03 October 2003

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In this week’s issue:

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Internet www.markets.hsbc.com
4 The recent strength in productivity growth has come from services rather than www.research.hsbc.com
manufacturing and may reflect the second round effects of the technology wave, as Bloomberg HSBE<GO>
service sector firms efficiently utilize the capital put in place in the 1990s boom.

4 The broad-based rise in productivity could have a number of implications. Service sector
output could get a boost. Service sector profits could also get a boost, at least for a while
before it’s competed away. However, service inflation could drop at a time when core
inflation is already very low. Furthermore, employment growth in the service sector could
remain persistently weak, as output gains are delivered by productivity increases instead.

4 The key risk is that employment weakness ends up derailing the expansion. This is one
reason why we expect only about 2½% GDP growth in 2004 compared to consensus of
4%. As a result, the Fed is still more likely to cut rates than raise them. Indeed, given
these risks, the first hike is unlikely to come until mid-2005.

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4 The French budget plans show the deficit falling from 4.0% of GDP in 2003 to 3.6% of
GDP in 2004, the third successive year above 3% of GDP. France is planning an
underlying tightening of 0.7% of GDP in 2004, with tightening of around ½% of GDP in
each of the next three years. The budget deficit then falls below 3% of GDP in 2005.
Despite the underlying tightening, European Commissioner, Solbes, has been very
critical of the French plans.

4 We expect the budget deficit for France to be unchanged at 4% of GDP in 2004 and 2005
while the German budget deficit could be 4.5% of GDP in 2004 after 4.3% this year. The
3 largest eurozone countries are likely to prevent any punitive action being taken against
any one of them. If Germany, France and Italy were to put in place major fiscal tightening
to ensure sub-3% of GDP deficits in 2004 the eurozone would probably move back into
recession. 'LVFODLPHU GLVFORVXUHV
This report must be read with the disclaimer, disclosures
8.*'3UHYLVLRQVZKDWKDVUHDOO\FKDQJHG"SDJH and analyst certifications on p28 that form part of it.

4 Now the dust has settled on the substantial revisions to UK economic history, this piece
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discusses whether the new set of data alters our economic outlook. The revisions have
changed the emphasis we would place on some key issues, namely the split between
US
internal/external imbalances, but have not fundamentally altered our view. Ian Morris US 1 212 525 3115
Eurozone
4 There is little to suggest that trend growth has changed. The consumer boom was less Gwyn Hacche UK 44 20 7991 6707
pronounced but vulnerability persists. Corporate debt is falling but still remains high. UK
While the widening current account deficit should put downward pressure on sterling. John Butler UK 44 20 7991 6718
Ian.morris@us.hsbc.com
4 Growth is stronger in Q2 2003 but the level of GDP and, hence, output gap is unchanged. Gwyn Hacche@hsbcib.com
John.Butler@hsbcib.com
Overall, the revisions should support a ‘wait-and-see’ approach to interest rates.
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There’s something different about productivity (FRQRPLVW

Ian Morris US 1 212 525 3115
The fact that the US productivity miracle appears to be rampaging ahead and resulting in
Ian.morris@us.hsbc.com
some tremendous profit growth currently is now well appreciated by investors. Delving into *HSBC legal entities listed on page 28
the productivity data, there is also something different going on compared to the 1990s “new
economy” experience.

This time around, the contribution to the productivity growth acceleration is being driven by
the service-sector. It is not that manufacturing productivity growth is slowing much, it is that
the service sector appears to be catching up as far as the measured statistics are
concerned. We approach service-sector productivity from three different angles to help
confirm this picture.

Three approaches to analyzing service productivity growth

Chart 1 shows the GDP of services divided by service-producing payrolls as our first
measure of service productivity (derived using the quarterly GDP report and the payroll
report). As it is notoriously difficult to measure service productivity, the actual growth rates
need to be taken with a grain of salt. However, it is useful to look at the series in relation to
its own history. After oscillating regularly between negative and positive growth for much of
the 1965-95 period, service productivity has managed to remain in positive territory since
about 1995, and recently experienced the strongest growth rate since the early 1960s. One
needs to go back to the 1958-68 period to see such sustained strength.

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% Yr % Yr
5 5

4 4

3 3

2 2

1 1

0 0

-1 -1

-2 -2
58 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04
Service Sector Productivity [GDP Services / Service-Producing Payrolls]

Source: Datastream, Bureau of Labor Statistics, Bureau of Economic Analysis

A second measure of service-productivity can be derived from the quarterly productivity

report. The report itself does not measure service productivity, but it is possible to “back-out”

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the implied service productivity growth rate, as data on manufacturing and the non-farm
business sector (which includes manufacturing and services) is given.

