Given that growth in the world economy is slowing and that most analysts believed output in the first half of the year was probably 2 million barrels per day above sustainable demand there is little reason to believe that there is a significant shortage of supply in the market. This could explain why there has been little pressure to release strategic stockpiles.

Given that there is no reason to believe that oil market conditions have changed, and that in the short-term supply is adequate, the current level of oil prices probably reflects the markets' perception of the probability of war and its effects on output. In a forward looking commodity market where stocks predominate, the expected rate of change in prices should reflect both the forgone interest on the revenues from unsold stocks, and the expected rate of change in marginal cost. Marginal costs of oil production are generally low, especially in the Middle East. However, if there were a destructive war then the short-run marginal costs of replacing lost Saudi output would be high. Large output expansions in the North Sea and elsewhere could only be justified at a considerably higher price than we currently observe, and this prospect is buoying up current prices. Our central forecast does not involve a destructive war, and we are projecting prices to fall slowly to $28 pb by the end of 1991 and to $22 pb by the end of 1992. (Chart 5 gives past and projected real oil prices). In the August 1990 Review we published some simulations of the effects of a higher oil price, and we refer the reader to them for an analysis of the effects of an alternative path for oil prices.

The current oil crisis differs from the last two in a number of ways. The most significant is the behaviour of non oil commodity prices. In 1974 commodity prices rose before oil prices, and acted as a good leading indicator of world inflation. Chart 6 plots institute indices for recent developments amongst the main commodity groupings on our model. Metal prices rose sharply at the end of 1988 as strong unanticipated demand further reduced stocks that had already been reduced as metals prices fell during a period of high real interest rates in the 1980s. However since mid 1989 metals prices have been failing as new capacity has become available. There has been little reaction from metals markets to higher oil prices. Aluminum prices have risen, in part because smelting the ore from bauxite is very energy intensive, but also because Kuwait is itself a major smelter and supplier. However recent increases in stock have been associated with rapid falls in aluminium prices. As is clear from chart 7 we are expecting real metals prices to continue to decline as improvements in extraction technology continue to proceed at a pace fast enough to offset the effects of real interest rates.

Table 2 contains the details of our commodity price forecasts. Chart 7 also contains our forecasts for real free market food prices over the longer term. The recent agreement between European Community farm ministers should, we feel, be seen as the first stage in a lengthy process of negotiations. We have assumed that the GATT round will be successfully concluded and that agricultural subsidies in Europe and the US will be significantly reduced, as will Japanese trade barriers. As a result we expect that over-production will decline and fewer surpluses will be dumped on world markets, and hence real agricultural prices on the free market will rise.

The reduction of food surpluses in the first world will have a number of implications for the third world. Higher grain prices and less dumping of 'food aid' on countries such as Egypt should allow them to re-establish themselves as grain producers. This in turn should allow a reduction in the production of cash crops such as cotton, tea and coffee as higher grain prices attract marginal land away from these areas. We are projecting that all free market prices for agricultural products rise by the end of the decade in real terms back to the levels they achieved in 1980. The only exception may be for sugar and hence for LDC food stuffs. Sugar prices have been very weak recently and demand conditions do not look favourable in the long run.

There are two potential risks in this forecast of agricultural prices, and they may have serious implications for the whole of world trade. First, if the European Community's current rather minimal subsidy cuts are not changed from a subsidy reduction of 30 per cent between 1987 and 1997(4) then the US and the Cairns group of agricultural producers may block the next GATT round settlement. There is a risk, albeit a small one, that obstinacy over agricultural reform and the building of a potential fortress Europe with the 1992 programme may lead to American retaliation and the establishment of trading blocks with considerable barriers between them. World free market food prices would remain low as a result. The second risk to our forecast for real agricultural prices also depends upon the actions of the European Community.

The Eastern European countries have for some time been net food importers. This does not reflect their historical comparative advantage but rather the distorted patterns of food prices. Very low meat prices have led to meat consumption levels in for instance Russia and Poland well above those seen in the west of Europe. These levels of consumption along with relatively inefficient production has necessitated large scale grain imports to feed cattle and pigs. The move to free market prices, along with reforms to the economic system may lead to both higher food output and reductions in the resource intensive consumption of meat. This should turn the countries of central Europe into food exporters once again. if the European community maintains its barriers against them then their increased output will put downward pressure on world free market prices. The countries of central Europe have been badly affected by the drought this summer. This has had little effect on food prices in part because European losses have been absorbed in reductions in stockpiles. Unlike the US drought of 1988 there has been little effect on world markets, and only pigmeat prices have risen. Exchange rates and interest rates Exchange rates have been quite volatile over the last ten months. The Yen depreciated by 10 per cent up until early May, and has appreciated by almost 20 per cent since then. The D-Mark has appreciated during the year, and the Franc and the Lira have risen with it. Chart 8 plots recent exchange-rate developments.

These major changes in exchange rates seem to have been hardly influenced by interest-rate changes. Table 4 sets out past interest rates along with our forecast and chart 9 plots recent weekly data. Rates have recently risen in both Japan and Germany, but only fractionally in both cases. In Germany in particular the adjustment that took place in early November was largely technical, and closed a 'round tripping' loophole. The rise in both German and Japanese rates reflects worries about potential inflation. Chart 10 plots recent and prospective inflationary developments. The source of the inflationary fears is in both cases related to the strength of domestic demand, and in the case of Germany these fears are compounded by serious worries about the budgetary position of the public sector. Inflation worries in these countries have been reflected in rising long-term rates on Government debt, whilst in the US, long rates on similar assets have dropped very slightly. Chart 11 plots representative long rates, including that for US corporate debt, where rates have risen relative to those on Government debt. We expect that budgetary worries in Germany and inflation fears in the US will lead to some further tightening of monetary conditions and a rise in real interest rates in these two countries over the next year.

