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The world economy.

Section I. Prospects for the World Economy

Introduction

It is increasingly clear that the world economy has been recovering relatively strongly from a pause in activity at the end of 1995. The recovery has also been relatively well spread around the globe, with Japan displaying the strongest growth amongst the larger economies, in part because of the effects of the depreciation of the yen, but also because government policy was expansionary throughout last year. Although growth rates in Europe appear low in 1996, with Germany and France both recording growth of less than 1 1/2 per cent, growth through the year has generally been strong. It appears there is still some spare capacity in Europe, and hence growth can be expected to strengthen further into 1998, at least within continental Europe. The US economy has been growing at or above capacity for several years; in the fourth quarter of last year output rose by a further 1 per cent, with growth through the year of over 3 per cent. Domestic demand also rose strongly in Canada and Mexico in the latter half of last year. Growth in the NAFTA economies is expected to strengthen in 1997, but to slow into 1998 in the aftermath of moves to tighten monetary policy. Overall, as can be seen from Table 1, we expect a period of above trend growth and low inflation in the majority of the OECD countries.

Prospects for a stable evolution have, in general at least, been improved by recent currency movements. The yen has continued to depreciate, reducing any deflationary pressures that might have emerged with the recent fall in equity prices and continuing declines in property prices. The yen has been hovering around 125 to the dollar recently, as compared to 84.5 in the second quarter of 1995. The US dollar has appreciated against other currencies as well, especially against those of continental Europe, where many economies have high unemployment and considerable spare capacity. Hence recent changes in real effective exchange rates, shown in charts 1 and 2, have helped to redistribute world demand in a way that should ease inflationary pressures. The US and the UK effective exchange rates have appreciated in real terms by five and ten per cent respectively over the last year; both economies were previously starting to face the prospect of rising inflationary pressures whilst operating above capacity. Short-term inflation prospects have also improved as a result of the unexpectedly sharp drop in oil prices since the turn of the year, with stock levels having accumulated in North America and a number of OPEC members having exceeded production quotas.

We also consider that, in general, over the last two years real exchange rates have moved closer to what might be considered long run sustainable levels. Our most recent calculations of FEERs(1) are based on effective exchange rates, and it is always difficult to move from a weighted average of all competitors to the analysis of nominal bilateral rates. However, bilateral measures suggest that, if all other exchange rates were at their equilibrium, a yen - US dollar rate of 116 and a D-mark - Dollar rate of 1.54 would seem appropriate. Hence, given the exchange rates shown in Table 3, the dollar may have appreciated to a level above its FEER, whilst the yen and DM are a little undervalued(2). However, we feel that these estimates should be treated with caution, especially in current circumstances.

There are a number of reasons for recent changes in exchange rates, and the effect of these adjustments depends both upon the causes of the movements and upon their permanence. To an extent they reflect a tightening of fiscal policy in much of Europe, accompanied by a fall in interest rates designed to ease monetary conditions and thus meet monetary objectives. Meanwhile, short term interest rates in the US and the UK have been expected to rise, again with the objective of keeping to existing targets for monetary policy. Some adjustment of relative exchange rates is inevitable in the face of such changes, especially if they are expected to persist. However, recent relative movements in exchange rates have been somewhat larger than might have been expected given the expected profile for interest rates, at least as revealed by the markets for longer dated government debt.

The strength of the dollar has been accompanied by a [TABULAR DATA FOR TABLE 1 OMITTED] very strong stock market in the US, at least until very recently, as can be seen from chart 3. It is possible that this rise in the markets is a speculative bubble, although there are grounds for believing that it may also reflect fundamental changes in the nature of the economy. The value of stocks has risen on the back of the strength of equities in companies with large intangible assets. These include knowledge-based companies such as Microsoft and Intel, whose assets flow from their research base. Traditional measures of equity capital based on physical investment do not capture all of these increasingly important assets, and it appears that the markets have been re-evaluating their worth in the light of their increasing importance in the processes of production. It is notable that productivity growth in the US manufacturing sector has averaged over 3 per cent per annum over the past three years in the midst of a sustained expansion in business investment in information technology.

If the value of knowledge-based assets is being upgraded, then we would expect to see structural capital flows into the US stock market, given the relative advantage of US companies in the production and ownership of such assets, and hence an appreciation of the dollar relative to other countries. If this re-evaluation ultimately reflects an underlying change in the productive potential of the economy, then internal and external balance relations may change, and hence any estimates of FEERs could have to be adjusted.

Other recent changes in exchange rates, such as the relative strength of sterling and the Australian dollar, may not be completely independent of the strength of the US stock market. Traditional links, cross-holdings and coherent economic cycles have made these markets move together in the past(3). In addition there is some suggestion that the approach of Monetary Union in Europe has changed the allocation of portfolios in favour of the currencies of non-participating economies, as fund holders concerned to ensure portfolio diversification can see increasingly little difference between the core European currencies, at least in terms of risks related to currency fluctuations. This might suggest that the movement of sterling away from a sustainable exchange rate has been larger than for the US dollar.

World Trade

We estimate that the total volume of world merchandise trade rose by around five per cent in 1996, less than half the growth experienced in 1994 and 1995. The slowdown was partly the consequence of slower growth in economic activity, especially in Europe. Trade growth in Europe probably slowed to three to four percent, almost half its level in 1995. However, the slowdown was largely related to a fall in import (and export) growth in East Asia, as can be seen from Chart 4. In this region economic growth slowed somewhat in 1996, but not enough to explain the rapid slowing of import growth. Much of the change appears to have been in intra-regional (and probably intra-firm) trade, especially between China and its three major local partners, Macao, Hong Kong and Taiwan. This in part reflects the removal of export tax rebates at the end of 1995 which induced a surge in exports from China, and hence reduced exports, and export growth, in 1996.

Prospects for world trade growth in 1997 are good, in [TABULAR DATA FOR TABLE 2 OMITTED] part because of a recovery of trade within East Asia, helped by renewed growth in the market for semi-conductors, but also because the devaluation of the D-mark bloc will have worked through and eased pressures within Europe. As can be seen from Chart 4, we expect trade growth in OECD Europe to rise from around 3 per cent in 1996 to around 7 per cent in 1997. This profile also reflects the differential pattern of behaviour in Europe, with the devaluers, France and Germany, responding more slowly to their gain than the appreciators, Italy and the UK, do to their loss. Hence the realignment of exchange rates initially slowed trade and output growth, although in the long run it will have no effects on output and relative prices. The trade growth we forecast for 1997 in East Asia is more than three times that seen in 1996, restoring the dynamism of this region.

Interest rates and exchange rates

Given the scale of exchange rate changes over the last year, interest rates have been remarkably stable. Short term interest rates in the US have recently edged up, with the Federal Funds rate rising by a 1/4 per cent in March. We expect that rates will continue to rise over the next year, and that they will stabilise around 6.4 per cent. Changes at the short end have been larger than at the long end of the liquidity spectrum, and we do not anticipate any further rise in long-term rates. It appears that real interest rates will remain relatively high in the US (and the UK) in the short term With inflation expected to remain below 3 per cent in both countries, short rates over 6 per cent imply real rates around 3 to 4 per cent, in line with the longer-term real interest rates implied by index-linked bonds in both countries. This is not particularly surprising given both economies are at their cyclical peaks, but it is significantly above forecast real rates elsewhere.

Interest rates in Japan and continental Europe continued to decline into the early part of this year. Rates in Japan have remained at around 1/2 a per cent at the short end, giving the hard pressed banking sector some relief. We do, however, expect them to rise somewhat given the beneficial (and inflationary) effects of the depreciation of the yen. In Europe French interest rates have fallen to German levels at both the long and the short end without any particular pressure from the Banque de France to ensure [TABULAR DATA FOR TABLE 3 OMITTED] that they do so, and the franc has remained relatively strong within the ERM. Italian interest rates have also fallen, and long term rates are now around the same level as in the UK. This in part reflects the disappearance of a government default risk premium at the long end; if sustained [TABULAR DATA FOR TABLE 4 OMITTED] [TABULAR DATA FOR TABLE 5 OMITTED] this will have a significant impact on the prospects for the public finances. Real interest rates in Europe are forecast to remain below 3 per cent for several years, although we expect to see some upward movement in short-term rates in 1998 as demand strengthens.

