WORLD ECONOMY AND FINANCIAL MARKETS IN 1998

MAJOR INDUSTRIAL COUNTRIES

In 1998, the global economic growth slowed down. According to preliminary data the gross production of the world countries increased by about 2%, remaining below the 1997 level (3.5%; see Table 1.1). The economic slowdown was brought along by the deepening economic and financial crisis, started in developing countries in Asia in 1997 and its expansion into other regions (Russia, Latin America).

The GDP growth rate dropped from 3 to 2.3% in developed industrial countries. This was caused, first and foremost, by decreasing export demand, and an economic downfall in Japan. The growth rate varied by countries. At the beginning of the year the US economy growth rate was forecast to slow down, but it managed to maintain the pace and in the background of the crisis in emerging markets it was a significant stabilising factor in the global economic system. The growth rate (2.8%) of the EU Member States remained below that of the USA but maintained more or less the 1997 level whereas the growing domestic demand played a positive role. In Japan the GDP decreased by 2.9%. Considering the magnitude and depth of economic problems in Japan, its economic crisis could sustain the GDP decrease in 1999 as well. In 1999, the economic growth rate in developed industrial countries is forecast to continue slowing down.

The most important developments of the year were reflected in international financial markets as well. A change took place in the US dollar trend in foreign exchange markets - by the end of the year the dollar weakened both against the Japanese yen and the German mark, by 13 and 6.8% respectively. The strengthening of the yen in August was somewhat unexpected undermining Japan’s position as an exporter and hindering progress in the economic situation. The exchange rate of the German mark strengthened against the pound sterling but remained relatively stable against the currencies of the euro area (see Table 1.2).

In stock markets of developed countries the year was rather hectic. The growth continued till mid-July but the anticipated economic slowdown and crisis in Russia in August brought along a significant downturn in share prices lasting till October. The stabilisation was facilitated by a base interest rate cut in the United States - from October to December a new surge took place in stock markets. Influential markets (except Japan) ended the year on an increase whereas in several countries (including the USA, Germany and Great Britain) the growth was contained below the 1997 level (see Table 1.3).

In bond markets the year 1998 was better than the previous one - the index grew in double digits at major markets (except Japan; see Table 1.4). It was preconditioned by a combination of two favourable aspects: firstly, the inflation continued decreasing and secondly, anticipation for the growth slowdown strengthened. The crisis in emerging markets facilitated a supplementary capital inflow into government bonds of industrial countries. Another favourable factor was a move towards the reduction of the budget deficit indicating a decreasing supply of government bonds.

USA

In the United States the economic growth continued for the seventh successive year, reaching according to preliminary data 3.9%, ie remaining on the level of 1997. Although the deepening crisis in developing markets (particularly in Asia) reduced external demand, being one of the reasons for the industrial growth rate downfall from 5.9 to 1.9% during a year, it did not slow the economic growth down as a whole. The weakening export demand was offset against large domestic demand, especially in private consumption and housing construction. Investments grew by 11%, receiving an additional impetus from interest cuts. The unemployment dropped to the lowest in the last 28 years level - down to 4.3%. Regardless of the long-term sustainable economic growth and further tightening in the labour market, the inflation rate declined to 1.6%.

The economic growth was uneven by quarters: in the first and fourth quarters GDP grew by about 5.5% but in the second quarter by only 1.8%. In the second half-year, the anticipated growth was subject to the Russian currency crisis-related instability rocking the international financial markets and bringing along a comprehensive but temporary downturn in the stock market and an interest rate cut from 5.5 to 4.75% by the central bank. The trade deficit continued to grow with the current account deficit of GDP increasing from 1.8 to 2.6%.

In 1999, the US economic growth is forecast to slow down to 1-3% according to various estimates. A major risk factor is the peak of the stock market whereas its drop would bring along a declining consumption growth, low saving and as an external factor - the deepening of economic difficulties in Latin America.

Japan

In Japan the economic recession continued. According to the preliminary data GDP decreased by 2.9%. It is the severest economic crisis in Japan after World War II, restraining both the economic growth of Group of Seven as well as Asia. GDP decreased in all areas except public consumption, which remained approximately on the previous level. In December, the industrial production had fallen by 6.4% and retail sale by 5.2% against the same period in 1997 revealing some depression both in the production sector and consumption. The unemployment grew from 3.4 to 4.1%. The growth rate of consumer prices fell from 1.7 to 0.7% whereas from July to September the consumer price 12 months change indicated deflation. Considering the economic concerns, rating agency Moody’s Investors Service reduced Japan’s country rating from Aaa to Aa1 in November.

