WORLD ECONOMY AND FINANCIAL MARKETS IN 1997

MAJOR INDUSTRIAL COUNTRIES

The year 1997 was relatively successful for the world economy[1] . According to the preliminary data, the gross production of the world's countries increased about 3.25%, which is the highest figure in the last decade. The development was regionally uneven - the fastest developing area, regardless of the end-of-the-year crisis, was still Asia, whereas the former CIS countries focused on stopping the economic downfall. The world's major industrial countries continued to display a modest economic growth - among the G7 countries the USA, Canada and Great Britain were strong leaders. Economic growth accelerated in continental Europe as well (see Table 1.1). The enlargement of the economic growth base by, first and foremost, Latin-America as well as by the Central and Eastern European countries gave a favourable impetus to the development of international trade, its volume growing by about 8%.

Apart from positive development trends, the other remarkable event in the second half of 1997 was the deepening financial and economic crisis in Asia, which became explicit in the sudden weakening of currencies of several relatively fast developing countries (Thailand, Indonesia, Malaysia, Republic of Korea, etc) and a drop in internationally influential securities markets. At the end of the year major industrial countries and the International Monetary Fund (IMF) developed a comprehensive assistance programme, helping several South-East Asian countries with standby loans. Such international attention to the crisis in Asia is warranted because of its effect on the outlook of global economy. Considering that the development of the Asian economic leader Japan is not so rapid any more, the crucial issue in 1998 will be whether the economy of the rest of the (mainly industrial) countries is strong enough to withstand the crisis in Asia and prevent the economic situation from worsening even further. Asia is counted for about one third of the global gross production, 31% of the USA and 9.3% of the EU exports.

Economic difficulties in Asia would probably hamper not only the economic growth but also price level increase, as sharply lower exchange rates make Asian goods cheaper for importers. Although the Asian economic crisis is not yet over, its significant retarding impact on the global economic growth in 1998 is evident already.

In 1997, the singularity of the economic growth in major industrial countries lied in the fact that regardless of the growth pace exceeding the long-term trend in production and consumption, the inflation remained low and even decreased in several countries, including the USA. On one hand it was due to lower prices of several raw materials (Commodity Research Bureau (CRB) index based on the prices of 17 most commonly used raw materials dropped by 4.6%), increasing labour productivity, a more efficient use of labour, stronger international competition, and an influx of cheap consumer goods from developing countries to the major industrial ones; on the other hand - due to the determination of central banks to contain the inflation.

Financial markets were relatively volatile in 1997. Compared to 1996, the magnitude of changes increased both in foreign exchange and stock markets. As an exception the fluctuation of exchange rates decreased in the prospective euro area. The US dollar continued to strengthen against all main currencies; in Europe the German mark weakened against most of the currencies (see Table 1.2).

In stock markets the year can be divided into two distinctive periods. Markets developed from January to August without major setbacks and main stock exchange indices set records, reaching the peak in late July-early August. In the second half of the year the growth of stock prices was restrained by the deepening economic downturn in Asia and stock market indices plunged several times, although never falling below the level of the beginning of the year. At the year end there was still an exceptional increase on the stock markets of all major industrial countries except Japan (see Table 1.3). However, the fall on Japan's stock market was still small relative to other Asian markets - shares of South-East Asian crisis countries (Korea, Thailand, Indonesia, etc) lost about half of their value in 1997.

Notwithstanding the larger than the average increase of 9%, bond markets stayed relatively stable in 1997. Interest rates dropped in all major markets, contributing to a more significant bond price boost than forecasted in interest rate projections earlier in the year. The increase was relatively stable (see Table 1.4). Such a global trend was preconditioned by an evenly low inflation in all major industrial countries. Another reason for the price increase was a combination of decreasing supply due to fiscal discipline and an increasing demand for government bonds. The demand increase can be attributed to the capital leaving Asia and moving now to the bonds of major industrial countries as well as to legislation amendments in several countries that forced pension funds to increase the share of bonds in their investment portfolios.

Prices of government bonds grew most in Great Britain (14.7%) where the long-term interest rates were higher relative to other European countries and decreased more than average due to general convergence. As most of the above factors will continue to have their influence in 1998 as well, the same trend can be expected to continue in bond markets at least at the beginning of the year.