Section II. Prospects for North America and Japan

United States

The present economic expansion in the United States continues to appear firmly based. GDP rose by 1 per cent in the fourth quarter of last year, giving growth through the year of 3.1 per cent. Activity has been supported by favourable financial conditions and the wealth effects arising from the appreciation in equity prices over the past three years. Although capacity utilisation has remained broadly flat over the past year, job creation has been exceptionally rapid and there is some evidence that the labour market has begun to tighten. Whilst we continue to expect that any upturn in inflation will be modest, there are increasing inflationary risks if the momentum of the economy continues to prove more robust than expected. Our projections now show calendar year growth in GDP of a little over 2 3/4 per cent this year, declining to 2 per cent in 1998.

Recent data indicate that growth has continued to be more robust than widely expected at the turn of the year and it appears that the pace of activity remains above trend levels. Consumer confidence in current economic conditions has risen to its highest point for 27 years, amidst signs that the sustained rise in the net financial wealth of the household sector over the past three years is starting to feed through into expenditure. Total retail sales rose by 3.2 per cent in the first quarter, implying a volume rise of around 2 1/2 per cent given movements in consumer prices. Civilian employment rose by 1.0 per cent in the three months to March, with a net 1.32 million jobs being created during this period. Industrial production rose by [TABULAR DATA FOR TABLE 6 OMITTED] 1.1 per cent in the first quarter of this year and the Purchasing Managers Index of business prospects has risen consistently over the past few months.

However the overall outlook for price inflation has continued to appear relatively benign. In part this reflects the recent evidence that inflationary pressures within the US economy have been weaker than might have been expected on the basis of past responses to above-trend levels of resource utilisation. Producer prices of finished goods fell by 0.2 per cent in the first quarter, helped by a decline in energy costs after oil prices weakened in February. Prices were some 2.1 per cent higher than in the first quarter of last year.

The drop in energy prices has also helped to reduce headline consumer price inflation in the early part of the year. Inflation in the year to March was 2.8 per cent, down from a recent peak of 3.3 per cent last November. In the first quarter prices rose by only 0.6 per cent, suggesting that some further moderation is to be expected in the coming months. The 'core' measure of consumer price inflation, which excludes food and energy, has declined to 2 1/2 per cent, the lowest level achieved for nearly 31 years. Price pressures also appear weak when judged by the national accounts deflators. The consumers' expenditure deflator and the overall GDP deflator both rose by only a little over 2 per cent in 1996, with investment goods prices remaining unchanged from 1995. Import price pressures have been weak, helped by the estimated 16 1/2 per cent appreciation of the dollar effective exchange rate over the past two years.

In the short-term the main inflationary pressures are likely to emerge from the labour market. Average hourly earnings in March were 4 per cent higher than a year earlier, compared to growth of 3 1/2 per cent over the year to the fourth quarter of 1996. In part this undoubtedly reflects the impact of the higher Federal minimum wage which was raised from $4.25 per hour to $4.75 per hour last autumn. Average earnings on a national accounts basis, measured in terms of labour compensation per employee, rose by 1 per cent in the fourth quarter. The growth of non-wage salary costs (around one-quarter of total compensation) has also begun to rise a little, after a sharp deceleration over the past two years due to structural reforms in health-care payments and provision. An additional upward shift in earnings is to be expected this autumn, with the minimum wage due to be raised further to $5.15 an hour. However the current low level of price inflation and the moderation in economic growth we project through the year can be expected to help restrain general pay pressures. We expect average earnings to rise by 3 1/2 per cent for the year as a whole, and by a further 33 1/4 per cent in 1998.

It appears that labour market trends lie behind the moves to tighten domestic monetary conditions in recent weeks. The Federal Funds rate was raised to 5 1/2 per cent in March, the first increase for 14 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. It is possible that the continuing absence of any firm agreement [TABULAR DATA FOR TABLE 7 OMITTED] over the means of balancing the Federal budget has also contributed to the recent rise in long-term interest rates. Our interest rate projections are summarised in Table 2. These continue to be based on forward rates in financial markets. We expect a further rise in short-term interest rates in the coming months, with rates reaching 6 1/4 per cent by the end of the year. Long-term interest rates are projected to settle at around 6 3/4 per cent. The sustained rise in equity prices over the past three years also appears to have lost some momentum, with prices at the time of writing some 5 per cent below their recent peak level. However they remain 14 1/2 per cent higher than a year ago, suggesting that recent declines are unlikely to have a substantive negative impact on expenditure.

Recent currency movements have also helped to tighten monetary conditions. The appreciation of the US effective exchange rate since the middle of 1995 has been helped by official intervention in the foreign exchange markets and the unexpectedly low level of interest rates in continental Europe and Japan. Our estimates shown in Table 4 indicate that the real effective exchange rate in the first quarter of 1997 was over 5 1/2 per cent higher than a year earlier, with the large bilateral appreciations against the yen and the D-mark being offset by smaller appreciations against the Australian and Canadian dollars, sterling and the Mexican peso.

The impact of the tighter monetary conditions we expect to see over the next few months should help to constrain output growth, much as it did in the aftermath of the last sustained rise in interest rates in 1994. We expect to see growth through the year of 2-2 1/4 per cent in line with the projections of the Clinton administration and the Federal Reserve. Short-term interest rates had to be raised to 9 1/2 per cent in 1989 as inflation last began to accelerate significantly. At present we do not expect to see a marked acceleration in wage and price inflation, although resource utilisation is close to the levels at which inflation began to rise during the last business cycle, and hence we expect short rates to rise to only 6 1/2 per cent.

On a whole economy basis, unit labour costs are expected to rise by 2.7 per cent this year, after growth of 3 1/2 per cent in 1995 and 2.9 per cent in 1996. These estimates may overstate the degree of cost pressures as it has been argued that service sector productivity growth has been understated in the national accounts in recent years. Productivity has recently grown rapidly in the manufacturing sector, rising by an average 3 1/2 per cent per annum in 1995 and 1996, compared to average growth of 1 1/2 per cent per annum over the past two decades. As a result unit labour costs in manufacturing have been falling in recent months.

The rapid decline in the unemployment rate up until the early part of last year gave a somewhat misleading impression of the degree of slack in the labour market. It has subsequently remained stable at around 5 1/4 per cent despite the above-trend growth of the past 12 months, with the labour force rising by 2.1 per cent over the year to the first quarter of 1997. It is also notable that average unemployment durations have remained stable over the past two years and are well above the levels seen at the last cyclical peak in 1989. We expect unemployment to edge up in the second half of this year to around 5 1/2 per cent by the year end. Our own econometric evidence suggests that the minimum wage rises should have a modest negative [TABULAR DATA FOR TABLE 8 OMITTED] impact on employment, with the size of the eventual effect depending on whether the minimum wage is held fixed in real terms.

On balance we continue to expect to see a modest pickup in inflation, with the consumers' expenditure deflator (CED) rising by around 2 1/4-2 1/2 per cent this year and 2 1/22 3/4 per cent in 1998. This would be consistent with growth of around 2 3/4-3 per cent in the headline consumer price index. Over the last two years the rate of growth of this measure has been around 1 per cent above that of the CED, possibly because the expenditure weights employed are more dated than those in the CED. A series of reforms are planned over the next two years, which should remove some of these discrepancies and hence we would expect some degree of convergence between the two series.

In the last quarter of 1996, personal consumption rose by 0.8 per cent, with the volume of expenditure some 2.7 per cent above that of a year earlier. It appears likely that expenditure growth accelerated in the early part of this year, although a number of commentators have argued that incomes were temporarily boosted in the first quarter by an unexpectedly quick payment of income tax refunds. We expect that expenditure will continue to grow steadily over the remainder of the year, 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 three years. Real net financial wealth is estimated to have risen by 10 3/4 per cent in 1995 and 13 per cent in 1996. However the aggregate figures hide evidence of a growing dispersion in household finances, with credit card delinquency rates having risen persistently since the middle of 1994, particularly amongst low-income households, and household debt interest payments as a proportion of post-tax incomes having risen close to the peak level prior to the last recession.

For the year as a whole, consumption is projected to rise by around 3 per cent, with a small fall in the personal sector savings ratio to 4.9 per cent. In 1998 we anticipate a further decline in the savings ratio, as a counterpart to the rise in the wealth-income ratio. The rise in long-term interest rates in the early part of this year can be expected to moderate housing investment, and we expect a rise of only 1 per cent this year and a small drop in 1998.

