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The world economy.

Section I. Recent Economic Developments

Introduction

Economic growth slowed in most of the major industrialised countries over the course of last year. The slowdown has been particularly apparent in continental Europe, with GDP falling in the fourth quarter in Germany, France and Italy. Early indications suggest that activity has been subdued in the first quarter of this year, with industrial production declining in Germany, Spain and Sweden, the provisional UK figures recording the lowest per quarter growth since 1992, and a continued deterioration apparent in indicators of the general business climate in Europe. We have made a significant downward adjustment to our previous forecasts for Europe, with EU-wide GDP now projected to rise by only 1 1/2 per cent this year, after growth of 2 1/2 per cent in 1995. We expect growth to pick-up over the course of the year as the contractionary effects of ongoing inventory adjustment come to an end and as the effects from a more relaxed monetary stance begin to outweigh those from ongoing fiscal consolidation. Recent currency movements should help to stimulate external demand in Germany and France, with the D-mark having depreciated against the US dollar by around 7 per cent over the past four months. Private sector expenditure is also likely to benefit from the recent sustained appreciation of equity prices in most national stockmarkets, with prices at the end of April having risen by over 11 per cent in Germany, France, Italy and Spain since the beginning of the year.

The short-term prospects for growth have continued to appear brighter outside Europe, with activity in Japan and North America proving to be more robust than previously expected. GDP rose by 0.9 per cent in Japan in the fourth quarter last year, to a level 2 1/4 per cent higher than a year earlier. Consumer and business sentiment fell sharply in the US at the turn of the year, but this now appears to have largely reflected the unusually severe winter weather and the temporary shutdown of much of the Federal government. The preliminary estimates for the first quarter suggest that GDP rose by 0.7 per cent, to a level 1.8 per cent higher than a year before. For the year as a whole we presently expect growth of 2-2 1/2 per cent in both the US and Japan. As these two economies account for around 50 per cent of output in the OECD we expect that the growth of OECD GDP will be largely unchanged from last year, at around 2 per cent. In 1997 we presently show growth of 2.6 per cent, with a period of synchronised growth across the world economy.

World trade has continued to expand more rapidly than might have been expected given the pace of economic growth, with trade levels continuing to benefit from the growth of inter-regional trade in Pacific-Asia and Central and Eastern Europe. This has had a marked effect on trade patterns. Amongst the major industrialised countries, the US, Canada, Italy and Spain all improved their share of export markets in 1995, helped by a depreciation of their real effective exchange rate. Germany and Japan lost market share as their real exchange rates continued to appreciate. The UK also lost market share even though the sterling real exchange rate weakened. In contrast, French exporters maintained their market share in spite of the real appreciation of the franc.

We expect growth of 6 3/4-7 per cent in total world trade both this year and next, with a slowdown in cross-border trade in Europe being offset by higher demand from North America and Asia, and a recovery in demand from Mexico. Trade with OPEC member states may also be boosted as a result of the recent rise in oil prices.

Inflationary pressures have continued to weaken in most of the major industrialised countries over the past year. Consumer price inflation in the OECD averaged 2.3 per cent in 1995 with prices falling by 1/2 a per cent in Japan. In the provisional US national accounts estimates for the first quarter of this year the consumers' expenditure deflator was 1.9 per cent higher than a year earlier, the lowest annual inflation rate recorded for 30 years.

However in recent weeks there has been increasing concern that inflation might start to accelerate following an acceleration in monetary growth in many industrialised countries and recent jumps in a number of commodity prices. Although the earlier sustained rise in primary product prices in 1994 and 1995 did not appear to have any significant impact on consumer prices, producer prices and export prices did rise sharply in large primary producers such as Canada and Sweden. This [TABULAR DATA FOR TABLE 1 OMITTED] suggests that higher input costs were absorbed into profit margins. If growth picks up as expected in the latter part of the year it is possible that any further jump in input costs may be passed through directly into the prices of consumer goods. Even so, at the present time we doubt whether such effects are likely to be provide a significant boost to inflation, largely because the importance of primary commodities in OECD final output has declined by around 40 per cent since the early 1970s.(1) In addition, as we discuss below, the recent rises in commodity prices have been narrowly based. Our forecasts show OECD inflation between 2 1/4-2 1/2 this year and next, with EU inflation averaging 3 1/4 per cent.

Interest Rates and Exchange Rates

The moderation in economic growth and improvement in inflation prospects led to a marked-drop in market interest rates in North America and Europe over the course of the 1995 and the early part of 1996, with continual evidence that the present expansion has failed to generate any significant inflationary pressures. Interest rates on 10 year government bonds in the United States, Japan and Germany have declined by around 1-1 1/4 percentage points since the start of 1995, while equivalent rates in France, Italy and Canada have declined by 1 1/2-1 3/4 percentage points. Movements in long-term interest rates reflect a number of factors, including revisions to inflation expectations, changes in prospective real returns and fluctuations in risk premia. There is little evidence of any substantive global movement in required real returns at present, with the yields on UK index-linked gilts and Canadian real-return bonds having remained steady at around 3 3/4 per cent and 4 3/4 per cent respectively over the past six months. This would suggest that a general downward revision to future inflation expectations has been largely responsible for the widespread drop in interest rates.

Since February long-term interest rates have in fact strengthened somewhat in the US, with 10 year rates rising to around 7 per cent at the beginning of May. This turnaround appears to reflect a modest upturn in inflation expectations, with the pace of domestic activity having proved to be more robust than widely expected at the start of the year. Political considerations have also meant that that a balanced budget programme now appears unlikely to be put in place before the presidential elections in November, contrary to previous expectations.
Table 2. Short-term interest rates


 Per
cent
 US Japan Germany France Italy
UK


1992 3.7 4.5 9.5 10.3 13.0
9.6
1993 3.2 3.0 7.2 8.6 8.8
5.9
1994 4.6 2.2 5.3 5.8 7.6
5.5
1995 5.9 1.2 4.5 6.6 9.0
6.7
1996 5.4 0.7 3.3 4.1 7.7
6.0
1997 6.2 1.5 3.7 4.4 7.4
5.9
1998 6.3 2.6 4.3 4.4 8.0
6.0


1999-2003 6.3 3.8 5.6 5.6 8.7
6.3


1994 I 3.5 2.2 5.8 6.3 7.2
5.3
 II 4.3 2.2 5.2 5.7 7.3
5.2
 III 4.9 2.3 5.0 5.6 7.9
5.5
 IV 5.9 2.3 5.2 5.7 8.1
6.1


1995 I 6.2 2.3 5.1 6.6 9.2
6.7
 II 6.0 1.4 4.6 7.5 9.2
6.7
 III 5.8 0.8 4.4 6.1 8.8
6.8
 IV 5.7 0.5 4.0 6.1 8.7
6.6


1996 I 5.3 0.4 3.4 4.4 8.4
6.2
 II 5.2 0.6 3.2 3.9 8.0
5.9
 III 5.5 0.8 3.1 4.0 7.3
5.9
 IV 5.8 1.0 3.3 4.2 7.3
5.9


1997 I 6.0 1.2 3.4 4.3 7.3
5.8
 II 6.3 1.4 3.6 4.3 7.3
5.9
 III 6.3 1.6 3.8 4.4 7.3
5.9
 IV 6.3 2.0 4.0 4.4 7.5
5.9
Table 2a. Long-term interest rates


 Per
cent
 US Japan Germany France Italy
UK


1992 7.5 5.1 7.8 8.9 13.9
9.1
1993 6.5 4.0 6.3 6.8 10.9
7.9
1994 7.4 4.3 7.2 7.8 11.0
8.0
1995 6.9 3.1 6.7 7.6 11.7
8.4
1996 6.7 3.3 6.3 6.5 9.9
8.0
1997 6.8 3.9 6.3 6.4 9.6
8.0
1998 6.8 4.3 6.3 6.4 9.6
8.0


1999-2003 6.8 4.3 6.3 6.4 9.6
8.0


1994 I 6.5 4.0 6.4 6.8 9.7
6.9
 II 7.4 4.3 7.1 7.9 10.5
8.2
 III 7.7 4.5 7.6 8.3 12.0
8.6
 IV 8.1 4.5 7.5 8.4 11.8
8.5


1995 I 7.7 3.7 7.3 8.0 12.9
8.6
 II 7.0 2.8 6.8 7.7 12.1
8.2
 III 6.8 2.8 6.5 7.7 11.3
8.2
 IV 6.3 3.0 6.0 6.9 10.8
8.5


1996 I 6.4 3.1 6.1 6.8 10.3
8.0
 II 6.8 3.3 6.3 6.4 10.0
8.0
 III 6.8 3.4 6.3 6.4 9.8
8.0
 IV 6.8 3.5 6.3 6.4 9.6
8.0


1997 I 6.8 3.6 6.3 6.4 9.6
8.0
 II 6.8 3.8 6.3 6.4 9.6
8.0
 III 6.8 4.0 6.3 6.4 9.6
8.0
 IV 6.8 4.2 6.3 6.4 9.6
8.0


In contrast activity has been weaker than previously expected in Europe and new fiscal measures have been announced in Germany, Sweden, Spain and Belgium in recent weeks. Monetary conditions have thus continued to ease in continental Europe, with policy being relaxed to offset the ongoing and planned fiscal consolidation. The Bundesbank reduced its discount rate to a record low of 2 1/2 per cent in April, a move followed by similar reductions in Austria, Denmark, Belgium and the Netherlands in the face of mounting concerns about the pace of growth and desire to maintain parity with the D-mark. In contrast, three-month interest rates have remained unchanged in the UK, although base rates were reduced by 25 basis points in March, whilst long-term interest rates have strengthened in line with those in the US.