The decision of the UK to join the ERM has given extra impetus to discussions on Stage Two of the process of monetary integration. The Rome Summit set a date for the start of Stage Two, but wisely did not say in detail what it would involve. The completion of Stage One requires that all EC countries join the ERM with narrow bands, and that the single market programme is well advanced. Stage Two will involve the setting up of some form of European monetary institution (5) and an agreement to begin the closer coordination of monetary policies. It may also involve a move to even narrower bands for exchange rates. The inter governmental conference in December will decide the details. Stage Three will involve the 'irrevocable' fixing of exchange rates, and perhaps a much more widely available common currency, and it may even involve the introduction of a single currency. (6)

The process of monetary integration in Europe has been under way for some time. The Netherlands and Austria have had basically fixed parities against the D-Mark for nine years (7), and the interest differential has declined to under half a per cent in both cases. This 'risk premium' will reflect both the risk of revaluation and also portfolio preferences. The Belgians decided to commit themselves to an 'irrevocable' D-Mark parity in the middle of 1990, and as a result the interest differential against Germany fell from 2 per cent to around a half. However credible the commitment to the D-Mark it is clear from recent discussions of the need for an incomes policy in Belgium that there is a need for some structural changes in the labour market. Otherwise the costs of a fixed parity may be high.

Our exchange-rate forecasts are given in table 5. We are assuming that the pattern of exchange rates will continue to depend upon the pattern of interest differentials, and therefore the Yen will continue to appreciate against the Dollar. The pressures for European monetary integration are building up, and we are assuming in this forecast that France joins the D-Mark block in the first quarter of 1994 at an exchange rate at the bottom end of its current band. The current inflationary problems besetting the UK and Italy lead us to believe that European monetary integration will proceed in two stages, with these countries, along with Spain joining a monetary union in the first quarter of 1997. This union is only likely to be feasible if some of the excess inflation in Italy and the UK is offset by realignments of their central rates. The number of realignments will depend upon the date at which the UK moves to narrower bands, but we believe that both countries will have to depreciate by more than 6 per cent before they can enter a union. The formation of a union should remove most risk premia, but we believe that Italian and UK interest rates will settle slightly above those in France and the D-Mark block, reflecting both the slightly higher risk associated with these currencies and also the portfolio preferences of institutions.

The combination of a strong Yen and the continued appreciation of the D-Mark block against the Dollar should gradually remove the large current account imbalances that have been observed over the last decade. Chart 12 plots past and forecast values of these imbalances. However developments in Germany have accelerated this process somewhat. We are projecting a higher budget deficit and hence a decline in the current account surplus. We are also now assuming that the price level in Germany in 1999 will be higher than it would otherwise have been despite a tightening of the fiscal stance from 1992 and afterwards, and despite higher real rates of interest. We have revised up our forecast of German inflation in the short term. This clearly helps the other members of the potential monetary union because it will raise the German real exchange rate and lower that of other members, making it easier for them to enter the union with a sustainable current balance.

The United States

The past 3 months have been a period of turmoil for the United States economy. The rise in the price of oil combined with a poor set of economic indicators fuel fears that the economy is going into recession. At the same time the President and Congress have struggled to find a way of tackling the US Federal deficit. The budget has now been agreed for fiscal 1991, but as the official projections for future years continue to be based on extremely optimistic assumptions, the issue cannot be considered to have been satisfactorily resolved. Fears of recession have led to an easing of monetary policy, signalled by reductions in the Federal Funds interest rate of a quarter of a percentage point in July, and at the end of October. Between the end of April and the end of July the trade-weighted exchange-rate fell 4.8 per cent, and by the end of October had fallen a further 6.9 per cent. In the latter 3 months there was a 6.2 per cent depreciation against the D-Mark and a 14.9 per cent depreciation against the Yen.

Our forecast for US GNP is shown in table 5. Data are available for the first 3 quarters of 1990, and hence we can be reasonably confident that GNP growth for 1990 will be around 1 per cent. This is markedly lower than the 2.5 per cent growth of GNP achieved in 1989, which was itself much lower than the 4.5 per cent achieved in 1988. This deceleration in the rate of growth can be attributed primarily to slower growth in domestic demand, and especially in consumers' expenditure.

The quarterly figures for GNP growth in 1990 have given conflicting signals as to whether the US will enter a recession. in the first quarter of the year real GNP rose by 1.7 per cent at an annual rate, in the second quarter 0.4 per cent, and in the third quarter by 1.8 per cent. The poor second quarter figure was associated with low growth in consumer spending (0.2 per cent seasonally adjusted annual rate), and the recovery in the third quarter can also be largely attributed to consumer spending which increased to 3.6 per cent growth (saar). Taken together the figures for the second and third quarters give GNP growth of 1 per cent and consumers' expenditure growth of 1.9 per cent. These rates of growth are low, but do not signify recession.

Survey evidence provides some support for those who fear that a recession is nonetheless imminent. The University of Michigan's index of consumer sentiment fell 13.4 per cent in August, while the Conference Board's index of consumer attitudes fell 16.7 percent. Weaker consumer expectations account for part of the 1.2 per cent fall in the Department of Commerce's leading indicators index in August. There was also a sharp fall in the National Association of Purchasing Managers' index in September, which reached its lowest level since December 1982. These surveys were generally conducted soon after the invasion of Kuwait. They therefore have the advantage that they encapsulate revised expectations following the escalation of the Gulf crisis, although we suspect that in the immediate aftermath of the invasion expectations of the deflationary impact on the US economy may have been exaggerated.

The rise in oil prices following the Gulf crisis has of course raised our forecast for inflation in the United States in both 1990 and 1991. The prospects for higher inflation have also been strengthened by the depreciation of the Dollar in the last 6 months. Slower growth in the US economy should however alleviate domestically generated inflation. Recent developments in the labour market appear to confirm this. Unemployment in August stood at 5.6 per cent of the civilian labour force, up from 5.2 per cent in June. Our forecast of low growth means that unemployment is likely to rise further in the year ahead. This should generate downward pressure on wage settlements.

Whilst the decline in the Dollar provides an unwelcome boost to inflation, it should also provide a stimulus to the United States economy through its effects on net exports. In the last 6 months the Dollar has depreciated by around 10 per cent against most European currencies and around 20 per cent against the Japanese Yen. The increase in competitiveness that this entails should result in strong export growth in 1991. The growth in imports will be comparatively muted, both because of the gain in competitiveness and the forecast of sluggish growth in domestic demand.

The deficit on the current account of the balance of payments was $43.5 billion in the first half of 1990, down from $54.0 billion in the second half of 1989. Most of this reduction can be attributed to a reduction in the deficit on trade in goods, which fell from $56.3 billion to $48.2 billion. The rise in the oil price is likely to lead to a rise in both trade and current account deficits in the second half of this year and in 1991. Table 6 shows our forecast for the US current account deficit. In 1991 the deterioration on the oil account will be partially offset by an improvement in the non-oil balance that arises from the competitiveness improvements associated with a lower exchange rate. As the oil price comes down the deterioration on the oil account is reversed, leading to a renewed contraction of the current account deficit.