Corporate investment expenditure continued to strengthen considerably over the course of last year. Business investment grew by 7 1/2 per cent, and has now risen by 47 per cent over the past 5 years. At constant prices its share of GDP has risen from 9 per cent in 1991 to 11.1 per cent in 1996. With capacity utilisation remaining close to its historical average, interest rates edging up and the cyclical growth of corporate profits beginning to slow, we expect business investment to moderate in the second half of this year, with projected growth of 6 1/4 per cent this year and 2 3/4-3 per cent in 1998. However it is possible that this projection may overstate the prospective slowdown if capital consumption is now higher than in the past as a result of a decline in average asset lives.

The current account deficit rose to 2.2 per cent of GDP last year, and was the second largest nominal deficit ever recorded. The deficit now exceeds the combined surpluses of the EU economies and Japan. Merchandise trade has continued to expand rapidly in the aftermath of recent changes in regional trade and investment patterns. In the three months to January the volume of merchandise exports was some 11 per cent higher than a year earlier, while merchandise imports rose by 11 1/2 per cent. Export performance appears to have been somewhat better than might have been expected given the appreciation of the real effective exchange rate. In the fourth quarter of last year net exports added some 0.6 per cent to GDP, with export sales being supported by above-trend growth in domestic demand in both Canada and Mexico. Total exports to Mexico rose by around 25 per cent last year.

We expect that the current account deficit will fall 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 recent acceleration in the growth of export volumes to be maintained as a result of the faster growth in both North American and Asian markets. For the year as a whole we expect export volumes to rise by around 8 1/2 per cent, in line with export market growth. Import growth is also expected to accelerate this year, helped by the faster growth of final domestic demand and the improvement in the competitive position of many foreign producers, particularly in Japan and China. Net trade is projected to reduce GDP growth by 0.3 percentage points both this year and next.

The fiscal outlook has steadily improved across the present economic cycle, with the Federal deficit declining to $129 billion (1.4 per cent of GDP) in the 1996 fiscal year, the lowest deficit since 1979. The Federal government has now run a primary budget surplus for the past three years. The improvement largely stems from the structural expenditure measures introduced in the Omnibus Budget Reconciliation Act of 1993 and the subsequent National Performance Review, along with the beneficial cyclical impact of above-trend growth on tax revenues. We expect the Federal deficit, on a national accounts basis, to fall further to 1.2 per cent of GDP in the 1997 fiscal year, a little below the deficit projected by the Clinton administration.

Thereafter we continue to expect a modest fiscal tightening over the forecast period as moves are made to try and achieve a balanced budget by 2002. However it remains unclear as to how this will be achieved and given the past history of such plans there must be some doubt as to whether this declared objective will be implemented fully. In practice any agreement is likely to involve a modest fiscal tightening at the turn of the century. We continue to assume that this will be achieved by welfare reforms, implying a modest reduction in the growth rate of transfer payments to the personal sector, and project that the Federal deficit declines to around 1/2 per cent of GDP by 2003.

Canada

Economic growth picked up significantly in Canada in the latter half of last year, with GDP some 1.4 per cent higher than in the first half of the year. This actually understates the scale of the recovery, with export performance and industrial output being adversely affected by strikes in the fourth quarter. The recovery largely reflects the relaxation in monetary policy over the course of the last two years, helped by improvements in the fiscal position and the continued low level of domestic inflation. Business confidence reached its highest ever recorded level at the turn of the year. We expect growth to continue at above-trend levels for some time, with overall GDP growth projected to accelerate to around 3 1/2 per cent this year.

Interest rates in Canada are now below comparable rates in the United States for the first time since the early 1980s. Short-term interest rates fell by 5 percentage points over the two years to the end of 1996, with long-term rates declining by 2 1/4 per cent. The yield curve thus steepened markedly over the course of last year. It is to be expected that short-term interest rates will rise a little over the course of the year as growth accelerates, with the interest differential with the United States gradually being narrowed. However we do not expect long-term rates to rise significantly from their present levels.

All components of final domestic expenditure strengthened [TABULAR DATA FOR TABLE 9 OMITTED] in the fourth quarter of last year, with the exception of final government consumption. Real consumer expenditure rose by 1.4 per cent in the quarter and 2.4 per cent in the year overall, with the savings ratio declining to its lowest level since 1961 over the course of the year. In part the acceleration in expenditure reflects the recent improvement in the net worth of the personal sector, with real net financial wealth estimated to have risen by 12 per cent last year. The declines in interest rates also appear to have boosted expenditure on consumer durables, particularly motor vehicles. However it is notable that consumer confidence remained relatively weak throughout the year.

In part this may reflect lingering fears about job security, along with the sustained decline in real consumer wages until the middle of last year. Whole economy employment rose by around 1 1/2 per cent in both 1995 and 1996, with job gains in the private sector being offset by significant contraction in public sector employment. Labour force growth of 1 1/2 per cent helped to hold the unemployment rate at around 9 3/4 per cent for most of last year. However there are now some signs that the labour market may be starting to tighten. Unemployment fell to 9.3 per cent in March and the rate of growth of earnings has begun to rise. In the three months to January the average weekly earnings of all industrial workers were some 3.3 per cent higher than a year earlier. We expect the growth of whole-economy average earnings to rise to around 3 1/4 this year from 2 1/4 per cent in 1996, with employment rising by 1 3/4 per cent.

The faster growth in labour incomes is likely to be offset in part by the continued slow growth of non-labour incomes, with net investment income having declined with the present low level of interest rates. Overall we expect real disposable incomes to rise by a little under 2 per cent this year. With consumers expenditure projected to rise by 3 1/4-3 1/2 per cent, the savings ratio is projected to decline a little further.

Investment grew particularly strongly in the latter half of last year. Residential investment levels recovered significantly, rising by 11 1/2 per cent in 1996 after a drop of 15 per cent in 1995. Business investment rose by 6 1/2 per cent last year, in spite of a decline in post-tax profits. Renewed inventory accumulation also added 0.7 per cent to GDP in the second half of the year, although for the year as a whole destocking lowered growth by around 0.8 percentage points. With demand expected to accelerate and interest rates remain low, we expect private sector investment to rise by between 7 1/2-7 3/4 per cent this year and 5 per cent in 1998. Business investment is projected to rise between 7 1/4-7 1/2 per cent this year, in line with the latest survey of investment intentions by Statistics Canada. Stock levels are presently low in relation to sales, and we expect that modest inventory accumulation will add around 0.1 per cent to growth this year and in 1998.

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 the end of 1998. Aggregate consumer price inflation has begun to pick up a little in recent months, rising from 1.2 per cent last July to 2.2 per cent in February. Movements in the underlying measure have been less marked, with this measure of inflation falling to 1 1/2 per cent in February. Domestic cost pressures have been weak, with the GDP deflator and whole-economy unit labour costs both rising by 1.3 per cent in 1996. Investment goods prices dropped by 2 per cent last year.

Although we expect the growth of unit labour costs to accelerate this year to between 1 1/2-1 3/4 per cent, cost pressures may be restrained by the continued weakness of import prices. 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 per cent this year and around 1 3/4 per cent in 1998.

The Federal Budget announced at the end of February reaffirmed the fiscal strategy put in place over the previous three years. This has resulted in a marked improvement in the fiscal position, with the Federal deficit declining from 5.9 per cent of GDP in 1993/4 to an estimated 2.4 per cent in the 1996/7 fiscal year. The present fiscal stance is designed to ensure that the deficit falls to 1 per cent of GDP by 1998/9, which would imply an approximately balanced budget on a national accounts basis. [TABULAR DATA FOR TABLE 10 OMITTED] Nearly all of the improvement will have arisen as a result of expenditure reforms, with programme expenditure projected to decline from 16.8 per cent of GDP in 1993/4 to 11.9 per cent in 1998/9. The fiscal position of many provincial governments has also improved over the last four years. We continue to expect that the objectives of the Federal government will be achieved, possibly a year earlier than planned given the prospect of sustained above-trend growth. The overall general government deficit is forecast to drop to 0.9 per cent of GDP in the present fiscal year and 0.4 per cent of GDP in the 1998 fiscal year.

The improvement in the fiscal position has been accompanied by an improvement in the external balance. Between 1989 and 1993 the current account deficit averaged 4 per cent of GDP. A sustained depreciation in the real effective exchange rate, alongside moves to expand trade in North America have subsequently helped to bring a marked rise in the visible trade surplus to 2.9 per cent of GDP last year. As a result the current account was close to balance last year. We expect the external deficit to remain in approximate balance both this year and next.

