Economic Affairs

▪ 2006

Introduction

In 2005 rising U.S. deficits, tight monetary policies, and higher oil prices triggered by hurricane damage in the Gulf of Mexico were moderating influences on the world economy and on U.S. stock markets, but some other countries had a robust year, the U.S. dollar strengthened, and oil companies reported record profits.

      In 2005 the world economy expanded by 4.3%, in contrast to the 30-year high of 5.1% in 2004. Several factors contributed to the more moderate growth that affected nearly all regions (notable exceptions were India and Japan). Higher oil and other commodity prices, which had begun causing capacity constraints at the end of 2004, were reducing incomes of importers. In the U.S., monetary policy was tighter. Other developed countries' macroeconomic policies were also less accommodative, and the booming housing markets of 2004 were becoming more subdued. Against this, at least for the time being, inflation and interest rates remained low, however, and a global slowdown in manufacturing output was offset by the strengthening services sector.For Real Gross Domestic Products of Selected Developed Countries, seeTable I (Real Gross Domestic Products of Selected Developed Countries).For Changes in Output in Less-Developed Countries, see Table III (Changes in Output in Less-Developed Countries).

      The global economy continued to be led by the U.S. and China. Higher oil prices, short-term interest rates that were still low but rising, and the exceptionally disruptive hurricane season slowed expansion in the U.S. to 2.5% (3.3% in 2004). Insurance brokers estimated that Hurricanes Katrina, Rita, and Wilma could cost global insurance and reinsurance sectors up to $80 billion. Although past experience of natural disasters suggested that the hurricanes would not have an impact on overall U.S. growth in the longer term, in the short term a major cost resulted from the shutdown of oil-refinery capacity that accounted for 13% of national capacity. In China economic momentum moderated only slightly, and the country's importance as a global player became increasingly evident. In July, in recognition of this development, the outgoing secretary-general of the Organisation for Economic Co-operation and Development stated that China should be admitted as a member.

      The slowdown in global growth, intense competition in many industries, and higher oil and commodity prices provided a stimulus for foreign direct investment (FDI) as major firms sought to improve their competitive positions. More than 100 countries introduced new regulations to improve their investment appeal. Total inflow of FDI was up 2% in 2004 to $648 billion, bringing the total stock to an estimated $9 trillion. Less-developed countries (LDCs) were the main beneficiaries, and after three years of declining flows, FDI in 2004 rebounded to rise 40%, giving the LDCs a record 36% share of the total. All less-developed regions had increased inflows, led by China, which accounted for a quarter of the total. LDCs offered new growth markets in which companies could boost their sales and gave access to rich supplies of natural resources when demand for oil and other commodities was forcing up prices.

National Economic Policies

      The International Monetary Fund projected a 2.5% rise in the GDP of the developed economies, compared with a 3.1% rise in 2004. For Real Gross Domestic Products of Selected Developed Countries, seeTable I (Real Gross Domestic Products of Selected Developed Countries).

United States.

      For Real Gross Domestic Products of Selected Developed Countries, seeTable I (Real Gross Domestic Products of Selected Developed Countries).In the first half of the year, the U.S. economy grew 3.6% year-on-year. Events in the third quarter temporarily dislocated output and dented U.S. and international confidence, but GDP was likely to exceed the IMF's projected expansion of 3.5% (4.3% in 2004). The economy quickly moved back on course, and third-quarter output rose much faster than expected, at an annual rate of 4.3%. The immediate effect of Hurricanes Katrina and Rita was the loss of oil, natural gas, and petroleum-products processing in New Orleans and the Gulf of Mexico, which resulted in a short-term extreme escalation of energy prices. The area represented only 2% of total U.S. GDP, but it accounted for a much larger share of oil and oil-derivatives activities. The hurricanes, together with a strike at aircraft manufacturer Boeing, caused industrial output and employment to fall in September, but there was a recovery in October when industrial output rose a modest 1.9% above year-earlier levels.

      The buoyancy in the economy was due to strong consumer demand. This was partly fueled by the strength of the housing market, where the median established-home price rose by 14.4% in the year-to-August. At the same time, the rate of unemployment fell steadily and at 5% in October was below the year-earlier level (5.5%). For Standardized Unemployment Rates in Selected Developed Countries, see Table II (Standardized Unemployment Rates in Selected Developed Countries). Fears that consumer confidence would be dented by high energy prices proved unfounded. Retail sales (excluding autos) rose 10.3% year-on-year in October.

      Headline inflation, which included food and energy, rose fast relative to rates over the previous decade, reflecting the higher oil prices. In October consumer prices rose 4.3%, compared with 3.2% a year earlier. The underlying rate (excluding food and energy) was well contained and slowed to 1.7% in the first half of the year but began rising toward the end of the year, which was attributed to the tighter labour market and higher unit-labour costs.

      Given a continuing decline in the national savings rate and a growing current-account deficit, public finances continued to be a cause of domestic and international concern. At 2.6% of GDP, the federal deficit for fiscal 2005 was lower than expected. Corporate income taxes and other revenue increases offset increased military expenditure.

United Kingdom.

      For Real Gross Domestic Products of Selected Developed Countries, seeTable I (Real Gross Domestic Products of Selected Developed Countries).The rate of economic growth slowed much more than expected in 2005, and the U.K.'s GDP was likely to fall slightly short of the IMF-projected 1.9% increase. This was in stark contrast to the 3.2% consumer-led growth in 2004. The 1.5% growth in output early in the year was the lowest in a decade. A modest improvement in the second quarter brought the annual rise to 1.7%. The slowdown was due to sluggish private consumption, which declined to 1.8% from 3.6% in 2004. Higher interest rates, which were subsequently lowered in August, contributed to the slowdown, as did the rapid cooling of the housing market. The rise in house prices peaked at 15.2% in August 2004, and in September 2005 the annual increase of 3.2% represented a nine-year low. At the same time, the rise in fuel prices contributed to the two-percentage-point decline in real income in the year to the second quarter.

      Despite the slowdown, the rate of inflation increased. Year-on-year the September consumer price index rose 2.5% before falling back in October to 2.3%. The rise in oil prices added 0.7 percentage point to the September index, compared with 0.25 percentage point a year earlier. Import prices for consumer goods also rose, which was surprising given that U.K. companies were increasingly outsourcing to countries such as China that had lower labour costs.

      Labour-market trends were more positive in the U.K. The 4.7% unemployment rate in September was unchanged over the same year-earlier period. For Standardized Unemployment Rates in Selected Developed Countries, see Table II (Standardized Unemployment Rates in Selected Developed Countries). Tight labour conditions were eased by the substantial net inflow of immigrants attracted to the U.K. by the abundance of jobs. There were an estimated 75,000 potential workers from countries that had joined the EU in 2004 who were eligible to join the U.K. workforce. The increase in the labour supply also eased pressure on the average wage, which rose 4.1%. Public-sector wages were rising much faster (5.6% annually) than those in the private sector (3.8%), with take-home pay some 13% higher for public-sector workers than that of their private-sector counterparts.

Japan.

      For Real Gross Domestic Products of Selected Developed Countries, seeTable I (Real Gross Domestic Products of Selected Developed Countries).Expansion over the year looked set to exceed the 2% (2.7% in 2004) projected by the IMF, and business confidence in Japan was at its highest level in a decade. For the fourth straight quarter, output rose in the three months to September, exceeding expectations with an annualized increased of 1.7%. This was despite adverse factors that included cuts in public expenditure and the increased cost of imported oil. Japan moved away from its traditional export-led growth to private domestic demand. This was helped by increasing household incomes and a drop in the unemployment rate to 4.2% in September (compared with 4.6% a year earlier), which brought it to the lowest level since August 1998. For the first time in a decade, firms were increasing the number of full-time jobs and reducing the amount of part-time work. For Standardized Unemployment Rates in Selected Developed Countries, see Table II (Standardized Unemployment Rates in Selected Developed Countries).

      Badly needed reforms were made in the banking sector, and bank lending increased for the first time since 1988. The sector had long underperformed because of the large number of bad loans being supported—they were estimated at $362 billion in 2002—but it was at last becoming more profitable. By March the major banks had exceeded government targets in reducing the share of nonperforming loans down to 2.9% from 8.4% in 2002.

      Although deflation persisted, it was on a downward trend. The core inflation rate (excluding fresh food but not energy products) fell 0.1% in the third quarter. Land prices nationwide were falling more slowly, and in Tokyo they rose for the first time in 15 years.

Euro Zone.

      For Real Gross Domestic Products of Selected Developed Countries, seeTable I (Real Gross Domestic Products of Selected Developed Countries).In 2005 Europe's long-awaited economic recovery did not materialize, and the euro zone remained weak and vulnerable. The IMF revised downward its forecast rise for GDP to 1.2% (2% in 2004), and the zone once again lagged the performance of Japan, the U.K., and the U.S. Second-quarter output slowed to 0.3% (down from 0.5% in the first quarter). The economic malaise that this generated was exacerbated by political turmoil surrounding the rejection of the proposed EU constitution by voters in France and The Netherlands (see World Affairs: European Union: Sidebar (European Union's Proposed Constitution )) and the failure of national governments at the June EU summit to agree on a budget. The EU institutions came under criticism, and for the 11th straight year the Court of Auditors refused to approve the EU's own accounts because of waste and fraud in the €100 billion (about $118 billion) budget. In March the once-sacred Stability and Growth Pact, which set a 3% limit on the budget deficits of national governments, was amended to give governments more time to reduce excessive deficits. This made it more difficult to enforce discipline, and the pact lost credibility. Several major countries, including Germany, France, and Italy, exceeded the limits, and Hungary's deficit was expected to reach nearly 7%.

      Economic performance across the zone varied widely, and monetary management was difficult. Unemployment remained high at 8.6%, and labour reforms were long overdue in several countries, notably Germany, Spain, and France, where unemployment was nearly 10%. For Standardized Unemployment Rates in Selected Developed Countries, see Table II (Standardized Unemployment Rates in Selected Developed Countries).The future of the monetary union was questioned, and the European Central Bank (ECB) once again came under pressure to cut interest rates. Headline inflation, which included the cost of energy, remained above the ECB's 2% ceiling and in September jumped to 2.6% owing to higher oil prices, though it dipped in October (2.5%) and November (2.4%). Core inflation was much lower, but the ECB moved to subdue prices and on December 1 raised interest rates for the first time since 2000, from 2% to 2.25%.

The Countries in Transition.

      For Changes in Output in Less-Developed Countries, see Table III (Changes in Output in Less-Developed Countries). Overall, the region, excluding the Commonwealth of Independent States (CIS), grew by 4.3%, which reflected a marked slowdown from 2004 (6.6%). The eight “emerging Europe” countries of Central and Eastern Europe (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia) that became members of the EU in May 2004 continued to benefit from EU accession, but the pace of expansion eased following the initial high level of activity and investment boom in the run-up to EU membership. Among the top performers were Estonia (7%) and Slovakia (5%), which were establishing reputations for being business-friendly and were attracting strong investment interest.

      The 12 transition counties of the CIS grew faster. Output in the seven low-income CIS countries (Armenia, Azerbaijan, Georgia, Kyrgyzstan, Moldova, Tajikistan, and Uzbekistan) accelerated to 8.9% (8.3% in 2004), led by an 18.7% increase in GDP in Azerbaijan, where oil production rose sharply. Output in the larger CIS countries ( Russia, Ukraine, Kazakhstan, Belarus, and Turkmenistan) increased more slowly at 6% (8.4% in 2004). GDP growth in Russia slowed to 5.5% (7.2% in 2004), as the oil sector was hampered by a lack of investment and manufacturing was hurt by capacity constraints. While inflation rates in most of the EU transition countries declined, in the CIS countries inflationary pressures were increasing, largely because of high oil prices and, in some countries, excessive private consumption.For Changes in Consumer Prices in Less-Developed Countries, see Table IV (Changes in Consumer Prices in Less-Developed Countries). In Russia social spending contributed to a 12.6% rise in consumer prices. Bribery and corruption were less of an obstacle to doing business in 2005, compared with 2002, according to a survey by the European Bank for Reconstruction and Development. Nevertheless, bribes were accepted as a business cost and still accounted for some 1% of annual revenues.

Less-Developed Countries.

      For Changes in Output in Less-Developed Countries, see Table III (Changes in Output in Less-Developed Countries).For Changes in Consumer Prices in Less-Developed Countries, see Table IV (Changes in Consumer Prices in Less-Developed Countries).The IMF projected a deceleration in LDC output from 7.3% in 2004 to a still-robust 6.4%, and all regions grew more slowly. China and India again boosted overall LDC expansion. Regional disparities were not as wide as in many previous years. On a per capita basis, the lowest growth was in Africa (2.4%).

      Output in Africa slowed to 4.5% from a higher-than-expected 5.3% in 2004. The resource-rich countries boosted growth in sub-Saharan Africa (4.8%). The GDP of South Africa, the region's largest economy, increased 4.3%, with higher metal prices helping to offset increased oil prices and rising unit-labour costs. Unemployment remained a problem. Zimbabwe continued to deteriorate, with output down 7.1% and consumer prices up 200%. Output in Seychelles also fell, for the third straight year, by 2.8%. The Angolan economy expanded strongly for the second straight year, at 14.7%. GDP in Nigeria, the region's second largest economy, slowed to around 4% (6% in 2004) as oil output was constrained by capacity constraints, but the non-oil sector was buoyant and at risk of overheating. The CFA franc zone lagged, with output falling to 3.3%.

 In Asia GDP was forecast to increase 7.3%, led by China (9%) and India (7.1%), but growth was mixed across the region. Pakistan grew by 7.4%, its fastest pace in two decades, as past macroeconomic reforms began to bear fruit. In Indonesia GDP expanded 5.8%, while the inflation rate reached a six-year high of 17.9% in October as fuel prices rose in response to government cuts in subsidies. Poor harvests and higher oil prices were detrimental in the Philippines, where growth slowed from 6% in 2004 to 4.7%, and in Thailand, where it declined from 6.1% to 3.5%. The newly industrializing Asian economies ( Hong Kong, Singapore, South Korea, and Taiwan) grew by 4%, led by Hong Kong, where GDP rose 6.3%. Higher oil prices and slower growth in information technology exports adversely affected South Korea (3.8%) and Taiwan (3.4%). Singapore expanded 3.9% and earned the distinction of overtaking the U.S. as the world's most successful economy in exploiting new information and communications technology.

      The better-than-expected recovery in Latin America in 2004 continued at a more sustainable pace in 2005, with output forecast at 4.1% (5.6% in 2004). Argentina expanded by 7.5% (9% in 2004); Uruguay grew 6% (12.3% in 2004); and though Venezuela rose 7.8%, that was much lower than the 17.9% growth recorded in 2004. Weaker manufacturing output was offset by the strong demand for the region's commodities, particularly coffee, copper, and oil, which accounted for 65% of the region's exports. The low interest rates and improved risk profile of the region also helped to stimulate an 11% increase in investment. The region's annual inflation rate fell to around 5% in September. Only Venezuela experienced high consumer price rises (16.6%), but the rate was declining with price controls and tighter monetary policy.

      Despite continuing terrorism and insurgency in some countries in the Middle East, overall economic growth was estimated at 5.4%. Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates, which constituted the Gulf Cooperation Council, generated nearly 40% of both oil imports and the world's oil reserves. Continuing high oil revenues enabled double-digit public spending, much of it on infrastructure improvements. The strong demand for labour in these countries assisted the non-oil-producing countries in the region through higher remittances and intraregional travel flows. Nevertheless, growth in the oil-importing countries fell from 4.6% in 2004 to 4%, partly because of the removal of quotas under the Agreement on Textiles and Clothing.

International Trade

and Payments

      The volume of world trade in goods and services was expected to rise 7%, which would make 2005 the fourth year of strong recovery. The deceleration from the exceptional 10.3% expansion in 2004 largely reflected the slowdown in the industrialized countries.

      Current-account balances in 2005 became a source of international debate and concern. The U.S. economy was being largely driven by the willingness of Americans to spend heavily on imported goods, while much of the world was building up dollar savings, providing support for the U.S. currency. This situation made the U.S. extremely vulnerable to externalities. The U.S. deficit continued to burgeon and was expected to exceed $760 billion. It was being counterbalanced, not only by the huge surpluses in Asia but also by the commodity-producing countries in the Middle East and Russia and, to some extent, by Latin America and Canada.

      Overall, the current-account deficit of the developed countries rose from $314 billion to $451 billion, with the value of exports rising more slowly than imports. The trade deficit closely matched that on current account, increasing from $314 billion to $476 billion. Continuing the well-established trend, the U.S. current-account deficit—which at $760 billion was well above the 2004 figure ($668 billion) and was expected to rise further in 2006—exceeded the total surplus of the other developed countries. In Japan the surplus fell for the first time in four years, to $153 billion. The traditional deficits in the Anglo-Saxon countries continued, with a slight fall in the U.K. to $41 billion and Australia unchanged at $39 billion. In the euro zone, however, the surplus halved to $24 billion, despite a 20% surge in Germany's surplus to $121 billion. Spain, Italy, and France saw their deficits rise. A 12% drop in the surplus of the newly industrialized Asian countries to $78 billion was accounted for by a decline in South Korea.

 Most notable were the changes in the LDCs. For the sixth straight year, the overall surplus rose dramatically, from $228 billion in 2004 to a record $410 billion. Significantly, the Middle East surplus more than doubled to $218 billion as higher oil prices sent the region's exports soaring to $543 billion ($388 billion in 2004). China accounted for a quarter of the surplus ($116 billion). Exports from LDCs in Asia rose by 21%, contributing to the $110 billion surplus. The surplus in Latin America rose slightly to $22 billion, and in Africa it was a record $12 billion, up from $600 million. Increased oil revenues produced a doubling of the surplus in Russia to $102 billion. Indebtedness of the LDCs rose in absolute terms by around 5% to almost $3.2 trillion. Measured as a share of exports of goods and services, it fell for the seventh straight year to 3.8%, compared with 4.2% in 2004 and 9.6% in 1998. The rate fell in all regions except in less-developed Asia, where it was unchanged at 2.4%.

Interest and Exchange Rates.

      For the early part of 2005, interest rates were benign and reflected the low-inflation environment. Low interest rates were particularly beneficial for the LDCs, which were able to reschedule debt and meet their financing commitments early. At the same time, the low rates contributed to much stronger economic growth, which in itself became inflationary through the act of raising commodity prices. These, in turn, had consequences for the industrialized countries, where inflationary pressures were building and creating uncertainty in central banks, which feared that the increased costs of fuel and other raw materials would feed into consumer prices and wages.

      It was against this background that monetary policies were being tightened, and interest rates, rather than the nature of public and current accounts, had the most bearing on exchange rates. The U.S. Federal Reserve (Fed) raised interest rates in quarter-point hikes from 2.25% at the start of the year to 4.25% at year's end. The Bank of England (BOE) cut interest rates for the first time in two years, by a quarter point to 4.5%. The ECB, prompted by signs of economic recovery in France and Germany, raised the interest rate to 2.25%, ending two years of inactivity. In Japan the zero-interest policy continued, but in much of Asia rates were rising modestly in the second half of the year. In Hong Kong monetary policy was kept in line with that of the U.S. Despite a modest rise, interest rates were declining in real terms in Asian LDCs.

      In contrast to 2004, in 2005 the dollar demonstrated considerable strength and resilience. In the first half of the year, the U.S. dollar appreciated against its trading partners, and in July the dollar was up 3.5%. This was due partly to the rise in U.S. interest rates, which had created a wider differential with Europe and encouraged investors to hold dollar- rather than euro-denominated assets. From the end of July, the dollar was more volatile. In mid-October it was reported that the September consumer price increase of 1.2% was the biggest in 25 years, while core inflation was only 0.1%. This news dampened speculation concerning more interest-rate increases, and the dollar slid. Good economic news and higher interest rates caused it to recover, and on November 10 the dollar reached two-year highs against the euro, British sterling, and the Japanese yen. The dollar fell back following comments by Fed Chairman Alan Greenspan, who warned against complacency about the current-account deficits and the buildup of dollar assets outside the U.S. By year's end the dollar had recovered to end its steep three-year decline.

      In late November the yen reached seven-year lows against the euro, sterling, the Australian dollar, and the South Korean won. The fall was prompted by positive economic news that sent the Nikkei 225 stock index soaring to a five-year high. The weakening yen was good news for exporters, and the Japanese government appeared complacent.

      On July 21 the People's Bank of China (PBC) announced long-awaited currency reforms following pressure on China from the U.S. and other industrialized countries to change the fixed exchange rate under which the renminbi was pegged to the dollar. The perceived undervaluation of the renminbi was seen as giving China an unfair trading advantage. Under the new regime the renminbi was revalued by 2.1% and moved to a managed float against a basket of currencies that included the dollar, the yen, the euro, and the won. This allowed the renminbi to fluctuate by 0.3% against the dollar. The Malaysian government announced that the ringgit, which was pegged to the dollar, would be subject to a managed float; it soon rose 0.7% against the dollar. The moves toward more flexible exchange rates were widely welcomed. In a further—and unexpected—move on September 25, the PBC announced a widening of the band in which currencies other than the dollar might trade against the renminbi. No reasons were given for the move, but it was likely that the wider band would ease pressure on China to intervene in the market to keep the yen and euro within the band.

IEIS

Stock Markets

      High energy prices, such as those experienced in 2005, usually push up inflation and interest rates, put companies under pressure, and undermine stock markets. Other economic shocks—such as the impact of natural disasters on the scale of the December 2004 tsunami in the Indian Ocean on Asia, Hurricanes Katrina and Rita on the United States in 2005, and the massive earthquake in October 2005 on the Indian subcontinent—traditionally unnerve stock market investors. In 2005, however, despite causing local economic disruptions and loss of life, these events had little effect on global stock markets.

       Inflation generally remained low and less volatile, as did output growth, thanks to three recent major structural changes: global economic liberalization; the maturing of financial markets, particularly in emerging economies; and the success of central banks in controlling inflation.

      Following a shaky first quarter, equity markets around the world performed strongly, buoyed by unexpectedly good corporate earnings. Investors had expected markets to slow from 2004's pace, but in Europe and the U.S., corporate earnings rose by more than 10% year-on-year in the second quarter of 2005. Terrorist attacks in London in July failed to disrupt the momentum. The equity markets were also resilient to the long-expected revaluation of the Chinese renminbi. Shares of Japanese exporters were hard hit at first by expectations that a major yen appreciation might follow, but although the yen did appreciate sharply at first, the currency returned to prerevaluation levels within a week. During the third quarter an improvement in the economic outlook reinforced the rally in equity markets, particularly in the U.S. and in Japan, where July's favourable Tankan survey of business confidence and an encouraging machinery-orders report in August prompted economists to upgrade growth forecasts.

      At first, further rises in oil prices did little to sour investors' enthusiasm. In the first half of 2005, firms appeared to have offset rising raw materials and energy costs against higher sales prices and cost cutting and thus maintain or even widen their profit margins. In late August investors started to doubt that this would continue into the latter part of 2005, and markets gave up some of their earlier gains. The price of Brent crude oil rose steadily from $47 a barrel in mid-May to $67 in mid-August, though it eased to just over $58 at year's end. High energy prices were one of the factors most often cited in profit warnings by companies.

      Other concerns also surfaced as the year continued. In September the International Monetary Fund warned of the excessive dependence of global demand on high spending by consumers and high asset prices, particularly housing, as well as the high and volatile price of oil. Low inflation also carried its own problems as low interest rates forced investors in search of yield to take on greater risk. Yet the Morgan Stanley Capital International (MSCI) world index, which ended the first quarter of 2005 in negative territory, rose to 4.7% by the end of the third quarter and ended the year up about 7.5%. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes).)

IEIS

United States.

 A combination of rising domestic interest rates and volatile fuel markets left U.S. stocks trading flat to lower for much of 2005 before a rally late in the year pushed the broad market into positive territory. The Standard & Poor's (S&P) 500 index ended up 3.00%. The Nasdaq (National Association of Securities Dealers automated quotations) composite index gained 1.37%, but the Dow Jones industrial average (DJIA), composed of 30 of the market's most respected stocks, ended the year down 0.61%. (See Graph—>.)

      The Federal Reserve (Fed) set the more cautious tone by raising short-term interest rates eight times during the year in order to relieve emerging inflationary pressures. The rate-setting Federal Open Market Committee raised the benchmark federal funds rate two percentage points to a four-year high of 4.25%, curbing the economy's expansive momentum in the process. As a result, the practice of borrowing money to fund corporate growth became more expensive.

      High oil prices remained a persistent drag on shares in many sectors as the rally in the energy markets that began in 2004 continued into 2005. Between greater global consumption of fossil fuels, occasionally precarious conditions in various oil-supplying regions, and more widespread speculation in energy markets, the price of a barrel of light sweet crude oil broke multiple records as the spring and summer wore on, with the benchmark contract eventually settling at $61.04. Because higher fuel prices generally act as a drain on both corporate profits (by raising the effective cost of doing business) and consumer budgets, equity markets grew increasingly fixated on official stockpile inventories, production forecasts, and even the weather. Both Hurricane Katrina in August and Hurricane Rita in September took their toll on stock prices before coming to shore as investors gauged the damage that the storms would wreak on oil and natural-gas production in the Gulf of Mexico.

      Investors also grappled with various political concerns, including the $319 billion federal budget deficit, increasingly vocal public displeasure with the Iraq war, and the spectre of high-level government scandals in Congress and White House inner circles. On the bright side, the markets applauded the nomination and almost certain confirmation of Ben S. Bernanke (Bernanke, Ben ) (see Biographies), chairman of the President's Council of Economic Advisors, to replace Alan Greenspan as Fed chairman when Greenspan's tenure expired in January 2006. The perception that Bernanke's expertise, clear communication style, and approach to fighting inflation would work to investors' favour was considered a major factor in the overall stock market's year-end upturn.

      The U.S. economy proved resilient despite the combined effect of rising interest rates and fuel prices and the disruptions caused by the year's destructive storms. On a sector-by-sector basis, 8 of the 10 major Dow Jones industry benchmarks advanced during the year. The automotive industry, however, suffered especially sharp declines amid General Motors' dramatic operating losses and mounting retiree expenses on the one hand and the high-profile October bankruptcy of former GM subsidiary Delphi Corp., the nation's largest automotive parts supplier, on the other. Massive obligations to retiring employees raised doubts about American automakers' ability to compete in global markets profitably; credit evaluation agency Standard & Poor's cut both GM's and Ford's credit ratings to “junk” status on May 5, and Moody's followed suit on August 25. As the year closed, the Securities and Exchange Commission was pursuing a wide-ranging investigation of GM and DaimlerChrysler for possible accounting irregularities surrounding the automakers' pension and retiree health care practices. Meanwhile, GM had announced plans to lay off 30,000 employees, and Ford was preparing to close at least eight manufacturing plants.

 Pension-related woes, coupled with the soaring cost of jet fuel, also spelled trouble for American airlines. Shares of Delta Air Lines, Inc., and Northwest Airlines Corp.—the country's third and fourth largest domestic carriers, respectively—plunged after both companies filed for bankruptcy protection on September 14 and their stocks were delisted from major exchanges. Bankruptcy allowed the companies to restructure their own pension funds and other aspects of their relationships with organized labour groups.

      On the bullish side, the energy sector led the market for the second consecutive year by delivering a 34% total return, followed by utilities. After achieving market capitalization of $385 billion in February, oil producer Exxon Mobil Corp. became the world's largest publicly traded enterprise for several months (briefly surpassing General Electric Co.) and went on in October to report the highest quarterly profit ($9.92 billion) and revenue ($100.72 billion) ever recorded by any company. (For Change in Share Price of Selected U.S. Blue-Chip Stocks, see Table VI (Change in Share Price of Selected U.S. Blue-Chip Stocks).)

      Companies playing other roles in the energy industry also delivered outstanding investment returns in 2005. Coal providers led the market, up 77% as the high price of oil brought coal-fired power plants back into favour as an alternative, while shares in oil-field service providers and pipeline operators jumped 64% and 27%, respectively. Other standouts included water utilities, diversified mining companies, heavy construction, and health care providers.

      While 66 of the 104 subsector groups in Dow Jones' reorganized market-classification system saw gains in 2005, two were unchanged and 36 ended in the red. Losers included the previously mentioned automotive group and auto parts makers, down 39% and 29%, respectively, as well as a broad swath of the chemical industry, which relied extensively on increasingly expensive petroleum products. U.S. forestry stocks also suffered, with the paper products group down 20%.

       Mutual funds investing in U.S. stocks delivered an average return of 6.89%. As in the stock market itself, the year's greatest funds' gains were concentrated in the natural-resources sector, where oil-heavy funds ended up an average 38.11%. More broadly based funds investing in large-capitalization stocks ended the year up 6.04% on average, while their small-cap counterparts rose 6.13%. The largest U.S. mutual fund, the Vanguard Group's passively managed $107 billion 500 Index Fund, ended the year up 4.8%, while the actively managed $51 billion Fidelity Magellan Fund gained 6.4%.

      On the New York Stock Exchange (NYSE), the nation's oldest, the pace of trading activity picked up substantially, with 1.61 billion shares being bought and sold every day, up 10% from the 1.46 billion shares traded daily in 2004. The dollar value of all trades surged 11% to an average of $56 billion a day, while computerized trading programs expanded their domination of the market to account for 57% of all shares exchanged.

      Between a relatively thin calendar of initial public offerings (IPOs) and a steady stream of mergers and acquisitions taking companies off the market, the number of securities traded on the NYSE edged up only slightly to 3,669 stocks issued by 2,775 companies. Nonetheless, rising share prices helped lift the aggregate value of all securities listed on the exchange 9.6% to $21.7 trillion. Losers outnumbered winners, with 2,008 issues falling over the course of the year, 1,642 advancing, and 19 closing unchanged. Lucent Technologies remained the exchange's most heavily traded stock; high trading volume also surrounded shares of Pfizer and Time Warner.

      The NYSE announced on April 20 that it planned to acquire electronic trading platform Archipelago to form the world's largest securities market and become a publicly traded entity in its own right. The deal would have awarded the exchange's 1,366 seatholders $300,000 in cash for their seats plus 70% of the new company's stock, while Archipelago shareholders would receive the other 30% of the shares. At least one NYSE seatholder balked at the terms of the arrangement, however, spurring debate for months before the membership eventually voted December 5 to approve the merger. Meanwhile, anticipation helped to fuel interest among investors hoping to buy seats on the exchange. A total of 94 seats traded hands in 2005, three times the number seen in the previous year, while the price per seat quadrupled, with three selling for a record-high price of $4 million.

      Trading sentiment on the NYSE revealed the market's ambivalent outlook. On the one hand, investors who believed that stock prices were likely to fall increased their short-selling activity, borrowing shares to sell in order to repurchase them later at what they hoped would be a lower price. In late December short interest on the NYSE was up 10% at 8.5 billion shares, representing 2.3% of all shares listed on the exchange. On the other hand, those with equally fierce bullish convictions continued to buy stocks on credit or “margin,” pushing the total level of margin debt on the exchange to a five-year high of $219 billion by November.

      On the Nasdaq, the nation's largest electronic share exchange, the average number of shares traded surged to 1.7 billion shares a day, with an average of $3.9 billion a day changing hands. The market's long-standing technological focus remained in force, with Microsoft ending the year as the most heavily traded Nasdaq stock, followed by equally computer-driven companies Intel, Cisco Systems, and Sun Microsystems. In all, 216 companies debuted on the market, but the number of securities delisted from the Nasdaq owing to mergers, acquisitions, or other reasons outstripped the number of IPOs, leaving 2,775 issues on the market at the end of the year. Nasdaq also engaged in a merger of its own, buying rival electronic-trading network Instinet in April for $1.9 billion in cash.

      While stock trading on the NYSE and Nasdaq expanded dramatically in 2005, the activity on the American Stock Exchange (Amex) was increasingly dominated by exchange-traded funds (ETFs), with the number of equities listed on the exchange edging up only slightly to 1,156. Moreover, the Amex's leading role in the popular but competitive ETF arena was challenged several times during the year. In July Barclays Global Investors announced plans to move its 81 ETF products to the NYSE and Archipelago.

      Given the lack of high-profile market scandals compared with previous years, investors were less inclined to file complaints against financial advisory firms. The number of arbitration cases filed with NASD, the primary U.S. market regulatory organization, sank 35% to 5,480 by November.

      Despite a background of rising short-term interest rates and inflation, both of which have historically had a negative effect on the bond market, U.S. Treasury securities displayed unexpected strength through much of the year and gained ground from May through July and again in early September. As the Fed's campaign to guide rates higher continued, long-term bond prices finally retreated in late September, pushing Treasury yields higher. (As demand for bonds falls, prices also decline, pushing yields higher.)

      The benchmark 10-year Treasury note ended the year paying an effective interest rate of 4.39%, above its closing 2004 level of 4.22%. Shorter-term securities followed the Fed more closely, with five-year Treasury rates climbing to 4.36% from 3.61% and the 13-week Treasury bill yield going to 3.98% from 2.18%. In fact, at the end of the year, short-term securities briefly paid a higher effective interest rate than their longer-term counterparts, which created a condition known as an “inverted yield curve,” generally considered to presage slower economic growth ahead. Short-term government funds ended the year up 1.23%; middle-term funds gained 1.79%; and long-term funds rose 3.29% on average.

      Once again, investors willing to accept higher risk for a larger return on their money pursued emerging market debt and more speculative or “junk”-rated bonds issued by companies with a proportionally high risk of defaulting on their debt. Emerging-markets bond funds gained 11.63% in 2005, far and away outperforming the rest of the fixed-income field. Demand for junk-rated corporate bonds pushed the associated yields lower, reducing the difference, or spread, between them and ultrasafe Treasury rates to 3.65%, versus a spread of more than 10% in 2002.

Canada.

      Global thirst for oil and other natural resources ensured that stocks in Canada (the world's fifth largest energy producer) outperformed not only their U.S. counterparts but also every other developed economy's equity market in U.S.-dollar terms. Not even the collapse of Prime Minister Paul Martin's minority Liberal government on November 28 managed to curtail the market's year-end performance. As a broad measure of all issues traded on the Toronto Stock Exchange (TSX), the S&P/TSX Composite index climbed 21.92%. The S&P/TSX 60, a basket of the nation's biggest companies, advanced 37.35%. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes).)

      Most sectors shared in the gains, but oil was the primary contributor to the market's bullish year. Shares in energy companies, which accounted for 24% of the weight of the S&P/TSX Composite, ended the year up 59%, while the nation's major utility stocks (including several power-generation companies and pipeline operators) gained 34%. Demand for industrial metals sent mining company shares up 45%. Shares in the volatile information technology sector ended the year in the red, as did health care and consumer staples companies.

       Nortel Networks, a leading global communications equipment maker, remained the most heavily traded stock on the TSX, but shares shed 14% of their value as investors continued to reevaluate that company's prospects. Semiconductor maker ATI Technologies and wireless network provider Research in Motion were also heavily traded, as were shares of industrial manufacturer Bombardier and several of the nation's gold-mining companies.

       Trade remained the primary driver of Canada's economic expansion in 2005, led by continued export of oil, natural gas, minerals, and forestry products. The Bank of Canada encouraged economic activity by keeping domestic interest rates relatively low. The central bank raised interest rates only three times during the year (on September 7, October 18, and December 6), leaving the key overnight rate target at 3.25% at year's end. As a result of this relatively loose monetary policy, global capital flows continued to favour the Canadian dollar, pushing the loonie to a 13-year high against its U.S. counterpart.

      On average, 255.6 million shares a day were traded on the TSX, representing a 5% increase from 2004 as activity hit a new record pace. The value of those trades jumped 30% to $4.28 billion to reflect the overall increase in individual stock prices. A steady stream of 137 IPOs and 46 graduations from the small-cap Venture Exchange helped to swell the number of issuers listed on the exchange to 1,537 by the end of the year.

Beth Kobliner

Western Europe.

      As the year began, the region's equity markets were the strongest performers in local currency terms, despite poor economic news (the IMF projection was for GDP growth of 1.8% in 2006) and the persistent inability of Germany and France to institute structural reforms. Investors were encouraged by the pace of corporate restructuring, which was seen as a driver of continued gains in productivity and profits; the level of merger and acquisition activity; and the opportunities opened up for companies in the developed markets by the new markets of the Central and Eastern European countries that joined the EU in 2004. Other positive factors included the demand from Asia for European industrial products and the opportunity in Germany to back companies likely to benefit from any restructuring programs once the political uncertainty surrounding the national elections in September was over. The inconclusive election result did cause stock market performance to waver a little. The German DAX 30 initially fell 1.1%, and the DJ Euro STOXX 50 index of leading euro zone shares slid by less than half a percentage point. Optimism returned with the confirmation in November of pro-reform politician Angela Merkel (Merkel, Angela ) (see Biographies) as German chancellor, and the DAX ended the year up 27.1%. There were substantial returns to investors who braved the EU's political and economic uncertainties. The S&P 350 Index, a broad measure of European stocks, was up 22.7% at year's end.

      European markets were judged to be attractively valued in comparison with other major markets, particularly the U.S. Europe's lower labour costs and low real-rates of interest were considered conducive to more growth, and despite the possibility of a global stock-market correction, investors expected companies with exposure to domestic European demand to be better able than most to weather it. In London the Financial Times Stock Exchange index of 100 stocks (FTSE 100) rose steadily throughout most of 2005, though the 16.7% increase for the year lagged most other European bourses. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes).)

      Interest in European stocks was reflected in takeover bids for the London Stock Exchange (LSE), Europe's biggest stock market. The total value of companies trading on the LSE was estimated at £1.3 billion (about $2.3 billion). A bid by Deutsche Börse, operator of the Frankfurt stock exchange, was rebuffed by the LSE in February. Euronext, which already operated the French, Dutch, Belgian, and Portuguese securities markets—as well as Europe's second biggest derivatives exchange, Liffe, in London—also expressed interest, and in August Australian company Macquarie Bank Ltd. stepped into the ring. By year's end Macquarie looked like the strongest contender, even though the LSE rejected the bank's offer.

Other Countries.

 Globally, emerging markets looked to be maturing—displaying a widening investor base, improved credit standing, and better hedging instruments that decreased the dependence of securities on global liquidity and thereby allowed markets to deepen. On September 26 trading began on the Dubai International Financial Exchange (DIFX). The DIFX was expected to provide a market for international investors in a region that had previously been underrepresented.

      Judicious investment in emerging-markets equities had delivered some spectacular returns, but there was wide disparity of stock-market performance between regions and between countries. By year's end, the MSCI Emerging Markets Standard Index had risen 30.3% from just over 1% up at the end of the first quarter. The regional breakdown showed Emerging Markets Far East to have risen 22% over the period, compared with 46% by Eastern Europe. The Emerging Markets Asia index rose by little more than 23%, compared with Latin America's rise of nearly 45%. Country indexes showed the same wide disparities, with tsunami-wrecked Sri Lanka producing an index return of more than 30.7% over the year to end December and Thailand just 4.8%. Analysts were bullish about Asia, despite worries about sustained high oil prices. Growing domestic demand in a number of countries was expected to counter the effect of weakening export markets. Corporations had repaired their balance sheets, and returns on equity were running at record-high levels, particularly in the financial, consumer, and industrial sectors.

      Disparity of country returns was generally less dramatic in the developed-world equity markets. While the MSCI World Index was up just under 5% by the end of the third quarter, in China economic momentum moderated only slightly to 9% (from 9.5% in 2004), helped by the 29% growth in exports in the first half of the year. This was spurred by the ending of textile quotas, which were subsequently reinstated. (See Business Overview.) At the same time, import growth slowed. MSCI country index returns for the year ranged from Norway's 20%, on the strength of its drilling services and shipping companies, to Spain's 1.5%. Nordic bourses, however, quoted gains of up to 40% for the year, and Spain's Ibex-35 ended the year up 18.2%. Throughout 2005, Japan's markets performed consistently strongly against a steady improvement in private consumption and investment and the reduction of the country's reliance on exports to drive growth. Japan's benchmark Nikkei index of 225 stocks ended the year up 40.2%. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes).)

Commodities.

      Investment success depended heavily on positioning in energy, and in June the energy sector was the strongest, recording a gain of 7.4% for the month. By August the impact of higher energy prices was beginning to weigh more heavily on businesses and consumers, particularly in the wake of Hurricane Katrina and the damage caused to oil refineries in the Gulf of Mexico. Although energy prices trended lower in October and, in aggregate, economic news was positive, markets still tended to drift down. Nevertheless, the Economist Commodity Price All Items Dollar index ended the year up 18.5%

      A sign that 2005's high oil and natural-gas prices were possibly beginning to dampen demand came from Brazil, where sales of a biofuel based on sugar cane rose sharply. Shortage of refining capacity around the world, particularly following Hurricane Katrina in August, forced gasoline prices higher than other fuel prices to make it 70% more expensive than bio-ethanol. By the end of 2005, most new Brazilian-built cars were powered by “flex fuel” engines.

      Whatever the likely success of new technologies and new fuels, commodity prices, including oil and gas, were expected to moderate as supply caught up with demand. The extent and timing of this event, however, was more problematic. Oil and gas prices were generally expected to remain relatively high and volatile into 2006, but in November the World Bank reported that growth in demand for oil had slowed from more than 3.5% in 2004 to an annualized rate of 1.4% in the first three quarters of 2005.

 The price of gold reached a 24-year high in November of $528.40 an ounce, as the metal again became popular as a store of value. At the same time, supply fell owing to decreased production and a five-year agreement by central banks to limit the sale of official reserves. The World Gold Council reported at the end of November that global demand was up 18% in dollar terms and investment demand was up 56% from a year earlier. Gold ended the year at $502 per ounce, for an increase over the year of 24%.

      Platinum and silver prices were strong because of increased use in industrial processes, and demand for steel held up, driven by China's continued boom. China was increasingly an important producer as well as a consumer of these commodities and was likely to produce 30% of the world's steel by 2006.

      The World Bank reported that, overall, commodity prices showed signs of stabilizing after a long bull run, supported in part by the higher energy costs that kept production tight. Agricultural prices fell by around 5% over the second and third quarters, but the price of agricultural raw materials such as rubber was rising, which reflected the use of those products as crude-oil substitutes.

IEIS

Business Overview

      The U.S. economy in 2005 endured a host of catastrophes, both natural and man-made, yet it managed not to fall into recession. To analysts this indicated that either the economy had levels of unfathomable resilience or old indicators of economic decline no longer had significance. One image that defined the economic year was that of gasoline pumps with a posted price of more than $3 per gallon. High energy costs were a hard fact of life throughout the year, and they affected every sector of the U.S. economy. The destruction caused by hurricanes in the Gulf of Mexico—particularly the damage to oil refineries by Hurricane Katrina—helped knock both oil and natural gas prices skyward. Prices for crude oil, which had been hovering around $50 per barrel in late 2004, reached $60 per barrel in June 2005 and hit a high of $70.85 per barrel on August 30. Natural gas prices by October had risen above $13 per million BTU, compared with $7 per million BTU one year earlier. Earlier in the year David O'Reilly, the chairman of Chevron, stated his belief that the era of “easy” oil and natural gas was over, a sentiment that was shared by producers and energy traders alike. Natural disasters and the continued threat of terrorist attacks led oil-futures traders to add a risk premium of as much as $15 per barrel.

      For the top oil producers, it was an astonishingly profitable year. The five largest oil companies in the world— ExxonMobil, BP, Royal Dutch/Shell Group, Total, and Chevron—reported record-breaking combined third-quarter earnings of about $33 billion. Top American oil producer ExxonMobil, which had a massive $9.9 billion profit in the third quarter alone, overtook General Electric as the most valuable company in the world. Shell posted the highest annual profit in British corporate history. The cash-fueled resilience of these oil companies was demonstrated by their having been able to cope with Hurricane Katrina and still post major profits. For example, BP managed to post a 34% increase in net profit for the third quarter despite having lost $700 million in pretax profit because of hurricane-related production shutdowns.

      As global spare petroleum capacity fell below one million barrels per day—the lowest in more than 20 years—expenditures for exploration and development soared. By May an average of 2,585 drilling rigs were active worldwide, the highest level of activity in 20 years. (In addition, the cost of drilling an onshore well in the U.S. had risen dramatically, topping $1,000,000 in 2005, compared with $800,000 in 2003.)

 One bright spot, however, was the ceremonial opening in May of the 1,760-km (1,094-mi)-long trination Baku-Tbilisi-Ceyhan pipeline, which began to transport oil from Azerbaijan in the Caspian basin through Georgia to the Mediterranean Sea in Turkey. (See Map—>.) The pipeline could eventually bring as much as a million barrels of Caspian oil a day to Western markets

      The biggest challenge for the major oil companies was that much of the world's untapped oil reserves lay in countries that were hostile to Western interests or were wracked by political chaos. Furthermore, many reserves were owned by nationalized oil companies. Nine of the top 20 oil companies, as ranked by existing reserves, were state-owned; privately held ExxonMobil ranked 12th. Power was expected to shift further to such companies as Saudi Arabia's Aramco, Iran's NIOC, Venezuela's PDV, and Nigeria's NNPC in the years to come.

      In a sign of the growing dominance of nationalized oil companies, China National Offshore Oil Corp. (CNOOC) attempted to purchase Unocal, which had been bid on by Chevron. CNOOC ultimately withdrew its offer after U.S. government officials expressed concern about the purchase and Chevron upped its offer, but analysts expected CNOOC and other Chinese producers to continue on the acquisition hunt. In Russia state-controlled Gazprom purchased a majority share, worth roughly $13 billion, in Russia's fifth largest producer, Sibneft, in what was the country's largest corporate takeover. As the Russian government continued to dismantle privately owned Yukos, which had been the country's largest oil producer, Gazprom emerged as Russia's champion energy power.

      The impact of rising oil and gas prices on utilities was varied. Among the utility companies that prospered was Texas-based TXU, which posted a net income of $791 million for the first half of 2005, compared with a loss of $425 million in the same period in 2004. Other utilities, such as Calpine, posted losses. The main difference between a winning and a losing utility often lay in whether it had locked in a long-term energy-pricing agreement. PECO Energy, for example, had an agreement in place to pay set, relatively low prices for the rest of the decade.

      In Europe a flurry of mergers occurred because European utilities were eager to expand beyond their national markets. The EU was to deregulate gas and electricity markets in July 2007, and some producers already had begun jockeying for position; France's Suez in August acquired the remaining shares of Belgium's Electrabel, and Spanish natural gas producer Gas Natural launched a $27 billion hostile takeover for utility Endesa. (The takeover of Endesa would leave Spain with two large energy companies, Gas Natural and Iberdrola.)

      Higher energy prices also at last ended the infatuation in the United States with low-mileage sport utility vehicles (SUVs), which proved terrible news for American automakers Ford Motor and General Motors. These companies had over the preceding half decade increasingly relied on the SUV to drive sales, and when SUV sales deteriorated, the results were brutal. GM, which controlled 60% of the large SUV market, watched its sales fall 24% year over year in September, while Ford's sales plummeted 19.5%. (By contrast, DaimlerChrysler, which relied far less on large SUVs, reported a 3.7% sales increase in the same period.)

      GM had been considered to be the healthiest of the Big Three automakers, but it was hit the hardest. GM's stock fell to its lowest level in more than a decade, and analysts said that GM's three consecutive quarterly losses (a $1.6 billion loss in the third quarter alone) represented the failure of CEO Rick Wagoner's efforts to streamline the company's North American operations without drastically cutting employees and downsizing brands. As the year went on, Wagoner, who personally took charge of GM's North American unit in April, said that he would cut roughly 25,000 jobs by 2008, eliminating about 22% of GM's hourly workforce. When its purges ended, GM would likely be left with 125,000 employees, compared with more than 600,000 in 1979. Furthermore, GM was seriously considering ending two of its most storied brands, Buick and Pontiac.

      The corporate ratings of both GM and Ford were cut in May to non-investment-grade status by the credit-rating agency Standard & Poor's, which said that it no longer had confidence in either company's business strategies. Along with declining sales, a major concern was the massive benefits-related cost obligations carried by GM and Ford. GM alone covered roughly 1.1 million current and former employees' health care—about 0.4% of the entire U.S. population—and the obligation was estimated to be in the $77 billion range. Negotiations between GM and the United Auto Workers produced a proposed $15 billion reduction in health care costs, but GM still was in dire straits as the year ended and was considering selling off its lucrative financial arm, General Motors Acceptance Corp., to achieve a massive cash infusion.

      Ford, although not as battered as GM, did not have a promising year either. In the third quarter, it posted a $284 million loss, and for the first nine months of 2005, net income was $1.9 billion, down from $3.38 billion in the same period in 2004. Ford blamed higher prices of oil and steel, the weak dollar, and rising health care costs, but analysts said that the largest factor was the decline in sales of the large pickup trucks and SUVs that had been the backbone of Ford's revenues for the past decade. By September the automaker had shaken up its top executive ranks. Mark Fields, Ford's top European executive, took over the company's ailing North American operations and became the fourth person to head that division in as many years. Ford also said that it planned to eliminate up to 30% of its white-collar workforce.

      DaimlerChrysler, which posted a profit during the first half of 2005, was by far the healthiest of the Big Three. One reason was the success of the company's hemi V8 engine, which was used in about one-half of Chrysler's Magnum, Dodge Ram, and Durango vehicles and retailed for $10,000 more than a standard engine even though it cost no more to build. DaimlerChrysler's CEO Jürgen Schrempp said that he planned to retire at year's end, three years before his contract expired. It would mark the end of a decade-long tumultuous tenure during which he had spearheaded the controversial merger of Daimler and Chrysler in 1998. He was to be succeeded by Dieter Zetsche, who would be aided by new Chrysler head Tom LaSorda.

      In contrast to Detroit's woes, Japanese automakers thrived in 2005. Honda Motor, for example, posted an 11.7% increase in sales in September, buoyed by sales of its compact Civic models. Toyota Motor sales were up 11.3% year-to-date as of September, and the Japanese automaker was one step closer to its goal of unseating General Motors as the world's largest carmaker. Toyota planned to ramp up its global production to 9.06 million units by 2006, compared with GM's estimated 2005 figure of 9 million units, and said that it intended to control 15% of the global auto market sometime in the following decade. Toyota's spending on research and development had grown from $4.5 billion annually at the beginning of the decade to roughly $7 billion a year, a figure that reflected the aging of the company's product lines. Moreover, the Japanese automaker was making a substantial bet that high energy prices would continue to spur sales of gasoline/electric hybrid cars, such as its Prius model. (The energy bill signed into law by U.S. Pres. George W. Bush in August provided a tax credit of as much as $3,400 per car to purchasers of the first 60,000 hybrids sold by an automaker.) By 2008 Toyota planned to have rolled out 10 hybrid models, and its hybrid sales already accounted for 64% of new hybrids registered in the United States. Honda was in second place, with 31%. If hybrids flopped, Toyota could be left with massive numbers of unsold cars, but the company was still in solid shape, with low pension-related costs and $30 billion in cash.

      Chinese automaker Chery said that it planned to introduce its first ultracheap imports to the U.S. in the next two years. China could provide a way for automakers to reduce costs, however. DaimlerChrysler said that it planned to build a subcompact car in China, where the hourly cost of wages and benefits for autoworkers was $1.96, compared with $49.60 in Germany.

      For European automakers one event of note in 2005 was the appearance for the first time of a single executive running two major automakers. Carlos Ghosn, already at the helm of Nissan Motor, became the CEO of French carmaker Renault in April. Ghosn had come full circle—Renault had bought a near-majority stake in Nissan in 1999 and installed Ghosn as Nissan's CEO. In subsequent years he helped convert Nissan's losses into a $7 billion profit while he reduced $23 billion in debt and pushed Nissan's operating profit margin up 11%. He had made Nissan the world's most profitable volume carmaker, and Renault was hoping that Ghosn could work the same magic at home.

      For auto suppliers it was an equally grim season. The world's second largest auto-parts supplier, Delphi, filed for bankruptcy protection in October after the company said that it could not come to terms with either its unions or GM, its largest customer. Delphi claimed that because it had to pay its employees the same wages as autoworkers (Delphi was spun out of GM in 1999), it was at a competitive disadvantage. Delphi planned to cut wages from $27 per hour to $10–$12 per hour. The auto-supply sector attracted the interest of financier Wilbur Ross, who had spent much of the decade consolidating companies in the steel industry. Ross's group bought stakes in Oxford Automotive, a French supplier that had recently emerged from bankruptcy, and Collins & Aikman, a Michigan-based supplier that was still in bankruptcy. Ross also expressed interest in Delphi.

      In 2005, for the first time since the terrorist attacks on Sept. 11, 2001, airline passenger traffic had been expected to return to pre-2001 levels. The chaos wreaked by Hurricane Katrina, however, proved to be a crippling blow to some already reeling airlines and played a large part in the decision by Delta Air Lines and Northwest Airlines—the nation's third and fifth largest airlines—to file for federal bankruptcy protection. With the two bankruptcies, both filed on the same day in September, four of the seven largest American carriers were operating under Chapter 11 protection.

      Delta, which had lost $12 billion since 2001, said that it would use its time under bankruptcy protection to reduce its fleet. It was cutting as many as 80 planes and retiring 4 of its 11 aircraft types. Delta also intended to cut its workforce by 17% (after having already reduced it by 20% since 2001) and lower employee wages and benefits by more than $600 million. Its goal was to save $3 billion annually. Northwest, which had lost $3.6 billion since 2001, said that it was seeking $1.4 billion in concessions from its unions. United Airlines, which was already under bankruptcy protection, received permission from a federal court to end its four employee pension plans, which thereby released the airline from about $3.2 billion in pension obligations over the next five years. It was the largest pension default in the three decades that the U.S. government had guaranteed pensions.

      High energy costs in the form of skyrocketing jet-fuel prices played a part in the downfall of Northwest and Delta and squeezed the other large “legacy” airlines. Jet-fuel prices over the course of 2005 rose even more sharply than crude oil prices, and by early September jet fuel was selling for $92 a barrel. Northwest had a $3.3 billion fuel bill in 2005, an increase of $1.1 billion over 2004, but some low-cost carriers were able to hedge fuel costs dramatically through the use of futures contracts. Southwest Airlines had much of its fuel needs hedged at a set price of $26 a barrel. There was some positive news for legacy U.S. airlines; US Airways gained federal approval to merge with low-cost carrier America West Airlines and emerged in late September from its second round of bankruptcy protection in as many years.

 Aircraft manufacturers unexpectedly had a very strong year. Both Europe's Airbus and U.S.-based Boeing experienced upticks in aircraft orders and deliveries. The two rivals together were expected to deliver about 670 jetliners in 2005, compared with a six-year low of 586 planes in 2003. After five years of trailing Airbus, Boeing retook the lead with the help of its new airplane, the 787. It was the first Boeing plane to be designed since Sept. 11, 2001, and the deliveries were expected to begin in mid-2008. Boeing's CEO Harry Stonecipher was forced out in March because of an indiscretion with a female executive and was replaced by James McNerney, who had run General Electric's jet-engine unit.

      The chemicals industry was shaken up by the combination of high energy costs and hurricane-related damage. DuPont posted an $82 million loss in the third quarter because of both a tax-related charge and Hurricane Katrina. DuPont said that storm damage to its Gulf Coast facilities would force it to spend $115 million to replace equipment and would result in about $250 million in lost sales revenue in the fourth quarter of 2005. Meanwhile, Dow Chemical, the nation's largest chemical company, escaped serious damage to its Gulf Coast sites and posted $801 million in net income in the third quarter, despite an $850 million increase in raw material and energy costs.

 In April London-based steel tycoon Lakshmi Mittal (Mittal, Lakshmi ) (see Biographies) acquired Ohio-based International Steel Group to create the world's largest steelmaker. Mittal Steel in October bought Kryvorizhstal, Ukraine's biggest steel mill. Meanwhile, American domestic steel producers had to contend with price softening throughout the year after having experienced a return to profitability in 2004 because of heavy demand from China. Nevertheless, the steel industry was in better shape to contend with a downturn than it had been in many preceding years, during which it had endured massive bankruptcies, mergers, wage reductions, and increased energy costs. In 2005 steel minimills, which used low-cost electric furnaces, produced about 48% of American steel, compared with 8% in 1995.

       Aluminum producers were also victims of the year's hurricanes and higher energy costs. Top producer Alcoa said that its energy costs increased by $374 million in the first nine months of 2005 and that Hurricane Rita knocked out some of its alumina refineries. Alcoa still managed to post a 13% increase in revenue for the first nine months of 2005. Alcoa CEO Alain Belda, who had run the company since 2000, began new measures to increase business, including courting airlines and increasing such foreign ventures as the purchase of Russian aluminum mills. Although global aluminum production was up 9% in 2005, much of that demand came from China, which was already taking action to curb aluminum exports.

      Not all metals faced price deterioration. Gold futures hit a 17-year high of $483 an ounce in mid-October before soaring to well over $500 per ounce by year's end. The price increases in gold came in tandem with increases in the value of the U.S. dollar, which was unusual. Analysts cited increased demand for jewelry as the cause. Gold jewelry fabrication in India was up 50% for the first half of 2005.

      For much of the year, the main issue for textile manufacturers was the confrontation between China, the European Union, and the U.S. over the growth of Chinese textile exports. On Dec. 31, 2004, decades-old quotas that had controlled worldwide trade in textile and apparel products expired, which opened the door for a massive increase in Chinese exports. In the first four months of 2005, U.S. imports of Chinese-manufactured shirts, blouses, and trousers were up more than 1,000%, compared with the same period in 2004. Even though import growth cooled as the year went on, the U.S. imported $9.43 billion in Chinese textiles in the first seven months. Some analysts predicted that in the next two years, China could capture up to 70% of the U.S. market, compared with its 16% market share before quotas were lifted.

      Pushed by domestic textile manufacturers, which feared that their business would collapse, the U.S. launched a number of trade investigations and threatened to impose annual limits on Chinese apparel imports. In May the Bush administration said that it would impose new quotas on items such as cotton shirts and trousers. As the year ended, China and the U.S. were still in disagreement on the growth rate that should be set for Chinese imports in 2007 and 2008, and the U.S. continued to impose “safeguard” quotas—annual growth caps of 7.5%—on specific categories of textiles. In September China and the EU came to an agreement after many European countries called for new quotas on Chinese textile exports to Europe, which had ballooned by 82% in the first four months of 2005 alone. The agreement imposed limits of 8–12.5% on imports of Chinese textiles until 2007.

      In the pharmaceutical industry Merck faced ongoing repercussions from its painkiller Vioxx, which it withdrew from the market in 2004. In August a Texas jury ordered the company to pay $253 million in damages to the widow of a man who had died after taking Vioxx, but in a similar case in New Jersey, Merck was found not liable. Merck, which had seen its stock value fall 60% since 2000, looked to shore itself up by replacing longtime CEO Raymond Gilmartin 10 months before his scheduled retirement in favour of longtime veteran Richard Clark. Rumours that Merck would seek a big merger persisted throughout the year, since the company faced other challenges, including the fact that its top-selling drug, Zocor, would become available as a generic in 2006. Other drugmakers faced similar problems. Pfizer had to take its painkiller Bextra off the market in April at the request of the U.S. Food and Drug Administration (FDA) and European regulators, who said that the drug posed substantial risks that included skin reactions and heart-related complications. The FDA also ordered labeling that would carry warning language on a number of painkillers, including Pfizer's Celebrex.

      The generic-drug sector continued to prosper, and generic-drug sales were expected to grow by more than 20% a year for the rest of the decade. Ties between generic and name-brand pharmaceutical companies continued as Swiss drug giant Novartis in February purchased two generic-drug makers—Germany's Hexal and its sister American company, Eon Labs—for $8.3 billion. The deal turned Novartis into the world's largest seller of generic drugs, with 600 generic products that together accounted for more than $5 billion in annual sales.

      The U.S. Supreme Court unanimously ruled in June that name-brand-drug companies had broad exemption from patent infringement during early-stage research. At the same time, the U.S. National Institutes of Health offered to pay for and run early clinical trials of experimental drugs through a $13 million program that was intended to encourage drug companies to pursue drug trials that might be unprofitable.

      The tobacco industry also benefited from a favourable decision by the Supreme Court. In October the court declined without comment to overturn a lower court's decision that the Department of Justice could not sue Philip Morris, R.J. Reynolds, and other tobacco companies under the federal antiracketeering RICO Act for allegedly misleading the public about smoking-related ailments.

Christopher O'Leary

▪ 2005

Introduction

       Real Gross Domestic Products of Selected Developed Countries Changes in Output in Less-Developed CountriesThe IMF-projected acceleration in world GDP to 5% from 3.9% in 2003 made growth in 2004 the fastest in three decades. The expansion in trade and output was unexpected. It was led by the U.S. and Japan, with only lacklustre recovery in the euro zone. The U.S. demand was fueled by investment and consumption at the expense of growing fiscal and current-account deficits, which in turn led to an apparently relentless decline in the value of the dollar. This created concerns at home and abroad. In contrast, expansion in Japan and the euro zone was export driven. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries); for Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).)

      While the global economy remained heavily dependent on the U.S., the economic emphasis was shifting to Asia, where much faster growth was being fueled by domestic and external demand. In this regard China's role was paramount. Its remarkable economic performance was helped by its membership in the World Trade Organization (WTO) and was underpinning growth in neighbouring countries, including Japan. With exports and imports rising at around 35%, China's demand pushed up the prices of many commodities, particularly oil, which had global repercussions on producers and user countries. The increased economic power of China gave it new confidence and outspokenness that surprised many observers. In November China's central bank responded to growing pressure for a revaluation of its currency to help curb the soaring U.S. trade deficit, proffering advice to the U.S. and criticism of U.S. policies.

      For the third consecutive year, global inflows of foreign direct investment (FDI) fell. The 17.6% decline to $560 billion in 2003 was accounted for by the 28% decrease to developed countries ($384 billion), with flows to the U.S. dropping 45% to $40 billion. FDI in less-developed countries (LDCs) rose 9%, with increases to Africa, Asia, and the Pacific. China overtook the U.S. to become the world's largest recipient of FDI. Competition to attract investment continued to be strong, and 82 countries made 220 regulatory changes to make their countries more favourable destinations, while some resumed privatization programs.

      Fundamental changes in the pattern of investment continued. Transnational corporations from LDCs increased their share of FDI stock to $859 billion following a rise of 8% in 2003. In all regions there was a shift in the composition of FDI away from the primary sector and manufacturing. The services sector accounted for two-thirds of all FDI inflows and some 60% of FDI stock, compared with one-quarter in the 1970s and less than half in 1990. While services were growing increasingly important, many were not tradable and had to be produced when and where they were consumed. The increasing availability of information and communications, however, was enabling more services to be produced in one location and consumed in another. This was creating a growing trend toward offshoring and outsourcing both to cut costs and increase access to skills to improve the quality of services offered. (See Special Report (Offshoring ).)

National Economic Policies

       Real Gross Domestic Products of Selected Developed Countries Standardized Unemployment Rates in Selected Developed CountriesThe IMF projected a 3.6% rise in GDP in the advanced countries following a 2.1% increase in 2003. (For Real Gross Domestic Products of Selected Developed Countries, seeTable (Real Gross Domestic Products of Selected Developed Countries); for Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).)

United States.

       Real Gross Domestic Products of Selected Developed Countries Standardized Unemployment Rates in Selected Developed CountriesThe IMF projected growth in 2004 of 4.3%, compared with the 3% achieved in 2003. (For Real Gross Domestic Products of Selected Developed Countries, seeTable (Real Gross Domestic Products of Selected Developed Countries); for Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) The early part of the year was marked by strong expansion, with first-quarter output rising 4.5% (annualized rate). In the second quarter, the quarter-on-quarter rate decelerated sharply to an annualized rate of 3.3%, largely because of an unexpected slowdown in personal consumption. A drop in consumer confidence was prompted by increased oil prices and slower-than-expected employment growth; spending on durable goods, particularly motor vehicles, suffered most. In the second half, growth accelerated, with third-quarter output rising at an annualized 4.4%, helped by a recovery in personal consumption to an annual growth rate of 4% against 1.6% in the second quarter.

      During the year the fall in the value of the dollar and the rising cost of oil were causes for concern, but the economy demonstrated a resilience that surprised many observers. It was better able to absorb increased oil costs than it had been at the time of previous oil shocks (1973, 1979, and 1991). In 2004 corporate profits and business investment remained strong, and while interest-rate rises had removed some of the stimulus to business activity, monetary policy was still supportive. The fears of deflation that were prevalent at the end of 2003 ironically gave way to apprehension in the first half of the year that inflation would resurface. This prompted the U.S. Federal Reserve (Fed) to reassure financial markets that it was prepared to intervene. In the second half of the year, more aggressive prices pushed the consumer price index (CPI) to end 2004 up 3.3% on December 2003, although the core rate (excluding food and energy) rose only 2.2%. There was limited pressure from wages, which in December were rising at 2.7% above year-earlier levels. While job creation was weak in the first half of the year, the number of hours worked increased by an annualized 4.1% in the third quarter, and the unemployment rate, at 5.4% in December, was well down on the year before (5.7%).

      As in 2003, public finances were a cause of domestic and international concern. The federal deficit for the year was $422 billion, or 3.6% of GDP. Spending increases under Pres. George W. Bush had escalated to an annual average 5.1% from 1.5% and 1.9% under former presidents Bill Clinton and George H.W. Bush, respectively. To maintain the government's borrowing ability, in November the president signed into law an $800 billion increase in the U.S. government's debt limit to $8.18 trillion; this brought the amount by which the limit had been raised to 25% since he took office in 2001. This allayed international fears that the U.S. would default on its debt. At the same time, Fed Chairman Alan Greenspan was warning that the country's burgeoning current-account deficit was “increasingly less tenable.” His comments on November 19 in an address to finance ministers and central bank governors in Frankfurt, Ger., ahead of the Group of 20 (G-20) meeting in Berlin had the effect of sending the dollar into further decline.

United Kingdom.

       Real Gross Domestic Products of Selected Developed Countries Standardized Unemployment Rates in Selected Developed CountriesFor most of the year, the U.K. economy remained surprisingly resilient, and output was projected to expand at an above-trend rate of 3.4%, although the outcome was likely to be closer to 3%. (For Real Gross Domestic Products of Selected Developed Countries, seeTable (Real Gross Domestic Products of Selected Developed Countries); for Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) Output in the second quarter rose at an annual rate of 3.7%, the fastest in four years. The third quarter saw a marked slowdown. Several industries experienced decline, and overall industrial output contracted by 1.4% following a 1.2% increase in the second quarter. Service-sector activity also moderated, and retail spending grew more slowly.

      Much of the impetus came from private consumption that was being supported by continued income growth and rising housing wealth. Consumer spending had outpaced GDP growth for the previous eight years. A continuing boom in the housing market, where prices had been rising at around 20% annually for five years, low unemployment, and an economy running at close to capacity generated fears of overheating. By the second half of the year, interest-rate increases were dampening the housing market, and in November the number of mortgage approvals fell to 77,000 in the steepest drop since 1995. House prices fell marginally in October and December, and annual house price inflation in 2004 eased to 12.7% from 15% in 2003. Jobs in the private sector declined slightly during the year, while public-sector employment continued to increase. Although the unemployment rate reached a new low at 4.6%, the number of unemployed claimants rose slightly in September and October, while total employment at 28.4 million was at its highest since records began in 1984. At the same time, employment in manufacturing fell to a record low of 3.35 million.

      Nevertheless, the manufacturing industry spearheaded growth in e-commerce, which more than doubled to £40 billion (£1 = about $1.79 at year-end 2003) in 2003, compared with 2002. Manufacturers' sales almost trebled to £15 billion as many required their customers to order online to keep costs down. Research showed that the larger the company was, the more it used the Internet. Nearly a third of spending by businesses with more than 1,000 employees was online, compared with 14% by companies with fewer than 10 employees. While consumers increased their online shopping by 78% in 2003, their share of online spending fell to 29%. The U.K. had the largest e-commerce economy in Europe.

Japan.

       Real Gross Domestic Products of Selected Developed Countries Standardized Unemployment Rates in Selected Developed CountriesThe strong economic recovery in 2003 continued to gather momentum in early 2004, and output was projected to increase by 4.4% following a 2.5% rise in 2003. (For Real Gross Domestic Products of Selected Developed Countries, seeTable (Real Gross Domestic Products of Selected Developed Countries); for Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) In the first quarter, output rose sharply to an annualized rate of 6.3%, but it fell in the second quarter to 1.3%, largely because of the drawing down of inventories and a decline in public final demand. Recovery continued to falter, with third-quarter annual growth in real GDP slowing to 0.3%, although in nominal terms the rate accelerated and even in real terms the year-on-year figures showed real GDP was still growing at 3.9%. Output for the year was likely to rise by nearer to 4%. The increased cost of oil imports on which Japan was heavily dependent was not helping the recovery. Japan was the world's third largest oil consumer, after the U.S. and China, but led the world in energy efficiency. A second fact hindering recovery was the slowdown in China, which had become Japan's largest trading partner.

      There were signs that after nine years of deflation, prices had stabilized and would begin to rise, bringing to an end the malaise that had eroded corporate profits and increased the real cost of the debt burden on borrowers. In November the CPI was up 0.8% on a year earlier, although it was still half a percentage point down over the year. Restructuring of the labour market continued, and labour was becoming more flexible. Many companies were no longer able to offer employees the traditional job for life, and more people were moving between jobs. Given the need to supplement family incomes and to insure against redundancy, female participation in the workforce was increasing. Because of the changes being made, unit labour costs declined, productivity was rising, and wage costs were lower. At the same time, the job-offers-to-applicants ratio rose to a 10-year high, and the unemployment rate in November fell to 4.5%, its lowest level since January 1999.

Euro Zone.

       Real Gross Domestic Products of Selected Developed Countries Standardized Unemployment Rates in Selected Developed CountriesAs in 2003, the euro zone as a whole lagged the performance of Japan, the U.K., and the U.S. The economy recovered strongly in the first half of the year, and output was projected to increase 2.2%, compared with a 0.5% expansion in 2003. (For Real Gross Domestic Products of Selected Developed Countries, seeTable (Real Gross Domestic Products of Selected Developed Countries); for Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) The promising start gave way to a dismal performance in the second half, and output growth for the year was unlikely to reach 2% in the wake of three years of below-trend growth. Factors contributing to the deterioration included the increased cost of oil imports and the weaker global conditions. International competitiveness was eroded by the appreciation of the euro. In general, the area remained dependent on external demand. In the first half of the year, a surge in exports pushed up industrial output, particularly in Germany, Italy, The Netherlands, and Spain, and in September industrial production was running at 2.9% above year-earlier levels. The rate of consumer price inflation showed signs of accelerating and for much of the year was running at slightly above the European Central Bank's 2% ceiling. Higher oil costs and indirect tax increases were largely responsible, but given the high level of unemployment—which in November stood at 8.9%, unchanged over a year earlier—there was no fear of a wage-price spiral.

      The composition and pace of growth varied widely across the region. In Germany, the euro zone's largest country, output was projected to increase by 2% following a 0.1% decline in 2003, but it was unlikely to exceed 1.5%. The surge in exports in the first half of the year had spearheaded the euro-zone recovery but moderated in the second half because of the fall in global demand, the stronger euro, and higher oil prices. Domestic demand during the year remained weak. Investment spending fell 2.5% year on year in the second quarter—the 14th consecutive decline. Despite household incomes' being boosted by lower taxes, in the first half of 2004, consumer spending remained flat, and retail sales were down 1.5% in the third quarter. Rigidities in the labour market kept the level of unemployment high and intractable, and at 10.7% in October, it was up on a year before (10.5%) and did little to boost consumer confidence. In France economic growth was more broad-based, and output was increasing at double the rate in Germany. France, however, also suffered high unemployment, which in November stood at 9.9%, unchanged from a year earlier. Rapid expansion in France in the first half of the year was fueled by strong domestic demand, with household and government spending and investment all contributing, but output faltered in the second half.

The Countries in Transition.

      Nearly all countries participated in the acceleration in output to 6.1% in 2004 from 5.6% in 2003. In the first half of the year, significant moves were made toward closer integration within Europe. On May 1 eight countries of Central and Eastern Europe (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia) joined the European Union, together with Cyprus and Malta. This subjected them to much tighter fiscal discipline to meet the requirements of the EU Stability and Growth Pact. (See World Affairs: European Union: Sidebar (Criteria for Joining the Euro Zone ).) In June, Estonia, Lithuania, and Slovenia joined the European exchange-rate mechanism in a move toward adoption of the euro. Entry for the others was delayed so that they could reduce their budget deficits and inflation rates. The initial effects of accession were mixed. It contributed to acceleration in inflation to 4.5% (from 2.9% in 2003) but improved investment potential and export opportunities.

       Changes in Output in Less-Developed CountriesAs it had since 2000, output increased fastest in the Commonwealth of Independent States, where growth was underpinned by high commodity prices. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).) The highest projected growth rates were for Armenia (7%), Azerbaijan (9.1%), Kazakhstan (9%), and Tajikistan (10%). Ukraine, where output was projected to increase by 12.5%, was expected to be the star performer before the uncertainty that followed the elections. (See World Affairs: Ukraine .) In Russia output was expected to decelerate slightly to 6.9%. In most of the southeastern European countries, output gains were made and GDP was projected to increase 5% from 4.4% in 2003, with Albania (6.2%) and Romania (5.8%) outperforming, while Macedonia lagged behind the trend (2.5%) because of a lack of investment. In nearly all countries of the region, inflation rates rose, and the median rate was projected to increase from 4.8% to 6.3%. Notable exceptions were Romania, Serbia and Montenegro, and Belarus, where there were sharp drops in double-digit rates.

Less-Developed Countries.

       Changes in Output in Less-Developed Countries Changes in Consumer Prices in Less-Developed CountriesThe IMF projected acceleration in output in the LDCs to 6.6% in 2004 from 6.1% in 2003, which was the fastest growth rate in a decade. While some industrialized countries provided strong markets, it was the dynamic performance of the large LDCs, particularly China and India, that boosted LDCs as a whole. Regional disparities remained, but these were less than in recent years. Latin America had been the laggard in 2003, but in 2004 that region's output increased faster than at any other time since 1997. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries); for Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

      Led by China, LDCs in Asia continued to spearhead growth. East Asian economies grew by 8.4% in the first half of the year, though the rate for the year was expected to slow to 7.3%. China was the world's most dynamic economy in 2004, expanding by 9.6% in the first half of the year. Despite the imposition of “macroeconomic controls” to rein in growth and prevent overheating, growth over the year was 9.5%, while the rate of inflation accelerated, reaching a seven-year high of 4.4% in May. The economies of Taiwan and Hong Kong were also buoyant. Investment provided strong stimulus, and although the flow into China slowed, it was still running 20–30% above year-earlier levels. Imports mainly of raw materials spiraled to more than 20% and outpaced exports. Increased domestic demand in all three economies contributed to GDP growth. Because of weaker domestic demand and the higher cost of oil, the South Korean economy performed less well as the year progressed.

      After three years of stagnation, output in Latin America staged an impressive recovery and was expected to increase by 4.6%. Nearly all countries performed better. Brazil resumed robust growth of 4%, following a 0.2% decline in 2003. Fears that Mexico (up 4%) would lose market share to China abated as exports rose strongly and large European and American firms made new investments. Recovery in Argentina (7%) continued, helped by high commodity prices. The major oil exporters (Colombia, Ecuador, Mexico, and Venezuela) benefited from higher prices, while the damage to oil importers was largely offset by increased prices of agricultural products (in Argentina, Brazil, and Uruguay) and metals (Chile, Jamaica, and Peru). Lower interest rates enabled many countries to reschedule their debt.

      In the Middle East growth slowed from 6% to a projected 5.1%. Risks associated with the conflict in Iraq and fears of terrorist attacks on oil infrastructures in the region deterred investors. There was little scope for oil production to increase as it had in 2003. Nevertheless, incomes in the oil-exporting countries were rising, and domestic demand was thus increasing. In the Mashreq countries ( Egypt, Jordan, Lebanon, and Syria), exports strengthened, helped in Egypt by a depreciation of the Egyptian pound, which in turn exacerbated the inflation rate.

      Output in Africa rose 4.5%, the fastest since 1996. Lagging behind the trend was South Africa, which accounted for half the GDP of sub-Saharan Africa but only 11% of the population. While the 40% appreciation of the South African rand since 2002 had helped reduce inflation, it slowed export growth and stimulated imports. Elsewhere the oil-importing countries suffered from increased costs, but many countries benefited from both increased oil production (Angola, Chad, and Equatorial Guinea) and an end to the drought (Malawi and Rwanda). In several countries—notably Burundi, the Central African Republic, and Madagascar—greater political stability increased investor and consumer confidence. In Zimbabwe the steep economic decline continued, with output down (−5.2%) for the sixth consecutive year and consumer prices up by 350%. GDP growth in Nigeria slowed from 10.7% to 4% as the oil production gains in 2003 leveled off.

International Trade and Payments

      The increase in the volume of world trade in goods and services was expected to exceed the projected 8.8% in 2004, which was the third consecutive year of strong recovery. This followed an expansion of 5.1% in 2003 and reflected the high level of industrial output and investment activity. China accounted for more than 20% of the increase in merchandise trade, as its trading role was enhanced by WTO membership and its share of world exports doubled from 2.9% to 5.8% between 2000 and 2004. China's demand for minerals and oil bolstered the volume of its imports, which rose by a third over the year, and stimulated world commodity prices. For the eighth time in nine years, the export volume growth of LDCs (10.8%) exceeded that of the advanced economies (8.1%). In dollar values world exports were projected to rise 17.4% to $10,806,000,000,000. Services accounted for 80% of the total and grew by 14.2%.

      Revenue from international tourism, which was the world's largest export industry and a major foreign-exchange earner ($500 billion in 2002) for many countries, was expected to reach a new high. The acceleration in economic growth and greater business and consumer confidence led to a strong recovery. The World Tourism Organization projected a 10% rise in arrivals from the 691 million recorded in 2003, the biggest increase in 20 years. All regions registered strong gains in the first eight months of 2004, with 37% more arrivals in Asia and the Pacific, which in 2003 had been adversely affected by the SARS (severe acute respiratory syndrome) outbreak, and 12% more in North America following three years of decline. The disruption of the Iraq conflict ceased to deter travelers, and Middle East arrivals rose by 24%. In absolute numbers Europe, which accounted for nearly 60% of all arrivals in 2003, experienced the second largest increase, with 16 million more arrivals, although this translated into a 6% increase.

      Current-account imbalances in the world economy became the largest in modern history. The overall current account of the balance of payments in the advanced economies remained in deficit for the sixth straight year. The total surplus rose from $247 billion to $266 billion. The U.S. deficit again exceeded the total surplus and at $63l billion had increased from the year before ($531 billion) to 5.4% of GDP. Its size provoked much international comment and speculation. When Fed Chairman Greenspan criticized this deficit as unsustainable, the downward pressure on the already-depreciating dollar increased. The growth in the deficit occurred in spite of the increase in exports aided by the weaker dollar. This was outpaced by the higher cost of oil, which added at least $10 billion a month to the widening deficit, as well as the rise in imports to meet the unexpectedly strong demand. The U.S. had a large and growing bilateral trade deficit with China that was a periodic cause of friction. This was at the expense of China's large trade deficit with other LDCs from which it imported the intermediate and primary goods to produce the finished goods it exported to the U.S.

      The largest deficits were in the Anglo-Saxon countries, with that in the U.K. rising to $43 billion ($33 billion) but only 2% of GDP, while in Australia, at $32 billion, it reached 5.9% of GDP. The euro zone surplus nearly tripled to $72 million because of the surge in Germany's surplus from $53 billion to $119 billion, while in Japan the surplus reached $159 million ($136 billion). The surplus of the four Asian newly industrialized countries (Hong Kong, Singapore, South Korea, and Taiwan) was unchanged from 2003 at $85 billion.

      After many years in deficit, the LDCs were in surplus for the fifth straight year. The surplus rose strongly to $201 billion from $149 billion in 2003, boosted by a near doubling of the Middle East surplus to $104 billion. The less-developed Asian countries' surplus fell from $86 billion to $69 billion as a result of the upsurge in imports. The aggregate positions of the LDC regions obscured the weakness of the more than 50 individual countries that had deficits in excess of 5% of GDP. Most of these were in Africa and Latin America. Indebtedness of all LDC regions except Africa and Latin America increased slightly, raising the total to $2,763,000,000,000.

Interest Rates.

      Early in 2004 the developed countries expected that falling inflation rates (or even deflation) and historically low interest rates would continue to be the norm. This changed as the U.S. economy exhibited growing strength and increasing employment rates. The extent and speed of tightening was the only question. The Fed made its first move to tighten the loose U.S. monetary policy on June 30 with a quarter-point rise. Four more quarter-point hikes brought the rate to 2.25% by year's end. In the euro zone Germany's hopes of interest-rate reductions were dashed by the expected rise in the U.S., as well as by an acceleration in the zone's inflation rate. The U.K. rate rose moderately and finished 2004 at 4.75%, up by 0.75% over the year. In Japan the authorities kept their commitment to a zero-rate policy. Tightening had taken place earlier than in the U.S. in Switzerland and New Zealand, while in Australia rates were already higher in 2003 and remained unchanged in 2004 because inflationary pressures were building.

      An important influence on inflation and the level of interest rates in the industrialized countries was the housing “bubble.” In 2004 the “bubble” and risk that it would burst became a key issue for many governments. They needed to dampen the markets by raising interest rates but not so fast or so high that the bubbles burst, which would cause consumer spending to collapse. In many countries prices had been rising at an accelerating rate for several years, and the property markets were exhibiting a high degree of synchronization. Cumulative growth rates between 1995 and 2003 were well in excess of consumer prices. Most affected were Ireland, where prices rose 193%, the U.K. (146%), Spain (122%), and The Netherlands and Australia (both up 110%). In the U.S. the 60% price rise concealed higher increases in certain, mainly coastal, areas.

Exchange Rates.

      The increase in the size of the U.S. public and current-account deficits led to the continued depreciation of the U.S. dollar, which was the main determinant of 2004 exchange-rate movements worldwide. In the industrialized countries nearly all currencies appreciated against the dollar on trade-weighted terms over the year. The Australian dollar fell marginally and was an exception. Among the major LDCs only the Chinese currency ( renminbi) depreciated. Because it was pegged to the dollar, the renminbi fell 10.7% in both local currency and dollar terms between Dec. 31, 2003, and Dec. 31, 2004. In most other countries the local currencies appreciated mainly because of improved oil and other commodity prices or because of increased confidence in their economies.

      Among the industrialized countries, the extent to which the euro rose against the dollar surprised many observers. Given the relative weakness of the euro-zone economy and the expectation that its interest rates would hold steady while those in the U.S. rose, there was no rational explanation. While the exchange rate rose nearly 8% over the year, its trade-weighted value had increased only 6.2%. Against British sterling the euro weakened in the first half of the year, after which it strengthened, with sterling back to €1.41. Intervention by the authorities in Japan to support the yen meant that its rise was negligible in trade-weighted terms and appreciated less than 5% in currency units. Of significance, however, was the trade-weighted rise of 10% in the Canadian dollar.

      The perceived undervaluation of the renminbi provoked criticism from industrialized countries that believed China should change its fixed exchange-rate policy, under which the renminbi was fixed to the dollar. In November the deputy governor of the People's Bank of China made it clear that China would not be rushed into revaluation. Toward year's end, however, rumours that China might move some of its reserves out of dollars caused panic in currency markets. As of September 2004, China's central bank held $174.4 billion in U.S. Treasury Bonds and was the second largest foreign holder, after Japan. Fears persisted that China and other Asian central banks, which had bought huge amounts of dollars to curb the appreciation of their own currencies, might dump U.S. assets to avoid large losses as the dollar fell.

IEIS

Stock Markets

      Confidence in equities returned in 2004. As the year began, investors seemed to base their longer-term strategies on the generally positive outlook for the corporate sector. Improved global growth prospects, corporate financial strength, and rising stock prices buoyed investors' confidence so well that the MSCI World index, which had gained 32% in 2003, gained a further 3% in just the first eight weeks of 2004. Thereafter, equities tended to trade within a narrow price range, caught between geopolitical uncertainty, oil-price hikes, and rising official interest rates on the one hand and robust corporate performance on the other.

      Markets were shaken by the terrorist attacks in Madrid on March 11 and entertained niggling worries about the possible effect of rising official interest rates on consumer spending in countries undergoing a housing boom, such as the U.K., Spain, and Ireland. Major stock markets weakened in late March and again in late May and mid-August. Equity investors turned more risk-averse in the second and third quarters of 2004 on concerns about the real strength of the global economic recovery. More immediately behind these reversals, though, were corporate profit warnings and weaker-than-expected macroeconomic data. By the end of August, the Standard & Poor's index of 500 large-company stocks (S&P 500) was 3% lower than at the end of June, and similarly, the Dow Jones Euro STOXX index of 50 European blue-chip equities and the Tokyo Stock Price Index (TOPIX) of large-company stocks were down 3% and 4%, respectively. Warnings of lower-than-expected profits by technology firms such as Cisco Systems, Hewlett Packard, Nokia, and Intel hit particularly hard. Oil prices rose steadily from the end of June, peaking in October at more than $55 a barrel. Investors seemed less concerned about the potential for inflation, however, than the possible dampening effect on aggregate demand and corporate profits.

       Selected Major World Stock Market IndexesAfter mid-August, major equity markets climbed back to earlier levels and then rose a little, or at least held steady. World stock markets rose sharply on the decisive result of the U.S. presidential election on November 2. (See World Affairs: United States: Special Report (U.S. Election of 2004 ).) The widely followed Dow Jones Industrial Average (DJIA) immediately gained as much as 150 points, or 1.5%, before drifting lower and then rose to peak at 10,854.54 on December 28. After the election the Financial Times Stock Exchange index of 100 stocks (FTSE 100) closed at 4718.5, the highest level since June 2002, before continuing its climb to the year's high (4820.10) on December 30. As of December 1 the Morgan Stanley Capital International (MSCI) World index was up 10%; it finished the year at a 12-month high of 1170.74, a 13% gain on the year. (For Selected Major World Stock Market Indexes, seeTable (Selected Major World Stock Market Indexes).)

IEIS

United States.

 The American public's preoccupation with the presidential election, a sometimes murky economic outlook, and continuing unrest abroad resulted in investors' spending much of 2004 waiting for uncertainties to resolve. As a result, stocks traded in a narrow range for much of the year until November, when the reelection of Pres. George W. Bush sparked a sustained year-end rally in the markets. The S&P 500, a broad gauge of the overall market, ended the year up 8.99%. The Nasdaq (National Association of Securities Dealers automated quotations) composite index gained 8.59%, but the more narrowly focused DJIA climbed only 3.15% in value. (For Closing Prices of Selected U.S. Stock Market Indexes, seeGraph—>.)

      The year began on a relatively bullish note, but the Federal Reserve (Fed) set a different tone on January 28 when it announced that after three years of aggressively low interest rates, the risk of inflation was becoming substantial enough to make higher rates desirable in the future. In the months that followed, the Fed's rate-setting Federal Open Market Committee (FOMC) made good on its promise by raising its short-term interest-rate target 0.25% a total of five times. While this left the key federal funds rate at 2.25% (still lower than it had been in four decades), companies that had become accustomed to even lower borrowing costs suffered nonetheless, and their shares reflected this.

      Fear of looming higher interest rates dominated investor behaviour in 2004. By February the market had adopted a pattern of perversely rewarding signs of economic weakness in the hope that it would delay the inevitable rate increase, while news that would traditionally have been considered positive was shunned as giving the Fed a reason to move with greater speed. Hedge funds (and other speculative investors), which eschew traditional long-term investment strategies in order to capture short-term trading advantages, fed into this contrarian activity. Once limited to a handful of secretive investment firms, the hedge fund industry had grown to encompass about 8,000 hedge funds controlling more than $900 billion in assets and accounting for fully half of all stock trading volume. On the whole, the retail investors who drove stock prices higher in the late 1990s remained largely absent, driven away by the losses that followed the market boom.

      Hedge fund speculation played a role in an unprecedented rally in the oil market, but strong demand from a recovering global economy and supply disruptions in several nations ranging from Iraq to Russia (where government pressure shut down leading oil producer Yukos) were more substantial factors. On October 25 the benchmark contract for light sweet crude touched an all-time high of $55.67 a barrel. While oil prices eventually receded, businesses and consumers alike still suffered under the increased burden of buying fuel.

      In 2003 tax cuts and low interest rates had created a catalyst for explosive economic growth. As the stimulating effects of these policies waned in 2004, however, economic expansion slowed to a more subdued but sustainable pace. The labour market remained a controversial topic throughout the year, and inflation, led by rising fuel and commodity prices, became a threat to continued economic expansion—and investor sentiment—as the year wore on.

      All 10 broad stock sectors classified by Dow Jones extended their 2003 rallies in 2004, though some showed only narrow gains. Energy stocks, an obvious beneficiary of the oil boom, ended the year up 29.94% as activity increased in segments of the oil and gas industry, from the giant producers to small companies prospecting for fresh sources of supply. China's hunger for steel and other basic materials for its own economic expansion supported a 10.62% gain for commodities producers. The telecommunications sector was another of the year's winners, climbing 14.88% as investors finally overcame their reluctance to add traditional telephone stocks to their already wireless-rich portfolios. On the other hand, demand waned for technology shares, the darlings of 2003, leaving the sector up only 1.37%. Health care stocks also struggled to rise 3.21%, pulled lower by regulatory concerns and the looming expiration of key drug patents.

      Within narrower segments of the market, mining companies logged the highest returns of any industry for the second year in a row, up 97.15%, followed once again by consumer electronics makers, which gained 73.82%. The high price of fuel translated into strong performance for oil-field-equipment stocks, as well as second-tier petroleum producers and, significantly, shares in coal-mining companies. Still, 9 of the market's 83 industrial groups—a diverse array of companies ranging from the long-suffering airlines and semiconductor manufacturers to automobile makers—lost ground in 2004.

       Change in Share Price of Selected U.S. Blue-Chip StocksSome of the market's largest companies struggled during the year as investors shifted their focus from traditional blue-chip stocks to more obscure names with growth potential. As a result, the Dow Jones industrials languished, while the Russell 2000 index, stuffed with small-capitalization (small-cap) growth companies, surged 17% to 651.57. The April 8 revision of the DJIA components also cooled interest in the three companies dropped from the venerable index (AT&T, Eastman Kodak, and International Paper) while fueling short-term demand for their replacements (American International Group, Pfizer, and Verizon Communications) from index fund managers and retail investors alike. (For Change in Share Price of Selected U.S. Blue-Chip Stocks, see Table (Change in Share Price of Selected U.S. Blue-Chip Stocks).)

      The market-timing scandal of 2003 expanded beyond a few mutual fund companies to challenge several of the foundations of the securities industry. The Securities and Exchange Commission (SEC) followed the lead of New York Attorney General Eliot Spitzer (see Biographies (Spitzer, Eliot )) by taking a more active interest in any transaction that presented financial companies with opportunities to act against the public interest. As a result, directed brokerage and other “soft dollar” practices (in which brokerage firms and mutual fund companies trade noncash compensation for preferential service or product placement) were banned. The mutual fund companies were fined more than $2 billion for various infractions, setting in motion the collapse or transformation of such venerable firms as Invesco, Pilgrim Baxter (now Liberty Ridge Capital), and Putnam Investments. Even the secretive hedge funds that initially made the controversial trades were forced to register with the SEC and abide by new rules. Meanwhile, Spitzer and the SEC turned their attention to a similar array of practices at insurance companies, uncovering a host of apparent abuses.

      Although the fund families that filled the headlines suffered in the eyes of investors, the mutual fund industry overall managed to expand. Total assets under management edged up 3.6% to $7.94 trillion as of November 30, led higher by $167 billion in net inflows to stock funds and $327 billion going into sophisticated hybrid funds, which combine stock and bond investments.

      Mutual funds investing primarily in large-cap stocks gained only 3.78% in 2004, substantially lagging their performance in the previous year. Funds concentrating on smaller companies delivered slightly better returns, up an average of 5.27%. The biggest U.S. stock fund by assets, the Vanguard Group's 500 Index Fund, gained 10.7% in value, while the next-largest fund, the Fidelity Group's Magellan Fund, returned 7.5%.

      An average of 1.46 billion shares changed hands every day on the New York Stock Exchange (NYSE)—a significant increase from 2003. In dollar terms, trading activity increased dramatically to $46.1 billion a day, up 20% from 2003 as retail investors cautiously returned to the market and hedge funds stepped up their activity. The number of stocks listed on the exchange held steady at 3,612 as new listings only slightly outnumbered companies being acquired or otherwise leaving the market. Market breadth for the year was decidedly mixed, with 2,358 issues ending higher, 1,235 losing ground, and 19 closing unchanged. Lucent Technologies, under CEO Patricia Russo (see Biographies (Russo, Patricia F. )), remained the most commonly traded stock on the exchange, followed by Nortel Networks, General Electric, and AT&T Wireless Services.

      A total of 30 of the 1,366 NYSE memberships, or “seats,” changed hands in 2004, but the price of these once-exclusive commodities plunged 33% as the year progressed. On December 14 a seat brought $1,030,000, a level not seen since 1995. The generally wary tone on the exchange was echoed by an increase in short interest, by which investors bet that stocks will fall in price. Short positions on the NYSE rose 6% over the previous year to 7,715,766,807 shares. Likewise, margin borrowing, a sign of confidence, went back on the rise, pushing aggregate margin debt on the exchange at $196 billion (nearly a three-year high) by November.

      Average daily volume of stocks traded on the Nasdaq stock market climbed to 1.8 billion shares, largely owing to the increased adoption of third-party electronic trading networks, and average daily dollar volume rose to $34.6 billion. Sirius Satellite Radio became the most heavily traded stock on the market, but computer-oriented shares such as Microsoft, Cisco Systems, and Intel maintained respectable trading volumes. Meanwhile, the Nasdaq's Apple Computer, up 201.4%, had the biggest percentage gain of all large-cap stocks. A total of 170 companies started trading on the Nasdaq in 2004, almost triple the number of initial public offerings (IPOs) completed in 2003. The most noteworthy of these debuts, Web search engine company Google, was the largest Internet offering ever, raising $1.7 billion. Although the company, founded by Sergey Brin and Lawrence Page (see Biographies (Brin, Sergey, and Page, Larry )), created some confusion by bypassing Wall Street underwriters to auction off shares directly to investors, the deal still sparked renewed interest in the once-desolate IPO market. Despite the increase in new listings, the number of companies trading on the Nasdaq fell to 3,358 from 3,725 as market regulators continued to prune from the list companies that no longer met size or other requirements.

      The nation's third national stock market, the American Stock Exchange (Amex), was the home of 1,273 issues, including a growing number of exchange-traded funds (ETFs) and other derivative investment vehicles. On average, 66 million shares a day were traded; once again, the most active security traded on the exchange continued to be the ETF equivalent of the Nasdaq 100 index.

      Headlines were filled with the hunt for conflicts of interest within the securities industry on an institutional level, but on a more mundane level investors found fewer grounds for dispute in their relationships with stockbrokers and other financial advisers. The number of arbitration cases that were filed with the National Association of Securities Dealers, the market's supervisory organization, fell 8% to 7,575.

      Negative factors for the bond market were numerous. Caught between rising interest rates, the threat of resurgent inflation, and a substantially weaker dollar, sophisticated investors fled from Treasury securities into higher-yielding corporate paper or the currency advantages of euro-denominated bonds.

      Investors overseas became less eager to fund the massive U.S. current-account and trade deficits, both of which climbed to record levels owing to a ballooning $2.4 trillion federal budget and continued consumer demand for cheap imports, ranging from crude oil to finished products. Fading foreign capital flows into dollar-denominated Treasury bonds weakened demand for the U.S. currency, pushing the dollar to four- and five-year lows against the Japanese yen and the euro, respectively. The unfavourable exchange rate in turn depressed the effective returns on Treasury bonds in terms of foreign currencies, creating a vicious circle that punished both bonds and the dollar.

      Nonetheless, continued interest in Treasury paper, considered the safest investment in the world, allowed both prices and effective yields to end the year almost unchanged in dollar terms. The yield on the benchmark 10-year Treasury note ended the year at 4.22%, slightly below 2003 levels. The Lehman Aggregate bond index, which includes corporate, mortgage, and government agency securities as well as Treasury debt, ended the year up only 4.3%, only marginally above the return investors would have received from simply holding long-term government bonds. Investors looking for more substantial rewards flooded into corporate bonds, which are more speculative than securities backed by the U.S. government but offer higher interest rates. Even in the riskiest areas of the market, demand for corporate debt regardless of credit rating narrowed the gap (or spread) between high-yield junk and investment-grade bonds to a six-year low of three percentage points.

      The weakness in the Treasury market was also felt in bond-oriented mutual fund holdings, but sophisticated managers still managed to eke out decent investment returns. Long-term government bond funds tracked by Morningstar gained 7.3% in 2004, but their short-term equivalents saw only a 0.93% increase in value. By contrast, bond funds with an international focus surged 8.91%.

Beth Kobliner

Canada.

      Booming commodity prices and a robust domestic economy propelled the Canadian stock market, the world's seventh largest, to its second consecutive year of positive performance. A strong Canadian dollar, however, made it difficult for manufacturing companies to export their products and left their shares from flat to lower.

      As a broad measure of all stocks traded on the Toronto Stock Exchange (TSE), the S&P/TSX Composite index climbed 12.48%. The S&P/TSX 60, a basket of the exchange's biggest stocks, advanced 11.60%. Most sectors ended the year in positive territory, but returns were mixed. Winners were led by oil and gas shares, up 29%, and the continued rebound of information technology (IT) stocks, up 23%. Sectors in disfavour included health care companies, industrial manufacturers, and the gold group, which lists the majority of the world's bullion-mining concerns.

      Telecommunications equipment maker Nortel Networks, by far the most widely held company on the exchange, lost 25% of its value, ending the year at Can$4.16 (Can$1 = about U.S.$0.84 at year-end 2004). Other actively traded TSE stocks included industrial conglomerate Bombardier as well as Wheaton River Minerals, which made headlines on December 23 by agreeing to merge with fellow gold miner Goldcorp.

      Average daily trading reached a new record level of 242.7 million shares, up 9.9% from the previous year, while the dollar value of these trades jumped to Can$3.3 billion per day, reflecting both increased volume and higher share prices. A total of 1,421 companies were listed on the exchange at year's end, reflecting 115 IPOs.

      The Canadian dollar continued to appreciate in value, reaching a 12-year high as its U.S. counterpart declined. Global demand for gold, oil, and Canada's other commodity products helped the economy grow at a surprising pace in the first half of 2004, but the strong currency and high fuel prices tempered the expansion by summer. The Bank of Canada maintained an activist stance toward interest-rate policy, lowering its official overnight-rate target three times (in January, March, and April) before raising it twice (in September and October), each by 0.25%. As a result, the rate ended the year down 0.25% at 2.50%.

      In November the national Investment Dealers Association fined three brokerage firms a total of Can$25 million for abetting trades similar to those that drew the wrath of regulators onto the U.S. securities industry. Only about 200,000 new Canadian mutual fund accounts were opened in 2004, but total assets in such funds surged an estimated 13.3% to a new record level.

Beth Kobliner

Western Europe.

      Economic recovery in the euro zone remained sluggish, and the terrorist bombings in Madrid on March 11 further undermined business and investor confidence, adding to markets' fragility. In the aftermath, European markets were down by between 1% and 2% in early trading, following a 1.6% drop in the DJIA. Madrid's Ibex 35 lost 1.5%. Share prices also fell in Tokyo, Hong Kong, and Singapore, as well as in Sydney, Australia, and Seoul, S.Kor. Investors' risk aversion became more marked in continental Europe with the drop in share prices and spike in volatilities that followed the attacks. Later in the year the impact of the U.S. dollar's weakness on European exports caused concern.

      Nevertheless, relatively high market valuations allowed companies to strengthen their balance sheets and reengage in mergers and acquisitions. Earnings had recovered substantially from 2001–02 lows, and listed companies' profits were ahead of forecasts in 2003, rising almost 100% year on year in the euro area. European stock markets closed the third quarter with small losses, down 0.4% in local currency terms.

      Investors tended to focus on finding European companies with exposure to China. Formal enlargement of the EU from 15 to 25 countries in May added only 5% to the region's GDP and had limited impact on the long-term growth prospects for corporate earnings. To benefit, companies in the mature euro-zone countries would have to either exploit the lower cost base in the acceding 10 countries or tap into fresh demand.

       Selected Major World Stock Market IndexesFrom January to midyear, investors judged European equities fairly valued, but a brief rally at the end of the second quarter ended in July when corporate results disappointed. The IT and consumer sectors were especially weak, and the IT sector was afflicted by doubts over the strength of the pickup in technology spending. The big markets of the U.K., France, and Germany were lacklustre. During the year, the S&P Europe index of 350 stocks rose by less than 9%, with the French CAC 40 and the German Xetra DAX up 7.4% and 7.3%, respectively (all in euro terms), and the FTSE 100 up 7.5% in sterling terms. Many smaller European markets did far better, including Italy's S&P/MIB (up 14.9%), the Ibex 35, which recovered to gain 17.4% for the year, Belgium's BEL20 (30.7%), and Austria's ATX, which soared 57.4%. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).)

Other Countries.

       Selected Major World Stock Market IndexesInvestment growth turned upward in most regions during the year. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).) Before a brief sell-off in late January, equity prices in emerging markets outperformed most other markets. Improved fundamentals and high levels of liquidity supported investor confidence. Although overall performance of emerging markets was strong, from the end of the first quarter through late May, major emerging stock markets fell sharply, following the pattern of the major stock markets of the advanced economies and indicating substantial correlation between markets. The downturn was driven in part by uncertainty about the impact of oil-price rises, as well as the effects on emerging economies of weaker-than-expected recovery in the major economies.

       Asian markets, which had performed strongly in 2003, were weaker in 2004. In the first half of the year, investors worried about possible overheating in the Chinese economy, the impact of high oil prices, and the direction of U.S. official interest rates. From mid-April the equity market sell-off was by far the sharpest in Japan and other Asian markets. The Japanese markets were particularly volatile in May. Although in the first quarter the strength of Japan's recovery exceeded expectations, the announcement on May 13 of lower-than-expected machinery orders prompted a 2% drop in the Nikkei 225 index. In the third quarter the Nikkei lost 9.6% when a disappointing second-quarter GDP result was published, but by the end of July, the TOPIX was up 3.8%, and the index ended the year up 13% in dollar terms. The Nikkei ended July up 0.7% and ended the year up 10.7% in dollar terms. India's Sensex and Hong Kong's Hang Seng index each rose more than 13%, while China's previously strong Shanghai and Shenzhen composite indexes plunged 15.2% and 16.5%, respectively.

      The strong performance of Latin America in the third quarter took many investors by surprise. The MSCI Latin America index jumped 17% in dollar terms over the third quarter, with a range of 4% for Mexico to 28% for Argentina. Brazil rose 17%. The rally led to a return for the MSCI Latin America index of 39.8% over 12 months and of 38.7% for the S&P Latin America 40 (in dollar terms). The region easily outperformed developed stock markets and the Asia-Pacific region.

Commodities.

      Prices trended up over the year, boosted by demand for raw materials from China. After more than a decade of relatively low prices for their goods, minerals and metals producers enjoyed an outstandingly good year. On December 1 the Reuters-CRB index, a basket of 17 commodity futures tracked by investors, hit a 23-year high.

      Oil took centre stage. Speculation by noncommercial traders—including institutional investors and hedge funds—was blamed for much of the increase in price during 2004. As most other markets began to lose steam through the year, traders turned their attention to commodities in general—and oil in particular. Speculative activity rose sharply in expectation of higher prices. By late November, U.S. crude prices were still around $49 a barrel, although $6 down from late October's record, as the highest OPEC production in 25 years rebuilt stocks in consuming countries.

      In late November, as the dollar fell to a record low against the euro, gold reached $450 a troy ounce for the first time since June 1988. Global gold equity indexes moved less strongly, though, on fears that the rally was not sustainable. Consumer demand for gold in the second quarter of 2004 rose 25% in dollar terms as gold reclaimed safe-haven status and a weaker dollar made dollar-denominated gold cheaper for holders of other currencies, especially the surging euro.

      Even coffee, after four years of prices so depressed that many growers abandoned the crop, made a substantial, if still fragile, recovery. The price rose from an average of 48 cents a pound in 2002 to an average of 60.8 cents a pound in March 2004.

      The Economist Commodity Price All Items Dollar index ended 2004 up 1.8%. According to the index, food was down 2.9%, with metals (21.1%), oil (34.1%), and gold (6.5%) up.

IEIS

Business Overview

      For the U.S. economy 2004 was a year with two faces. At times the economy seemed to have shed the last traces of the past recession, yet it also seemed to be bogged down throughout the year; the annual growth rate of gross domestic product fell to 3.5% by late 2004 after having been on a 5% pace earlier in the year. Job losses waned and waxed with each month, and many sectors contended with serious price hikes. The health of the economy became a central issue of the U.S. presidential campaign as Pres. George W. Bush pointed to indicators of economic recovery while his Democratic challenger, Sen. John Kerry, cited continued layoffs as a sign that the economy was still fragile. Each candidate had plenty of evidence to bolster his case. (See World Affairs: United States: Special Report (U.S. Election of 2004 ).) The outsourcing of jobs to less-developed countries was also a significant economic issue in the campaign, and the number of jobs being outsourced from the United States continued to increase during the year. (See Special Report (Offshoring ).)

      Although price inflation hit sectors that ranged from steel production to titanium mining, no industry was more defined by high prices in 2004 than the energy industry. Producers of oil and gas, coal-mining concerns, and other energy companies benefited from skyrocketing prices. Crude-oil prices rose above $55 per barrel in late October, the highest price posted since the New York Mercantile Exchange began trading oil in 1983. Oil prices, historically adjusted, remained below their all-time highs of the early 1980s; nevertheless, they translated into pain for consumers. Gasoline prices in the U.S., for example, remained above $2 per gallon for most of 2004. The price hikes had a number of causes, including low producer inventories and unstable global conditions. Energy traders said that fears about global conditions at times created a $10-per-barrel risk premium in oil-futures trading. Even OPEC, which for decades had been able to control oil prices, proved powerless to manage prices in 2004. Few analysts expected any halt to the rise of oil prices in the short term. Demand was being driven by China's growing thirst for oil, which at 5.5 million bbl a day was second only to that of the U.S., and supply remained tight; in 2004 spare oil-pumping capacity, which was about one million barrels per day, was no greater than what it was in 1973, but the demand for oil had risen by 44% since then.

      Despite being flooded with cash, few oil companies were pushing to find new drilling opportunities. The six global oil “supermajors,” including ExxonMobil and TotalFina Elf, were expected to gain $138 billion in cash flow in 2004, up 28% from 2003, but at the same time, the capital spending by these companies was expected to rise only 8%. Top oil companies concentrated instead on selling off poorly performing assets and buying back shares. Some analysts predicted an increase in exploration activity in 2005, since energy firms gained a tax break in October 2004 for the domestic production of oil and gas, but many analysts expected most new activity to come from low-risk efforts to boost production at existing sites.

      Not all top oil producers flourished in 2004, however. Notably, Royal Dutch/Shell Group revealed that it had been greatly overstating its oil and gas reserves, and in January it reduced its proven reserves by 22%—by nearly four billion barrels, which was worth about $400 million. The subsequent shock to its stock value, along with lawsuits and government probes, caused Shell's board to oust its chairman, Sir Philip Watts, and the company's head of exploration and production, Walter van de Vijver. After he was sacked, van de Vijver claimed that he had been warning Shell officials since 2001 that reserve levels were being inflated. Buoyed by increased revenues from price hikes as the year went on, Shell managed to control the crisis and in August settled with the U.K.'s Financial Services Authority and the U.S. Securities and Exchange Commission without admitting or denying its responsibility for the overbooking.

      Other top oil companies were not so lucky. Yukos, which was Russia's largest oil producer and accounted for 2% of global oil production, spent 2004 in a desperate fight for its life. Following the jailing of Yukos founder Mikhail Khodorkovsky for fraud and tax evasion in October 2003, the Russian government claimed that Yukos owed back taxes that at times were estimated to be in the $28 billion range. Yukos maintained that it could not make those payments. In December the Russian government sold off the company's major production facilities to the previously unknown BaikalFinansGroup, and it was expected to continue to dismember the company in 2005. In what appeared to be a last bid to avoid destruction, Yukos filed for bankruptcy protection in a Texas court, though Yukos's argument that its Houston-based banking accounts qualified it as having a presence in the U.S. and thus having protection under U.S. laws was immediately challenged. Despite this turmoil, Western oil companies increased their involvement in Russia. In September ConocoPhillips paid nearly $2 billion for the government's stake in Lukoil, which was Russia's second largest oil producer.

       Electric utilities had disparate results, since many utilities had to contend with the high production costs caused by soaring oil prices and a doubling of the price of coal. Some companies, having cleaned up their balance sheets and sold off underperforming units, greatly outperformed analyst expectations. TXU Corp., for example, posted a 69% increase in net income in the third quarter of 2004 compared with the same period in 2003. Profits fell, however, for a number of other utilities, including Northeast Utilities, Duquesne Light Holdings, Ameren, and Xcel Energy. (See Sidebar (Alarming State of the U.S. Electricity Grid ).)

      The airline industry was defined by bankruptcies, labour battles, and rising costs, as it had been since 2001. Rising costs in particular were a serious problem for many airlines, crippling the slight recoveries some carriers had enjoyed early in 2004. Airlines typically needed oil prices to be no more than $33 per barrel to break even, so it was a serious blow when prices soared to the $40–$50-per-barrel range for most of the year.

      Few domestic carriers ended 2004 in good shape. United Airlines remained under bankruptcy protection, having failed to win federal loan guarantees; US Airways filed for bankruptcy for the second time in two years in September, and it indicated that unless it won major labour concessions, it would have to start to liquidate its assets in early 2005. Even discount airlines were not immune, as ATA Airlines filed for bankruptcy in October. Delta Airlines, which unlike most of its competitors had fairly easily weathered the economic storm following the terrorist attacks of Sept. 11, 2001, flirted with bankruptcy throughout the year. It entered into desperate negotiations with its unions to stave off collapse and planned to lay off 12% of its workforce. Delta had posted losses of $5.6 billion since 2001 and had piled up more than $20 billion in debt. Were Delta to file for bankruptcy, about 42% of the American air-carrier industry would be under court protection.

      Aircraft producers were in no better shape. The Boeing Co. still trailed its European rival Airbus in the construction of commercial jets and spent much of the year embroiled in scandal as a former top U.S. Air Force weapons buyer, Darleen Druyun—who later became a Boeing executive—admitted that she had favoured Boeing in rewarding air force contracts and that Boeing would not have won some bids without her influence. Boeing rivals such as Lockheed Martin Corp. called for further investigations into past Boeing deals, and analysts predicted that Boeing would ultimately have to pay substantial fines and possibly face strong third-party monitoring.

      Domestic carmakers had a tumultuous year, the result of sporadic sales hindered by rising gasoline prices and overproduction, estimated at 14 million vehicles. As of September, total year-to-date American auto sales were down 5.6% compared with 2003. Car sales were down 2.4% from previous-year totals, although light-truck sales were up 12.4%. The Big Three American carmakers continued to lag behind their foreign competitors in terms of profitability. Toyota Motor Corp., for example, earned about 10 times as much per vehicle as General Motors Corp. (GM), while Ford Motor Co. and DaimlerChrysler posted losses per vehicle because of aggressive discounting. The Big Three were giving up to $5,000 in discounts per car, while their Japanese rivals were providing only up to one-half that figure.

      Another growing problem for American carmakers was the increased burden of their massive pension and employee medical programs. GM, which covered the health care costs of 1.1 million current and former employees and could face $68 billion in retirement health care costs over the next few decades, had annual health care spending of $5.1 billion in 2004, compared with $3 billion in 1996. Ford's obligations rose to an average of $12,443 per worker, compared with an inflation-adjusted figure of $2,300 per employee in 1970. Health care costs for Japanese carmakers were nowhere near as high.

      Ford, under the leadership of Bill Ford Jr. (Henry Ford's great-grandson), moved away from volume-oriented to value-oriented business strategies, and it saw a combination of dwindling market share and increasing revenues. Ford's American market share as of September was 11.7%, less than Toyota's 14.5% share and down from Ford's 25.4% market share a decade before. Although its market share had dwindled, Ford rebounded financially. The company posted $537 million in earnings for the third quarter of 2004, compared with $242 million in the same period in 2003. Ford also took steps to shore up its troubled European operations by slashing jobs at its underperforming Jaguar unit.

      GM remained the world's largest carmaker, but it had a troubled year. Its third-quarter earnings fell short of analysts' expectations—$440 million, compared with $448 million in the third quarter of 2003. Worse, a large part of these earnings came from GM's lending operations, since its automotive operations lost $130 million, one of its worst performances in a decade. GM also suffered from declines in its European businesses (posting a $236 million loss in the third quarter alone). To reduce expenses, GM slashed 12,000 jobs in Europe and mandated that its global units standardize parts and design cars so that they could be sold in any country with few alterations—a break from GM's long tradition of giving overseas units a fair degree of autonomy. GM also tried to push into new markets such as China, where it planned to spend up to $3 billion by 2007 to beef up production, particularly of luxury cars. Analysts estimated that China could provide 20% of the Cadillac customer base by 2010.

       DaimlerChrysler had a successful year. It hammered out an agreement with the United Auto Workers in which the union agreed to a two-tier pay scale and some outsourcing, and DaimlerChrysler posted a $1.21 billion profit for the third quarter of 2004. Analysts said that there were promising signs for the carmaker's future growth—for one thing, its upcoming product line was the freshest of the Big Three, since it was expected that 88% of its volume would be replaced by 2008, compared with 66% for Ford and GM. Yet the corporation did not escape controversy. In April DaimlerChrysler chose not to bail out troubled Mitsubishi Motors, of which it was the largest shareholder. It was a blow to CEO Jürgen Schrempp, who had been a strong advocate of increasing DaimlerChrysler's ownership of global competitors such as Mitsubishi and Hyundai.

      Japanese carmakers put in stronger performances on the whole than their American counterparts but faced their own share of troubles. Mitsubishi was left reeling after DaimlerChrysler declined to extend it cash, and it devised a restructuring plan that would entail cutting more than 10,000 jobs. Honda's net income cratered owing to slumping sales in North America. Other Japanese carmakers had a sunnier year, none more so than Toyota. Toyota cemented its position as the world's second largest carmaker, and it was the most profitable; the company reported $2.5 billion in net income for the second quarter of 2004, more than the profits of GM and Ford combined. Toyota benefited from an increase in sales worldwide (Asian sales alone shot up 65% over 2003), and it was set on achieving a 15% global market share by the end of the decade, up from its current 10% position.

      By contrast, many European carmakers had an indifferent-to-down year, and some undertook major renovations to improve their businesses. Volkswagen, which saw its net profit fall 65% in the third quarter, planned to further increase its Chinese operations, and it hired Wolfgang Bernhard, a former top official at Chrysler, to revive its depressed auto business. Volkswagen was the largest foreign carmaker in China and was planning to open a $240 million factory there to step up production.

      China was a major factor in the battering of the American textile sector, and American textile companies were bracing for an event that could shatter the domestic industry. On Jan. 1, 2005, a 40-year-old system of quotas on Chinese-made clothing was to end, and many expected Chinese manufacturers to flood the U.S. with inexpensive apparel. The World Trade Organization estimated that once the quotas ended, Chinese apparel would account for 50% of American textile imports, up from roughly 16% in 2004. Saying that the import wave could cost hundreds of thousands of jobs, American textile makers ferociously lobbied the Bush administration for renewed protections.

      Many textile makers engaged in desperate pricing strategies to push up sagging revenues. Levi Strauss & Co., for example, launched a new line of jeans, the price of which was half that of its core lines. Levi Strauss had shuttered all its American operations and had cut more than 75% of its staff. Other humbled former giants in the American textile industry had chosen to be acquired by private investment groups. Galey & Lord Inc. filed for bankruptcy for a second time as part of its acquisition by buyout firm Patriarch Partners. Cone Mills and Guilford Mills undertook similar moves.

      The American steel industry, which had come close to collapse just a few years earlier, was in the midst of a rebirth. Solid years were posted by the new top steelmakers, including U.S. Steel Corp., which returned to profitability in the first quarter and kept going strong throughout the year. The greatest transformation came in October, however, when International Steel Group (ISG), which had gone public in December 2003, was sold to the Mittal family. The family, which was from India and had interests in steel mills in 14 countries, planned to merge ISG with the steel companies it already owned—Ispat International and LNM Group—to form the world's largest steel company.

      Steelmakers around the globe benefited from a tide of rising steel prices that lifted every boat in the harbour. The price of domestic hot-rolled steel was $650 a ton late in the summer of 2004, compared with $260 a ton the year before. Behind this price wave was one key factor—China, whose insatiable demand for steel (about double the annual production of steel in the U.S.) was so great that some producers revived long-shuttered steel mills to meet production needs. A series of strikes at several North American mines also affected prices.

      As the ISG merger demonstrated, however, American steelmakers might soon have to decide whether to go global. Competition was increasing. Luxembourg's Arcelor bought a stake in a major Brazilian crude-steel producer, CST, and planned to transfer much of its production from Europe to Brazil in order to cut costs, a move that would transform Brazil into a top steel-producing nation. China both boosted steel prices and presented a growing threat to American steelmakers. China's top steelmaker, Shanghai Baosteel Corp., was rapidly expanding its production capability and, unlike its American competitors, did not have to deal with pension-related costs. In addition, it was backed by generous government support.

      The price of aluminum rose through the year, hitting a nine-year high in 2004, and inflated prices were expected to be the norm for the next two years, with estimates for 2005 of about $1,730 per metric ton. The American annual rate of production as of September was 2.5 million metric tons, down 7.7% from the 2003 annual rate of 2.7 million metric tons. Top producers such as Alcan pursued ambitious plans to expand market share. Alcan, which had purchased Pechiney in late 2003, planned to spin off its rolled-products assets to resolve antitrust issues with regulators. The newly formed company, called Novelis, would become the world's largest producer of aluminum rolled products.

      Long-term high prices were reached in almost every metals sector, from platinum (which hit a 24-year high) to titanium (up 100% over 2003) to silver (which reached a 17-year high). The price of gold had risen 50% in the past two years and hit $458 per troy ounce, a 16-year high, late in the year. For much of the year, the price remained above the $400 mark, a psychologically important achievement that spurred investors' belief that gold's price run would extend for some time. (There were signs late in the year, however, that metal prices had peaked.)

      The allure of high gold prices led to ambitious maneuvering in the gold-mining sector. Russia's top metal company, Norilsk Nickel, in March purchased a 20% stake in Gold Fields, a major South African mining company, and became its largest shareholder. A tentative merger agreement between Gold Fields and Canada's Iamgold (which had failed to buy Wheaton River Minerals) was challenged by Harmony Gold Mining, which in October launched a hostile takeover bid for Gold Fields. Norilsk supported the hostile bid against the wishes of other Gold Fields shareholders. If the Harmony–Gold Fields merger succeeded, it would create the largest gold producer in the world, knocking leader Newmont Mining into second place.

      The paper-and- timber industry slowly recovered from the malaise of the past few years. The weak U.S. dollar helped a number of American paper companies to achieve better cost structures for exports, while Canadian paper manufacturers, which exported 80% of Canada's paper shipments to the U.S., improved their profitability. Many storied paper companies, however, spent the year looking for ways to cut their ties to traditional paper manufacturing. Boise Cascade Corp. sold off its paper- and timber-manufacturing assets to private-equity investment firm Madison Dearborn in July and decided to concentrate on its Office Max office-supplies retail chain, which it had purchased in 2003. Louisiana Pacific Corp. also sold off its remaining timber assets.

      Many chemical companies scrambled to compete with the largest American chemical maker, Dow Chemical Co., which had slashed its workforce by 7% in 2003 and had embarked on a campaign of aggressive cost cutting. Lyondell Chemical Co.'s $2.3 billion acquisition of Millennium Chemicals Inc., which created the third largest publicly held chemical company in North America, was completed in response to Dow's growing threat. DuPont Co. planned to cut about 6% of its workforce by the end of the year—in response, it said, to the rise in natural gas prices and its desire to push into faster-growing markets, such as South America and Asia. Also in 2004, U.S. and European prosecutors stepped up investigations into alleged price-fixing by top chemical companies.

      At long last the hotel sector appeared to have recovered from the post-9/11 collapse of the travel industry. Top American hotel operator Marriott International Inc. posted third-quarter profits that showed a 45% increase compared with the same period in 2003 as its room rates increased faster than occupancy for the first time since 9/11. Revenue per available room, the primary measure of fiscal health for the industry, rose by 8.3% for North American hotels in the third quarter, and international customers at American hotels rose by 21%—a sign that tourism and business travel had resumed its normal pace.

      A number of hoteliers, including Choice Hotels, Starwood Hotels & Resorts, and InterContinental Hotels Group, planned new boutique chains that offered relatively cheap rooms ($100 or less a night) with improved amenities—a sort of “business-class” hotel. These new boutique hotels were meant to trump rivals such as Hilton Hotels and Best Western in the bid for the business traveler's dollar, as many market players believed the hotel industry might be oversaturated and highly competitive in the next few years. It was expected that about 100,000 new rooms would be built in 2005, up from 75,000 in 2004.

      Other industries remained embroiled in scandals and political battles. Tobacco manufacturers underwent yet another round of lawsuits and investigations, years after a $250 billion manufacturer settlement with U.S. state governments. This time the federal government led the charge. In September the case brought by the Department of Justice opened against Philip Morris, R.J. Reynolds, and Brown & Williamson. The case alleged that the companies, by colluding to downplay and hide smoking risks, had violated the Racketeer Influenced and Corrupt Organizations (RICO) Act, a statute that heretofore had usually been applied against organized crime. The federal government sought to have the companies return about $280 billion in profits. Besieged by such cases and losing market share to importers and to discount cigarette manufacturers (whose market share had risen since 1977 from 2% to 12%), top cigarette manufacturers considered accepting the once unthinkable— Food and Drug Administration (FDA) jurisdiction over tobacco products. Tobacco manufacturers sought a compromise; they would accept government regulation (which would include such changes as reduced marketing, greater disclosure of health hazards, and limits on tar and nicotine content) in exchange for the end of 60-year-old production quotas that had kept domestic crop prices high. The tobacco industry achieved an enormous victory, however, when lawmakers stripped out the FDA regulation requirements during negotiations to draft the final $10.1 billion quota buyout bill (which had been attached to a massive corporate tax-cutting bill). The bill, which was signed into law by President Bush in October, provided roughly $9.6 billion in compensation to tobacco growers in exchange for the end, after the 2004 growing season, of the federal programs regulating tobacco production.

      The insurance industry was roiled when New York Attorney General Eliot Spitzer (see Biographies (Spitzer, Eliot )) began probes into fraud and bid rigging in the insurance industry. In particular, he investigated allegations that Marsh & McLennan, the world's biggest insurance broker, had received payments from insurance companies in exchange for sending client business to insurers and that the firm had concocted false bids. In October Spitzer announced that he was suing Marsh in civil court and that two executives at insurer American International Group had pleaded guilty to bid rigging.

      The pharmaceuticals industry also bore the brunt of political attacks throughout 2004. Drug pricing was a critical issue during the presidential campaign, with Democratic candidate Kerry excoriating large drug companies for high prices. American demand for cheaper Canadian drugs at times led to shortages in Canada, and some Canadian drug sellers began importing drugs from countries with even tighter price controls, such as Australia, to meet demand. Nevertheless, in trade negotiations during the summer, the U.S. sought increased protections against foreign generic-drug manufacturers.

      Brand-name drugmakers relied on the strategy of having a few “blockbuster” drugs generate the lion's share of their revenues and of creating variations of such drugs in order to replace market share when the initial drug went generic. By relying on a core of therapeutic drugs for revenues, however, drugmakers were increasingly at risk when a particular cash-cow drug encountered controversy. The company that presented the most notable example of this situation in 2004 was Merck, which had to pull its successful painkiller Vioxx from store shelves after it acknowledged that the drug had a host of dangerous side effects, including an increased risk of heart attacks and strokes. Merck had spent tens of millions of dollars to advertise Vioxx, which had racked up sales of $2.5 billion in 2003, roughly 11% of Merck's total revenues. Analysts speculated that Merck, deprived of its Vioxx revenues and faced with many consumer lawsuits, could be the target of a hostile takeover or could be forced into a defensive merger.

      Merger activity in the pharmaceuticals industry was heavy. French drugmaker Sanofi-Synthelabo won a $65 billion takeover bid for its French-German rival, Aventis, to create the world's third largest drug company. The merger, which was encouraged by the French government, might benefit from the success of a new drug created by Aventis that combatted both obesity and smoking. Bayer bought the over-the-counter-drug business of Swiss conglomerate Roche to create the world's largest nonprescription drugmaker.

      Manufacturers of generic drugs faced their own problems. Although the market for generic drugs was still enormous (about $13.6 billion in generic drugs were sold in 2004, up 9% from 2003), generics faced heightened competition from less-developed countries such as India. Furthermore, generics were faced with some grim facts—fewer patents for top-selling branded drugs were expected to expire in the next few years than in the recent past, and legal challenges from brand-name manufacturers were expected to increase. For example, Alpharma Inc., which began selling the first generic version of Pfizer's anticonvulsant drug Neurontin in October, was at the same time in court with Pfizer, which accused Alpharma of transgressing its patents.

      Some generic manufacturers decided to join forces with their former competitors. The second largest generic manufacturer, Mylan Laboratories, took steps to acquire King Pharmaceuticals in a $4 billion deal that would enable Mylan to break into the branded-drug business. In a variation on the theme, branded-drug manufacturer GlaxoSmithKline signed deals with generic manufacturers to produce authorized generic versions of its former patent-protected drugs, such as Paxil.

Christopher O'Leary

▪ 2004

Introduction

       Real Gross Domestic Products of Selected Developed Countries Changes in Output in Less-Developed CountriesIn the second half of 2003, there were signs that the global economy was recovering faster than had been expected earlier in the year. In November an International Monetary Fund spokesman stated that the IMF would revise upward its 3.2% forecast for global growth in 2003. It was widely expected that the increase over 2002 would be closer to the 4% being forecast by the Organisation for Economic Co-operation and Development (OECD), which would make it the best result for the world economy since 2000. Growth in the less-developed countries (LDCs) outpaced that of the advanced countries at 5% and 1.8%, respectively. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries); for Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).)

      The clearest evidence of strengthening economic activity came from the U.S., which had the most expansionary policies. Annualized third-quarter growth in the U.S. was an unexpected 8.2%, the fastest pace in 20 years. This gave rise to concerns that the world was once again becoming too reliant on the U.S., where record public and current-account deficits were seen by some as unsustainable. In all regions inflation rates were falling, and in those countries where declines in consumer prices had occurred in 2002—most notably Japan—fears of deflation were receding. In the U.K. third-quarter output was running at an annual rate of 3.1%. Even in the euro zone, where several countries, including Germany, were in recession and there was limited scope for fiscal stimulus, surveys indicated that business confidence was increasing. In September the Japanese economy recorded its seventh straight quarter of expansion, growing at an annual rate of 2.2%. In Asia economic activity was returning to normal after having been disrupted by the outbreak of SARS (severe acute respiratory syndrome) and its quick spread through some 26 countries.

      Competitive pressure to attract the lacklustre flow of foreign direct investment (FDI) continued to build. This was reflected in the fact that 70 countries in 2002 made a record 236 changes in legislation as they attempted to make their economies more favourable to FDI. Several factors contributed to the slowdown in FDI. These included the continuing slow and uncertain economic growth, as well as stock market declines that discouraged cross-border mergers and acquisitions, which fell 38% in 2002 to $370 billion. There was also a decline in the number of privatizations in several countries. In 2002 global FDI inflows fell for the second straight year after a decade of rapid growth. At $651 billion, inflows were 21% less than in 2001, following a 41% decline in 2000. The developed and less-developed countries suffered similar decreases of 22% and 23%, respectively, with the U.S. accounting for nearly 90% of the FDI reduction in the LDCs. Africa suffered the sharpest drop (41%), while a modest 11% decline in Asia and the Pacific was due to the buoyant conditions in China, where the FDI inflow of $53 billion overtook that of the U.S. ($30 billion). In Central and Eastern Europe (CEE), the Czech Republic contributed to a modest FDI increase with its $4 billion sale of natural gas importer Transgas to Germany.

