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The UK economy.

Section I. Recent Developments and Summary of the Forecast

Last year again proved a disappointing one for the UK economy with GDP declining by around 3/4 per cent, although activity does appear to have stabilised over the course of the year with some continuing weakness in domestic demand in the fourth quarter being offset by more favourable trading conditions in export markets. Since our last forecast in November little has happened to change our view as to how the economy will develop over the coming months. Domestic activity should be buttressed by the recent relaxation in monetary policy, allowing a moderate export-led recovery to get underway. However, conflicting signals as to the state of the economy may appear for some while since it is to be expected that the full impact of the recent reductions in interest rates will take some time to materialise.

The preliminary trade statistics for the fourth quarter suggest that the depreciation of sterling since mid-September has had a faster impact on the economy than many commentators had expected, with an improvement in net export volumes being accompanied by a substantial rise in import prices. As a result the visible trade deficit widened to |pounds~4.3 billion in the fourth quarter from |pounds~3.2 billion in the third, and further deteriorations can be expected in the coming months.

On a balance of payments basis, the price of imported goods rose by 9 per cent in the fourth quarter, a rise which, if maintained this year, can be expected to put upward pressure on domestic wages and prices, although in the short term the impact may be muted by the weak trading conditions that many firms presently face. Recent movements in import and industrial input prices--a good leading indicator of future inflationary trends--are shown in Chart 1. Over the year to the fourth quarter of 1992 the rate of increase in prices is less marked, with many import prices having fallen in the early part of the year at a time when the dollar was weak.

Export volumes rose by some 1 1/2 per cent in the fourth quarter, with export performance being particularly strong in the manufacturing sector, where sales rose by 5 per cent. As yet, the higher level of export sales does not appear to have generated any notable response in production, suggesting that much of the higher level of demand has initially been met from existing stocks. With capacity utilisation in manufacturing presently some 18 per cent below the peak reached in 1988 and sterling having depreciated further in recent weeks, we continue to expect that exports will grow strongly over the coming months.

The main uncertainty concerns the extent to which the slowdown in continental Europe will affect export demand, with around 56 per cent of UK exports currently going to EC markets. The forecast discussed in the World Economy chapter implies that trade volumes in the main export markets of the UK will rise by around 3 3/4 per cent this year, some 1 per cent lower than we projected last November. However, in the short term this may be offset by a greater improvement in price competitiveness than we had previously expected following the further depreciation of sterling in the early weeks of 1993. The relative price of UK manufacturing exports may fall by 10 per cent in 1993 (on a calendar year basis), and it is likely that the volume growth resulting from this relative price effect will be quite considerable, particularly as the gradual erosion of trade impediments in world markets can be expected to have raised the price sensitivity of export demand. Overall, we expect the volume of exported goods and services to rise by around 6 1/2 per cent this year.

Recent trends in trade volumes are shown in Chart 2, with the rise in import volumes in the early part of last year being partially reversed in the fourth quarter, when volumes fell by 1 1/2 per cent. Imports of goods were still some 5 per cent above their level at the end of 1991 even though total final expenditure may only have risen by some 3/4 per cent over the same period. Such a rise in import penetration is unusual at this stage of the economic cycle and may reflect the difficulties faced by many domestic producers in competing with foreign suppliers at the previous level of the real exchange rate, with the sterling price of imported manufactures having fallen by 2 1/2 per cent over the year to the third quarter of 1992.

The latest round of business surveys suggest that companies are beginning to benefit from the lower level of sterling and the reductions in interest rates, with sentiment returning to the levels of last spring in the aftermath of the general election. Whilst survey evidence always needs to be interpreted with caution, particularly since misleading signals were given in both the autumn of 1991 and last summer, the strong level of manufacturing exports in the fourth quarter does suggest that there is more to the recovery in confidence than a simple hope that better times must lie ahead. The improvement in expectations of new orders in the latest CBI Industrial Trends Survey is more marked than in previous surveys, with firms presently being more optimistic than at any time since early-1989.

It appears that the widespread uncertainty over the future objectives of economic policy prevalent last autumn was the main factor behind the decline in confidence reported at that time. Whilst the macroeconomic policy of the government still remains in confusion, it seems clear, both from the Autumn Statement and the recent reduction in interest rates to 6 per cent in the immediate aftermath of the publication of the unexpectedly poor unemployment figures for December, that the short-term priority of the government is to ensure that recovery finally gets underway.

Overall, the company sector has responded quickly to the recession, with cutbacks in investment expenditures and a gradual decline in stockholdings and employment levels helping to ease financial constraints. Chart 3 illustrates that the company sector financial deficit--a component of the CSO longer leading cyclical indicator--has gradually been reduced over the course of the recession from a peak deficit of 5.4 per cent of GDP in the third quarter of 1989 to some 0.15 per cent in the third quarter of last year. However many companies, particularly small businesses, are still under considerable pressure, with interest spreads having widened to cover the perceived risk of default and the latest CBI Survey indicating that an inability to raise external finance remains something of a problem for those companies with under 200 employees.