Our forecast of the public sector budget deficit is shown in table 7. Slower growth in the United States economy has meant that the federal deficit for fiscal 1990 (which ended in September) increased to $220 billion from $153 billion in fiscal 1989. The projected deficit for calender 1990 is around $250 billion, but this includes the first large scale allowance for Savings and Loans losses. The losses taken on board increase the National Debt, but should be treated as capital account items when considering the national income accounts. Table 7 includes deficits on both bases. Overall the authorities will have to take responsibilities for loans worth $500 billion. However not all of these are completely bad, and we are projecting that the net cost will be $75 billion in calender 1990 and 1991 and $50 billion in 1992. Assets sales should recoup the rest. (8) We have allowed these losses to feed into our forecast of government interest payments and hence they ultimately do affect the deficit on a national income basis.

Slower economic growth, has affected the longer-term prospects for the budget, and the deterioration will only be partly offset by the recent budget agreement. The budget for fiscal 1991 includes a series of measures that reduce the projected deficit from $294 billion to $254 billion. These measures include an increase in the top marginal rate of income tax from 28 per cent to 31 per cent; an increase in the excise tax on petrol from 9 cents to 14 cents a gallon; increases in taxes on beer, cigarettes and wine; a luxury tax of 10 per cent on aircraft, boats, cars, furs and jewellery; federal entitlement programmes cut by 2.5 per cent over 5 years; and tighter controls on overspending. The Gramm-Rudman targets have been revised, and made more flexible. The new targets exclude a number of items: the costs of the Savings and Loan rescue and bank deposit insurance; the surplus on the social security funds and the costs of the Desert Shield operation in the Middle East. The targets have also been made more flexible, in that they can be revised if for example growth turns out to be lower than expected. This may well turn out to be the case. The budget assumes GNP growth of 1.3 per cent in 1991, 3.8 per cent in 1992 and 4.1 per cent in 1993. Our own forecast suggests this profile is optimistic.

US monetary policy is currently caught between opposing pressures. There is a pressure to reduce interest rates in order to sustain economic growth, and the pressure to maintain or perhaps even increase interest rates in order to maintain downward pressure on inflation. The reductions in the Federal funds rate at the end of October and in mid-November appear to have been a concession to the administration for reaching a budget settlement, and was interpreted by some as a sign that the Fed had weakened its anti-inflationary stance. We suspect that this is a misinterpretation, and that it is therefore unlikely that further interest-rate cuts will be forthcoming in the near future. The judgement is based on our central forecast in which recession is avoided and inflation is well over 5 per cent in 1991. There is also upward pressure on US interest rates both from the withdrawal of funds that has followed from the decline in the Tokyo stockmarket and also from the increased demand for capital that is likely to be observed in Germany as a result of unification.

Japan

The Japanese economy has grown strongly in 1990, despite the turmoil that has afflicted its stockmarket and the volatility of the Yen. In the first half of the year GNP was 6.7 per cent higher than a year before, and it now appears likely that GNP growth for the year as a whole will exceed 6 per cent for the first time since 1973. The strong growth has been driven by domestic demand, especially business investment, which looks set to record growth in excess of 10 per cent for the third consecutive year.

In spite of this strong economic performance the Japanese stockmarket has continued to fall (see Chart 13). in the first half of the year, most of this fall could be attributed to correction of an apparent misalignment between Japanese and foreign stockmarkets which appeared to develop in the second half of the 1980s. More recently however the fall appears to reflect uncertainty over the immediate prospects for the Japanese economy, especially whilst the Gulf crisis remains unresolved. Japan is especially dependent on oil supplies from the Middle East, and hence especially vulnerable to any major disruption of oil markets. The stockmarket fall itself has also imparted additional uncertainty over immediate prospects for the economy since it reflects a major loss of wealth that is likely to lead to lower domestic spending. As it was generally accepted that the Japanese stockmarket was overvalued we do not feel that the effects of the fall on consumption will be great. Uncertainty has been further fueled by the effect of price falls in both the stockmarket and the property market on the Japanese banking system (see Box 2).

Japanese exporters and importers have had to contend with continued instability in the value of the Yen. During the course of 1989 the Yen depreciated 13.6 per cent. By the end of April 1990 there had been a further depreciation of 10.5 percent. However since August the Yen has appreciated strongly: by the end of October it was 17.1 per cent higher than at the end of April. in both the May and August issues of the Review we expressed the view that the Yen had depreciated too much, although we did not fully anticipate the strength of its recovery. The strong appreciation since August has occurred in spite of the rise in oil prices, which would generally be expected to cause the Yen to depreciate (see, for example, the oil price simulations reported in Annex 1 of the World Economy Chapter in our August Review). However this tendency was swamped both by the re-evaluation of the Yen's long-term prospects, and aided by the increase in Japanese interest rates at the end of August.

The tightening of monetary policy had already been included in our August forecast. The factors behind it were the apparent strength of the Japanese economy, combined with the inflationary impulses imparted by the weak Yen and the rise in oil prices. Evidence of high domestically generated inflationary pressures can be found in labour market statistics. Seasonally adjusted unemployment stood at 2.2 per cent of the labour force in September, and the ratio of vacancies to job seekers stood at 1.43, only fractionally less than the June figure of 1.47 which was the highest for 16 years. in July industrial wages were 6.4 per cent higher than a year previously, up from 4.6 per cent in 1989.

Our forecast for Japan is presented in table 8. We expect that strong growth in investment will result in domestic demand growth of 6.2 per cent this year, and that the weakness of the Yen in the early part of the year will result in net exports adding 0.2 percentage points to GNP growth.

The tightening of monetary policy that has occurred this year will result in much lower growth of domestic demand next year. The growth-rate of consumers' expenditure is forecast to slow from 3.9 per cent to 2.6 per cent and the growth-rate of business investment from 14.6 per cent to 5.8 per cent. However net exports should still be benefiting from the depreciation of the Yen in 1989 and 1990. in spite of its appreciation in the second half of 1990, the Yen is still expected to be at a lower level in 1991 than it was in 1989.