There appears to be a growing perception that some form of monetary union will proceed in 1999, with political considerations overriding the possible failures of likely participants to satisfy the Maastricht convergence criteria in full. The spread between long-term interest rates in France and Germany has now declined to zero from a recent peak differential of 1 percentage point last October, and Italian and Spanish long-term rates have fallen by over two percentage points over the past year. Although it is remains unlikely that either of these two countries will be able to join any monetary union at first, recent discussions have raised the likelihood that both may join a revamped version of the ERM once monetary union takes place. In contrast the spread between German and UK long-term interest rates has widened to 1 3/4 percentage points since the start of the year, with UK long-term interest rates now as close to Italian rates as they are to German ones.

The Bank of Japan has continued to hold its discount rate at 0.5 per cent over the past three months, reflecting the desire to maintain liquidity within the financial system and ensure that private sector demand continues to strengthen. With many domestic prices continuing to decline, short-term real interest rates remain positive and we expect that nominal rates will be raised only slowly.

We continue to derive our interest rate projections from the information contained in the term structure of interest rates at the time of the forecast. This allows us to extract a future profile for short-term interest rates consistent with the present yields on long-term government bonds. The one exception to this is the UK, where the forecast profile for interest rates is that judged to be required to achieve the authorities' stated inflation target of 2 1/2 per cent. Our projections for short-term and long-term interest rates are set out in Table 2.

The slope of yield curve in the US remains relatively flat at present; this is reflected in our projections which show short-term interest rates rising from 5 1/4 per cent to 6 per cent by next year, with long-term interest rates remaining around 6 3/4-7 per cent. In contrast, the yield curve is much steeper in Germany and Japan, implying that interest rates are expected to rise more sharply from their present levels once activity begins to pick up. German three-month interest rates are projected to remain around 3-3 1/4 per cent until the end of the year before rising to 4 per cent by the end of 1997. French interest rates are projected to rise from 4 to 4 1/2 per cent over the same period, before converging on German rates in 1998-99.

Exchange rates have exhibited relatively little volatility over the past three months, with a further modest appreciation of the US dollar and the lira having taken place since our last forecast and the D-mark and franc having depreciated a little. Our exchange rate estimates, set out in Tables 3 and 4, indicate that the dollar effective exchange rate is likely to have risen by some 2 3/4 per cent in the first half of this year. The changes in effective exchange rates seen over the past year should help to ensure sustainable growth within the world economy, with the currencies of countries such as the US, Italy, Spain and Sweden where activity had been robust in 1994 and early 1995 having appreciated, and the currencies of countries such as Japan and Germany where activity was weak having depreciated.

Commodity Prices

The commodity price pressures that emerged in 1994 and the early part of last year have begun to reappear over the past two months, although, as yet, they have been fairly narrowly based. The Economist Commodity Price Index rose by 8 per cent during the first four months of this year, but remains below the levels in the first half of 1995. In dollar terms, the food component of the index is some 0.4 per cent higher than a year ago, but the industrials component has declined by 7 per cent.

There has been a continued acceleration in the prices of food products produced in developed countries, with a projected overall rise of 27 per cent this year. This largely arises from the recent increases in the price of wheat and maize, reflecting severe supply shortages. Grain stocks have been declining for the past year after droughts [TABULAR DATA FOR TABLE 3 OMITTED] depressed the harvest in key producing countries such as Australia. Wheat stocks are expected to decline this year to their lowest level since 1948, with the outlook for the US winter wheat crop having worsened as a result of the severe weather at the turn of the year. US Department of Agriculture estimates suggest that around 45 per cent of the winter crop is in a poor state. EU grain shipments have also been constrained as a result of export taxes imposed by the European Commission in order to maintain internal prices. Maize prices rose to an all-time high in April, with stocks in the US some 33 per cent lower than last year and reports that the crop planted this year would be smaller than the market had expected. We expect prices to remain at relatively high levels until at least the autumn and then stabilise at lower levels. However prices are not expected to decline rapidly to the levels of a year ago, with prices being supported in the medium term by the growing demand from Asian economies for animal feedgrains.

Oil prices have also strengthened significantly since the turn of the year, with US refiners raising demand sharply as weather conditions deteriorated and stocks declined. US stocks are reported to be 12 per cent lower than a year ago and reached a 19 year low in early April. Prices had previously been weak, with OPEC output remaining above its production ceiling and expectations of an agreement between the United Nations and Iraq to allow Iraq to resume oil sales. We assume that prices average a little below $18 per barrel this year, around 4 3/4 per cent higher than projected in our February forecast.
Table 4. Real effective exchange rates




1987=100


year average US Japan Germany France Italy
UK


1992 93.3 97.3 99.2 95.8 105.5
105.9
1993 96.9 114.2 104.8 98.4 91.1
97.7
1994 96.7 121.1 105.3 98.4 88.9
98.0
1995 92.3 124.5 109.8 100.3 83.0
93.0
1996 96.1 109.6 106.5 100.3 90.3
89.8
1997 95.7 113.1 106.6 100.1 90.9
87.9
1998 93.9 117.0 107.0 100.2 94.1
86.8


1994 I 99.0 118.0 103.8 98.1 88.5
99.6
 II 97.9 121.1 104.6 97.7 90.9
97.9
 III 95.2 123.0 106.6 99.0 88.8
96.6
 IV 94.6 122.2 106.3 98.8 87.4
97.8


1995 I 94.3 123.9 109.0 99.6 83.4
95.8
 II 89.4 137.4 110.9 100.3 79.3
92.6
 III 91.9 123.4 109.7 100.6 84.1
92.4
 IV 93.7 113.2 109.5 100.6 85.0
91.4


1996 I 95.7 109.2 108.1 100.5 88.8
90.0
 II 96.5 109.1 105.8 100.1 91.0
90.3
 III 96.2 109.8 106.0 100.3 90.8
89.8
 IV 96.0 110.4 106.2 100.3 90.8
89.2


1997 I 95.7 111.2 106.3 100.1 90.8
88.6
 II 95.2 113.0 106.5 100.1 90.8
88.1
 III 94.9 113.8 106.8 100.1 90.9
87.7
 IV 94.6 114.6 106.9 100.1 91.1
87.4


The prices of developing country food products have remained weak and are presently projected to decline by around 10 per cent this year. Coffee prices have been volatile, but have been on a general downward trend, with supplies recovering after frosts in Brazil last year. The Association of Coffee Producing Countries has yet to reach agreement on export quotas after the present quotas expire in July. Sugar prices have eased, with stocks projected to be at a three year high in the summer.

Metals' prices have remained largely unchanged since the beginning of the year, with lower demand from developed countries being offset by higher imports by some developing nations. Imports of copper into China in the first quarter were 10 per cent higher than a year earlier. Copper prices have also strengthened as stocks have declined, with world copper stocks now estimated to be equivalent to only four weeks consumption. On average metals' prices are projected to be some 8 1/2 per cent lower this year than in 1995.

[TABULAR DATA FOR TABLE 5 OMITTED]

Section II. Developments in North America and Japan

United States

The US economy grew by 2 per cent in 1995 after growth of 3 1/2 per cent in 1994. The slowdown in activity largely reflected the tighter monetary policy put in place over the course of 1994, with the growth of housing investment and the production of durable goods slowing sharply. As news emerged of the moderation in economic growth and the continued absence of any significant inflationary pressures, interest rates eased over the course of 1995, with the Federal Funds rate being cut by 75 basis points to 5 1/4 per cent and long-term interest rates declining by 1 3/4 percentage points over the year to this February. However the impact on overall monetary conditions has been off-set in part by the sustained appreciation of the dollar over the past nine months.

[TABULAR DATA FOR TABLE 6 OMITTED]

Recent data indicate that growth has been more robust than widely expected at the turn of the year. The deterioration in consumer and business confidence apparent at that time appears to have largely been due to a combination of the effects from severe winter weather and the temporary shutdown of much of the Federal government. By April the Conference Board index of consumer confidence and the National Association of Purchasing Managers index had recovered to their highest levels for over a year. After declining in January, payroll employment rose by 624,000 (0.34 per cent) in February, the largest monthly gain for 12 years, and the unemployment rate has subsequently declined to 5.4 per cent in April. This is the lowest rate attained over the course of the present expansion.

On balance it appears that the rate of growth remains close to trend levels. The provisional estimates for the first quarter of 1996 suggest that GDP expanded by some 0.7 per cent in the quarter, compared to growth of 0.1 per cent in the last quarter of 1995. The level of GDP was some 1.8 per cent higher than a year earlier. We expect that growth per quarter will remain around 0.6 per cent for much of the year, giving calendar year growth of 2 to 2 1/4 per cent. This largely reflects the extent to which activity is being supported by favourable financial conditions and the wealth effects arising from the appreciation of 33 per cent in equity prices over the past twelve months.

Long-term interest-rates have risen since February, reflecting an increased perception that the pace of domestic activity is proving to be more robust than had been expected. Our interest rate projections are summarised in Table 2. These continue to be based on forward rates in financial markets. We now expect a rise in short-term interest rates in the coming months, with rates settling at 6 1/4 per cent over the course of next year. Long-term interest rates are projected to settle at around 6 3/4 per cent. The US effective exchange rate has appreciated steadily since the middle of last year, helped by the official intervention in the foreign exchange markets, and the unexpected extent of recent reductions in interest rates in continental Europe. Our estimates shown in Table 4, indicate that the real effective exchange rate in the second quarter of this year may be 7 3/4 per cent higher than a year earlier.