Financial markets had a significant impact on Japan’s economic disturbances as well. The considerable strengthening of the yen beginning from August reduced exporters’ profits and tightened the deflationary pressure on the economy. The decision taken at the end of the year for reviving the economy to increase the supply of government bonds coincided with decreasing demand and brought along a sharp rise in long-term interest rates, prejudicing thereby the balance of banks and insurance companies through decreasing bond profits.

As the Japanese government has envisaged several measures to improve the economic situation, they hope to restrain the downfall in 1999. The implementation of fiscal programmes doubled fiscal deficit of GDP in 1998 (from 3.5 to 7.1%). Apart from that the economy also needs comprehensive structural reforms with long-term implications.

European Union

In the EU Member States the moderate economic growth continued in 1998. According to preliminary data GDP increased by 2.8% remaining on the 1997 level (2.7%). The economic growth was the largest in Ireland (9%), followed by Finland (4.9%) and Portugal (4.1%). The inflation rate dropped from 1.9 to 1.5%.

In 1998, the preparations for the start of the third stage of the European Monetary Union (EMU) and introduction of the euro were completed. By the beginning of May the countries joining the EMU were named: out of 15 EU Member States Denmark, Great Britain, Greece and Sweden remained aside. They will consider joining at a later date. In July, the European Central Bank started functioning playing a co-ordinating role in cutting the benchmark interest rate to 3% in euro-zone countries. Due to Maastricht criteria-guided sustainable convergence and co-operation between governments and central banks in euro-zone countries, the changeover to the euro to be used in accounting beginning from 1 January 1999 was smooth.

On the basis of reports by the European Commission and the European Monetary Institute on the fulfilment of convergence criteria by the EU Member States, the recommendation by the Economic and Financial Affairs Council (ECOFIN) and the approval of the European Parliament, on 2 May 1998 the European Council confirmed the list of countries adopting the euro on 1 January 1999: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. On the same day ECOFIN approved of the members of the Executive Board of the European Central Bank and bilateral conversion rates of the currencies of euro-zone countries. The European Central Bank came into operation on 2 June 1998.

Together with establishing the central bank, the European System of Central Banks (ESCB) was born. The ESCB main objective is to maintain sustainable price stability and to support the EU economic policy without undermining stability. The European Central Bank (ECB) strategy is based on quantitatively determined price stability measured by the growth of HICP[1] in the euro area below 2% a year. The price stability is secured according to the determined reference value of the growth of money supply (M3) (4.5% a year during a mid-term period). Parallel to analysing money supply, price development and corresponding risks undermining price stability are studied as well.

Based on the bilateral conversion rates of euro area countries fixed on 2 May 1998, the ECOFIN fixed the exchange rates of currencies of euro countries against the euro[2] .

The economic growth of euro-zone countries was 2.9% in 1998, the unemployment decreased from 11.7 to 11.1% and inflation from 1.6 to 1.1%. In the first half-year, the growth was faster as economic disturbances deepening in Russia and other developing countries brought along a slowdown in exports and overall in the economy in the second half of the year. Although the current account surplus in the single currency area was about 1.5% of GDP, the domestic demand exceeded the external demand, reducing, thus, net exports. Investments grew most among GDP components.

In 1999, the economic growth in the euro area is forecast to slow to 2.1%, the unemployment to decrease and current account surplus to dwindle due to falling export demand. Exports will also be influenced by the exchange rate of the euro which contrary to the expectations dropped at the beginning of the year.

Germany

The German economy developed moderately in 1998, GDP grew by 2.8%. Omitting the reunification of two Germanies, it was the largest growth in the decade. The unemployment decreased from 11.4 to 11.2%. Private consumption grew by 1.7%. The stringent fiscal policy reduced the fiscal deficit to 2.1% of GDP. The current account deficit decreased to 0.1% of GDP. By the end of the year the business climate deteriorated and the economic growth slowed down. The crisis in emerging markets had its impact here as well.