We expect that the rate of inflation will increase from 3.2 per cent in 1990 to 4.5 per cent in 1991. This is due to a combination of factors: strong growth in average earnings caused by the labour market operating at close to full capacity, higher oil prices, and the effects of higher import prices associated with a lower level of the Yen. The last of these factors has already been partially reversed, and the other two factors are expected to reverse during the course of 1991, as the Japanese economy grows more slowly, and as oil prices start to fall. We therefore expect that the rate of inflation will fall in 1992 to around 3 per cent.

An important element in our forecast is our assumption for Japanese interest rates. We have assumed that interest rates will remain at around their current level until the middle of next year. By then we expect that both the growth-rate of GNP and the rate of inflation will have begun to decline, enabling the authorities to reduce interest rates.

Germany

1990 has been a momentous year in the history of Germany. Following the breach of the Berlin Wall in November 1989, events have moved rapidly to encompass economic and monetary union in July and full political union in October. On December 2nd, the new Germany will elect its first Government. That Government will have to face the consequences of the events of 1990. The most pressing of these consequences will be the need to regenerate the economy of the Eastern Lander and the need to address the financial implications of unification.

The speed with which unification took place, together with the unprecedented nature of the exercise of integrating a planned economy with a highly developed market economy has meant that some of the consequences of unification are only just becoming apparent. Prior to monetary union it was difficult to forecast how much of the economy of the Eastern Lander might be viable when exposed to Western competition. Prior to unification the full costs of the undertaking were still not fully apparent. It is almost certainly still too soon to assess such costs. The chairman of the Treuhand agency, which is supervising the privatisation of East German companies, believes that the process will take some years.

While the process of unification presents some problems it also provides tremendous opportunities. Already in 1990 the economy of the former Federal Republic has benefited from the stimulus provided by increased demand for its products from the former GDR. This has enabled GNP growth to remain high at a time when growth in the US and in other European economies has started to turn down. We expect that GNP growth in 1990 will exceed 3.5 per cent for the third consecutive year.

Consumers' expenditure has grown especially strongly this year, propelled firstly by the tax cuts implemented in January, and secondly by the spending of East Germans. In the first half of the year East Germans still had to travel to the West to buy Western goods, but in the second half of the year Western goods have become available in the Eastern part of the country as a consequence of economic and political union. As national accounts statistics have not yet been made available for the unified country our forecast remains one of prospects for the Western Lander. The initial stimulus to consumers' expenditure is expected to recede in 1991 both because many Western products will now be sold in the East and because unemployment and short-time working have risen dramatically in the Eastern Lander, leading to lower purchasing power for many East Germans.

Investment expenditure is also expected to benefit from unification, as there is ample scope for improving the quality of the East German capital stock, and a need for increased capacity to supply the demand of the expanded German market. In addition it should not be forgotten that the implementation of the European Community's 1992 programme for a single European market is also likely to stimulate investment.

We expect housing investment will grow strongly in the early 1990s as a consequence of the increased demand resulting from migration into Western Germany. Business investment should also benefit, although the size of the stimulus will depend on how rapidly the economy of the East picks up. The immediate consequence of economic and political union has been to cause a 'shake-out' of uncompetitive enterprises in the eastern Lander. This process may well continue for another year, but should give way to a recovery as the process of restructuring the Eastern economy gathers momentum.

Unemployment in Eastern Germany rose to 540,000 in October, with a further 1.8 million on short-time working. Further increases are expected in the months ahead as the process of 'shake-out' continues. The rise in Eastern unemployment has brought an increase in the prospective German budget deficit. It is now estimated that the budget deficit will be around D-Mark 1 00 billion in 1990 and D-Mark 150 billion in 1991. This rise in the deficit has alarmed the Bundesbank, who have warned that it will be necessary to tighten monetary policy unless the new German parliament increases taxes to reduce the prospective budget deficits. At the end of October the Bundesbank backed up its warning by increasing the Lombard interest rate from 8.0 per cent to 8.5 per cent. While this was described as a largely technical change, it was almost certainly intended as a signal that the Bundesbank is prepared to be tough if the politicians fail to address the budget problem.

This raises the question of whether the budget deficits really are a serious problem for Germany. We feel that the deficits themselves could be easily financed, both from domestic and international sources, since German Government debt is a safe asset, and the burden of debt is not great. However the Government deficit represents an injection of demand into the German economy. Although this extra purchasing power is being directed at the East, much of it is likely to be spent in the West, at least in the short term. The Western Lander therefore face a likely increase in demand at a time when they are already close to full capacity. The IFO survey reported capacity utilisation of 89.4 per cent in June, close to the 90.0 per cent peak recorded in December 1989.

A substantial increase in demand at this time is likely to generate further inflationary pressure, which is the Bundesbank's chief concern. However part of the extra demand will be met by increased imports, resulting in a reduction in the current account surplus. This provides a safety valve for some of the inflationary pressure that high budget deficits will generate, although we suspect that increased imports would not absorb enough of the extra demand to prevent an upturn in German inflation. We therefore expect that the 1991 budget will include tax increases, and on this expectation we have assumed that there will be no further increase in German interest rates. We are anticipating that indirect taxes will rise by 3 per cent in 1992, and that this will add over 1 per cent to the price level in that year. However if the budget fails to raise taxes we would expect that interest rates will rise further next year.

Details of our forecast for GNP and the balance of payments are presented in tables 10 and 11 and table 12 presents our forecast of the Germany public sector. This latter forecast is discussed further in a box. GNP growth this year is expected to be close to 4 per cent, but to decline to 3.2 per cent next year. In spite of the decline this represents a fourth year of strong growth with attendant inflationary pressures. We anticipate that the stimulus of unification will keep GNP growth at around 3 per cent per annum throughout the early 1990s. However the inflationary impetus should be alleviated by the absorption of excess labour supply in the Eastern Lander. it is estimated that around 100,000 people already commute from east to west, and it is expected that this will rise to 400,000 by the middle of next year.

Table 11 shows that the current account surplus is expected to decline from 4.6 per cent of GNP in 1989 to 1.7 per cent in 1992. This reflects the fact that increased German demand will be met both by higher imports and by the diversion of German production from exports to domestic markets, and also the fact that some of the funding of German restructuring will come from foreign investors, thus reducing the capital outflow from Germany that arose in the late 1980s.