Using this approach, one can see that the service productivity upswing in this cycle has
pretty much kept up with manufacturing (chart 2). This is somewhat different from the early
1990s experience, where services lagged. More importantly, chart 3 shows that the 5-year
moving average for service productivity has crept up from a 1¼% growth trend between
1990-99 to 3% now. This is still under-performing 4% manufacturing productivity growth, but
the gap is closing.

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% Yr Nonfarm business sector productiv ity : % Yr % Qtr Ann: 5-y ear av g Nonfarm business sector productiv ity : % Qtr Ann: 5-y ear av g
8 8 6 6
7 7
5 5
6 6

5 5 4 4
4 4
3 3
3 3

2 2 2 2

1 1
1 1
0 0
-1 -1 0 0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Manufacturing Non-manufacturing Manufacturing Non-manufacturing

Source: HSBC, BLS Source: HSBC, BLS

A third approach to gauging service productivity growth is to utilize the data on the service
sector in the annual industry-GDP accounts, and divide it by hours worked. On this
measure, private-service sector productivity grew 3.6% in 2002, the quickest growth rate
since data is available on this basis (1988). The drawback with this series is that the data is
only annual and 2002 is the latest observation. Nevertheless, it confirms the upbeat trend of
the other two measures (chart 4).

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% Yr % Yr
4 4

3 3

2 2

1 1

0 0

-1 -1

-2 -2
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Productiv ity grow th: Total priv ate serv ices Linear (Productiv ity grow th: Total priv ate serv ices)

Source: HSBC, BLS, BEA

Strong service game across the board

Within private services, the productivity gains appear fairly widespread. Communications
productivity appears to be skyrocketing at a 9-10% annual growth rate in 2001-2002 (despite
making large losses and cutting debt and workers through this period). Retail productivity
topped 6% in 2002. Productivity for wholesalers’, utilities, transport and “other services”
have also performed well (charts 5-10).

5HWDLO :KROHVDOH
% Yr % Yr % Yr % Yr
8 8 14 14
7 7 12 12
6 6 10 10
5 5
8 8
4 4
6 6
3 3
4 4
2 2
2 2
1 1
0 0 0 0

-1 -1 -2 -2

-2 -2 -4 -4
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Productiv ity grow th: Retail trade Linear (Productiv ity grow th: Retail trade) Productiv ity grow th: Wholesale trade Linear (Productiv ity grow th: Wholesale trade)

Source: HSBC, BLS, BEA Source: HSBC, BLS, BEA

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% Yr % Yr % Yr % Yr
12 12 8 8

10 10
6 6
8 8
4 4
6 6

4 4 2 2

2 2
0 0
0 0
-2 -2
-2 -2

-4 -4 -4 -4
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Productiv ity grow th: Communications Linear (Productiv ity grow th: Communications) Productiv ity grow th: Transportation Linear (Productiv ity grow th: Transportation)

Source: HSBC, BLS, BEA Source: HSBC, BLS, BEA

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% Yr % Yr % Yr % Yr
2.0 2.0 10 10

1.5 1.5 8 8

1.0 1.0
6 6
4 4
0.5 0.5
2 2
0.0 0.0
0 0
-0.5 -0.5
-2 -2
-1.0 -1.0
-4 -4
-1.5 -1.5 -6 -6

-2.0 -2.0 -8 -8
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Productiv ity grow th: Other serv ices Linear (Productiv ity grow th: Other serv ices) Productiv ity grow th: Utilities Linear (Productiv ity grow th: Utilities)

Source: HSBC, BLS, BEA Source: HSBC, BLS, BEA

In contrast, the laggard in productivity is the finance industry. When giving examples of the
potential for IT to improve service productivity, the financial industry tends to be used as one
example. It is surprising, therefore, that the reported data for financial sector productivity has
been poor (charts 11 and 12 show two versions of finance productivity that we have
constructed). Of course, measurement issues could be to blame, but even relative to its
history the performance has been under-whelming. The 5-year average is lower today than
it was in the early 1990s. Yet this is one industry that has been contributing mightily to the
upswing in profits recently.

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% Yr Financial sector productiv ity : % Yr % Yr % Yr
10 10 8 8

8 8
5-y ear mov ing av erage
6 6
4 4
2 2
7 7
6 6
5 5
4 4
3 3

0 0 2 2
1 1
-2 -2
0 0
-4 -4 -1 -1
-6 -6 -2 -2
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02
Productiv ity grow th: Finance Linear (Productiv ity grow th: Finance)

Source: HSBC, BLS, BEA Source: HSBC, BLS, BEA

The fascinating thing is that the rest of the service sector has been and is doing extremely
well. Chart 13 shows the relationship between non-financial service productivity and
manufacturing. (Although not available, we “backed-out” non-financial service productivity
from the quarterly productivity report, using data for manufacturing and the non-financial
corporate sector – the difference being non-financial corporate services.)