The lack of inflationary pressure on the economy was manifest in the declining annual growth rate of consumer prices from 1.9 to 0.4%. The decision taken together with other euro-zone central banks to bring the base interest rate down from 3.3 to 3% did not therefore endanger the inflation rate. The aim was to maintain the economic growth and to establish by a benchmark rate a significant prerequisite for the changeover to the euro in 11 qualifiers.

Taking into account the persisting crisis in the emerging markets and a relatively high unemployment rate restraining consumption growth, the economic growth is likely to slow down in Germany. According to most forecasts it will be contained below 2% in 1999.

Sweden

The economic growth in Sweden was similar to the European Union as a whole: GDP grew by 2.7%. Both private and public consumption strengthened, investments grew by 8%. The business climate deteriorated in the second half of the year and the annual growth rate of industrial production slowed down, being only 1.4% in November. One of the underlying reasons was the fall in export growth rate whereas the trade surplus remained on the year-earlier level. The economic growth reduced unemployment from 8 to 6.5% but the contained growth in the second half of the year had a negative impact on the consumer confidence, which had currently relied on employment growth. The maintained current account surplus was reduced to 1.9% of GDP.

The inflation rate decreased from 0.9 to 0.4%, beginning from August it was replaced by deflation. The economic slowdown and non-inflationary environment led the central bank to reduce the benchmark interest rate from 4.35% at the beginning of the year to 3.4% at the end of the year and most likely the base interest rate will be curbed in 1999 as well.

For 1999 the economic growth is forecast to continue slowing whereas it is expected to be above 2% helping to reduce unemployment. The further economic outlooks depend also on relations with the European Monetary Union. Although Sweden opted to remain outside the euro for the time being, opinion polls conducted at the end of 1998 reflected that euro-supporters could prevail. A referendum is possible in the year 2000.

Finland

Finnish economy grew faster than the overall EU economy. In 1997, GDP increased by 6% and in 1998 according to preliminary data by 4.9%. Private consumption and investments grew most whereas export growth rate slowed slightly. The key factor in Finnish economic growth was the rapid development of electronics industry. The current account had a continuous surplus, being 5.6% of GDP. The unemployment rate dropped from 12.6 to 11.4%.

The relatively rapid growth brought along a fear of economic overheating and resultant inflationary pressure in mid-year. The threat dispersed and by December the annual growth rate of consumer prices had dropped to 0.8% (annual average inflation was 1.4%).

Beginning from 1999 Finland is one of the countries in the euro area. A continuously significant growth is anticipated in the electronics industry whereas in other industries declining export demand could slow down the growth rate as well. Nevertheless, Finland should be able to maintain a faster than average growth rate in the euro-zone, enhancing further decrease in unemployment.

TRANSITION ECONOMIES IN CENTRAL AND EASTERN EUROPE

General Survey

The growth of the gross domestic product (GDP) slowed down practically in all transition economies in 1998. The aggregated economic growth of five major transition economies (CEEC 5)[3] was 4.9% in 1997, falling to 3.2% according to preliminary data (in Baltic countries 7.3 and 4.4%, respectively). The Russian economy which had grown by 0.8% in 1997, decreased by 4.6% in 1998 according to preliminary data. Only Hungary manifested faster growth among the above countries in 1998 - from 4.6% in 1997 to 5%. A post-crisis revival was visible also in Bulgaria, the indicators being -6.9% and +4.0%, respectively (see Table 1.5).

The economic slowdown had various reasons. One of the major ones was the financial crisis in Russia, which brought along a rapid decline in the trade between other countries in the region and Russia. In the environment of an overall global economic slowdown, exports to the west could not offset the decreasing exports to the east. However, the implication of the Russian crisis on the transition economies varies from state to state.

Among domestic reasons a moderate slowdown in structural reforms should be mentioned, which together with high real interest rates and deteriorating trade conditions increasingly hinders business developments. This is manifest in slower industrial production growth rates in CEEC 5 in 1998: from 8.3 to 5.2%. Constraints in the real sector could have a negative impact on the loan quality in the financial sector. Another reason for decreasing industrial production rates was a downfall in labour productivity growth.

The price increase revealed a downward trend in transition economies in 1998. This was mostly due to slower inflation in the world economy. The price growth slowed especially fast at the end of the year (except in Russia).