France

Real GDP grew by 0.7 per cent at an annual rate in the second quarter of 1990, lower than the 2.5 per cent recorded in the first quarter, and significantly lower than the 2.9 per cent experienced in the fourth quarter of 1989. Growth in the second quarter decelerated in response to the slower growth of consumers' and public expenditure as well as falls in investment and exports. The slowing of economic growth has resulted in a slight easing of capacity constraints on French industry. Capacity utilisation fell back to 85.7 per cent in the third quarter of 1990 from its record high of 86.3 per cent in the second quarter. Industrial production in August remained unchanged from its record level in July but was 2.4 per cent higher than a year ago.

Unemployment rose in September after having fallen in July and August. The jobless total increased by 1 1, 1 00 to 2.5 million in September. Overall though, the unemployment rate remained unchanged in September at 8.9 per cent, and the jobless total was 1.3 percentage points lower than that recorded a year earlier. Consumer prices rose by 0.5 per cent in September, less than the 0.6 per cent gain posted in August. Higher oil prices, as a result of events in the Gulf, have been the main reason for the increase in consumer prices over the past two months. Stripping out the effects of the Gulf crisis, consumer prices would have risen only 0.2 per cent in August and by only 0.1 per cent in September. The annual inflation rate stood at 3.8 per cent in September, its highest level since January 1986.

On November 1 st the Bank of France lowered its main money market rates by a quarter of a percentage point, taking the central bank's intervention rate to 9.25 per cent and its repurchase rate to 1 0.0 per cent. The Bank of France justified its decision in terms of the firmness of the Franc and favourable monetary conditions. For some weeks the Franc has stood above its central parity against the D-Mark in the exchange rate mechanism of the EMS. M2, the measure of the money supply targeted by the authorities, fell by 0.2 per cent in the year to August. The cut in official money market rates was the second development in monetary policy in as many weeks. From October 16th the Bank of France lowered its compulsory reserve levels, in response to which commercial banks cut their base rates by 15 basis points to 10.35 per cent.

Our forecast for the French economy is set out in tables 13 and 14. In 1990 we are forecasting that the growth of the French economy will slow further to 2.3 per cent. We expect domestic demand to grow by 2.6 per cent during 1990 as the lagged effects of the monetary tightening enacted through 1989 bear down on economic activity. Private investment is projected to grow by only 2.7 per cent in 1990 as compared to 5.8 per cent in 1989. Net exports are forecast to reduce the growth of real GDP by 0.3 percentage points in 1990 after contributing positively to growth in 1989 for the first time since 1984. Export volumes however are expected to remain strong, despite the appreciation of the Franc, reflecting the strength of demand in the German economy. inflation is projected at 3.6 per cent in 1990. The cyclical downturn is forecast to persist into 1991. Output growth is expected to be no higher in 1991 than in 1990. However, inflation is expected to rise further during 1991 as the effects of higher oil prices continue to be felt.

Italy

The short-term outlook for the Italian economy is principally influenced by two factors. These are the likely course of the world economy and the policy stance of the Italian authorities. Elsewhere in this Review we have argued that the world economy is entering a cyclical downturn from the peak achieved during 1989, although the European economy will be supported by the stimulus that German reunification will provide. Italian monetary policy was tightened throughout 1989, although the decision to incorporate the Lira within the narrow bands of the exchange-rate mechanism led to the monetary authorities cutting the discount rate by 1 percentage point in January 1990. Recently the Italian Government introduced a fiscal programme aimed at reducing the budget deficit. We are assuming that fiscal policy will tighten further during the 1990s. The deficit is currently around 1 0 per cent of GDP and this will be difficult to sustain during the transition to Monetary Union in Europe. However, it is possible that the economic slowdown that we are projecting in Italy might, at least in the short term hinder progress in the process of budget deficit reduction.

Our forecast for the Italian economy is set out in table 15. Real GDP is forecast to grow by 2.1 per cent through 1990 as compared to 3.2 per cent in 1989 and 4.2 per cent in 1988. Domestic demand is expected to weaken further during 1990 reflecting the slower growth of consumers' expenditure and investment. Net exports, reflecting the unfavourable external environment, are projected to reduce the growth of real GDP by 0.6 percentage points in 1990. The economy is expected to deteriorate further in 1991. Real GDP is forecast to grow by only 1.6 per cent next year.

The economic slowdown is expected to have only a marginal effect on inflation. Inflation, as measured by the consumers' expenditure deflator, is projected to be 5.8 per cent through 1990 and 1991. However, recent developments in the Italian labour market suggest that there may be considerable risks attached to our inflation forecast. In June industrial employers formally withdrew from the 'Scala Mobile' wage indexation agreement in response to unions' demands for wage rises of over 40 per cent over 3 years and their refusal to negotiate a new wage bargaining system. In July, against the background of a threatened 1-day general strike, the Government, employers and unions signed an agreement to continue wage indexation until end 1991. Whilst these developments engender a risk to our forecast in the short to medium-term, we believe that membership of exchange-rate mechanism will serve to discipline the actions of wage bargainers in the long run. (The institutional structure of the Italian labour market is discussed in more detail in this Review in a Note on European wage and price systems).

The current account of the balance of payments is projected to improve during 1990 as a result of an improvement in invisibles which more than offsets a deterioration in the visible balance. However, the current account is expected to move further into deficit next year reflecting a significant deterioration in visible trade as the terms of trade worsen. The growth of import volumes picks up in 1991 whilst the growth of export volumes is in decline. The growth of trade volumes in 1991 is the result of an unravelling of the J-curve induced by the appreciation of the Lira this year.

Canada

High interest rates, a high exchange-rate, especially against the US Dollar, and declining demand in the US economy have combined to give low Canadian growth in 1990. Indeed GDP actually fell in the second quarter of the year, as a consequence of falls in both consumers expenditure and investment expenditure. GNP growth in 1990 will be the lowest since the recession of 1982.

High interest rates were aimed at bringing down the rate of inflation which rose from 4.0 per cent in 1988 to 4.7 per cent in 1989. An attempt to reduce interest rates in January caused the exchange rate to depreciate almost 4 per cent in a fortnight and had to be rapidly reversed. The Canadian discount rate stood at 12.3 per cent at the end of January, and had risen to 13.9 per cent at the end of May. This represented a differential of over 5.5 percentage points against short-term rates in the United States and led to a continuing appreciation against the US Dollar. By the end of August the Canadian Dollar had reached a 12 year high of US $ 0.886.