USA

In the USA the economic growth continued for the sixth year in a row, reaching 3.8% according to preliminary data and surpassing most forecasts. Unemployment decreased from 5.4 to 5%. In December, the unemployment rate dropped to 4.6%, the lowest in last 24 years. Regardless of the tightening in the labour market, that ordinarily leads to an acceleration in the increase in wages and prices, the consumer price index dropped from 3 to 2.3% and down to 1.7% in December. Increase in income and wealth of the people boosted consumer optimism to the highest of this decade. In 1998, the economic growth is forecasted to slow to 3.5% (according to several analysts, even to 2.5%) and the unemployment to decrease further.

The significant economic growth in 1997 strengthened the dollar further against other major currencies. The strong dollar and increasing domestic demand contributed to the rapid growth in import demand and increased the trade deficit to an estimated USD 115 billion. It is forecast to continue increasing in 1998.

The modest rate of inflation was the main reason why the US Federal Reserve increased its bench-mark interest rate only once (in March by 0.25%) to 5.5% where it remained for the rest of the year. In the second half of the year, the crisis in Asia prevented a further raise in the bench-mark rate, increasing, thus, the turbulence in financial markets and strengthening the expectations of an economic slowdown.

Japan

Japan's economic growth was slower than expected and did not exceed 1% according to preliminary estimates. Economic disturbances in continental Asia extended to many Japanese financial institutions. In November, the fourth largest investment company in Japan, Yamaichi Securities, had to close down.

Foreign exchange and financial concerns in Asian emerging countries came at an opportune time for Japan. As the domestic demand decreased, Japan's expectations of avoiding the economic downfall were mainly based on growing exports boosted by the weakening of the yen. It worked in 1997 and the current account surplus increased by 42.4%. At the end of the year the situation changed as currencies of several Japan's competitors weakened more than the yen. In 1998, the trade balance surplus is forecast to increase by only USD 6 billion, ie 0.1% of GDP.

Due to the modest economic growth, the unemployment rate remained unchanged at 3.4% compared to the previous year. The inflation rate increased from 0.1 to 1.7%. By the end of the year most of the large businesses considered the market outlook unfavourable and therefore 1998 will be difficult for the Japanese economy, possibly resulting in an economic crisis. Because of the currently low interest rates the Japanese central bank cannot stimulate the economy by lowering them further.

EUROPEAN UNION MEMBER COUNTRIES

The year 1997 was better than the previous year for the members of the European Union (EU): according to preliminary estimates GDP increased by 2.6%. The economic growth was largest in Ireland (8.0%), followed by Finland (5.9%) and Great Britain (2.9%). The three largest economies in continental Europe (Germany, France and Italy) experienced higher economic growth than in 1996, but it was not high enough, however, to decrease the high unemployment rates (over 10%) which prevailed in these countries as well as in other EU member states.

One of the major factors influencing the development of the EU countries was the European Monetary Union (EMU). The probable countries joining the single currency area were identified: out of the 15 EU countries, probably four - Great Britain, Denmark, Sweden, and Greece - would stay outside the first wave. Although the participation of the remaining 11 countries is not absolutely certain, favourable prerequisites have been established through economic convergence based on Maastricht criteria (see Table 1.5).

Major progress has been made in restraining inflation: only Greece was unable to meet the required level. Reducing the budget deficit to 3% of GDP or below was more complicated but still achievable. The government debt criterion in the strictest sense was achievable for only four member states. Nevertheless the financial markets have already discounted the timely start of the third stage of the EMU, and the long-term interest rate differential in candidate countries converged to below 0.35 percentage points in late 1997.

1998 is important for the EMU as in early May countries joining the EMU in the first round will be finally determined and their bilateral exchange rates will be established. The European Central Bank will be established in July. The single currency will be introduced into accounting on 1 January 1999. The forecasted economic growth of the euro-countries in 1998 is 2.9%, inflation rate 2% and unemployment rate 12%.

Germany

The German economy developed somewhat slower than expected in 1998, GDP growing by 2.2%. Better performance was hampered by the growth being mainly export-led; exports grew by 10.7%, supported by the weakening of the German mark. The growth of domestic private consumption was low (0.2%) whereas public consumption even decreased by 0.4%. The gross production in the construction sector continued to decline, falling by 2.2%. The high and ever increasing unemployment rate reached 11.8% by the end of the year and hindered any increase in domestic demand. The high unemployment rate is caused by relatively high ULC and the after-effect of the reunification of the eastern and western parts of Germany (the unemployment level in East Germany reached 18% in 1997).