In the short term, the outlook is brightest for those companies who conduct a significant proportion of their business abroad, whether by means of export or through foreign subsidiaries. Outside Europe prospects appear good with a continued recovery expected in the States. Whilst the North American market only accounts for some 12 per cent of British exports, nearly half of UK foreign direct investments are located there. Our latest forecast suggests that earnings from foreign direct investments could rise by some 14 per cent this year.

The earlier false dawn in business optimism led to renewed pressure on unit costs in the second half of last year, with new pay settlements averaging around 4 per cent and the level of redundancies accelerating once again, with unemployment rising by 61,000 in December. It appears that the slower rate of increase in unemployment in the early part of 1992 largely reflected the temporary suspension of employment cuts in the belief that the economy was about to pick up. Overtime working in the manufacturing sector in October was at a lower level than at any time since the recession began.

The renewed rise in unemployment, along with a sizable fall in house prices in the fourth quarter of last year (leaving average prices some 7 3/4 per cent below the levels of a year earlier), has led to continued restraint in consumers' expenditure. Whilst expenditure has begun to recover since the early part of last year, with retail sales rising by 1.3 per cent over the year to the fourth quarter 1992, the higher level of expenditure has largely been financed out of disposable incomes rather than by borrowing. Indeed the level of savings has continued to rise, with the personal sector savings ratio, shown in Chart 4, having reached a new peak of 12.3 per cent in the third quarter of 1992. Our forecast implies a gentle decline in the savings ratio over the coming months.

It seems probable that expectations about future income have been considerably revised during the course of the recession, leading to a higher level of precautionary savings in order to provide a guard against the perceived risk of future volatility in employment incomes. The regional incidence of the rise in unemployment in the present recession differs markedly from that of the early-1980s, with a high proportion of job losses concentrated in the South. To the extent that households in this region have both higher outstanding debts and a higher propensity to consume than households elsewhere, it is possible that the impact on income expectations of the rise in unemployment has been somewhat greater than would be implied by the actual level of unemployment itself.

Policy Assumptions

Since our previous forecast sterling has again come under renewed pressure in the foreign exchange markets and(at the time of writing) is presently trading at a level some 15 1/2 per cent below the average level of the effective rate in August of last year.

The renewed weakness in the exchange rate primarily reflects the absence of a clear and consistent framework for monetary policy, with foreign exchange markets increasingly uncertain as to the future course of interest rates. In part this reflects the fact that the operational judgments on interest rates are made with reference to a wide range of indicators, allowing the authorities a large degree of discretion. However the government has also created the impression that it is not particularly concerned, at least in the short term, with the officially stated target for underlying inflation. With the present priority being to ensure that recovery gets underway (suggesting that the range of indicators influencing monetary policy is even more extensive than that officially stated), any reductions in interest rates beyond those anticipated in financial markets are likely to result in further sterling depreciation and greater inflationary pressures once the economy begins to emerge from recession.

Concerns about future inflation are reflected in both longer-term interest rates and the spread between those rates and the rates on indexed-linked gilts. The latter presently stands at 5 percentage points, close to the rate of inflation shown in our medium-term projections below in Table 12. In spite of the four point reduction in short-term rates since the suspension of sterling from the ERM, long-term rates have moved little, with the yield on benchmark UK government bonds remaining around 1 1/4 per cent above that on the equivalent German bonds. In December the government raised some |pounds~0.8 billion from sales of 8-9 per cent long-term (10-year plus) bonds. If the authorities wish to provide a stronger signal of their concern about future levels of inflation, then it might prove more appropriate to attempt to sell a higher level of index-linked stock, rather than bonds that will prove costly to finance if inflation is indeed held at the officially stated long-term target of 2 per cent.

We continue to base our interest-rate projections, both in the UK and abroad, on the present term structure in the forward markets, with the forecast path for the exchange rate derived using an uncovered interest parity assumption. Details on interest and exchange rates are given in Table 10 and Chart 5. We expect a further decline in domestic interest rates in the middle of this year before rates begin to rise at the end of the year once recovery is under way. To the extent that our forecasts for growth and inflation are above the current consensus expectation for the UK this year, it is possible that the turnaround in interest rates will be faster than we allow in the present forecast.

In the short term we expect sterling to depreciate further against the dollar as short-term US rates remain some 2 per cent below those in the UK. In contrast there may be a small appreciation of the pound against the main European currencies after the first quarter, as German interest rates may not reach UK levels until the early part of next year. Taken together these projections imply that the sterling effective rate may remain little changed from its present level. In the medium term the present differentials in long rates imply that sterling may depreciate by around 1 1/4-1 1/2 per cent per annum.

The financial position of the public sector has continued to deteriorate sharply in recent months, with recent borrowing on a scale far greater than most commentators anticipated at the time of the 1992 Budget. On present projections the PSBR in 1992/3 should be around |pounds~37 billion (6 1/4 per cent of GDP) and |pounds~43 1/2 billion in 1993/4. Much of the deterioration is due to the continuing recession, with unemployment some 500,000 higher than projected at the time of the Budget and tax revenues weakened by the repayment of corporation tax receipts (due to carry-back provisions for current trading losses) and the effects of depressed demand for durable goods.