In the first quarter of this year, personal consumption rose by 0.9 per cent, with the volume of expenditure some 2.7 per cent above that of a year earlier. Consumer confidence has strengthened noticeably since the turn of the year, possibly as a result of improved expectations about future employment prospects. A number of commentators have argued that expenditure was temporarily boosted in the first quarter by an unexpectedly quick payment of income tax refunds and the provision of back-pay to some Federal employees. We expect that expenditure will continue to grow, with real incomes underpinned by continued growth in labour income, and the improvements in the net worth of the personal sector following the appreciation of asset prices over the last 18 months. Real net financial wealth is expected to grow by around 9 per cent this year. For the year as a whole, consumption is projected to rise by around 2 1/2 per cent, with a small rise in the personal sector savings ratio to 4.8 per cent. The reduction in long-term interest rates in the latter part of last year has already provided some impetus to housing investment, with investment rising by 1 per cent in the first quarter.

Corporate investment expenditure strengthened appreciably in the first quarter. The total volume of business fixed investment rose by 2.9 per cent, with computer purchases expanding by 9.4 per cent. The level of investment was some 5.9 per cent higher than a year earlier. This may reflect the recent improvement in corporate profitability, with post-tax profits rising by 14 3/4 per cent in 1995, and the decline in long-term interest rates over the course of the year. We continue to expect that investment growth will moderate over the course of the year, with capacity utilisation remaining some 3-4 per cent below the peak levels attained in the latter months of 1994. The November 1995 survey of investment intentions indicated that business fixed investment was planned to rise by 1.5 per cent in 1996, after a rise of 8.1 per cent in 1996. Given the growth in investment in the first quarter, this projection would imply an average decline of 1 3/4 per cent per quarter in the level of business investment over the remainder of the year. Whilst we expect some slowdown in new investments, particularly in 1997, we do not yet expect any decline in the level of investment. Indeed it is possible that the forecast may understate the prospective growth of gross investment, if capital consumption is now higher than in the past as a result of the greater use made of information technology.

In contrast to fixed investment the pace of inventory accumulation has continued to slow, with stockbuilding in the first quarter at the lowest level since 1992. It is likely that stocks of primary products have been temporarily reduced as a result of the unusually severe climactic conditions at the turn of the year, raising demand for oil products. In the manufacturing sector, stocks may have been run down as a result of the disruption arising from the strike at General Motors. The process of stock adjustment has been underway since the middle of 1995 after domestic and external demand began to slow. Overall, the inventory cycle may have reduced GDP growth by 0.4 percentage points in 1995, depressing production and job creation. We expect the downward pressure on inventories to lift over the remainder of this year, although it may be some time before stocks can be built up in the agricultural sector in the wake of recent disruptions to grain supplies. Stockbuilding is projected to add 0.25 per cent to GDP growth in the second half of the year.

The rate of claimant unemployment has fallen by 2 1/2 percentage points over the course of the present expansion, and in April stood at 5.4 per cent. Past experience suggests that earnings growth should have begun to accelerate with unemployment around this level, yet there has been little evidence of this so far. It is possible that the claimant rate understates the degree of slack in the labour market at present, as over the past year the labour force has grown less rapidly than the population of working age. We expect the unemployment rate to average 5.7 per cent per annum this year and next, with employment rising by a little over 1 per cent per annum.

The rate of growth of the employment cost index has in fact begun to edge up a little in recent months, rising from 2 1/2 per cent in the autumn of 1995 to 3 per cent in the year to March, but it remains lower than at any other time since 1987. The rise was largely due to growth in wages and salaries, which rose by 1.1 per cent in the first quarter and were up by 3 1/4 per cent over the year. Benefit costs declined by 0.2 per cent in the first quarter and were only 2 per cent higher than a year ago. Aggregate compensation per head rose by a little over 3 1/2 per cent in 1995. Our projections show growth of 3.4 per cent this year and 3 per cent in 1997, with unit labour costs rising by around 2 per cent.

Inflationary pressures have remained subdued throughout the present business cycle in spite of the marked rise in resource utilisation. Consumer price inflation averaged 2.7 per cent in the first quarter of the year, up from 2.6 per cent in the last quarter of 1995. The monthly growth in prices has recently accelerated, with prices in March some 1.4 per cent higher than in December, helped by growth of over 10 per cent in fuel prices. This has prompted renewed fears of inflation in the financial markets; the yield on 10 year bonds rose from 5.9 per cent in early February to 7 per cent at the start of May.

However the rise in commodity prices has been narrowly based and does not appear to have fed through into general product prices. Producer prices of finished goods in March were some 2.4 per cent higher than a year [TABULAR DATA FOR TABLE 7 OMITTED] earlier, whilst import price inflation was only 1.6 per cent, reflecting the appreciation of the dollar over the past 12 months. The implicit price deflators in the national accounts also reveal few signs of any acceleration in inflation. The aggregate consumers' expenditure deflator (CED), shown in our forecast tables, rose by 0.5 per cent in the first quarter to a level 1.9 per cent higher than a year earlier. This is the lowest recorded annual rate of inflation for thirty years. The aggregate GDP deflator reveals a similar picture, rising by only 2.1 per cent in the year to the first quarter.

For the 1996 calendar year, we expect the CED to rise by around 2 1/4 per cent and the GDP deflator to rise by 2 1/2 per cent. This would be consistent with headline consumer price inflation of around 2 3/4-3 per cent. Some of the differences between the CED and the consumer price index may be removed in 1997 and 1998 as the Bureau of Labour Statistics makes changes to the survey sample used in collecting consumer prices to allow for the growth of discount stores and changes in the pattern of expenditure. (The current consumer price index is based on expenditure patterns in the early 1980s.)

The current account deficit rose sharply in 1994, to 2.2 per cent of GDP, with import volumes rising by around 13.5 per cent, helped by the strength of domestic demand. Export volumes also increased sharply, helped by the recovery in many industrialised countries and improved market access in North America. A similar pattern was apparent for much of last year, with a current account deficit of 2.1 per cent of GDP and a visible trade [TABULAR DATA FOR TABLE 8 OMITTED] deficit of 2.4 per cent of GDP. The balance on investment income shifted to a deficit in 1994 and 1995 from a small surplus in 1993, primarily due to a marked rise in payments of income on inward foreign direct investment after a period of sustained growth in domestic profitability.

We expect that the current account deficit will improve this year, possibly declining to around 1 3/4 per cent of GDP. In part this reflects a projected improvement in the terms of trade. However we also expect the growth of export volumes to continue at a robust pace, with a slowdown in demand from Europe being offset by a recovery in demand from Mexico and continued growth in trade within Pacific-Asia. In the first quarter of the year the volume of imports rose by 2 1/4 per cent, reflecting the overall pick-up in domestic demand. For the year as a whole we expect export volumes to rise by around 8 per cent, with import volumes up by 6 per cent.

The fiscal outlook has steadily improved over the last three years, largely reflecting the measures introduced in the Omnibus Budget Reconciliation Act of 1993 and the subsequent National Performance Review. The volume of final expenditure has fallen over the last two years and the Federal workforce has been reduced by over 200,000. Tax revenues have also risen significantly, helped by the beneficial impact of above-trend growth since 1993 and the additional tax measures introduced in 1993. In the 1995 fiscal year the Federal deficit fell to $164 billion (2.1 per cent of GDP). This was the lowest deficit since 1979. The Federal government has now run a primary budget surplus for the past two years.

Agreement has yet to be reached on the budget for 1995-96, some six months after the start of the 1996 fiscal year. However, the Clinton administration and the Congress still appear to agree that the budget should be balanced within seven years. This implies a modest fiscal tightening over the forecast period, the majority of which is likely to be implemented towards the end of the decade. Given the past history of such plans there must be some doubt as to whether the latest agreement will be fully implemented. It is possible that the continuing absence of any firm budget agreement has also contributed to the recent rise in long-term interest rates. We continue to expect that the combined Federal and state deficits will decline over the next two years, with a projected deficit of 1 per cent of GDP in 1998. This is slightly higher than shown in our February projections because of the higher level of interest rates assumed over the forecast period. Thereafter we continue to build in a modest reduction in the growth of transfer payments to the personal sector in order to ensure that the Federal deficit declines to around 1/2 per cent of GDP.

Canada

Economic growth slowed through 1995 in Canada, reflecting both the tightening of the policy stance in the early part of the year and the slowdown in the US. Provisional figures suggest that GDP rose by 2.2 per cent, with around half of this being accounted for by a further improvement in the net trade performance. Domestic demand weakened considerably, with housing investment falling by 13 3/4 per cent, a continued decline in government final expenditure and a sharp drop in the level of inventory accumulation in the latter half of the year. Fiscal policy is likely to remain tight over the course of this year and next, but the monetary stance has recently been eased, reflecting the continued moderation of inflation and the steady improvement in both the fiscal and external positions. Indeed in April, Canadian short-term interest rates fell below those in the US. We [TABULAR DATA FOR TABLE 9 OMITTED] presently expect growth close to 2 per cent this year and 3 per cent in 1997.

The economy only grew by 0.2 per cent in the fourth quarter of 1995, with a small decline in all components of domestic demand apart from machinery and equipment investment. Overall, business investment rose by 5 1/4 per cent last year, helped by improved profitability. Pre-tax profits rose by 15 per cent following a rise of 36 per cent in 1994. Consumers expenditure only rose by an estimated 1.4 per cent last year, possibly reflecting both the slow growth in personal incomes and the effect of the contractionary fiscal stance put in place during 1994 and 1995. Consumer confidence also fell sharply. The small decline in expenditure in the fourth quarter pushed the personal sector savings ratio back to 7 per cent, from 6 1/2 in the third quarter, the lowest level since 1971. With final demand slowing, stock levels rose sharply over the course of the year, accounting for some 0.4 percentage points of GDP growth.

