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The prospects for sustained recovery in the UK.

The preliminary figures for GDP in the first quarter of the year show a small increase. If oil and gas production are excluded the rise was about 1/2 per cent, following four quarters in which there was virtually no change at all. This confirms other indications of an incipient recovery, such as the rise in production and retail sales, increases in the volume of both exports and imports, more activity in the housing market and a surprising fall in unemployment. Surveys of business confidence also show a marked improvement. An upturn in economic activity would be a natural consequence of the fall in the exchange rate when sterling left the ERM and of the subsequent expansionary policy measures--as we have been predicting since last September.

Our central forecasts for the UK economy are very little changed since February, and indeed since last November. We have revised upwards our forecasts of domestic demand this year, but this is offset by a rather less optimistic view on exports as activity elsewhere in Europe weakens. We still expect growth of about 2 per cent this year (or given a normal margin of uncertainty, between 1 per cent and 3 per cent). Inflation will be a little higher by the end of the year, probably just over the top of the target range (1 to 4 per cent for the r.p.i excluding mortgage interest payments). The balance of payments deficit on current account, for which we lack outturn data this year, is most probably widening at the present TABULAR DATA OMITTED time and may well be over 3 per cent of GDP for the year as a whole. The fall in the unemployment figures in February and March is difficult to explain. We have revised down our forecast for the claimant count for the rest of the year, but this almost certainly exaggerates the underlying change in the pressure of demand for labour.

The economy is now responding to the stimulus of the expansionary policies introduced last year. This year growth should be roughly in line with trend; for next year we are predicting growth a little above trend because the main effect on consumption and on investment of the interest-rate reductions will be felt with a significant lag. This more than offsets the contractionary effect of the tax increases announced in the March Budget. But if we look further into the medium term the impetus from the monetary policy expansion will die away and the economy could well revert to trend, leaving unemployment still very high.

In our projections there seems little scope for a further stimulus to demand once the effect of last year's measures wears off. To let the exchange rate fall sharply again would be to risk inflation well in excess of recent experience. To cut interest rates much further would be to encourage more spending than the economy can afford. (Our forecast in fact assumes a small rise in interest rates next year.) The size of the present fiscal deficit makes a net reduction in taxation (or a net increase in spending) unlikely.

The recovery we foresee in 1993 and 1994 is, of course, a vast improvement on the performance of the economy over the past two years. It is enough to produce a substantial improvement in company sector profits. The revival of the housing market will come as a great relief to a large proportion of households, as will the end of the rise in unemployment. Nevertheless the level of output remains well below the pre-recession trend (by perhaps 5 percentage points) and the level of unemployment must be very disappointing compared with the position at the end of the 1980s. It is best described as a 'half-recovery', since the legacy of recession persists into the indefinite future. The possibility of achieving something more like full employment in the long term is discussed below.

The response of British industry to the fall in the exchange rate

A meeting of company chairmen and senior executives was held at the National Institute early in May to discuss the effect on the British economy of the depreciation of sterling following its exit from the ERM in September last year. Many observations were made which are clearly important to an understanding of recent events, to assessing future prospects and to policy recommendations. In particular:

* Devaluation undoubtedly helps exporters, but a great deal remains to be done by industry if the full benefit is to be reaped. Exports cannot just be turned on and off at will.

* The profit margins of British firms will be rebuilt to the extent that this is possible, but the foreign competition is responding by cutting prices to preserve their market share.

* Industry can compete, on costs or price, at broadly the present level of the exchange rate (say around $1.50--some would extend the margin a good way up, others a good way down). Stability of the real exchange rate remains an important concern of British industry. For some at least a devaluation of sterling within the ERM would have been preferable to an 'ignominious exit'.

* The devaluation is different from previous ones because it came at a time when activity was very slack. This has reduced the effect on the cost of imports. Wage costs are also being held down by the fear of redundancy and unemployment. This means that the improvement in competitiveness resulting from the fall in the exchange rate will not be reversed for a long time.

* This continuing growth in the volume of imports results from gaps in the product range of British industry. It is now often quite impossible to source materials or new equipment from UK producers. Having lost capacity in previous recessions, firms cannot easily re-create it. Where opportunities exist to restart production in the UK, following the fall in the pound, they are most likely to be taken in the first instance by foreign firms, resulting in more inward investment.

* The advantages of producing close to the market are now generally recognised. In consequence, some of the benefit of depreciation may show up, not in the trade statistics, but in the profits earned by the overseas subsidiaries of UK companies.

* Much more remains to be done to improve the performance of British industry. There was some support for a closer 'alliance' of British firms with one another and with government to promote their common interests. Companies in the same sector could often co-operate with support from government; working relationships should be closer.
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Title Annotation:Commentary
Publication:National Institute Economic Review
Date:May 1, 1993
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