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% Yr Nonfinancial corporate sector productiv ity : % Yr
8 8

6 6

4 4

2 2

0 0

-2 -2

-4 -4
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Manufacturing Non-manufacturing

Source: HSBC, BLS, BEA

The performance of this sector in recent years has been astounding, and is clearly different
from the 1990s new economy experience. Having averaged 2% productivity growth in the
1990s, it quickened the pace to over 6% in 2002, and is managing to maintain a 5½% rate in
the year to 2003Q2 – faster than the manufacturing sector, which has recently slowed to
below 4%. And when viewed from a 5-year moving average perspective, as chart 14 does,

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the performance is impressive, with manufacturing and non-financial service productivity

growth rates nearly converging at about 4%.

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% Qtr Ann: 5-y ear av g Nonfinancial corporate sector productiv ity : % Qtr Ann: 5-y ear av g
6 6

5 5

4 4

3 3

2 2

1 1

0 0
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
Manufacturing Non-manufacturing

Source: HSBC, BLS, BEA

So why has it happened? Why does there appear to be a second-leg of the new economy
underway that first kicked off in the mid-1990s? Service productivity may have improved in
recent years thanks to the sector finally climbing the technology learning curve, after having
had time in recent years to think about how to utilize the excess capital stock it was left with
after the over-investment boom in the 1990s. Moreover, relatively strong consumer
spending allowed service sector sales to remain relatively upbeat, providing the opportunity
to raise sales with less labor input.

So what are the consequences? In theory, a genuine productivity revolution in services

should bring with it a rise in service output and service profits. And indeed the whole
economy’s profit share has recently risen. However, if the technology is widely diffused
throughout the economy, and can be easily replicated, then it might not be so profitable after
all. The productivity benefits could accrue to buyers instead in the form of lower service
sector inflation, rather than fatter margins. Or, a little of both could occur (higher profits and
lower inflation). We look at this next.

Service with a smile, but is it profitable?

The rise in service productivity does appear to have translated into a rise in service profits.
Chart 15 shows that manufacturing, non-financial services and financial services have all
enjoyed some profit upswing from their recent lows as a proportion of GDP. Although from
the start of 2002 the increase in the profit share came from manufacturing and finance, not
non-financial services, that changed in 2003Q2, when non-financial service profits enjoyed a
large increase.

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%GDP
4.5
Profits
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
95 96 97 98 99 00 01 02 03

Finance Non-financial Serv ices Manufacturing

Source: HSBC, BEA, Profits with IVA and CCA; CCA is estimated by HSBC, Latest observation is Q2 2003

To get a better gauge of each sector’s margins, we need to look at sector profits as a
proportion of its own sector output (not total GDP). Chart 16 shows service profits as a
proportion of service output, compared with manufacturing profits as a proportion of
manufacturing output. Both measures have risen since the cyclical lows, but the
manufacturing share has risen quicker, even though service productivity has contributed
most to the overall productivity upswing recently. Still, service profits never plunged the way
manufacturing profits did in 2001.

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16 16

14 14

12 12

10 10

8 8

6 6

4 4
95 96 97 98 99 00 01 02 03

Manufacturing Profits % Mfg Output Serv ice Profits % Serv ice Output

Source: HSBC, BEA, Profits are with IVA and CCA, with CCA estimated by HSBC, Latest observation is Q2 2003

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Chart 17 shows a similar chart, except here we focus on non-financial services. Again, the
profit share has improved relative to its cyclical low, but has lagged the margin performance
compared to manufacturing (although it made good ground in 2003Q2).

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16 16

14 14

12 12

10 10

8 8

6 6

4 4
95 96 97 98 99 00 01 02 03

Manufacturing Profits % Mfg Output Non-Fin Serv ice Profits % Non-Fin Serv ice Output

Source: HSBC, BEA, Profits are with IVA and CCA, with CCA estimated by HSBC, Latest observation is Q2 2003

Indeed, one phenomenon in recent years is that financial profits have generally kept pace
with non-financial service profits (chart 18), even though financial sector productivity has
been poor (at least as reported). It suggests that financial profits are being driven by factors
other than productivity. The obvious drivers are strong mortgage lending and rising earnings
from a steep Treasury yield curve.

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Profit Index (1995Q1=100)

200 200
Finance
180 180

160 160

140 140

120 120

100 100
Non-Financial Services
80 80
95 96 97 98 99 00 01 02 03 04

Source: HSBC, BEA, Profits are with IVA and CCA, with CCA estimated by HSBC, Latest observation is Q2 2003

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That there is a profit upswing underway in the service sector is not in doubt. What is yet
unclear is how much of this rise in service productivity can be kept in the form of sustained
service profit growth. Recent indications are promising, although manufacturing profits
coming off extreme lows and financial profits that are not so productivity-related have
bolstered the rise in economy-wide profits and explained the rise in the overall economy’s
profits share of GDP since the start of 2002 to 2003Q1. In 2003 Q2, however, non-financial
service profits did leap.