Although the inflation rate increased slightly over the year, its growth was still contained to below 2%. Due to the modest price increase, the central bank increased the repo rate just once by 0.3%.

The surplus of the trade balance contributed to the reduction of current account deficit to 0.3% of GDP and there is hope to achieve a balanced current account in 1998.

Future prospects depend both on the domestic demand development and on the impact of the Asian crisis. As exports to Asia are only 12% of Germany's total exports, the direct impact of the Asian crisis on Germany's GDP should be limited to 2.4% of GDP. Considering the factors restraining the growth of the domestic demand, a modest economic growth is predicted for 1998 (2.5%), but an increase in unemployment is also possible.

Great Britain

The British economy grew relatively fast in 1997: GDP increased by 2.9%. Unlike Germany, the growth was supported by increasing domestic private consumption (4.2%). Such a growth rate cannot probably be maintained for long and the economic growth should slow down in 1998. It is mainly caused by a raise in the base interest rates, tighter fiscal policy and the strong pound sterling (which appreciated by 12.6% against the German mark in 1997) as well as the impact of the economic crisis in Asia.

The economic growth was accompanied by growing inflation, reaching 3.7% by the end of the year. The central bank increased its bench-mark interest rate by 1.25% in order to restrain the price level increase; nevertheless the price index of main consumer goods did not drop below the CB's target level of 2.5%.

The unemployment decreased, reaching 5.1% - the lowest level of the last 18 years - in December. The labour market tightness is forecast to continue in 1998, when unemployment rate is expected to drop to 4.8%. If the rapid growth in wages were to continue, it could add inflationary pressure on the economy.

Although the trade balance remained negative, a GBP 116 million current account surplus was achieved. A further growth of the trade deficit will probably lead to a current account deficit, forecast to be about GBP 11.5 billion or 1.4% of GDP.

Sweden

Economic growth in Sweden was slower than in the European Union: GDP grew by 1.8%. The 2% increase in private consumption acted as the main contributor whereas public consumption and corporate investments decreased. For 1998 a faster economic growth is forecast (2.8%). The economic position of Sweden in Europe is going to change as Sweden will be one of the four countries remaining outside of the third stage of the EMU for the time being.

The rate of inflation remained a low 0.9% in 1997. In 1998, the inflation rate should increase to 1.5%. The unemployment rate did not change considerably either (on the average 8%), although it is expected to decrease in the environment of improving economic growth in 1998.

Both the trade balance and the current account were in surplus in 1997 which is expected to grow this year.

Finland

Unlike Sweden, Finland is clearly oriented towards joining the EMU. After the economic crisis of early 1990s, Finnish economy grew rapidly in 1997: GDP grew by 5.9%. Corporate investments increased by 11.3%, creating a favourable environment for further economic growth. Developments in forestry, metal industry, machine building and telecommunications were especially significant. The economic growth projection for 1998 is 4.5%. It also depends on developments in Asia, a major market for Finnish exports and investments in recent years.

Inflation accelerated in 1997 but was only 1.3%. Inflation will continue to grow in 1998 due to the rapid economic growth, reaching 1.9% according to forecasts. The unemployment rate, 14.5% in 1997, should decrease to 12.5%.

As exports grew significantly, both trade balance and current account were in surplus. The current account surplus is forecast to decrease in 1998 but it should still be about 5% of GDP.

TRANSITION ECONOMIES OF CENTRAL AND EASTERN EUROPE

Survey of Emerging Markets

The financial crisis in South-East Asia changed considerably the risk assessment of emerging countries, including Central and Eastern European countries[2] by major international financial markets in summer and spring of 1997. Increasing capital flows into emerging countries over the recent years had brought down the interest margin, simplifying debt refinancing. Beginning from mid-1997 the process reversed and interest rate started to rise, becoming a concern for countries in South-East Asia who are more dependent on foreign capital than Central and Eastern European countries.

As a result of an attack against the Czech koruna, the central bank had to give up the fixed exchange rate against the German mark and US dollar and switch to managed exchange rate. The Slovak koruna and Polish zloty were under pressure as well, but the exchange rate policy was not changed. In Slovakia the central bank had to continue the stringent monetary policy expressed in reduced liquidity in the banking system and increased interest rate.

A major event in the monetary policy of Central and Eastern European countries in 1997 was the adoption of the currency board system in Bulgaria. It helped to achieve an initial economic balance following the very high inflation and a significant drop in real GDP earlier last year.