Japan

The economic recovery in Japan appeared to become more firmly based during the course of 1996. GDP rose by 1.0 per cent in the final quarter of the year, giving growth through the year of 3 per cent. However this masks the considerable divergence between the traded and nontraded sectors, with robust growth in manufacturing, but continued weakness in many service sectors. We expect growth to moderate this year as fiscal policy is tightened, with improvements in net trade providing the main impetus to activity. GDP is expected to rise by around 2 per cent this year, with industrial production rising by around 4 1/2 per cent.

The Bank of Japan reduced the official discount rate to a post-war low of 0.5 percentage points in September 1995 and has since continued to indicate that monetary conditions will not be tightened until there is clear evidence of a sustained recovery in private sector activity and an improvement in the health of the financial system. The overall monetary policy stance has also been eased significantly as a result of the continued depreciation of the yen over the past eighteen months. Our exchange rate projections in Table 4 suggest that the real effective exchange rate in the second quarter of this year may be some 30 per cent lower than two years ago, when judged on the basis of relative consumer prices.

We expect short-term interest rates to begin to rise from the second half of this year, reaching 1 1/2 per cent by the end of 1998. 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 the latter half of this year given the present structure of cross-country interest rates. However the real exchange rate is projected to remain below its average level in 1996 for some time to come, suggesting that recent currency movements should provide some further stimulus to net trade. The low level of interest rates should also continue to support domestic demand, as inflation is projected to rise faster than nominal short-term rates, implying a reduction in real interest rates.

The initial recovery in demand at the turn of last year was led by a temporary expansion in public sector investment, with the volume of investment in the first half of the year being some 9 1/4 per cent above that in the latter half of 1995. This came to an end in the latter half of the year, with expenditure declining by 4 3/4 per cent. New orders for public works have continued to fall and we expect that the average level of investment this year will be around 4 1/4 per cent lower than in 1996.

In more recent months the recovery has gained momentum from an expansion in personal sector expenditures and an improvement in the external position. The volume of exports of goods and services rose by 4 1/4 per cent in the last quarter of 1996, the first significant rise for nearly two years. Consumers' expenditure rose by 1.2 per cent and housing investment by 4 per cent. In part both are likely to reflect the extent to which planned expenditures were brought forward to avoid the rise in the tax rate on goods and sales from this April. Houses started before October last year are exempt from the higher rate of tax, as are properties started after October but completed before this April. This expenditure switching is reflected in our forecast, with housing investment projected to fall this year, after growth of 13 per cent in 1996, and the calendar year growth in consumers' expenditure projected to drop to between 1 1/4-1 1/2 per cent.

Early indications suggest that activity has continued to expand this year in the manufacturing sector, with industrial production rising by 3 per cent in the three months to February, to a level 5 1/4 per cent higher than a year earlier, and business sentiment in the April Tankan survey rising to its highest level for five years. This largely reflects continuing improvements in export performance, with business conditions in the first quarter proving better than expected. Capacity utilisation in the manufacturing sector is now some 11 per cent above the level at the trough of the last recession, and is close to its long-run average level over the past twenty-five years. In contrast, as can be seen from Chart 5, business sentiment has weakened a little in the non-manufacturing sector, and the price of shares in many financial institutions have declined sharply in the aftermath of recently announced plans for further financial deregulation over the next four years.

The prolonged period of price deflation appears to be coming to an end, largely as a result of the sustained depreciation of the yen. Import prices are estimated to have risen by 17 per cent over the year to February. Aggregate producer prices in the three months to February were some 1.2 per cent higher than a year earlier, with national consumer prices rising by 0.6 per cent. In the near future prices are likely to be pushed upwards by the rise in the goods and sales tax rate from 3 to 5 per cent this April. Our calculations suggest that this will add around 1 1/4 per cent to the consumer price level if passed through in full. Overall we expect the consumers' expenditure deflator to rise by between 1 1/2-1 3/4 per cent both this year and next.

The level of employment in the Japanese economy has continued to rise throughout the last five years in spite of the downturn in economic growth. At the end of 1996 the number of employees in employment was some 5.7 per cent higher than five years earlier. However the recent rate of growth of total employment has been much slower, reflecting the poor trading conditions of many small family businesses, particularly in the retail sector. There are signs that the labour market has begun to strengthen in recent months, with total employment rising by 0.6 per cent in the three months to February, to a level 1.9 per cent higher than a year earlier. The ratio of job-offers to applicants, often used as a guide to employment trends, has recently averaged 0.75 (4 applicants for every 3 jobs), compared to a low point of 0.60 in the middle of 1995. The unemployment rate has remained at 3.3 per cent though, with faster employment growth being offset by faster labour force growth as previously discouraged workers re-enter the labour market. We expect to see a modest reduction in the unemployment rate over the next eighteen months to around 3 per cent in the second half of next year.

The recent improvement in business conditions has been reflected in the recent spring wage round, with basic wage rises averaging close to 3 per cent. There are some indications that the traditional industry-wide system of pay negotiations has begun to weaken, with greater divergence [TABULAR DATA FOR TABLE 11 OMITTED] in agreements both within and between sectors. Basic wages account for around 70 per cent of total earnings. With corporate profits now rising sharply, and hence boosting bonus payments, we expect average earnings to rise by 3-3 1/4 per cent this year, implying a rise in real consumer wages of around 1 1/2 per cent. This should help to support personal incomes at a time of rising tax payments. Real personal disposable income is projected to rise by 22 1/4 per cent this year, in line with the provisional estimates for 1996. Whilst the year-on-year pattern of consumers expenditure is likely to be distorted by expenditure switching, we expect to see expenditure rising by 0.5-0.6 per cent per quarter by the turn of the year.

The recovery over the past two years has also been underpinned by the steady growth of business investment. This rose by 2.1 per cent in the fourth quarter of last year, to a level 14 per cent higher than two years earlier. Growth has persistently exceeded indications from surveys of investment intentions at the start of the financial year. With long-term interest rates remaining low, and profitability improving further, particularly in the manufacturing sector, we expect further robust growth of 7 1/2 per cent in business investment this year and 5 1/4 per cent in 1998.

The fiscal measures introduced since the onset of the la. st recession in 1992 have had a marked impact on the public finances, with the general government financial balance moving from a surplus of 2.9 per cent of GDP in 1991 to an estimated deficit close to 4 1/2 per cent of GDP last year. The combined deficit of the central and local governments in 1996 is estimated to have been around 7.4 per cent of GDP, offset by a surplus on the social security funds. Since the assets of the social security fund are unlikely to be used to finance ongoing current or capital expenditures, there is a clear need for fiscal consolidation. Policy is to be tightened significantly in the present fiscal year (beginning this April), with the introduction of a number of tax and social security rises worth around 1 1/21 3/4 per cent of GDP in a full year and declines in the volume of final expenditures.

Continued uncertainty still remains as to the eventual fiscal cost of government support to the financial sector. The government has recently announced a package of measures designed to ease the position of financial institutions with property-backed non-performing loans. The value of the collateral has fallen significantly in recent years, with commercial property prices having declined by 65 per cent since 1991, and residential land prices by 36 per cent. The government package introduced a series of new regulations and tax allowances to encourage land development and permit the sale of property-backed securities. Overall we continue to assume that the series of off-budget measures introduced over the past year to support the financial sector will eventually raise the debt stock by around 1 1/2 per cent of GDP.

We expect to see further fiscal consolidation over the next two or three years. The government has announced an intention to introduce legislation to set formal targets for the budget deficit, with the intention of reducing the combined deficits of the central and local governments to 3 per cent of GDP by 2005 at the latest. (This would imply a balanced budget given the position of the social security funds.) We have therefore built in a number of further modest tax increases in the forecast in order to ensure that the budget deficit returns towards balance in the medium term. The consumption tax is assumed to be raised by a further 1 per cent, with pension contributions rising in real terms each year, in line with existing legislation. The overall general government deficit is projected to decline to around 1 1/2 per cent of GDP in 1998 and move to approximate balance around the turn of the century.

Signs are now starting to emerge that the depreciation of the yen is having a marked impact on trade performance. The rise in net exports in the final quarter of last year has been sustained in the early part of this year. In the three months to February export volumes were some 11 per cent higher than a year earlier, whilst import volumes only rose by 2 per cent. For the year as a whole we expect net trade to add around 0.8 per cent to GDP, with the current account surplus rising once again to 1 3/4 per cent of GDP this year and 2-2 1/4 per cent of GDP in 1998. The bilateral trade surplus with the United States has risen sharply over the past six months, and there is thus some danger of renewed trade conflict in the year ahead.