Service inflation implications

An implication of strong productivity growth is lower inflation. If the service sector is enjoying
a genuine productivity revolution, then service sector inflation could decline. Indeed, it
already has, and it might continue to do so by more than generally expected.

Chart 19 shows two components of the CPI that we have created, the competitive goods
CPI and the competitive services CPI. As is well known, declining goods prices have pushed
core inflation down. Meanwhile, service inflation has slowed too, but it has generally
oscillated between 2-3% since the beginning of the 1990s. In the past couple of years, our
competitive services CPI measure has slowed from 3% in mid-2001 to 1.8% over the year to
August 2003. This occurred in the period where service productivity accelerated, suggesting
a causal link between productivity and prices.

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% Yr % Yr
4 4

3 3

2 2

1 1

0 0

-1 -1
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04

Recessions CPI Competitiv e Goods CPI Competitiv e Serv ices

Source: HSBC, BLS

A further drop in service inflation could be the next driver of a further decline in core inflation
through 2004. This would fit in with our other research, suggesting that inflation risks remain
to the downside (see “Life in the low lane”, World Economic Watch, 15 August 2003). And
the point here is that it could be the service sector that pulls overall inflation down in the next
few quarters.

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The substitution effect: why payrolls could remain weak

Strong productivity is typically good for jobs (after a short lag). For a given level of
employment, a step-up in productivity raises output and hence raises the marginal
productivity of labor. As a result, marginal costs are reduced. Profit-maximizing firms will
then have an incentive to raise output even further, this time by raising employment, for a
given price level. This way, everyone’s happy!

This effect has been seen in plenty of previous cycles where an initial spurt in growth is
followed by jobs soon after. But the lag between output and jobs this time seems unusually
long, suggesting something else might be at work. That “something else” may be the
substitution effect.

In other words, labor might be being replaced by capital. The reason could be that the
relative price of capital equipment has fallen relative to the price of labor (chart 20), and IT
equipment especially is far more amiable to replacing labor than say, industrial or transport
equipment. Admittedly, this process has been underway for a while, but if firms have a better
idea on how to adopt these technologies usefully, then the substitution effect could suddenly
accelerate.

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Index Index
140 140
130 130
120 120
110 110
100 100

90 90
80 80
70 70
60 60
50 50
95 96 97 98 99 00 01 02 03
Labor costs Capital prices Info-tech capital prices

Source: BEA, BLS, Capital prices relate to equipment/software prices

This substitution effect has already been quite a force for manufacturing. Looking back at
the manufacturing productivity “miracle” of the 1990s, the key outcomes were strong output,
strong profits (for a while), weak prices and weak employment (chart 21).

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Index Manufacturing sector: Index

240 240
220 220
200 200
180 180
160 160

140 140
120 120
100 100
80 80
60 60
92 93 94 95 96 97 98 99 00 01 02 03
Profits Prices Jobs Output

Source: BLS, BEA

If service output is now going to be driven by something similar, it makes sense that weak
service employment could persist for a while. Table 22 highlights service industries that are
in the midst of installing capital to replace labor. Some of these developments have been
going on for sometime, but may be in the process of acceleration.

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Occupation Technology
Air reservations agents Online reservations, automated self-ticketing, and ticketless travel
Bookeepers and accounting clerks Computers and automated booking systems
Forklift operators Automated material handling
Gasoline station attendants Self-service stations
General office clerks Electronic business equipment
Land surveyors GPS technology and electronic distance measuring equipment
Postal service clerks Electronic scanning and sorting equipment
Printing press operators Advanced printing technology
Refuse collectors Automated garbage and recycling trucks
Shipping and receiving clerks Computers systems and mechanical equipment
Stock clerks Price scanners and shelf label pricing
Telephone operators Computerized call handling and voice synthesis systems
Tellers Internet banking and automated bank machines
Source: HSBC, California Occupational Guides

There is, importantly, a world of difference between a substitution effect in manufacturing

and in services, and that difference is sheer magnitude. Service jobs account for 80% of
total employment, compared to 15% for manufacturing, and hence the potential negative
consequences of a service sector substitution effect for total payrolls in the short-run are
large. This suggests that should productivity remain strong in the next few quarters, service

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jobs could also remain unusually soft, if firms are indeed substituting capital for labor. We
know that the service sector has shown little appetite for increasing its labor inputs recently,
but what about its capital inputs?