Czech Republic

Several years of successful growth were followed by a setback in Czech economy in 1997, where the growth of GDP slowed down to about 1.3% from 4.1% in 1996 (see Table 1.6).

The continuous inflow of foreign capital in previous years had promoted the expansion of domestic demand whereas reforms on corporate level were weak and, thus, prevented the increase in labour productivity in domestic industry. The rapidly increasing demand pushed the inflation rate up and due to the fixed exchange rate, the international competitiveness of Czech businesses started to decrease. This led to current account deficit reaching 7.6% of GDP in 1996.

In 1997, instability in the external sector deepened and by the end of May investors continued pressure on koruna and forced the Czech central bank to give up the fixed exchange rate policy and to switch to the managed exchange rate. As a result of this change, the Czech koruna depreciated against the currencies of major trade partners. However, the extent of the depreciation was much lesser than that in several SEA countries.

The weakening of the exchange rate accelerated export growth. As the tightening of fiscal and monetary policies oriented to restraining domestic demand prevented the growth of imports, the current account deficit decreased to 5% of GDP in the second half of 1997.

Due to a lack of political consensus, the long-awaited privatization of large banks was not launched in 1997. Preparations to privatize several larger banks have nevertheless been started.

Poland

The remarkable growth in the Polish economy in 1997 was mainly based on a significant growth of industrial output and increasing domestic demand. Industrial output grew due to increasing labour productivity and employment. Domestic demand was boosted both by increasing real wages and booming consumer lending. These factors contributed to the increase in the current account deficit to 3.5% of GDP (compared to 1% in 1996).

The budget deficit was 1.4% of GDP in 1997, being far below the forecast made earlier in the year due to the rapid economic growth.

High inflation caused by increasing demand and the crawling peg system remained a problem. Fighting inflation and speculative pressures, the central bank has maintained high interest rates (exceeding 20%), thus promoting foreign portfolio investments and money supply. The central bank has taken active steps in its monetary policy to counteract the above influence. In order to make commercial banks raise interest rates, the central bank started to accept 6 and 9 months deposits from the public last autumn.

The share of state holdings in the banking sector is still quite high. At the end of 1997, one of the leading commercial banks was privatized; several more will be sold to the private sector.

Hungary

1997 was a successful year for Hungary following several years of stagnation. The higher external demand for industrial output and investments into the private sector spurred economic growth. As the government reduced its budget deficit and external debt, the share of the public sector in GDP growth was close to zero.

In 1997, the budget deficit was about 4.1% of GDP due to large debt servicing costs. Without debt servicing costs the national budget had a primary surplus of 1.9% of GDP.

In 1997, the average inflation was 18.3% compared to 23.6% in 1996. Meanwhile, the average wages increased by 21-22%. Higher real income led to an increase in savings by about 9%.

The contained domestic demand and increased external demand improved the balance of the external sector considerably in 1997. The current account deficit/GDP ratio decreased. The external debt fell from 64% in 1996 to 58% in 1997.

As the inflation rate decreased, the central bank could cut the devaluation rate of the forint from 1.2 to 1.1% per month in April and then to 1.0% in August 1997.

The restructuring of the banking system has developed fast in Hungary. All major banks were privatized in 1996 whereas most of the banking sector is now controlled by foreign investors. In 1997, the banking system development was stable.

Slovenia

In Slovenia GDP grew by 3.3% in 1997, whereas the growth of the industrial output reached only 1.3%. The modest development is mainly due to the slow property reform and few foreign investments made into industry. High real interest rates, reaching about 10%, are also restraining the development of businesses. Economic growth was backed by external demand increasing by 7.5%; domestic demand grew by 3%.

As several of the administratively regulated prices were raised, the inflation rate remained relatively high at 9.1%. Real wages grew by 4%, a bit less than in 1996. The unemployment rate was 15%.

It was difficult to implement the 1997 budget as the budget law was adopted only at the end of the year, weakening the control over expenditures. This led to a 1.3% budget deficit. The surplus of the general government was 0.3% of GDP in 1996.

Several commercial banks, including the largest one by total assets, are still owned by the state.

Lithuania

According to Lithuania's official statistics, the economic growth was close to 6.4% in the first three quarters of 1997. By the end of the year the figure fell to 6%. Considering both consumption and production, GDP grew mainly at the expense of the government sector.