Although projections for the PSBR in the medium term increasingly suggest that some form of fiscal tightening may be required in order to ensure that the ratio of outstanding public sector debt to GDP begins to stabilise, we do not expect any net tax changes in the March Budget in addition to those already announced in the Autumn Statement (with higher motoring duties recouping the revenue lost by the abolition of car tax). Continuing uncertainty over the health of the economy is likely to mean that any fiscal retrenchment will await clear signs that the recovery is firmly based.

Tax changes are therefore likely to be introduced in the December Budget this year. We have assumed that an additional |pounds~3 billion of revenue (around 1/2 per cent of money GDP) will be raised in 1994/5. On our medium-term projections this serves to reduce borrowing to 3 per cent of GDP (in line with the Maastricht criteria) by 1997/8. There are obviously a number of possible means of raising additional revenue; the most frequently mentioned is an extension of the VAT base to some goods and services that are currently zero rated for tax purposes. Whilst this option could raise a considerable amount of revenue, it would undoubtedly put additional upward pressure on the price level at a time when import price changes are feeding through and the public sector pay squeeze is beginning to unwind. It is more likely that the Budget judgment will attempt to be price neutral, if not demand neutral. Thus we have assumed that additional revenue will be raised through a combination of higher excise duties, employers' National Insurance Contributions and the freezing of personal sector income tax allowances during 1994/5, with some |pound~1 billion being raised from each measure.

The level of public expenditure in our forecast over the next three financial years differs little from that projected in the Autumn Statement, with a higher level of expenditure on current grants (resulting from both higher inflation and unemployment) accounting for much of the contingency reserve allocated to future expenditure. The higher level of inflation we project implies that the pressures on the volume of expenditure may prove more severe than the government presently expects.

In the short term, the level of public expenditure is likely to be constrained by the decision to impose a public sector incomes policy, with pay settlements for public sector workers restricted to 1 1/2 per cent for a year. With settlements held to this level we anticipate that the total pay bill will rise by around 3 per cent, with some groups of workers benefiting from the second stages of previously agreed pay deals and some from incremental progression. It is likely to be some time before the full effects of the pay squeeze emerge as some groups of public sector workers, such as firefighters, received pay rises of 5 per cent in the fourth quarter of 1992.

Prospects for the public finances in the medium term depend crucially on both the level of activity in the economy and the extent to which the government is able to maintain control over expenditure. In the Autumn Statement the Treasury showed money GDP growing by around 6 per cent a year in the medium term. The rate of growth in our forecast is somewhat faster, reflecting the extent to which a higher level of inflation offsets a lower level of real growth. In such circumstances, for given expenditure, tax revenue must be higher and borrowing lower. Details of the medium term profile of the PSBR are given in Table 12 below and in Box 1.

Summary of the Forecast

Recent developments within the economy have been much as we anticipated in November and therefore we have made little change to the forecasts for 1993, with growth still projected to be 2 per cent on a calendar year basis. (We now use 'average' GDP rather than the output measure.) Activity both this year and next will be supported by the recent changes in monetary policy along with the temporary package of fiscal measures introduced in the Autumn Statement, with the full effects of the recent cut in interest rates unlikely to emerge until well into next year.

Domestic demand has picked up slowly since the middle of 1991, and by the third quarter of last year was some 0.6 per cent higher than a year earlier. However this had failed to translate into output due to a marked rise in import penetration in the early months of 1992. Preliminary data for the fourth quarter suggest that an improvement in the net trade position may have added some 0.9 per cent to GDP in the quarter, although some of the overall impact on activity could well have been offset by the use of existing stocks to meet export demand. With both retail sales and car registration figures indicating that consumers' expenditure also rose in the fourth quarter, it seems likely that there may have been a small rise in GDP, although it is unlikely that there was any substantial pick-up in on-shore activity.

Over the coming year activity is likely to be supported by a small rise in all categories of expenditure as financial constraints on the private sector begin to ease. Activity in the corporate sector is likely to be boosted by both the lower level of real interest rates and the enhanced level of first year capital allowances announced in the Autumn Statement. The measure of the real cost of investment finance used in the Institute model is projected to be at a lower level in 1993/4 than at any time since the mid-1970s, averaging just over 1 1/2 per cent. The overall user cost of capital in the manufacturing sector, taking account of tax structures and depreciation as well as the real rate of return required by lenders, is projected to average a little over 8 per cent in 1993, some 5 percentage points lower than at the onset of the recession in 1990.

The cost of stockholding is also likely to fall, helping to ease the pressure on firms to reduce their existing stock levels. Some destocking may still take place in the early part of the year as survey evidence indicates that stocks remain above desired levels. The moderation in destocking may have added some 0.5 per cent to GDP in 1992 and we expect the continued moderation in 1993 to add another 0.7 per cent.