National Economic Policies

      The IMF projected a 1.8% rise in GDP in the advanced economies in 2003. Economic momentum in the second half of the year was building up much faster than expected, and it was likely that the rate would be exceeded.

United States.

       Real Gross Domestic Products of Selected Developed CountriesAs the year drew to a close, it was clear that the rise of 2.6% projected by the IMF for the U.S. would be revised to closer to 3%. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) The economic recovery that began in the second quarter gathered momentum and confounded its critics. The U.S. once again became the driver of the global economy. The stimulus came from consumer spending, which was underpinned by the lowest interest rates in 45 years, reduced taxes, and an escalation in house prices. By the end of November, business confidence was reaching its highest level since the mid-1990s, and inventory stock levels were rising.

       Standardized Unemployment Rates in Selected Developed CountriesThe unemployment rate rose to 6.1% (from 5.8% in 2002) as employment opportunities were slow to respond to the upturn in economic activity. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) The rate of nonfarm business productivity increased sharply, rising to a 20-year high in the third quarter to an annualized 9.4%. The high-tech sector continued to lose jobs but more slowly than in 2002; over a two-year period some 750,000 jobs had been lost. From the second quarter, productivity rose strongly to meet increased demand, but in September nonfarm payrolls rose by 57,000—the first increase in eight months—and first-time claims for unemployment were beginning to fall. Unemployment officially fell to 5.7% at year's end, but this was in large part because more than 300,000 people reportedly stopped looking for employment in December.

      The size of the public deficit became a contentious issue. A series of tax cuts and increased defense spending—military spending rose sharply in the second quarter after the start of the U.S.-led war in Iraq, and the level was maintained in the third quarter—pushed the federal budget deficit to an estimated $455 billion, or 4.2% of GDP. If state budgets were included, the deficit was 6% of GDP, compared with 1% in 2000.

      Fears of deflation were diminishing, but the rate of inflation remained low. Consumer prices fell by 0.2% in November but rose at the same rate in December. This brought the increase over the year to 1.9%, or a core rate of 1.5% (excluding food and energy components).

United Kingdom.

       Real Gross Domestic Products of Selected Developed CountriesThe U.K. economy exhibited strong resilience in 2003, as it had in 2002, with growth exceeding that of most other advanced countries. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) The IMF forecast a 1.7% rise in GDP, compared with 1.9% in 2002, but fourth-quarter outcomes and indications suggested that growth would at least match that in 2002. Growth in the third quarter was revised up from 1.8% year-on-year to 2%. Economic activity was being led by public and private consumption. The latter had outpaced personal disposable income since the beginning of 2002, but this was not perceived as a problem. Much of the impetus came from the services and construction industries, with the latter fueled by a booming housing sector, in which prices were rising at an annual rate of 16% in October. Despite a 25-basis-points boost in interest rates in November, the rise in house prices accelerated to 1.5% in December, bringing the increase over the year to 15.6%. Nevertheless, turnover was the lowest since 1996, largely because fewer first-time buyers entered the market.

       Standardized Unemployment Rates in Selected Developed CountriesThe annual rate of inflation was falling toward year's end. It was slightly above the government's target of 2.5% but, excluding housing costs, was only 1.4%. The labour market also exhibited resilience and remained tight. Unemployment was 5% in September, which was in sharp contrast to the 8.8% comparable euro-zone rate. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) In the year to September, the number of self-employed rose by 284,000, which accounted for most of the increase in the workforce.

      A negative factor was the weakness of business investment. This was mainly because of the decline in manufacturing activity, which fell by 10% in the second quarter, the weakest performance since 1999. Subsequently, surveys suggested an improvement, but this was likely to be tempered by the need for companies to divert resources into pension funds, which had been badly depleted by earlier equity declines.

Japan.

       Real Gross Domestic Products of Selected Developed CountriesThe tentative recovery in Japan strengthened and accelerated in 2003, with growth in output expected to exceed 2%. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) The extent of the recovery surprised observers. As the year progressed, momentum increased. Even after downward revision, the second-quarter output reached 2.3% on an annual basis, with the stimulus coming from a rise in business investment and private consumption. Performance in the third quarter exceeded expectations; export demand from the U.S. and China pushed GDP by another 0.6%. This was the seventh straight quarter of recovery. Improved business confidence was reflected in rising corporate capital spending, and fixed capital expenditure jumped 14% over the 12 months to September. The stronger stock market generated capital gains, and the bankruptcy rate was falling dramatically.

       Standardized Unemployment Rates in Selected Developed CountriesRecovery was partly helped by continuing low interest rates and a ¥1.8 trillion (about $14.9 billion) tax cut, although the effects of the latter would be mitigated in 2004 by a broadening of the tax base. An upsurge in employment growth led to a drop in the unemployment rate to 5.1% by September from 5.4% a year earlier. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) Of continuing concern was deflation, which by some measures was in its eighth year. Prices were falling at the slowest rate in four years—down 0.2% in September, compared with 0.7% a year earlier—and in November the core consumer price index was up 0.1% from a year earlier, the first rise since 1998. Nevertheless, any strengthening of the yen could lower imported price pressures and further exacerbate deflation.

Euro Zone.

       Real Gross Domestic Products of Selected Developed Countries Standardized Unemployment Rates in Selected Developed CountriesIn sharp contrast to the U.S., the U.K., and Japan, there were few signs of a recovery in the euro zone, and a modest rise in GDP of 0.5% was projected. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) The economy ground to a halt in the second quarter following a 0.1% quarter-on-quarter rise in the first. Third-quarter GDP rose by 0.4%. Industrial production in the year to September fell by 1.8%, and the unemployment rate (at 8.8%) was still rising. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) The rate of consumer price inflation for 2003 was revised down to 2% in October, which placed it in line with the European Central Bank's target rate of 2%.

      Among the major euro-zone countries, Germany was in recession, and the economy failed to grow for the second straight year. German exports declined sharply, and domestic demand was weak. The French economy was expected to expand just 0.5%, the worst performance in a decade. Growth in France was hampered by a series of public-sector strikes in May and June when workers protested against planned pension reforms. In the third quarter, tourism, which accounted for about 7% of GDP, suffered from poor demand in Europe, with a lack of American visitors because of diplomatic tension over France's refusal to back the U.S. in the war against Iraq. Strikes in the entertainment industry, soaring temperatures, and forest fires also played a role. Against the general trend, Spain showed its resilience to external factors. Lifted by strong domestic demand and a buoyant construction industry, Spain's economy expanded 2.3%. The rate of employment remained high at 11.2% in September but was falling steadily (down from 11.5% in September 2002).

      Throughout the year France and Germany were the joint cause of rising tension over the Stability and Growth Pact, under which budget deficits in euro-zone countries were limited to 3% of GDP. The pact had been the brainchild of Germany, but both countries breached it by a wide margin for the second consecutive year. They faced stiff penalties and sanctions for their failure to make necessary structural reforms and rein in spending. On November 26 the pact was “suspended” when European Union (EU) finance ministers succumbed to pressure from the two countries. Thereafter, tension and division between the member countries increased.

The Countries in Transition.

       Changes in Output in Less-Developed CountriesDespite weakness in much of the global economy, growth in the countries in transition accelerated to 4.9% from 4.2% in 2002. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).) As in earlier years, output in the Commonwealth of Independent States (CIS), at 5.8%, outpaced that in the CEE countries, which increased 3.4%. The strength of the Russian economy (up 6%) and other net energy exporters boosted the apparent robustness of the CIS economies. In the CEE much of the momentum came from strong increases in government consumption, which caused excessive fiscal deficits that were not sustainable over the longer term. Eight of the countries in transition were due to join the EU in May 2004, where they would have to exercise much more fiscal discipline.

       Changes in Consumer Prices in Less-Developed CountriesThroughout the region inflation rates fell, with the CEE countries down to 4% (from 5.6% in 2002). The CIS rate of 13% was distorted by the high prices in Russia (14%), where the rate had steadily declined from 86% in 1999. Inflation in the group of EU accession countries was 3.2%. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

Less-Developed Countries.

       Changes in Output in Less-Developed Countries Changes in Consumer Prices in Less-Developed CountriesOutput in the LDCs rose by 5% (from 4.6% in 2002). (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries); for Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).) Regional disparities narrowed except for Latin America, which continued to lag behind other regions following its economic contraction in 2002. Asia was the driver of growth in the LDCs. It expanded by 6.4%, although the rate was constrained by the effect of the SARS outbreak, which caused a second-quarter decline in Hong Kong, Singapore, and Taiwan, though all three recovered in the latter half of the year. China fared better, temporarily losing momentum but growing by about 9% over the year. China's industrial output surged ahead at an annual rate of close to 20%. India's output, which was expected to rise 5.6%, was supported by a recovery in agriculture and strong expansion in the service sectors, especially in information technologies. This was well below the official 8% target, however, and undermined efforts to reduce regional disparities and poverty.

      In the newly industrialized countries (NICs), including Hong Kong, South Korea, Singapore, and Taiwan, output growth slowed to just 2.3% from 2002. South Korea was adversely affected by appreciation of the won against the U.S. dollar, a slowdown in the electronics industry, labour unrest, and worries over North Korea's nuclear program.

      The Association of Southeast Asian Nations “group of four” (Indonesia, Malaysia, the Philippines, and Thailand) grew by 4.1%, slightly below the faster-than-expected 2002 increase of 4.3%. Thailand was likely to exceed the projected 5%, as it was helped by strong investment and export growth. In Indonesia improved income from oil helped raise output by 6.6%. It was likely that foreign investor confidence had been dented by the bombing of a Marriott Hotel in Jakarta on August 5. The rate of inflation fell in Indonesia to a more manageable 6%, while in Thailand it rose 1.4%, alleviating fears of deflation.

      In the Middle East a major influence on the region was the war in Iraq, including the buildup to the war and the conflict that followed the declared end of major combat. Growth accelerated to 5.1% (from 3.9% in 2002) as oil exporters benefited from increased income. The private sector in Saudi Arabia and some Persian Gulf countries benefited from subcontracted work for the reconstruction of Iraq's infrastructure. The cost of reconstruction in Iraq up to 2007 was assessed at more than $55 billion. Tourism was another casualty of the war; arrivals in Egypt, for example, were well down in the first half of the year.

      Although the African economies were resilient and expanded by 3.7% (up from 3.1% in 2002), growth was insufficient for making improvements to the inadequate social and physical infrastructure. The Maghreb countries (Algeria, Morocco, and Tunisia) grew fastest (5.7%), with those in sub-Saharan Africa (3.6%) held back by falling output in Zimbabwe (down 11%) and Côte d'Ivoire (down 3%). The best performances were in Nigeria, Tanzania, and Uganda, where outputs rose in excess of 5%. Many African countries were helped by higher commodity prices and improvements in government policies. Inflation rates were generally tame, with the notable exceptions of Zimbabwe (420%) and Angola (95.2%).

      The Latin American economies made a fragile recovery from the 2002 recession and were expected to grow a modest 1.1%, helped by a real depreciation in exchange rates. High debt levels and political uncertainty continued to limit confidence in the region. Venezuela's economy contracted for the second straight year (−17%) as the country's political difficulties compounded the macroeconomic problems. Stronger copper prices helped Chile, and Mexico benefited from the U.S. upturn in the second half of the year. Many countries were in the process of making much-needed tax reforms, and inflation was gradually being brought under control. Consumer prices in Brazil (15%), the Dominican Republic (26%), and Venezuela (34%), however, rose much more sharply than in the year before.

International Trade and Payments

      The projected 2.9% rise in the volume of world trade in 2003 was a deceleration from 2002's rate of 3.2% and was below the growth in world output for only the second time in more than two decades. For the seventh time in eight years, the export volume of the LDCs (4.3%) outpaced that of the advanced economies (1.6%). Nominal trade growth reflected the depreciation of the dollar against the major trading country currencies in Europe and Asia. In dollar terms global exports were projected to rise by 13.5% to $8,938,000,000,000 and imports by 13.7% to $7,119,000,000,000. By year's end it seemed likely that these would be revised upward. In the first half of the year, Western Europe's actual exports and imports rose by more than 20% in U.S. dollar terms. China was the major contributor to Asia's 15% increase in exports and 20% in imports. China's imports rose 45% and in value terms overtook those of Japan. The much-less-buoyant trading picture after adjustment for price and exchange-rate changes was reflected in the OECD forecast that advanced countries' exports would increase 1.5% and imports would rise 3.1%.

      It was against a backdrop of sluggish real trade growth that the trade ministers from 148 member countries—including new members Cambodia and Nepal—met in Cancún, Mex., for the World Trade Organization annual meeting. The agenda for talks and negotiations was wide-ranging and covered agriculture, nonfarm trade, access to patented drugs, the setting of rules for investment, and competition policy. It was hoped that the talks would pave the way for a multilateral agreement by Jan. 1, 2005. According to World Bank estimates released before the meeting, an achievable reduction of trade barriers could increase global income by $290 billion–$520 billion a year and by 2015 could take 144 million people out of poverty. The talks failed—mainly because of differences over agricultural reform. In November a plan to create the world's largest common market—in the Western Hemisphere—sputtered forward.

      While moves to liberalize world trade appeared to be faltering, an increasing number of regional trade agreements (RTAs) were concluded or being planned. By the beginning of 2003, there were 176 RTAs, an increase of 17 over the previous year. The internal trade of the six major regional trade groups accounted for 36.3% of world trade in 2002. The differences in degree of integration were wide, however, with nearly two-thirds of EU exports and imports and more than half of the North American Free Trade Agreement's exports being intraregional, while the other groups were trading less than a quarter of their goods internally.

      The overall current-account deficit of the balance of payments of the advanced economies rose to $245 billion. It was the fifth straight year of deficit following six years of surplus. Once again the size and increase were due to the burgeoning U.S. deficit of $553 billion, which was equivalent to more than 5% of GDP. The main counterparts to this were the current-account surpluses of Japan, China, South Korea, Taiwan, Hong Kong, and Singapore. The U.S. current-account deficit (combined with its large public deficit) was seen as unsustainable in the longer term and was a major factor in the depreciation of the U.S. dollar. In reality the U.S. was able to finance its deficit; it was uniquely placed to borrow in the world's reserve currency (the dollar) and well able to attract capital because of its large and liquid financial markets. Nevertheless, the U.S. was concerned about its trade deficit with China, which was expected to reach $125 billion.

      The euro zone maintained a surplus ($62.4 billion) that was little changed from the year before. While most euro countries had a surplus, the deficits in Spain ($22.3 billion) and Italy ($21.4 billion) widened markedly. Germany's surplus ($62.4 billion) rose marginally, while France's ($57 billion) was up by nearly a quarter on 2002. Outside the euro zone, Japan's surplus ($121 billion) rose for the second straight year, while the U.K.'s usual deficit rose modestly to $17 billion. The surplus of the Asian NICs rose from $68 billion to $76 billion. Overall, the countries in transition were in surplus.

      The low rates of inflation in most advanced countries and actual deflation, or fears of it, in a few prompted most governments to adopt expansionary policies. In the first three quarters of the year, some central banks cut rates from what were already historically low levels. In the U.S. fears about underlying deflationary trends, mixed economic indicators following the end of major fighting in Iraq, and investor concern about the sustainability of the economic recovery led to a fall in the dollar that took it to an all-time low against the euro. At the end of May, in trade-weighted terms the dollar was 6% lower than at the end of 2002. In June the Federal Reserve reduced interest rates to a 45-year low with a reduction of 25 basis points to 1%. Also in June, the euro-zone policy rate was cut by 50 basis points to 2%, which made real short-term rates effectively zero. In July U.K. interest rates were cut to 3.5%, the lowest level in nearly 50 years, but the move was reversed back to 3.75% in early November to curb household spending and soaring house prices.

      Exchange-rate volatility persisted, however, with the euro under pressure on concerns about fiscal laxity and the fact that three of the euro-zone economies were in recession. At the end of August, the euro was at a four-year low against sterling (€1 = £0.693). In September a joint statement from the Group of Seven called for “more flexibility in exchange rates.” Financial markets interpreted this as a sign of increasing concern at the growing imbalance in the global economy, especially the U.S. current-account deficit. There was also speculation that U.S. officials would try to bring the dollar down to increase output growth and would move away from the traditional strong-dollar policy.

      As the year drew to a close, there was no sign of an imminent strengthening of the dollar despite increasing evidence that the U.S. economic recovery was well under way. By year's end the dollar was trading at an all-time low against the euro (€1 = $1.2579), which raised fears that euro-zone exports would be jeopardized. In Japan the authorities were containing appreciation of the yen by intervening in the markets. In September reserves of ¥4.46 trillion (about $40 billion) were sold to limit the yen's rise. The Australian dollar rose 33% over the year to a high of U.S.$0.7495 at year's end, despite two interest increases in two months. A major beneficiary of the dollar depreciation was China. It was under growing pressure from trading partners to revalue the renminbi, which was pegged to the U.S. dollar.

IEIS

Stock Markets

       Selected Major World Stock Market IndexesU.S. politics and economics weighed heavily on world stock markets in 2003. The inevitability of war with Iraq triggered a sharp rally at first, but while uncertainty had depressed major markets as the year began, in April U.S. and European stock markets fell again as investors began to calculate the cost of the war and postwar commitments to an already weak U.S. economy. Summer brought signs of a firmer market recovery, as interest rates in the U.S. and Europe hit their lowest post-World War II levels and inflation was clearly dormant. Although between the mid-March low point and mid-September the Standard & Poor's index of 500 large-company stocks (S&P 500) rose by almost 30%, some world stock markets again dipped sharply in November as a series of devastating suicide-bomb outrages in Istanbul marked another lethal twist in the war with terrorism. Despite upbeat world growth forecasts, uncertainty remained. By the end of the year, however, most markets globally had turned positive, with some making substantial gains, although still ending far off their all-time highs. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).)

      Globalization posed a serious challenge to Western companies; already China and India were becoming the world's manufacturing bases. Investors worried that the long bull market had led to overcapacity, that growth in the U.S. economy was largely due to extra defense spending, and that even when companies reported profit growth, too much of this resulted from cost cutting and a weaker dollar. Many people also worried about high levels of government and consumer debt.

IEIS

United States.

 Despite war with Iraq, mutual fund scandals, and economic uncertainty, 2003 saw stock prices regain much of the ground lost in the previous three years, the longest period of stock market decline since World War II. As reflected by the S&P 500 index, the broad market surged 26.38% in 2003, recovering 44% of its cumulative losses since 2000. The most widely watched index, the Dow Jones Industrial Average (DJIA) of 30 blue-chip companies' stocks, rose 25.32% for the year, while the Nasdaq (National Association of Securities Dealers automated quotations) composite index soared by 50.01%. (For Closing Prices of Selected U.S. Stock Market Indexes, see Graph—>.) The Russell 2000, which represented small-capitalization (small-cap) stocks, did almost as well, with an increase of 45.37%. Although investors became more sanguine about the health of the U.S. economy as the year wore on, public confidence in financial markets remained tentative, with both positive and negative news (and rumours) spurring sometimes unusually volatile trading activity.

      Caution dominated the market through much of the early months of the year. Ambiguous economic data did little to assuage fears of simultaneous deflation and economic stagnation, while tensions surrounding Iraq kept corporate planning in limbo and money out of the stock market. This bracing for war continued until the actual outbreak of hostilities in March allowed investors to discount the most pessimistic scenarios about Saddam Hussein's ability to fight a sustained conflict or to unleash unconventional weapons. Despite a few false starts, a surge of relief eventually became a market rally in April, sustained by government policies designed to stimulate investment. Although economic doubts lingered, tax incentives provided as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (signed into law in May) made stocks more attractive as investments. The act lowered the rate at which capital gains and shareholder dividends were taxed and thus allowed investors to enjoy richer after-tax stock market returns.

      The Federal Reserve's interest-rate-setting Federal Open Market Committee (FOMC) provided additional stimulus in June by cutting the key federal-funds rate 0.25% to a 45-year low of 1%, a move that was explicitly intended to nurture economic growth. While the already-favourable interest-rate environment meant that few if any additional cuts could be expected, FOMC officials continued to assure financial markets throughout the remainder of the year that rates would not move significantly higher in the immediate future.

      Even experts found it difficult to interpret the year's economic data, which painted a widely variable and often contradictory picture of an economy that sometimes appeared more sluggish than the statistics would indicate. While business owners put expansion plans on hold before the Iraq war, leaving GDP growth—the broadest measure of all economic activity—stalled at 1.4% in the first quarter of 2003, the dam broke shortly thereafter as companies rushed both to reengage with the new business environment and to take advantage of the tax cuts, low interest rates, and other government stimuli. As a result, GDP grew at a rate of 3.3% in the second quarter and then at the explosive pace of 8.2% in the third quarter, the most robust U.S. economic expansion reported since 1984.

      The rising tide did not lift all boats, however. The unemployment rate climbed to successive nine-year highs of 6.1% in May and 6.4% in June. While labour markets historically trailed economic growth, signs of real job creation were sometimes scarce, although official unemployment gradually slipped back to 5.7% at year's end. The pace of corporate layoffs continued, while resentment grew as it became apparent that jobs in many industries, especially manufacturing, information technology, and customer service, had been shipped overseas and would not be returning. Productivity-enhancing technology helped companies maintain and even increase their activity despite having fewer employees, but this provided little comfort for those looking for work.

      Speculation that deflationary conditions in Japan could presage falling prices across the Pacific failed to materialize. U.S. inflation gauges did briefly dip into negative territory in April and again in November, which led federal bankers to note that deflation remained the primary (albeit minor) threat to the still-fragile economy.

      The U.S. stock market's strength was broad based, with all 10 stock sectors tracked by Dow Jones ending the year in positive territory. Battered technology stocks enjoyed the most spectacular performance, climbing 50%, but the reduced dividend tax also drove investors into areas of the market that traditionally paid dividends. Shares in manufacturers and basic-materials producers climbed 31% and 32%, respectively. Cyclic consumer stocks also climbed 32%. After a steep three-year decline, even the telecommunications sector managed a slim 3% gain on the year, boosted by a 48% surge in wireless shares as investors (and consumers) flocked to cellular-telecoms providers. Within individual industry groups, mining companies and consumer-electronics manufacturers outperformed the rest of the market easily, soaring 156% and 148%, respectively, while the long-suffering Internet group gained 126%. Losers were limited to land-line-telecoms operators, who finished down 3% as the flight to wireless gathered momentum.

       Change in Share Price of Selected U.S. Blue-Chip StocksThe majority of traditional blue-chip stocks performed splendidly in 2003, generally recouping their 2002 losses and in many cases recapturing levels last seen in 2001. (For Change in Share Price of Selected U.S. Blue-Chip Stocks, see Table (Change in Share Price of Selected U.S. Blue-Chip Stocks).)

      News that a stockbroker had allowed hedge fund Canary Capital to trade mutual fund shares after the market close (a practice considered unethical but not explicitly illegal) broke in September and gathered force throughout the remainder of 2003. The scandal quickly spread to cover a wide range of trading practices at numerous mutual fund companies. By year's end the heads of several fund companies, including Putnam Investments and Strong Financial, had resigned, and regulators were mulling both criminal charges and sweeping reforms in the previously loosely regulated fund business.

      While investors were quick to shun afflicted funds, however, the news did little to dissuade investors from investing in funds managed by other companies with unblemished reputations. Despite a weak start, money flooded back into stock funds after Iraq war fears dissipated in April, creating net inflows of $138.1 billion for the year through November. Large-cap stock mutual funds gained an average of 28%, according to fund tracker Morningstar. Small-cap funds focused on capturing the investment potential of renewed economic growth and did vastly better, surging 43%. The two largest U.S. stock funds, Vanguard's 500 Index Fund and Fidelity's Magellan Fund, climbed 28.05% and 24.82%, respectively.

      The New York Stock Exchange (NYSE) reported average daily trading of 1.4 billion shares in 2003, slightly less than that recorded in the previous year, for a value of $38.5 billion, down 6% from 2002. A total of 2,760 issues were listed, 24 fewer than in 2002, and there were 106 new listings, a stark decline from the previous year's figure of 152. The most actively traded issues on the exchange were Lucent Technologies, Nortel Networks, Pfizer, General Electric, and Time Warner, which officially dropped the “AOL” from its name on October 16.

      The exchange was wracked by controversy after news about NYSE Chairman and CEO Richard Grasso's $187.5 million compensation package sparked public outcry and calls for fundamental reforms to the exchange's oversight and structure. Grasso resigned on September 17 and after a quick search was replaced by former Citigroup chairman John S. Reed, who was named interim CEO and chairman. Three months later Goldman Sachs president John A. Thain resigned his position and was appointed the NYSE's permanent CEO. Exchange members voted in November to create an independent supervisory board of directors in order to ensure greater operational transparency in the future.

      Several seats on the exchange changed hands in 2003. The last sale took place on December 18 at a price of $1.5 million, a slight improvement from a five-year low of $1.3 million set on November 5 but still nowhere near the $2.65 million such a seat fetched in the market's heyday of 1999. Short selling, wherein investors bet that a stock will decline, fluctuated through the year but ended lower—a reflection of the market's generally optimistic tone. Short interest on the exchange was 7.2 billion shares as of December 14, down 7% from the previous year. The risky practice of margin borrowing rebounded in popularity after waning during the market's long retreat; in late November margin debt on the exchange stood at $172.1 billion, the highest point since debt balances began to decline in earnest in May 2001.

      The Nasdaq market showed average daily trading of 1.69 billion shares through late December, a significant decline from the 1.75-billion-share pace recorded for the equivalent period of 2002. Daily dollar volume averaged $28 billion in the same period, down slightly from the previous year. Through November, 58 companies had made their Nasdaq debut, while the total number of companies listed on the exchange fell to 3,343 from 3,620, indicating the large number of companies that had been delisted for various regulatory infractions over the year. The most actively traded issues were Microsoft, Cisco, Intel, and Sirius Satellite Radio.

      The American Stock Exchange (Amex) listed 1,121 securities at year's end, reflecting the increased popularity of various types of exchange-traded funds (ETFs), an Amex specialty. The average daily volume of equities and ETFs traded on the Amex in 2003 climbed to 67.8 million shares, compared with 60.7 million in 2002. The most actively traded issue on the exchange continued to be the Nasdaq 100 index itself. In November the National Association of Securities Dealers (NASD), owner of both the Amex exchange and the Nasdaq, announced its intention to spin off the Amex as an independent entity. A month later the company was quick to rebuff reports that it was planning to merge the Nasdaq with the NYSE.

      Avenues remained bleak for companies seeking capital through public stock offerings. There were a total of 68 initial public offerings (IPOs) on U.S. markets, valued at a total of $15 billion, compared with 70 IPOs in 2002. By contrast, 406 IPOs had taken place in 2000.

      Feelings that the securities industry had betrayed the public trust intensified in 2003, and investors filed an increased number of complaints. The number of arbitration cases that were filed with NASD, the market's regulatory organization, hit a fresh record at 8,900, a 16% increase from 2002. NASD also filed 1,352 enforcement actions and banned or suspended 830 individuals from the securities industry as a result of violations.

      Once considered a refuge from weakness in the stock market and the larger economy, bonds suffered their worst reversal in a generation once stocks went back on the rise. The bond market's losses began in June and steepened through August, outstripping the bond-market crashes of 1980 and 1987 and wiping out billions of dollars in value. Bond returns, as measured by Lehman Brothers, fell 3.36% in July alone, the sixth worst monthly performance on record, while Treasury bonds in particular tumbled 4.39%, their second worst month in 30 years.

      Bond mutual funds deflated as investors returned to the revitalized stock market. In the third quarter alone, investors pulled $23.8 billion out of taxable bond funds, mostly government bond funds, reversing record bond-fund inflows earlier in the year. Despite this, investors moved a total of $40 billion into taxable bond funds through November, though this was well under the previous year's inflow of $117 billion. Compared with bond funds' impressive investment returns in 2002, the rewards were meagre. According to Morningstar, long-term government bond funds returned 2.18% for the year, while short-term government bond funds returned an uninspiring 1.41%. The Lehman Aggregate bond index ended the year up 4.1%.

      As demand for bonds decreased, prices fell, pushing effective yields higher in order to attract investors. Ten-year Treasuries yielded 4.26% at year's end, returning to 2002 levels and effectively erasing all progress made in the previous 12 months. The spread between the yields of investment-grade corporate bonds and similar-maturity Treasuries narrowed to under 1%, bringing the interest rates on corporate and government debt closer than they had been since 1999. The razor-thin spread reflected general optimism about the prospects of strong companies in the improved economic environment but revealed minimal room for further upside ahead in the corporate-debt market.

Canada.

      Canadian stock prices climbed in tandem with global equity markets in 2003, ending a two-year losing streak amid renewed investor enthusiasm worldwide. Continuing interest in mining shares and a rebound in technology (as embodied by market heavyweight Nortel Networks) supported the Canadian market, the world's seventh largest.

      The broadest measure of the Canadian stock market, the S&P/TSX Composite index, climbed 24.28%. This index measured the overall performance of the Toronto Stock Exchange (TSE), Canada's largest share-trading forum. The S&P/TSX index of 60 blue-chip stocks advanced 22.93%. The Dow Jones Global index for Canada gained 25.14% in U.S. dollar terms. All sectors shared in the rebound, led by mining stocks (up 76%) and the resurgent information technology group (59%).

      The TSE reported that average daily trading hit a record 220.9 million shares, up 19.9% from the previous year. The dollar value of these trades, however, was only slightly better than 2002's average Can$2.5 billion (about U.S.$1.9 billion) per day, reflecting lower share prices. At the end of the year, 1,340 companies were listed on the exchange, up from 1,304 in 2002. IPOs increased to 77, compared with 75 for the same period of the previous year.

      Business-information company Thomson Corp., the largest TSE stock by market capitalization, gained 28% in value to an adjusted close of Can$47.08 (about U.S.$36.38). Nortel Networks, for years the largest stock on the TSE and still the most actively traded, bounced off its 2002 lows, soaring 118% to close at Can$5.49 (about U.S.$4.24). Other heavily traded TSE stocks were Bombardier, Wheaton River Minerals, and Air Canada. The Vancouver-based TSX Venture Exchange, which focused on smaller and more speculative securities, leapt 63%, as measured by the S&P/TSX Venture Composite index. Through November, 44 companies graduated from this exchange to the larger TSE.

      The soaring value of the Canadian dollar (which hit a 10-year high against the U.S. currency during the year) hampered attempts by local companies to sell their wares in foreign markets and thereby hurt the profits of exporters. The Bank of Canada raised its key overnight interest rate twice (in March and April) and lowered it twice (in July and September) in an attempt to moderate the currency's rising value, and the rate was ultimately left unchanged for the year at 2.75%.

      Overall, the economy found it difficult to gain momentum in 2003 as GDP edged up 2% in the first quarter only to slip 0.7% in the second and grow 1.1% in the third. The spring outbreak of SARS (severe acute respiratory syndrome) in Toronto cost the nation an estimated Can$1.5 billion (about U.S.$1.2 billion) in lost trade and was followed by the local discovery of mad cow disease and a crippling power outage, both of which had additional negative impact on the economy.

      Although Canada's securities industry remained relatively untainted by the U.S. mutual fund scandal, the general public failed to muster much enthusiasm for Canadian mutual funds until late in the year. An estimated Can$544 million (about U.S.$420 million) more was drawn out of Canadian fund accounts than was added in fresh investment. The number of such accounts shrank by 1.1 million.

Beth Kobliner

Western Europe.

      Major European markets swayed with the vicissitudes of war, but European investors faced other worries closer to home as economic recovery in Europe lagged behind Asia and the U.S. Although stock markets generally trended upward, they remained volatile. Investors saw labour and product-market rigidities throughout the euro zone and the impact of a strong euro on exports as serious impediments to market recovery.

      In January a sharp dip in the DJIA was echoed on major stock markets in London, Paris, and Frankfurt, Ger. Shares in Paris collapsed to just a third of their value at peak in 2000. Frankfurt's Xetra DAX index, which had sunk by 44% in 2002, fell further still. Analysts at the American investment bank Merrill Lynch said that the drop, which represented a 70% plunge in equity prices since March 7, 2000, made Germany's bear market worse than that of the 1930s Great Depression. Traders blamed the declines in Europe on poor corporate news, high oil prices, and war jitters. Shares stalled again in May as investors feared a falling U.S. dollar would weaken foreign investment and dampen company earnings and that a corresponding strengthening of the euro would hit exports. Worries about deflation and coordinated terror attacks also dragged down European markets. In August the German economy dipped into recession, and in September leading stock indexes in the U.S., Japan, France, and Germany all fell in response to a call from the Group of Seven developed countries for greater flexibility in letting market forces set exchange rates. Investors feared that greater flexibility would depress the dollar further and deter foreign investment, and in response the Paris Bourse's CAC 40 index fell 2.7% and the DAX declined 3.4%.

       Selected Major World Stock Market IndexesLater in the year, levels of corporate debt in the euro zone were also seen to represent a potential brake on investment as companies used their cash to repay debt. A third successive breach by France and Germany of the European Union's Growth and Stability Pact (by which members undertake to limit government deficits to below 3% of GDP) also raised concern. Yet markets were able to regain some of the ground lost in the previous three years against a background of generally improving economic data. By year's end all major European indexes were in positive territory, and most had solid double-digit increases, with the notable exceptions of Finland (up 4.4%) and The Netherlands (5.1%). The CAC 40 and Great Britain's benchmark Financial Times Stock Exchange index of 100 stocks (FTSE 100) showed gains of 16.1% and 13.6%, respectively, while the DAX jumped 37.1%. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).)

Other Countries.

      For investors in some parts of the world, 2003 was an excellent year. In February shares on the tiny Baghdad Stock Exchange were reported to have risen 56% since August 2002 and thus vastly outperformed the world's major stock markets. In general, emerging markets had consistently outperformed developed markets since 2001.

      The pace of Asia's recovery outstripped that of the U.S. and Europe. Most Asian markets outperformed U.S. and European markets between May and August. In Japan fundamentals improved, and the benchmark Nikkei 225 index managed a 24% rise by year's end after having fallen in March to its lowest level since March 1983 on poor corporate news and war fears. Investors judged that Asian economies were in better shape than before the financial meltdown of 1997 and that Asian consumers were far less burdened with debt. China, spectacularly successful in attracting foreign money, continued to fuel economic and investment activity in the region. Foreign direct investment reached $33.4 billion in the year-to-end July, according to official figures, and was expected to exceed $60 billion, up from $52.7 billion in 2002. China's Shanghai Composite index gained more than 10% for the year.

      Anxiety over terrorism and the influenza-like SARS virus took its toll on markets early in the year. In February Pakistan's stock market, having performed strongly through 2002, fell by more than 4% after a bomb attack on the head office of the Pakistan State Oil company. Indian stocks, which had undergone a rally that took prices to their highest in 29 months, crashed in August after bombs exploded in the financial centre of Mumbai (Bombay). Yet when the year ended, all the main Asian indexes had gained at least 20%—Hong Kong's Hang Seng was up almost 35%, both Pakistan and Indonesia had risen more than 60%, India had climbed nearly 73%, and Thailand had soared an astounding 117%.

      Overall, the most spectacular increases were seen in major South American stock markets. On November 26 Brazil's benchmark Bovespa index hit its highest point since its creation in 1968, on investor confidence in a new government regime, after which it climbed even higher to finish the year up more than 97%. In October Argentina's leading Merval index surpassed its highest level since the index's launch in 1986. Argentine stocks gained more than 104% for the year, following the country's economic collapse of 2002. Debt problems and continued political instability, however, left the whole region vulnerable to reverses in investor sentiment.

      Similarly, European emerging markets, particularly those countries scheduled to join the EU in May 2004, made solid gains as investors saw good value in their stock markets. Hungary, despite its budget deficit of 5% of GDP, and Poland, despite similar fiscal problems and falling bond and currency markets, recorded market gains of about 20% and 45%, respectively.

Commodities.

      Mined commodities traded strongly throughout 2003. Volatile stock markets, a weakening U.S. dollar, and increasing worries about the war with Iraq lifted the price of gold to a seven-year high, rising above $400 per ounce in November and ending the year at about $415. The price of gold was still far below its 1980 peak price of $850 per ounce, but some analysts believed the heavy indebtedness of Europe and the U.S. carried the potential to reignite inflation and undermine both the euro and the dollar as stores of value. China, where personal saving rates were high, was also seen as a good future customer.

      Copper, nickel, and aluminum prices all rose, buoyed by demand from Asia as manufacturing boomed there; analysts also suspected some speculative buying by institutional investors and hedge funds. By year's end copper was trading at $2,245 a metric ton, its highest price in six years; nickel was at $16,100 a metric ton, a 14-year high. Over the year the Economist commodity price index for all items rose by just over 16% and for industrial metals by a little over 34%.

      Crude-oil prices fell from a high of more than $37 per barrel to about $25.50 after the end of major fighting in Iraq, but they began to rise again in the autumn after OPEC unexpectedly announced a cut in output by 900,000 bbl a day beginning November 1. The oil cartel, which feared that restored Iraqi production would cause prices to fall too far, held oil prices at about $30 or higher in December. Although inventories were low—and despite the risk of oil price spikes in the event of terrorism—the price was expected to fluctuate around $25 a barrel through 2004.

      Food prices generally fell, picking up with the onset of autumn as low grain stocks raised wheat prices, which were expected to fluctuate during the winter. Coffee prices moved up in response to cuts in Brazil's production but later came under pressure from high stock levels and lower growth in consumption. Average overall commodity prices, which had risen by just 1% in 2002, increased by about 12% in 2003, but they were predicted to fall by 5% in 2004.

IEIS

Business Overview

      Following a pair of grim years packed with all manner of economic catastrophe, 2003 was a respite for many American companies—for some it was a time of recovery, while for others it was at least a time when things did not get worse. The U.S. National Bureau of Economic Research declared during the year that the recession had ended officially in November 2001, so that the economic turmoil many companies endured in 2002 and 2003 had been actually the aftereffects of the crisis. The long-anticipated U.S.-led war in Iraq had little negative impact on the overall economy, and many battered sectors showed signs that they were stabilizing and recovering.

      The U.S. GDP grew at an annual rate of 3.3% in the second quarter, but that was nothing compared with the third quarter, when GDP grew at an astonishing 8.2% annual rate, blowing away forecasts of a 4.7% increase and marking the fastest-growing quarter since 1984. A number of factors were cited for this improvement, including the impact of Pres. George W. Bush's administration's income-tax cut, the continuing mortgage-refinancing boom, and rising orders for durable goods in the manufacturing sector.

      Warming economic conditions helped even sectors left shattered by the terrorist attacks of Sept. 11, 2001. One example was the airline industry, a sector that had come close to a colossal multicompany collapse in 2002 and was kept alive at times only by infusions of government financing. Those harrowing days seemed to be at last over. While many airlines likely would not be profitable until 2005 at the earliest, industry analysts believed that the majority of airline companies had managed to stanch losses and had secured enough financing to get through the next few years.

      There were only two major-airline bankruptcies in the U.S., both of which had taken place in 2002. U.S. Airways Group emerged from Chapter 11 bankruptcy protection on March 31, 2003, but it continued to struggle and posted a net loss of $90 million in the third quarter. U.S. Airways could point to some improvements, as its revenue per available seat mile was up 7.8% from third-quarter 2002, and its passenger load factor (the number of seats filled per plane) was up to a solid 77%. UAL, the parent company of United Airlines, was not likely to exit Chapter 11 until 2004. Throughout 2003 UAL officials implemented a major restructuring plan, which included cost-cutting measures and the implementation of such new strategies as creating a low-cost airline to compete directly with such budget carriers as Southwest Airlines and JetBlue, which remained the industry's most profitable players. Even though Southwest faced the challenge of more aggressive labour unions and an, at times, deteriorating stock price, a strong summer travel season helped the company post a 41% increase in earnings for the third quarter.

      AMR, the parent company of American Airlines, spent the first half of 2003 dangling over a financial precipice and came within hours of filing for bankruptcy protection in April. AMR avoided this fate only because its three main labour unions agreed to $1.8 billion in annual wage and benefit concessions. That agreement almost fell apart, however, when the unions discovered that AMR had not disclosed a controversial $41 million pension and compensation package for top executives. CEO Donald Carty resigned after the controversy. In the third quarter, AMR posted $4.61 billion in revenues and managed to squeeze out a small profit of $1 million.

      Despite these slight gains, the airline industry was far from being a prosperous sector and still faced many pitfalls. In September a U.S. district court judge ruled that the families of people killed in the September 11 attacks could proceed with massive lawsuits against AMR and UAL, whose airplanes had been used in the attacks. The airlines planned to appeal the ruling, which, if it resulted in successful lawsuits, could cost them millions in settlements and legal fees.

      The European airline industry also was in rocky shape, as the industry on the whole reported losses of up to $2.5 billion. The largest European airline, British Airways, reported that its annual loss in 2003 could be its worst since it became a private company in 1987. After a dismal first-quarter performance ending June 30, in which it posted a $101.5 million net loss, British Airways was hit in July by a wildcat strike that could ultimately cost the airline up to $65 million. Worse, British Airways was dethroned as the top European carrier in September when Dutch airline KLM and Air France entered a partnership that would create a massive new European air power to be named Air France–KLM. The new partnership, which would generate $22 billion in annual revenues, would run the airlines as separate companies under a single corporate umbrella. Meanwhile, Canada's largest carrier, Air Canada, filed for bankruptcy protection in April.

      The airline industry's volatility had a parallel in the aircraft-production sector. Top American manufacturer Boeing faced a pair of challenges. It had to try to reclaim its formerly dominant share of commercial-aircraft production—which it had lost to its chief rival, Airbus—by pushing ahead with its new brand of aircraft, the 7E7, while also trying to boost its military-aircraft production. For the latter strategy, Boeing racked up a number of lucrative military production commissions, but the company also faced a host of controversies—politicians attacked Boeing's $20 billion contract to supply the U.S. Air Force with 100 new 767 jetliners, calling the deal overly expensive, and the Department of Justice investigated whether Boeing had won a federal rocket-launcher contract fairly. On December 1 Chairman and CEO Phil Condit resigned in the wake of a scandal involving an air force procurement official hired by Boeing. Airbus indicated that it would make a major attempt to break into the U.S. military market, which it heretofore had been unable to penetrate.

      As the woes of some industries abated, those of other sectors became a public spectacle. The power industry in 2003, for example, would be remembered for its colossal failure. On August 14 much of the Northeast and the Great Lakes region of the U.S. experienced what many called the worst blackout in U.S. history. (It also affected some areas of Canada.) The blackout, which darkened the skylines of cities such as New York, Detroit, and Cleveland, Ohio, and which endured for days in some areas, could ultimately cost $6 billion. Blame initially fell on Ohio-based First Energy Corp., the fourth largest American utility, which experienced an hour of growing failures on its Midwestern power lines before the power collapse spread outward. First Energy, which denied it was primarily responsible for the blackout, was cooperating with federal investigators into the blackout's cause. To many critics the blackout was simply a vivid indication of how decayed and overburdened the U.S. electric grid had become.

      For oil producers the year was surprisingly undramatic. Most of the oil market's top players, including ExxonMobil Corp., BP Amoco PLC, and Royal Dutch/Shell Group, were in solid shape. The latter, for example, posted a 52% increase in net income for the first nine months of 2003 and in November signed a deal to explore for oil and gas in Saudi Arabia, the first such agreement between the Saudis and a Western oil company in 30 years. Just before the U.S.-led invasion of Iraq began in March, many analysts expected oil prices to skyrocket—some claimed that a price of $50 per barrel was feasible if the war went badly and Iraqi oil fields were destroyed. That never happened, and crude-oil prices remained in the $20–$28-per-barrel range for most of the year, prices that were moderate enough to cause OPEC nations to cut back production schedules. After toppling Saddam Hussein's regime, coalition forces scrambled to get Iraq back into oil production, but they had to contend with an Iraqi oil infrastructure that was blasted by war, sabotage, and decades of neglect. Still, U.S. officials expected Iraq to generate up to $15 billion from oil production in 2004.

      Moderation and stability were not keywords for natural gas, a traditionally cheap commodity that in 2003 became quite costly. The price spiking began early in the year when, after a long, brutal winter, natural gas suppliers were left with their lowest inventory levels in 10 years. At the same time, companies consumed natural gas in ever-greater quantities, as many power plants constructed in the past decade used natural gas as their primary energy source. The result, during the summer of 2003, was that prices spiked up to $6.30 per million British thermal units (BTUs), double the typical price, and hovered at a still unnaturally high $5 per million BTU range for months. Producers benefited, notably the corporations Amerada Hess, Anadarko Petroleum, and Kerr-McGee.

      Scrambling to contend with a possibly long-term period of high gas prices, companies with heavy natural gas needs, such as Dow Chemical Co., ramped up projects to import greater volumes of liquefied natural gas (LNG)—that is, natural gas that is liquefied in another country, shipped to the U.S., and then converted back to gas form at the receiving port. These receiving terminals were relatively rare in the U.S., since traditionally low natural gas prices had meant that there was no need to spend money to increase import capacity. This was no longer the case, however, as LNG imports were predicted to total about 25.5 billion cu m (900 billion cu ft) by 2005, compared with about 6.5 billion cu m (229 billion cu ft) in 2002.

      In the background throughout the year was the unfolding investigation of the bankrupt Enron Corp., whose collapse in early 2002 had rattled the entire energy sector. Former Enron treasurer Ben Glisan became the first official sent to prison because of his role in the scandal, and other convictions were likely, although there were growing doubts about whether the investigation would turn up enough evidence to implicate the top Enron officials, including former CEO Kenneth Lay. A number of Enron's former rivals in energy trading either fell into bankruptcy themselves, as did Mirant Corp., or feverishly sold off many of their assets, as did Calpine Corp., Reliant Resources Inc., and former Enron merger candidate Dynegy Inc.

      Steel manufacturers continued to struggle, though there were signs that growing demand could begin to push prices upward. Bankruptcies, which had become a hard fact of life for many American steel companies in the previous five years, were not as frequent in 2003, but there were still some casualties; Weirton Steel Corp., for example, filed for Chapter 11 protection in May. Worldwide steel demand increased substantially, driven mainly by China's insatiable hunger for steel products. China's steel demand was expected to be in the range of 282 million tons, up 22% from 2002. This helped American exports, as did continuing tariffs introduced by the Bush administration in 2002, which were set to remain in place until March 2005. Political pressures, however, soon put an end to the tariffs. They were watered down throughout the year until they applied to only about 25% of steel imports by the latter half of 2003, and in December the administration decided to repeal them. Steel imports to the U.S. were down substantially; there was a 22% drop in the first half of 2003 compared with the same period the previous year.

      There were signs that a stronger, healthier top class of American steel producers was emerging. Most notable was International Steel Group, a two-year-old company run by mogul Wilbur Ross. ISG's business was built primarily on the ruins of two bankrupt former giants, LTV Corp. and Bethlehem Steel Corp., whose assets it had purchased. U.S. Steel Group bought the assets of bankrupt National Steel Corp. in May. U.S. Steel, formerly the largest steelmaker in the world but more recently demoted to a humble 10th place among global producers, firmed up its outlook in 2003 with a new, less-costly labour contract and boosted its prices by $20 per ton in September. Not every steel producer's health was improving—in particular, “minimills” had a mixed-to-poor year. Because these firms made steel by melting scrap, rising scrap costs drove up their expenses substantially. Top minimill Nucor Corp. posted a 59% drop in profits for third-quarter 2003.

      It was an undistinguished, steady year for aluminum producers. Year to date as of August, American and Canadian aluminum shipments totaled 7 billion kg (15.5 billion lb), down 2.1% compared with the same period in 2002. Year-to-date net imports were roughly 1.9 billion kg (4.2 billion lb), up 6% from the previous year. There was a major shift among top producers as Canadian aluminum maker Alcan Inc. acquired French rival Pechiney SA for $4.7 billion. The deal would make the new combined company the world's largest aluminum company in terms of sales, dethroning Alcoa Inc., although Alcoa remained the largest aluminum producer.

      Gold had its best year since 1996 as the gold spot market broke the $400-per-ounce barrier in late 2003, and some gold producers predicted prices in the range of $450 per ounce in 2004. Analysts said price spikes were due to the plummeting value of the U.S. dollar, rising interest rates, and more consolidation among top producers, which created a more controlled supply-price environment. A projected merger would create a new industry king. AngloGold Ltd.'s $1.1 billion bid for Ghana's Ashanti Goldfields Co. in August would make it the world's largest gold-mining company, vaulting over top producer Newmont Mining Corp. South Africa's Randgold challenged the deal with its own—higher—bid, but in October Ghana approved AngloGold's final bid of $1.48 billion, despite its being lower than Randgold's offer.

      The lodging industry continued to be weak, but the industry was banking on an improvement in 2004. Slow economic conditions, continuing joblessness, a vicious hurricane season, and general geopolitical fears continued to hurt travel rates, though the summer of 2003 saw an improvement in vacation activity. There were indications of a hotel-sector resurgence in the making. Revenue per available room (a key indicator of hotel growth) was down a mere 0.8% at the end of the third quarter, and industry players were hopeful that 2003 would ultimately be a growth year and thus end a period of contraction that had begun in 2001. Hotel occupancy rates were 65.6% in the third quarter, up from the depths of 2002, which had posted the lowest rates in more than three decades—59%. Most of the top hotel chains, however, were still on the ropes and were conservative in their outlooks. Host Marriott Corp., one of the top upscale hotel chains, reported a net loss of $136 million for the first nine months of 2003. Hilton Hotels Corp., while in stronger shape, posted a 62% drop in profits for the same period.

      The domestic auto industry found that a formula that had spurred sales in the past—serious price concessions, including 0% financing—could not prevent a slowdown in sales for much of 2003. Years of brutal price wars had taken their toll on the Big Three American automakers, which continued to trail their foreign competitors dramatically in terms of profitability. General Motors Corp. (GM), although it remained the most profitable of the Big Three, still earned only about $700 per vehicle, compared with the $2,000 per vehicle that Nissan Motor Corp. earned. The Big Three also continued to lose competitive ground. In the first nine months of 2003, their combined market share fell to 60.1% from 61.7% in the same period in 2002, while Japanese manufacturers' market share rose to 29% from 27.6% and that of European automakers increased to 7% from 6.8%. The Big Three did manage to close the gap in terms of productivity. By midyear 2003 GM was able to produce an average vehicle in 24.4 hours, close to Honda's rate of 22.3 hours. In addition, all of the Big Three secured favourable labour agreements with the United Auto Workers union, which agreed to some of its most serious concessions in decades in terms of layoffs and wage increases.

      Ford Motor Co. officials and Ford family members who gathered in June in Dearborn, Mich., to celebrate the company's centennial could contemplate a far rosier past than future. Ford had lost two-thirds of its stock value in the past few years, and its business continued to deteriorate in 2003. In the third quarter, Ford reported a net loss of $25 million. The most battered sector of Ford's business was its European division, which lost $525 million in the second quarter alone. With such grim earnings to report, the company scrambled to reduce expenses and vowed to slash $2.5 billion in costs from its automotive division, up from an initial $500 million target. GM was in slightly stronger shape. Taking advantage of low interest rates early in the year, GM offered a colossal $13 billion debt offering to investors—the third largest corporate bond deal ever—and used the proceeds to fund its foundering pension program. GM's $901 million profit in the second quarter was due primarily to its lending unit, General Motors Acceptance Corp., and that unit's enormous mortgage-lending operation. DaimlerChrysler, the last of the Big Three, was in the most trouble; its U.S. market share had eroded each year since Daimler-Benz bought Chrysler in 1998, and such fiscal woes as a massive $1.14 billion loss in the second quarter made its stated goal to earn $2 billion in profits in 2003 a lofty, if not inconceivable, one.

      Japanese auto manufacturers were far healthier than their American competitors, as had been the case for many years, but the Japanese carmakers were not immune to the market's overall slowdown and the pricing wars that had become a staple of the American market. Toyota Motor Corp. reported that its North American auto sales deteriorated in the first half of 2003, although the manufacturer remained far more resilient than did its domestic rivals and was optimistic that business would return by year's end. Toyota's net income for the first quarter was greater than the combined income of the Big Three, and the company stated that it hoped to sell 5.85 million vehicles globally in 2003, up 60,000 from prior projections. Nissan CEO Carlos Ghosn said that his company wanted to boost its worldwide sales by 40% in the next two years and to increase its 4.7% market share in North America. To win more of the American market, Nissan still needed to find a top-tier brand of car. To that end Nissan rolled out several new models during the year.

      The tobacco industry spent another year on the defensive. In March, New York City banned smoking in bars and restaurants, which essentially made it illegal to smoke anywhere but outdoors and in private residences. This type of broad prohibition, already popular in California, was emulated by other states and cities (even pub-friendly Dublin, Ire., planned to offer a similar ban in 2004). With increasing bans, growing taxation, and a huge increase in imports from areas such as Zimbabwe, it was no surprise that American tobacco production was at its lowest level since 1874. Some top producers faced a grim prognosis for future health and took radical measures. R.J. Reynolds Tobacco Holdings Inc., which had been forced to slash its workforce by 40% and had an abysmal profit margin ($5.79 per 1,000 cigarettes, compared with Philip Morris's $21.05 per 1,000 cigarettes), reported in October that it would merge with Brown & Williamson Tobacco Corp.

      If tobacco manufacturers struggled, the general mood of the textile industry was near surrender. Domestic textile companies endured another year of rising imports, bankruptcies, and layoffs. Pillowtex Corp., which filed for bankruptcy protection in July, marked its second turn in bankruptcy court in three years, and WestPoint Stevens Inc., which filed in June, had previously filed in the early 1990s. Textile industry job losses were staggering, with 26,000 jobs lost in the April-to-August period alone. While surviving textile manufacturers lobbied for new protections against competitors such as China, it seemed that the trade imbalance would likely grow more pronounced in 2004, when quotas that currently kept some low-cost imports out of the U.S. were scheduled to expire. In what could be seen as a symbolic last act for the domestic textile industry, Levi Strauss, the company that had made denim jeans one of the country's most enduring exports, announced plans to shutter all of its remaining North American plants.

      Even the pharmaceutical industry, which had weathered much of the economic downturn relatively unscathed, showed signs of trouble. Sales slowed for cholesterol-lowering statin drugs, which had helped drive earnings at Merck & Co. and Pfizer Inc. for a decade. After years of double-digit sales growth, analysts expected only single-digit growth in 2003. Top drugmakers such as Merck also faced the continued threat from generic drugs—which made up a majority of prescriptions in the U.S.—as well as from brand-name drugs from rival manufacturers, including an attempt by GlaxoSmithKline and Bayer AG to cut into Pfizer's lucrative market share for the impotence drug Viagra through a jointly developed copycat product, Levitra. Drugmakers spent much of the year lobbying against and trying to influence proposed federal legislation to add prescription-drug benefits to Medicare. What drugmakers most feared were provisions to make it easier for U.S. citizens to import prescription medicines from Canada and Europe, which could cut average drug prices significantly and upset the drug industry's elaborate pricing systems. (See World Affairs: Canada: Sidebar (Filling Prescriptions for Americans-Big Business in Canada ).)

      In December Parmalat SpA, a global food giant based in Italy, collapsed in an Enron-like financial scandal and accepted an offer from the Italian government to file for bankruptcy protection.

Christopher O'Leary

▪ 2003

Introduction

      In early 2002 there were signs of recovery. The downturn in the world economy and fears of a global recession generated by the terrorist attacks in the U.S. on Sept. 11, 2001, ended around the turn of the year. Growth in 2002, however, was below trend, with economic momentum undermined by the relentless decline in share prices and an erosion of wealth, as well as by the likelihood of military confrontation between the U.S. and its allies and Iraq. The recovery in early 2002 was led by the U.S. and Asia, where economic turnarounds were stronger than expected. In the U.S. output rose strongly; household spending proved resilient, and businesses rebuilt stocks, reversing the upward trend in unemployment that began in November 2000. At the same time, U.S. output of information technology (IT) goods started to increase as demand for computers rose.

      Although growth weakened after the first quarter, the economy continued to recover from the sharp slowdown in 2001, when world output rose by only 2.2%, down from a 15-year high of 4.7% in 2000. The International Monetary Fund (IMF) projection for 2002 was for an acceleration in growth to 2.8%, despite the continuing weakness of world financial markets. Global equities were volatile and fell by an average 24% in the year to early October, down 42% from their April 2000 peak. The latter decline reflected the erasure of $14 trillion of wealth, or the equivalent of more than 40% of annual world economic output—the largest loss of wealth since World War II. The decline reflected the lowering of profit forecasts in the industrialized countries and widespread concerns about accounting and auditing practices, particularly in the U.S.

   The advanced countries (up 1.7%) grew more slowly than the less-developed countries (LDCs), which rose 4.2% in 2002. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries); for Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).) Among the major industrialized countries, much of the impetus from trade was coming from the U.S., where growth was sustained by government spending and strong levels of personal consumption. Low interest rates in many other industrialized countries were boosting demand, particularly for housing. (For Interest Rates: Short Term,see Graph—>; for Interest Rates: Long Term,see Graph—>.) Fortunes in the 12 euro-zone countries were more mixed. In contrast to other countries where inflation was well under control and deflationary trends were a concern—in Japan falling prices had become the norm—prices in the euro-zone countries were rising at different rates, and national governments had no power to influence them. (For Inflation Rate, see Graph—>.) The European Central Bank (ECB) controlled interest rates and was mandated to keep the overall inflation rate below 2.5%. Wide-ranging inflation rates were exacerbating wage and other disparities and defeating the “level playing field” objective of the European Union (EU). This systemic problem was creating political and economic difficulties. The countries in transition (also called the former centrally planned economies) expanded by 3.5%, with most countries continuing to make progress with reforms. Rural areas, however, still lagged well behind urban areas, with poverty and stagnating living standards affecting many of the 134 million rural poor.

      In the industrialized countries the need for transparency and improved corporate governance took on a new importance in 2002. The loss of confidence in global financial markets that had been sparked by the events of Sept. 11, 2001, as well as by a correction from excessive stock valuations, was briefly restored at the beginning of 2002 before deepening and spreading. Subsequent scandals involving aggressive accounting practices and poor internal governance at some companies further dented investor confidence. Worldwide, people's faith in financial reporting, corporate leadership, and the integrity of markets was being undermined. The collapse of Enron Corp., the American energy trading company, in late 2001 and the subsequent shredding of documents by its auditors, Arthur Andersen LLP, had brought into question the reliability of corporate financial statements. (See Sidebar (Enron-What Happened? ).) In March 2002 several high-profile technology firms were under scrutiny by the U.S. Securities and Exchange Commission (SEC), and at the same time, the practices of Wall Street analysts were being investigated. Perhaps the most significant event was a $3.8 billion restatement by the large American telecommunications firm WorldCom, Inc., on June 25. Within days this was followed by reports of inflated profits by other companies, including the American photocopier giant Xerox Corp. and the French media company Vivendi Universal. The erosion of confidence triggered by these and other scandals was reflected in the volatility of stock markets worldwide.

      The U.S. government was quick to respond to the scandals and reported irregularities with measures to strengthen corporate governance and auditing. On July 30 the Sarbanes-Oxley Act became law in the U.S., replacing the accountancy profession's self-regulation with a public oversight body. It made far-reaching changes to existing legislation in order to ensure the provision of timely corporate information to investors, improve accountability of corporate offers, and promote the independence of auditors. In the U.K. the Institute of Chartered Accountants also adopted measures to strengthen auditor independence.

      In emerging countries, where investors were even more risk-aware, the global effects of the financial problems were in some cases compounded by local events. Political concerns in Brazil, exacerbated by the national debt, were temporarily eased by the announcement of a $30 billion IMF package in early August. In Turkey, however, the sudden departure of senior cabinet ministers in June led to a flight of capital. Confidence was boosted there, though, following the November 3 election, in which a single party achieved an absolute majority for the first time in 15 years. China was increasingly embracing capitalism and making further progress in becoming the next Asian superpower. The transfer of production facilities from other Asian countries was making China a major export centre. In the first nine months of 2002, China received 22.5% more foreign direct investment (FDI) than it had in the same 2001 period.

      The combination of slower economic growth and a failure of financial markets to recover had a dampening effect on FDI. The largest falls were in developed countries as transnational corporations (TNCs) responded to recession and cross-border mergers and acquisitions decreased in number and value. Nevertheless, sales of foreign affiliates of TNCs rose by 9%, and the number of employees increased by 7% to 54 million. Global FDI in 2001 declined sharply following strong increases in the 1990s. This trend persisted in 2002, although there were rises in individual countries. China was a notable exception, with FDI expected to continue to increase as a result of Beijing's recent entry to membership in the World Trade Organization (WTO). At $735 billion in 2001, global inflows of FDI were 51% less than in 2000, and the $621 billion outflow was down 55%. These were the first drops since 1991 and 1992, respectively, and the largest for 30 years. Most affected by the decline were the developed countries, where inflow had halved since the year before, bringing their share down from 80% to 68%. This was largely due to the slowdown, particularly in the EU, in cross-border mergers and acquisitions, which had been the main vehicle for FDI. By contrast, inflows to LDCs fell only 14% to $205 billion.

National Economic Policies

      The IMF projected a 1.7% rise in gross domestic product (GDP) of the advanced economies. In the last quarter of 2002, a slowdown in the recovery occurred, and there was uncertainty about the downside risks associated with the situation in Iraq and oil prices.

United States.

  Although the U.S. made the widely feared “hard landing” after the Sept. 11, 2001, attacks, it recovered much more quickly than expected. For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) In 2002 performance was uneven, and although there were signs of a slowdown toward year's end, output was predicted to rise by 2.2%. (For Industrial Production, see Graph—>.) This followed a 0.3% increase in 2001, which brought to an end a decade of continuous expansion. Inflation was not an issue, and there was little risk of deflation, as falling prices for goods were being offset by services inflation. (For Inflation Rate, see Graph—>.) While the recession had been short-lived and mild by historical standards, it differed in two ways. The downturn was precipitated by a fall in corporate profits between the June 2000 peak and September 2001, which in turn generated job losses, and inventories had been less run down than in earlier recessions, which left less scope for increasing output when demand recovered. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).)

   The U.S. wasted little time in reestablishing its position as the driver of world growth. (For Industrial Production, see Graph—>.) Domestic demand was strong relative to the rest of the world. Household spending, which contributed three-quarters of GDP, remained buoyant and was helped by well-timed tax cuts and access to the lowest interest rates in 40 years. The latter had encouraged the refinancing of $1 trillion of mortgage debt in 2001, freeing up finance for other spending. (For Interest Rates: Short Term,see Graph—>; for Interest Rates: Long Term,see Graph—>.) In the summer there was strong demand for homes, and automobile sales were boosted by incentives and zero-interest-rate offers from automakers. Given that stocks accounted for only about 20% of Americans' personal wealth, the fall in share prices did little to detract from household spending. In October real personal disposable income was increasing at more than 3% a year. Third-quarter GDP growth accelerated to an annual rate of 4% from 1.3% in the second quarter. Much of the strong demand was met by imports, which rose 3.4% in volume terms, compared with a 1% decline in exports. (For U.S. Trade Balance with Major Trading Partners, see Table (U.S. Trade Balance with Major Trading Partners).)

      There was a strong deterioration in public finances. The fiscal-year budget that ended on Sept. 30, 2002, registered a deficit of $159 billion, the equivalent of around 1.5% of GDP. It was the first deficit since 1997 and was in sharp contrast to the $313 billion surplus (3% of GDP) that had been estimated in January. Several factors contributed to the reversal of fortunes: the extra spending that followed the September 11 attacks, the tax reductions introduced to support demand, and the increased cost of defense and security. The budget plan envisaged a fall in the deficit to $81 billion in fiscal 2003 (based on a growth rate of 3.6%) and a return to surplus in 2005. The growth rate for 2003 looked optimistic, however, and tax revenues were likely to be below target, especially if additional tax cuts were forthcoming.

United Kingdom.

 The U.K. proved its resilience once again and, aside from the North American members, grew faster than the other Group of Seven (G-7) countries. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) Although U.K. output was below trend and was likely to fall marginally short of the projected 1.7%, it was nevertheless robust in comparison with the large euro-zone countries. This followed a 2001 rise of 1.9%, which had outpaced the growth rates of all other G-7 countries. (For Industrial Production, see Graph—>.) Output of manufacturing, services, and the construction industry remained positive, with some of the impetus coming from public-sector demand. Agricultural output was recovering following the end of the outbreak of foot-and-mouth disease in 2001, although exports of live cattle had not yet returned to earlier levels. Other agricultural output was under pressure from cheap imports.

 Economic growth was led by domestic demand. The sharp falls in equities and weak global economy did little to dampen consumer confidence. (For Inflation Rate, see Graph—>.) The lowest mortgage rates in 37 years and annual house-price rises of 25–30% pushed household debt as a proportion of income to record levels. Retail sales in October were running at 6% above year-earlier levels. In the summer the association football (soccer) World Cup and Queen Elizabeth II's Golden Jubilee celebration temporarily boosted sales of electronic and other goods, while overseas holiday bookings were strengthened by poor weather at home. Trends in the labour market were mainly positive, with the unemployment rate expected to rise only slightly to 5.3% (from 5.1% in 2001). (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) There were layoffs in manufacturing, despite the slow recovery in output, and capacity contracted as multinationals rationalized their production, often moving factories to China or Eastern Europe. Professional services companies also were cutting jobs, and many companies had imposed a freeze on recruitment. An easing in the tight labour market was reflected in lower voluntary turnover rates and more applications for advertised jobs. A shortage of low-skilled labour was being eased by immigrant labour, and labourers having special skills were being recruited from abroad.

   Increasing dissatisfaction of workers in the expanding public sector was of growing concern for the government. In the last week of November, teachers and firefighters took strike action for more pay. The government was rejecting their demands on the grounds that meeting them would erode the spending required for improving public services. Increases in resources to modernize the health, education, and transport systems were rising faster than total government spending. In November Chancellor of the Exchequer Gordon Brown announced that because of a weaker-than-expected surplus in fiscal 2001–02 and falling tax revenues, public-sector borrowing was to nearly double to £20 billion (about $32 billion) in 2002–03. (For Interest Rates: Short Term,see Graph—>; for Interest Rates: Long Term,see Graph—>; for Exchange Rates of Major Currencies to U.S. Dollar, see Graph—>.)

Japan.

 At the beginning of the year, the outlook for the Japanese economy was pessimistic following three quarters of declining output, a phenomenon not experienced in Japan since the end of World War II. It was quickly followed by guarded optimism when signs emerged that the economy had at last bottomed out. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) The recovery that followed proved unsustainable, however, and output was expected to decline by 0.7%, following a 0.3% decline in 2001. (For Industrial Production, see Graph—>.)

  Nevertheless, Japan was well positioned to take advantage of the recovery in world trade, particularly in IT, and needed to rebuild its inventories. Buoyed by the weaker yen, which had depreciated 17% over the previous 18 months, exports rose 6.4% in the first quarter. (For Exchange Rates of Major Currencies to U.S. Dollar, see Graph—>.) Output continued to rise through the second quarter but slackened in the third quarter, not helped by a 0.7% appreciation of the yen, which increased it to 1.5% over the same year-earlier period. For a brief period, consumer spending rose modestly, reflecting the increase in confidence, but as the year ended, most indicators reflected the deflationary environment. (For Inflation Rate, see Graph—>.)

  A major concern of policy makers was the health of the banking system and the size of its bad loans. A new classification system for bank loans was put in place that resulted in a more than fourfold increase in the estimate of nonperforming loans to ¥43 trillion (about $362 billion). (For Interest Rates: Short Term,see Graph—>; for Interest Rates: Long Term,see Graph—>.) This was the equivalent of 8% of GDP, and it was feared that even this was an understatement and that the true size of the debt could be double that amount. The problem was compounded by the fact that the value of the banks' shareholdings, which had been falling, could be included for capital adequacy purposes. In September the Bank of Japan (BOJ), under the direction of its governor, Masaru Hayami (see Biographies (Hayami, Masaru )), purchased some of the banks' shares before the midyear financial results, and additional injections of public funds were likely. In the meantime, “zombie” companies, which the banks failed to foreclose on, continued to produce goods and services at a loss. This was perpetuating the deflationary pressures and undermining the profitability of more viable companies. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).)

Euro Zone.

 On Jan. 1, 2002, euro notes and coins were introduced in the euro zone. The member countries had already adopted a fixed euro rate for their national currencies, and the main rationale for the introduction of notes and coins was political—to create a European identity. (For Exchange Rates of Major Currencies to U.S. Dollar, see Graph—>.) The abolition of national currencies nevertheless increased transparency and competition within the zone and helped businesses and other consumers compare prices and select competitive suppliers more easily. While some retailers took advantage of the changeover to increase prices, in general the introduction went smoothly and was an administrative success. An increase of 0.9% in GDP was projected for 2002, compared with 1.5% in 2001. The political preoccupation with gaining wide acceptance for the euro, particularly in France and Germany, was in stark contrast to the lack of attention given to structural reforms in product and labour markets. It also partly obscured the economic frailty of the euro zone, where activity had slowed more than expected in 2001 following a 0.2% decline in the final quarter. Although Europe had the advantage of a weak currency and less exposure to falling equity prices, the ECB underestimated the impact of the U.S. downturn. It did not take into account the euro zone's huge increase in investment exposure to the U.S., which had taken place since the mid-1990s. The lower earnings of European companies' affiliates in the U.S. were adversely affecting business income and confidence.

  Structural differences between the 12 countries in the European Monetary Union (EMU) were reflected in a wide range of growth rates and prospects. (For Real Gross Domestic Products of Selected Developed Countries, see Table (Real Gross Domestic Products of Selected Developed Countries).) In several countries budget deficits were a major concern. Under the Stability and Growth Pact, they were limited to 3% of GDP. Portugal had breached this limit in 2001 and was expected to do so again in 2002, while Germany, the architect of the pact, was extremely close, as were France and Italy. (For Inflation Rate, see Graph—>.) The need for governments to exercise spending restraint was causing political problems. The lack of confidence in the euro was a mixed blessing; its weakness helped exports to provide much of the impetus from growth. Germany, which had once spearheaded growth in mainland Europe, was in recession, with weak domestic demand, declining industrial output, and sluggish retail sales. (For Industrial Production, see Graph—>.) Its banking sector was in crisis, with major banks either taking losses or suffering a huge decline in profits.

      Relative to the U.S., most labour markets in mainland Europe were inflexible and productivity was lower. Employment grew only 0.4%. Unemployment was high and rose gradually over the year to the third quarter from 8% in 2001 to 8.3% in 2002, at which time the unemployment rate for the under-25s was 16.4%. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries).) Employment was declining in agriculture and industry, except for the construction sector, which was booming in several countries. The strong growth in service-sector jobs moderated to a 1.5% year-on-year rate.

The Countries in Transition.

      Growth in the countries in transition slowed from 5% in 2001 to 3.9% in 2002. Central and Eastern Europe (up 2.7%) was growing more slowly than the Commonwealth of Independent States (CIS) and Mongolia (both up 4.6%) and Russia (4.4%), since that region was most affected by the slowdown in the euro zone. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).) In the CIS countries reforms continued to be implemented, while in Russia progress was made in strengthening financial discipline and improving standards of corporate governance. Strong domestic demand was driving growth in Russia, and privatized firms were becoming more efficient despite high labour and other cost pressures on competitiveness. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

Less-Developed Countries.

      The IMF projection was for an acceleration in output in the LDCs to 4.2% from 3.9% in 2001. Regional and country disparities were wide, with Latin America making a negative contribution. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries); for Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

      In Africa GDP was expected to increase by 3.1% following a 3.5% rise in 2001. Across the region political and economic problems persisted, compounded by civil unrest and armed conflicts, the HIV/AIDS pandemic, and other diseases. The World Health Organization reported that some 29.4 million people in sub-Saharan Africa were living with HIV/AIDS in 2002. Nevertheless, economic and social progress was being made. The nature of FDI was changing, with a growing share destined for the services industry, the financial and banking sector, and the transportation sector. Of the major countries, South Africa was expected to grow by 5.2%, little changed from 2001. South African industrial output in September was rising 8.6% year on year, and consumer prices were up 14.5%, which largely reflected the depreciation of the rand in 2001. The currency had recovered in 2002, however, and the inflation rate was easing. In Nigeria political instability and cutbacks in oil production contributed to a contraction of around 2%.

      In much of Asia there was a marked recovery from the start of the year as countries responded quickly to the upturn in the U.S., on which many of their exports depended, and to the improvement in the IT market. Inflation rates, a modest 2.1% on average, ranged from 15% in Myanmar (Burma) and 12% in Indonesia to a slight fall in prices in China following a rise of only 0.7% in 2001.

      Output of the newly industrialized countries (NICs), including Hong Kong, South Korea, Singapore, and Taiwan, grew 4.9%. They were led by South Korea, where increased exports, combined with strong domestic demand, pushed the annual growth rate to above 6%. Unemployment was stable at 3%, and consumer prices rose more slowly despite inflationary pressures. Singapore recovered from its deepest recession in 37 years, and its GDP rose 3.9% in the year to June. Taiwan's recovery was narrowly based on exports, which were outpaced in the second quarter by high imports. Falling prices gave cause for concern—in October they were 1.7% down from a year earlier. Hong Kong's growth was marginal as the former colony struggled with a weak property market, which had fallen by 60% since 1997, but there were some positive indicators, including a fall in the rate of unemployment in August

      The Association of Southeast Asian Nations' “group of four” (Indonesia, Malaysia, the Philippines, and Thailand) expanded 3.6%. Indonesia's expansion was driven by domestic consumption, with fixed investment and exports in the second quarter running below year-earlier levels. Recovery in Malaysia was broad based and was helped by strong government consumption and fixed investment, but the economy remained highly dependent on electronics exports. In the Philippines exports were strong, but a major concern was the hefty budget deficit.

      China's economy gathered more momentum, with output accelerating to 7.4% from 7.2% in 2001. In the year to August, exports rose 25% in U.S. dollar terms. While the export industries had effective management and the advantage of foreign investment and technology, however, most of China's industry remained inefficient and overmanned. India's GDP growth rate accelerated to 5%, despite the poor monsoon's adverse effect on agriculture.

      The Latin American economy was contracting after a negligible rise in 2001. Although growth in Argentina was expected to fall by 15% over the year, in the second half the high rate of inflation was decelerating and the exchange rate was steadying. Confidence was boosted when the IMF agreed on November 20 to a one-year extension for repayment of a $140 million loan. The financial crisis in Argentina had been sparked by the government's inability to fund its debt at the end of 2001. Initially, the effects were contained, but in 2002 trouble spread throughout the area and most currencies lost value. Uncertainty in the run-up to the October election in Argentina caused the peso to depreciate by 40%, but stability was returning by year's end. The IMF projected growth of 3.6% in the Middle East. The region was heavily influenced by factors relating to security as well as oil-price movements and the global economy. Output in Israel was declining, and most indicators were negative. Most rapid growth was occurring in Bahrain, Iran, Jordan, and Saudi Arabia.

International Trade, Exchange, and Payments

International Trade and Payments.

      World trade in 2002 began to recover from the second quarter, and the IMF predicted that it would rise in volume terms by 2.1% over the year. Recovery was from the worst growth performance in two decades in 2001, when the value of world merchandise exports declined 4% and global exports of services fell 1%. After two decades in which trade growth had outpaced production, it was the second consecutive year in which the rate lagged the increase in world output. In value terms the rise was 3.1% to a projected $7.7 billion, of which $6.2 billion was merchandise rather than services. Momentum in the market once again came from the LDCs and countries in transition, which provided the strongest growth markets for world exports. In volume terms their imports were projected to rise by 3.8% and 6.9%, respectively, in contrast to 1.7% for the advanced economies. There was a similar picture on the supply side, with LDC exports up 3.2% and countries in transition up 5.3%, while those of advanced countries rose only 1.2%.

      Recovery was strongest in the U.S. and among IT producers in East Asian countries, which had experienced the fastest slowdowns in 2001. In the EU and Japan, exports rose more strongly than imports. The opposite was true in the U.S., where merchandise imports in the first half of the year rose at an annual rate of 7.2% from the second half of 2001, a pace exceeded by services imports. (For U.S. Trade Balance with Major Trading Partners, see Table (U.S. Trade Balance with Major Trading Partners).) Trade increased at an annual rate of 6% between the fourth quarter of 2001 and the second quarter of 2002. Despite this, global merchandise trade in the first half of the year was running at 4% below the same year-earlier period. Exchange rates, prices, and volume changes contributed to this decline. In dollar terms imports by the EU, the U.S., Japan, and Latin America fell. Trade in Asian LDCs was extremely buoyant and was being boosted by the strength of China's market.

      The balance of trade continued its relentless shift toward the LDCs, with a 3.2% rise in the value of exports (excluding services) following a fall of 3.2% in 2001. Merchandise exports were projected at almost $1.32 trillion, of which nearly half was from Asian LDCs, while imports rose marginally to $1.19 trillion, leaving a slight increase in the trade balance compared with the year before. After taking into account trade in services and other transactions, for the third successive year LDCs returned a surplus on current account, although at $18.9 billion it was less than half the $39.6 billion achieved in 2001. Much of the momentum once again came from LDCs in Asia, where exports rose 7.4% to a record $638 billion. Increased imports contributed to a drop in the current-account surplus from $39.4 billion in 2001 to $33.5 billion. This was despite the strength of the Chinese economy, which produced a $19.6 billion surplus on current account. A growing trade surplus in India resulted from the rapid increase in exports, which outpaced imports.

      Among the other less-developed regions, the Middle East (including Turkey) maintained a current-account surplus ($25 billion) for the third straight year. Latin America achieved a trade surplus after many years of deficit, but other current-account transactions resulted in a deficit of $32.6 billion. In Africa stagnating exports and rising imports contributed to a $7.2 billion deficit.

      The overall current account of the advanced countries was projected to remain in deficit for the fourth straight year, rising from $188 billion to $210 billion. In value terms exports and imports rose only marginally, and the trade deficit increased from $179 billion to $188 billion. Once again the burgeoning U.S. current-account deficit exceeded the total surplus of the other advanced countries. At $480 billion, it was well up on 2001's $393 billion deficit, and no decline was expected in the near future. As was customary, the only other G-7 country to have a deficit was the U.K., with $32 billion, up from $30 billion in 2001. By contrast, the traditionally large surplus of Japan surged from $88 billion in 2001 to $119 billion. Most of the non-G-7 advanced countries maintained current-account surpluses. Notable exceptions were Spain, where the deficit fell from $15 billion to $11 billion, and Australia, where it rose from $9 billion to $15 billion. The euro-zone surplus jumped from $22 billion in 2001 to $71 billion in 2002. In Germany and France, where import demand was weak, deficits of $39 billion and $27 billion, respectively, contributed strongly to the euro-zone surplus.

      The $58 billion surplus of the Asian NICs was almost unchanged from 2001. The current account of countries in transition moved back into deficit (down $1.4 billion) following two years of surplus. Of these, the Central and Eastern European deficit was more than offset by the surplus in the CIS.

Exchange and Interest Rates.

  Interest rates in the industrialized countries were stable in 2002 compared with the previous year. Attention continued to focus on Alan Greenspan, chairman of the U.S. Federal Reserve (Fed), following an unprecedented 11 cuts in the Fed funds interest rate in 2001. The rate started 2002 at the 40-year low of 1.75%, and, contrary to the expectations and second guesses of the financial markets, it remained there until November 6. (For Interest Rates: Short Term,see Graph—>; for Interest Rates: Long Term,see Graph—>.)

      Despite evidence that the U.S. and global economic outlook had improved in the first quarter, the Federal Open Market Committee (FOMC) took the view in March that “the degree of strengthening in final demand over coming quarters … is still uncertain.” By contrast, financial markets were of the opinion that the global monetary cycle was at an end and that the Fed would raise interest rates shortly. Some central banks, including those of Sweden and New Zealand, raised their rates in expectation. It was not to be so. Growth in the second quarter faltered, and in the third quarter the signals were mixed. On September 24 the FOMC stated, “Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the Committee believes that the risks continue to be weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” In the meantime, the Bank of England and the ECB held fast, as did the BOJ. In Australia in May and June, the Reserve Bank raised its target cash rate in two moves by a total of 50 basis points (0.5%) to avert the risk of inflation and prevent the economy from overheating. The Bank of New Zealand again raised its rates.

 Throughout the year exchange-rate attention focused on the dollar. (For Exchange Rates of Major Currencies to U.S. Dollar, see Graph—>.) At the start of the year, the launch of euro notes and coins generated some debate as to whether the U.K. might enter the EMU and adopt the euro. Despite the fact that most financial market participants believed that if British sterling did go ahead, it would be at a much lower rate, sterling continued to appreciate against the euro. Exchange movements generally were linked to the perceived strength or weakness of the U.S. economy. It was this that determined euro movements. In the first weeks of the year, the dollar continued to make modest gains against the yen and even larger gains against the euro. Against sterling the dollar was unchanged.

      From the middle of February, however, the picture changed, and the dollar came under pressure for several reasons. The growing concern about the sustainability of the U.S. deficit was given credence by Greenspan in the middle of March, when he said that the deficit would have to be restrained. U.S. equity markets were weak, and U.S. equities were seen as overvalued. There was also the threat that the U.S. would impose tariffs on some foreign steel products, which was seen as protectionist because of the strength of the dollar. Heavy selling of the dollar over the ensuing months produced a 5.5% depreciation against the euro and the yen and 1.9% against sterling. By June all the major currencies, including the Swiss franc and the Canadian, Australian, and New Zealand dollars, had appreciated against the U.S. dollar. In July sterling bounced and appreciated against all currencies, particularly the euro and the dollar, against which it reached a 27-month high. In August, however, economic news sent sterling sliding, and in September selling pressure on the dollar declined.

      On November 6 the Fed cut official interest rates by half a percentage point, but the official rates of other major economies were left unchanged until December 5, when the ECB announced a similar cut to 2.75%. The U.K., however, left its rates unchanged.

IEIS

Stock Markets

      Those who forecast stock market recovery beginning in the second half of 2002 reckoned without the impact of successive corporate scandals and profit warnings from major companies in all developed markets. In the event, hopes of a sustained stock market recovery died in the summer, along with investors' faith in the honesty of company accounts, and 2002 ended as the third year of a global bear market that had proved to be the longest in post-World War II stock market history. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).) Early in the year Enron Corp., the world's largest and most successful energy-trading company, collapsed amid debts of more than $1 billion, the combined result of fraud and creative accounting. (See Sidebar (Enron-What Happened? ).) With it went accounting firm Arthur Andersen LLP, the auditor that had signed off on Enron's accounts, and some $60 billion of investors' money. As the Enron debacle unfolded came news of questionable accounting by many other world-class companies struggling to present themselves in the best possible light to investors. The news in July that giant telecommunications company WorldCom, Inc., had overstated its earnings by more than $3.8 billion (a figure that WorldCom later almost doubled) shook markets worldwide.

      Sleaze was not the only factor keeping stock markets depressed and volatile. Political risk throughout the world also weighed heavily on investors' minds. Throughout the year stock markets continued to weaken, even against a trend of improving economic fundamentals in the United States, where share prices fell despite the beginning of economic recovery at the start of the year, something that had not happened since 1912.

      By late November the consensus among market watchers was that a global rally, begun in October, would be sustained as the threat of a “double dip” recession in the U.S. receded; companies benefited from cost cutting and restructuring; South American and Asian markets stabilized. The price of oil also stabilized at about $30 a barrel, having jumped 4% in early December when general strikes in Venezuela halted shipments. Most analysts expected equity stock prices to end 2003 higher than in 2002.

IEIS

United States.

      The year 2002 marked the third consecutive year of falling U.S. stock prices, the first time this had happened since 1941. The decline was driven by a still-sluggish economy, national security concerns, and a widespread loss of faith in corporations and their financial practices. A string of corporate accounting scandals uncovered an epidemic of misleading accounting practices, aided by crippling conflicts of interest among the outside auditors who inspected the financial statements of publicly traded companies. Congress responded with sweeping legislation, and the Securities and Exchange Commission (SEC) introduced a wave of new regulations. The possibility of war in Iraq, the continued threat of terrorism, and the lack of satisfactory insurance against future terrorist acts had a negative impact on stocks and the economy and contributed to the overall climate of uncertainty. Unemployment reached an eight-year high of 6% in April and again in November, and the prospect of recovery from the previous year's economic recession became doubtful.

      The year's financial news was dominated by corporate scandal and the ensuing legislative and regulatory response. With the accounting troubles and subsequent bankruptcy of Enron fresh in their memory, investors dumped stocks of companies with hints of accounting irregularities. As the year progressed, a growing number of corporate scandals emerged. Bernard Ebbers, the CEO of WorldCom, resigned under pressure in April, and in July the company filed the largest U.S. bankruptcy claim in history, surpassing the previous record set by Enron. (Four former WorldCom executives, though not Ebbers, pleaded guilty to fraud charges in the case.) In May fraudulent accounting practices by energy company and Enron rival Dynegy, Inc., came to light, ultimately resulting in a $3 million fine, assessed by the SEC in September, and a stock price of less than a dollar per share, down from $26.11 in January. Shares of manufacturer Tyco International Ltd. fell nearly 90% after its CEO resigned in June amid accusations of concealing multimillion-dollar loans he took from the company; he was indicted for tax evasion in the scheme. Samuel Waksal, the former CEO of ImClone Systems Inc., was arrested in June on insider-trading charges in a case that also implicated media icon Martha Stewart; Waksal pleaded guilty in October. ImClone's stock fell by 93%, and stock in Martha Stewart Living Omnimedia, Inc., lost as much as 75% of its value. In May executives of cable television operator Adelphia Communications Corp. resigned their posts as accounting irregularities at the firm came to light. The company went bankrupt in late June, and five former top executives were indicted on fraud charges in September. The stock was trading for pennies a share, down from $33 in January.

      Arthur Andersen, one of the “Big Five” accounting firms, was convicted in June of obstruction of justice for having destroyed documents relevant to the 2001 investigation of its client Enron. The company was sentenced to five years' probation and fined $500,000, the maximum criminal penalty under federal law, and was closed for business by the end of the year. These scandals tainted the entire stock market and were a principal reason stock prices overall fell sharply between mid-May and late July. Stock prices recovered some lost ground in October and November but finished the year in negative territory. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).)

      Congress responded to the wave of corporate accounting scandals in July, passing sweeping legislation known as the Sarbanes-Oxley Act. The act created a new regulatory board to oversee the accounting industry, particularly its auditing of publicly traded corporations. The act also provided broad new grounds on which to prosecute corporations and their executives for fraud, prohibited accounting firms from offering certain consulting services to companies they audited, forbade companies to extend certain types of loans to their executives, and protected research analysts from being punished by their employers for making negative statements about client companies, among other provisions. The act required the SEC to create a new accounting oversight board, and it charged the agency with adopting many of the new rules outlined in the act.

      The act also authorized a massive increase in the budget and staff of the SEC. This expanded budget remained in doubt at the end of the year, however, as Pres. George W. Bush requested a smaller increase. The agency, widely considered to be overworked and underfunded, struggled to meet the requirements of the act while increasing its pace of enforcement, bringing a record 598 cases in its fiscal year 2002, which ended on September 30. This pace was up 24% from the previous year; it resulted in recovery of $1.33 billion in illegal gains, more than twice the amount recovered in the previous year. As part of the act, the SEC required CEOs of all publicly traded companies to personally sign off on the companies' financial statements.

      After a short but controversial tenure, SEC Chairman Harvey Pitt (see Biographies (Pitt, Harvey )) resigned on November 5. The resignation followed the appointment of William Webster to head the new regulatory board to oversee the accounting industry; Webster resigned shortly thereafter. On December 10 Wall Street executive William Donaldson was named to replace Pitt. The accounting oversight board remained leaderless through the end of the year.

      Stock prices were also dogged by continuing revelations of conflict of interest between research analysts and brokerages. Several major firms, including Citigroup's Salomon Smith Barney and Merrill Lynch, were subjected to fines for making conflicted recommendations. These concerns created a crisis of confidence in stock investing that helped to take share prices to new lows for the year in September and early October.

      At the same time, aggressive enforcement actions by New York Attorney General Eliot Spitzer brought the nation's major brokerage firms and regulators to agreement on a major restructuring of analyst research. The plan, announced on December 20, included a fine of $900 million to be shared by 10 brokerage firms, created a new system whereby the firms would purchase independent stock research to provide to their investors (at a cost of roughly $450 million over five years), and set aside $85 million for investor education.

      As the year began, the economy seemed poised for recovery. The broadest overall measure of the size of the economy, gross domestic product (GDP), was rising, as were consumer spending and home sales. Corporate earnings estimates were optimistic. Jobless claims were falling, and manufacturing output was on the rise. The recession that had begun in March 2001 seemed to be coming to an end. Corporate profits and business investment, however, were still declining. By midyear the recovery appeared weak at best. Earnings proved much lower than expected, and unemployment was near an eight-year high of 6% in April. Consumer confidence and spending were flagging, and business investment was improving only modestly. Stock prices had fallen sharply through the spring, a reflection of a lack of confidence in the economy and the health of corporations.

      Falling stock prices led to a growing crisis in the funding of many company pension plans. As companies experienced lower-than-expected investment returns, they were forced to dip further into earnings to shore up weakened pension funds to help meet plan obligations. A new regulation proposed by the Bush administration would allow these companies to convert traditional pension plans to another type of plan known as cash balance plans. Analysts said this would save companies money at the expense of older workers.

      In November unemployment once again crept up to 6%. Worries over a possible war with Iraq sent consumer confidence sharply lower, and manufacturing slipped back into decline after seven months of growth. Announced layoffs reached 1.5 million for the year, according to outplacement firm Challenger, Gray, and Christmas. Not all signals were negative, however. GDP grew in all three quarters—5% annualized in the first quarter, 1.3% in the second, and 4% in the third. Productivity (which measures output per hour worked and is considered important to long-term economic growth) rose sharply in the first and third quarters.

      Despite a seven-week rally in October and November, by year's end it was clear that investors were generally unimpressed with whatever positive signals the economy had to offer. Stock prices fell in 9 of 12 months.

      Venture capital investment fell sharply, reaching only $16.9 billion by the close of the third quarter, less than half the level of the same period of 2001 and down from more than $100 billion in 2000. Mergers and acquisitions activity was down more than 40% for the year.

      On December 6 U.S. Secretary of the Treasury Paul O'Neill and White House economic adviser Lawrence Lindsey resigned. The resignations came at the request of the White House and were thought to be connected to the economy's poor performance. Railroad industry executive John Snow was named to replace O'Neill. Stephen Friedman, formerly of investment banking firm Goldman Sachs, was named to replace Lindsey.

      The Federal Reserve (Fed), having cut interest rates a record 11 times in 2001, chose to leave the federal funds rate, the rate charged on overnight loans between banks, at 1.75% for much of the year before lowering it by one-half percentage point on November 6. The federal funds rate ended the year at 1.25%, its lowest point since July 1961. The Fed's action underscored the weakness of the economy's recovery. It also reflected a lack of concern over inflation, which remained quite low throughout the year.

      All 10 stock sectors tracked by Dow Jones declined over the year. Utilities (−28.6%), telecommunications (−36.3%), and technology (−38.8%) stocks fared worst, while consumer noncyclicals (−6.3%), basic materials (−10.6%), and financial (−14.4%) stocks fared least poorly.

      The year was especially hard on telecommunications firms. WorldCom's accounting scandal and record-breaking bankruptcy was the largest failure of a telecommunications firm in 2002. Global Crossing and Adelphia Communications also filed high-profile bankruptcies, while Qwest Communications, Inc., narrowly escaped bankruptcy but did not escape a stock collapse that brought its price down nearly to the one-dollar mark in August, from a high of $14.93 in January. The sector's collapse was due in large part to excessive speculative investment in previous years.

      Energy and utilities stocks suffered as well, as the fraudulent accounting practices of Enron proved to have been more widespread than previously believed, and allegations of price manipulation in California's energy crisis of 2000 gained credence. Dynegy stock traded above $25 per share at the start of the year but fell to as low as 51 cents. Stock in El Paso Corp., a major energy company, fell by 84%.

      Financial stocks on the whole did less poorly than other sectors. While the bear market squeezed brokerage firms, many of which responded by laying off workers, regional banks' traditional lending business benefited from low interest rates and increased deposits. Regional banks benefited from a wider-than-usual difference between the rates they paid to depositors and the rates they charged borrowers. By contrast, the nation's largest banks, known as money centre banks, were hurt by their dependence on investment banking, trading, and venture capital, as well as weak commercial credit quality. Stocks of consumer goods manufacturers also did less poorly than others as consumers continued to spend throughout the economic slump.

      The slow recovery in businesses' capital spending had a disproportionate impact on technology firms as companies held off on making upgrades to computer systems and other technology purchases. Litigation against Microsoft drew closer to resolution when the judge in charge of the case approved, with minimal alterations, a settlement agreement reached between the company and the federal government. The agreement restricted certain anticompetitive actions by the firm but stopped short of more extensive changes sought by some states. The judgment was a victory for Microsoft, but it could not keep the software giant's stock from losing more than 20% for the year.

   The New York Stock Exchange (NYSE) showed average daily trading of 1.44 billion shares, up 16% from 2001, for a value of $40.9 billion, down 3.4%. There were 3,579 issues listed on the NYSE, nearly unchanged from 2001, and 151 new listings, up from 144 for the previous year. A total of 1,793 issues advanced on the year, 2,118 declined, and 45 were unchanged. The most actively traded issues on the exchange were, in sequence, Lucent Technologies, Tyco, General Electric Co., AOL Time Warner, and Nortel Networks. (For Selected U.S. Stock Market Indexes Closing Prices, see Graph—>; for New York Stock Exchange Common Stock Index Closing Prices, see Graph—>; for Number of Shares Sold, see Graph—>.)

      Several seats on the NYSE changed hands in 2002. The last sale took place on November 25, at a price of $2 million, down from $2.55 million, fetched on June 5. Short selling—wherein investors bet that a stock will decline—was up. Short interest on the exchange was 7.8 billion shares as of December 13, up from 6.4 billion shares as of mid-December 2001. The risky practice of margin borrowing continued to fall; in November 2002 margin debt on the exchange stood at $133.1 billion, down from a recent peak of $150.9 billion in April and an overall peak of $278.5 billion in March 2000.

      The National Association of Securities Dealers automated quotations (Nasdaq) showed average daily trading of 1.5 billion shares through September, down slightly from 2 billion in 2001. Dollar volume averaged roughly $30.2 billion daily through September, down sharply from $33.9 billion daily in 2001. In 2002, 141 companies were added to the exchange. A total of 4,471 issues were listed on the Nasdaq, down somewhat from 2001, with 1,648 issues advancing on the year, 2,797 declining, and 26 unchanged. The most actively traded Nasdaq issues were, in sequence, WorldCom, Cisco Systems, Sun Microsystems, Intel Corp., and Oracle Corp.

      The American Stock Exchange (Amex) listed a total of 1,160 issues, virtually unchanged from the previous year. Trading was down through September, with 12.5 billion shares traded, compared with 11.6 billion in the same period of 2001. The most actively traded issue on the Amex continued to be the Nasdaq 100 index.

      Electronic communications networks (ECNs), continued to gain market share in Nasdaq trading, handling up to half of shares of Nasdaq-listed stocks through August. Nasdaq's own systems handled less than 25% of transactions. The rest were handled by private brokers. On October 14 Nasdaq introduced its new trading platform called SuperMontage, which was expected to create tough competition for ECNs. By December all Nasdaq-listed stocks were trading on the new platform.

      There were a total of 83 initial public offerings (IPOs) of stocks on U.S. markets, valued at a total of $22.6 million, compared with 85 IPOs in 2001. By contrast, 451 IPOs took place in 2000.

      Through November, 7,087 arbitration cases were filed with the National Association of Securities Dealers, up 12% from the same period of the previous year, and 5,400 such cases were resolved, a rise of 7%.

 In 2002 the three major stock indexes all declined for the third straight year. The Dow Jones Industrial Average (DJIA) of 30 blue-chip stocks fell 16.8% in 2002. (For Component Stocks of Dow Jones Industrial Index, see Table (Component Stocks of Dow Jones Industrial Index) .) The Standard & Poor's index of 500 large-company stocks (S&P 500) was down 23.4%, and the Nasdaq composite index plunged 31.5%. (For Selected U.S. Stock Market Closing Prices,see Graph—>.) The Russell 2000, which represented small-capitalization stocks, ended the year down 21.6% after having eked out a tiny 1% gain in 2001, while the Wilshire 5000, the market's broadest measure, fell 22.1%.

      The performance of the Dow's traditional blue-chip companies' stocks was disappointing, with only 4 of the 30 components ending the year in positive territory: AT&T (up nearly 44% for the year, from $18.14 to $26.11), Eastman Kodak (which opened at $29.43 and rose to $35.04 at year's end), Procter & Gamble (up from $79.13 to $85.94), and 3M (up from $118.21 to $123.30). Those that closed down for the year included American Express (down from $35.69 to $35.35), Philip Morris ($45.85 to $40.53), General Motors ($48.60 to $36.86), Walt Disney ($20.72 to $16.31), Merck & Co. ($58.80 to $56.61), IBM ($120.96 to $77.50), ExxonMobil ($39.30 to $34.94), Intel ($31.45 to $15.57), Johnson & Johnson ($59.10 to $53.71), Coca-Cola ($47.15 to $43.84), Caterpillar ($52.25 to $45.72), Wal-Mart Stores ($57.55 to $50.51), and General Electric ($40.08 to $24.35).

      Mixed signals on the economy and a disappointing stock market kept mutual fund investors guessing. Money flowed into stock mutual funds in the first five months of the year and out from June to October, reversing course again in November. Investors were especially panicked in July after a wave of corporate accounting scandals came to light. Investors pulled a record $40.9 billion out of stock funds that month, far exceeding even the $23.7 billion outflow in the catastrophic month of September 2001. Through November, investors moved a net total of $16.2 billion into stock mutual funds, compared with an inflow of $38.7 billion the previous year.

      Large-cap stock mutual funds lost an average of 23.21%, according to fund tracker Morningstar. Small-cap funds did marginally better, losing 21.13%. The two largest U.S. stock funds, Vanguard's 500 Index Fund and Fidelity's Magellan Fund, lost 22.15% and 23.66%, respectively.

      The market's plunge had a profound effect on the retirement prospects of American workers. More than 65% of the assets held by over 40 million Americans in 401(k) retirement plans were invested in stocks and stock mutual funds, and many workers had to postpone their retirement owing to declines in the value of their 401(k) plans.

      Bonds played their standard role as foil to a declining stock market and a sluggish economy. Treasuries returned 11.79%, according to the Lehman Brothers U.S. Treasuries Composite index. Corporate bonds returned somewhat less, 10.52%, according to Lehman's U.S. Credit index. This reflected investors' desire for the security of government bonds and their lack of faith in corporate debt.

      Mutual fund investors fled stock funds in favour of bond funds, which contributed to the decline of stock prices and boosted bond prices. In the third quarter, investors plunged a record $43.5 billion into taxable bond funds, mostly government bond funds. Through November, investors moved $103 billion into taxable bond funds, compared with the previous year's inflow of $86 billion. They were largely rewarded. According to Morningstar, long-term government bond funds returned 13.15% in 2002, and short-term government bond funds returned 6.61%. An important indication of the move from stock funds to bond funds was the fact that PIMCO Total Return, a bond fund, surpassed Fidelity Magellan and Vanguard 500 Index, both stock funds, to become the largest mutual fund in September. Vanguard 500 Index ended the year as the largest fund, however, followed by PIMCO Total Return.

      Ten-year Treasuries yielded less than 4% at year's end, reflecting the uncertain economy and poor stock market returns. (As demand for bonds increases, prices rise and yields fall.) Yields on high-yield corporate bonds, also known as junk bonds, however, soared as uneasiness over the business climate grew. The spread between the yields of junk bonds and similar maturity treasuries reached 10.63% in October, breaking the previous record set in 1991. This spread reflected concern over the risk of default among troubled firms.

Canada.

      Despite a relatively strong economy in Canada, stock prices fell considerably in 2002 for the second year in a row. Market indexes were brought down in part by the struggling computer network manufacturer Nortel Networks and by banks, which suffered from bad loans made to U.S. telecommunications companies. The market also suffered from worries about the possible effect of the flagging U.S. economy. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).)

      The TSX Group, formed by the 2001 merger of the Toronto Stock Exchange (TSE), Canada's largest share-trading forum, and the Canadian Venture Stock Exchange (CDNX), announced several branding changes in April. The CDNX became the TSX Venture Exchange; the TSE 300 index, which measured the overall performance of the TSE, became the S&P/TSX Composite index; the TSE 60 index of blue-chip stocks became the S&P/TSX 60 index; and the S&P/CDNX Composite index became the S&P/TSX Venture Composite index. There were no related changes in the values of the indexes.

      The broadest measure of the Canadian stock market, the S&P/TSX Composite index, fell 13.87% in 2002, while the S&P/TSX 60 dropped 15.68%. The Dow Jones Global index for Canada declined 12.96% in U.S. dollar terms.

      The TSE reported that average daily trading was 184.3 million shares, up 23.9% from the same period of the previous year. The dollar value of these trades, however, averaged $2.5 billion per day, down 11% from the previous year, reflecting lower share prices. All told, 1,654 issues were listed on the exchange, up from 1,645 in 2001. IPOs were up at 75, compared with 56 for the same period of the previous year.

      The Royal Bank of Canada, the largest TSE stock by market capitalization, gained 11.6% to close the year at $57.85. Nortel Networks, which ended its run as the largest stock on the TSE, lost 79% of its value to close at $2.52. The most actively traded TSE stocks were Nortel Networks, Bombardier, Kinross Gold Corp., Placer Dome, and BCE.

      The three-year-old TSX Venture Exchange (formerly CDNX) rose 2.9% as measured by the S&P/TSX Venture Composite index. Through November, 24 companies graduated from this exchange to the larger TSE. There were 77 new companies listed on the exchange through November, down 53% from the same period of the previous year. Through November, average daily trading on the exchange was 33.9 million shares, down 3.1% from the previous year, and was valued at $12.8 million, down 13.4%. Average market capitalization remained roughly constant at $3.8 million.

      Standard & Poor's on July 9 announced that the S&P 500, its blue-chip index, would no longer include non-U.S. stocks. This affected five Canadian issues: Nortel Networks, Alcan Inc., Barrick Gold, Placer Dome, and Inco Ltd., all of which suffered temporary losses as a result of the delisting.

      Corporate profits were up approximately 8% through the third quarter. Foreign investment in Canadian stocks continued to fall, showing a net withdrawal of $3.8 billion through the third quarter, compared with a net investment of $3.8 billion in the same period of the previous year. Canadians also withdrew $13.5 billion from foreign stocks, continuing the trend of previous years.

      The Canadian central bank, the Bank of Canada, cut its key overnight interest rate once, on January 15, and raised it three times, on April 16, June 4, and July 16. All changes were in quarter-point increments. The rate began the year at 2.25% and ended it at 2.75%. Unemployment remained fairly high, at 7.5% in November. Overall, however, the economy performed well, as 502,000 jobs were added through November, and GDP grew 5.7% annualized in the first quarter, 4.4% in the second, and 3.1% in the third.

Beth Kobliner

Western Europe.

      Corporate governance was less an issue with European investors, according to the European Commission (EC), although the markets appeared to react in concert with the U.S. to each piece of bad corporate news wherever it arose. Between May 21 and July 23, when negative news flow was at its height, the S&P 500 fell 26%, the U.K.'s Financial Times Stock Exchange index of 100 stocks (FTSE 100) also was down 26%, and Germany's Xetra DAX dropped 30% (all in local currencies). (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).) Tough trading conditions and corporate governance worries left firms more concerned with cleaning up their balance sheets than with planning new investments. In its autumn economic forecast for 2002–04, the EC predicted that business investment in almost all member states would continue to contract for another year.

      Some of the world's largest companies shrank dramatically. Although Enron's implosion was the most notorious, the biggest failure was ABB, a Swiss-Swedish engineering conglomerate, which dropped 300 places in the FT 500 index of the world's largest companies by capitalization.

      The overall stock market decline raised the cost and cut the availability of capital, eroded household wealth, and undermined the financial structure of insurance companies and pension funds. July's share price falls indicated more strongly than ever before a loss of confidence in the financial sector as a whole, the Bank for International Settlements reported in September. In July share prices of European insurers had dipped below the levels to which they had fallen immediately after the terrorist attacks of Sept. 11, 2001. Many insurers around the world were placed under extreme pressure by their high exposure to equity markets. By year-end 2002 Europe's biggest insurer, Standard Life, had cut policy bonus payments, while troubled U.K. insurer Equitable Life had cut stock market exposure to 5% from 25% in May. Germany's banks, which were heavily invested in domestic industry, were badly hit by collapsing stock markets. In the three months to the end of October, shares in the country's biggest bank, Deutsche Bank AG, fell by 28%. The share prices of Commerzbank, HVB Group, and Allianz were all down more than 40%.

      Across Europe the stock exchanges were themselves in a state of flux. In the two years to the end of September, the S&P Euro index lost half its market value. Trading volumes shrank dramatically, and competition squeezed margins. As much as 30% of business was being lost to big investment banks that matched buy and sell orders in-house rather than through exchanges. In Germany the Deutsche Börse closed down the Neuer Markt spin-off that it had set up to serve “new economy” companies. The strongest exchanges were offering new, mainly electronic, products and services as fees from traditional sources dried up and thus became data vendors, systems providers, and transaction processors. Alliances and mergers proliferated, and a paper written for the Organisation for Economic Co-operation and Development proclaimed an irresistible trend toward a single global market through the interlinkage of national equity markets.

      European markets reacted badly to the threat of war in Iraq, and sentiment was further undermined by the reelection in September of German Chancellor Gerhard Schröder, who had been judged, particularly by foreign investors, to have been dragging his feet over imposing necessary economic reform. Most European markets tracked the U.S. trend and hit their lows in October before edging up slightly at year's end. Germany's DAX remained the region's worst performer, plunging 43.9% for the year, followed by Sweden, The Netherlands, Finland, and France's CAC 40, all of which dropped more than 30%. The FTSE 100 ended the year down 24.5%. Only Austria was in positive territory, with a gain of less than 1%.

Other Countries.

      Global equity markets established a long-term trend of increasing correlation as markets became more integrated and investors tended to choose industry sectors globally, rather than by region or country. A rise in global risk aversion added to the domestic economic and political problems of many emerging markets. Worst punished by investors were Latin American countries, such as Brazil and Argentina, that combined political instability with huge debt burdens that also undermined their financial stability. Over the year Brazil's market fell some 46% and Argentina's dropped nearly 50% (in U.S. dollars), though measured in the heavily devalued local currency the Argentine Merval index peaked at almost 78% and ended the year up 60% over 12 months. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes).)

      Although the S&P/International Finance Corporation Investible Asia regional indexes ended the third quarter around 5% down year-to-date, stock markets in some countries outperformed strongly. Thailand's market entered the fourth quarter up by more than 21%; Indonesia's was up 13.7%; and South Korea's was up more than 12%, in dollar values. The most consistently strong performer was Australia, where the S&P/ASX All Ordinaries index peaked in March and subsequently dropped around 10% over the next six months. In the third quarter the market was up 4% over three years, compared with an 18% drop by the S&P Asia Pacific 100 index over the same period. Australian companies generally met earnings expectations, and the economy showed 4% growth, but there were signs that the prolonged drought was beginning to affect that growth. The Australia (All Ordinaries) index ended the year down 2.6% in U.S. dollar terms.

      The star performer was Russia, where the stock market entered the final quarter 37% up in dollar terms and held on. China's top-down approach to building a market economy disconcerted some foreign investors, and the country's economic statistics were widely doubted. The Chinese stock market ended the year down 16.1% (per the Morgan Stanley Capital International [MSCI] China index) in U.S. dollars. Of the main Asian markets, only Taiwan recorded a marginally weaker performance, with the MSCI Taiwan index ending the year 25.3% down.

      Although warnings about terrorist attacks and rising political tension between India and Pakistan led to a sell-off in the U.S. and European stock markets in early summer, Japan's markets held up well until mid-summer, when technology stocks fell further and investors' continuing doubts about government commitment to reform of the country's financial sector kept the market depressed. Sentiment was improved, though, by the Tokyo Stock Exchange's announcement in late summer of new delisting rules. Under these changes, a company would be delisted if its market capitalization fell below ¥1 billion (about $8.5 million) for more than nine months or it recorded a negative net worth for two successive years. The new plan aimed to end the problem of disconcertingly sudden bankruptcies among apparently well-capitalized companies and the fact that share prices might not reflect their state of near bankruptcy. In October the Bank of Japan, led by Masaru Hayami (see Biographies (Hayami, Masaru )), launched a program of buying shares from banks in a move to break a cycle of falling markets and lower financial sector capital adequacy ratios. A similar course of action by Hong Kong, begun in 1998, was nearing what looked to be a successful conclusion, but views on Japan's experiment were mixed. The broad MSCI World index entered the final month of the year down just 0.6% over 12 months.

Commodity Prices.

      While stock markets struggled, commodity markets performed well overall. The Economist Commodity Index (U.S. dollars) for All Items recorded a rise of more than 15% over the year ended November 30. Food commodities rose 17.1%, narrowly beating gold's 16.4% increase, but gold climbed higher in December. The most spectacular rise over the year was in oil, up 57.3%.

      Oil prices increased to close to $30 per barrel in the third quarter of 2002 amid high tension in the Middle East, fell back by November to $26 a barrel as the immediate threat of war with Iraq receded, and then spiked to more than $31 a barrel after a strike by oil workers in Venezuela cut off that country's exports. The continuing uncertainty and the determination of OPEC to keep the world price above $18 dollars a barrel boosted oil industry investment in other parts of the world. Beneficiaries included West Africa, where some potential was found for offshore development, Mexico, Brazil, and Russia. By the beginning of 2002, Russia's output of 7.1 million bbl a day rivaled that of the U.S. (7.7 million) and the world's biggest producer, Saudi Arabia (8.8 million). Yet the OPEC countries, of which Saudi Arabia was the most prominent, controlled 75% of the world's oil reserves, and Russia controlled just 5%.

      Over the year, gold's popularity as a safe investment in times of uncertainty raised the price per ounce to $324 in May from its 20-year low of $252 in August 1999 and then sent it up to $348 at year's end. There was a marked increase in demand for gold jewelry on the Indian subcontinent, particularly at the height of tensions between India and Pakistan. Figures released by the World Gold Council in November showed that the rates of decline in the demand for gold had slowed sharply from 14% in the first half of 2002 to just 7% year-on-year. A glut of reserves held down the prices of silver and most base metals.

IEIS

Banking.

      The global banking industry, which was challenged by generally weak market conditions for its products and services in 2002, also grappled with broad new requirements to combat money laundering and the financing of terrorism while at the same time having to deal with the fallout from the collapse of Enron Corp. and WorldCom, Inc., and other corporate and accounting scandals. (See Sidebar (Enron-What Happened? ).) In other developments, the year saw the smooth changeover to euro banknotes and coins at the beginning of the year in the 12 European Union countries constituting the Economic and Monetary Union. Meanwhile, a number of countries continued to modernize the regulatory structure governing their financial markets.

      The repercussions from Enron and similar cases of corporate malfeasance reverberated throughout much of the banking industry during the year. The Sarbanes-Oxley Act was signed into law on July 30 by Pres. George W. Bush. The act included provisions that, among other things, created a new regulatory board to oversee the accounting industry, prohibited public companies from making personal loans to their directors and executive officers, and prohibited investment banking firms from punishing research analysts who issued negative reports on firm clients. Concerns were raised outside the U.S. about the extraterritorial reach of the act, particularly with regard to the prohibition on loans to directors and executive officers. Notably, an exemption in the statute that allowed American banks insured by the Federal Deposit Insurance Corporation to continue to make such loans under applicable banking regulations was not applied to non-American banks that were also subject to their home country's supervision of insider trading. At the same time, other countries undertook their own initiatives in response to the collapse of Enron. In the U.K., for example, a variety of precautionary measures were taken by the government and regulators, focusing on issues of corporate governance, auditor relationships, and financial reporting.

      U.S. congressional inquiries into Enron, WorldCom, and other corporate meltdowns—and the possible role of their banks in having facilitated some of the alleged abuses—led some observers to suggest a need to revisit the Gramm-Leach-Bliley Act of 1999, which repealed provisions of the Depression-era Glass-Steagall Act that separated commercial from investment banking. Others pointed out that the potential conflicts of interest and related problems also applied to stand-alone securities firms that were not affiliated with banks and bank holding companies.

      In addition to having influenced the creation of new anti-money-laundering initiatives, the terrorist attacks of Sept. 11, 2001, focused the attention of the financial-services industry and regulatory authorities on disaster-recovery/business-continuity issues, including the risk of having operations concentrated in one area. In August 2002 a draft White Paper on “sound practices” was issued jointly by the U.S. Federal Reserve, the Office of the Comptroller of the Currency, the Securities and Exchange Commission, and the New York State Banking Department. This draft paper emphasized the need for major banks and securities firms to consider establishing “out-of-region” back-up sites. The New York Stock Exchange, which had been forced to shut down for several days in September 2001 following the attacks on the nearby World Trade Center, was looking into building a back-up trading floor outside Manhattan.

      On June 6 the House Financial Services Committee passed on to Congress the Financial Services Regulatory Relief Act of 2002 bill, which would, among other things, ease restrictions on interstate branching and clarify merchant-banking provisions of the Gramm-Leach-Bliley Act to ease cross-marketing restrictions. The bill also included an amendment proposed by the comptroller of the currency that would eliminate the mandatory 5% capital equivalency deposit requirement applicable to federally licensed American branches and agencies of international banks in favour of a risk-focused approach under which the comptroller would have the discretionary authority to impose such a requirement in appropriate circumstances. Ultimately, no action was taken on regulatory-relief legislation before Congress adjourned for the year, but the measure was expected to be taken up again early in 2003. The New York State Banking Department revised its asset-pledge requirement, greatly reducing the approximately $35 billion of collateral currently pledged by New York-licensed branches and agencies of international banks. Asset-pledge reform initiatives were also completed in Connecticut, which lowered the requirement to 2% of third-party liabilities from 3% and capped the maximum requirement for qualified institutions at $100 million. Other than the U.S., only Canada applied asset-pledge requirements to branches of nondomestic banking organizations.

      A number of countries implemented sweeping regulatory-reorganization measures in 2002. On April 1 the Austrian Financial Market Authority assumed its powers and responsibilities under the Financial Market Supervision Act. The Austrian approach to financial-system supervision concentrated on the core functions performed by the financial system, rather than on institutions or sectors, and was in line with a functional approach to supervision.

      Bahrain in April announced the creation of a single integrated financial-sector regulator within the Bahrain Monetary Agency, the central bank of Bahrain. Responsibilities for the regulation and supervision of the stock exchange and the insurance sector were in the process of being transferred to the agency. Banking supervision had been a key function of the agency since its creation in 1973.

      In the spring the German Bundestag (parliament) passed the Act on the Integrated Supervision of Financial Services, which radically reformed the institutional framework for financial-services supervision in Germany. Germany's three separate supervisory offices for banking, insurance, and securities trading were combined on May 1, 2002, into a single agency, the Federal Financial Supervisory Agency, which was overseen legally and professionally by the Ministry of Finance. The restructuring mirrored changes made in several other European countries to establish single financial-supervisory authorities.

      The Central Bank and Financial Services Authority of Ireland Bill was published in April. The bill allowed for the restructuring of the Central Bank of Ireland to include a new regulatory authority with extended supervisory responsibilities that included control over the insurance sector. The measure was aimed at ensuring that the system of prudential regulation and coordination of financial stability enhanced the regulatory system. The considerable role given to consumer issues in the new measures was also designed to increase protection to the customers of financial services and to promote greater consumer awareness and education. An interim board has been appointed to manage the transition to the new regulatory arrangements.

      Under new financial-sector reform measures in Canada, regulated, nonoperating holding companies were permitted for the first time, offering financial institutions the potential for greater operational efficiency and lighter regulation. The holding-company structure allowed banks the choice of moving certain activities that had been conducted in-house to an outside entity that would be subject to lighter regulation than the bank. A broader range of investments were permitted for both the holding company and the parent-subsidiary structures and included expanded opportunities for investment in the area of e-commerce. As a general principle, any activity carried out by a financial institution could be carried out through a subsidiary of the financial institution or of its holding company. This gave banks and insurance companies in Canada greater choice and flexibility in the way they structured their operations. Trust companies could also have a broader range of investments.

      [This article is based in part on the Global Survey 2002 of the Institute of International Bankers.]

Lawrence R. Uhlick

Business Overview

      The year 2002 was a strange, tumultuous one that held few moments of rest for weary investors and companies. The recession seemed to continue unabated; many sectors were rife with bankruptcies; and executives were hauled before judges and congressional investigators. (For the 10 Largest U.S. Bankruptcies Filed Since 1980, see Table (10 Largest U.S. Bankruptcies Filed Since 1980).) Behind the chaos lurked the possibility of a war with Iraq.

      The technology-fueled stock market boom that defined the 1990s was a fading memory. Signs of hope that the worst was over were matched by fears that poor conditions would extend for another year. The Consumer Confidence Index hit 79.4 in October, its lowest standing since 1993. Nevertheless, U.S. gross domestic product expanded by a rate of 4% in third-quarter 2002, an improvement over the previous year's performance.

      There was no ambiguity about the poor shape of many industries. Sectors ranging from energy to steel to textiles had appalling years, owing in part to the aftereffects of the terrorist attacks of Sept. 11, 2001, and also to evidence of mismanagement and fraud at some companies. The airline industry was perhaps the most visibly distraught sector, and many airlines bled losses throughout the year. The overall American airline industry lost $1.4 billion in the second quarter of 2002 alone and was expected to post more than $7.7 billion in losses for the year.

      In August U.S. Airways filed for Chapter 11 bankruptcy protection, listing assets of roughly $7.81 billion, compared with liabilities of $7.83 billion. The airline, which was one of the carriers most affected by the September 11 attacks owing to its business concentration on the East Coast, had lost $2 billion between August 2001 and August 2002. It arranged financing to keep some of its flights going while it reorganized, but it also gutted its staff and canceled many of its routes. United Airlines followed suit, filing for bankruptcy protection on December 9 after a long, fruitless bid for billions of dollars in federal loan guarantees. UAL Corp., United's parent company, had lost $3 billion over 18 months, posted an $889 million loss for the third quarter alone, and slashed more than 1,250 jobs. UAL's more than $1 billion in debt obligations, which were due before year's end and which it ultimately could not pay, made bankruptcy the only route possible. The only American airlines that kept above water were low-cost regional companies such as Southwest Airlines and JetBlue. These companies showed increased ambition; Southwest planned its first nonstop coast-to-coast route, which would put it in direct competition with the major carriers.

      The airline industry in Europe showed some improvement early in the year. In the spring Swiss Air Lines, Ltd., launched a new airline to be called swiss to replace the bankrupt Swissair. British Airways, Air France, and Lufthansa revealed better-than-expected profits for the first half of 2002. As in the U.S., however, low-cost airlines such as Ireland's Ryanair and the U.K.'s easyJet, which completed its £374 million (about $590 million) takeover of budget rival Go, showed the strongest growth. Air Afrique, which officially went bankrupt in February, was replaced by two new, privately financed airlines in Africa: Uganda-based AfricaOne and Afrinat International Airlines, which expected to fly between New York City and several West African countries.

      The woes afflicting aircraft carriers spread to aircraft manufacturing. Boeing Co., the world's largest aircraft maker, said it would greatly reduce its jet production through 2004. Boeing planned to deliver 380 planes in 2002, a 28% drop from the previous year, and in 2003 it would likely deliver between 275 and 285 planes, even fewer if more carriers declared bankruptcy. This opened a door for Boeing's most aggressive European rival, Airbus, which said that it would likely deliver more airplanes in 2003 than Boeing. If so, this would be the first time that Airbus had surpassed Boeing in aircraft production.

      Another woebegone sector was energy production. In this case many of the industry's problems were due to one prime culprit; Enron Corp., a company that had once symbolized the sector's ambitions for the 21st century, poisoned the well for many of its competitors in 2002. (See Sidebar (Enron-What Happened? ).) The size and scope of the ongoing Enron scandals soon enmeshed other companies and industries, most notably Enron's accounting firm, Arthur Andersen, which was virtually destroyed after its conviction on charges of obstruction of justice.

      The investigation into the 2000–01 California power crisis hit other West Coast players. El Paso Corp. was charged by a federal administrative judge with having distorted California energy prices, and one by one many of the energy producers that had attempted to match Enron's massive trading operations of the late 1990s began bailing out of the market. CMS Energy Corp. admitted to $4.4 billion in fraudulent trades and halted its trading operation. Dynegy Inc., which had almost bought Enron in late 2001, closed down its energy-trading operation after it also faced allegations of fraudulent trades. Many other American energy producers, including TXU Corp., Mirant Corp., Calpine Corp., and Williams Companies Inc., experienced stock-value depreciation and in some cases severe earnings losses.

      In addition to experiencing financial difficulties stemming from the Enron fallout, energy companies suffered from not receiving a boost from oil prices, which stayed relatively flat despite rumours of war with Iraq. Crude oil hovered in the $25–$30-per-barrel range all year, though a strike by oil workers in Venezuela pushed prices up at year's end, and average monthly gasoline prices in the U.S. increased just two cents a gallon from April through September. One reason for the relative stability was an increase in European gasoline exports to the U.S. Flat oil prices for much of the year squeezed even the top global oil superpowers, such as ExxonMobil Corp., ChevronTexaco Corp., BP Amoco PLC, and Royal Dutch/Shell Group. Chevron had its net income fall 75% to $1.13 billion for the first half of 2002 compared with the first half of 2001. Exxon's third-quarter net income fell by 17% compared with the previous year's period.

      Another in the queue of battered industries was steel manufacturing, a sector that inspired Pres. George W. Bush's controversial decision in March 2002 to introduce tariffs on foreign steel imports. The tariffs, which ranged from 8% to 30%, were to be a short-term measure meant to buy the American steel industry time to recover and improve market share and would be phased out in 2005. The tariffs sparked protests from the country's trading partners, however, and the European Union for a time considered retaliating with duties of its own. As the year went on, the Bush administration began watering down its decision. The number of product categories hit with tariffs soon narrowed until by year's end more than half of European steel exports were exempt. American steelmakers also lost a bid to increase the tariffs when the U.S. International Trade Commission in August slapped down their request to impose duties on cold-rolled steel. The tariffs had a quick impact on pricing. The U.S. price for hot-rolled steel (which had a 30% tariff) jumped to $350 a ton at midyear from $210 a ton in late 2001. A counterbalance for higher pricing was the increasing amount of supply from international producers. Brazil, for example, produced 36% more steel in July 2002 than in the same month the year before—indicative of a worldwide glut in production. Even with the tariffs, steel imports by the U.S. boomed. Total steel imports, as of the end of the third quarter, were 8.2% higher than in the same period in 2001, and 2002 was expected to be the fourth highest steel-import year in U.S. history.

      There were signs of recovery, however, in the American steel industry. U.S. Steel posted two profitable quarters in a row; in third-quarter 2002 it posted $106 million in earnings, compared with a loss of $23 million in the same period in 2001. This was its best quarterly performance in more than four years. U.S. Steel's recovery was due in part to higher prices, which helped the company run its mills at nearly 94% capacity, compared with the 65–70% capacity at which many domestic mills had run in the late 1990s. In October U.S. Steel sold its coke mills, iron mines, and transportation holdings to a new company formed by Apollo Management, a New York City-based private equity firm, for $500 million, and the company also planned to sell off its coal business. Meanwhile, bankrupt Bethlehem Steel Corp. said that it would likely take a charge of $1.5 billion at the end of the year to cover its burgeoning pension costs and reported a third-quarter loss of $54 million. The rise of “minimills”—smaller steel-producing operations with higher efficiency rates and lower employee payrolls than traditional manufacturers—also presented a challenge to the traditional producers. Minimill operators such as Nucor Corp. and Steel Dynamics Inc. both prospered in 2002.

      It was a mixed year for aluminum producers. Prices declined, and there was idle capacity for producers. Year-to-date American aluminum shipments as of September were up 4.7%, but foreign imports overwhelmed exports. Total American exports of aluminum ingot and mill products were 818 million kg (1.8 billion lb) year-to-date as of September, down 2.3% from the 841 million kg (1.85 billion lb) in the same period in 2001, while imports were up 15% for the year. The leading worldwide aluminum producer, Alcoa Inc., had a down year. For the first nine months of 2002, Alcoa's net income was $643 million, compared with $1 billion in the same period in 2001. Anglo-Dutch steelmaker Corus Group began pulling out of the aluminum market during the year. In August Corus sold its stake in a Quebec aluminum smelter to Alcan of Canada, and in October the French metals giant Pechiney bought two of Corus's remaining aluminum businesses. Corus, which announced a loss of some $364 million in the first six months of 2002, intended to sell its remaining aluminum business to focus on steel.

      Gold, a traditional haven during tough market conditions, had a solid year. Gold prices sustained long runs above $300 per ounce throughout the year, which it had not done since the mid-1990s, and in June gold hit its highest per-ounce price since 1997. Analysts credited the pricing improvements to the weakening U.S. dollar and dismal stock market. Some top producers indicated that they expected gold's improvement to continue. Barrick Gold Corp., which had been a major proponent of using hedging as a protection against falling prices, said that it would cut back on hedging devices, such as options. Top producers such as Barrick and Placer Dome Inc. instead would put much of their production on the spot market (where prices were always in flux), rather than trying to get a predetermined price via futures contracts. In May Placer announced plans to buy AurionGold of Australia. The takeover would make Placer the world's fifth largest gold-mining company.

      The lodging industry was hammered by the poor economy. The hotel occupancy rate in 2002 was roughly 60%, one of the lowest levels in the industry's history. Business travel and convention business, which historically made up about 75% of the overall lodging demand, seriously slowed throughout 2002, and whatever business there was tended to go to lower-end hotels. Leisure travel, a crucial business for higher-end operators, was at much lower levels than those of the pre-September 11 environment. The lodging industry also faced a glut of supply. In the period between 1996 and 2000, new room construction rose by roughly 19%. Demand did not nearly match that pace, however, and hotel operators found that whatever revenues they earned were diluted by excess room capacity. PricewaterhouseCoopers LLP estimated that revenue per available room would decline by 2.3% in 2002 to $49.68, down from $50.83 in 2001. These factors drained many of the top American hotel operators. Marriott International Inc. reported a slight increase in earnings for third-quarter 2002, mainly on its nonlodging businesses, but was fighting a brutal court battle with some of its hotel owners and contending with reports that its most recent earnings releases obscured key information.

      In order to keep revenues up during a difficult environment, auto manufacturers turned to severe price reductions that, for the short term at least, translated into improved performances. Critics believed that automakers were setting up for serious losses in the years to come. Total American light-vehicle sales for the January–September period were 12.87 million vehicles sold, up 0.8% from the 12.76 million posted in the same period in 2001. Sales were expected to wind up in the 16.8 million range overall in 2002, which would be one of the best performances in the market's history. The key reason that sales held steady was the continued prevalence of 0% financing plans, which inspired many buyers to make purchases that they normally might have put off for years. The 0% plans, however, also ate away at the auto industry's profitability. General Motors Corp. gave customers as much as $2,600 off per vehicle, which translated into the squeezing out of more than $1 billion from overall revenues in 2002, according to analysts. When GM suspended its program in September, it experienced a sharp 13% sales drop, and the company swiftly reinstituted the program the following month.

      Despite such issues, GM's market share rose to 28.2%, and its productivity improved—it had shaved its vehicle-construction time by 20% over the previous four years and cut its materials expenses substantially. Perhaps most important, GM increased sales of its high-profit vehicles such as trucks and sport utility vehicles, a crucial profit centre for an automaker. Sales of full-size pickup trucks were up 4.6% at midyear, and researchers said that 2002 could be the first year that trucks outsold cars in the U.S. Italian car company Fiat, which was 20% owned by GM, announced huge losses for the year, however, and proved to be a drag on the American automaker.