Our forecasts for this year and next are partly shaped by the expected cycle in inventory and business investment, with corporate expenditure slowing as final demand continues to moderate. We expect that total domestic demand will only rise by around 1 per cent this year, with a further decline in the volume of government expenditure and residential investment and a marked slowdown in the level of stock accumulation. Business surveys indicate that stocks of finished goods are currently at their highest level since 1992. This has already led to production cutbacks, with new orders in the manufacturing sector in the three months to February some 1 per cent lower than a year earlier. We expect the inventory-sales ratio be reduced over the course of the year, with the lower level of stockbuilding reducing GDP growth by 0.5 percentage points.

The Bank of Canada has been committed to specific inflation control targets since 1991. The present objective is to ensure that underlying inflation, defined as the consumer price index excluding food, energy and indirect taxes, is held within a band of 1 to 3 per cent until 1998. Aggregate consumer inflation peaked at 2.9 per cent in the middle of 1995 before declining to 1.7 per cent by December. Inflation continued to moderate in the first quarter of 1996 and stood at 1.4 per cent in March. Underlying inflation fluctuated between 2-2 1/2 per cent for most of 1995, but declined at the year end and stood at 1.6 per cent in January this year. Domestic costs have risen only slowly, with the GDP deflator rising by 1.8 per cent in 1995 and unit labour costs by 0.7 per cent. Producer prices rose more rapidly, but they largely fed through into the price of exported commodities rather than into domestically consumed goods.

Import price inflation has moderated in the early part of this year, with annual inflation falling from 2.3 per cent in the fourth quarter of 1995 to 1.6 per cent in March. For the year as a whole we expect import prices to be broadly unchanged from last year. However we expect the growth of unit labour costs to rise this year to 0.8 per cent from 0.6 per cent in 1995, with productivity growth slowing to a projected 0.7 per cent, and growth of 1 1/2 per cent in average earnings. Inflation expectations appear to have moderated, since there has been little change in the yield on real return bonds over the past 12 months even though nominal long-term interest rates in the first quarter of 1996 were some 1 1/4 percentage points lower than a year earlier. Our forecasts imply that underlying inflation is likely to remain within the target range. The forecast in Table 9 is for the consumers' expenditure deflator in the national accounts. This is projected to rise by 2 1/4 per cent this year and around 1 3/4 per cent in 1997. Short-term interest rates are projected to move closely in line with those in the US, averaging 5.4 per cent in the second half of this year and 6.4 per cent in 1997.

For most of 1995 labour market developments were dominated by the restructuring of the public sector. Total employment rose by some 100,000 in 1995 (1.6 per cent) in spite of a decline of over 130,000 in public sector employment. The level of employment growth has recently begun to accelerate a little, rising by 0.7 per cent in the first quarter of this year. However the claimant unemployment rate rose to 9 1/2 per cent over the same period, with improved employment prospects helping to induce a marked rise in labour force participation. We expect the unemployment rate to remain around 9 1/2 per cent both this year and next, with employment rising by 1 1/2 per cent per annum on average.

The Federal Budget announced at the end of February reaffirmed the fiscal strategy put in place the previous year. This was designed to ensure that the Federal deficit declined to a target of 3 per cent of GDP in the present fiscal year (1996-97) and 2 per cent of GDP in 1997-98. The improvement in the fiscal position largely arises as a result of expenditure constraint, with the nominal value of programme expenditure planned to decline by 4 1/4 per cent this year (0.6 per cent of GDP) and 2 3/4 per cent in 1997-98. Fiscal consolidation is also being pursued by many provincial governments, with six out of ten administrations having tabled balanced budgets for the present fiscal year. In spite of this, the spreads between Canadian and US long-term interest rates have remained wide, possibly suggesting that fiscal credibility has not yet been fully established. Our forecasts have shown an underlying improvement in the fiscal position for some time, with the total general government financial deficit presently projected to decline from 3.7 per cent of GDP in fiscal 1995, to 2 per cent of GDP in 1997-98.

These projections imply that the Federal targets are likely to be met. In interpreting the forecasts it is important to note that our figures are for the financial deficit of Federal and provincial governments on a national accounts basis. This compares to the Federal objectives which relate to the deficit on a public accounts basis. The national accounts measure is lower than the public accounts one, largely because expenditure in the public accounts includes an allowance for the interest expense on past 'borrowings' from the pension plan surplus of public employees.

The prospects for the public finances in Canada are particularly sensitive to the future level of interest rates, as the outstanding (gross) level of general government debt is currently equivalent to 95 per cent of GDP. Improvement in the fiscal position thus requires that the fiscal commitment be maintained for some time. Our present forecast is that 10 year interest rates in Canada will average 7.8 per cent over 1996 and 1997, around 25 basis points lower than that assumed in the Federal Budget projections.

Net exports accounted for some 1.1 per cent of GDP growth in 1995, with import growth moderating as domestic demand slowed and exports continuing to benefit from the improvement in the competitiveness resulting from the depreciation of almost 20 per cent in the Canadian real effective exchange rate over the last four years. On the basis of relative costs the Canadian real exchange rate is now lower than at any time in the post-war period. The overall external position improved markedly last year, with the current account deficit declining to 1.7 per cent of GDP for the year as a whole and 0.6 per cent of GDP by the fourth quarter. This was the lowest level for 10 years. Over this period Canada's net external liabilities rose from 33 per cent to 45 per cent of GDP.

We expect some further improvements in the external deficit over the next two years, and project a small current account surplus of 0.1 per cent of GDP in 1997, with the surplus on visible trade rising to 3 3/4 per cent of GDP. Net export growth is projected to add 1.1 per cent to GDP growth this year and 0.7 per cent in 1997.

Japan

The economic recovery in Japan now appears to have become more firmly based, with GDP rising by 0.9 per cent in the final quarter of 1995 after growth of 0.6 per cent in each of the two preceding quarters. Growth has been led by residential and public sector investment, reflecting reconstruction expenditure in the Kobe region and the series of fiscal measures announced in the autumn. These can be expected to continue to boost demand this year. Monetary policy has also been relaxed, [TABULAR DATA FOR TABLE 10 OMITTED] with the official discount rate having been held at 0.5 per cent for eight months and the effective exchange rate having depreciated significantly over the past twelve months. Early indications suggest that activity has continued to expand this year, with industrial production rising by 1.3 per cent in the first quarter, and business confidence in the February Tankan survey rising to its highest level for four years. We continue to expect growth of 2 1/4-2 1/2 per cent in GDP both this year and in 1997.

The Bank of Japan reduced the official discount rate by 0.5 percentage points to a post-war low of 0.5 per cent in September and indicated that monetary conditions would not be tightened until there was clear evidence of a sustained recovery in private sector activity. The overall monetary policy stance has also been eased significantly as a result of the continued depreciation of the yen since last August. Our exchange rate projections in Table 4 suggest that the real effective exchange rate in the second quarter of this year may be some 20 per cent lower than a year ago. This reflects both the nominal depreciation of the yen and the present price deflation in the Japanese economy at a time when the (dollar) price of traded goods is rising more sharply elsewhere.

Market interest rates have recently begun to strengthen as evidence has emerged of the strength of the activity at the turn of the year, and we now expect short-term interest rates to rise to around 1 per cent by the end of this year and 2 per cent by the end of 1997. We continue to derive our exchange rate projections from an assumption of uncovered interest parity, and therefore show a small appreciation of the yen in 1996 given the present structure of cross-country interest rates. However the real exchange rate in 1997 is still projected to be some 8 per cent below its average level in 1994 and 1995, suggesting that the recent currency movements should provide some stimulus to net trade.

The fiscal package announced last September was the sixth such package in the last three years. In total the measures introduced amount to over 11 per cent of GDP. This has had a marked impact on the public finances, with the general government financial deficit forecast to average 5.2 per cent of GDP in 1996 and 4.5 per cent of GDP in 1997. These would be significantly higher deficits than previously anticipated, since the authorities had originally planned that this period would be one of fiscal consolidation after the earlier fiscal measures adopted in 1992-94. The need for a further relaxation of the fiscal stance has largely arisen as a result of the prolonged nature of the recent downturn. The measures announced last autumn included an expanded public works programme, financial aid to finance reconstruction in the Kobe region, financial support for small companies and rice producers and additional government land purchases. The overall value of the package was estimated to be some Y14.2 trillion (2 1/2 per cent of GDP). We continue to assume that the net cost of the package is likely to be around Y7-8 trillion, with around Y5 1/2 trillion going directly into government final expenditure, and additional transfers of Y2 1/4 trillion to the private sector. The volume of government investment is projected to rise by 9 1/2 per cent this year, before declining gently in both 1997 and 1998 as the present series of measures are phased out.

Continued uncertainty still remains as to the potential fiscal cost of government support to the financial sector, whose remaining bad debts are estimated at Y38 trillion (8 1/2 per cent of GDP) after debt write-offs of Y7 trillion before the end of the financial year in March. Equity prices have risen by a third from their low point in June last year, improving the capital position of those banks with large equity portfolios. However it is clear that the upturn in activity has not removed all of the structural problems within the financial system.

In particular concern still remains about the irrecoverable debts of the seven housing loan corporations (HLCs). These companies expanded into the commercial real estate market in the 1980s, using funds raised from loans from other financial institutions. The HLCs have total assets of some Y13 1/2 trillion (3 per cent of GDP), with around half of these thought to be irrecoverable. The potential losses of these companies could therefore help to generate systemic failure within the banking system. An orderly liquidation of the HLCs has thus been seen as a necessary prerequisite to the restoration of stability within the financial sector as a whole. The government has proposed an immediate cash injection of Y685 billion to cover part of the irrecoverable loans, with up to half of any losses on remaining loans also being paid for from public funds. The potential cost of this latter commitment is estimated to be an additional Y600 billion. A special body is to be set up to take over the HLCs assets and a number of changes to deposit insurance laws are planned. However widespread public opposition to the use of public funds in this manner has led to these measures being temporarily postponed in order that the Budget for the present fiscal year could receive parliamentary assent.