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Consumers' expenditure is expected to grow by a little over 1 per cent this year, close to the projected growth in disposable income. In contrast to business sentiment, consumer confidence has hardly improved from the levels reached last autumn. We expect the savings ratio to remain close to its present levels for some time, with the improvement in the financial position of many borrowers being offset by continued fear of unemployment and talk of tax increases in the Budget. The present strength of the equity market should help to underpin the balance sheet position of the personal sector this year. Our forecast implies that the average level of personal sector net financial assets will be some 12 per cent higher in 1993 than in 1992, although some of this will be offset by a continued decline in the market value of the housing stock since we do not expect house prices to stabilise until the second half of the year.

We expect the recovery to gain momentum towards the end of the year, with GDP forecast to expand by close to 3 per cent in 1994 in spite of the gradual tightening of fiscal policy. In part this reflects the continued impact of the recent changes in interest rates and the assumption that they do not rise significantly until the latter part of next year. In addition a gradual recovery in the major world economies helps to raise the growth rate of world trade and offset some of the gradual erosion of the competitiveness gains from the sterling depreciation. The recovery we show in 1994 is a little higher than in our November forecast, reflecting the lower average level of interest rates prevailing through 1993. Box 2 provides details about past forecast errors.

The impact of the depreciation on import prices appears to have been faster than many commentators were expecting, with import prices rising by around 9 per cent in the fourth quarter of 1992. Whilst the depth of the recession may delay the speed with which higher import prices are passed through into domestic wages and prices, we expect the rate of inflation to begin to pick up towards the middle of the year, with wholesale price inflation forecast to be 3 1/2 per cent by the fourth quarter and consumer price inflation 4 3/4 per cent, implying that the government's chosen measure of underlying inflation--retail prices excluding mortgage interest payments--could well move out of the chosen target range in the latter half of the year. At the present level of the exchange rate average import prices could be some 12 per cent higher in 1993 than in 1992.

In the short term wage pressures may well be moderated both by the continuing rise in unemployment and by the prospective low level of mortgage rates this year which helps to limit headline retail price inflation to 2 1/2 per cent. We expect whole economy average earnings to rise by some 4 1/2 per cent this year, with a lower level of basic settlements in the private sector being augmented by wage drift as overtime working begins to pick up from its present low levels. Thereafter pay pressures could well begin to re-emerge, with the public sector pay squeeze beginning to unwind and a gradual rise in interest rates ending the divergence between the headline and the underlying rates of inflation. Inflation is projected to average around 5 per cent in 1994, although it could easily be higher if public sector workers seek to restore existing differentials with their private sector counterparts and the government continues to give the impression that its antipathy to inflation is weak.

The higher average level of import prices in 1993 is likely to mean that the 'J-curve' effect from the depreciation of sterling at a time when trade was already in deficit proves more marked than we previously expected. Our latest estimates suggest that the current account deficit could exceed |pounds~20 billion (3.2 per cent of GDP) both this year and next.

The rate of increase in claimant unemployment began to accelerate once more towards the end of 1992, with the headline total standing at 2.97 million in December. We now expect the total to rise to a peak close to 3.2 million in the first quarter of 1994, with unemployment having doubled since the onset of the recession. Employment may start to stabilise a little earlier, with the improvement in economic conditions attracting a number of people back into the active labour force, increasing claimant unemployment. Thereafter unemployment may begin to turn round somewhat faster than in the early-1980s, reflecting a slower growth in the population available for work than in the first half of the previous decade. As we have commented in previous Reviews, the duration structure of the unemployed has begun to change, with a sharp rise in the numbers out of work for more than six months. Our latest research into wage bargaining suggests that a compositional change of this kind could limit the extent to which the continuing rise in unemployment serves to moderate wage pressures.

We have not made any allowance for the possibility that the March Budget contains any measures to help the long-term unemployed. If such schemes were introduced, we would expect them to begin to have some impact on the claimant count by the autumn, although it may be some time after that before they are fully operational.

Section II. The Forecast in Detail

Personal Sector

Consumers' expenditure has begun to pick up from its low level in the first quarter of 1992, with the level of expenditure in the third quarter of last year some 0.9 per cent higher than the first quarter and 1/4 per cent higher than a year earlier. The rise in expenditure is primarily due to the continuing rise in real disposable income, which in the third quarter was some 2 1/2 per cent above the level a year earlier. We expect to see a further small rise in recorded expenditure in the fourth quarter, as the volume of retail sales rose by some 0.3 per cent in the quarter and new car registration rose by 10 per cent in the year to December.

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Doubts about the durability of the recovery in expenditure have been raised following a drop in the volume of sales in December. However, this figure conflicts with other evidence on expenditure, notably the pick up in the growth of notes and coin in circulation, and there may be considerable statistical difficulties in obtaining a good estimate of sales volumes at a time of widespread price discounting. It is also possible that some expenditure may have been switched towards cars (which are not included in retail sales) in December following the abolition of car tax in the Autumn Statement.

Our forecast shows consumers' expenditure rising by a little over 1 per cent in 1993 and by 2 1/4 per cent in 1994, with the lower level of interest rates and an improvement in the capital gearing of the personal sector permitting a small reduction in the savings ratio.