      Ford Motor Co. spent much of the year under the gun, burdened with a heavy debt load—roughly $170 billion—that showed no signs of lessening. Ford's worldwide automotive operations had a loss of $243 million in the third quarter, despite a 14% increase in revenues. The company struggled to control costs, which ran higher than most of its major rivals. The push to reduce costs caused companies such as Ford to begin exploiting their alliances with foreign automakers and essentially outsource their development and engineering departments overseas. DaimlerChrysler AG's revenues for the year were expected to fall slightly, although its net income fell 22% in the third quarter alone, and officials indicated that they expected 2003 to be worse should consumer demand lessen. DaimlerChrysler moved to buy a stake in Mitsubishi's truck division. DaimlerChrysler sold fewer than 1% of trucks on the road in Asia, a major truck market, while Mitsubishi had a 24% share of the total Asian truck market.

      For all their hustle, the Big Three American automakers continued in 2002 to lose ground to foreign imports. GM, Ford, and Chrysler's total market share for cars and light trucks was 61.7% of the total American market, compared with more than 80% 20 years earlier. There was also a pricing imbalance between American and foreign car manufacturers. The Big Three spent an average of $3,764 a vehicle, or 14% of the selling price, on selling incentives, and Japanese and South Korean manufacturers spent about half that figure. Worse, studies found that consumers were replacing American cars with foreign counterparts at much greater margins than they were replacing foreign cars with American vehicles. Toyota Motor Corp., which sold about 1.8 million vehicles a year in the U.S., wanted to boost that number to 2 million by 2005 and expand its 10% market share to 15% market share by 2010. That could make Toyota a larger player in the U.S. than DaimlerChrysler. BMW also announced increased sales in the U.S., especially of its redesigned Mini Cooper.

      Tobacco manufacturing was another American industry facing a pricing conundrum. The major producers—R.J. Reynolds Tobacco Co., Philip Morris Companies, and Brown & Williamson Tobacco Corp.—had grown used to raising prices when it suited them and had raised them often. The average retail price in 2002 was $3.58 per pack for premium cigarettes, up 90% since 1997. As increased taxes hit such major markets as New York City—and increased the price of a premium-brand pack of cigarettes to more than $7—consumers began turning to the generic markets for price relief. By 2002 cut-rate cigarette manufacturers owned about 10% of the overall market, compared with 3% only four years earlier. As a way to fight back, the major cigarette companies began to offer their own incentives, including two-for-one deals and other short-term promotions. This in turn helped to dilute profits. Philip Morris's domestic tobacco unit was expected to have its profit per thousand cigarettes fall by more than 50% in fourth-quarter 2002 compared with fourth-quarter 2001; Reynolds's tobacco unit's profit was expected to fall by 70% in the same period. The wild card for tobacco companies continued to be the possibility of consumer lawsuits. While the drain caused by the $206 billion legal agreement many companies signed in 1998 had lessened, cigarette companies remained frequent courtroom visitors. Reynolds alone was hit by $34 million in fines in 2002.

      Other traditional industries continued to experience hard times. The textiles sector endured Depression-era conditions as several major American players were swept off the board and more than 30 mills closed. Guilford Mills Inc. filed for bankruptcy in March, but the company emerged six months later after having cut its senior debt substantially, laid off thousands of workers, and vowed to concentrate on core business areas such as technical textiles and select apparel. Top denim producer Galey & Lord was not so lucky—it remained under bankruptcy protection at year's end. The Bush administration said that it was stepping up plans to help domestic textile manufacturers by trying to reduce foreign nations' reliance on cheap imports, which had flooded the U.S. Total American imports for the year as of August were up 12% over the same period in 2001.

      The Bush administration also played a key role in the pharmaceutical industry in 2002, as its decision to try to bring generic drugs more quickly to market had the potential to further increase the power of generic manufacturers over premium-brand players. The battle between generics and premium manufacturers had come to define the industry, and the generics appeared to be winning. According to the Federal Trade Commission, about 47% of all prescriptions filled were generics, compared with 19% in 1984. After raking in profits for a decade, thanks to exclusive patents, many drug manufacturers were watching their former market shares wither in the face of generic competition. A generic alternative to Prozac, for example, received eight times as many new prescriptions as the formerly exclusive drug did. Eli Lilly & Co., which saw its net income fall by 11% and worldwide sales decline by 7% for the first nine months of 2002, blamed much of the decline on lower Prozac sales. British drugmaker GlaxoSmithKline faced a similar problem after a U.S. court ruled in May that the patents on its antibiotic Augmentin were invalid and thus opened the door to generic competition. In July Pfizer Inc., the world's biggest pharmaceutical company, with such best-selling drugs as Viagra, announced that it would acquire Pharmacia Corp., maker of Rogaine and Celebrex among other popular products, in a $60 billion deal.

      The retail industry experienced some of the most extreme variations in 2002. Kmart Corp., the nation's second largest discount retailer, filed for Chapter 11 bankruptcy protection in January and spent most of the year trying to regroup. Meanwhile, industry giant Wal-Mart displaced ExxonMobil in the number one spot on Fortune magazine's list of the top 500 companies in the world.

Christopher O'Leary

▪ 2002

Introduction

Overview

       Real Gross Domestic Products of Selected OECD Countries Changes in Output in Less-Developed CountriesExpectations of an economic slowdown at the start of 2001 proved to be well founded, and as the year drew to a close, fears of a global recession were being expressed. In the year 2000 the global economy had grown by 4.7%, its fastest rate in a decade and a half. In November the International Monetary Fund (IMF) revised down its projection for 2001 to 2.4%, but by year's end this looked too optimistic. Growth in the 30 industrialized countries of the Organisation for Economic Co-operation and Development (OECD), which accounted for most world output, was not expected to exceed 1%, which in turn constrained growth of the less-developed countries (LDCs). (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries); for Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).)

  The slowdown in the first half of 2001 was more severe than had been expected. The world's stock markets were already falling, and interest rates were being steadily lowered in the U.S. and the European Union (EU) to stimulate economic activity. (For short-term interest rates, see Graph—>; for long-term interest rates, see Graph—>.) While several factors had contributed to the global slowdown, regions and countries were differently affected. A key factor was a stronger-than-predicted fall in demand for information technology (IT) products. This particularly affected the producer countries in Asia, which were heavily dependent on technology exports. In Western Europe and other industrialized areas, growth slowed more than expected—partly because of the effects of tighter monetary policies and the need to adapt to higher oil prices—and corporate profits were falling. The Japanese economy was still bordering on recession, but its imports continued to rise strongly. China's economy remained buoyant, with strong domestic demand and a stable currency in terms of the U.S. dollar. In the first half of the year, China's trade was slowing, but it was still recording double-digit growth in imports and a 9% increase in exports.

      While the slowdown had been more severe than expected, it was the unprecedented terrorist attacks in the U.S. that really shook world confidence. While the initial impact was felt in the U.S., where there was a huge loss of life and the physical destruction of much of the business infrastructure of lower Manhattan, the attacks created fear and uncertainty across the world. The economic might of the U.S., which had been a driving force behind much of the world's economic growth, was seriously undermined. The insurance cost of the damage was likely to reach $50 billion, according to early estimates by the U.S. Bureau of Economic Analysis. This was well in excess of the $19 billion in damage caused when Hurricane Andrew hit Louisiana and Florida in 1992, previously the largest claim to date.

       Standardized Unemployment Rates in Selected Developed Countries, TableThe loss of confidence was quickly reflected in the world's leading financial markets, and acceleration in corporate failures and job losses; major European firms laid off 97,000 workers in October alone, almost twice as many as in September. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table).) At the end of November, one of the world's largest conglomerates, the energy trader Enron Corp., filed for Chapter 11 protection in what would be the world's biggest-ever bankruptcy. Possibly the most lasting impact was on transport and world travel and tourism. Within weeks once-strong national airlines Swissair and Belgium's Sabena were being declared bankrupt as a result of the slump in demand for air travel. The number of international tourist arrivals in 2000 reached 699 million and generated $476 billion. Before the terrorist attacks international tourism in 2001 was on track for a 3–4% increase; in November the World Tourism Organization lowered its forecast to 1%.

 On a more positive note, despite the critics of trade liberalization, the World Trade Organization (WTO) meeting in Doha, Qatar, on November 11–14 went ahead as planned, and a new agreement was reached. Most countries were continuing to make efforts to participate in globalization by attracting foreign investment. Of the 150 regulatory changes in investment conditions made by 69 countries in 2000, 147 were more favourable. As a result, foreign direct investment (FDI) continued to be a major influence on economic development, increasing at a much faster rate than world trade or production.(For Industrial Production of selected countries, see Graph—>.) In 2000 world FDI reached a record $4,270,000,000,000, 18% up on the previous year and well in excess of forecasts. Sales of the over 800,000 affiliates of transnational corporations also rose by 18% to reach $15,680,000,000,000, while the number of employees, which had doubled over the previous decade, reached 45,600,000. In 2001, however, the slackening in merger and acquisition (M&A) activity was expected to result in a decline in overall FDI.

      Once again a strong surge in cross-border M&A to $1,140,000,000,000 provided the impetus for most FDI, an increase of 49.3% over the year before. In the first half of 2001, M&A activity declined by 17% to $300 billion, one-quarter of the same-year-earlier level, and no increase was expected in the second half of the year.

      Most FDI activity continued to be in the developed countries. The U.S., Japan, and the EU countries (collectively known as the Triad) in 1998–2000 received three-quarters of global FDI and accounted for 85% of outflows. The U.S. remained the largest host country for FDI, receiving $281 billion in 2000, largely the result of several large acquisitions made by American firms. Since 1999 the U.K. had overtaken the U.S. as the largest outward investor, and in 2000 France joined it. The $139 billion U.S. flow of outward investment was largely the result of M&As in the EU, which was the destination of nearly half its total FDI. The slowdown in the Japanese economy, especially in the manufacturing sectors, deterred some investors. FDI in 2000 was down 36% to $8.2 billion from a record high in 1999. Japanese outward investment at $33 billion rose strongly to its highest level in a decade, being led by M&A activity in telecommunications.

      FDI into and out of Canada reached record levels in 2000, totaling $100 billion, mostly because of cross-border M&As with partners in Europe and the U.S. Australia and New Zealand FDI was closely linked to Asia-Pacific developments and was also constrained by unfavourable exchange rates.

      The share of FDI to the LDCs declined to 19% in 2000, the lowest since 1990, but the picture was mixed. Although FDI into Africa fell by around 10% to $9.1 billion, much of the reduction was in sub-Saharan Africa because of an easing in Angola's petroleum industry and the reduction in M&A transactions in South Africa. South Africa contributed 40% of the region's FDI outflows. Since the ending of apartheid, many of the larger companies, such as South African Breweries, were becoming more international and acquiring businesses abroad in order to secure new markets and increase their competitiveness.

      Against the overall trend, FDI into the LDCs of Asia rose 44% to a record $143 billion in 2000. This was due to an investment boom in Hong Kong associated with China's forthcoming membership in the WTO. At $643 billion in 2000, Hong Kong's share of the total inflow into Asia rose to 45% and overtook that of China. Nevertheless, China was making policy changes in advance of joining the WTO, and it received 12% more FDI in the first four months of 2001 than in the same 2000 period. Southeast Asia's share fell to 10% in 2000, mainly because of divestments in Indonesia. In South Asia, India continued to be the largest recipient, with $2.3 billion.

       Changes in Consumer Prices in Less-Developed CountriesOutward investment from Asia doubled to a record $85 billion, led by Hong Kong but with increasing flows from China and India. Investment in Latin America and the Caribbean declined from the particularly high level of 1999. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

National Economic Policies

      The revised IMF growth forecast for output in the advanced countries was 1% (in November), compared with the 3.8% achieved in 2000. By the middle of the year, economic activity in many of the advanced countries was, at best, stagnating. The effects of the terrorist attacks in the U.S. in September led to output falls in the final months of the year, for the first time in 20 years.

United States.

       Real Gross Domestic Products of Selected OECD CountriesThe longest period of continuous expansion since the National Bureau of Economic Research (NBER) began keeping records in 1854 came to an abrupt halt in 2001, just 10 years after it began. Following expansion of 4.1% in both 1999 and 2000, it was doubtful whether the U.S. economy would grow by the revised IMF economic forecast of 1%. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries).) From being the dynamo of world growth, the U.S. suddenly became the generator of a serious global slowdown. After lengthy deliberations the NBER concluded on November 28 that the U.S. had slid into recession in March.

 The slowdown in the economy had begun in the second half of 2000 when demand for information and communications equipment began to slump, bringing an 80% drop in high-tech company share prices. It gathered momentum in 2001 as the loss of confidence in high-tech companies, which then had to meet the higher costs of investment, and in the “new economy” was followed by a general deterioration in business and consumer confidence. An easing of monetary policy from the start of 2001 contributed, however, to continuing strong investment in housing as the cost of mortgages fell. Household spending remained buoyant, with retail sales in April and May up 3.9% on year-earlier levels. (For Inflation Rate of selected countries,see Graph—>.)

       Standardized Unemployment Rates in Selected Developed Countries, TableThe downturn in demand led companies to reduce output to lower stock levels. As a consequence, manufacturing activity in May reached a 10-year low. Job losses pushed unemployment to 4.9% by August, and reductions in overtime led to shorter workweeks. Nevertheless, by historic standards the unemployment level remained compatible with “full employment” conditions. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table).) An easing of the tight labour market was desirable insofar as it brought some stability to employee compensation, which had been spiraling out of control. While rises in average earnings slowed down, however, there was an acceleration in unit labour costs. Company profits fell 13% in the year to the second quarter, with a bigger decline in the year to the third quarter.

      By midyear there were mixed signals and some speculation that economic growth would resume by the end of the year. Consumer spending, which accounted for more than two-thirds of U.S. gross domestic product (GDP), was expected to accelerate in the second half of the year as a result of tax cuts and repeated reductions in interest rates.

 After the September 11 terrorist attacks, however, the downside risks to the economy were intensified. The U.S. was making the hard landing that had been the subject of speculation and fear just a year earlier, when there had been no suggestion that the country could be the target of such terrorism. The deterioration in the economy continued. In October industrial output fell (−1.1%) for the 13th consecutive month, which made it the longest unbroken decline since 1932. (For Industrial Production of selected countries, see Graph—>.) There were glimmers of hope, with consumer confidence rising in November for the second straight month At the same time, new claims for unemployment benefits, at 427,000, fell for the fourth consecutive month. In December it was reported that unemployment had risen to 5.8%, the highest in more than six years.

      While it was too soon to determine the effect on future activity, the immediate impact contributed to a slight fall in GDP in the third quarter. Qualitative effects included the huge costs to the U.S. of the destruction, compensation to families for loss of lives, and job losses associated with services to the World Trade Center. There was considerable disruption to financial market activity, air traffic, retail business, and entertainment events. In the longer term, increased security and insurance costs would have to be borne by government and business. Business confidence and investment would take time to recover.

  In the weeks following the attacks, Pres. George W. Bush was given authority to spend $40 billion to respond. Another $15 billion of support was granted to help the American airline companies, many of which had been in trouble before September 11. A further package of $75 billion was being planned to stimulate the economy. This was beginning to reverse the trend in fiscal policy established in the previous seven years, during which the large federal budget deficit had been eliminated and replaced with a healthy surplus. A return to a federal deficit was likely in 2002. On November 6 the Federal Reserve (Fed) cut the federal funds rate for the 10th time in 2001, by half a percentage point to 2%, which brought it to a 40-year low and nearly 70% below the end-of-2000 level. Another cut in December brought the rate down to 1.75%. (For short-term interest rates, see Graph—>; for long-term interest rates, see Graph—>.)

United Kingdom.

       Real Gross Domestic Products of Selected OECD CountriesDuring the year the U.K. had one of the most resilient economies among the major advanced countries. The growth in output was forecast at 2–2.25%, compared with 3.1% in 2000, which made it the fastest of the industrialized Group of Seven (G-7) countries. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries).)

      While economic growth had been strong since the summer of 2000, this was largely because of global factors. The collapse of the information and communications technology sector, the U.S. recession, and a general slowdown in overseas demand constrained exports of goods and services, which were expected to rise only 3–4%, compared with 10.6% in 2000.

  On the domestic front, however, the combination of a foot-and-mouth epidemic and poor weather conditions proved disastrous for much of the agricultural sector and the tourism industry. In theory, the relative strength of sterling against the euro was eroding the competitiveness of U.K. goods and services, especially in continental European markets. (For Exchange Rates of Major Currencies to U.S. $, 2001, see Graph—>.) At the same time, however, it was prompting industry to take measures to increase efficiency, particularly in manufacturing. (For Industrial Production of selected countries, see Graph—>.)

      The main stimulus to the British economy once again came from domestic demand, which increased by 3.7% in 2000 and was expected to rise in 2001. Household spending rose 1.2% in the first quarter and gathered momentum in the second, when it rose 3.7% above the year-earlier level—the biggest increase in more than a year—and underpinned increased retail sales. Buoyant conditions continued through the third quarter. In September retail sales rose 5.9% over the same year-earlier period, which made the third-quarter year-on-year growth the fastest in 13 years. Prospects for the retail sector remained positive, with a Confederation of British Industry survey showing the strongest outlook for the sector since October 1966. By contrast, survey results for the services sector indicated a weaker outlook, with signs that contracts had been deferred because of the September 11 attacks.

      For most of the year, activity in the U.K.'s housing market was so strong that there were fears of a boom-and-bust cycle in the sector, such as had occurred a decade earlier. The cost of borrowing and uncertainty about equity investments combined to make residential property an attractive investment. Regional disparities remained wide, however, with London prices rising at an annual rate of 17% in the second quarter, compared with an average 7.7% for the country as a whole. In absolute terms London house prices were running at almost three times the level of those in northern England.

       Standardized Unemployment Rates in Selected Developed Countries, TableA strong influence on consumer confidence was the high level of employment. In September unemployment was 5.1% (5.4% a year before), compared with an average 8.3% in the euro zone. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table).) The number of jobless increased in October and again in November, however, the first time since 1992 unemployment had increased for two straight months. On a claimant-count basis, it was the lowest in 26 years. As a result, wage pressure remained strong and was reflected in higher average earnings, which nevertheless eased back to 4.4% in September, year on year. Unusually, public-sector earnings were rising faster than those in the private sector, a reflection of the priority the government was giving to the public services.

Japan.

      During the year the Japanese economy deteriorated sharply, and output was estimated to have fallen by 0.9 %. The modest recovery in 2000, when the economy grew 1.5%, was due mainly to the strong growth in capital investment and was not sustainable. The 2001 recession was the fourth in 10 years and was predictable, given the decline in technology-related demand in Asia. The harsher-than-expected slowdown in the global IT industry was particularly damaging to Japan, and this had implications for the region. Although Japan's economic role in the Asia-Pacific region had diminished over recent years, it remained important. Reciprocal trade with East Asia in particular was badly affected by the downturn.

   Real Gross Domestic Products of Selected OECD CountriesFirst-quarter economic indicators reflected the economic stagnation, which was to continue unabated. Capital-goods shipments were falling, industrial production was down, household incomes were deteriorating, and unemployment was continuing to rise. Real GDP shrank by 0.2% and was followed by a 2% drop in the second quarter. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries).) The outlook deteriorated further in the wake of the September 11 terrorist attacks in the U.S., and in that month industrial output fell 12.7% (from a year earlier). (For Industrial Production of selected countries, see Graph—>.) Retail sales continued to decline, not helped by declines in average earnings because of reductions in overtime. Consumer prices continued to fall and in September were 0.8% lower than one year earlier. (For Inflation Rate of selected countries, see Graph—>.)

       Standardized Unemployment Rates in Selected Developed Countries, TableUnemployment was becoming a growing problem. Although the rate had dipped temporarily in 2000, reflecting the improvement in the economy, the trend had been generally upward. From just over 3% in early 1997, the rate had climbed to a record high of 5.3% by September 2001, and it continued to rise in October (5.4%) and November (5.5%). Of particular concern was the mismatch in the labour market. While the unemployment rate was rising, the level of job vacancies remained unchanged at around 2%. By the beginning of the year 2001, around 40% of job seekers were over 50 years old. Companies tended to want employees in the 25–29-year age group. They not only were less expensive to employ but also did not expect the status that older workers commanded. It was also perceived that older workers were less able to adapt to new duties and technologies. It was estimated that 70% of all unemployed workers in Japan had lost their jobs because of a mismatch of skills. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table).)

      The emergency economic package unveiled by the Japanese government in April 2001 aimed to stimulate employment through measures that included deregulation, provision of child care, and vocational training. This was in marked contrast to previous policies, which were directed toward preventing layoffs through subsidies, but it was unlikely to produce an early solution to the mismatch problem.

Euro Zone.

       Real Gross Domestic Products of Selected OECD CountriesThe belief among many euro-zone policy makers that somehow the region would be, at worst, only marginally affected by a global downturn (which in turn depended on what happened in the U.S.) gradually became discredited. GDP growth in the euro zone increasingly weakened as the year progressed. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries).) Sluggish trade and a stagnation in business investment were exacerbated by the September 11 attacks. Nevertheless, the European Commission at the end of November optimistically estimated that euro-zone growth would outpace that of the U.S. at 1.6% in 2001 and 1.3% in 2002. This was in sharp contrast to the record growth of 3.5% in 2000, when many of the smaller countries, such as Ireland (11.5% growth) and Luxembourg (8.5%), outperformed, making a contribution to output that was disproportionate to their size.

 The final outcome was heavily dependent on Germany, the zone's largest economy and the country leading the downturn. Economic indicators suggested that there would be no early upturn. In the third quarter, GDP contracted by 0.6% (annual rate), industrial output was down 2.6%, and retail sales fell 2.1%. Unemployment, at 9.5% in October, was marginally higher than a year earlier. France, Germany's largest European neighbour, proved more resilient to the downturn in the first half of the year, being supported by tax cuts and employment growth. Even in the third quarter, French GDP was still growing at an annual rate of 1.9%, and industrial output, though slowing, was still rising in September in contrast to falling output in most advanced countries. France's better performance was partly due to the progress it had made in labour-market reforms that had made it easier to create jobs. (For Industrial Production of selected countries, see Graph—>.)

       Standardized Unemployment Rates in Selected Developed Countries, TableAcross the euro zone the improvement in the labour market had come to a halt, and unemployment was a cause of growing concern. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table).) It remained intractably high in several countries, led by Spain (13% according to national statistics), Belgium (11.7%), Germany (9.5%), Italy (9.4%), and France (8.9%), but it was not an issue in Luxembourg or The Netherlands.

      The standardized unemployment rate had been falling slowly since 1997 but had stabilized in the first three quarters of 2001 at 8.3%; the rate for those under 25 years old was much higher, 16.4%, but had been falling, while the 7.3% rate for workers over 25 was unchanged. The deceleration in the number of employed had been slowing during the second half of 2000, while the growth in employment had increased at only 0.2% a quarter since the second quarter of the year. This was the slowest rate since the beginning of 1997. It was mainly due to the fall in opportunities in the services sector—particularly trade, transport, and communications—in part reflecting the weak growth in private consumption. Employment in industry started to contract in the second quarter, and the decline was expected to continue to year's end. While unit labour costs rose faster than in the previous year—2.3% up in the second quarter—this was due to cyclic labour productivity rather than change in employee compensation.

  The rate of inflation was rising for much of the year. (For Inflation Rate of selected countries, see Graph—>.) The initial problem was the euro's weakness against the dollar and then the rapid rise of commodity prices, particularly of oil. (For Exchange Rates of Major Currencies to U.S. $, 2001, see Graph—>.) In the second half of the year, however, the effect of lower energy prices brought the consumer price rise to 2.7% in the September quarter over the year before. Food prices, which accounted for about 20% of the index, escalated for much of the year as a result of the foot-and-mouth and “mad cow” diseases. Unprocessed-food prices were running at 7.8% up on the year earlier in August and September, having peaked at 9.1% in June.

The Former Centrally Planned Economies.

       Changes in Output in Less-Developed CountriesThe former centrally planned economies (also called the countries in transition) saw an increase in output for the third year in succession. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).) Nevertheless, at around 2% the rate represented a considerable decline from the record 6.3% growth in 2000 and a bigger fall in output growth than that sustained by any other region. Several factors contributed to the decline, including the slowdown in the world economy and the uncertainty created by the attacks on September 11. More specifically, export growth fell sharply from 12% in 2000 to around 5% in 2001, largely as a result of the reduction in import demand from Western Europe, which accounted for half the region's exports.

      The fall in economic activity was most marked in the Commonwealth of Independent States (CIS), where output was expected to rise at around half the rate of increase of 7.8% achieved in 2000. Growth was constrained in 2001 by a slowdown in Russia, where output growth was unlikely to exceed 4% following on from an exceptional 8.3% rise in 2000 that was largely the result of increased oil revenues. Output in Central and Eastern Europe also moderated from a 3.8% increase in 2000, but steep declines were averted by a strengthening of domestic demand in many member countries.

       Changes in Consumer Prices in Less-Developed CountriesRates of inflation were contained in most countries, and over the region the rate was expected to fall for the third consecutive year to around 15% (20% in 2000), with rates much lower in Central and Eastern Europe (around 9%). Inflation in Russia continued to be a problem, with the annual rate running at around 20%, as in the previous year. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

      There was a growing gap between the 12 central and southeastern European and Baltic (CSB) countries and the 12 CIS countries, according to the findings of research carried out during the year. After more than 10 years of transition, GDP of the CSB countries in 2000 surpassed the 1990 level by 6%, while GDP of the CIS countries remained at only 63% of the 1990 level. Over the same period, Poland, the largest country in the CSB, had increased its GDP by more than 40%, while Russia, which had the largest population in the CIS, saw its economy shrink by a similar percentage. Within the subregions, however, there were marked disparities. Hungary, Latvia, Poland, and Slovenia had grown strongly in recent years, but other CSB countries such as Bulgaria and Romania had exhibited volatile economic performances, and their GDP was still only some 80% of the 1990 level. Among other things, the research suggested that new enterprises in the transition countries tended to be more productive than old enterprises in sales, exports, investment, and employment. New firms employing 50 or fewer workers had become the most important generators of jobs in the CSB, and this was seen as an important factor in economic performance.

Less-Developed Countries.

       Changes in Output in Less-Developed Countries Changes in Consumer Prices in Less-Developed CountriesThe weaker-than-expected global economy led to adjustments in output forecasts. The IMF projection for LDCs of 4% for 2001 was, if achieved, the same as the 1999 outcome but well below the 5.8% growth in 2000. (For Changes in Output in Less-Developed Countries, see Table (Changes in Output in Less-Developed Countries).) The wide regional disparities, which had long been a characteristic of the less-developed world, narrowed considerably in 2000 but were expected to reemerge in 2001, with conditions in Latin America and the Middle East deteriorating more sharply than expected at the start of the year. Within regions, too, wide disparities persisted. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries).)

      Asia, excluding the newly industrializing countries (NICs) of South Korea, Taiwan, Singapore, and Hong Kong, continued to drive growth in the LDCs, although the 5.6% IMF projection appeared overly optimistic, given the dramatic falloff in trade, on which many Asian countries depended. While some countries, including China and Malaysia, increased fiscal spending to mitigate the effects, for most this could be only a short-term solution because of concerns about raising the level of public debt. In Indonesia and the Philippines, for example, this was already too high. The increase in China's GDP was expected to fall to 7–7.5% from 8% in 2000. China's exposure to high-tech exports was low relative to much of the region, and in the short term the economy was less vulnerable to the global slowdown because of its strong reserves and the buildup of investment in earlier years. In the longer term its major challenge was preparing the country for more competition in the wake of its WTO membership.

      South Asia, which remained one of the world's poorest regions, relied less on trade. Output in this area was expected to fall from 4.9% in 2000 to 4.5%. Because of the military response in Afghanistan to the September 11 attacks, the region faced special risks. Pakistan was most affected, with its trade being severely disrupted. That country reduced its fiscal deficit to 5.2% of GDP, but its external debt was a large $38 billion and its reserves were low. India was more insulated from the global slowdown because of its relatively closed economy. India's IT sector was directed at its domestic market, particularly the highly competitive services sector. Nevertheless, the effects of drought, the catastrophic earthquake in Gujarat in January, and energy price increases contributed to a decline in output from 6% in 2000 to 4.5%. By contrast, in neighbouring Bangladesh agricultural output was well up after the flood-induced 2000 slowdown, and tax revenue increased strongly.

      In Africa output accelerated from 2.8% in 2000 to 3.5%. Improvements in the Mahgreb countries (Algeria, Morocco, and Tunisia), where output was projected to more than double over the year before, made a major contribution to overall growth. Increased agricultural output reflected the recovery from drought, and domestic consumption was also boosted by the earlier increase in oil revenues, although the reduction in OPEC quotas and lower oil prices had negative consequences in the medium term.

      In sub-Saharan Africa output growth declined (from 3% to 2.7%) because of the global slowdown. Nevertheless, in many countries, including Kenya, Ethiopia, and Mozambique, agriculture and, hence, household incomes were helped by better weather. Political instability continued to hamper growth in several countries, including Angola and The Sudan, while the politico-economic crisis in Zimbabwe intensified as elections due in early 2002 approached. In South Africa, the region's largest economy, sound macroeconomic policies reduced the country's vulnerability to external shocks. Restraints on public spending and limits on the public deficit to some 2.5% of GDP had brought inflation down to a year-on-year rate of 4% by October. Nevertheless, the short-term outlook had weakened because of South Africa's strong trading and financial links with the advanced countries and regional difficulties. In Nigeria windfall gains from oil led to an increase in economic activity. Much higher spending at the federal government and local level caused escalation in the inflation rate from 6.9% to over 20%, and money supply expanded. A failure to implement badly needed structural and institutional reforms was combining with corruption, however, to prevent economic progress. There was an increasing dependence on the burgeoning informal economy, and social as well as economic instability was rising.

      Output in Latin America rose by 1% at most, following on from the strong 4.2% export-driven growth of 2000. The largest three countries, Argentina, Brazil, and Mexico, were worst affected by the global and U.S. slowdown, and lower interest rates did little to help. Political and financial problems in Argentina led to a dramatic decrease in confidence, and output was declining. Sentiment toward the region was adversely affected, and access to international capital markets was restricted. The slowdown in Argentina and Brazil, which suffered a drought-induced energy crisis, together adversely affected Chile. Costa Rica was particularly hard hit by the fall in the price of semiconductors, which accounted for two-fifths of its exports. Throughout the region countries faced the problems of their high levels of debt and poor-quality institutions.

      Middle East output was not likely to exceed half the 5.5% advance in 2000. The reduction in oil quotas and lower oil prices, combined with lowered global demand for goods and services, constrained economic activity. A major preoccupation in the region at the end of the year was the unprecedented escalation in the Arab-Israeli conflict at the beginning of December, which added to the uncertainty already created by the September 11 terrorist attacks in the U.S.

International Trade, Exchange, and Payments

International Trade and Payments.

      The increase in the volume of world trade in 2001 was expected to be just 1% in 2001, following a record 13.3% in 2000. The contraction created a new and unfamiliar situation in which the growth in world output exceeded the volume of world trade. For at least two decades, annual rises in world output had exceeded export growth. During the 1990s the annual rise in the volume of merchandise exports had outpaced the growth of GDP by three to one, and in each major region exports increased faster than domestic demand. Trade in services, too, had expanded rapidly over the previous decade and accounted for a quarter of all cross-border trade.

      In 2001, in contrast to the year before, when all regions had participated in the upsurge in trade, there were many individual country and regional losers in the downturn. The volume of exports from the advanced countries had risen 11.5% in 2000 and by 16.1% (25% in U.S. dollar value) from LDCs. In 2001 the simultaneous slowdown in the U.S., Europe, and Japan meant that any increase in exports of either group would be close to negligible. Even before September 11 it was evident that the world slowdown, which centred on the recession in the high-tech sector, was deeper than expected.

      The most affected was the East Asia–Pacific region, which relied on the U.S. and Japanese markets for around 40% of its exports. Exports in the first half of the year were already running at levels well below the year earlier, by up to 25% in Taiwan, South Korea, Malaysia, Singapore, and the Philippines. South Asia was expecting to see a modest increase, as some countries had depreciated their currencies to increase their competitiveness. In Latin America little growth could be expected. In the first half of the year, Mexico's export growth rate fell from 23% in 2000 to zero. Like many other countries in the region, its exports were mainly destined for the U.S. market. The severe slowdown in the EU was affecting many of the former centrally planned economies, and few would see any increases.

      The overall current account of the balance of payments in the advanced economies remained in deficit for the third straight year after six years of surplus. It was expected to fall to $223 billion, from a higher-than-expected $248 billion in 2000. The U.S. deficit once again exceeded the total surplus but at $407 billion had fallen from the year before ($445 billion). Among the major G-7 countries, the U.S. and the U.K., as usual, had substantial deficits. The euro zone moved from a deficit in 2000 to a $16 billion surplus, with member countries Germany and Spain each sustaining $14 billion surpluses. The U.K. deficit, at $23 billion, was little changed from the year before. By contrast, Japan's traditional surplus fell quite heavily, from $117 billion to $89 billion. Of the other advanced countries, only Portugal and Australia had significant deficits—$10 billion and $11 billion, respectively. All four of the Asian NICs remained in surplus, with a total of $48 billion, just slightly down on the year before.

      After many years of deficits, the LDCs had a surplus for the second year running. It fell sharply, however, from $60 billion to $20 billion owing to a halving of the Asian LDCs' surplus to $22 billion and an increase in Latin America's deficit to $58 billion.

      Indebtedness of the LDCs eased up slightly to $2,155,400,000,000. All regional groups experienced moderate increases except for Africa, where indebtedness fell from $285 trillion to $275 trillion. Latin America continued to be the most heavily indebted region, with $766 trillion, and its debt-service payments, at $167 trillion, accounted for half of all LDC debt-service payments. The external debt of the countries in transition continued its steady rise to reach $367 trillion.

      As a share of exports of goods and services, however, the external debt of the LDCs and countries in transition fell for the third consecutive year to 137% and 104%, respectively. All regions showed an improvement by this measure, with Latin America's share falling to 209%, just marginally down on the year before. Least indebted was Asia, where the share fell modestly to 97%.

Globalization.

      Events during the year demonstrated the extent to which world trade and financial markets had become interlinked and global. The synchronized downturn by the Triad (the U.S., Europe, and Japan) could not have occurred even a decade before. Nevertheless, the debate on whether the continued liberalization of world trade was desirable continued. There was no evidence to show that imports led to a widening of the gap between rich and poor. On the contrary, research published in 2001 showed that a representative sample of LDCs that had globalized since 1980 had benefited strongly from rising incomes and a reduction of poverty. By contrast, those countries unable to participate in globalization had experienced growing income disparities. In India national surveys showed that poverty was steadily declining, and did so particularly in the 1997–2000 period, and the poor had benefited strongly from economic growth.

      Nevertheless, the failure of many industrialized countries to lower tariffs on LDC exports of agricultural products and textiles, in particular, was cause for concern. Many of the LDCs, which in 2001 made up 70% of the WTO membership, felt that negotiations were biased toward the interests of the industrialized countries and that its rules and regulations were inappropriate or unenforceable in their countries.

      The annual meeting of WTO international trade ministers in Seattle, Wash., in 2000 had been disrupted by violent protests against the perceived capitalist ambitions behind any attempts to increase globalization. The 2001 meeting to expand and extend the multilateral trading system was held in Qatar at a time of increased uncertainty fueled by the sharp downturn in world trade and the terrorist attacks in the U.S. It took place amid the highest security, which limited access of antiglobalization protesters, and most nongovernmental organizations were too busy to protest.

      The meeting was successfully concluded. Of great international significance (because of its massive market and trading potential) was the November 11 ratification of membership for China, which became the 143rd member of the WTO a month later. China's membership followed drawn-out preliminary negotiations on various issues dating back to 1986, when it first applied to join the General Agreement on Tariffs and Trade, the WTO's predecessor. In 2001 these issues included a China-U.S. agreement reached on June 8. This limited the amount of support and export subsidies the Chinese government could give to its agricultural sector, as well as easing and clarifying the conditions on various aspects of foreign investment. On the day after China's ratification, membership for Taiwan was approved. To satisfy Beijing (which considered Taiwan part of its sovereign territory), the newest member was designated “a separate customs territory” of Taiwan and its offshore islands of P'eng-hu, Quemoy, and Matsu. The two countries were committed to opening their markets and gradually liberalizing sectors in which the government was involved. China would also have more export opportunities, which many other countries feared would erode their competitiveness.

      The conference ended with agreement on a new program to be implemented in coming years. It committed the ministers to dealing with the particular difficulties and vulnerabilities of the least-developed countries and the structural difficulties they faced as a result of globalization, through a work program for negotiations to be completed before Jan. 1, 2005. This was expected to give poor countries better access to richer countries for their agricultural and textile products. The new round of trade negotiations dealt with issues related to agriculture and services, including tariffs and competition policy, and environmental concerns that were not to be used as a reason for protectionism. Public health and access to medicines, as well as intellectual property, were also included in the new round of trade negotiations.

Exchange and Interest Rates.

  The global slowdown in 2001 and the September 11 attacks were the major influences on interest and exchange rates during the year. The U.S. started cutting interest rates in January, and Canada quickly followed suit. (For short-term interest rates, see Graph—>; for long-term interest rates, see Graph—>.) As the year got under way, most central banks in the industrialized countries outside the euro zone were cutting interest rates, and fiscal policy was being directed toward boosting confidence at household, corporate, and market levels to prevent outright recession. In March these included Australia, Canada, New Zealand, and Switzerland. For many years the U.S. dollar had been the world's strongest currency, but in 2001 that strength—built on superior economic fundamentals and positive interest differentials—was beginning to pall.

      The U.S. wasted no time in cutting rates to prevent the “hard landing” that much of the world had been fearing since the middle of 2000. Weak data over the Christmas 2000 period, as well as low business and consumer-confidence indicators, prompted Fed Chairman Alan Greenspan to take early action. On January 3 the Fed cut its Fed funds interest-rate target from 6.5% to 6%. The move came before formal meetings and was on a scale that surprised many observers. It was intended to boost confidence but was not enough, and it was quickly followed by a second cut on January 31 and then a third on March 20, bringing the target down to 5%. Markets reacted positively, and the dollar remained firm against sterling, the euro, and the yen. Further cuts brought the Fed rate to 3.75% in June, down 275 basis points since the start of the year. In the wake of the terrorist attacks on September 11, more reductions were made. By early November the Fed rate was down to 2%, its lowest since 1961. At the start of December, there were positive signs that some sectors of the economy were growing again; equity prices were rallying, and long-term bond yields were up. Despite this, interest rates were cut again, for the 11th time, to 1.75%.

      In the U.K. interest rates moved almost in tandem with the U.S. through most of the year. To reduce vulnerability to the effects of the global slowdown, the Bank of England steadily cut the interest rates from February 8. By August 2 the rate had been reduced four times, by 100 basis points, to 5%. After September 11 raised more recession concerns, three more reductions were made. The last, on November 8, was the most aggressive at half a percentage point and brought the rate to 4%, the lowest in nearly 40 years. The Bank of England, which took the view that inflationary pressures were continuing to ease and the global slowdown might last longer than previously thought, did not cut rates again in December.

      The euro zone was widened on January 2 to include Greece, which was relinquishing its drachma in favour of the euro and became the 12th EU member to join the euro system. The European Central Bank (ECB) was slow to experience and recognize the extent of the global slowdown. Its economic output accelerated slightly in the fourth quarter of 2000 over the previous three months, and going into 2001 consumer confidence was higher because of falling oil prices, tax cuts, and lower unemployment. Over the three months to the end of January 2001, the euro appreciated by 15% against the dollar and 8% against sterling. By mid-March, however, there were clear signs of a serious economic downturn, and sentiment turned against the euro. The ECB was widely criticized for not cutting interest rates. The ECB justified its inaction on the grounds that inflation was too high and that growth over the year would exceed 2.25%, a view not shared by the market.

 In the following weeks all sectors of the economy were affected by falling demand, and the euro continued to weaken against the dollar and even the yen, despite the ailing Japan. Finally, on May 10 the ECB cut its interest rates by 25 basis points to 4.5%, which was seen as too little too late. It was not until August 30, after the euro had softened against most major currencies, that the ECB cut the rate again, by a meagre 25 basis points to 4.25%. The events of September 11 prompted a final and more decisive cut of 50 basis points to 3.75%. By the end of November, compared with a year earlier, the euro was trading slightly less than a percentage point lower. (For Exchange Rates of Major Currencies to U.S. $, 2001, see Graph—>.)

      A major preoccupation of consumers, businesses, and banks as the year drew to a close was the likely effect of the arrival and circulation of some 10 billion euro notes and several hundred thousand metric tons of coins on Jan. 1, 2002. These were to replace the 12 national currencies in the euro zone, including the French franc and the Spanish peseta. The German Deutsche Mark was to cease to be legal tender on January 1, while most other currencies had until the end of February. The physical logistics of distributing the new currency across the euro zone had already encountered difficulties, not least because of organized crime committed to hijacking supplies. Surveys late in the year showed that many small shopkeepers, who would be most affected at the consumer end of the supply chain, were not adequately prepared for the change. Nevertheless, dual prices had been displayed in many retail outlets throughout 2001, and much had been done to reduce confusion. Some consumers were unhappy at losing their national currency, and many were concerned that the switch would cause prices to rise.

  In Japan nominal interest rates had been below 1% since the mid-1990s, underlying inflation was negative, and land and stock prices were declining, which left little room for maneuver on interest rates. (For short-term interest rates, see Graph—>) The year 2001 started on a gloomy note as fears rose that the economic recovery in the second half of 2000 was not as strong as expected, despite large injections of capital. There was speculation that the Bank of Japan (BOJ) would reverse the interest-rate increase implemented in August 2000. This had followed an 18-month zero-interest-rate policy. Growing doubts about the recovery led to a weakening of the yen against the dollar, and by March 8 the exchange rate had reached ¥120 to the dollar for the first time in 20 months. (For Exchange Rates of Major Currencies to U.S. $, 2001, see Graph—>.)

      On March 21 the BOJ announced a further easing of its monetary policy, increasing liquidity and effectively reinstating zero rates. The yen continued to depreciate. It had reached a new two-and-a-half-year low at ¥126 to the dollar on April 6 when the government announced an emergency package that included a proposal to force the banking sector to deal with its bad-debt problems. At the end of March, bad loans at all deposit-taking institutions were officially estimated at ¥3l.2 trillion, although a widely used broader measure estimated ¥45 trillion. A combination of this, the election of Junichiro Koizumi as prime minister, and continuing uncertainty about the U.S. economy stemmed the slide of the yen.

      In mid-May it briefly rose to ¥118 to the dollar before returning to the ¥121–¥124 range, in which it remained until September 11. Immediately after the terrorist attacks in the U.S., short-term interest rates rose because of a rush to secure funds. Given the abundant liquidity, however, the BOJ intervened in the market with large-scale yen selling to prevent an appreciation of the yen that might adversely affect the ailing Japanese economy. This steadied the yen, which remained around ¥120 to the dollar for a while—just half its value of a year earlier—before sliding again to end the year at around ¥131.

IEIS

Stock Exchanges

       Real Gross Domestic Products of Selected OECD CountriesGlobalization works both ways: just as the internationalization of financial markets can power worldwide growth, it can equally throw the development into reverse. By the end of 2001, all the signs of impending global contraction were in place. The United States, usually the driver of international growth, had entered recession, dragging most of Asia with it and forcing Europe almost to a standstill. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries).)

      The third-quarter 0.4% drop in gross domestic product (GDP) signaled that the recession had started in the U.S. in March, following the longest period of expansion in U.S. history—121 months, compared with the earlier record of 106 months between 1961 and 1970. Long before the terrorist attacks in the U.S. on September 11 and their aftermath, the year had produced a succession of bleak facts for the record books.

  As early as midyear, operating earnings per share in the U.S. were recorded to be down nearly 40% overall, the worst performance since the Great Depression of the 1930s. Consumers, the backbone of the stock markets' long bull run, had been nervous months before the terrorist attacks, and after September 11 they all but stopped spending. Business investment fell 11.9% that month, and by year's end the Federal Reserve (Fed) had cut the base interest rate for the 11th time in the year to just 1.75%, the lowest short-term rate in more than 40 years. (For short-term interest rates, see Graph—>; for long-term interest rates, see Graph—>.) Growth in business investment was forecast to rise only 2% over the year 2001, compared with an actual growth of 9.9% in 2000. July ushered in the most severe worldwide synchronized slowdown in GDP growth since the oil crisis of 1974. In the same month, there was turmoil in emerging markets, with the news of problems in Argentina, Poland, and Turkey affecting equity prices in several countries. Producers' prices fell 1.6% in October, the biggest monthly decline since recordkeeping began in the 1940s.

      For more than a year, investors had been grappling with a seemingly endless succession of bad news about company earnings, not only in the high-technology sectors devastated by the bursting of the dot-com bubble but also increasingly across all sectors. In summer the corporate news had looked far worse than the economic fundamentals: by October the whole picture had darkened, even though stock markets soon recovered to pre-September 11 levels. The rout when markets reopened after the attacks was only partly the result of the deep uncertainty the events induced.

      According to the Organisation for Economic Co-operation and Development (OECD), the industrial world had contracted for the first time in 20 years. It was, said the organization, the cumulative effect of the collapse of the high-tech sector and a slump in equity values generally, reduction in inventories, rises in the price of oil, which tripled in 1999–2000, and the rise in interest rates over the same period.

      The extent of the slowdown in the rest of the world varied in severity according to countries' trading links with the U.S. Although Europe was undergoing a less-severe contraction, forecasts for the region were revised down. Much of Asia was hard hit, and Japan, suffering a fourth recession in 10 years, was expected to contract more in the coming year.

       Selected Major World Stock Market Indexes, TableIt was perhaps not surprising that the year ended with nearly all the major developed country stock exchange indexes well down on the year before, in both local currency and U.S. dollar terms. Austria was an exception (up 11.7% in dollar terms), while Japan's Nikkei index declined 23.5%. Germany, France, The Netherlands, and Italy all suffered market falls in excess of 20% over the year. In the U.K. the Financial Times Stock Exchange 100 (FTSE 100) index was down 16.2% and was closer to the Morgan Stanley Capital International (MSCI) World Index drop of 16.9%. In the less-developed countries, stock market performances were more mixed, but by December 31 most were sharply down on year-end 2000, with the Hong Kong Hang Seng index slumping 24.5%. The major exceptions were South Korea, Taiwan, Mexico, and Russia, all of which were up for the year. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes, Table).)

IEIS

United States.

      Falling corporate profits, recession, and the continuing decline of the Internet sector combined to make 2001 a down year for stocks. The technology-driven plunge in stock prices from the heights of the previous year persisted and broadened to create a bear market affecting nearly all sectors. It was the second year in a row that stock prices had declined after a nearly decade-long bull market. The Fed cut the federal funds rate a record 11 times throughout the year, motivated by a manufacturing-led downturn that had evolved into a recession by March. The terrorist attacks on September 11 shocked the markets and the nation, forcing the longest closure of the U.S. stock exchanges since the Great Depression. Stocks rallied at year's end but did not make up for earlier losses.

       Selected U.S. Stock Market IndexesAll three of the major indexes were down for the second year in a row. The Dow Jones Industrial Average (DJIA) of 30 blue-chip stocks fell 7.10% on the year; the broader Standard & Poor's index of 500 large-company stocks (S&P 500) slid 13.04%; and the National Association of Securities Dealers automated quotation (Nasdaq) composite index, made up largely of technology stocks, suffered the worst, dropping 21.05%. The Russell 2000 index of small market-capitalization (small-cap) stocks fared better, eking out a 1% increase, while the broadest market measure, the Wilshire 5000 index, fell 12.06%. (For Selected U.S. Stock Market Indexes, see Table (Selected U.S. Stock Market Indexes).)

      The DJIA began the year at 10,786.85 and showed no major movement through January and February. The index fell more than a thousand points in March but largely recovered in April, rallying to its yearlong peak of 11,337.92 on May 21. This was followed by a steady decline that progressed largely uninterrupted through the summer months.

      The Nasdaq began the year at 2470.52 and showed respectable gains through January, briefly reaching a yearlong peak of 2859.15 on January 24. A decline through February and March cost the index more than a thousand points; some of that loss was recovered in an April rally that gave way to a long, slow decline lasting through the summer.

      The S&P 500 index began at 1320.28 and roughly mirrored the Nasdaq's path, pointing to the relatively new prominence of technology stocks in the overall stock market. The S&P 500 hit its yearlong peak of 1373.73 on January 30. On November 30 the S&P 500 had an estimated price-to-earnings (P/E) ratio of 30.97, up from 24.59 at the year's beginning, which reflected a sharp decrease in earnings.

      The attacks on the World Trade Center towers crippled the financial district of New York City. The New York Stock Exchange (NYSE), the Nasdaq stock market, and the American Stock Exchange (Amex) remained closed until September 17, the longest the NYSE had been closed since 1933 and the longest closure ever for the other exchanges. In the first week of trading following the attack, the DJIA fell 14.26%, the Nasdaq was down 16.05%, and the S&P 500 slid 11.6%. Each of these three indexes hit its yearlong low on September 21, with the DJIA falling to 8235.81, the Nasdaq at 1423.19, and the S&P 500 at 965.80. The energy-heavy Amex reached its yearlong low, 780.46, on September 25.

      Markets then embarked on a rally lasting through year's end, fueled by expectations of economic recovery. The major stock indexes' decline for the year reflected the influential role of technology stocks. JDS Uniphase, for example, went from single-digit value in 1999 to over $100 per share in early 2000, gained entrance to the S&P 500 in 2000, and fell back down to single-digits in 2001. Cisco Systems, the leading Internet networking company, fell by more than 50% over the course of 2001. Dramatic price declines were also seen in the stocks of other Internet-related companies such as Amazon.com and Yahoo! and in a wide range of technology firms, including Oracle, Compaq, Advanced Micro Devices, and Vitesse Semiconductor, all of which had risen dramatically in recent years.

      Stock prices largely followed expectations about the state of the economy. The year began with an economic downturn centred in the manufacturing sector and marked by excess inventories. By February this slump had broadened, affecting many sectors, including media, telecommunications, and pharmaceuticals. Stock prices plunged in February and March, and the economy entered recession.

      Corporate profits, already declining, fell sharply in the first three quarters, as did businesses' capital spending. Third-quarter profits were 22.1% lower than a year before, marking the largest 12-month drop in the 47 years that the government had tracked these statistics. The National Association of Purchasing Management's PMI index showed reduced manufacturing activity in every month through November. In mid-November 4,420,000 people were collecting or had filed for unemployment insurance, the largest such number since 1982. By the end of the month, firms had announced 1,795,000 layoffs, according to outplacement firm Challenger, Gray & Christmas. At the same time, the unemployment rate had climbed to 5.7%, already its highest level in six years; it rose again in December to 5.8%.

      The Fed responded to the economic distress with 11 interest-rate cuts. The federal funds rate ended the year at a 40-year low of 1.75%, down from 6.5% on January 1. Holding strong all year, however, were consumer spending and home sales, aided by low mortgage interest rates. Though personal spending fell 1.7% in September after the terrorist attacks, it shot up a record 2.9% in October, owing in part to buying incentives offered by automobile manufacturers. The federal budget surplus, which had been projected to grow over the next decade, fell to $153 billion in fiscal 2001 from a record $236 billion in fiscal 2000.

      Businesses reduced their inventories in nearly every month of 2001, and by October there were indications of recovery in manufacturing as new orders rose. Oil prices, which had hit $34 in August 2000, fell below $20 per barrel in November 2001.

      Investors' enthusiasm for stocks waned in 2001. According to the Investment Company Institute, through October a net of only $14.9 billion had entered stock funds in 2001, down from $292.8 billion for the same period in 2000. The two largest stock mutual funds, Fidelity's Magellan Fund and Vanguard's 500 Index Fund, both large-cap blend funds, were down 11.7% and 12%, respectively, for the year, while the average large-cap blend fund declined 12.9%. By the end of November, four out of five U.S. stock mutual funds were down on the year.

      Caution and pessimism dominated the investment landscape. Venture capital investment, which had topped $20 billion in every quarter of 2000, was at $12 billion in the first quarter of 2001 and declined to $7.7 billion in the third quarter, matching the level of the first quarter of 1999. Through September there were only 65 initial public offerings (IPOs) in U.S. markets, with another 32 IPOs between October and December, down from a total of 451 in 2000. Mergers and acquisitions activity was at about $99.9 million a month on average, a 30% decline from the 2000 average monthly activity, according to Thomson Financial. The risky practice of margin borrowing fell sharply; in June margin debt stood at $157.9 billion, down from its peak of $299.9 billion in March 2000. Short selling—wherein investors bet that a stock would decline—was up. Through November 12 short interest on the NYSE had increased to a record 6.3 billion shares, up from 4.9 billion shares in December 2000. Through October investors filed 5,690 arbitration claims with NASD Dispute Resolution Inc. (a unit of the National Association of Securities Dealers), up from 4,646 for the same period in 2000.

    NYSE average daily trading through October was 1,240,000,000 shares, up slightly from the previous year. (For NYSE Composite Index 2001 Stock prices, see Graph—>; for Average daily share volume, see Graph—>.) Dollar volume was $42.6 billion, down slightly. Of the 3,973 equities traded on the NYSE, 2,370 advanced on the year, 1,569 declined, and 34 ended the year unchanged. (For annual NYSE Common Stock Index Closing Prices, see Graph—>; for Number of shares sold since 1979, see Graph—>.) The most actively traded stocks on the exchange in 2001 were Lucent Technologies (6.4 billion shares traded), General Electric, EMC Corp., Enron Corp., AOL Time Warner, and Nortel Networks. Enron, which traded 4.4 billion shares, peaked above $84 before collapsing to end the year at 60 cents.

      On January 29 the NYSE completed its conversion mandated by the Securities and Exchange Commission (SEC) to a system of decimalized trading, wherein stocks were traded in dollars and cents rather than in the traditional sixteenths of a dollar. Preliminary evidence suggested that decimalization had reduced bid-ask spreads by 37%, according to SEC staff analysis,which resulted in lower transaction costs. This particularly benefited small investors and active traders and improved trading capacity and transparency. A seat on the NYSE sold for $2,200,000 on October 29, down from its peak of $2,650,000 on Aug. 23, 1999.

      Average daily trading on the Nasdaq stock market was 1.9 billion shares, up slightly from 2000; dollar volume, however, was $46.6 billion, down sharply from $88.3 billion in 2000, reflecting the lower average price per share. Some Nasdaq stocks began a slow recovery, and at year's end advancers led decliners 2,690 to 2,450, with 32 unchanged. The most active shares traded on the Nasdaq were all high-tech companies—Cisco, Intel, Sun Microsystems, Oracle, Microsoft, JDS Uniphase, and Dell Computer.

      The Nasdaq completed its decimalization on April 9. The SEC reported that bid-ask spreads had been reduced by 50%. The Nasdaq temporarily loosened its continued listing requirements to accommodate stocks hit by the market drop in the week following the September 11 attacks. The $1 minimum bid and public float requirements were suspended until Jan. 2, 2002.

      The Amex composite reached a yearlong high of 958.75 in mid-May and slid thereafter to close at 847.62, down 5.59% for the year. Advancers narrowly led decliners 550 to 539, and only 9 issues were unchanged. Surprisingly, the most actively traded issue was the Nasdaq 100.

      In 2001 the Chicago Mercantile Exchange for the first time became the largest futures exchange in the U.S., surpassing its annual trading record in August. This record volume was attributed to continuous interest-rate adjustments by the Fed and stock market uncertainty. In November the Chicago Board of Trade recorded the highest monthly trading volume in its history, at 30,009,125 contracts, reflecting a positive shift in market sentiment. Volume was up 10.3% on the year. On September 14 the New York Mercantile Exchange introduced its Internet-based version of NYMEX ACCESS, which led to heavier-than-normal volume.

      The Commodity Futures Trading Commission, which regulated the U.S. futures and options markets, issued a warning to the public to be wary of companies promising profits from commodity futures and options trading based on information relating to the September terrorist attacks.

      Electronic communications networks (ECNs)—computerized systems used to match buyers and sellers of securities without using the traditional trading venues—continued to grow in importance. During October the nine registered ECNs accounted for 34.5% of the reported share volume in Nasdaq trading, up from 26.8% a year earlier. In January the SEC approved Nasdaq's SuperMontage, a redesign of the market's stock-trading platform intended to provide a range of improvements, including better access to price information and simpler order executions in the Nasdaq market.

      It was a good year for bonds as investors avoided stocks. Bond prices rose for most of the year, falling only during the stock rallies in January, April, and May, before dropping sharply in November and December as stocks recovered. High bond returns coincided with the slowing of the economy. The Lehman Brothers U.S. Aggregate Bond Index showed a return of 3.03% in the first quarter, 0.56% in the second, and 4.61% in the third, well down from 2000 figures.

      The Fed's repeated rate cuts resulted in a steep yield curve for Treasuries. In December the spread, or difference, between 2-year Treasury notes and 30-year Treasury bonds was 2.3%. In October the U.S. Treasury announced that it would no longer issue its 30-year bond; this prompted an immediate 30-basis-point drop in yields. Many bond experts saw this discontinuation as an attempt to drive down long-term interest rates. The spread between the yields of high-yield corporate, or junk, bonds and 7-year Treasuries rose sharply, nearing 10%, a level last seen in 1990. This spread reflected concern over the risk of default among troubled firms, driven by several high-profile bankruptcies, notably Pacific Gas & Electric, which was caught up in California's energy crisis, and Enron. The high-profile bankruptcy of energy trader Enron was the largest in U.S. history.

      Cantor Fitzgerald, the dominant broker in the U.S. Treasury market, lost more than 600 employees in the World Trade Center attack. By late October Cantor had rebuilt its business by distributing its price data through several alternative sources and had made a complete shift to electronic brokering through its eSpeed unit.

      In 2001 the SEC cracked down on accounting fraud, investigating between 240 and 260 cases. The first antifraud injunction against a Big Five accounting firm in more than 20 years was entered against Arthur Andersen, which agreed to a settlement of $7 million, the largest civil penalty ever imposed on a major accounting firm. In June the SEC issued an alert to investors, urging them not to rely solely on analyst recommendations. The SEC reported widespread conflicts of interest among analysts who covered stocks underwritten by their firms or those they personally owned.

      The fortunes of traditional blue-chip stocks were mixed. Philip Morris gained 4.2% and Procter and Gamble 0.9%, while General Motors lost 4.6% and Minnesota Mining & Manufacturing lost 1.9%. Media giant Disney lost 28.4%, and pharmaceutical company Merck & Co. lost 37.2%.

      In November, after more than three years of litigation, the Microsoft Corp. reached a settlement with the Department of Justice and 9 of the 18 states that had joined the suit. This settlement was widely seen as a victory for Microsoft, despite the fact that the nine other states had refused to sign on. The software giant's stock ended the year up by about 53%. Personal computer manufacturer Dell was up some 55%, and technology blue chip IBM rose by roughly 42% on the year.

      At year's end 8 of the 10 stock sectors tracked by Dow Jones were down on the year, with only consumer cyclicals (+0.18) and noncyclicals (+1.12) in positive territory. The best-performing individual industries were consumer services (+57.12%), office equipment (+50.38%), toys (+38.89%), and water utilities (+37.07%), while the worst were gas utilities (−71.60%), communications technology (−56.58%), advanced industrial equipment (−46.85%), nonferrous metals (−39.85%), and airlines (−34.13%).

      Profits and payrolls at many brokerage firms tumbled. Discount broker Charles Schwab reduced its staff by 17% through the third quarter of 2001 as its new assets fell from $31 billion in the first quarter to $11 billion in the second and $18 billion in the third. Merrill Lynch, the largest full-service broker, saw new assets drop from $35 billion in the first quarter of 2001 to only $5 billion in the second and $13 billion in the third.

Canada.

       Selected Major World Stock Market Indexes, TableThe Canadian stock market declined considerably in 2001. The primary measure of the Canadian market, the Toronto Stock Exchange (TSE) 300, fell by 13.94% over the year. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes, Table).) The Dow Jones Global Index for Canada fell by about 20% in U.S. dollar terms.

      Through October the TSE reported average daily trading of 147.3 million shares, 11.4% lower than the same period in the previous year, and dollar volume of $2.9 billion, 23.7% lower than the same period of 2000. A total of 1,322 companies were listed on the exchange, down from 1,430. IPOs were roughly steady at 42, compared with 43 for the same period of 2000.

      Nortel Networks, the largest TSE stock by market capitalization, lost more than 75% of its value on the year and closed at Can$11.90 (Can$1 = about U.S. $0.63) from its yearly high of Can$61.10. The next largest, Thomson Corp., lost 16% of its value and ended the year at Can$48.35, down from a high of Can$57.85. Canada 3000, the country's second biggest airline, filed for and received bankruptcy protection in early November.

      The Canadian economy shrank by 0.2% in the third quarter, the first contraction in almost a decade, and recession was considered likely. The U.S. recession had its impact on Canada's exports as sales to other countries decreased 9.8% through November. Imports fell 9.3%, dropping the trade balance by 13.2%. The Canadian unemployment rate was 7.5% in November, the highest since mid-1999.

      The two-year-old Canadian Venture Stock Exchange (CDNX) was up 8.7% through December 7, though it was down 11.1% from its peak of June 8. On December 10 the main CDNX index was replaced by the new S&P/CDNX Composite index, introduced as a broad indicator of the venture capital market in Canada. Through September 113 IPOs were completed on the CDNX, up from 101 in the same period of 2000. Average market capitalization was down to $3,820,000 on September 30, from $5,740,000 at the end of the previous year. The TSE and CDNX merged on August 1, but the exchanges continued to operate separately under joint ownership.

      The terrorist attacks in the U.S. on September 11 caused a 294-point drop in the TSE 300, and trading was halted. The exchange reopened on September 13, but interlisted American companies were not traded until September 17, the day the major U.S. markets reopened.

      On November 14 the Securities Industry Committee on Analyst Standards issued a report recommending that securities firms require their analysts to disclose conflicts of interest and prohibit certain activities.

      Foreign investment in Canadian shares plummeted. Through July foreign investors made net investments of only $3.8 billion in Canadian stocks, compared with $36 billion in the same period of the previous year. Canadians made net withdrawals of $26.8 billion from foreign stock markets, continuing the trend from the previous year. The Canadian brokerage industry reported an operating profit of $1.4 billion through July, 31% below the same period of the previous year. Mergers and acquisitions totaled $71 billion in the first six months, less than half the $149 billion of the same period of 2000.

      The Canadian central bank, the Bank of Canada, followed the Fed for much of the year and reduced its overnight interest rate nine times, from 5.75% to 2.25%.

Beth Kobliner

Western Europe.

      Early in the year most investors judged the European Union to be the only relatively safe place for their money as problems mounted in Japan and in the United States. Yet as early as March—and despite the confidence of many in the region that the euro zone would continue to grow—European equity funds suffered their first overall outflows in six years. Investors sold two billion in fund holdings. By year's end many more were disappointed.

  Selected Major World Stock Market Indexes, TableEurope's main stock markets approached the winter holiday season firmly in negative territory. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes, Table).) Most had lost around a quarter of their value, with the German Xetra DAX down 25%, France's CAC 40 down 27.4%, and Italy down 28.6% (all in U.S. dollar terms). The U.K.'s FTSE 100 fared a little better, recording a sterling loss of 17.7%, (20.4% in dollars). (For the FTSE Industrial Ordinary Share Index since 1978, see Graph—>.) Dollar investors who lost least were those invested in the constituents of Spain's Madrid Stock Exchange, down 8.9% late in the year. The newest entrant to the euro zone, Greece, continued to perform poorly. Early in the year a 3.7% drop in the level of the Athens index dashed hopes that investors would pile in when interest rates fell to euro-zone levels. Within a month of the country's May 31 upgrading by the MSCI index series from an emerging to a developed market, investors fled, sending the market down by 12%. Emerging market investment funds reportedly had pulled out an estimated $1 billion.

      Markets had reacted positively to the surge in U.S. markets that followed the surprise New Year's cut in the federal funds interest rate by the Fed. The European Central Bank (ECB) left interest rates unchanged in January, concerned that inflation was above the bank's target ceiling of 2%, and through the year the continued reluctance of the ECB to cut rates made investors increasingly nervous.

      By midyear short-term prospects had deteriorated further with a spike in oil prices. Manufacturing activity declined as big exporting companies in Germany, France, Italy, and Spain faced slowing demand from the U.S. and Japan. Industrial production fell sharply in the second quarter, down 1.4% in July alone. Europe's slowdown was exacerbated by the effects of the sharp tightening of monetary policy by the ECB between the end of 1999 and October 2000, weakening retail sales. Inflation, however, rose well above the central bank's 2% target to 2.9%, again choking off any likelihood of rate cuts.

      In June additional signs of global weakness disappointed investors awaiting a second-quarter revival. Little progress could be made in markets dominated by concerns over corporate weakness and the ECB's failure to deliver rate cuts as expected. It was August before the bank made a quarter-point base-rate cut to 4.25%. By contrast the Fed had, between January and June, cut its rate by 2.5 percentage points. In November the U.S. rate was 2%, compared with the euro-zone rate of 3.25%. Profit warnings, especially from Finnish mobile phone company Nokia, sent the Helsinki exchange down 16.7% in June and undermined the position of other technology stocks, especially when U.S. high-tech companies also reduced their profit forecasts. (Nokia's huge impact on the Finnish economy was clear, as Finland's stock market fared the worst of all major European bourses at year's end.) Pessimism was deepened by falling demand for factory goods, inducing greater declines in activity in Europe and the U.S. Amid anxiety over the slowdown in the U.S. and Japan and another spike in oil prices, euro-zone GDP growth dropped to 2.5%, against 2.9% achieved in the last quarter of 2000.

      As the summer wore on, European investors' sentiment increasingly matched that of U.S. investors as prospects for euro-zone growth deteriorated. They were concerned about the continued weakness of the euro and the ECB's resistance to calls for rate cuts. Manufacturing activity declined more than expected, and unemployment rose sharply. Germany's influential Ifo Business Climate Index fell to a five-year low, and the U.K. manufacturing sector entered recession, output having fallen for a second successive quarter.

      Although the European Commission's forecasters expected euro-zone growth to turn negative in the fourth quarter of the year, they remained confident that the area would escape technical recession (i.e., contraction for a second consecutive quarter).

Other Countries.

       Selected Major World Stock Market Indexes, TableWhile all eyes were on the United States, most of Asia became engulfed by a deeper and possibly more dangerous downturn. In Japan, which set the pattern for the region, the recession continued unabated, and the market was volatile. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes, Table).) The fall in the yen and tumbling share prices raised fears of a credit crisis. The level of prices had fallen in five of the past six years and was forecast to fall further. As the year began, Japan's retail sales slumped 0.9% year-on-year as household spending fell and retail sales were down for a fourth successive year. Unemployment hit 5% at the end of November, outstripping a post-World War II record high of 4.9%, and ended the year at an estimated 5.4%. Consumer prices had registered their steepest drop in 30 years during 2000, and by January 2001 foreign investors were deserting the market in droves, forcing share prices down.

      Nevertheless, the Japanese market enjoyed a brief respite in January 2001 when the unexpected rate cut by the U.S. Fed lifted sentiment. Soon after, equity markets sank, weighed down by reports of weak corporate earnings. The election of a new Japanese prime minister on April 24 triggered a 6% rise in the Topix index, but again this was short lived. In July the market fell when the Tankan survey showed a further weakening of the economy, only to rise again in August on news that the Bank of Japan would boost the money supply. It reverted to a downward trend when it became clear that the earnings of Japan's healthiest companies were set to decline.

      The contraction of Singapore's and Taiwan's economies—5.6% and 4.2% of GDP, respectively—was unprecedented. By the end of November, output was stagnating in Malaysia, Hong Kong, and Thailand, and export growth was slowing sharply in China, although domestic demand was helping to sustain output. Despite this, a lack of confidence in the global economy pushed the China market down by more than 20%.

      Commentators again feared for Asia's financial stability. Recession in the region, brought on especially by dependence on American information-technology production, was worsened by the continued fragility of banking systems in many countries. An estimated one-fifth of loans in East Asia were nonperforming, which reduced credit available and undermined the positive effect of interest-rate cuts. Their situation seemed uncomfortably similar to Japan's, presenting the same signs of deflation: excess capacity, corporate debt, falling prices, malfunctioning banks, resistance to structural change, and high government borrowing. Indonesia, the Philippines, and Thailand all carried debts equivalent to 65% of GDP or more. Hong Kong's prices had been falling for three years. The output gap (the difference between actual and potential GDP) was at its widest since the 1930s, levels that could swell real debt to cause bankruptcies and bank failures.

      In other emerging markets the situation worsened as tech-stock valuations fell in mature markets. In Malaysia the market fell by 18.5% between January and June because of political as well as economic anxieties, but it later staged a strong recovery. Investors' sentiment toward emerging markets was further affected by a financial crisis in Turkey, which, because of funding difficulties with a local bank and political difficulties, in February was forced to devalue the lira. Continuing weakness in the banking sector, a spiraling inflation rate (67% in November), and falling GDP exacerbated the financial crisis and pushed the Turkish market down 31% over the year.

      Argentina was the focus of attention in South American markets. Early in the year the U.S. interest-rate cuts briefly lifted investor confidence, but on July 10 the failure of an Argentine government bond auction precipitated another financial crisis. In September the International Monetary Fund agreed to increase its loan to $22 billion. In November, however, the Argentine government announced that it would restructure its debts through exchanging loans, which involved both local and international investors. The proposal was seen by many as debt default, and the country quickly moved into a deeper crisis, with the markets ending down 29% in dollar terms. The problem in Argentina had a contagious effect on Brazil, which was already suffering an energy crisis. The Brazilian currency depreciated 28% in the first 10 months of the year, and although it recovered slightly, the Brazilian stock market ended the year down almost 24% in dollar terms.

      According to the investment bank Morgan Stanley Dean Witter, the risk of global deflation was higher at the end of 2001 than at any time in the previous 70 years. Yet in the final quarter of 2001, there was consensus among professional investors in global equities that the “bear” market had hit bottom on September 21. The attacks on September 11, they judged, might have helped to resolve more quickly the problem of past overinvesting by prompting faster rate cuts and reducing capacity in the travel and leisure sectors.

Commodity Prices.

      Commodity prices were expected to weaken generally as global growth slowed. Amid the general gloom, however, there were a few winners. Cocoa prices rose during October and November by around 30% to reach a three-year high. The market expected production to fall by around 200,000 metric tons over the year to September 2002, mainly because of disease and poor farm maintenance in Côte d'Ivoire, the chief producer. Another more marginal winner was gold. Even before September 11, sentiment for the yellow metal was positive. As the year drew to a close, it had regained some of its attraction as a store of value to reach a price of more than $278 an ounce, a three-year high. Demand had eroded over the previous few years to make a high level of precautionary investment necessary to offset that erosion.

      The prices of other metals had fallen steadily despite lower levels of stock, which indicated low expectation of demand. Aluminum fell 11% between April and August and was expected to slide further in the short term. Copper, however, which followed a similar pattern, was always the metal to watch. Traditionally, copper was the first metal to recover from a stock market correction, as the liquidity that results when investors cash in their stock market holdings usually lifts construction activity. (Historically, the price of copper shows a statistical feature known as an “absorbing state.” When the price reaches a certain level, it tends to remain there until an unexpected event jars it and sends back to its long-term average price of around 91 cents a pound. Absorbing states arise from the tendency of each phase of the economic cycle to linger.) Copper entered an absorbing state in July 2001 at below 70 cents a pound and ended the year at 67 cents; analysts were not expecting an early “breakout.”

      The price of oil had been highly volatile, and the outlook remained deeply uncertain by the end of the year. In 2000 production cuts, low stocks, and high demand driven by global growth had pushed prices well above the target price range of $22–$28 dollars a barrel set by OPEC. By the third quarter of 2001, demand from the U.S., the world's biggest oil consumer, was 300,000 bbl a day lower than in the third quarter of 2000. The slowdown and the need to sell oil caused producers outside OPEC to be less inclined to cooperate in cutting production, and it was thought that their need to keep up production and sales could keep prices, which ended 2001 below $20 a barrel, depressed. Any extension of the war in Afghanistan, though, could cause interruptions to supply that would force prices up in 2002.

IEIS

Banking

      The September 11 attacks in the United States and the resulting international efforts to cut off the source of terrorist funding gave rise to sweeping new legislative and other measures that brought the global banking and financial services industry to the front lines of the war on terrorism in 2001.

      On October 26, U.S. Pres. George W. Bush signed into law the U.S.A. Patriot Act, which granted the government broad new investigative and surveillance powers and provided for a significant expansion of anti-money-laundering requirements applicable to banks and other financial institutions. The U.S. measures were part of an intensive global campaign against terrorist-funding sources. International groups such as the Financial Action Task Force (FATF), the anti-money-laundering arm of the Organisation for Economic Co-operation and Development, were deeply involved in the global war against terrorism.

      Even before the September 11 attacks, actions had been taken or were under consideration in a number of countries to combat money laundering. Particularly notable were the actions taken by countries identified in the June 2000 report by the FATF as jurisdictions where existing measures to combat money laundering were deemed to be inadequate. The Cayman Islands and Panama instituted a number of remedial actions in response to the FATF report, and in June 2001 they were removed from the FATF list. Israel for the first time enacted an anti-money-laundering law, an action recognized by the FATF as “welcome” progress.

      In other places, including Bermuda and Luxembourg, legislation was enacted expanding the coverage of anti-money-laundering laws. The European Union (EU) had under consideration revisions to its 1991 directive in order to expand its scope. Actions to enhance the effectiveness of reporting on suspicious activity were instituted in Argentina and Canada. Italy adopted guidelines (commonly known as the “Ten Commandments”) that provided for significant enhancements to anti-money-laundering practices.

      There were also widespread efforts in 2001 to adapt existing laws and regulatory structures to the requirements of an increasingly globalized and integrated financial system. A number of countries continued to grapple with the problem of how to modernize their financial services laws to permit their domestic institutions to meet the challenges presented by advances in information and communications technology that make possible the delivery of a broad array of financial services and intensify the competitive pressures on those institutions to provide their customers with banking, investment, insurance, and other financial services on an integrated basis. Canada passed Bill C-8, which revised the policy framework for its financial services sector and for the first time provided bank financial groups the option of organizing their business activities in Canada under a holding company structure. Equally significant changes were under way in Denmark, which passed the Act on Financial Undertakings unifying in a single legislative act provisions relating to banking, investment, insurance, and mortgage activities.

      Similarly, reform of domestic regulatory systems to enable them to meet the challenges presented by the formation of complex financial groups engaged in a diverse array of activities both at home and abroad was high on the legislative agenda in many countries. In Austria a Financial Market Supervisory Authority Bill was introduced. It would provide for the devolution of banking supervision from the Ministry of Finance while also creating a central supervisory authority for financial services. Germany had under consideration legislation that would significantly revise the financial supervisory system by combining the three supervisory offices for banking, insurance, and securities activities into a single organization. This Federal Agency for Financial Service and Financial Market Supervision would be affiliated with the German Ministry of Finance.

      Ireland contemplated legislation that would provide for a new structure for the regulation of financial services. It proposed that the Central Bank of Ireland be restructured and called the Central Bank of Ireland and Financial Services Authority, which would consist of two functional divisions, one responsible for prudential regulation of all financial services (the Irish Financial Services Regulatory Authority) and the other charged with the management of external reserves and the country's participation in the European System of Central Banks (the Irish Monetary Authority). Portugal adopted legislation creating a National Council of Financial Supervisors to promote coordination between the three existing financial supervisors responsible for oversight of the banking, securities, and insurance industries.

      Reviews of existing regulatory and supervisory relationships were under way in other countries. In Finland the government assigned a special advisory body the task of preparing a proposal on how to integrate insurance companies into the financial markets' supervisory structure. South Africa continued to debate whether to follow the route taken by Australia and the U.K. and establish a single financial regulator outside the central bank, while in Switzerland debate centred on a recommendation that the Swiss Federal Banking Commission and the Federal Office of Private Insurance be melded into a single integrated financial-market supervisory authority.

      The global trend clearly continued to be in the direction of some form of consolidated oversight, but there was as yet no international consensus in 2001 on what kind of governmental authority should exercise this responsibility.

      Another important development in 2001 was the pending transition to the euro in the 12 euro-zone countries and the ultimate disappearance of their local currencies in favour of euro banknotes and coins as legal tender for cash transactions. This was scheduled to occur on Jan. 1, 2002, and extensive efforts were under way to ensure that the changeover occurred with minimal disruption. The possible shortage of euro cash in the first weeks of 2002 and the logistic and security challenges of moving euro and legacy currencies at the end of the transition phase were the two major concerns of this gigantic project. In some countries special security arrangements were instituted to protect the new euro banknotes and coins as they were shipped to banks for distribution.

      There was also extensive debate surrounding the changes to the Basel Capital Accord proposed in January 2001 by the Basel Committee on Banking Supervision. Key issues in these debates included the use of an “internal ratings-based approach” to setting risk-based capital standards and whether (and how) to incorporate measurements of operational risk into the standards. Another important issue was the role of home and host country authorities in the supervisory review process contemplated under Pillar 2 of the proposal as well as in connection with the application of disclosure standards contemplated under the market discipline principles set forth in Pillar 3.

      Deposit insurance schemes were introduced or strengthened in several countries, including Luxembourg, South Africa, and Turkey, while in South Korea deposit insurance coverage was reduced. In the U.S., reform of deposit insurance coverage was the subject of heightened scrutiny by Congress, which considered several proposals to raise coverage limits as well as premium payments. This issue drew public attention in late July when the U.S. Federal Deposit Insurance Corp. seized Illinois-based Superior Bank FSB in a bailout that analysts suggested could cost as much as $500 million. Important revisions to bank-liquidation procedures, including enhancements to depositor protection, also were under consideration in Switzerland.

      A number of countries, including India, Pakistan, and Panama, implemented changes to enhance their banks' practices regarding classification of assets and loan loss provisions. In this connection an initiative was undertaken in Spain, where an “insolvency statistical coverage fund” was created. The idea behind the fund was to accumulate additional resources during healthy economic periods to be used in the worst periods of the cycle.

      Corporate governance issues also received increasing attention in several jurisdictions, notably Singapore, where a Corporate Governance Code was introduced, and Germany, where consideration was given to a Corporate Governance “Best Practices” Code.

      In addition, there were extensive efforts to adapt legal and regulatory systems to the changing world of electronic banking and commerce. Luxembourg adopted a law on electronic commerce, and several countries, including Belgium, Italy, and Sweden, adopted measures to establish the legal framework for electronic signatures. Germany and Singapore undertook efforts to promote Internet payment systems and virtual banking. Legislation on electronic funds transfers (EFT) was adopted in Belgium, while Australia adopted an EFT Code of Conduct.

       World's 25 Largest BanksPrivatization of banks continued in a number of countries, including the Czech Republic and Romania. Pressures for cross-industry consolidation resulted in several large mergers. In Germany Allianz AG took control of Dresdner Bank in a $21 billion deal that created the world's sixth largest financial services institution. (See Table (World's 25 Largest Banks).) Kookmin Bank and Housing & Commercial Bank combined under the Kookmin name to create South Korea's largest commercial bank, with some $121 billion in assets. In the U.S. two North Carolina-based institutions, First Union and Wachovia, joined forces to create the nation's fourth largest bank holding company, with assets estimated at $322 billion.

      Cross-border merger activity also continued, as witnessed by the ongoing integration occurring within the Nordic region. BNP Paribas of France increased its presence in the U.S. market by purchasing 55% of BancWest in early 2001 and then acquiring United California Bank from UFJ Holding of Japan in a $2.4 billion buyout. Several countries, notably Israel and Poland, took measures to promote an expanded foreign bank presence in their domestic markets, while in Japan such actions focused on the rescue of failed institutions. Japan was also notable in that it permitted nonfinancial enterprises to establish commercial banking operations. At year's end the regional Ishikawa Bank became the first middle-level Japanese bank to file for bankruptcy since 1999.

      A number of countries, including Austria, Belgium, Denmark, Germany, Latvia, Luxembourg, and Singapore, undertook measures to improve the operation of stock exchanges and the financial soundness of securities firms and to enhance the regulation of financial institutions' securities and derivatives activities. The EU was engaged in an informative discussion of the ongoing efforts to develop a new regulatory structure for the EU securities markets.

Lawrence R. Uhlick

Business Overview

      It was a new, unstable era in 2001. Any hopes that the boom years of the 1990s would extend into the next decade ended for good after the September 11 terrorist attacks that destroyed the World Trade Center, launched the United States into war, and sent the business world into chaos.

      The U.S. economy was skirting the edge of recession before the attacks; afterward it tumbled. Already-suffering industry sectors begged for government bailouts, and what had been known as the “new economy” of technology companies and Internet-based start-ups—the stars of the 1990s boom—fell further into disrepair. (See Computers and Information Systems .)

      The stock market had been deflating in value throughout the year, equally reducing valuations of traditional companies such as the ExxonMobil Corp. and new economy titans such as Yahoo! Inc. By year's end all signs of a recession were in place. Real gross domestic product (GDP) growth in the U.S. fell at a 0.4% annual rate in third-quarter 2001, the biggest drop since the 1991 first quarter, and real GDP was expected to fall by 1% in the fourth quarter, compared with an annual growth rate of 5% for full-year 2000. The Consumer Confidence Index hit 85.5 in October, its lowest standing in seven years, and during the same month, manufacturing activity fell to its lowest level since February 1991.

      For many industries the havoc caused by the terrorist attacks was more toxic than a typical recession. The worst affected were those sectors connected to travel, in particular the airlines, which were rattled to the point of near collapse. Analysts expected the U.S. airline industry to have an after-tax loss of $5.6 billion in 2001.

      The airlines already had been in fragile financial health for most of 2001—the result of years of price wars and rising fuel costs. The U.S. government's freeze on air travel for two days in September, combined with the public's overall fear of flying in the weeks after the hijackings, pushed many airlines to the brink of bankruptcy. U.S. airlines lobbied for a government bailout to help compensate for the loss of revenues and ultimately came away with a $15 billion package that, while enormous, still was not enough to prevent most leading airlines from posting severe losses. Almost all the major U.S. and foreign airlines cut staff by the thousands and slowed production drastically in the last few months of 2001. AMR Corp., which had completed a takeover of Trans World Airlines in April, reduced its flight schedule by 20% and its staff by 15%, suffering a $414 million loss in the third quarter alone. UAL Corp., which had seen the proposed merger between its United Air Lines unit and the US Airways Group nixed by the Federal Trade Commission in the summer, was in worse shape. The airline suffered a colossal $1.16 billion loss in third-quarter 2001, reduced its flights by around 30%, and laid off 20,000 workers. In mid-October, UAL Chairman James Goodwin warned that the airline could “perish” in the next year; soon afterward he was forced to resign and was replaced by UAL board member John W. Creighton.

      European airlines, faced with the economic downturn and a drop in passenger traffic to North America, also registered massive losses. In early October Swissair briefly grounded all flights as it sought an infusion of cash. Sabena, jointly owned by Swissair and the Belgian government, was formally declared bankrupt in November. Out of the ashes of Sabena, Belgian investors created a successor of sorts, former Sabena unit Delta Air Transport, which seemed likely to merge with Virgin Airlines in early 2002. Air France announced staff cuts and reorganization plans for troubled Air Afrique, which it had acquired in August after the 11 African countries that shared ownership relinquished control of the airline.

      Aircraft manufacturers were in equally rough shape. The Boeing Co., which moved its headquarters to Chicago in 2001, planned to cut up to 30,000 employees by the end of 2002 and slashed its airplane deliveries for 2001 to roughly 500, down from an expected 538. That total was anticipated to fall to about 350 deliveries in 2002. Boeing's chief rival, European manufacturer Airbus, announced plans to deliver 320 aircraft in 2001 but acknowledged that cutbacks by airlines would reduce future orders. On a positive note, the Anglo-French Concorde aircraft, grounded since a fatal accident in July 2000, officially returned to the air in November.

      Other industries linked to travel suffered as well. The lodging industry's profits for the year were expected to decline to between $18 billion and $20 billion, compared with 2000's record profit of $23.5 billion; revenue per available room was expected to fall by as much as 5% in 2001, the worst performance in 33 years. Industry occupancy rates were anticipated to fall to 60% of capacity, the lowest since the Persian Gulf War. The damage was such that some analysts predicted 6–10 hotel-chain bankruptcies by early 2002.

      In the American automotive sector, sales were weakened by a reduction in rental car usage as well as consumer wariness about making large purchases. After September 11 all of the Big Three auto manufacturers initiated layoffs and began reducing production. The Ford Motor Co. planned to reduce its output by 13%, or up to 120,000 units, and stop production at five North American assembly plants. Ford posted a $692 million loss in the third quarter, and its worldwide automotive revenues fell by 12.4% in the quarter. Ford's woes were compounded by the expenses incurred because of the Firestone tire recall in 2000 and what critics termed a costly acquisition spree. By year's end Ford Chairman Jacques Nasser had been ousted in favour of William Clay Ford, Jr., the great-grandson of company founder Henry Ford. The General Motors Corp., although it posted a loss for the third quarter of $368 million, seemed to be in better shape. Sales of GM pickup trucks and sports utility vehicles shot up by 10% in the otherwise grim month of September. On September 21 GM revealed an agreement to buy the bankrupt South Korean Daewoo Motor and its international subsidiaries. DaimlerChrysler AG, which saw net income fall by 69% in the third quarter, was shaking out its operations to improve productivity. The company planned to slash more than 2,700 jobs and close three plants to get its troubled Freightliner LLC truck subsidiary to profitability by 2003.

      As of September, 1,560,000 import cars had been sold year-to-date in the U.S., compared with 1,550,000 in the 2000 period. Imported light-vehicle sales rose to an estimated 2.2 million cars, compared with 2.1 million in 2000. It was good news for Japan's Nissan Motor Co., which said it would post $2.7 billion in profits for its fiscal year ending in March 2002. In November German carmaker BMW AG reported strong international sales and higher-than-expected revenue, with net profits (before taxes) up 63.3% for the first nine months of 2001.

      The overall market volatility also had an impact on the energy sector, which was coming off one of its best years in recent history. As many analysts had predicted, the spike in oil prices that had helped deliver record revenues to oil and gas companies in 2000 began to abate in mid-2001. Where oil had been in the $30-per-barrel range for much of 2000, prices cooled down to roughly $24 per barrel by August. With jet-fuel usage dramatically down in the third quarter owing to reduced flight loads, many oil players lost revenues.

      The oil market continued to tier into the ranks of global superpowers—The ExxonMobil Corp., The ChevronTexaco Corp., BP PLC (formerly BP Amoco), and the Royal Dutch/Shell Group—and lesser, regional players. Many of the latter went on acquisition binges to increase their meagre market shares. The Canadian oil and gas market was ripe for American companies looking for acquisitions, and some observers predicted that the Canadian energy market would no longer be independent by mid-2002. American energy players that bought Canadian energy companies included the Anadarko Petroleum Corp., the Duke Energy Corp., and Conoco Inc. There were signs that some companies had grown overextended during the energy boom of 1999–2000. The most prominent case was the fall of the Enron Corp. After a string of accounting irregularities came to light in late 2001, Enron's stock value collapsed to pennies per share as the company faced charges of massively defrauding its shareholders and formally declared bankruptcy in December. Controversy over ties between Pres. George W. Bush's administration and the ruined company was expected to be a major political issue in 2002.

      Heightened demand for electricity also fueled a rebirth in the coal industry, which grew at a rate of about 4.5%, more than double the average growth rate. Spot prices for western coal soared from $5 a ton to as much as $14 a ton. The Peabody Energy Corp., the largest coal company in the U.S., beat analyst expectations when it posted $4.1 million in net income for third-quarter 2001.

      The chemicals industry was hammered by continued high oil and gas prices and declines in business and consumer demand for plastics and other products. Earnings eroded across the board. Market leader E.I. DuPont de Nemours and Co. continued to struggle; total revenues fell by 11% in the first half of 2001. DuPont, which already had sold its oil subsidiary, Conoco, in 1999, pulled out of the pharmaceuticals sector by selling its pharmaceuticals subsidiary to the Bristol-Myers Squibb Co. for $7.8 billion. The Dow Chemical Co. started the year by completing a $10 billion acquisition of the Union Carbide Corp. but wound up posting severe declines in revenues and net income by year's end. A host of smaller chemical manufacturers had declining earnings, including the Cambrex Corp., the Crompton Corp., Cytec Industries Inc., the PolyOne Corp., and Praxair Technology, Inc.

      The textiles industry proved no safe haven either, as company revenues suffered from increased imports and depressed retail sales. U.S. worldwide exports of textiles and apparel fell by 6.5% as of August, while total apparel was down 16% and apparel imports were up by 2.4%. All the major American players were hurting. Burlington Industries, Inc., posted a $14.4 million loss for the nine months ended June 30; Guilford Mills, Inc., had a $44.9 million net loss for the first half of 2001; and Galey & Lord, Inc.'s net income fell by 39% in the same period. The ailing companies were considered acquisition targets, and Warren Buffett's Berkshire Hathaway Inc. investment group snatched up the bankrupt Fruit of the Loom, Ltd., for $835 million in early November.

      Few sectors were as hard-pressed as the U.S. steel industry, which appeared to be on the verge of collapse throughout the year. When Bethlehem Steel Corp. filed for Chapter 11 bankruptcy protection in October, it was the 25th domestic steel company to have done so since 1998. Other steel companies filing for bankruptcy in 2001 included the Riverview Steel Corp., Edgewater Steel Ltd., GS Industries, Inc., the LTV Corp., and CSC Ltd. The industry was reeling with losses in 2001, recording a $1.4 billion loss in the third quarter alone. Steel manufacturers pointed to high energy costs and, most emphatically, extremely low import prices as the causes of their industry's troubles. The steel manufacturers that managed to avoid bankruptcy often took drastic measures to keep afloat. Top steelmaker USX Corp., which owned the U.S. Steel Group and the energy company Marathon Group, decided to separate the two companies to give them more flexibility to expand through acquisitions. U.S. Steel, which posted an $18 million net loss in third-quarter 2001, was spun off in October into a publicly traded company called the United States Steel Corp.

      The situation was dire for steel manufacturers by midyear—U.S. shipments fell 10% in the first eight months of 2001 to 68.1 million net tons, from 75.6 million net tons in the same period in 2000, and prices of U.S. hot- and cold-rolled sheet metal were down 17% and 16%, respectively, in August from the same period in 2000. The U.S. International Trade Commission (ITC), after an investigation into the market, planned to recommend that the government raise quotas and tariffs on imported steel slabs, hot- and cold-rolled steel sheets, hot-rolled bars, and other products. Steel importers began rallying to protest possible ITC actions. Pohang Iron and Steel Co. Ltd. of South Korea, the world's second largest steel manufacturer, said it would possibly appeal to the World Trade Organization if new tariffs appeared excessive. Steel-mill imports to the U.S. had declined by 28% in 2001, as of August. The merger of three European companies—Usinor of France, Aceralia of Spain, and Luxembourg's Arbed—was announced in February. The deal, which was expected to be approved, would create the world's largest steel group.

      Other metals industries were also on the decline. In aluminum, year-to-date shipments as of August were down 14.4%, in part because of the slowdown in automobile production. American exports of aluminum ingot and mill products were 725.8 million kg (1.6 billion lb) year-to-date as of August, down from 861.8 million kg (1.9 billion lb) in the same period in 2000, while imports were down 11.7% for the year. The leading worldwide aluminum producer, Alcoa Inc., remained strong, however, with revenues of $17.7 billion for the first three quarters, up from $16.4 billion in the comparable 2000 period. The company's health was in part due to an intensive cost-cutting initiative designed to offset falling demand. In November Alcoa reported that it was buying an 8% stake in China's largest aluminum producer.

      Gold demand held up fairly well against signs of a growing worldwide economic slowdown. After a 17-month low of about $260 per ounce in February, gold prices rebounded to the $270–$290-per-ounce range for much of the year, and prices shot up after September 11, as investors poured into the market for security. Top worldwide gold producer AngloGold Ltd., based in Johannesburg, S.Af., bought Normandy Mining Ltd. of Australia for $2.3 billion in September. This followed an earlier $2.3 billion merger of Canada's Barrick Gold Corp. and its American rival, the Homestake Mining Co., which had created the world's second largest gold producer. Analysts approved of the mergers, hoping that less competition and production would improve the market's overall health.

      The forest-products industry foundered owing to overall industry volatility, declining prices, and collapsing markets. The U.S. imposed higher duties on Canadian softwood lumber, which it claimed had been dumped on the American market at artificially low prices. (See Canada. (Canada )) In 2000 there had been a divide between rising pulp prices and falling lumber prices, which provided many manufacturers with steady earnings, but in 2001 all paper markets suffered. Prices for northern bleached softwood kraft—the benchmark grade of pulp—declined throughout 2001, to about $464 per ton in October from $710 per ton at the start of the year. Bleached hardwood kraft pulp prices also declined to $418 per ton in late October from $703 per ton in early January. The lumber market bottomed out at a 10-year low of $180 per 1,000 bd ft in early 2001 and hovered weakly around $250 per 1,000 bd ft for much of the year.

      The result was predictable, as top paper manufacturers such as the Weyerhaeuser Co. and Bowater Inc. reported serious declines in business for the year. Weyerhaeuser reported a 54% drop in quarterly profits in third-quarter 2001, and its net earnings were $369 million for the first nine months of 2001, compared with $646 million in the same period in 2000. The International Paper Co. posted a $632 million net loss for the first nine months of 2001, and the Georgia-Pacific Corp. had a $289 million loss from continuing operations in the same period.

      Home building had enough ballast from yearlong low mortgage rates to withstand a declining economy. Total new houses sold were 8.1 million through September, up slightly from the 8 million in the same period in 2000. Total construction starts for 2001 were estimated to be worth $481.4 billion. Commercial space construction, however, was expected to fall by 16% in 2001 and by 9% in 2002, with the steepest declines hailing from the industries most afflicted by the September 11 attacks, including hotels and office spaces. The weaker economy also caused banks, which had seen their earnings erode in 2001, to be more stringent with funds for commercial development, and this caused some projects to be delayed or canceled. Other sectors were expected to improve, including public-works projects, health care facilities, and multifamily housing.

      The only sectors that seemed relatively immune from the storm were those tied to industries providing products that promised relief or solace from the turbulence. The tobacco industry was healthy overall, in good part owing to rising product prices. Top manufacturers such as R.J. Reynolds Tobacco Holdings, Inc., had net sales rise 7% to $6,490,000,000 and net income from continuing operations spike up 16% to $355,000,000 for the first nine months of 2001.

      The pharmaceutical industry was resilient for much of the year, and top players were thriving. Market leader Pfizer Inc. had a 153% increase in net income for the first nine months of 2001, driven by worldwide sales increases for its key products, including a 13% increase for Viagra and a 37% increase for Lipitor, its cholesterol-reducing drug that in 2001 became the largest-selling pharmaceutical in the world. Heightened competition between generic and patent drug manufacturers threatened to erode revenues for top pharmaceuticals. About $50 billion in drug patents were scheduled to expire in the next five years, and already generic players were profiting at the expense of patent manufacturers. Barr Laboratories, Inc.'s generic knockoff of Eli Lilly and Co.'s Prozac had been a strong success; Eli Lilly lost about 80% of its market share in the drug once Barr's generic reached the shelves.

      Drug companies, faced with criticism of high drug prices and the threat of competition from cheaper generics, reached agreements to provide drugs to combat AIDS in several less-developed countries at a fraction of the Western prices, but demands for cheaper drugs continued. When mailborne anthrax hit newsrooms and government offices in September and October, the German pharmaceutical company Bayer AG faced intense pressure from the U.S. government to either reduce the price of its antibiotic Cipro or face the loss of its patent. Waiting in the wings with their generic versions of Cipro were manufacturers, including Barr, that offered their products free or at a steep discount to the government for its stockpiles. While Bayer managed to hold onto its patent by agreeing to reduce Cipro prices, the continuing threat of chemical and biological war ensured that the rivalry between generics and patent drug manufacturers had taken on new, unknowable connotations.

Christopher O'Leary

▪ 2001

Introduction

Overview

      The year 2000 got off to a good start and ended on a positive note. Overall, the world economy experienced its fastest growth for more than a decade, and the prospects were for only a modest slowdown in 2001. (For changes in Real Gross Domestic Products of Selected OECD Countries, see Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) As the year began, widespread predictions of disruption or even chaos being caused by Y2K problems, or the “Millennium Bug,” proved ill-founded. In the first few months of 2000, it was evident that the economic momentum, largely driven by American consumer demand, was building up. In much of the world, including the U.S., the growth rate had peaked by midyear, after which there was a slowdown. (For Standardized Unemployment Rates in Selected Developed Countries, see Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

 The International Monetary Fund (IMF) projected that real output would rise 4.7% in the year 2000, compared with an actual increase of 3.4% in 1999. The rate was by far the fastest since 1988 (4.6%) and took place against a background of volatile oil and stock markets. Despite inflationary pressures in some parts of the world, consumer prices were kept under control, helped by tight monetary policies. Consumer prices in the transition countries rose by 18.3%, well down from the 43.8% rate in 1999. In the economically advanced countries, consumer prices rose a modest 2.3%, up from 1.4% in 1999, when there were fears of deflation. (For changes in the Inflation Rate of selected developed countries, see Graph I—>.) These fears were realized in Japan, where there was a fractional fall. Inflation in less-developed countries (LDCs) moderated slightly to an average 6.2%, which was inflated by more excessive rates in a few countries. (For Changes in Consumer Prices in Less-Developed Countries, see Table IV (Changes in Consumer Prices in Less-Developed Countries, Table ).)

      As usual, growth in the LDCs was faster (5.6%) than in the advanced countries (4.2%). Although the difference between the two rates widened from 1999 (0.6 percentage point), it was modest compared with the early 1990s. In those years the LDCs were expanding at between two and four times the rate of the advanced countries, a reflection of the dynamic expansion in many Asian economies. (For Changes in Output in Less-Developed Countries, see Table III (Changes in Output in Less-Developed Countries, Table ).)

  The U.S. continued to provide a strong market for world exports and output growth, as it had done since the Asian financial crisis began in July 1997. (For changes in Industrial Production of selected developed countries, see Graph II—>.) In 2000, however, there was also buoyant demand from Europe and the transition countries. Japan's modest recovery, too, made a contribution. The slowdown in the U.S. economy was a growing cause of concern. The country had been spending beyond its capacity and means. To meet the shortfall, it was relying on credit and a huge flow of imports. Despite the slowdown, there were no signs of an easing in the burgeoning U.S. current-account deficit, which ended the year at around $450 billion, well above that of the year before. In November, imports unexpectedly rose sharply, which caused a record one-month deficit of $34 billion. The fear was that a sudden change in sentiment, such as one that might be prompted by a further escalation of oil prices, would cause a hard landing with a sharp slowdown in inflows of foreign direct investment (FDI) and foreign share buying with turbulence in world financial markets. The close and contested finish to the U.S. presidential election was not perceived as threatening a negative effect in the coming year. Any fiscal stimulus carried little risk of the economy's overheating. Given a parallel weakening in the euro-zone economies, the dollar was not expected to fall dramatically. (For changes in the Exchange Rates of Major Currencies to the U.S. dollar, see Graph V—>.)

      An increasing influence on international production was FDI. The strong desire of many nations and companies to participate in and benefit from globalization was reflected in changes in the regulatory environments of most countries to smooth the path for foreign investors. In 1999, of the 140 regulatory changes in investment conditions made by 60 countries, only 9 were less favourable to FDI. Global FDI outflows were expected to exceed $1 trillion in 2000, 20% more than in 1999. The number of transnational companies rose to 63,000, with 690,000 foreign affiliates whose sales, at $14 billion, were nearly twice global exports. The number of workers employed by affiliates was growing rapidly and by the year 2000 had reached 41 million.

      Cross-border mergers and acquisitions (M&As) continued to account for a high proportion of FDI, reaching $720 billion in 1999. Most of these were acquisitions between firms in the same industry. Where a corporate objective was to build a strong position in a new market, it was often considered quicker and simpler to buy an established company and with it acquire instant local knowledge and contacts. Because these deals involved a transfer of ownership and assets into foreign hands, however, acquisitions were often the targets for local opposition from nationalistic groups and the press, whether in advanced or less-developed countries. The alternative to an M&A was to set up a new operation in a little-known location, which might take too long in the current highly competitive environment. In the manufacturing sector, the focus of most worldwide M&A activity was automobiles, pharmaceuticals and chemicals, and food, beverages, and tobacco. In these industries economies of scale could be achieved and synergies exploited. There also were numerous cross-border bank mergers. (See Banking (Economic Affairs ).)

      Most acquisitions continued to be in the advanced countries, although the share of M&A activity in the LDCs was steadily rising. The U.S. was the most attractive single FDI destination, and in 1999 acquisitions in the U.S. by foreign investors reached $233 billion. In the European Union (EU) the rate of takeover activity accelerated to $344 billion, much of it intra-European deals driven by the introduction of the euro in January 1999. Latin America, mainly attracted by privatizations in Argentina and Brazil, led activity in LDCs. Asian firms, notably those in Singapore, were actively buying companies in the less-developed world. While still recovering from the earlier financial crisis, South Korea saw foreign acquisitions that exceeded $9 billion in 1999. In Central and Eastern Europe, where cross-border sales reached $10 billion, Poland, the Czech Republic, and Hungary were the main locations for M&A activity because of their many privatizations. The largest buyers of foreign enterprises were from the U.K., followed by Germany and France.

National Economic Policies

      The IMF projected a rise in gross domestic product (GDP) of the advanced economies—which included the industrialized countries, the 11 EU members that made up the euro zone, and the newly industrializing countries (NICs) such as South Korea, Taiwan, and Singapore—of 4.2%, compared with an actual outturn of 3.2% in 1999.

United States.

 The U.S. proved once again to be the dynamo for world growth, with output projected to increase 5.2%. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) This was the fastest rate among the industrialized countries and reflected an acceleration from 4.2% in 1999. The country was experiencing its longest period of continuing growth on record—the expansion had begun in 199l. Much of the strength of the U.S. performance could be attributed to the flexibility of American labour and product markets. (For Industrial Production, seeGraph II—>.) Over the years, labour productivity had been increased by the strong inflow of investment. Much of this went into the adoption of new information and communications technology, which represented half of all nominal spending on equipment and software. This was giving the U.S. a competitive edge over markets and industries that were less flexible and capital intensive. The country's “new economy” was reflected in the continuing rise in personal computer ownership—information technology-related stocks rose 40% in 1999 and faster in the first half of 2000.

      Consumer spending accounted for two-thirds of economic output, and there were good reasons for the consumer confidence that was stimulating the economic growth. Unemployment remained low during the year, and job opportunities kept increasing. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).) In May, 1.2 million jobs were added to nonfarm payrolls, and in the first four months of the year, unemployment fell from 4.1% to a 30-year low of 3.9%. The September labour report showed nonfarm payrolls had risen by more than 250,000, with most of the new jobs in services and 30,000 jobs in the construction industry. Unemployment was expected to show a slight increase at year's end.

      Rises in average earnings, supplemented by the use of credit, were fueling the consumer boom and rose consistently by 0.3% a month in the first half of the year. By September and October, incomes were rising at their fastest since 1993, and in the same period, another 332,000 jobs were added to the nonfarm payroll.

   As the year 2000 drew to a close, there were definite indications of a slowdown. (For Inflation Rate, see Graph I—>.) The signs were not of the long-predicted and feared recession—with its global implications—but rather of a hoped-for “soft landing.” The first half of the year was one of phenomenal growth, with GDP rising by 5.6%. In the third quarter, however, output slowed dramatically to less than 2.5%. Several factors contributed to the decline, including tighter credit, cutbacks in government spending, a reduction in stockpiling, and the slowest decline in housing construction for five years. Corporate profits and business investment also grew more slowly in response to higher interest rates. The signs of a slowdown were widely welcomed, quelling fears that the economy was overheating. The Federal Reserve (Fed) raised interest rates three times in early 2000 but left the Fed funds target rate unchanged at 6.5% in November, as it had in the June, August, and October meetings. (For Interest Rates: Long-term— and Short-term—>, see Graphs.) Although rates remained steady in December, there were signs that the Fed was changing its stance on inflation. Fed chairman Alan Greenspan (see Biographies (Greenspan, Alan )) hinted that a rate cut might be possible in early 2001.

United Kingdom.

 Growth in the U.K. was robust in the year 2000, with output expected to rise at least 3%, which reflected a sharp acceleration on the 2.1% increase of 1999. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) Since 1992, when sterling was withdrawn from the European exchange-rate mechanism, the country had been experiencing its longest period of sustained growth since World War II. The increasing economic output, helped by sterling's relative strength against the euro (see Graph V—>), pushed the U.K. into fourth place among the world's largest economies, after the U.S., Japan, and Germany.

      Once again, growth was led by domestic demand. At 3.6%, household consumption rose at a slower pace than in 1999 (4.3%). Nevertheless, the rate still exceeded that of household disposable income, which was growing at around 2.5%. This meant that households were borrowing to fuel their consumption, continuing a trend that started in 1996. As a result, the household savings ratio fell from 5.1% in 1999 to 3.6%, the lowest level for a decade.

      Several factors combined to maintain consumer confidence. The number of unemployed fell to just 1,000,000, down from 1,250,000 in 1999. This partly reflected a welcome decline in the number of long-term unemployed. The IMF expected the unemployment rate to end the year at 3.9% (claimant basis), compared with 4.3% in 1999. This was the lowest rate among the industrialized countries. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

 Despite the tighter labour-market conditions, which disguised some serious skills shortages, wage and price inflation were modest. Fears that the economy was overheating and that higher oil prices would increase the rate of inflation proved ill-founded. There was little evidence to suggest that producers were passing on the higher cost of oil, possibly because the stronger pound reduced the cost of other imported input, and the inflation rate in 2000 was expected to be around 2%, slightly below the 2.3% rise in 1999. (SeeGraph I—>.)

  Public finances were boosted by the buoyant economy, and the British government was on target to make a net debt repayment of some £12 billion (about $18 billion) in the current fiscal year (2000–01). (For Interest Rates: Long-term— and Short-term—>, see Graphs.) In the March 21 budget, the chancellor of the Exchequer increased spending on the national health service and education and announced welfare reforms designed to help society's least advantaged. Later in the year additional spending commitments of £4.4 billion (about $6.9 billion) were announced for 2001–02 as tax revenue rose faster than expected as a result of higher oil prices and lower unemployment-related expenditure.

 Despite the strength of sterling, exports of goods and services rose 9% in the first half of 2000 after having stagnated in the same 1999 period. In August a trade surplus with the EU was recorded for the first time since 1995. Manufacturing output rose by 1.7% in the first half of the year over that of the same 1999 period. (For Industrial Production, see Graph II—>.) Performance of the sector was mixed and partly reflected loss of competitiveness because of the weaker euro. Many manufacturers used this to their advantage, taking the opportunity to increase productivity and cut unit-wage costs. During the year there was a continuing shift from the “old economy”—for example, coal, steel, and automobiles—to the “new economy” of high-technology companies. Output of the new-economy sectors, including telecommunications equipment, grew strongly, while old-economy sectors, such as textiles and clothing, continued their downward trend.

      The country's attraction as a business centre and its entrepreneurial spirit persisted. It continued to be a magnet for foreign investment, accounting for more than a fifth of the inflow into the EU and retaining its competitive edge in Europe, where there was ongoing deregulation and adoption of Anglo-American business methods. In 1999 the U.K. invested $199 billion overseas, overtaking the U.S. as the world's largest investor. In the euro zone, companies were still restructuring and making themselves more efficient to adjust to the new exposure to competitive pressure.

Japan.

      During the year the Japanese economic performance was mixed, but it was recovering from a recession that caused a decline in output in 1998 and only a modest rise of 0.3% in 1999. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) Growth in 2000 was expected to be 1.5–2%. The year began well, with quarter-on-quarter output increasing by 2.4% in the first three months; after a seasonal correction taking into account the fact that 2000 was a leap year, it probably would be nearer 1.5%. April to June saw a further 1% rise (4.2% annualized), but there was a slowdown in the second half of the year.

 Economic indicators during the first half of the year were mixed. Personal consumption of durable consumer goods was buoyant, which reflected the growing confidence of consumers. Sales of cars, electrical goods, and, especially, mobile phones and computers were particularly buoyant. The rate of increase in business and housing investment decelerated in the second quarter, however, with the slack being taken up by public investment generated by the government spending packages announced in 1999. The recovery in the corporate sector was being helped by strong import demand from much of Asia, and this boosted industrial output, which in turn stimulated investment spending, particularly in information technology. (For Industrial Production, see Graph II—>.)

 Although the recovery was patchy, it was sufficient for the Bank of Japan (BOJ) to raise its call rate (the target interest rate on uncollateralized overnight call loans) from virtually zero to 0.25%. This brought to an end the 18-month emergency “zero interest-rate policy” (known as the ZIRP), which had been introduced in the face of sluggish private demand and fears that the economy was on the verge of a serious deflationary spiral. The ZIRP had effectively prevented market speculation on higher future interest rates and a stock market meltdown. The interest-rate move was not unexpected and had no adverse consequences in the financial markets. Interest rates remained extremely low for the prevailing business conditions. (For Short-term Interest Rates, see Graph III—>.)

      Confidence continued through the second half of the year. The BOJ's Tankan survey confirmed the improvement in business conditions for large manufacturers, particularly the electrical machinery and telecommunications sectors, which were benefiting from the information technology-related demand. Increasing domestic demand was helping the automobile and industrial machinery industries, while the retail and construction sectors exhibited less confidence. Small enterprises were continuing to recover, albeit more slowly.

 Labour-market conditions were improving, with the unemployment rate stabilizing at 4.6–4.7% (October) and a rising trend in the number of job vacancies. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).) An emerging problem, however, was the mismatch of skills to jobs, which was curbing employment growth. For the first time in two years, wages were rising, largely because of overtime worked, and bonus payments increased in the summer. The rate of inflation was not an issue, since consumer prices were expected to rise by less than 1% over the year. (For Inflation Rate, see Graph I—>.)

      There were many casualties in the corporate sector. In July the well-known department store Sogo collapsed. On October 9 the 12th largest life insurance company, Chiyoda Mutual, became the biggest bankruptcy in Japan since World War II. Restructuring of Japanese companies and the heavily indebted banking sector continued. This was encouraged by tax aid and other incentives under the Industrial Revitalization Law, as well as more transparent accounting standards. The progress of these reforms was at least partly reflected in unprecedented levels of investment. In the year up to March 2000, direct inward investment more than doubled over that of the previous year to exceed $20 billion. More than half of this was accounted for by M&A activity, led by France with $6.7 billion in FDI. Renault SA took a controlling share of the Nissan Motor Co., and other French companies purchased Japanese life insurance companies. Japan's outward direct investment at $66.7 billion was the second highest on record and reversed a two-year decline.

Euro Zone.

      The IMF forecast that growth in the euro zone, or euro area, would reach 3.5% in 2000, following a better-than-expected 2.4% in 1999. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) The expansion was being helped by increasing weakness of the euro, which made exports more competitive at a time of strengthening global demand. A high point of 3.7% (year on year) was reached in the second quarter, after which demand and output moderated and growth of closer to 3% was more likely.

 Several factors influenced confidence and economic performance in the second half of the year. Possibly the most significant factor was the effect of rising oil prices, which was made more damaging by the weakness of the euro against the U.S. dollar and other currencies (see Graph V—>). While this made exports much more competitive, the higher cost of imports was causing consumer prices to rise faster and real incomes to fall. The economic consequences were made worse by Europe-wide oil blockades staged in protest against the increases in gasoline and diesel oil prices. Another factor was the series of interest-rate hikes imposed by the European Central Bank (ECB) between November 1999 and October 2000, with rates rising from 2.5% to 4.75%.

  The rate of inflation was the prime concern of the ECB, and by October it had reached 2.7%, which was well in excess of the bank's 2% target limit. By the end of November, however, it was clear that the economy was slowing down. Despite indications of a slight increase in inflation to 2.9%, the ECB did not raise interest rates in December. (For Long-term—> and Short-term—> Interest Rates in selected countries, see Graphs.)

      The differences in individual country performances were less marked than in 1999, except in the case of Ireland, which once again grew fastest, with GDP up 8.7% following much faster growth than expected in 1999 (9.9%). All other euro-zone countries saw either similar or faster expansion than in 1999. France again led the major industrial country members, with growth of 3.5% (2.9% in 1999), and was followed by Italy, with 3.1% (1.4%). Germany, the region's biggest economy, was forecast by the IMF to expand 2.9% (1.6%). As the year drew to a close, however, a more marked slowdown than expected made this look overly optimistic. The other countries surged ahead, led by Luxembourg 5.1% (5.2%), Finland 5% (4%), and Spain 4.1% (3.7%). The Netherlands and Belgium both anticipated growth of 3.9% (3.6% and 2.5%, respectively). Greece, Portugal, and Austria each grew by around 3.5%.

 More marked were the differences in inflation rates (see Graph I—>), which were exacerbated by the requirement for a single euro-zone interest rate. Ireland suffered most with 4.8%, and many others were between 2% and 3%. In Germany the year-on-year inflation rate reached 2.4% in October, and producer prices reached their highest level for 18 years. In France too the ECB's 2% ceiling, or “tolerance level,” was being exceeded. The ECB was expected to raise interest rates to defend this limit early in 2001.

      Large budget deficits remained a problem in many countries, and structural reforms were needed. Germany announced tax cuts and income tax reforms, and there were concerns that these could be inflationary when implemented. At the end of November, the European Commission reprimanded Germany for not paying attention to the potential risks posed to its budgetary objectives by the country's aging population. In most euro-zone countries, reforms of pensions and health systems were necessary if the cost pressure of the increasing proportion of elderly citizens was to be met.

      The stronger economic activity brought a welcome decline in unemployment. The unemployment rate fell during the year from 9% in 1999 to an estimated 8.3% in 2000. While all countries experienced falling rates, in many they remained high. In Belgium, Germany, Greece, and Italy, for example, between 8% and 15% of the labour forces were without jobs. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

Economies in Transition.

      Recovery from the 1998 financial crisis was well under way in 2000, and average growth in the region was 4% to 5%. (See Table III (Changes in Output in Less-Developed Countries, Table ).) The recovery was broad-based and helped by the strength of the global economy, particularly the buoyant EU. Higher oil and gas prices stimulated faster growth in Russia and other oil-rich countries in the Commonwealth of Independent States. While output in the Russian economy was expected to expand by more than 7% as a result of higher energy prices, any acceleration in the rate of future growth was likely to be handicapped by continuing slow progress toward structural reform. Inflation, too, was again accelerating, and in December, prices were up 20% from a year earlier.

      Output by the group of countries destined to join the EU rose 4.1% after a 0.3% decline in 1999. Stronger exports and continuing structural reforms helped boost output, which was led by Hungary (5.5%) and Poland (5%)—with both countries experiencing record GDP rises, in excess of 6%, in the first quarter. Unemployment continued to increase in nearly all countries as it had done throughout the decade of transition. A high level of unemployment was an expected result of the shift of labour from the overmanned state sector to a more efficient private sector. The official statistics understated the problem. A lack of workforce surveys in most countries meant that the unemployment rate was based on registration. Low or nonexistent benefits and poor job prospects deterred people from registering. Also excluded were some state employees who were not being paid and had little work to do. Notwithstanding this, except in a few countries, including Hungary, Slovenia, Belarus, Moldova, and Tajikistan, the rate of unemployment was in double digits. The biggest problem was in Bosnia and Herzegovina (40%), followed by Macedonia (32%), Slovakia (19%), Albania (18%), and Bulgaria (16%).

Less-Developed Countries.

      The IMF projected an acceleration in the rate of growth in output of the LDCs to 5.6%, compared with 3.8% in 1999. While there continued to be wide disparities between individual country performances, regional differences were less than in 1999. (For Changes in Output in Less-Developed Countries, see Table III (Changes in Output in Less-Developed Countries, Table ); for Changes in Consumer Prices, see Table IV (Changes in Consumer Prices in Less-Developed Countries, Table ).)

      As in previous years, the Asian LDCs were the major contributors to growth in the less-developed world. The region experienced the fastest growth as recovery from the Asian financial crisis, which had begun in July 1997, got well under way. Expansion was projected at 6.7%, compared with 5.9% in 1999. The recovery was partly export-led, fueled by strong demand for the electronic equipment for which the region had become the world's largest supplier. Individual governments were providing monetary and fiscal support. In China the economy remained buoyant, with output expected to rise by 7.5%, compared with 7.1% in 1999. Much of the activity was in anticipation of China's pending membership in the World Trade Organization (WTO), which necessitated further economic liberalization, the modernization of inefficient industries, and restructuring of the Chinese financial sector. In India the rise in economic output was expected to exceed 6%, boosted by the recovery of agriculture and the strength of the high-tech sector. (See World Affairs: India: Sidebar (India's Computer Revolution ).)

      In Africa, GDP was expected to increase from 2.2% in 1999 to 3.4%. Individual country performances were mixed. In South Africa, the region's largest economy, the finance minister announced that growth in the current fiscal year had been revised down from 3.6% at the time of the February budget to 2.6%. This was because of the loss of agricultural output due to flooding and the contagion effect of uncertainty in global financial markets. The rand weakened, largely as a result of the turbulence in Zimbabwe, the only African country to suffer a fall in output (−6%) and an excessive rate of inflation.

      Several countries in sub-Saharan Africa were being helped by a resumption of IMF funding. In July a three-year poverty-reduction and growth facility loan was approved for Kenya, where the economy was stagnating and suffering from severe power and water shortages. Zambia, which was expected to grow 3.5%, received 10 million Special Drawing Rights (about $13 million). In August a conditional credit was approved for Ghana, where output grew more slowly at 2% (3.5%). Most unexpected was a $1 billion IMF standby credit granted to Nigeria in August that raised the country's financial status. Nigeria and Algeria had the advantage of increased oil prices, which boosted their public finances. Several countries, including Côte d'Ivoire, Eritrea, and the Democratic Republic of the Congo, had their economies disrupted by political events or war.

      During the year a key issue in Africa became the economic and social cost of disease, particularly from HIV/AIDS and malaria. A wider global involvement in tackling these diseases was promoted. It was estimated that of the world's 33.6 million AIDS victims, 25 million were in Africa, mainly southern Africa. The highest proportion of infected adults was in Botswana (36%), followed by Zimbabwe and Swaziland (25% each) and South Africa and Zambia (20% each). It was expected that within a decade the disease would halve the life expectancy in the worst affected countries from 60 to 30 years. IMF studies indicated that this could reduce per capita GDP by 5% by 2010. Initially the public sector would be most affected because of the increased health care and other costs, the loss of public-sector workers, and the erosion of tax revenue, but all sectors of the economy would be adversely affected. The cost of malaria to African development was discussed at a conference in Abuja, Nigeria, in April. The World Health Organization and others put forth the case for a $1 billion global fund to fight the disease.

      In Latin America the recovery from the emerging market crisis in 1997–98 was expected to be between 4% and 4.5%. Although growth was being fueled by exports to the U.S., there was also a revival of consumer demand. The region generally was vulnerable to fluctuations in commodity prices, and Mexico, Venezuela, and Colombia benefited from higher oil prices.

      The Mexican economy led growth in the region with expansion of 6.5% (from 3.5% in 1999); the inflation rate fell from 16% to 9%. The maquiladora sector (which imported and assembled duty-free components for export) remained buoyant, and jobs were increasing at an annual rate of 13% (August), with wages rising at a slightly lower rate. Progress was being made in reforming and restructuring the banking sector. In Brazil real GDP rose 4% after a 1% increase in 1999, and public-sector finances moved into surplus. The rate of inflation increased a little faster than in 1999, at 7%, as a result of accelerating wage demands, high oil prices, and exchange-rate pressures.

      Output in Chile expanded by 6% after a decline of 1.1% in 1999, with a modest annual inflation rate of 3.2%. High commodity prices and appropriate macroeconomic policies helped the strong recovery. In Colombia business confidence remained at a low level because of continuing internal armed conflict and the weakness of the currency. Output rose by 3%, which partially made up the 4.5% decline in 1999.

      Economic performances in the Middle East were boosted by higher oil and gas prices. A major preoccupation was the Israeli-Palestinian conflict, which intensified in October. Overall growth in the region was expected to be 4–5%.

International Trade, Exchange, and Payments

International Trade.

      The increase in the volume of world trade in goods and services nearly doubled to 10%, compared with a faster-than-expected increase of 5.3% in 1999. This meant that the difference in the rate of growth in production (4.7%) and trade was much wider than in previous years. The dollar rise in global exports, at $7,497,000,000,000, was just under 9% compared with 1999. All regions actively participated in the upsurge. The year marked a return to the buoyant trading conditions experienced before the Asian financial crisis. The economic recovery in Western Europe and Latin America, combined with the continuing recovery in Asia and strong growth in demand from the buoyant U.S. economy, helped to fuel the global expansion. World fuel exports increased 8% in volume terms but, because of higher prices, jumped by 46% in value terms. Sales of manufactured goods rose by 14% over 1999, while primary products (excluding fuel) increased by 11%.

      In volume terms both the advanced and less-developed countries showed similar increases. The advanced countries provided strong growth markets. The U.S. and Canada increased imports by 13% (7.6% in 1999). Euro-zone imports rose 8.9% (6.3%), while imports to the U.K. rose 8.2% (7.6%). Japan bought 6.8% more than in 1999 (5.9%). Strong economic recovery in the NICs stimulated 14.1% more imports (8.3%).

      In value terms, however, the rise in the rate of exports by the LDCs more than doubled to over 20%, and imports accelerated from a 1.5% annual increase to 15% in 2000. At the same time, the LDCs' share of world exports was increasing and reached 27.5% in 1999, compared with 17% in 1990. This rise reflected their greater manufacturing capability. Nevertheless, many LDCs remained extremely vulnerable to changes in commodity prices. In 2000 nonfuel primary commodity export prices showed a modest overall rise after four years of decline, largely because of the recovery in metals prices. World fuel exports surged 46% in value terms but only 8% in volume. The value of manufactured goods exports increased 14% over 1999, while primary products (excluding fuel) exports rose 11%.

      Unusually, the most rapid rise in exports was from Africa, where the increase was a record 25.6% (7.2% in 1999). The rise from sub-Saharan Africa was 22.8% (5.6%); imports increased by 9% after two years of decline. Asian exports rose 14% in dollar terms (14%), while the 17.3% growth in imports reflected the strong recovery in many Asian countries. Trade in the Middle East largely reflected higher oil prices, with exports rising 37% and imports up 15% after a 2.7% decline in 1999. Latin America's exports were up sharply at 18%, while imports rose 14% following a 6% contraction in 1999.

Regionalism.

      Although the concept of globalization was firmly established and the general thrust of many small as well as large businesses was to support it, the trend toward greater regionalism persisted. Membership of the WTO grew to 140 countries in 2000, and, with China expected to join early in 2001, the WTO was representative of most of the world's governments and people. Its prime goal was the liberalization of world trade in goods and services, which was compatible with, and essential to, globalization. (See Sidebar (Globalization-Why All the Fuss? ).) At the same time, regional trading arrangements with integration objectives and their built-in preferences and rules were proliferating. Global and regional interests were not always compatible, however, and this contributed to the WTO's difficulty in launching a new trade policy. There was also a risk that some of the world's poorest countries would be excluded if regional arrangements took precedence over the WTO.

      With 170 regional agreements in existence and another 70 under discussion, there were signs that the regional versus global debate was developing. WTO Director-General Mike Moore raised the issue in connection with the growing intratrade of the Southern Cone Common Market (Mercosur) in a speech he made in Buenos Aires, Arg., on November 28. At about the same time (November 21 in Geneva), EU Trade Commissioner Pascal Lamy reaffirmed the EU's support for a comprehensive round of WTO trade talks with an extended remit to include health and safety and the “environment” as well as core labour standards to meet areas of public concern. Japan also shared this broader view. By contrast, the U.S. and Australia favoured a narrow approach, wanting the WTO to concentrate initially on agriculture, services, and industrial tariffs. The trade minister of Thailand, Supachai Panitchpakdi, who was to be the next director-general of the WTO, responded with the view that the EU approach could kill the negotiations already under way.

      Established regional groups continued to work toward closer internal cooperation and expansion. After months of tense negotiations, the EU and the African, Caribbean, and Pacific (ACP) group signed a 20-year partnership agreement on June 23 in Cotonou, Benin. The Cotonou Agreement replaced the 25-year-old Lomé Conventions, the last of which, Lomé IV, expired in February. There were accusations that the EU was using the trade provisions of the WTO, to which the EU and 55 of the ACP's 77 members also belonged, to override the old agreement. ACP Secretary-General Jean-Robert Goulongana, however, claimed that the final accord would smooth the integration of the ACP member states into the world economy and benefit globalization.

      In November government representatives of the 10 members of the Association of Southeast Asian Nations (ASEAN) held an informal summit in Singapore, which was also attended by China, Japan, and South Korea. An e-ASEAN Framework Agreement was signed under which a collective effort would be made to plug ASEAN into the global networked economy in order to increase ASEAN's global competitiveness. At the meeting China indicated its willingness to establish trading links with ASEAN or establish a free-trade zone between China and ASEAN; ASEAN was due to implement its free-trade agreement in 2002. Significantly, the China proposal was developed further and culminated in the idea of a free-trade zone for the entire region.

Exchange and Interest Rates.

  Rapid growth in the advanced countries in the first half of the year and the potential for inflation led many central banks to raise interest rates. By midyear, however, slackening output put most rates on hold outside the U.S. The year ended with many countries' interest rates running above year-earlier levels. (For Interest Rates: Long-term— and Short-term—>, see Graphs.)

      Once again the main focus of international interest was on the value of the euro against the dollar, as it had been since the euro's launch on Jan. 1, 1999. In early January 2000 the euro rose above the $1.03 level, having dipped below parity late in 1999. Thereafter it exhibited the same weaknesses as it had in its launch year, and, notwithstanding some volatility, the overall trend was downward. In the final weeks of the year, the euro's exchange rate was fluctuating at around 85 cents  =  €1, but it finished the year at about 94 cents. The euro also declined rapidly against the Japanese yen over the year, falling from a 1999 average of ¥121 =  €1 to ¥93 in the last quarter of 2000. It strengthened slightly to end the year at ¥107.

      The ECB announced in its January 2000 report that no direct intervention had been made to influence the euro's exchange rate. It admitted that the weakness of the euro had exacerbated inflation in the euro zone because of high oil prices. At the same time, the report gave details of the procedures to be followed if intervention did take place. Markets were not impressed, and when the decline persisted, the ECB on March 16 began a series of interest-rate rises. By April 27 the euro had fallen to new lows against all currencies, and there were fears that inflation would exceed the ECB's 2% limit. Markets responded briefly to a third rise in May, and the euro appreciated strongly against sterling and the dollar. Following a further 50 basis-point rise in June, however, the euro began to slip back again. Yet another interest rate rise at the end of August failed to stem the fall. On September 22 the ECB led a coordinated international intervention to prevent a fall below 85 cents; this was followed by another rise in interest rates on October 5. Confidence was dented further by a statement from ECB Pres. Wim Duisenberg that further intervention would not be appropriate. Nevertheless, the ECB continued to intervene with little success.

      Several factors explained the lack of competitiveness of the euro against the dollar. The spectacular economic performance of the American economy was attracting investment from Europe. While the euro- zone economy was increasingly buoyant—not least because of the weakness of the euro—it lacked the dynamic of the American economy, where productivity was increasing faster, there were higher returns on capital, and the labour market was more flexible. More fundamental was a lack of confidence in the EU policy-making institutions and the sustainability of the 11-member European Economic and Monetary Union. As the year drew to a close, it was not clear whether the U.S. slowdown would provide the widely predicted stimulus to the euro.

      In Japan the BOJ began intervening in the market at the end of 1999 and in 2000 to prevent the yen from rising above 100 to the U.S. dollar; it saw the yen's continuing strength as a threat to Japan's fragile recovery. Despite the BOJ's interventions, the yen came under continuing pressure in the first quarter as confidence in the economy increased. Pressure was particularly acute against the euro, with the yen reaching record levels in March—a pattern that continued throughout the year. The lifting of the 18-month emergency zero-rate measure in August made little impact on the markets. In the last few months of the year, the yen was trading in a narrow band, dipping briefly after a no-confidence vote in the government on November 20, which, though it did not pass, was perceived as having left the country with a weak prime minister. The yen ended the year at 114 to the dollar.