The high interest-rate strategy appears to have been successful in arresting the increase in inflation. Consumer price inflation peaked at 5.5 per cent in January and February and fell to 4.1 per cent in August. However industrial production in May was 2.2 per cent below its level of a year before, and unemployment rose from 7.1 per cent in March to 8.3 per cent in August. Such indications of the poor performance of the real economy in 1990 have led to a reduction in interest rates. By the end of October the discount-rate had fallen to 12.7 per cent. This has reduced the interest-rate differential against United States short-term rates, and contributed to a depreciation against the United States Dollar to US $0.86 in October.

Our forecast for Canada is presented in table 16. In spite of the easing of monetary policy and depreciation against the United States Dollar, we expect that there will be slow growth in GDP in both 1990 and 1991. The reductions in interest rates should enable a gradual recovery in consumers' expenditure and investment, but the benefits of depreciation against the US Dollar will be reduced by the low growth of economic activity within the United States.

Low demand growth should ensure that downward pressure on inflation is maintained. However the introduction of the goods and services tax on the 1 st January 1991 will raise the consumer price level by around 1'/4 per cent. The deficit on the current account of the balance of payments is expected to worsen from 2.9 per cent of GDP in 1990 to 3.4 per cent in 1991 as the recovery in Canadian demand precedes that in the United States. In the longer term we expect the Canadian Dollar to depreciate against the US Dollar, and this should allow the deficit to fall as a proportion of GDP.

NOTES

(1) All forecasters have revised down their projections for the U.S.A. number of forecasts are given below.

(2) The divergence of real interest rates is not inconsistent with our assumption that the ERM hardens and becomes a monetary union. Nominal interest rates have to converge, but the relative price of goods may still change. This implies that inflation rates may differ, albeit it only slightly, between regions, and hence real interest rates will also differ slightly. We are of course assuming that the speed of arbitrage for nominal rates and for goods exceeds that of capital. We also observe that the supply of capital for investment is not infinitely elastic.

(3) This statement has to be qualified by the remote possibility that the Saudi Arabian Government is overthrown by Iraqi sympathisers.

(4) Over half of the cuts have already been implemented.

(5) This may be based around the Committee of European Central Bankers at the BIS which has already begun to appoint a secretariat. They are also about to produce a draft constitution for a European Central Bank.

(6) There is, of course, no such thing as irrevocably fixed exchange rates. The monetary union between the United Kingdom and Eire survived for some decades after the abolition of a common central bank, but eventually the authorities in Eire decided to withdraw from the monetary as well as the political union.

(7) The Dutch did realign slightly in 1983. See table 1 in the note on the EMS in this Review.

(8) Losses on this scale cannot all be the result of lending on poor security, and some must be the result of large scale intentional fraud.

(9) The growth of GDP in the old Federal Republic will exceed that of GNP. The increase in cross border commuting will mean that some domestic product is paid as factor income to residents outside the old Federal Republic. The potential 400,000 commuters could put an extra wedge of 1/2 per cent between GDP and GNP in 1991. This effect will only disappear when the national accounts of the two Germanies are unified.

GEM

THE NATIONAL INSTITUTE'S

GLOBAL ECONOMETRIC MODEL

GEM is a 640 equation macroeconomic model covering the whole of the world economy, but focusing particularly on the seven major industrial countries. The National Institute publishes the current version of GEM together with a user-friendly, menu-driven operating package designed to enable economists to produce their own forecasts and simulations.

Background

GEM is used by the National Institute to produce forecasts and analyse events and policy options in the world economy. It was developed from a model maintained by HM Treasury to produce internal world forecasts. in the last two years it has established itself as one of the leading half dozen world econometric models, participating (as the only UK based model) in comparative exercises organised by the US Federal Reserve and the Brookings Institution in Washington. It has been used in academic studies of international policy co-operation, and research and development of it is financed by the Economic and Social Research Council. The institute has already provided the model to the Bank of England, HM Treasury and the World Bank for use in their published forecasts.

Scope and coverage

GEM is divided into sixteen sectors. Each of the G7 country sectors contains around 60 variables covering individual components of demand, price indices, exchange rates and interest rates, trade and the current account. Much smaller sectors exist for Belgium, Netherlands and the rest of OECD. The remaining six sectors cover OPEC, Asia, Latin America, Africa, the Centrally Planned Economies and Miscellaneous developing countries. These sectors contain equations for trade volumes and prices, which depend on five commodity price indices.

The model package

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

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

Hardware requirements

The package requires a 80386 based PC, such as the IBM P/S2 Model 70 or 80, with a minimum of 2 megabytes of memory (although we recommend 4 megabytes). A maths co-processor (80387) is also recommended. The computer should also have at least 20 megabytes of hard disk and a VGA graphics board.

The annual subscription is [Br pound]4,500 plus VAT with a reduced rate of [Br pound]500 for academic users. This rate will increase to [Br pound]5,000 from January 1991 tor non-academic users.

BOX 1. ECONOMIC TRANSITION IN EASTERN EUROPE

The collapse of communism in the states of Eastern Europe has brought in new Governments that aim to disband the centrally planned economic system and replace it with a market system. This has been widely welcomed in East and West alike, and has brought predictions that these economies will be able to attain growth rates in the region of 1 0 per cent per annum in the second half of the decade. However, the prospects for growth depends in part on their ability to attract capital from the West, and this can only be achieved either with a high rate of return to capital or with a Marshall Aid Plan' support system. We do not doubt the long-run potential of these economies, but would caution against premature euphoria. The transition to a market system will inevitably involve considerable instability in the near term. As subsidies are removed prices will rise. As consumers are given greater choice many existing producers will find their products have no market, leading to high unemployment. Both phenomena are already apparent in Poland and in the former state of East Germany. In East Germany the consequences are mitigated by generous social security provisions and the possibility of finding employment in Western Germany. in addition it is likely that Government and private investment will enable a relatively rapid realisation of Eastern Germany's growth potential. None of these factors exist for the remaining independent states. High unemployment and high inflation are the ingredients of political unrest. It would therefore be foolish to assume that the desired transition of these states to Western-style democracies and economies is an inevitable collary of the events of 1990.