Total personal incomes rose by some 6 per cent over the year to the third quarter of 1992 even though the total wage and salary bill only rose by a little over 2 per cent. Incomes were supported both by a marked rise in the level of redundancy payments and by the continuing high level of dividend payments. We expect the growth of incomes to slow over this year, with the impact of the public sector pay squeeze helping to hold down the growth of income from employment. Net property income may continue to rise as income gearing improves, with around 30 per cent of mortgage holders yet to benefit from the recent reductions in lending rates. Whilst the growth in average earnings is likely to accelerate once the recovery is fully underway, the growth in real disposable incomes in 1994 could be little changed from this year, with inflation beginning to rise to around 5 per cent and income tax allowances assumed to be frozen in the 1994/5 fiscal year.

One accounting change which we have not attempted to take account of in our present forecast is the decision to treat further education institutions as part of the personal sector from April 1993, in line with the treatment of universities and polytechnics, rather than as part of general government. Figures in the Autumn Statement indicate that this could add around |pounds~750m to recorded consumers' expenditure (primarily through payment of wages and salaries) and reduce general government procurement expenditure correspondingly.

Investment and Stockbuilding

The level of fixed investment at constant prices has remained flat at close to |pounds~18 billion per quarter since the middle of 1991. In part the relative stability of investment over 1992 reflects both the rise in imported capital goods (which are often used as an estimate of investment levels in some sectors) and the continued weakness in investment goods prices. The level of average plant and machinery prices in the third quarter was little changed from that of a year earlier (implying a fall of 4 1/2 per cent in real terms using the GDP deflator) and commercial property prices continue to decline. Even so, in many respects it is surprising that investment has not fallen further given the weakness of demand.

The static level of total investment masks considerable sectoral differences, with investment in the service sector declining sharply over 1991 and 1992. Our estimate is that investment in business services fell by over 20 per cent in both 1991 and 1992, with investment in the distributive sector declining by some 9 1/2 per cent last year. In contrast, investment in production industries has been more buoyant, helped by the high level of investments undertaken by the newly privatised utilities and a sharp rise in North Sea investment in 1992. We expect that investment in the North Sea will fall back towards its 1991 level this year, although the latest DTI survey of investment activity on the UK Continental Shelf indicates that it possible that the high levels of capital expenditure will continue until the middle of the decade, with investment intentions having risen by 5 per cent from the levels recorded in the 1991 survey.

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Housing starts in the private sector in the three-month period to November were some 12 per cent below the level of starts in the previous three-month period and some 21 per cent below the level in the equivalent period a year earlier. We expect some pick up in total housing investment in 1993, with local authority capital expenditures raised by the decision in the Autumn Statement to allow authorities to spend all capital receipts raised from sales of council houses this year. Our domestic model now contains two separate equations for the components of total personal sector investments in housing, with expenditure on home improvements driven by consumption of durable goods and investment in new dwellings determined by housing completions in the private sector. In turn completions are determined by housing starts which react to activity, mortgage rates and expected profitability. All three of these factors suggest that housing investment should rise this year, with total private sector starts this year expected to be some 16 per cent above last year's levels. Further details on our empirical work are given in Tsoukis and Westaway (1992).

An additional factor that has helped to support the level of investment over the course of the recession has been a gradual decline in the user cost of capital, with the cost of raising external finance having been constrained by the relatively strong level of the stock market and investment goods prices failing in real terms. Chart 7 shows the measure of the real user cost of capital in the manufacturing sector used in the Institute domestic model, along with the real cost of investment finance. Further details are given in Young (1992) and the August 1992 Review. We expect the cost of capital to decline further this year, with a higher level of first year capital allowances being introduced in the Autumn Statement (for this year alone) and reductions in the cost of finance. In conjunction with the forecast improvement in output, the decline in the cost of capital helps to raise investment in manufacturing by over 5 per cent this year.

The level of stocks and work in progress in the UK fell by some |pounds~200 million in the third quarter, taking the total decline for the first nine months to around |pound~1 billion, some |pounds~1.9 billion below the level of destocking in the equivalent period a year before. We expect to see a somewhat higher level of destocking in the fourth quarter and in the first quarter of 1993, with retailers using price discounting to get rid of unwanted stocks and manufacturers meeting export demand out of existing stocks. The latest CBI Survey indicates that stock levels remain higher TABULAR DATA OMITTED than desired, although firms were relatively successful in diminishing stocks in the fourth quarter in spite of the shortfall in demand.

From the second half of 1993 stock levels may begin to pick up, with firms beginning to restore stocks of raw materials and work in progress in anticipation of future demand. For the year as a whole we now show a total addition to stocks of |pounds~0.9 billion, with the turnaround from 1992 adding some 0.7 per cent to GDP. A further rise in stocks is shown in next year, again equivalent to 0.7 per cent of GDP.

Balance of Payments

The preliminary trade figures for the fourth quarter are consistent with the effects that would normally be expected to follow a depreciation in the real exchange rate, with net trade volumes improving, but the trade deficit widening due to higher import prices. However, interpretation of the published figures is more difficult than usual due to an unusually large discrepancy between the imports data on a balance of payments (BOP) and overseas trade statistics (OTS) basis, with import volumes rising by 1 per cent on an OTS basis but falling by 1 1/2 per cent on the BOP basis. (The latter figures are the ones used in determining gross domestic product.) Correspondingly, there is a large difference in the price deflators, with the price of imported goods shown to have risen by 9 per cent on the BOP basis, but only 6 1/2 per cent on the OTS one.