      In Australasia deteriorating economic conditions led to currency weakness and prompted increases in interest rates, but the currencies remained vulnerable to the strength of the U.S. dollar. In South Africa the inflationary pressure exerted by high fuel prices led to an increase of 25 basis points in the key repo rate in mid-October. This was not reflected in higher bank lending rates, however, for fear of dampening business confidence.

Payments.

      As was predicted in 1999, the overall current account of the balance of payments in the advanced economies moved into deficit following six years of surplus. The deficit continued in 2000, rising to a projected $176 billion, compared with $134.2 billion in 1999. As in 1999, the negative cause of the overall deficit was the U.S. with its own deficit of around $420 billion, well up on the $331.5 billion of 1999. The U.S. shortfall was an increasing cause of concern in the final weeks of the year, when there were clear signs of a slowdown in economic output. If there was a sudden fall in the high level of U.S. imports as the economy rebalanced, there was a risk of serious damage to investor confidence and currency realignments that together would have global repercussions.

      Among the major Group of Seven industrial countries, only the U.S. and the U.K. had significant deficits. In the U.K. the deficit rose modestly to $20.9 billion ($17.8 billion in 1999). In Germany there was a dramatic fall from $19.8 billion to $3.7 billion. Of the other advanced European countries, only Spain ($12.6 billion), Austria ($5.8 billion), Greece ($5.7 billion), and Portugal ($11 billion) had deficits. Most other European countries were in surplus, led by France ($35.7 billion), Switzerland ($24.2 billion), Belgium/Luxembourg ($22.9 billion), and Norway ($22.6 billion). The euro zone remained in surplus despite the increased cost of imports.

      The Japanese surplus remained high and was expected to exceed the 1999 level of $109 billion. Exports, particularly of semiconductors and office machinery destined for Asia, grew strongly. Trade with China was burgeoning and, at $38 billion in the first half of the year, was running 38% up on the same year-earlier period. In Australia and New Zealand there were falls from the record deficits of 1999 to $18.6 billion ($22.5 billion) and $3.2 billion ($4.4 billion), respectively. Monetary tightening caused a slowing of domestic demand, and the depreciation of their currencies was creating inflationary pressures. The shifting of demand to the external sector was being helped by the weaker currencies. In Australia the Olympic Games boosted the economy in the third quarter and thereby contributed to a reduction in the current-account deficit.

      All four of the Asian NICs had surpluses, led by Singapore with $22.1 billion ($21.3 billion). In South Korea the surplus fell sharply from $25 billion, which reflected the higher cost of fuel imports. In Taiwan there was a slight fall to $6.6 billion, while Hong Kong's rose to $11.2 billion ($9.3 billion).

      The overall current account of the LDCs was expected to move into surplus for the first time in many years. The improvement from a deficit of $24.1 billion in 1999 to a $21.1 billion surplus reflected the higher oil prices. The 1999 surplus of $3.8 billion in the Middle East jumped to $43.9 billion. Improved commodity prices and agricultural output shrank the deficit of Africa from $16.8 billion to $3.6 billion. The Latin American deficit was little changed at $58.7 billion. In Asia the surplus fell from $45.2 billion to $39.4 billion because of the higher fuel costs.

      Indebtedness of the LDC countries rose by a modest 1% to $2,068,000,000,000. Short-term debt, which accounted for 18% of the total, fell to $270 billion ($299 billion). Latin America, with $775 billion, remained by far the most heavily indebted region.

      As a share of exports of trade and services, regional indebtedness fell from 164% to 140%. By this measure all areas improved, with Latin America's share falling from 260% to 225%, followed by Africa at 193% (from 237%) and the Middle East, which, with its debt falling from 122.5% to 94%, improved its relative position to third place. Asian debt fell from 104% to 99%.

      Debt of the countries in transition rose marginally to $51.3 billion, a quarter of which was incurred by Russia. As a share of exports, this was a modest 16%.

IEIS

Stock Exchanges

      The year 2000 opened to one anticlimax—the failure of the “Millennium Bug” to attend the party—and ended with another—the failure of the American electorate to be unequivocal in its choice of president. Throughout the intervening months, stock markets worldwide were highly volatile, dominated by speculation on the economic outlook for the United States and the tensions between “old economy” and “new economy” businesses. The vast disparity of price-earnings (p/e) ratios in the information technology (IT) sector compared with all other sectors was the single most influential factor in world market sentiment. According to the International Monetary Fund (IMF), this marked divergence, or bifurcation, of the stock prices of IT and non-IT sectors had been developing since the mid-1990s. What was newer was the growing market capitalization of the IT sector worldwide and the greater internationalization of capital markets. Those led to closer cross-border correlation of stock prices, particularly IT stock prices. The increased weight of IT stocks in national indexes amplified any general market volatility and left markets around the world highly sensitive to events, particularly in the U.S., the home country of most IT companies that operated internationally. Macroeconomic expectations exerted greater influence on the markets than before.

      Investors' nervousness was heightened by rising oil prices, a falling euro, and, from late summer, the threat of war in the Middle East. The main victim of bearish sentiment had been the technology media and telecommunications subsector, the star of 1999, tarnished in the first quarter of 2000 by the high-profile collapse of some Internet, or “dot-com,” companies. The aftershock of these collapses reverberated through the year, compounded by fears that many telecommunications companies might have paid too much for third-generation mobile telephony licenses. The technology-dominated National Association of Securities Dealers automated quotations (Nasdaq) composite index peaked on March 10 and by late November had fallen by 45.4%—more than the Dow Jones Industrial Average (DJIA) fell in the crash of 1987 but still leaving many high-tech companies at exceptionally high valuations unjustified by their profits.

      As early as June some of the tech stocks that had entered the U.K.'s Financial Times Stock Exchange 100 (FTSE 100) index in March were out again because their valuations no longer met index criteria and old economy stocks had returned to favour. Against this background came moves, led in September by the U.S. company Dow Jones, to recalculate the weightings of stocks in global indexes to reflect the real number of “free float” shares that investors could buy and sell. Shares tied up in corporate cross holdings, privately or government held, would no longer count in the company's market capitalization. The likely effect was that investors would seek to avoid companies with low free floats, many of them high-grade blue-chip firms, particularly in Europe and Asia but also in the U.S.

      The main concern of investors, however, was the long steady fall in share prices across sectors and regions. By year's end the Morgan Stanley Capital International World Index had lost some 14%. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes, Table ).)

IEIS

United States.

      The longest bull market in history, with market indexes achieving unprecedented gains and trading volumes since it began in 1991, came to an end after peaking in March 2000. By the end of the year, all of the major indexes were down significantly. (See Table VI (Selected U.S. Stock Market Indexes, Table ).) The DJIA slid 6.18%; the broader Standard & Poor's index of 500 stocks (S&P 500) was down 10.14%; and the Nasdaq composite index, heavily weighted with IT stocks, sank 39.29%. The Russell 2000, which represented mostly smaller capitalization (small-cap) stocks, was down only 4.2%, while the broad-based Wilshire 5000 fell 11.85%. The last time that all of those indexes had experienced no growth on an annual basis was 1981. Of the major indexes only the energy-heavy American Stock Exchange (AMEX) eked out a gain of 2.37%. The few big winners included indexes of financial stocks and utilities. Many widely held blue-chip stocks also were down for the year, including AT&T, Lucent Technologies, and Microsoft Corp. Pharmaceutical companies such as Merck, Pfizer, and Eli Lilly, on the other hand, were up.

      Adverse changes in the economy accounted for much of the market decline during the year. During the third quarter the economy grew at an annualized rate of 2.4%, less than half the second quarter's growth rate of 5.6%. Capital spending was down, while concerns about corporate earnings and a continued rise in oil prices and weakness of the euro were factors leading to investors' apprehensions about the short-term stock market prospects. The index of industrial production, which climbed steadily during the first three quarters of 2000, dipped by 0.1% in October. Business inventories in September were growing at their slowest pace in nearly two years. Personal income fell 0.2% in October, the slowest rate in six months. The Conference Board's Index of Leading Indicators declined irregularly between January and year's end.

      The DJIA fluctuated between an all-time high of 11,722.98 in mid-January and a low of 9796.03 in March, after which it climbed to above 11,000 in April and then drifted irregularly throughout the remainder of the year. The Dow was down 9.4% at the end of November, which signaled its worst year since 1977, when it fell 17.3%. It strengthened slightly in the final days of the year to close at 10,786.85. The Nasdaq composite index, which ended 1999 at 4069.31, set monthly highs or lows six times in the first nine months of 2000—three monthly record gains and three monthly record losses—before plummeting in the final quarter to close at 2470.52. The 39.29% drop for the year was the Nasdaq's worst ever and was well greater than the 35.1% loss the index suffered in 1974.

      Electronic communications networks (ECNs), automated trading systems that disseminated orders to third parties and dealers and executed such orders within the network itself, grew in importance in 2000. The nine registered ECNs, which focused on other brokers and institutional investors, captured approximately 26% of the volume of Nasdaq trading, and the expectation was that this ratio would rise to 50%. The networks' share of New York Stock Exchange (NYSE) volume was only 4% in 2000. During the year the Pacific Exchange (PCX) in Los Angeles merged with one ECN, Archipelago, to convert to an all-electronic system, closing down its trading floor. The ultimate goal was to create a fully electronic national stock exchange for NYSE, AMEX, and Nasdaq stocks.

      Over half of all U.S. households owned stock either directly or indirectly through pension and mutual funds, by far the largest proportion ever. On-line trading accounts rose to 18 million by midyear. Trading volume and margin debt were on the rise. On-line stock-fraud cases also were up sharply, with the Internet replacing the brokerage “boiler rooms” of the past. The Securities and Exchange Commission (SEC) caseload nearly doubled during the year.

      Net purchases of American stocks by foreign portfolio investors rose to more than $150 billion in 2000, a record high. Venture capital flows continued strong in 2000, although at a slower pace than 1999. More than $15 billion was invested by venture capitalists each quarter in the year 2000. More than 14 venture capital firms each raised upwards of $1 billion, with IT start-ups favoured.

      Investor confidence gradually shifted during 2000 from optimistic to cautious, with concerns about a slowing economy. The initial public offering (IPO) market continued strong but was more selective than in previous years. New issues attracted $57 billion on 325 separate issues through August, up 59% over 1999's volume. Another 117 IPOs worth some $23 billion were issued in the remainder of the year.

      During the third quarter, IPO issuance rose 24% to $18.2 billion from $14.7 billion for the same period of 1999. Follow-on issuance by already public companies rose 55% to $27.2 billion from the corresponding earlier period. Although the number of completed deals was down from 1999, the amount raised hit a record owing to numerous large $1 billion-plus IPOs that came out in 2000. More money was raised by IPOs in the first nine months of 2000 than in all of 1999. Among the major mergers of the year were General Electric's acquisition of Honeywell International for $45.2 billion and Chevron's acquisition of Texaco for $35.9 billion. The biggest deal, the $165 billion merger of Internet provider America Online, Inc., and media giant Time Warner, Inc., announced in January 2000, was still awaiting government approval at year's end.

  Interest rates generally rose during the year, although the Federal Reserve (Fed) held official rates steady after announcing its sixth straight increase in May. (For Interest Rates: Long-term— and Short-term—>, see Graphs.) At the end of November, key rates included the prime rate at 9.5% (7.75% a year earlier), the discount rate at 6% (4.5%), and the federal funds rate at 6.62% (5.58%). Three-month Treasury bills were 6.02% (5.08%); six-month Treasury bills were 5.89% (5.32%); and 10-year Treasury notes stood at 5.47% (4.16%). The 30-year Treasury bond, however, was 5.61%, down from 6.32%.

    Volume on the NYSE for the first 11 months of 2000 was 239,539,935,000, up 29% from the 1999 figure of 185,369,204,000. The record for one day was 1,512,000,000, set April 4, 2000. Of the 3,999 stocks listed on the NYSE, 2,337 advanced in 2000, while 1,623 declined and only 39 were unchanged. (For NYSE Composite Index 2000 Stock prices and Average daily share volume, see Graphs VI—> and VII—>; for annual NYSE Common Stock Index Closing Prices and Number of shares sold since 1977, see Graphs VIII—> and IX—>.) Short interest hit a record on the Big Board through mid-November, betting on a market decline. The level of short sales not yet closed out, known as “short interest,” rose 2.2% to 4,591,354,587 in the month ended November 15 from 4,494,751,764 one month earlier. A membership seat on the NYSE sold for $2 million on September 15. At the end of September, an exchange seat was bid at $1,750,000 and offered for sale at $6.5 million. Despite its rank as the world's largest centralized bond-trading exchange, the NYSE gave consideration to selling its bond-trading exchange at year-end 2000. Approximately 78% of NYSE bond volume was in straight fixed-income securities, with the rest in convertible bonds.

      The stocks in the AMEX performed well in the first nine months of 2000, closing at 967.92, up 10.3% for the year to date. Although the AMEX slid in the final quarter to finish at 897.75, it was the only major index to end the year in the plus column. Of the 1,104 issues listed, 401 advanced, 665 declined, and 38 remained unchanged. Volume for the first 11 months was 11,902,736,000, up 26% from 7,335,678,000 in the corresponding period of 1999.

      The dot-com “bubble” burst in 2000, and the average issue on the Nasdaq, where most high-tech stocks were listed, was down 50% from its 52-week high at the end of November. The index plunged an additional 22.9% in November, its worst month since the crash in October 1987, and, despite a short rally, it fell even farther in December. After surging 40% in 1998 and 86% in 1999, the index fell sharply from its March all-time high of 5048.62 to end at 4069.31. Despite the overall plunge, 1,917 of the 6,765 Nasdaq stocks gained for the year, with 3,816 down and 48 unchanged. Volume on Nasdaq during the first 11 months of 2000 was 391,796,171,000, up 66.8% from 234,800,067,000 in November 1999.

      Stock mutual funds attracted a net $231 billion in the first seven months of 2000. Net investments made into stock mutual funds peaked in February at $55 billion and then fell sharply to about $20 billion in May and under $20 billion by November. According to the Investment Company Institute, ownership of mutual funds reached a new peak in August 2000 to a record 50.6 million U.S. households. A year earlier the figure had been 47.4%, or 48.4 million households. Bond mutual funds sustained the strongest net outflows since 1994. First-quarter outflows were nearly $15 billion, with further declines during subsequent quarters. In order to ensure independence of mutual fund directors, the SEC proposed that a majority of directors be independent and disclose their investments in the funds on whose boards they sat.

      The S&P 500 closed 1999 at 1469.2, peaked above 1500 in March 2000, and then drifted irregularly downward to close 2000 at 1320.28. The p/e ratio, based on expected earnings as reported by analysts, was 25.3 in January but then drifted down to 21.4 in the fourth quarter. This was the lowest p/e ratio for this index since October 1998.

      Treasury bonds returned 13.9% and Treasury bills 3.9% for the year, both outstripping the 2.2% return from stocks, according to Ibbotson Associates. Convertible bonds set a record, with more than $40 billion being issued in the year 2000. Weak economic data helped push bond prices up. Bond yields fell to 15-month lows in August. The spread between U.S. high-yield bonds and 10-year Treasuries in percentage points rose steeply from 5% to more than 7% during the year. Concerns about the default risk and the flotation of record volumes of new debt issues accounted for much of the change. Disappointing corporate profits resulted in the downgrading of investment-grade bonds. Antitrust regulators launched an investigation of on-line bond-trading and foreign exchange systems owned by several of Wall Street's biggest securities firms to examine whether the trading platforms were used to limit competition.

      A seat on the Chicago Board of Trade (CBOT) sold for $355,000 in 2000, down nearly $100,000 to a 20-year low. After topping out at $642,000 on April 14, the value of a CBOT seat had fallen nearly 45% by mid-August, a record low. Demutualization of the Chicago Mercantile Exchange resulted in a material downsizing in the layers of governance. More than 200 committees shrank to 14 during the year. The New York Mercantile Exchange also made the move to demutualization as a result of a favourable Internal Revenue Service ruling. With more than 10 million employees having unrestricted stock options, there were concerns about whether insider trading could be adequately regulated. The Commodity Futures Trading Commission filed a number of enforcement cases alleging that promoters used the Internet to claim that they had earned enormous profits from nearly fail-safe commodities-trading formulas.

      The National Association of Securities Dealers (NASD) was very active in 2000. Through August, investors filed 152 margin-related arbitration claims with NASD Dispute Resolution, Inc., a unit of the NASD. That was up from 117 margin claims in all of 1999 and just 44 a year earlier. Nasdaq aggressively pursued market share in 2000. Among its major changes since its creation in 1971 was a proposal to establish “SuperMontage,” a proposed new trading platform. SuperMontage would make Nasdaq more of a conventional stock exchange and less a network of market makers who quote prices at which they will trade with investors. Nasdaq's practice was to show each market maker's best price; under the new plan it would show up to three of a participant's best bids and offers. Opposition came from the ECNs, which contended that the system would discriminate against them and aggressively opposed SuperMontage.

      The SEC also was very active in 2000, with initiatives to more aggressive enforcement of the securities laws. The SEC attempted to resolve the issue of auditor-consultant conflicts of interest by prohibiting auditors from representing the same companies for which they did audits. Accountants responded by spinning off their consulting arms. PricewaterhouseCoopers LLP, the largest accounting firm, negotiated to sell its consultancy to Hewlett-Packard Co. Ernst & Young LLP, the second largest accounting firm, sold its consulting arm in May. Audit failures provoked the interest by the SEC, which sought to have publicly traded companies disclose consulting fees paid to their auditors.

      The U.S. Department of Justice and the SEC reported that the four major options exchanges—the Chicago Board Options Exchange, the AMEX, the PCX, and the Philadelphia Stock Exchange—signed a consent decree and accepted censure from the SEC but did not admit any wrongdoing. These exchanges were charged with restraint of competition by not seeking to trade options already traded on other exchanges. The SEC took steps to restrain selective disclosure of nonpublic information to selected persons and approved a move toward demutualization of the exchanges, following the move by the NASD to privatize. On June 13, 2000, the SEC ordered the exchanges and the Nasdaq market to submit a plan to phase in decimal pricing for listed stocks and certain options. The argument for decimal pricing was that it would be advantageous for international trading and would lower transaction costs owing to narrower spreads than were customary under the fractions quotation method common in the U.S. The first 13 U.S. stocks—seven on the NYSE and six on the AMEX—began trading in decimals on August 28.

Canada.

      The Canadian stock market had a positive year in 2000, with the Toronto Stock Exchange's index of 300 issues (TSE 300) up well above the previous year's high. In early December the index closed at 9230.59 for a 9.71% rise for the year to date, although it had slipped to 8933.70 (6.18%) by year's end. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes, Table ).) The Dow Jones Global Index for Canada showed a gain through August of 32.7% on a year-to-date basis. During the second half of the year, the market lost some of its momentum as the index plunged by 8.1% in one day with a sell-off of its biggest single component, Nortel Networks. Nortel accounted for almost one-third of the Toronto market's capitalization. Trading was halted at midday on August 25 owing to the overwhelming volume of trading.

      Foreign investors swarmed into the Canadian market in 2000, according to Statistics Canada, a government agency. Foreign investors bought a total of Can$33 billion (U.S. $22.3 billion) of Canadian stocks in the first half of the year alone, compared with about Can$35 billion for the previous three full years combined. A Canadian shareholder study, sponsored by the TSE, found that 49% of adult Canadians directly or indirectly owned shares. This was a sharp increase from previous studies conducted in 1996 and 1989, which had indicated 37% and 23%, respectively. Share owners moved to on-line trading in substantial numbers. The growth rate in on-line trading was projected at 45% by year's end.

      Trading volumes on Canadian stock exchanges in 2000 were 50% higher than in the previous year, with high-tech stocks leading the way. Canadian banks recorded higher-than-expected fiscal earnings, and this led to strong market activity. Among the most active issues on the TSE were Bank of Nova Scotia, Bank of Montreal, BCE Inc., Bombardier Inc., JDS Uniphase Canada Ltd., Nortel, Royal Bank of Canada, Seagram, Thomson Corp., and Toronto Dominion Bank.

      The Canadian brokerage industry reported a nine-month operating profit of $2.8 billion, according to the Investment Dealers Association of Canada. This was more than double the year-earlier figure. The Canadian Venture Exchange (CDNX), a marriage of the Vancouver and Alberta exchanges, celebrated its first full year in operation. The CDNX, with nearly 2,300 companies listed, was down 34% from its peak of 4526.06, set on March 20. Computer problems halted trading for several hours on November 28. Technical problems also interrupted trading at the TSE, which was forced to close several times during the year. Nasdaq launched the first phase of Nasdaq Canada from its base in Montreal, in cooperation with the Montreal Stock Exchange.

      The TSE index climbed to a 52-week high at the end of August, led by technology and energy shares, with Canadian banks also delivering strong performances. During November the TSE 100 at 559.43 was up 37.1%, the TSE 200 was up 14.2% to 492.05, and the TSE 300 was up 33.4% to 9024.43. By September oil- and gas-related issues had depressed the market and reduced the year-to-date gains in stock prices of major corporations, though the TSE 300 ended the year up 6.18%. On December 5 the TSE posted its second biggest one-day gain ever, climbing 3.74% on news that the U.S. might cut interest rates.

      Canadian interest rates trended upward in 2000, with three-month money-market rates at 5.63% in November, up from 4.73% a year earlier. The prime rate was 7.5%; two-year government bonds were at 5.63%; and 10-year government bonds were down slightly to 5.55%, versus 6.14% a year earlier. Corporate bonds averaged 7.18%.

Irving Pfeffer

Western Europe.

      The power of the American market continued generally to suck investment capital out of Western Europe, where economic performance undershot expectations and the euro continued to fall. Following the first quarter correction in IT stocks, mergers and acquisitions continued to generate some stock market activity. Outstanding among these was the British Vodafone Group's takeover of German telecommunications company Mannesmann. This was the world's biggest hostile bid and the first to succeed in Germany, Europe's largest economy. Mannesmann was made vulnerable to attack by the 60% foreign ownership of its shares—an indication of the growing equity culture in Western Europe.

 The increasing European passion for equities received a reality check before the end of the first quarter. Technology media and telecom stocks plummeted as investors became aware of how long they would take to show profits. Germany's Nemax 50 Index halved in value between March and October. Dramatic stock market declines around the world on November 13 appeared to result not only from uncertainty surrounding the U.S. presidential election but also from worse-than-expected results from technology company Hewlett-Packard. By year-end 2000 the London FTSE 100 had fallen 10.2%. and Germany's Frankfurt DAX was down about 7.5%, while the Paris Bourse's CAC 40 had slipped less than 1%. (For the FTSE Industrial Ordinary Share Index since 1977, see Graph X—>.) Rising consumer prices, an uptick in unemployment in France, failure to keep inflation below the European Central Bank's target rate of 2%, and the continuing decline of the euro all sapped confidence.

      The IT-stock bubble burst early in the year, but the technological and logistic shakeout in the stock exchange companies took longer. Members of the London Stock Exchange (LSE) voted to demutualize on March 15 and pursued cross-border mergers with other European exchanges, principally Germany's Deutsche Börse. The merger of the LSE with Deutsche Börse to form International Exchanges (iX) was announced on May 3, with each former exchange to hold 50% of the new one. It was expected to form the biggest stock market in Europe. The practical and technical problems facing the iX venture, however, were enough to sow widespread doubt that LSE shareholders would support the merger. The Swedish technology company OM Group, owner of the OM Stockholm Exchange, entered a hostile $1.2 billion bid for the LSE on September 12, forcing the 200-year-old London exchange to withdraw the merger plans. LSE shareholders rejected the OM bid in November, but new partnership deals were under discussion with Nasdaq, Euronext, and the merged Paris, Brussels, and Amsterdam exchanges.

      The year began with more liquidity (investors' cash) available than U.K. brokers, at least, could cope with. On-line brokerages were swamped with business as the small investors' appetite, particularly for Internet stocks, continued into the new year. An estimated 10% of share deals were being made on-line. Sentiment turned decisively negative in March when the U.S. Supreme Court ruled against Microsoft after a long battle over antitrust law. Flows into equity mutual funds generally slowed, shrinking the revenues of the new on-line brokerages that had expanded with the dot-com stocks bubble. In Europe the outlook for equities was almost unanimously bearish, although indexes in a few countries, notably Ireland and Switzerland, managed to show gains. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes, Table ).)

Other Countries.

      Global trends powered by the U.S. economy dominated stock market behaviour in every region, but the high correlation of technology stock price fluctuations between Asia and the U.S. posed particular problems for Asia. Through their development of high-technology business, Asian markets had been directly exposed to the developed world's market fluctuations and to the increased influence of stock price fluctuations on the international capital flows. Any serious correction was likely to cut output in Asia more than in other regions.

      The effect of oil price rises on the more oil-dependent countries of Asia and the reemergence of structural financial problems and political instability also added to stock market volatility. China, where the stock market looked set to end the year 50% up in dollar terms, was among the countries struggling most to pay the increased price of oil. The bill to China was predicted by the International Energy Agency to rise by around 250% by the end of the year.

      Between mid-September and mid-October, the Philippine peso fell 8.1% following political scandal and government failure to contain debt. The currency strengthened again in November only on news of Pres. Joseph Estrada's impeachment on corruption charges, including price manipulation at the Philippine Stock Exchange. Most Asian stock exchanges also rose on this news, but political, economic, and fiscal problems remained for most countries. Even in Taiwan, where the financial status had appeared relatively sound, a financial crisis was looming by the end of the year. Between March and November the stock market fell by 35%. The Taiwanese government had been buying publicly traded equities in an attempt to shore up share prices, producing a flight of foreign capital from the Taipei stock market.

      On Latin American stock markets, share prices were rising sharply at the beginning of the year, but investors later suffered the less-positive effects of market globalization. Some of the most actively traded shares were in companies sought by foreign owners, particularly large Spanish firms, and others were being traded in the U.S. Plans for the privatization of former state-run industries also added to the problem when large tranches of shares were sold to single buyers, often foreign consortia. The result was that there were fewer shares for local markets to trade. In local currency terms the Bovespa, the stock exchange in São Paulo, Braz., had hardly grown over two years.

      Another globalization effect emerged when on May 3 Nasdaq announced plans to create the first “global digital stock market.” In June shares of Japanese companies started trading on Nasdaq Japan, a joint venture between Nasdaq and the Japanese Internet company Softbank. At the end of July, Nasdaq began exploratory discussions with representatives of 10 Middle Eastern stock exchanges. In the rush to go global, the Tokyo Stock Exchange began talks with the NYSE on creating a 24-hour global stock market. Analysts warned, however, that the problem with multiple currencies and their variable exchange rates was just one of several practical and technical obstacles to 24-hour trading. (For Selected Major World Stock Market Indexes, see Table V (Selected Major World Stock Market Indexes, Table ).)

Commodity Prices.

      The potential for the price of one staple commodity—oil—to destabilize world markets entered the realm of folk memory. In the 1970s similar rises ushered in a bear market in equities that lasted more than a decade. In February 1999 prices for Brent crude dipped below $10 a barrel. By Sept. 7, 2000, however, the price had hit a 10-year high of $35 a barrel; it later topped $37, setting off popular unrest across Europe against rising prices and the levels of taxation on fuel.

      OPEC producers had been trying since March to raise the price to around $25 a barrel, but control over output had been too imprecise to achieve a measured and gradual rise. The price dropped back toward $30, only to spike up above $32 again in early October following freezing weather in the U.S. and growing Middle East tension. In response the U.S. government sanctioned the release of 30 million bbl of oil from its strategic reserve. The IMF estimated that prices sustained at 20% higher than in the first half of 2000 would reduce output by about 0.2 percentage points in major industrialized countries and as much as 0.4 percentage points in Asia. OPEC announced in November that it would no longer try to peg back the oil price, because an impending glut would send prices falling sharply over the next 12 months. The problem, it claimed, was not shortage of oil but shortage of refinery capacity and stocks. At the root of anxiety however, was the fact that, apart from a few OPEC members, most oil producers were operating at close to maximum output capacity. They had little incentive to invest in expanding capacity if the aim of this expansion was to cut prices and thus lower their own income.

      While black gold dominated the news, the yellow metal kind failed to record the price rises predicted for it a year before. In July 1999 the price of gold had hit a 20-year low of $255 an ounce when the IMF announced plans to sell 300 tons of gold to aid international debt-relief programs. Following representations from the gold-producing countries, 15 European central banks agreed to restrict sales of official reserves to a total of 2,000 tons over the forthcoming five years. The gold price, having spiked up to $295 an ounce in December 1999, drifted back down to remain at around $273 for much of 2000, dipping to $264 on November 14.

      In many nonfuel commodity markets, particularly in agricultural commodities, the level of prices remained low compared with 1997 pre-Asian crisis prices. In the wake of recovery, improved supplies had kept prices in check, but a further difficulty was the slow pace at which producers were able to adjust to changed conditions. For example, coffee, cocoa, and sugar carried high fixed costs that made it potentially profitable to harvest in the short term, even when prices were below production costs. Rising stocks might then also restrain prices.

      Price increases were less than expected in most metals and industrial commodities, given the rise in global demand, for similar reasons. Only nickel attained a price increase above its average price in 1995–97.

IEIS

Banking

      Industrywide consolidation, including significant cross-border transactions involving European banks and American securities firms, continued to reshape the global banking and financial services landscape in 2000. At the same time, however, enactment of sweeping financial modernization legislation in the United States did not trigger significant merger activity between banks and insurers—combinations that had previously been prohibited under federal banking law but had become permissible under the Gramm-Leach-Bliley (GLB) Act, which was enacted in November 1999 and became effective in March 2000.

      The year's most dramatic merger transaction came in mid-September with the announcement that the Chase Manhattan Corp. had agreed to buy J.P. Morgan & Co. through an exchange of shares valued at the time at approximately $36 billion. The merger agreement between the American banking giants followed earlier rumours of a trans-Atlantic combination of Morgan and Germany's Deutsche Bank AG, which had completed the purchase of the Bankers Trust Corp. in 1999. In Germany merger talks between Deutsche Bank and Dresdner Bank AG and later between Dresdner and Commerzbank AG were announced and then called off. In December a proposed government-backed merger of Kookmin Bank and Housing & Commercial Bank in South Korea triggered massive protests and nationwide strikes by unionized bank employees.

      Though each deal was only a third of the value of the Chase-Morgan merger, the acquisitions of Wall Street securities firms Donaldson, Lufkin & Jenrette (for about $13 billion) and PaineWebber Inc. (for $11.8 billion) by Swiss banking giants Credit Suisse Group and UBS AG, respectively, stood out among the year's cross-border transactions, which further underscored the fact that competitive strategies were being driven by a reach for massive size and global scale. The MeritaNordbanken Group, created in 1997 by the merger of Finland's Merita Bank PLC and Nordbanken AB of Sweden, continued to expand across Scandinavia. Early in 2000 the bank purchased Unidanmark of Denmark, and in October the newly renamed Nordic Baltic Holding Group (NBH) announced the acquisition of Norway's Christiania Bank. The series of cross-border transactions made NBH, to be renamed Nordea AB, the region's largest financial institution.

      Apart from the ongoing global consolidation, one of the most significant developments in 2000 was also the most anticlimactic—the smooth transition to the new year without any of the feared “Y2K” computer meltdowns. Indeed, there were strong indications that the intensive efforts by banks and other financial institutions around the world to renovate and test their systems and develop contingency plans for the year 2000 “millennium bug” yielded a number of important collateral benefits, including a better understanding and increased enhancement of their information technology systems and improvements in their business continuity planning.

      Another development with important ramifications for the international financial markets in 2000 was the implementation of the euro, the single currency adopted by the 11 European Union (EU) members that then constituted the Economic and Monetary Union (EMU). Although the euro's trading value had declined since its inception on Jan. 1, 1999, the operational transition to the euro appeared to have been accomplished smoothly. Much work still remained to prepare consumers in EMU countries for the transition to the ultimate disappearance of their local currencies in favour of euro banknotes and coins as legal tender for cash transactions. This final stage was scheduled to occur by Jan. 1, 2002.

      Meanwhile, a number of countries continued to grapple with the question of how to reform their domestic regulatory systems to enable them to meet the challenges presented by the formation of complex financial groups engaged in a diverse array of activities both at home and abroad. For example, Japan established a new Financial Services Agency, which would assume the responsibilities previously exercised by three agencies: the Financial Supervisory Agency, the Financial System Planning Bureau of the Ministry of Finance, and, when its mandate expired in January 2001, the Financial Reconstruction Commission.

      Reviews of existing regulatory and supervisory relationships were also under way in South Africa and Switzerland, while Belgium and The Netherlands were striving to strengthen cooperation between existing authorities. Elsewhere, significant changes in the allocation of supervisory responsibilities within the financial sector were legislated in Latvia, where a new Financial and Capital Market Commission was due to assume responsibility for consolidated supervision of the financial system on July 1, 2001; in Turkey, which had vested bank-supervisory authority in a new Banking Regulation and Supervision Agency; and in Venezuela, where a Financial Regulation Board had been established to oversee the financial system. The global trend clearly was in the direction of some form of “umbrella” oversight, but there remained as yet no international consensus on what governmental authority or authorities should exercise this responsibility.

      In the United States the Federal Reserve Board (Fed) was vested with statutory responsibility for oversight of financial holding companies established under the GLB Act. Culminating the 20-year effort to pass comprehensive financial-modernization legislation, the GLB Act repealed provisions of the Glass-Steagall Act that for more than six decades had restricted affiliations between commercial and investment banks. Unlike Glass-Steagall, the GLB Act permitted financial holding companies to own commercial banks and engage—through separate nonbank subsidiaries—in securities underwriting, insurance underwriting, merchant banking, and other types of financial activities. The appropriate primary bank regulators (including the Office of the Comptroller of the Currency in the case of national banks and the state banking agencies in the case of state-chartered banks) and functional regulators (such as the Securities and Exchange Commission in the case of securities broker-dealers and state insurance commissioners in the case of insurance companies) would oversee the component operations of a financial holding company, with umbrella oversight of the consolidated group entrusted to the Fed.

      The GLB Act provided that international banks might qualify as financial holding companies if, among other conditions, they met a capital standard “comparable” to the “well-capitalized” standard applicable to American bank subsidiaries of domestic financial holding companies, which included both risk-based and leverage measures. The act further directed that this comparable standard be applied by the Fed “giving due regard to the principle of national treatment and equality of competitive opportunity.” As originally announced by the Fed in January, the comparable-capital standard for international banks included both risk-based and leverage tests, notwithstanding that a substantial number of international banks operating in the U.S. were not subject to a leverage test under their home country's capital standards. In response to the very strong concerns raised by the international banking community and governmental authorities in other countries regarding the inclusion of a leverage test as part of the comparable-capital standard, the Fed in December removed the leverage test from the numerical criteria applied to international banks. Instead, it added the leverage ratio to the list of other factors it might take into account in assessing an international bank's capital. Other factors included the composition of a bank's capital and the rating of its long-term debt. Under this revised approach, the comparable-capital standard was applied on the basis of numerical criteria limited to an international bank's risk-based capital ratios determined in accordance with the internationally agreed-upon Basel risk-based standards.

      There were a number of other significant developments occurring in global financial markets during 2000. Deposit insurance schemes were strengthened in several countries, notably France, Ireland, and Japan. A number of countries, including Brazil, China, Panama, and Turkey, instituted changes to enhance their banks' practices regarding classification of assets and loan loss provisions. Measures to improve banks' assessment of their country risks were introduced in Latvia and The Netherlands, while efforts to promote risk-management practices within banks in general were initiated in India and Israel. Corporate governance issues received increasing attention in several jurisdictions, including Australia, Hong Kong, and Singapore. Reforms in accounting and financial-reporting practices to bring them up to the level of international standards were adopted in Bahrain, the Philippines, and South Africa.

      One theme common to many countries was the extensive effort under way to adapt banking and other financial services to developments in the “new economy”—for example, initiatives to promote Internet payment systems and virtual banking. Although exclusively on-line banks faltered, many traditional brick-and-mortar financial institutions increased their on-line components. The EU issued a directive establishing the legal framework for electronic signatures, while similar legislation was enacted in several countries, notably Australia, Colombia, and the U.S. The EU also took the lead in authorizing nonbanks to issue electronic money through the formation of electronic money institutions.

      Action was taken, or was under consideration, in a number of countries to combat money laundering. Legislation prohibiting money laundering was introduced in Israel, while in other countries, including Italy and Japan, measures were enacted to expand the list of predicate crimes that could give rise to money-laundering violations. Actions to enhance the effectiveness of suspicious-activity reporting were instituted in Canada and Colombia. At the international level, the Financial Action Task Force on Money Laundering in June 2000 issued a report identifying 15 jurisdictions where the existing measures to combat money laundering were deemed to be inadequate. The 15 locations—which included such high-profile offshore financial centres as The Bahamas, the Cayman Islands, Dominica, Israel, Liechtenstein, the Philippines, and Russia—were described as “non-cooperative in the fight against money laundering.” An additional 14 jurisdictions had been investigated. Just days before the report was released, six jurisdictions (Bermuda, the Caymans, Cyprus, Malta, Mauritius, and San Marino) issued letters offering to eliminate by the end of 2005 practices that had made them offshore tax havens.

      Privatization of banks continued in a number of countries, including the Czech Republic and Poland. In Brazil the privatization of a list of large-scale government-owned assets was completed when Banco Santander Central Hispano SA, which already owned banks in 12 Latin American countries, won the auction to buy the state-run Banco do Estado de São Paulo SA, or Banespa, for a record price of nearly $3.6 billion.

Lawrence R. Uhlick

Business Overview

      The year 2000 was likely to be best remembered for hosting a changing of the guard in the business world. Stumbling was the “new economy” of technology start-ups, Internet sites operating without profits, and media-telecommunications companies; surging were some of the high elders of the “old economy”: energy providers and a number of traditional manufacturers.

      For the American stock market, the ebullience that marked the late 1990s seemed to have dissipated, as evidenced by the volatile stock performances of such New Economy icons as the Intel Corp. and Amazon.com. The cooling off of once red-hot areas such as telecommunications and technology contributed to poor performances in such areas as growth mutual funds and the high-yield corporate bond market.

      Real gross domestic product growth for the U.S. was projected to be 4.3% for 2000, up slightly from 4.2% in 1999, but a slowdown in the second half of the year portended a reduced rate for 2001. Job growth was vigorous for much of the year, and the unemployment rate hovered at a 4% average, down from 4.2% in 1999. Wage growth was modest, while core inflation remained about 2.5%, and the unadjusted Consumer Price Index rose to 3.4%, partly because of rising oil prices.

      The most vigorous performances came from some of the most traditional business sectors, especially the energy market. Out of fashion for much of the previous decade, energy companies showed a stunning return to form, in many cases posting record or near-record earnings. One of the most crucial influences was the spike in oil prices throughout 2000, with a year high for crude oil in September of $37.20 per barrel and a high of $1.68 per gallon for gasoline in June.

      The top global firms in oil and gas—ExxonMobil Corp., BP Amoco PLC, Royal Dutch/Shell Group, Texaco Inc., and Chevron Corp. (the latter two set to merge early in 2001)—controlled a growing majority of the worldwide oil market. Such consolidation was likely to be echoed in the natural gas market in the near future, as analysts expected the current dozen major players to begin merging. Improving efficiencies and, most of all, high oil prices caused all major oil providers to exceed fiscal expectations. ExxonMobil, for example, earned $4,500,000,000 in the third quarter of 2000, up 105% from the third quarter of 1999. Chevron more than doubled its third-quarter net income, increasing to $1,531,000,000 while its proposed acquisition Texaco posted a record income of $798,000,000, up 106% from the same period in 1999.

      Such influx of new profits allowed the major oil firms to expand their research and exploration-production operations as well as set the stage for further industry consolidation. Investors showed a preference for the top global companies at the expense of those with smaller capitalization; thus, the stock value of ExxonMobil was valued at more than 20 times earnings, while that of second-tier Phillips Petroleum Co. was only 11 times earnings. The lopsided situation gave more buying power to the top companies and seemed likely to provide them with further means to raid their less-valued counterparts in 2001.

      The situation was muddier in the utilities sector, which continued to undergo a massive reorganization made necessary by the regulatory reforms of the previous few years. States in the U.S. ranging from California to New Jersey had broken up their former utility monopolies in the late 1990s, and this created at times a bewildering array of new utilities contending for market share. In many cases a former monopoly decided to split its businesses; for example, Consolidated Edison Co. moved out of the energy-production business, selling its power plants to new companies, in favour of the merchant power distribution market, in which utilities sell bulk power to buyers located across the U.S.

      Some deregulation agreements eventually hindered the performances of the former monopolies. California utilities such as Pacific Gas & Electric and Edison International were caught in a fiscal bind, as their deregulation agreements had frozen the rates at which the companies could charge consumers, which caused considerable financial problems when the utilities were confronted with increases in oil and gas prices. The U.S. Federal Energy Regulation Commission in November ruled that the utilities could expand their methods of buying bulk power as a way to keep the companies solvent.

      The confusion and volatility of the U.S. utility market also presented an opportunity for international power companies to begin incursions into North America. Such former national monopolies as Scottish Power and Italy's ENEL SpA, which had limited customer bases in Europe, saw the potential to win market shares in the U.S. and Latin America as a significant way to expand their growth.

      The American auto industry experienced a mixed year during which most major car manufacturers posted healthy growth rates while at times being hobbled by negative outside influences. The industry's light vehicle sales totaled about 18 million shipped for the year, said to be a new industry record. The growth of imports of new car and noncommercial light trucks was, however, just as impressive. While American manufacturers exported $40.2 billion of road vehicles in the first nine months of 2000, imports for the same period totaled about $106.4 billion. During the first nine months, imports from Germany increased 15.2%, those from Japan rose 15.9%, and, most notably, Korean imports increased 48.5%.

      The surge in imports helped the Toyota Motor Corp., the Nissan Motor Co., and the Honda Motor Co., Inc., to post their best production rates in three years. Toyota, for example, increased its North American exports by 15.7% at mid-2000 but believed that increase would lessen to about 8% by the end of its fiscal year in March 2001.

      The heightened presence of foreign competitors caused difficulties for American auto manufacturers. The Ford Motor Co. increased its total revenues by 9% to $127.5 billion for the first nine months of 2000, but its net income declined. Ford was also hurt by being tarred with public relations damage from its association with Bridgestone/Firestone, Inc., which in August recalled 6.5 million tires after defective tires were blamed for a number of fatalities. The great majority of the tires in question had been equipped on the automaker's popular Ford Explorers.

      Even worse was the lot of DaimlerChrysler AG. The merged company, which was considered in 1998 a herald of future North American–European supermergers, posted a $512 million operating loss for the third quarter of 2000 and saw its stock lose $60 billion in value from a $108 per share high in January 1999. DaimlerChrysler's production in North America declined by about 100,000 vehicles in the first three quarters of 2000, and the company began idling plants and considering layoffs in late 2000. General Motors Corp. also had a slight decline in earnings in the first nine months of 2000, dropping 5% to $829,000,000 in consolidated net income.

      Aerospace companies had a successful year overall. The American aerospace industry booked $32.4 billion in firm orders in June, shattering the previous record of $20.7 billion set in November 1997. Orders for the first half of 2000 totaled $85.4 billion, up from $62.6 billion in the first half of 1999. The recovery of the Asian markets helped increase export orders, although a strike at the Boeing Co. in early 2000 depressed exports in the first quarter. Manufacturers were also heartened by NASA's announcement in October of a long-term strategy for the exploration of Mars, which would result in expenditures of $500 million per year for the next five years.

      The improved health of the industry generated a number of mergers, perhaps the most significant being the General Electric Co.'s $45 billion acquisition of Honeywell International Inc. Honeywell's space avionics division gives GE a foothold in space transportation, an area in which it had previously had no direct involvement. The Northwest Airlines Corp. and Continental Airlines, Inc., also explored a merger, but it was contested by the U.S. government in late 2000.

      The metals industries contended with surging imports, a drawdown of inventories by spot purchasers, and a spike in natural gas prices. Steel companies were faced with the difficult equation of rising energy costs cutting into whatever increases in demand they received, although most top manufacturers still posted gains. For example, the U.S. Steel Group, the largest U.S. steelmaker, had third-quarter revenues of $1,430,000,000, up from $1,340,000,000 in the same period of 1999 despite a decline in steel shipments to 2.6 million tons for the quarter from 2.8 million a year earlier.

      Steel production in the U.S. through late October totaled 94.8 million tons at a capability utilization rate of 88.3%, a 12% increase from the 85 million tons produced during the same period of 1999, when the capability utilization rate was 80.5%. Much of the industry's growth came from increased shipments to service centres, construction enterprises, and oil and gas manufacturers, while shipments to the automotive, industrial equipment, and appliance industries were down for the year.

      For aluminum a strong first half was followed by slower third and fourth quarters, with declines in construction, forging, and fastener businesses caused by weakening demand. The leading worldwide aluminum producer, Alcoa Inc., posted net income of $1.1 billion for the first nine months of 2000, up 53% from the same period in 1999, but said that continued high energy costs seemed likely to be a constraint on future growth.

      Gold-mining producers continued to be disappointed by poor prices. Although the price of gold had risen to $340 per ounce in late 1999 owing to an accord by 15 European central banks to limit gold sales and trading, prices sank back to the $260–$270-per-ounce range for much of 2000. The strength of the U.S. dollar throughout the year made dollar-denominated precious metals such as gold more expensive to international gold buyers, and there was also a decline in gold investments from traditional buyers in such nations as India and China.

      The forest products industry experienced a dichotomy in 2000. Pulp prices soared, while lumber prices greatly deteriorated, and this created a situation in which companies increased their lumber production for the sole purpose of creating pulp. Prices for northern bleached softwood kraft—the benchmark grade of pulp—were $710 per ton in October, up from $600-per-ton average prices earlier in the year. Meanwhile, lumber prices fell roughly 31% compared with 1999, reaching $270 per 1,000 bd ft, while production at Western sawmills rose 2.6% to 22.1 billion bd ft in the first seven months of 2000. The situation created a good fiscal climate for such leading firms as the Georgia-Pacific Corp., Weyerhaeuser, and International Paper, which had contracts to supply lumber to construction shops such as Home Depot. International Paper, for example, registered a 21% increase in revenue during the first nine months of 2000.

      The strong economy and overall low mortgage rates helped home builders experience one of their healthiest years of the last decade. Economists expected 2000 to post a near-record 5,970,000 homes sold during the year. The construction market experienced some cooling, however. Spending on residential construction fell at an annual rate of 9.2% in the third quarter, the first decline in a year, and, while housing starts began robustly with 1.7 million in January, they fell to a rough average of 1.5 million in the latter months. The manufactured housing industry was not as solid, as many of the top lenders of subprime mortgages and manufactured housing loans came under scrutiny. Conseco, Inc., a leader in mobile home lending, suffered a $489 million net loss in the third quarter alone.

      There were a number of industries, however, that encountered trouble in 2000. The textile industry had a grim year, with many of the top American textile manufacturers, including Burlington Industries, Guilford Mills, Inc., and Galey & Lord, experiencing declines in revenues and thus being forced to undertake major personnel layoffs. The woes were in part due to a continued emphasis on business casual clothing in the American workplace at the expense of suits, as even such Wall Street firms as Goldman Sachs and J.P. Morgan had moved to a business casual dress code. The trade deficit continued to worsen for American textiles; apparel imports rose 14% to $37.9 billion, and textile imports were up 15% to $9.8 billion during the first eight months of 2000. Meanwhile, American apparel exports increased only 2.2% although textile mill product exports rose dramatically by 16%.

      Many companies in the imaging/copying business suffered, in part owing to softening demand as well as to the growing use of digital alternatives to their products; this trend gave the edge to such Asian companies as Canon Inc. The traditional business of such manufacturers as the Polaroid Corp., the Eastman Kodak Co., Lexmark International, Inc., and Pitney Bowes Inc. suffered, but one of the most adversely affected was the Xerox Corp. Xerox, which experienced a net loss of $167 million in the third quarter alone and did not expect to recover until mid-2001, planned to hold a fire sale for its operations, including ventures in Japan and China and its highly regarded research center in Palo Alto, Calif.

      The increase in oil and gas prices was felt yet again in the chemicals industry, where many major firms experienced business declines owing to higher operating expenses. E.I. du Pont de Nemours and Co., the largest worldwide chemical company, served as a case in point. The firm's decision to sell its oil subsidiary, Conoco, in 1999 may have hurt it in 2000, as one of DuPont's major problems was contending with ballooning operating expenses caused by high oil and gas costs. DuPont's operating earnings fell by 14% in the third quarter of 2000 alone.

      DuPont was not alone in its woes. The Union Carbide Corp., the Rohm and Haas Co., and the PolyOne Corp., among others, struggled in 2000 as energy costs rose and the weak euro caused export sales to Europe to slow. The Dow Chemical Co. during the year mounted a challenge to DuPont's supremacy through its proposed takeover of Union Carbide, as well as by going against the industry grain by posting record sales increases. Raising its sales prices helped Dow avoid being submerged by energy cost increases.

      Two industries—pharmaceuticals and tobacco—were perhaps the most affected by government actions in 2000, though with vastly different results. The large pharmaceutical companies became one of the cornerstones of Vice Pres. Al Gore's presidential campaign when Gore charged the manufacturers with spending too much on advertising and overcharging consumers. Sentiment in the U.S. Congress also ran against the interests of pharmaceutical manufacturers. In July legislation was passed to reduce restrictions on imported drugs, considered a loss for American pharmaceuticals' lobbying interests. Legislation was also considered that would greatly expand Medicare coverage for seniors, in some cases putting one-half of prescriptions under price controls. Both Gore and rival presidential candidate Texas Gov. George W. Bush supported some measure of prescription drug relief.

      The top pharmaceutical companies, however, continued to prosper despite the political attacks. Pfizer Inc., the American Home Products Corp., and the Schering-Plough Corp. posted solid increases in earnings on the strength of their prescription drug businesses. Pfizer, for example, had a 31% earnings increase in the third quarter, helped by the popularity of such products as Viagra and cholesterol fighter Lipitor.

      Along with threats of government action, however, was a rising threat by generic pharmaceuticals. Generics worked to whittle away at drug monopolies held by the large companies, often beating their rival's legal challenges. For example, a federal district court in August approved Barr Laboratories' plan to market a generic alternative to Eli Lilly and Co.'s Prozac, starting in 2001. The decision gave generics the green light to go after such popular drugs as AstraZeneca International's Prilosec and the Bristol-Meyers Squibb Co.'s Glucophage. Generic pharmaceutical manufacturers also received a boost via Congress, as legislation introduced in September was designed to streamline the federal approval process for generics.

      Ironically, perhaps the most reviled industry of the previous decade experienced a healthy year overall. Tobacco companies, especially industry leaders R.J. Reynolds Tobacco Co. and Phillip Morris Co., began a recovery in 2000 after a decade in which the once-invulnerable industry endured a series of legal challenges that culminated in the $206 billion settlement in November 1998 between tobacco manufacturers and 46 states. As the year progressed, it became clear that the major tobacco companies had been able to stem the tide against further legal action as well as increase their revenues.

      The U.S. Supreme Court ruled in March that Congress had not empowered the Food and Drug Administration to regulate tobacco, and legislation introduced subsequently to give the FDA such powers stalled in Congress. In addition, tobacco companies won several significant consumer lawsuits throughout the year in which states had tried to gain punitive damages. The companies also were in better fiscal shape, as R.J. Reynolds posted an 8% increase in income from continuing operations for the first nine months and Phillip Morris's profits were up 15% at the end of the third quarter.

      The cigarette companies were not home free, however. The impact of tax-influenced price increases was felt, as manufacturers had to raise prices by 13 cents per pack in January and again by 6 cents in July. There was also a growing discomfort about the long-term potential for tobacco companies, which resulted in their stocks' becoming less favoured by a number of investors. For example, the U.S.'s largest pension fund, the California Public Employees' Retirement System, voted in October to divest its $560 million of tobacco stock holdings.

      Consequently, it appeared that even the healthiest of industries had an inevitable downside during 2000, influenced by such factors as rising energy costs and general market uncertainty about Internet technology. Market analysts and investors concluded, however, that the return to form by such disparate industries as oil drillers and tobacco manufacturers showed that traditional industries may not be as appealing as those in high-tech enterprises, but they often are more rewarding.

Christopher O'Leary

▪ 2000

Introduction

Overview

  Selected Major World Stock Market Indexes, Table In early 1999 the mood of gloom and despondency persisted. It had been generated by the Asian financial crisis, which started with the collapse of the Thai baht in July 1997 and was further exacerbated by Russia's default of debt in August 1998. By the second quarter of 1999, however, there were signs of a return to financial stability and indications that the potential for a global crisis had been defused. Stock markets were getting back to normal in the developed countries (see Table V (Selected Major World Stock Market Indexes, Table )), led by Wall Street, and were recovering in Asia and Latin America, the less-developed regions most affected by the earlier financial turbulence. By the second half of the year, global economic conditions were improving, and the International Monetary Fund (IMF) revised upward its projections for real growth in 1999 from 2.3% to 3%. This compared with an actual increase in output of 2.5% in 1998, which was higher than had been projected. (For Industrial Production in selected countries, see Graph—>.)

       Real Gross Domestic Products of Selected OECD Countries, Table Changes in Output in Less-Developed Countries, Table Standardized Unemployment Rates in Selected Developed Countries, Table The less-developed countries (LDCs) experienced faster growth in 1999 (3.5%) than the advanced countries (2.8%), continuing a 30-year trend. (For Real Gross Domestic Products in Selected OECD Countries, see Table I (Real Gross Domestic Products of Selected OECD Countries, Table ); for Changes in Output in Less-Developed Countries, seeTable III (Changes in Output in Less-Developed Countries, Table ).) The difference in the growth rates, however, as in 1998, was much less than in earlier years. The U.S. provided the dynamo for much of the world growth, with the strength of its economy continuing to fuel strong import demand, but at the same time, it was creating a growing deficit on its current account. The burgeoning deficit was a cause of concern in case the U.S. had to take measures to curb it. The U.S. current-account deficit was in sharp contrast to the large surpluses held by most advanced countries. Growth in the Asian and Latin American countries would be particularly vulnerable to any slowdown in the U.S. economy. Elsewhere in the world, the Japanese economy gradually moved out of recession, helped by public investment, and output rose slightly in 1999 after a 2.8% decline in 1998. Nevertheless, economic hardship persisted in Japan. Restructuring of companies and new ways of doing business brought to an end the traditional expectation of employees of a job for life, and unemployment rose steadily. The unemployment rate apparently peaked at 4.9% in June, after which it fell to 4.6% (October). (For Unemployment Rates in Selected Developed Countries, see Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

   On Jan. 1, 1999, a new single currency, the euro, was introduced in 11 of the 15 European Union (EU) member states. (See World Affairs: European Union: Sidebar. (Euro's First Birthday )) Growth in the so-called euro zone decelerated to 2.1% in 1998 from 2.8% a year earlier. Two main factors contributed to the sluggishness in the first half of 1999: first, the tight fiscal policies put in place in 1998 by those governments seeking to qualify for the final stage of economic and monetary union (EMU) in the run-up to the creation of the euro and, second, the falloff in demand from LDCs. The European Central Bank (ECB) reacted to these conditions by making a half-percentage-point cut in interest rates—its first ever—in April. (For Interest Rates: Long-term— and Short-term—>, see Graphs.) Domestic consumption in the euro zone was boosted by consumer confidence. In the second half of the year, exporters benefited from the steady fall in the value of the euro since its launch. In the final quarter of the year, the euro depreciated against all major currencies and, in trade-weighted terms, reached new lows. In early December the euro fell sharply to parity with the U.S. dollar. (See Graph—>.)

 In the U.K., which had not joined the EMU, the economy performed more strongly than expected, and the recession predicted by many did not occur. The start of the year was marked by near stagnation as a result of the appreciation of sterling combined with weak demand for British exports. Activity gradually picked up, however, with output in the third quarter rising by 0.9%. Price pressures were greater in the U.K. than in the euro zone, but by the third quarter the annual rate of inflation had fallen well below the government's 2.5% target. This was despite the strong appreciation of the pound sterling against all major currencies, which largely reflected the weakness of the euro. (See Graph—>.) While the high pound was undoubtedly making life more difficult for exporters, the evidence suggested they were overcoming it.

  Changes in Consumer Prices in Less-Developed Countries, Table Global inflation fell to its lowest level in 40 years and, at the same time, disparities in national inflation rates narrowed. (See Graph—>.) This was largely a reflection of the fiscal disciplines followed by governments, many of which had adopted anti-inflationary policies in response to high price rises in the early and late 1970s. At the same time, increased global competition had a supply-side impact in keeping prices down. The financial instability in 1998 had given rise to fears of deflation (falling prices), and these persisted in some countries. In China, Japan, and Argentina, for example, prices in the final months of 1999 were running below year-earlier levels. (For Changes in Consumer Prices in Less-Developed Countries, see Table IV (Changes in Consumer Prices in Less-Developed Countries, Table ).)

      World trade became the focus of international attention during the year. Interest was prompted largely by the World Trade Organization (WTO) summit in Seattle, Wash., on November 30–December 3. This ministerial meeting of representatives of the 135 WTO member countries was to negotiate and agree upon the ongoing process of opening up and liberalizing world markets. The event was disrupted, however, by protesters from nongovernmental organizations and other groups, and the talks broke down. Opinions within the WTO differed in a number of areas. Significantly, however, the WTO ministers agreed that the existing tax moratoria on sales over the Internet should be extended for up to two years. The WTO negotiations were to be resumed in Geneva in April 2000.

      During 1999 the pace of globalization continued to gather momentum and was reflected in an upsurge in foreign direct investment (FDI) and increased economic integration worldwide. Mergers and acquisitions, led by the oil sector, provided most of the impetus for the FDI flows. While much of the activity was between transnational companies on both sides of the Atlantic Ocean, the share of LDCs was more than a quarter, most of going to Asia. The number of transnational companies reached 60,000, and they, along with their 500,000 affiliates, accounted for an estimated 25% of global output. According to the UN Conference on Trade and Development (UNCTAD), in 1998 sales of the affiliates were $11 trillion, compared with world exports of $7 trillion. Also in 1998, the latest year for which full figures were available, FDI rose more than 40% to more than $640 billion, and UNCTAD estimated that it could exceed $700 billion in 1999. The total stock of FDI in 1998 rose 20% to more than $4 trillion.

National Economic Policies

       Real Gross Domestic Products of Selected OECD Countries, Table The IMF projected a rise in gross domestic product (GDP) of the advanced economies—which included the industrialized countries, the euro zone countries, and newly industrializing countries (NICs) such as South Korea, Taiwan, and Singapore—of 2.8% in 1999. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).)

United States.

   Once again the United States was at the forefront of economic growth among the industrialized countries, with output projected at 3.7%, just below the 3.9% recorded in each of the previous two years. This made 1999 the eighth year in succession in which U.S. output had outstripped that of most other advanced countries. (For Industrial Production, see Graph—>.) As the year drew to a close, it seemed likely that the IMF's growth projection was too conservative and output would match the 3.9% of the two preceding years. In the third quarter output rose 5.5%. The rapid growth raised concerns that the economy would overheat and generate a high rate of inflation, which would prompt the Federal Reserve to raise interest rates. (For Interest Rates: Long-term— and Short-term—>, see Graphs.)

      From the start of 1999, the continuing strength of the economy surprised observers. The slowdown (or even a recession) expected as a result of the Asian financial crisis did not occur. Nearly all economic indicators were positive throughout the year. Demand continued to be fueled by confident consumers, whose spending accounted for two-thirds of U.S. economic activity. Consumer spending rose at an annual rate of 4.6% in the third quarter. The consumer confidence index of the Conference Board (a private business financial research group) reached a 30-year high when it peaked in June. Although it fell back subsequently, it rose again in October to close at its earlier level.

  Standardized Unemployment Rates in Selected Developed Countries, Table Confidence derived from several factors. The unemployment rate of 4.1% in November was at its lowest in 29 years. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).) Surveys showed that fewer consumers thought jobs were hard to find, while more thought that current business conditions were good and would improve further over the coming months. Around a quarter of a million new jobs were being created monthly. The hourly earnings rate, which reached $13.41 in November, reflected the low inflation rate as well as the tight labour supply. Personal income (wages, interest, and government subsidies) rose strongly, by 1.3% in October, which was the biggest monthly increase in over five years. The near lack of inflation was another key factor influencing spending. (See Graph—>.)

      A number of reasons explained the continuing economic boom in the economy. Increases in productivity (the amount of output for each hour of work) were being helped by the use of more advanced technology associated with computer networking and telecommunications. Revisions to historical figures released in November reflected the impact of new technologies and deregulation. These showed that productivity had been increasing at a faster rate than previously thought—by 2.8% in 1998—and was rising at an annual rate of 4.2% in the third quarter, when unit costs rose only 0.6%. The revised statistics also showed that the personal savings rate was much higher than previously estimated; instead of declining by 1.1% in the first nine months of 1999, it actually rose by 2.5%.

United Kingdom.

       Real Gross Domestic Products of Selected OECD Countries, Table In the U.K. the pessimistic note on which 1998 ended and 1999 began quickly gave way to muted optimism as economic indicators showed an unexpected resilience to the much weaker world economy. At 2.2%, GDP in 1998 had increased faster than the IMF projected; once again its projection of 1.1% for 1999 was looking too conservative, and the final outcome was likely to be at least 1.5%. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) At 0.9% the third-quarter rise in GDP was the biggest in two years.

      As in 1998, economic growth was led by domestic demand. Even in the first half of 1999, consumer demand rose at an annual rate of 5.2%. The buoyant demand was helped by the continuing increase in employment, low inflation, and the lower cost of variable rate mortgages as a result of the interest rate cuts.

   The preoccupation with keeping inflation below the government target of 2.5% was maintained throughout the year. Fears of a surge in prices were ill-founded, and, despite the oil price rise, housing boom, and other perceived stimulants, the rate of inflation remained low and was unlikely to exceed 2% over the year. (See Graph—>.) The most visible sign of consumer confidence was the housing market, which remained strong throughout the year, with prices rising by over 20% in Greater London and more than 10% in much of the rest of the country. In the first half of the year, house prices were buoyed by the lack of supply but after that turnover increased and did much to support further consumer demand. Sales of household goods were growing at a similar rate. To some extent the housing boom reflected investment rather than residential demand, particularly in the London area, where disposable incomes were highest. Nevertheless, the belief that housing activity was inflationary was a contributory factor in the Monetary Policy Committee's decision to raise interest rates from 5% to 5.25% on September 8. (For Interest Rates: Long-term— and Short-term—>, see Graphs.)

  The manufacturing sector bore the brunt of the weaker demand for exports and the strength of sterling. (See Graph—>.) This caused a fall in the competitiveness of some products, including textiles and metal, while others, including aerospace, electronics, and pharmaceuticals, performed well. Output increases in the services sector were led by demand for telecommunications, which was expected to increase more than 10%. Overall, however, investment in the manufacturing sector declined by about 12%. (For Industrial Production, see Graph—>.)

      Investment by the public and private sectors to achieve “Y2K compliance” (i.e., to reach a sufficient level of preparedness in anticipation of potential computer problems at the dawn of the year 2000) rose to the equivalent of 0.5% of GDP in 1998 and was likely to have been as much in 1999. Many firms were bringing forward their investment in information technology to try to ensure that the possible “Millennium bug” did not disrupt their business.

       Standardized Unemployment Rates in Selected Developed Countries, Table Trends in the labour market were mainly positive. Against the consensus view, the number of jobs continued to increase. Unemployment fell to a 19-year low at below 6%, in contrast to the 10% average for the euro zone, where rigidities in the labour markets contributed to the lack of labour demand. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).) There was a modest tightening of the labour market, but pay pressures were muted, and average earnings growth remained stable at an annual rate of increase of about 4.5%. The introduction of a minimum wage in April was estimated to have raised earnings by less than one percentage point, with an almost negligible effect on the rate of inflation.

      The March budget was broadly neutral, focusing on reforms to make work more financially worthwhile for lower-earning families with children. It provided a mild stimulus to the economy of just over $1 billion. Fiscal policy generally was restrictive, however, as various taxation changes announced in earlier budgets came into effect and were expected to raise £3.6 billion (about $6 billion) in revenues in 1999–2000.

Japan

   Real Gross Domestic Products of Selected OECD Countries, Table By the end of 1999, it was clear that Japan had moved firmly out of the deep recession that had caused it to contract by 2.8% in 1998. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).) The fragile recovery allowed a modest 1% rise in output in 1999. After five quarters of decline, the first-quarter growth of 1.9% halted the deterioration. The improvement was partially artificial in that it resulted from the major stimulus provided by two 10% increases in public-works spending for two quarters running. In addition, however, there were other signs of recovery in private construction orders and housing starts. Business confidence was rising across the corporate spectrum and was reflected in a 2.5% increase in corporate investment following a cumulative decline exceeding 20% over the previous two years. Small and medium-sized companies were benefiting from increased government support, and most businesses were helped by the lower long-term interest rates triggered by the Bank of Japan's (BOJ's) monetary easing in February. (For Interest Rates: Long-term— and Short-term—>, see Graphs.) Stock prices increased accordingly, and the Nikkei index rose for the first time since September 1997. Personal consumption rose despite falling earnings.

 The recovery continued, though in the second half of the year, growth was more modest, which reflected the end of the boost provided by public spending. As the year progressed, however, there were other favourable indicators. Industrial output by August was well up on expectations, rising 5.2% above year-earlier levels. (See Graph—>.) Overall capital spending was not expected to decline by as much as the forecast 11.1% in fiscal 1999–2000. Inventories were declining, while company profits were rising and were expected to increase by 25% in the current fiscal year.

  Standardized Unemployment Rates in Selected Developed Countries, Table Of some concern, however, was the strength of the yen, which intervention by the BOJ in June and July failed to curb. At the Group of Seven (G-7) meeting on September 25, the IMF stated that an exchange rate of ¥105 to the dollar was acceptable, but in early December this rate was exceeded. (See Graph—>.) Structural reforms continued to take place. The government was giving high priority to corporate restructuring, for example, through the Industrial Revitalization Law. A side effect of corporate restructuring was an increase in outsourcing by large firms, not only to reduce transaction costs as in the past but also to gain expertise to improve competitiveness. Unemployment at 4.6% (October) remained high and painful by Japanese standards and was bringing a change in expectation of a job-for-life culture. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

Euro zone

       Real Gross Domestic Products of Selected OECD Countries, Table In the euro zone, also known as the Euro-area, the long-awaited launch of the euro on January l went as planned and was the culmination of much preparation and debate among the countries of Western Europe. While the 11 countries that adopted the euro shared many common objectives, their economic structures and development paths had been very different, and this was reflected in their respective growth rates and prospects. Together the group had produced an increase in GDP of 2.8% in 1998, and a rise of 2.1% was projected for 1999. (See Table I (Real Gross Domestic Products of Selected OECD Countries, Table ).)

      The benefits of sharing a currency were perceived as lower transaction costs, but there was a downside. Possibly the biggest danger was asymmetric shock—when an economic event was felt very strongly in one country but passed unnoticed in the euro zone as a whole. Monetary policy was in the hands of the ECB, which acted in the interest of the euro zone as a whole and could not respond to local problems. The new system was powerless to prevent the higher unemployment that, for example, might result from such a shock without directing fiscal transfers between countries to compensate for loss of national monetary sovereignty. Such a solution would require political union, which was not on the stated agenda.

 After its strong and healthy birth, the euro quickly became a victim of its disparate owners and lost value. Of the four large economies (Germany, France, Italy, and Spain) that accounted for most of the euro zone's GDP, Germany and France were weak and curbing the area's growth. The harmonious relations that existed at the start of 1999 were soon disrupted in the first quarter when the German finance minister, Oscar Lafontaine, criticized the ECB for imposing a 3% interest rate when average inflation was 0.6% and unemployment 10.8%; he felt a one-size-fits-all interest rate was not appropriate for Germany at that time. Lafontaine resigned, but he had successfully exposed policy problems in the euro zone that were now revealed to the rest of the world. International confidence in the euro was shaken, and the currency moved into a steady decline. (See Graph—>.)

      The top performers in 1998 once again achieved the fastest growth in 1999. Germany, once regarded as Europe's most powerful economy, was not among these countries, but France was performing strongly. While rapid growth was experienced by several countries, including Ireland, Portugal, and, to a lesser extent, Spain, they were still catching up with the longer-established advanced economies such as France and Germany. On a per capita basis, GDP in all three smaller countries was below $15,000, compared with around $30,000 in France and Germany. While these stark differences were not necessarily reflected in living standards because of the different purchasing power parities, over time the closer integration of markets was expected to erode price differences.

      The most progress in 1999 was once again made by Ireland, where GDP rose 7.5% (8.9% in 1998), Spain 3.4% (4%), Austria 2% (3.3%), The Netherlands 2.5% (3.8%), Finland 8.6% (5.6%), Portugal 3% (3.9%), Luxembourg 3.5 (5.7%), and France 2.5% (3.4%). The laggards were Germany, where output was projected to increase 1.4% (2.3%), Belgium 1.4% (2.9%), and Italy 1.2% (1.3%).

       Standardized Unemployment Rates in Selected Developed Countries, Table A major problem remained the large budget deficits of Germany, France, and Italy in particular. They were limited to a maximum of 3% under the Stability and Growth Pack, and little progress was made in 1999 toward reducing or eliminating them. The level of employment fell slightly over the year to September to an average of 10%, compared with 10.7% a year earlier. (See Table II (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

The Former Centrally Planned Economies.

      For the former centrally planned economies, November 1999 was the 10th anniversary of the fall of the Berlin Wall and the end of a decade of upheaval and market reforms. Mixed progress had been made in institutional reforms, privatization, and the many other changes required to develop a market economy. Only in Poland and Slovenia had economic output exceeded the 1989 levels, and average output of the Commonwealth of Independent States was only just over half that of a decade earlier. In 1999 the region registered slight growth (0.8%). There was no growth in Russia because of the 1998 financial crisis, and neighbouring countries suffered from increased inflation rates and currency depreciation. There were wide disparities in performances, with falls in output in Croatia, Belarus, Moldova, and Ukraine among others while Albania and Turkmenistan increased strongly.

Less-Developed Countries.

       Changes in Output in Less-Developed Countries, Table Changes in Consumer Prices in Less-Developed Countries, Table The IMF projected that output of the LDCs would increase 3.5% in 1999, a slight acceleration on the 3.2% achieved in 1998. (See Table III (Changes in Output in Less-Developed Countries, Table ).) The performances between and within regions, however, were very mixed. (For Changes in Consumer Prices in Less-Developed Countries, see Table IV (Changes in Consumer Prices in Less-Developed Countries, Table ).) Latin America made no contribution to overall growth, with most countries experiencing drops in output. The emerging country crisis, which had caused regional conditions to deteriorate in 1998, had raised the cost of debt, limited the amount of external funds, and depressed commodity prices. Brazil's decision on January 13 to float the real caused an outflow of dollars and created further chaos in the region. The Brazilian real fell sharply, and at one point in January it was down 40% against the dollar. The economic collapse was most devastating for Brazil's trading partners in the Southern Cone Common Market (Mercosur)—Argentina, Uruguay, and Paraguay—which depended on Brazil for around a third of their exports.

      The crisis did not, however, deepen as expected. The central bank moved quickly to reduce liquidity, and when IMF funding of $9 billion and more financial support from the Group of Seven (G-7) countries was announced in March, confidence returned. Fears that the high interest rates imposed would fuel inflation were allayed, and prospects for the year 2000 were for growth of about 3.5%. By contrast, Mexico performed well, growing by around 3% on top of a 4.8% rise in 1998. Industrial output rose strongly, helped by increasing retail sales, and unemployment fell. There was greater political stability, and a major factor contributing to growth was the strong North American market, from which Mexico, through its North American Free Trade Agreement membership, was a major beneficiary.

      Venezuela, as in 1998, was one of the region's worst performers, with output likely to have declined by more than 7% in 1999. The inflation rate remained high at an annual rate of around 25%, and political problems persisted. Conditions in Colombia deteriorated sharply following many years of growth and stability. The cost of the guerrilla war and banking-sector problems contributed to economic stagnation and the worst recession since the 1930s.

      From early in 1999 there were signs of recovery in much of Asia, particularly among the Association of Southeast Asian Nations (ASEAN) countries, which had suffered real declines in GDP in 1998. The speed and sustainability of recovery in the region, however, depended on the effectiveness of the financial and corporate reforms. This would enable the more efficient allocation of financial and human resources, which in turn would increase international credibility and prevent further shocks. The 5.4% rise in output of the Asian LDCs (excluding the NICs), therefore, once again provided much of the growth in the less-developed world and was the fastest-growing region. Performances were mixed, however, ranging from China, where output rose fastest at 6.5%, to Indonesia, which was the only country where output was still in decline.

      China proved to be the most resilient in the emerging countries crisis, but its impressive first-quarter rise in output of 8.3%, following the previous quarter's rise of 9.6%, was the result of heavy state investment to prevent the increase in unemployment from reaching politically unacceptable levels. The rate of growth slowed during the year and was projected at 6.6% for 1999, which reflected a decline from the 1998 rate of 7.8%. Fundamental structural problems of excess capacity in industry and overproduction in many of the loss-making state-owned enterprises continued. These, combined with the reluctance of consumers to spend because of concerns about unemployment and the need to save to compensate for lower welfare benefits, were reflected in deflation. Following a decline of 0.8% in prices in 1998, consumer prices were expected to fall a further 1.5% in 1999. The proposed Chinese membership in the WTO was controversial because of the exposure to competition, particularly in the motor industry, petrochemicals, and heavy industry, much of which was heavily protected by the state.

      Elsewhere in Asia, India's GDP was expected to increase by 5.7%. Like China, it benefited from capital controls in the foreign exchange markets as well as its low ratio of exports to GDP. The economy also benefited from improvements in the agricultural sector, which boosted domestic demand because of higher agricultural incomes, improving exports, a halving of the inflation rate from 13% in 1998, and rising industrial output. In Thailand there was a stronger-than-expected recovery from the deep recession that had resulted in seven quarterly contractions in real GDP from the middle of 1997, with output rising by 4%. As in the Philippines (2.2%) and Malaysia (2.4%), the turnaround was helped by the recovery in demand for electronics. All three depended heavily on electronics for export revenue (over a third for Thailand and more than half for Malaysia and the Philippines), and the depreciation of their currencies over the year improved competitiveness.

      Indonesia remained the sick man of Asia, but there were signs of a turnaround despite the disruption to the economy because of political turmoil and civil unrest. After a decline of 13.7% in 1998, output was expected to decline only marginally in 1999 (−0.8%). The rate of inflation was projected to tumble from 60% in 1998 to 23% over the year. In November the year-on-year price increase had fallen to 1.6%, and second-quarter industrial output was up more than 10% on year-earlier levels. A major area of concern was the banking sector, where complicated and expensive reforms were required. The government's own estimate of the cost of recapitalizing the banks was around $70 billion.

      In the Middle East the rise in GDP was expected to decline from 3.2% in 1998 to 1.8% in 1999, while the IMF projected an increase of 3.1% in Africa, only slightly less than in 1998 (3.4%). In both regions inflation fell in most countries to below 5%, the principal exception in the Middle East being Turkey (85%), where the devastating earthquake in August made a decline in GDP inevitable. In Iran inflation remained stubbornly high at more than 20%. A potential boost to the economy came from the largest national oil discovery in 30 years close to the Iraq border. The new field was estimated to contain 26 billion bbl of oil and was a major attraction for foreign oil companies.

      Much of sub-Saharan Africa was being adversely affected by conflicts and civil unrest, compounded by the global economic slowdown. In North Africa, Egypt (6%) was growing strongly, and there was considerable international interest in its large and vibrant market. Tunisia benefited from strong export growth and tourism earnings. In South Africa growth was modest and was not helped by industrial action in the public sector. The battle against inflation, however, appeared to have been won (projected at 6.5%), and in August inflation fell to its lowest rate in 30 years. In October the year-on-year rate was 1.7%. Nigerian GDP was expected to increase only marginally (0.5%) because of lower oil prices early in the year and then lower output later in the year as a result of quotas imposed by The Organization of Petroleum Exporting countries. Non-oil GDP, however, rose by 3%.

International Trade, Exchange, and Payments

      The projected rise in the volume of world trade in 1999 of 3.7% was low by long-term growth rates but better than had been predicted, given the deterioration of world trading conditions. In dollar terms global exports rose by just 2.4%—to $6,844,000,000,000—compared with 1998. Industrialized countries with links to Asia suffered less than expected. The increase followed a sharp slowdown to 3.6% in 1998 from the 9.9% peak reached in 1997. The lack of buoyancy in world markets resulted from the financial crisis, which started in parts of East Asia in 1997 and threatened a global recession. This appeared to have been averted, helped by the faster-than-expected recovery in East Asian countries and the strength of the U.S. economy, which continued to absorb a large proportion of world output. It was the U.S. demand for imports that fueled global expansion.

      As in 1998, it was the advanced countries that provided the strongest growth market for exports, taking 5.9% more than in 1998, which in turn was up 4.8% on 1997. Demand from the LDCs rose marginally by 1.1%, compared with a 1.3% decline in 1998. Imports by the countries in transition fell sharply, largely reflecting the deterioration in the Russian economy, but their exports rose by 2.7%. For the second year running, exports of the LDCs reflected the slowdown in the economic activities of the advanced countries. This broke a trend established over more than a decade previously in which the export momentum was being driven by the LDCs, led by Asia.

      Despite the global slowdown, efforts to liberalize world trade continued, and there were few overt signs of attempts to return to protectionist measures. There was, however, a disappointing outcome to the WTO meeting in Seattle, where the disruption caused by protesters caused the talks to break down. Opinion differed in a number of areas. For example, delegates were divided on whether agricultural products should ultimately be treated the same as other products. One group wanted agricultural trade to be subject to the same rules as other products and to have all subsidies eliminated, while another group would not accept the lifting of subsidies on the grounds that agriculture was different from other sectors. The EU was among those opposing the elimination of subsidies, but during negotiations it modified its stance. While considerable achievements had been made in liberalizing industrial goods, there had been much less progress in the agricultural sector, which was heavily protected and subsidized. According to producer support estimates, these subsidies amounted to 60% in Japan, 40% in the EU, and 20% in the U.S. By contrast, there was very little support in Australia and New Zealand.

      Proposals for creating a labour standards group within the WTO were the cause of considerable controversy and were opposed by a number of LDCs, which saw the proposals as a move toward the imposition of trade sanctions if labour standards were defined and not met.

      The failure of the WTO meeting also represented a threat to China's accession to the WTO. At the seventh annual meeting of the Asian-Pacific Economic Cooperation (APEC), held in Auckland, N.Z., in mid-September, U.S. Pres. Bill Clinton had talks with Pres. Jiang Zemin of China that culminated in agreement to negotiate China's membership in the WTO. Anti-Chinese and protectionist members of Congress, which was to vote on China's accession early in the year 2000, might well try to block this.

      The APEC meeting, however, was more positive. Its 21 member countries accounted for around two-thirds of world trade. So far APEC had made only limited progress toward its objective of removing trade barriers by 2010 (2020 for LDCs), with only a third of its tariff cuts having been made by the start of 1999. A stumbling block was the requirement that when an APEC member cut its tariffs, it had to simultaneously cut them for all WTO members. The meeting concluded with a pledge by the economic leaders to resist protectionism and to open markets further. They would work together to strengthen their markets through, among other things, greater transparency, increasing competitiveness to improve efficiency, and the building of a more favourable regional and international environment for free and fair competition.

      The strong commitment to liberalization in the member countries was reflected in a preliminary meeting of 250 corporate executives from the Asia-Pacific region to discuss globalization in the 21st century. The meeting was also attended by several APEC leaders, including the presidents of the U.S., China, South Korea, and Mexico. Delegates put a strong case for trade and investment liberalization to be treated as urgent, stressing the fact that technology was accelerating globalization and bringing down barriers between people as well as obstacles to trade. They communicated the need for APEC leaders to take initiatives to adapt and harness the power of new technologies to serve the public in order “to maintain sovereignty.”

      The trend toward greater regionalism continued, and by 1999 there were more than 100 regional trade agreements in force. While such agreements led to the dismantling of barriers within the groupings, they were not often applied outside them, which was a cause of concern. The EU continued to remove trading barriers with neighbouring countries, and in the December meeting in Helsinki, Fin., it reached agreement to extend EU membership to many other countries, including Turkey and Malta. EU trading practices, however, appeared increasingly inward-looking; during the 1990s intraregional trade rose steadily to reach 62.5% by 1999, a higher proportion than any other trading group. By contrast, intraregional trade of the ASEAN countries was only around 20%, its main thrust being to secure a large world market share.

      The trade of Mercosur fell by close to a third in 1999 from $22 billion in 1998 as a result of the Brazilian devaluation and recession. At their twice-yearly meeting on December 8, the Mercosur countries' leaders failed to reach agreement on how they would liberalize their managed trade in cars and car parts at the end of the year. They did, however, agree on a “mini-Maastricht” and discussed the possibility of a single currency based on a basket of the dollar, yen, and euro. The West African Economic and Monetary Union members reduced their external tariff in preparation for establishing a common external tariff in January 2000.

 In 1999 exchange-rate attention was heavily focused on the euro and developments in the euro zone. The objective of monetary policy was the achievement of price stability across the region. After a promising start, however, markets quickly became disillusioned, and the lack of confidence was reflected in its steady fall in value against all major currencies. (See Graph—>.) In trade-weighted terms, the decline was more than 11% over the year to December 6. Because of the relatively closed nature of the euro zone, imports accounted for less than 10% of GDP and therefore did not create an inflation problem. In any case, because of competitive pressure, producers were absorbing increases in import costs, much of which was generated by the oil price rises.

      The leaders of the euro countries suffered a loss of face over the weakness of the currency and the lack of business confidence. Nevertheless, most of them were thereby provided with a valuable and badly needed boost for exports, which were made more competitive against American and British products. Because of the weakness of the euro, sterling, the dollar, and, to a lesser extent, the yen became safe havens.

      The weakness of the Japanese yen ended in early January on signs that the recession in Japan had at long last bottomed. It broke through the ¥110 level against the dollar for the first time since September 1996. At the same time, the BOJ was under pressure to ease monetary conditions by buying government bonds. On February 12 it announced that it would lower overnight target interest rates on unsecured loans from “around 0.25%” to “approximately 0.15%.” Measures were also taken to curb the rise in bond yields. The yen drifted down slightly and for the first half year fluctuated in the range of ¥120–¥125 to the dollar, underpinned by the strong current-account surplus running at around $10 billion a month. The first-quarter GDP growth rate announced in June confirmed the economic recovery and provided a further stimulus. Intervention by the BOJ, which had pushed foreign exchange reserves to a record $246.4 billion in June, failed to stem the rise, and the statement on September 25 by the G-7 on the “shared concern regarding the appreciation of the yen” provided only the briefest respite. By October the yen was trading at ¥105 to the dollar, with the BOJ still maintaining its zero-rate interest policy until it perceived there was no risk of deflation. As the year drew to a close, it appeared that the Japanese economic recovery, the apparent inevitability of a U.S. slowdown, and the continuing relative weakness of the euro would prevent the yen from falling to a more competitive level. In the first week of December, it was trading at ¥103, compared with ¥ll8 a year earlier. On a trade-weighted basis (1990 = 100), the yen rose 19% to ¥154 from ¥129 to the dollar over the year to December 8.

      The overall current account of the advanced countries was projected to move into deficit once again following six consecutive years of surplus. The turnaround indicated by the $77 billion deficit, compared with a surplus of $37 billion in 1998, was more than accounted for by the increase in the U.S. deficit from $22l billion to a projected $3l6 billion, which was likely to be exceeded. The strength of consumer demand, low inflation, and the drop in non-oil commodity prices led to record imports through much of the year. By September, when imports exceeded $106 billion and the trade deficit widened to $24 billion, the 12-month deficit stood at a record $314 billion. The size of the deficit with China was becoming highly controversial ($6.9 billion in September) and posed a threat to the agreement on closer trading links, and the deficit with Japan was only slightly less.

      Higher oil prices contributed to a drop in the surplus in the euro zone of more than a third to $58 billion, with Germany and Spain each having deficits approaching $10 billion. Most other euro zone countries had large surpluses, led by France ($43 billion), Italy ($23 billion), and The Netherlands ($21 billion), but those had fallen from year-earlier levels. Outside the euro zone, the U.K. moved into deficit (around $20 billion) after a small and unexpected surplus in 1998, as the high value of sterling encouraged imports but made exports less competitive. Elsewhere, the deficit in Australia grew by about 15% and was likely to have exceeded $20 billion. The modest improvement in New Zealand's economy and the heavy dependence on domestic demand still left the current account at around $3.2 billion, or the equivalent of more than 6% of GDP.

      The overall current-account deficit of LDCs fell from to $77 billion to $56 billion, with Africa unchanged ($19 billion). The improvement was brought about by the rise in oil prices, which reduced the Middle East deficit by $14 billion to $6 billion. A halving in the Asia current-account surplus to $26 billion was offset by a fall in Latin America's deficit. The external debt of the LDCs rose marginally to $l,969,600,000,000, which, as a proportion of exports of goods and services, fell by 7 percentage points to 160.6%. The debt of the former centrally planned economies remained on a steadily rising uptrend, reaching $59.4 billion ($53.7 billion), or 110% of exports of goods and services.

IEIS

Stock Exchanges

       Selected Major World Stock Market Indexes, Table Late in 1998 the consensus was for, at best, severe correction in the U.S. stock market in 1999. In popular wisdom the market was grossly overvalued and narrowly led by overhyped Internet and information technology shares. Yet the strength of the U.S. market continued to underpin market activity worldwide, and at year-end 1999 both the National Association of Securities Dealers automated quotations (Nasdaq) composite index, which was heavily weighted in technology stocks, and the Dow Jones Industrial Average (DJIA) stood at all-time record highs. Asian markets consolidated a remarkable recovery despite widespread disquiet about the slow pace of economic and financial reforms. The new European currency, the euro, was widely tipped to go from strength to strength but languished around parity with the dollar for much of its first year. (See World Affairs: European Union: Sidebar (Euro's First Birthday ).) Most European bourses, however, continued their upward trends. (See Table V (Selected Major World Stock Market Indexes, Table ).)

      During 1999 another potential consensus emerged—that a “paradigm shift” had broken the familiar economic and business cycles. The argument ran that the spread of new technologies, spawning increased international competition and greater price transparency, would exert downward pressure on inflation and upward influence on growth. There would be a more permanent shift to higher growth with low, stable inflation. According to British economist DeAnne Julius, however, these changes were not new. They represented the re-emergence of trends last at work in the 50 years up to World War I, when new technology also powered global growth and kept prices stable. The danger was in continuing to use the economic models of the 1970s and 1980s to make sense of the present.

      The run-up to the year 2000 presented investors with the prospect that stocks would remain the most lucrative place for their money. According to the U.S. Federal Reserve (Fed), in 1998 Americans held more of their assets in stocks than in their homes, and more than 28% of household assets were in stocks, the highest level yet recorded. Much of that investment represented retirement savings and reflected the growth in popularity of day trading, in which players engage in quick-turnaround stock and option trades on the Internet. On-line share transactions tripled in the third quarter and were expected to triple again within six months. The growth of electronic communications networks (ECNs) and on-line brokerages posed a threat to the world's traditional stock exchanges. (See Special Report (Electronic Trading ).) The nine ECNs based in the U.S. had already taken around 25% of equity trading there in just two years. Although the share of trade taken by on-line services in Europe was still only 5%, most American ECNs planned to enter the European market. Only the possibility of computer problems associated with the beginning of the year 2000 (Y2K) undermined confidence, but that occurred generally only in investment in parts of the world judged to have largely neglected or ignored their “Y2K compliance” problems, such as Eastern and Central Europe and sub-Saharan Africa.

IEIS

United States.

       Selected U.S. Stock Market Indexes, Table The U.S. stock market achieved record levels of trading and volatility in 1999 as investors took advantage of a booming economy to invest in stocks. The DJIA, which began the year at 9181.43, moved irregularly through the end of February, hit the 10,000 mark in March, then climbed rapidly to a peak above 11,000 in May. The index moved irregularly through the end of August, declined to 10,000 in October, and then rose to close at a record 11,497.12, a 25.22% rise for the year. The broader Standard & Poor's index of 500 stocks (S&P 500) stood at 1469.25 at year-end, up 19.53%, and the Nasdaq index rose steadily during the first nine months of the year before a huge spurt beginning in mid-October pushed it to 4069.31, up a record 85.59%. The Russell 2000 index, which represented primarily small-capitalization (small-cap) stocks, gained 19.62%. (See Table VI (Selected U.S. Stock Market Indexes, Table ).) Volatility was high, with the S&P 500 moving up or down by at least 1% on more than 35 trading days in 1999, the highest turnover rate since the 1974 bull market, when stocks moved more than 1% on 45.1% of trading days. Stock market gains were widespread, with technology stocks leading the way. Bond prices declined as interest rates rose in response to efforts at controlling inflation. The 30-year Treasury bond yielded 6.3% or more in the last half of the year, compared with 4.99% a year earlier.

      The U.S. economy enjoyed its ninth year of expansion, with the index of leading economic indicators registering gains in most months. Consumer confidence was high, and securities analysts were predicting continuing advances in stock prices through the year 2000 based on record corporate-profit levels. The Fed raised interest rates three times in an effort to control inflation in the face of rising commodity prices and an unemployment rate of 3.41%, the lowest in three decades.

      More than 1.5 billion shares traded daily in record turnover. The annual turnover rate of shares rose to a 50-year high of 95%, closing in on the all-time high of 119% recorded in 1929. Stock trading on the Internet accounted for more than 20% of all market volume. The movement toward markets' remaining open after the close of the stock exchanges' normal hours of business also accelerated in 1999 with the advent of ECNs.

      Initial public offerings (IPOs) met with very warm receptions in 1999. In the biggest first-day gain of an IPO, shares of VA Linux Systems, Inc., rose 698%, despite little revenues and poor prospects for any earnings in the foreseeable future. Companies deriving most of the sales from Internet services performed markedly better than most new issues, generating on average a 224% return, compared with a 157% overall average. The IPO market raised more dollars in 1999 than in any other previous year on record, almost twice as much as in 1998.

      The number of stock owners in the U.S. soared to 78.7 million people early in 1999, 85% more than in 1983, when the long bull market was getting under way. Among households, 48.2% owned stock directly or through mutual funds, more than double the 19% with such a stake in 1983. Margin debt shot up to $189 billion at midyear, a 25% increase in just six months and the most ever recorded. It accounted for 1.2% of the stock market's total capitalization. This was the greatest volume increase of margin debt since the 1930s.

      Mergers and acquisitions activity flourished as deals worth $570 billion were completed in the first half of 1999, compared with $528 billion for the same period in 1998. Capital raised in IPOs totaled more than $75 billion, roughly equal to the amount raised in new stock issues during all of the 1980s, according to Sanford Bernstein & Co. The average stock rose 60% on its first day of trading in 1999. Wall Street investment banks competed aggressively for leadership in underwriting the $33 billion market for convertible securities. Merrill Lynch & Co. ranked first with a market share of 23.1% and proceeds of $5,190,000,000. Morgan Stanley Dean Witter was second with $5,190,000,000 and a market share of 16.5%. Goldman Sachs was third with $5,130,000,000 raised and a market share of 16.4%. The three leading bond underwriters in 1999, each with more than 1,000 offerings, were Merrill Lynch with 1,649 offerings for $262,610,000,000, Salomon Smith Barney with 1,280 for $226,450,000,000, and Morgan Stanley Dean Witter with 1,825 for $153,870,000,000.

      The prime rate began the year at 8%, was raised to 8.25%, and remained steady at 8.5% at the end of the year, while yields on bonds of all maturities rose. The 30-year Treasury bond yield was 6.16% on December 10, up from 5.02% a year earlier. The 10-year Treasury note yielded 6.06% in mid-December, up from 4.61% in the corresponding period of 1998. Telephone bonds were 8.09% in December, up from 6.72% a year before, and municipal bonds were 6.07%, up from 5.1% in December 1998. The Fed's interest policy was a major factor in investor expectations about the duration of the bull market. Each time the interest rate was raised, a cautionary warning was given about the need to markedly diminish the risk of rising inflation's going forward.

    Average weekly volume on the New York Stock Exchange (NYSE) was 3.8 billion shares in 1999, compared with the prior year's 3.2 billion, a gain of 18.75%. (For New York Stock Exchange Composite Index—> and Common Stock Index Closing Prices—> and for volume of shares sold: in 1999— and since 1977—>, see Graphs.) Despite the impressive rise in the DJIA, on the Big Board only 1,432 of the 4,206 stocks listed rose for the year, while 2,727 declined and 47 remained unchanged. The list of most active issues reflected the market's volatility: America Online almost doubled on a volume of 5.1 billion shares traded, second-place Compaq Computer dropped by more than half on nearly 4.2 million shares, followed by AT&T, virtually unchanged on just under 2.7 million shares traded.

      The Big Board announced plans to introduce an electronic trading (e-trading) platform designed for individual investors. Rule 390, which restricted off-board trading of certain listed securities, was abolished as the various exchanges began to open their facilities to the securities listed by other exchanges. New institutional products, competitive pricing initiatives, and consideration of new electronic networks would give an entrée to Nasdaq stocks. The NYSE also announced plans to go public, which would enable it to respond better to the challenges posed by ECNs. On Aug. 23, 1999, a seat on the Big Board sold for $2,650,000, an all-time record. There were 1,366 seats on the exchange, and, with a current bid of $2.4 million, there were no offers to sell.

      Average weekly volume on the American Stock Exchange (Amex) in 1999 was 151,315,265, up from 137,551,918 a year earlier, a gain of 10%. As on the NYSE, declines (607) exceeded advances (406), with only 14 equities unchanged. The Amex embarked on an aggressive campaign to boost its market share. Following on its success with index funds that could be traded throughout the day like stocks, the Amex worked on a project that would allow trading of actively managed mutual funds, too. Such a fund might have a lower expense ratio, in addition to certain tax advantages. Shares of exchange-traded funds, which tracked popular indexes, were among the most heavily traded securities on the Amex. Notable among these was the Nasdaq 100, which rose almost 80% on more than 1.4 million shares.

      Nasdaq announced that it was applying to become a formal stock exchange, rather than continuing merely as a trading “facility.” Formal registered-exchange status would give Nasdaq the ability to trade certain NYSE-listed stocks such as IBM and AT&T. The 5,500 broker members of the National Association of Securities Dealers (NASD) were scheduled to vote on the issue of having the board become a public company with the filing of an IPO. In an effort to adapt to the technological revolution in the market, Nasdaq planned to contract with Primex Trading to offer trading in both Big Board and Nasdaq stocks, using an e-trading auction approach. In other initiatives Nasdaq negotiated trading facilities in Europe and Japan. In 1999 three stocks, Microsoft Corp., Intel Corp., and Cisco Systems, accounted for nearly a quarter of Nasdaq's total capitalization. The trio, which finished the year second, third, and fourth, respectively, behind Dell Computer Corp. on the Nasdaq most-active list, had an average price-earnings ratio of about 65. Internet-related “dot.com” companies were among the most widely followed stocks on the Nasdaq, particularly Amazon.com, headed by entrepreneur Jeff Bezos (see Biographies (Bezos, Jeffrey P. )), which ended 1999 seventh on the most-active list.

      More than $2 trillion was invested in domestic mutual funds in the U.S., and each day another $1 billion was placed in this area of investment, with 28% of all households reporting ownership. More than 3,600 domestic mutual funds were in operation, predominantly consisting of portfolios with stocks, bonds, or a combination. Cash inflows into equity funds were decreasing, having peaked at $227 billion in 1997. By August 1999 the annualized rate was about $180 billion. Funds were seeking long-term investors to reduce turnover. The increase in short-term trading in mutual-fund shares led many funds to adopt redemption fees (often for shares held less than 90 days) in order to reduce the impact of the administrative short-term costs of trading by investors. Investors were gradually becoming aware of the toll taken by fund costs, which resulted in lower net cash flows into equity funds. According to Business Week magazine, nearly 96% of the diversified U.S. equity funds underperformed the S&P 500 index over the most recent five-year period.

      Inflation concerns and widely publicized hawkish comments by Alan Greenspan, chairman of the Fed's Board of Governors, made bond investors nervous. The benchmark 30-year bond, which lost more than 9% of its value during the first half of the year, fell further as yields climbed on speculation about the likelihood of higher interest rates. The yield curve firmed up to reflect inflation concerns, and fixed-income investors sustained a reduction in total investment returns. The corporate bond market was dismal in 1999, suffering its worst year since 1994 and its second worst since 1973. With stock market returns at all-time highs, investors had little incentive to move into bonds.

      The Commodity Futures Trading Commission, in an effort to simplify performance claims, proposed a rule under which commodity advisers would be able to use a hypothetical account size to figure their returns for all sales and promotional materials. The current practice was to calculate returns on the basis of actual amounts invested, as they were in the securities industry.

      The SEC played an active role in encouraging the development of ECNs and general market competition by encouraging discussion by the NYSE about relaxing its monopolistic market in listed stocks. By rule, the SEC permitted expansion of the Intermarket Trading System to include all Big Board stocks, as well as Nasdaq stocks to be traded by ECNs. Among major issues identified by SEC Chairman Arthur Levitt in 1999 were the proposed demutualization of the national exchanges, the impact that greater competition was having on order flow, liquidity and execution costs, the need to interlink market centres, and, more broadly, the challenge to provide investors with the efficiency of central markets without sacrificing innovation.

Canada.

      The Canadian stock market rose to record levels in 1999, with the economic indicators achieving new highs. The Toronto Stock Exchange's index of 300 stocks (TSE 300), which began the year at 6,485.94, climbed past 7000 in April, fluctuated within a narrow range, and then broke through the 7000 mark again in July with a year-end spurt to 8413.75, for a gain of 29.7%. Much of the index's rise was credited to the high-tech telecommunications-equipment firm Nortel Networks Corp., which soared 281%. The best-performing sector was industrial products, up 102.5% for the year; the worst was pipelines, down 33.5%. Volatility, measured by changes on a daily basis, rose during 1999 well above prior levels. Net sales of mutual funds investing in national stocks fell during the first three quarters of the year compared with the corresponding period of 1998.

      The Canadian economy grew at a robust rate fueled by consumer spending and corporate investment. At an annualized rate of 3.7%, 1999 marked the fifth year of growth in the total value of goods and services produced in the country. The minister of finance reported that “Canada is in the process of achieving a financial turnaround of historic proportions.” Fast-rising budget surpluses were to be used to reduce the national debt and lower tax rates. The jobless rate fell to 7.2% in October (the lowest level since March 1990), then fell again to 6.9% in November. Investors felt that economic prospects were good; oil and gas prices rose sharply in 1999; and the Asian recovery fueled demand for minerals and wood products.

      More Canadian money was invested in U.S. securities than in Canadian, according to the government agency Statistics Canada, but Americans were also investing in Canadian stocks. In the first seven months of 1999, Americans increased their holdings of Canadian stocks by $6.5 billion, a sevenfold increase over the corresponding period in 1997. American direct investment in Canada passed the $100 billion mark, a record high. In the first nine months of 1999, U.S. companies bought 181 Canadian companies for $124 billion, double the amount spent during the corresponding period of 1998, according to a survey by KPMG Corporate Finance.

      Yields on Canadian government bonds began the year at about 5.2% and climbed to a peak above 6% by year's end. The prime rate, however, was stable at 6.5%.

      In response to rapid changes in the market structure of the securities industry, with electronic communications networks expanding their scope, the major stock exchanges in Canada began a process of restructuring. The Canadian Exchange was established as an association of the Montreal Exchange (ME), the Calgary Stock Exchange, and the Vancouver Stock Exchange. The Canadian Venture Exchange (CDNX) was set up to contain companies listed on the existing Alberta and Vancouver exchanges. Quebec was offered its own specialized stock exchange by securities industry officials eager to keep the planned National Junior Market on track. The purpose would be to allow Quebec to have its own specialized junior exchange that would operate alongside the CDNX, which began trading in November.

      Stock trading on the ME, except for some 120 tiny stocks, stopped, and those stocks were moved to the TSE. The remaining stocks were traded on an electronic communications network set up by the CDNX in western Canada. The ME became the country's sole exchange dealing in derivatives such as futures and options.

      The restructuring of the market, with well-capitalized companies listed on the TSE and less-well-capitalized companies traded on the CDNX, inevitably reduced the market for securities formerly traded on the ME. The Quebec government was reportedly trying to lure Nasdaq to Montreal. The Nasdaq link in Montreal would be an electronic exchange that would list high-tech firms and other small-cap companies in the province, linked to its New York trading network. It was believed that Nasdaq would give small firms exposure to investors in the U.S., who were believed to be more creative and less conservative, and would give higher values to small-cap companies. Nasdaq had made an arrangement for the creation of both a pan-European and a Japanese stock market, and it was felt that a Quebec affiliation would be worthwhile. At year's end about 130 small-cap firms were listed on the ME, although trading took place on the facilities of CDNX in Vancouver.

Irving Pfeffer

Western Europe.

 The launch on Jan. 1, 1999, of the new European single currency, the euro, was greeted throughout the world as an immensely positive development. On the euro's first day of trading, shares and bonds moved up sharply. The currency, created at a level against the dollar of below $1.17, moved up to $1.19 in Asian trading before falling back to $1.18 on European bourses. Dealers reported that the euro had completely taken over from the old currencies and that trading in the Deutsche Mark had almost disappeared. Contrary to expectations, however, the U.S. dollar remained strong and the euro faded, losing 15% of its value by December. (See Graph—>.)

      The internationalization of markets continued through the increasing popularity of equity mutual funds, including index and hedge funds, and through fundamental changes in buying and selling securities. Until recently, traditional stock exchanges had been mutuals—that is, owned by their members. By 1999 many exchanges were becoming listed companies quoted on their own markets, including the NYSE and, under pressure from the rapid development of e-trading, the London Stock Exchange (LSE), which needed to raise capital for technological development and business expansion. On November 4 the LSE launched techMark, a market within a market for technology companies, with which it hoped to rival the Nasdaq. Progress in merger talks, which started in 1998 with European bourses, had been slow. It was not until September 22 that the eight exchanges—Brussels, Frankfurt (Ger.), Amsterdam, Madrid, Milan, Paris, Zürich (Switz.), and London—agreed on a common basis for trading blue-chip stocks and to implement a common electronic interface by November 2000. In the meantime, a consortium of 19 U.K.-based securities managers had set up an e-trading network, E-crossnet, that was intended to bypass the LSE and the continental bourses. Asset managers expected to save up to 80% on the matched trades that accounted for one in 10 of the total, the system anonymously matching buy and sell orders between managers. Several leading securities houses also bought equity stakes in Easdaq, a Brussels-based pan-European electronic market.

      The London International Futures Exchange was forced to abandon its open-outcry system of trading, having come close to collapse after losing business to European electronic rival Eurex. The exchange went electronic on November 4, clearly not too soon; the arrival of intelligent stock-picking software that learns as it works was announced at the end of September.

      Traditional exchanges showed continued growth, with Britain's benchmark Financial Times Stock Exchange 100 (FTSE 100) closing the year at 6930.2, up 18%. With the notable exception of Ireland, which rose less than 0.5%, most Western European bourses did even better, including Sweden (up 66%), France (51%), Germany (36%), and Italy (22%). Finland, propelled by telecommunications-equipment giant Nokia, surged more than 160%.

Other Countries.

      Across Asia stock markets rose, currencies strengthened, and the economic outlook improved, but arguments continued about the fundamentals. Many believed that the market rises were not built on any change in the “crony capitalism” that had led to global financial crisis two years earlier. Most agreed, however, that important lessons had been learned. In precrisis days governments largely directed investment, not always to where it would be most efficient or effective. By 1999 the power of world market forces was being accepted and was visible even in closed economies. There was less faith in the view that Asian values made the region's economies invulnerable, but equally countries were less likely to be pressured into opening their financial markets before they were ready.

      Investors had also become more discriminating. Some economists observed that they were differentiating more sharply between emerging markets. In 1999 these markets formed three groups: economies that were converging with developed economies such as Mexico and Poland, those that had periodic access to international debt markets such as Argentina and Thailand, and those completely outside the markets such as Russia and Ecuador. Stricter credit controls and better regulation were also deterring the highly leveraged investors who were inclined to overbuy in bull markets and oversell in bear conditions.

      Of the four newly industrializing economies of Hong Kong, Taiwan, Singapore, and South Korea, Taiwan seemed to be the least affected by the crisis. Inward investment pushed the Taipei index up 40% between February and June, while low debt and high currency reserves supported business investment and cushioned the economic shock of September's massive earthquake. By year's end, however, Hong Kong (up 69%), Singapore (75%), and South Korea (83%) had far exceeded Taiwan's 32% increase. Manufacturing gained from the lower cost of imports from regional economies and strong export demand from the U.S. The “Asian tigers” still looked to Japan, erstwhile powerhouse of the region, for leadership, although their interests did not coincide. The strength of the yen had been undermining Japan's ability to export, vital in the absence of growth in domestic demand. Japan needed the yen to weaken, but if it did, the export trade of Tokyo's Asia-Pacific neighbours might suffer. While the Japanese government wrestled with this dilemma, the stock market powered ahead. The Nikkei index of 225 stocks rose some 37%, driven almost entirely by foreign investment.

      Central European markets fell back at the end of the third quarter following a strong second-quarter surge. Investors took cash to lock in gains from the March-to-July share-price recovery and as preemptive defensive action against the anticipated computer problems wrought by the “Millennium Bug.” Central and Eastern Europe were widely seen to be most at risk for Y2K problems. Hungary and Poland had disappointed investors over the year against a background of slowing growth and weakening currencies. Outside the main markets, shares in Croatia's leading pharmaceuticals group, Pliva, fell sharply on the impact of the fighting in Kosovo, health care reforms in Poland, and pricing concerns in Croatia. In Hungary another pharmaceuticals giant, Richter Gedeon, suffered from the instability of Russia, its main market.

      It was the health of the Chinese economy that caused the greater concern in the latter part of the year. On October 1 Beijing celebrated the 50th anniversary of the founding of the People's Republic of China, but huge losses by the republic's state-owned industries and imprudent bank lending to them had unnerved investors, who were scaling back their commitment. They observed weakening exports, falling retail sales and prices, and massive inventory oversupply. Pressure to devalue the yuan could cause further loss of confidence, but the country had vast foreign-exchange reserves to spend on supporting growth.

Commodity Prices.

      The long general slump in commodity prices looked to have ended by the middle of the second quarter as the world economy picked up. Some, particularly oil, recovered alongside Asian economies and as major producers cut output. From a low of below $10 a barrel in December 1998, by year-end 1999 prices had risen above $25 a barrel, a three-year high, and were set to stay high for several months as production cuts by OPEC began to take effect. Gold prices, which in July slumped to a 20-year low of $255 an ounce, recovered to around $295 an ounce by December, close to the price at the start of the year. The dip was caused by debate about the role of gold as a reserve asset as it became common knowledge that central banks throughout the world had been quietly selling gold stocks in favour of paper assets.

      Overall, metals did well—nickel best of all, gaining 55% between March and December as exports from Russia fell and demand picked up. By the end of October, the price of zinc on the London Metal Exchange (LME) had doubled to a two-year high of $7,900 a metric ton. Production of stainless steel, which consumed around two-thirds of all world nickel production, was booming again in Asia. Aluminum, having fallen to a five-year low in mid-March, then rose 9% on the LME, supported by news that two major producers, Alcoa and Alcan, planned to cut production. Nevertheless, a surplus of around 400,000 metric tons remained. The market for platinum, however, faced a record deficit. Russian shipments were expected to fall by 38% over the year to a six-year low. World supplies were expected to fall by 6%, despite record production by South Africa, which accounted for around 75% of output. The metal was trading at around $456 an ounce by December.

      Rubber prices fell to a 30-year low in July, which prompted two of the three major producers, Thailand and Malaysia, to cooperate in fixing prices to the world market at not less than 80 cents a kilogram (about 36 cents a pound) while managing controlled disposal of stockpiles. Thailand held more than 250,000 metric tons.

      Food prices remained depressed, particularly cocoa, which by May hit a six-year low and, after a summer rally, fell even lower in November. Extreme weather conditions in Brazil pushed up coffee prices, and dry weather was likely to damage the year 2000 crop, which had been expected to be a record 40 million bags. Stocks, however, remained high.

IEIS

Banking

      Enactment of sweeping financial modernization legislation in the United States, the introduction of a single currency in 11 of the 15 European Union members, and the accelerating pace of industrywide consolidation on a global basis combined to make 1999 a truly historic year for banking and financial services, with far-reaching implications for the new century.

      On November 12 U.S. Pres. Bill Clinton signed the Gramm-Leach-Bliley Act, marking the end of a two-decade struggle to tear down Depression-era barriers between banking, securities, and insurance in the U.S. Although the barriers had already been eroded considerably over the previous 10 years through bank securities affiliates and the creation of Citigroup in 1998, passage of comprehensive financial modernization legislation was widely expected to lead to further consolidation of financial services in the U.S., particularly mergers involving commercial banks and insurance firms. This would be consistent with developments in Europe and likely would further the global trend toward the integration of banking and insurance. Gramm-Leach-Bliley also significantly expanded merchant banking opportunities for U.S. and international banking organizations to invest in nonfinancial companies, although it preserved the long-standing separation under U.S. law between banking and commerce.

      Enactment of financial modernization legislation had been held up in recent years in large part by serious policy disagreements regarding the allocation of supervisory responsibilities for financial conglomerates comprising banks, insurance companies, and securities firms. A key dispute centred on whether expanded financial activities by banking organizations should be conducted only through nonbank affiliates of bank holding companies subject to “umbrella” oversight by the Federal Reserve (Fed) or whether such activities should also be permissible for direct “operating subsidiaries” of national banks, which were supervised by the Department of the Treasury through the Office of the Comptroller of the Currency. In addition, there were policy differences with regard to whether authority to engage in such activities should be conditioned on an ongoing basis on the level of compliance by depository institution affiliates with the Community Reinvestment Act, which required that they demonstrate that they were satisfactorily meeting the credit needs of their local communities. These and other differences ultimately were reconciled by a House-Senate conference committee, which began deliberations on the legislation in September following passage of separate bills in the House of Representatives and the Senate earlier in the year.

      A number of other countries also implemented or debated significant changes to the structure of their financial regulatory systems during 1999. New regulatory agencies with responsibility for consolidated oversight of banks and other financial institutions were established in Australia, South Korea, Japan, and the U.K. Plans for the creation of such an agency were under way in Estonia, and The Netherlands had decided to establish a Council of Financial Supervisors consisting of supervisors of the banking sector, insurance sector, and the stock exchange. While many of these initiatives contemplated some form of umbrella supervision of financial conglomerates, there was as yet no international consensus on what governmental authority or authorities should exercise this responsibility.

      Meanwhile, after years of preparation, the introduction of the euro took place on Jan. 1, 1999, among the 11 countries constituting the Economic and Monetary Union (EMU). (See Sidebar (Euro's First Birthday ).) The event also had a significant impact on countries outside the EMU, which were required to adjust their systems to the requirements of transacting business in euros. Responsibility for monetary policy within the EMU shifted from the central banks of individual countries to the European Central Bank, and the money markets of the EMU's 11 member countries merged into a single market. This led to the development of two new reference interest rates: the Euro Interbank Offered Rate (EURIBOR) and Euro OverNight Index Average (EONIA). The adoption of a single currency also required modification of domestic payment transfer systems and, by enabling the choice of settling in up to 20 different payment systems all using the euro, complicated liquidity management.

      To ensure a smooth transition to the euro, individual countries adopted legislation to address, for example, the changed status of their central banks and, of no less importance, the continuity of contracts. The transition to the euro was to be completed with the replacement of individual country currencies with euro banknotes and coins, scheduled to occur by Jan. 1, 2002.

      The introduction of the euro contributed to an increase in merger activity across Europe, although the transactions were mainly in-market deals, as opposed to cross-border combinations. Banco Bilbao Vizcaya SA and Argentaria (both of Spain) announced plans to merge in October, following the combination earlier in the year of Spanish banking giants Banco Santander and Banco Central Hispano. In France, Banque Nationale de Paris acquired Paribas but was unable to complete a three-way deal involving Société Générale. In the U.K., National Westminster Bank was the object of competing takeover efforts by two rival Scottish banks, Royal Bank of Scotland and Bank of Scotland.

      Consolidation also spread to the Japanese banking sector in 1999. A three-way merger was announced in August involving Fuji Bank, Dai-Ichi Kangyo Bank, and Industrial Bank of Japan. Following quickly on the heels of that deal were separate merger announcements by Tokai Bank and Asahi Bank and by Sumitomo Bank and Sakura Bank.

      Despite the prevalence of in-market deals, one of the more notable transactions of 1999 involved the completion of a trans-Atlantic deal—the acquisition of Bankers Trust Co. in New York by Germany's Deutsche Bank. Within the U.S. there were no mergers in the financial services sector to rival the size and scope of the Citicorp-Travelers combination in 1998. Amid speculation that it would buy brokerage giant Merrill Lynch, the Chase Manhattan Corp. announced a smaller acquisition involving Hambrecht & Quist, a securities firm specializing in the high-technology sector.

      Although they did not get as much attention, perhaps, as some of the big-ticket merger announcements, there were a number of other significant developments occurring in the global financial markets in 1999. Reflecting the increased supervisory focus on credit- related issues during the year—as highlighted by the consultative papers published by the Basel Committee on Banking Supervision—a number of countries, including Bolivia, the Czech Republic, India, South Korea, Panama, and Venezuela, sought to enhance their banks' practices regarding classification of assets and loan loss provisions. Actions to improve banks' assessment of their country risk were also taken by other bank supervisors, such as those in Belgium, Chile, and The Netherlands. Requirements intended to expand the role of internal and external auditors in the supervisory process were adopted in Estonia, Israel, the Philippines, and other countries. Reforms in accounting and financial-reporting practices were initiated in several countries, including South Korea and Panama, to bring them up to the level of international standards.

      Meanwhile, supervisors around the world continued their efforts to develop and refine risk-based capital adequacy standards. The Basel Committee's June 1999 proposal for a new capital adequacy framework to replace the Capital Accord that had been in effect since 1988 was particularly significant. The proposed new framework would consist of three “pillars”: minimum capital requirements, which would seek to incorporate risk weightings of assets based on ratings assigned by recognized credit-assessment institutions such as Moody's and Standard & Poor's; a supervisory review of an institution's capital adequacy and internal-assessment process; and the effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices. The proposal, which was open for comment until March 31, 2000, attracted considerable attention, particularly its reliance on external ratings. As an alternative, many observers proposed that attention be concentrated on developing risk-based standards that incorporated banks' internal rating systems and, ultimately, portfolio credit risk models. In the U.S. the Fed emphasized the growing need for banking organizations to take greater efforts to ensure that their capital was not only adequate to meet formal regulatory standards but also fully sufficient to support their underlying risk positions.

      As problems in their banking sectors mounted in connection with the events in Southeast Asia in 1997 and throughout the global economy in August and September 1998, many countries in 1999 instituted measures to enhance their ability to address the issues presented by troubled banks, including, where necessary, through liquidation. Among these measures were the establishment in China and the Philippines of special entities to dispose of problem assets, the expansion of the authority of bank supervisors in the Czech Republic and Estonia to intervene against troubled banks, and the adoption in Japan of the “Law Concerning Emergency Measures for the Reconstruction of the Functions of the Financial System,” which set forth principles and methods for dealing with failed financial institutions.

      Additional actions were also taken to combat money laundering. Canada introduced legislation to implement a mandatory suspicious-transactions reporting system, and the Cayman Islands introduced a Code of Practice that provided financial institutions practical guidance in preventing money laundering. Hong Kong reduced the threshold for criminal liability for money laundering in connection with drug trafficking and organized crime, while Luxembourg expanded the activities from which criminal liability for money laundering could arise. In a particularly notable development, the federal banking agencies in the U.S. withdrew proposed “know your customer” (KYC) regulations after an unprecedented public outcry regarding their potential impact on bank customers' privacy. The subsequent disclosure in congressional hearings of suspected money-laundering activities in connection with private banking and the movement of funds from Russia through U.S. banks triggered new legislative proposals in Congress focused specifically on banks' KYC practices with regard to their foreign customers.

      Privatization of banks continued in a number of countries, including the Czech Republic, France, Israel, Norway, Poland, and Turkey. Foreign financial institutions developed, expanded, or were given new authority to develop or expand, their presence in other countries such as Canada, China, Poland, and Singapore.

Lawrence R. Uhlick

Business Overview

      Americans would likely remember 1999 as the most prosperous year in at least three decades. Not only did the unemployment rate hit a 30-year low, but the securities markets extended a rally that had begun at the start of 1991, bringing in an 85.6% gain in the value of the technology-stock-heavy National Association of Securities Dealers automated quotations (Nasdaq) Composite Index and a 19.5% gain for the broader Standard & Poor's 500 index. Many of the most skeptical observers, such as Alan Greenspan, the chairman of the Federal Reserve Board of Governors, accepted at least in part the thesis that the United States could maintain a higher level of growth and profits without getting into another inflationary cycle.

      Even so, businesspeople, investors, and workers wondered whether the boom was a miracle of technology-generated productivity or a speculative bubble. For all the prosperity, a surprisingly large part of the stock market was already in a decline by the end of the year. Most—in truth, all—of the spectacular performance of the stock indexes was accounted for by a relatively small number of companies. These included semiconductor producers such as Intel, computer manufacturers such as Dell, “solutions” companies such as IBM, and, most dramatically, the Internet companies, or “dot.coms,” such as Amazon.com (see Biographies: Jeff Bezos (Bezos, Jeffrey P. )), America Online (AOL), Yahoo, and Priceline.com. Outside this favoured circle, many profitable companies that did not have dramatic “new economy” stories saw their stock prices drift lower.

      Thus, a crash in perhaps 100 or 200 critical stocks would have an enormous negative effect on the perceived wealth of the nation's investors, just as the rise in the price of those stocks led many to the belief that they were getting rich without having to reduce their consumption and save. This “wealth effect” mattered a lot more in 1999 than it ever had before, as more than half of American households had invested in the stock market, either through the ownership of individual stocks or through mutual funds. Many of those households had made relatively modest gains in earnings from their employment, which was part of the reason for the low inflation readings. Nevertheless, they were able to open their checkbooks to buy autos, homes and home improvements, and, of course, the computers and cellular phones that were the decade's new staples.

      After decades of inflation, unemployment, Cold War, and intermittent recessions, 1999 might have seemed like a magic year, but the American boom was being shored up by the rest of the world's savings. By the end of 1999, the U.S. was running a current-account deficit with the rest of the world that was the highest in history. At an annual rate of about $360 billion, it represented nearly 4% of all the goods and services produced and consumed in the country for the year. Put another way, the deficit with the rest of the world consumed all of the lendable surpluses of Europe, Japan, South Korea, and China, which among them accounted for 70% of the world's supply of capital. Even in the best of circumstances, it would be impossible for the U.S. to continue to speculate, spend, and grow at the rate it had in the last year of the 1990s.

      Many American businesspeople had developed a mild pity or even contempt for their European counterparts over the course of the 1990s. There was a collective belief that the political structure of Europe, with the exception of the U.K., would effectively keep the continent from catching up with U.S. productivity and growth. There were exceptional European enterprises, of course, such as Airbus Industrie, the multinational commercial jet maker, and SAP AG, the German developer of “enterprise management” software. Still, with 10% unemployment and low growth rates in Europe, there was a lot of evidence to support the American “triumphalism.” What Americans did not consider as carefully as they might have was the dependence they had developed on Europe's exports of capital.

      The euro, the new unified European Union (EU) currency, was launched in January 1999. (See World Affairs: European Union: Special Report (Euro's First Birthday ).) Much promoted by EU officials as an alternative to the dollar as an international currency and store of value, it embarrassed its sponsors by dropping some 14% in value against the U.S. dollar over the course of 1999. Part of the reason for this was the flow of capital from Europe to the U.S. to buy securities, which by the fourth quarter was running at an annual rate of $235 billion. All but $81 billion of this went into bonds and other fixed-income securities, which offered a relatively low fixed yield. The American businesspeople, on the other hand, were able to profit from their stock and stock-option holdings—effectively subsidized by the vast foreign credit line.

      One interesting question as 1999 drew to a close was how much of the world's savings the U.S. would obtain at relatively low interest rates in 2000 and the years ahead. If, as seemed likely, Europe's growth rates accelerated, and if both China and Japan continued to pull out of their periods of low growth, then much higher interest rates would be needed to finance the continued growth of the U.S. economy, given that its corporations and consumers were, on a net basis, “dissaving,” or spending, 2.5% of the country's total product. That was unprecedented.

      While the financial underpinnings of the U.S. economy were somewhat shaky, however, the country had spent a huge amount on computers and software and on telecommunications networks tying all those machines together. The most dramatic beneficiary of this was the telecommunications industry, which had to meet a seemingly insatiable demand for “bandwidth,” or message-carrying capacity. The biggest single impetus for this demand was the expansion of Internet traffic. Transmissions via the Internet included more complex graphics, sound, and full-motion visual images, all of which required either high-capacity cable or fibre-optic cable that had the necessary bandwidth. In 1999, fibre-optic cable capacity was being increased by 100% every nine months. Cellular telephones and wireless data transmission also continued to expand; 31% of American consumers had cellular phones by the end of 1999, up from 25% just two years earlier.

      As late as the 1980s, the telecommunications industry had been financially stable and was growing at a moderate pace. By 1999 there were winning companies such as Qualcomm, Inc., which developed an innovative, high-quality cellular-telephone technology. Its stock rose more than 20-fold in the year, and it had revenues of nearly $4 billion. By way of contrast, Iridium, Inc. a “go-anywhere” mobile phone company that depended on a multibillion-dollar array of satellites, went bankrupt in July, its equity effectively wiped out and its bonds dropping to 17 cents on the dollar. An industry that had been composed of steady monopolies turned into a competitive free-for-all.

      The demand for new and replacement personal computers also held up in 1999, propelled partly by price cuts, partly by the appeal of fast new machines, and partly by a perceived need to get “Y2K compliant” systems in place before the year 2000. The computer software industry underwent two revolutionary shocks. First was the successful antitrust suit by the U.S. Department of Justice against Microsoft Corp., which was seen as a potential cause for a breakup of the company. Ironically, however, any harsh treatment of the company would have to face the political reality that a large fraction of the middle-class public owned Microsoft shares, and that could easily lead to a backlash against the government litigation. The judge's finding against Microsoft also led to an increasing investor and user interest in computer operating systems other than Microsoft's own Windows system. The major beneficiaries were companies that wrote software based on the open Linux operating system. (See Biographies: Linus Torvalds (Torvalds, Linus ).)

      The second shock for the software industry was the extent to which companies writing large “enterprise software” programs were losing market share to companies that based their applications on Internet protocols. This could be seen as part of the “democratization” or “networking” of software. The enterprise software companies such as the German SAP, or PeopleSoft Inc. and Oracle Corp. in the United States, had based their communications within corporate communications networks on proprietary software rather than the increasingly popular Internet. SAP, which made its name by offering one large system to tie together all the elements of a company's computing, saw its reputation hurt by the difficulties several large companies such as Hershey Foods Corp. had in implementing the huge, monolithic programs.

      Perhaps the most remarkable phenomenon in the valuation of companies was the extraordinary stock market performance of the “pure” Internet companies. These companies, few of which earned any profits during the year, saw increases in their stock prices of up to several thousand percent. These valuations could not be based on increases in profits or even revenues but were based just on investors' hopes that at some distant point in the future a selection of companies using the Internet would be able to displace established commercial competitors using “bricks and mortar” facilities. Despite the high stock prices of companies such as Amazon.com or Priceline.com, there was an increasing realization that moving commerce to the Internet would still require conventional facilities. This led to enormous interest in the public stock offering of United Parcel Service, whose trucks were needed to deliver many of the items ordered on-line from the Internet companies. (See also Computers and Information Systems .)

      Growth in high-tech companies had a spillover effect on other American industries. For example, auto sales hit a record level of 17 million vehicles in 1999. The prosperity of the auto manufacturers fed through to their suppliers of components as well, so even “old economy” firms such as Genuine Parts Co. had 15–20% increases in sales. Nevertheless, the worldwide trend toward consolidation and globalization continued, with the merger that formed DaimlerChrysler AG leading to further rationalization of auto manufacturing in both Europe and the U.S. The effective takeover of Nissan Motor Co., a Japanese auto company, by France's Renault that was announced in March would have been unthinkable a few years earlier. The Japanese, however, realized that even their vaunted automobile industry needed Western-style rationalization and cost cutting.

      While Detroit's overall sales numbers and production were extremely strong, domestic manufacturers lost market share for traditional passenger cars, as distinct from light trucks or sport utility vehicles. Despite years of improvement in the quality ratings of American-built cars, it seemed that consumers still believed that European cars were better made. European sales of passenger cars in the U.S. were up 30% on the year, while Asian manufacturers sold 8% more cars and American manufacturers 5% more cars. Not all American auto manufacturers were equally affected by the trend; in the last two months of the year, Ford Motor Co. car sales were up more than 20% over 1998 levels. Ford was perceived to have more advanced styling for passenger cars such as its Taurus than was to be found in the General Motors Corp. line.

      Home builders also benefited from consumers' cashing in their stock market gains to acquire material goods. The growth in residential construction peaked at the beginning of 1999, however, and while orders for new homes continued to increase, the industry was weakened by the increase in interest rates over the course of the year. Manufacturers of wallboard and other construction materials saw their inventories rising owing to oversupply, and it appeared as though new home sales were likely to decline in the following year. Overproduction also hurt the companies in the manufactured-housing industry, which served the less-affluent home-buying public. Not only were their customers not major beneficiaries of the stock market rise, but also credit for marginal buyers became tighter over the course of the year.

      While wage pressures were low over the course of 1999, the pickup in manufacturing in the U.S., Europe, Japan, and the rest of Asia put upward pressure on raw materials prices, most notably on the price of oil and its products. Over the course of 1999, oil prices more than doubled to $26 per barrel. In addition to increased demand for oil, OPEC was better able to enforce production quotas in 1999 than it had been for several years, which reduced the potential supply. American electric and gas utilities, which for decades had been relatively stable, low-risk, moderate-return companies, began to show far greater volatility in their results as deregulation took effect. A company such as Enron Corp. of Texas, which aggressively reorganized for a competitive environment, showed sales increases of more than 25% and a profit increase of more than 35% in 1999. In contrast, the traditional Florida Power & Light Co. saw sales increase by only 0.6% and earnings by 1.4%. The energy service companies, which provide the equipment and contracted services that the energy companies require, were still recovering from the cuts in exploration and production budgets from low prices in 1998. Schlumberger Ltd., a key exploration service company, experienced a sales decline of over 20% and an earnings decline of over 42%.

      Steel companies also benefited from increased demand for their products; hot rolled coil steel prices rose by approximately 40%, to $310 per ton. A basic steel producer, AK Steel Holding Corp., had sales increase by over 60% and earnings increase by over 15%. Aluminum producers also did well on the back of a 23% increase in prices to $1.552 per kilogram (69 cents per pound). The two largest American producers of aluminum, Alcoa Inc. and the Reynolds Metals Co., agreed to a merger, which continued a trend among the basic industries to consolidation. Since commodity materials had become a smaller part of the industrial costs, there was much less opposition to these mergers than there would have been in previous years. Domestic commodity producers were also able to justify consolidation and cost cutting even in prosperous times by pointing to import competition driven by ever-lower shipping costs and tariffs.

      Paper manufacturers, which had been plagued by overcapacity in previous years, were able to control their tendency to overinvestment in 1999, adding only 1% in additional capacity. That made it possible for their price increases to stick, which brought major companies such as the Georgia-Pacific Corp. back into profitability. The lumber sector of the forest-products industry profited from the dramatic increase in prices brought on by high levels of construction, with 2 × 4 boards increasing in price from $146 to $203 per cubic metre ($345 to $480 per thousand board feet).