Overall, we continue to assume that off-budget government support to the banking sector will add some 2-3 per cent to the debt-to-GDP ratio. This is projected to rise from 84 per cent in 1995 to 95 per cent next year. The rise in the burden of public sector debt raises the likelihood of a future fiscal contraction once recovery is clearly underway. Plans to raise the sales tax in 1997 and to tighten pension provisions have already been announced. We assume that additional tax measures will be introduced, with the overall indirect tax rate rising by 2 percentage points between 1997 and 1999, giving an upward impetus to consumer prices over this period.

The prices of many consumer and producer goods and services have continued to decline over the past year. Aggregate producer prices in the first quarter of 1996 were some 0.9 per cent lower than a year earlier, after a decline of over 1 per cent in 1995. National consumer price inflation was estimated at around 0.1 per cent, although the index is widely believed to overstate inflation as it excludes many of the new discount stores. The national accounts data suggest that the overall consumers' expenditure deflator, taking account of a broader range of expenditure, fell by 0.4 per cent in 1995, some 1/2 per cent below official consumer price inflation. A similar picture is revealed by the GDP deflator which fell by 0.5 per cent in the fourth quarter of 1995. We expect that the CED will only rise by around 0.5 per cent this year, with the main price pressures arising from higher import costs. Import prices in March were 5.4 per cent higher than a year earlier. Unit labour costs are projected to fall by 1 per cent this year.

The labour market also appears to have picked up in recent months, with the unemployment rate declining from its post-war peak of 3.4 per cent in January to 3.1 per cent in March. The ratio of unfilled vacancies, a measure of employment trends, has averaged 0.67 (three applicants for every two jobs) compared to a low point of 0.60 last year and 1.41 at the peak of the economic cycle in 1990/1. However total employment growth has remained modest and labour force participation has declined over the past year. We expect that unemployment will remain around the present level for some time to come, with any pick-up in employment growth being offset by faster labour force growth as previously discouraged workers re-enter the labour market.

Whilst the growth of compensation has steadily moderated over the past few years and income from self-employment and asset holdings have both declined, falling prices have helped to support personal income in real terms. Incomes have also been supported by the reductions in personal taxation introduced in the middle of 1994. Thus consumption has grown by 1 3/4 per cent on average in 1994 and 1995 with little change in the personal savings ratio. The growth of disposable incomes may be constrained this year with total compensation only projected to rise by 1 1/4 per cent. However consumers expenditure' is projected to rise by 1.7 per cent, helped by some improvement in the overall financial position of the personal sector. Net financial wealth is forecast to rise by some 9 3/4 per cent in 1996. Housing investment is projected to rise by 2 1/2 per cent this year, with expenditure supported by the present low level of interest rates offered by many mortgage lenders.

There are some signs that the prospects for corporate investment have begun to improve, with a rise of 1.4 per cent in business fixed investment in the fourth quarter of last year to a level 5 1/2 per cent higher than a year earlier. Growth through the year was considerably higher than [TABULAR DATA FOR TABLE 11 OMITTED] might have been expected from surveys of investment intentions at the start of the year. We expect a similar pattern to emerge this year if private sector demand strengthens as we expect. Early indications suggest that investment demand has continued to expand this year, with the nominal value of new machinery orders in the three months to February being some 13 1/2 per cent higher than in the previous three month period. Financial constraints on new investment have eased over the past year, with the yield on industrial bonds having declined by 1 1/2 percentage points and corporate profits having started to recover. Capacity utilisation in the manufacturing sector rose by 5 1/2 per cent last year, although it remains well below the peaks attained in 1991. Our projections continue to show a marked growth in business investment of 6 1/2-7 per cent this year and next.

Net imports of goods and services have risen strongly since 1994, reflecting the impact of the continual appreciation of the real effective exchange rate up until the middle of last year and the restructuring of the Japanese economy. Domestic retail markets have gradually been deregulated and many domestic companies have continued to expand their overseas operations. The volume of merchandise imports rose by 13 1/2 per cent in 1995 and is projected to rise by a further 7 1/2 per cent in 1996. Growth thereafter is likely to depend in part on the extent to which the government is able to introduce all the measures considered in the Deregulation Action Plan of March 1995.

The share of output produced overseas has risen sharply in some sectors; for example foreign output accounted for around 30 per cent of production by Japanese car makers in 1994, compared to 18 3/4 per cent in 1990. However, across manufacturing as a whole, foreign production is only equivalent to around 10 per cent of domestic output. This is a considerably lower proportion of output than in other large foreign investors such as the US and Germany, whose foreign outputs are some 25 and 18 per cent of domestic output. This suggests that the restructuring observed in recent years can be expected to continue. The motivation for overseas direct investment has changed in recent years, with increasing emphasis on reallocation to lower cost sites elsewhere within Asia, rather than relocation within the regional markets of Europe and North America in order to bypass trade restrictions. This has changed the structure of trade, with many firms now exporting capital-intensive intermediate products to their subsidiaries rather than labour-intensive final goods and around a third of all manufactured imports into Japan now estimated to come from Japanese plants established overseas. Such intra-firm trade can be expected to be less sensitive to short-term variations in relative prices given the scope to adjust internal accounting arrangements. This implies that the improvement in export performance generated by the recent drop in the real exchange rate may be smaller than might be expected.

Many Japanese companies have also attempted to maintain market share over the past five years by reducing their prices in dollar terms. As can be seen from Table 11, the deterioration in competitiveness measured using relative export prices has been considerably less severe than measured on the basis of relative costs. At least part of the recent depreciation in the yen is likely to be used to restore profit margins. Thus we project export volume growth of 4 per cent this year and 5 3/4 per cent in 1997, a little below the growth in potential export markets. The latter is expected to remain relatively buoyant, with over 40 per cent of Japanese trade now with the fast-growing economies of East Asia.

In 1995 as a whole net import growth reduced GDP growth by 0.6 per cent, with particularly strong growth in manufacturing imports. Our forecast suggests that the growth of net imports will reduce GDP growth by a little over 0.8 per cent this year and a further 0.5 per cent in 1997. On a dollar basis the current account surplus is projected to decline to $56 billion this year (1.2 per cent of GDP), and $75 billion in 1997 (1.5 per cent of GDP). The medium-term decline is considerably faster than shown in our previous forecasts. This primarily reflects the sharp recent decline in the terms of trade at a time when the structure of trade is becoming less sensitive to relative price movements.

Section III. Prospects for Europe

Economic and Monetary Union

Recent developments in the European economies are likely to have an important bearing on the prospects for achieving the economic convergence required by the Maastricht Treaty (summarised in Box A). In the final quarter of last year output fell in Germany, France and Italy. We are now predicting significantly slower growth for the EU at around 1 1/2 per cent this year compared with 2 3/4 per cent in 1995. This is likely to mean lower tax revenues and larger social security expenditure as unemployment remains high. Therefore the slowdown in Europe is likely to make it harder for countries to improve their public finances in order to meet the Maastricht fiscal criteria, although debt-service burdens will have been eased by recent declines in interest rates.

However at the same time there have been a number of new fiscal measures taken by European governments. A number are discussed in detail in the individual country sections. The German government is seeking to introduce a DM 70 billion package of expenditure and social security cuts. The new administrations in Italy and Spain are both planning mini-budgets to reduce expenditure over the next two years. The French authorities, whose plans to reduce social security expenditure provoked a wave of industrial unrest, appear to have achieved the majority of the cuts they were seeking. They are now preparing the ground for further cuts in public expenditure and privatisations in 1997. Additional measures have also been announced by the Swedish and Belgian administrations. The financial markets now appear to be expecting a monetary union between Germany and France as long-term bond yields have recently converged between these two countries.

Box A. The Maastricht Convergence Criteria
Inflation Each country must have a sustainable price
 performance which means that its consumer price
 inflation rate must not exceed that of at most
 the three best performing states (in terms of
 price stability) by more than 1.5 per cent in
 the last year.


Fiscal Situation The government deficit to GDP ratio should not
 exceed 3 per cent and the government debt to GDP
 ratio should not exceed 60 per cent unless the
 excess is either exceptional and temporary, or
 unless the ratio is declining toward the target
 level at a satisfactory pace.


Interest Rates Long-term interest rates must not exceed those
 of at most the three best performing countries
 (in terms of price stability) by more than 2 per
 cent in the last year.


ERM Maintained ERM parity (within normal margins)
 without severe tensions for at least two years.
 No bilateral devaluation of a country's central
 rate (on its own initiative) over the same
 period.


In the light of these developments we have revised our assessment of the prospects for Economic and Monetary Union. Box B gives details of our latest forecasts for the major European economies.

It should be noted that the measures we report are [TABULAR DATA FOR BOX B OMITTED] based on the national accounts measures used in each country. These are not necessarily the same as the harmonised measures that will actually be used in judging whether a country meets the criteria for monetary union. It is well known that there are important differences in the fiscal numbers for some countries. There may also be important discrepancies between the national numbers for consumer price inflation, and inflation rates shown when a harmonised inflation indicator becomes operational next year. This is because countries differ in their treatment of factors such as insurance costs and the costs of housing in their national price indices. Preliminary estimates released by Eurostat in February suggest such differences might prove to be important. For example, the January inflation rate in the Netherlands was some 0.6 per cent lower using the harmonised price index, and inflation in Germany was reduced by 0.2 per cent. In contrast inflation in the UK and Italy was some 0.3 per cent higher than implied by their separate national price series.