In fact the forecast improvement in net trade is somewhat smaller than implied by the price and expenditure elasticities in our trade model. Measures taken to deregulate the distribution system have helped to bring a structural change in the growth of import volumes over the past three years. We expect these changes to continue further over the forecast period. Other recent changes in the location of production have also affected the pattern 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 may be smaller than might be expected given the recent drop in the real exchange rate. It is also clear that many Japanese companies continue to attempt to maintain market share by absorbing currency movements into profit margins. As can be seen from Table 11, the movements in competitiveness measured using relative export prices have been considerably less severe than those measured on the basis of relative costs. At least part of the recent depreciation in the yen was used to restore profit margins last year. Overall we project export volume growth of 12 1/2 per cent this year and 7 1/2 per cent in 1998. The growth of trade in potential export markets is expected to pick-up this year as trade growth accelerates in Pacific-Asia.

Section III. Prospects for Europe

There was a marked slowdown in the European economies last year. Real GDP in the European Union (EU) rose by around 1 1/2 per cent compared with 2 1/2 per cent in 1995. Activity was particularly subdued in Germany, France, Italy, Sweden and Austria, all of whom experienced growth of less than 1 1/2 per cent. Activity was stronger in the UK, Netherlands, Denmark, Ireland, Spain and Portugal who each recorded growth of 2 1/4 per cent or more. In nearly all member states the slowdown was concentrated in the latter half of 1995 and the early part of 1996, with growth picking up during the course of the year. Growth in the EU through the year to the end of 1996 was just over 2 per cent. Outside the EU, activity has been robust in Norway but very weak in Switzerland where output has been falling.

We remain optimistic about the prospects for a pick up in growth. GDP in the EU is projected to rise by 2 1/2 per cent this year and in 1998. Activity in those countries whose currencies are part of the D-mark bloc is likely to be supported by a strong performance of net exports in the aftermath of currency weakness over the past eighteen months. We also expect that growth will be supported by an ending of the inventory adjustment experienced in some countries last year, and a recovery in business investment. Industrial confidence has begun to rise over the past six months, as shown in Chart 6, and is well above the levels experienced in the recession of 1993. Consumers' expenditure is unlikely to provide a major stimulus to growth in many countries. Although consumers have benefited from higher net wealth as equity prices have risen, real income growth has slowed in the face of ongoing fiscal consolidation and rising unemployment. Low job security and the expectation of further fiscal measures in some countries may also have made consumers reluctant to undertake major purchases.

There are a number of exceptions to this summary of the prospects for European growth. Net export performance is likely to be weaker in the UK and Italy this year, in the aftermath of the appreciation of sterling and the lira over the past year. The industrial sector also seems markedly weaker in Italy than in the other large industrial economies and there seems little prospect of a pick up in private investment. In Britain consumer confidence is very buoyant, as shown in Chart 7, as both real incomes and net wealth are rising quickly and consumers' expenditure is expected to rise by nearly 4 per cent this year.

Inflationary pressures have been very weak, despite the depreciation of many European currencies. EU inflation last year was around 2 3/4 per cent as measured by the consumers' expenditure deflator. We expect this to decline to 2 1/5 per cent this year. Annual inflation in February fell to 2 per cent, helped by the recent marked declines in inflation in Italy and Sweden.

Prospects for Economic and Monetary Union

The prospects for the large European economies achieving the Maastricht convergence criteria are summarised in Box A. Although we have become slightly more pessimistic about the fiscal position in Germany and France we continue to expect that a monetary union will start in 1999. In order to qualify for entry into the single currency, countries must be judged to have satisfied the convergence [TABULAR DATA OMITTED] criteria in 1997. Most countries appear likely to meet the inflation criterion, although because the wording of the Maastricht Treaty is ambiguous it is not clear precisely what the target value will be. Different interpretations of the treaty could yield differences in the target rate of up to 1/2 per cent. Given inflation developments in the other European economies it seems that the likely range for the target value will be 2 1/2-3 per cent. The measure we show in Box A is based on the consumers' expenditure deflator from the national accounts. This could differ significantly from the new harmonised consumer price indices introduced by Eurostat, since the latter exclude many housing, health and education costs because of national differences in their treatment.

It now appears possible that all the countries shown in the Box may meet the inflation target, with inflation having fallen more quickly than we had expected in Italy. However this partly reflects the continuing weakness of the Italian economy and may not be indicative of any structural improvement in inflation performance.

However we continue to expect that Italy will fail to meet the fiscal criteria. Of the remaining countries, it appears likely that the UK, Netherlands and Belgium will achieve deficits below the target of 3 per cent of GDP this year. Our forecasts suggest that Germany, France and Spain may record deficits slightly above the target, but that the excess will be less than 1/2 per cent of GDP. This is unlikely to prove an obstacle to the entry of these countries into the single currency, assuming that the present administrations remain in office, as it is likely that further measures will be taken to achieve the target value.

Germany

Growth in 1996 was estimated to be just 1.4 per cent, representing a significant slowdown from the 2 per cent growth rate recorded the previous year and well below the 2.9 per cent achieved in 1994. During the course of last year activity was strongly supported by the external sector which generated almost half of the total growth. Export volumes rose in every quarter, whereas imports remained very subdued until the last three months of the year. The performance of the external sector partly reflects the fall in the value of the D-mark, with the effective exchange rate having depreciated by around 7 per cent since the middle of 1995. However the subdued import growth was also a consequence of a slowdown in domestic activity. Private consumption expenditures only grew by a little over 1 per cent and investment fell by 0.6 per cent during the course of the year.

The year on year growth figures for 1996 paint a rather misleading picture of the timing of the slowdown. This is because last year's sluggish growth partly reflects weakness in the latter part of 1995. Growth from the end of 1995 to the end of 1996 was 2.2 per cent, around the long term trend level. Over this period consumption was still weak, growing by around 1 per cent, construction was stagnant but business investment was much stronger, rising by 6.8 per cent. Given that the economy grew at around its trend level over this period what needs to be explained is the relative weakness of consumption and housing investment.

A major factor behind the weakness in consumers' expenditure was probably the slow growth in real personal disposable incomes. This was not due to a rise in the tax burden as fiscal policy was, if anything, expansionary last year, following a number of constitutional court decisions which lowered taxation. The main factor behind slow income growth appears to have been the slow growth in real wages. Average earnings grew by 2 1/2 per cent compared with inflation of 1.9 per cent (as measured by the consumers' expenditure deflator). However consumption grew more slowly than income so it may also be that rising unemployment and growing expectations of further fiscal consolidation led to greater caution amongst consumers. Consumer confidence was very weak during the course of [TABULAR DATA FOR TABLE 12 OMITTED] 1996 (see chart 7). Unemployment averaged 11 1/2 per cent of the workforce last year and carried on rising in the early part of this year. There are some signs that unemployment may now have peaked. The unemployment rate fell slightly in March to 11.2 per cent and vacancies rose in February by 3 3/4 per cent. Despite this we expect that any improvement in the labour market will be gradual, with the unemployment rate being around 11 per cent this year and 10-10 1/2 per cent next year.

High and rising unemployment does appear to have contributed to a slowdown in wage growth. Our work suggests that the level of unemployment has a large impact on the development of wages in Germany, particularly compared to some other European economies (Morgan, 1996). At the turn of the year wage growth in the western Linder was under 2 per cent, although slightly faster in the east. We estimate that average earnings rose by around 2 1/2 per cent last year and will rise by around 2-2 1/2 per cent this year.

The lack of domestically generated inflation has contributed to the slow growth in prices. Overall the consumers' expenditure deflator rose by 1.9 per cent last year and so far in 1997 it is apparent that inflationary pressures remain very weak. Consumer price inflation in west Germany fell to 1.6 per cent in March, from a recent high of 1.9 per cent in January. Wholesale prices have remained subdued, rising by around 1 1/2 per cent in early 1997, whilst producer prices were up by only 0.6 per cent in the year to February. Import price inflation has been higher, at 3 per cent in the year to February, reflecting the fall in the German currency. We anticipate that inflation this year will average a little under 2 per cent, with a continuing weakness in domestically generated inflation offsetting rises in import prices.