      Perhaps the most frustrated commodity producers were the gold-mining companies. They had waited for years for an increase in the gold price to a sustainable level above $300 per troy ounce (1 troy oz = 31.1 g). When the European central banks announced in September that they would place a cap on their sales of gold from reserves, the price of the metal briefly rocketed from about $270 to more than $330 per ounce, but it quickly fell back to below $300. Many of the gold miners actually lost money on the price increase, since they had entered into complicated forward sales contracts that required them to put up expensive cash margin if the price increased.

      In the financial services industry, 1999 was the year that Congress repealed the Glass-Steagall Act of 1933, a Depression-era law that kept banks and securities dealers from operating under the same corporate roof. Even though the banks and dealers had found many ways to reduce the law's effect over the years, the deregulation was expected to lead to a dramatic consolidation of the nation's financial system. The biggest single corporate beneficiary was Citigroup Inc., which was formed out of the merger of Citibank, the Travelers' Group, and Salomon Smith Barney Inc. If the law had not been passed, it might have been necessary for the combined company to be broken up.

      The Wall Street securities brokers had a spectacular year, with huge fees for arranging corporate underwriting and mergers and acquisitions added to profits on equity trading. The only financial sector to do badly was bond investors, who suffered their second worst year, the worst having been 1990. The growing economy with its demand for funds and fears of inflation led to an increase in short-term interest rates of more than one percentage point, and in long-term rates of about 1 ¹/₃%. For most banks and dealers, the losses created by those interest-rate increases were more than offset by the increases in equity prices and transaction fees.

      Those sectors of the economy that depended most directly on the government had mixed results, since there was still some restraint on the willingness of the executive branch or Congress to spend the increased tax revenues. The defense manufacturers saw the first increase in procurement since 1991 as the Pentagon's budget went up by 2%, with more increases on the way. Commercial aircraft orders, principally for the Boeing Co., were weak owing to cutbacks by financially stressed Asian carriers and to increased competition from Airbus Industrie. Managed-care companies, popularly known as heath maintenance organizations, or HMOs, were adversely affected by federal government cost controls on reimbursement for patients covered by its insurance, which had the effect of reducing spending by $200 billion. Pharmaceutical companies, while still highly profitable, were also under pressure to cut prices. Pfizer Inc., which in 1998 had a windfall from sales of Viagra, its drug for the treatment of erectile dysfunction, saw its 1999 profits decline by over 12%. The Bristol-Myers Squibb Co. saw a slight decline—less than 1%—in its profits. Some companies with a stream of new products, though, did extraordinarily well. Amgen Inc., a biotechnology company, enjoyed an increase in profits of more than 30%.

      As for the question of whether 1999 was the last of an unsustainable “bubble economy” or the beginning of a “new era” led by digital electronic technology, the answer most likely, based on past such boom years, was that it was both. There was an element of “bubble” in the prices of stocks, but there was also a dramatic expansion of the possibilities for Internet commerce and the other fruits of decades of computer industry development.

John Dizard

▪ 1999

Introduction

      From the beginning of 1998, prospects for the world economy were marked by uncertainty as the Asian crisis that began in July 1997 with the collapse of the Thai baht deepened. (See The Troubled World Economy (Troubled World Economy ).) As the year progressed, it was clear that the effects of the recession in Japan and the repercussions of the financial crisis in East and Southeast Asian countries were worse than expected, although both Thailand and South Korea were showing strong signs of recovery. Because of the deterioration, the International Monetary Fund (IMF) revised its projections for world growth in 1998 to 2%, only half the level it was projecting a year earlier. (See Special Report (IMF's Changing Role ).)

   Real Gross Domestic Products of Selected OECD Countries, Table Changes in Consumer Prices in Less-Developed Countries, Table By September—in the wake of the August financial collapse in Russia, which caused a general retreat by investors from all emerging markets—the financial turbulence was spreading to the developed countries of the Organisation for Economic Co-operation and Development (OECD). (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries, Table ).) Stock markets were falling, and trading losses were being made by some of the world's largest investment funds. Interest rates in the U.S., the U.K., and much of continental Europe were reduced. (For Interest Rates: Long-term— and Short-term—> , see Graphs.) In Japan new legislation was adopted, supported by ¥60 trillion to recapitalize and reform the banking system. Many less-developed country (LDC) currencies came under severe pressure, which forced further drops in commodity prices. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries, Table ).) The lack of investor confidence created particular problems in LDCs, given their limited access to external capital.

 During the year output in the major industrialized countries rose 2%, compared with 3.1% in 1997. (For Industrial Production in selected OECD countries, see Graph—> .) The overall picture was distorted, however, by the recession in Japan, where a marked deterioration in the first half of the year led to a 2.5% decline, compared with a marginal rise in 1997. In the newly industrializing economies such as South Korea, Taiwan, Hong Kong, and Singapore, there was an even sharper fall of 2.9% after a 6% increase in 1997. The American economy was extremely buoyant, particularly in the first half of the year, when it appeared to be overheating, and output increased 3.5%, which was only slightly below 1997 growth. Strong domestic demand provided the impetus for growth in the U.S. as it did in the European Union (EU), where output increased from 2.7% in 1997 to 2.9% in 1998. This included a 2.3% rise in the U.K., which was at a much more advanced stage in the economic cycle than France and Germany. Output in Central and Eastern Europe accelerated to 3.4% in 1998 from 2.8%, but only Poland, Slovenia, and Slovakia regained their 1989 levels of output; most were well below it. The 6% decline in Russia was the cause of a slight overall decline in output in the formerly centrally planned economies.

       Changes in Output in Less-Developed Countries, Table The growth rate of output in LDCs fell back from 8% in 1997 to 2.3% in 1998. (See Table (Changes in Output in Less-Developed Countries, Table ).) Contributing to the increase was a 3.7% rise in Africa, where financial restructuring continued and good weather boosted agricultural output in some countries, whereas others benefited or suffered from falling commodity prices and strengthening demand in Europe. Lower output in the Middle East (2.3%) and in Latin America (2.8%) was closely linked to the slump in oil prices. Holding down growth in output to l.8% in Asia were Thailand, Malaysia, Indonesia, and the Philippines, where there was a decline of more than 10%. In Indonesia output in the third quarter was running at 17% below that of the same period a year earlier. By contrast, China, which retained its currency link with the U.S. dollar, and Taiwan showed more resilience

      The volume of world trade in goods and services grew more slowly in 1998—by 3.7%, compared with 9.7% in 1997. In value terms, export growth was similar to 1997, reflecting the fall in oil and other nonfuel commodities. Despite the difficult trading conditions, the trend toward opening up multilateral, regional, and unilateral markets was maintained. At the end of 1997, agreement was reached by 70 members of the World Trade Organization (WTO) to further liberalize financial services. The members, which represented 95% of global markets and included some of the East Asian countries most affected by the financial crisis, agreed to open up their financial markets. At the WTO meeting in May, the commitment to liberalization of markets was reinforced when governments rejected protectionism.

  Consumer Prices in OECD Countries, Table In much of the world, the problem and fear of inflation receded as the year progressed. In most advanced countries price rises eased gradually throughout the year. Although the average inflation rate for these countries was projected at 2%, compared with 3.l% in 1997, consumer prices were falling in several countries in the last months of the year. (For Consumer Prices in OECD Countries, see Table (Consumer Prices in OECD Countries, Table ); for Inflation Rate in selected countries, see Graph—> .) Concern about inflation was being superseded by the growing fears of deflation—and the associated risk of recession—over which governments could exercise little control.

      In a crucial development that had as-yet-unclear implications for the world economy, 11 EU countries—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain—were preparing their economies for the final stage of economic and monetary union (EMU). This was to culminate on Jan. 1, 1999, with the replacement of national currencies by a new currency, the euro. Monetary control was to move to the European Central Bank (ECB), which would set a single interest rate for the 11 countries. The four other members of the EU—Denmark, Greece, Sweden, and the U.K.—were not adopting the euro, at least for the time being.

National Economic Policies

United States.

  Real Gross Domestic Products of Selected OECD Countries, Table Once again the U.S. led growth among the major industrial countries. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries, Table ).) For the seventh year in succession, the U.S. had exceeded by far the increase in output of most other advanced countries. (For Industrial Production in selected countries, see Graph—> .) The IMF projected rise in gross domestic product (GDP) was 3.5%, but with higher-than-expected third-quarter output, it could be slightly more. In any event, it was expected to be close to the 3.9% recorded in 1997. The strength of the economic performance was reflected in the achievement of the first balanced federal budget since 1960; it followed an unexpected fall in the 1997 deficit to $23 billion. The need to cut the deficit had become a political imperative since it peaked at $290 billion in fiscal 1992, but eliminating it before fiscal 2000 had not been thought possible.

      The momentum continued to be driven by consumer spending, which accounted for some two-thirds of economic activity and showed few signs of slowing over the year. In the third quarter it was rising at an annual rate of 4.1%. The fact that spending was exceeding earnings in September and October raised some concerns. The personal savings rate (savings as a share of after-tax income) fell by 0.3% in those two months as Americans took advantage of falling interest rates through cheaper credit or drew on their savings or other assets. In the first quarter, when GDP was rising at an annual rate of 4.2%, retail sales advanced 3.3%, housing demand was buoyant, and cars and small trucks were selling at the rate of 14 million a year. The second quarter showed even more activity, with retail sales increasing by 6.3% over a year earlier. By November consumer spending had not fallen in any month since June 1996.

  Standardized Unemployment Rates in Selected Developed Countries, Table Consumer demand was being fueled by the strong growth in personal incomes, high employment, and low inflation. (See Graph—> .) The tighter labour market forced employers to increase compensation at a faster rate than inflation in order to retain and attract employees. Wages and salaries rose by 4% in the year to end September, the fastest rate for seven years, easing back slightly to 3.1% in the three months to November before it rose again in December. New job creation was helped by the flexibility in the labour market; relative to labour conditions in Europe, American minimum wages and social benefits were low, and fewer members of the labour force were unionized. In 1998, for the first time, American manufacturing workers cost more than those in Spain while remaining ahead of Canada and Italy. There were, however, signs of an easing in the tight labour market during the second half of the year. The average rate of unemployment continued the annual downward trend that began in 1992 (7.5%). (See Table (Standardized Unemployment Rates in Selected Developed Countries, Table ).) The unemployment rate edged up from a 28-year low of 4.3% in May and was holding at 4.6% through to October. It fell back again, to 4.4% in November and 4.3% in December, boosted by holiday recruitment in the retail sector and in the buoyant construction sector. The number of new jobs being created also declined from an average 244,000 a month in the first half of the year to 165,000 in the third quarter and in the fourth quarter.

       Consumer Prices in OECD Countries, Table Nevertheless, consumer confidence was only slightly dented. After falling for four months from the June peak, it recovered again in November (according to the Department of Trade Conference Board). The housing market remained buoyant, with construction in the third quarter rising at an annual rate of 9%. The amount of consumer credit was cause for some concern because Americans appeared to be living beyond their means. In September, when consumer installment credit was $8.4 billion and rising at an annual rate of 7.9%, spending exceeded saving for the first time since records began in the 1930s. Despite the strength of consumer demand, inflation was no longer considered a problem as the price stability achieved in 1997 (when the average inflation rate was 2.3%) continued. In November 1998 consumer prices were up only 1.5% (see Table (Consumer Prices in OECD Countries, Table )), and the lower GDP deflator at 0.8% was the lowest for 35 years.

      Although household expenditure remained buoyant, there were signs of a slowdown in areas affected by global trade. Industrial output rose by only 1.5% in the 12 months ending in November, although the latest three months showed some acceleration (up 2.4%). Factory orders for big-ticket goods declined in October for the first time in five months, a reflection of weaker demand for industrial hardware, railroad equipment, ships, and primary metals. The key indicator of spending on new equipment used in manufacture (nondefense capital goods excluding aircraft) fell 9.2% in October, the largest drop since November 1990, when the U.S. was in recession. The falloff in demand was also reflected in factory shipments of durable goods.

  Because of the strength of the economy and the risk of its overheating, federal policy remained tight for the first three quarters. Until August policy makers had been ready to raise interest rates, but this changed as the impact of the global slowdown became apparent. For the first time in 40 years, export sales fell for three consecutive quarters while imports rose. The October deficit fell to $14.2 billion as export sales of farm products shot up. Nevertheless, the trade deficit with Pacific Rim countries in the first 10 months of the year was up by 34% to $134 billion. The uncertainty generated by the external factors and fears that the domestic economy could slow down led the monetary authorities to cut the target Fed Funds rate three times from September 29, each time by 0.75 percentage point, down to 4.75%. (For Interest Rates: Long-term— and Short-term—> , see Graphs.)

United Kingdom.

       Real Gross Domestic Products of Selected OECD Countries, Table The economy started the year on a high note. Indicators reflected the buoyancy built up over the previous five years, when annual growth in output exceeded the long-term trend rate of 2.25%. During the year common EU statistical practices were being adopted, and—among other changes—all the national accounts were rebased. The revisions to historical economic indicators showed that the annual average increase in real GDP since 1991 was 0.25 percentage point higher than previously calculated. On this basis the 1997 increase output rose from 3.4% to 3.5%. As 1998 progressed, however, the economy lost momentum—not least because of the deterioration in the international economy—and the increase in 1998 output was expected to decline to 2.8%. By year's end business confidence had fallen, and a short period of recession was being widely predicted, with growth in 1999 not expected to exceed 1%. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries, Table ).)

 Economic growth was led by the domestic economy, which was less vulnerable than the trade sector to the effects of the strong pound and the weak demand in Asian and other LDCs. Consumer demand and business investment provided the main impetus in the first half of the year. By the third quarter, however, it was clear that growth in consumer demand was slowing down. Retail sales growth eased over the year and in September and October fell compared with one year earlier, although it unexpectedly recovered in November. Turnover in the housing market declined further from the 1.4 million units in 1997, but prices remained high because of supply shortage. Business investment remained buoyant in the early part of the year and was likely to increase by up to 8% over the year. It was expected to slow down in response to lower profits. The dominant service sector, accounting for 60% of output, outperformed the rest of the British economy, but by the second quarter the growth rate had eased despite continuing strong demand in the transportation and telecommunications sectors. Manufacturing accounted for only 20% of output but was a major consumer of services. Demand for business services grew more slowly, a reflection of the slowdown in demand from manufacturers. (For Industrial Production, see Graph—> .)

   There were a number of positive developments during the year. The rate of inflation (see Graph—> ) was more the result of external factors than actions by the Bank of England's Monetary Policy Committee (MPC), which was responsible for managing interest rates to facilitate an economic growth rate compatible with low inflation. (For Interest Rates: Long-term— and Short-term—> , see Graphs.) The MPC benchmark was 2.25%, growth above which was perceived to be inflationary. Given the effect of the slowdown of global demand, however, this approach looked too simplistic. Fears of inflation were being superseded by uncertainty created by the less-familiar prospect of deflation.

       Consumer Prices in OECD Countries, Table Consumer prices were expected to have risen by 2.7% (excluding mortgage payments) in 1998, the same rate as in 1997. (For Consumer Prices in OECD Countries, see Table (Consumer Prices in OECD Countries, Table ).) The annual rate rose above 3% in April and May as a result of increases in local tax and road-fuel excise duties and seasonal food prices. As the effects of indirect taxes diminished, the rate declined, helped by the impact of the Asian crisis and the strength of sterling, which, combined with falling exchange rates outside the euro area, resulted in lower year-on-year prices on a wide range of goods. The cost of services was continuing to rise around 5% a year.

       Standardized Unemployment Rates in Selected Developed Countries, Table Revisions to the average earnings data showed that growth in the first quarter fell to an annual rate of 3.9%, compared with a peak of 5.3% in the same period a year earlier. By midyear the rate had accelerated to 5.4%, with most of the pressure coming from the private sector (6.2%) and more restrained growth in the public sector (2.5%). Over the year, average earnings were expected to rise by around 4% but to slow down in early 1999 in response to falling corporate profits. Despite signs of recession and the closure of a number of manufacturing plants, job creation was maintained at a brisk level, and unemployment fell by another 11,900 (to 1.3 million) in September. Additional job gains were recorded in the three months to October, when the number of employed rose to 27.2 million, up 259,000 on a year earlier. At around 6.2%, unemployment was at its lowest since 1980. (See Table (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

Japan.

      The year began on a weak note following signs of deepening recession and scandals and bankruptcies in the financial sectors, which had started at the end of 1997. International as well as domestic confidence in the Japanese economy had been badly damaged. Growth in output fell to a low 1% in 1997 following a real decline in the final quarter; this marked the start of the longest period of decline since World War II. In 1998 the economy continued to deteriorate despite government measures to shore it up, and by the end of the year the 2.5% decline predicted by the IMF seemed optimistic. In late December, however, the government predicted a fall of 2.2% in the year through March 1999.

  The government's response to recession marked a reversal of policy. It announced at the end of l997 a surprise ¥2 trillion in tax cuts and an acceleration of public investment planned for fiscal 1998. This did little to restore confidence or solve the country's problems. In the first quarter of 1998, industrial production fell for the third quarter running. (See Graph—> .) Inventories rose as consumers remained cautious, and exports fell to Asian countries suffering their own crises. At the same time, imports declined, which added to the already large current-account surplus. By April the unemployment rate, which had been rising slowly but steadily, rose to a record-high 4.1%. Nearly all the first-quarter indicators (in year-on-year terms)—including real consumption (down 4.9%), retail sales, new car registrations (down 20.4%), and machinery orders (down 5.8%)—reflected the continuing deterioration. Deflationary pressure was growing as both the overall and the domestic wholesale price indexes rose ever more slowly. (For Inflation Rate in selected countries, see Graph—> .) In March, for the first time, each recorded declines of l.1% and 0.1%, respectively. The next month the Bank of Japan presented a gloomy forecast of the economy that, among other things, reflected its concerns about the stability of the financial system.

  On April 24 the government announced details of Japan's largest-ever economic stimulus package to pump prime the economy. Of the ¥16,650,000,000,000 involved, two-thirds was to go to new public-works spending, special income and residential tax cuts, and more central and local government spending on social infrastructure. The defeat of the Liberal Democratic Party in upper house elections on July 12 led to the resignation of Prime Minister Ryutaro Hashimoto and plunged Japan into more uncertainty. A major fear was that the planned reforms to stimulate the economy and measures to deal with the bad debt problems in the banking sector would be delayed. Concern also centred on whether bank reforms would address the problem adequately. If they dealt only with technically failed institutions and not the bad loans in apparently healthy banks, the reforms would be ineffective. (For Interest Rates: Long-term— and Short-term—> , see Graphs.)

      In fact, all three possible successors to Hashimoto were committed to such policies. The new government, led by former foreign minister Keizo Obuchi (see BIOGRAPHIES (Obuchi, Keizo )), announced a fiscal-stimulus package of ¥17 trillion in the form of tax cuts and more public spending. In October legislation was finally agreed for banking reforms to be put in place. To support them an exceptionally large sum of public funds (around ¥60 trillion, the equivalent of 12% of GDP) was made available, including ¥18 trillion for the nationalization of weak but essentially solvent banks and ¥17 trillion for the protection of depositors.

       Real Gross Domestic Products of Selected OECD Countries, Table Consumer Prices in OECD Countries, Table Standardized Unemployment Rates in Selected Developed Countries, Table The government's fiscal package provided little relief, and economic conditions continued to deteriorate. In the April-June quarter real GDP contracted by 0.8%, and by the third quarter it was down 3.6% at an annual rate. (See Table (Real Gross Domestic Products of Selected OECD Countries, Table ).) Business and consumer confidence remained low, with corporate spending still falling. The continuing decline in consumer spending reflected the fall in incomes because of lower bonuses and less overtime (nonfarm incomes were down 3.8% on the year earlier) and offset the effect of tax rebates. Deflationary fears were realized, with consumer prices falling in both July and August. (See Table (Consumer Prices in OECD Countries, Table ).) The unemployment rate increased to 4.4%, low by international standards but a postwar high for Japan. (See Table (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

      The government announced another rescue package in November of a record ¥23.9 trillion. It included more spending on infrastructure as well as permanent income and corporate tax cuts. Despite the stimulus being provided by the government and a hoped-for strengthening of the financial sector, the outlook remained uncertain. The weakness of the external sector was expected to continue, with increasing pressure on Japan's Asian operations and the prospect of shrinking demand from advanced countries. Output was not expected to recover until the year 2000.

Euro Area.

      By early 1998 the 11 EU countries scheduled to adopt the euro as a single currency on Jan. 1, 1999, were increasingly being viewed as one economy. The IMF designated these countries the euro area, but the new bloc was also known as euroland and the euro zone.

      On May 2, 1998, formal approval was given for the 11 countries to participate in the third stage and final stage of the EMU. It was agreed that on December 3l the 11 national currencies would be converted into euros. The internal exchange rate of the euro to the 11 national currencies (Belgium and Luxembourg would have the same rate) was to be irrevocably fixed, whereas the market would determine its external value. The new currency was to be managed by the 17 governing members of the ECB, which was to become operational on January 1. A six-member executive board, led by Dutch banker Wim Duisenberg (see BIOGRAPHIES (Duisenberg, Wim )), was to share decision making with the central bank governors of the 11 member countries. The status of the ECB was one of strict independence and neutrality, and the central bank governors in turn had to preserve their independence regardless of pressure from their governments.

      In the first few months of 1998, fiscal and monetary policy in the euro area continued to be influenced by the necessity to meet the convergence criteria set out by the Maastricht Treaty in order to qualify for the third stage of EMU. A flexible approach to achievement of the criteria was adopted so that countries qualified even if they failed to meet all the criteria. For example, the ratio of public debt to GDP in Belgium and Italy exceeded 120%, whereas the criteria stipulated a 60% "reference value." This was waived on the grounds that the ratio was declining.

       Consumer Prices in OECD Countries, Table In accordance with the stability and growth pact signed by the EU members in June 1997, most governments maintained a tight monetary policy in 1998. This was to keep fiscal deficits within the 3% of GDP limit that was one of the EMU qualification requirements and the maximum allowed under the pact. In 1998 the euro-area budget deficit was expected to meet its limit—for only the second time in 20 years—resulting in an improvement in the euro area's government finances. The ECB had to pursue price stability as a priority, and other objectives, such as employment and growth, could be pursued only if they were consistent with low inflation. A principal objective of the ECB was to maintain price stability. (For Consumer Prices in OECD Countries, see Table (Consumer Prices in OECD Countries, Table ).) There were signs, however, that faced with the new threat of deflation rather than that of inflation, some euro-area governments wanted to relax fiscal policy and spend their way out of trouble in the short term rather than risk a return to recession. Significantly, the strong political swings to the left in France, Italy, and Germany, which were major influences in the euro area, were shifting emphasis away from austerity, and there was more likelihood that public spending would be used to boost demand.

  Some easing of monetary conditions was provided by the downward trend in short-term interest rates. (For Interest Rates: Long-term— and Short-term—> , see Graphs.) These were converging in readiness for January l, after which interest rates were to be fixed by the ECB and be binding on all the euro-area countries. By November 1998 it was widely believed that the rate would be set at a floor of 3.3%, which had been the rate for several months before in France and Germany. Spain, Italy, Ireland, and Portugal had made moves toward this rate. On December 3, in an unexpected move, the Bundesbank cut its rate to 3%. The other currencies, with the exception of Italy (3.5%), followed suit. The ECB was not expected to cut the rate again at its first meeting in January 1999.

   Real Gross Domestic Products of Selected OECD Countries, Table Standardized Unemployment Rates in Selected Developed Countries, Table Export-led growth in output in the euro area accelerated in the first quarter to an annual rate of 3.2% from 3% in the last three months of 1997. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries, Table ).) Leading the growth among the larger economies were The Netherlands (3.9%) and Spain (3.7%), whereas Italy's output stagnated at 2.5%. There was a modest slowdown in the second quarter, with industrial orders being adversely affected by the Asia crisis. The slack, however, was largely taken up by domestic demand; this was being reflected in more construction activity and investment in plants, as well as increased car sales. Consumer confidence was boosted by the fall in inflation to 1.2%, faster real-income growth, and cheaper credit. (For Inflation Rate in selected countries, see Graph—> .) At the same time, the appreciation of the European Currency Unit against the dollar was damaging export prospects in the euro area and increasing the imports. In the third quarter industrial output rose by an annual rate of less than 3%, compared with 6% in the first three months. (For Industrial Production in selected countries, see Graph—> .) As the year drew to a close, business and consumer confidence was falling and the decline in unemployment had ceased. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table ).)

The Former Centrally Planned Economies.

      In 1998 economic output in these countries was expected to decline by 1% or more. This followed an increase in output of 2% in 1997, the first regional rise after five consecutive years of decline and the first in Russia since 1989. The downturn was the result of several factors. These were led by the financial crisis in Asia, which prompted a fall in confidence in emerging markets generally and in the Russian financial system more specifically. Owing to financial market concerns, the authorities took emergency measures. On August 17 Russia devalued its currency, defaulted on a large portion of its government debt, and stopped foreign credit repayments by companies and banks. The sharp depreciation of the ruble and the fall of Prime Minister Sergey Kiriyenko's government later the same month generated instability and uncertainty through much of the region.

      In Russia output was expected to decline by around 6%, but elsewhere the overall picture was less-gloomy. In Central Europe and Eastern Europe, real output was forecast to rise for the sixth consecutive year, accelerating from 3.1% in 1997 to 5.1% in 1988. Output was forecast to increase in Poland (5.8%) and in Hungary (5.2%), helped by strong domestic demand. The Czech Republic (up 1%) remained in recession because of policy mismanagement and the aftereffects of the May 1987 currency crisis. Only Romania and Ukraine experienced real declines (4% and 1%, respectively).

      In the Transcaucasus and Central Asia, growth in output rose for the third straight year—4.1%, compared with 2.1% in 1997—with most countries experiencing faster growth. Against the trend, however, there was a marked turnaround in Turkmenistan, where, following several years of decline, the economy was variously forecast to grow by 5-20%.

      Despite the return to growth in many of the transition economies, only Poland, Slovenia, and Slovakia regained their 1989 levels of output. For all of the countries together the projection for real gross domestic product in 1998 was an average 55% of the 1989 level. The output of the majority was well below half the 1989 level, with Georgia (35%) and Ukraine (37%) having the most ground to make up. Elsewhere, progress had been made, but most countries were still only three-quarters of the way or less to their 1989 levels.

      There was a marked easing in inflationary pressures, but there was no room for complacency, as few countries had achieved the low inflation rates of most advanced countries. The International Monetary Fund projected an annual rise of 30% across the region, compared with 28% in 1997. The increase, however, obscured sharp falls in most of the 26 countries, and many were below or close to single-digit rates. In Central and Eastern Europe (excluding Russia), the rate fell from 15% to a projected 11%, with a dramatic dive in Bulgaria, where the rate fell from 1,082% to 27%. In the Transcaucasus and Central Asia, the inflation rate declined from 31% in 1997 to a projected 21%.

      The notable exception to this trend was Russia, where the IMF projected an increase from 15% to 48%. By the year-end this looked too optimistic. The collapse of the ruble and crisis in the banking system resulted in spiralling price increases that were expected to exceed 100% year on year. At the same time, there were signs that Russian consumers were more willing to spend their devalued currency on products produced by domestic manufacturers than on the more expensive products of the foreign companies.

      Restructuring suffered a setback in 1998. The numerical transition indicators of the European Bank for Reconstruction and Development provided a means by which the cumulative progress of the former centrally planned economies toward market economies since 1994 could be measured. Among the indicators being monitored were large- and small-scale privatization, price liberalization, corporate governance and restructuring, trade and foreign-exchange systems, competition policy, and financial-sector reforms. The indicators showed a much slower pace of reform in 1998 than in previous years, with progress that was made tending to reflect the catching up on long-delayed reforms. In Poland there was progress in the privatization of banking, and in Hungary private investors played a role in improving corporate governance. Progress in Russia slid backward in four areas: banking reforms, price liberalization, securities markets, and trade and foreign-exchange liberalization. Croatia tightened capital controls to contain the domestic credit growth stimulated by short-term capital inflows. Some countries—including Belarus, Turkmenistan, and Uzbekistan—continued to delay or deviate from the road to market economies.

Less-Developed Countries.

       Changes in Output in Less-Developed Countries, Table Changes in Consumer Prices in Less-Developed Countries, Table At the end of 1997, the IMF projected that growth in the LDCs would be about 6% in 1998. At that time it was not realized how deep and widespread the contagion effect of the Asian and Russian crises would be on the global economy. Subsequent downward revisions were made, and LDC output was expected to increase by 2.3%, compared with 5.8% in 1997. (See Table (Changes in Output in Less-Developed Countries, Table ).) On a per-head basis, GDP grew by 0.7%, a sharp decline following six consecutive years in which real GDP per head grew by 4% or more. The latest output projection for 1999 was for 3.6%, although the outcome would heavily depend on the movement of commodity prices, which remained uncertain. (For Changes in Consumer Prices in Less-Developed Countries, see Table (Changes in Consumer Prices in Less-Developed Countries, Table ).)

      For the first time, the Asian LDCs, which had averaged real growth of 7% annually in the 1980s and '90s, trailed the other regions. It was clear by mid-1998 that the recession in Asia was much deeper than expected. (See The Troubled World Economy (Troubled World Economy ).) Africa grew fastest in 1998, with output up by 3.7% despite the war in the Democratic Republic of the Congo and the civil unrest it generated in surrounding countries. This was in excess of the average annual performance over the previous two decades and produced a modest increase per head of 1.2%. The Middle East grew by 2.3%, falling slightly on a per-head basis. This compared with a 4.7% expansion in each of the previous two years. Latin-American output was expected to increase by 2.8%, compared with 5.1% in 1997.

      Oil and nonfuel commodities were a major influence on the performance of Africa and the Middle East. In Africa the government oil revenues as a share of GDP in 1998 were 15-25% in Algeria, Angola, the Republic of the Congo, Gabon, and Nigeria. In the Middle East there were even higher dependencies on oil. In Kuwait the government relied on oil revenue as the GDP equivalent of 38%, followed by Qatar (27%), Oman (23%), and Saudi Arabia (19%). Latin-American governments were less reliant on oil, with the notable exception of Venezuela, where 58% of total revenue in 1996-97 was from oil; in l998 oil revenue was 7.3% of GDP.

      For the oil-importing countries in the Middle East, the benefits of lower oil prices were partially offset by lower remittances and investment and reduced demand from oil-exporting neighbouring countries. Nonfuel commodity price declines in 13 of the 43 oil-importing African countries were expected to offset the gains from lower oil prices.

      The overall growth in Africa was boosted by strong expansion in several countries, including Algeria and Morocco (up 6%) in the north, where better weather conditions improved agricultural output following drought in 1997. No expansion was expected in South Africa following a 1.7% rise in 1997 and more than 3% in each of the previous two years. The country suffered financial contagion from the Asian crisis, and international investors were deterred. The fall in value of the rand (in dollar terms) brought inflationary pressure, and by November consumer prices were up 9.4% on a yearly basis.

      In Latin America weaker oil prices and cutbacks in production contributed to lower-than-expected growth in Colombia, Mexico, and most of Venezuela. Most countries were forced to tighten monetary and fiscal policies because of the Asian crisis, which helped keep inflation down to an average 10.8%. Investor confidence remained strong until Russia devalued its currency in August. Given the region's low savings rate and heavy dependence on external funding, there was growing pressure on currencies. In September Colombia, Chile, and Ecuador adjusted their exchange rates. In Brazil political uncertainty led to heavy outflows of capital and fears of a financial crisis. An IMF rescue package that was agreed on in November was expected to stabilize the situation, depending on how quickly interest rates could be lowered. Argentina grew by 7% in the first half of the year and was expected to expand by 6% over 1998. Its strong credit rating enabled it to successfully launch a $250 million euro bond toward the end of the year. The Mexican economy grew by 4.5% despite some peso volatility as a result of the Asia crisis and lower oil prices.

International Trade, Exchange, and Payments

      Whereas the economic problems being experienced by all regions of the world in 1998 had their origins in the financial system, international trade played an important role for individual countries in either alleviating or exacerbating the difficulties. In volume terms international trade of goods and services rose by 3.7%. This reflected a sharp deceleration from the much faster actual growth of 9.7% in 1997, which marked a new annual peak in international trade and exceeded the IMF's projected increase of 7.7%. Although the increase in 1998 was modest, it strongly outpaced the projected 2% increase in world output, reflecting the growing importance of international trade in global output. In value terms, however, at $6.6 billion trade was similar to that in 1997. The relative decline in value terms was largely because of the fall in the price of oil by nearly one-third over the year and nonfuel commodities by some 14%. Prices of manufactured goods continued to weaken but less steeply than in 1997.

      The advanced countries overall provided the momentum in the market, which marked a decisive shift away from the LDCs, which for several years had provided the strongest growth markets for world exports. Whereas imports by the advanced markets rose 4.5% (9% in 1997), they increased only 1% in the LDCs (9.8% in 1997). Exports increased 3.6% (10.3%) from the advanced economies while rising a slightly faster 3.9% from the LDCs. In dollar terms total LDC exports and imports fell by 2.8% and 2%, respectively, compared with strong growth every other year since 1991.

      The overall slowdown in the advanced countries' trade was skewed by Japan, which for the first time in decades experienced a drop in exports. In value terms these were down 8.5% in the first nine months, and weaker domestic demand pushed imports down 19% over the same period. In volume terms Japanese exports turned negative in the second and third quarters, when the buoyant demand from the U.S. and the EU was more than offset by the downturn in sales to its Asian markets. Export volumes were projected to fall 1.9%. The slowdown in the average rise in exports of goods and services of the advanced countries of 3.6%, however, was not influenced only by the recession in Japan. In the U.S. there was a dramatic deceleration in exports from the 12.8% rise in l997 to only 3.1% in 1998, reflecting the drop in demand in its Asian markets. The U.S. nevertheless played a major role in sustaining global trade by raising the volume of its imports 11.5%, not far short of the l997 level (13.9%).

      Trade in goods and services from several EU countries reflected strong activity in the first half of the year, especially because of the buoyant conditions within the euro area. Lower inflation and continued economic recovery combined with the relative strength of European currencies and real increases in household disposable incomes. In the second half of the year, however, the effects of the global slowdown and increased competitiveness of Asian goods was beginning to be felt. EU exports were projected to rise 6.1% over the year (9.9% in 1997), whereas imports at 7.5% were maintained at close to the 1997 levels (8.8%). Germany, France, and Italy led trading activity of the major EU countries. In the U.K. the volume of exports rose only marginally (0.8%), compared with an 8% rise in 1998. The traded sector of the British economy was under severe pressure from the strength of sterling, both within and outside the euro area, and the fall in demand in LDCs. Imports (up 5.2%) became increasingly competitively priced as a result of the devalued Asian currencies and stronger pound sterling.

      The most notable change in the trade picture of the 28 advanced countries was the group of four newly industrializing countries (NICs)—Hong Kong, Singapore, Taiwan, and South Korea. For the first time, these countries were a negative source of trade momentum. For most years in the last three decades, this group had registered close to double-digit export and import growth, but in 1998 the volume increase in exports from the NICs fell from 10.9% in 1997 to 0.7%. Imports fell sharply by 8.7% after a 7.3% rise in 1997.

      The LDCs' trade performance in 1998 was as varied as that of the advanced countries. Overall, the volume rise in both exports and imports (3.9% and 1.3%, respectively) translated into declines (6.5% and 3.4%) in dollar-value terms from the 1997 peak, which reflected the decline in fuel and nonfuel commodity prices. Although Asia still accounted for the major share of LDC trade—nearly one-half—the region's 1998 exports were expected to rise marginally (0.4%) at best, with imports falling 9%.

      The buoyant trading conditions in Latin America that had made it the most dynamic region in 1997 continued into 1998 but were soon dissipated. The value of exports, which had increased by more than 10% in 1997, stagnated in 1998. The dollar value of imports fell from 18% to under 9%. The decrease in commodity prices resulted in currency devaluations, with Chile, Colombia, and Ecuador adjusting their exchange rates in September, which further depressed revenue from exports. Imports into Brazil fell by nearly 5% in the first nine months of 1998, compared with a rise in 1997.

 The crises in emerging financial markets and the failure of Japan to move out of recession were the main influences on exchange-rate movements in the developed countries. (For Effective Exchange Rates in selected countries, see Graph—> .) In the first half of the year, both the U.S. dollar and sterling benefited from being perceived as safe havens as well as exhibiting strong economic growth accompanied by low inflation. The dollar appreciated by 2.7% between the start of the year and mid-July, with rates against sterling and the Deutsche Mark remaining steady at around $1.64 and $1.78, respectively. Later in the year, however, as the emerging countries' crisis took on global dimensions, the dollar weakened against the Deutsche Mark.

      Against the yen the dollar appreciated strongly as the yen fell to new lows. Concerns that the problems in the Japanese banking system would not be quickly resolved pushed the yen to an eight-year low of 146 to the dollar in mid-June. There also were fears that the yen-to-dollar rate would put the Chinese fixed exchange rate under pressure, adding to the financial turmoil in the Pacific Rim. These concerns prompted the Fed and the Bank of Japan to intervene in the foreign exchange to try to prevent a further decline of the yen. Following a brief fall the yen strengthened through September and October, helped by the easing of U.S. interest rates. The dollar fell by 4.5% in October and ended the year at around 116 yen to the dollar. This compared with a 1998 high of 114.37 and a low of 147.25. The Australian and New Zealand dollars, which reached lows against sterling in September, stabilized in the last weeks of the year.

      The pound sterling traded firmly against the dollar in the first three quarters of the year in the $1.64-$1.68 range. Although it appreciated toward the end of the year, it remained little changed over a year earlier. In Europe, however, sterling strengthened against the Deutsche Mark and euro currencies, mainly as a result of higher interest rates in the U.K. In early July sterling was trading at DM 3, but it fell on signs that the British economy was slowing and indications that interest rates had peaked. In October sterling fell to its lowest level against the Deutsche Mark in 15 months. By the end of the year, sterling was trading at around DM 2.80, close to the average for 1997. On December 31 the European Commission announced the 10 irrevocably fixed rates of the euro for the currencies in the euro area.

      The balance on the current accounts of the advanced countries was expected by the IMF to narrow in 1998 to $39.6 billion from $69.4 billion in 1997. The deterioration was more than accounted for by the widening of the U.S. deficit by $8l billion to $236.3 billion. The strong domestic demand that was driving growth in the U.S. and the stronger buying power of the dollar encouraged imports, particularly from the crisis countries of Asia, which were extremely competitive in the first half of 1998. Exports were being held back by the deceleration of demand and reduced buying power in the Asian NICs and LDCs in general.

      In the euro area strong domestic demand in the first half year, combined with currency weakening against the dollar, left the current-account surplus virtually unchanged at $111 billion. The current account of the U.K., however, moved into deficit ($18.7 billion) under pressure from the strong pound, which inhibited exports but encouraged purchases of competitively priced imports. In Australia the economy was expected to grow by 3.5% because of the buoyant domestic economy. This, combined with the decline in exports to the Asian markets on which Australia was heavily dependent, produced an increase in the deficit to around $19 billion. In New Zealand, where the economy was contracting, the deficit was expected to fall to $3.5 billion ($4.7 billion in 1997).

      In Japan the surplus increased by more than a third, with the fall in demand from exports from its Asian neighbours being offset by the depreciation of the yen, reduced domestic demand, and lower commodity prices. The position of the NICs was similar, with Taiwan in particular moving into surplus.

      Overall, the LDCs' current deficit was expected to increase by some $16 billion to $78 billion. The decline in oil prices pushed the Middle East into deficit from a small surplus in 1997, and in Africa the deficit grew to nearly $15 billion because of lower commodity prices. In Asian emerging countries the tighter financial conditions that resulted from the sharp depreciation in currencies, combined with much lower imports, pushed the surplus from $4.7 billion to $14.7 billion. The current-account balances of Indonesia, Malaysia, the Philippines, and Thailand were expected to move from a $15 billion deficit in 1997 to a combined surplus of $17.6 billion.

      The total external debt of the LDCs rose more slowly in 1998 to $1,812,000,000,000, according to IMF predictions, compared with $l,774,000,000,000 in 1997. This was the equivalent of 148% of exports of goods and services, and although it was up on the 141.8% in 1997, it was well down on earlier years. The trend for the growth in export earnings to outpace the increase in indebtedness continued in Asia, where indebtedness was lowest as a percentage of exports, at 110%. External debt fell in absolute terms in both Africa and in Asia but rose slightly in the Middle East. In Latin America, which was the world's most indebted region in 1998, it rose slightly to $681 billion. The external debt of the former centrally planned economies reached a new peak at $45 billion, but as a proportion of exports of goods and services, it remained modest at 14.8%.

IEIS

Stock Exchanges

       Selected Major World Stock Market Indexes, Table By the end of 1998, world stock markets had formed two camps: the strong markets of Western Europe and North America and the weak markets of the rest of the world, particularly Asia. Lack of financial probity in Asia lay at the heart of this polarization. Following the collapse of Southeast Asian markets and currencies in summer 1997, investors largely abandoned debt-ridden emerging markets for the greater security of developed markets. By spring 1998 braver investors had been attracted back by the prospect of buying sound assets cheaply. Over the year to end November, the MSCI Emerging Markets Free Index fell 27.5% in U.S. dollar terms, but by year's end the stock market of one of the worst-affected Asian countries, South Korea, had risen by more than 49%. (For Selected Major World Stock Market Indexes, see Table (Selected Major World Stock Market Indexes, Table ).)

      The full implications of Asia's collapse were realized by midyear, when the gravity of Japan's financial plight and growing signs of economic stress in the hitherto strong markets of Latin America became plain. Until then investors' "flight to quality" had sent the markets of Europe and North America soaring, but by September successive economic shocks had undermined confidence. Fears surfaced that moves by banks to impose tougher lending criteria threatened a credit crunch that would stall investment and consumption in the U.S. and precipitate a global recession. Fear of inflation was overtaken by fear of a downturn. In the U.S. short-term interest rates were reduced to ease liquidity concerns, but although American markets were volatile, the overall trend was upward.

 In the rest of the world, investors' heightened fear of risk had driven down equity prices. The Financial Times/Standard & Poor's (FT/S&P) World Index had fallen nearly 12% from its July peak, and the Financial Times Stock Exchange 100 (FT-SE 100) had fallen by 20%. (For annual averages of the Financial Times Industrial Ordinary Share Index, see Graph—> .) The slump in equity prices had lowered consumer-spending growth and lowered investment growth as firms reacted to the higher cost of capital. In the U.K. interest rates were cut in three successive months, by a quarter-percentage point in October and November and a half point in December, to stand at 6.25%.

      Michel Camdessus, managing director of the International Monetary Fund, outlined plans for building a strong global financial system through the adoption of international standards of good practice. Even in the U.S., where financial systems were among the most robust, authorities were confronted in August by the $2 billion collapse of Long Term Capital Management, a hedge fund that had extensive exposure to the international financial markets. The event was seen to have profound implications. Like the failed fund, nearly all major American banks and investment houses were trying to beat the market by using highly complex computer-aided trading strategies. These models failed to predict the sudden drying up of cash availability across markets. As Russia defaulted on its debts in August, Asia's crisis deepened and investors worldwide switched their money into safe securities such as U.S. Treasury bonds.

IEIS

United States.

       Selected U.S. Stock Market Indexes, Table The American stock market was highly volatile in 1998, with wide swings in the averages. (For Selected U.S. Stock Market Indexes, see Table (Selected U.S. Stock Market Indexes, Table ).) The general pattern was one of relatively steep increases in the first half of the year, followed by a sharp decline in the third quarter and a recovery in the last quarter. In early October the market was locked in the grip of a near panic over whether the shaky world financial markets would push stocks into a major bear market. On October 8 the Dow Jones Industrial Average (DJIA) fell to a point more than 20% below its July peak, on the verge of what many securities analysts considered the technical onset of a bear market. The market lost $1.5 trillion between the end of July and the middle of October. Six weeks later the Dow broke new records, passing the 9000 mark as it surged more than 16% in just over a month.

      The DJIA itself was particularly volatile during 1998. Beginning the year at 7908.25, it rose steadily to the 9000 level by the beginning of April, dipped in June, rose to 9337.97 in July, and then slid back in August. On August 31 the Dow fell 512.61 points, or 6.4%, to 7539.07, which left the bellwether index 4.7% below where it had started the year. The decline was the second largest in the Dow's history in point terms, trailing the 554-point drop in October 1997. There were numerous sharp swings on a daily basis, and less than two weeks later, on September 9, the DJIA had its biggest increase ever in point terms: 380.53, or 5%, to 8020.78. Although so-called blue-chip stocks fell more than 15% between the end of July and mid-October, the recovery that followed pushed the Dow into record territory, reaching the all-time high of 9374.27 on November 24. Amid continuing volatility, the DJIA finished 1998 at 9181.43, up 16.1% for the year.

      Meanwhile, the over-the-counter stocks monitored by the National Association of Securities Dealers automated quotations (Nasdaq) index soared from an October low of 1419.12 to end the year at a record-high 2192.69, up 39.63%. The S&P index of 500 stocks (S&P 500) also finished well ahead of the Dow, up 26.67% for the year. Stocks of companies with low levels of capitalization (small-cap stocks), represented by the Russell 2000 index, were more vulnerable than the blue-chip stocks on the Dow, moving from 425 in January to a peak of 485 in late April before declining irregularly to under 350 by the end of September and ending the year down 3.45% at 421.96.

      The near collapse of Long Term Capital Management LP, the largest hedge fund, with capital of $1.5 billion leveraged to about $1 trillion, was rescued by a bailout by major financial institutions at the behest of the New York Federal Reserve. Using high-powered computers, some of the most profitable trading on Wall Street involved complex, innovative products known as derivatives. Such trading was designed to protect users from disadvantageous economic shifts such as currency devaluation or interest-rate risks.

      August recorded one of the worst declines in stock market history. There was an erosion of consumer confidence, given that 60% of American households were invested in equities. Credit contraction in the financial system, partly because of losses suffered by its exposure to leveraged hedge funds and emerging market debt, added to investor uncertainty in the last quarter of the year.

      In October investors' gloom deepened as international financial leaders meeting in Washington, D.C., failed to make tangible progress in sorting out the world's financial troubles. The flight to quality continued, pushing up Treasury bonds and some blue-chip stocks while trampling technology issues and smaller stocks on the Nasdaq.

      Stock exchanges were consolidating worldwide. The National Association of Securities Dealers (NASD), parent of the Nasdaq, merged with the American Stock Exchange (Amex) in June, and the Amex acquired the Philadelphia Stock Exchange. The Pacific Stock Exchange and the Chicago Board Options Exchange also attempted to merge in 1998. The initial public offering (IPO) market started strong in the first quarter but then slowed remarkably as investors turned wary. During the first nine months of 1998, 305 issues were announced, compared with 524 a year earlier, a decline of 14.7%. Some $30.7 billion were raised in 1997, compared with $20.9 billion in the first three quarters of 1998.

      Analysts' strong optimism during 1998 was prompted by less worry about emerging markets and confidence in the Fed's cuts in interest rates. Bullish opinion was strong throughout the year. Americans had almost twice as much money invested in the stock market as in commercial banks during 1998. About 500 companies offered direct stock-purchase plans—up from 52 in 1994, and as many as five million investors participated in them. American investors had holdings in some 3,300 hedge funds around the globe with about $375 billion invested, up from roughly $145 billion a year earlier. Heavy losses were sustained, however, and the funds were under pressure as banks increased their margin requirements and investors fled to safer securities.

      The third quarter was one of the slowest periods for IPOs in a decade. The total of 72 deals in the third quarter was the lowest since the first quarter of 1991 and the first time in over three years that fewer than 100 deals were completed in any single quarter. The $5.9 billion raised during the third quarter was the lowest since the first quarter of 1997 and about half the $10.8 billion raised a year earlier. Overall underwriting in the first nine months of 1998 was up sharply. In the first nine months, Wall Street raised nearly $1,410,000,000,000, surpassing the $1,310,000,000,000 raised in all of 1997.

      The top underwriters of U.S. bonds and stocks during the first nine months of 1998 included Merrill Lynch & Co., $233,523,700,000 (for a market share of 16.5%); Salomon Smith Barney, $176,729,200,000 (12.5%); Morgan Stanley Dean Witter, $164,693,400,000 (11.6%); and Goldman Sachs, $156,561,900,000 (11%). As of mid-November the value of merger deals was more than $1,390,000,000,000, with many deals in the multibillion-dollar range. Among the biggest were the merger of Travelers Group Inc. with Citicorp for $72.6 billion, British Petroleum PLC's acquisition of Amoco Corp. for $43.2 billion and Daimler Benz AG's $40.5 billion merger with Chrysler Corp. Exxon Corp. and Mobil Corp. announced a $78.9 billion merger in November. More than 10,000 deals were reported through mid-November, compared with 12,000 in all of 1997.

      The yield on the 30-year bellwether Treasury bond plummeted to 4.713% in early October, the lowest yield for long-term government debt since April 1967. The Fed cut the Fed Funds rate, the lending rate on overnight funds between dealers, to 5.25% from 5.5% on September 29. The object was to cushion the effects on prospective economic growth in the U.S. of increasing weakness in foreign economies. On October 15 the Fed cut the target for the overnight lending rate by a quarter point to 5%. This cut was intended to encourage more lending and to bolster the economy by making it cheaper for consumers and businesses to borrow. They also lowered the discount rate for loans from the Fed to banks to 4.75%, the first change since January 1996.

  Through October 20 volume on the New York Stock Exchange (NYSE) was 136,184,481,000, up from 105,184,933,000 during the corresponding period of 1997. (For New York Stock Exchange Composite Index and volume of shares sold: in 1998— and since 1977,—> see Graphs.) During the third quarter, average daily trading volume rose 35% above the corresponding period of 1997. Forty-three new companies joined the list of stocks traded on the exchange, down from 65 a year earlier. A total of 4,285 issues traded on the NYSE, of which 1,850 advanced, 2,360 declined, and only 75 remained unchanged. High-tech companies dominated the most active list, including Compaq Computer Corp., America Online, Lucent Technologies, and IBM Corp. As an industry, oil-drilling companies fared the worst. Seat prices on the NYSE plummeted 32.5% from a record high of $2 million in February to $1,350,000, largely owing to the growth of on-line trading.

      The NASD, hoping to use its technology and marketing muscle to boost the Amex's growing options business, completed its takeover by the end of October. Smaller companies were expected to favour Amex over Nasdaq because they had difficulty getting the market makers common to Nasdaq. The new organization, called the Nasdaq-Amex Market Group, had 6,178 listed companies with a combined market value of $2.2 trillion. By contrast, the NYSE had 3,090 listings with a market value of $11.6 trillion. The Nasdaq and Amex markets continued to operate separately. Through December 4 volume on the Amex was 6,758,536,000, up from 5,710,113,000 a year earlier, an increase of 18.4%. The Amex index ended the year less than 1% higher.

      Through October 20 volume on the Nasdaq was 155,415,083,000, up 19% from 130,055,757,000 in the same period of 1997. A bear market in small stocks, coupled with tougher listing requirements, drove hundreds of companies off the Nasdaq stock market. Through August 564 companies had been delisted. At the beginning of the year, about 226 Nasdaq stocks, or 4.1% of the 5,500 on the market, were in the danger zone, priced below $1. By midyear nearly 600 additional stocks, or 10% of the market, traded under $1. Of the 6,584 total issues traded on the Nasdaq, 1,711 advanced, 2,898 declined, and 41 ended the year unchanged.

      The NASD planned to pursue affiliations with eight international stock markets—including those in Tokyo, Paris, and Mexico City—in an effort to forge links that would let companies trade their shares around the world. Globalization was being pursued by all of the exchanges. Nasdaq volume through December 4 totaled 183,157,854,000, up from 151,593,495,000 a year earlier. The Nasdaq composite showed record highs for the year, led by computer, software, and telecommunications companies such as Dell Computer Corp., Intel Corp., Microsoft Corp., Netscape Communications Corp., and Yahoo. Banks and other financial securities were among the poorest performers during 1998.

      Mutual funds disappointed investors in 1998 as the average diversified American stock fund posted a negative return of −15.02%, with small stock funds sagging even worse (−21.52%) according to Lipper Analytical Services Inc. during the third quarter. It was the worst quarter for American stock funds since the third quarter of 1990, when the average fund delivered a −16.07% return, according to Lipper. The average stock fund was down −4.89% for the year through September. By contrast, bond funds and money market funds made money. The average taxable-bond fund posted a 4.98% return for the year to date. Value mutual funds (managers that specialize in out-of-favour stocks while steering clear of the fastest-growing, most glamorous growth companies) climbed 11.7% over the 12 months ended October 31, whereas an index of growth stocks climbed 32%. This was the widest disparity in 11 years between the S&P's growth and value indexes, which split the S&P 500 composite index between stocks with higher and lower ratios of price-to-book value. An unprecedented 9 out of every 10 American equity mutual funds performed worse in 1998 than the S&P 500 because most of the S&P's growth (22%) was due to a sharp rise in the 50 largest market capitalization firms, which were underweighted in the mutual-fund portfolios. The largest mutual funds averaged one-year returns of 6.2%, but a few specialized groups—notably those invested in high-tech stocks—had returns for the year of more than 40%. Equity mutual funds recorded net new cash flow of $141 billion, versus $173 billion year to year through September.

      The S&P 500 rose from 975.04 in January to a peak of almost 1200 in July, then slid to below 950 in October before making a strong recovery to end the year at 1229.23. The index's price-earnings ratio was 25.1 times estimated 1999 earnings, a near-record multiple.

      The bond market advanced with prices of Treasuries surging by the end of September to drive yields on the 30-year bonds below 5% for the first time in more than 30 years. U.S. Treasury securities, according to Lehman Brothers' indexes, rose across the board in 1998. Intermediate-term bonds were up 8.9%, long-term were up 14.96%, long-term (price) were up 8.29%, and the composite index was up 10.64%.

      The bond market was capitalized at $12.5 trillion in 1998. American corporate debt issues, according to Merrill Lynch, gained during 1998. Bonds with maturities of 1-10 years climbed 8.75%, those with maturities of more than 10 years were up 10.19%, and high-yield bonds were up 3.73%.

      The futures exchanges campaigned for the business of derivatives trading by citing clearinghouse protection against credit risk as a central reason futures exchanges offered greater safety than the over-the-counter market. The Dow Jones index of weekly closing prices of futures declined from a peak of 136 in January to a low of 120 in August and September. The price of a seat on the Chicago Board of Trade (CBOT) plunged 52% from the year-earlier level, and a seat on the Chicago Mercantile Exchange sold for $312,500 in October. The Market Enhancement Committee, a group of option-trading firms that preferred the traditional open outcry system, lobbied against changes aimed at the development of computerized options trading. The CBOT voted against a move to electronic trading. The futures markets for grains and energy reached near historic lows in 1998. The Bridge Commodity Research Bureau Index of spot prices fell to 196.54 in November, just above the 21-year low of 195.35. Hog futures fell to an 18 1/2 -year low in December.

      The international financial crisis, the move toward on-line trading by investors, and market uncertainties caused securities firms to take heavy losses. Massive layoffs in the securities industry began in October with Merrill Lynch laying off more than 1,000 representatives. Retail distribution of securities shifted increasingly toward the Internet on the part of noninstitutional investors in 1998. Regulators were encouraging cybermarkets—on-line trading. The new electronic brokerage industry was projected to have 5.3 million customer accounts by the end of the year, and assets available for transactions in on-line accounts were $233 billion.

      The Securities and Exchange Commission (SEC) focused on three principal areas in 1998: retail sales practices and supervision; municipal securities-market practices, including disclosure, pay-to-play, and "yield-burning" issues; and investment adviser abuses, including pricing, conflicts of interest, and "soft-dollar" issues. There were smaller investigations into insider-trading violations, false financial reporting, and small company "microcap" fraud and manipulations. The SEC proposed new rules to streamline stock offerings by public companies. Under the proposal, larger companies would no longer be subject to a month-long review process after filing with the SEC to sell securities, companies would have fewer restrictions in communicating with potential investors, underwriters would have increased due diligence responsibilities, and investors would get more timely and better information. The SEC also went after yield-burning practices by underwriters, which occurs when investment banks slap excessive markups on bonds used to complete certain types of municipal bond refundings. By marking up the bonds, thus "burning" down the yields, underwriters pocket money that should have gone to the federal government and sometimes to the issuing municipality itself. Of the 5,600 brokerage firms required to file "year 2000" software-problem reports, some 37 firms were fined for failure to report on their plans for meeting the Y2K problem. (See COMPUTERS AND INFORMATION SYSTEMS: Sidebar.) In March the SEC required fund companies to replace unwieldy prospectuses with streamlined guides for investors and allowed them to issue even-more-brief fund profiles as well.

Canada.

      The Canadian markets were depressed because of languishing resource stocks and weak commodity prices. Commodities were down sharply most of the year, with gold stocks off about 36% and forestry stocks off 14%. Base-metal stocks were about even, whereas oil stocks rose about 9%. The overall market performance mirrored that of the U.S. Canada had its first budget surplus in 28 years.

      Canada's economic growth rate dropped in the second quarter of 1998 to an annual rate of 1.8%, down from an annualized 3.4% rate in the first quarter. The Bank of Canada raised its bank rate a full point in August, which led to slower consumer and business spending. The Canadian economy grew at a rate of about 3% through the year, whereas consumer prices rose by only 1%. With the economy in its seventh year of expansion, GDP rose at an annual rate of 1.8% in the third quarter. The unemployment rate declined to a level of 8% in November, the lowest rate in 8 1/2 years, with strong job growth. The Bank of Canada, matching the moves of the U.S. Fed, trimmed the bank rate to 5.75% from 6% and explained the move as a response to good inflation control and increased confidence in Canada's financial markets. On October 19 Canada reduced the bank rate a quarter point, paralleling the action of the Fed. The rate was dropped to 5.5% from 5.75%. Commercial banks lowered their prime rate to 6.75%. Corporate profits fell by 14% in the third quarter, and analysts expected a year-to-year decline of about 7.5%. For the first nine months of 1998, profits were down by 16%, according to a Wall Street Journal poll. Canada's mining companies suffered a sharp earnings downturn of 68% in the third quarter. Gold mining companies were up 25% in the quarter. Ten oil and natural gas companies reported earnings down 39% in the third quarter.

      The Toronto Stock Exchange index of 300 stocks (TSE 300), which began the year at 6699.44, rose from January through April to reach the year's high of 7822.30. After slipping during the early summer, the TSE 300 followed the Dow on August 27, plunging 372 points in response to Russia's default. It closed at 5481.84 on October 9, down 18.17% from the corresponding date in 1997. After recovering somewhat in the fourth quarter, however, the TSE 300 finished 1998 at 6485.94 for an annual decline of 3.2%. The Montreal Stock Exchange index was down slightly less (2.1%) for the year, but the Vancouver Stock Exchange (VSE) index plummeted 35.9%. November recorded TSE record equity volume of 2.4 billion shares, with a November value of $39.2 billion. Year-to-date volume was 24.4 billion shares in 1998, compared with 23.4 billion a year earlier, a gain of 4.03%. The VSE, which traded smaller, more speculative issues, established an active Investigations and Enforcement Division concerned with manipulative trading and related abuses.

      Canadian bond yields fell on expectations of strong economic growth in the world's largest trading partners. The benchmark 30-year Canada bond yielded 5.49% in early November and fell to 4.82% in December. Corporate bond yields were 6.26% in early December. Bank prime was 6.26% but ticked up to end the year at 6.75%.

IRVING PFEFFER

Western Europe.

      Markets that made steady gains through 1997 continued to perform strongly, although the contraction of Asian economies, the increased attractiveness of Asian exports, and the fall in global demand began to weaken the region's manufacturing base. The markets of the core euro-area bloc—France, Germany, and Italy—were buoyed by confidence in progress to monetary union in 1999. As the century drew to a close, substantial globalization had again been achieved, and financial markets had become far more integrated.

      Convergence took on a new twist with steps toward a single European stock market. In July London and Frankfurt announced an alliance, and in November Madrid said it wished to join, closely followed by Milan and Amsterdam. The Paris Bourse, having first expressed outrage at the Anglo-German link, declared that Paris also would join. The London-Frankfurt alliance was scheduled to begin on Jan. 4, 1999. In the U.S. the S&P announced the launch of two new euro-equity indexes to cover companies in the 11 countries of the European monetary union.

      Interest rates moved down in several countries: Italy, Spain, Sweden, Denmark, and the U.K. On December 3 Germany's Bundesbank, the Bank of France, and all other euro-area central banks except the Bank of Italy brought down their base rates to 3%. European stock markets rallied on the news. Finland (up 69%) topped the euro area, but all continental markets ended the year higher, including those in France (31%), Germany (15%), Spain (37%), Belgium (45%), and Italy (41%). Outside the European Monetary Union, the FT-SE topped 5883 at year-end, a rise of 15%.

Other Countries.

      Whereas investor sentiment toward the U.S. remained benign, sentiment toward Japan continued to be negative despite the availability of stock on very attractive valuations. Little headway on banking reform and restructuring had been made by summer, and in August the seriousness of Japan's banking failures became clearer. Years of poor lending practices had left the country riddled with debt, estimates of which continued to rise. American officials put total banking industry debt at $1 trillion, double the estimate of Japanese officials. Concern remained high over the state of Japan's economy as the recession deepened. By October the Nikkei 225 index had fallen a further 13.2% since January 1, but by the end of November the government had announced a new package of measures to stimulate domestic demand and passed legislation to deal with problems in the banking system. It also pledged financial support to Asian countries in crisis. The Nikkei ended the year at 13,842.17, down 9.3%.

      Japan's bleak economic performance spilled over into other Asian countries, exacerbating their problems. Contagion threatened to spread to Latin America's emerging markets, which had hitherto weathered the crisis. In South Korea and Thailand, financial indicators were positive for much of the year; appreciating exchange rates, falling interest rates, and very strong reserves signaled a turning point in performance and indicated recovery for 1999. Asia appeared set to be the first region to recover, and Asian markets had outperformed Latin-American markets since the middle of the year.

      The stock markets of Europe's former centrally planned economies suffered declines ranging from 12% by Poland to a staggering 84.9% by Russia. Markets were shaken in August by Russia's unilateral decision to reschedule its debt, and fears were raised that other large debtors would do the same. Once that danger was seen to have receded, investors' attention moved elsewhere. Although there was political risk in the economic and social instability of the nuclear power, Russia's economy had become too small to have any significant impact on the progress of world markets. As the year ended, China faced increasing pressure to devalue its currency. Devaluation could cause American corporate profits to weaken further and stock prices to fall.

Commodity Prices.

      Commodity prices fell by 25% over the year and were at their lowest for more than 20 years. The price of North Sea Brent crude, used as a benchmark for global oil prices, averaged $13 a barrel, its lowest in real terms since the crisis of 1973-74, and dropped below $10 a barrel on December 10. It ended the year only slightly higher at $10.385. The root cause had been oversupply coinciding with mild weather and weak consumption in the winter of 1997-98. Oil stocks had been high throughout the summer. A number of producers agreed to cut production to help run down stocks and halt the slide in prices. Sluggish world economic growth was expected to hold prices well below the average $19 a barrel recorded in 1997.

      The price of non-oil commodities was at its lowest since 1986, and the price of industrial materials was estimated to have fallen by more than 24%. Asia accounted for 25-30% of global consumption of industrial materials, and the slump in demand brought about by the contraction of these economies combined with a slowdown in developed economies to depress prices further.

      Following a slump earlier in the year, demand for gold stabilized. Demand in the 25 countries monitored by the World Gold Council totaled 1,712 tons in the first nine months of the year, 20% down on the same period of 1997. Although the demand for gold had increased, the price continued to fall. An ounce of gold that cost $400 in early 1996 cost less than $300 by early December. The Economist Commodity Price Index showed the price to be down 3.9% over the year.

      Foodstuff prices fell by 9% in the year to October. Good harvests in the U.S. and stagnant import demand were likely to hold down grain prices well into the first half of 1999. Short supply looked to be shoring up cocoa prices, and sugar prices appeared to stabilize. Downward pressure on coffee prices came from the marketing of a new Brazilian crop of around 35 million bags.

      Low commodity prices eroded the revenues of countries dependent on the export of them but exercised a check on inflation in the developed economies. The decline in prices caused by the recession in Japan and the rest of East and Southeast Asia had been a factor in the spread of the Asia crisis. The wide range of affected prices had, in turn, further weakened equity markets.

IEIS

Banking

      Amid a global financial crisis and intense efforts to prepare for the introduction of the European Union common currency (the euro) and the computer problem caused by the year 2000 date change, industrywide consolidation both within and across national borders continued to reshape the financial services landscape in 1998. At the same time, 1998 was marked by ongoing efforts in the United States and other countries to modernize laws governing the affiliation of banks with other financial institutions.

      In response to these pressures, consolidation within the American banking industry continued apace with the merger of major institutions such as NationsBank and BankAmerica. The merger of Citicorp and the Travelers Group—creating Citigroup—combined for the first time in the U.S. a major banking organization and an insurance company. Indicative of the extent to which the Depression-era barriers against combining banking and securities activities had been eroded by regulatory interpretations made by the Federal Reserve System during the past 10 years, the Citicorp-Travelers merger included one of the largest American investment banks, Salomon Smith Barney Inc. Without passage of financial modernization legislation, under existing law Citigroup would have to divest its insurance-underwriting activities within two years of the merger (under certain circumstances this divestiture period could be extended for up to an additional three years). Interestingly, no such requirement applies to its securities business.

      Elsewhere around the world, Swiss Bank and Union Bank of Switzerland combined to form UBS AG, Fortis won the bidding to buy Generale de Banque of Belgium, Credito Italiano bought Unicredito Italiano, and Bayerische Vereinsbank AG merged with Bayerische Hypobank, to name but a few of the more notable transactions completed during 1998. Banks in several Latin-American countries were acquired by Spanish and other European banks, but proposed mergers among four of the largest Canadian banks were blocked by the government, which was concerned about their impact. As the year drew to a close, Deutsche Bank and Bankers Trust reached a merger agreement valued at approximately $10 billion, signaling that global competition in financial services was intensifying and that industry consolidation, including across borders, would continue in 1999.

      Against this backdrop of market activity, legislative efforts in the U.S. Congress to lift the legal restrictions on the formation of financial conglomerates once again fell short. In May the House of Representatives passed financial-modernization legislation that would permit banks to affiliate with securities and insurance underwriters without limitation and expand merchant banking opportunities for their securities affiliates. Despite extensive efforts to secure the bill's enactment, the legislation failed to reach the floor of the Senate for a vote prior to Congress's adjournment late in the year. The legislation was to be reintroduced when the new 106th Congress convened in January 1999 and was expected to receive serious consideration, though significant policy differences, particularly between the Department of the Treasury and the Federal Reserve Board, remained to be resolved.

      As the operations of financial institutions throughout the world became more complex and multifaceted, the functions and responsibilities of the supervisory authorities of financial services were being restructured, and increasing attention was being devoted to the exercise of "umbrella" supervision of financial institutions. In the wake of the Asian financial crisis, the default on Russian debt, and the repercussions those events had throughout the emerging markets, increasing attention also was being devoted to strengthening the organization of the international financial system as a whole.

      At the national level Japan, South Korea, and the United Kingdom created new authorities and vested them with the responsibility for oversight of the financial system as a whole. Australia began implementing a comprehensive restructuring of its financial supervisory authorities that shifted supervisory responsibilities from the central bank to the new Prudential Regulation Authority. China was considering significant reform of its financial system, including restructuring the central bank along the lines of the U.S. Federal Reserve System. Questions about which governmental authority would exercise "umbrella" supervision of financial holding companies became a central part of the financial modernization debates in the U.S. Other countries, including Finland, Panama, South Africa, and Turkey, were either implementing or considering measures to enhance the effectiveness of their financial supervisory authorities without undertaking a wholesale restructuring of their financial systems.

      Measures were also taken in 1998 to enhance the safety and soundness of financial institutions. Countries such as Belgium, China, Colombia, Latvia, and Uruguay strengthened the effectiveness of internal control and audit procedures, whereas Indonesia, Peru, Philippines, Turkey, and Venezuela adopted stricter rules relating to loan loss reserves and the classification of loans.

      Preparations for the introduction of the euro in January 1999, meanwhile, extended well beyond the 11 countries that initially would constitute the Economic and Monetary Union (EMU). The magnitude of converting to a common currency was truly daunting, as the shift to a single currency necessitated the extensive reformulation of the systems used to conduct the myriad of transactions that occurred each day in the financial markets.

      The year 2000 date change presented even greater technological and managerial challenges in 1998, and efforts to prepare for the new millennium were expected to intensify in 1999. It was clear that addressing the year 2000 issues was among the highest priorities within the international banking community and that it was being addressed through the concerted efforts of the regulators, banks, and banking associations. (See Sidebar. (Millennium Bug ))

      Throughout 1998 many countries continued to bolster their efforts to combat money laundering. These actions included imposing "know your customer" (KYC) requirements (in the U.S., for example, federal bank regulators in December published for comment proposed KYC regulations), expanding the types of institutions that would be subject to reporting requirements, creating special governmental agencies to investigate suspected money-laundering activities, and increasing penalties for money-laundering offenses.

LAWRENCE R. UHLICK

LABOUR-MANAGEMENT RELATIONS

      The economic malaise in much of East Asia and in Russia continued in 1998, but for the economies of most Western industrial countries it was a modestly successful year. The unemployment situation, however, remained disappointing in many nations. For the world as a whole, the International Labour Organization (ILO) expected that the number of jobless would reach 150 million by the end of the year. Among the industrialized countries of the West, more than 10% of the workforce was unemployed in Belgium, Finland, France, Germany, Italy, and Spain.

      Controversy continued as to whether observance of minimum labour standards should be made a condition of international trade agreements, with the United States and France among those arguing in favour of the proposition and others holding either that it was unnecessary or, particularly in the less-developed countries, that it was a protectionist device on the part of the advanced industrialized nations. In June the annual Conference of the ILO arrived at a declaration on fundamental labour standards, pledging member countries to uphold seven of the organization's key labour standards dealing with freedom to organize and bargain collectively and banning forced labour, child labour, and discrimination in the workplace. Juan Somavia of Chile was elected to be the next director-general of the ILO.

Europe.

      Of the 15 member countries of the European Union (EU), 11 were approved for membership in the European Monetary Union, requiring fixed rates of exchange to come into effect on Jan. 1, 1999, as a step toward the replacement of national currencies by the euro in 2002. Denmark, Sweden, and the United Kingdom did not request membership, and Greece did not satisfy the economic criteria needed for entry. While the present moves were not likely to produce Europe-wide collective bargaining, at least not in the short term, the expected economic transparency and the fact that control of economic levers was increasingly moving from national governments to the EU were bound to strengthen the international links in industrial relations, as was evidenced in September when trade unions from Germany, Luxembourg, The Netherlands, and Belgium met to discuss a common approach to collective bargaining.

      The European Commission invited the European employers' organizations and trade unions to prepare a European-level agreement requiring each country to enact rules giving workers rights to information and consultation within enterprises. Opposition to the idea arose, especially among employers, on the ground that such matters should be left to the individual countries to determine. The European employers' organization refused to engage in negotiations with the unions on the subject. At a meeting in October the employers confirmed their stance, and the Commission seemed likely to prepare its own draft legislation.

      In the U.K. the government moved to fulfill its election promises on low pay and union recognition. In May the Commission on Low Pay recommended that there should be a national minimum wage of £3.60 an hour from April 1999 (£1 = $1.65). The government adopted this rate for workers 22 years old and over, coupling it with a rate of £3.00 an hour for those aged 18 to 22, subsequently to be increased to £3.20; no rate was fixed for those under 18. On May 22 the government announced its proposals on employment rights in a White Paper entitled "Fairness at Work." The most important proposal concerned an obligation for employers to recognize trade unions in cases when at least 40% of eligible employees voted in favour of having a union, with automatic recognition taking place when more than half of the relevant workforce belonged to a union. In disputed cases an existing body, the Central Arbitration Committee, could grant recognition. The recognition procedure would apply to firms employing more than 20 workers. Other noteworthy proposals in the White Paper concerned reducing the qualifying length of service for claims alleging unfair dismissal from two years to one year, giving an employee a statutory right to be accompanied by a fellow employee or trade union representative during grievance and disciplinary procedures, and introducing a right for time off for urgent family reasons. Statutory maternity leave would be increased from 14 to 18 weeks. Subsequent debate about the White Paper suggested that while its main provisions would go into the bill, expected in January 1999, there would be some modifications.

      Unemployment continued to be particularly worrisome in Germany, but there the most significant event of the year was the election, in September, of a left-of-centre coalition government. It was announced that the new government would reverse the cuts in pensions and sick pay decided upon by its predecessor. It intended to work with the unions and employers in an alliance on jobs and training to attack unemployment. Strong voices among the unions quickly expressed the view that after years of union moderation in collective bargaining and acceptance of labour market flexibility, and in a buoyant economy, the time had come for workers to receive substantial improvements—the huge metalworkers' union spoke of a wage increase of 6.5% in the coming round of wage negotiations.

      In France the centre of attention was the government's intention to ensure that the workweek be reduced to 35 hours by 2000 (2002 for firms employing fewer than 20 workers). A law to that effect was promulgated on June 14. Employers continued to deplore the measure and began trying to mitigate its damaging effects. Thus, in July the important metal employers' federation, covering employers of about 1.8 million workers, reached agreement with some—though not all—of its union counterparts, providing an actual working year of 1,645 hours for full-time workers (for some firms 1,610 hours). The agreement increased annual permitted overtime per worker from 94 to 180 hours (in some cases 150 hours), those limits being extendable by 25 hours for the first two years of the life of the agreement. A possibility was provided for workers to offset overtime by extra days of leave. Companies introducing annualized working hours would have a daily limit per employee of 10 or 12 hours (for some workers) and a weekly limit of 48 hours or 42 hours, averaged over 12 weeks. These limits could be increased by negotiation within companies. The minister responsible for the law was angered by the agreement, which she considered did little to further the law's intention of reducing unemployment.

      In Italy the government submitted its bill to reduce working hours to 35 a week, which had earlier been hotly contested but had led to an employer-union joint declaration on wider issues to the effect that the two parties should discuss new rules concerning concerted action, the government should discuss the operation of the 1993 inter-confederal agreement with them, and unions and employers should try to promote employment creation in southern Italy, where unemployment had long been high. It was agreed that collective bargaining should continue on a normal basis. It appeared at the year's end that the unions and employers had ensured that they would be fully involved in the discussions on the reduction of working hours in the wider context of Italian industrial relations.

      Usually notable for industrial peace rather than conflict, Denmark in April, for the first time since 1985, suffered a major stoppage of work. Negotiations on a new two-year agreement had ended with the approval of a joint mediation proposal, which was put to a vote—regarded in advance as a formality. Voters, however, rejected the proposal, and a strike by more than 500,000 workers began on April 27. After 10 days of the strike and no progress in employer-union negotiations, parliament imposed a settlement based on the original mediation proposal but added some concessions, including an additional day's leave and extra leave after six months of service for workers with children under 14. Employers were given some tax concessions.

United States.

      A long-standing and often bitter period of difficult management-union relations at Caterpillar Inc., the world's largest maker of earth-moving equipment, appeared to have ended in March, when the company and the United Automobile Workers union (UAW) arrived at a six-year agreement. The settlement was facilitated by the firm's undertaking to reinstate 160 workers dismissed for action related to strikes; the union, for its part, agreed to readmit to membership workers who had continued to work for the company and to drop unfair labour practice claims against the firm. The agreement allowed the company to engage new labour at lower wages, and changes were made in incentive arrangements, linking pay more closely to the performance of specific units. Caterpillar conceded pay raises and undertook to improve job security and pension entitlements. The UAW was also involved in a major dispute at General Motors Corp. (GM), which started in June with strikes in two parts plants in Flint, Mich., related to the firm's desire to improve productivity and make changes in workplace rules. The union was concerned about job security, fearing that the firm would move jobs to cheaper labour markets, and also about health and safety. The firm filed suit asking for arbitration, arguing that the strikes were illegal as they did not involve strikeable national issues. The dispute shut down the great majority of GM's facilities in North America, and settlement was only reached on July 29, when the company pledged not to sell its Delphi plant in Flint before the end of 1999 and withdrew its legal suit and the parties agreed to work together on improving negotiating procedures.

Australia.

      In Australia the operation of the docks has long been regarded as one of the least efficient in any industrialized country, the unions exercising a stranglehold on working practices. In April, Patrick Stevedoring, one of the two largest stevedoring firms, withdrew financial support from its subsidiary labour-hire companies, resulting in their bankruptcy and the laying off of 1,400 dockworkers. Patrick then opened up dock work to nonunion labour. The union reacted strongly, receiving support from the International Transport Workers Federation, which said that it would boycott shippers using nonunion labour. A federal court required Patrick to reinstate the dockers. A deal was then struck, with Patrick undertaking to reinstate the dismissed workers and not use nonunion labour and the union agreeing not to proceed with further legal action and also to accept changes in working practices.

South Korea.

      In the summer South Korea's biggest car maker, Hyundai, was hit by strikes, and its production complex in Ulsan was occupied in protest against job cuts. A deal was reached on August 24, however, with the company agreeing to cut the number of workers dismissed to 277. Other workers the company had wanted to dismiss would have 18 months of unpaid leave and would receive training in the last six months of that period.

R.O. CLARKE

International.

      Food concerns, world economic turmoil, and trade issues loomed large on the consumer agenda in 1998. As genetically modified (GM) food products reached supermarket shelves around the world, consumer organizations were concerned that consumers were being told far too little about the ethical and health implications of these products. Many foods made with GM organisms were not even required to be labeled as such. In May a committee of the Codex Alimentarius Commission—the UN body responsible for setting international food standards—held a meeting to discuss food labeling. At the meeting consumer groups and other nongovernmental organizations urged the Codex committee to require compulsory labeling of all GM food. Consumers International (CI), a federation of some 235 consumer organizations in more than 100 countries, ran a campaign exhorting people to fax the Codex committee directly and urge mandatory labeling. Hundreds of such faxes were sent, but the Codex committee, under heavy pressure from industry, rejected the call for mandatory labeling. Instead, it decided to seek further expert scientific opinion and take up the issue again in 1999.

      Consumer issues became increasingly entangled with trade issues, due to the liberalization of global trade through such agreements as the 1994 General Agreement on Tariffs and Trade and the establishment of the World Trade Organization (WTO). Consumer groups grew increasingly concerned that such trade agreements, which in theory could mean lower prices and more products, could also mean lower standards in a variety of areas, from food to product safety.

      Consumer organizations and other nongovernmental groups were also active in discussion on international trade and economic agreements. One of the successes exposed a little-known but potentially powerful trade deal called the Multilateral Agreement on Investment (MAI). The MAI was generated by the 29 member countries of the Organisation for Economic Co-operation and Development. Many organizations feared the MAI could give free rein to multinational companies in the area of foreign investment by weakening and perhaps overriding local and national consumer and environmental regulations. Progress toward passage of the MAI—scheduled for 1998—stalled under public opposition. In May, during the WTO's ministerial conference in Geneva, consumer organizations joined with other groups to demand greater transparency and accountability at the WTO.

      Transatlantic trade between the European Union (EU) and the U.S. was a major issue for consumer organizations, which feared such relations were too heavily influenced by business and industry. In response, consumer organizations from the 15 EU countries and the U.S. met in September to discuss the launch of a transatlantic consumer dialogue to offset an already existing transatlantic business dialogue.

      The Euro-Mediterranean Forum on Consumer Policy, held in October, included 12 Mediterranean countries or territories that were not part of the EU—Morocco, Algeria, Tunisia, Egypt, Syria, Jordan, Lebanon, the Palestinian Authority, Malta, Cyprus, Turkey, and Israel. The goal of the meeting was to promote the development of effective consumer policy in those places and to provide a forum for consumer organizations from the EU and the Mediterranean partner countries to exchange experiences and ideas.

      Eastern and Central European consumer organizations and government consumer departments were involved in the process of harmonizing their laws with EU legislation in order to accelerate accession to membership in the EU. This included the regulation of marketing practices; consumer credit, guarantees, and after-sales services; and the regulation of package travel and time-share property. Consumer organizations also were campaigning to improve standards of health care and public utilities, which continued to deteriorate in many parts of the region. Economic turmoil in Russia brought the work of consumer groups to the forefront. Consumer organizations, through the media and other outlets, highlighted the critical need for consumer protection, particularly in the banking sector.

      In Latin America the privatization of public utilities continued to be an important area of activity. The First Regional Conference on Consumers and Public Utilities, held in January, was the culmination of two years of research and lobbying work in Brazil, Peru, Chile, Mexico, and Colombia. Consumer groups in all five countries took important first steps to monitor the provision of basic services, such as electricity, water, and telecommunications, and in participating in national regulatory agencies. Consumers in El Salvador and Guyana began organizing to press for more participation in the regulation of basic services. CI's office for Latin America and the Caribbean published seven reports on the state of consumer participation in public-utility regulation. Argentina launched new Consumer Defense Courts (three-member arbitration boards with consumer representation) for the settlement of consumer complaints and enacted reforms to its Consumer Defense Law. In Ecuador the new constitution adopted in 1998 included several articles devoted to consumer protection. In Brazil authorities decreed that consumer education be included in the national school curriculum for grades 5 through 8.

      The ongoing economic crisis in Asia dominated the lives of consumers there. In Hong Kong the Consumer Council lobbied for legislative reforms on behalf of thousands of people who had lost millions of dollars on popular discounted prepaid coupons, which normally would be redeemed at a later date. Many consumers were left holding hundreds of useless coupons, however, when the businesses that had sold the coupons suffered financial troubles.

      The most vulnerable consumers in Asia were the poor, who bore the brunt of the financial crisis. That was one of the reasons why the theme of 1998's World Consumer Rights Day was "Poverty: Rallying for Change." The day was commemorated on March 15 around the world in a variety of innovative ways, including a speech dedicated to the topic by Russian Pres. Boris Yeltsin. In Africa the consumer movement also was heavily involved with poverty issues, such as access to and quality of food, health services, and shelter. About 89 consumer organizations existed in 45 of Africa's 56 countries. The movement was gaining a foothold in the region, however, and the CI regional office had undertaken an ambitious three-year program called "Consolidating and Strengthening the Consumer Movement in Africa."

ALINA TUGEND

United States.

      Consumer affairs at the federal level in 1998 involved the continuing efforts to address information, safety, and fraud—with some attendant controversy. The Department of Agriculture delayed setting long-anticipated national organic-food standards; an extraordinary deluge of some 200,000 responses to its proposed regulations, issued in mid-December 1997, prompted the agency to make fundamental revisions. The standards were intended to govern the National Organic Program called for in the Organic Foods Production Act of 1990, which aimed to resolve the confusion created by a patchwork of private and state rules regulating organic-food production and labeling. The majority of the comments received opposed the proposal's inclusion of biotechnology-derived products as organic foods and the use of biosolids (municipal sludge) in their production and irradiation in their processing. One consumer group, however, warned that such concerns could backfire, with standards made too restrictive for the organic-food industry to expand into large-scale production.

      With expansion of a new food-safety system called Hazard Analysis and Critical Control Points (HACCP) underway at the beginning of the year, the Food and Drug Administration (FDA) in April called for retail food businesses to test the feasibility of the system in restaurants, grocery stores, and institutional food services. The FDA also proposed requiring food processors of packaged fruit and vegetable juices to implement HAACP. Following an outbreak of food-borne illness from apple cider the previous year, the agency issued final rules in July regarding warning labels on unpasteurized juices. The White House, meanwhile, established a President's Council on Food Safety to coordinate the various food-safety activities of the separate federal agencies into a comprehensive, strategic, federal food-safety plan. The General Accounting Office and National Research Council weighed in with reports suggesting coordination could entail streamlining safety laws and oversight in a single agency, rather than the existing 12 agencies and 35 different statutes.

      Concerns about the risk that large vehicles, particularly sport utility vehicles, posed to people in smaller cars were highlighted when the National Highway Traffic Safety Administration (NHTSA) began crash testing light trucks and vans with passenger cars. The NHTSA reported on incompatibilities or mismatches in vehicle design, such as bumper heights, that might increase the consequences of crashes. The Insurance Institute for Highway Safety provided helpful perspective with its report, based on real-world crash data, that showed the relative importance of vehicle size in safety, but it also showed that other factors mattered, such as design, use patterns, and where and how vehicles were driven. The NHTSA proposed to increase the prominence of mandatory rollover warning labels in sport utility vehicles.

      The Federal Trade Commission (FTC) reported a relatively new consumer problem known as cramming, in which unscrupulous billing firms added charges for unwanted products or services to consumers' local telephone bills without their knowledge. Sparked in part by the confusing complexity of local phone bills, cramming generated about 9,000 complaints to the FTC over a 12-month period and led to calls for federal or state intervention. Opponents of anticramming legislation wanted consumer safeguards for phone bills similar to those for credit card bills, which were developed successfully and voluntarily by the industry.

      Stating that fraud could slow the growth of consumer business over the Internet, the FTC launched Consumer Sentinel, a secure consumer fraud and complaint database for use by law enforcement organizations in the U.S. and Canada. Following its report to Congress on Internet privacy, the FTC also suggested that legislative measures should be taken to protect consumer financial information, which prompted concern that overly rigid rules would hamper commerce.

      As states cracked down on misleading and fraudulent sweepstakes pitches, 32 states and the District of Columbia reached a settlement with American Family Publishers, one of the largest sweepstakes outfits, over alleged misleading offers. The National Association of Attorneys General began to study whether additional specific laws were needed to protect consumers from abusive and deceptive sweepstakes activities.

PETER L. SPENCER

▪ 1998

Introduction

Overview

 The world economy grew by 4% in 1996 and was expected by the World Bank and the International Monetary Fund (IMF) to grow slightly faster in 1997. Despite the financial and economic crisis in Asia, a reasonably rapid pace looked sustainable into the next decade, as the inflation rate in most countries was low or declining (see Graph—>) and fiscal deficits had been curtailed. Among the developed economies, growth rates edged up to 3%, compared with 2.7% in 1996. Growth in the U.S. and the U.K. remained robust, and recovery in Western Europe broadened. In Japan, however, overall economic recovery faltered. The rate of growth in the less-developed countries (LDCs) as a group remained high at 6%, double that of the developed countries.

       Real Gross Domestic Products of Selected OECD Countries, TableThis overall picture masked considerable variations across the world. In the U.S. and Great Britain, growth, at around 3.5%, was strong and long-established, with little spare capacity remaining. The strength of domestic demand was the main engine of growth in both countries. In Western Europe, excluding the U.K., the recovery was still at an early stage, and growth rates remained below long-term trends. Growth stimulus was provided by the previous reductions in interest rates. This was partly countered in many European Union (EU) countries, however, by the continuation of restrictive policies designed to reduce fiscal deficits to ensure compliance with economic and monetary union (EMU) entry criteria of 3% of gross domestic product (GDP). By contrast, appreciation of the dollar and the pound sterling strengthened external demand. Against these developments, GDP in the EU increased an estimated 2.5% from the previous year's 1.7%, with virtually all member countries participating in the upturn. In Japan the economy faltered following a recovery in late 1996 and early 1997. The ending of the stimulatory effects of previous measures, combined with an increase in the consumption tax in April, led to a steep downturn in economic activity. This was exacerbated by the fallout from the financial crisis in Asia, which led to renewed weakness of the Tokyo stock market and Japanese financial institutions. In view of the sharp downturn, GDP growth in Japan was projected to slow to under 1% from 3.6% a year earlier. In Australia and New Zealand, where recovery was well-established, the growth rate moderated somewhat. (For Real Gross Domestic Products of Selected OECD Countries, see Table (Real Gross Domestic Products of Selected OECD Countries, Table).)

      The economies of the former centrally planned countries as a whole registered an estimated growth rate of 1.2%—the first increase since the transition began eight years earlier. The Central and Eastern European countries grew much faster than Russia and the Central Asian countries. The long-expected return of economic growth in Russia appeared to be materializing in the second half of the year, but with the exception of Poland, output in this group of countries remained below 1989 levels. The gap was widest in the Commonwealth of Independent States (CIS), including Russia.

      Economic performance among the LDCs was also variable. Asia remained the fastest-growing region, even with the slowdown that resulted from the financial crises that engulfed the region in the autumn. It was surprising how fast the July currency crisis and stock market crash in Thailand spread. Malaysia, the Philippines, and Indonesia had been affected by September or October. Rapid devaluation and austerity measures were followed by assistance from the IMF. The crisis then moved on to South Korea and indirectly influenced Japan.

      Compared with an estimated 7% GDP growth in Asia, Latin America headed for 4% growth as it continued its recovery from the Mexican crisis of 1995. In the closing months of 1997, Brazil and, to a lesser extent, neighbouring countries in Latin America were adversely influenced by a loss of confidence in the wake of the Asian crisis. Growth rates in Africa and the Middle East, affected by a fall in commodity prices and by civil wars, moderated to around 4%.

       Standardized Unemployment Rates in Selected Developed Countries, TableAs in 1996, unemployment worsened in many Western European countries and Japan but improved in the U.S. and the U.K. To some extent this was attributable to a lack of flexibility in labour markets in continental Europe and to different ideological and practical approaches among EU countries. At the November EU employment summit in Luxembourg, there was some evidence of willingness to try a new approach centred on employability, education, and reduced bureaucracy. Marking a break with previous thinking, the EU leaders showed little enthusiasm for French-style direct interventionist solutions. Instead, they agreed to introduce measures to provide work training for the young unemployed and the long-term jobless, similar to Britain's "new deal" for the unemployed. In the U.K. and the U.S., where there was greater labour market flexibility and economic growth was much faster, the number of unemployed continued to fall rapidly. The unemployment rate dropped to under 5% (about 7 million people) in the U.S. and to 5.2% (1.4 million) in the U.K. near the end of the year. This compared with 18.3 million jobless in the EU, or 11.25% of the workforce. Against the backdrop of a weaker economy, the unemployment rate in Japan edged up to more than 3.5% late in the year, a high level by Japanese standards. (For Standardized Unemployment Rates in Selected Developed Countries, see Table (Standardized Unemployment Rates in Selected Developed Countries, Table).)

      The slowdown in world trade during 1996 was short-lived, and the volume of trade rose by a projected 8% in 1997 (6% in 1996). Much of the acceleration stemmed from the higher volume of imports and exports in the U.S. and the improved export performance of EU countries and Japan. There was no significant change in the volume of trade in the LDCs. Regional deficits widened, with Japan and many EU countries running larger current-account balances while the U.S. deficit widened. As a result of an upsurge in imports by some Latin-American countries, the current-account balances of LDCs as a group widened. As in 1996, the LDCs did not experience any problems in funding the current deficits or in servicing existing loans.

  In the U.S. and Britain, the primary aim of policy makers was to prevent the emergence of higher inflation rates. In most EU countries, however, the policy continued to be framed mainly by reference to political rather than economic considerations. Thus, in many countries there was a modest rise in interest rates and a continuation of deficit-reduction measures. In the U.S. the Federal Reserve Board (Fed) raised the federal funds rate by 0.25% in March in a precautionary move. As the economy continued to expand at an above-average rate in the autumn, a further rise in interest rates appeared imminent. In the wake of the correction in global stock markets and the financial crisis sweeping Asia, which resulted in a steep devaluation against the dollar, the Fed, however, adopted a wait-and-see policy and refrained from raising the interest rates. By contrast, the Bank of England, with its operational freedom in setting the interest rates to meet the newly elected Labour Party government's inflation target, judged that the economy was expanding at an unsustainable rate. To prevent the economy from overheating, it raised interest rates in five small steps, by a total of 1.25%, to 7.25%. There was a slight tightening in monetary policy in Germany, too, signaling a turning point in the interest rate cycle. Following a 0.3% rise in the Bundesbank's repo rate in October, France and other EU countries that shadowed German monetary policy raised their interest rates by a similar amount. In Japan, against the background of a faltering recovery, interest rates were held steady at their rock-bottom levels. In the crisis-stricken Asian countries and in some Latin-American countries, short-term interest rates rose sharply to defend the depreciating currencies and restore economic stability. (For Interest Rates: Long-Term— and Short-Term—>, see Graphs.)

      Public-sector deficits continued to shrink rapidly in 1997 as a result of buoyant tax revenues and/or continuing tight control on government spending. In the U.S. and Britain, faster-than-expected reductions in the budget deficits were largely due to higher tax revenues from rapidly growing economies. The budget deficit in the U.S. for the fiscal year ended September 1997 came in at $23 billion, compared with $125 billion forecast a year earlier. In the U.K. the deficit for 1997-98 was revised down to £11.9 billion, compared with a July forecast of £13.4 billion. In France, Germany, and, to a lesser extent, other EU countries, the continuation of existing deficit-reduction measures, supplemented by selective new programs, reduced the budget deficit to close to the 3% of GDP needed to meet the entry criteria for the EMU in 1999. Following years of tax concessions and government spending measures to stimulate the economy, a medium-term fiscal-consolidation plan came into force in Japan in 1997. This program was further extended during the year, and a reduction in government expenditure was envisaged for 1998. Faced with the twin problems of a faltering economy and the crises in the financial institutions, however, the policy was partly reversed as the Bank of Japan bailed out many bankrupt banks and injected liquidity into the system.

National Economic Policies

United States.

       Real Gross Domestic Products of Selected OECD Countries, TableDespite expectations of a slowdown, growth of the U.S. economy accelerated in 1997, and for the year as a whole, GDP was estimated to have expanded by 3.6%—the best annual rate since 1989 and well above 1996's revised growth of 2.8% (see Table (Real Gross Domestic Products of Selected OECD Countries, Table)). With inflation stable and unemployment levels still falling, the economy was in remarkably good shape seven years into the present expansion cycle. Even though there was evidence of some slowdown late in the year, analysts remained concerned about the considerable risks of overheating if the economy continued to expand at this rate.

       Consumer Prices in OECD Countries, TableThe economic growth was driven by a combination of strong increases in consumer spending and fixed investment. Consumers spent heavily during most of the year except for a small pause in the spring. Retail sales, which accounted for nearly half of consumer spending, bounced back in the second half of the year and registered an estimated 4% annual growth. Total consumer spending rose by an average of 3.5% during 1997. (For Consumer Prices in OECD Countries, see Table (Consumer Prices in OECD Countries, Table).) Rising real-income levels, the continuing strength of labour markets, and booming stock markets buoyed consumer confidence and encouraged higher spending, particularly on durable goods. Business investment continued the uptrend that had been a feature of the current expansion. Investment in machinery and equipment grew by nearly 12%. Investment in computers grew much faster, whereas that in buildings increased by a modest 4.5%. This high level of investment was not surprising, given the rapid expansion in manufacturing production, high rates of capacity utilization, and stable long-term interest rates. The housing market plateaued at a fairly high level despite a small rise in mortgage rates in the spring.

  Standardized Unemployment Rates in Selected Developed Countries, TableThe unemployment rate continued to edge downward and in November stood at 4.7%, compared with the already-low level of 5.2% a year earlier (see Table (Standardized Unemployment Rates in Selected Developed Countries, Table)). During the year nearly 700,000 jobs were created. Had it not been for the continued expansion of the labour force, the unemployment rate would have dropped farther and resulted in faster growth in wage rates. The inflation rate remained remarkably stable despite the tightness of the labour market and high rate of capacity utilization. The unadjusted inflation rate, having touched a low of 1.9% in August, rose slightly to 2.2% in October (see Graph—>). The strength of the dollar and a drop in oil prices, which translated to a 3% decline in overall import prices, also reduced the inflationary pressures.

 Despite the strength of domestic demand and a 15% average appreciation in the value of the dollar (on a trade-weighted basis), the deterioration in the trade balance was relatively small. The value of imports rose by around 16%, but this was largely offset by a 14% growth in exports. As a result, the trade deficit widened by about $10 billion and was projected not to exceed $200 billion. Export markets in Western Europe and the North American Free Trade Agreement members were particularly strong. Demand from the Asian markets was fairly modest and was expected to cool off further in the wake of the sharp depreciations in local currencies against the dollar. The trade deficit with Japan widened during 1997, which reflected the large depreciation of the yen against the dollar, and became a political issue again. (For Effective Exchange Rates, see Graph—>.)

      U.S. economic policy was tightened slightly during 1997, but given the maturity of the recovery, the policy stance was best interpreted as fairly neutral. In March the Fed raised the federal funds rate, one of its key interest rates, by 0.25% to counter future inflationary pressures. In early autumn, in the absence of any evidence of a significant economic slowdown, further interest-rate rises were widely expected, but in view of the slide in stock prices and the steep currency devaluations in Asia, the Fed held back from further tightening. Some commentators, however, became pessimistic and claimed that real interest rates (after stripping out inflation) were much higher than historical averages and were too restrictive in any case. Coupled with the sharp appreciation of the dollar and deflationary pressures emanating from Asia, they saw no need for higher interest rates. Other economists remained convinced that in the absence of higher interest rates, growth would continue at an unsustainable rate and the tight labour markets would inevitably lead to an upward pressure on wage rates. At year's end, the odds remained in favour of a small rise in interest rates, intended to take the economy off the inflationary boil.

      In February Pres. Bill Clinton's administration forecast that the budget deficit would increase from $107 billion in fiscal year 1996 (ended September 1996) to $125 billion in fiscal 1997. Higher tax revenues from the rapidly growing economy, however, cut the deficit to just $23 billion, the lowest since 1974. In view of this development, the balanced-budget deal agreed to in May, which provided for state spending reductions balanced by tax cuts, looked potentially expansionary even though it was expected to result in a budget surplus in 1998.

United Kingdom.

       Real Gross Domestic Products of Selected OECD Countries, Table Consumer Prices in OECD Countries, TableDriven by strong consumer demand and private-sector investment, the British economy raced ahead, ignoring the negative influences of the strong pound and tight public spending. GDP rose by an estimated 3.5% in 1997, compared with 2.4% the year before (see Table (Real Gross Domestic Products of Selected OECD Countries, Table)). Consumer demand was driven by higher real incomes and "windfall" payments. As a result of a continued decline in unemployment, salaries and wages rose by about 6.5% in money terms. Consumer confidence was also boosted by an estimated £30 billion received from the building societies that were converting to banks from "mutual" societies. Unsurprisingly, the volume of retail sales rose by nearly 5% for the year as a whole, despite a temporary dip in most sectors in the weeks immediately following the death of Diana, princess of Wales. (For Consumer Prices in OECD Countries, see Table (Consumer Prices in OECD Countries, Table).)

 Investment spending also picked up, with most of the 6% growth provided by the private sector. Reflecting the government's spending restrictions, public-sector investment fell by 11%. The manufacturing sector also felt the benefit of rapid economic growth, and industrial production expanded by nearly 2% during the year despite the strong pound (see Graph—>). British firms appeared to have protected their share of export markets by reducing their export prices. This led to growth of export volumes at a similar rate as in 1996—nearly 7%. As import volumes rose faster, the balance of payments deficit widened.

       Standardized Unemployment Rates in Selected Developed Countries, TableUnemployment continued to fall, and toward the close of the year 5.2% of the workforce was without a job, compared with an unemployment rate of 7.3% a year earlier (see Table (Standardized Unemployment Rates in Selected Developed Countries, Table)). Although skill shortages emerged in some sectors, pay settlements remained remarkably stable, though at a high level. The inflation rate, having dipped to 2.5% at the time of the general election on May 1, moved up a little to 3.7% as a result of higher interest rates and a rise in food prices during the summer. The underlying inflation rate, which excluded mortgage interest, also rose and remained above the government's target of 2.5%.

   Apart from ruling out an entry to the EMU in the first phase (in 1999), the incoming Labour government had an economic policy that was largely unchanged from that of its Conservative predecessor, including the continuation of the tight public-spending plans. As expected, monetary policy was tightened to bring inflation under long-term control (see Graph—>). The new chancellor of the Exchequer, Gordon Brown, having reaffirmed the inflation target, provided operational freedom to the Bank of England in setting interest rates to meet it. In keeping with its long-standing view of the need for higher interest rates to prevent inflation from accelerating, the newly formed Monetary Policy Committee raised interest rates four times in as many months by a total of 1%. After a short pause, another 0.25% rise in November took the base rate to 7.25%. (For Interest Rates: Short-Term— and Long-Term—>, see Graphs.) Fiscal policy was also subtly tightened in the July budget, the main feature of which was a £3.5 billion windfall tax on privatized corporations to fund the government's program of putting the young unemployed into jobs. Abolition of tax credits on dividends was expected to raise another £2.3 billion annually in future years. Although taxes on gasoline and cigarettes were increased, there was no increase in direct taxation. Even before most of the revenue-raising measures were enacted, the public-sector deficit narrowed sharply, thanks to bumper tax revenues and the Labour government's continuing squeeze on public spending. Ultracautious official figures in Brown's "Green Budget" pointed to a deficit of £11.9 billion, compared with a July forecast of £13.4 billion, excluding the windfall tax. Many independent observers projected a figure of about £6 billion.

Japan.

       Real Gross Domestic Products of Selected OECD Countries, TableAs the stimulatory effect of the measures introduced in 1996 and earlier ended, the economy faltered. The decline in activity was exacerbated by the increase in the consumption tax and lower government spending that came into effect in April. The fallout from the Asian financial crisis and the renewed weakness of the Tokyo stock market, coupled with the crisis in the domestic financial sector, affected business confidence. On the basis of these developments, GDP was estimated to have grown by around 0.9% in 1997 after having expanded by 3.6% in 1996 (see Table (Real Gross Domestic Products of Selected OECD Countries, Table)).

      The year opened strongly, and GDP surged to an annualized growth rate of 6.6%, largely because of increased demand ahead of the consumption tax increase in April. This lopsided growth was highlighted by the different GDP components; real private consumption rose by nearly 5% over the previous quarter, whereas public investment and housing investment declined. Although export growth was maintained, the role of external demand was less important than in 1996. In the second quarter GDP declined by 2.6% more than the opening quarter increase, more than wiping out the earlier gains. In the second half of the year, the feeble recovery petered out, with consumption, business investment, and housing activity all declining. The new financial initiatives introduced in November, which authorities claimed would add 10 trillion yen to the economy in the next financial year, were seen to be too late and too little to revive the stalled economy.

 Despite the uneven GDP trend, industrial production held up reasonably well and rose by nearly 5.5% for the year as a whole (see Graph—>). In the first part of the year, production was sluggish, anticipating the decline in domestic demand. In the spring it rebounded as companies started building inventories to meet stronger foreign demand. The construction industry, however, continued to be adversely affected by falling land prices and declining public-sector building programs. One visible indicator of the misery of the construction sector was the first bankruptcy since 1945 of a contractor with a stock exchange listing.

       Standardized Unemployment Rates in Selected Developed Countries, TableThe recovery in industrial output was not sufficient to prevent unemployment levels from edging upward. In November the unemployment rate stood at 3.5%, compared with 3.3% a year earlier. This level, very high by Japanese standards, was partly due to an increase in the labour force. Against the background of a weak labour market, wages (including summer bonus payments) rose by nearly 3.5% in the first half of the year before slowing down to well under 3% by the year's end (see Table (Standardized Unemployment Rates in Selected Developed Countries, Table)).

 The trade surplus rose during 1997, despite the higher value of the yen earlier in the year. Exports rose strongly in both volume and value. In the final quarter demand from crisis-ridden Southeast Asia, which normally accounted for 30% of Japan's exports, began to weaken. The trade surplus with the U.S. and Europe increased as the yen depreciated. The fragility of the Japanese economy and the regional financial crisis took their toll and pushed the yen steadily down in the second half of the year, reversing earlier gains. In December it was down to 127.5 yen against the dollar—the year's low (see Graph—>).

      Fiscal policy became tighter in 1997, extending the budget-deficit measures adopted in 1996. In the early part of the year, measures that came into force included a 2% rise in the sales tax, the ending of the special reductions in income and residential tax, and a large reduction in public-works spending. A medium-term plan adopted in 1997 aimed to reduce the government's fiscal deficit to 3% of GDP by 2003-04 (compared with a 7% deficit in 1996). The new measures, programmed to start in 1998, represented the first overall reduction in government expenditure in 11 years. In the event, as the economy faltered, the government was forced to introduce a package in November to stimulate the economy. Surprisingly, it did not include additional government money but relied largely on private finance initiatives.

      To balance the fiscal tightening and avoid pushing the economy into a recession, the monetary policy remained accommodating. The official discount rate was held at its record-low level of 0.5%—unchanged since September 1995. The governor of the Bank of Japan stated that the bank's main priority was to ensure that the economic recovery was nurtured. The currency crisis that sparked a slump in the region's stock markets, including Japan's, led to a renewed weakness among Japanese financial institutions. As share prices fell, many Japanese banks became overexposed. Indeed, Sanyo, a large securities house, fell victim to the crisis in early November, followed by Hokkaido Takushoku, Japan's 10th largest commercial bank. A week later Yamaichi, Japan's fourth largest securities house, collapsed with an estimated $25.5 billion in liabilities. Although this was the largest corporate failure, it may have marked a turning point in Japan's financial institutions crisis. The government and the Bank of Japan moved to protect customers' deposits at Yamaichi and other firms that might run into similar difficulties. Hokkaido Takushoku, however, was allowed to fail.

Germany.

       Real Gross Domestic Products of Selected OECD Countries, TableAfter a pause in the last quarter of 1996, economic growth resumed, and GDP expanded by an estimated 2.4% in 1997 (see Table (Real Gross Domestic Products of Selected OECD Countries, Table)). The rebound was led principally by exports and business investment, and private consumption lagged behind. Exports grew by nearly 8% for the year as a whole, mainly because of a favourable combination of strong growth in major export markets, a decline in the value of the Deutsche Mark, and improved productivity. By contrast, domestic demand remained weak and expanded by about 1%. Stagnation in real disposable incomes and continuing high unemployment rates, as well as the high savings rate maintained by cautious consumers, dampened domestic demand. The volume of retail sales fell for the second consecutive year.

   Standardized Unemployment Rates in Selected Developed Countries, TableLed by buoyant export orders, manufacturing output rose by nearly 3%, and investment in machinery and equipment picked up later in the year (see Graph—>). Construction orders and output continued to fall as the postunification boom came to an end. Because of budgetary restraints, the sharpest declines were in public construction. Strong exports pushed up the trade surplus, and the current account, which had been in deficit since the unification, headed toward its traditional surplus. The moderate economic recovery, however, failed to be translated to any improvement in the labour market. In November the unemployment rate stood at 11.8% (4.4 million unemployed), compared with 10.6% a year earlier (see Table (Standardized Unemployment Rates in Selected Developed Countries, Table)). The other unfavourable development was a gradual rise in the inflation rate. Although it peaked in the summer, inflation at 1.8% late in the year was above the 1.5% in 1996 (see Graph—>). One reason for the adverse trend was the depreciation of the Deutsche Mark, which induced higher import prices. Other influences included higher prescription charges and vehicle taxes.

      The government remained committed to bringing the EMU into operation on time (January 1999), and economic policy focused on reducing the budget deficit to the 3% target. As the midyear projections pointed to a higher deficit than planned, Germany was forced to moderate its plans to reduce the overall tax burden. It still looked as if the deficit would be around 3.2% for 1997, but despite this, it seemed highly unlikely that the start of the EMU would be postponed. The main reason for this was that a postponement might jeopardize the whole EMU project. Furthermore, it might leave the government rudderless, as it would no longer be able to present the much-needed tax- and pension-reform policies to the electorate in a coherent and convincing way. As in France, with a little bit of creative accounting and flexible interpretation of the criteria, this decimal-point dispute was likely to be overcome, which would enable the EMU to start on time. Tighter control on growth of public spending, coupled with higher tax revenue arising from faster economic growth, was projected to lower the deficit to below 3% in 1998. For most of the year, monetary policy remained accommodating as growth in money supply eased to within the target range. Interest rates remained unchanged until October, when the Bundesbank increased the repo rate from 3% to 3.3%, signaling a preemptive tightening in policy to prevent a buildup of further inflationary pressures.

France.

       Real Gross Domestic Products of Selected OECD Countries, TableEconomic growth accelerated in 1997, with GDP growth rising about 2.3% from 1.5% in 1996 (see Table (Real Gross Domestic Products of Selected OECD Countries, Table)). This was an encouraging performance against the background of political uncertainty following the spring elections, which resulted in a surprising change in government as well as continuing austerity in anticipation of the EMU.

  Standardized Unemployment Rates in Selected Developed Countries, TableMuch of the growth was provided by foreign demand, whereas domestic demand remained comparatively weak. Consumer spending, excluding automobiles, made a modest recovery, thanks to growth in family incomes outpacing inflation. Business investment rose slightly, reflecting the encouraging outlook. The construction sector remained weak as demand for commercial and private property stagnated. Industrial production gained momentum on the back of a weaker franc and rose by around 3%, in stark contrast to 1996's flat output (see Graph—>). Exports grew as a result of the weaker franc and continued growth in the main export-destination countries. By contrast, imports were held back by the weak domestic demand and rose by around 4%, or less than half the increase in exports. As a result, France's trade balance more than doubled to a projected F 27 billion and headed to a record. The economic recovery was not sufficiently strong to improve the unemployment situation. Monthly unemployment peaked in autumn 1996, but a year later the rate, at 12.5%, was almost unchanged (see Table (Standardized Unemployment Rates in Selected Developed Countries, Table)). Relatively high unemployment kept wage increases to about 2.4%, above the inflation rate of 1.1%—the lowest for almost three decades. The new Socialist government proposed reducing the working hours to provide work for more people.

      As the July audit of the public finances revealed a large fiscal slippage, the new government of Prime Minister Lionel Jospin ) (Jospin, Lionel ) moderated its opposition to the policies of its predecessors and agreed to introduce new deficit-reducing measures to ensure that France met the EMU entry criteria. Following spending cuts of F 10 billion and corporate tax increases, the 1998 budget deficit was projected at 3% of GDP—the target set for monetary union. Even if the actual deficit, as expected, came in above this figure, France was expected to qualify through a flexible definition of the criteria. Monetary easing continued during 1997, with long-term interest rates dipping to 5.5% and converging with German rates. The central bank raised its intervention rate by 0.2% in late summer, which reflected the interest-rate rise in Germany.

The Former Centrally Planned Economies.

      The expected increase in economic output of this group of countries had failed to materialize in 1996. After five years of consecutive decline, however, output stabilized and was projected to grow by 1.2% during 1997. The outlook for 1998 was growth of 3-4%. Despite this revival, output remained well below the 1989 levels. According to the European Bank for Reconstruction and Development (EBRD) estimates, Eastern European countries (especially the Baltic states) were within 5% of closing the gap, whereas output in the CIS, including Russia, was at 56% of the 1989 value. In 1997 only Poland, which was one of the first countries to modernize its economy, exceeded its 1989 output, whereas output in Georgia and Moldova remained at 34% of 1989 levels.

      Growth in Eastern Europe slowed from around 4% in 1996 to a projected 3% in 1997, largely as a result of economic decline in Albania, Bulgaria, and Romania. Growth in the Czech Republic also slowed, which reflected an austerity program introduced following a financial crisis in the spring. Most of the other countries experienced faster growth rates, though expansion in Poland and Slovakia moderated in 1997. In the CIS the fastest rate of expansion remained in Georgia, Kyrgyzstan, Armenia, and Azerbaijan, whereas negative growth was still the case in Turkmenistan, Ukraine, and Moldova. In Russia it looked as if the long decline was over, and the economy was expected to grow in the second half of 1997.

      Despite faster growth, unemployment remained high. In 1996 the number of registered unemployed was 14.4 million, nearly 400,000 more than a year earlier. Although unemployment in the Central and Eastern European countries moderated, it was still rising in the CIS. In view of the contraction in output since 1989, even those unemployment rates suggested overmanning.

      According to EBRD estimates, the median inflation rate fell from 32% in 1995 to a projected 14% in 1997. Inflation performance, however, was not uniform. Reflecting financial problems in Bulgaria and Romania, it doubled to 592% and 116%, respectively. In the CIS the average inflation rate was halved to 33%. Lower inflation was expected in most countries—including Russia, where it was projected to decline to 14% from 22%. Relaxation of earlier stabilization efforts, however, led to an upturn in inflation rates in Armenia, Belarus, and Tajikistan. A contributory factor to lower inflation in the CIS was the development of a securities market, which enabled governments to reduce borrowing from the banking system.

      Limited progress was made in reducing fiscal deficits, which remained higher in the CIS than in Eastern Europe and the Baltic region. Lack of progress was attributed to poor revenue performance rather than weak expenditure control. In turn, a decline in tax revenues was attributed to policies introduced to reduce the high levels of taxation, as well as to poor economic performance. In the absence of fundamental public-sector reforms, it was thought that many countries would find it difficult to raise sufficient government revenue and implement expenditure controls.

      The devaluation, followed by austerity measures in the Czech Republic, highlighted the potential problems of growing trade deficits and deterioration in current-account positions in many countries in the region. In more than half, current-account deficits exceeded 7% of GDP in 1996. This trend was attributable to strong domestic consumption and investment as well as growing capital inflows. It was feared that if unchecked, the growing current-account deficits, in particular the rapid buildup of foreign debt, could lead to economic instability.

Less-Developed Countries.

       Changes in Output in Less-Developed Countries, Table Changes in Consumer Prices in Less-Developed Countries, Table(For Changes in Output (Changes in Output in Less-Developed Countries, Table) and Changes in Consumer Prices (Changes in Consumer Prices in Less-Developed Countries, Table) in Less Developed Countries, see Tables.)

      The IMF expected the rate of growth in the LDCs as a group to remain high, at around 6%. A slight downturn was predicted for 1998. Despite expansion's remaining high, many of the poorer countries failed to increase their per capita incomes. Once again, the fastest growth in 1997 was in Asia, with growth projected at around 7%. Spillover from the currency crisis in Thailand engulfed other countries in the region, including the Philippines, Indonesia, and Malaysia. By late November it had spread to South Korea, a much larger and more developed economy. Economic measures taken by those countries to restore stability and standby loans from the IMF ($17 billion for Thailand, $40 billion for Indonesia, and $20 billion for South Korea) led to a widespread slowdown in the final quarter of 1997, but the main effect of these measures was not expected to be evident until 1998. Because China was unaffected by the turmoil, economic growth there remained intact at about 9%.

      The economies of Latin-American countries, having recovered fully from the effects of the 1995 Mexican crisis, grew by an average of 4% in 1997. The buoyancy came to a sudden halt in the wake of the Asian crisis, however, when an unsustainable current-account deficit in Brazil led to similar minicrises in the region, which necessitated widespread austerity measures. Despite lower oil prices, many countries in the Middle East achieved robust economic growth of around 4.6%. Growth in Africa, which declined as a result of civil wars and adverse weather conditions, was projected to moderate to 3.5% from 5% in 1996.

      Inflation continued to fall to a projected median rate of 5% (7% in 1996) despite the global economic buoyancy. The highest inflation rates remained in the Middle East and Africa, whereas rates edged down in Latin America. Compared with Latin America's average of 13%, Argentina enjoyed virtually zero inflation. Once again the area with the lowest inflation rate was Asia, with a projected average rate of just under 6%.

      The current-account deficits widened in many LDCs. In Asian countries this was largely due to a slowdown in export growth and policies to reduce domestic demand in order to avoid overheating the economy. In Latin America it was primarily because of the resumption of economic growth and capital inflows. (See Spotlight: Latin America's New Investors.) A decline in commodity prices was the main reason for larger current-account deficits in many African countries. The currency crisis in Thailand highlighted the vulnerability of the LDCs to a sudden reversal of capital inflows and demonstrated how easily it could spill over to neighbouring countries.

International Trade

      The slowdown in world trade during 1996 was short-lived, and during 1997 the volume of trade in goods and services was projected by the IMF to have risen by 7.7%. This compared favourably with 6.3% in 1996 but was not as high as the 9% increase registered in 1994 and 1995. In value terms (in U.S. dollars) the rise was much smaller, at about 3%, which reflected the rise in the dollar and weaker prices for some electronic products and commodities. The main source of growth was stronger demand from the developed countries, which accounted for most of world trade. The flow of imports into the developed world rose by an estimated 7% in volume terms, compared with 6% a year earlier. Export growth from the developed countries, at a projected rate of 8%, also expanded at a faster rate than in 1996. Whereas the volume of goods exported from the LDCs rose at a projected rate of 7.4%, import growth accelerated to 8.9% over 7.9% in 1996.

      Among developed countries the fastest growth in demand was from the U.S. (up 13%), followed by Canada (11.7%), which reflected the economic buoyancy in North America. Acceleration was fastest in many EU countries—led by Germany, Italy, and France—as a result of a pickup in the economic growth rate. By contrast, the growth in volume of imports into Japan, the world's second largest economy, slumped to a projected 1.4% from 10.5% in 1996, mainly because of faltering domestic demand and the weakness of the yen.

      Export volume of goods and services rose, however, at a projected rate of 11%, compared with 2.3% in 1996. Other developed countries to have experienced faster volume growth in exports included Germany and France, which, like Japan, benefited from a combination of weaker local currency against the dollar and stronger global demand. Following the slump in exports from the LDCs in the Asia-Pacific region during 1996, there was a small recovery in 1997, but the total value of exports, at a projected $9.4 billion, was 50% below the value of exports realized in 1994 and 1995. The region continued to be adversely affected by excess capacity and weaker prices of semiconductors and related information technology products. The appreciation of the dollar, to which many of the countries in the region linked their exchange rates, made exports from those countries to Japan and Europe noncompetitive. This was the root cause of the currency crisis that started in Thailand. Reflecting a slowdown in investment in the region, imports into the Asian "tiger" economies (Hong Kong, Taiwan, Singapore, and South Korea) moderated to around 8%, compared with nearly 20% two or three years earlier. As a result of an economic slowdown in China, import inflow remained largely unchanged, whereas exports in dollar terms rose by 24% in the first nine months of 1997, albeit from the previous year's depressed levels. During the remainder of the year, export volumes were expected to moderate, reflecting lower demand from the tigers in the wake of their large currency devaluations.

      Liberalization measures and faster economic growth in Latin America stimulated import inflows. During 1997 imports into the region rose by nearly 15%, compared with 11% in 1996. Argentina, Brazil, Mexico, and smaller countries in the region that were experiencing rapid economic growth provided stronger import demand. In Africa import volumes continued to increase, reflecting acceleration in regional economic growth. Both the volume and value of exports from the region grew more slowly than in 1996.

      Although comprehensive figures were not available for the former centrally planned economies, current-account balances suggested that import inflow in those countries grew at a faster rate than their exports. An acceleration in the rate of domestic demand and continuing modernization and investment programs sustained import-growth momentum in 1997. Both exports from and imports into Russia were largely unchanged in dollar terms. The higher value of imports into Eastern European countries reflected the weakness of local currencies against the strong dollar and the continuing inability of local producers to supply high-quality consumer products. Despite this manufacturing difficulty, faster economic growth in Western Europe enabled exports from the region to rise modestly. By contrast, import inflow in many of the CIS nations continued to grow at a faster rate than their exports.

      Meanwhile, various trade-liberalization talks continued during 1997. The smaller of these was between South America's two largest trade blocs, the Andean Community and the Southern Cone Common Market (Mercosur), in an effort to form a single free-trade area. The four-nation Mercosur (Argentina, Brazil, Paraguay, and Uruguay) and the five-nation Andean Community (Bolivia, Colombia, Ecuador, Peru, and Venezuela) represented a market of 310 million consumers with a combined GDP of $1.2 trillion. At a summit in Venezuela in October, despite considerable differences on "sensitive products," member countries agreed to aim toward reaching agreement by the end of the year. Apart from replacing bilateral trade agreements, due to expire on December 31, such an agreement would strengthen South America's negotiating position in regard to a 34-nation Free Trade Area of the Americas. As the year drew to a close, however, the talks had not made as much progress as had been hoped, and an agreement before December 31 looked increasingly unlikely. The annual meeting of the Asia-Pacific Economic Cooperation forum in Vancouver, B.C., liberalized trade in nine categories of goods and services. Against the backdrop of financial turmoil in Asian markets, the U.S. increased its efforts to persuade countries in the region to sign a planned World Trade Organization agreement to open their financial markets to international competition.

International Exchange and Payments

 (For Effective Exchange Rates, see Graph—>.)

      The main developments in international exchange rates during 1997 were the volatile swings in the value of the Japanese yen and a strong advance by the British pound sterling and the U.S. dollar against most currencies. The most spectacular development, however, was the speculative attack against many Asian currencies in the summer and the subsequent slump in many currencies in that region. The yen opened the year on a weak note and had fallen to 127 yen against the dollar by April. This reflected the strength of the U.S. economy as contrasted with concerns for economic recovery in Japan. As the economic outlook improved in Japan and the U.S. economy slowed in the second quarter, the yen strengthened for a short time and reached a high of 110 yen per dollar in June. As the Japanese economy faltered under the weight of the April tax hike and the U.S. economy regained its strength, the yen retraced its steps and fell back to around 120. After the steep fall in Asian currencies in early autumn followed by the decline in the South Korean won, the yen weakened further and settled at the year's low, 127.5 to the dollar. As the Japanese economy became increasingly dependent on exports, no early appreciation was expected.

      The dollar's strength against most currencies was a reflection of the continuing rapid economic expansion in the U.S. Although inflationary pressures were subdued for most of the year, expectations of a rise in interest rates boosted the dollar. In November the dollar was almost 10% higher than a year earlier, on a trade-weighted basis. The strength of sterling was largely due to robust economic growth and to rises in interest rates. In the summer the pound was trading against the Deutsche Mark at a level above the trading range prior to Britain's withdrawal from the European exchange-rate mechanism. A late-summer correction inspired by expectations of a long pause in further increases and prospects of an early entry into the EMU was short-lived. Sterling rose again in November when the government ruled out an early entry into the EMU and the Bank of England unexpectedly raised interest rates again. Despite a pickup in German economic recovery and modestly higher interest rates, the Deutsche Mark weakened by about 5% during 1997 on a trade-weighted basis and delivered a boost to the German economy.

      The currency crisis in Asia that sparked a slide in share prices around the world started with a speculative run on the Thai baht in mid-May. A large current-account deficit led to concerns about the sustainability of the existing exchange rate pegged to a basket dominated by the strong U.S. dollar, and a series of sharp devaluations of 25-30% followed. By October the Malaysian ringgit was depressed by 25%, the Indonesian rupiah by 33%, and the Philippine peso by 23%, with the Singapore dollar losing 9% of its value. A potentially more serious crisis, however, came in November when South Korea, a much larger economy than the others, could no longer sustain the existing exchange rate and the won fell by over 35% against the dollar. In the spring, against the backdrop of large current-account deficits, there was a similar speculative pressure on the currencies of the Czech Republic and Slovakia, which resulted in a 20% devaluation in the Czech koruna.

      The current-account imbalances between some of the developed countries were projected by the IMF to widen but were expected to remain smaller than they had been in the 1980s. The overall current-account surplus of the developed countries was projected to rise modestly to $19 billion from $16 billion. While the current-account balance of the EU was largely unchanged, the British deficit widened, which reflected the appreciation of sterling and the strength of domestic demand. In Germany and France the current-account surpluses widened somewhat against weaker currencies and strong external demand. The Japanese surplus widened significantly and was projected to exceed $100 billion, and the long-standing U.S. deficit was projected to top $200 billion, as strong economic activity and the strength of the dollar increased imports.

      In the LDCs the current-account deficit widened significantly to a projected $109 billion, compared with $81 billion a year earlier, according to the IMF. Latin America registered the most significant widening as a result of a strong recovery in domestic demand in countries like Mexico, Argentina, and Brazil. In Africa the current-account deficits widened marginally as a result of a fall in commodity prices. While the deficit in a number of CFA franc zone countries remained largely unchanged in 1997, arrangements for the CFA franc remained uncertain post-1999, pending France's strategy for the region. Deficits in Kenya, South Africa, Tanzania, Uganda, and Zimbabwe also changed little, but oil exporters like Algeria and Nigeria experienced a reduction in their current-account surpluses. In Asia, even before the currency crisis that engulfed the region, both trade and current-account deficits were expected to widen in a number of countries, including Thailand, Malaysia, the Philippines, and South Korea, as a result of a continuing slowdown in exports and policies to contain domestic demand. Current-account deficits in many former centrally planned economies continued to widen. This was particularly evident in some Eastern European countries and many CIS countries, except Russia.

      Capital inflow to the LDCs, having reached a high of $207 billion in 1996, was projected by the IMF to remain strong in 1997. In those countries where currencies depreciated following speculative attacks, a decline in net inflows for the year as a whole was a distinct possibility. The IMF projected that the total external financing requirements of the LDCs would moderate to around $200 billion from the previous year's $224 billion. As the proportion of non-debt-creating inflows was projected to continue to increase, the debt burden was likely to have moderated. Even so, reflecting a slowdown in the growth of value exports (both value and volume), debt-servicing ratios—i.e., export earnings as a proportion of interest on total external debt—moved up a little to a projected 9.5%, reversing the decline that began in 1991.

IEIS

      This article updates economic growth.

Stock Exchanges

       Selected Major World Stock Market Indexes, TableThe phenomenal bull run in stock markets around the world during the previous two to three years suffered a setback in October 1997, and for a time share prices experienced a roller-coaster ride. Although this turned out to be a short, sharp downturn in the U.S. and Western European stock exchanges, it was a cataclysmic decline for Japan and many other Asian markets. Even so, the Financial Times/Standard & Poor's (FT/S&P) World Index registered a 13.2% gain in dollar terms (19.3% in local currency) for the year. The Dow Jones industrial average (DJIA) ended the year 22.6% higher, and European shares registered a gain of 34%, as measured by the FT/S&P Europe index. Japan, an underperformer since 1989, contracted by another 21.2% (17.3% in local currency), but, as it had started from a lower base, it fell by a smaller percentage than the Pacific region as a whole. (See Table VI (Selected Major World Stock Market Indexes, Table).)

      The main influence on the strong global performance was an unusual combination of strong economic growth, stable interest rates, falling unemployment levels, and the absence of inflationary pressures in the U.S. and many other Western nations. In this environment the markets and investors, assuming that corporate profitability would continue to grow at the same rate, drove the markets to dizzying heights and made them vulnerable to external shocks. The crisis began in July with a series of devaluations in Thailand, Indonesia, the Philippines, and Malaysia, which created ripple effects on equity markets. The Hong Kong stock exchange also came off its summer high, but for a while the Western stock exchanges ignored this development. In late October, when interest rates were raised in Hong Kong to defend the Hong Kong dollar, the market there nose-dived and lost a further 30% in a few days. This alarmed world markets and resulted in drops ranging from 7% to 15% in one day. The panic in London and on Wall Street appeared to spread, but soothing remarks from world leaders, including Clinton and Fed Chairman Alan Greenspan, coupled with the underlying strength of the Western economies, encouraged many private investors to see this as a buying opportunity. After a highly volatile week, a period of relative calm returned, only to be shattered when the financial crisis in South Korea deepened and posed a threat to Japanese banks and financial institutions. The government bailout of Yamaichi Securities and the promise of public funds to assist the financial sector restored a sense of relative stability in Japan. Large-scale IMF assistance to Thailand, Indonesia, and South Korea also improved investors' confidence. At the end of the year many Western markets—still nervous but confident that the worst was over—were only slightly below their summer peaks.

IEIS

United States.

      The U.S. stock market achieved record levels in 1997 as the bull market maintained its upward momentum in spite of several significant setbacks. The increase of short-term interest rates by the Fed caused a dip in April, but the most traumatic event of the year was the sharp decline on October 27 and the next day's rebound, when record trading volume was achieved on all the exchanges. On October 28, for the first time in history, the New York Stock Exchange (NYSE) had trading volume of 1,200,000,000 shares, shattering the previous one-day record of 684,590,000 shares. Turnover on the over-the-counter market, monitored by the National Association of Securities Dealers automated quotations (Nasdaq) index, was 1,370,000,000 shares, well above its previous record of 970,700,000.

      The widely watched DJIA broke 7000 on February 13 and climbed irregularly to a peak of 8259.31 on August 6. The price-earnings ratio of the Dow Jones industrials at the end of September was 21.26, compared with 18.26 a year before. The market jolt on October 27 resulted in the Dow's dropping 554.26 points, or 7.18%, with a next-day recovery of 337.17 points, or 4.71%, the largest point gain ever. During October the Dow slid 7.7%, but for the year the average was up nearly 1,500 points, or 22.64%. Extreme volatility in December, partly as a result of the financial crisis in Asia, pushed the DJIA well down from its August peak before it recovered somewhat to finish the year at 7908.25. The Standard & Poor's index of 500 stocks (S&P 500) achieved a record of 983.12 on October 7, while the Nasdaq index reached a high of 1745.85 on October 9 and the Russell index of 2000 stocks hit 465.21 on October 13. Late in the year investors turned cautious, despite a booming economy, as a number of Asian markets sustained heavy losses. On average, investors achieved stock market returns in excess of 21% during 1997.