A full examination and discussion of multi-factor productivity will be presented separately in

an upcoming article. However, we can make the observation that the capital deepening
effect on labor productivity has been large in recent years, as Robert Gordon from
Northwestern University and Oliner-Sichel from the Federal Reserve have shown in their
research.

Although BLS data only go to 2001, we have constructed proxies for the capital-labor ratio
for 2002 and 2003H1, and it suggests that the growth rate in the capital-labor ratio continued
to be strong in last year and in the first half of this year (charts 23 and 24). This tentatively
suggests that the substitution effect is still present.

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Index Priv ate nonfarm business sector: Index % Yr Priv ate nonfarm business sector: % Yr
140 140 7 7

6 6
130 130
5 5
120 120
4 4

110 110 3 3

2 2
100 100
1 1
90 90
0 0

80 80 -1 -1
90 91 92 93 94 95 96 97 98 99 00 01 02 03 90 91 92 93 94 95 96 97 98 99 00 01 02 03
Capital to labor Capital to labor

Source: BLS, 2002 and 2003H1 are HSBC estimates Source: BLS, 2002 and 2003H1 are HSBC estimates

Conclusions and implications

The recent strength in productivity growth has come from the service sector. This is different
to the 1990s, which was a manufacturing phenomenon. The strength in service productivity
may reflect the fact that enough time has passed for service firms to climb the technology
curve, transform their operations and utilize the over-hang of capital from the 1990s boom in
a more efficient way.

The breadth of service sectors participating in the productivity upswing is widespread. (The
notable laggard is the finance industry.) There are four probable consequences of a
genuine service-productivity upswing. In the short-run, two effects are clearly positive but the
other two pose policy challenges.

First, service sector output could get a boost relative to historical trends. Second, service
sector profits could also get a boost, at least for a while before competition possibly eats
away these gains. Third, service inflation could drop at a time when the core inflation rate is

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already threatening to be too low. Fourth, employment growth in the service sector could
remain persistently weak, as output gains are delivered by productivity increases instead.

Jobs could continue to be weak if technology continues to provide firms with opportunities to
substitute capital for labor. Capital deepening continues to occur, with the capital-labor ratio
continuing to rise strongly in 2002 and 2003. Of course, the key risk is that employment
weakness ends up derailing the expansion. This is one reason why we expect only 2½ GDP
growth in 2004 compared to consensus of 4%. As a result, the Fed is still more likely to cut
rates than raise them. Indeed, given these risks, the first hike is unlikely to come until mid-
2005.

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Gwyn Hacche UK 44 20 7991 6707
Big fiscal tightening planned Gwyn.hacche@hsbcib.com
*HSBC legal entities listed on page 28
The French finance minister, Francis Mer, put his budget plans to cabinet on 25th
September, showing the budget deficit falling to 3.6% of GDP in 2004 from 4.0% in 2003.
The French government is, therefore, admitting that the deficit is likely to be above 3% of
GDP for 3 successive years, seemingly flouting the eurozone’s Stability Pact. However, in
order to achieve its 3.6% target it has indicated that it is planning an underlying fiscal
tightening of 0.7% of GDP in 2004, a little greater than the 0.5% suggested as being the
minimum necessary by, for example, the ECB. It also shows the budget deficit falling below
3% of GDP in 2005, a year earlier than suggested by Mer in earlier comments, and falling to
1.5% of GDP in 2007. But has France done enough to avoid being fined under the growth
and Stability Pact? Or are its actions so blatant as to blow the pact out of the water?

Deficit problem reflect structural and cyclical factors

The French budget deficit has deteriorated markedly in recent years, widening to a likely
4.0% of GDP in 2003 from a low of 1.3% of GDP in 2000. About half of the deterioration has
reflected an underlying loosening of fiscal policy with the remainder reflecting below trend
growth in 2002 and 2003.

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% %
0 0

-1 -1

-2 -2

-3 -3

-4 -4

-5 -5

-6 -6

-7 -7
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

Budget deficit Structural deficit

Source: HSBC, Thompson Financial Datastream

The structural budget deficit, as measured by the cyclically adjusted balance, rose from
1.5% of GDP in 1999 to 3.1% in 2002. Three quarters of the underlying loosening occurred
in 2002, the year of the parliamentary elections. The loosening reflected both a rise in
cyclically adjusted current spending and a fall in cyclically adjusted current revenues.

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% GDP % GDP
48.0 52.5

47.5 52.0

51.5
47.0
51.0
46.5
50.5
46.0
50.0
45.5 49.5

45.0 49.0
90 91 92 93 94 95 96 97 98 99 0 1 2 3
Cyclically adj. govt. current receipts (L.H.Scale) Cyclically adj. current spending (R.H.Scale)

Source: HSBC, Thompson Financial Datastream

Meanwhile, GDP growth slowed to 1.2% in 2002 and we are forecasting growth in 2003 of
just 0.3% compared with trend growth of around 2.2%. (This week’s revisions to the
national accounts data showed growth in France being a little weaker than that in Germany
in Q2 2003 both in q-o-q and y-o-y terms.) As a result, the output gap has widened by
almost 3% points since 2000 which would have been expected to push up the budget deficit
by around 1½% of GDP. It should be noted that if there hadn’t been the underlying fiscal
ease in 2002 the economy would have been teetering on the edge of recession.