Money supply growth strengthened at the start of 1996 and remained well above the target growth rate of 4-7 per cent for M3. Growth in M3 since the last quarter of 1996 was 11.7 per cent on an annualised basis in January and 9.1 per cent in February. The Bundesbank have suggested that the strong growth in M3 at the start of the year was affected by a 'statistical overhang' at the end of last year which has tended to exaggerate growth in the early part of this year. Official interest rates have remained unchanged since the discount and lombard rates were last cut by 1/2 per cent a year ago to 2 1/5 per cent and 4 1/2 per cent respectively.

Housing investment has been weak following the end of the reunification boom and the reduction in tax concessions for the construction of rented housing at the start of last year. The German authorities have announced measures to help the construction industry. Many of these appear to be designed to reduce the employment of foreign workers. The plan is to give small and medium sized companies, who tend to employ more German workers, a better chance of securing public contracts. Large public orders are to be split into smaller units so that small companies can compete against bigger contractors. Moreover, there is to be increased policing of a law introduced last year to impose minimum wages for the construction industry. This will reduce the incentives for firms to employ 'cheap' foreign labour. Even so, we anticipate that housing investment and other construction activity will remain [TABULAR DATA FOR TABLE 13 OMITTED] weak over the next two years.

The outlook for investment in plant and machinery appears somewhat brighter. Growth during the course of 1996 was rapid and we expect this to continue this year. Capacity utilisation in west German manufacturing has been on a gentle upward trend since the start of 1996 and in the fourth quarter it reached 83.2 per cent. Whilst this is below the recent high of 86.4 per cent in June 1995, it is well above the eight year low of 78 per cent in September 1993. German industrial output is showing signs of recovery, notably in the capital goods industry. Total output increased by 1.9 per cent in February, erasing the previous month's weather affected fall of 1 1/2 per cent. New orders also rose further in February. The improvement was particularly marked in domestic orders. Overseas orders fell back slightly in February after recording a very large rise in January and last year. Industrial confidence appears to have been steadily increasing in recent months (see chart 6). However a survey of 25,000 companies by the German chambers of commerce (DIHT) suggested a weak start to 1997 as there was an increase in the number of companies expecting to cut investment and employment this year.

In 1996 the general government deficit is estimated to have been 3.8 per cent of GDP, up from the 3 1/2 per cent of GDP recorded the previous year and 2.4 per cent in 1994. The deterioration in the fiscal position began in the middle of 1995 and stems from a combination of slower growth and discretionary fiscal changes. Last year's GDP growth of 1.4 per cent was well below the rate of 2 1/2 per cent assumed at the time that the 1996 budget was announced, leading to a shortfall in revenue and additional social security expenditures as unemployment rose. The policy stance was relaxed in 1996 following Constitutional Court rulings on the exemption of minimum subsistence incomes from income tax, the abolition of the 'coal penny' levy and the expansion of the family benefit system. The Bundesbank has suggested that there may also have been some worsening in the relationship between activity and tax receipts in recent years due to changes in the tax system. Our analysis would tend to support this, as direct tax receipts last year were around DM 6 1/2 billion lower than we would have expected given income growth and the discretionary tax changes.

The 1997 budget measures aim to raise DM 66 1/2 billion (1.8 per cent of GDP), with expenditure cuts at the federal and local government level and in social security. Plans to cut the Solidarity Tax this year have been delayed until next year, when it will be reduced by 2 percentage points to 5 1/2 per cent. There appears to have been some further fiscal slippage in the early part of this year. For example, tax revenues were very weak in Bavaria in the first two months of the year and there have been reports of similar trends in other states. The cash deficit of the federal government increased to DM 31.7 billion in January-February, more than twice the level recorded a year earlier. Whilst changes in tax regulations make the trends in the early part of the year hard to read, there has been official recognition of the weakness of the budget. A major factor behind the slippage is likely to have been the rise [TABULAR DATA FOR TABLE 14 OMITTED] in unemployment. The 1997 budget assumed that unemployment would average 4.1 million this year, but it is currently around 4.3 million (seasonally adjusted).

In order to reduce the deficit to the Maastricht target of 3 per cent there may thus need to be further measures. Our projections envisage a deficit of 3.3 per cent of GDP this year suggesting that at least a further DM 13 billion will need to be found. Given the present political commitment to the single currency, it seems likely that the authorities will take further steps to hit the target, although these are unlikely to include measures designed to reduce the structural deficit. The authorities in France and Italy have already made use of 'Treasury Operations' to reduce their deficit this year and there should be ample scope for the German authorities to follow suit. Another possibility is that there could be a delay in the payment of civil service bonuses which are normally paid at the end of the year. A short postponement of the 1997 payments, possibly of only a few days into early 1998, could help reduce this year's deficit.

The authorities have recently announced plans for major reforms of the income tax and the pensions system. Notably, there is a proposal to make significant cuts to both the top marginal rate of income tax and the starting rate as well as making cuts in the tax rate on corporate profits. The projected overall loss in revenue would be around DM82 billion which would be partly financed by a DM51 billion reduction in tax exemptions and a rise in VAT of 1 per cent which would generate additional revenues of DM15 billion. The government has passed the first stage of the 1999 tax reform consisting of all the measures due for 1998, but there remains significant political opposition to the rest of the package, and we have thus not attempted to allow for these reforms in the present forecast. At the same time there are proposals for reform of the pension system which is under strain from projected demographic changes which will lead to an ageing of the German population. The proposals envisage a cut in pension benefits and a rise in contribution rates from 20.3 per cent to 22.9 per cent of gross wages.

France

GDP rose by 1.3 per cent last year, well below the 2.2 per cent in 1995 and 2.8 per cent in 1994. Activity was supported by the growth in consumers' expenditure of 2.3 per cent for the year as a whole. However all the growth in private consumption occurred in the first three months and for the remainder of the year there was a slight fall in expenditure. The external sector made a marked contribution to growth, with net exports of goods and services adding some 0.4 per cent to GDP. In part this reflects the depreciation of the effective exchange rate since the middle of 1995. Private investment was very weak last year recording a rise of just 0.1 per cent, with construction investment being notably weaker than business investment. Stockbuilding fell by 0.6 per cent of GDP and made a major contribution to the slowdown in activity. However, as with Germany, the annual numbers give a somewhat misleading picture of the slowdown. In the year to the fourth quarter of 1996 real GDP rose by 2.1 per cent. We anticipate that growth will accelerate slightly from this rate during 1997 and will average around 2 1/2 per cent, led by the external sector, an ending of the inventory adjustment [TABULAR DATA FOR TABLE 15 OMITTED] and a pickup in business investment.

We project that investment will grow by 2 1/2 per cent this year and in 1998. At the start of this year investment intentions were weak, with the January INSEE survey suggesting that firms planned to increase investment (in value terms) by only 2 per cent this year. However the intentions reported in this survey are not always a reliable guide to the future investment developments. For example in the January 1996 survey, firms suggested that they were planning to increase investment by 9 per cent, when in reality the value of business investment rose by around 3 per cent. More optimistic signals for investment come from rising levels of industrial confidence (see chart 6) and a gradual pick up in capacity utilisation, which is now close to its multi-year average. We expect that during the course of this year investment will respond to the pick-up in growth and the historically low level of interest rates.

Although there has been a gradual recovery in business confidence, there is considerable variation across sectors. The March INSEE business survey showed a slight fall in opinions on future production but the balance has so far been significantly positive for all of the year. The slippage in March was strongly influenced by weakness in the car industry. This masked improving conditions elsewhere, notably a strong pickup in the capital goods industry. Production in the car industry had been strong in the autumn of 1996 but fell sharply with the ending of the government's subsidy scheme. Opinions on foreign orders remain strongly positive and since the end of 1996 there has been a notable pickup in domestic orders. Opinions on inventories were broadly stable, at near normal levels.

The most recent data suggest that household consumption has remained weak so far this year. In the first two months of the year it was around 2 per cent lower than in the equivalent period in 1996. Growth in real disposable incomes has been slow, with incomes estimated to have risen by only around 1/4 per cent last year. Whilst we expect a gradual pickup in income growth this year, it may take some to feed into spending patterns. However the 40 per cent rise in equity prices which has taken place since the end of 1995 will have raised net wealth, and should act to support private consumption. For 1997 we anticipate that consumers' expenditure will rise by 1-1 1/2 per cent before accelerating to 2 1/2 per cent in 1998.