      The business and economic news throughout 1997 was very positive. The National Association of Purchasing Management index of expected business conditions was more positive than it had been in 1996, and the consumer confidence index published by the Conference Board achieved record levels. The index of industrial production rose steadily in 1997, with the third-quarter jump the biggest in 13 years. The economy was growing at a healthy rate throughout the year. The industry operating rate was 84.4% in September, the highest since February 1995. The U.S. unemployment rate declined below 5%, which raised concerns about inflationary pressures, and the actions of the Fed were closely watched by investors. The national budget deficit fell to $22.6 billion, the lowest since the early 1970s, and most economic signs were encouraging during the year.

      Although the market was somewhat volatile on an uptrend, investors placed record sums into mutual funds of all kinds. The stocks of companies with low levels of capitalization (small-cap stocks) underperformed in the first three quarters of 1997 by failing to generate the earnings momentum that large-cap stocks exhibited. Large-cap stocks delivered so well that the price-earnings multiples of the top stocks in the S&P 500 rose from 18 to 25 times earnings. Early in October Greenspan described the reemergence of inflation as without question the greatest threat to the U.S.'s economic expansion. His remarks caused a drop in the Dow that day, and the 30-year Treasury bond yield rose to 6.4% after his remarks provoked fears that interest rates would need to rise. Margin calls were very heavy on October 27. The level of margin credit at major brokerage firms was at an all-time high of almost $125 billion, up more than 25% from the previous year. After Greenspan's warning about "irrational exuberance" in the market, the October crash was viewed as a healthy readjustment of expectations.

      More than 40 million U.S. families owned stocks in 1997, a record high. By September 30, there were $86.7 billion in domestic equity issues. Equities as a percentage of household financial assets were 31% at the end of the third quarter of 1997. High-yield ("junk") bonds were only 21% of all corporate debt issued. The largest public corporations, ranked by market capitalization in billions, were: General Electric Co., $224.5; Microsoft Corp., $164.6; Exxon Corp., $160.4; Coca-Cola Co., $148.4; and Intel Corp., $141.6.

      Wall Street firms raised $943,900,000,000 in the first three quarters of 1997, slightly below the $967,700,000,000 raised in the same period of 1996 and below the record of $1,050,000,000,000 in 1993. The number of new issues increased by 28% in the first three quarters to 2,721, up from 2,123 a year earlier. By late in the year, 469 initial public offerings of stock had raised $24.2 billion. The leading managing underwriters of corporate securities, ranked by dollar amount raised through new issues, were Merrill Lynch & Co.; Morgan Stanley Dean Witter; Salomon Brothers; J.P. Morgan & Co.; Goldman, Sachs; Lehman Brothers; Bear, Stearns & Co.; Credit Suisse First Boston; and Chase Manhattan Corp.

      The top merger and acquisition deal in 1997 was WorldCom, Inc.'s acquisition of MCI Communications Corp. for $37 billion. Other major deals included NationsBank Corp.'s taking over Barnett Banks, Starwood Lodging Trust's acquisition of the Sheraton chain from ITT Corp., First Union Corp.'s taking over CoreStates Financial Corp., and Lockheed Martin Corp.'s acquisition of Northrop Grumman.

      Interest rates remained relatively steady in 1997. At the end of October, the prime rate was 8.5%, up from 8.25% a year earlier, while the discount rate at 5% was unchanged. Thirty-year Treasury bonds were 6.14%, down from 6.83% a year earlier. Treasury bills were at 4.97%, down from 5.04% in 1996. The interest rate on three-month Treasury bills ranged from a high of 5.5% in March to a low of 4.8% in June and finished the year at 5.18%.

 The NYSE had its busiest week in history in November, with 3,990,000,000 shares changing hands. There were 3,050 companies listed, and 487 brokerage firms were members with trading authority. The average daily volume was 541,000,000 at the end of September. A seat on the NYSE sold for $1,475,000 on July 31; a year earlier a seat had sold for $1,162,000. Market capitalization totaled $8,890,000,000,000 on October 25 but declined to $8,310,000,000,000 on October 27, a drop of $580,000,000,000 in one day. "Circuit breakers" were activated for the first time in October, halting trading for 30 minutes when the Dow dipped to 350 points below the previous day's close and again for an hour after the market index had dropped a total of 550 points. Of the 4,182 stocks listed on the Big Board (up from 3,895 in 1996), 3,110 advanced, only 975 declined, and 97 remained unchanged for the year. Computer maker Compaq Corp. topped the active list, with more than 1.6 billion shares traded. (For New York Stock Exchange Common Stock Index Closing Prices, see Graph—> .)

      Sales volume on the American Stock Exchange (AMEX) rose by slightly more than 1% in 1997. As of October 17, volume was 4,705,524,000 shares, compared with 4,584,983,000 shares in the same period a year earlier. The record volume on October 28 was about 60,600,000 shares, some 40% ahead of the previous record of 43,900,000 shares traded in a single day. Advances exceeded declines by 651 to 329, with only 13 issues unchanged.

      Nasdaq volume in 1997 rose 16.9%, with an average daily volume as of September 30 of 699,000,000 shares. Through October 17 the volume was 128,582,754,000 shares, compared with 110,022,495,000 for the corresponding period in 1996. The total market capitalization was $1,930,000,000,000 on October 25, but it dropped $140,000,000,000 on October 27 to $1,790,000,000,000. Nasdaq had 5,500 companies listed (more than half of which advanced for the year), and in October it became the first U.S. stock market to trade more than one billion shares in one day. Intel Corp., headed by Andrew Grove ) (Grove, Andrew S. ), was the most active stock, with more than 3,800,000,000 shares traded. Nasdaq's Bulletin Board, on which some 7,000 very small companies traded, was the subject of concern because there were virtually no listing requirements. Nasdaq proposed delisting those companies that failed to file their financial statements with the Securities and Exchange Commission (SEC). Among those companies affected would be major overseas corporations that traded American Depository Receipts on the Bulletin Board.

      There were 6,685 active mutual funds late in 1997, with total assets of $4.2 trillion. Money market mutual funds held $1,046,000,000,000 in assets. Through mid-October U.S. stock funds gained 27.37% in value, whereas bond funds were up only 6.88%. More than 80% of U.S. mutual funds outperformed the S&P index, with technology and small-cap funds the stellar performers. Investors funneled new money into mutual funds at a record pace in 1997.

      The stocks in the S&P indexes showed significant gains in 1997. At the year's end, the S&P industrial index was up 28.9% from Dec. 31, 1996; utilities rose 18.61%, financial 45.38%, and the S&P 500 31.01%. The Dow indexes reflected similar gain patterns in 1997. The industrials index was up 22.64%, with transportation up 44.37%, utilities up 17.43%, and the composite index up 28.71%.

      U.S. government bond yields declined in 1997, with the bellwether 30-year Treasury bond falling below 6% for the first time since January 1996. The average yields began the year at about 6.8%, rose to 7.3% in April, and then began a steady slide, closing at 5.99% by the middle of December. Treasury prices rose sharply on October 27 in a very active session as panicked investors searched for security. Short-term securities were particularly popular.

      Corporate bond yields declined moderately during the year, with AAA bonds (the highest quality) at 6.95% in mid-October, down from 7.4% a year earlier. Private placements of bonds were being done at a record pace, with corporate issuers selling a record $138.5 billion of debt and preferred stock privately by October 1997, according to Securities Data Co.—far outpacing 1996's corresponding figure of $116 billion. These bonds were sold directly only to big institutional investors under the SEC Rule 144a guidelines. These private placements tended to dominate the junk-bond market.

      During the year the Chicago Board of Trade and the Chicago Board Options Exchange launched futures and futures options contracts that were pegged to the DJIA. Previous action on indexing had centred on the S&P 500, which had become a benchmark for institutional investors. S&P 500 futures, which were traded on the Chicago Mercantile Exchange (Merc), were among the most heavily traded futures contracts in the world. The panic on October 27 demonstrated the effectiveness of circuit breakers in the trading pits of the Merc, where four separate trading limits were imposed on the S&P 500 contract to slow down the frantic trading.

      The SEC was very active in 1997. It urged the marketplaces to move toward decimalization, which advocates contended would make stock prices easier to understand and would probably narrow the spread between bid and ask prices, saving investors money by enabling them to buy at lower and sell at higher prices. The SEC advised regulated companies and funds that they had to keep investors informed about the costs of adapting computer systems to handle the "year 2000 problem," as well as the potential legal liabilities associated with the necessary changes. Prospectuses and registration statements were to be reviewed for disclosure of these risks. The SEC also required disclosures about the policies used to account for derivatives and provide certain quantitative and qualitative information about market risk exposures. The circuit breakers, which were introduced in 1988, worked effectively during the October 27 frenzy, permitting orderly trading in the face of record volume. The SEC, the Commodity Futures Trading Commission, and the Bank of England formally agreed to step up their cooperation and keep one another better informed of regulatory matters involving multinational corporations.

Canada.

      The Canadian stock market performed well in 1997 as the economy grew at a higher rate than had been forecast. There was an undercurrent of concern in the market because of the inflation threat, but share prices were well above those of the previous year. The weakness of the Canadian dollar led to persistent fears that the Bank of Canada would raise interest rates to protect the declining currency. In December the Canadian dollar fell below U.S. 70 cents for the first time in 11 years as a result of the financial turmoil in Asia and a showdown between currency traders and the Canadian central bank.

      The Bank of Canada raised its bank rate to 4% in November, its highest level in a year. Responding to the central bank's action, Canada's commercial banks raised their prime lending rates to 5.5%, up from 5.25%. The bank rate and prime rate were both raised again later to end the year at 4.5% and 6%, respectively. A report by the consulting firm KPMG Peat Marwick, which compared business costs to help companies consider where to locate, found that Canada had significant advantages as a result of low land prices and construction costs. Canada also had among the lowest labour costs, electricity prices, and telecommunications fees. In addition, it had among the lowest corporate income tax rates and interest-rate charges among the seven industrialized countries studied. Canada experienced robust economic growth and low interest rates in 1997 as fiscal and monetary policies promoted reductions in the government's heavy debt-service costs. Canadian corporate profits rose sharply during the year, propelled higher by the country's strong economy. Corporate profits rose by more than 20% compared with the figures for 1996.

      Market activity paralleled that of the American market. The leading indexes were up about 13% for the year, and the crash on October 27 resulted in a drop of 7.88%, with the Toronto Stock Exchange being shut down after the composite index of 300 stocks (TSE 300) lost 434.3 points, 6.12% of its value. The collapse of the gold-mining company Bre-X Minerals, which arose from the discovery of massive fraud Sidebar) (Bre-X Minerals Scandal ), caused the TSE computer system to break down owing to an overload of trading resulting from panic selling of the stock. The market made a speedy recovery, however, and moved on to establish new records. The TSE index of 300 stocks ended the year at 6699.44, up 13%.

      Canadian bond markets rallied in line with those of the U.S., even though the Bank of Canada indicated further tightening moves. At the end of September, the 10-year government yield was 5.85%. Interest rates declined steadily after March 1997.

      Mutual funds invested heavily in financial services, communications, and consumer stocks to profit from Canada's strong economic growth. There was less emphasis on mining and forestry stocks, but precious-metal and commodity-based stocks remained popular with mutual funds.

IRVING PFEFFER

Western Europe.

 The European markets performed well in 1997, despite the November correction. As continental Europe was at a relatively early stage in the economic-recovery cycle, corporate profits benefited from stable interest rates, low wage increases, and strong export markets. Corporate restructuring and pan-European mergers and acquisitions also drove the European markets during the year. The largest and most important market in Europe, the London Stock Exchange, rose by nearly 20%. The Financial Times Stock Exchange 100 (FT-SE 100) index opened the year strongly, buoyed by prospects of an upturn in economic growth and stable interest rates. In May the incoming Labour government was perceived as financially prudent and business-friendly, and the Bank of England, with its newly granted operational freedom in setting interest rates, moved swiftly, raising interest rates by a total of 1.25% in five small successive rises. The market continued to make good progress as the higher interest rates and the strength of sterling failed to dent consumer spending or the outlook for corporate profitability. The FT-SE 100, following Wall Street's lead, rose to 5100 in late summer. Following a consolidation phase related to fears of higher interest rates in the U.S., an autumn surge took the index to a new all-time high of 5330.80, a gain of nearly 30%. A minicrash related to the Asian crisis then took place; at one time the British market was down 457 points (9.3%). A partial recovery in the following days left the FT-SE 100 at 4842, or 128 points down on the week. The worst casualties in London were stocks with a direct link to Hong Kong, such as HSBC, Standard Chartered, and Cable & Wireless. Following the mid-November volatility caused by an unexpected rise in British interest rates and the deepening crisis in the Japanese financial sector, relative optimism returned. In a traditional pre-Christmas rally, the market rose, ending the year up 25% at 5135.5. (For Financial Times Industrial Ordinary Share Index, see Graph—> .)

      The best-performing large market in Europe was Germany, with an annual gain of nearly 40%. An export-driven economic recovery, growing confidence that the budget deficit would meet the EMU criteria, and prospects of economic reforms drove the German bourse. A spring setback that reflected the rise in U.S. interest rates was followed by a strong summer rally that took the FAZ Aktien to 1481 and the DAX index to 4439—a gain of 54%. Following summer profit taking and autumn weakness induced by a precautionary rise in German interest rates, the market rallied before it was hit by the turmoil in the Asian markets. After November the market regained its poise. The liberal market in The Netherlands, with the presence of many international trading companies, staged another year of strong gains, rising 42%.

      The Paris Bourse was relatively less rewarding for investors. Early gains were reduced by badly shaken sentiment when the Socialist Party unexpectedly won the French elections in the summer. As concerns about economic reforms and commitment to meeting the entry conditions to the EMU receded, a strong late-summer rally developed and took the CAC 40 Index to a peak of 3094.01, a gain of 33%. Following the autumn correction and volatility, the French market ended the year showing a gain of nearly 30%. The Belgian market, which was closely linked to the French economy, was another laggard and rose by a similar percentage. Although the best gains were seen in southern Europe, where renewed hopes of EMU membership and better-than-expected corporate results drove the markets, Italy, with a gain of 58%, strongly outperformed Spain's 42% rise. With the exception of Denmark, the Nordic countries underperformed much of the continent, but gains of 25-32% represented a good return for investors.

Other Countries.

      The Asian markets performed disastrously in 1997. The Japanese market, the largest in the region, was overshadowed by the weakness of the nation's economic recovery even before the autumn currency crisis. The market started the year on a weak note, and by April it was down 10%. It rallied strongly, however, when the first-quarter GDP figures came in, and the Nikkei 225 Index average reached a peak of 20,681.07 in June. As the economic recovery faltered and the outlook worsened, the stock market started to retreat. By early October the Nikkei was well below the psychologically important 18,000 level. During the week of the Hong Kong crash, the Nikkei lost about 1,000 points, or 6% of its value, and it then fell by another 623 points the following week. In mid-November the Nikkei dropped again, but as the government stepped in to safeguard the assets of the customers of Yamaichi Securities after its collapse on November 24 and promised public funds to support the other ailing banks, the market rose strongly to above the 17,000 level. The rally was short-lived, however, and the Nikkei fell to a low of 14,775.22 on December 29 before recovering slightly the next day to finish the year at 15,258.74, down 21%. In Hong Kong the Hang Seng Index, up 25% by July, fell victim to the currency upheaval, higher interest rates, and concerns over export prospects in Thailand, Indonesia, and Malaysia and retraced its steps, ending 20% down for the year.

      Stock exchanges in many export-driven smaller Asian countries collapsed as a result of unsustainable balance of payments deficits and subsequent currency devaluations. This led to a large-scale sell-off by local and foreign investors. The largest declines were seen in Thailand (down 55%), Malaysia (52%), South Korea (42%), the Philippines (41%), and Indonesia (37%). China and Taiwan managed to stay above the fray and registered modest rises for the year as a whole.

      The Asian turmoil also took its toll on other emerging markets. Many Latin-American stock exchanges had risen by 70-80% by the autumn as a result of strong economic growth and encouraging prospects. In the wake of the Asian crisis, however, investors' concerns focused on the growing balance of payments deficit in the region, particularly in Brazil, and a large sell-off resulted. Even so, many markets in the region ended the year with reasonable gains, notably Mexico (56%), Brazil (40%), and Argentina (25%). Some Eastern European markets and Russia (up 86%) registered among the highest gains in 1997.

Commodity Prices.

      Most commodity prices weakened during 1997 as a result of excess supply as well as low inflation and interest rates throughout the world. In early December The Economist Commodities Price Index was 2% below the previous year. The price of crude oil, which was not included in The Economist Index, fell by about 16%. For most of the year, prices for North Sea Brent, which served as a global price benchmark, fluctuated around $18 per barrel. In October, at the height of the Iraqi confrontation with the UN, it rose to almost $22 per barrel. During the year demand for oil was reasonably strong, and the supply was ample, despite occasional shortfalls from Russia and the North Sea. The December weakness in oil prices was largely the result of a 10% rise in OPEC production quotas. Analysts estimated that in 1998 global demand would rise by 2 million bbl a day, compared with a projected boost in supply of 2.7 million bbl. This excluded the possibility that the UN might allow Iraq to export more oil than was permitted in 1997.

      The two main components of The Economist Index moved in different directions, with the food index rising by 7% whereas industrials fell by 11% in dollar terms. Higher beverage prices were the main influence behind the rise in the food index. Although coffee prices fell by nearly 40% from a speculative peak in May, they rose 30% during the year, and a bumper crop was expected in 1988. Cocoa prices could not hold to summer gains of 20% and were drifting as concern over the effect of the El Niño weather pattern on West African production subsided. Tea prices rose by 24% as a result of higher demand and a drop in Kenya's output. After rising earlier in the year, industrial material prices slipped back in the autumn. Nickel prices fell to a four-year low; copper was at its lowest for 17 months, compared with a 11-month low for zinc. These reflected a slowdown in global demand, particularly in Japan. Gold remained on a downward trend and in December fell to a 12 1 /2 -year low of $292 per troy ounce, a fall of 21%. As a nonproductive asset, gold looked increasingly unattractive in the noninflationary environment of the late 1990s. Record consumption of gold for jewelry was not sufficient to counter the downward pressure exerted by the sale of gold by some central banks and those mines in Australia and South Africa that continued to produce at a loss.

IEIS

      This article updates market.

Banking

       25 Largest U.S. Banks(For the World's 25 Largest Banks, see Table (25 Largest U.S. Banks).)

International.

      In late 1997 banks and other financial institutions in Southeast and East Asia fell like dominoes—one after another—as currencies and share prices collapsed in many of the much-admired "tiger" economies across the region. Beginning in July with the crash of Thailand's baht, the crisis spread to the Indonesian rupiah, Malaysian ringgit, and Philippine peso, all of which dropped to historic lows against the dollar by mid-December. Many Asian banks that had tied the repayment of short-term foreign debt to the value of Asian currency and other assets found it increasingly difficult to repay the loans, as falling currencies and plummeting stock markets left them short of capital with which to buy the foreign currency needed for repayment. Other banks had made overly large or insufficiently secured loans to companies that were unable to keep up with their payments.

      The South Korean won plunged to an 11-year low in December, which forced creditor banks from the Group of Seven industrialized nations in Europe and North America to extend loan repayments and to help arrange new loans, many backed by the International Monetary Fund and the World Bank. In an effort to restore stability, the South Korean government rescued some failing banks, including two of the nation's largest, Korea First Bank and SeoulBank.

      The crisis in South Korea and Southeast Asian countries triggered several failures in the already-weakened Japanese financial sector. When Hokkaido Takushoku Bank went under on November 17, the Japanese government allowed the long-troubled bank to collapse. The move was well received, and some analysts speculated that it could be a step by Japanese regulators toward a much-needed restructuring of the entire banking industry. In April the government had merged the failing Hokkaido Bank with the larger Hokkaido Takushoku in an unsuccessful attempt to shore up both.

      In 1997 the banking industry in Switzerland, under pressure from the Swiss government, the media, and the international community, finally announced what it called a definitive total of dormant accounts, many opened by German Jews prior to World War II. The Union Bank of Switzerland (UBS), the Swiss Bank Corp. (SBC), and Crédit Suisse—together with the country's central bank—set up a special fund for Holocaust survivors. The fund exceeded $190 million by the end of the year. Sidebar.) (Swiss Banks in Disarray ) In December the UBS and the SBC announced a planned merger that would create the United Bank of Switzerland, with assets of at least $600 billion and more than $900 billion under management. It would be the world's second largest bank, jumping past Germany's Deutsche Bank and exceeded in size only by the Bank of Tokyo-Mitsubishi, Ltd.

      The giant Swiss merger overshadowed several previously announced European deals, including the merger of two Bavarian banks, Bayerische Hypotheken- und Wechsel-Bank AG and Bayerische Vereinsbank AG, with combined assets of some $470 billion. The largest financial services company in The Netherlands, ING Group—which had already purchased Barings PLC, Great Britain's oldest merchant bank, and the New York investment bank Furman Selz Inc.—announced the takeover of Banque Bruxelles Lambert in Belgium. The fragmented Belgian banking sector also recorded the sale of the French company Groupe Paribas's Belgian retail-banking business to Belgium's Bacob Bank SC. In Italy another French bank, the state-controlled Crédit Lyonnais, agreed to sell its stake in Credito Bergamasco SpA to the Banca Popolare di Verona. Crédit Lyonnais, which had been the object of a government-backed rescue in 1995, reported a return to profitability in the first half of 1997.

MELINDA C. SHEPHERD

United States.

      Among U.S. commercial bankers, 1997 would be remembered as the year the Great Depression finally ended. Exactly 64 years after Congress passed the Glass-Steagall Act of 1933, which barred commercial banks from underwriting stocks and bonds, U.S. banks once again began reasserting themselves in the securities business. In April Bankers Trust New York Corp., the nation's seventh largest bank, agreed to pay $1.7 billion in stock to acquire the Baltimore, Md.-based Alex. Brown Inc., one of the country's oldest and best-regarded securities firms. Although Glass-Steagall remained technically in place, the deal was made possible by the Fed's little-noticed decision in late 1996 to loosen dramatically the restrictions on the investment-banking work commercial banks could undertake.

      Bankers Trust's historic move was followed by a succession of acquisitions of securities firms by banks, including BankAmerica Corp.'s purchase of Robertson, Stephens & Co., NationsBank Corp.'s purchase of Montgomery Securities, First Union Corp.'s purchase of Wheat First Butcher Singer, Inc., Fleet Financial Group, Inc.'s purchase of the Quick & Reilly Group, Inc., and U.S. Bancorp's purchase of the Piper Jaffray Co. Even foreign banks stepped into the fray, with the Canadian Imperial Bank of Commerce agreeing to buy Oppenheimer & Co., Inc., and the Swiss Bank Corp. agreeing to purchase Dillon, Read & Co., Inc.

      The deals sent the stock prices of investment banks soaring and left observers wondering when the nation's biggest bank, Chase Manhattan Corp., might make a similar move. Chase officials, under fire from some analysts for dawdling, indicated they were in no hurry. They were willing to wait, they said, until prices came back down to earth. In any case, they had their eyes on a far bigger prize: a blockbuster acquisition along the lines of Merrill Lynch & Co., Inc., the nation's largest securities firm, or Donaldson, Lufkin & Jenrette, Inc. (DLJ), another big investment bank. Merrill Lynch, for its part, rebuffed an initial overture from Chase, while DLJ's French parent, the AXA Group, indicated no eagerness to sell out.

      Meanwhile, Wall Street was not exactly sitting idly by, waiting for the commercial bankers to act. In February Morgan Stanley Group Inc. and Dean Witter, Discover & Co. merged in a bid to create a brokerage firm rivaling Merrill Lynch in size and reach. In September Travelers Group Inc., which already owned the Smith Barney brokerage house, added Salomon Inc. to the fold.

      In other ways, too, bankers with a case of merger fever sent the walls between various branches of financial services tumbling down. There were bank acquisitions of money-management firms, from Mellon Bank Corp.'s purchase of Founders Asset Management, Inc., to J.P. Morgan & Co.'s purchase of a 45% stake in American Century Companies, a mutual-fund firm. There were bank deals for credit-card issuers, from Banc One Corp.'s acquisition of First USA Inc. to Fleet's acquisition of Advanta Corp. and Citicorp's purchase of the Universal Card business from AT&T Corp. There were also several mergers, including First Bank System's merger with U.S. Bancorp, NationsBank's acquisition of Barnett Banks, Inc., and First Union's purchase of CoreStates Financial Corp.

      All the deals were made possible by a red-hot stock market that sent the shares of banks and other financial-services companies soaring and provided them with the currency to strike deals. The market in turn was fueled by a remarkable "Goldilocks economy"—not too hot and not too cold—that combined low unemployment, low inflation, and low interest rates and produced record profits for financial firms. Bankers surveying the landscape realized that if there was ever a time to bulk up and broaden their reach, it was now, before the economy—and their stock prices—cooled off.

      Indeed, as year-end approached, there were reasons to worry about the future. The economic turmoil in Asia, driven in part by concerns over the soundness of various big Asian financial institutions, caught several American banks with large overseas operations off guard. Chase Manhattan, J.P. Morgan, and Bankers Trust all acknowledged that they had sustained sizable losses in their emerging-markets trading operations, with Chase alone taking a $160 million bond-trading hit in the last week of October.

      The U.S. comptroller of the currency warned U.S. banks that their lending practices to big corporations were becoming too aggressive. Increased competition between bankers to win corporate financing assignments had driven the profit margin on big, multibank corporate loans to record lows, even as the level of such lending soared to record highs. At the same time, banks began taking more risks in their consumer lending, offering home equity loans and unsecured lines of credit to growing numbers of individuals with spotty credit records. Coming at a time when loan losses on credit-card portfolios were already hovering near record levels, the bankers' heightened risk tolerance gave analysts as much reason to worry about 1998 as they had reason to celebrate the historic profits of 1997.

STEPHEN E. FRANK

      This article updates bank.

Labour-Management Relations

      For the industrialized countries, economic growth in 1997 was generally good. Unemployment was a different story. Though low in the United States, fairly low in the United Kingdom, and low, as usual, in Austria, Japan, Luxembourg, and Switzerland, it averaged more than 10% in the European Union (EU) as a whole. The continuing differences in unemployment and job creation between the U.S. and most continental European countries revived the argument about labour-market flexibility. It was argued that the flexibility of the U.S. labour market favoured efficiency and low unemployment, whereas the more highly regulated practices common in much of Western Europe had led to high labour costs and unemployment. Others maintained that not only did a high degree of regulation afford a level of worker protection that was appropriate in an advanced industrial society but also that there was no strong evidence that it resulted in unemployment or was detrimental to competitiveness.

Europe.

      In the EU the idea of forming European companies, i.e., companies with establishments in more than one member country incorporated under one (European) law rather than different laws in different countries, had been put forward in 1970 but had made little progress, mainly because of opposing views about the position of workers vis-à-vis the management of these enterprises. In May 1997 an expert group proposed that European companies be required to negotiate, with workers' representation, a "system of written involvement such as workers on the company's board or a works council with specific rights to be informed and consulted about matters of concern to workers. If negotiations proved unsuccessful 'reference rules' for such information and consultation rights, as established by the European Union, would apply." In June the European Commission launched discussions with unions and employers on a proposal that there be a binding EU-wide framework agreement requiring regulations in all member countries for companies to have arrangements for workers to be informed and consulted. An intergovernmental agreement reached in Amsterdam in June proposed new chapters to be added to European treaties dealing with employment and social policy, the latter replacing the Social Policy Protocol agreed upon in Maastricht, Neth., in 1991. An agreement by European unions and employers that intended to remove discrimination in the conditions of part-time workers compared with full-time workers was signed in June and formed the basis of a proposal for a directive to be made by the Council of Ministers.

      In Great Britain the major event in 1997 was the sweeping success of the Labour Party in the general election on May 1. In recent years trade union influence had waned, and the party made it clear that Labour would leave in place most of the basic elements of the Conservative Party government's labour laws enacted between 1980 and 1993. There were, however, four matters on which the new government proposed to act immediately. First, it would reverse a ruling by the Conservative government that, on the grounds of national interest, had denied union membership to workers at the Government Communications Headquarters, an intelligence-gathering agency. Second, it would set up a commission on low pay, with a view to establishing some form of national minimum wage. Third, it would end the "opt-out" from certain EU labour proposals, which the Conservatives had negotiated at Maastricht in December 1991. And fourth, it would move toward establishing a means whereby employers could be required to recognize trade unions when a majority of their workers so wished. The government acted quickly on the first three of these matters, but the complicated question of union recognition was seen to need extensive consultation.

      In Germany unemployment continued at historically high levels—over 10%. A revision of the Employment Promotion Act in March provided a wide range of modifications aimed at helping the unemployed, with some special sections concerning the long-term unemployed. The new act covered unemployment benefits, training, job creation, liberalization of arrangements governing temporary work, and funding for small businesses. In collective bargaining, wage increases were modest. In April the metal trades union announced that, with the objective of reducing unemployment, it would campaign for a workweek of 32 hours, to start in 1999.

      When the unexpected general election in France replaced the right-of-centre government with a Socialist government in June, the new administration quickly announced an ambitious program, including creation of 700,000 jobs for young people in the public and private sectors, reduction of the normal workweek from 39 to 35 hours, financial support for companies making innovative working-time arrangements, strengthening of collective bargaining, a review of unemployment legislation and pension arrangements, and an increase in the national minimum wage. Repeating action taken in 1996, French truck drivers stopped work on November 2, complaining that promises made to them at the end of 1996 had not been honoured. They set up roadblocks, which impeded not only French truck drivers but also those from other countries using French roads. The strike ended after five days, with the truckers gaining an immediate increase in pay of 6%, part of a three-stage rise that would take them up to the year 2000.

      In February the Renault car company's Belgian plant at Vilvoorde informed more than 3,000 employees that the plant would close in July. The European Commission saw Renault's action as having ignored the European Works Council Directive and having raised serious doubts about the adequacy of worker-protection laws. Belgium's National Labour Council opened consideration of stronger legislation concerning substantial layoffs, and tribunals in both Belgium and France ruled that the company had failed to meet its obligation to consult workers. Renault's chairman, Louis Schweitzer ) (Schweitzer, Louis ), confirmed that economic considerations had necessitated the closure, but subsequent discussions with the unions resulted in the introduction of a number of measures to help the Vilvoorde workers.

      In Italy a hard-fought agreement reached by the government and unions in 1996 led to legislation in June. The measure adopted concerned the use of temporary employment agencies, training arrangements, encouragement of part-time work (used less in Italy than in other European countries), help for young unemployed workers in the south, employment on socially useful projects, and reduction of the maximum workweek from 48 to 40 hours. A crisis arose in October when the Communist Refoundation Party refused to accept the provisional budget for 1998. Negotiations resulted in agreement that certain of the proposed changes in the pension system would not apply to factory workers and that the government would introduce a measure for the workweek to be reduced to 35 hours by 2001. The package of pension changes was subsequently modified by an agreement that provided for some pension anomalies, such as the right of some public-sector workers to retire after only 19 years' work, to be ended but failed to produce much-needed structural changes.

      In Spain unions and employers in April reached agreement on labour-market reform and the strengthening of collective bargaining. The general goal was to reduce the extensive use of short-term contracts and increase competitiveness. In support of the agreement, the government in May promulgated decrees aimed at promoting stable jobs and employment relations and offering reductions in employers' social security costs.

North America.

      In the United States a nationwide strike by some 185,000 Teamsters Union drivers and package sorters took place at United Parcel Service (UPS). The main point of contention, apart from pay, was union dissatisfaction with the conditions and insecurity of part-time workers, whose numbers had risen to comprise more than one-half of the workforce, and the company's desire to replace the Teamsters' industrywide pension scheme with a company plan. Discussions to settle the strike, which lasted 15 days, went as high as the U.S secretary of labour. A settlement was reached on August 19 on the basis of a wage increase of about 15% for full-time and about 37% for part-time workers over five years. The company undertook to convert 10,000 part-time jobs into full-time jobs, as far as revenue permitted, over the five-year life of the agreement. The company also agreed to maintain its participation in the union's pension plan.

      The Teamsters faced additional problems during the year when union president Ron Carey, who was first elected in 1991 as a reform candidate, was found by a court-appointed adjudicator to have engaged in illegal fund-raising during his 1996 reelection campaign. The 1996 vote was declared invalid in August, and Carey was later barred from the rerun called for 1998. Carey's chief opponent, James P. Hoffa (the son of longtime Teamsters leader Jimmy Hoffa), was also under investigation for similar allegations.

      Another dispute of interest concerned the more than 9,000 pilots employed by American Airlines. The pilots were concerned about who should fly new jets operated by American Eagle, a subsidiary commuter airline, whose (lower-paid) pilots belonged to a different union with its own collective agreement. When a strike was called in February, Pres. Bill Clinton ordered the union to halt it, invoking his powers under the 1926 Railway Labor Act—the first use of these powers with regard to a commercial airline in 31 years—and set up a Presidential Emergency Board. The settlement of the dispute provided a degree of flexibility in the manning of the airplanes acceptable to American's pilots. In another action the U.S. national minimum wage rose from $4.75 to $5.15 an hour on September 1.

      In Mexico an era ended with the death, on June 21, of Fidel Velázquez Sánchez. .) (Sanchez Vilella, Roberto ) His union career spanned 75 years, much of that time as general secretary of the Confederation of Mexican Workers, Mexico's main trade union body, and as a power in the ruling Institutional Revolutionary Party.

R.O. CLARKE

      See also Business and Industry Review .

      This article updates organized labour: trade unionism (organized labour).

Consumer Affairs

International.

      Sustainable production and consumption and the privatization of public utilities were the issues that dominated the world consumer movement in 1997. Meeting people's needs without destroying the environment was fast becoming a key concern of consumer organizations both in developed economies and in less-developed countries.

      In July a major step forward was achieved when the United Nations Economic and Social Council agreed to set up an expert group to expand consumer protection guidelines into the area of sustainable consumption. The first UN Guidelines for Consumer Protection was adopted in 1985 and covered such areas as consumer safety, product standards, education, and information. In 1995 the UN had agreed for the first time to revise and update the guidelines to include more recent areas of consumer concerns, such as how to use purchasing power to reduce the environmental impact of consumption. The 1997 resolution was one of the key steps needed to turn that earlier agreement into a reality. An expert group of government representatives, international organizations, and nongovernmental organizations, coordinated by the UN, would develop the new guidelines—which could cover such areas as ecolabeling, product pricing that takes environmental costs into consideration, education, and the control of misleading "environmentally friendly" advertising—with the aim of having them approved by the summer of 1998.

      Consumers International, a federation of 215 member organizations in over 90 countries, celebrated World Consumer Rights Day on March 15 by issuing a booklet, Consumers and the Environment: Meeting Needs, Changing Lifestyles. It looked at the enormous problems that face consumers in the areas of water, waste, and energy and used case studies to examine how some organizations were working to make consumers more environmentally responsible. The booklet also focused on advertising and the role it plays in promoting irresponsible consumerism. Consumer organizations campaigned at the World Trade Organization (WTO), which hears international trade disputes, to allow consumer and other nongovernmental groups input in dispute decisions. As of August 1997, the WTO had 100 such disputes in the pipeline.

      The concerns from 1996, particularly in the areas of food safety and the genetic manipulation of food products, continued into 1997. Consumers waged a successful battle against a move by the Codex Alimentarius Commission, the international food-standards-setting body, to pass a draft standard that would have allowed the use of a genetically engineered growth hormone to increase milk production in cows. Consumer organizations claimed that use of the hormone could be detrimental in both economic and health terms. Codex delegates agreed to postpone the vote to review new scientific information regarding the hormones. Consumers also lobbied for greater participation by nongovernmental organizations at Codex; in 1997 the approved list of 111 organizations included 104 industry-funded groups, six health and nutrition foundations, and Consumers International.

      Western European consumer organizations remained highly concerned about bovine spongiform encephalopathy ("mad cow" disease). A European Union-wide ban on the export of British beef remained in place in 1997. Electronic commerce—including use of the Internet—also became a major consumer issue in Western Europe. The Organisation for Economic Co-operation and Development initiated work on consumer protection guidelines in the areas of fraud, redress, and privacy.

      In Eastern and Central Europe and the former Soviet republics, the consumer movement continued to expand, but the emphasis in some parts of the region—particularly in Eastern Europe—was shifting from products to services. In particular, financial services and consumer credit were major issues. The problem of uninformed investing was most clearly demonstrated by the civil unrest in Albania over the collapse of pyramid schemes that had drawn in financially unsophisticated people by promising extremely high rates of return. More than 90% of Albanians participated, with many losing all of their investment. Sidebar.) (Pyramid Schemes in Eastern Europe ) Consumer organizations lobbied local and national governments to pass laws protecting investors and worked to educate the public about such schemes. Consumer input into privatization of public utilities remained a high priority for consumer organizations in Eastern and Central Europe.

      Privatization was also a key consumer concern in Latin America, where there were renewed efforts to increase consumer representation into the regulatory mechanisms governing utilities. Consumer organizations undertook a series of in-depth studies and initiated a sequence of training seminars in Chile, Brazil, Colombia, Mexico, and Peru aimed at promoting consumer input in the newly privatized electrical, telephone, and water services. In Latin America and the Caribbean region, consumer organizations stepped up activities related to the promotion of sustainable production and consumption. A major initiative in 1997 was the creation of a Regional Environmental Citizen's Forum, which would work with other regional groups to promote awareness of the environmental impact of consumer choices.

      Privatization—along with structural adjustment programs and deregulation—meant Asian consumers faced formidable challenges in 1997. In some countries poor monitoring of the privatization process caused waste of resources, while deregulation led to corruption and anticompetitive practices. The consumer movement responded through the promotion of legal reforms, policy formulation, trade practices, and dispute-resolution schemes. Consumers International's Regional Office for Asia and the Pacific (ROAP), together with the Consumer Unity and Trust Society of India, held an international conference in New Delhi in January with the theme "Consumers in the Global Age."

      By the end of 1997, five states in the Pacific Islands—Kiribati, Samoa, Cook Islands, Tuvalu, and the Federated States of Micronesia—had passed draft laws and consumer protection regulations. ROAP also instigated a nine-country household consumption survey to examine trends of specific target groups in the region.

      In 1990 only seven active consumer organizations existed in five African countries. As of 1997, however, they existed in 45 out of 56 African countries. The French version of the 1996 Model Consumer Protection Law for Africa was launched during the year. In addition, Consumers International's Regional Office for Africa was conducting a survey, funded by the Economic Commission for Africa, intended to halt deterioration of the continent's air transport services. Meanwhile, the head of the National Consumers Movement in Cameroon was jailed for alleging that certain chocolate candies contained pesticides.

ALINA TUGEND

United States.

       Consumer safety was an issue on several fronts in the United States in 1997. The year began with the National Highway Traffic Safety Administration (NHTSA) issuing a formal proposal—finalized in November—to allow car owners to have air bag on-off switches installed by auto dealers and repair shops. The NHTSA and the National Transportation Safety Board had reported in 1996 that air bags—mandated for both the driver and the passenger side of all new automobiles and light trucks—actually increased the risk of injury and death for children under 12 riding in the front seat during a frontal crash.

      Official data also revealed that despite a positive record overall, air bags showed small, sometimes negative, effectiveness in protecting the elderly and people of short stature. Automakers and the government quickly reached agreement on rules to implement air-bag-design changes for future model years to reduce these risks but stalled over the disconnect policy, which was intended to help affected populations in the more than 56 million air-bag-equipped vehicles already on the road. Opponents of an open disconnection policy feared many people would choose to deactivate air bags unnecessarily and thus increase their risks.

      A special White House commission to improve aviation safety and security issued 57 proposals in February following concerns raised in 1996 with the crash of TWA Flight 800 off Long Island, N.Y., and the ValueJet Flight 592 crash into the Florida Everglades. The far-reaching proposals covered aviation safety, air traffic control, airport security, and aviation disaster response. Some safety-regulation experts noted that the costs of certain measures, particularly airport security, would outstrip the benefits to the traveling public by a significant margin, given that the risks of flying were small. Meanwhile, the Federal Aviation Administration reported that publishing airline safety rankings, in the manner of on-time and complaint rankings already provided by the government, would not be helpful because there were "no consistent or persistent distinctions among the major jet carriers."

      Ongoing efforts to intensify food-safety oversight were underscored by a string of well-publicized foodborne-illness outbreaks, from tainted raspberries to bad apple cider to hamburger meat processed by the Hudson Foods Co. of Arkansas. (The latter led to Hudson's recall in August of some 11.3 million kg [25 million lb] of hamburger.) Key among several educational and regulatory initiatives were plans to extend the Hazard Analysis and Critical Control Point (HACCP) system of food inspection to cover fruit and vegetable juices. HACCP became fully effective in seafood plants at the end of 1997, and many large meat and poultry plants scheduled to implement HACCP fully by January 1998 already had the system in place. Initiatives also included expansion of the FoodNet monitoring system, which established a national network of "sentinel" sites in the states to provide early warning of food-illness outbreaks. Increased enforcement powers of federal meat and poultry inspectors and increased oversight of imported foods were proposed but eventually bogged down in Congress.

      After 10 years of lobbying, broadcasters persuaded the Federal Communications Commission (FCC) to begin the formal transition to the broadcast of digital television signals, which promised to revolutionize the quality of TV. The FCC decided that conventional broadcasts would be phased out by the year 2007. Against their will, however, broadcasters still had to choose precisely the type of digital signals to broadcast and thus were reluctant to choose one format, such as the long-promised "high definition television," over other digital formats until it was clear what competitors would do. This left consumers with the promise of great technological advance, the prospect of having to replace soon-to-be obsolete TV sets (within a year in some markets), and no assurance that near-term purchases would comply with the future standard.

      Consumers were more likely to find drug ads on television and radio broadcasts after the Food and Drug Administration issued new guidelines for advertising prescription drugs. Aimed at making such ads more consumer friendly, the guidelines said drugmakers could describe drug benefits without having to post the lengthy, detailed side-effect notices, as was required prior to the August ruling. Drug companies still had to summarize the major risks and include toll-free telephone numbers or Internet addresses for additional consumer information. Nevertheless, the Food and Drug Administration still was vigilant and warned one major drugmaker about misleading ads only a few days after issuing the new rules.

PETER L. SPENCER

      See also Business and Industry Review: Advertising; (Business and Industry Review ) Retailing (Business and Industry Review ); The Environment (Environment ).

▪ 1997

Introduction

      World economic and financial conditions charted a favourable course during 1996, and growth became more widespread, particularly in the less-developed countries (LDCs). According to International Monetary Fund (IMF) and World Bank estimates, global economic output expanded close to 3.8%, a little faster than the year before, despite a disappointing economic performance in many Western European countries.

    Real Gross Domestic Products of Selected OECD Countris, TableThe rate of economic growth in the developed economies as a whole picked up a little to an estimated 2.3%, compared with 2.1% in 1995. (See Table I (Real Gross Domestic Products of Selected OECD Countris, Table).) The effect of the mid-cycle dip, much in evidence in 1995, still influenced many countries. Lower interest rates (Graph I—>), introduced in 1995 to counter faltering growth, together with steady exchange rates (Graph V—>) (particularly in Japan and Germany) should have stimulated economic activity in the developed countries more strongly than they actually did. (For industrial production in selected countries, see Graph II—>) In some Western European countries, however, this easier monetary stance was countered by tighter budgetary policies in preparation for economic and monetary union (EMU). Thus, economic growth in the European Union (EU) drifted down to an estimated 1.6% from the 1995 level of 2.5%. With the exception of the U.K., where growth remained steady, the slowdown in countries such as France, Germany, and Italy was seen as an unfavourable development, as the recovery from the 1992-93 recession was still incomplete, with unemployment at relatively high levels. By contrast, economic activity rebounded in the U.S. and Japan, partly in response to the relaxed monetary conditions. The Japanese economy registered the strongest growth for 20 years in the opening quarter but lost momentum as the effect of the 1995 measures to stimulate the economy wore off. Even so, gross domestic product (GDP) in Japan expanded by around 3.75%. There was a similar upsurge in the U.S. during the second quarter, but more moderate growth conditions returned in the second half. Thus, for the first time in many years, growth in the world's two largest economies was more synchronized. Despite close links with the U.S. economy, output continued to decline in Canada in response to tight policies. Benefiting from relatively buoyant conditions in the Pacific region, Australia and, to a lesser extent, New Zealand experienced an upturn.

       Changes in Output in Less-Developed Countries, TableRelatively strong economic growth—at around 6%—was maintained in the LDCs during 1996. (See Table IV (Changes in Output in Less-Developed Countries, Table).) In many countries investment and exports were the main sources of growth. The expansion in exports from the LDCs, both to the developed countries and to each other, partly offset economic weakness in industrialized countries and enabled the LDCs to sustain above-average growth rates.

      As in previous years, this overall high growth rate concealed many regional and national differences. Despite a slowdown, growth in South and East Asia remained close to 8%, the highest rate within the less-developed regions. While rapid growth in some of the "Tiger Economies" (Singapore, Hong Kong, Taiwan, South Korea, and Thailand) cooled as a result of tighter monetary policies, rapid growth was maintained in China. Vietnam, benefiting from strong foreign investment, registered the fastest growth rate in the region, nearly 10%.

      Growth accelerated in Africa from around 3% in 1995 to an estimated 5%. As this was ahead of population growth for the first time since the mid-1980s, per capita income registered significant growth. Favourable weather conditions and supportive economic policies were the main reasons for the upturn. Despite this economic recovery, most African countries remained among the poorest in the world. Latin America emerged from the 1995 recession, which was induced by the financial crisis in Mexico. Growth remained patchy in the region, however, as a number of large countries, including Brazil, Chile, and Colombia, experienced a slowdown.

   Consumer Prices in OECD Countries, TableAs inflationary pressures remained subdued and public-sector deficits contracted, policy makers in the developed countries were concerned with nurturing noninflationary growth. (For Consumer Prices in OECD Countries, see Table II (Consumer Prices in OECD Countries, Table).) This led to a modest easing of monetary policy during 1996, particularly in Europe. (For short-term interest rates, see Graph III—>; for long-term interest rates, see Graph IV—>.) In the U.S. the Federal Reserve Board (Fed) refrained from further interest-rate cuts in 1996 as the economy responded to the previous year's relaxation of policy. In Japan interest rates were held steady to sustain economic recovery. In Europe, against a background of sluggish economic activity and low inflation rates, monetary policy was eased further, particularly in Germany, France, and other countries where the monetary policy shadowed that of Germany. A similar trend was in evidence in the U.K., where base rates were reduced in three steps despite reservations by the Bank of England. Then in October the chancellor of the Exchequer, Kenneth Clarke, unexpectedly raised short-term interest rates by 0.25%, signaling a turning point in the interest-rate cycle.

      Public-sector deficits continued to shrink in 1996 as policy makers in most countries kept fiscal policy on a tight rein. In the U.S., as budget deficits continued to fall, fiscal policy remained largely neutral ahead of the November presidential elections. The deadlock relating to the budget negotiations for the fiscal year ending September 1996 dragged on until April 1996. Even so, there was no firm agreement on how to balance the budget in the long term. The Japanese authorities adopted a "wait-and-see" policy as they judged that the economy did not require further economic-stimulation packages. It was argued that what the Japanese economy required was a speeding up of the deregulation and liberalization moves already under way. The thrust of fiscal policy in Europe remained tight during 1996, as many countries were concerned with reducing their public-sector deficits in order to meet the criteria for the EMU under the Maastricht Treaty on European Union, due to start in 1999. Budget deficit reduction measures were adopted in Germany, France, Belgium, Italy, and other EU countries. Many of these measures were not as severe as some official commentators made out, as "creative-accounting" techniques, particularly in France, were utilized to reduce the deficits without deep cuts. There were extensive protests from workers in France and Germany on proposed cutbacks on social benefits, and doubts were expressed by economists as to whether France and Germany would succeed in reducing their public deficits to 3% of GDP by 1997. The British public-sector deficit proved to be more stubborn than expected. The 1996-97 outturn, at £26.5 billion, while lower than the previous year's £ 32 billion, was double the target set in 1993.

       Standrardized Unemployment Rates in Selected Developed Countries, TableWith the exception of the U.S. and the U.K., employment growth experienced another disappointing year. There was no perceptible improvement in the unemployment rate in the developed countries belonging to the Organisation for Economic Co-operation and Development (OECD), where unemployment remained at around 7.3%. This excluded those who had retired early (often involuntarily) or who for various reasons were discouraged from joining the ranks of job seekers. (See Table III (Standrardized Unemployment Rates in Selected Developed Countries, Table).)

      The U.S. economy had been most successful in creating new jobs. During 1996 the number of people in work increased by nearly two million. Even though the labour force grew by around 800,000 people, largely as a result of legal immigrants (an estimated 300,000 illegal immigrants were excluded from labour force data), unemployment at year's end stood at 5.3%, compared with 5.5% a year earlier. Similarly, in the U.K. the number of those out of work and claiming unemployment benefits steadily fell during the year and in November stood at under two million, which gave an unemployment rate of 6.9% (down from 8.1% the year before). In France and Germany sluggish economic growth and rigid employment markets led to higher unemployment rates. There was a small rise in unemployment in Japan as the hesitant economic recovery failed to create sufficient new job opportunities to absorb a rise in the labour force. This trend hit hardest the young and led to a youth unemployment rate of double the national average. The IMF and similar organizations, citing the examples of relatively more flexible labour markets in the U.S., the U.K., and New Zealand and their success in reducing structural unemployment, urged other developed countries to speed up the reform of their labour markets.

      As a result of sluggish growth in the developed countries, the volume of world trade expanded at an estimated 6.4%, compared with nearly 9% the year before. Not surprisingly, little progress was made in eliminating the large regional deficits. The U.S. trade balance grew, as stronger domestic demand sucked in higher imports, and was heading for a $175 billion deficit, a deterioration of 60%. Weaker export markets, combined with a depreciating currency, led to a 25% reduction in the Japanese trade surplus as measured in U.S. dollars.

      The IMF projections pointed to continued easing of the debt problems of the LDCs. This was partly attributed to a larger part of the capital inflows being non-debt-bearing. The growing volume of exports further eased the problem of servicing existing debts.

NATIONAL ECONOMIC POLICIES

United States.

       Real Gross Domestic Products of Selected OECD Countris, TableHaving achieved a soft landing in 1995, the U.S. economy avoided slipping into a recession in 1996. Partly as a result of the easing of monetary conditions that began in mid-1995, economic activity picked up in 1996 and reached 4.7% in the second quarter. A slowdown in the summer put the economy on course for a sustainable growth rate and led to GDP growth for the year of 2.3%—a little ahead of 1995. (Table I (Real Gross Domestic Products of Selected OECD Countris, Table).)

  Economic growth was sustained by a recovery in domestic demand, in particular personal consumption. During the first half of the year, consumers spent freely with the aid of easily available credit. Having grown at a fast rate of 4%, consumer spending cooled in the second half as debt levels rose to record levels and fears of higher interest rates resurfaced. In contrast, government spending remained flat. Investment, both business and housing, staged a recovery and grew by around 6%. Business investment reflected the ending of the inventory overhang and an improvement in manufacturing output (see Graph II—>). Capacity utilization rose to 83%, close to its post-World War II average. As long-term interest rates (Graph IV—>) rose in the autumn, there was some evidence of a slowdown in both industrial output and the rate of business investment.

  Standrardized Unemployment Rates in Selected Developed Countries, Table Consumer Prices in OECD Countries, TableContinuing economic growth enabled further gains to be made in reducing unemployment (Table III (Standrardized Unemployment Rates in Selected Developed Countries, Table)). In November the U.S. jobless rate stood at 5.3%, compared with 5.5% a year earlier. The December rate remained unchanged. Since 1992, 10 million jobs had been created, more than Pres. Bill Clinton promised during his campaign that year. Four million of these jobs had been created since the beginning of 1995, and, unlike in previous years, two-thirds were in sectors paying above-average wages. Despite full employment, inflation remained subdued. (See Graph I—>.) In November the core inflation rate, excluding food and energy, was running at 2.7%, compared with 3% a year earlier. Economic observers were surprised by the lack of upward pressures on prices (Table II (Consumer Prices in OECD Countries, Table)) despite the jobless rate's falling well below 6% (often regarded as the threshold for accelerating inflation). Structural changes in the labour market and stagnation in real wages were seen as possible reasons.

 The combination of robust domestic demand with a stronger dollar (Graph I—>) halted the improvement in the trade balance. On the basis of incomplete data, the trade balance was heading for a $175 billion deficit—much higher than the previous year's deficit of $108 billion. The current account was likely to remain largely unchanged as a result of higher capital inflows into the U.S. and a smaller deficit on investment income.

 Economic policy during 1996, both monetary and fiscal, remained largely neutral. While it did not provide any stimulus to the economy, the primary goal of economic policy makers remained one of ensuring that the noninflationary growth was sustained. As the economy responded to lower interest rates (Graph III—>)—introduced between July 1995 and February 1996—and activity rates picked up, the monetary authorities kept the base rates under review. In the wake of the 4.7% GDP growth in the second quarter and continued growth in employment, independent observers started worrying that interest rates might have to be raised soon to counter the threat of future higher inflation. The Fed took the view that there was no need for higher interest rates, as economic growth would be moderating spontaneously, the inflation risk remained low, and lower levels of unemployment were sustainable without triggering higher wage rates. The economic indicators available at the close of the year pointed to this judgment's being accurate. Fiscal policy, having achieved a reduction in the U.S. budget deficit in the last three years, was largely neutral in 1996. Clinton's proposals for fiscal 1997 (beginning Oct. 1, 1996) allowed for only a slight growth in spending on many programs, with the exception of health care and similar mandatory programs.

Japan.

  Real Gross Domestic Products of Selected OECD Countris, TableThe long-awaited economic recovery in Japan ran out of steam after an exceptionally strong performance in the first quarter (Graph II—>). The recovery that got under way in the second half of 1995 accelerated in the winter, leading to a 3% growth over the previous quarter (an annualized growth of 12.7%)—the strongest growth in more than 20 years. While the surge in activity was boosted by exceptional factors, there was no denying the strength of the underlying trend. This led to an upward revision of economic forecasts to 4.25%, putting Japan at the top of the economic growth league among major economies. In the event, economic activity lost momentum and the next quarter registered a decline, followed by a minuscule rise in the third quarter. Despite this uneven performance, GDP in Japan was estimated to have grown by about 3.7% during 1996 as a whole—the best performance in five years.(Table I (Real Gross Domestic Products of Selected OECD Countris, Table).)

      The strong recovery early in the year reflected the large stimulus provided by the lower interest rates and public-investment programs announced in April and September 1995. The subsequent slowdown was attributable to the effect of these measures fading away. Domestic demand was the main driving force supported by strong growth in investment. Consumer spending, which was boosted by gains in disposable income, lost momentum in the second half of the year. Sales of automobiles, personal computers, and such high-tech equipment as mobile phones, car navigation systems, and digital cameras registered good gains. Sales in supermarkets and some department stores remained relatively weaker.

  Housing investment grew robustly, stimulated by prospects of higher interest rates later in the year and the planned rise in the consumption tax in April 1997. The commercial construction industry benefited from the huge injections of public-works investment in the economy and the reconstruction of Kobe after the 1995 earthquake. Spending on plant and equipment strengthened during the year, reflecting improved business confidence and record-low interest rates. (For short-term interest rates, see Graph III—>; for long-term interest rates, see Graph IV—>.) Although business investment grew by 5% over the year, compared with 10% for private housing, as the year drew to a close, the trend of the former was pointing upward while the latter was decidedly downward.

      Against the background of a recovery in economic activity, fiscal policy remained largely neutral and monetary policy was accommodating. There were no pump-priming emergency packages that had been repeatedly used in past years to stimulate the economy. On the contrary, policy makers began anticipating a tightening in 1997 on the assumption of sustained recovery. In June the Cabinet approved a rise in the consumption tax from 3% to 5%, effective from April 1997.

      Interest rates remained at a record low but would have risen before the year-end had rapid economic growth been sustained. Maintaining interest rates at low levels was deemed by the authorities to be beneficial to the banking system, which had not recovered from the problems caused by "nonperforming" loans. Several bills were passed to bolster the role of regulatory and supervisory bodies to forestall future collapse of financial institutions, but these could not prevent further bankruptcies among financial institutions. The $9 billion bankruptcy of Nichiei Finance in late October marked the largest collapse in Japan's corporate history. This would have resulted in further claims on the deposit insurance scheme and added to the government's already large deficit, which had risen to 5% of GDP—an unsustainable level against the low-inflation and low-growth economic backdrop.

       Standrardized Unemployment Rates in Selected Developed Countries, Table Consumer Prices in OECD Countries, TableAs unemployment is usually a lagging indicator, the uneven recovery did not halt the inexorable rise in Japanese unemployment (Table III (Standrardized Unemployment Rates in Selected Developed Countries, Table)). The unemployment rate reached a new peak of 3.5% in May, its highest since 1953, and fell to 3.4% in November. This looked low in comparison with rates in the U.S. and Europe, but it was significantly understated because of the way Japanese statistics were calculated. Despite the rise in unemployment, wages rose in 1996. The spring shunto round of wage negotiations resulted in a weighted average pay raise of 2.86%. Although the nominal gains were low in both 1995 and 1996, the minimal increase in the consumer price index (Table II (Consumer Prices in OECD Countries, Table)) resulted in a good real rise.

  Despite the currency value's (Graph V—>) weakening from 80 yen to the dollar in April 1995 to 113 to the dollar in autumn 1996, there was little evidence that inflation was picking up. Following a 0.3% fall in the first quarter, the subsequent rise resulted in a 0.2% increase overall. Given the sharp rise in import prices in yen terms, inflation (Graph I—>) was expected to upturn significantly in 1997.

      The slowdown in domestic demand, coupled with the decline in the value of the yen, resulted in a slowdown in the growth of imports. Compared with a 16% overall rise in 1995, imports toward the end of 1996 were 3% up on the year before (both in yen terms). Exports rose by 3%, but export growth was held back by sluggish growth in many OECD countries. Because of the depreciating yen, Japan's trade surplus and the current-account balance declined in dollar terms. The trade surplus was heading for $100 billion ($135 billion in 1995), compared with a $75 billion current-account surplus ($111 billion in 1995).

United Kingdom.

       Real Gross Domestic Products of Selected OECD Countris, TableEconomic growth in the U.K. gained momentum during the year, reversing the previous year's second-half downturn. Stronger consumer spending and a small pickup in key European export markets were the main influences behind the upturn. These stronger-than-expected developments enabled GDP to grow by 2.5%—a similar pace to that of the year before. (Table I (Real Gross Domestic Products of Selected OECD Countris, Table).)

       Consumer Prices in OECD Countries, TableConsumer spending (for consumer prices, see Table II (Consumer Prices in OECD Countries, Table)) was driven higher by incomes from employment growing almost 2% above the inflation rate, a slight easing in the tax burden, and lower interest rates on home mortgages. Consumer confidence was also boosted by a gradual recovery in the housing market. After many years of decline, house prices rose by an average of 6%. The improvement in the housing market spilled into related sectors of consumer spending, such as furniture, carpets, and do-it-yourself products. Consumer spending as a whole expanded by almost 4%, the fastest rate since 1989.

  Although investment charted an erratic course during 1996, assisted by lower interest rates and a rebound in housing investment, it expanded by an average of 3% and contributed to domestic demand. (For short-term interest rates, see Graph III—>; for long-term interest rates, see Graph IV—>.) Investment by industry lagged behind, reflecting weak manufacturing output, which was held back as industrialists tried to clear excess inventories that had built up. In the fourth quarter of 1996, factory production finally rebounded, despite export orders' remaining flat.

  Standrardized Unemployment Rates in Selected Developed Countries, TableAgainst a background of higher economic activity rates, unemployment (Table III (Standrardized Unemployment Rates in Selected Developed Countries, Table)) continued to fall and reached the lowest rate since 1991. At the year's end the total number of unemployed stood at around two million, or 7.2% of the workforce, compared with 8.1% a year earlier. The fall in unemployment was probably exaggerated by a large number of people's leaving the workforce, as well as by a change in the benefits system that tightened conditions for eligibility. While the ruling Conservative Party tried to make political capital from the continuing decline in unemployment ahead of the 1997 general election, financial markets were unsettled by fears that it could be fueling inflationary pressures and bringing forward the need for another interest-rate rise. These worries were heightened by a gradual acceleration in the inflation rate (Graph I—>), particularly the underlying rate, which excluded mortgage interest rates. Having remained at around 3% for most of the year, in the autumn the underlying rate moved up to 3.3%, well above the government's medium-term target of 2.5%. Even so, it remained low by historical standards.

      Economic policy was aimed at nurturing economic growth and consumer confidence in the hope that this would translate to electorate support for the Conservatives. During the first half of 1996, interest rates were trimmed back by 0.75% in three steps, despite reservations voiced by the governor of the Bank of England. Chancellor Clarke was influenced by the stagnation in manufacturing output and wanted to ensure that the slowdown in economic growth did not turn into a recession. Taking a chance that cost pressures on industry would remain constrained, in June he unexpectedly cut interest rates to 5.75%. This surprising move was followed by an equally unexpected rise back to 6% in October.

      Compared with the relative freedom the chancellor enjoyed in framing monetary policy, the scope for tax cuts in his last budget before the election was severely limited. The main constraint was the stubbornly high public-sector borrowing requirement (PSBR). Revised summer forecasts pointed to a £ 25 billion PSBR, below the 1995 level of £ 32.2 billion but double the original £ 12 billion target. As in 1995, Clarke found room to cut personal taxes by £2.2 billion but recouped most of it through a £ 1.5 billion rise in indirect taxes. Similarly, a large increase in key areas such as education, health, and law and order was offset by a £1.9 billion planned reduction in overall public spending.

Germany.

  Real Gross Domestic Products of Selected OECD Countris, TableThe economic decline that took place in the last quarter of 1995 and early in 1996 came to an end, and the economy rebounded. Since the recovery was not strong enough to fully offset the earlier weakness, GDP for the year as a whole expanded by an estimated 1.5%, compared with 1.9% in 1995 and 2.9% in 1994 (Table I (Real Gross Domestic Products of Selected OECD Countris, Table)). The recovery was partly due to a rebound of activity from the exceptionally severe 1995-96 winter. An improvement in competitiveness, following the reversal of 1995's currency appreciation (Graph V—>), and the priority given to cost reductions were also strong contributory factors.

      Although the second-half recovery was partly investment-led, export growth was relatively strong. Consumer spending was also strong, despite sluggish growth in real incomes and rising unemployment levels. Business investment strengthened throughout the year as confidence improved, reflecting stronger export demand and lower interest rates. While most of the investment was intended to improve efficiency, about a third of it was for expanding capacity. In contrast to the manufacturing sector, investment in construction fell during 1996 as a whole. This reflected the severe recession sweeping through the construction sector following the ending of the postunification boom.

       Consumer Prices in OECD Countries, TableConsumer spending charted an uneven course. (For consumer prices, see Table II (Consumer Prices in OECD Countries, Table).) Early in the year it was up 0.75%, encouraged by income tax reductions for people on low incomes and termination of an 8.5% annual levy on electricity bills. Although spending in the shops remained positive in the second half of the year, as job insecurity and low wage settlements held back consumer spending, its overall rate of growth was weaker than in 1995.

 Industrial production (Graph II—>) picked up in the spring and registered a 3% increase for the year as a whole. This was accompanied by an improvement in the overall business climate following the deterioration in 1995. Exports rose by nearly 6%, helped by the weakening of the Deutsche Mark and by the efforts of German companies to reduce costs by restructuring and rationalization of production. More encouraging was the fact that foreign orders were running considerably higher toward the end of the year. As a result of sluggish import growth coupled with stronger export performance, the trade surplus improved in Deutsche Mark terms, but the gain was much smaller when measured in U.S. dollars.

  Standrardized Unemployment Rates in Selected Developed Countries, TableWhile inflation (Graph I—>) remained low, averaging 1.5%, with no upward pressure from producer prices, the unemployment position continued to deteriorate. The upward trend that started in mid-1994 continued until the spring. The jobless total (excluding disguised unemployment) peaked at 3,993,000 (seasonally adjusted) and then fell back slightly in the summer. The unemployment rate toward the year's end stood at 10.1%, compared with 9.2% a year earlier (Table III (Standrardized Unemployment Rates in Selected Developed Countries, Table)). This high unemployment prompted the German government to introduce a "Program for Growth and Jobs." The main elements of this included reducing government expenditure as a proportion of GDP back to preunification levels, lowering social security insurance contributions, and introducing measures to make the labour market more flexible and to reduce nonwage labour costs. Many independent observers thought the aim of halving the unemployment rate by the year 2000 had little chance of being realized.

      Despite the fiscal-consolidation measures in place, the sluggishness of the German economy resulted in a smaller-than-expected reduction in the budget deficit during 1995. As a result, a tough action plan was introduced in 1996, which aimed at achieving budget savings of DM 70 billion from 1997 onward. The savings were a mixture of cuts in the federal budget, state and local authority spending, and social security spending. Despite opposition from the Bundesrat (the upper house), the government was able to pass most of its austerity budget. As in France, however, doubts remained whether Germany would be able to meet the Maastricht Treaty requirement for a budget deficit/GDP ratio of 3%.

  Monetary policy was further eased during 1996 against the background of low inflation and sluggish economic activity. The Bundesbank cut its discount rate and Lombard rates in April. The securities repurchase rate (Repo rate), which influences money market rates, remained unchanged between February and August. It was then cut by a larger-than-expected rate, signaling a further loosening of monetary policy. (For short-term interest rates, see Graph III—>; for long-term interest rates, see Graph IV—>.)

France.

       Real Gross Domestic Products of Selected OECD Countris, TableContinuing the weakness experienced during the latter part of 1995, the French economy remained sluggish during 1996, despite a large rebound in the opening quarter. Reflecting the underlying weakness, GDP as a whole grew by around 1% during 1996, compared with 2.2% the year before. (Table I (Real Gross Domestic Products of Selected OECD Countris, Table).)

      In the early part of the year, economic activity was sustained by buoyant consumer consumption, which was up 2% during the first half of the year. The upturn was partly due to a reduction in interest rates and a package introduced in January to encourage personal consumption and home buying. As the year progressed, however, household consumption weakened, which reflected the cumulative effect of a 2% rise in value-added-tax rates in August 1995, a social-debt levy of 0.5% effective from February 1996, and a wage freeze applying to civil servants.

 As a consequence of weakening demand, the trend of industrial production (Graph II—>) remained downward, capacity utilization remained flat, and new investment by manufacturing companies grew modestly. In the absence of need for new capacity, new investment was undertaken mostly for modernization purposes. Export activity gathered pace during the year and made a positive contribution to growth as a result of sustained growth in Japan, the U.S., and the U.K., the leading importers of French goods. A 2.5% total increase in the volume of French exports of good and services was matched by a similar rise in imports. Nevertheless, the trade balance remained in healthy surplus, as did the current-account balance.

       Standrardized Unemployment Rates in Selected Developed Countries, Table Consumer Prices in OECD Countries, TableBecause of the slow economic growth, the unemployment (Table III (Standrardized Unemployment Rates in Selected Developed Countries, Table)) position continued to worsen in France. By October unemployment as a proportion of the labour force had reached 12.6%. At this level it was one percentage point higher than a year earlier. The young as well as those in the older age groups were most affected. Consumer price inflation, having edged up since late 1995, peaked at an annual rate of 2.4% in the summer. Following a subsequent moderation, the average increase for the year was expected to be 2%, compared with 1.7% in 1995. (Table II (Consumer Prices in OECD Countries, Table).)

      The economic policy continued to be framed to enable France to meet the conditions for joining the EMU in 1999. Hence, increased fiscal stringency was heaped on top of the previous year's austerity measures. Some progress was made in reducing the budget deficit in France in 1995, and the goal of the government was to reduce the public deficit to 3.6% of GDP in 1996 and to 3% in 1997—the level required by the Maastricht Treaty. The draft budget announced in September 1996 aimed to keep overall public expenditure at the same level as in the previous year. Given an inflation rate of 2%, this meant a decline in the volume of central government expenditure. Cuts in welfare spending, a reduction in the number of civil servants, virtual standstill on education spending, higher gasoline taxes, and a freeze on family allowances were the main measures introduced to reduce the deficit.

   As in 1995, cutbacks in social and welfare spending led to large-scale protests and strikes, although those in 1996 were not as widespread or prolonged. The need for larger public-sector spending cuts, which would have triggered more widespread social disturbances, was avoided by some creative accounting, including a F 37.5 billion pension-fund transfer from France Telecom to reduce the budget deficit. Among other sweeteners, the outlines of a tax-reform program were announced. This included a proposed reduction in some income taxes over a five-year period from 1997. While the stance of fiscal policy remained restrictive, as in previous years, the Bank of France continued to reduce short-term interest rates in small increments shadowing cuts by the Bundesbank in Germany. (For short-term interest rates, see Graph III—>; for long-term interest interest rates, see Graph IV—>.) Thus, after a series of cuts, the French central bank's intervention rate fell to 3.5% in the autumn—the lowest level in 20 years. The business community remained unimpressed, however, believing that commercial bank base rates were still too high, given the low level of inflation (see Graph I—>).

The Former Centrally Planned Economies.

      In 1996, following five consecutive years of decline, economic output in these nations was expected to increase by a modest half a percentage point. In 1995 the decline had moderated sharply to 1.3% after four years in which economic output had fallen by between 8.5% and 15%. The prospects for 1997 were for growth of around 4%. While progress was being made, however, real levels of GDP remained well below 1989 levels for nearly all countries, according to European Bank for Reconstruction and Development estimates. In 1996 only Poland, which had been quick to implement market reforms, had surpassed its 1989 output. In several countries, including Azerbaijan, Georgia, Moldova, and Lithuania, GDP was less than 40% of its value in 1989.

      Performance throughout the region was, as in previous years, not uniform. In Central and Eastern Europe, growth was 1.6%, compared with 1.2% in 1995. If Belarus and Ukraine were excluded, the expansion was 4.2%, reflecting a slowdown from the year before (4.9%) but nevertheless making it the third year of strong growth. The rest of the Central and Eastern European countries—except Bulgaria, which was expected to register negative growth—saw progress. A few Eastern European countries (including Poland, Romania, and Slovakia) experienced a slowdown in expansion, partly because of weaker demand in Western Europe. In Ukraine output fell by 8%, more slowly than in the previous four years. In Russia, which had a fall of only around 1%, the decline in output appeared to be coming to a halt. Both of these countries were expected to see a rise in production in 1997.

      In the Transcaucasus and Central Asia, the decline in output was halted for the first time in five years, and output was expected to rise by a symbolic 0.6%. Many of the nine countries in the region were at an intermediate stage of transition. Armenia, for the third year running, achieved growth of 5-7%, but this apparent progress followed several years of sharp contraction. Production rose by 8% in Georgia and by 6.2% in Turkmenistan. Only Azerbaijan, Tajikistan, and Uzbekistan were still registering drops in output, but the rate of decline for all three continued to fall sharply.

      Inflationary pressures eased, with consumer prices rising on average by around 40%, compared with 128% in 1995. There was no longer any sign of the hyperinflation that had been running at four and five figures in the 1992-94 period, when price liberalization first started to take place. Nevertheless, many countries remained vulnerable as governments reduced subsidies and took measures to restructure their economies.

      In Central and Eastern Europe (including Belarus and Ukraine), consumer price rises were expected to fall from 26% to 21% per annum. In Bulgaria inflation accelerated to over 70% as a result of a drop in the exchange rate that followed a collapse of confidence in the financial system. In Albania the rate rose from 8% to 12%. In the Transcaucasus and Central Asia, all countries registered sharp falls in the inflation rate, mainly from three to two digits. The average rate, which fell from 259% to 69%, was being held up by the continuing hyperinflation in Tajikistan and Turkmenistan, where the rates declined only slightly, to 633% and 904%, respectively. An IMF-supported stabilization program had been adopted in Tajikistan and was expected to bring the rate down during 1997 and 1998.

      Financial-sector reforms proceeded only slowly in 1996. The degree to which securities and nonbank financial institutions developed in 1995 and 1996 depended largely on the method of privatization and financial requirements of governments. There was an urgent need for improvements to banking systems, in particular, across the region. In most countries governments and central banks failed to provide adequate regulation, and the role of banks as providers of investment finance remained modest.

      Privatization continued to be an important element in the region's progress. Several of the countries that had reached advanced stages of transition to market-orientated economies—including the Czech Republic, Estonia, Hungary, Poland, and Slovenia—had privatized most of their industrial firms and were concentrating their efforts on the financial sector and those areas that had not been privatized earlier because they were perceived to be of strategic importance to the state. In Estonia and Hungary the focus in 1996 was on privatization of utilities and transport, with Estonia's national airline and Hungarian power companies among the enterprises coming under foreign control. In Slovenia mass privatization proceeded slowly, but by the end of 1996 three-quarters of the 1,549 companies that had completed their plans for privatization had been given approval to go ahead.

      In countries at the intermediate stage of transition, such as Albania, Bulgaria, and Romania, mass voucher-based privatization programs moved ahead in 1996. In Russia, however, the pace slowed because of political uncertainties, and in July 1996 a new privatization program was adopted by the government. Among other things, it withdrew the privileged access to ownership share previously extended to collectives and enabled regional authorities to initiate privatization.

      While considerable progress had been made in 1996, many problems associated with restructuring remained to be solved. Unemployment was an inevitable consequence of dismantling inefficient and overmanned enterprises and of improved productivity. Social protection systems in most countries were both inadequate and too expensive, needing urgent reform. It became increasingly apparent that if maximum benefits were to be derived from foreign investment, it was important that earnings be able to be repatriated and foreign investors be given sufficient legal protection in, for example, property rights.

Less-Developed Countries.

       Changes in Output in Less-Developed Countries, TableThanks to a recovery in Latin America and strengthening of growth in Africa, real economic growth (Table IV (Changes in Output in Less-Developed Countries, Table)) in the LDCs as a whole averaged 6.5%, a little higher than the previous year. Economic activity in the LDCs was underpinned by the relatively strong domestic situation and continued large foreign inward investment flows. Despite a slowdown in some Asian economies, including China and Thailand, this region grew by nearly 8%, marginally below the 1995 level. China, Malaysia, Vietnam, and Thailand produced GDP growth of 8% per annum or more. Latin America bounced back as the effects of the Mexican financial crisis faded further. Chile was the most successful economy in this region, followed by Brazil.

       Changes in Consumer Prices in Less-Developed Countries, TableInflation (for consumer prices, see Table V (Changes in Consumer Prices in Less-Developed Countries, Table)) remained under control despite continued rapid economic growth. The IMF expected the median inflation rate in 1996 to fall to 7% from the previous year's 10%. Latin America was no longer the region with the highest inflation rate. Persistently high inflation in some Middle Eastern countries pushed this region to the top of the inflation league.

      Rapid export growth in recent years had been one of the remarkable features of these countries. Since 1994 export volume of this group had expanded by more than 10% per annum, much faster than imports. Even so, there was a slight rise in the balance of payments deficits of LDCs, but the debt burden of most countries remained stable.

INTERNATIONAL TRADE AND PAYMENTS

      In 1996 the improvement in world growth was reflected in continued buoyant trade in goods and services, which the IMF projected to have risen by 6.7% over the previous year. This compared with a better-than-expected rise of 8.9% in 1995. In value terms the rise was 5.7% above 1995 at a projected $6.6 billion, with just over half being accounted for by the industrial countries. Once again the momentum in the market came from the LDCs, which provided the strongest growth markets for world exports. In value terms their imports rose by a projected 11.3%, while those of the industrialized countries increased by only 5.3%. There was a similar picture on the supply side, with exports from LDCs up 10.3% in 1995 and from the industrial countries by 4.3% (7.3% in 1995). Trade volumes in the "countries in transition" were maintained at close to the high levels of 1995, when exports rose by 12.2% (10.7% projected for 1996).

      At the first ministerial meeting of the World Trade Organization, held in Singapore in December, agreement was reached on the elimination of tariffs on information technology products and on the need to ease restrictions on the importation of textiles from LDCs.

      The shifting balance of trade toward the LDCs continued in 1996, and a value rise in exports (excluding services) of 11.2% followed a 20% rise in 1995. Goods exported from the LDCs, together with four of the Tigers—Hong Kong, South Korea, Singapore, and Taiwan—were projected at $2 billion, around 38% of all goods exported. The share had been rising steadily; in 1990 it was 32%. At the same time, however, far-reaching structural reforms, particularly trade liberalization and the removal of domestic product and financial distortions, had led to an expansion of the manufacturing sector and export capabilities in many of the LDCs. In Africa, for example, exports were expected to increase by 13% in volume (7% in value), with exports from sub-Saharan Africa rising 7.9% (5.1% in value). LDC trade continued to be dominated by Asia, with two-thirds of the LDC exports in 1996.

      Among the industrial countries, it was the seven major economies (the U.S., Japan, Germany, France, Italy, the U.K., and Canada) that saw the greatest overall deterioration, with export growth declining from 7.7% in 1995 to 3.9% in 1996. This compared with a fall from 7.3% to 4.3% for all industrialized countries. Japan saw the increase in volume of its exports tumble from 5% to less than 1%, and Germany's rate was down from 5.9% to 3.3%. Italy and Canada experienced sharp declines from the 12% growth each achieved in 1995 to around 4%. Most buoyant were the U.S. and U.K. exporters, whose sales were expected to be over 6% above the year before. Export growth of industrial countries outside the major seven grew by 5.2% overall, one percentage point less than in 1995 but substantially below the 8.7% increase in 1994. The import picture was similar for most industrialized countries, with growth dropping from 7.8% in 1995 to 5.3% in 1996. Only Japan maintained its high level; its imports were expected to increase by nearly 13%, similar to the rise in 1995.

      There was an improvement in the current-account position of many of the industrial countries, although cumulatively there was expected to be a fall in the 1995 surplus to $2.5 billion. This was because Japan's large surplus, which had for many years been a cause of controversy with its trading partners, was falling sharply. In the few years to 1995, the surplus had been in the range of $110 billion to $132 billion. From September 1995, however, it had been on a monthly year-on-year decline and was expected to end 1996 at around $6.5 billion. Elsewhere, in North America the Canadian deficit of $8 billion in 1995 was expected to give way to a small surplus. In the U.S. the current-account deficit of $150 billion was expected to have eased slightly.

      The current-account surplus of the 15 EU countries was expected to increase from $54 billion to $74 billion, with most EU countries improving their positions. Of the major countries, Germany's deficit fell slightly to around $18 billion, and in the U.K. the deficit was expected to fall from $9 billion to around $3.5 billion. France and Italy were expected to increase their surpluses to $22.5 billion and $22.8 billion, respectively. Outside Europe, Australia's deficit fell by around $2 billion to $16 billion, while New Zealand's increased to $3.1 billion from $2.5 billion in 1995.

      In the countries in transition, the trade performance was comparable to that of the LDCs. Imports rose by 12.3%, just one percentage point less than in 1995, while exports rose by 10.7% (12.2% in 1995). The continued buoyancy of trade was an important factor in attracting foreign investment and, therefore, in helping the process of restructuring.

      Direct foreign investment continued to be concentrated in Hungary and the Czech Republic, which in the period 1989-95 reached $11.5 billion and $5.5 billion, respectively. Other countries where the cumulative flow reached over $1 billion included Poland, Russia, and Kazakstan. On a per capita measure, Slovenia and Estonia ranked among the top four, along with Hungary and the Czech Republic. Social and economic stability in these countries meant, as was also the case in Poland, that the investors' perception of the relative risk was low. In Hungary and Estonia another factor affecting investors was the deliberate focus of their governments on attracting foreign investors to their privatization programs.

      In the LDCs the trade performance remained impressive compared with that of the industrialized countries. Exports increased by a projected 11.2%, with imports rising faster at 12.5%. This was, however, in marked contrast to 1995, when the increases were 19.9% and 20.3%, respectively. The slowdown in demand from the industrialized countries was partly responsible for the deceleration. A key factor was the sluggish performance of exports of electronic products from Asia, which was by far the largest trading region in the less-developed world. A 7% fall in sales of semiconductors—mainly used by the computer industry—hit the Tigers, especially South Korea, from which semiconductor exports rose 21% (year-on-year) in the first quarter, after which the rate of increase fell sharply and actually turned into a decline in the third quarter. While this problem may have been short-term—it was caused to some extent by the overstocking of semiconductors in the U.S.—the international price of memory chips had fallen sharply, and it was questionable whether it could recover fully given the overcapacity of the market. Overall export performance in Africa reflected the progress that had been made in restructuring and the increasing role of the private sector in the economy. Rising commodity prices in 1995 had led to a 14% increase in the value of exports, but the falling back in prices meant exports rose only 7.1% in 1996.

      In the LDCs the 1995 deterioration in the current-account deficit from $90 billion to $112 billion was due to the growing deficit in Asia, where some of the economies were overheating. The rapid growth in the value of exports was more than matched by import demand, which created a trade deficit of $54 billion. By the end of 1996, there were signs of greater stability in some of the economies, notably those of Thailand and Malaysia.

      Export values were up by around 10% in the Middle East, being boosted by higher oil prices. In Latin America lower commodity prices meant that in overall terms the value of exports rose much more slowly—under 10%, compared with over 20% in 1995. Venezuela benefited from higher oil prices, and Mexico's general economic recovery was export-led. (IEIS)

      This article updates economic growth; government budget; international trade.

STOCK EXCHANGES

       Selected Major World Stock Market Indexes1, TableIn 1996 the world's stock exchanges continued the bull run that got under way during the previous year and registered a 12% gain in dollar terms (15% in local currency), as measured by the Financial Times/Standard & Poor's (FT/S&P) World Index. Sustained economic growth (or recovery) and continuing low or falling interest and inflation rates, coupled with higher corporate profitability, were the main factors that drove up the world markets. Successive record-breaking performances of the Dow Jones industrial average (DJIA) also acted as a locomotive for the world bourses. Starting from a lower base and recovering from the past year's disappointing performance, Europe rose by 19%, while the Pacific markets, including Japan, lagged behind with a 3% gain (both in local currency). (See Table VI (Selected Major World Stock Market Indexes1, Table).)

      These broad gains would have been higher had it not been for a sharp correction in early December following remarks by Alan Greenspan, the Fed chairman, about "irrational exuberance" in asset markets. While most markets subsequently recovered a large part of the 2-3% fall suffered on that "Frantic Friday," they remained volatile during the closing weeks of the year. The markets interpreted Greenspan's comments as a veiled signal that the Fed would, sooner rather than later, have to raise interest rates to cool off potentially inflationary pressures. There was a similar midsummer setback on Wall Street and in other equity markets when it looked as if the U.S. interest rates were about to rise. As the Fed left the U.S. interest rates unchanged, share prices recovered and then reached record levels in many countries.

      Given Wall Street's runaway form, it was not surprising that some of the features seen in the 1980s staged a comeback. Salaries on Wall Street and to a lesser extent in London broke records, with massive bonuses for high-flying investment bankers and equity dealers. Many investment houses on both sides of the Atlantic poached each other's best staff with massive pay offers.

      The main stimulus for the U.S. market was continuing low interest rates, which made deposit accounts unattractive to investors and in turn encouraged high levels of money to flow into mutual funds. Productivity improvements leading to robust earnings growth, stock repurchase by corporations, and considerable merger-and-acquisition activity were the other main factors behind the exceptional performance of Wall Street. In Europe the rises seen during the first half of the year mirrored declining short-term interest rates in Germany and other European countries with currencies that shadowed the Deutsche Mark in the foreign exchange markets. The Japanese market was driven up early in the year by the dual stimulus to the economy of the decline in the value of the yen against the U.S. dollar and the cumulative effect of the fiscal packages introduced the year before. Foreign investors' enthusiasm for Japanese equities also propelled the Japanese market. The Japanese market came under pressure in early autumn and could not hold on to its earlier gains.

      The mixture of continued low inflation and gently declining long-term interest rates against a background of higher economic activity turned out to be a favourable backdrop to government bonds. A major beneficiary of this trend was the European Bond markets, in particular German and French bonds. (IEIS)

United States.

       Selected U.S. Stock Market Indexes1, TableThe U.S. stock market maintained a strong bullish trend in 1996 as investors, hungry for stock to buy, invested more than $104.5 billion through November, exceeding the full-year record total of $102.3 billion set in 1993, according to the Securities Data Corp. A record number of new issues, rising corporate earnings, low inflation, privatizations of overseas government entities, continued restructuring of U.S. corporations, and a strong demand for stock mutual funds combined to propel the market to record levels. Most analysts were surprised by the performance of the stock market in 1996 after the 1995 bull market, when the DJIA rose by 30%; a lacklustre 1996 had been expected. Instead, the index of leading indicators rose month by month, the value of stocks relative to GDP was at record levels, and all of the major stock indexes achieved new highs. (See Table VII (Selected U.S. Stock Market Indexes1, Table).)

       Monthly Dow Jones Industrial Average, TableThe DJIA began the year at 5200, rose to 5600 in February, climbed irregularly to 5800 in May, leveled off in June, and then dropped from 5600 to 5400 in July. It rose sharply from 5400 at the beginning of August to 6000 by the end of October, followed by a steep rise after the general election to close November above 6500. Extreme volatility reigned in December as the postelection rally vied with investor concerns over the economy. The DJIA fell almost 100 points to 6300 on December 12. One week later, on December 19, it climbed nearly 127 points. The Dow reached an all-time high of 6560.91 on December 27 but dropped more than 101 points on the final day of trading to end the year at 6448.27. (See Table VIII (Monthly Dow Jones Industrial Average, Table).)

   Selected U.S. Stock Market Indexes1, TableThe Dow was up 26% for the year. At year's end the Dow transportation index was up 14%, the utilities were up 4%, and the composite was ahead 20%. The average price-earnings ratio on the DJIA ranged from a low of 15.8 in January to 18.3 in November. The average yield was 2.28% in January and down to 2.07% by November. Many other indexes reached record highs. (See Table VII (Selected U.S. Stock Market Indexes1, Table); see Graphs VI—> and VII—>.) The S&P 500 hit 757.03 and the National Association of Security Dealers automated quotation (Nasdaq) composite index 1,316.27. The Dow utilities average achieved a three-year high at 238.12. The S&P 500 had a price-earnings ratio of 18.9, a record for a period of moderate economic recovery.

      The S&P 500 maintained a relatively steady growth trend in 1996, continuing the expansion of 1995. The index rose irregularly from the 600 level in January to 757 by the end of November before a year-end pullback to 740.74, up 20% for the year. There was a 50-point plunge in July, the worst retreat since the 1990 recession, but otherwise no untoward development. The dividend yield of the S&P 500 at 2.1% in September was the lowest of the century.

      The soaring stock market was driven by a confluence of positive macroeconomic factors—like low unemployment and stable interest-rate and inflation environments. Growth slowed from its breakneck speed early in 1996, and there were no signs of rising wage pressures. The employment cost index, published by the Labor Department, increased only 0.6% between June and September, less than in the previous two quarters. Unemployment was just above 5% during the summer and held steady to end the year at 5.3%. Bond prices soared to their highest levels in six months. A moderate slowdown was expected by most economists. Corporate profits rose sharply in 1996. Leading sectors were utilities, energy, technology, and consumer cyclical stocks. The Federal Open Market Committee kept the overnight funds rate at 5 1/4%, where it remained all year. The stability in U.S. interest rates was aided importantly by the buying of Treasury securities by foreign investors. At the end of August, this figure passed the $1 trillion mark, or 30% of all Treasuries outstanding. For the 1996 fiscal year, the federal budget deficit was $107 billion, lower than in any other year since 1981.

      Responding to the strong demand for retail sales, the number of registered representatives—licensed securities salespersons—rose to 527,000, the most in the history of the market. The Internet, which brought buyers and sellers together, was perceived as a threat to brokers. By providing information and a market, it was performing many of the functions normally performed by brokers—information, advice, and execution. A popular example of this trend was the Motley Fool World Wide Web site run by David and Tom Gardner. (See BIOGRAPHIES (Gardner, David and Tom ).)

      Investor sentiment was predominantly bullish in 1996. Consumer confidence in the economy held steady through November, according to the Conference Board Index, which indicated that most Americans were optimistic about current business conditions. Nearly one-third of all U.S. households were invested in mutual funds, either privately or through their office 401(k) plans, during 1996, according to the Investment Company Institute.

      The merger-and-acquisition market was very strong in 1996, with major developments in the telecommunications industry. British Telecom, which owned 20% of MCI Communications Corp., announced a tender offer for the remaining 80% for $22 billion. The biggest telecom mergers in 1996 were: Nynex Corp. by Bell Atlantic Corp. for $21.3 billion; Pacific TelesisGroup by SBC Communications, Inc., for $16.5 billion; and MFS Communications Co. by WorldCom, Inc., for $13.4 billion. The largest previous merger was McCaw Cellular, which was acquired by AT&T in 1993 for $15.7 billion. The British Telecom deal brought the total volume of mergers in the first 10 months of 1996 to $537 billion, up from $518 billion for all of 1995 and well ahead of the $341.9 billion in all of 1994. The trend continued in December with the much-publicized $14 billion merger of Boeing Co. and McDonnell Douglas Corp.

      The Securities and Exchange Commission (SEC) was considering a review of its net capital rules owing to the widespread use of derivatives. Net capital rules were becoming increasingly important as securities firms delved deeper in the trading of exotic securities that often required hefty capital levels. Because of the net capital rules, this business was moving overseas. The SEC began legal action to control stock promotion on the Internet. Many stock promoters were reaching unwary browsers on the net with less than the required disclosures. The SEC had about a dozen investigations pending to see if mutual funds and investment advisers improperly pocketed rebates from handling their trades. At issue were so-called soft-dollar arrangements between mutual funds and brokers who handled the lucrative business of trading for the funds. Competition for the mutual fund trading business was intense. The SEC required the mutual funds to disclose such arrangements to their shareholders in order to lessen the apparent conflict of interest. The National Securities Markets Improvement Act of 1996, a significant overhaul of the securities regulatory structure, provided for SEC oversight of investment advisers and offered consumers access to records of disciplinary action against them. The SEC changed the rules to curtail abuses of "offshore" offerings. Under Regulation S, corporations could make placements offshore without registration in the U.S. Frequently, this led to abuse as unregistered securities placed offshore went back into the U.S. market without the usual disclosures. Under the new rule, such offerings would have to be disclosed to U.S. investors. Corporations were required to detail the price, amount, and date of sale for the offering and give a general description of the purchasers.

      Securities firms had the most profitable year ever in 1996. For the first nine months, total profits before tax were $9.2 billion, more than for all of 1995. The 603 initial public offerings (IPOs) through September surpassed the record set in 1993 by 5%. At that rate IPOs for 1996 hit $46.9 billion, or 13% more than the record achieved in 1993. The total value of merger-and-acquisitions activity was on a pace to hit $496 billion in 1996. The leading underwriters in the IPO market were: Goldman Sachs & Co., Morgan Stanley, Merrill Lynch, Smith Barney, and Alex Brown & Sons for the 12 months ended Oct. 30, 1996. Through November, Bloomberg Financial Markets counted 863 IPOs, which raised a total of $57 billion. For all of 1995 there were 666 deals, with $37 billion raised.

      The yield on 30-year Treasury bonds fell from 8.16% in 1995 to 6.64% in 1996. The proportion of Treasury securities held by foreign governments, individuals, and institutional investors climbed to 30%, largely because of favourable comparative yields vis-á-vis foreign government bonds. As of October 31, long-term corporate bond yields were at 7.43%. The prime rate in the U.S. held steady at 8.25%.

   Trading volume on the New York Stock Exchange (NYSE) was a record 104.6 billion shares, up from 87.9 billion in 1995. Average daily share volume (Graph VII, bottom—>) on the Big Board was a record 412 million, with July 16 (680.9 million) and December 20 (654.1 million) being the two busiest days ever recorded. Advances exceeded declines 2,498 to 1,256, with 141 issues unchanged. Micron Technology and Iomega Corp. topped the active list, with each trading more than 1.4 billion shares. (For prices on the NYSE, see Graph VIII—>, and for numbers of shares sold, see Graph IX—>.)

      The NYSE reported that a seat had sold for $1,160,000 in August, down $287,500 from the previous sale of a seat on May 7. By December 30 the price had risen to $1,285,000. To curb some perceived abuses, the NYSE governing board took positions opposed to "preferencing dealers," where dealer orders were favoured over public orders, and payment for order flow because customers were not aware that they were getting less than the best prices.

      Volume on the American Stock Exchange (Amex) in the first 11 months of 1996 was 5,201,917,000 shares traded, up from 4,656,800,000 in the corresponding period of 1995. In a drive for increasing membership, 55 companies were persuaded to list their stocks on the Amex by the end of September, 35% more than in the comparable period of 1995. Stocks that moved from Nasdaq to the Amex showed a big decline in volatility, as measured by intraday deviations in price, from typical trading. The specialist system was credited with reduction of volatility. It was used on the Big Board and the Amex but not on Nasdaq. The Emerging Company Market, which was established in 1992 to attract fledgling companies to the exchange, was abandoned in 1996 because of adverse publicity. The Amex differed from the NYSE in two important ways; the Amex permitted the issuer to choose the specialist firm that would trade its stock, and, unlike the Big Board, it had no rule preventing companies from leaving its market at will.

      Through November volume on Nasdaq was 126,431,543,000 shares traded, up from 90,236,881,000 in 1995. At year's end 2,676 issues had advanced, 1,967 had declined, and 79 were unchanged. Once again, the microprocessor company Intel Corp. was by far the most active issue, trading nearly 2,339,000 shares. Nasdaq decided to impose tougher listing standards for companies trading on the lower-tier Nasdaq SmallCap market. The lower tier housed some 2,000 of the more than 6,000 issues. Such companies would be required to obtain shareholder permission for any significant change in the company's capitalization. They would also require at least two outside directors and an audit committee including such outside directors. Both the U.S. Department of Justice and the SEC investigations found that spreads between bid and asked prices on Nasdaq and dealer manipulation commonly found in that market were harmful to investors.

      Stock and bond mutual funds numbered more than 7,000 in 1996, representing some $3 trillion in individual and institutional accounts. There were also more than 1,000 money market funds. Equity funds had assets totaling $1,250,000,000,000 in 1996. Through September investors flooded stock funds with $179 billion, compared with $88 billion through September 1995. The average management fee climbed to 1.4% of assets, versus 1.2% in 1995. The average stock fund was up 14.06% through October 1996, while bond funds were up 3.5%. The top sector was financial services, up 19.94%. There were also more than 22,000 investment clubs and more than 4,700 hedge funds in operation during the year.

      Trading in stock options in 1996 hit a record high. The Options Industry Council said that through November, 180,693,189 options contracts had been traded on U.S. exchanges. With a month of trading left in the year, the total topped the annual record of 174,380,236 contracts set in 1995. The Chicago Mercantile Exchange (Merc) established links to exchanges in London and Paris to boost business in the increasingly competitive and global futures industry. In the U.S., financial futures such as short-term and long-term interest rates increased in volume to more than 600 million contracts in 1996.

      The Commodity Futures Trading Commission filed complaints against several grain-elevator operators that marketed "hedge-to-arrive" contracts, grain-trading instruments that generated losses of hundreds of millions of dollars across America's Farm Belt in 1996. Hedge-to-arrive contracts were designed to help farmers manage price risk. Financial disaster was caused in the summer when corn prices soared to record highs and farmers used loopholes to defer delivery under lower-priced grain-supply contracts with elevators. The rally increased the cost to elevators of maintaining their own hedges in the futures markets. Margin requirements could not be met. Some of the contracts were illegal because they were essentially off-exchange futures contracts.

Canada.

      With interest rates at 40-year lows, the Canadian stock exchanges did a booming business in 1996. In the third quarter the Canadian economy had its best spurt of growth in more than two years. GDP was at an annual rate of 3.3%, up from 1.1% and 1.2%, respectively, in the first two quarters. Exports climbed, and corporate profits were favourable. The government's drive for fiscal stringency resulted in a decline in the federal national debt, while the current-account deficit was replaced by a surplus. Canadian fundamentals included moderate growth, a 1.25% inflation rate, falling interest rates, and a rising Canadian dollar. The Bank of Canada cut interest rates continually, citing the rising Canadian dollar as the reason. It reduced rates for the 20th time in 18 months, cutting the bank rate to 3.5%, the lowest level in more than 30 years, at the end of October and dropping the prime rate to 4.75%, the lowest since 1956. The country's unemployment rate remained high, near 10%.

       Selected Major World Stock Market Indexes1, TableThe Toronto Stock Exchange index of 300 stocks (TSE 300) hit 6018.65 by the end of November. The Montreal index peaked at 3030.98, and the Vancouver Stock Exchange index rose to 1472.55. The TSE 300 ended the year up 25.7% at 5927.03 (Table VI (Selected Major World Stock Market Indexes1, Table)), Montreal was up 27.4%, and Vancouver rose 49.6%. Average daily volume for the first 11 months was 94.7 million shares. The financial sector performed best (up 50%), along with real estate (39.4%) and oil and gas (36.6%). Forest products (up 7.5%) and the metals sector (6.8%) performed poorly. Gold issues were down 4% year-to-date in November but recovered enough to manage a small gain.

      Some 15%, or 189, of the 1,260 issues listed on the TSE also were listed on a U.S. exchange. In 1995 the Toronto market handled more than 60% of the volume in Canadian listed stocks. In 1996 the NYSE share rose to 10% from 9%, and the Nasdaq stock market's share increased to 11% from 9%. It was expected that trading volume would increase, offsetting the loss in spreads in Canada. The Vancouver Stock Exchange (VSE) had corporate financings of Can$1.4 billion in its 1996 fiscal year, about one-eighth the size of the TSE. The number of listings on the VSE was 1,477 as of March 31, down from 1,527 a year earlier. The VSE embarked on a major marketing campaign focusing on its upgraded standards.

      The four Canadian stock exchanges switched from pricing stocks in eighths (like the U.S. markets) to the decimal system followed by European and Asian markets. The Canadians would quote prices in dollars and cents, with stocks priced at less than Can$5 a share priced in one-cent increments and stocks above Can$5 priced in five-cent increments. Decimalization was a popular move among investors, especially institutional investors, but some brokers were not pleased with the switch, since they feared it might cut into their trading desk revenue.

      During August the Canadian government issued inflation-adjusted bonds. Known as Canada Real Return bonds, they had interest rates adjustable semiannually for inflation. In November the Canadian government sold, at an average yield of 5.273%, a total of Can$2.7 billion 7% bonds maturing Sept. 1, 2001. Canadian bonds were up 14.2% in November compared with the same period of 1995. Investor sentiment was strongly bullish throughout most of 1996. (IRVING PFEFFER)

Western Europe.

       Selected Major World Stock Market Indexes1, TableMost European stock exchanges performed strongly during 1996 and provided a good rate of return for investors who were not deterred by the previous year's lacklustre performance. (For Selected Major World Stock Market Indexes, see Table VI (Selected Major World Stock Market Indexes1, Table).) Encouraged by prospects of further cuts in short-term interest rates, economic recovery, and improved corporate profitability, as well as higher performance in London and on Wall Street, continental bourses started the new year in good form. By the summer, average gains of 10% had been achieved on the back of a series of small cuts in interest rates. A summer consolidation and a Wall Street-induced setback were followed by a recovery and rise to higher levels. Notwithstanding Frantic Friday, the FT/S&P Euro Index of 720 leading shares was 18% up on the year. The best gains in Europe were seen in markets in Spain, The Netherlands, France, and Germany, all with at least a 20% rise in local currency since the beginning of the year. London, having strongly outperformed continental bourses in 1995, lagged behind in 1996, but a strong rise in the external value of sterling offset the relative weakness of London to the foreign investors.

 Although the Financial Times Stock Exchange 100 (FT-SE 100) in London reached a new all-time high of 4,118.5 at year-end, its overall gain lagged behind most of its European counterparts. As British interest rates were reduced by 0.5% point in two steps in the spring in response to a sluggish economy, the FT-SE 100 rose by over 150 points to a spring peak of 3,860 (Graph X—>). Corporate earnings growing in line with expectations and prospects of economic recovery, as well as buoyancy in stock markets elsewhere, were the main factors behind the rise. As evidence of faster economic activity on both sides of the Atlantic emerged in the summer, rekindling fears that higher interest rates were on the way, the market came under pressure. In the event, base rates were unexpectedly cut by 0.25% in the summer, and, contrary to expectations, interest rates remained unchanged in the U.S. Continuing good earnings figures, coupled with a strong upturn in the DJIA, resulted in a record-breaking late summer rally by the FT-SE 100. Many institutions, with strong cash positions, thanks to special dividends and share buybacks, bought back into the market, which sent it higher. The soaring London Stock Exchange was upset and the FT-SE 100 fell well below the psychologically important 4000 level when the base rates were unexpectedly raised by 0.25% in early November. Although the actual increase was small and merely restored the base rate to its June level, it signaled a turning point in the interest-rate cycle. Following a prudent budget and the continuing bull run on Wall Street, the London market rose above the 4000 territory again. Then came the sudden drop on Frantic Friday. While this turned out to be a short-lived upset, it confirmed earlier fears that the market was looking expensive at this stage in the economic cycle. Political uncertainties and the approaching general elections in 1997 also added to market uncertainty, but the FT-SE 100 recovered at year's end and eked out a rise to record territory on December 31 to finish the year with a gain of 11.6%.

      The Paris Bourse performed in line with continental Europe and rose by almost 25% during 1996. Lower interest rates offset the sluggish economy and improved corporate profitability. The CAC 40 Index benefited from Wall Street's buoyancy and followed the broad pattern set by the DJIA. A spring rally, which took the index 10% higher, was followed by a summer correction. As interest rates fell to their lowest level in 30 years in August, and inflationary pressures receded, the Paris market staged a powerful rally. In the autumn it was hit by a combination of events, including two weeks of chaos caused by the truckers strike and blockade and the abandonment of plans to privatize Thomson, the electronics and defense group. Even before Frantic Friday, sentiment was adversely affected by calls from former president Valéry Giscard d'Estaing for a devaluation of European currencies—and of the French franc, unilaterally if necessary—against the dollar.

      The Dax Index of 30 stocks in Germany performed similarly, recording a 22% gain. Compared with Paris, Frankfurt was less volatile, and during the summer it consolidated the spring gains before rising to an all-time high of 2909.91 in early December. The German market got over the slack summer period encouraged by a weaker Deutsche Mark against the U.S. dollar and indicators of faster economic activity. Sentiment also improved when the Bundesbank further eased monetary policy in August. The approval of the government's austerity budget also gave a boost to the German market. In The Netherlands, where the economy was closely linked to Germany's, the stock market was among the best European performers, with a nearly 30% rise. The presence of many international companies, in particular oil companies, which benefited from higher oil prices, pushed the Dutch market to uncharted territory in 1996.

      Some of the other bigger gains in Europe were made at the fringes of the continent. Countries such as Spain and Italy were perceived to be a net beneficiary of the moves toward the EMU. As was the case with sterling, the strength of the lira provided a better return to overseas investors. Apart from lower interest rates and economic recovery, factors common to other European countries, the Spanish market was also stimulated by the spring general election victory of the centre-right party, as well as privatization issues. Likewise, the Nordic bloc outperformed, with Sweden showing a 38% gain. Switzerland, having risen by some 23% in 1995, staged another good performance in 1996. After the weakness of the Swiss currency was taken into account, however, the 17% gain deteriorated to a 5% gain in dollar terms. The decline in value of the Swiss currency was largely attributable to record-low interest rates of 1%.

Other Countries.

       Selected Major World Stock Market Indexes1, TableAsian stock markets, having recovered strongly in 1995, made little progress in 1996. (For Selected Major Stock Market Indexes, see Table VI (Selected Major World Stock Market Indexes1, Table).) The disappointing performance of the Tokyo stock market and economic slowdown in the smaller export-driven "Tiger Economies" resulted in significant underperformance against U.S. and European markets. Apart from the relative strength of the dollar (many of the Tigers fixed their exchange rates against the U.S. currency), sluggish European and Japanese export markets adversely affected these countries. Better returns available in the major markets discouraged investors from allocating additional funds to Asian shares. The FT/S&P Pacific Index, which included Japan, increased by only 3% in local currency terms. Excluding Japan, the region's performance was up 16%, largely because of Hong Kong and Malaysia.

      The Japanese market performed well until the middle of the summer, with the Nikkei 225 Index rising 12% to 22,666.8. The market was positively influenced by the weakness of the yen against the dollar, the economic upturn, and foreign investor enthusiasm for Japanese shares. After July the market came under pressure from the economy's running out of momentum, a glut of new issues, paralysis of government policy in the run-up to the October general election, and profit taking.

      Despite more cheerful news on the economy and corporate profitability in the autumn, the recovery in the market was patchy, and the Nikkei made up for only 50% of the summer losses. Even before Frantic Friday, the Nikkei was struggling to stay above the 21,000 level. Greenspan's comments led to near panic selling in Japan, with the index down by 667 points, the biggest single-day loss of the year. Despite a subsequent bounce back, the Japanese market ended the year showing a 3% overall loss.

      Of the other larger markets in the region, Hong Kong, up more than 33%, was the star performer. Hong Kong benefited from the rising confidence about the territory's prospects after the handover to China in 1997 and a boost to the property sector from low interest rates. Hong Kong's performance was all the more impressive in view of the fact that during the first six months of the year, the stock market was in a subdued mood. Malaysia, with a gain of 23%, also went against the regional trend. Unlike Hong Kong, Malaysia was particularly strong in the first half of the year, thanks to the improved economic outlook and strong liquidity.

      Singapore disappointed investors by declining 3.5%. Although the Singapore Straits Index rose strongly during the first half, it fell back, undermined by the economy's heavy dependence on the electronics industry, where exports collapsed. Taiwan produced the best performance among the smaller markets, with a rise of 34%. Against the backdrop of confrontation with China early in the year and uncertainty during the run-up to the presidential elections, this was an impressive achievement. Indonesia and the Philippines produced reasonable gains in the region of 20%, while Thailand and South Korea declined. Thailand produced the worst performance, down by 35%, as a result of weak government and a severe recession in the property sector. The South Korean market was another poor performer, down 19%.

      Australia produced a modest gain of 10% despite a favourable response by investors on economic liberalization measures and lower interest rates. Weaker commodity prices, however, were a bearish factor. New Zealand, by comparison, performed better, with a 19% gain, on the back of economic recovery and hopes of lower interest and inflation rates.

Commodity Prices.

      Commodity prices declined during 1996, largely in response to relatively weak demand and low global interest and inflation rates. In early December The Economist Commodities Price Index was 6.5% below the level at the beginning of the year in dollar terms (13% in Sterling terms).

      The price of crude oil, which was not included in the The Economist Index, rose by 34% during 1996. From the second quarter, oil prices were on a steep upward trend and rose by 40%. In December the North Sea Brent, which serves as a global price benchmark, traded at $24 a barrel, the highest level since the Persian Gulf War. At one stage it was over $25 a barrel, but with the resumption of limited oil sales by Iraq in mid-December, oil prices moderated. Strong demand for refined products, such as heating oil, pushed up prices during 1996, as did the fact that stocks held by the oil companies were low.

      The two main components of The Economist Index, food and industrials, showed a similar overall decline of 6% in dollar terms. Bumper cereal crops, including wheat and barley, led to a steep fall in cereal prices. Sugar prices fell less sharply (15%, compared with 45%). Coffee prices also slumped as a result of overproduction and excess stock overhang. Tea prices declined but not as much. The Economist nonfood agricultural products index was largely unchanged. Performances of the main commodities differed widely. While rubber, cotton, and wool fell by 20%, 8%, and 2%, respectively, hides and timber rose by 23% and 50%. Rubber prices were hit by weak demand and excess stocks; timber prices reflected restricted shipments from Canada. Prices for hides rose partly because of the "mad cow" crisis in the U.K., which reduced supplies. Higher prices by U.S. packers also increased hide prices.

      The gold price disappointed again in 1996. Having risen by 7% to $415 per troy ounce in February, it fell back steeply. Toward the year-end it was trading at $367, 5% below that prevailing at the beginning of the year. (IEIS)

      This article updates market.

BANKING

International.

      The banking industry was rocked by accusations that banks in Switzerland had concealed extensive World War II gold trading with Nazi Germany and that Swiss banks had deliberately hidden the deposits of Holocaust victims (mainly Jews). Jewish groups claimed that the banks held billions of dollars in assets, which they had prevented Holocaust survivors and their heirs from collecting, often by demanding unobtainable proofs and official documents, including original bank books and death certificates for those killed in the concentration camps. Swiss officials argued that no more than a few thousand dollars had been identified, but, under pressure from U.S. Sen. Alfonse D'Amato, the Swiss Bankers Association agreed to join with Jewish organizations to investigate the claims. A seven-member commission, headed by former U.S. Federal Reserve Board (Fed) chairman Paul Volcker, was expected to make its report in 1998.

      Many Eastern European countries suffered banking crises in 1996, notably the Czech Republic, where the Czech National Bank stepped in to take over Agrobanka Praha (the nation's largest privately owned bank and the fifth largest overall) in September. More than two dozen people were charged with fraud, including five top financial officials charged in connection with the failure in August of Kreditni Banka Plzen (the country's sixth largest), with losses of close to $500 million. Twelve smaller banks had also been liquidated or placed under forced administration during the past three years (six in 1996 alone) because of fraud or excessive loan losses. On August 1 a new regulation come into force, aimed at improving bank security. In October the Prague government announced plans to reorganize the largely state-owned industry and privatize the four largest banks. In the first half of 1996 alone, 145 Russian banks had their licenses withdrawn, while new regulations were also introduced in Romania, Bulgaria, Lithuania, and Latvia.

      In Japan, after 15 bank failures in a two-year period, the government allowed Hanwa Bank Ltd. to close. This was generally perceived as an indication that the government was at last dealing with the industry's underlying problems of bad loans and overvalued land assets. Meanwhile, Japanese banks remained atop the list of the world's largest, led by Tokyo-Mitsubishi Bank, a $738 billion financial institution formed by the merger in April of Mitsubishi Bank and Bank of Tokyo.

      At the other end of the spectrum "microbanking," which sought to help poor borrowers by providing loans of very small amounts, had become extremely successful in Bangladesh and elsewhere. (See Sidebar (BANKING: Microbanking ).) In Canada Native Indians and Inuits were expected to gain from the creation of the First Nations Bank of Canada, a joint partnership between Toronto Dominion Bank and a federation of Saskatchewan native chiefs.

      Major privatizations continued in several countries, including Australia, Brazil, Venezuela (which offered stakes in the country's two largest banks), and Austria (which finally accepted bids on Creditanstalt Bankverein, more than six years after announcing its privatization plans).

      The British banking industry was shaken in July by the apparent suicide of Amschel Rothschild, chief executive of asset management and investment for the London branch of the Rothschild dynasty and heir apparent to the family's global banking operations. In December Michael Bruno, a chief economist with the World Bank in Washington, D.C., and the former hyperinflation-fighting governor of the Bank of Israel, died. (MELINDA C. SHEPHERD)

United States.

      Wearing flowered, open-necked shirts and sipping colourful cocktails, bankers attending the 1996 gathering of the American Bankers Association in Honolulu toasted a year of record profits. Back on the mainland, their stockholders were also celebrating. U.S. banks earned more than $50 billion in 1996, a new record, and their stock prices soared. Money-centre banks led the way, with the value of their shares increasing by nearly 50% for the year, more than twice the increase in the Standard & Poor's 500. Just eight years earlier the U.S. had been on the brink of a recession, the savings-and-loan crisis was becoming a scandal, and the banks' sizable commercial loan portfolios were falling apart. What changed? First and foremost, the economy. Low interest rates meant strong profit margins on loans and healthy returns on government bonds, both key sources of bank earnings. Commercial loan volume soared, fueled by an explosion in merger-and-acquisition activity. Syndicated loans—big multibank loans to companies—topped $1 trillion in 1996, a new record.

      U.S. banks continued to become increasingly shareholder-oriented and to focus their attention on the bottom line, boosting investments in back-office technology while encouraging consumers to bank by telephone and automated teller. Efficiency ratios, which measure how much a bank spends for every dollar of additional revenue it brings in, improved to their lowest level since the 1950s.

      Many banks used excess cash to launch major stock buybacks, which in turn helped boost their share prices. New York City-based Chase Manhattan Corp., the country's biggest bank, and San Francisco-based BankAmerica Corp., the third biggest, offered multiyear options packages to all full-time and most part-time bank employees, joining a small but growing cadre of companies in other industries that used stock options as performance incentives.

      Although consolidation in the industry, which set a record in 1995, eased a bit, two of the biggest deals in banking history happened in 1996. In January San Francisco-based Wells Fargo successfully completed its $11.6 billion hostile acquisition of in-state rival First Interstate, the largest bank merger ever. In late August Charlotte, N.C.-based NationsBank Corp. stunned rivals with an $8.7 billion acquisition of St. Louis, Mo.-based Boatmen's Bancshares, the third largest bank deal on record.

      In December Citicorp engaged in unsuccessful talks to acquire American Express, a transaction that, if completed, would have been the largest merger in U.S. history, worth more than $25 billion. The deal would have had the potential to reshape the financial services landscape, uniting the nation's leading provider of revolving credit (Citicorp) with the leading provider of nonrevolving credit (American Express) and creating an international investment-management powerhouse, with operations in well over 100 countries.

      Banks did face several obstacles in 1996, including worrisome losses in their credit card portfolios. Credit card delinquency rates, which measure the percentage of payments more than 30 days late, hit 3.66% at midyear—a new record—before tapering off slightly. Meanwhile, personal bankruptcies topped the one million mark for the first time. Even as they were writing off credit card loans worth tens of billions of dollars, however, banks were pocketing hefty earnings on those same portfolios, collecting record spreads between their cost of funds and what they charged consumers in credit card interest. Nevertheless, credit cards were the number one item on analysts' worry lists for 1997, with some predicting dire consequences in the event of a national recession.

      Bankers also failed to persuade Congress to repeal the Glass-Steagall Act, the Depression-era law separating commercial and investment banking. In 1987 the Fed began granting some banks the power to underwrite stocks and corporate bonds—taking advantage of a loophole in the 1933 law—but it had imposed severe constraints on how significant their involvement in those activities could be. As 1996 drew to a close, the Fed responded to Congress's inaction by dramatically raising the cap on investment-banking activity. Bankers hailed the move but vowed to continue their legislative battle in 1997. (STEPHEN E. FRANK)

      This article updates bank.

LABOUR-MANAGEMENT RELATIONS

Europe.

      In Europe a generally high level of unemployment continued throughout 1996. In January the president of the European Commission, Jacques Santer, proposed a "confidence pact for employment," which, while emphasizing the need for sound economic policies, also stressed the value of the European Union's single market and infrastructure policies and modernization of the labour market.

      In addition to unemployment, there were other important issues engaging governments and labour and management organizations in several countries. One not confined to Europe was concern about the heavy costs of the social security arrangements developed over the years, particularly pensions, health care, and unemployment benefits, with labour unions striving to prevent cutbacks proposed by governments. A second problem arose from the plan for economic and monetary union (EMU) in 1999. After this had been decided in the Maastricht Treaty, there was doubt as to the desire of various member countries to join and their ability to satisfy the stringent criteria laid down for entry relating, notably, to public deficits, price stability, long-term interest rates, exchange-rate stability, and independent central banks. By 1996, however, it had become apparent that a substantial number of member governments had decided in favour of entry and that several of them would have to follow tough economic and expenditure policies to satisfy the entry criteria. In some of the countries, the proposed policies provoked union-led demonstrations during the year.

      Though no major initiatives concerning labour relations were launched by the European Commission, the year was not uneventful. For example, using the special procedure agreed upon at Maastricht, European employer organizations and unions reached an agreement concerning parental leave and asked the Commission to propose it as a directive, which was duly effected. And the European Works Council Directive, requiring many multinational companies (except most of the British ones, on account of Great Britain's opting out of the Maastricht social policy) to set up consultative bodies for their workers in member countries, became effective in September.

      Two noteworthy disputes in Britain were mainly in the form of repeated short stoppages of work. One, involving London Underground train drivers, concerned wages and working hours and was settled by an agreement to reduce the workweek to 35 hours by 1998, with pay increases over the intervening period at less than the rate of inflation. The other was in the Post Office's Royal Mail service and concerned flexible working practices and pay structure. Both disputes caused some irritation to the public and led the government to announce that it was considering legislation that would cause unions striking in "essential" public services to lose their immunity from legal action for damages, even if a prestrike ballot had been in favour of a strike. It was recognized that it would be difficult to produce workable legislation to this effect. One question that particularly exercised the British labour movement during the year was the desirability of a national minimum wage. Though the government and employers generally saw no virtue in this, both the unions and the Labour Party were committed supporters. The party's intention was to set up a commission that, when the party came to power, could make recommendations concerning the amount of such a minimum. The unions, however, generally supported a target figure of half the median male earnings (at present £ 4.26 an hour). The two views clashed at the Trades Union Congress (TUC) conference in September when, eager to avoid disharmony that might hurt the Labour Party's chances in the upcoming general election, the TUC insisted on maintaining the union viewpoint but also supported the establishment of a commission on minimum wage, which would name a figure.

      In January the German government, unions, and employers agreed on a program for the economy aimed at increasing investment and jobs. It envisioned substantial reductions in public expenditure and changes in social security contributions and arrangements for early retirement. Implementation was going to be difficult, but with future entry into the EMU in mind, as well as Germany's weakened competitiveness, the government decided to press on with its proposed reforms, which also included pay freezes for government workers and for unemployment benefits, together with other measures to reduce public expenditure. A sticking point in the negotiations was the unions' unwillingness to accept cutbacks in Germany's generous sick-pay scheme, from 100% to 80% of wages. In the metals industry, the union argued that the industry's sick-pay arrangements were contractual and could not be broken because of a change in government policy. The chancellor then made it known that in his view contractual arrangements did indeed have precedence in this case, and the metal employers agreed to deal with the matter in their forthcoming round of negotiation. In December negotiators agreed to keep workers in Lower Saxony on full pay during sick leave for five years.

      In Belgium tripartite talks aimed at reducing unemployment, improving competitiveness, and moving to meet the criteria for entry into the EMU resulted in an agreement in April, which one of the two major union confederations—the socialist-inclined Fédération Générale du Travail de Belgique (FGTB)—did not ratify. The government then decided to legislate, again in consultation with the unions and employers organizations. Again the FGTB disassociated itself from the proposals, but the legislation was approved by Parliament on July 26. Its most unusual feature was a reform of the wage-determination system, requiring that the maximum annual wage increase not be more than the average increases in the neighbouring countries of France, Germany, and The Netherlands. The minimum level of increase would be indexed to the Belgian rate of inflation, and agreements would run for two years. A procedure was laid down for negotiation, with the government mediating a decision if the parties could not agree. The central deal would be followed by industry-sector and company-level negotiations within the framework established. Subsequent negotiations proved difficult.

      On January 25 the Spanish employers organizations and the main trade union centres finalized an agreement providing for compulsory mediation of several types of labour disputes. The mediator was to be chosen from a list maintained by the parties and would be given a maximum of 10 days to propose a solution. While the parties would be free to reject the mediator's proposal, they might then call in an independent arbitrator, who would make a binding decision. A new health and safety law came into force in February. It gave workers the right to stop work if they believed there to be a serious and imminent risk to their health or safety.

      In Portugal a central agreement for 1996 was made in January by the government, employers organizations, and the trade union confederation. It provided a general increase in wages, contractual annual bonus payments, increased government help for the unemployed, and a phased reduction of the normal working week to 40 hours.

North America.

      On August 20 U.S. Pres. Bill Clinton signed a bill raising the U.S. federal minimum wage to $4.75 an hour, effective October 1, the first increase since 1991. A further increase to $5.15 an hour was scheduled for Sept. 1, 1997. The Teamwork for Employees and Managers Act, which would have effectively repealed section 8(a)2 of the National Labor Relations Act (1935), which forbade the establishment of employee groupings that were dominated by the employer, was vetoed by President Clinton on July 30. There were not enough votes in favour of the bill in Congress to override the veto.

      The most important collective bargaining of the year took place in the automobile industry. The United Automobile Workers (UAW) union first focused on the Ford Motor Co., where it secured a range of improvements including a strong job guarantee (guaranteed minimum employment floor of 95% of current covered jobs) and an up-front lump-sum payment of $2,000. An agreement with Chrysler Corp. containing similar job-security provisions followed. Finally the union turned to the General Motors Corp. (GM), which was the most difficultly placed of the "big three" in that it believed it needed to eliminate a considerable number of jobs. Agreement was reached on November 2, however, and it also included a measure of employment protection. The negotiations were concluded without any full-scale strikes (though two GM plants went on strike in the late stage of the GM-UAW negotiations). Canada, on the other hand, experienced a three-week strike in its GM factories—which also caused layoffs in some U.S. plants—before all of the companies and the union reached agreement.

Australia.

      For more than 90 years, Australian labour relations centred on a system of federal and state tribunals to which unions and employers took their claims and responses. From 1983 to 1996 the system also depended heavily on the series of "accords" made between the Labor Party government and the Australian Council of Trade Unions (ACTU). An era ended when a Liberal-National Party coalition came to power in March. The new government lost no time in presenting its Workplace Relations and Other Legislation Amendment Bill. It proposed a system of Australian Workplace Agreements in which employees could appoint a bargaining agent (which might, but need not, be a trade union) to negotiate on their behalf, or they could also negotiate individually. A new public official, the employment advocate, would be available to advise employees and employers. Limitations were proposed on the right to strike. The powers of the federal tribunal, the Industrial Relations Commission, would be reduced, though it retained many of its functions and was expected to provide a safety net of minimum conditions. The government gave a guarantee that workers would not be worse off as a result of the legislation.

      The bill was strongly opposed by the unions, the Labor Party, and the Australian Democrats in the Senate, who were in a position, together with the Labor senators, to block it. In an agreement between the government and the Senate Democrats made in October, however, the government made sufficient concessions to permit the bill to become law without further opposition by the Democrats. (R.O. CLARKE)

      See also Business and Industry Review .

      This article updates organized labour: trade unionism (organized labour) and industrial and organizational relations (industrial relations).

CONSUMER AFFAIRS

      In November 1996 governments and nongovernmental organizations from around the world gathered in Rome for the United Nations Food and Agriculture Organization's (FAO's) World Food Summit. The conference identified policies needed at the national, regional, and international levels to alleviate global hunger and malnutrition. Its aim was to motivate government departments to tackle major global problems related to nutrition and the sustainability of the food supply.

      As part of World Consumer Rights Day 1996, on March 15, Consumers International, a federation of 215 consumer organizations in more than 90 countries, issued a booklet, entitled Safe Food for All, that discussed crucial food concerns throughout the world, including agricultural trade policies, advertising, and issues of scarcity. The UN Environment Programme used the booklet as part of its global campaign to educate consumers on various aspects of food production and consumption and their impact on the environment.

      Concerns about food safety became headline news in 1996 as consumers across England and much of Europe stopped buying English beef because of fear of bovine spongiform encephalopathy (BSE), or "mad cow" disease. An international furor occurred after several young people died of a new strain of Creutzfeldt-Jakob disease, which was thought to be related to BSE, and consumer groups demanded that governments make more rigorous efforts to eliminate BSE from the food chain.

      The genetic manipulation (or modification or engineering) of food was another major food issue of 1996. Generally, this aspect of biotechnology refers to such processes as transferring genes from one organism to another—for example, from bacteria to plants or from humans to cows. One important application is the creation of pest-resistant crops. The genetic manipulation of everyday foods became an issue of increasing concern by consumers during the year as, for the first time, supermarkets in many countries stocked genetically engineered tomato paste and cheese. Genetically modified soybeans were expected to enter the European market by the beginning of 1997.

      Consumer organizations were insisting that products created by genetic manipulation be rigorously monitored and properly labeled and that consumers understand the pros and cons of food that had undergone such processes. Few regulations requiring labeling of most genetically engineered food currently existed on national or regional levels. In October the World Health Organization and the FAO held an expert consultation on food safety and biotechnology in an effort to determine basic policies on both of these issues.

      Western European consumer groups heavily lobbied the European Commission to pass strict laws on the labeling of genetically modified foods. The Commission was expected to pass regulations by the end of 1996.

      In Central and Eastern Europe, as well as in the countries of the former Soviet Union, the dumping of poor-quality and mislabeled food from other countries was the major consumer concern in 1996. At the same time, however, many consumers in those regions believed that foreign food was better than the domestic offerings, which thereby undermined the local producers. A similar problem in the region existed in regard to pharmaceuticals. Medicine was commonly available on the black market, and people thus were able to prescribe for themselves. Aggressive marketing heavily influenced citizens, who, less aware of the influence of advertising than their Western counterparts, tended to believe advertisers' promises.

      Consumer groups were tackling these issues in a variety of innovative ways. In Poland, for example, a consumer group issued an information packet that looked identical to a box of aspirin. Entitled "Med-Sense," it contained leaflets on common medications and ways in which consumers could assert their rights.

      In Latin America and the Caribbean, consumer organizations focused on obtaining access to basic goods and services for vulnerable consumers as well as on ensuring that consumers played an active and critical role in decision-making and legislative processes. A major area of concern during the year was consumer input into the operation of newly privatized public utilities. The British Overseas Development Administration in 1995 began funding a two-year organizing, training, advocacy project in Argentina, Brazil, Chile, Colombia, Mexico, and Uruguay to empower Latin-American consumer organizations to represent the consumer on matters related to public utilities.

      Many countries in Asia and the Pacific deregulated and liberalized trade and services to meet the challenges of the global market. But increased choices for consumers did not come in tandem with adequate market rules and controls. In many countries policies governing quality and safety were nonexistent or not enforced. Fast-track development such as indiscriminate logging and unplanned housing and road construction caused serious environmental problems. In the South Pacific consumers grappled with the problems of toxic-waste dumping and the poor quality of foodstuffs, pharmaceuticals, and other products.

      In response to such problems, the consumer movement continued to flourish. Consumers International's Asia office held the first-ever joint meeting with the China Consumer Association on the subject of consumer complaints and law. Considerable growth occurred in India, where more than 700 consumer organizations were operating. Western Samoa passed its first consumer protection legislation.

      The Model Consumer Protection Law for Africa was launched in 1996. The law marked a milestone in the development of the consumer movement on a continent where only two countries (Zimbabwe and South Africa) had small claims courts and only a handful had adopted legislation conforming to the 1985 UN Guidelines for Consumer Protection. (ALINA TUGEND)

      In February the U.S. Congress passed and Pres. Bill Clinton signed into law the most wide-ranging reform of the nation's telecommunications laws since 1934, promising consumers a new level of price competition and a wider array of services through the telephone, television, and computer. Amid many complicated provisions, a basic goal of the reforms was to dismantle regulations that gave the seven regional Bell phone companies monopoly control over their respective local service areas. Although consumers had been able to choose from various long-distance companies since the partial breakup of the phone monopoly in 1984, such competition was not allowed for local phone service (except for relatively expensive cellular offerings). Meanwhile, the Bells were not allowed to compete in the long-distance or the cable television markets, so additional competition and innovation were quelled there. The new Telecommunications Act freed the Bells to offer long-distance service to their customers, providing they opened their local markets to competitors such as the long-distance carriers and cable companies. The main issues remaining were how quickly anticipated consumer benefits would accrue and who would be left behind.

      Health care as a consumer issue continued to provoke legislative attention in the U.S., at both the federal and state level. Federal mandates for minimum maternity stays in hospitals were signed into law. Concerns about access to health insurance prompted federal reforms that guaranteed "portability." For example, people who had insurance at a previous job were promptly eligible for coverage at their next job, regardless of preexisting medical conditions. Health insurance consumers were also offered a new tax incentive to facilitate their financial control over health care in a pilot program that allowed them to buy less-expensive, high-deductible insurance policies and keep the tax-free savings in so-called medical savings accounts for their future medical spending. At the state level campaigns by provider and consumer groups focused attention on the growing managed-care insurance industry. Some 33 states enacted laws regulating managed-care plans, largely aimed at practices designed to limit patient care. These included laws prohibiting or restricting contractual "gag clauses," which limited what physicians could tell patients about treatment options under their plans; laws guaranteeing access to specialists; and reform of methods for reviewing doctors' practice patterns.