The difference between the two measures consists of coverage and valuation adjustments such as the cost of insurance and freight charges. The initial fourth quarter figures contain an unusually large figure for the volume measure of the adjustment and a correspondingly small one for the adjustment deflator. We expect this discrepancy to be removed once the figures are revised and we have therefore attempted to allow for this by reducing the volume adjustment to a more appropriate level. This was achieved by allocating some of the recorded adjustment to individual categories of imports based on their share in total imports. As a result the fourth quarter growth in the volume of manufactured imports was lowered to 1.1 per cent from 3 per cent and the rise in the average value of manufactured imports was raised to 6.6 per cent from 4 1/4 per cent.

Even after this revision the level of manufactured imports remains some 7 1/4 per cent above the levels in the fourth quarter of 1991, with total imports of goods having risen by some 4 1/2 per cent over the same period. Our new system for determining imports, discussed in the section below on output and employment, suggests that much of the recent rise in imports can be accounted for by two factors: the improvement in the price competitiveness of imported goods over the course of the recession (with import prices falling by 2 1/2 per cent in the year to the third quarter of 1992) and the moderation of destocking. We estimate that some three-fifths of additional expenditure on stocks leaks into imports. Thus even after the recent improvement in competitiveness, import volumes can be expected to rise substantially in 1993 and 1994, with the forecast showing a rise of 5 1/2 per cent this year and 6 1/4 per cent in 1994.

Exports of manufactures responded well in the fourth quarter, with volumes rising to a level 5 per cent above that of a year earlier. Total exports of goods rose by 3 per cent over the same period. This year we expect a rise in export volumes (of goods and services) of around 6 1/2 per cent, somewhat above the growth of world trade. The analysis in Box 1 of the World Economy chapter in this Review shows that growth in the main export markets of the UK slowed more rapidly in 1991 and 1992 than it did in those of either France or Germany, largely reflecting the higher levels of trade with North America. This year, the situation may be reversed, with the continuing recovery in the US helping to raise forecast growth in UK export markets to 3 3/4 per cent.

Overall, we now expect the current account deficit to widen to some |pounds~20 billion this year (3.2 per cent of GDP) and |pounds~21.7 billion next year. In spite of the short-term improvement in competitiveness following the sterling depreciation, it seems likely that the structural imbalance in UK trade will persist into the 1990s. As imports are now considerably higher in value than exports, exports have to grow faster than imports for a number of years to prevent the trade balance from deteriorating further and to ensure that the net trade position does not prove a consistent constraint on real growth.

Output and Employment

The recession has affected all areas of the economy, with the level of GDP having declined to around the level recorded in mid-1988. All the main categories of output--with the exception of the public sector and oil and gas extraction--are likely to have fallen further in 1992, with the brief recovery in manufacturing output in the first half not being sustained. Chart 8 shows the course of manufacturing, construction and service output over the recession, with construction being hardest hit. The level of output in the construction sector in the third quarter was some 16 1/2 per cent below the peak reached in 1990 and we expect the decline to continue into this year. TABULAR DATA OMITTED TABULAR DATA OMITTED TABULAR DATA OMITTED Whilst a number of public sector projects may begin to boost activity in the latter part of the year, the commercial property market shows little sign of picking up.

Preliminary figures for the fourth quarter of 1992 suggest that there may have been a small rise in the level of GDP. It is likely that most, if not all, of this will be accounted for by a higher level of oil and gas production, with many summer maintenance programmes in the North Sea having come to an end. We expect North Sea production to continue to rise until the mid-1990s, helped, in part, by the relatively high levels of capital investment expected over the coming five years. However the prospective rise in gas extraction could be limited if the government decides to change the present structure of the energy market.

We expect to see some recovery in most industries this year, with manufacturing output possibly rising by some 2 1/2 per cent, helped by a continuing rise in export sales. A new system for determining the way in which total final expenditure at factor cost determines the level of sectoral output and imports of goods and services has just been incorporated into the Institute model. The system, based on the flexible dynamic demand model reported in Pain, TABULAR DATA OMITTED Anderton and Westaway (1992), allows for both relative price effects and time varying marginal propensities from the different components of final expenditure. It suggests that a 1 per cent rise in export volumes adds around 0.4 per cent to value added in manufacturing industry.

In spite of the rise in output expected in 1992, it seems likely that unemployment will continue to rise for some time to come. Employment in the year to September fell by some 877,000 with the workforce in employment declining by over 400,000 in the third quarter alone. The level of redundancies has been particularly high in the manufacturing sector, possibly reflecting a temporary postponement of many job cuts in the early part of the year at a time when output was expected to improve. (The employment figures we show in Table 8 continue to include an estimated allowance for the level of self-employment in particular industries.)