4*'3JURZWKDOLWWOHZHDNHULQ)UDQFHWKDQ*HUPDQ\

% Yr % Yr
5 5

4 4

3 3

2 2

1 1

0 0

-1 -1

-2 -2

-3 -3
92 93 94 95 96 97 98 99 00 01 02 03
France GDP growth (L.H.Scale) German GDP growth (R.H.Scale)

Source: HSBC, Thompson Financial Datastream

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2004 budget arithmetic looks too optimistic

The projected fall in the budget deficit to 3.6% of GDP in 2004 looks over-optimistic in two
respects: the underlying growth forecast and the reliance on public spending controls to
achieve the underlying tightening.

The deficit forecast is based on a growth assumption of 1.7% after 0.5% in 2003. We regard
this forecast as being over-optimistic, particularly if the government were to achieve the
underlying fiscal tightening scheduled for 2004. We are forecasting growth of 0.3% of GDP
in 2003 and 1.3% in 2004, assuming an underlying tightening of 0.4% of GDP in 2004;
taking their tightening of 0.7% we reckon growth would be just 1%.

Although income taxes and company pay-roll taxes are being cut (by around 0.2% of GDP)
they are largely offset by hikes in taxes on tobacco and diesel as well as increases in
hospital fees. The other key element of deficit reduction is the freezing of central
government spending in real terms although this will be easier said than done against a
weak economic background.

Given likely disappointment on economic growth in 2004 and with difficulty curbing public
spending, the government will do well to keep the deficit below 4% of GDP in 2004, let alone
reduce it to 3.6%.

The ratio of public debt to GDP is forecast to move above 60% of GDP in 2003 with a further
rise in 2004. Although the 60% level does not play a role in the Stability and Growth Pact it
carries a warning as regards future debt interest payments and public finance sustainability.

Medium term pain

The government’s medium term strategy is based on steady underlying fiscal tightening,
based on spending control, and an assumption of growth a little above trend. It is planning
to reduce the structural budget deficit by a further 0.6% of GDP in 2005, 0.5% in 2006 and
0.6% in 2007 and is assuming GDP growth of 2.5% a year from 2005 on.

*RYHUQPHQW·VPHGLXPWHUPILVFDOSODQV
2003 2004 2005 2006 2007
Budget deficit as % GDP 4.0% 3.6% 2.9% 2.2% 1.5%

Reduction in structural 0.0% -0.7% -0.6% -0.5% -0.6%

deficit as % GDP
GDP growth (%) 0.5% 1.7% 2.5% 2.5% 2.5%

Source: HSBC, French Ministry of Finance.

The government is committed to keeping spending unchanged in real terms until the end of
its mandate in 2007, thereby falling as a per cent of GDP. It is arguing that an overhaul of

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the health care system planned for next year means growth in health spending will be limited
to the real growth rate in the economy of 2.5%. However, there must be big question-marks
over the public spending assumptions given the impact of the ageing population on health
spending, and commitments to raise defence spending. (The government has said that if
stronger than expected growth boosts tax revenues above budget projections the fiscal
windfall will be allocated to faster deficit cuts.)

The growth assumptions for 2005–2007 are also probably too optimistic. French trend GDP
growth is probably set to decline to 2% a year as a result of slower labour force growth while
the government is tightening policy by around ½% a year. So the government seems to be
assuming underlying growth of around 3%, well above trend. Such growth is not out of the
question given the large excess capacity but cannot be taken for granted, particularly given
that in EMU the government will not be rewarded by rate cuts from the central bank.

Solbes stands firm

The views of the European Commission on the French proposals were put forward by Pedro
Solbes, EU Monetary Affairs Commissioner, in a presentation to a Committee of the EU
Parliament on 30th September and subsequent interviews with reporters:

• Solbes noted that Germany and Portugal have taken steps to correct their deficits but “it
seems at this stage that France will not comply with the deadline of October 3 set by the
Ecofin for corrective measures.”

• He added “France has presented a draft budget for 2004 with a deficit above 3%. The
(EU) Treaty requirement is very clear. We have to move to the next step of the EDP
(Excessive Deficit Procedure) as soon as it is evident that countries do not comply with
the Council (of Ministers) recommendation.”