We think it is possible that Germany will meet all the criteria in 1997. This is based on the assumption that a significant proportion of the measures announced in the recent fiscal package are actually implemented. We expect that the deficit will fall to a little under 3 per cent in 1997 and that the debt stock (on the Maastricht definition) should not exceed 60 per cent of GDP. France is likely to continue to make progress towards the targets but we currently expect that its deficit will be a little in excess of 3 per cent next year before falling to under 3 per cent in 1998. However this is unlikely prove a significant obstacle to France joining a single currency given the progress made in reducing the deficit from 6 per cent in 1994. The Netherlands also appears to be a likely founder member of the monetary union as it will meet both the deficit and inflation criteria. Although the debt limit of 60 per cent will certainly be exceeded there would be a strong case for allowing the Netherlands to join as it is placed at a particular disadvantage by the definition of debt stock used. The Netherlands has a high gross debt but because the government retains a large stock of assets, its net debt is comparatively low.

A case could also be made for EMU membership for Belgium, the UK (if it chooses) and possibly Spain. Belgium is likely to meet the inflation target and should come close to the deficit limit. Its debt stock is likely to remain well over 100 per cent of GDP, although it is likely to be steadily declining. Spain has recently made significant progress in reducing inflation, which previously appeared to be its greatest obstacle in meeting the criteria. It now appears likely that Spain will meet the inflation criterion next year, but may have a budget deficit of around 4 per cent and a debt to GDP ratio of over 70 per cent. Given the progress that will have been made since 1993 when the deficit was nearly 7 1/2 per cent of GDP this could perhaps be viewed as constituting satisfactory progress towards the targets.

The outlook for the UK appears to have deteriorated a little, and there is some danger that the inflation criteria may not be satisfied in 1999, although it is at present. The reported UK deficit is higher than before as we now show estimates on the Maastricht definition. Further details are given in the UK economy chapter in this Review.

The UK is unlikely to have been a member of the ERM for two years, but it now appears that the Maastricht Treaty requirements are to be interpreted as meaning that a country's currency simply has to remain within the bounds implied by the ERM. Membership of the ERM itself is not required in order to satisfy this, as we have argued for some time.

It remains unlikely that Italy will meet any of the criteria for some time and it is therefore doubtful that Italy will be a founder member of the monetary union.

Germany

The German economy experienced a sharp slowdown in activity at the end of last year. Overall real GDP is now estimated to have risen by 2.1 per cent in 1995, with domestic demand up by 1.8 per cent and net exports rising by 0.3 per cent. However all the growth took place in the first half of the year. This was followed by a stagnation in output in the third quarter and a drop in activity of 0.4 per cent in the final three months of 1995. Two factors can account for the slowdown in the fourth quarter: investment (down 1.4 per cent) and lower stock-building (down 1.1 per cent of GDP). The depth of the slowdown was something of a surprise and we discuss the reasons in Box C. The slowdown in growth along with lower than expected tax revenues has also contributed to a marked deterioration in the government's fiscal position, with the public sector deficit rising above the Maastricht ceiling to 3 1/2 per cent of GDP. Moreover due to Constitutional Court rulings that tax thresholds for those on low incomes be reduced and that the 'Kohlenpfennig' levy on electricity bills be abolished, it is likely that the deficit will widen somewhat this year.

The authorities now face the twin problem of trying to improve the government's fiscal position to satisfy the Maastricht fiscal criteria, whilst ensuring that the economy recovers during the course of 1996. To achieve the first of these two ends a number of new budgetary measures to improve the German public finances were announced at the end of April. The total package is worth around DM 70 billion, split between DM 25 billion cuts in the federal budget, DM 25 billion cuts in state and local authority spending and nearly DM 20 billion [TABULAR DATA FOR TABLE 12 OMITTED] reductions in social security spending. The precise details of how these proposals will affect individual spending departments will not emerge until the draft federal budget is approved in July, although it is widely expected that the defence budget will be particularly affected. The majority of the cuts at the state and local authority level are expected to come from a public sector pay freeze.

The social security savings will be generated by savings in pension expenditures as the retirement age for women is raised next year to 63 from 60 and cuts in pensions for ethnic Germans migrating from the former Soviet Union. There are also planned cuts in the health budget, with sick pay limited to 80 per cent of basic pay. The cuts in social security also reflect concerns about the long term viability of the system. Germany's comprehensive social security arrangements have had trouble coping with unification and the rise in unemployment. As a result, employee and employer contributions to social security now consume 40.8 per cent of the wage bill. The debate about social security reform appears to have become increasingly polarised and the old post-war consensus seems to be breaking down. The Federal government has recently suggested that pensions should be subject to income tax.

On the revenue side the government has modified its plans for reducing the solidarity surcharge on income tax that has been used to help finance reconstruction in the former East Germany. Instead of being reduced by 2 per cent in July 1997 it will be cut in two I per cent stages at the start of 1997 and 1998. The wealth tax is to be abolished at the end of this year and inheritance tax revised following Constitutional Court rulings.

The government proposals for cuts in social security spending and a public sector pay freeze are already encountering strong union opposition. The public sector trade union OTV has warned that it will not accept a wage freeze. Moreover there is widespread public opposition to the plans, with polls showing that nearly three-quarters of Germans are against the proposals. German employers have given the proposals a cautious welcome. The programme could also encounter legislative difficulties as the government has only a small majority in the Bundestag. The package must also pass through the Bundesrat, the upper house where the opposition parties have a majority. It seems most unlikely that the whole package will survive intact. This is reflected in our forecast. We have assumed that DM 25 billion of cuts in social security transfers and government expenditure will be achieved in 1997. However with a reasonable recovery in economic activity this should still be sufficient to reduce the deficit to around the Maastricht limit of 3 per cent. We expect that the debt stock will rise to around 57 per cent of GDP (58 per cent on the Maastricht basis) and fall slightly in 1997(2).

Another new measure which has also attracted widespread union opposition has been a deregulation of labour legislation which raises to 10 from 5 the number of persons a firm must employ before rules protecting workers against dismissal take effect. It has been suggested that the existing legislation reduced job creation, with firms reluctant to take on more than 5 employees. The reform is aimed at reducing Germany's unemployment rate which rose to 4 million (seasonally adjusted) in March, nearly 10 1/2 per cent of the workforce(3). Short-time working has also increased sharply to over 400,000 employees.

Official interest rates have continued to decline in the early part of 1996. In a surprise move the Bundesbank cut its discount and lombard rates by 0.5 per cent in April to 2.5 per cent and 4.5 per cent respectively. The annual growth of broad money was 12.2 per cent in March, well above the target range of 4-7 per cent, so it was widely expected that the Bundesbank would not feel that conditions were yet conducive for a rate cut. The rate cut clearly reflected concern about the state of the economy and the fact that inflation has remained muted. The annual rate of inflation in March was 1.7 per cent and producer prices have been growing very slowly. The Bundesbank also argues that the recent M3 data overstate monetary growth due to a number of technical factors such as increased bank lending to the public sector and a shift towards short-term bank deposits as an interim investment.

Economic indicators have been giving somewhat conflicting signals in the early part of 1996. Business climate and industrial confidence indicators have continued to decline as have domestic new orders. However domestic activity in the early months of the year has been affected by the severe winter. Provisional data show that German industrial production rose by 2.1 per cent in March after falling significantly in the first two months. Employment and activity in the construction sector appear to have picked up in March and April, whilst new orders for German exports have been recovering steadily since reaching a two year low in November 1995. We anticipate that there will have been another fall in GDP in the first quarter of this year, primarily due to further destocking [TABULAR DATA FOR TABLE 13 OMITTED] and lower construction investment. However we expect that growth will pick-up as the year progresses due to higher net exports and modest growth in consumers' expenditure. As shown in Table 12, we expect that GDP will grow by about 1 per cent in 1996.

A drop in construction investment was a major factor in the slowdown in growth in the second half of 1995. Investment declined by over 2 1/2 per cent and there has also been a large fall in sentiment in the construction industry. As we reported in the February edition of the Review there have been two factors behind this turnaround. To some extent it is a correction after the years of very rapid growth in construction following reunification. However there have also been changes in tax concessions for the building industry. These are being reduced over the next two years, most notably the special 50 per cent depreciation allowances for construction in east Germany. It therefore seems likely that the construction industry is set for a period of stagnation over the next few years. Investment in plant and machinery fell only marginally in the latter part of last year and we anticipate some rise as the economy recovers through the course of this year. Capacity utilisation levels have fallen back somewhat but still remain at around their multi-year average. As activity picks up there is likely to be some growth in plant and machinery capital formation, particularly as long-term interest rates remain at historically low levels. Overall we expect that total investment will be around 1 per cent lower in 1996 than 1995.

We expect that net exports will make a significant contribution to growth in 1996 of around 1 per cent. This [TABULAR DATA FOR TABLE 14 OMITTED] follows the 0.3 per cent contribution to growth in 1995 which was somewhat surprising given the rise in the D-mark in the early part of the year. The main factor behind this development was that goods import volumes grew more slowly in 1995 than we would have expected given the level of activity and the level of the real exchange rate. As shown in Table 13, we expect that import volume growth for goods will rise but remain fairly modest this year at around 4 per cent, reflecting slow growth in total final expenditure and the depreciation of the D-mark which took place in the second half of 1995. At the same time we expect an improvement in export performance with goods' exports rising by 6 1/2-7 per cent due to growth in export markets of around 6 per cent and the depreciation of the real exchange rate.