As a result, the recent monthly rises in unemployment have accelerated back to the average levels of 1991, although the stock of unfilled vacancies in the last two months of the year did pick up a little from the low point reached in October. The forecast shows unemployment peaking at some 3.17 million in the first quarter of next year, with the average level of unemployment in 1993/4 some 250,000 higher than assumed in the public expenditure projections in the Autumn Statement.

Average Earnings

The profile of the growth in average earnings this year will be disrupted by both the echo effect of the sharp rise in the wage bill in the first quarter of 1992 (with many annual bonuses being paid prior to the general election) and the gradual impact of the controls on public sector pay. It will be some time before the full effect of the one year restriction on public pay settlements introduced in the Autumn Statement appears in the earnings figure. A number of public sector groups had only just received a pay increase at the time the controls were announced, with firefighters receiving a general rise of 4.9 per cent from November and the police receiving an increase of 6 1/2 per cent in September. This implies that the public sector pay controls will continue to directly affect the profile of earnings growth until the fourth quarter of next year.

The latest official figures on earnings show the underlying rate of increase in whole economy earnings falling to 5 per cent in the year to November, around half the underlying level at the onset of the recession. The Industrial Relations Service estimates that settlements fell to a little below 4 per cent in the final quarter of last year. Early indications are that many new settlements announced in recent weeks are in the 3-4 per cent range, with settlements arising from the second stage of existing agreements averaging between 4-5 per cent, possibly reflecting the fact that inflation expectations were a little higher at the time those agreements were reached. A number of settlements continue to be enhanced by additional payments for changes in working practices and there is some evidence of cash payments replacing benefits-in-kind, such as company cars, that have become less tax efficient.

Our forecast assumes that the restriction of new public sector pay settlements to 1 1/2 per cent will imply a rise in the public sector wage bill of some 3 per cent in the fiscal year 1993/4, reflecting both incremental drift and the extent to which recent awards will continue to feed through into the autumn. On a calendar year basis we expect the public sector pay bill to rise by a little over 4 per cent. With private sector earnings forecast to rise by close to 5 per cent, we show whole economy average earnings rising by around 4 1/2 per cent this year, with a low point being reached in the first quarter. The rise in earnings in 1994 is considerably stronger at 6 1/2 per cent, with a rise in inflation, the assumed freezing of income tax allowances and the gradual unwinding of the public sector pay programme all putting upward pressure on wage levels.

Costs and Prices

The faster rise in unemployment in the latter part of last year, together with the present moderation in pay settlements suggest that the unit labour cost growth should continue to behave in a counter-cyclical manner in the TABULAR DATA OMITTED early months of this year. With whole economy productivity projected to rise by around 3 1/2 per cent this year, unit labour cost growth may be restricted to under 1 1/2 per cent, some 1 per cent lower than we projected last November. In the short term this should offset some of the cost pressures arising from the sterling devaluation, with manufacturing input prices having risen by 4 per cent in the fourth quarter of 1992.

The coming months are likely to see a widening gap between inflation indices such as the consumers' expenditure deflator with a considerable import content, and other measures such as the GDP deflator at factor cost which reflects domestic unit costs alone. Whilst consumer prices may rise by around 4 1/4-4 1/2 per cent this year, the rise in the GDP deflator could be as low as 2 1/4 per cent. Some divergence between 'underlying' inflation (retail prices excluding mortgage interest payments) and the headline rate of retail price inflation is also likely to appear this year. Retail prices may rise by around 2 1/2 per cent this year and 3 per cent in the year to the fourth quarter, with the mortgage component of the index falling by more than a fifth. In contrast, underlying inflation is likely to closely reflect consumer price inflation. We TABULAR DATA OMITTED expect it to rise to 4 1/2 per cent by the year end, with some additional inflationary impetus coming from the previously announced rise in motoring costs in the March Budget and an above inflation rise in payments to local government following the introduction of the council tax. (A much larger step occurred in 1990 following the introduction of the community charge.) Import prices, underlying inflation and the GDP deflator are shown in Chart 9.

We expect the rate of inflation to continue to rise into next year, with much depending on both the anti-inflation resolve of the authorities and its effect on expectations, and the extent to which the unwinding of the public sector pay controls leads to significant catch-up awards. We do not allow for this in the present forecast which shows inflation, on nearly all measures, averaging around 5 per cent next year.

Public Sector Finances

Provisional estimates of the public sector borrowing requirement indicate that the recession is continuing to have a substantial impact on the public finances, with borrowing in the first nine months of the present financial TABULAR DATA OMITTED year standing at |pounds~25.7 billion, some |pounds~15.4 billion above the levels in the corresponding period of 1991/2. Our forecast is that the PSBR this year will total |pounds~37.8 billion (6.2 per cent of GDP) and rise further next year to |pounds~43.4 billion, a little below the level shown in the Autumn Statement.

The sharp rise in borrowing this year reflects both a higher level of expenditure, with general government expenditure rising by around 10 1/4 per cent in nominal terms and a continued weakness of tax receipts. Inland Revenue receipts in the first nine months of 1992/3 were some 3 1/2 per cent below the levels of a year earlier, with corporation tax receipts particularly depressed. Our own estimate for borrowing in 1993/4 is a little higher than before, reflecting a higher level of unemployment and a lower level of money GDP than previously projected.