• Solbes also stated that “Measures have not been taken or they are insufficient to
correct the excessive deficit within the agreed deadline. The Council on the basis of a
recommendation from the Commission should decide that no effective action has been
taken and issue a notice under Article 1049 of the Treaty. The next phase of the Treaty
will involve a specific recommendation from the Commission and Ecofin as to how
France should correct its deficit”.

• “We have always applied the “Stability Pact) rules very strictly and that will apply to
France” he said. “if there are to be fines against France, we will apply them.” He noted
that after the October 3 deadline, the Commission will draw up further specific
recommendations on France’s budget.

• He noted that depending on the decision of EU finance ministers, this could eventually
lead to financial sanctions. However, he did say that the Commission is also examining
whether a Stability Pact escape clause in the case of “special circumstances” could
allow France to avoid sanctions. He also noted that the budget’s point of departure and
its growth assumptions are quite realistic”.

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Why pick on France?

Why is France coming under so much criticism when Germany isn’t? After all Germany has
admitted that the budget deficit in 2003 will be 3.8% of GDP and our suspicion is that it will
exceed 4% of GDP. Furthermore, the German deficit overshoot for 2002 was 0.4% whereas
that of France was a trivial 0.1% of GDP. Germany’s promised income tax cuts are 10 times
the size those in France.

The key reason why Germany has avoided the wrath of the Commission is that it is
maintaining its stance that the budget deficit in 2004 will be below 3% of GDP, although it
has admitted that this will be difficult and that it assumes GDP growth of 2.0%. It will
probably not set out a well articulated view of public finances until well into November and
the final version may still be unclear until late December with the major parties taking a long
time to agree on how the 1% of GDP tax cuts should be financed.

France seems, therefore, to be coming under attack for putting forward an articulated and
not too far fetched budget for 2004, based on below trend growth, which generates a deficit
of 3.6% of GDP. Meanwhile, Germany is getting away with making vague commitments for
2004 to get the deficit below 3% based on an unrealistic above trend growth. We expect
German growth of just 0.9% in 2004 with the deficit likely to be above 4% of GDP. One
could argue that France is being up-front about the 2004 budget whereas Germany is still
delaying the inevitable.

The Commission may also have been placing weight on the fact that the German
government has taken some corrective measures this year in the form of tax increases.
However it should be noted that the government is planning to cut taxes sharply in 2004
with, as yet, no agreement on how the cuts will be financed. The Commission may also be
impressed with the reforms coming through in Germany with measures to deal with the
health deficit and to reduce unemployment benefits while France has not as yet put in place
measures to make their medium spending plans credible.

France will co-operate but.......

In reaction to Solbes’ comments, the French budget minister, Alain Lambert, said that:

“We’re all going to work with him (Solbes) to see what measures he would like to see
introduced and provided those measures are compatible with the government's policy there
is no reason why it should not be solved”

However, he went on to say that the government

“wanted to ensure that these measures do not result in recession in France which would
drag Europe into recession.......France is doing “the maximum” but that in the current climate
it seemed very difficult to bring the deficit below the 3% limit”

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The problem for France is that to get the deficit below 3% of GDP in 2004 the government
would have to tighten fiscal policy by another 1½% of GDP which would could well mean
recession in 2004. (the ex ante tightening is roughly double the required deficit reduction
given that the tightening would hit growth and raise the budget deficit)

Meanwhile, on reform the finance minister said that the government will need “several
months to negotiate reforms :

“Have faith in us. We have reformed pensions, we are going to act on health”.

He also said that:

“The Commission has neither the competence nor desire to make detailed
recommendations. It can ask us to do better to respect the Stability Pact but not to do away
with whatever expense or raise taxes”.

Stability Pact to hobble along

The smaller eurozone countries are putting pressure on the European Commission not to
ignore the breach. The Belgium Prime Minister has said that France should follow a strict
timetable to cut its deficit. The Netherlands has threatened to sue the Commission unless it
enforces the budget pact and is itself putting in place a major fiscal tightening despite
recession to keep its deficit below 3% of GDP. The Portuguese government’s fiscal
tightening in 2002 to get the deficit back below 3% of GDP pushed the Portuguese economy
into recession.

However, as the autumn progresses it will become clear that Germany’s deficit will also be
close to 4% of GDP in 2004 and Germany, France and Italy would almost certainly block
any punitive action against France recommended by the Commission. It also looks as if
Spain may side with the Big3 despite its exemplary fiscal performance. The large countries
may use the special circumstances exception based on the length of below trend growth the
eurozone is experiencing even if the Commission does not accept this argument.
Alternatively, France may beef up its reform agenda which could get it off the hook. But it is
difficult, given the economic outlook, to see Germany, France and Italy putting in place
major fiscal tightening in 2004 to ensure sub-3% of GDP deficits in 2004 – which is just as
well as such action would probably push the eurozone back into recession.