Inflation was very subdued in 1996 with the consumers' expenditure deflator rising by 1.7 per cent. Inflationary pressures continue to remain low and in the year to February inflation was also 1.7 per cent on the EU harmonised measure. Although import prices are likely to rise following the depreciation of the Franc, there seems little prospect of a pick up in domestically generated inflation. The growth of hourly wages remained very sluggish in 1996, at under 2 1/2 per cent for manual workers and those in manufacturing. Considerable slack exists in the labour market, helping to constrain wage pressures. The unemployment rate reached a new record of 12.8 per cent in February, up by 0.1 per cent from the previous month. However it may well be that unemployment has reached a peak at this rate as there are a number of positive signs in the labour market. The number of people hired by temporary agencies, seen as a good leading indicator for future employment, was up by 14 per cent in the year to March. New vacancies have picked up steadily since the autumn of 1996. Our projections envisage an average unemployment rate of 12 1/4 per cent this year, and 11 3/4 per cent in 1998.

Official interest rates gradually came down during the course of last year, and at the end of January the Banque de France cut its intervention rate by 0.05 per cent to 3.1 [TABULAR DATA FOR TABLE 16 OMITTED] per cent. Market interest rates have also come down, with three month rates some 4 percentage points lower than the middle of 1995. Over the same period yields on ten year government bonds have come down from 7.7 per cent to under 6 per cent. We expect short-term interest rates to remain low for the remainder of this year, although it is possible that the recently announced general election could induce some short-term volatility in the financial markets, given the uncertainty over the extent to which the opposition parties are committed to monetary union.

There was significant slippage in the 1996 fiscal deficit, which is now estimated to have been 4.1 per cent of GDP compared with the target of 3.6 per cent. In 1997 the authorities aim to achieve a deficit in line with the Maastricht limit of 3 per cent through a freeze in nominal expenditure, a rise in social security contributions and a cut in some taxes and employees' contributions to health care. There continues to be some uncertainty about the extent to which these savings can be achieved. The government announced a unilateral increase in civil servants pay of 1/2 per cent from the 1 March to be followed by a further 1/2 per cent rise from October this year. Civil servants held a one day strike on the 6 March against the government's proposed pay increase for 1997-98 following the wage freeze of 1996. Unions are demanding compensation for this and want a rise of 4.4 per cent in line with inflation from 1996-98. There has also been some slippage in the plans to reduce the social security deficit to FF 3'0 billion this year. According to the Central Agency of Social Security Bodies (ACOSS) the deficit on the social security fund at the end of 1996 was FF54.2 billion and this year's deficit is now expected to be FF35.2 billion, some FF5 billion above the announced target.

The government also plans to raise FF37 1/2 billion through a one off payment from France Telecom. This payment is treated as a capital transfer, a down payment for the future take-over of part of the pension liabilities prior to privatisation. Overall, our projections now envisage a deficit of 3.4 per cent for this year, slightly above the Maastricht target figure. If the current administration is re-elected then it would appear to have considerable scope to take the measures necessary to ensure that France qualifies for the single currency.

Italy

The slowdown in Italy in 1996 was even more marked than it was in Germany and France. Real GDP rose by just 0.7 per cent last year following growth of 2.9 per cent in 1995. Activity was almost entirely driven by the external sector, as net exports contributed 1/2 per cent to growth whilst domestic demand rose by just 0.2 per cent. The only component of domestic demand to record significant growth was investment, which rose by 1.2 per cent. Consumers' expenditure grew very modestly by 0.7 per cent reflecting the slow growth of real incomes. Stockbuilding fell by 1/2 per cent of GDP and government consumption declined, reflecting the efforts being made towards fiscal consolidation.

Our projections for the Italian economy are given in Table 17 and Table 18. Overall, we expect that growth will remain very low this year at around 1 per cent, before accelerating to 2 per cent in 1998. We anticipate that this year's growth will be entirely generated by domestic demand, with both consumers' expenditure and private investment rising by a little over 1 per cent. A modest recovery in stockbuilding will contribute around a 1/4 per cent to GDP. The external sector is not expected to support activity due to the growing effects of the past appreciation [TABULAR DATA FOR TABLE 17 OMITTED] of the Lira. Since the middle of 1995 the Italian effective exchange rate has risen by 15 per cent.

Consumers' expenditure this year is likely to be significantly affected by ongoing fiscal consolidation in the attempt to meet the Maastricht fiscal criteria. Consumer confidence is presently at an historically low level. However we anticipate that there will be some recovery in real pre-tax earnings, as we expect that for the first time since 1991 earnings growth will significantly exceed inflation. Despite the slowdown, nominal wage growth has remained fairly robust with contractual wages rising by 4.1 per cent in the year to December. Moreover, there is every prospect of an acceleration in wage growth in the coming months due to pay settlements already agreed. We predict that average earnings will rise by 4 1/4 per cent this year. At the same time inflation has fallen dramatically, with the annual rate of increase in consumer prices slowing from 6 per cent at the end of 1995 to 2.2 per cent in March this year. Producer prices are growing by only around 1 per cent. Our projections suggest that growth in the consumers' expenditure deflator will be around 2 3/4 per cent this year, down from 4.3 per cent last year. Thus despite large rises in taxation we anticipate that there will be a small rise in real personal disposable incomes of around 1/2 per cent. Moreover consumers should benefit from higher net wealth stemming from the rise in Italian equity prices. Since the end of 1995 the value of Italian shares has risen by 25-30 per cent.

Investment is likely to continue to grow slowly this year. There are currently a number of indications of weak investment, notably low domestic orders for firms producing capital goods and low levels of capacity utilisation. [TABULAR DATA FOR TABLE 18 OMITTED] In contrast to Germany and France industrial confidence remains at an historically low level. Industrial production in the three months to January was 5 per cent lower than a year earlier. Indeed after allowing for seasonal factors and variations in the number of working days, industrial production at the start of 1997 was lower than at any time since late 1994. The recent weakness has been particularly marked in production of capital goods. With little sign of a significant pickup elsewhere in the Italian economy we anticipate that investment growth will at best remain at last year's rate.

As we had previously anticipated there was a significant overshoot in the budget deficit in 1996. The general government deficit was L126 1/2 trillion (6.7 per cent of GDP), scarcely lower than the previous year's deficit of L123 trillion (7 per cent of GDP) and about 1 1/2 per cent of GDP above the initial target. The overshoot was partly due to slower than expected growth, although the most important factor was a failure to achieve the planned budgetary improvement from a number of the new fiscal measures. However the poor performance in 1996 may be a little misleading, as it seems likely that some planned expenditures were brought forward into 1996 from the early part of 1997 in order to help achieve a lower deficit in 1997. The state deficit rose sharply at the end of last year, whilst in January a surplus was recorded. The magnitude of the shift may be around L5trillion (1/4 per cent of GDP). The debt stock, measured on the Maastricht Treaty basis, fell to 123 per cent of GDP at the end of 1996, helped by a L20 trillion reduction in cash deposits held by the Treasury with the Banca d'Italia. These deposits are part of the general government debt according to the Maastricht rules.

The 1997 austerity budget, which aimed to reduce the deficit by L62 1/2 trillion (3.6 per cent of GDP), has now been supplemented by some further measures. The authorities have recognised that a further tightening was needed if there was to be any chance of achieving a deficit close to the Maastricht reference value of 3 per cent. The official growth forecast was revised down from 2 per cent at the time of the budget to 1.2 per cent. The mini-budget announced just before Easter was intended to find an extra L15 1/2 trillion. However the package was very disappointing in that it contained few structural measures. The extra money is scheduled to come from delays in expenditure and the early payment of future taxes. L6 trillion is expected to come from the early payment of taxes due on severance payment funds and L2.6 trillion from a delay in payment of severance pay to government employees. L3 trillion is expected to come from a reorganisation of tax collection procedures and the early payment of some duties, whilst L1.8 trillion is projected to come from a freeze in government spending. Smaller sums are due to be raised from an amnesty for unpaid social security contributions, higher charges for postal services and a reduction in tax evasion.

Our projections for the Italian public finances are shown in Table 18 We continue to anticipate that even after taking into account the supplementary budget measures, the deficit will remain around 4 per cent of GDP this year, still well in excess of the Maastricht reference value. Moreover, we anticipate that the temporary nature of many of the measures taken to reduce the deficit this year will lead to a larger deficit in 1998. Our projection for a deficit of 4.2 per cent next year assumes that a further L20 trillion (1.1 per cent of GDP) of fiscal measures are adopted. Without these the deficit would worsen to over 5 per cent of GDP.