The problems faced by these countries are easily illustrated, since they are already emerging. Poland embarked on the first phase of its transition programme at the beginning of 1990. The removal of subsidies, and devaluation of the Zloty caused consumer prices to more than double between December 1989 and February 1990. Wages were permitted to increase by only 20 per cent of the change in prices. The real money supply was also cut by 50 per cent. The combination of these policies prevented an escalation into hyper-inflation, and helped bring inflation down to 5 per cent per month (34 per cent per annum) by September 1990. The second phase of the programme started in the middle of the year. Indexation was raised to 0.6, and trade was liberalised further. Signs of an acceleration in inflation began to emerge in late summer and in the Autumn monetary and fiscal policy were tightened. The devaluation of the currency has been effective in increasing trade with the West, especially in traditional heavy industries. However, GDP probably fell 15 per cent in the first half of the year. The liberalisation programme has also produced a large reduction in industrial production, which fell 27 per cent between the fourth quarter of 1989 and the second quarter of 1990. Similar problems are emerging in Hungary, where inflation is predicted to increase from 30 per cent this year to 40 per cent next year. GNP is expected to fall by 5 per cent both this year and next. The Hungarians have benefited from having had a comparatively large market sector in agriculture, and through adopting a less drastic liberalisation programme, which should help to spread the costs of adjustment. However, the Hungarians are more dependent on cheap imports of oil than are the Poles. The move to free market energy prices in January 1990 will therefore have a larger impact on the import bill than in Poland. Despite this there appears to be some reluctance to depreciate the exchange rate. The country's problems have been exacerbated by a severe drought in the summer of 1990, and the longer term prospects are dependent to a large extent on the removal of agricultural import barriers in Western Europe.

Czechoslovakia has come late to the process of liberalisation, and has been proceeding slowly partly because it is clear from the Polish example that the process of liberalisation can involve major costs. In particular there is considerable worry that a dash for market orientated growth combined with a devaluation will not only boost inflation but will also slow the process of structural adjustment. Because of the level of past investment the country's main comparative advantage lies in heavy industry. if this is allowed to blossom, as in Poland, the associated pollution problems would become worse. However, a 50 per cent devaluation is being contemplated for January when price controls are to be removed, and it is possible the Czechs may follow the Polish path. If they do then Czech economists are generally predicting that growth prospects will not improve until the late 1990s. The prospects of economic collapse in USSR is also pushing these economies toward the West. The USSR was their largest single market, and the degree of disjunction in the economy is now considerable making continued trade very difficult. Enterprises have not yet found ways to cope with the collapse of central planning and central Government. All the evidence points to a drop in output this winter on the scale experienced by Poland a year ago. As this reduction in output is not associated with intentional and planned institutional change then the chances for a rapid recovery seem to be small. The prospects for the economy in the USSR look bleak indeed.

Further disruption will occur next year as the current trading system between the states of Eastern Europe and the USSR is changed. To date the system has been centrally planned with trade taking place in 'Convertible Roubles' at planned prices. As f rom the 1 st January 1991 trade will take place in US Dollars at market prices. One consequence is that the East European states will no longer receive Soviet oil at subsidised prices. A second consequence is that whereas previously there was a planned demand for example for Hungarian buses from other members of the Eastern bloc, exporters will now have to compete on world markets. A third problem with the break-up of the planned trading system is confusion as to where responsibility for trade deals now lies. A severe disruption to trade will accelerate the difficulties these economies are already experiencing. The implication for the West of developments in the East are, in the short run at least, rather limited. The old Eastern bloc contributed only 3.5 per cent to trade in the rest of the world. Even if their imports and their exports doubled over ten years then simulations on our world model, GEM, suggest that total world trade would rise by only 5 per cent. This would have little effect on either world growth or on the world price level. In the longer term developments in the East, which has a large pool of educated and underutilised labour may lead to changes in the patterns of trade and relative prices.

While the short-term outlook for these economies is poor, the medium-term prospects are more hopeful. Their agricultural sectors may be able to weather the transition relatively rapidly. The development of tourism will enable them to earn Western currency. The services sector has the advantage of low labour costs relative to the West. The future of manufacturing and industrial enterprises is likely to be more troubled. The existing industrial base is likely to require capital investment in order to become internationally competitive. One advantage is that labour costs are lower than in Western Europe, but the quality of product is also generally inferior: The Eastern Europeans are therefore most likely to find themselves in competition with the newly industrialising countries of Asia. Here their geographical proximity to Western markets will assist them in countering the headstart of their competitors. As experience in the newly industrialising countries has shown, success tends to breed success, as purchasing power within the economy is increased, leading to increased investment and increased demand for local goods and services. The difficulties lie in reaching the point of take-off. The future is potentially far more prosperous than the past, but in the interim there will be considerable hardship. In this interim period it may at times be tempting to try to retrace steps or find alternative paths. This temptation will be greatest if the Governments of the West are seen to be indifferent to the plight of their neighbours.

BOX 2. THE JAPANESE BANKING SYSTEM

The collapse of the Tokyo stockmarket has caused some commentators to raise the spectre of a Japanese banking crisis and its potential spread to world financial markets. On 1 st October the Tokyo stockmarket was some 48 per cent below the record highs achieved at the end of 1989. Chart 13 plots the real value of the index. As a result of these falls the profits of banks and securities firms are likely to be markedly lower in 1990. Banks' profits will suffer as a result of losses sustained on their securities portfolios, whilst lower profits for securities firms will be the product of low trading volume, in turn reducing broking commissions, and falls in underwriting fees as firms postpone and/or cancel new issues planned on the assumption of an endless bull market.

The stockmarket's fall has bitten into the equity value of Japanese banks. A company's equity or net worth is the difference between the value of its assets and the value of its liabilities. A bank's equity therefore is the difference between the value of its loans and other investments and the value of its deposits. At the end of 1989 holdings of securities accounted for 21.5 per cent of the assets of all Japanese banks. Of these securities holdings almost 25 per cent are accounted for by stocks and shares. Therefore up to 5 cent of the assets of all Japanese banks are affected by movements in the Tokyo stockmarket and their equity could have declined by up to 2/2 per cent of their total deposits. As the Tokyo stockmarket has declined so too has the equity value of Japanese banks, in turn increasing both the leverage (the ratio of deposits to equity capital) and the probability of bankruptcy of Japanese banks. Under new rules introduced by the Bank for International Settlements (BIS) which are aimed at strengthening the stability of the international banking system all banks must raise their capital-adequacy ratio (the ratio of equity capital to total assets) to 8 per cent by 1993. in addition to introducing a minimum statutory capital-adequacy ratio the BIS proposals involve a common definition of bank capital. Under the new guidelines bank assets are weighted according to their perceived riskiness. For example, cash is considered riskless and carries a zero weight whilst claims on the private sector and claims on banks and central governments outside of the OECD carry a I 00 per cent risk weighting. By the end of this year interim international guidelines set by the BIS come into effect at which time all banks must have a capital-adequacy ratio of 7.25 per cent. The stockmarket fall will have pushed Japanese banks well below this level during 1990. Recently Japanese banks have been turning towards subordinated debt in order to bolster their capital base.