Several central banks lowered interest rates repeatedly in 1998 because of the slower inflation growth. Due to decreasing inflation rate the role of domestic demand, as an engine of economic growth became more important. The restrained external demand increased current account deficit (except in Czech Republic). However, differences in current accounts were large by countries.

Poland

The economic growth slowed to 4.8% (having been 6.8% in 1997). The slowdown was linked to falling domestic demand rate and worsening terms of foreign trade. Investments saw the fastest growth, ie 15.4% on the demand side although it has been the smallest indicator since 1995. Private consumption growth declined from 7.1% in 1997 to 5%, government consumption maintained its level. The growth of industrial output slowed throughout the year and in the fourth quarter - for the first time since 1992 - it even decreased. The growth in the agricultural sector was significantly suspended by reduced exports to Russia.

The slower growth in domestic demand managed to prevent a major growth in the current account deficit in the rapidly worsening external environment. The deficit against GDP grew from 3% in 1997 to 4.3%. The deficit was financed by more than 100% from direct investments.

The tight monetary policy was pursued through most of 1998. Beginning from November the national bank has reduced interest rates repeatedly in order to stimulate domestic demand and prevent short-term capital inflow. Partly due to the above as well as due to deteriorating economic outlooks the exchange rate of the zloty declined close to the parity by February 1999, having remained in the stronger area of the rate corridor (7-8% of the parity) throughout 1998.

Czech Republic

The Czech economy decreased by 2.6% in 1998 after having grown about 1% in 1997. In 1998, the only growth-accelerating factor on the demand side was net export. The deteriorating external environment caused the largest decrease in the gross domestic product probably in the fourth quarter. Demand restraining measures implemented after the 1997 financial turbulence by the government and the central bank have had a significant impact on domestic consumption and investments (both decreased in 1998, investments fell by 6.5%). The growth of the industrial output slowed from 4.5% in 1997 to 2.2%.

Due to slowing domestic demand positive changes took place in the external sector. In the first half of 1997, the current account deficit against GDP increased by more than 7%, decreasing to about 1.5% in 1998. Foreign direct investments covered the deficit by more than 100%.

The Czech National Bank has reduced interest rates repeatedly since mid-year in order to boost domestic consumption (from 15% in June 1998 to 8% in March 1999). The switch from the fixed exchange rate policy to the floating rate[4] in May 1997 has been successful. The koruna strengthened throughout 1998 (at the beginning of the year the exchange rate was 34 CZK to 1 USD, in November 29 CZK to 1 USD) but started to weaken due to low interest rates and somewhat unstable economic environment. By February 1999 the koruna reached the level of the beginning of 1998. This development would improve Czech foreign trade conditions, however a weaker koruna could impact price stability.

Hungary

Hungary's economic growth accelerated close to 5% in 1998 (4.6% in 1997). It was boosted by industrial exports, which was increasingly supported - for the first time in many years - by domestic demand. The growth of industrial output accelerated from 11% in 1997 to 13%. This was based not only on increasing labour productivity but also on improved employment (unemployment decreased from 10.4 to 9.1%). In engineering industry employment increased even by 10%.

The current account deficit grew from 2.1% in 1997 to about 4.8% of GDP in 1998. Both in exports and imports industrial products of significant added value (engineering products) prevailed. Trade with the EU Member States reached a modest surplus during the ten months of 1998. Direct investments covered most of the current account deficit.

Slowing down of the rapid price increase allowed the central bank to reduce the monthly devaluation rate of the forint from 0.9% in January 1998 to 0.6% a year later. The exchange rate was maintained mainly on the stronger side of the exchange rate corridor. Turbulence on emerging markets caused by the Russian crisis in autumn pushed the forint to the weaker side of the exchange rate corridor until the end of the year.

Slovenia

In Slovenia the economic growth was about 4% in 1998 (3.8% in 1997). The external sector was the main contributor to the economic growth. The sales of industrial output grew significantly, mostly due to good performance in the first half of the year. Slow reforms are a growing concern in the industry. The unemployment level was high - 14.5%.

In 1998, the export growth surpassed import growth; they were 8.1 and 7.7%, respectively. Therefore the trade balance deficit remained on the 1997 level. The significant surplus of services balance, generated from tourism, maintained the current account surplus.