The growth of consumers' expenditure in 1996 is expected to be around 1 1/4 per cent, in line with growth in real personal disposable incomes. Disposable incomes will be held back by slow growth in average earnings of around 3 per cent. The main public sector unions are demanding a 4 1/2 per cent rise beginning in May, following last year's rise of 3.2 per cent. However this is likely to be resisted by the authorities' given their commitment to a public sector pay freeze in 1997. Unions and employers in the engineering industry have been negotiating an 'alliance for jobs' which seeks to introduce more flexible working arrangements. Relations between the unions and the government have worsened since the announcement of the package of spending and social security cuts so it is not clear what further progress can be made. The high level of unemployment, which we expect to remain at around 10 per cent for the next two years, should act to moderate wage pressures in 1996 and 1997. We expect that inflation will pick up slightly as the year progresses due to faster economic growth and higher import prices. The consumers' expenditure deflator is projected to grow by a little over 2 per cent this year and next.

France

The French economy also experienced a sharp slowdown in the latter half of 1995 but the causes were different from those in Germany. In the last three months of the year GDP fell by 0.4 per cent with the slowdown coming from a fall in consumption and exports. Both consumers' expenditure and exports will have been affected by the industrial unrest in reaction to government plans to reform the social security system. Earnings were affected by the strikes and total compensation was unchanged between the third and fourth quarter. Real personal disposable incomes fell by around 0.4 per cent in the fourth quarter of 1995 whilst consumers' expenditure fell by 0.2 per cent. Export volumes fell by a further 1 per cent following a drop of 1.4 per cent in the third quarter. The performance of exports, which had been surprisingly good in the early part of last year, has been affected by the strong value of the Franc and slower growth in French export markets, most notably Germany.

The French authorities face the same twin problem as their German counterparts of improving public finances whilst maintaining the economic growth. Fiscal policy was tightened in the June 1995 budget when the government announced tax increases and expenditure cuts amounting to over FF50 billion (0.7 per cent of GDP) in an attempt to reduce the deficit to 3.5 per cent of GDP by 1996. This was followed in November by a plan to reduce the social security deficit from FF65 billion in 1995 to FF17 billion in 1996 and a surplus of FF11 billion in 1997. This ambitious plan resulted [TABULAR DATA FOR TABLE 15 OMITTED] in a wave of unrest with major strikes and the authorities were forced to moderate their stance somewhat by dropping some of the welfare reforms and agreeing to greater consultation with the unions. In December plans to streamline the SNCF and to bring civil servants pension benefits back into line with those in the private sector were abandoned.

The prospects for further fiscal consolidation in France now appear to be good. Despite having to make some concessions to the trade unions the bulk of the welfare reforms remained in place. Moreover the position of the Chirac administration seems to have improved in recent months and they appear to have weathered the storm of the strikes and the currency markets. The administration appears increasingly confident about its ability to achieve its programme. In the wake of only limited union opposition a bill has been introduced which would [TABULAR DATA FOR TABLE 16 OMITTED] permit the sale of 49 per cent of the capital of public utilities to employees and outside investors.

The government is presently preparing the ground for deep public spending cuts in the 1997 budget. The government plans to cut overall public spending in real terms next year. They have ruled out further tax increases and are now committed to keeping the growth of public expenditure constant in nominal terms, implying a real cut of 2 per cent. The areas facing cuts are likely to be housing and job subsidies, rather than final expenditure. However the government strategy now seems to be that government deficit cuts will yield lower interest rates as a way of restoring growth. We anticipate that the government deficit will fall to around 4 1/2 per cent of GDP this year from 5 1/4 per cent in 1995. This is 1 per cent above the stated target of 3 1/2 per cent but we expect that as economic activity picks up, this figure will be achieved in economic activity picks up, this figure will be achieved in the following year. Moreover, if further progress is made on controlling public expenditure then it is possible that the deficit could be nearer 3 per cent of GDP in 1997.

The Banque de France has steadily cut official interest rates in very small stages since December last year. By mid-April the intervention rate had come down to 3.7 per cent from 4.9 per cent in December. These cuts have been possible due to falling interest rates in Germany and the strengthening of the franc against the D-mark. The franc rose by around 1 1/2 per cent against the D-mark in the first three months of this year. Market interest rates have also come down and ten year bond yields are now comparable with those in Germany. This suggests that the markets are now expecting monetary union to go ahead in 1999.

There are some signs of a turnaround in the French economy in the first few months of this year. The March and April INSEE surveys showed that the decline in overall industrial activity had halted. However the situation varied significantly between sectors - in the intermediate and capital goods industries activity remained weak, whilst the downturn in the consumer goods and car industries appears to have levelled out. Total order books remained poor and stocks too high but production prospects were a little brighter. In April the majority of industrialists predicted an upturn in activity in their sectors following a stabilisation in the first quarter.

Our forecast for French GDP is given in Table 15. We expect that some further destocking will take place in the first half of the year which will hold back GDP growth. However as the year progresses we predict that all components of domestic demand will recover and we anticipate that GDP will rise by around 1 1/2 per cent this year and 3 per cent in 1997. The fastest growing component of domestic demand is likely to be investment. Despite the slowdown in activity, capacity utilisation levels have remained high, and the INSEE surveys of investment intentions continue to point to strong growth. Housing investment is likely to benefit from lower short-term interest rates, whilst business investment will be boosted by the fall in long-term rates. Overall we predict that investment will grow by around 3 1/4 per cent this year and around 4.5 per cent in 1997.

Consumers' expenditure is expected to grow slowly at a little over 1 per cent in 1996 due to the slow growth in real personal disposable incomes. Incomes are likely to be held back by the tax increases enacted in last June's budget. However we are also expecting very slow growth in average earnings of around 3 per cent, due to the slowdown in the economy and the persistently high level of unemployment which we expect to remain at around 1 1/2 per cent of the workforce. As economic growth picks up in 1997 we expect that average earnings growth will rise to around 4 1/2 per cent and that consumption growth will reach around 2 1/2 per cent. Inflationary pressures are likely to remain muted in France, although we do expect some rise in inflation this year due to the effects of the rise in indirect taxation. Consumer price inflation is expected to average a little under 2 1/2 per cent this year before falling to around 2 per cent in 1997.

We foresee little immediate prospect of export led growth in France. Table 16 shows that we are anticipating that exports and imports of goods will both grow by around 5 1/2 per cent this year and around 7 per cent in 1997. Growth in French export markets is expected to be around 6 1/2 per cent and 7 1/2 per cent respectively in these years but the high level of the franc will restrained export volumes. Imports of goods into France are also expected to benefit from the strong French currency.

Italy

The Italian election resulted in a victory for the 'Olive Tree' alliance, a loose coalition of former Christian Democrats, central bankers, environmentalists and Marxists. The results have been broadly welcomed by the financial markets who believe that this grouping are more likely than another weak minority administration to successfully consolidate the public finances. The lira strengthened by around 2 per cent against the D-mark after the election results and short-term interest rates fell by 1 percentage point.

The first and most important task for the new government will be to restart progress towards fiscal consolidation. The previous prime minister, Lamberto Dini, had already warned of the need for further measures if the deficit target of 5.9 per cent for 1996 was to be met. The new administration plans a mini-budget which is expected to take additional measures to save L10,000bn for the 1996 budget with further cuts following in 1997. There is also likely to be some relaunching of the privatisation programme, with the sale of the remaining minority stake in Ina, the Italian insurance company, and possibly the sale of the majority stake in Stet, the Italian telecommunications company. At present it appears unlikely that the target of reducing the deficit to under 6 per cent of GDP will be achieved this year. We expect a deficit of around 6 1/4 per cent, falling to 5 1/2 per cent in 1997.

The new administration is hoping to rejoin the Exchange Rate Mechanism (ERM) and to cut the discount rate. However any official rate cuts will probably have to wait until the government's mini-budget and the consequent reactions of the financial markets. Recent developments in inflation do not augur well for a further monetary easing. The steady downward trend in Italy's [TABULAR DATA FOR TABLE 17 OMITTED] rate of inflation halted in April, raising concern regarding the probability of achieving the official inflation target of 3.5 per cent. Consumer prices rose by 0.6 per cent in April, giving an annual rise of 4.5 per cent. The governor of the Banca d'Italia is reported to have made a cut in the discount rate conditional on inflation declining below 4 per cent. Whilst official rates have remained constant, market interest rates have come down reflecting the improved prospects for fiscal consolidation. Three month rates have fallen by around 2 percentage points since the first quarter of last year, whilst long term rates have fallen by nearly 3 percentage points.

The Italian national accounts have recently been re-based to 1990 prices (from 1985 prices). At the same time there have been some revisions to growth figures in 1994 and 1995. GDP growth has been revised down to 3 per cent in 1995 and 2.1 per cent in 1994 (from 3.3 per cent and 2.2 per cent respectively). Growth last year came from a 2.3 per cent expansion in domestic demand combined with a rise in net exports of 0.7 per cent of GDP. Investment was the fastest growing component of domestic demand, rising by nearly 6 per cent. Capital formation has been stimulated by high capacity utilisation rates and tax incentives which encouraged firms to bring forward capital expenditure. This latter factor, combined with slower economic growth is likely to lead to lower investment growth this year and in 1997. As Table 17 shows we are projecting growth in investment of around 3 1/2 to 4 per cent in 1996 and 1997.

Consumers' expenditure also grew slowly in 1995 at 1.7 per cent. Consumption has been affected by the slow growth in real personal disposable incomes. Real wages fell in both 1994 and 1995. Consumption fell in the final quarter of last year and the prospects for a rapid recovery in the first half of this year do not appear good. Measures of consumer confidence have declined significantly since September due to greater uncertainty about the outlook for employment and incomes. However we expect that earnings growth will pick up this year. We have argued for some time that wage bargainers in Italy were surprised by the rise in inflation over the last two years. It is therefore likely that there will be significant pressure to recoup the losses of the last two years and we expect that wages will rise by around 6 1/2 per cent this year and 6 1/4 per cent in 1997. Faster earnings' growth should lead to faster growth in personal incomes and consumption in the latter part of this year and in 1997. However, because of the fall in consumption at the end of last year and the slow growth at the start of this year, we think that consumption growth of only about 1 per cent will be recorded for the year as a whole. In 1997 we anticipate that consumers' expenditure will rise by around 2 1/2 per cent.