      Twenty-four states' attorneys general asked the U.S. Supreme Court to uphold the states' powers to limit the late fees that credit-card companies charge consumers. The court ruled in early June, however, that national credit-card companies can charge the maximum allowable fees applicable within the state where each credit-card company is based and thus were not subject to rate restrictions in other states. Some consumer groups argued that banks would begin charging consumers higher rates. Industry observers noted, however, that vigorous competition kept such fees to a minimum, regardless of the court's sanction.

      The U.S. Food and Drug Administration approved olestra, the first calorie-free fat substitute. The approval limited its use to potato chips and other salty snacks, but the manufacturer of olestra, Procter & Gamble, wanted approval eventually for a wider range of foods. Some medical experts, including five members of the Food and Drug Administration's advisory panel that recommended approval, raised concerns about olestra's side effects, especially possible detrimental nutrient loss, particularly in children. Procter & Gamble's safety studies were criticized as too limited in scope.

      Gasoline prices temporarily rose to the highest levels since the Persian Gulf War in 1991, which prompted several consumer groups and politicians to call for a federal investigation of the pricing practices of oil companies. This overlooked the fact, reported in April by the American Petroleum Institute, that gas prices were about half what they had been when government price controls were first lifted in 1981. As a result of deaths and injuries to children and frail adults caused by air bags, the National Highway Traffic Safety Administration proposed in December that car makers be authorized to reduce the air bag inflation power by 20-35%. (PETER L. SPENCER)

      See also Business and Industry Review: Advertising (Business and Industry Review ); Retailing (Business and Industry Review ); The Environment (Environment ).

▪ 1996

Introduction

Overiew

       Real Gross Domestic Products of Selected OECD Countries, TableIn 1995 the world economy experienced another year of robust growth. According to International Monetary Fund (IMF) estimates, total output expanded by about 3.5%, largely unchanged from the previous year's level, which in turn was the best performance since 1988. This strong overall performance, however, disguised a pronounced slowdown in the developed countries as a group. (For Real Gross Domestic Products of Selected OECD Countries, see Table I (Real Gross Domestic Products of Selected OECD Countries, Table).)

      The pace of economic expansion in the developed countries slowed to an estimated 2.5% in 1995 from the previous year's 3.1%. Measures taken in 1994, which included preemptive rises in interest rates to prevent an upturn in inflation and higher taxes to rein in budget deficits, contributed to this moderation, as did turbulence on foreign exchange markets. Growth moderated most in those countries where the recovery had been strong and long established. Thus, U.S. growth fell back to 2.5% (4.1% in 1994) as interest-sensitive sectors, including residential investment and consumer consumption, reacted adversely early in the year before recovering later on. Because of its close links with the U.S., Canada experienced a similar moderation in growth. In Australia and New Zealand the economic growth rate also slowed sharply. In Europe, with the exception of the U.K., the slowdown was fairly mild. In the U.K. the rate of economic growth moderated from 4% in 1994 to 2.7% in 1995. The Japanese economy did not pull out of the long economic slowdown, despite the government's introduction of several packages to stimulate activity in both 1994 and 1995. The deflationary effect of the appreciating yen prevailed for most of the year, as did a lack of confidence in the financial system since the high (often overvalued) prices of real estate and other assets of the 1980s collapsed. Economic output in Japan in 1995 expanded at 0.5%, the same rate as in 1994.

       Real Gross Domestic Products of Selected OECD Countries, TableOnce again, the economies of the less developed countries (LDCs) grew much faster than those of the developed countries (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). Total growth at 6% was twice as fast as in the developed countries. As this growth rate exceeded the birthrate, there was a small gain in living standards. Regionally, Asia, led by China, experienced the fastest economic growth. The economic growth rate in Latin America slowed rapidly as a result of the financial crisis in Mexico (see Mexico, the Painful Changes (Spotlight: Mexico, the Painful Changes )), which led to the introduction of stabilization measures in the region. By contrast, there was a welcome pickup in economic activity rates in Africa and the Middle East.

      Exchange-rate instability was an important development that produced a negative impact in the early part of the year. The Mexican crisis, which started in December 1994 with the collapse of the peso, had repercussions outside the region. Initially, there was an outflow of capital funds from many LDCs as the weakening of investor confidence led to reassessment of investment risk in those countries. This was accompanied by wider but short-lived exchange-rate volatility among the exchange rates of LDCs.

 The Mexican crisis coincided with concern in the international markets about the large balance of payments deficit in the U.S. and uncertainty relating to the future direction of interest rates in the U.S., Japan, and Germany. This led to a sharp decline in the value of the U.S. dollar against the Japanese yen and the Deutsche Mark during the first half of 1995. The yen appreciated by 15% against the dollar and the Deutsche Mark by 9%. The other European currencies that were closely tied to the Deutsche Mark appreciated similarly. However, as a result of coordinated intervention by central banks and lower interest rates in Japan, the U.S., and Germany, the misalignment of the key currencies had been adjusted by the autumn. By that time the yen, for example, which had strengthened from 100 yen to the dollar to 80 yen to the dollar, had receded back to the level it had at the beginning of 1995. (For Effective Exchange Rates of selected currencies, see Graph V—>.)

  As economic growth slowed, central banks in North America and Germany changed their previously counterinflationary stance and allowed short-term interest rates (Graph III—>) to fall. (For long-term rates, see Graph IV—>.) The German Bundesbank cut its discount rate by 0.5% as early as March. Japan followed suit by cutting its interest rates twice to curb the strength of the yen. A 0.75% cut in April was followed by a further 0.5% reduction in September. This took the Japanese interest rates to a record-low 0.5%. In the U.S. the Federal Reserve Board (Fed) cut the Fed funds rate by 0.25% to 5.75% in July, which enabled a similar reduction in the banks' prime rate to 8.75%. On December 19 the Fed announced another 0.25% cut, and the prime fell accordingly to end the year at 8.5%.

      In the U.K. a 0.5% increase in February was the last increase in this cycle and meant interest rates peaked at 6.75%. A faster-than-expected slowdown in the British economy led to a change of attitude in the summer and heightened expectations of an interest-rate cut early in 1996. In contrast to the relaxation in monetary policy, many governments in the developed world continued to reduce their budget deficits. This meant another year of tight government spending and tax reforms instead of tax giveaways. Partly as a result of the prior year's measures to rein in public spending and higher revenues arising from taxation and continued economic recovery, budget deficits in many countries narrowed. In the U.S. the deficit for the 1994-95 fiscal year (ended October) narrowed to $164 billion, the smallest gap since 1988-89 ($203 billion the year before). The administration of Pres. Bill Clinton bowed to pressure from the Republican-controlled Congress, however, and agreed to the principle of a balanced budget over the next seven years, although the exact details of how this was to be achieved remained unresolved at year's end.

      In the U.K. progress was slower than expected, and the public-sector deficit narrowed to £29 billion, £7 billion less than the year before but £ 6 billion above the target set in November 1994. This slippage effectively deferred the projected date of a balanced budget by a year to 1997. An austerity package of reduced public spending, higher taxes, and social security reforms proposed by French Prime Minister Alain Juppé caused widespread discontent and strikes. A key aim of this package was to reduce the public-sector deficit to 3% of gross domestic product (GDP) by 1997 in order to meet the convergence criterion stipulated in the Maastricht Treaty. Good progress was made in Germany as well as in other countries, including Italy, Canada, Spain, and The Netherlands, in reducing public-sector deficits. Japan once again went against the trend. To stimulate the flat economy, the government announced three packages containing a mixture of tax cuts and higher public spending. To pay for the proposed spending, the government issued additional bonds. This added to the public-sector deficit, which was heading for 4% of GDP in 1995-96.

       Standardized Unemployment Rates in Selected Developed Countries, TableEmployment growth was disappointing in 1995, and the rate at which jobs were created slowed in both North America and Europe. Although there was a reduction in the average unemployment rate (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) in countries belonging to the Organisation for Economic Co-operation and Development (OECD), to 7.9% from 8.1% in 1994, this meant that 33.6 million people were searching for work in OECD countries during 1995. The official figures excluded those who failed to register as unemployed because of poor prospects or because they believed they were too old or lacked necessary skills.

      In Japan the unemployment rate, at 3.2%, remained the lowest among developed countries, but it was up from the 1994 rate of 3%. In the U.S. continuing economic recovery reduced the unemployment rate, which at the end of 1995 stood at 5.6%, compared with 5.8% a year earlier. Europe still had the highest rate of unemployment and the slowest job-creation rate. The average unemployment rate in Europe, at 11.1%, barely improved from the previous year's 11.3%. The highest unemployment rate was in Spain, at about 22%, only a slight improvement on the 24% rate in 1994.

  Consumer Prices in OECD Countries, TableInflationary pressures remained subdued in most regions and countries. In OECD countries, with the exception of Turkey and Mexico, average inflation for 1995 was about 2.5%, compared with 2.2% in 1994. (For Consumer Prices in OECD Countries, see Table II (Consumer Prices in OECD Countries, Table); for Inflation Rates in selected countries, see Graph I—>.) No significant upturn was expected in the near future. The median inflation rate moderated to 8% in the LDCs (11.5% in 1994). By region, Latin America, the Middle East, and Europe continued to experience above-average inflation rates.

 World trade remained buoyant during 1995 and expanded at a rapid pace of 8%, close to the rate in 1994. The strength of world trade was largely due to increasing trade between the developed countries and recovery of trade in the former communist countries in Europe. Large regional trade surpluses and deficits remained. Despite some improvement in the U.S. because of the economic slowdown and currency appreciation, a large deficit of about $200 billion remained. In Japan the trade surplus narrowed in yen terms but was largely unchanged in dollar terms at about $145 billion. (For Industrial Production in selected OECD countries, see Graph II—>.)

      With the exception of Africa, the IMF expected the debt burdens of the LDCs to remain manageable. As a result of a large proportion of capital inflows being non-debt-creating, the overall debt levels of LDCs was rising gently. Although in absolute terms their debt was rising, as a proportion of exports of goods and services, it was declining.

NATIONAL ECONOMIC POLICIES

United States.

       Real Gross Domestic Products of Selected OECD Countries, TableEconomic growth slowed sharply in the first half of 1995, but a recovery in the second half put the U.S. economy on a sustainable growth rate. GDP (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)) for the year as a whole expanded at about 2.5%, down from 4.1% the year before, which in turn was the best performance for a decade. In view of the slowing economy and the relatively low inflation rate, the Fed cut short-term interest rates by 0.25% in July, signaling an easing in its tight money policy.

      The slowing of the U.S. economy early in 1995 was largely due to the reaction of interest-sensitive sectors—residential investment and private consumption—to the rise in interest rates over the previous 18 months. Consumer spending fell by 3.4% in the opening quarter, led by a slump in automobile sales. Retail sales were also weak. As longer-term interest rates fell in the spring and the effects of the higher taxes introduced in the November 1993 budget dissipated, spending recovered, ending the year 2.6% up (3.5% in 1994). Retail spending at Christmas proved to be a disappointment, which indicated shaky consumer confidence. Government spending recovered in the second half of the year, reversing declines recorded in the opening quarter.

 Industrial production (Graph II—>) mirrored the trend in domestic demand. As demand weakened, manufacturers reduced output to prevent an excessive buildup in inventories. After four months of decline, output stabilized and rose in the second half of the year, registering a 2% gain for the year as a whole. Likewise, capacity utilization, having reached a 15-year high of 85.5% in January, fell back to below 83%.

      For the second year running, nonresidential investment climbed at a double-digit rate, encouraged by healthy corporate profits, high-capacity utilization, and a drop in long-term interest rates, as well as by good export prospects. Residential investment did not fare so well and fell after a strong gain in 1994.

       Standardized Unemployment Rates in Selected Developed Countries, TableThe labour market improved in the autumn, but job creation remained relatively low. Payrolls grew by a monthly average of 226,000 in the first quarter, 82,000 in the second, and 114,000 in the third. As in past years, most of the new jobs were in low-paid, part-time service sectors. From a peak of 5.8% in April, the unemployment rate (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) improved in the summer and autumn and stood at 5.6% in November.

  Against the background of economic slowdown, inflation remained subdued. Year-on-year inflation (Graph I—>) moderated to 2.6% at the end of December from a two-year high of 3.2% in May. The rise in the inflation rate earlier in the year was largely due to the decline in the external value of the dollar (Graph V—>). Wages and salaries grew by an average of 3% during 1995. This meant there was hardly any real growth (inflation adjusted) in the take-home pay of most employees.

      After a slow start in early 1995, export growth picked up and expanded by about 9% for the year as a whole. Export growth was largely due to the strong demand from industrial countries and LDCs, with Asia leading the way. The lower value of the dollar early in the year also boosted exports during the summer and autumn.

      Once again, imports grew faster and the trade deficit widened. The current-account deficit (which includes trade balances on invisible and capital movements) was expected to rise by a record $176 billion, up from $151 billion the year before.

   Consumer Prices in OECD Countries, TableEconomic policy during 1995 was characterized by two main features: the easing of the Fed's monetary policy and disagreement between Congress and the Clinton administration on future spending cuts and tax reform. Given the sharp economic slowdown earlier in the year, coupled with low inflationary pressures and a money supply expanding at the low end of the target range, the easing of monetary policy was a relief to businesses and consumers (Table II (Consumer Prices in OECD Countries, Table)). Following the 0.25% reduction in the Fed funds rate to 5.75% in July, banks cut their prime rates by 0.25%, to 8.75%. Late in the year both rates were cut another 0.25%. Further reductions in interest rates during 1996 were widely expected. (For short-term rates, see Graph III—>; for long-term rates, see Graph IV—>.)

      In contrast to an easier monetary policy, there was a move toward a tighter fiscal policy. The budget planned by the Clinton administration in February intended a nominal fall in the real value of the budget deficit. The Republican-controlled Congress passed a budget resolution to reduce spending over the next seven years on various federal programs, however, including social security, Medicare, and Medicaid. Tax cuts of $245 billion were also proposed. It was claimed that this proposal would have balanced the budget by the year 2002. Clinton subsequently proposed an alternative plan, to balance the budget in 10 years. The differences between the two proposals proved difficult to resolve, and the new fiscal year started without an agreement. With presidential elections due in 1996, neither side wanted to back down first. Following a partial shutdown of some government services in mid-November and the furloughing of some 800,000 "nonessential" federal employees, a compromise was reached to balance the budget in seven years, but it failed to hold. Another shutdown in December left 280,000 government workers idle and thousands of contractors without pay. Clinton and the Congress remained at an impasse at year's end. Treasury Secretary Robert Rubin, who juggled funds to prevent a default on interest payments on the national debt in November, indicated that a default on interest due in February 1996 was still a possibility.

Japan.

       Real Gross Domestic Products of Selected OECD Countries, TableThe recovery from the long economic slowdown in Japan failed to take root during 1995. Although the recession had touched bottom nearly two years earlier, the upturn was so feeble that 1995 marked the fourth consecutive year of negligible growth. Renewed economic downturn in evidence in the closing months of 1994 continued into 1995, and GDP in the opening quarter registered zero growth. Economic growth picked up a little in the second and third quarters, helped by the reconstruction in the Kobe area after the Great Hanshin Earthquake, reversal of the earlier rise in the yen, lower interest rates, and higher government spending. On the basis of incomplete data, GDP was likely to have grown by about 0.5% for 1995, virtually unchanged from the previous year's growth rate (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)).

  In part, the continuing weakness of the economy was due to unfavourable developments in the value of the yen (Graph V—>) and the Japanese stock market in the first half of the year. By the summer the yen had appreciated by 17% against the U.S. dollar, or by about 15% against a basket of currencies, and share prices on the Tokyo stock market had fallen by 25%. The strong yen, by making Japanese exports more expensive and imported goods cheaper, undermined domestic production (Graph II—>) and weakened consumer confidence and investment. The prolonged weakness in asset prices (share prices had fallen by 60% from their peak level and land prices were down by 50%) affected the balance sheet and profitability of many banks. This weakened the banks' ability to extend new loans and threatened a financial crisis.

      To help boost the stagnant economy, the economic policy makers announced various measures during the year. The Bank of Japan cut the discount rate twice to curb the strength of the yen. A cut of 0.75% in April was followed by a further 0.5% cut in September to a record low of 0.5%. This, together with concerted moves by the authorities in the U.S. and Germany, succeeded in moving the yen against the U.S. dollar to about 100 yen to the dollar, back to the level it had been at the beginning of the year.

  In addition to interest-rate cuts, the government announced three fiscal packages. (For short-term rates, see Graph III—>; for long-term rates, see Graph IV—>.) The first one was in April in the aftermath of the Great Hanshin Earthquake, and it was quickly followed by another one in June. As both were modest and were seen by economists to have had only a limited impact on the weak economy, a third attempt in September to kick start the economy came as no surprise. This sixth package in three years proposed 14.2 trillion yen in extra spending. About one-third was earmarked for public works projects, 15% for Kobe, and a smaller amount for land purchase to improve property prices. Given the unresolved problems surrounding the Japanese financial system, trade barriers, and land and tax reform, the long-term effectiveness of the latest package was also questioned.

       Consumer Prices in OECD Countries, TableDespite these measures to boost domestic demand, private consumption, in particular retail sales, remained weak. Early in the year, consumption was affected by the Kobe disaster. High unemployment and low wage increases also made consumers cautious. Excluding the effect of the opening of new stores, retail sales during the first nine months of the year were about 1.5% down from the same period in 1994. Although the strength of the yen reduced the prices (Table II (Consumer Prices in OECD Countries, Table)) of imported goods in the shops, it did not encourage consumers to change their spending habits and bring forward into 1995 purchases that they had intended to defer until a later date.

  Standardized Unemployment Rates in Selected Developed Countries, TableThe labour market, having begun to improve in late 1994, stalled in early 1995, reflecting the renewed weakness of the economy. The strong yen increased production costs and encouraged firms to shift manufacturing abroad. The unemployment rate (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) in November stood at a record level of 3.4%. At this level 2,170,000 workers were seeking employment. If unemployment were to be defined in the same way as in other industrialized countries, it would be considerably higher than the official figures suggested—perhaps about 9%. Despite the rise in unemployment, wages rose by nearly 2.5% in 1994, but both overtime working and bonuses declined. Because the inflation rate (Graph I—>) was close to zero, however, the small increase in wages meant there was a real rise in earnings, after adjusting for inflation.

      The underlying investment trend strengthened a little. Stronger expenditure on plant and equipment, boosted by reconstruction at Kobe, was partly offset by a reduction in housing investment. Government investment recovered, too. Thus, total investment was nearly 2% up in 1995.

      The strong yen in the first half of the year reduced the trade deficit by depressing exports and making imports cheaper. Although the sharp weakening of the yen from the summer eased the burden of the exporters, in yen terms exports were only 3% higher than a year earlier, but imports increased by nearly 10%. In dollar terms the trade balance was likely to have been close to the 1994 figure of $146 billion, but as a result of a larger deficit on invisible items, such as services and foreign travel, the current-account surplus fell a little to $177 billion ($129 billion in 1994). Although this was still high in absolute terms, Japan's trade partners, the U.S. in particular, welcomed the downward trend.

United Kingdom.

       Real Gross Domestic Products of Selected OECD Countries, TableUnder the impact of higher taxes and interest rates introduced in 1994, combined with a slackening in world economic growth, the pace of economic activity slowed in the U.K. Following a GDP growth (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)) of nearly 4% in 1994, the economy expanded at an annual rate of 2.5% in 1995.

  Concerned with a likely upturn in inflation later in the year, the chancellor of the Exchequer, Kenneth Clarke, and the governor of the Bank of England, Eddie George (see BIOGRAPHIES (George, Eddie )), extended their policy of preemptive rises in interest rates. (For short-term rates, see Graph III—>; for long-term rates, see Graph IV—>.) The Bank rate went up by 0.5%, to 6.75%, in February. This was the third increase since the previous September. Although the Bank of England urged a further rise in interest rates, Clarke's wait-and-see approach proved to be a more accurate assessment of the underlying trends. Given a rapid slowdown in economic activity, coupled with subdued inflationary pressures, the Bank of England changed its view in the autumn, which paved the way for lower interest rates before the end of the year.

      The chancellor also faced a dilemma in framing the government's fiscal policy because he came under pressure for substantial tax cuts in the November 1995 budget to restore the electoral fortunes of the government. The difficulty for Clarke was that the public-sector deficit for 1995-96 turned out to be £ 6 billion higher than the revised target of about £ 23.5 billion. The overshoot was largely due to lower tax revenue, reflecting the economic slowdown. In the event, Clarke produced a cautious tax-cutting budget, reducing taxes by £ 3,250,000,000—less than expected. This was balanced by reductions in public spending.

      The economic slowdown was largely caused by a fall in exports rather than by developments in the domestic economy. By the autumn the three-month average growth rate of exports was down to 2%, from 8% at the beginning of the year. The lull in world economic growth was the main cause of this adverse trend.

 Consumer spending weakened under the cumulative impact of higher taxes and interest rates introduced in the previous years. Retail sales increased by just over 1% in real terms, compared with over 3% in 1994. The weak housing market, a hot summer, and continuing gloom about job security also led consumers to spend less and save more. There was no significant contribution to economic growth from investment spending. Total gross fixed investment rose by an estimated 3%, down from nearly 4% in the previous year. The weakest areas were private housing and new industrial and commercial buildings. Investment into new plant and equipment was more encouraging. Against this background of weaker domestic and external demand, industrial production (Graph II—>) weakened. For the year as a whole, total output expanded by an average of 2.7% (5% in 1994). As the year drew to a close, however, the underlying growth rate of industrial production was 0.5%, compared with 5.5% at the beginning of the year.

  Standardized Unemployment Rates in Selected Developed Countries, Table Consumer Prices in OECD Countries, TableThe trend in the number of unemployed closely reflected the overall economic slowdown. After a steady two-year decline in the number of people out of work, there was a small increase in unemployment in October. Even so, the unemployment rate (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) of 8.1% was below the previous year's 9%. Both wage and price inflation (Table II (Consumer Prices in OECD Countries, Table)) remained restrained. Average earnings growth remained about 3.5% for most of the year. The headline annual inflation rate (Graph I—>) peaked at 3.9% in September and fell sharply to 3.2% in October.

Germany.

       Real Gross Domestic Products of Selected OECD Countries, TableThe unexpectedly strong economic growth seen in Germany during 1994 continued into 1995 but lost momentum as the year unfolded. During the first half of the year, GDP (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)) in Germany as a whole expanded by 2.5% (3% for 1994). The result for the full year was about 2.1% (1.8% in western Germany and 6% in eastern Germany). As the German national account statistics were revamped in 1995 to show GDP components for the first time on a pan-German basis, the early estimates were subject to greater uncertainty than usual. The overall slowdown, however, was unmistakable. Growth in eastern Germany remained stronger than in the west, with investment and manufacturing output the most dynamic components. Because the region was still heavily dependent on transfers and subsidies from western Germany, however, growth in eastern Germany was not yet self-sustaining.

 One of the main reasons for the economic slowdown was a loss of competitiveness arising from the relatively high wage settlements and the appreciation of the Deutsche Mark (Graph V—>). Wage settlements, at about 4%, were above the inflation rate, but they were partly offset by some productivity gains. The appreciation in the Deutsche Mark, at 6%, was large and potentially more serious. Slower world growth was another cause of this slowdown.

 Economic growth was underpinned by growth in investment activity and higher export volumes. Gross capital investment during the year was 6% higher (4.5% in 1994). Investment in machinery and equipment was relatively modest. Despite higher capacity utilization, manufacturer's investment was targeted at efficiency improvements instead of adding to manufacturing capacity and facilities (Graph II—>). Construction activity trends were mixed, too. Industrial and residential construction were comparatively weak in western Germany but buoyant in the east.

 The volume of exports expanded by about 5%, a little slower than the year before. The loss in competitiveness was to some extent offset by a relatively strong external demand from Germany's main trading partners and by productivity gains. Surprisingly, private consumption recovered in 1995 and grew a little faster than the year before. The squeeze on consumers' disposable income by the reintroduction of the 7.5% Solidarity levy and lower unemployment benefits was partly offset by wages and salaries growing well above the moderating inflation rate (Graph I—>). Increased consumer spending went on housing-related expenditures and on holidays. Retail spending remained flat.

       Standardized Unemployment Rates in Selected Developed Countries, Table Consumer Prices in OECD Countries, TableAgainst a background of sustained higher economic activity, there was no real improvement in the labour market. A small decline in unemployment for all of Germany was more than offset by a natural rise in the labour market. Thus, the unemployment rate (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) toward the close of the year stood at about 9.2%, compared with 8% the year before. The employment rate in eastern Germany rose faster than in recent years as a result of higher industrial output in the east. Further progress was made in stabilization of prices. After an upward surge about the turn of 1994-95, the inflationary pressures eased. In November the year-on-year rise in consumer prices (Table II (Consumer Prices in OECD Countries, Table)) was just under 2% (2.8% the year before) in western Germany and 2.5% in eastern Germany (3.2% a year earlier).

  As the inflationary pressures abated, money supply expanded well below the target rate, and economic growth slackened, monetary policy was eased. At the end of March, the Bundesbank cut the discount rate by half a percentage point. This was followed by a similar cut in August, reducing the discount rate to 3.5% and the Lombard rate to 5.5%. (For short-term rates, see Graph III—>; for long-term rates, see Graph IV—>.) The fiscal policy, on the other hand, remained tight. As a result of higher taxes (voted the year before), additional revenue arising from economic upturn, and expenditure restraints, the total public-sector deficit for 1995 shrank to about DM 100 billion from the previous year's DM 145 billion. The 1996 budget, approved in the summer, envisaged a 7.6% real reduction in the federal government's spending. Some of these savings were offset by tax cuts forced on the government by the Constitutional Court's decision that child benefits and tax thresholds of those close to the minimum subsistence level were too low. As a result, the federal government's deficit was likely to widen in 1996, but the total public-sector deficit, as a proportion of GDP, was expected to remain unchanged at about 2.9%.

France.

       Real Gross Domestic Products of Selected OECD Countries, TableThe steady economic recovery experienced in 1994 continued in 1995 but at a slightly weaker pace. As a result, GDP (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)) expanded by close to 2.5%, compared with 2.7% in 1994. Against the background of political uncertainty arising from the presidential elections in the spring, currency weakness that prompted higher interest rates, and a higher tax burden, this was a creditable economic performance.

  Consumer Prices in OECD Countries, TableThe year's economic growth was largely investment-led, with some assistance from export growth. The role of consumer spending (Table II (Consumer Prices in OECD Countries, Table)) was not as important as in the previous year because of sluggish growth in incomes, continuing high levels of unemployment, and higher taxation. Although both capacity utilization and industrial output (Graph II—>) improved during 1995, manufacturers used industrial capacity more efficiently and deferred some of their planned investment. Nonmanufacturing sectors experienced higher levels of new investment. As there was no improvement in the price competitiveness of French exports, growth was largely due to stronger demand from foreign markets. The 7% improvement in export volume was largely offset by a similar rise in imports, however.

  Standardized Unemployment Rates in Selected Developed Countries, TableUnemployment, which had been a source of concern for several years, declined a little in 1995 but not as much as the government had hoped. As the year drew to a close, the unemployment rate (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) stood at 11.5%, marginally down from the 12.5% of the year before. The incoming government of Pres. Jacques Chirac (see BIOGRAPHIES (Chirac, Jacques Rene )) introduced a package of measures in June providing assistance to the long-term unemployed. Employment subsidies of over F 2,000 per month and exemption from social security contributions for two years were the main planks of this program. Independent observers thought that in the absence of higher economic growth, Prime Minister Juppé's target of 700,000 new jobs to be created by this package was far too optimistic. The high level of unemployment was one of the reasons hourly wage rates grew by only 2% during 1995. Although a wage freeze was imposed on the civil servants, built-in contractual increments provided for an automatic 2% rise. Despite repeated protests by the trade unions, the government and the employers did not bend. Against this background, inflation (Graph I—>) remained subdued; the average rise of 1.8% was largely unchanged from the previous year.

      Even though there was a change in government, economic policy remained largely unchanged, contrary to references made by Chirac during his election campaign. An "alternative" economic policy, designed to produce faster economic growth and drastically cut unemployment, was soon ditched in favour of an austerity program aimed at cutting the public-sector deficit to ensure that France could join the European economic and monetary union in 1997. Thus, a minibudget, introduced in June, raised the standard rate of the value-added tax by 2 percentage points to 20.6%. A 10% surcharge was also introduced on corporate tax liabilities and personal wealth taxation. Measures to raise taxes were accompanied by a cut in government spending. Continuing the drive to reduce government spending, in particular the spiraling social security spending, in November a new income tax of 0.5% was levied, together with a wide-ranging reform of the welfare system. This triggered another wave of protests and strikes from the public-service unions, paralyzing the transport system.

   The tightening of the fiscal policy, together with the reduction in German interest rates, led to a temporary easing of monetary policy. As the franc (Graph V—>) came under pressure in the autumn, however, largely because of the financial market's concern over the high level of public-sector deficit, short-term interest rates (Graph III—>) were raised to defend the currency. (For long-term rates, see Graph IV—>.) This reignited fears that the franc fort strict monetary policy and the accompanying high interest rates could choke off economic growth.

The Former Centrally Planned Economies.

      While the economic decline in the former centrally planned economies persisted for the fifth consecutive year, the rate fell sharply to 2%. This compared with 9.5% in 1994, and the prospect was for real growth of over 3.5% in 1996.

      The performance across the region was by no means uniform. In Central and Eastern Europe, the economy expanded very slightly following a 38% economic decline in 1994. If Belarus and Ukraine were excluded, output showed much stronger growth of 4%, which compared favourably with the better-than-had-been-expected 2.8% advance in 1994. In much of the Transcaucasus and Central Asia, however, restructuring and stabilization measures were less advanced, and here there was a contraction of 5.9% following on from a 16% decline in 1994.

      In Russia there were signs by the end of the year that the recession had bottomed. Output fell by about 4% during the year after the 1994 decline of 15%. Russia faced special difficulties in adjusting to the requirements of a market-based economy. The breakup of the Soviet Union had disrupted its trade and payments system. Its military and enterprise infrastructure had been dictated by strategic rather than economic considerations, and there were particular problems and costs involved in dismantling them.

      The most successful individual economies—including Poland, the Czech Republic, Slovakia, Hungary, Slovenia, and Albania—were those that were most advanced in their structural reforms. This resulted in strong and productive investment and impressive trade performances. These countries achieved growth rates in the 4-6% range.

      Overall inflation in the region was expected to average 150%, less than half the 1994 rate. Across the region the performances were mixed. The rate for Central and Eastern Europe—once again excluding Belarus and Ukraine, where prices were still soaring by over 700% and 300%, respectively—was only 64%, down from 87% in 1994. In the Transcaucasus and Central Asia, where reforms were generally much less advanced, inflation was running at over 200%, with the average being forced up by the very high rates of inflation that persisted in Azerbaijan (464%) and Tajikistan (389%). Nevertheless, this was well down from the 1,583% average rate in 1994.

      Consumer price inflation in most countries rose much more slowly than in 1994. Hungary, partly as a result of the March devaluation, and Tajikistan were notable exceptions. Many of the falls in inflation rates were dramatic, as in Georgia, where prices rose by under 200% after increasing by 7,380% in 1994, and in Armenia, where they declined from over 5,000% to under 200%. The lowest inflation was experienced by Albania, Croatia, the Czech Republic, Slovakia, and Slovenia, where prices were rising at an annual rate of less than 10%.

      By the end of 1995, 10 Central and Eastern European countries (CEECs) had signed association agreements with the European Union (EU). They were Bulgaria, Estonia, the Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia. The CEECs, which had already received EU assistance worth ECU 38.7 billion in 1990-94, were told by the European Council that they could join the EU when the necessary economic and political conditions required had been met and when the EU institutions were able to cope with a larger membership. The promise had stimulated liberalization, economic restructuring, and commercial activity. By the end of 1995, more than half the CEECs' trade was with the EU.

      Early accession to the EU was not expected, however, given EU concerns about sensitive sectors that accounted for 40% of imports from the CEECs. The EU was concerned about the adverse effects on its own industries if it opened its markets completely. A 1995 EU study of the CEECs' agricultural sectors highlighted the difficulties and vulnerabilities, with 25% of the CEEC workforce dependent on agriculture, compared with only 6% in the EU. Despite its greater efficiency, EU prices were much higher, and the group had no intention of abolishing its subsidy mechanism, the common agricultural policy.

      Six years after the end of the Cold War, there were signs that many formerly communist countries were gradually being integrated into the global trade and payments system. Until the late 1980s, the state had been responsible for nearly all aspects of activity, but by the end of 1995, the impetus was firmly shifting to the private sector. In many of those countries that had implemented comprehensive and large-scale privatization programs, the private sector accounted for more than half of GDP and employment. In the Czech Republic, for example, the privatization program was almost complete, and some 80% of all assets were in the private sector. Unemployment, at 3%, was by far the lowest in the region and well below Western European levels. Elsewhere, unemployment was often understated, and there was no easy solution in sight.

      Financial-sector reforms continued to be made, with help from international institutions, but they remained inadequate and an obstacle to enterprise restructuring and investment finance. Banking reforms were under way, with new private banks being established and gaining significant market shares. By the middle of 1995, for example, there were 220 banks in Ukraine, with only two owned by the government. The banking systems remained fragile, however. Local institutions lacked experience in risk evaluation, and the allocation of financial resources and the inappropriate regulation and supervision of the banks reflected this. As a result, many banks became insolvent in 1995. Notably, in August the Russian banking sector suffered a liquidity and confidence crisis. Interbank lending came to a halt and spiraled overnight interest rates to 1,000% a year. In Latvia the largest commercial bank collapsed, and the government took over its management. Throughout the region better supervision and monitoring, as well as appropriate accounting standards, were required.

Less Developed Countries.

      Despite a slowdown in the industrial countries, real economic growth in the LDCs remained strong and averaged an estimated 6%. The rapid pace of economic activity in 1995 was sustained by the ongoing benefits of economic reforms, steady interest rates, export growth, and an inflow of capital funds. The impact of the Mexican financial crisis on capital flows was short-lived, as confidence returned fairly quickly.

      As in previous years, the region with the fastest growth rate was Asia, in particular South Asia. This was a welcome offset to the weakness in Japan. Once again, China experienced the fastest rate of growth in the region, but as a result of earlier measures, growth stabilized at about 11%, compared with around 10% in 1994 and nearly 14% in 1993. In several countries in the region, including South Korea, Malaysia, Thailand, and Vietnam, GDP grew by over 8%, assisted by a combination of strong export growth, investment, and domestic demand. Hong Kong, Indonesia, and the Philippines lagged behind the region's growth rate. The recovery in India remained intact, and economic output grew by 5.5%, thanks to earlier economic reforms and inflow of capital. Latin America was adversely affected by the financial crisis in Mexico, and overall regional growth slowed to an estimated 1.5% from 4.5% in 1994. Not surprisingly, Mexico and Argentina were particularly affected by a loss of confidence, decline in capital inflows, and restrictive measures that were introduced. The growth rate in both Africa and the Middle East picked up considerably in 1995, despite some weakness in oil prices.

      The inflation rate continued to moderate among the LDCs, reflecting the worldwide downward trend. The IMF expected a median inflation rate of 8% in 1995, down from 11.5% the year before. Even so, inflation remained high in some countries and regions. In Latin America the regional average was over 30%, but remarkable progress was made in controlling the hyperinflation in Brazil. The overall inflation rate was almost as high in the Middle East and Europe. Turkey was the worst problem spot, with an inflation rate over 75%. In Asia inflation remained relatively high at about 12% but was steady, despite high capacity utilization in many export-oriented South Asian countries.

      Following a sharp improvement in the trade performance of the LDCs during 1994, thanks to the rapid expansion in world trade, there was no significant change in their trade or current-account balances. With the exception of Africa, the debt burden of the LDCs was expected to ease during 1995.

INTERNATIONAL TRADE

      Following a rapid growth in the volume of world trade in goods and services in 1994, the momentum was maintained in 1995. IMF projections pointed to a growth rate of about 8%, largely unchanged from the previous year's upswing. This represented another year of strong performance, well above the long-term growth rate of 5%.

      The buoyancy in world trade during 1995 was largely attributed to demand from countries with strong exchange rates, rising trade among the LDCs, and continued recovery among the former communist countries in Europe.

      Reflecting the sharp slowdown in economic activity rates in the developed countries, growth in their export volumes fell to about 6.5% from the previous year's 8%. Import growth slowed even more and rose by an estimated 7%, compared with more than 9% in 1994. The slowdown in the developed countries as a group was largely offset by a higher volume of trade by the LDCs, however. The export growth of this group as a whole, at 11%, was largely unchanged from the previous year, while their import growth rose from an estimated 8.5% in 1994 to 11% in 1995.

 Changes in exchange rates (Graph V—>) usually affect the trade pattern and flows after a time lag. Consequently, the changes in exchange rates, particularly the weakening of the yen and Deutsche Mark in the second half of the year, did not significantly influence the outcome in 1995. The changes that occurred the previous year and in the opening months of 1995 were more influential. Loss of competitiveness in Japan, as a result of a 15% appreciation in the trade-weighted value of the yen during the first half of the year on top of a 7% appreciation in 1994, reduced the volume of export growth from Japan to 2.5% from 5% the year before. The strong yen made imported goods cheaper and accelerated the growth in the volume of imports to over 9%, despite the stagnant economic background. In the early months of the year, the Great Hanshin Earthquake affected exports more than imports because the Kobe port was more important for shipment of exports than handling imports. As in previous years, Japan came under pressure to open its markets, and this prompted imports to grow faster than they would otherwise have done.

      Conversely, the weakness of the dollar encouraged U.S. exports. IMF estimates pointed to an 11% increase during 1995, compared with 9% in 1994, which, in turn, was the fastest growth rate since 1989. As the economic growth slowed sharply in the first half of the year, imports into the U.S. faltered, cutting the growth rate to under 10% from the previous year's 14%.

      Export growth in Germany and the U.K. slowed appreciably for different reasons. German exports were affected by the strength of the Deutsche Mark, as well as by economic slowdown in the developed countries. The British exports were not so much handicapped by an unfavourable exchange rate but could not escape being dragged down by the economic slowdown experienced by its major trading partners. Although the trading volumes in the other European countries varied less between 1994 and 1995, because of the relative importance of Germany and the U.K., the EU's overall export volumes slowed to 6% (8% in 1994). Import volumes into the EU slowed by a similar amount and declined to 5% from 7.5% in 1994.

      Despite the slowdown in the developed world, the pace of export growth from the LDCs was maintained at a high rate of 11%. Coincidentally, imports by the LDCs expanded at a similar rate. Import growth by this group during 1995 was 2.5 percentage points higher as a result of improved imports by Asian countries, including China. Regionally, trade volumes were most buoyant in Asia, with a 13-14% increase over 1994. There was a good upswing in Africa, too, leading to 8% volume gains. By contrast, trade in the Middle East and Latin America was subdued. The sharp devaluation and austerity measures in many Latin-American countries following the Mexican crisis drastically reduced the imports into the region.

      In spite of a small decline in commodity prices, favourable currency movements in the first half of 1995 enabled the LDCs to improve their terms of trade. According to IMF estimates, the terms of trade of the LDCs as a group improved by 0.2 point, somewhat below the previous year's 0.5-point improvement. Oil exports suffered a large drop in their terms of trade, largely because international oil prices traded within a narrow range during the year. More important, as oil is priced in dollars, the decline in the value of the dollar early in 1995 reduced the effective value of the LDCs' import revenues.

      Following the successful conclusion of the Uruguay round of the General Agreement on Tariffs and Trade in 1994, the World Trade Organization (WTO) was established on Jan. 1, 1995. Within months of its birth, the U.S. and Japan moved to the brink of a trade war over automobiles, a topic that had not been satisfactorily concluded in the Uruguay round. A last-minute truce in June avoided the imposition of huge tariffs on luxury Japanese cars and enabled both countries to claim victory. Regulatory changes were agreed upon. The Japanese market would be opened up for U.S. automobiles, but as a face-saver for the Japanese, there would be no numerical targets. The U.S. announced its own forecasts regarding the impact of the agreement, but the Japanese did not endorse the report.

      A more important development was the agreement by China to cut its import tariffs so that it could join the WTO. The agreement was announced at the 18-nation Asia-Pacific Economic Cooperation (APEC) meeting in Osaka, Japan, in November. Chinese Pres. Jiang Zemin told delegates that from 1996 Beijing would reduce its overall tariff level by 30%. Up to 4,000 items were expected to be covered, and average tariffs were projected to decline to about 25% from 35%.

      To the disappointment of the Western markets of APEC, notably the U.S. and Australia, insufficient progress was made in an agreement on more liberalism in agricultural products. East Asian countries—China, Japan, South Korea, and Taiwan—voted to move cautiously and protect their domestic markets. The Western members wanted greater liberalization in order to expand the market for their agricultural produce.

INTERNATIONAL EXCHANGE AND PAYMENTS

 A year of two halves is an apt description of the sharp variation in exchange rates (Graph V—>) during 1995. A sharp fall in the value of the dollar against the yen and Deutsche Mark in the opening months was largely reversed in the late summer and early autumn. Against foreign currencies the dollar ended the year close to the levels at the end of 1994 and more in line with the level suggested by the underlying economic situation.

      The turbulence in foreign-exchange rates in the spring was caused by a combination of various factors. The Mexican crisis following the collapse of the peso at the end of 1994 turned sentiment against the dollar. This coincided with signs of a sharp slowdown in the U.S. economy and a continuing current-account deficit. In turn, this put a question mark on the future direction of U.S. interest rates. Yet another adverse development was reduced investment by Japanese investors in dollar-denominated assets. Given the earlier rises in the yen against the dollar, which reduced the value of Japanese assets in the U.S., this was understandable. The combination of these adverse developments triggered a sharp dollar decline against the yen and the Deutsche Mark. In the spring the dollar fell to a record low of just under 80 against the yen and slightly less than 1.35 against the Deutsche Mark. This represented a swing of 17% and 9%, respectively.

      In August the dollar began to strengthen against the yen and Deutsche Mark as the central banks in all three countries reduced their interest rates. There was also a coordinated intervention on the foreign-exchange markets in support of the rising dollar. Following these concerted moves and lower interest rates, stability returned to foreign-exchange markets, and during the second half earlier dollar gains were held. As the year drew to a close, the dollar traded at about 103 yen and DM 1.44.

      During the early summer, when the dollar was at its weakest, its effective rate (trade-weighted) was only 1% down on previous year-end levels. The strength of the dollar and the yen was offset by the weakness of the Canadian dollar and the Mexican peso. Both currencies had large weights in the calculation of the effective rate. At the year-end the dollar was showing a small gain on its effective rate. By contrast, during the spring the Deutsche Mark was showing a 5% appreciation in its effective rate before the summer correction. It ended the year still showing a small overall gain. A number of European currencies, including the Italian lira, the Swedish krona, and the British pound sterling, depreciated against the Deutsche Mark during 1995, particularly in the early months. The French franc experienced periods of strong turbulence against the Deutsche Mark. In October the French interest rates were raised to defend the franc as it fell on concerns relating to the adequacy of measures proposed to bring down the budget deficit to meet the Maastricht criterion.

      The distortions in exchange rates in the early months of the year did not last long enough to seriously affect the relative competitive positions or the balance of payments of the countries concerned. The balances on the current accounts of the developed countries as a group were projected by the IMF to show a wider deficit in 1995—$19 billion, compared with $6 billion the year before. This was largely due to a wider deficit in the United States and a smaller surplus in Japan. The continued recovery in the U.S. encouraged imports to grow faster than exports and led to a wider trade deficit. The current-account deficit widened as well (IMF forecasts pointed to $176 billion in 1995, up from $150 billion in 1994), reflecting a larger shortfall in invisibles and transfers. The IMF was forecasting a reduction in Japan's balance of payments surplus to $116 billion, compared with $129 billion in 1994. If confirmed, this would be the first reduction since 1990, but it was unlikely to satisfy demands by the U.S. that Japan open its domestic markets more and increase its transfer payments. The continued buoyancy in global trade enabled the EU to increase its current-account surplus to a projected $52 billion, up from $27 billion in 1994.

      The current-account deficit of the LDCs as a whole, at $64 billion, was expected to be smaller than the previous year, continuing the improvement seen in 1994. Higher exports from the Latin-American countries contributed to this improvement. The currencies of these countries declined against the dollar, giving them a competitive advantage in exporting to the U.S., Japan, and Europe. Regionally, the current-account deficit in Africa and Asia worsened, while the Middle East and Europe remained unchanged.

      The total external debt of the LDCs was expected by the IMF to rise by 8% in 1995 to $1,852,000,000,000. This was broadly in line with the increase in the previous two years. With the exception of Africa, the debt burden of the LDCs continued to ease as growth in export earnings outpaced growth in debt. (IEIS)

      This updates the articles economic growth; government budget; international trade.

STOCK EXCHANGES

       Selected Major World Stock Market Indexes, TableThe world's stock exchanges in 1995 were characterized by an accelerated rise, following an earlier stagnation or fall. Despite this uneven performance, most investors had a vintage year. The Financial Times/Standard & Poor's (FT/S&P) World Index gained 26%, in dollar terms, over the year, thanks to the strong performance of Wall Street. Europe, led by the U.K., was 18% higher, in dollar terms, while the Pacific Basin made no headway. (See Table I (Selected Major World Stock Market Indexes, Table).)

      Early in the year, European stock markets were held back by two main concerns, uncertainty about the future direction of interest rates and the weakness of the dollar against the Deutsche Mark. In addition to similar concerns, investors' confidence in the Asia-Pacific region was further undermined by Japan's economic weakness, the Great Hanshin Earthquake, and the aftershocks of the Mexican crisis. The latter caused a run on some currencies tied to the dollar and led to a temporary rise in short-term interest rates.

      The trigger for the recovery and the robust rise from the summer was the investors' perception that global interest rates had peaked. In early 1995 economic indicators in North America, the U.K., Australia, and, to a lesser extent, continental Europe indicated a slowing economy with inflation under control. It was expected that economic policy makers would reduce interest rates to support moderating economic activity. In the event, interest rates came down three times in Germany and twice in Japan and the U.S. In the U.K., after a rise of 0.5% in February, interest rates were held steady until December, when they were eased down by the same amount. Initially, government fixed-income securities (bonds) responded to these developments. Sharp rises in bond prices reduced the yields and made equities look more attractive. Prospects of lower interest rates also reduced the attractions of holding cash deposits. Further stimulation came from a series of corporate takeovers in both the New York and the London stock markets.

      As in previous cycles, the U.S. led the way, and the positive sentiment spilled over into other markets. Led by technology shares, the Dow Jones industrial average (DJIA) outperformed the rest of the world, setting almost daily new records from June. As the year drew to a close, there was no decline in global investors' enthusiasm for equities, though few expected to see the same superlative gains in the U.S. repeated in 1996. The prospects looked more encouraging in Japan, however, than they had for a long time. (IEIS)

United States.

      The stock market had a record-breaking year in 1995 as the bull market continued its longest and strongest performance on record. By year-end the upward move in the S&P 500 index was in its 62nd month, with not so much as a 10% pullback in the process. Stocks were trading at three times book value; dividend yields were at a 100-year low of 2.4%; and the number of initial public offerings (IPOs) reached an all-time high. The price of a seat on the New York Stock Exchange (NYSE) was back to the pre-October 1987 level of $1 million. There was great enthusiasm for mutual funds and technology stocks, especially biotechnology, which was the year's best Dow Jones industry group. The DJIA achieved new highs more than 65 times in a steady rise throughout the year. By the close of 1995, the DJIA was up more than 33% from the beginning of the year; the S&P 500 was up nearly 35%; and the National Association of Security Dealers automated quotation (Nasdaq) composite index, with its heavy weighing of technology stocks (especially high tech), was up just under 40%.

      Low interest rates, low inflation, a healthy economic climate, high corporate profits, and huge pools of liquidity in the form of net cash inflows into mutual funds helped fuel the bull market. Productivity gains due to radical restructuring and globalization of business were also credited for some of the upward momentum. Expectations of a lower rate of taxation on realized capital gains in 1996 caused investors to defer selling appreciated securities at the higher tax rates of 1995.

      The DJIA began the year at a level of about 3830, rose to 4000 by the end of the month, dipped slightly after the collapse of Barings PLC, the oldest British investment bank, in late February, declined in early March as the dollar hit a post-World War II low against the Deutsche Mark, and climbed through April, despite falling slightly to about 4200 in mid month as the dollar reached a new low against the Japanese yen. A strong rally kept the upward momentum through July, passing 4700, when the Federal Reserve (Fed) cut the discount rate 0.25%, its first cut in nearly three years. The index fell briefly to 4600 in August and then moved above the 5000 mark on November 21, just nine months after crossing the 4000 barrier. The positive trend continued through the end of the year. The broader averages also gained, with the S&P 500 hitting a record 621.69 before easing to 615.93 at year's end and the NYSE composite index rising to a record 331.17 and ending 1995 at 329.51. Other indexes showed similar increases.

      During the first half of 1995, there were concerns that the economy had turned sluggish, and many economists anticipated lower interest rates because of the threat of a recession. These concerns were dissipated in the second half as the growth rate in gross domestic product (GDP) accelerated.

      Despite the euphoria of the bull market at year-end, many securities analysts expected that a correction in the equities market could come from overenthusiasm about the likelihood of an imminent interest-rate reduction and a belief that the single-digit earnings growth likely to be experienced in 1996 was insufficient to support the market. The price-earnings ratio on the S&P 500 was 15 in 1995, considered high by historical standards.

      Stock ownership by Americans was valued at about $5 trillion in 1995, passing, for the first time, equity in homes, which aggregated approximately $4.5 trillion. This massive shift into the stock market was largely due to a slowing of inflation in house prices and a major flow of cash into mutual funds and retirement plans.

      There were more than 425 new stock issues in 1995, collectively raising more than $26.7 billion in fresh capital for a widely diverse group of corporations. This was below the record of 1993, when there were 543 equity offerings, which raised more than $33.2 billion. The most dramatic IPO was Netscape Communications, a designer of Internet-browsing computer software, which went public in August at $28 per share and rapidly climbed to $171, or 20 times 1997's projected revenues. The average gain for 1995's IPOs was 37.4%. More than 25% of all common stocks brought to market were trading below their initial offering prices, however, while roughly 5% remained unchanged. Among the new issues were 227 spin-offs, 29 reverse leveraged buyouts, and 34 U.S. underwritings by foreign entities. Technology offerings accounted for 164 transactions, or 40% of all new issues floated. The average communications issue rose 114%; computer-equipment offerings averaged a 70% gain in value, while average electronics stocks rose 38%. Netscape gained 500%.

      The top underwriters of new equity issues were Goldman Sachs & Co., with 31 issues valued at $5,632,700,000; Merrill Lynch, with 24 at $3,162,300,000; Morgan Stanley, with 29 at $2,520,000,000; Smith Barney, with 27 at $2,413,800,000; CS First Boston, with 11 at $1,734,200,000; Donaldson, Lufkin & Jenrette, 23 at $1,570,000,000; Robertson, Stephens & Co., 30 at $1,208,100,000; Alex Brown, 29 at $1,114,300,000; Hambrecht & Quist, 25 at $781.1 million; and Montgomery Securities, 16 at $699.1 million. The major underwritings were in the fields of technology and health care.

      Many corporations bought back their shares instead of declaring dividends. Repurchase announcements through mid-October soared to a record $72.5 billion, surpassing all of 1994's $69 billion.

  Interest rates declined during 1995, with a pronounced reduction in the spread between long- (Graph IV—>) and short-term (Graph III—>) rates. The yield on 30-year Treasury bonds fell from about 8% in January to under 6% by year-end. Bond investors realized significant price appreciation after 1994's bear market, when the price of 30-year Treasuries was down 22% at one point and yields topped 8.1%. Bullish sentiment was supported by expectations of further rate cuts by the Fed. Key interest rates in mid-December were: prime rate, 8.75%; discount rate, 5.25%; three-month Treasury bills, 5.25%; and 30-year Treasury bonds, 6.08%. Municipal bonds averaged 5.7% and telephone bonds 7.25%. A cut in short-term rates by the Fed on December 20 pushed other rates lower and bond prices higher. The yield on 30-year Treasuries fell to 5.95%, the lowest in more than two years.

      Mid-December year-to-date volume on the NYSE was 84,033,762,400 shares, up 18.6% from the year-earlier figure of 70,844,452,600. December 15 saw a record one-day volume of 653.2 million shares, eclipsing a mark that had stood since the market crash of October 1987. The extraordinary day's trading was accounted for by expiring stock options, stock index futures, and options on futures, a so-called triple witching day, and year-end portfolio adjustments. Average daily trading volume on the NYSE was a record 346 million shares, up from 291 million a day in 1994. In a reversal of 1994, advances outnumbered declines 2,751 to 788, with 82 of the 3,621 issues traded on the NYSE left unchanged. For the second consecutive year, Teléfonos de México was the most active stock. Year-to-date bond sales at mid-December were $6,788,205,000, slightly below the prior-year level of $6,959,179,000.

      Big Board member firms posted record pretax profits in the first three quarters of 1995. Pretax earnings for member firms increased 72% to $5.7 billion from $3.3 billion in 1994. Revenue increased 28% to $68.7 billion from $53.3 billion a year earlier. Strong trading activity, asset-management fees, and declining interest rates were factors.

      Trading volume for stocks on the American Stock Exchange (Amex) by mid-December was 4,865,780,300, up 11.6% from the previous year. Out of 1,058 Amex stocks 661 advanced, 375 declined, and 22 held unchanged for the year. Bond sales were off sharply.

      Nasdaq (6,597 issues) became the largest U.S. stock market on the basis of turnover in 1995, with average daily volume of some 400 million shares, compared with the Big Board's 346 million average. By comparison, the Amex traded an average of only 20 million shares a day. Nasdaq's volume, which was 36% above 1994's average daily volume, was accounted for in large measure by its many technology company shares. Year-to-date volume by mid-December was 98,095,081,900, up from 71,886,448,100 shares traded in the corresponding period of 1994. At year's end 2,898 stocks had advanced, 1,380 had declined, and only 62 were unchanged.

      The National Association of Securities Dealers (NASD), a self-regulatory organization for the brokerage industry and the operator of Nasdaq, was under investigation by the Department of Justice and by the Securities and Exchange Commission (SEC) for alleged antitrust violations. An independent committee headed by former U.S. senator Warren Rudman also issued a report, which led to a reorganization of the NASD, with Nasdaq being spun off as an independent subsidiary with its own board of directors, separate from the regulatory functions of the parent organization.

      The five regional exchanges—Cincinnati (Ohio), Boston, Philadelphia, Chicago, and Pacific—traded an aggregate of 36.5 million shares a day but provided significant competition for the larger exchanges by offering better services to investors, including superior handling, cleaner trade executions, potentially better pricing, and longer hours.

      Mutual funds had their best year ever as money market fund assets rose to $766,390,000,000 by mid-December 1995 from about $640 billion in a steady rise during the course of the year. No-fee fund "supermarkets" evolved that permitted investors to trade mutual funds without incurring commission or transaction fees. Initiated by Charles Schwab & Co., the movement grew rapidly in 1995 with entry into the field by major brokerage firms. The first nine months were the best since 1957, with a year-to-date total rate of return of 25.2%. Funds specializing in health and biotechnology stocks returned 15.37%, science and technology 14.95%, and financial services 15.37%. At mid-October, U.S. stock funds were up 25.34% year-to-date, and U.S. bond funds were up 11.81%.

      In index options trading, the ranges for underlying indexes at mid-December 1995 were S&P 100(OEX) closed at 591.75, up 162.12 or 38.1% from the beginning of the year; the S&P 500(SPX) closed at 616.92, up 34.3%; and the S&P Midcap(MID) closed at 213.38, up 25.9%. The Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) studied ways of curbing the incidence of fraud in the sales of futures contracts through "blind" advertisements. The CFTC reviewed its statutory enforcement powers, while the NFA increased its surveillance of member firms promoting blind pools.

      The SEC filed more than 500 enforcement cases, an all-time high, in 1995. Among its priorities was a scrutiny of order-flow fees and related order-handling practices on Wall Street because of their potential to reduce competition based on published quotes. The SEC also eased limits on the use of computer technology in communicating with investors, allowing financial documents to be sent via E-mail or downloaded from an Internet site. Legislation introduced would eliminate controls over how much stock institutional investors could buy on margin; scrap rules that required brokers to give investors a prospectus before a stock purchase; free brokers of their duty to recommend only "suitable" investments to institutional clients, including state and local governments; and, most controversially, preempt "blue sky" laws, under which states police securities and mutual fund sales within their borders. The SEC dropped a proposal to allow companies to delete financial footnotes from annual reports sent to shareholders.

Canada.

       Selected Major World Stock Market Indexes, TableCanadian stocks were up 12% in 1995, according to the Dow Jones World Stock Index, as contrasted with the DJIA gain of 33.5%. The Toronto Stock Exchange (TSE) index of 300 stocks closed at 4713.5, a gain for the year of 11.8% (Table I (Selected Major World Stock Market Indexes, Table)). The TSE 300 rose from about 4000 in January to within a narrow range of 4600 in July, eased to 4500 in October, and dipped sharply to 4300 before climbing to a high of 4745.1 in early December. Trading during October included the sixth largest one-day decline ever, as the separatists in Quebec gained ground before the separatist referendum, and the largest single-day increase in eight years, following the razor-thin victory by the federalists. There were concerns that the Canadian government might relax its fiscal discipline as its main priority in order to appease the Quebeckers. Corporate profits were up, particularly for forest product concerns, especially those producing pulp and paper; petroleum concerns; and base-metal miners. Industrial companies performed well, but gold-mining stocks declined on average.

      Total rates of return on Canadian bonds in U.S. dollars were up 20.5%. Because of political uncertainties and a declining growth rate in GDP early in 1995, both Moody's Investors Service and S&P downgraded Canadian government bonds. The government sold bonds at auction without the benefit of a top rating. Following the referendum on the constitution, the bond market rallied.

      Merger mania swept the Canadian stock market in the third quarter, pushing the value of deals in 1995 to a record with three months left. The value of mergers and acquisitions in the first three quarters was Can$64.5 billion, a 76% increase from the corresponding period of 1994 and well above the 1994 full-year record of Can$48.4 billion. The top-valued deal announced in the third quarter was a hostile takeover, valued at Can$1,770,000,000, begun by a Canadian company, the Moore Corp., for Wallace Computer Services, Inc., of Schaumburg, Ill. Second was the Canadian government's sale of most of its stake in Petro-Canada. The value of mergers in the third quarter was 46% higher than a year before. The transaction value was $18.5 billion on 260 deals, compared with $12.6 billion on 323 deals in 1994.

      After a close brush with recession early in the year (GDP, which had grown 4.5% in 1994, fell to about 2%), the Canadian economy appeared likely to resume growing until the end of 1997, according to a report by the Royal Bank of Canada. GDP was expected to rise by 2.2% in 1995 and 2.3% in 1996. The Bank of Canada reduced its overnight lending rate by 25 basis points in July.

      The Investment Funds Institute of Canada proposed a sales code that would limit "trailer fees" that kick in only when brokers and other mutual fund salespeople have sold a minimum of a fund. The concern was that there would be undue incentives to oversell investors.

      Market sentiment was bullish by year-end, with strong expectations that the Canadian stock market would perform well into 1996 in tandem with its U.S. counterpart. The U.S. accounted for 8% of all Canadian foreign trade, and the two economies were closely integrated. (IRVING PFEFFER)

Western Europe.

       Selected Major World Stock Market Indexes, TableMany European stock exchanges turned in a good performance in 1995. (For Selected Major World Stock Market Indexes, see Table I (Selected Major World Stock Market Indexes, Table).) During the first five months of the year, Western European stock markets made little headway. Investor confidence was undermined with the strength of the Deutsche Mark against the dollar. In order to protect their currencies from weakening against the Deutsche Mark, France, Italy, Sweden, and Spain kept their short-term interest rates high. Political uncertainty in France and Italy also had an adverse impact, as did fears that interest rates might go up again in the U.S. However, beginning in May the sentiment changed, and share prices rose in many markets. This was largely triggered by lower interest rates in Deutsche Mark bloc countries. Another push came from the U.S., where Wall Street was reaching new highs. As measured by the FT/S&P Euro top 100 index, European stock markets as a whole were 12.3% up from the beginning of the year. Some of the best performers were peripheral markets. Switzerland, with a gain of 22%, led the field. Other good performers included Ireland (20%), the U.K. (20%), and Sweden. Austria, with a decline of 13%, was the worst European performer. France was nearly flat.

 The London Stock Exchange, the largest and the most influential market in Europe, started the year concerned with a poor inflation outlook and the prospect of higher interest rates. The Mexican crisis and the collapse of Barings PLC also affected sentiment. By mid-March the Financial Times Stock Exchange 100 (FT-SE 100) index was close to the psychologically important 3000 level, having been above 3100 a month earlier and 3066 at the end of 1994 (Graph VIII—>). However, encouraging prospects for corporate profits, export growth, and increasing takeover activity started moving the market higher. It was also encouraged by Wall Street's reaching new highs. By early summer economic statistics pointed to a slowing in the economy but, with inflation not yet under complete control, Chancellor Kenneth Clarke surprised the markets and held interest rates unchanged. Bond prices were stimulated, and new strength spilled into the equity markets. In mid-June, by the time Prime Minister John Major resigned the Conservative Party leadership, the FT-SE 100 had gained 400 points, or 13%, since the lowest point of the year. After Major's reelection as party leader, the market regained its strength and reached 3500, close to an all-time high, by August. For the next three months it drifted sideways, and it fell a little in late October on concerns that the weakening economy and faltering export growth could reduce corporate profitability in 1996. The market rallied again in November when a prudent budget signaled that lower interest rates were on the way. The continued strength of Wall Street, speculation on further takeovers, and traditional year-end buying buoyed up the market. It ended the year at an all-time high of 3689.30.

      Among the larger markets on the European continent, Germany and France started the year on a weak note. The German DAX Index fell by 10% to 1910.96 by the end of March. The combination of a strong Deutsche Mark against the dollar, relatively high wage settlements in the engineering sector, and a poor outlook for corporate profits drove the market down. In May, as short-term interest rates were cut and the Deutsche Mark weakened against the dollar, the market rallied, and it reached a record high of 2317 in mid-September. The summer rally was sustained by a further cut in interest rates and the new highs reached by most foreign stock markets. After that, however, the DAX Index slid to around the 2260 level because of concern about a sharp economic slowdown and poor corporate profitability. It closed the year at 2253.88. The FAZ Aktien Index followed a similar pattern and ended the year at 815.66, up just over 4% for the year.

      The Paris Bourse experienced a volatile and disappointing year. In the early months of 1995, the French bourse fell steeply as interest rates were temporarily raised in response to a decline in the franc. Subsequent lower interest rates in Germany and France, as the currency turbulence subsided, pushed the CAC 40 Index to the year's high of 2017.27. The optimism surrounding Jacques Chirac's presidential victory in May soon evaporated as it became clear that France's problems were deep seated. The continuation of the franc fort policy effectively kept interest rates too high in France, given the depressed state of the economy. Widespread strikes and protests in December against proposed reductions in public spending and welfare reforms also adversely affected sentiment. The CAC 40 closed the year at 1871.97, just below its level at the beginning of the year.

      The Nordic countries were among the best performers in Europe. Sweden led the way with an 18% rise. Across the border Norway gained 10%, and Denmark was 5% up on the year. Finland, an earlier star performer, gave up all its gains in the second half of the year. These countries benefited from a combination of global enthusiasm for telecommunications stocks and high prices for paper and forestry products. The performance of the southern European bourses was lacklustre. An economic boom in Spain led by strong export growth pushed share prices up by 12% during 1995. Italy and Portugal performed badly, and share prices fell by around 7% and 14%, respectively.

Other Countries.

      After experiencing considerable volatility, particularly in the opening months, the Asian equity markets, with the exception of Hong Kong, were flat throughout the year as whole. The Japanese market, until the autumn, was held back by pessimism over the economy and the strength of the yen. The FT/S&P Pacific Index (excluding Japan) rose by 6%, in dollar terms, over the year. This lacklustre performance was initially due to shock waves from the Mexican crisis. Interest rates in Hong Kong and Thailand were temporarily raised to defend the Hong Kong dollar and Thai baht from speculative attacks. At the same time, there was substantial selling by local investors. As the direction of interest rates in the U.S. became clearer, international investors' interests in the summer and the autumn were focused on the rising markets in the U.S., Europe, and Japan. Little interest was shown in the Pacific Basin stock markets. Although economic growth was two to three times as fast as in the developed countries, the risk of overheating and low growth in earnings per share of companies in the region reduced their attractions. Hong Kong's 23% gain over the year was in stark contrast to sharp declines in some other countries, including Taiwan (down 27%), South Korea (down 14%), and Thailand (off 5%). Indonesia, Singapore, and Malaysia bucked the trend and rose by 9%, 4% and 2.5%, respectively, over the year.

      The Japanese stock market fell sharply from January until July before recovering strongly in response to a weaker yen, lower interest rates, and increased government spending. The poor performance of the Japanese stock market in the first half of 1995 caused the Nikkei 225 Index to plunge to 14,485 in July, a decline of 26% from the level at the beginning of the year. As the Bank of Japan moved to reduce interest rates, the market surged, and it continued to move upward. Its path was eased by the weakness of the yen against the dollar and a third economic stimulus package introduced in September. Surveys also showed that the profits of Japan's top 1,500 nonfinancial businesses improved by 20% in the half year to September. During 1995 the Japanese market was driven by foreign buying. Local investors preferred to sell selectively. The Nikkei approached the year's end on a strong note and closed at 19,868.15, just above its level of a year earlier. Lower interest rates, rapid economic growth, and good demand for commodities helped the Australian market to rise by 15% over the year. The New Zealand stock market benefited less from these trends and rose by just over 12%.

      The emerging markets were very volatile during 1995. Following a loss of confidence caused by the Mexican crisis in January 1995, equity markets in the emerging markets regained their poise. A good recovery began in March, particularly in Latin America, and continued, albeit at a slower pace.

Commodity Prices.

      The sharp gains seen in commodity prices during 1994 were partly reversed during 1995. Economic slowdown in the developed world and lack of speculative activity were the main reasons for the weakening in commodity prices during the year. The Economist Commodity Price Index of spot prices for 28 internationally traded foodstuffs, nonfood agricultural products, and metals fell by nearly 5% during the first 11 months of the year. In sterling terms the decline was slightly smaller, at 3.5%.

      The price of crude oil, which is not included in The Economist Index, rose by 8% over the year and was trading at around $17 per barrel in early December. For most of the year, it traded in a narrow range between $16 and $18 a barrel. Oil prices were stronger early in 1995. In response to seasonal demand and anticipated continued recovery in the industrialized countries, it touched $19 per barrel. Prices weakened in the summer, however, as production continued to run ahead of demand and OPEC decided not to change the quotas. A short-lived price recovery gave way to renewed weakness, which continued into the autumn, reflecting below-average seasonal temperatures and lower demand. Following the November meeting of OPEC, the market firmed and oil prices increased by 6%.

      Both sectors of The Economist Index declined during 1995. The food index fell by 5.5% and the industrials by 3.3%. Lead, with a gain of 15% over the year, was one of the few metals to rise strongly. Reduced exports from the former Soviet Union and Eastern Europe, coupled with stronger industrial demand, particularly from auto battery manufacturers, boosted prices. Copper, tin, and zinc were broadly steady during 1995 following strong rises the year before. Nickel prices declined by over 10%.

      Cereal prices increased 10-20%. Bad weather, which disrupted grain production in the U.S. and Russia, was largely responsible for the upward pressure on prices. The prices of other agricultural commodities were mixed. Coffee prices fell by 25% from the previous year's peak after the crops in Brazil were not damaged by rainfall and output was higher than anticipated. Cotton was up by 7%, while wool prices declined by 10% under the weight of surplus stock. Gold prices in 1994 traded within a range of $374 to $394 per troy ounce and ended the year at $388, barely above the level of a year earlier. (IEIS)

      This updates the article market.

BANKING

International.

      The biggest story in international banking in 1995 was the collapse of the London-based merchant bank Barings PLC in late February. Nicholas Leeson, a trader in the 233-year-old bank's Singapore office, had run up losses of more than $1 billion trading futures contracts on the Asian markets. Barings management claimed that Leeson was carrying out unauthorized transactions and then covering up his losses in a secret account. Inspectors in Singapore, however, alleged that bank officials, anxious to participate in the lucrative derivatives market, had allowed the 28-year-old trader to use highly risky instruments without adequate supervision. (See Special Report (Concern over Derivatives ).) In March Barings was acquired by a Dutch financial group, Internationale Nederlanden Groep NV. Leeson, who was arrested after fleeing to Germany, was returned to Singapore for trial and sentenced to 6 1/2 years in prison.

      Unauthorized trading by a single individual was also blamed for the $1.1 billion in losses accumulated by Daiwa Bank Ltd. of Japan. In September Toshihide Iguchi, a U.S. Treasury bond trader based in New York City, was charged with falsifying records to conceal the deficit, which he had incurred through some 30,000 unauthorized trades over an 11-year period. Unlike Barings, Daiwa, one of the world's 25 largest banks, was able to absorb the enormous losses. However, state and federal bank regulators discovered that Iguchi had confessed to Daiwa executives two months before U.S. authorities were notified. In November the authorities ordered Daiwa to close its operations in the U.S. within three months, while the Japanese Finance Ministry demanded that the bank cut back all of its international operations.

      In August the Bank of Japan announced that it would liquidate the Hyogo Bank, which had built up $6 billion in debts through unwise property speculation, rather than arrange a bailout, as had been expected. It was the first time since World War II that the Japanese government had allowed a commercial bank to fail. The government of Fiji approved a taxpayer-financed bailout of the National Bank of Fiji (NBF). Critics accused politicians of having benefited from the NBF's questionable loan practices. In the United Arab Emirates, the emirs of Ajman and al-Fujayrah agreed to pay $10 million to settle claims against them resulting from the 1991 collapse of the Bank of Credit and Commerce International. In June the Chinese government agreed to allow five foreign banks to open branches in Beijing, including the Bank of Tokyo and Citibank of the U.S.

      The British banking industry saw several mergers and acquisitions in 1995. In May S.G. Warburg accepted a bid from Swiss Bank Corp. for its investment banking arm. In September the Bank of Scotland paid $A 900 million to acquire 100% ownership of the Bank of Western Australia. The merger of Lloyds Bank PLC and TSB Group PLC, announced in October, was completed at year's end. The new institution, called Lloyds-TSB Group PLC, would form the largest retail bank in the U.K., with assets of £ 150 billion. (MELINDA C. SHEPHERD)

United States.

      They called it the "Goldilocks economy" in the banking industry—not too hot, not too cold, just the right temperature. U.S. banks made very good profits in 1995 as loan losses remained low, borrowing picked up at a modest pace, and their huge bond portfolios increased in value. The big news for banks was a tidal wave of mergers and takeovers. About $73 billion worth of mergers and acquisitions were announced in the U.S. banking community. Fifteen deals exceeded $1.1 billion in value, including the three largest takeovers of all time. There were two forces driving the takeover movement: the high stock prices of the acquiring banks, which made it relatively cheap for them to offer stock to the shareholders of the banks being taken over, and the realization that the good times of 1995 were unlikely to last forever.

      Increasingly, big banks were merging in hopes of cutting costs by reducing payrolls and closing buildings. In a flurry of activity, deals were announced between First Union Corp. of Charlotte, N.C., and First Fidelity Bancorp of Newark, N.J., and First Chicago Corp. and NBD Bancorp Inc. of Detroit, Mich., among others. The biggest example of this phenomenon in 1995 was the merger of Chase Manhattan Corp. and Chemical Banking Corp., both of New York. The combined bank, which would surpass Citicorp as the nation's largest, with assets of nearly $300 million, would retain the Chase name. There was no question, however, that the transaction was a takeover by Chemical, which paid Chase stockholders about $10 billion worth of Chemical Bank stock in exchange for all their shares. While Wall Street cheered the Chase/Chemical merger, it was clear that thousands of employees soon would be laid off.

      Loans to individuals at commercial banks, which had been growing at around 15% a year in 1993 and 1994, increased at a much slower pace in the last part of 1995 and were heading down to an annual rate of 5% to 6% as the year closed. Americans, who had seen little if any growth in income in 1995, were maintaining their standard of living by borrowing more on their credit cards. This effect had to slow down and reverse, and this "reliquification" process was already in sight at the end of 1995. Bankers and the Wall Street investment community were expecting a big increase in loan losses on those credit cards in 1996. In an economic slowdown, the losses could rise from about 3.25% of the credit card loans outstanding to 4% or higher, a significant increase in an industry where net interest margins were only a little over 4% before taxes and other expenses. The growth of bank loans to commerce and industry was also declining. "C & I" loans peaked in May 1995 at an annual rate of 17.7% and by the end of 1995 were about 12% over the year-earlier level.

      The other mainstay of bank earnings, the bond market, performed extremely well in 1995. The decline in interest rates led to a rise in the price of bonds. Since U.S. Treasury bonds represented around 20% of the total loans and securities held by banks, this was a good source of profit. If interest rates rose in 1996, however, bond prices could fall, and there was a risk that any inflationary threat in 1996 could turn bond profits into losses.

      U.S. banks may have made good profits in 1995, but they still faced an uncertain future. The record level of mergers and acquisitions was a symptom of competitive pressures and the need to reduce costs, and bankers knew that "Goldilocks" was, in the end, a fairy tale.

      (JOHN W. DIZARD)

      This updates the article bank.

LABOUR-MANAGEMENT RELATIONS

      In 1995 the economic environment improved in most of the industrialized countries, the main exception being Japan, which had another lacklustre year. There was healthy growth in world trade, and inflation was low. Unemployment tended to fall, but it was still high in many countries.

Europe.

      Unemployment was a major concern in the European Union (EU), where in December 1994 the European Council had adopted a five-point plan to improve the functioning of labour markets. The creation of jobs was prominent in the European Commission's Social Action Programme for 1995-97, put forward in April. The program reflected the reaction against the heavy concentration on legislation in recent years and contained few significant new proposals. It was mainly a program of consolidation, of ensuring that existing legislation was implemented, and of providing for analyses and consultation about future work.

      In the U.K. there were a number of minor disputes and a series of strikes in the railways in the summer, but on the whole it was a quiet year for labour-management relations. The most notable event was the abolition in July of the Department of Employment. There had been a government department for labour matters since 1893 and a full ministry since 1917. The functions of the department were distributed among other departments, mainly Education—which became the Department of Education and Employment—and Trade and Industry.

      In two decisions the European Court of Justice found that the U.K. had failed to implement fully EU directives on large-scale layoffs and workers' acquired rights, which required consultation with workers' representatives. In response the government put forward regulations in October requiring such consultation where 20 or more employees were to be dismissed at one establishment during a 90-day period. How to consult was left to the employer, but consultation had to be with employee representatives whether or not the employees were unionized.

      British law required workers wishing to appeal their dismissal to an industrial tribunal to have at least two years' service with their employer to do so. Two women, dismissed by different employers and each having only 15 months' service, were refused access to the tribunal. They turned to the courts on the basis that women tended to change jobs more frequently than men and were therefore less likely to have as much as two years' service, which made British law incompatible with EU law on equal treatment. In July the Court of Appeal ruled in favour of this view. The case could go to the highest British court, the House of Lords, which in turn might refer it to the European Court of Justice.

      In German industry the annual wage round generally passed without much strife, but the resultant pay increases were criticized by the Organisation for Economic Co-operation and Development (OECD) as being "disappointingly high." A lengthy series of negotiations with Volkswagen ended in September with the company's concession of a postdated 4% wage increase and commitment to guaranteeing jobs for its workers in Germany (about 100,000) for two years. In return, the union (IG Metall) made concessions increasing the flexibility of working time, though not as extensive as the company had wanted. An important judgment of the Federal Constitutional Court confirmed the government's stance on the interpretation of a section of the Work Promotion Act that refused state temporary jobs and unemployment benefits to employees temporarily laid off on account of a strike in their sector, even if it was not in their region. Unions had counted on benefits being paid to laid-off members to lower their costs in industrial disputes. In the former communist part of the country, wage rates continued to move closer to those in the west. Unemployment, though still severe—and much higher than in the west—was declining.

      In France the main central employers and trade union organizations signed a declaration in February expressing their intention to establish a continuing social dialogue. Talks started in March and were particularly concerned with encouraging employment and with fighting unemployment, which continued to hover around 11% to 12% in spite of an economic recovery that seemed to stall late in the year. Among other matters discussed were the vocational integration of young people, flexibility of working time, and ways to articulate collective bargaining at the national-central, industrywide, and enterprise levels. In July the parties agreed to set up a joint intervention fund to improve the functioning of the labour market. The fund would be used particularly to help workers who might wish—subject to their employer's agreement—to retire early and who had already paid pension contributions for at least 40 years and whose jobs could then be filled by the unemployed. The government also introduced the Employment Initiative Contract to subsidize employers who hired certain classes of people, such as the long-term unemployed. By mid-August 23,000 such contracts had been effected. Beginning in August, however, labour troubles increased. The government proposed to reduce public expenditures, including the costs of civil service pensions and health care and the debts of the railways. Starting with a well-supported one-day strike in October, union opposition grew, with strikes causing massive disruption in November and December and, at one time or another, involving civil servants, workers on the railways and the Paris transport system, and employees in power supply, telecommunications, and schools.

      The thorny question of modifying Italy's overly generous pension arrangements was settled, at least for the present, by a comprehensive agreement on May 29 between the government and the three main union confederations. The agreement formed the basis of a law published on August 17. A wave of protests against limits on pensions broke out by year's end, however. A series of issues put to a national referendum on June 11 included questions concerning the legal obligation of employers to facilitate the deduction of union dues from pay, when requested by workers, and concerning the representational rights of trade unions in an enterprise. The referendum went in favour of repealing the obligation to deduct union dues and of reducing the monopoly of the three main union confederations as representative bodies. The government was also active in the area of employment, promoting bills to encourage optimal flexibility in employment contracts and to create the new National Agency for Employment. In Spain the main trade union and employers confederations agreed in April on the establishment of conciliation, mediation, and arbitration procedures to replace the services run by the state.

      In an unusual move, Sweden's trade union confederations set an objective of negotiating wage increases in 1995 corresponding to the European norm, considered to be 3.5%. In the event, after gaining annual increases of 3.8% a year in a two-year agreement in the paper and pulp industry and even more in a three-year agreement with hotels and in catering, the unions did better than expected. In the metal industry the union secured a 12-minute cut in the 40-hour workweek to be added to vacation time, as well as wage increases. There were also institutional changes; union mergers reduced the number of Swedish Trade Union Confederation affiliates from 23 to 21, but the central employers organizations were unable to merge into a single body.

United States.

      The report of the Dunlop Commission on the Future of Worker-Management Relations became available in January 1995. Though the commission made a number of recommendations, the report was widely viewed as a disappointing document that failed to address a number of problems affecting American labour-management relations. Admittedly, any radical proposals would have had little chance of being legislated in the present Congress. The commission's most disputed proposal was one that would ensure that cooperative labour-management bodies could be constituted in the workplace without running afoul of the section of the National Labor Relations Act that forbids company unionism. On March 8, Pres. Bill Clinton signed an executive order sanctioning federal contractors who hired permanent striker replacements.

      It was an important year for U.S. trade unions. On June 12, following lengthy controversy within the American Federation of Labor-Congress of Industrial Organizations (AFL-CIO), Pres. Lane Kirkland announced his retirement, after 16 years in office, effective August 1. Thomas R. Donahue, secretary-treasurer, took over the presidency until the election scheduled for October 25, when he contested the office against John J. Sweeney, president of the Service Employees International Union. Sweeney, a dissident leader in the AFL-CIO, defeated Donahue.

      The continued decline of U.S. trade union membership in recent years was the major factor prompting a number of union mergers. The mergers included those between the International Ladies' Garment Workers' Union and the Amalgamated Clothing and Textile Workers Union, the United Steelworkers of America and the United Rubber Workers of America, and (to be effective by the year 2000) the United Automobile Workers, the United Steelworkers, and the International Association of Machinists and Aerospace Workers. The Department of Labor estimated that labour contracts for 42% of workers under major agreements would expire or reopen during the year. With employers tending to take a tough line, it was not surprising that a number of negotiations ended in strikes, several of which hinged on meeting the ever-rising costs of health care, while others concerned work rules and antiunion action by employers.

Canada.

      In the populous and industrially important province of Ontario, the conservative government moved to replace significant parts of the industrial relations legislation of its New Democratic Party predecessor. The government added new provisions that reversed a ban on the permanent replacement of striking workers and that required secret ballots in cases of certification of a union, in ratifying a collective agreement, or in calling a strike. A general strike in London, Ont., in December protested the government's pro-business policies.

South Africa.

      The new South Africa stood in need of revised labour legislation, and much of 1995 was taken up with preparing a comprehensive labour relations measure. Progress was slow and difficult, but agreement was reached by the National Economic Development and Labour Council in July and was carried into law in October as the Labour Relations Act. It provided for a Labour Court, with a more refined role than the existing Industrial Court; a Commission for Conciliation, Mediation, and Arbitration; and Workplace Forums (a form of works council). A union demand for centralized collective bargaining was not taken up, but the act did make provision for bargaining councils. (R.O. CLARKE)

      See also Business and Industry Review .

      This updates the articles labour economics; organized labour: trade unionism (organized labour).

CONSUMER AFFAIRS

International.

      Consumer concerns were significantly addressed in 1995 when the UN Economic and Social Council (ECOSOC) passed a landmark resolution calling for extensive revision and updating of the 1985 UN Guidelines for Consumer Protection. The guidelines, which covered consumer safety and product standards and education, provided both a framework and a benchmark for governments, particularly those in less developed countries, to establish a legal basis for consumer protection. The impact made by the guidelines could be seen in India, where a consumer forum was set up to resolve problems outside the legal system, and in Eastern Europe and the states of the former Soviet Union, where there was an explosion of activity in consumer affairs. The 10-year anniversary marking the establishment of the guidelines was celebrated on World Consumer Rights Day, held annually on March 15. The 1995 ECOSOC resolution was the most significant broadening of the guidelines in the past decade and was expected to lead to a sustainable level of consumption.

      The World Trade Organization (WTO), a court set up by the 1994 General Agreement on Tariffs and Trade to arbitrate international trade disputes, officially opened its doors on Jan. 1, 1995. The WTO, headed by Renato Ruggiero (see BIOGRAPHIES (Ruggiero, Renato )), had several cases in its docket, but none was heard during 1995.

      Consumers International (formerly the International Organization of Consumers Unions) launched a Consumer Charter for Global Business for transnational corporations. Those signing the charter would agree to abide by consumer-friendly standards in such areas as competition, advertising, and environmental impact.

      Most consumer activity in 1995 took place at the grassroots level and often against great odds. As democratic reforms and market liberalization spread in Africa, consumer movements also emerged, particularly in Western Africa. Yet Africa as a whole remained mired in deep economic crisis, which had taken its toll on humans through increased malnutrition, reduced social services, lowered incomes, and higher unemployment.

      The consumer movement—working with very limited resources—was swamped with issues needing urgent attention. Fewer than 10 African countries had organizations with permanent offices and staffing, and 21 had no identified consumer groups at all. Most of the offices were operating at capacity and were working to open new centres to handle the high volume of consumer complaints. Attempts also were made to assess the impact of economic structural adjustment programs on Africans. In January, 27 consumer leaders from 17 West and Central African countries attended a conference on the subject.

      The African Office of Consumers International was studying the state of consumer protection legislation in Africa and was in the process of drafting a model consumer protection law, which was expected to be completed by year's end.

      Eastern Europe also was struggling to build a consumer movement virtually from ground zero. Six years after the fall of the Berlin Wall, nearly every country in Eastern and Central Europe had formed some type of consumer organization. Macedonia, Armenia, and Georgia joined the group in 1995.

      Most countries in Central and Eastern Europe instituted, at the minimum, basic consumer protection laws and, with an eye toward joining the European Union (EU) by the end of the century, many were working hard to bring their laws in line with those of Western Europe. As a sign of how rapidly times were changing, Albania was hoping to have a consumer protection law in place in 1996.

      Overall, a major concern was to educate consumers who had little experience with savings and investment so they could make wise investments with their earnings. Newspapers reported numerous scandals in Eastern and Central Europe and the republics of the former Soviet Union, where fraudulent and incompetent banks and financial service companies were operating.

      Western Europeans faced different problems, many of them related to the EU, which included 15 members after Sweden, Finland, and Austria were admitted in 1995. (Norway rejected membership.) The single market—the world's largest trading bloc—was intended to remove all trade barriers across member countries. Consumer groups, however, continued to confront the European Commission (EC) in areas they felt—despite promises of trade liberalization—continued to hurt consumers. (For example, automobile distributors were still excluded from EC competition rules and could maintain monopolies across Europe.) In 1995, however, consumer groups scored a victory by persuading the EC to allow competing car manufacturers to advertise where monopolies existed.

      Consumer organizations lobbied the EC regarding pending legislation about after-sales services and guarantees. Consumer representatives argued that in a single market, guarantees should be honoured across borders—guarantees on goods bought in France should be honoured in Spain, and services on products purchased in Germany should be available in the United Kingdom.

      In Latin America, improving economies and expanding trade signaled an end to a long period of economic isolation and recession. Yet very few benefits appeared to be trickling down to the 165 million Latin Americans classified as poor—80 million of whom were living in dire poverty, according to the World Bank. An estimated 19% of Latin Americans lacked access to clean drinking water, while 32% had no electricity and 43% were without drainage or sanitary services. Low-income consumers were especially vulnerable to hazardous or substandard products and such abusive practices as false advertising and adulterated weights and measures.

      Nonetheless, consumers fought back; 16 Latin-American countries established national consumer protection laws. In 1995 the governments of Argentina and Colombia added consumer protection to their respective constitutions.

      In November, with the help of a manual published by Consumers International, more than 100 organizations involved in adult education planned to introduce consumer education into their curriculum.

      In Asia the consumer scene was characterized by glaring contrasts both within the region and within individual countries. Though foreign investment poured into the area, Asia's booming growth produced greater economic disparity; millions of impoverished consumers were confronted by higher prices, unregulated markets, and an influx of substandard imported goods. As a result, more than 60 consumer representatives from Malaysia, India, Thailand, the Philippines, and Vietnam attended a conference in Malaysia to discuss "Consumerism in Developing Economies: Agenda for the Future."

      In the South Pacific, consumers banded together to halt the dumping of both toxic wastes and poor-quality food. Since 1992 Papua New Guinea and the Solomon Islands had passed consumer protection laws, and Western Samoa and Tonga were expected to follow suit by the end of 1995.

      (ALINA TUGEND)

United States

      In the United States the Federal Aviation Administration concluded in May 1995 that legislative efforts to mandate the use of child safety seats during air travel for children under two would not accomplish its intended goal of saving lives. Strapping children into safety seats—as opposed to the more common practice of allowing them to sit on the lap of a parent—would increase the cost of flying and cause some families to choose less-safe modes of travel.

      A cost-benefit approach to safety regulations was a central theme in congressional legislation introduced during the year. In July two major bills on regulatory reform—both requiring the federal government to provide evidence that the benefits of proposed regulations justified their costs—were postponed indefinitely. The new Republican-majority Congress effectively changed the tenor of the policy debate concerning a number of food-, drug-, and pesticide-safety regulations.

      In February new meat-inspection regulations proposed by the U.S. Department of Agriculture recommended instituting Hazard Analysis and Critical Control Points, an inspection procedure in which key stages of meat production would be targeted to prevent the spread of pathogens. Although the procedure was considered an important advance in food inspection, critics in the industry charged that imposing it without dismantling the traditional system would raise costs without bringing about a commensurate improvement in safety.

      At the state level, a groundswell of consumer and physician complaints prompted lawmakers in New Jersey and Maryland to pass the first state legislation requiring minimum maternity stays in hospitals. In some states women were routinely discharged 12 hours after giving birth, down from the typical 2 and 3 days of recovery time traditionally paid for by insurers. Groups such as the American College of Obstetricians and Gynecologists warned that early discharges presented a health hazard, especially when women and infants went home before complications could be observed or child-care guidance provided. Health insurers and managed-care groups maintained that one-day stays with follow-up home-care visits met the needs of most maternity patients. The laws guaranteed women 48-hour stays after delivery and 4 days of hospitalization for deliveries by cesarean section.

      Action against fraudulent and misleading auto-leasing deals took place in Florida, Maryland, Washington, and New York. Each state passed a law aimed at increasing dealer disclosure of the various costs incurred by consumers in leasing. The Federal Reserve Board also drafted new disclosure standards under the federal law that governed leasing. Law-enforcement officials who were tracking the recent upward growth of auto leasing reported widespread deceptive leasing practices. Frequently, consumers were persuaded to sign leasing agreements that apparently carried low monthly payments, but lessees were not furnished with important basic information such as the amount of principal upon which payments were based.

      The U.S. General Accounting Office (GAO) questioned the reliability of the government's automobile crash-test scores as a source of consumer information. The results of the New Car Assessment Program—undertaken by the National Highway Traffic Safety Administration and widely disseminated by the news media and consumer publications—improved the overall crashworthiness of cars. But the GAO determined that individual car scores were not reliable and could mislead consumers to purchase less-safe cars.

      (PETER L. SPENCER)

      See also Business and Industry Review: Advertising (Business and Industry Review ); Retailing; The Environment (Environment ).

▪ 1995

Introduction

Overview

       Real Gross Domestic Products of Selected OECD Countries, TableWorld economic output recovered strongly during 1994 and headed for the fastest growth since 1989. According to estimates by the International Monetary Fund (IMF), global economic growth averaged 3.1%, compared with 2.3% in 1993. The pace of recovery was faster than had been expected. This bounce back was largely attributable to faster growth in the U.S., a well-established recovery in the U.K., an upturn in continental Europe, and the bottoming out of the recession in Japan. (For Real Gross Domestic Products of Selected OECD Countries, see Table I (Real Gross Domestic Products of Selected OECD Countries, Table).)

      Economic recovery in the developed countries as a group accelerated to 2.7%, twice as fast as the year before. Higher interest rates in the U.S.—and to a lesser extent in the U.K. and other European countries—which had been raised in a preemptive move to prevent inflationary forces from getting stronger, did not affect the outcome in 1994. Large budget deficits, a legacy of the recession and high social spending, and high unemployment (except in the U.S.) remained concerns of economic policy makers. These factors also explained why the "feel good" factor, which accompanied previous upswings, was missing this time around.

       Changes in Output in Less Developed Countries, Table Real Gross Domestic Products of Selected OECD Countries, TableFor the third year running, the less developed countries' (LDCs') economies (Table IV (Changes in Output in Less Developed Countries, Table)) continued to grow much faster than those of the industrialized countries (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). Economic output growth (close to 5.6%) was as great as the year before and exceeded population growth, leading to a slight increase in personal living standards. As in recent years, the main engine of growth remained Asia, especially China. Growth in Africa was slightly higher, but in Latin America and the Mediterranean region, output stagnated or fell.

      Among the developed countries, growth in the U.S. accelerated to nearly 4% from 3.1% in 1993, despite higher interest rates, as improvement in consumer and corporate confidence led to higher consumption and investment. Canada, as a result of its close ties with the U.S., expanded by a similar rate. Australia and New Zealand also marked another year of good progress thanks to rapid growth in export markets in Asia and North America. The British economy enjoyed an investment- and export-led acceleration in recovery and grew by 4%. The speed of upturn in continental Europe was much faster than expected. Western Germany, the powerhouse of Europe, surprised forecasters as gross domestic product (GDP) growth bounced back to above 2% and reversed the 1.3% decline in 1993. In eastern Germany a 10% growth rate was achieved. The rest of Europe experienced average growth rates of between 1.7% and 2.5% during 1994. Most of the growth came from exports to rapidly growing North America and Asia, but a recovery in consumer spending and business confidence also contributed to the overall recovery.

 Relaxation of the German Bundesbank's tough anti-inflationary policy in 1993, which allowed interest rates to fall, continued early in 1994. Lower interest rates were encouraged by low inflation and, more important, by stable exchange rates in Europe. (For Effective Exchange Rates of selected currencies, see Graph V—>.) By mid-1994 many of the currencies within the European exchange-rate mechanism (ERM) were back inside, or close to, their old narrow 2.25% divergence bands against the Deutsche Mark. Fears that the widening of the currency bands from 2.5% to 15% in August 1993 would create greater instability, keep interest rates high, and prolong the recession in Europe proved unfounded. The long recession came to an end in Japan thanks to the cumulative effect of four stimulatory economic packages of tax cuts and higher public spending introduced in 1993 and 1994. Despite the strength of the yen, a gradual pickup in exports also helped Japan's GDP grow by nearly 1%.

      Among LDCs, economic growth in China remained very strong. Measures introduced in 1993 to control a very rapid economic boom were partly successful. In the rest of Asia, economic growth continued to be rapid, with many countries registering 8-9% growth. Economic growth in Latin America remained steady at 3-4%, but in Africa drought and civil war held back growth in many countries.

      Most Central and Eastern European countries continued to make progress, and economic growth accelerated. Growth climbed to 4% in Poland, 2.5% in the Czech Republic, and more than 1% in Hungary. In the countries of the former Soviet Union, where economic reforms were still progressing slowly, economic decline held at around 10%, a slightly slower pace than in 1993.

      Many components of demand strengthened as world economic growth gathered pace. In a number of countries, external demand, led by exports, grew more strongly than domestic demand (which depends on spending by households and businesses). Private consumption (which accounts for a large proportion of total private demand) expanded by nearly 2% in the developed world. There were wide regional differences, however, depending on each country's relative position in the recovery cycle. In the U.S. and Canada, where the recovery was well established, private consumption expanded by 3.6% and 5%, respectively. Retail sales were strong through most of the year, and investment outlays, both business and residential, surged ahead. In Western Europe, where households were still worried about job security and business confidence remained low, consumer spending was sluggish and business investment flat. Even in the U.K., where the recovery started earlier than in continental Europe, growth in retail sales and business investment was shallower than in previous upswings. At the same time, higher government spending or lower taxes contributed little to growth. Governments in North America and Europe were concerned with reducing their large budget deficits and either froze or scaled back public spending. Japan, unburdened by such constraints, continued to spend heavily on new public-works projects and cut income taxes. Thus, private consumption grew faster (2%, compared with 1% in 1993), while export growth slowed to below 3%. By contrast, Europe and North America enjoyed a boom in exports—7% in the U.S., 10% in the U.K., 5% in Germany, and 4% in France.

       Standardized Unemployment Rates in Selected Developed Countries, TableAs new employment usually lags behind economic recovery, unemployment in the developed countries remained at historically high levels. (For Standardized Unemployment Rates in Selected Developed Countries, see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table).) In the 25 countries belonging to the Organisation for Economic Co-operation and Development (OECD)—which included the U.S., Canada, Japan, all Western European countries, Australia, and New Zealand—official unemployment rates averaged around 8%, compared with 7.8% in 1993. Some 35 million people were registered as unemployed in the OECD at the end of 1994. This figure excluded countless millions of workers who had withdrawn from the job market because they faced poor prospects, believed they were too old, or lacked necessary skills. The fastest job creation was in the U.S., where the unemployment rate fell to 5.4% from nearly 7% in 1993. In Japan the rate rose to 3% from 2.5%, but it was still low by most standards. The real problems were in Europe, where average unemployment within the European Union (EU) rose from 10.6% in 1993 to 11.5% in 1994. The highest unemployment was in Spain, Belgium, France, and Denmark (24%, 14%, 13%, and 12%, respectively). Those individuals with jobs also faced unsettling change and job insecurity as companies continually restructured and streamlined operations to become more efficient.

      In Central and Eastern Europe, unemployment averaged around 20%. In Russia and other former Soviet bloc countries where output had fallen sharply, unemployment remained understated in the published statistics.

  The long downward trend in interest rates came to an end in 1994, and in some countries the trend turned up, reflecting the strength of economic activity. (For short-term interest rates in selected countries, see Graph III—>.) In many industrialized countries real interest rates were regarded as historically high in relation to the comparatively low inflation rates. Despite inflation's being under control, the outlook for interest rates in 1995 was for continuing small increases in line with faster economic recovery. In the U.S. the Federal Reserve Board (Fed) raised short-term interest rates for the first time in five years. The first move came in February (earlier than anticipated) and, together with subsequent rises, led to instability in the financial markets and an upward movement in long-term interest rates across the world. (For long-term interest rates in Selected Countries, see Graph IV—>.) By year's end, after six successive rate increases, the Fed funds rate (the rate the banks pay when they borrow from each other's reserves held at the Fed) stood at 5.5%, compared with 3% at the beginning of the year. British rates went up by 0.5% in September, mimicking the preemptive moves in the U.S. Elsewhere in Europe interest rates followed Germany's lead. A series of small cuts in the spring reduced the discount rate in Germany from 5.75% to 4.5%. In France the intervention rate came down to 5% from 6.2%. In Denmark, Italy, Spain, and Portugal, similar small reductions occurred in the spring. In late summer, however, interest rates went up slightly in Italy, Sweden, and Spain. In Japan interest rates had been reduced to historically low levels by a 0.75% cut in September 1993, and no further reductions took place in 1994.

 The decline in inflation rates in most countries continued in 1994. (For information inflation rates in selected countries, see Graph I—>.) A few notable exceptions were found in Latin America and Eastern Europe. In the developed countries the outturn was better than expected, and inflation was ceasing to be a major issue. In OECD countries inflation dipped to around 2.5%, the lowest in more than two decades, but central banks remained vigilant and prepared to raise interest rates to prevent an upsurge in inflationary rates as economic recovery gathered pace. In the LDCs the median inflation rate rose slightly to 9%. Inflation remained relatively high in Latin America and Eastern Europe. Brazil's inflation accelerated to over 2,300% early in the year, but the introduction of a new, stronger currency, the real, brought monthly rates down to single digits, and at year's end annual inflation was under 1,100%. By contrast, it was only 3-8% in Argentina, Chile, and Mexico (despite the devaluation of the peso in December). In Central and Eastern Europe, ongoing economic reforms kept inflation relatively high. There was a dramatic slowdown in Russia from almost 1,000% in 1993 to around 300% in 1994. Inflation accelerated in Turkey, but in South Asia it was generally stable. In China inflation had doubled to 27%, despite measures taken to slow the pace of activity in the economy.

      Economic policy makers remained concerned with reducing their budget deficits during 1994. In the developed world this meant tight control of government spending and few tax concessions. Fortunately, the faster-than-expected recovery had begun shrinking deficits by boosting tax revenue and reducing payouts to the unemployed. In the U.S. the budget deficit fell to $202 billion from $255 billion the year before and was heading for $168 billion in 1995. In the U.K. it came in at £ 34 billion. In 1993 it had been £ 45 billion, and it was forecast to fall to £ 21 billion in 1995. In other EU countries, except Italy, and in Sweden, budget deficits as a proportion of GDP were expected to fall within a few years from the 1994 average of 6.5% to the less than 3% stipulated in the Maastricht Treaty as a convergence criterion for economic and monetary union. Japan was the only large economy where fiscal policy was stimulatory; significant tax cuts were accompanied by long-term plans to further boost government spending.

      The IMF expected the external debt of the LDCs to rise by around 8% in 1994. This was similar to the increase seen the year before. Although in absolute terms the LDCs' debt continued to increase, as a proportion of exports of goods and services it was expected to be slightly down from the year before, with a further decline possible in 1995.

NATIONAL ECONOMIC POLICIES

United States.

       Real Gross Domestic Products of Selected OECD Countries, TableThe pace of U.S. economic activity accelerated during 1994, and GDP grew by nearly 4%—the best performance in five years (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). At this level the economy was running close to full capacity, and the Fed repeatedly raised interest rates in an effort to keep inflationary pressures at bay and to prevent the economy from overheating. Despite charting an uneven course, economic growth during most of the year was at a rapid and unsustainable level. A blistering 6.3% rise in the final quarter of 1993 was followed by an abnormally slow 3.3% in the opening quarter of 1994, largely because of severe weather and an earthquake in California. Unsurprisingly, economic growth accelerated to 4.1% in the second quarter, but the pace eased a little to 3.9% in the third quarter, only to pick up again in the final quarter.

      The economic expansion during 1994 was driven by fixed investment (including housing investment), export sales, and stronger consumer demand. Despite the increasing cost of borrowing, business investment rose by over 10%. Residential investment surged by a similar amount earlier in the year. Faced with a high capacity utilization and improved corporate profits, companies invested heavily, especially in information technology.

 Responding to higher demand, production (Graph II—>) and capacity use rose further in 1994, and output reached record levels. Although the pace moderated somewhat after the summer, manufacturing output for the year grew by more than 6%, leading to tightness in manufacturing industries. The industrial-capacity utilization rate of 84.9% in October was a touch higher than the previous cyclical peak of 84.8%.

      Consumers, encouraged by modest income growth and higher employment, increased their retail spending by 6% in real terms during the year, at a slightly faster pace than the year before. Spending on interest-rate-sensitive durable goods, including automobiles, furniture, and household goods, was strong during most of the year. Overall, retail sales were up 7.6%, but retailers reported a falling off in November and December.

      In contrast to private spending, government spending fell by nearly 6% as a result of budget-reduction measures introduced in 1993 and earlier. Most of the decline was attributable to lower defense outlays. Nondefense spending also fell slightly, while expenditure at state and local levels picked up as a result of federal infrastructure projects. The U.S. economy showed robust growth, despite the faster-than-expected fall in government spending and a rapid contraction in the budget deficit. The budget deficit for fiscal year 1994, ended in September, was $202 billion, down from the previous year's $255 billion.

       Standardized Unemployment Rates in Selected Developed Countries, TableThe robust economic recovery created new jobs at an average rate of 300,000 a month and reduced the unemployment rate to its lowest level since 1990 (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)). As in the previous 10 years, most of the new jobs occurred in low-paid, part-time service sectors. Nevertheless, this strong job creation cut the unemployment rate to 5.4% in December from 6.7% in January.

  Consumer Prices in OECD Countries, TableA striking feature of the sustained economic growth in 1994 was the lack of inflationary pressures. Consumer prices (Table II (Consumer Prices in OECD Countries, Table)) rose 2.7%, less than generally expected, and the core inflation rate (Graph I—>) declined to 2.6% from 1993's average of 3%. Wages and salaries grew at a similar rate during the year, squeezing real (inflation-adjusted) take-home pay.

 Exports performed better in 1994, stimulated by the decline in the external value of the dollar and by the worldwide economic recovery. Exports of goods and services rose by more than 7%, but export growth was once again outstripped by that of imports, reflecting the strength of domestic demand. Imports grew by around 12% but in the closing months slowed considerably. This was due to the weakness of the dollar (Graph V—>), which made imports more expensive. Nevertheless, the U.S. was heading for a larger trade deficit of $150 billion, much higher than in 1993, which, at $116 billion, had been the worst since 1988. Likewise, the current-account deficit (including trade balances on invisibles and capital movements) widened.

  Economic policy making during 1994 was characterized by the active use of monetary policy. The Fed reversed the five-year trend of falling or stable interest rates (Graph III—> and Graph IV—>) with six successive rate increases. The first move, in February, was seen as a preemptive strike to stop the economy from overheating. In August, when it raised the Fed funds rate for the fifth time, from 4.5% to 4.75%, the Fed indicated that it had almost attained its goal of neutral monetary policy. In November, however, the Fed raised interest rates by another 0.75%, higher than generally expected. Significantly, the Fed left the door open for further rises in 1995 to check inflation before it became a problem. In line with the upturn in the Fed funds rate, commercial banks raised their prime rates from 6% in January to 8.5% in August. As the year drew to a close, a lively debate continued among economists about whether the successive interest-rate increases had tightened policy sufficiently to cool the economy. The financial markets did not think so and were betting on another rise in the new year.

Japan.

       Real Gross Domestic Products of Selected OECD Countries, TableThe stagnation in the world's second largest economy ended during the last quarter of 1993, but the recovery in 1994 was less robust than previous ones. After uneven progress in the first half of the year, the pace of economic activity picked up in the summer, giving a GDP growth of nearly 1% for the year as a whole (Table 1 (Real Gross Domestic Products of Selected OECD Countries, Table)). A pickup in consumer spending was largely responsible for this recovery. The sluggish upswing was explained by the fact that previous recoveries had been led by strong growth in capital investment and exports. In 1994 both of these factors were weak because of three structural weaknesses in the economy: surplus industrial capacity, deflation, and the weakness of the financial system.

      Faced with a stagnant economy despite four spending packages totaling 45 trillion yen over the previous two years, the government introduced further measures in February to boost demand. These included tax cuts of 5,850,000,000,000 yen, with reductions in income, residential, and car sales taxes. These benefits were passed on as a tax rebate in the summer. Helped by a hot summer, lower-priced imports, and heavy retail discounting, consumer spending improved. In the three months to August, sales in department stores and supermarkets were 3.4% higher than a year earlier, compared with a 1.5% annual decrease in the previous three months. On the basis of partial data, total private consumption (a wider measure of spending) was estimated to have risen by 2%.

       Standardized Unemployment Rates in Selected Developed Countries, TableThere was little contribution to demand from employment and rises in wages. The jobless total rose to more than two million, or about 3% of the workforce (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)), in the final quarter of the year. At this level 20% more people were out of work than a year before. This was a large rise in an economy where layoffs were still taboo and employers accomplished reductions in workforce by curbing recruitment and encouraging early retirement. The immediate outlook was not too encouraging, as employment traditionally lags behind the economy. In an effort to safeguard jobs, employees were agreeing to lower increases, smaller bonuses, and reduced overtime. In the autumn industrial wages were down more than 1% from a year earlier.

 Despite the hesitant recovery, industry made good progress in reducing its vast inventories of unsold goods. As private consumption growth boosted imported goods, industrial production (Graph II—>) was a late beneficiary. Industrial production picked up late in the year and in the third quarter was 1.6% higher than a year before. Because of a 2% decline in the first half, however, it was virtually flat for the year as a whole. Although there had been some improvement, Japanese industry still suffered from a large overhang of surplus capacity—a legacy of large capital investment during the halcyon days in the 1980s. During 1994 a decline in industrial capital investment eased to 4% from 8% the year before, giving rise to hopes that it might start rising in 1995.

    Consumer Prices in OECD Countries, TableThe disinflationary effect of the yen's strength on the prices of imported goods, coupled with heavy price discounting by large retailers, pushed down the annual inflation rate (Graph I—>) of 0.2%. Earlier in the year the rate had been negative, but higher prices for seasonal foodstuffs in the summer pushed up inflation a little. This return to the previous low levels was good news for consumers (for information on consumer prices, see Table II (Consumer Prices in OECD Countries, Table)), but there was a risk that it could squeeze the profits of manufacturers. It was feared this could further undermine manufacturers' confidence and cause them to delay or cancel investment decisions. A related problem was the continuing decline in the prices of land and commercial property. (Since the bubble burst in 1990, commercial property prices had fallen by nearly 50%.) This had increased the amount of nonperforming or bad debts, making the banks even more cautious about extending new loans. Thus, money-supply growth was sluggish and in the third quarter edged up by 1-2% year-on-year, well below the 5% annual growth considered necessary to fund a strong revival. Against this backdrop, the Bank of Japan's monetary policy remained accommodating. Short-term interest rates were unchanged during the year. (For short-term and long-term interest rates, see Graph III—> and Graph IV—>.)

 As a result of a surge in imports and a slowdown in exports (partly a reflection of the yen's appreciation), the trade surplus fell back to an estimated $130 billion from the previous year's record $142 billion. There was no corresponding reduction in the huge current-account surplus, estimated at $135 billion ($130 billion in 1993). Because only a part of this surplus was recycled, it maintained an upward pressure on the yen (Graph V—>), but it was not enough to deflect from Japan's long-standing trade friction with the U.S. and the EU.

United Kingdom.

       Real Gross Domestic Products of Selected OECD Countries, TableDuring 1994 the U.K. economy enjoyed a favourable combination of rapid expansion, subdued inflation, relatively stable interest rates, booming exports, and falling unemployment. Nevertheless, this rosy economic picture had not translated into a "feel-good" factor or government popularity. A late upward revision to economic statistics indicated that GDP grew by nearly 4% (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). This better-than-expected performance was largely due to higher consumer spending, stronger export demand, and a recovery in investment, albeit from a low level.

  Concerned that the rapid pace of economic growth might lead to faster inflation in the future and blow the economy off course, Chancellor of the Exchequer Norman Lamont and the governor of the Bank of England raised interest rates (for short-term and long-term interest rates, see Graph III—> and Graph IV—>) sooner than expected. A surprise 0.5% rise in the banks' base rates to 5.75% in early September mirrored similar preemptive moves by the Fed. The move marked the beginning of a shift toward neutral monetary policy, and higher interest rates were widely anticipated in 1995.

      Despite better-than-expected progress in reducing the public-sector deficit, fiscal policy remained restrictive. For the second consecutive year, overall government spending was cut substantially and, as a result of phased tax increases introduced in 1993, the tax burden further increased. Arguing that "sound economics is good politics," Lamont opted to apply the revenue windfall arising from faster-than-expected economic growth and lower-than-projected inflation to reducing the public-sector deficit. Thus, voter-friendly tax cuts were deferred to a future date closer to the next general elections, which were not due before April 1997.

       Consumer Prices in OECD Countries, TableThe engine that fueled growth until mid-1994 was the rise in consumer spending. (For information on consumer prices, see Table II (Consumer Prices in OECD Countries, Table).)The delayed impact of April tax increases, continuing fears about job security, and unease about the future direction of interest rates, however, caused the pace of consumer spending to slow. In the final quarter of the year, retail-sales volumes were barely 3% higher than those of 1993, compared with more than 4% earlier in the year. Car sales also lost momentum, particularly private (nonfleet) purchases.

 As consumer spending faltered, export growth sustained the pace of economic activity. During 1994 export volumes were up by 10%, reflecting the global economic recovery. Improved competitiveness of British exports, thanks to low inflation and the relatively weak pound sterling (Graph V—>), also contributed to export growth. Imports grew more strongly than in 1993, but the annual growth rate lagged well behind that of exports. As a result, both trade and current-account deficits were smaller than in 1993.

      Investment in manufacturing, having fallen steeply since 1989, picked up in 1994, but its contribution to economic recovery was small. Total investment grew by more than 3% in 1994; it was mostly aimed at improving productivity and efficiency with only a small increase in capacity. Construction activity, including home building, also showed some recovery, again from a low base.

 On the supply side, the pace of industrial production (Graph II—>) quickened, reflecting growth in demand. By late summer, however, a slowdown was evident. Manufacturing output in the third quarter stood 3.7% higher than a year earlier, having been 5.8% higher in the second quarter.

 Historically, inflationary pressures had revived early when the British economy was coming out of a recession. During 1994, after more than two years of recovery, the various inflation (Graph I—>)indicators all remained at a low level. The headline rate of inflation in November was 2.4%, which was below the Bank of England's forecasts. Strong price competition between retailers and continuing productivity gains were the main reasons for slack inflationary pressures. Average earnings growth in the closing quarter was below 4% and steady, but because of efficiency gains, wage costs per unit of output fell slightly.

       Standardized Unemployment Rates in Selected Developed Countries, TableThe modest increase in wage settlements reflected the general improvement in the labour market. Unemployment (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)), having reached a peak of 2,960,000 in January 1993, dipped to under 2.5 million, or 8.9% of the workforce, in October. In addition to economic expansion, this better-than-expected reduction in joblessness was largely due to an increase in self-employment and a decrease in the number of people registering as available for work.

Germany.

       Real Gross Domestic Products of Selected OECD Countries, TableEconomic activity in Germany exceeded expectations in 1994, and GDP in Germany as a whole expanded by almost 3% for the year (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). Growth in the western part of the country was around 2.5%, while in eastern Germany it was 10%. Although the eastern German economy was still heavily dependent on western Germany for transfer payments, it made progress toward self-sustained growth.

 The economic upswing in western Germany was mainly supported by strong growth in exports, a rise in construction, and increased business investment activity. Boosted by stronger foreign demand, manufacturing output (Graph II—>) and capacity utilization both rose. Export volume grew by nearly 5% during 1994, reversing 1993's 10% decline. Apart from the faster pace of economic growth being enjoyed by Germany's main trading partners, this rise in exports was due to an increase in the competitiveness of German products. Moderate wage settlements, corporate restructuring, and substantial staff reductions were cited as the main elements behind this.

      Gross capital investment rose by an estimated 2.5% in the west and 14% in the east, giving a pan-German increase of 4%. Investment in machinery and equipment was comparatively sluggish despite improved capacity utilization, suggesting that industrialists were in no hurry to expand capacity. Construction activity remained strong in eastern Germany, where housing construction complemented infrastructure improvements. Construction also expanded rapidly in western Germany, where demand for housing was stronger in response to lower interest rates and government incentives to ease housing bottlenecks caused by the high levels of immigration in recent years.

      By contrast, consumer expenditure remained flat. A modest decline in the west was offset by a 1.3% gain in the east. Spending was depressed in the west by the introduction of higher taxes in January 1994 and by the virtual freeze on wages. Although inflation moderated, real disposable incomes in western Germany declined slightly.

  Standardized Unemployment Rates in Selected Developed Countries, Table Consumer Prices in OECD Countries, TableUnemployment (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) stabilized rather than improved, which was to be expected in the early stages of a recovery. Total unemployment stood at 3.6 million at year's end, nearly half a million above 1993 but below the spring peak. In western Germany the unemployment rate averaged 8%, compared with 15% in the east. The latter figures excluded disguised unemployment (early retirement, job creation, and training schemes), which stood at close to one million. Considerable progress was made in reducing the inflation rate (Graph I—>); after three years of relatively high inflation in the east, prices moved broadly in line with those in western Germany. Consumer prices (Table II (Consumer Prices in OECD Countries, Table))in October were 2.8% higher than a year before in western Germany and 3.2% in the east.

  Against the backdrop of economic recovery, the government's fiscal policy remained one of tackling the deficits that had resulted from unification. Thus, the budget approved in July planned a nominal increase in federal government spending while holding the borrowing requirement broadly unchanged at DM 69 billion. The total deficit, however, including deficits of the Treuhandanstalt (privatization agency) and those of the states and municipalities, was much higher. Despite measures introduced in 1993 but not due to come into force until 1995 (such as reduced unemployment benefits and reintroduced solidarity surcharge), no early reduction in the deficit was projected. Monetary policy, on the other hand, was geared toward maintaining stable interest rates (Graph III—>) following a series of stepped reductions in the spring. These reduced the discount rate from 5.75% to 4.5% and the Lombard rate (the rate at which the Bundesbank offered emergency funding) from 6.75% to 6%. Despite the growth of the money stock outside the target range and weakness in the bond markets, which increased long-term interest rates (Graph IV—>), the Bundesbank opted for a policy of consistency and did not reverse the spring cuts in interest rates.

France.

       Real Gross Domestic Products of Selected OECD Countries, TableThe modest economic recovery, which started in the summer of 1993, gathered pace during 1994 (Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). Compared with expectations of around 1% growth, GDP expanded by 2.7%. This strong upturn effectively negated the claims of those who argued during the 1993 currency crises that France's tough anti-inflationary stance and its policy of keeping interest rates tied to German rates would prolong the stagnation of the economy.

      The recovery in 1994 was based on a mixture of stronger external demand, higher consumer spending at home, and a rise in investment. Consumer spending was stimulated early in the year by a F 5,000 government incentive to new-car buyers. Although the effect of this incentive tailed off by the autumn, consumer spending held up and rose by 1.5%. Improved external demand, however, came from economic recovery in Germany, France's most important trade partner, and from the U.S. and the Far East. As domestic demand picked up during the year, the contribution of foreign trade to economic growth declined. Nevertheless, the trade balance was heading for a surplus of F 80 billion, only slightly down from F 83 billion in 1993 and well in excess of 1992's F 32 billion.

  Standardized Unemployment Rates in Selected Developed Countries, TableBusiness investment recovered in 1994 in response to a marked increase in capacity utilization, particularly in automobile and capital-goods sectors. The upturn in production (Graph II—>), investment, and consumption had a marginal effect on the labour market. Thus, the total number of unemployed, at 3.3 million, was higher at year's end than at the beginning of 1994. At this level, the rate of unemployment (Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) stood at 12.6%, just below the post-World War II record level of 12.7% reached in May 1994. Not surprisingly, unemployment remained a major concern for the government, and several measures to fight unemployment were included in the September 1994 budget. These were aimed at reducing the cost of training less-qualified people and encouraging firms to hire young people.

    Consumer Prices in OECD Countries, TablePartly as a result of the gloomy employment market, wages and salaries grew at a subdued rate of 2.5% (2.8% in 1993). The downward drift in consumer prices (Table II (Consumer Prices in OECD Countries, Table)) also dampened the rise in earnings. Average inflation (Graph II—>) edged down to 1.7% from 2.1% in 1993. This outcome was in line with the Bank of France's objective of price stability. Despite greater freedom allowed by the 15% bands within the ERM, the value of the franc remained stable against the Deutsche Mark. This was achieved by keeping the French interest rates (for short-term and long-term interest rates, see Graph III—> and Graph IV—>) closely tied to German rates. The intervention rate, the floor for money market rates, was gradually reduced to 5% from 6.2% in the spring.

      Fiscal policy in France remained focused on curbing the public-sector deficit in line with a five-year plan. With the aid of higher revenues from privatization and a freeze on real expenditure, the government aimed to cut the deficit in 1994 to F 330 billion—a reduction of F 16.5 billion. The target was to reduce the deficit by a further F 25 billion in 1995. With the approach of presidential elections in the spring of 1995, fiscal rigour would have been increasingly difficult to maintain had it not been for the economic recovery.

The Former Centrally Planned Economies.

      The economic decline in the former centrally planned economies continued for the fourth consecutive year, but the rate slowed from the peak decline of 15.5% in 1992 to 9% in 1993 and 8.3% in 1994. The outlook was improving, with many countries beginning to expand, and output was expected to fall by only 1% in 1995.

      The best-performing countries were those in Central Europe, where the reforms necessary to create a market economy had been put in place soon after the fall of communism, five years earlier. The overall output of Central and Eastern Europe (excluding Belarus and Ukraine) grew by 1.4% in 1994, compared with a decrease of 2.3% in 1993. Several countries were growing rapidly, with, for example, Hungary's output expected to increase by more than 4% because of strong investment and export performances.

      Russia was still lagging behind, with output falling by 12% in 1994, as it had in 1993. Most of the former Soviet republics were also continuing to experience declines in output. Many had high rates of inflation that were causing social problems as well as acting as a deterrent to investment. Worst affected was Georgia, where prices in 1994 were expected to rise by 10,000%, followed by Azerbaijan with an increase of more than 5,000%.

      Exceptional among the former Soviet states were the three small Baltic countries, Estonia, Latvia, and Lithuania, which all registered increases in output and had sharply falling inflation rates. All of them were asserting their economic independence from Russia and were anxious to become part of the EU, with which they were expected to negotiate association agreements in the near future.

      Problems associated with restructuring continued. One of the most refractory was unemployment, of which the countries had had little experience under the old regimes. In many countries, as in Western Europe, early retirement was being used as a means of reducing labour forces. Welfare systems were able to offer little assistance, financial or otherwise. The numbers of unemployed were estimated to have risen in most countries in 1994. The situation was compounded by the lack of training or retraining facilities. There was a general lack of entrepreneurial skills and little knowledge or willingness to encourage them. People often needed more than one job to meet basic needs.

      Open unemployment was greatest in the countries most advanced with economic reform, including Hungary, Poland, Albania, and the Baltic states, where the number of registered unemployed was equivalent to between 10% and 20% of the workforce. In some countries the rates exaggerated the true situation. The Czech Republic was exceptional among the more advanced countries because of its low unemployment rate of 4%. Although strict eligibility conditions applied to unemployment benefits, which may have influenced registrations, the many training programs under way, as well as the prospect of job opportunities in nearby Germany, contributed to the improved employment figures.

      In the Transcaucasian and Central Asian countries, registered unemployment levels remained low, partly because of the stigma attached to being without a job but also because of the low or negligible benefits that were available. In Russia official unemployment stood at 1.5% of the labour force, but by international measuring standards the figure would be at least 6%, with as many again working short hours.

      The privatization process was continuing in 1994 but was far from complete. In 9 of the 25 countries in the region, the private sector contributed over half of national GDP. The Czech Republic led in this respect, with private enterprise contributing 65% of GDP. Little headway was made in privatization of the agricultural sector, and land reforms were needed. The Czech Republic, Hungary, Poland, Slovakia, and the Baltic states were beginning to make progress on large-scale privatizations and the reforms needed in the financial sector to support them. The other former Soviet republics, including Kyrgyzstan and Russia—where political difficulties hampered the reform effort—carried out large programs of privatization in 1994, but their financial sectors needed reforms and restructuring.

      Privatization was a vital part of the restructuring process in the region, not least because of the foreign direct investment (FDI) it attracted. Central and Eastern Europe privatizations attracted 67% of all FDI flows into the region in the four years to 1992, a much greater share than any other of the world's regions attracted. The share of FDI in privatizations in all LDCs averaged 5%, led by Latin America and the Caribbean, where privatizations took a 14% share.

      The cumulative inflows of FDI registrations in the transitional countries reached nearly $20 billion in the period 1991-93. The U.S. and Western European countries were most active, while Japan, which was one of the world's leading investors, showed little interest. More than half of the investment was in manufacturing. Often single projects—such as in the automobile industry in Poland and the Czech Republic—accounted for much of the investment. Certain sectors, too, attracted the interest of single countries. For example, more than two-thirds of all medium or large hotel investments were being promoted, developed, financed, or managed by Austrian companies.

      Although foreign investment into Central and Eastern Europe was increasing at a fast rate, it was from a very low base. In absolute terms, the amount was not so significant. Between 1990 and 1993 total FDI into the region was less than the $15 billion received by Singapore alone. Investment was also heavily concentrated in the Czech Republic, Slovakia, Hungary, and Poland.

      There were a number of reasons why the region failed to attract a larger share of world FDI flows. Output was still declining and was not providing the strong consumer demand investors liked. Inflation rates were high, and currencies in some countries were unstable. These factors often combined with inadequate physical and financial infrastructures and with a lack of the regulatory mechanisms associated with free markets. This made the region less attractive for foreign investors than other destinations, such as countries in Asia that were competitive and politically stable.

      Nevertheless, foreign investment was playing a more significant role in the region than its size might have suggested. Foreign capital was revitalizing industries, and transnational companies from Western Europe were forging new trade links with the East. Most important were the transfer of technology and the development of human resources that were taking place. Franchising, which was becoming more acceptable, was already popular in Hungary and was growing in Poland, Slovakia, and the Czech Republic. McDonald's had been established in the region for several years, and other fast-food restaurants were making headway, as were print shops, hair salons, hotels, and computer centres.

      Restructuring was having an adverse impact on tax revenues in the short term. High inflation eroded the value of tax collected, and the private sector, which was producing most of the economic output, was harder to tax. Taxation systems were being modified to be more compatible with a market system. Value-added taxes were replacing turnover taxes, and corporation taxes had become necessary. Tax administration needed to be improved and accounting skills learned. With falling revenues, governments were finding it difficult to meet the growing demand for social services, such as housing, education, and health care, which had often been provided by state enterprises in the past. The need to protect the most vulnerable members of society and provide for future pensioners was a growing concern.

Less Developed Countries.

       Changes in Output in Less Developed Countries, TableEconomic growth in the LDCs, at 5.6%, remained largely unchanged from 1993. (For Changes in Output in Less Developed Countries, see Table IV (Changes in Output in Less Developed Countries, Table).) The main factors driving growth for the second year running were continuing benefits of economic reforms, low interest rates, and export growth. The latter was of strong benefit to countries in South Asia. Regionally, growth was strongest among the Asian countries, led by China. As a result of measures introduced in 1993 to control an unsustainable economic boom, GDP growth in China moderated to around 10% from over 13% in 1993. In many other Asian countries, economic growth remained strong. Singapore, Malaysia, South Korea, Thailand, and Vietnam all experienced economic growth rates of 8-9%. The economies of Hong Kong and Indonesia expanded relatively less strongly. The manufacture of electronic and consumer goods was an important element of economic activity in this region, and faster U.S. economic growth and an upturn in global economic activity stimulated their exports. The recovery in India accelerated a little to 4.5% as the economy continued to respond to liberalization. In Latin America, with the exception of Venezuela, economic growth remained largely unchanged at 3-4%. In Africa, despite a recovery in South Africa, drought, internal strife, and civil war induced stagnation or decline in other countries. In the Mediterranean region a financial crisis in Turkey and the effects of civil war in former Yugoslavia led to lower growth rates.

       Changes in Consumer Prices in Less Developed Countries, TableAlthough median inflation in LDCs moderated somewhat, it remained at a high level in many countries. (For Changes in Consumer Prices in Less Developed Countries, see Table V (Changes in Consumer Prices in Less Developed Countries, Table).) Brazil had an annual inflation rate of close to 1,100%, but there were signs of easing. Venezuela's inflation increased to around 70%. Elsewhere in the region, however, inflation was below 10%. Economic reforms in Central and Eastern Europe kept inflation at 10-30%. In Russia there was a dramatic slowdown from almost 1,000% in 1993 to around 300% in 1994. Most of South Asia held steady at 3-9%, while China (27%), to the east, and Turkey (over 100%), to the west, rose rapidly. Across Africa inflation was generally stable at around 35%, but in South Africa it remained unchanged at around 9%.

      There was no improvement in the external balances of the LDCs during 1994. IMF projections pointed to an expected current-account deficit of $106 billion. This was true despite the fact that exports from the LDCs increased slightly faster than imports. In Asia export volumes increased by 10%, two to three times as fast as in other regions of the world. Although the financing of the deficit was not problematic, the IMF expected the total external debt of the LDCs to rise by 8% to $1,675,000,000,000. Total debt as a proportion of exports and services continued to decline, however, and was expected to drop to 121% in 1994.

INTERNATIONAL TRADE

      The volume of world trade grew by 7% in 1994, well above the long-term growth rate of 5%, according to IMF projections. Revisions to the previous year's figures indicated that the slowdown in world trade in 1993 was not as sharp as previously estimated. The revised estimates suggested that world trade grew by 4% in 1993—1.5 percentage points faster than earlier projections. (This revision was caused by distortions and delays in data collection within the EU since the abolition of customs controls.)

      The upswing in world trade in 1994 was largely due to increased economic activity in developed countries, higher imports by the former communist countries in Europe, and continued rapid growth in LDCs. It was increased trade among the developed countries, however, that really buoyed world trade. Imports by the developed countries as a group grew by over 7% in 1994 from under 2% in 1993. By comparison, their exports expanded by 6%, up from 2.4% in 1993. Exports from the LDCs, on the other hand, improved marginally from 8.9% to 9.1%, while the volume of their imports dropped to 7% from the previous year's 9%.

      Germany and the U.K. were the largest contributors to the surge in export volume in the developed world. Improved competitiveness, thanks to moderating inflation, corporate restructuring, and favourable currency movements against the dollar, boosted export growth in Germany (nearly 10% after a loss of 2% in 1993) and the U.K. (9% versus 2% in 1993). Despite the strength of domestic demand, exports from the U.S. gathered pace, thanks to the weaker dollar. By contrast, Italian exporters could not maintain the previous year's rapid growth rate, and export growth eased back to 6% from 8% in 1993. The appreciating yen and continuing trade hostility from the U.S. and Europe meant another year of slight decline in exports from Japan.

      The growth in import volumes in developed countries was strongest among those at an advanced stage of recovery. Thus, the volume of import growth in the U.S., which was in its third year of recovery, swelled rapidly at 11.5%, well above the long-term average but not as fast as the previous year. In Europe economic recovery led to strong growth in imports by around 5%, more than making up for the 4% decline in 1993. There was a strong rise in imports into Japan, despite weak domestic demand. This was almost entirely due to the stronger yen, which made imported goods cheaper, but it was also in response to pressure on Japan to open its markets.

