Business outlook: Is it deflation or inflation we should fear most in 1998?

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"May you live in interesting times", the famous Chinese curse says. Unfortunately, it seems this year to have been cast on China's own region, Asia Pacific, which has been condemned by the world's capital markets to two to three years of severe belt tightening and structural reform.

The coming year will see the impact of the financial crisis hitting the people on the streets or in the fields. A recent Oxfam report warned of the effect the loss of jobs in construction across the region would have on rural poverty, given the numbers who depend on money sent back from family members working in the cities. Politicians will be caught between the rock of popular discontent and the hard place of IMF conditions.

Growth forecasts for Asia have been slashed. For example, IBJ is predicting just 1 per cent GDP growth in Japan, while HSBC puts growth for South- east Asia excluding Japan and China at just 2.1 per cent. It sees GDP falling by 1.5 per cent in South Korea and 3 per cent in Thailand, the two worst-afflicted countries.

It will therefore be a year when politicians' determination to go ahead with structural economic reforms will be put to the test. Will the South- east Asian countries dismantle their crony capitalism to satisfy the IMF?

And will Japan implement the root and branch change in financial and other services that will allow its transition to a modern service economy? As Stephen Hannah, chief economist at IBJ in London, says: "It's crunch time." It is hard to see, in these circumstances, how there can be any significant recovery in equity markets, either in Japan or elsewhere in the region. Deregulation of the protected construction, service and financial sectors may provide Japan with a way out of its present downward deflationary spiral, but the road is a long and hard one. Moreover, apart from the likes of big multinationals such as Sony, which are already fully integrated in the global market, most Japanese stocks are still wildly overvalued compared with the rest of the developed world, even at present depressed levels. They will have to fall to something more like normal levels before they can start to rise again. The outlook for the Japanese stock market therefore continues to look bleak.

American optimism

There could scarcely be a greater contrast between the storm clouds over Asia and the sunny optimism brightening US economic prospects. Although US growth is expected to slow in 1998 from something near 4 per cent in 1997, even this is taken as a good sign by the Pollyannas. Why, if not for the weakness in Asian markets, the Federal Reserve would certainly have raised interest rates for the first time since March by now.

While it is correct to argue that the economic spill over from the Asian crisis to the US and Europe is likely to be small, it is still too early to accept the truth of the "new paradigm" so beloved by one camp of US commentators. They argue that the technological revolution and strong US position in key markets means growth can continue well above trend without triggering inflation.

Certainly, unemployment has fallen impressively with only a modest pick up in pay pressures. But the US (and UK) are at exactly that stage of the business cycle where false miracles are spotted. Normally growth then slows as inflation picks up. This time next year it will be clearer how far the "paradigm" has changed.

What of the more pessimistic camp? According to this outlook, the Asian crisis could spark global deflation. Certainly, there are some eery parallels, particularly in the competitive devaluations going on throughout the Far East, between the situation now and that of the late 1920s. According to this theory, the shock to growth in the region, and its huge currency devaluations, will hit exports from OECD countries and boost their imports from Asia. At its most extreme, the effect of this might be to cause investment to dry up a global scale - not just in Asia, but in the US too. In those circumstances there would also be a marked fall off in consumption. On balance, however, this would seem an unlikely scenario. The buoyant US economy is probably still too insular and big for this to be a likely outcome.

So is there anything on the horizon that might cause a serious setback on Wall Street, aside from the inevitable short-term volatility if the new year brings fresh turmoil in the Far East? The biggest risk is probably not so much that of deflation as the possibility that inflationary signals cause a sharp change in sentiment about the Fed's interest rate policy. That would hit both Treasuries and equities. The risk on the other side would be a shift in sentiment in favour of the global deflation view. That would be good for bonds, but very bad for equities. There is little evidence for this view yet, but that does not mean the markets will not react to the fear. Wall Street looks harder to call than ever.

Brakes on the British economy

All the economists surveyed each month by the Treasury agree that growth in the UK will slow in 1998. They all agree about the ways it will come about, too. Exports will turn down as the effect of the strong pound finally bites, and markets in Asia and the US slow. The consumer boom will continue to ebb, thanks to the five increases in interest rates - with perhaps one or two more rises to come.

But the forecasters could not disagree more about the scale of this slowdown. Predictions for growth in 1998 range from 1.5 per cent to 3.6 per cent, and for the target measure of inflation from 2 per cent to 4 per cent.

This is partly a disagreement about the degree of momentum in the economy. Are personal incomes rising fast enough, thanks to the tight jobs market, to keep consumer spending robust? Are British exporters more competitive than some feared? But it is also a disagreement about how sharply the Bank of England would be prepared to step on the brakes again to keep inflation on target.

One thing seems certain. Whether the economy slows of its own accord in the next year, or the Bank imposes the slowdown, it will be a less buoyant year than 1997. Profits forecasts are, nevertheless, not much more subdued than the 6-7 per cent increase expected for 1997. As ever, the main influence on the FTSE 100 will be which way Wall Street goes in the next 12 months.

No derailment of Emu train

There are plenty of key dates for the launch of the single currency coming up this year, for on 1 January 1999 the participating currencies are locked together irrevocably.

Under the UK Presidency of the European Union, in March the European Monetary Institute and the European Commission will formally report on which countries have qualified. A special summit on 1-3 May will decide who joins and at what bilateral exchange rates their currencies are to be tied. Conversion rates to the euro will be formally set on 31 December.

It seems all but certain that there will be 11 members - excluding the UK but including Italy. If Germany had decided to set its face against Italian membership, the politicking would have had to start already. Economists see little chance of either any surprises on membership or timing. Alison Cottrell of Paine Webber argues that it would take an unexpected severe economic downturn in Germany or France, causing them to miss the 3 per cent of GDP target for the government budget deficit, to delay the start. And, as she notes: "It's difficult to have a recession when you're hosting the World Cup."

-Diane Coyle

What's the outlook for the world and British economies this year? How are financial markets likely to react to the vicissitudes of world events? And how are our leading companies and industries going to respond to the twin challenges of globalisation and rapid technological change? Crystal-ball gazing is rarely a rewarding endeavour, but it is possible with reasonable precision to examine the pressures and strains at work in commerce and business, and from that to form a view of the future. The Independent's business writers assess below and opposite what 1998 has in store.

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