Net exports made a significant contribution to growth in 1995. As Table 18 shows this was primarily due to a very large rise in export volumes. We do not expect this to continue into this year due to the rise in the value of the lira. The Italian currency has appreciated significantly since the middle of last year with the effective exchange rate rising by over 10 per cent. We predict that the volume of merchandise exports will grow by 3-3 1/2 per cent this year and 6-6 1/2 per cent in 1997. Imports are [TABULAR DATA FOR TABLE 18 OMITTED] expected to grow slowly due to the slow rise in total final expenditure anticipated for this year. The volume of goods imported into Italy is expected to rise by around 3 3/4 per cent this year before rising to 7 1/2 per cent next year as domestic demand increases. Overall we expect that total net exports of goods and services will be little changed over the next two years.

As Table 17 shows we are forecasting overall GDP growth of 1 1/2 per cent this year followed by 2 1/2 per cent in 1997. Unemployment is expected to remain at 11 1/2-12 per cent this year and next due to slower economic growth and faster real wage growth. Inflation is predicted to average around 4 1/2 per cent this year and 4 per cent in 1997.

Spain

Despite leading the right of centre Popular Party (PP) to an election victory on the 3 March, Jose Marie Aznar had [TABULAR DATA FOR TABLE 19 OMITTED] to wait almost two months before he was in a position to form a government. The new Aznar administration takes control of the Spanish economy at a time when it has experienced a significant slowdown in economic activity. GDP growth in the final quarter of 1995 was 0.4 per cent, down from over 1 per cent in the first quarter. However growth in the year as a whole remained robust at 3 per cent. The decline in growth rates has been caused by slower growth in domestic demand, with private and public consumption and investment all growing slowly in the latter part of last year. The moderation in economic growth was not generated by declining net exports, despite slower growth in other parts of Europe. Export and import volumes both grew very rapidly at around 8 per cent in the year to the fourth quarter.

The government have embarked on a Pta250bn (0.4 per cent of GDP) package of cuts as part of a mini-budget aimed at improving the government's finances. The package involves postponing capital spending projects across all departments, especially public works such as roads. As Table 20 shows we estimate that the general government financial deficit will have averaged about 5 3/4 per cent last year. We expect that, if successfully enacted, the new fiscal measures will help to reduce the deficit to a little under 4 per cent of GDP by 1997, still nearly 1 per cent above the ultimate Maastricht limit of 3 per cent.

Since the March election the Banco d'Espana has made further cuts in its benchmark interest rate, reducing it by 3/4 per cent in two stages to 7 1/2 per cent. This reflects the considerable progress made toward reducing inflation, the improved prospects for fiscal consolidation and also concern about flagging economic growth. Monetary policy is targeted at reducing inflation to under 3 per cent by 1997. Inflation rose sharply in 1995 when prices were boosted by a 1 per cent rise in VAT, and reached a peak of 5.1 per cent in June. The Banco d'Espana responded by raising its intervention rate by 2 percentage points to 9 1/4 per cent. In the second half of the year inflation declined and by March of this year it had fallen back to 3.4 per cent. We expect that the slowdown in growth and moderate level of pay settlements will allow continued progress to be made in reducing inflation. We anticipate an inflation rate of around 3 1/4 per cent this year and in 1997, only 1/4 per cent above the authorities' target.

The growth of consumers' expenditure slowed [TABULAR DATA FOR TABLE 20 OMITTED] throughout 1995 and averaged 1.8 per cent for the year as a whole. Consumption has been affected by the slow growth in real personal disposable incomes as average earnings growth lagged slightly behind inflation. There are signs that consumption growth is likely to remain slow in 1996. Retail sales fell in the first two months of this year. Average earnings are also expected to continue to grow slowly at a little under 4 per cent this year and 4 1/2 per cent in 1997. We foresee real personal disposable incomes growing by around 1 1/2 per cent this year and 2 1/4 per cent next year. In turn we expect that the growth in consumers' expenditure will slow to around 1 1/2 per cent this year before rising nearly 3 per cent in 1997.

Investment was the fastest growing component of domestic demand in 1995 as a whole, rising by 8.4 per cent. The recent rapid rises in investment have been linked to the turnaround in profitability and lower mortgage interest rates during 1994. With interest rates continuing to fall and capacity utilisation rates remaining high we expect that investment growth will continue this year and next, albeit at a significantly lower rate of growth. We expect that investment will rise by around 4 1/4 per cent this year and 3 3/4 per cent in 1997.

Overall we forecast GDP growth of around 2 per cent this year, rising to 3 per cent in 1997, helped by the rebound in growth elsewhere in Europe.

NOTES

(1) Recent trends in the consumption of primary commodities in the OECD are discussed in the December 1994 OECD Economic Outlook, page 6.

(2) We have revised down our estimated debt stock for 1995 significantly. This is because we had overestimated the impact of the Government taking on the responsibility for the debts of the Treuhand privatisation agency.

(3) We have changed the measure of the unemployment rate reported in Table 12. We now use unemployment as a percentage of the total workforce rather than just the dependent workforce. The previous measure yielded unemployment rates about 1 percent point higher.

RELATED ARTICLE: Box C. What has Caused the Slowdown in Germany and France in 1995?

The extent of the slowdown in Germany and France over the course of 1995 came as a surprise to many commentators, including ourselves. For example, in May last year the consensus forecasts for these countries both predicted GDP growth of 3 per cent in 1995 and 2.8 per cent in 1996. The reasons for the slowdown in the latter part of the year and the errors made in our earlier forecasts remain unclear. Interest rates fell over the course of the year, but the real exchange rate appreciated and announcements were made of future fiscal consolidation. Business and consumer sentiment declined towards the end of the year.

One well established technique of examining the source of forecast errors is to return to the model used in the earlier forecasts and undertake a series of forecast variants, putting in alternative sets of residual judgements and alternative paths for exogenous variables (external demand, fiscal policy etc}. Britton and Pain (1992) provide a detailed illustration of this approach. Unfortunately we are not able to undertake such an exercise for our recent German forecasts, as our forecasting model in November 1994 and February 1995 related to West Germany rather than pan-Germany. We do not have a full set of national accounts for West Germany in 1995 from which to calculate forecast errors.

As an alternative we have undertaken a related exercise using our present model. We have produced a set of variant forecasts for France and Germany for 1995, conditional on the actual settings of monetary and fiscal policy in 1995 and the level of external demand from third countries. This provides an indication of the extent to which the model is able to explain what happened in 1995, given what we now know about policy settings.

In Germany the model underestimates the strength of GDP growth in the first half of the year and fails to capture the full extent of the slowdown in the second half. However overall growth for 1995 is about right. The model forecasts the growth of consumption and stockbuilding very well but is very inaccurate in its predictions for investment and net trade. The model does not pick up the stagnation in investment in the first half of the year or the large drop in the second half. This error has come entirely from a failure to forecast the decline in construction investment in 1995. The fact the consumption expenditures but not housing investment are tracked closely, suggests that the decline in consumer confidence, which is not included specifically in our model, may not account for much of the downturn in Germany. The same is true of the real exchange rate. The difference between the actual trade performance and that predicted by the model is that whilst the appreciation of the D-mark in 1994 and the first half of 1995 did indeed reduce net trade growth, it did so by much less than might reasonably have been expected. This is the mirror image of the position in countries such as the UK, where export performance appears to have been worse than might have been expected given the improvement in competitiveness.

It is also surprising to note that the model succeeds in capturing the broad trends in stockbuilding, although it does not predict the sudden downturn in inventory accumulation in the final quarter of 1995. The model fails to pick up the large deterioration in the German public finances in 1995 which emerged mainly because of lower than expected tax receipts.

The model does not capture the full extent of the slowdown in France last year. However in contrast to Germany, this largely arises from the failure to predict the slowdown in consumption and net trade. This may provide some indication that declining confidence affected household expenditure, although it is clear that consumption was also constrained as a result of a fall in earnings during the strikes at the end of the year. We have not attempted to allow for this effect in the calculations reported below. The main error in projecting net trade occurs in the second half of 1995; the corresponding errors made in the projections of German domestic demand suggest that in part this error may reflect the extent to which the actual slowdown in Germany has affected export sales from France. However exports were also affected by the industrial unrest in the latter part of the year.

Overall, these results do not point to any single, simple explanation of the source of recent errors in forecasting either Germany or France. In particular there is relatively little evidence to support the claim that the full extent of the slowdown can be attributed to the appreciation of the D-mark and the franc. However it is of interest to note that the pattern of errors across the two countries is consistent with the pattern of changes in business and consumer sentiment. Survey evidence indicates that construction industry sentiment fell sharply in Germany in 1995, but remained unchanged in France. Equally separate survey evidence shows that consumer confidence deteriorated in France in 1995 much more rapidly than it did in Germany. This suggests that it could prove of benefit to put greater weight on the relatively timely information provided by such surveys.

[TABULAR DATA FOR TABLE A OMITTED]

REFERENCES

Britton, A. and Pain, N. (1992), 'Economic forecasting in Britain', National Institute Report no. 4.
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Title Annotation:includes related article on the 1995 economic slowdown in Germany and France
Author:Morgan, Julian; Pain, Nigel
Publication:National Institute Economic Review
Date:May 1, 1996
Words:17117
Previous Article:The UK economy.
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