      Many formerly communist countries looking for new export markets in the industrialized countries, particularly the EU and the U.S., found it difficult going. Their exports, which increased only by around 5%, were constrained by non-tariff barriers. Although a slower increase in import volumes prevented the trade balance from deteriorating, this group of countries continued to experience a fairly large current-account deficit.

      The volume of exports from LDCs rose faster than imports owing to higher demand from manufacturers in the recovering developed countries as well as continuing rapid growth in Southeast Asia. Not surprisingly, Asia continued to increase its share of trade, with export volumes rising by 11% and imports by over 10%. Rapidly expanding domestic demand in China limited the resources available for exports and led to a surge in imports. In other regions export volumes in 1994 grew at the same rate as the year before (2-6%). Middle Eastern countries and Africa were at the lower end of this range, while Latin America experienced relatively faster growth in its exports. The volume of imports into LDCs grew more slowly for the second year in succession. The largest contributor to this slowdown was an actual drop in imports by Middle Eastern and European countries, but there was a slight slowdown in Asia and Latin America, too.

      Although the LDCs earned more per unit of exports (partly because of currency movements and higher commodity prices), prices paid for imports rose faster. According to IMF estimates, their terms of trade declined by around 1.7%—slightly faster than the year before. The fuel-exporting countries were affected most, and their terms of trade fell by 8%, largely as a result of the weak dollar. In most developed countries, the terms of trade declined marginally, reflecting higher commodity prices. Japan, with its appreciating currency, went against the trend and experienced an 8.5% gain in its terms of trade.

      The trade-liberalization process continued in 1994. The U.S.-Japan trade talks were successfully concluded in October but not without another cliffhanger reminiscent of the talks between the U.S. and the European Communities on the General Agreement on Tariffs and Trade (GATT) Uruguay round in December 1993. After 15 months of acrimonious talks, the U.S. and Japanese negotiators reached a partial agreement on trade just in time to avert U.S. sanctions against Japan. Two of the agreements opened up the Japanese telecommunications equipment market to foreign competition. The third deal was intended to make it easier for foreign companies to bid for Japanese government contracts to supply medical equipment. The fourth would classify regulations in Japan's insurance market. In one important area—automobiles and auto parts, which accounted for more than half of the U.S. trade deficit with Japan—no agreement could be reached. The U.S. was to investigate this Japanese market under Section 301 of U.S. trade law and threatened to impose sanctions in 12-18 months' time.

      Last-minute ratification by the U.S. Congress and the European Commission of the GATT Uruguay round agreement paved the way for the World Trade Organization to take over from GATT on Jan. 1, 1995. This followed a ceremonial signing of the Uruguay round in Marrakech, Morocco, in April by representatives of 120 governments. Once again the wrangling and brinksmanship delayed the ratification by the leading players until very close to the deadline of December 31.

      The timetable was nearly wrecked by three unrelated developments. First, there was prolonged opposition from Republican protectionists in the U.S. Congress. This was overcome by a deal between Pres. Bill Clinton and Robert Dole, Republican leader in the Senate, after the November midterm elections ensured the Republicans majority control in Congress. Second, a power struggle broke out between the EU Council of Ministers (representatives of its 12 national governments) and the European Commission (unelected administration) on whether the Commission had the right to be the sole negotiator on trade matters. The dispute was resolved by a ruling by the European Court of Justice. The final delay was due to continuing political upheavals in Japan that disrupted the parliamentary calendar.

      Despite huge uncertainties surrounding any estimates on economic benefits likely to arise from the Uruguay round, GATT economists in 1994 increased their estimates. If implemented by all 123 countries, by the year 2005 (the target date for full implementation of liberalization commitments), world income would rise by an estimated $510 billion a year (previous estimates had been $235 billion). The biggest gainer was the EU, with $164 billion a year by 2005. The annual gain for the U.S. was expected to be put at $122 billion, with Japan gaining $27 billion.

INTERNATIONAL EXCHANGE AND PAYMENTS

 The year 1994 was characterized by large swings in foreign-exchange markets (for Effective Exchange Rates of selected currencies, see Graph V—>), largely driven by the weakness of the U.S. dollar and the strength of the Japanese yen. The most striking swing was in the Mexican peso, which fell 42% in 11 days after the newly elected government of Pres. Ernesto Zedillo Ponce de León (see BIOGRAPHIES (Zedillo, Ernesto )) devalued the currency on December 20. The European currencies, however, did not exhibit the kind of instability feared following the widening of the ERM bands to 15% in August 1993.

  The closing months of 1993 witnessed interest rates (for short-term and long-term interest rates, see Graph III—> and Graph IV—>) falling steadily in Europe, with hopes of more to come in the new year. The continuing weakness of the Japanese economy prompted expectations of a further interest-rate cut. By contrast, interest rates had been widely expected to rise in the U.S. as economic recovery moved into top gear. Sure enough, in early February the Fed raised its Fed funds rate by 0.25% to counter possible inflationary pressures arising from rapid economic growth. This was followed by another small rise in March. The tightening in policy was a shot in the arm for the dollar, and it moved up briskly to 113 yen and DM 1.76. Despite further interest-rate rises in April and May, however, sentiment turned against the dollar. New economic indicators pointed to continuing rapid economic recovery in the U.S., industries working at almost full capacity, and rising commodity prices. The financial markets became concerned with inflationary pressures building in the U.S. economy. This led to uncertainty on when and how far the Fed would have to raise interest rates to slow down the pace of activity. All this, together with the deadlock in its trade dispute with Japan and a continuing large U.S. trade deficit, undermined the international investor's confidence in U.S. assets and resulted in capital outflows. In turn, this weakened the dollar in spite of widening short-term interest-rate differentials between the yen and Deutsche Mark. By June the dollar had breached the psychologically important 100-yen level and moved below DM 1.60.

      The weakness of the dollar in early summer was amplified by signs of economic recovery in Germany and Japan. This led to expectations that short-term interest rates in Germany and other EU countries had reached their bottom during the current cycle. Likewise, a 1% growth in Japan during the first quarter made further interest-rate cuts unlikely and attracted international capital into yen-denominated financial assets. Failure of the large developed countries in the Group of Seven to take action in their July meeting to support the dollar sent the U.S. currency plunging to a post-1945 low of 96.9 yen and a 20-year low of DM 1.52. A brief period of relative stability followed, helped by three factors: reassuring statements by the U.S. administration that it did not want a weaker dollar, GDP data for the second quarter that were less strong than expected, and another increase in the Fed funds rate (the fifth) in August.

      By September the financial market's fears of inflation were being reignited by new economic indicators signaling that economic activity was strengthening again. Consequently, for the next two months the U.S. bond market and the dollar came under pressure, despite a last-minute settlement of the U.S.-Japan trade talks, and hit new lows against the yen and the Deutsche Mark. The dollar rallied somewhat after the year's sixth and final rate increase by the Fed, in November. As the year drew to a close, the dollar was almost to 100 yen and DM 1.57, representing an effective decline of 7.5% against the Japanese and German currencies. On an effective exchange-rate basis, however, the decline was smaller. In December the effective exchange rate of the dollar stood at 62.8%, compared with 66.2% a year earlier, a decline of just over 5%. An unusual feature of the strength of the yen in 1994 was that it tended to reflect the weakness of the U.S. dollar. In 1992 and 1993 the yen's appreciation had been more general and not just against the dollar.

      The global balance of payments position worsened slightly in 1994, reflecting economic recovery and pickup in trade generally. Despite a faster rate of economic activity among the developed countries, the improvement in their current-account balances continued in 1994. IMF estimates pointed to a surplus of $18 billion, a little less than the previous year's dramatically revised surplus of $19 billion. For the second consecutive year, most of the surplus was attributable to the EU. Many European countries were able to take advantage of the buoyant export markets in the U.S. and Asia and increased their exports at a much faster rate than their imports. The U.S. absorbed more imports as the recovery strengthened and ran a smaller surplus on invisibles. Consequently, according to IMF projections, the U.S. was heading for a larger current-account deficit, $150 billion, compared with $103 billion the year before.

      The relentless rise in Japan's current-account surplus continued in 1994, albeit more slowly. Despite a rise in the value of the yen, economic recovery in Europe, and buoyant export markets in the U.S. and Asia, Japan's surplus was heading for a record $136 billion, compared with $131 billion in 1993. If confirmed, this would be the lowest rate of increase since 1990, but it remained a source of friction with Japan's trading partners, particularly the U.S.

      The current-account deficit of the LDCs as a whole was largely unchanged during 1994. IMF projections available in December pointed to an expected deficit of $105 billion, compared with $106 billion in 1993. In Asia the current-account deficit, which had expanded rapidly in recent years, stabilized at around $22 billion. Export growth from the dynamic, rapidly industrializing countries in the region were in line with imports of capital goods and raw materials. Some African countries benefited from higher commodity prices and improved their export earnings. As a region, however, Africa ran slightly larger trade and current-account deficits in 1994. In some Latin-American countries, an upsurge in foreign investments improved their capacity to finance higher imports and led to a widening of the trade and current-account deficit in the region.

      The external debt of the LDCs was expected by the IMF to rise by around 8% in 1994 to $1,675,000,000,000. This was similar to the increase seen the year before. Although in absolute terms the LDCs' debt continued to increase, as a proportion of exports of goods and services it was expected to be slightly down from the year before, with a further decline possible in 1995. Asia and Latin America accounted for two-thirds of all debt. (IEIS)

      This updates the articles bank; economic growth; government budget; international trade.

STOCK EXCHANGES

       Selected Major World Stock Market Indexes, TableWhereas 1993 had been a year of spectacular gains, 1994 turned out to be a year of decline and volatility. (For a combination of Selected Major World Stock Market Indexes, see Table VI (Selected Major World Stock Market Indexes, Table).) Having entered the new year in sparkling form, most stock exchanges found the tide turned against them once the Federal Reserve began raising interest rates in the U.S. The Financial Times Actuaries (FT-A) World Index fell by 3% despite a relatively stronger performance in Japan. Wall Street also avoided an outright fall, and the Dow Jones industrial average (DJIA) ended the year roughly where it started. By contrast, Europe registered a 9% decline, according to the FT-A Europe Index of 708 leading shares. Likewise, most Asian stock markets fell sharply, reversing the steep gains of 1993.

      As for the reasons behind the underperformance, equity markets were upset by the interest-rate environment, even though the economic news was positive. This was understandable, for falling interest rates had been the driving force behind the surge in share prices worldwide in 1993. In 1994, however, rising interest rates in the U.S. and stronger-than-expected economic growth introduced an element of uncertainty: how far would interest rates have to rise in the U.S. to prevent economic overheating? This uncertainty was mirrored in European and Asian markets.

       U.S. Government Long-Term Bond Yields, Table U.S. Corporate Bond Yields, TableRising U.S. interest rates first upset government fixed-income securities (bonds; for U.S. Government Long-Term Bond Yields, see Table VIII (U.S. Government Long-Term Bond Yields, Table)), which in turn undermined equities. The reason for the sharp fall in bond prices, in the face of a series of small rises in U.S. interest rates, was initially the surprise element. More important, the markets had expected the cheap-money policy to continue. As a result, speculative positions were held in bond markets through the use of borrowed funds. Realizing that this was the beginning of a policy tightening and that higher interest rates were on the way, bond funds scrambled to reduce their holdings. This pushed bond prices down and yields up (for U.S. Corporate Bond Yields, see Table IX (U.S. Corporate Bond Yields, Table)), first in the U.S. and then across the world. As there is a direct relationship between bond prices and equity share prices, based on their respective yields, share markets in turn came under pressure. During the rest of the year, bond markets fell steadily and undermined share markets. Thus, investors in bond markets saw a negative return of 17% in the U.S. and over 15% in the U.K., in local currency terms, between January and November. Once a major uncertainty was out of the way with the sixth interest-rate rise in the U.S. in mid-November, relative calm returned to the bond and equity markets, but this was short-lived, and within a week the DJIA had plunged by 50 points, unsettling the rest of the world.

      Many analysts viewed these adverse short-term developments in the share markets not as the beginning of a bear market but as a mid-cycle correction—a transition period between equity markets driven by falling interest rates and those driven by corporate profits. Fundamentally, global economic recovery was seen as a positive development as it improved corporate earnings, and once bond yields stabilized in 1995, growth in earnings and dividends were expected to push equity markets upward. (IEIS)

United States.

 Investors were disappointed in 1994 as a result of a generally sluggish market in the U.S. Stock prices were relatively flat during the year. The range of index prices for the DJIA was an all-time high of 3978.36 to a low of 3593.35. At year's end it stood at 3834.44, an annual gain of a mere 2.14%. The Standard & Poor's (S&P) 500 stock index fluctuated between a high of 482 and a low of 438.92, ending the year at 459.27, an overall decline of 1.54%. The over-the-counter (OTC) stocks represented by the National Association of Security Dealers automated quotation (Nasdaq) composite index moved between a high of 803.93 and a low of 693.79 and closed at 751.96, down 3.2% for the year. Trading volume was up from a daily average on the New York Stock Exchange (NYSE) of 255 million shares traded in 1993 to 291.1 million in 1994. (For New York Stock Exchange Composite Index stock prices, and average daily share volume, see Graph VII—>.) The heaviest volume of trading occurred on Dec. 16, 1994, when 483.2 million shares traded.

      The DJIA climbed steadily in 1993, to close above 3750. It peaked on Jan. 31, 1994, slid below 3600 in April, then rose unevenly to 3923.93 on October 17 before moving down. The market tended to gain gradually for weeks at a time around a trading range with little direction, waiting for some bad news or an unfavourable trend, which would set off a headlong flight. Each time, after a few days the buyers would reappear, and a correction would occur. The first major correction came February 4, when the Dow dropped 96.24 as the Fed raised interest rates for the first time in five years. Between March 24 and April 14, the index fell 302.30 over 10 sessions when a second rate rise persuaded wavering investors to sell. A third bearish movement occurred during June 17-24, dropping the DJIA 174.40 in seven sessions. Sharply higher oil prices and a hard slide by the dollar depressed equity markets. Beginning November 17 the market fell 167.21 in four sessions.

      The best-performing industry groups in the DJIA were: drug retailers, up 33.9%; footwear (1993's worst industry), up 32.58%; and computer software, up 30.59%. The worst performers were: home construction, down 32.62%; entertainment, down 30.24%; and airlines, down 30.11%.

      The actions of the Fed—raising interest rates six times during the year to curb the risk of incipient inflation as the economy grew more rapidly than projected—depressed bond prices and restricted credit. The unemployment rate fell to a four-year low of 5.4%. Bond investors, particularly, feared that vigorous economic growth would lead to inflation that would erode the value of their fixed-income investments. Stock traders were concerned about the impact of recurrent inflation and the rise of interest rates. As the economy gained in strength, investor anxiety about inflation resulted in reluctance to support the bond market and discouraged stock buyers as well. Heavy use of computerized selling programs also depressed stock prices.

      U.S. households owned about $2.8 trillion of stock directly in 1994, three times as much as their mutual funds, in both stocks and bonds. Individuals' direct holdings of Treasury, municipal, corporate, and mortgage bonds totaled another $1.6 trillion. With U.S. workers actively involved in the running of an additional $1.2 trillion of pension funds through 401(k) and other "defined contribution" plans, the universe of hands-on investors grew rapidly. It was also the biggest year for stock buybacks. The total authorized expenditure of companies buying back their stock reached $65.3 billion, shattering the old record of $61.9 billion set in 1989. General Electric announced its intention to buy back $5 billion worth of shares. In a sluggish stock market, cash-rich companies favoured share buybacks as a means of boosting stock prices and strengthening stockholder confidence.

      Merger and acquisition activity in 1994 was the highest in history, surpassing 1988, when $335.8 billion was reported. As of October 31, deals valued at $284.4 billion had been announced, but a flurry of activity late in the year raised the total to $339.4 billion. Among the most active industries were food, telecommunications, health care, and pharmaceuticals. About 8% were hostile takeovers, compared with 1-3% in the early 1990s. The dominant consideration in 1994 was large corporations seeking strategic alliances. Companies that slashed costs in the early 1990s were looking to increase their revenues, and acquisitions were an easy way to do it. Many of the buyers were foreign companies taking advantage of the weak dollar to make their expansion in the U.S. more affordable. The biggest deal completed during the year was AT&T's stock swap for McCaw Cellular Communications Inc. (valued at $18,920,000,000). In other big deals, American Cyanamid Co. was acquired by American Home Products Corp., a hostile tender offer ($9,270,000,000), and Syntex was acquired by Roche Holding Ltd. in a friendly cash tender offer ($5,310,000,000). In much-publicized deals, Viacom Inc. acquired Paramount Communications ($9.6 billion) and Blockbuster Entertainment Corp. ($7,970,000,000). Through November, 1,298 publicly traded U.S. companies were involved in mergers and acquisitions, a record number.

      The leading underwriters in domestic merger and acquisitions activity through mid-October on the basis of completed deals were Salomon Brothers ($44.8 billion), Lazard Freres & Co. ($42.1 billion), and Goldman Sachs & Co. ($38.8 billion). The top three firms in initial public offerings, excluding closed-end funds, were Goldman Sachs, $4,055,000; Merrill Lynch, $3,303,000; and Morgan Stanley, $2,328,000. Leaders in domestic corporate junk bonds, excluding split-rated issues, were Merrill Lynch, $3,953,000; Donaldson, Lufkin & Jenrette, $3,453,000; and Salomon Brothers, $3,374,000. The top three firms in domestic corporate investment-grade debt were Merrill Lynch, $29,261,000; Lehman Brothers, $23,032,000; and CS First Boston, $20,889,000.

      Interest rates made headline news throughout 1994. After the yield on 30-year Treasury bonds sank to a low of 5.78% on October 15, investors in Treasury securities suffered hundreds of billions of dollars in capital losses as the bond yield rose to the 8% level in the last quarter of the year. On October 24 the 30-year Treasury bond finished at 8.04%, the highest close since April 29, 1992, and the first time long-term interest rates had ended the trading day above 8% since April 30, 1992. It slipped back under 8%, however, to end the year at 7.87%. A major cause of losses to investors was the assumption that interest rates would fall, and a wide array of new financial instruments made it easy to place highly leveraged bets on interest rates. Big profits from making the bets in 1992 and 1993 turned into big losses in 1994. Orange county, Calif., lost some $2 billion on derivative investments and had to file for bankruptcy protection. It had grossly overleveraged itself in a gamble on a drop in intermediate and long-term interest rates. The prime rate, which was 6% at the beginning of the year, ended it at 8.5%.

 The volume of shares traded on the NYSE was well above the previous year (For New York Stock Exchange Common Stock Index Closing Prices and Number of Shares sold annually, see Graph VI—>.). For the year a total of 73.4 billion shares were traded, up from 1993's 66.9 billion, an increase of more than 9%. Declines outnumbered advances 2,405 to 944, while 57 of the 3,406 issues traded on the Big Board ended the year unchanged. The most active NYSE stocks were: Teléfonos de México (Telmex), with a volume of 1,048,663,100 shares traded; RJR Nabisco, 780,728,000; General Motors, 702,171,600; Merck, 679,062,400; Wal-Mart, 661,180,000; and IBM, 600,784,900.

      Bond volume on the NYSE was down substantially. As of December 16, bond volume was $6,983,845,000, a decrease of 26.4% from the year-earlier figure of $9,494,878,000. A seat on the Big Board sold in October for $825,000, down $5,000 from the price paid for the previous seat sold, on June 27. The bid price was $760,000 and the offering price was $830,000 in October. The record price for a seat was $1,150,000, paid in 1987.

      Trading volume on the American Stock Exchange (Amex) was close to its 1993 level of 4.5 billion shares. By year-end, stock prices were down 10.67%, while bond volume had risen to $1,104,690,000, up more than 44% above the corresponding period of 1993. Of the 1,056 issues traded on the Amex, there were 720 declines, 321 advances, and only 15 unchanged. XCL Ltd. topped the active list as 236,738,900 shares changed hands.

      Total sales on Nasdaq (6,274 issues) were 74.3 billion shares, with 1,576 issues advancing, 2,379 declining, and 79 left unchanged. All of the most active issues were computer-related companies. Intel Corp., with a volume of 1,184,213,700 shares, led the way, followed by Cisco Systems, 1,007,663,600; Microsoft, 841,901,800; and Novell, 836,291,700.

      Many mutual fund investors were discouraged in 1994. The heavy flow of investments in bond mutual funds reversed course, causing the funds to liquidate their portfolios, thereby putting downside pressure on bonds and contributing to rising interest rates. Between October 1993 and August 1994, more than $30 billion was taken out of bond funds, according to the Investment Company Institute, a trade group. During the first nine months of 1994, net new investments in mutual funds plunged 53%. Stung by losses and lured by rising interest rates on much safer money market funds and certificates of deposit, investors pulled $26.8 billion out of bond funds in the March-September period. The rate of inflow in stock funds was positive but very modest.

       U.S. Stock Market Prices, TableThe S&P 500 composite index (Table VII (U.S. Stock Market Prices, Table)) began the year at 472.99 in January, drifted down to 447.23 in April, rose slightly to 454.83 in June, slipped to 451.40 in July, and then climbed moderately to 463.81, almost exactly where it had been a year earlier. The industrials followed a similar pattern, although the average was somewhat higher than the previous year. In January the S&P industrials averaged 550.53; they peaked in February at 551.04 before dipping to 520.36 in April. During the summer the average was about 525 before a rise in September to 551.48. Public utility stocks were generally depressed. From a high in January of 168.70, there was a steady decline until May at 153.74 and a brief leveling off during June and July. After a peak in August at 158.41, the index fell to 150.89 in October. Transportation stocks declined irregularly from an average of 441.47 in January to 359.20 in October.

       U.S. Government Long-Term Bond Yields, Table U.S. Corporate Bond Yields, TableU.S. government long-term bond yields (Table VIII (U.S. Government Long-Term Bond Yields, Table)) rose steadily during 1994, from 6.24% in January (contrasted with 7.17% a year earlier) to 7.47% by May, and remained above 7.5% from July to the year-end. U.S. corporate bond yields (Table IX (U.S. Corporate Bond Yields, Table)) were generally lower than the previous year, rising from 5.14% in January to 5.88% in July.

      Business on all three futures exchanges was booming in 1994. Average monthly contracts traded in millions for 1994 were Chicago Board of Trade (CBOT) 14, Chicago Mercantile Exchange (Merc) 14, and the Chicago Board Options Exchange 11. For the year the CBOT, the largest exchange, showed a record 219,504,074 contracts traded. Individuals accounted for less than 5% of turnover on the CBOT and the Merc, both of which asked the Commodity Futures Trading Commission for broad regulatory exemptions for contracts used only by professional traders. They sought permission to create a new derivatives market that would offer a variety of simple swap arrangements for institutions.

      The Securities and Exchange Commission (SEC) took steps to change the way bonds were traded in the municipal bond market. Three proposals required municipalities to provide more information about their financial health to the buyers of bonds, made bond dealers disclose more about their profits, and made it easier for buyers to get municipal bond prices. The SEC hoped that these measures would lead to more trading, improved information, better price data, and more buyers and sellers. In theory, the increased activity would lead to lower bond prices, making it more cost-effective for municipalities to borrow money and cheaper for investors to buy bonds. The SEC also called for new disclosure rules for municipalities, which would be required to publish annual reports. The Justice Department's antitrust investigation of the Nasdaq market focused on whether dealers set prices to wrest unfair profits from investors by fixing spreads on securities transactions. At year-end the SEC initiated an investigation of the Orange county financial municipal bond derivatives disaster.

Canada.

      Investors were bullish as the Canadian dollar strengthened and stock prices were close to their all-time highs. The fundamentals were good. Inflation and wage increases were the lowest among the most advanced industrialized countries, while growth in industrial production was strong. The market rallied in August as fears about the Quebec elections diminished. Canadian dollar fixed-income markets rallied after a downgrade of Quebec's debt rating in August, as investors were attracted to Canada with its high yield levels and low inflation pressures. The 10-year bond was 9.09% at mid-October, compared with 6.87% a year earlier.

      The Canadian economy was strong, with robust sales and earnings as a result of the global business expansion. Major corporations such as Canadian Pacific Ltd., Bombardier, BCE, Inc., and Alcan Aluminum Ltd. did exceptionally well, particularly with exports. Canada reported a record trade surplus in July of Can$2.34 billion. While unemployment was a drag factor, at 10% GDP expanded at a rate of about 4% for the year. Canada also benefited from a sharp increase in foreign direct investment, as countries expanded there to gain access to a liberalized market arising from the North American Free Trade Agreement. Canadian interest rates of all maturities rose sharply in the first half of 1994 before leveling off toward year-end. The 10-year government bonds at 6.4% in January peaked at 9.2% in June at about the same level as the 20-year government bond. Short-term rates were more volatile.

      The Toronto Stock Exchange (TSE), which handled 83% of Canadian stock transactions by value, compared with 12% on the Montreal Stock Exchange (MSE), was relatively flat throughout 1994. The TSE 300 composite price index began the year at 4400, climbed to 4470 in January, dipped to 4350 in February, climbed to a high of 4580 in March, and then dropped irregularly to a low of 3950 in June. It rallied in July, August, and September, when it reached 4400 before tapering off to 4200 in November. The TSE composite index closed the year at 4213.61.

      Stock-exchange regulation was tightened up across Canada as the government took steps to conform more closely to the standards of the U.S. SEC. Listing requirements were strengthened, and an increasing number of companies were able to be listed on more than one exchange. Of the 579 companies on the MSE, 373 were also listed on the TSE and 28 on the NYSE. (IRVING PFEFFER)

Western Europe.

       Selected Major World Stock Market Indexes, TableMost of the European stock exchanges performed poorly in 1994, losing money for investors (Table VI (Selected Major World Stock Market Indexes, Table)). Encouraged by signs of an economic recovery, prospects of lower interest rates, and improved company profits, the European bourses entered the new year strongly and raced to new highs in February. However, the rise in U.S. interest rates, followed by the decline in U.S. and European bond prices, reversed the trend. A fall of nearly 10% from the February peak, as measured by Eurotrack Index, was exceeded by most markets. The worst performers were France with a 17% decline, Spain with a 12% drop, and the U.K. with a 10% drop; Austria and Germany were almost as weak, with falls of around 8%. Surprisingly, some smaller stock exchanges ended the year showing positive gains. The best performers were Finland and Portugal, with 17% and 11% gains, respectively.

 The London Stock Exchange, being the largest and the most liquid in Europe, was an early casualty of the downward trend (For Financial Times Industrial Ordinary Share Index, see Graph VIII—>.). The Financial Times Stock Exchange 100 (FT-SE 100) index peaked at 3520 in early February but fell rapidly to 3100 by the end of March. With the U.S. interest rates rising repeatedly during the spring and bond yields soaring, the psychologically important 3000 level was breached in May, and the index fell further in June—a drop of 16% from the peak. The second half of the year was characterized by some recovery but greater volatility. A summer rally was followed by a decline as the market reacted to a surprise 0.5% rise in British interest rates and then followed Wall Street's concern about strong U.S. economic growth data and fears of an imminent rise in interest rates. In the autumn a volatile Wall Street, frightened alternately by the prospects of higher interest rates and of a lower dollar, set the scene in London. Following short-lived calmer conditions after the 0.75% rise in the U.S. rates in mid-November, turbulence returned, and the FT-SE 100 index fluctuated around the 3050 mark to close at 3065.50.

      With a strong economic recovery in Germany and further easing of interest rates in the spring, the German stock market proved less volatile and more resistant to the downward pressures. A modest decline in the spring, after the U.S. interest-rate increases, was followed by a sustained rally. The market was encouraged by a moderate wage agreement and by the favourable outlook for German interest rates. By the early summer, with the German economic recovery looking firmer and global bond yields nearly two points higher, prospects of early interest-rate cuts diminished. The market then fell under the influence of Wall Street, and by early October it was 12% below the summer peak. In the closing months, despite relative stability and a hesitant recovery, the FAZ Aktien Index closed the year below the 800 level with a loss of nearly 8%—a very different outturn from the previous year's 41% gain.

      The Paris Bourse was among the worst performers in Europe, as the economy and company profits recovered hesitantly, and the French economy was perceived to be vulnerable to higher U.S. interest rates and political uncertainty at home. The CAC 40 Index followed London's pattern and by June was 20% below its January peak, canceling most of the previous year's gains. As in other European stock exchanges, an early summer rally gave way to further weakness and volatility, followed by relatively more settled conditions. By the year's end, the CAC 40 Index was more than 17% lower.

      The Nordic block once again outperformed other European bourses generally, with a 17% gain in Finland, an 8% increase in Norway, and a 5% rise in Sweden, while Denmark registered a small decline. Economic recovery, continued corporate restructuring, and potential benefits of joining the EU in 1995 were some of the attractions of the bourses in these regions.

      Southern European bourses were mixed. While the Madrid Stock Exchange could not hold on to early gains and ended the year 12% lower, Portugal and Italy bucked the trend with 11% and 2% gains, respectively. The election of media tycoon Silvio Berlusconi (see BIOGRAPHIES (Berlusconi, Silvio )) as Italy's prime minister provided a boost to Italy, and the Milan Index soared by 36% between January and May. Under the weight of higher Italian interest rates, widespread protests against the proposed cuts in the generous pension scheme, and allegations about Berlusconi's unethical business dealings, the market fell steeply in the second half of the year and gave up its gains.

Other Countries.

       Selected Major World Stock Market Indexes, Table(For a comparison of Selected Major World Stock Market Indexes, see Table VI (Selected Major World Stock Market Indexes, Table).) Stock markets in Asia, the highfliers of 1993, were impaled on higher U.S. interest rates, policy tightening in China, and recovery prospects in Tokyo. The flow of money from investors in the developed markets, particularly the U.S., seeking new opportunities slowed to a trickle as investors kept their money at home or switched to Tokyo. Although the export-driven economies of Pacific Rim countries continued to grow rapidly, the stock markets looked expensive after several years of heady growth. The FT Pacific Index, excluding Japan, registered a fall of 15% during 1994. Hong Kong (down 31%) and Malaysia (down 24%) performed worse than the regional average. The Philippines, Singapore, and Thailand fell by 13%, 15%, and 20%, respectively. South Korea, with a 28% gain, was the star performer of the region. Taiwan also went against the trend and ended the year in plus territory, up 17%.

      Japan was one of the few large stock exchanges to buck the global decline and, together with the rise in the value of the yen, it returned good profits to overseas investors. Encouraged by hopes of economic recovery and improvement in corporate profits, foreign investors switched into Japanese shares at the start of the year and drove the market higher. The Nikkei 225 Index rose from the low of 17,370 in January to 21,553 by June—a gain of 24%. This marked a turning point, and the index fell steadily in the second half of the year to below 19,000. The downward trend was attributable to various economic and political factors, including uncertainty caused by the summer slowdown in the economy, arrival of a new, untried Socialist prime minister, the strength of the yen, and lack of progress in the trade talks with the U.S. The single most important factor, however, was lack of support from Japanese investors. Having been burned so many times since 1991 by poor market performance, Japanese investors remained on the sidelines. Against this lethargic second-half performance, foreign investment funds dried up, and the market ended the year drifting below the psychologically important 20,000 level but still showing gains of about 13%.

      Australia, often seen as a global player on economic recovery and upswing on commodity prices, failed to reward investors in 1994. Despite the background of a 5% economic growth rate, low inflation, a stable political climate, and rising commodity prices, the collapse in world bond prices prompted by the Fed's interest-rate rises, put the skids under Australian shares. The All Ordinaries Index ended the year around the 1913 level, 12% below the start of the year, after having been as high as 2341 in early February.

      The emerging markets, having burst into the big-time global investment scene in 1993 with phenomenal increases, consolidated their position in 1994. (See Emerging Equity Markets. (Emerging Equity Markets )) After the early setbacks caused by the U.S. interest-rate rises, global emerging market indexes moved into positive territory. The Barings Emerging Index, for instance, was nearly 3% above the previous year. This rise, however, masked huge regional and countrywide variations. While the European and Middle Eastern markets ended 1994 well below their highs achieved at the end of 1993, the Asian and Latin-American markets had more than reattained their highs. The best-performing individual markets, in U.S. dollar terms, included Brazil (70%), Chile (45%), and Hungary (2%), while the worst performers included Poland (-45%), Turkey (-40%), Venezuela (-30%), and the Czech Republic (-20%).

      In Mexico the devaluation of the peso on December 20 triggered a sharp drop in the market there. The IPC index, which was already well below its February high of 2881, plunged more than 11.5% the next morning. It continued to be volatile but finished the year at 2375.66, down only 9%.

Commodity Prices.

      Commodity prices rose strongly during 1994, largely in response to global economic recovery and low interest rates. The activities of speculators were thought to be the main reason why the steep upturn in commodity prices occurred so soon in the global recovery cycle. (In November 1994 The Economist Index was less than 10% below its mid-1980s high). The Economist Commodity Price Index of spot prices for 28 internationally traded foodstuffs, nonfood agricultural products, and metals rose by 37% in U.S. dollar terms during the first 11 months of the year. In sterling terms the increase was slightly lower, at 29%.

      The price of crude oil, which was not included in The Economist Index, rose by 10% to close to $17 per barrel in December, having been as low as $13 a barrel in February—a five-year low. A relatively mild winter in Europe and weak demand from the former Soviet Union were the main reasons for the weak oil prices in the spring. Recovery from this low point was steady, and oil prices reached a high for the year of $19.50 a barrel in early August as the market feared a politically motivated strike in Nigeria might reduce supplies. Following the collapse of this strike in early September, prices drifted back to the $16-$17-a-barrel level. This volatility left oil producers and consumers confused about the direction of oil prices. As the year drew to a close, oil prices were stable but poised to rise further. Supporting an upward trend was OPEC's decision in its November meeting to hold its output ceiling at 24.5 million bbl a day (in place since September 1993) and indications that Saudi Arabia, the world's largest exporter, was keen to see prices move up to $22 a barrel.

      Both sectors of The Economist Index rose strongly in 1994. The Food Index rose by 30%, but the Industrials Index rose faster, by 47%. Copper, lead, and aluminum rose by nearly 50%, while nickel, tin, and zinc rose 5-30%. For most metals stronger industrial demand exceeded output and exports, reducing stock overhang and improving prices. Zinc and tin prices were held back by higher Chinese exports.

      Food production was affected by drought, floods, and frosts. The wheat crop in Australia was cut back by a severe drought, while in Canada output fell as farmers switched to more profitable crops. Coffee prices soared in the summer to an eight-year high but fell from the July peak as frost damage in Brazil was less extensive than at first feared. Tea prices also improved in 1994 in sympathy with coffee prices. Nonfood agricultural products such as rubber rose by 50%; wool prices, responding to stronger demand, improved by 34%.

      The gold price in 1994 was less volatile than in recent years and, although it moved in a fairly narrow range of $350-$390 per troy ounce, it ended the year 10% higher, close to the year's high. (IEIS)

      This updates the article market.

▪ 1994

Introduction

OVERVIEW

       Real Gross Domestic Products of Selected OECD Countries, Table Economic growth in the world remained sluggish in 1993. Partial International Monetary Fund (IMF) estimates and other economic indicators available at year's end pointed to a growth rate of 2.2%. This represented a small improvement on the previous year and meant below-average growth for the fourth year running. The continuation of the global recession was largely attributable to declining growth rates in Europe (excluding the U.K.) and Japan. (For real gross domestic products of selected countries, see Table I (Real Gross Domestic Products of Selected OECD Countries, Table).) Falling output in these countries neutralized relatively faster economic growth in the Asian countries, the U.S., and, to a lesser extent, the U.K. Although government policy in Europe, particularly Germany, became increasingly supportive of economic growth during 1993, large public-sector deficits and the need to maintain counterinflationary policies constrained the speed of interest-rate cuts. As the change in policy in Europe came late in the year, it did not make much of an impact on the economic outcome. As 1993 drew to a close, however, there were encouraging indicators that the low point in the current economic cycle had been passed and that most countries would grow faster in 1994.

       Real Gross Domestic Products of Selected OECD Countries, Table Changes in Output in the Less Developed Countries, TableReflecting the continuing economic adjustments in the developed world, once again those countries' overall performance (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)) lagged behind growth rates in the less developed world (see Table IV (Changes in Output in the Less Developed Countries, Table)). Thus, the gross national product (GNP) of the developed countries rose by an estimated 1.1%, down from the previous year's anemic 1.7%. By contrast, the economies of the less developed countries (LDCs) grew by an estimated 6.1%, against 5.8% in 1992.

   The strongest performance among the developed countries was in the U.S., with an estimated 2.8% gross domestic product (GDP) growth, slightly faster than the previous year. It was followed by Canada, Australia, and the U.K. By and large, these countries entered into a downturn ahead of the others and were recovering, thanks to lower interest rates in place since 1992 or earlier. (For short-term and long-term interest rates in selected countries, see Graph III—> and Graph IV—>.) In contrast, in Germany and Japan the economy went into the downturn later and was slow in emerging from it. In fairness, the German Bundesbank's policy became less restrictive in response to moderating inflationary pressures and measures introduced by the government to stabilize the public-sector deficit. However, it was not until the widening of currency bands, from 2.5% to 15%, within the European exchange-rate mechanism (ERM; for effective exchange rates of selected currencies, see Graph V—>) in August that interest rates were reduced significantly in Germany. The wider bands meant the breakup of the old, rigid ERM, and the action implied a suspension of the Bundesbank's obligations to support the other European currencies within the ERM. (Such intervention added to the already buoyant money stock and made it harder to combat inflation.) France, Belgium, and The Netherlands all followed high-interest-rate policies aimed at maintaining the agreed value of their currencies against the Deutsche Mark within the ERM and, as a result, those countries experienced prolonged recession and rising unemployment. Japan, by contrast, pursued a progressively stimulatory fiscal and monetary policy but could not escape sliding deeper into recession. Continuing corporate and household adjustment to the steep fall in stock and asset prices in 1991 and 1992, together with attendant uncertainty and a rise in the Japanese yen, led to zero GDP growth—the worst performance since the 1974 oil crisis.

       Standardized Unemployment Rates in Selected Developed Countries, TableIn eastern Germany the economic recovery that had started in 1992 continued, leading to an estimated GDP growth of about 6%. However, unemployment remained a serious problem (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)). Likewise, modest growth took place in most Central and Eastern European countries, consolidating the recovery that had started in 1992. Poland, Hungary, and the Czech Republic performed better than Bulgaria and Slovakia. The latter was experiencing adjustment problems following the dissolution of Czechoslovakia. In the former Soviet Union, economic decline continued. Development in the dynamic Asian economies (Hong Kong, South Korea, Malaysia, Singapore, Taiwan, and Thailand) recovered from a slight slowdown in 1992, and GDP expanded by 6.5% (up from 5.7% in 1992). The main reason for the upturn was recovery in the U.S. and continued expansion in China, which had become an important market for their exports. In Latin America growth that had started in 1991-92 after a decade of stagnation continued in 1993 but at a slower pace than the year before.

  Consumer Prices in OECD Countries, TableAgainst the background of another year of low global economic growth, many components of demand either remained flat or declined compared with the previous year. Private consumption was the most buoyant element and expanded by an estimated 1.3% in the developed world. Even so, it grew more slowly than the previous year's 1.8%. A relatively robust increase of nearly 3% in the U.S. and a rise of more than 2% in Canada were offset by declining private consumption in Japan as well as in Germany and other European countries. Consumer confidence appeared to have been weakened in many countries by a squeeze on purchasing power, fear of unemployment, and a desire to reduce high personal debts incurred before the recession. (For consumer price increases in selected countries, see Table II (Consumer Prices in OECD Countries, Table).) The weakness of domestic demand, a slackening of industrial capacity (see Graph II—>), and relatively high real interest rates reduced the incentives for business to invest. During 1993 real private nonresidential fixed investment in the developed countries was estimated to have fallen faster than the previous year (down 5.5%, compared with a 3.8% decline in 1992). Once again the U.S., reflecting its well-established recovery, went against the trend and registered an 8% gain. In Japan and Europe (except the U.K.) business investment fell. Likewise, in most developed countries the need to reduce the public-sector deficits led to cancellation or deferral of many public programs. Japan, unburdened by such constraints, went against the trend and introduced several public works programs to stimulate its flagging economy. As world trade grew by only 3% during 1993 (4.6% in 1992), external demand contributed to a smaller proportion of economic growth in the world, particularly in some developed countries such as Germany and Japan that relied heavily on exports.

 Against a background of weak economic activity, high and rising unemployment, and declining oil prices, the inflation rate (see Graph I—>) continued to moderate during 1993. In the industrialized world it slowed down to an annual increase of 2.7%, compared with 3.3% in the previous year. This was the best performance in more than 20 years. In the LDCs the average inflation rate accelerated to 44% from 39% in 1992, but the average was influenced by very high inflation in a few countries. The median inflation was a more modest 7%. Thanks to structural reforms and stabilization programs, inflation in most LDCs remained low. In Turkey, while inflation was stable at around 65%, it remained very high on account of fiscal deficits. Likewise, in many Central and Eastern European countries, where basic structural reforms were still being implemented to complete the transition to free-market economies, inflation remained high. In Bulgaria and Romania, for instance, it was heading for 90% and 165%, respectively, while in Poland, Hungary, and the Czech Republic and Slovakia it was more modest, between 16% and 40%. Hyperinflationary conditions were experienced in the former Soviet Union, however. While there were no reliable estimates in late 1993, the outcome was likely to be worse than the previous year's 2,000%. With the exception of Brazil, where annual inflation was running at about 900%, Latin-American countries made considerable progress in moderating their inflation rates, although they remained at around 12%. In Asia inflation was stable, between 6% and 7%, but it varied across the region. It was the highest among the relatively less developed countries such as Thailand and Malaysia, while in Singapore and Taiwan it was comparable to the European levels. China, which was experiencing rapid economic growth rates, was showing signs of overheating, with inflation in urban areas running at 10-15%.

       Standardized Unemployment Rates in Selected Developed Countries, TableIn most developed countries unemployment (for unemployment rates in selected countries, see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) continued to rise in 1993 but at a slower rate than the year before. This was partly a result of reducing interest rates too cautiously, which did succeed in keeping inflation at bay but delayed economic recovery and added to unemployment. The U.S. went against the trend of rising unemployment—the proportion of the labour force that was unemployed was 6.8% in October, compared with 7.4% a year before. Elsewhere during the year, it rose by between 0.2 and 4.6 percentage points. In the industrialized countries as a whole, unemployment rates rose from 7.9% to an estimated 8.6%. This meant that during 1993 an average of 35 million people were out of work, of which nearly 30% were in North America and 60% in Europe. Spain (with over 23%) had the highest rate of unemployment in Europe, followed by France and Italy. Because unemployment usually begins to fall well after a recovery is under way, most observers expected unemployment to continue to rise in Europe well into the second half of 1994, albeit at a slower pace. The U.S. and the U.K. were expected to see steady drops in the numbers of people out of work.

  Interest rates (for short-term and long-term interest rates in selected countries, see Graph III—> and Graph IV—>) remained stable in the U.S. and the U.K. from autumn 1992 or early 1993. In Japan rates declined to 1.75%, a historically low level. Across continental Europe, the high interest rates declined appreciably only after the European currency turmoil in August and the attendant widening of the currency bands. Despite these reductions, it could be argued that interest rates remained high in real terms, particularly against the background of continuing recession, and did not stimulate the economy sufficiently.

      In contrast to an easing of monetary policy, which reduced the cost of borrowing, the fiscal stance was tightened in most developed countries. This meant increased tax burdens and reduced government spending, which were in conflict with the overall objective of encouraging economic recovery. Given the spiraling public-sector deficits, however, in the interests of sound money and financial stability, unpleasant but necessary measures were introduced. In the U.S., for example, Pres. Bill Clinton's administration put forward a complex package of tax and expenditure changes of $500 billion, which was projected to reduce the deficit over five years. In the U.K. the largest tax increase in real terms since 1945, amounting to £10.6 billion, was announced in March, but its implementation was deferred by a year so as not to stall the fragile recovery. In France and Germany supplementary budgets were introduced to cut planned public-spending levels and contain the budget deficits. Japan was the only developed country where both monetary policy and fiscal policy were relaxed during 1993. Most developed countries faced increasing public-sector spending in the years ahead as an aging population put greater demands on the social welfare systems. (See Special Report (Financial Support for the Elderly ).)

NATIONAL ECONOMIC POLICIES

Developed Market Economies.

       Real Gross Domestic Products of Selected OECD Countries, TableUnited States. Revisions to the U.S. economic statistics showed that the 1990-91 recession was not as deep as had been thought previously. GDP fell by 1.6% instead of the 2.2% originally reported. Moreover, the recovery had been stronger than anticipated but still remained subdued compared with previous upturns. During 1993 economic activity gained momentum, and real GDP grew at an annualized rate of 2.8% in the third quarter, well above the anemic rates of 0.8% and 1.9% in the first and second quarters, respectively. Had it not been for the summer floods in the Midwest, growth in the third quarter would have been stronger. With economic indicators pointing to stronger activity in the closing months of the year, GDP for the year grew by an estimated 2.8%, marginally faster than in the previous year. Despite this sluggish recovery pace, the U.S. economic performance during 1993 was better than that of any other major industrial country (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)).

      Among the various factors that underpinned economic expansion in 1993, capital spending, housing investment, and consumer spending were the most potent. As corporate profitability improved sharply in response to steps taken previously that reduced payrolls and repaired balance sheets by reducing debts and scaling back loss-making activities, business confidence recovered, boosting investment in equipment and buildings by over 7%.

      Housing investment strengthened as consumers were less burdened with debt payments than they had been in recent years. This was partly because they had repaid large amounts of debt and partly because low interest rates made it easier to carry existing debts. Both housing starts and permits rose strongly in the second half and, for the year as a whole, were estimated to have risen by around 8%.

      Despite continuing job insecurity and higher taxes introduced by the Clinton administration, consumer spending gained strength, rising 4.2% in the third quarter, compared with 3.4% in the second and 0.8% in the first. For the year as a whole, it rose by an estimated 3%—up from 2.3% the year before. Spending on automobiles, furniture, and household goods was strong, as was spending on services. As a result of higher spending, total consumer debt outstanding rose by around 4%.

 Production and capacity use both began to move up in late 1992 and continued to improve during 1993. Output reached record levels in the autumn as industrial production (see Graph II—>) grew by an overall 4% during the year. Capacity utilization stabilized at 81.6% in the autumn, the highest level since October 1990.

      Government spending in real terms went against the general trend and weakened. In the third quarter, for instance, it fell by 1.1% after picking up from a 6.4% drop in the opening quarter. For the year as a whole, it declined by an estimated 2.5%. Defense spending was a notable casualty, with an 8% fall reflecting reduced defense commitment following the ending of the Cold War. Nondefense spending was static and would have declined but for higher spending by state and local authorities on buildings and highway construction.

  Standardized Unemployment Rates in Selected Developed Countries, TableThe job market, however, was slow to respond to the economic upturn (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)). Because of competitive pressures, U.S. companies were still reluctant to increase staff levels. Many companies continued to lay off workers or to turn increasingly to temporary and part-time employees. (See Special Report (Changing U.S. Workforce ).) Unemployment stood at 6.8% in October, down from 7.4% a year before but barely changed from the spring and summer levels. It fell to 6.5% in November and edged down to end the year at 6.4%. Most of the job gains were in the service sector rather than in manufacturing, where employment fell back a little. Productivity, which rose strongly during the recession, appeared to have run out of steam, particularly in the all-important services sector. During the second half of the year, productivity growth was negative. The sluggish labour market restrained wage increases, raising concern about the outlook for consumer spending. Average weekly earnings in the autumn were 2.7% higher than a year before. At that level they were only marginally above the inflation rate (see Graph I—>) and thus did not confer a significant real increase in employee purchasing power.

      In the short term, worries about unemployment were linked with the growing trade deficit, which had become a political issue. During the first nine months of the year, the trade deficit averaged $10.2 billion a month and was heading for a deficit of $125 billion, compared with $96 billion in 1992. During the same period, export growth was a modest 3.1%, owing in part to the downturn in Europe and Japan but also to the relatively high value of the dollar. Imports, on the other hand, rose by an estimated 9%, reflecting higher domestic demand. What provided ammunition to the protectionists was not just the absolute increase in imports. The share of domestic demand accounted for by imports had risen by a fifth since the recession, to 25%. This meant, the protectionists argued, that U.S. business had missed out on the consumer recovery. The current-account deficit was set to widen to over $100 billion from $66 billion recorded in 1992 despite the traditional large U.S. surplus on invisible exports.

       Consumer Prices in OECD Countries, TableInflation during 1993 remained stable. Consumer prices (see Table II (Consumer Prices in OECD Countries, Table)) rose by an average of just over 3%—largely unchanged from the previous year. This satisfactory outcome was partly due to lower commodity prices, particularly oil and other imported materials. The absence of wage pressures and low interest rates were also factors. The subdued inflation was seen by many commentators as a positive development in that it underpinned real demand and supported economic growth by improving business confidence.

      Meanwhile, both fiscal and monetary policy remained relatively tight. During previous recoveries the tax burden had been eased to assist the economy; in 1933 it was increased. Congress passed Clinton's budget package, though with the smallest of majorities. The five-year, $500 billion package of tax increases and spending cuts was intended to reduce the budget deficit. To achieve the reduction, spending was to be cut by $255 billion and revenue increased by $240 billion. Income taxes went up for the higher paid, with the top rate rising to 36% from 31%, backdated to January 1993. Tax relief on pensions was reduced and the wage ceiling on Medicare payments removed. The corporate tax rate went up from 34% to 35%. A new gasoline tax of 4.3 cents per gallon was imposed from October 1.

  Unlike previous years, there was no stimulus to the economy from lower interest rates. (For short-term and long-term interest rates, see Graph III—> and Graph IV—>.) As the money supply was subdued and grew well within the target ranges, there was no change to the Federal Reserve Bank's (Fed's) discount rate. Thus, commercial banks' prime rates remained unchanged at 6%. Some critics thought the real rate of interest rates was too high—nearly twice as high as it had been in previous recoveries. The financial markets thought otherwise and feared the Fed might gently raise short-term rates in the new year to prevent faster growth from pushing up inflation.

  Real Gross Domestic Products of Selected OECD Countries, TableUnited Kingdom. The U.K. economy pulled out of the recession during 1993 ahead of its European neighbours (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)), but the pace of recovery remained sluggish and uneven, with some loss of momentum in the closing months of the year. It appeared that GDP had grown by about 2%, the best performance since 1989 and well above earlier estimates. The recovery was principally due to lower interest rates following the withdrawal of sterling from the ERM in September 1992. The return of economic growth had been underpinned by a rise in private consumption, higher industrial output, a modest recovery in housing activity, and improvement in corporate profitability. Inflation remained subdued (see Graph I—>), despite the sizable devaluation of sterling.

   Following the ERM debacle, short-term interest rates (see Graph III—>; for long-term rates see Graph IV—>) were progressively cut and additional stimulus was provided by a package of measures introduced in the closing months of 1992. The base rate was cut a further 1% to 6% early in 1993 as new doubts emerged about the pace of the recovery. By that time the effective exchange rate had fallen by nearly 15% (see Graph V—>), giving British exporters a competitive advantage. The new chancellor of the Exchequer, Kenneth Clarke (see BIOGRAPHIES (Clarke, Kenneth Harry )), had not found it necessary to change the policy stance he inherited from his predecessor, Norman Lamont. The exchange rate had remained broadly stable at close to $1.50 and DM 2.50, and in the absence of inflationary pressures, there was no change in monetary policy. Interest rates remained unchanged at 6% until November 23, when a half-percentage-point cut was sanctioned a week before Clarke's first budget. However, a further cut of 0.5-1% in the near future seemed a strong possibility in view of fiscal tightening announced in the budget a week later.

      The policy makers faced a dilemma with regard to fiscal policy. Partly as a result of the recession and partly because of higher spending before the 1992 elections, the public-sector borrowing requirement spiraled, and the deficit for 1993 was approaching £50 billion, or 8% of GDP. Urgent measures were needed to control the deficit and bring it down, but the recovery at the time of the March budget was too weak to risk introducing higher taxes. Lamont had partially resolved this dilemma by introducing deferred tax increases, to become effective in April 1994. The main reason for announcing tax increases in advance was to signal to the financial markets that the government was serious about tackling the burgeoning public-sector deficit. The tax burden during 1993-94 was increased by only £500 million by nonindexation of income tax allowances. The sting in the tail was the £6.7 billion tax increase announced to take effect from April 1994, rising to £10.3 billion the year after. The most unpopular feature of the package was the proposed imposition of value-added tax (VAT) on domestic heating bills. Representing 1.5% of GDP, the forthcoming changes were the biggest tax increase in real terms since 1945. The future tightening of fiscal policy was accompanied by a squeeze on public-sector spending, including a virtual pay freeze in the public sector. In his first budget (the budget date was brought forward from March 1994 to November 1993 to bring together decisions on spending and revenues), Clarke set out to reduce the public-sector deficit more quickly than had previously been planned and added another £1,750,000,000 tax to what was in the pipeline. In a bold move he also announced a £10 billion cut from previously published public-spending plans for the next three years. However, it was not immediately clear where all the cuts were coming from.

      Early in the year the recovery was led by a surge in exports, reflecting the competitiveness of British products. In the opening quarter total exports rose by over 7% in real terms compared with the same period a year before, but in the summer the growth rate slowed to 3.5%. During the autumn the trade deficit fell unexpectedly, as exports strengthened and imports slowed. However, this was not sufficient to reverse the underlying deterioration. On the basis of incomplete data, export volumes were estimated to have grown by 5% for the year as a whole. Imports, on the other hand, grew steadily at an average rate of 6%. As a result, the trade gap widened and was heading for a total deficit of £14 billion, the highest since 1991.

 Industrial production (see Graph II—>) reflected the changes in total demand, external and domestic. Early in the year it grew strongly and was at its highest since October 1990. By autumn the growth rate had become erratic. For the year as a whole, industrial production was estimated to have grown by under 2%. There was a marginal improvement in capacity utilization and, not surprisingly, business investment remained flat. Total investment had risen by an estimated 0.6%, largely as a result of increased government investment and higher housing starts. Total construction output had fallen for the third consecutive year and declined by 1.25%.

       Consumer Prices in OECD Countries, TableAs external demand faltered, consumer spending took over as the main engine of growth. During 1993 it rose by an estimated 2.5%, led by retail sales. The strength of consumer spending was somewhat surprising against a background of continuing job insecurity and high personal debts relative to incomes. (For consumer price increases in selected countries, see Table II (Consumer Prices in OECD Countries, Table).) However, consumers sensed that the worst of the recession was over. Lower interest rates meant that repayment of mortgages and other debts absorbed a lower proportion of household budgets, so a higher proportion of incomes was spent. The savings ratio, which had risen sharply in 1992 to a high of 12.5%, fell back to an average 10.5%. Car sales also rose sharply in response to lower interest rates and the abolition of the car tax in 1992. New registrations showed a year-on-year gain in excess of 12%. Partly as a result of higher car sales, total new credit increased. As new borrowing exceeded repayments, total outstanding consumer debt rose.

       Standardized Unemployment Rates in Selected Developed Countries, TableAnother surprising feature of the U.K. economy in 1993 was an unexpected decline in unemployment (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)), which began in February. Usually unemployment continued to rise for six to nine months after output began to recover. This reduction in the number of unemployed was, at least in part, a reaction to deep job cutting in late 1992. In November the total number of unemployed stood at 2,810,000, an unemployment rate of 10%, the lowest since August 1992.

 Despite the devaluation in 1992, inflation (see Graph I—>) remained subdued and was well within the government's target, thanks to low oil and other commodity prices as well as strong competition in the retail trade. In November the annual rate of inflation unexpectedly slowed down to 1.4%, the level it stood in early summer, after rising by 1.8% in the run-up to autumn. The underlying index, excluding mortgage interest repayments, slowed down to 2.8% from 3.3% and was well within the government's 1-4% target.

      Given the high levels of unemployment and subdued inflation, growth in average earnings decelerated to under 3.5% in the third quarter, compared with over 4% at the beginning of the year. However, the slowdown in earnings was in response to lower inflation, not ahead of it. This meant that the real earnings of those who remained employed had risen in real terms throughout the recession. Perhaps this was the only positive feature of the longest recession since World War II.

  Real Gross Domestic Products of Selected OECD Countries, TableJapan. Hopes for an upturn in the Japanese economy, which had declined for nearly two years, were short-lived. Despite stimulatory measures introduced by the government in 1992 and again in April 1993, economic recovery stalled (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). A rapid rise in the value of the yen (see Graph V—>), combined with an exceptionally wet and cool summer, pushed the economy back onto a downward track. Continuing adjustment by the corporate and finance sectors (and to a lesser extent by households) to the sharp fall in stock prices and real estate prices that had occurred in 1991 and 1992 was also a drag on the economy. The net effect of this adjustment process was reduced willingness by corporations to invest and greater caution by financial institutions in lending, particularly for high-risk projects. It also reduced consumers' propensity to spend.

  As a result of these adverse developments, real GNP fell by 0.5% in the second quarter, reversing a similar gain in the opening quarter. The new government of Prime Minister Morihiro Hosokawa (see BIOGRAPHIES (Hosokawa, Morihiro )), which ended 38 years of continuous Liberal-Democratic Party rule in August, acted swiftly and introduced a new packet of stimulatory measures in mid-September. The Bank of Japan quickly cut its discount rate (for short-term and long-term interest rates, see Graph III—> and Graph IV—>) by 0.75% to 1.75%—a larger-than-expected cut—to curb the strength of the yen and improve confidence. However, the September measures came too late to influence the outcome in 1993. On the basis of incomplete data in December, the economy remained flat for most of the second half and was heading for zero growth in 1993—the worst outcome since the oil crisis in 1974.

      Against the background of sluggish economic activity and low inflationary pressures, the government and the Bank of Japan pursued expansionary policies. Since April 1992 four packages of stimulatory measures had been introduced, some spending had been brought forward into the first half of the fiscal year, and various new public-works programs had been planned. A 13.2 trillion-yen package was announced in April 1993—the largest ever introduced by a Japanese government. In addition to government spending on infrastructure projects, easier loan conditions were introduced to promote investment, together with training programs and measures to support imports and the stock market. As these proved ineffective in stimulating the economy, a further 6 trillion-yen package was announced in mid-September. Electricity and gas prices, telephone charges, and domestic airfares were also reduced.

  Consumer Prices in OECD Countries, TableDespite these repeated measures, which in normal times would have sparked an economic growth, most components of demand remained weak. Private consumption was only 0.6% higher in the first half of the year than a year before. Retail sales, a large component of private consumption, fell by 2.5% during the same period. A lack of confidence was instilled in consumers as their purchasing power declined. (For consumer price increases in selected countries, see Table II (Consumer Prices in OECD Countries, Table).) Slower growth in the economy reduced wage rises to 1% in the first half, less than the 1.4% rise in the second half of 1992. Overtime and bonuses also slowed. Summer bonuses in 1993 were 1.1% lower than a year earlier—the first reduction in over 10 years. As bonuses accounted for up to a quarter of salaries, such a reduction was a significant setback. However, as inflation (see Graph I—>) remained stable at around 1.3%, it softened the blow of declining earnings somewhat by propping up their purchasing power.

       Standardized Unemployment Rates in Selected Developed Countries, TableRising unemployment also made people more cautious about spending. Although unemployment in Japan (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)), by world standards, remained very low at 2.7%, it was at the highest level in over five years. Since October 1992 the job-offer to job-seeker ratio, a key indicator for labour, had consistently declined. In September it stood at 0.69, down from a peak of 1.47 in March 1991. If unemployment had been defined in the same way as in other industrialized countries, it would have been considerably higher than the official figures suggested. Furthermore, the Japanese tradition of companies offering lifetime employment minimized layoffs. Asahi Bank estimated that Japan's true unemployment rate, if "hidden" unemployment were taken into account, was 6.5%. Judging by the moves by leading giant corporations such as Fujitsu and Nippon Telegraph & Telephone to reduce their labour force, the recession might force some change in attitudes.

 Inevitably, the weakness of domestic demand and the strength of the yen were reflected in the trend of industrial production (see Graph II—>). In the year to September, industrial production was 2.6% lower than a year before. Despite an increase in shipments in the autumn, the level of inventories of finished products remained at historically high levels. The Bank of Japan's quarterly Tankan survey indicated a continued fall in business confidence in the third and the final quarter of 1993; there was little optimism for an upturn in the short term. Not surprisingly, gross fixed-capital investment was flat in the first half of the year, reflecting reduced investment in machinery and equipment. In contrast, private-housing investment and government investment picked up strongly, reflecting the effects of the government's packages.

      Since 1991 Japan's trade surplus had been on the rise again as exports benefited from the recovery in the U.S. and imports weakened as the economy slowed. The strength of the yen boosted export revenues in dollar terms and depressed imports. In September exports were up 6% over the year before in dollar terms but were down 11% in yen terms, largely because of currency fluctuations. Nevertheless, in November Japan showed a 12-month trade surplus of $140 billion, up from $133 billion in 1992. This raised concerns that the trade friction with the U.S. and the European Community (EC) might further increase and heightened the dilemma faced by the policy makers. While policy makers wanted to stimulate domestic demand to pull the economy out of the recession, correction of external imbalances also required reforms that opened up the Japanese markets to imports, particularly of manufactured goods. Given the depressed state of the manufacturing industry and the softening employment market, this option would have been highly unpopular.

 A related dilemma was the rapid rise in the yen (see Graph V—>) since the summer. At one point it almost reached the psychologically important level of 100 yen to the dollar. This was caused by the rising current-account surplus and the turmoil in European currencies that led capital to seek refuge in the yen. In the short term a high yen was a drag on economic growth because it slowed exports and eroded the profits of export-dependent companies. In turn, these companies curtailed new investment and squeezed employees' income. Also, the influx of cheap imports reduced the profits of domestic producers. In the longer term, however, the economy would benefit from lower costs and increased competition. The business community, which sought short-term protection, seemed to have been reasonably successful in slowing the reform and deregulation necessary to open up the economy and let the long-term benefits flow through.

       Real Gross Domestic Products of Selected OECD Countries, TableGermany. The recession in the German economy (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table))—the deepest in some 50 years—had not yet run its course, despite encouraging indicators as the year drew to a close. Furthermore, there were few signs that a sustained recovery was on the way. After falling for four consecutive quarters, real GDP in western Germany picked up by 0.6% in the second quarter. A similar rise in the third quarter indicated that economic activity was still sluggish. For the year as a whole, the western German economy was estimated to have declined by nearly 2%. In former East Germany, the recovery continued, and real GDP was officially estimated to have increased by 6%.

      This worse-than-expected downturn was largely due to the tight monetary and fiscal policies pursued by the authorities in 1992 to dampen the inflationary pressures unleashed by unification. However, the weak recovery in the U.S. and the U.K. also played a role. Given that the money supply was growing well outside its target range and inflation was still too high, the Bundesbank's scope for sharply reducing interest rates was limited. Likewise, to prevent the budget deficit from widening further, the government was forced to introduce measures to cut its planned expenditure despite the deep recession.

      However, the effect of the DM 21 billion in cuts planned for 1994 (larger cuts were agreed for 1995 and 1996) was to hold the central government's budget deficit unchanged from that of 1993, which was up sharply from the previous year. The overall public-sector deficit, inclusive of social security funds, was expected to rise to DM 160 billion, or 5% of GDP in 1993.

      The thrust of the cuts was to reduce welfare support, particularly for the unemployed. In this respect it was unprecedented, as generous welfare provision had been one of the main features of the German social and economic system. Reduced spending was the only avenue open to the fiscal authorities, for there was no room for additional taxation. The tax burden had risen to 41.5% in 1993 (compared with 39.75% in the 1980s) and was set to rise further.

      These cuts came soon after the so-called Solidarity Pact agreed in March between the government and the opposition. The need for this came about from the need to provide medium-term funds for eastern Germany. The principal instrument of the pact was the reintroduction of the 7.5% solidarity surcharge on personal and corporate incomes from January 1995. This lifted the threat of immediate tax increases and paved the way for spending cuts by the government.

  The long-awaited fall in German interest rates (for short-term and long-term interest rates, see Graph III—> and Graph IV—>) materialized in 1993 but only slowly, as the Bundesbank had cautiously relaxed its tough anti-inflation monetary policy following a moderation in the inflation rate, public-sector spending cuts, and widening of the ERM bands in August. The Bundesbank cut its interest rates by 0.5% on October 22. Previous cuts had been made in September, twice in July, and in April. As a result, in November both the discount and the Lombard rates were three percentage points below their summer 1992 peak.

 Inflation (see Graph I—>) in western Germany stabilized at around 4% during 1993. Although this was above the government's target of 3.5%, the overshoot was largely due to higher VAT rates and higher rents. The upward push from higher wage settlements, much in evidence during 1992, moderated. In eastern Germany, although the headline inflation was close to 15%, the differential was largely due to a hike in administration prices.

 The recession took its toll on the manufacturing sector as domestic and foreign demand weakened. Production (for industrial production, see Graph II—>) in the western sector, excluding construction, remained largely flat during most of 1993 but showed signs of an uplift near the end of the year. However, compared with the previous year, it was down 8%. In eastern Germany manufacturing production continued to recover and was 8% higher in the first half of the year. Capacity utilization at 78.6% in the second quarter fell to the lowest point in more than eight years. Likewise, investment in the west fell by an estimated 2% during 1993, while in the east it expanded by nearly 15%, largely as a result of robust reconstruction activity.

       Standardized Unemployment Rates in Selected Developed Countries, TableAs employers took steps to bring the workforce in line with lower levels of activity, unemployment soared (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)). An estimated 600,000 fewer people were employed in western Germany during the autumn compared with the same period a year earlier. The unemployment rate stood at 8.8% in October—up from the previous year's 7%. In the eastern states, despite the strength of the recovery, unemployment continued to rise, albeit at a slower rate. In September the number of unemployed stood at 1,160,000. This was below the January 1992 peak of 1,340,000 but a little higher than the figures in the spring. Unemployment remained a serious problem in former East Germany, as illustrated by the 16% unemployment rate. A further 1.5 million people were on job-creation or retraining programs or had retired early. Some estimates suggested that the true unemployment rate was close to 35%.

       Consumer Prices in OECD Countries, TablePrivate consumption (for consumer price increases in selected countries, see Table II (Consumer Prices in OECD Countries, Table)) followed a downward path for most of the year. Retail sales plunged by 8% in January when higher VAT rates came into force. Although it picked up gradually in the summer, it was still 2% lower in real terms than a year before. New vehicle registrations fell steeply, reversing the sharp gains seen in previous years. By contrast, in the east a modest increase of 2-3% took place in private consumption. Apart from higher VAT, consumption was held back by a lower rise in earnings. The efforts to curb inflation succeeded in moderating wage rises to 3-4%—down from the previous year's 6%.

 The foreign-trade position had been complicated by the EC's move to a single market from Jan. 1, 1993. The initial estimates pointed to a sharp drop in exports owing to weakness in EC countries and the high value of the Deutsche Mark (for effective exchange rates of selected currencies, see Graph V—>) earlier in the year. However, imports were estimated to have fallen even faster because of the weakness of the economy and higher VAT rates. As a result, a trade surplus of DM 42 billion was expected, somewhat higher than the DM 33 billion recorded in 1992. The current-account deficit, on the other hand, was likely to have stabilized at around DM 40 billion after having risen in the previous two years.

       Real Gross Domestic Products of Selected OECD Countries, TableFrance. The economic slowdown, much in evidence since the Gulf war, developed into a full-blown recession during 1993. Compared with a modest rise of 1.3% in the previous year, real GDP (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)) was estimated to have declined by 0.7% during 1993. However, thanks to the stimulus (lower interest rates and lower exchange rate) provided to the French economy by the August ERM crisis, the recession appeared to be coming to an end, as indicated by a faster rate of economic activity in the closing months of the year.

 While the recession in Germany and the sluggish pace of recovery in the U.S. and the U.K. were contributory factors, what worsened the recession was the government's policy of strong currency and a sound finance. Unlike authorities in the U.K. and Italy, the French authorities resisted devaluation in September 1992 through higher interest rates and intervention in the currency markets. In the relative calm of the subsequent months, instead of taking action to stimulate the economy, which was rapidly sliding into a recession, economic policy remained focused on maintaining the franc/Deutsche Mark exchange-rate parity (for effective exchange rates of selected countries, see Graph V—>) within the ERM. However, the high interest rates that were needed in Germany to counter the inflationary effects of unification were totally incompatible with the domestic situation in France and exacerbated the recession. They also provided new opportunities for speculators to put pressure on the franc. Despite the willingness of the French authorities to defend the currency, when the financial crisis in August 1993 pushed the franc to its floor within the ERM, they reluctantly agreed to a widening of the bands to 15%.

       Standardized Unemployment Rates in Selected Developed Countries, TableClearly, the deteriorating economic situation at home and rapidly rising unemployment (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) made it impossible to continue with the previous policy. This paved the way for lower interest rates, yet the Bank of France remained cautious and did not lower its interest rates immediately. French interest rates began falling after a reduction in the German official rates in September and October. In November the franc stood at 3.45 against the Deutsche Mark, 3.45 centimes lower than its old floor. Toward the end of the year, the French prime rate stood at 8.15%, down from a peak of 10% in early 1993 but still high in real terms.

      The other plank of the newly elected conservative government's economic policy consisted of measures to check rapidly deteriorating public finances. (The 1992 budget deficit had been significantly overshot partly as a result of the recession.) This, too, was in conflict with the aim of ending the recession. Nevertheless, in June a supplementary package of measures was announced to restrict the budget deficit to F 317 billion. A state loan was issued to fund some of the additional expenditure. The loan raised F 110 billion, far above the target of F 40 billion. Ironically, the success of the loan heightened dissatisfaction among the business community, as it was not followed by any new programs to stimulate the economy.

   Consumer Prices in OECD Countries, TableHigh short-term interest rates (see Graph III—>; for long-term rates, see Graph IV—>) and insufficient measures to stimulate private consumption led to a sharp rise in unemployment and declines in consumer spending, manufacturing output, and fixed-capital investment. Consumer spending was one of the weaker components of demand early in the year, reflecting a squeeze on households' real purchasing power. (For consumer price increases in selected countries, see Table II (Consumer Prices in OECD Countries, Table).) Consumer spending, in real terms, rose by less than 0.5% in 1993, down from the previous year's 1.7%. Lower wage rises and higher unemployment were the main factors depressing consumption. In the second half of the year, disposable incomes were cut by the arrangements introduced for the financing of Unedic, the unemployment benefit system. This siphoned off nearly F 10 billion from household incomes on an annual basis, on top of rises in indirect taxes introduced at the time of the May supplementary budget. Sales of automobiles and other durable goods were hardest hit by the slowdown in consumer spending.

 Industrial production (see Graph II—>) reflected the weak domestic and export demand and fell by an estimated 2.5%. This was the weakest performance since 1983. Not surprisingly, capacity utilization fell to 80% in the second half of the year—to the lowest level since early 1976. Investment also continued to fall for the second year running. It was forecast by the government to have declined by 4.2% in 1993.

  Standardized Unemployment Rates in Selected Developed Countries, TableUnemployment (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) rose to a post-World War II record of 3,250,000 in September as firms cut back in the face of stagnant or falling demand. At this level 11.8% of the work force was out of work, compared with 10.5% a year earlier. Hardest hit were young workers. The unemployment rate for those under the age of 25 was 22% in the autumn. In protest against the rising tide of layoffs, low wage increases, and the government's austerity measures, several groups of workers went on strike. The strike by Air France workers received the most media coverage and resulted in a partial backdown by the government. That year-on-year inflation rate (see Graph I—>) remained largely unchanged at around 2.5% was of little comfort to many consumers, as most wage settlements came in at below 3%.

Less Developed Countries.

       Real Gross Domestic Products of Selected OECD Countries, Table Standardized Unemployment Rates in Selected Developed Countries, TableThe LDCs as a group experienced another year of above-average economic growth, in contrast to the sluggish or declining pace of economic activity in the developed world (see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). According to IMF estimates, real GDP growth (see Table III (Standardized Unemployment Rates in Selected Developed Countries, Table)) in the LDCs in 1993 was around 6%, slightly faster than the previous year's 5.8%. Encouragingly, as the pace of population growth slowed somewhat, GDP growth per person accelerated to an estimated 3.8%, compared with 3.2% in 1992. At this level it was well above the 1982-92 average growth of 2.5%. Nevertheless, per capita incomes in some of the poorest countries continued to fall to below what they had been a decade earlier. The overall satisfactory economic performance of the LDCs as a whole was largely attributable to policy reforms and low interest rates, particularly on dollar-denominated loans. Relatively faster economic growth in Asia and, to a lesser extent, the U.S. also played a role by stimulating trade and economic activity.

      The pace of economic activity was broadly based, with most regions, except the Middle East, experiencing a modest uplift in growth rates. The rapid upswing that got under way in 1992 in the aftermath of the Gulf war could not be maintained in the Middle East, and GDP growth there slowed to an estimated 3.4% from 7.8%. Saudi Arabia and Israel slowed most, the former in response to declining oil prices. Growth in Iran remained strong at around 5% as the positive effects of recent reforms continued. The UN embargo on Iraq continued during 1993.

      The fastest growth was once again achieved by the Asian countries as they maintained their underlying economic dynamism and grew by an estimated 8.7%. Growth in this group was led by China, which achieved GDP growth close to 13%. Rapid growth in China was fueled by rising domestic demand and foreign investment following certain reforms. However, a slowdown was experienced late in the year as the economy appeared to be overheating and monetary policy was tightened. Other economies in Asia—including Hong Kong, South Korea, Singapore, Indonesia, Taiwan, and Thailand—remained buoyant as they benefited from increasing intratrade stimulated by China. The continuing recovery in the U.S. also stimulated exports from this region. India was another success story in the region, with an estimated real growth of 4.5% thanks to continuing stabilization and reform programs that included liberalization of trade and payments systems. Pakistan also experienced faster growth despite political uncertainties and foreign exchange constraints.

      Economic performance in the LDCs of the Western Hemisphere remained satisfactory, and growth averaged 3.5% in 1993. A strong recovery in Brazil with growth of 4%—reversing 1992's decline of 1%—was in contrast to a moderate slowdown in Argentina, Chile, and Venezuela. Economic activity in Mexico remained sluggish, reflecting efforts to reduce the current-account deficit.

      In Africa, because of adverse weather, weak demand from industrial countries, and policy imbalances, growth remained sluggish at around 1.5%. Among the larger economies, activity in Algeria contracted in 1993, while it strengthened in Kenya. Rapid inflation and fiscal imbalances led to a sharp slowdown in The Sudan. Likewise, activity in Morocco remained sluggish owing to drought and weak export markets in Europe.

      The improvement in the external balances of LDCs in 1992 was short-lived, and both the trade and current-account balances widened during 1993. Exports from the LDCs increased by around 9%, with most of the increase coming from non-oil-exporting countries. The weak demand for oil reduced the volume of exports from oil-producing countries. Strong economic activity in many of the LDCs led to increased demand for imports, particularly from non-oil countries. Sluggish economic activity and declining oil prices reduced the import capacity of oil-producing countries.

      According to IMF estimates, the aggregate trade deficit of the LDCs was projected to rise to $19 billion, compared with $9 billion in 1992. Owing to a fall in surpluses on services, official transfer payments, and private inflows, the aggregate current-account deficit was expected to widen to $80 billion from $62 billion in 1992. This was equal to 1.5% of the aggregate GDP. Regionally, most of the deterioration occurred in Asia, reflecting higher demand for imports arising from rapid economic growth. Large deficits also persisted in the Western Hemisphere countries, including Argentina and Mexico. The deteriorating terms of trade in some African countries also adversely affected the trade balances in that region.

      The financing of the moderately wider current-account deficit did not pose any difficulties, as net financial flows (comprising official transfers, direct investments, and external borrowing) rose by an estimated $4 billion to $115 billion. Furthermore, the funding of this deficit did not lead to a rise in debt levels, as there was a strong rise in direct investment. The IMF noted that direct investment as a share of non-debt-creating flows recovered in the Western Hemisphere, dominated by Latin America, to the level prevailing before the debt crisis, around 90%. The IMF expected the proportion in Asia to have risen to 85% in 1993, compared with 50% in 1979. The main factors that encouraged greater direct investment into Latin America and Asia included sound monetary and fiscal policies, as well as privatization programs that increased the efficiency of the private sector. Measures taken to improve their creditworthiness and reduction of debt overhang were also contributory factors. The relatively less attractive conditions restricted the flow of direct capital investment to Africa, however. For the poorest countries official flows (grants and soft loans) still made up a high proportion of all inflows—up to 80%. Such flows had risen considerably in real terms over a decade, but World Bank figures showed that aid from very few countries was close to the World Bank target of 0.75% of GDP.

      During 1993 the total external debt of the LDCs rose by an estimated 6% to $1,476,000,000,000. Although this increase was larger than in the previous year, total debt of the LDCs as a proportion of exports of goods and services continued the declining trend apparent since 1986 and fell to around 117.

      Average inflation in the LDCs rose in 1993 to an estimated 44% from 39% in 1992, but the very high inflation rate in a few countries affected the average, giving a somewhat misleading impression. Median inflation, which was more representative of the underlying trends, was around 7%. Regionally, average inflation was the highest in the Western Hemisphere at 220%, up from the previous year's 166%. This increase occurred in spite of a reduction in inflation in a number of countries in that region, including Argentina, Peru, and Nicaragua. In Brazil inflation remained at very high levels. According to IMF estimates, inflation in the region, excluding Brazil, was heading for 16% and was on a moderating trend.

      In Africa inflation was still high at around 36% but was declining gently. Inflation was expected to rise in Kenya during 1993 and to remain high in Algeria, Nigeria, and The Sudan. In Zaire, however, hyperinflationary conditions continued. Inflation also rose in Asia to over 8%, largely as a result of rapid economic development in China. Inflation was expected to decline slightly in the Middle East and Europe to 23%. Turkey continued to experience the fastest inflation rate in this region, at around 66%, mostly because of large fiscal deficits.

The Former Centrally Planned Economies.

      For the third consecutive year, economic output in the former centrally planned economies declined in 1993. The estimated 10% fall in output, however, was less than the 15% recorded in 1992. Economic conditions showed signs of improvement in many countries as measures to restructure and create market systems began to work. The reforms were expected to lead to only a small further decline in economic output in 1994, after which overall output from Central Europe and the former Soviet Union would rise.

      Already the reforms in Central Europe were showing positive results. This area was expected to see an economic decline of less than 2%, compared with a drop of 9% in 1992, when setbacks in agriculture—because of severe drought in the region and uncertainty about land privatization in some countries—had hampered restructuring efforts. In some cases the return of land to the pre-communist-era owners created plots that were too small to be economic. In 1993 output in the 15 countries that made up the former Soviet Union fell by 14%, slightly less than the 18% decline in 1992. Economic progress and structural reforms were being hampered by political difficulties and, in some countries, armed conflict.

      Many of the problems that existed in 1992 persisted. Economic links between the republics had stalled, as had state demand for military and other capital goods. Trade with countries outside the former Soviet Union had collapsed, and new markets had to be found. Nevertheless, progress in restructuring was beginning to be made. In September 1993, 9 of the 15 former republics signed a treaty of economic union that, if agreement on the details could be reached, would create a free-trade zone with strong monetary cooperation in the form of an exchange-rate mechanism, with currencies being linked to the Russian ruble. The treaty was not signed by the three Baltic states, but Ukraine and Turkmenistan became associate members.

      Inflation continued to be a problem throughout the region. Because of this, many countries experienced a depreciation of their currencies. The average rate for the countries in transition was expected to exceed 560% in 1993, down from 786% the year before. The total figure was misleading, however, as the inflation picture varied greatly from country to country, reflecting mainly the success or failure of stabilization programs. The most dismal picture was in the former Soviet Union, where prices were expected to have increased by 940% during 1993, compared with nearly 1,300% in 1992. The high rates of inflation were almost entirely due to the expansion of money supply resulting from excessive subsidies and low-interest credits to support state enterprise and imports. In Central Europe prices were still rising much too fast, at an estimated 142% over the year, only slightly below the 162% recorded in 1992.

      Accurate data on unemployment in most of the former centrally planned economies still did not exist. In Russia, where economic output had declined by nearly 40% in the previous three years, official unemployment in October 1993 was 1.3%, but that figure was misleading. Until the passage of the Employment Act of 1991, it was a crime to be unemployed in Russia, and after the act it was a disgrace. Registration for unemployment benefits was time-consuming; it was a long and difficult task to obtain the needed documentation; and the benefits, for those meeting eligibility requirements, were very little. In addition, there were many employees on involuntary or unpaid leave who were excluded from the statistics. These factors existed to some extent in several countries, and unemployment in most of the former Soviet republics remained hidden.

      In the more open economies, such as Bulgaria, the Czech Republic, Hungary, Poland, Romania, and Slovakia, data were more reliable. Unemployment levels in those countries were in the range of 14% to 17%, with the exception of the Czech Republic, where the unemployed accounted for only about 3.5% of the workforce. In general, unemployment rates increased slightly faster in 1993 than in the year before. This was inevitable as the overmanned state enterprise sectors continued to shed employees and the growing private sector introduced more efficient work practices and up-to-date technology that required fewer workers. In the short term the decline in real wages and rising unemployment reduced popular support for the reform process and remained a threat to democracy.

      Not surprisingly, the high rates of inflation and growing unemployment brought a deterioration in the lifestyles of many. The value of the state benefits being paid out had been eroded by high inflation. Inevitably, restructuring and reform caused temporary distortions in the economy, creating severe hardship for some people, such as the elderly and disadvantaged. The problem was how to target the benefits to those in most need without hampering the change to a market economy or stifling individual initiative. Limited progress was made in this area.

      Meeting the cost of statutory benefits—family allowances, maternity leave, and sickness pay—was increasingly difficult for all governments, as the revenue from state enterprises had declined. New benefits, such as unemployment insurance, which had been unnecessary under communism, also had to be established. The communist governments had made pension promises to their citizens, which their successors would not be able to honour in years to come. Plans were being made to reform pensions, and the old pay-as-you-go systems were likely to be replaced by funded pension schemes such as existed in the U.K. and the U.S. The lack of sophistication of the region's financial markets posed a problem since pension funds needed suitable outlets for investment. The merits of various pension systems were being considered before final decisions could be taken.

      The region's trade with industrialized countries continued to grow as a result of far-reaching trade-liberalization programs, but there were signs of protectionism in some of the industrialized countries. Western European countries with which a number of trade and cooperation agreements had been signed were suffering from recession and were reluctant to open their markets further to products that were particularly competitive. The EC was quick to respond to an outbreak of foot-and-mouth disease affecting livestock in the former Yugoslavia and, from April 8, 1993, imposed a temporary ban on imports of livestock, fresh meat, and dairy and meat-based products from 18 Central and Eastern European countries. Nevertheless, trade between the two regions was developing well. Exports from the Visegrad countries (Czech Republic, Hungary, Poland, and Slovakia) to countries in the Organization for Economic Cooperation and Development (OECD) rose an average 23% a year between 1989 and 1992, while imports increased by an average 30%. Since trade liberalization, however, the region's trade with the EC countries had moved from a surplus to a deficit of $3.6 billion in 1992. The overall deficit on current account of the former centrally planned countries grew from $4 billion in 1992 to a projected $15 billion in 1993. Increased financial assistance, with the rescheduling of official debt, meant an increase in financial flows to a projected $30 billion in 1993, up from $22 billion in 1992.

      The shift of assets from the state to the private sector continued as privatization programs progressed. By 1993 a large number of small enterprises had been successfully privatized in most Eastern European countries, with the notable exception of Bulgaria. The main difficulty encountered was the privatization of land because of uncertainties about ownership. Most of the former Soviet republics had moved slowly to implement any privatization programs.

      Privatization of the large-scale enterprises that formed the core of the command economy was proving more difficult than had been expected. Even in Hungary and Poland, which had started their reforms in 1989, problems were being encountered. In 1992 more than half of Hungary's revenue from privatization was from foreign capital. In 1993 the flow of foreign investment faltered, partly because of the recession in Western Europe and partly because it was being attracted to other destinations in Eastern Europe. In October Hungary announced plans to offer state shareholdings in 70 companies. They were designed to encourage small investors, and the government wanted to attract up to a million buyers. Toward the end of 1993 an ambitious program was getting under way in Poland to transfer a large and profit-making share of industry to private management. Nearly 400 companies were targeted for the plan, and under the Pact on State Enterprises signed late in 1993, privatization was to be accelerated. It had already brought the share of the private sector to about 45% of the Polish economy. Overall, Poland led the region, with economic growth of about 4%. In the Czech Republic 800 companies with a book value of about $5 billion were being privatized through the use of vouchers issued in November 1993. It was estimated that 40-60% of the national economy was in private ownership, and when the privatizations planned in 1993 were completed, 80% of state property would have been sold off.

      Management buyouts were proving an attractive means by which management and employees could obtain significant control. By September official Russian statistics showed that 80% of 70,000 large and medium-sized enterprises (covering four million employees) had been privatized in this way. The success of such buyouts, however, was often threatened by poor management skills and inadequate financing.

      The means by which countries privatized had different financial implications, and banking systems in many countries were inadequate and lacked the necessary experience in providing credit to the private sector. Efforts were being made to strengthen the balance sheets of commercial banks. In the meantime, privatization continued to erode the role of governments in setting prices and allocating resources. With a growing share of output coming from the private sector, the governments' revenues depended increasingly not only on private-sector profits but also on the development of efficient taxation systems. In the short term, large budget deficits had emerged, and the governments had little option but to increase their debt to meet current obligations.

INTERNATIONAL TRADE

      World trade growth faltered in 1993 following an encouraging upturn in 1992. Although the estimates and projections available toward the end of the year were subject to a greater degree of error because of the EC single market, which led to the discontinuation of customs controls, all the indications pointed to a global slowdown. IMF projections issued in October anticipated a growth of 3%, compared with 4.6% the year before. If confirmed, this would be the slowest growth rate since 1991 and below the 1975-84 average of 3.4%.

      The slowdown in world trade in 1993 was largely the result of the recession in Europe and Japan, which reduced the amount of demand. By contrast, stronger economic activity among the LDCs was reflected in faster growth in trade. This helped to sustain the overall level of world trade. Exports from the developed countries were estimated to have remained unchanged during 1993, while the estimated volume of their total imports had grown marginally by 1.2%. The comparative figures for the LDCs were 9.4% (export growth) and 9.3% (import growth).

      Germany and France were the largest contributors to the slowdown in export volume in the developed world. The relatively high value of their currencies, coupled with the recession in Europe and sluggish recovery in the U.S., resulted in an estimated decline in their export volume by 5.4% and 7.1%, respectively. The appreciating yen and dollar also contributed to a slowdown in exports from Japan and the U.S. In the U.S., domestic recovery diverted some products for the home market and further reduced exports. Significant depreciation in the lira and the pound sterling, following the withdrawal of Italy and the U.K. from the ERM in September 1992, led to relatively faster growth in their export volume—around 4% and 7%, respectively.

      The continuing economic recovery in the U.S. was reflected in a strong growth in import volume, estimated at 8.8%. Although this was somewhat slower than the 10.9% rise the year before, it was comfortably ahead of the long-term projection and by far the fastest growth anywhere in the developed world. Despite the weak economy, there was a modest increase in imports into Japan. This was partly a reflection of cumulative pressure on Japan to cut its trade surplus, but it was also created by the rise in the yen and economic reforms introduced in Japan. In contrast, the deepening recession in Germany and France cut back imports by about 5% and 8%, respectively.

      The level of trading activity in the former communist countries remained weak, as exports, particularly from Central and Eastern European countries, had declined because of the recession in continental Europe. In the former Soviet Union, with the exception of energy-related products, exports had continued to decline. Many of the former Soviet republics had not been successful in finding new markets for their products following the collapse of the Soviet bloc. In any event, continuing economic decline and hyperinflationary conditions reflected the slow progress in developing free-market mechanisms to replace the collapsed central planning system. Although hard currency imports had been sharply reduced, by up to 50%, this had been offset by a decline in exports. Thus, chronic trade and balance of payments problems remained.

      The LDCs' trade performance was much better than that of the developed countries, given the global sluggish economic activity, but a slowdown was inevitable. However, the slowdown was more marked in imports than in exports. Thanks to China's booming economy, which provided lucrative export markets for smaller countries in southern Asia, the volume of total exports from the developed world remained largely unchanged at about 9.5%. Elsewhere there was a small drop in export volumes. In Africa the combination of declining commodity prices and weak global demand meant there was no growth in export volume. In the Western Hemisphere the growth rate was halved to 3.3%. Export volumes from the LDCs in the Middle East and Europe fell, but their performance, with an estimated 7% growth, was relatively better. On the import side, the overall volumes for the LDCs fell by an estimated one percentage point to just over 9%. Most major regions saw a marked slowdown in their imports; an exception was in Asia, where it was estimated to have remained largely unchanged at around 14%. Western Hemisphere countries experienced the sharpest decline, from 21% to 4%, as they took steps to reduce their net borrowing.

      During 1993 the trend of world trade prices remained generally unfavourable to the LDCs. According to IMF estimates, the prices of nonfuel primary commodities declined by nearly 3%, the fifth consecutive annual decrease, bringing the cumulative decline since 1988 to over 17%. Weak overall demand from developed countries and mounting stocks were the main reasons behind the downward trend in commodity prices. Food prices fell by around 2%, following a drop of 1% the year before. The long-running decline in the prices of beverages came to an end as prices stabilized during 1993. Despite a rise in the price of gold, prices of metals and minerals as a whole declined steeply by 13%. As with commodities in general, weak demand and excess production were the main reasons behind it. In December oil prices were around $14.20 a barrel, which was 23% lower than at the start of the year—the lowest level in over five years. In addition to the fundamental imbalance between supply and demand, the short-term price weakness was attributable to renewed speculation that the UN would allow Iraq to resume oil exports in early 1994, thus adding to the excess supply of oil in the world.

      Because of adverse currency movements, the LDCs earned less per unit of exports than in 1992. However, they benefited from a 3% fall in the prices of manufactured goods, partly because of low inflation. This favourable combination resulted in a smaller decline in the terms of trade: 1%, according to IMF estimates, compared with 1.2% in 1992 and 3.7% in 1991. The terms of trade fell most in Africa and the Middle East. The improvement in the terms of trade in the developed countries was a modest 0.6% in the wake of 1.5% the year before. The largest gain was in those countries with appreciating currencies; Japan's improvement was 7%, followed by Germany, Canada, and the U.S. The U.K. and Italy faced a decline in their terms of trade.

      Considerable progress was made in trade liberalization during 1993. First, the North American Free Trade Agreement (NAFTA), concluded in December 1992, was approved by the U.S. Congress. This agreement created a free-trade area between the U.S., Canada, and Mexico—a vast area with a population of more than 370 million, slightly larger than the EC. This meant tariffs on 99% of goods traded between the U.S. and Mexico would be phased out over the next decade. It was to take another five years for some sensitive agricultural products to be traded completely freely. The scope of NAFTA was wide ranging. In addition to physical goods and products, it included financial services, telecommunications, investment, and patent protection.

      The ratification of NAFTA was the logical conclusion of the close ties that already existed in the region. Canada and the U.S. had implemented their own free-trade agreement in 1989. Trade interdependency between the U.S. and Mexico was high and had risen quickly since Mexico's accession to the General Agreement on Tariffs and Trade (GATT) in 1986. This was reflected in the trade figures, which showed that over 70% of Mexico's imports came from the U.S. in 1992 and that 76% of Mexico's exports were destined for the United States. Mexican tariffs on U.S. goods had fallen from 100% in 1981 to 10% by 1993, and U.S. tariffs on Mexican goods averaged 4%. Nevertheless, hostility to NAFTA in the U.S. was strong just before Congress voted. Opponents feared that it would lead to an exodus of jobs from the U.S. and Canada into Mexico as employers scrambled to take advantage of lower wages and less-strict environmental and labour laws in Mexico.

      The winning of the NAFTA battle encouraged expectations that a GATT deal between the U.S. and the EC would follow suit, enabling successful completion of the Uruguay round by the December 15 deadline. (See Agriculture and Food Supplies .) Farm trade remained the issue that had prolonged the Uruguay round negotiations for seven years and repeatedly threatened to sink them. Negotiations continued at a fairly leisurely pace during most of 1993. As the deadline approached, however, France finally reached a compromise with the U.S. on agricultural subsidies it deemed necessary to pacify militant French farmers, and Japan reluctantly agreed to ease its ban on imported rice. France again threatened to derail the talks when it announced it intended to continue subsidizing the French film industry. On December 14 the U.S. and the EC "agreed to disagree" and postponed final negotiations on the toughest issues, including shipping, financial services, and entertainment. The next day the delegates of the 117 GATT member nations approved by consensus the biggest trade deal in history, although the accord had to be formally approved by all 117 national legislative bodies before it went into effect as scheduled on July 1, 1995. The agreement would create a new organization to replace GATT, reduce tariffs by an average of one-third, eliminate many import quotas in favour of less-restrictive tariffs, cut agricultural subsidies, and ensure the protection of intellectual property, including copyrights, patents, and trademarks. Estimates by the World Bank and the OECD suggested that the successful completion of the Uruguay round could add between $213 billion and $274 billion to the world economy over 10 years.

INTERNATIONAL EXCHANGE AND PAYMENTS

 For the second year in succession, the international monetary scene was plagued by prolonged and, at times, intense exchange-rate instability (see Graph V—>). As in 1992, this was centred principally on the ERM of the European Monetary System (EMS). However, the dollar and the Japanese yen had also seen significant movements, mostly upward. Following the crises in September and November 1992, which forced sterling and the lira out of the system and led to devaluation of the Spanish peseta (twice) and Portuguese escudo (once), a period of relative calm prevailed. One exception to that was the devaluation of the Irish pound in January 1993 to bring it closer to the pound sterling.

  In early 1993, despite a deepening recession, France and Denmark successfully defended their currencies, through a mixture of high interest rates (for short-term and long-term interest rates in selected countries, see Graph III—> and Graph IV—>), intervention in foreign-exchange markets, and support from the German Bundesbank. In May the escudo and the peseta were devalued again, by 6.5% and 8%, respectively. Financial markets appeared to regard these devaluations as reflecting local cost-competitive pressures rather than applying to all ERM currencies, and there was no immediate pressure within the system. During this period the markets appeared to be content with actual or expected reduction in German interest rates. There was virtually no upward pressure on the Deutsche Mark, as the Bundesbank had cut the Lombard and discount rates in February in response to moderating money-supply and wage rises. Consequently, in the spring France and other ERM countries reduced their interest rates close to the German rates.

      The easing of interest rates in Europe was widely seen as the right move, as economic statistics released during the summer indicated a further deterioration in many European economies. A modest interest-rate cut by the Bundesbank on July 1 heightened expectations of further cuts before the summer holidays to stimulate economic recovery. Contrary to expectations, the Bundesbank became concerned that rapid growth in money supply and weakness of the Deutsche Mark could add to inflationary pressures, so it decided to slow the pace of interest-rate reductions. This heightened the underlying conflict between the need to keep interest rates high in Germany to dampen inflationary pressures and the necessity for other ERM partner countries to lower their interest rates. ERM currencies came under speculative pressure as the markets came to believe that the existing exchange rates were indefensible. True to form, on July 26 the central banks in Belgium and Portugal raised interest rates and intervened in the currency markets. The markets' and ERM partners' attention focused on the Bundesbank's scheduled meeting on July 29. It was widely expected that the Bundesbank would make a significant cut in the discount rate to allow interest rates to fall across Europe and end the latest currency crises. The decision of the Bundesbank to cut its securities repurchase rate by 50 basis points but leave the crucial discount rate unchanged sent shock signals to the markets. Immediately, the Deutsche Mark and the Dutch guilder came under intense upward pressure, while the other ERM currencies were under downward pressure. Despite massive intervention and a hike in overnight interest rates to defend the currencies under attack, many of them were pushed close to or below their ERM floors. At an emergency meeting during the weekend of July 31, it became clear there was no realistic option but to abandon the rigid ERM system. It was agreed to widen the bands around the ERM central parities from 2.25% to 15%.

      This provided considerable flexibility for the ERM countries to reduce their interest rates to enable a rapid economic recovery. Several countries, however, particularly France, reacted very cautiously and were reluctant to reduce their interest rates independently of Germany for fear of a drop in the value of their currencies, which, in turn, could stimulate inflationary pressures. In France significant interest-rate cuts came in September after Germany had cut its discount and Lombard rates, and France again followed the Bundesbank's lead and reduced the discount rate in October. The French authorities remained wedded to a policy of a strong currency and sound finance. In December the franc stood at 3.45 against the Deutsche Mark, representing a small devaluation of around 4%. After the widening of the ERM bands in August, relative calm returned to the European currencies.

 The U.S. dollar and the yen also moved upward against the European currencies (for effective exchange rates of selected currencies, see Graph V—>), partly in response to the ERM turmoil and partly because of interest-rate differentials. The dollar appreciated strongly against the European currencies in the early part of the year as interest rates started coming down gently in Europe. In early summer the dollar moved lower as the growth rate slowed in the U.S. and expectations of rapid interest-rate cuts in Europe were dashed. Following the widening of the ERM bands, European interest rates declined, growth in the U.S. economy strengthened, and the dollar gained ground. In December the effective exchange rate of the dollar was close to 67, compared with 65.3 at the beginning of the year, an effective appreciation of 2.6%. The yen also appreciated against other currencies during 1993 by around 20%, reflecting continuing large current-account surpluses. Against the dollar the Japanese currency strengthened from 125 yen per dollar and in September touched 100 yen per dollar. Thereafter, the weakness of the Japanese economy and expectations of interest-rate cuts weakened the yen somewhat. In December it averaged 110 yen per dollar and was still falling.

       Real Gross Domestic Products of Selected OECD Countries, TableThe balance of payments position around the world had reflected the sluggish demand in Europe, economic recovery in the U.S., and rising intraregional trade in Asia. Despite sluggish economic growth among the developed countries, their current-account deficits widened appreciably in 1993 (for real gross domestic products of selected countries, see Table I (Real Gross Domestic Products of Selected OECD Countries, Table)). IMF estimates indicated a deficit of $51 billion in 1993, up from $39 billion the year before. Most of the increase was attributable to a larger deficit in the U.S., where continuing economic recovery sucked in imports and resulted in an estimated current-account deficit of $111 billion. By contrast, export growth in the U.S. was modest, as many of its trading partners, in particular Europe and Japan, were in recession. The EC saw a modest narrowing in its deficit, reflecting weak demand. The EC countries with large deficits included Germany ($29 billion), the U.K. ($26 billion), and Italy ($21 billion). With the exception of Germany, all the others were traditionally deficit-prone countries. Germany, however, started running a current-account deficit after unification in 1990. By contrast, the seemingly unstoppable rise in Japan's current-account surplus continued in 1993. Despite a rise in the value of the yen and recession in Europe, Japan's surplus was heading for $140 billion, compared with the previous year's $117 billion. Although it was the lowest rate of increase since 1990, it remained a source of friction with Japan's main trading partners, particularly the U.S.

      The LDCs also experienced a widening in their current-account deficit from $62 billion in 1992 to an estimated $80 billion. A large proportion of the increase in the deficit was attributable to a larger trade deficit. The dynamic Asian economies rapidly sucked in imports of capital goods and raw materials and contributed to a widening of the region's balance of payments deficits from $4.8 billion in 1992 to over $20 billion. In Africa weak export demand and declining commodity prices led to a widening of the deficit to an estimated $9 billion, a deterioration of over 20%. The position in former communist countries in Central and Eastern Europe also deteriorated. The IMF expected the current-account deficits of those countries to rise to $4.6 billion in 1993 from the prior year's $1.5 billion. The economies of the former Soviet republics remained in a very precarious state, with declining output and hyperinflationary conditions. The hard currency exports were constrained by the recession in Europe, while imports depended on the availability of foreign aid. Ironically, if more aid were made available, this would increase their capacity to import and add to their deficit. The IMF expected the current-account deficit in the former Soviet Union to rise fourfold during 1993 to $11 billion.

      Fortunately, the financing of the wider current-account deficits of the LDCs was not problematic, as net financial flows that comprise official transfers, direct investments, and external borrowing rose. IMF estimates were for a 6% rise in the total debt of the LDCs to $1,476,000,000,000—a slightly faster rate of increase than the year before. However, total debt, expressed as a ratio of the value of exports of goods and services, remained stable at 123, effectively continuing the good progress since 1986. The level of indebtedness as a proportion of GDP also improved among LDCs. In 1993 it was estimated by the IMF at 27.2%, slightly below the prior year's 28.6%.

      The modest improvement seen in 1993 was due in part to lower interest rates but also to a number of debt-restructuring arrangements. These included debt relief granted by Paris Club creditors to four middle-income countries (Costa Rica, Guatemala, Jamaica, and Peru) as well as to five low-income countries (Benin, Burkina Faso, Guyana, Mauritania, and Mozambique). Russia's debt arrears and service payments due in 1993 (totaling some $15 billion) were also rescheduled by its official bilateral creditors, while commercial banks had agreed on a $35 billion debt-relief package for Brazil. Similar arrangements were entered into with the Dominican Republic and Jordan. Low or declining interest rates in the U.S., Japan, and Europe also had a beneficial effect on the LDCs' debt burden. (IEIS)

      This updates the articles BANKS AND BANKING; ECONOMIC GROWTH AND PLANNING; GOVERNMENT FINANCE; INTERNATIONAL TRADE.

STOCK EXCHANGES

       Selected Major World Stock Market Indexes*, TableIt was a vintage year, with double-digit gains for most stock exchanges (see Table V (Selected Major World Stock Market Indexes*, Table)) across the world. What drove the European stock markets upward in 1993 were falling interest rates, which, it was anticipated, would boost economic recovery and company profits, while in South Asia it was the high economic growth rates and the positive outlook for corporate profits. Falling interest rates reduced the attraction of putting savings in deposit accounts and encouraged private investors to switch to equity-linked investments. This, in turn, stimulated demand for stocks and shares underpinning the high levels reached. Despite a very poor performance in Japan, overall the world stock markets gained some 20% in 1993, as measured by the Morgan Stanley Capital International Index. This led the chairman of a leading securities house in London to comment, "This has been a splendid year, not only in this country, but across the world. If you have not made money this year, you never will."

      The rise in stock and share prices led to an upsurge in trading activity in most stock markets. In London, for instance, during the third quarter, British and Irish shares valued at £ 147 billion were traded. This was slightly higher than the previous record of £143 billion established in the third quarter of 1987. During the third quarter of 1993, the average volume of deals concluded rose to 40,000 bargains. Trading in overseas shares was even higher, reaching £161 billion. The activity was frantic during August following the virtual collapse of the European exchange-rate mechanism (ERM). The strong markets also encouraged companies to float or raise money on the stock exchange. During the first nine months, in the London market, rights issues raised £ 9.6 billion. The total for the year was expected to be £ 10.1 billion, which would set a new record. More than 100 companies had taken full listings on the London market.

      Yields from fixed-income securities declined sharply during 1993, reflecting the downward trend in global interest rates and decelerating inflation rates. This led to a sharp rise in prices. The highest total gains (income plus price rises) from government bonds and other fixed-income securities were seen in continental Europe, with typical gains between 11% and 15%. The scope for interest-rate cuts was greatest in continental Europe following the ERM crisis in August. Until then, countries within the ERM were forced to follow the high German interest rates. (IEIS)

United States.

       Selected Major World Stock Market Indexes*, TableThe stock market was bullish in 1993, with the major indexes of stock prices achieving healthy gains. The Dow Jones industrial average (DJIA; for a comparison of selected major world stock market indexes, see Table V (Selected Major World Stock Market Indexes*, Table)) rose 452.98 points, or 13.7%, to 3754.09, while the broader Standard & Poor's (S&P) 500 stock index ended the year with a 7.1% gain, up 30.74 points to 466.45. On the over-the-counter (OTC) market, the National Association of Securities Dealers automated quotation (Nasdaq) composite index closed the year up 99.85 points, or 14.8%, at 776.8, just below its all-time closing high of 787.42, set on October 15. The American Stock Exchange (Amex) market-value index climbed 77.92 points, or 19.5%, to 477.15. Spurred by a sharp drop in interest rates and by the economic recovery, investors were drawn to formerly shunned groups, such as automobile, airline, and machinery stocks. Short-term interest rates were at a 30-year low, and stock and bond prices reached record highs. Dividend declarations were up 23% in 1993, with 1,635 increases, compared with 1,333 in 1992.

      The economy gained power steadily in 1993 despite major burdens imposed by federal deficit reduction, defense cutbacks, state and local fiscal problems, weak exports due to an international recession, continuing corporate down-sizing, depressed commercial real estate, and relatively high corporate and personal debt. Capital spending was up 7%.

      Increased business investment in capital equipment and consumer durable goods, including autos, computers, appliances, home furnishings, medical equipment, environmental technology, and the space industry, gave the economy a boost in 1993. Low interest rates were a major factor. Vigorous consumer spending and booming new car business drove the pace of recovery in the final quarter of the year. Foreign direct investment in the first nine months aggregated $21 billion, compared with slightly more than $2 billion in 1992.

      The best performing groups in the DJIA in 1993 were: communications, up 69.8%; lodging, up 63.48%; heavy machinery, up 63.17%; auto manufacturers, up 62.24%; precious metals, up 59.10%; and entertainment stocks, up 54.83%. The worst performers were: footwear, down 30.24%; pollution control, down 27.53%; tobacco, down 25.56%; clothing and fabric, down 23.43%; advanced medical devices, down 21.53%; and pharmaceuticals, down 10.58%.

      A major market development in 1993 was the expansion in trading of derivative securities, securitization of debt portfolios, and the development of synthetic securities, which introduced new instruments for hedging and diversification. With many economists predicting continued low inflation and low interest rates, the bullish mood prevailed all year.

      In the third quarter of 1993, the government reported that net U.S. purchases of foreign securities were a record $43.3 billion, compared with $24.1 billion in the second quarter. The third-quarter figure nearly equaled the total net purchases for 1992 of almost $48 billion. Net purchases of foreign stocks in the third quarter by U.S. investors were a record $24.4 billion, compared with $13.5 billion in the second quarter. Net purchases in Western Europe jumped from $11.8 billion to $22.8 billion.

      Merger and underwriting activity reached record levels in 1993. The volume of mergers announced rose nearly 80% to $275.2 billion from $153 billion a year earlier. The strong U.S. financial markets encouraged merger activity, as did the growing alliance between high-technology and entertainment companies. Wall Street recorded sales of new stocks and bonds in excess of $1.1 trillion (excluding tax-free securities such as Treasury and municipal bonds), up from $860.9 billion in 1992. Major corporations refinanced high-interest debt. Because of low interest rates on bank deposits, investors moved to stocks and bonds for higher returns. There were 6,652 U.S. stock and bond deals through mid-December, well ahead of 1992's total, according to Securities Data Co., a financial research firm.

      The junk-bond market set an annual record for new issues. This was mainly because a growing number of lower-rated credits were welcomed by investors hungry for higher yields and many companies took advantage of low interest rates to issue new debt and use the proceeds to retire older, higher-cost debt. Through the end of November, the new issues of high-yield bonds totaled slightly more than $50 billion, compared with $38.2 billion for all of 1992.

      Share offerings, including new issues of closed-end mutual funds, totaled $102 billion, up more than 25% from a year earlier, while the number of stock offerings rose to 931 from 760. Through the first nine months, initial public offerings (IPOs) totaled $27.6 billion, up 43% from the corresponding 1992 period. Among the various industries represented in 1993's huge class of IPOs, financial services took the biggest share, with $15.1 billion, while technology issues turned in the best overall performance in trading after the initial offerings. During the first 11 months of 1993, 622 companies went public, not counting closed-end funds. This broke the 1992 full-year record of 513. The $36 billion raised in IPOs came close to the $40 billion total for the two previous years combined.

      New corporate bond issues totaled a record $433 billion in 1993. During the first nine months, municipal bond issuance rose 28% over the year-earlier period to $218.5 billion; it ended the year at $287.4 billion. Issuance of real estate investment trusts in the first nine months was $3.9 billion, more than five times the volume in all of 1992.

      Wall Street underwriters had a very successful year, collecting a record $9.1 billion in underwriting fees, up 35% from the year before. Merrill Lynch & Co. was the top underwriter for a sixth year, with $192.8 billion, or 13.1% of the global market. Merrill Lynch had 16.4% of the total U.S. market, totaling $173.8 billion; Goldman, Sachs & Co. had a 12% market share, totaling $127.3 billion; and Lehman Brothers Inc. had a 10.9% market share, totaling $116 billion.

      Interest rates declined in 1993, with Treasury bond yields falling from the 7.38% level at the beginning of the year to 6.41% at year's end. Yields on bank money-market accounts declined to 2.34%, down from 2.72% a year before, but the prime rate remained unchanged at 6%.

  The major stock exchanges engaged in strong promotion campaigns to attract new listings. The New York Stock Exchange (NYSE; for New York Stock Exchange stock index closing prices and number of shares sold annually, see Graph VI—>) advertised its competitive advantages, as did the other major exchanges in 1993. The market value of NYSE securities was $4.5 trillion, more than four times all other U.S. markets combined. In 1993 more than $36 billion was raised in new equity capital by IPOs on the NYSE, nearly three times all other U.S. markets combined. Trading volume on the NYSE was 66,920,000,000 shares, up 30.26% from 1992's 51,380,000,000. There were 1,790 advances, 729 declines, and 41 unchanged for a total of 2,957 issues traded. (For New York Stock Exchange composite index stock prices and average daily share volume, see Graph VII—>.) In the month that ended December 15, the number of shares sold short and not yet covered rose to a record 1,240,000,000 shares. Bond volume on the NYSE in 1993 was $9,752,161,000, down 16% from the $11,629,012,000 recorded the previous year.

      The NYSE chairman reported that 1993 was the greatest year ever. Forty-five companies moved over from Nasdaq to the Big Board. A record 306 companies were newly listed, up from a previous high of 251 in 1992. Of the 306, a record 191 were IPOs that raised $45.2 billion in capital. In 1992 there were 165 IPOs that yielded $34.5 billion in fresh capital. The most active stocks traded on the Big Board were: Merck, with a volume of 791,353,400 shares traded; RJR Nabisco, 773,160,700; WalMart, 758,946,300; Philip Morris, 722,235,200; Telefonos de México, 593,685,900; General Motors, 586,661,000; IBM, 579,564,800; Chrysler, 563,596,000; Citicorp, 535,185,700; and Glaxo Holdings, 483,753,600.

      Volume on the Amex was up 29.3% in 1993, with 4.5 billion shares traded. Short sales reached 104.5 million in August, a record. The Amex index gained 19.52% for the year. There were 583 advances, 259 declines, and 17 unchanged for a total of 997 issues traded. The smaller exchanges similarly showed record trading activity.

      Volume on Nasdaq through December 22 was 67,052,627,700, up 42.6% compared with 1992. The Nasdaq composite index ranged from a high of 787.42 to a low of 645.87 and closed the year at 776.8, a gain of 14.75% for the year. There were 1,715 advances, 1,085 declines, and 51 stock prices unchanged. In all, there were 5,284 issues traded on Nasdaq and the OTC markets. Short interest on the Nasdaq Stock Market set a record for the 11th consecutive month in mid-December, rising marginally to 672 million shares from mid-November's 671.3 million. Telecommunications and technology companies were among those with the largest short positions.

      The mutual fund industry continued its explosive growth during 1993 as 1,300 new funds were offered, bringing the total number to 4,385, more than the number of company listings on the Big Board. Mutual fund assets grew to $1.8 trillion. Money-market funds made up more than 70% of all funds in 1992, but their market share dropped to 30% in 1993. They were the largest buyers of common stocks and municipal bonds. More than a third of the $200 billion that poured into U.S. mutual funds in the first nine months of 1993 went into funds that specialized in foreign investments. Gold funds did particularly well, accounting for 15 of the top 25 individual funds.

       U.S. Stock Market Prices, TableThe S&P 500 (see Table VI (U.S. Stock Market Prices, Table)) composite index began the year at 435.23, 4.6% above the corresponding figure of 416.08 in January 1992. The index rose in February and March, dipped to 433.08 in April, and then climbed slowly to 463.9 in October, 12.5% above the corresponding month in the previous year. It closed the year at 466.45. The industrials followed a similar pattern, beginning the year at 504.96 and moving irregularly to 527.13 in October, 9% over the comparable 1992 figure. For the entire year the S&P industrials were up more than 6% at 540.19. The S&P public utilities index began the year at 159.79, rose to 186.76 by September, and then dipped to 183.5 in October for an 18.9% gain on a year-to-year basis. The utilities were up 14.12 overall at 172.58 at year's end. Transportation stocks rose from 374.27 in January to peak at 402.75 in October, a 7.6% gain for the 10-month period but 23% above the corresponding year-earlier figure. The transportation index finished the year at 425.6.

       U.S. Government Long-Term Bond Yields, TableU.S. government long-term bond yields (see Table VII (U.S. Government Long-Term Bond Yields, Table)) were well below prior year levels all though 1993. From a high average of 7.17% in January, the yield slid gradually to 6.64 in April, paused in May, and resumed its decline to 5.9% in October, 23% below the corresponding 1992 figure.

       U.S. Corporate Bond Yields, TableCorporate bond yields (see Table VIII (U.S. Corporate Bond Yields, Table)) declined steadily throughout most of the year. From a level of 7.91% at the beginning of the year, the average slid to a low of 6.66% in September before rising slightly in the last quarter of the year. On a year-to-year basis, the October level was nearly 20% lower than in 1992.

      Trading volume in the nation's futures and options markets continued to climb toward record levels, with volume more than 9.2% above that of 1992. Some 45% of all futures and options contracts traded were interest-rate instruments, an increase of 32% above the prior year. It was a record year at the Chicago Board of Trade. Contract volume soared past its previous annual record in December as the 1993 volume hit 155 million contracts, an all-time high. Financial futures and options led the way, compared with agricultural futures and options and stock index futures and options, which had been more popular in earlier years. An attempt by the Chicago Board Options Exchange (the nations biggest stock options exchange) to take over the Philadelphia Stock Exchange (the fourth largest) was rebuffed.

      U.S. stock options trading never returned to its pace set before the 1987 crash. There were 125 million stock option contracts traded in 1993, up 22% from 1992 but still nearly 24% fewer than the 164 million options traded in 1987, according to Options Clearing Corp.

      The Securities and Exchange Commission (SEC) was very active in 1993 on a number of regulatory issues. It proposed several new rules to make mutual fund investing safer and easier to understand. One proposed rule called for mutual funds to disclose how much compensation each director earned from all the funds in the same family of funds. The proposals marked the SEC's first change in mutual fund proxy material since 1960. Another proposal provided that national tax-exempt money funds would be barred from investing more than 5% of their assets in any one security. The SEC was also interested in proposals that would, for the first time, require continuing financial disclosure on the $1.2 trillion municipal bond market. While the disclosure was expected to increase costs for municipal bond issuers, it would provide bond buyers with a basis for valuation of their securities in the after market. The plan would prohibit dealers from underwriting new bonds unless the issuer agreed to continuing financial disclosure. The SEC also escalated its pressure on securities firms to change brokers' compensation and to control "cold calling"; that is, soliciting investments from people who were not clients of the firm. The adequacy of supervision of brokers was the subject of an ongoing investigation as of year's end because of what appeared to be widespread abuses in the sale of highly speculative limited partnerships.

Canada.

      The stock exchanges in Canada performed very well during 1993, in part because the Canadian dollar was near a six-year low relative to the U.S. dollar. The recession was easing, with an inflation rate below that of the U.S., although unemployment was still unacceptably high at more than 11%. Low inflation, a gradually improving trade balance, and commodity prices that appeared poised to rise supported the Canadian currency and bond markets. Investors bought Can$20 billion of new equity in 1993, nearly twice the $11 billion of 1992, the previous record year. Foreign purchases of Canadian securities hit Can$45.8 billion in the first nine months of 1993, three times the volume of the equivalent period in 1992. In September foreign holdings of Canadian debt hit an all-time high of Can$271.8 billion. The Canadian Dow Jones Equity Index had a yearly high of U.S.$99.72 and a low of U.S.$81.40 for a 14.03% year-to-year gain.

       Selected Major World Stock Market Indexes*, TableThe composite index of the Toronto Stock Exchange (TSE), which did 78% of all the trading in Canada, rose 29% in 1993, outperforming Wall Street and many other markets abroad. (For a comparison of selected major world stock market indexes, see Table V (Selected Major World Stock Market Indexes*, Table).) Volume was never stronger. The same was true of Montreal, with 17% of the activity, the Vancouver Stock Exchange (VSE), with 3%, and the Alberta and Winnipeg exchanges, which did the rest of the business. In August the TSE 300 index passed its former record, set in 1987. For the year it set 17 new highs, including 4320.88 attained on December 30. Bullishness was accompanied by ever increasing volume. The daily average was 60 million shares, almost twice the 1992 figure. The TSE (300) composite price index began the year about 3300 and climbed steadily throughout the year with brief pauses in July and September to reach a level of 4321.43 by year's end. Toronto's gold index doubled in 1993, oil stocks were up about a third, and forest products rose some 50%. Trading volume on the VSE reached 4.4 billion shares during the first three quarters of the year. The VSE composite index reached a 52-week high of 1052.86 on November 12 on the strength of several factors, including strong gold prices. VSE companies raised more than $770 million in 1993, up from $390 million during 1992. (IRVING PFEFFER)

Western Europe.

       Selected Major World Stock Market Indexes*, TableAll of the major stock markets (for a comparison of selected major world stock market indexes, see Table V (Selected Major World Stock Market Indexes*, Table)) in Europe outperformed Wall Street and Japan as they surged strongly in the summer, anticipating economic recovery following the near collapse of the ERM, which heralded lower interest rates. Most European bourses experienced a further spurt up in December and set their 1993 highs in the last week of the year. An overall gain of more than 40% shown by the Euro Top-100 Index, since the January low, was matched or exceeded by many European bourses during 1993. The best performance among larger European bourses was seen in Sweden and Spain, which toward the end of the year were 54% and 51% higher, respectively, than they had been at year-end 1992. Germany, with a 41% increase over the same period, was also a good performer.

  Selected Major World Stock Market Indexes*, TableThe London Stock Exchange (LSE; for Financial Times Industrial Ordinary Share Index annual average, see Graph VIII—>) lagged behind its continental European counterparts, as the share prices had risen by 20% during the previous autumn after the pound withdrew from the ERM and interest rates fell by three percentage points. Thus, the Financial Times Stock Exchange (FT-SE 100) Index (see Table V (Selected Major World Stock Market Indexes*, Table)) in London fluctuated narrowly in the first seven months of the year between 2800 and 2950—rising when traders sensed interest rates might be cut and retreating when hopes were dashed or company profits were disappointing. In the spring the index tested the psychologically important 3000 level on hopes of an early cut in German interest rates, but it fell back when these did not materialize. The FT-SE drifted throughout the summer, as economic activity proved to be sluggish and there was no change in policy to stimulate the economy. In August, when the German interest rates were cut, the FT-SE rose strongly, and by early September it was 10% higher than the July low. By early November the FT-SE 100 Index stood at 3200, but this level could not be sustained, and it fell back to under 3100 as the market was perceived to be ahead of the recovery in company profits. Uncertainty was injected ahead of the unified budget on November 30. In the event, the budget was a major stimulus as tax increases were less than feared and the chancellor of the Exchequer aimed to reduce the public-sector deficit more quickly than previously planned. The FT-SE 100 Index soared to its highest-ever level of 3462 and finished the year at 3418.4.

       Selected Major World Stock Market Indexes*, TableIn Germany, despite the deepest recession in 50 years, investors were rewarded by a 41% gain in 1993, as measured by the FAZ Aktien Index (see Table V (Selected Major World Stock Market Indexes*, Table)). In the opening months of the year, the FAZ Aktien Index rose from around 600 to 650 on hopes of interest rates easing following agreement on measures to reduce the public-sector deficit. A setback in late March was followed by three months of drifting as the economic indicators worsened and company profits slumped. In the summer, as the tension within the ERM grew and the French franc fell to its floor against the Deutsche Mark, the markets anticipated a cut in interest rates and recovered. Although the Bundesbank cut the discount rate by a paltry 0.5% in early August, the market soared as investors anticipated that other European countries had more room to reduce interest rates. This, in turn, was expected to benefit German exporters. By November the FAZ index had breached the 800 level, despite disappointing news on the economic front and a cautious approach by the Bundesbank to cutting interest rates. Factors that stimulated prices in the autumn included expectations of further interest-rate cuts, restructuring by companies that would improve their competitiveness and profitability, and external demand, particularly from U.S. investors. By year's end the market had consolidated at around the 850 level.

       Selected Major World Stock Market Indexes*, TableThe Paris Bourse also registered a gain (of more than 20%) during 1993. Although the Bank of France was too cautious in cutting interest rates and the old "franc fort" policy survived the revision to the ERM, investors still remained optimistic of further cuts. The CAC 40 Index (see Table V (Selected Major World Stock Market Indexes*, Table)) entered the year strongly and by March stood at 2010, showing a gain of 13% from the January low. The market was encouraged by the small cut in German interest rates and by the legislative election results. In the spring it lost most of the gains as the recession deepened, unemployment mounted, and corporate profitability headed for an estimated 15% fall on top of a 25% decline in 1992. The desire to maintain the franc/Deutsche Mark exchange-rate parity kept interest rates artificially high and exacerbated the recession. The surge in the market in August and September, up to a new high of 2230, reflected France's freedom to pursue a more independent line in the new era of wider ERM bands. The market entered a volatile phase in the autumn and fluctuated between 2050 and 2230 as it was influenced by conflicting sentiments of uncertain economic outlook. Sentiments improved in December and, after setting a new high of 2282 on the 27th, the CAC 40 ended the year at 2273.

 The Swiss and Austrian stock markets had risen by 47% and 37%, respectively, since the end of 1992. The purchase of equities was seen by investors as a way of gaining international exposure with limited risks. The banks and pharmaceutical companies that dominated the Swiss market were perceived to be strong beneficiaries of lower interest rates. Likewise, the strong Swiss currency was a safe haven against the turbulence in other European currencies (see Graph V—>).

      The Benelux countries benefited from a combination of low inflation, declining interest rates, and projected economic recovery. The Netherlands, in particular, was seen as a Germany without the burden of the unification and finished the year with a similar gain. The Belgian market rose more modestly, with an increase of 30%.

      Floating exchange rates and lower interest rates since autumn 1992 improved the export earnings of most Scandinavian countries and signaled a recovery ahead of the rest of continental Europe. Finland was the star performer, with a rise of over 90% as it continued to recover from the sharp falls caused in 1991 by the collapse of the Soviet Union. Ironically, the severity of the recession in Sweden and cost cutting in industrial sectors was expected to improve company profitability and made it attractive to the international funds. Both the Swedish and Norwegian markets rose by more than 50% during 1993, while Denmark registered a slightly smaller gain (40%).

      The southern European bourses also proved sensitive to lower interest rates and currency devaluations. Spain was among the best performers in 1993, with a 51% gain as it looked relatively undervalued early in 1993 following a large decline in 1992. Investors were also encouraged by the Social Pact between the government and the unions to moderate wage rises and reform Spain's rigid labour laws. In the longer term, it was hoped that these measures would accelerate Spain's integration into the EC. Italy bounced back to a yearly high in August of 633, then fell below 600 as sentiment was adversely affected by political crises and financial scandals that refused to go away. It staged a partial recovery to end the year at 619.

Other Countries.

       Selected Major World Stock Market Indexes*, Table Selected Major World Stock Market Indexes*, TableAlthough most stock markets (for a comparison of selected major world stock market indexes, see Table V (Selected Major World Stock Market Indexes*, Table)) performed well in 1993, the region that caught the imagination of the investors was Asia. Its super growth prospects on the back of U.S. economic recovery and continued rapid growth in China led to a boom in most stock markets in the region except Japan. Despite a setback in November, the Philippines was one of the best performing countries, with a 150% increase since the beginning of the year. Malaysia also rose by more than 100%. Taiwan and Thailand had gains of some 80%. Singapore, too, rose strongly (59%) owing to faster economic growth and a generous budget. Hong Kong, the second most important stock market in the region, was in good form, and the Hang Seng Index (see Table V (Selected Major World Stock Market Indexes*, Table)) rose 116% to 11888.39, despite a strong correction in the summer due to worries about the austerity program in China and the worsening relations between China and the U.K. However, the forecast of rapid economic growth in China and Hong Kong, coupled with some progress in the talks between China and Britain, pushed the market to new records.

       Selected Major World Stock Market Indexes*, TableJapan, meanwhile, suffering from weak domestic demand and strong currency, remained in a recession despite 30,000 billion yen pumped into the economy by the government in the previous 15 months in three economic packages. The poor economic outlook was reflected in the Tokyo stock market, which slumped in November, canceling earlier gains. The Nikkei Average (see Table V (Selected Major World Stock Market Indexes*, Table)) ended the year at around 17,400, only slightly above where it started and 36% below the December 1991 peak. The market, having entered 1993 on a weak note, recovered steadily between March and June and rose by 25%. Political problems caused a modest decline in the summer, but the lost ground was made up in August and September. The larger-than-expected cut in the discount rate in late September encouraged the market, and the Nikkei briefly exceeded the 21,000 level. In late October and early November, sentiment turned bearish, and foreign investors withdrew their support. The market fell by more than 20%, close to the psychologically important support level of 16,000. What worried investors most were the potential bad debts of the banks, declining corporate profitability, and confirmation from the Economic Planning Agency that a recovery was not likely to emerge until between mid-1994 and March 1995. In December the market recovered somewhat on expectations of new economic-stimulus measures.

Commodity Prices.

      As the world economy experienced its fourth consecutive year of sluggish growth, it was not surprising that prices of many commodities declined or remained weak. The Economist Commodity Price Index of spot prices for 28 internationally traded foodstuffs, nonfood agricultural products, and metals rose by 6.8% in U.S. dollar terms during the first 11 months of the year. In sterling terms it was marginally farther ahead at 9.2%.

      The price of crude oil, which was not included in The Economist Index, fell by around 18%. North Sea Brent, for instance, fluctuated between $19.5 and $16 for most of the year, but in December it was below $14, the lowest level in over five years. The price weakness was induced by supply exceeding the weak demand from the recession-stricken industrial countries. A mild winter and the possibility that Iraqi oil would come to the market in 1994 did not help either. In its November meeting, OPEC decided to hold its output ceiling at 24.5 million bbl a day, but output from member countries regularly exceeded the target. Production from Russia and other non-OPEC members was also rising.

      The two major sectors of The Economist Index performed very differently. The food index rose 16% in dollar terms, while the industrials index rose by only 1%. Floods in the U.S. and frosts and droughts elsewhere reduced yields and led to a fall in output of some products. Excess stocks and problems with international price-support agreements depressed the prices of beverages. Nonfood agricultural products such as rubber were also weak. Wool prices recovered from earlier weakness as production was expected to fall at a time when demand from both Japan and Europe was on the upswing. The Economist Metals Index fell by 20% in dollar terms as demand fell short of production. An increase in production was especially noticeable in the countries of the former Soviet Union.

      Gold came back to life in 1993 and at one point was 25% up, but the price fell back, trimming the gain to 12%. The price of gold was quiet early in 1993 at around $326 per troy ounce until two veteran speculators, George Soros and Sir James Goldsmith, stirred it up by investing in gold and gold shares. The price swiftly moved up to $405 at the end of July. As they realized most of their gains and reduced their holdings, the gold price tumbled back to $344 in September. After that, gold traded in a narrow range and at year's end stood at $390.80. Gold bugs remained optimistic and predicted that the gold price would rise to $500 once the world economy was fully out of the recession. (IEIS)

      This updates the article market.

* * *

▪ Table

1950 1991 2025**

Area Pop.* % Pop.* % Pop.* %

More developed countries 832 33.1 1,219 22.6 1,412 16.3

European Community 278 11.0 346 6.4 348 4.0

United States 152 6.1 253 4.7 334 3.9

Japan 84 3.3 124 2.3 135 1.6

Less developed countries 1,684 66.9 4,165 77.4 7,234 83.7

World total 2,516 100.0 5,384 100.0 8,646 100.0

*Population in 000,000. **Projected.

Source: Eurostat Demographic Statistics 1993.

* * *