After the central bank decided to increase the monetary base annual growth rate in mid-1997, interest rates started falling and borrowing gained pace. Declining interest margin allows the central bank to loosen restrictions on financial account transactions. The entry into force of the Association Agreement with the EU has made it a topical issue. The reform of the banking system is becoming ever more urgent due to opening the financial markets to external competition.

Latvia

Latvia’s economic growth was about 4% in 1998 (6.5% in 1997). The growth rate changed significantly subject to decreasing exports to Russia. In the worsening external environment, domestic demand and according to preliminary data, first and foremost, investments became more important contributor to the GDP growth. The government consumption remained modest. The industrial output growth started decreasing rapidly in the second half of the year, being negative beginning from September.

The current account deficit grew from 6.2% in 1997 to about 10% of GDP in 1998. It was mainly caused by the Russian crisis-led deterioration of foreign trade environment. The collapse of the eastern market was significantly recovered by a 30% growth in west-oriented exports. Mainly timber and timber products were exported to the west. The foreign direct investment inflow decreased on the financial account, covering about a half of the current account deficit.

In the second half of the year the money supply manifested a downward trend, having an impact on interest rates as well. In autumn the government bonds’ interest rate rose from 3-4% to 6-8%. Having been very low (2-5%) throughout the year, inter-bank money market interest rates rose to 7-8% by the end of the year. Long-term loan interest rates grew from 12-13% to 15-16% at the end of the year. Negative impacts of the Russian crisis to the banking system became also visible by end-1998.

Lithuania

According to preliminary estimates Lithuania’s economic growth slowed from 6.1% in 1997 to 4.5% in 1998. Domestic demand acted as a growth generator, being pushed by rapid growth of real wages. The external demand growth was hindered by the economic crisis in Russia. The manufacturing, first and foremost oil processing, developed most in the production sector.

Exports fell by 4% in 1998 against 1997 in the worsening external environment whereas imports grew by about 3%. The current account deficit increased because of the trade deficit to about 13% of GDP. Direct investments covered three fourths of the current account deficit during the first three quarters. Foreign direct investment inflow was boosted by privatisation of the majority share in Lietuvos Telecomas.

The crisis in Russia raised the interest rates of short-term government bonds from 9-10% in mid-year to 14-16% in end-1998. Loan and deposit interest rates have been relatively stable. In September 1998, it was decided that the third stage of the monetary programme (abolition of the currency board system, unpegging of the lit from the dollar and repegging it to the dollar-euro basket) adopted in early-1997 will not be started before the year 2000. According to previous plans the third stage was to begin in mid-1999. The postponement was caused by the emerging markets instability.

Russia

After a slight stabilisation phase in Russia’s economy in 1997 when for the first time during the current decade GDP slightly increased (0.8%) and inflation slowed down to 11%, in summer 1998 the country was hit by another crisis, the deepest since the beginning of reforms. GDP decreased by 4.6% and industrial output by 5.5% in 1998. GDP was influenced by downward trends in private consumption (the population’s real income fell by 18.9% in 1998) and investments. The crisis was initiated by slow process of structural reforms, which caused unsustainable budget deficit and accumulation of debts. The external environment played a decisive role as well - continuously falling Russia’s main export articles' prices in world markets and investors’ departure from emerging markets after the financial crisis started in autumn 1997 in Asian countries.

The peak of the crisis arrived on 17 August when the Russian government resolved to change its exchange rate policy, restructuring of short-term domestic debt and start controlling capital account transactions.

In the second half of the year, the rouble lost half of its value, the annual growth of the consumer price index reached 84.4%. In the fourth quarter, the central bank credited the government with 23.5 billion roubles. Banking, payment system, financial markets and the overall economy fell into a deep depression in the post-crisis months.

By the end of the year the situation improved to some extent in the foreign trade, the balance growing significantly after the devaluation of the rouble. The growth is sustained not by increasing the trade volume but by rapidly decreasing imports.

[1] HICP - Harmonised Index of Consumer Price.
[2] Council Regulation (EC) No 2866/98 of 31 December 1998 on the conversion rates between the euro and the currencies of the Member States adopting the euro. See Official Journal of the European Communities L 359, Vol 41, 31.12.1998.
[3] Czech Republic, Hungary, Poland, Slovakia and Slovenia.
[4] The Czech National Bank considers the stability of the exchange rate of the koruna to the German mark but beginning from 1999 to the European single currency the euro.