Japanese banks have also been trying to reduce their overseas assets, reflected in the fact that the Japanese were net sellers of US securities in the first half of 1990. The collapse of the Tokyo stockmarket has forced Japanese banks and other financial institutions to sell their overseas assets in order to achieve their desired portfolio composition. The repatriation of Japanese capital from overseas has been associated with a weakening of the Dollar and a resurgence in the fortunes of the Yen. Whilst there are other factors causing the dollar to be weak and strong economic fundamentals and interest-rate differentials are the cause of the strength of the Yen, the effects of the repatriation of Japanese capital cannot be completely discounted. The repatriation of Japanese capital will have tended to exert a degree of upward pressure on US long-term government bond yields and will have tended to depress yields on Japanese long-term government bonds. it is interesting to note that Japanese government bond yields have been failing recently, though this may also reflect the Bank of Japan's move to a more credible anti-inflationary monetary stance and a downward revision of inflationary expectations.

The decline of the Tokyo stockmarket might have a more fundamental impact through its effect on the cost of capital. The cost of equity finance of investment projects has almost doubled in the last year. if Japanese banks are forced to cut their lending then Japanese firms might have to place greater emphasis on retained earnings in order to finance planned capital expenditures. Potentially this could restrict the growth of Japanese industrial capacity at a time when domestic demand is relatively buoyant. On the international front if Japanese banks reduce their lending then industry overseas may suffer, particularly at a time when the world economy is entering a cyclical downturn and when firms might be more vulnerable to a reduction in international liquidity with their cash flow being squeezed. Other dangers exist for the Japanese banking system. The large issues of bonds with equity warrants attached during the 1980s, at the time perceived as a cheap source of capital, may mean that Japanese borrowers, and especially banks, might have to repay bonds that they assumed that they would never have to. This perception on the part of Japanese issuers may have caused them to overborrow. The collapse of the Tokyo stockmarket has meant that the exercise price of equity warrants may now stand above the prevailing market price. in such circumstances warrant-holders will not exercise their right to buy and issuers do not receive a cash payment that may be used finance repayments to bond-holders. The rise in interest rates over the last year coupled with a property market slump might also pose problems because property prices in Tokyo do appear to have stopped rising, and a slowing economy may cause them to fall. A fall in property values may lead to an increasing number of non-performing loans which may further worsen the position of Japanese banks.

NOTES

Appendix 1: Annex to Bank for International Settlements, international Convergence of Capital Measurement and Capital Standards, Basle, July 1988.

BOX 3. THE GERMAN PUBLIC SECTOR FORECAST

The scale of potential public sector deficits was not clear at the inception of Economic and Monetary Union in Germany on 1st July 1990. The major reason for the uncertainty was the lack of any clear idea about the prospects for industry in the GDR. By the end of August industrial output in the East had halved. Unemployment had risen from almost zero in January to over half a million in October. By early October 40 percent of East German chemical plants had been closed down. The car industry has effectively disappeared, and by the end of the year it is anticipated that East Germans will have bought 100,000 new cars and 600,000 second hand cars from the West.

The collapse in output and employment has cut government revenues in the East considerably, but this has not been the major cause of the increase in the projected budget deficit for Germany. Transfers to households in the East are expected to rise by at least DM50 billion between 1989 and 1991, and those to firms are projected to rise by a further DM20 billion. When this is combined with rising interest on the stock of debt and a large scale investment programme in the East it is projected that government expenditure in the East will rise by DM100 billion between 1989 and 1991 whilst revenues are not likely to rise above their 1989 level. Most of this shortfall is to be made up by transfers from the West, and the rest will come from debt issued by the Eastern Lander and local authorities, and this will count as debt of the consolidated German public sector.

Not all of the increase in expenditure will take place in the East. At monetary union the West German authorities had to take responsibility from almost DM100 billion of Eastern debt, much of which is bad. The authorities also had to convert DM30 billion of Eastern bank assets at one to one in order to ensure that the Eastern banks remained solvent. The increase in public sector debt has raised interest payments by at least DM 3 billion a year. There are also expected to be at least DM15 billion of extra transfers to persons from the Western government. These are mainly to new immigrants in the West, but some reflect new liabilities in the East.

When we constructed our last forecast in August we had taken on board many of the changes in the German public sector accounts. The assumptions we made, along with other changes to German data, such as the consolidation of the balance of payments accounts of the two Germanies, were discussed in a box in the World Economy chapter. We were then projecting a public sector deficit in 1991 of only per cent of GNP. We are now projecting a deficit of 5.5 per cent of GNP. We do not feel that this will be politically acceptable, and we are assuming a rise in taxes in early 1992. We assume that the budget deficit will be reduced to 3 per cent of GNP by 1994 and around one per cent by the end of the decade. In the short term we are assuming that the savings ratio in the West will rise as a result of this budgetary shock. Transfers to the East on the scale we are envisaging will make consumers in the West permanently poorer then they had expected to be. If they are at all forward looking this will affect their perception of their future incomes and hence cause them to lower consumption now. This argument is independent of the method of finance of the deficit. Even if the Government finances the transfer by issuing bonds forward looking consumers will realise that the interest payments on the debt involve them in a future tax liability. We have adjusted down our forecast of consumers' expenditure by around half a per cent to reflect the fact that the transfers to the East will involve consumers in the West in a cumulative resource cost equivalent to 10 per cent of current GNP. The rest of the financing of the transfer to the East will in the short run have to come from lower levels of overseas investment and a lower current account surplus.

NOTE

See H. Siebert, The Economic Integration of Germany - an update Kiel Discussion Paper 160a.