The Autumn Statement indicated that real growth in the control total would be limited to 1 1/2 per cent a year, whilst growth in general government expenditure would be kept to a maximum of 2 per cent. As we discuss above in Box 1, our inflation projections are somewhat higher than those in the Autumn Statement, implying a somewhat greater restriction on the volume of expenditure.

TABULAR DATA OMITTED

REFERENCES

Pain, N., Anderton, B., and Westaway, P., (1992), 'A systems approach to the demand for imports and domestic output in the UK', NIESR Discussion Paper No. 12.

Tsoukis, C. and Westaway, P., (1992), 'A forward-looking model of housing construction in the UK', NIESR Discussion Paper No. 13.

Young, G. (1992), 'Industrial Investment and Economic Policy', in Andrew Britton (ed), Industrial Investment as a Policy Objective, NIESR. Report Series No. 3.

Box 1. Public Sector Borrowing in the Medium Term

The purpose of this box is to discuss some of the issues relating to the medium-term profile of the PSBR that we report in Tables 11 and 12 below and to compare the economic assumptions lying behind our numbers with those in the Autumn Statement and the IFS 'Green Budget'.

One feature of interest in our forecast is that the public finances, whilst remaining in deficit throughout the present decade, do not deteriorate to the extent presently expected by many commentators, (although projecting the PSBR so far ahead is inevitably a hazardous business). For example, the Institute for Fiscal Studies, in their 'Green Budget' estimate that, on the basis of the expenditure plans announced in the Autumn Statement, the borrowing requirement will remain over |pounds~50 billion until 1997/98 (at which point it would be 6 1/4 per cent of GDP), well in excess of the Maastricht convergence criteria. This leads the authors to argue that cumulative tax increases of the order of 2-4 per cent of GDP could be required in the medium term. By way of contrast, our projections, with present policies augmented by the additional |pounds~3 billion we assume is raised from higher taxation in 1994/5 (a rise in taxation of 0.4 per cent of GDP), show the PSBR declining to some |pounds~26 1/2 billion (3 per cent of GDP) by 1997/8. The PSBR we show for 1993/4 is also a little below the projection made in the Autumn Statement.

Table A1 reports the different assumptions with regard to growth, inflation and expenditure made by ourselves, the Treasury and the IFS. On the expenditure side all three projections are close to one another, although the higher level of inflation in our projections implies less real growth in spending programmes. The main differences in outlook arise from the higher level of nominal activity--'money GDP'--in our projections, largely as a result of the higher inflation that can gradually be expected to emerge from the aftermath of the recent depreciation in sterling. In turn this yields a higher level of tax revenues. An additional assumption that income tax allowances are continually uprated after 1994/5 by inflation rather than by the rate of growth in earnings ensures that the government continues to benefit from fiscal drag. Implicitly, relaxing the stated inflation target helps to stabilise the fiscal position of the public sector.

The medium-term path for the PSBR is also affected by the prospective level of privatisation proceeds. At present, these are planned to diminish from |pounds~8 billion in the current fiscal year to some |pound~1 billion by 1995/96, by which time most of the readily marketable assets of the public sector will have been sold. However, the total value of assets (both tangible and financial) held by the public sector at the end of 1987 (the latest year for which full estimates are available) was |pounds~552 billion, suggesting that further ways of attracting private finance could be found. Prospective measures may include the privatisation of activities that currently have Agency status, a higher level of joint ventures and the introduction of user fees for activities such as road use.

It is also far from clear what the appropriate medium-term target for the level of the PSBR should be. One possibility would be to attempt to stabilise the ratio of public sector debt to GDP. There are number of possible definitions of public sector debt. The Maastricht agreement refers to gross government debt, whilst the appropriate analogue of the PSBR would be a net debt measure. A further option would be to stabilise the net worth of the public sector, taking into account tangible assets as well as financial ones. Chart 6 illustrates the path of net public sector financial debt to GDP implied by our forecast. Although the ratio rises sharply in the mid-1990s, the resulting level is far from unprecedented by historical standards, and the decline in the PSBR/GDP ratio to around 2 1/2 per cent by the end of the decade serves to stabilise the real stock of outstanding debt.

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Box 2. Forecast error margins

This Box reports the average absolute errors made in the NIESR forecasts published in the February Review over the period from 1981. The average absolute error, a measure of accuracy, is calculated by comparing the forecast with the latest available outturn. Errors are given for both current year and one year ahead forecasts, along with an indication of the error range, reflecting the maximum and minimum absolute errors made over the reported sample. All figures relate to calendar year forecasts apart from inflation (fourth quarter on fourth quarter) and the PSBR which is for the fiscal year. The errors only provide a broad guide to the size of errors that might reasonably be expected since the margin of error itself could change over time.

TABULAR DATA OMITTED
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Title Annotation:The Economic Situation; includes related article
Author:Pain, Nigel
Publication:National Institute Economic Review
Date:Feb 1, 1993
Words:9032
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