The inflation rate slowed down considerably in 1997. At the end of 1996, the annual growth of the consumer price index was 13.1%; according to official statistics it dropped to 8.4% by the end of 1997. Prices of goods increased a bit more than five per cent and prices of services by 15% year-on-year. The growth of the consumer price index slowed down and was only 0.9% in December, whereas the index reflecting price changes in mining and processing industries decreased by 2.9% year-on-year.

In spite of lower inflation, the growth of average wages gained speed. In the second half of the year the real wages increased by 17% as compared to 1996.

The 1997 budget implementation mostly complied with forecasts and the budget deficit was about 1.9% of GDP at the end of the year. The government external and internal debt increased by 21 and 44%, respectively, over the year. The government external debt/GDP ratio was low: about 15%.

The current account deficit in the first three quarters of the year was 8.5% of GDP, considerably worse compared to 6.6% in the first nine months of 1996. The increase was mostly caused by a 28% increase in imports. Exports increased by 17% over the same period. The current account deficit was increased by the restrained growth of the surplus of the services balance.

Earlier in the year the Lithuanian central bank disclosed a monetary programme that involved giving up the currency board system. In compliance with the programme the central bank started deposit and repo auctions for commercial banks. The stable development of private banks as well as the significant government participation in the banking sector have influenced the results of 1997. The state maintained its ownership in three major commercial banks.

Latvia

Latvia's economy grew by 5.6% during the first nine months; annual GDP growth was about 6.5%. The service sector (transit traffic and trade) was the main contributor to the economic growth. The growth of industrial output accelerated in the second half of the year, reaching 16.2% in the fourth quarter.

Latvia had the lowest inflation of the Baltic countries in 1997. Annual growth of the consumer price index was 7.0% in December. The producer price index grew by 3.8%. Both in Lithuania and in Latvia, the price level increase was restrained by the depreciation of the currencies of major foreign trade partners from Western Europe against the local currency.

The fiscal policy was successful in 1997, and the budget tax receipts surpassed all hopes. Instead of the planned 2% deficit, a surplus of 63 million lats was achieved (without considering the social insurance funds). The successful budgetary performance contributed to the significant reduction of government internal debt.

The government external debt grew by only a few million lats in 1997. The concern of the external sector is the sharply increasing current account deficit (7.9% of GDP in the first three quarters). The deficit grew mainly because the surplus of the services balance decreased.

The banking sector developed well in Latvia. In the second half of the year the loan volume grew significantly (the annual growth reaching 75% in the fourth quarter). Loans to residents were about 12% of GDP at the end of the year.

No major changes took place in Latvian monetary policy. The central bank continued de facto pegging the lat to the SDR currency basket, thus, promoting the harmonious development of financial markets.

Russia

Russia's economy stabilized in 1997 for the first time after seven years of decline. The stabilization is due to a modest growth in the industrial output (about 1.9%) and a lower than expected drop in agricultural output. On the demand side, decreasing investments and diminishing surplus of the trade balance are of major concern. The growth was mainly due to larger private consumption, caused by an increase of 3% in real income.

The restructuring of industry is still modest. In 1997, foreign direct investments doubled, reaching USD 4.4 billion. The unemployment rate was quite high - 9%.

Significant success was achieved in reducing inflation. At the end of 1996, the annual growth of the consumer price index was 22%, but by December 1997, it had dropped to 11%. The stabilization of the exchange rate of the ruble and its maintenance within the currency band against the US dollar helped to reduce inflation significantly. The annual growth of money supply was 30% in December, caused by an extensive inflow of short-term foreign capital in the first half of the year.

Maintaining the state budget continued to be a major concern. 47% of the planned annual revenue were collected within the first nine months of 1997; therefore, the government budget deficit reached about 5.3% of GDP. The unpaid salaries in the public sector totalled USD 1.6 billion by the end of 1997.

The financial crisis in Asia caused a flight of short-term capital from Russia. The accompanying higher interest rates complicated loan servicing by the government. The profitability of short-term government bonds was 20% in early October and increased to 30% by the end of the year. In order to reduce the selling pressure of assets quoted in rubles, the central bank had to increase twice the refinancing and lombard rates to 28 and 36%, respectively, at the end of the year. This complicated the position of weaker commercial banks.

[1] Publications by Deutsche Morgan Grenfell (DMG) and Salomon Smith Barney, data from REUTERS, Bloomberg and Eesti Pank Financial Markets Department have been used in this overview.
[2] Publications by central banks, Bank for International Settlements and Wiener Institut für Internationale Wirtschaftsvergleiche and Creditanstalt have been used in this overview.