The recent declines in interest rates will continue to aid fiscal consolidation by reducing debt interest payments, although the full benefits will not be felt for some years until the current debt stock matures. The proportion of government debt which is held in short-term 'Treasury Bills' has declined steadily in recent years, and thus a given change in official short-term rates now has a comparatively smaller impact on government interest payments. Movements in long-term interest rates have become much more important, as over two-thirds of debt is now held in medium and long term bonds. Thus short-term fiscal prospects have become more dependent on market sentiment; any reduction in long-term rates brought about by a belief that Italy will join a monetary union makes it more likely that Italy will be able to join by satisfying the fiscal criteria.

Spain

The slowdown in the Spanish economy in 1996 was modest. GDP growth was 2.2 per cent compared with 2.8 per cent in 1995. Moreover, as the year progressed the pace of activity quickened, so that growth through the year to the fourth quarter was 2.6 per cent. Private consumption rose by 1.9 per cent, but private investment was more subdued, rising by just 0.7 per cent after growth of 8.2 per cent in 1995. Strong growth of investment in plant and equipment was offset by weakness in the construction sector.

The construction industry was significantly affected by unfavourable weather conditions as well as by reductions in public investment in infrastructure. Between the end of 1995 and the end of 1996 construction investment fell by over 5 per cent. Survey indicators from the end of 1996 highlight the weakness of this sector, with both the indicators of overall confidence and employment expectations being a little below their long run average levels. However this pessimism may in part reflect the poor weather conditions [TABULAR DATA FOR TABLE 19 OMITTED] prevailing at the time of the surveys. Also there are some signs of a potential for improvement, as order books are now above their historical average. The Government has been concerned about the position of the sector and has announced that Pta180 billion from the privatisation of Telefonica will be allocated to finance infrastructure projects over the next three years.

For the rest of the economy, survey indicators have shown rising optimism. In the final quarter of last year both the consumer and industrial confidence indicators moved up to around their long run average levels. We expect an acceleration in the growth of consumers' expenditure and gross fixed capital formation this year. Consumers should benefit from a marked pick up in real incomes, with average earnings rising significantly faster than inflation. We also anticipate that investment, particularly in plant and machinery, will be stimulated by stronger activity, rising capacity utilisation and historically low interest rates. Consumption and private investment are expected to grow at around 3 1/4 and 2 3/4 per cent respectively in 1997. Total domestic demand is projected to rise by 2 1/2 per cent. GDP growth is forecast to be around 2 3/4 per cent in 1997, rising to 3 1/4 per cent in 1998.

Net exports made a substantial contribution of 0.6 per cent to growth in 1996. The robust performance of the external sector was partly due to exchange rate movements and partly due to slow domestic activity. There was a marked depreciation of the peseta against the US dollar of 15 per cent between the end of 1995 and the start of this year. The overall change in the effective exchange rate was lower, at 4.3 per cent, as many of Spain's trading partners in Europe also depreciated against the dollar. In spite of this, merchandise export volume growth of 11 per cent still appears unusually strong, given the slowdown in activity in Spain's main export markets in the early part of 1996. Lacklustre domestic activity contributed to the comparatively slow growth of imports. The current account surplus rose slightly to around 1/5 per cent of GDP.

Net exports are expected to add around 0.3 per cent to GDP growth this year. Merchandise import and export volumes are both anticipated to rise by around 6 1/2 per cent. Exports should continue to benefit from the fall in the peseta and will also be supported by a pick up in overseas markets. However growth in exports of services, primarily tourism, should accelerate as consumer demand recovers in other European economies. Import growth should quicken as it will be boosted by the faster growth of total final expenditure.

The unemployment rate fell from 22.9 per cent in 1995 to 22.3 per cent in 1996, with a net 401,000 jobs being created. Around a third of workers last year were employed on temporary contracts. It is widely believed that the increased use of temporary contracts coupled with very stringent employment protection for permanent workers has contributed to a considerable lack of wage flexibility in Spain (Morgan, 1996). A new agreement on employment stability aims to reduce the imbalance between permanent and temporary contracts by simultaneously giving temporary workers more protection and making it less difficult for firms to shed permanent staff. Individual unfair dismissal payments for new permanent contracts are to be cut of from 45 to 33 days per year of service and the eligibility for these payments is to be tightened up to avoid abuses. There will be a new fixed contract for 16 to 21 year olds who have no work experience. This training contract offers improved protection, remuneration and education. Fiscal incentives are also to be provided to encourage firms to adopt the new permanent contract. The Spanish Ministry of the Economy expects [TABULAR DATA FOR TABLE 20 OMITTED] this new labour reform to eventually create up to a million new jobs. In principle these reforms, once enacted, appear likely to generate some increase in wage flexibility, which should help to lower unemployment in the longer term. In the meantime faster economic growth should allow the unemployment rate to fall to 21 3/4 per cent this year and less than 21 1/2 per cent in 1998.

The 1996 State deficit on a national accounts basis was 3'.3 per cent, 0.2 percentage points lower than targeted, helped by lower than expected interest payments following the decline in interest rates. However the deficit for both the social security budget and the territorial administrations were higher than planned. Overall, the general government budget deficit just met the revised government target of 4.4 per cent in 1996.

The 1997 budget aims to cut expenditure by Pta800 billion (1 per cent of GDP), with revenues forecast to rise by 6 per cent. The authorities have also announced that Pta180 billion gained in tax receipts from the sale of Telefonica will be spent on infrastructure projects over the next three years. The remainder of the income from the privatisation of Telefonica, some Pta370 billion, has been used to lower the general government debt. Further privatisations of large firms such as Repsol (an oil, chemicals and gas group) and Endesa (an electricity generator and distributor) are planned throughout the year. These sales may raise as much as Pta1,500 billion (1.9 per cent of GDP). In our forecast we have assumed government spending will only be cut by Pta 400 billion (1/2 per cent of GDP), Pta 1,100 billion (1.4 per cent of GDP) will stem from privatisations and that an extra Pta 180 billion will be earned in tax receipts and spent over three years. Revenues are projected to rise by close to 6 per cent. The general government budget deficit is forecast to decline to 3 1/4 per cent of GDP in 1997 and 2 3/4 per cent of GDP in 1998, with the debt to GDP reaching 63 3/4 per cent in 1998.

Inflation, as measured by the consumers' expenditure deflator, slowed significantly from 4.7 per cent in 1995 to 3.6 per cent in 1996. On an annualised basis using the EU's harmonised consumer price index, inflation was 2 1/2 per cent in February. The good inflation performance, together with a tighter fiscal policy, has allowed interest rates to fall. The three month interbank rate has declined from 8.9 per cent in January 1996 to 5 1/2 per cent at the time of writing and the ten year interest rate differential with Germany fell to a historically low level of 1 percentage point at the end of last year. We anticipate that the inflation performance will continue to improve, with the consumers' expenditure deflator growing by 2 1/2 per cent this year. Long-term interest rates are assumed to remain close to 6.8 per cent throughout the remainder of the year.

Overall, our forecast suggests a further improvement in macro-economic performance in both 1997 and 1998. The improved inflation prospects together with the ongoing decline in the fiscal deficit make Spain a plausible candidate for entry into the first round of EMU.

We are grateful to Martin Weale and participants at a meeting of representatives from Central Banks, Finance Ministries and other European institutes held at NIESR on April 14, for helpful comments and to Dawn Holland and Dirk Te Velde for statistical assistance. The forecast was completed on April 17, 1997.

NOTES

(1) Fundamental Equilibrium Exchange Rate calculations reflect internal and external balance, and are as subject to margins of error as are estimates of the underlying structure of the economy. Our most recent analysis of these topics can be found in Barrell and Sefton (1997).

(2) On the same basis a Sterling DM rate of around 2.45 would be appropriate. Given a possible bilateral FEER of 1.57 against the dollar the importance of the US in UK trade means that the effective potential overvaluation is less than suggested in comparison to Germany alone.

(3) Arrowsmith, J., Barrell, R., Pain, N., Young., and Wlodek, K., (1997) 'Capital Market Liberalisation in Europe' Kogan Page for the European Commission contains some analysis of the coherence of stock market prices. Although the relation between the US and the UK has declined, it is still stronger than the statistical relation with the rest of Europe.

REFERENCES

Barrell, R., and J. Sefton (1997), 'Fiscal policy, real exchange rates and monetary union', NIESR, mimeo.

J. Morgan (1996), 'Structural change in European labour markets', National Institute Economic Review, no. 155, pp. 81-89.

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Author:Barrell, Ray; Morgan, Julian; Pain, Nigel; Hubert, Florence
Publication:National Institute Economic Review
Date:Apr 1, 1997
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