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4 There is little to suggest that trend growth or the relationship between growth and
inflation has changed

4 The consumer boom was less pronounced but vulnerability persists (FRQRPLVW
John Butler UK 44 20 7991 6718
4 Widening current account deficit puts downward pressure on sterling John.butler@hsbcib.com
*HSBC legal entities listed on page 28
Now the dust has settled on the revisions to UK economic history that were introduced in the
"Blue Book", it is worth asking the question, does the new set of data undermine our
economic outlook? In particular, have estimates of the output gap changed? has the
relationship between GDP and inflation improved? Are the MPC more likely to raise interest
rates in the next few months? Have the risks surrounding the consumer diminished? is the
corporate sector in better shape? And, is sterling vulnerable to a sharp correction? The
follow series of bullets tries to summarise the data revisions and whether these changes
cast any light on these key issues.

1. GDP, trend growth and the output gap: any change?

4 While chain-linking may have raised the level of GDP, average GDP growth, whether
measured over the past 3 or just the current cycle, is still the same at 2.5%. Hence,
there is little reason to revise up estimates of trend growth and little justification in
arguing that the trade-off between growth and inflation has improved.

/HYHORIRXWSXWKLJKHUSRVWUHYLVLRQV

Level Level of GDP Level

106 106

104 104

102 102

100 100

98 98
00 01 02 03
Previous estimates (re-based to 2000=100) Current estimates

Source: National Statistics and HSBC

4 Given the doubling of the pace of growth in the first half of the year, GDP growth in 2003
is likely to be 2%, compared to our previous estimate of 1.8%. That compares to the
HMT Financial Year estimate - which underpins the borrowing projections - of 2.25%.
Hence, there is no reason for or pressure on the Chancellor to revise his growth

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estimates or borrowing forecasts at the Pre-Budget Report in November. Nevertheless,

we still believe that the Chancellor’s 3.25% and 3% projection for GDP growth in 2004
and 2005 respectively will prove too optimistic.

4 Chart 1 plots the difference in the current level of GDP compared to the pre-revised data -
we have re-based the previous GDP estimates so that the new and old data are
comparable (2000=100). The level of GDP is now 0.3% lower than previously assumed
in the middle of 2002. However the stronger H1 2003 has meant that by 03Q2 the level
of GDP is 0.1% higher than before - a small change (chart 1). Hence, that suggests
that the output gap is broadly unchanged.

2. Do the revisions alter the probability of a rate rise in the

forthcoming months?
4 Assessing the probability must depend on what your or, more importantly, the MPC’s
starting point is. If the MPC are comparing the current situation with the July MPC
minutes, then most of the reasons they used to justify the rate cut have clearly unwound.
At that time the cut was justified by the following 4 factors:

1 In July, GDP growth in 2003Q1 had been revised down to just 0.1%. Moreover, at
0.3% in Q2, growth was weaker than they had expected - since then revisions have
meant that GDP growth in the first half of the year is now double the original estimates
(chart 2).

*'3ORZHULQEXWIDVWHUSLFNXSLQ+

%QoQ GDP growth %QoQ

1.0 1.0
0.9 0.9
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
0.1 0.1
0.0 0.0
Q1 02 Q2 02 Q3 02 Q4 02 Q1 03 Q2 03
Previous estimates New estimates

Source: National Staitstics and HSBC

2 In July, UK-weighted world activity was weaker than they had expected - most news
since suggests that global demand has picked up.

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3 Trade weighted sterling has risen - it is at a broadly similar value now as in July.

4 The MPC did not expect that a rate cut would cause house prices or consumer
spending to accelerate - since then debt and activity in the housing market has
subsequently picked up.

4 Alternatively, if we compare the current situation with the hawkish minutes in

September, the differences are less severe. At that time a possible rate rise was
reasoned by:

1 Whether the world recovery would prove strong and durable - since then the weakness in
US consumer confidence and labour market has continued to raise doubts about the
sustainability of the global recovery. At a very minimum this supports a ’wait-and-see’
policy.

2 The MPC were surprised by the resilience of consumer spending and continued rise in
household debt. As the MPC stated in September, "recent news raised the possibility
that consumer growth had not in fact started to slow...and, if so, the stimulus previously
provided to domestic demand by the current level of interest rates might prove to be more
than was needed" (page 9, September minutes). Since then consumer and domestic
demand growth during the first half of this year has been revised down considerably
(chart 3). Indeed, growth in consumer spending over the past year is now estimated to
be 0.9% lower and domestic demand growth 1.4% lower than previously thought.

:HDNHUFRQVXPHUVSHQGLQJ

%QoQ Consumer spending %QoQ

1.4 1.4
1.2 1.2
1.0 1.0
0.8 0.8
0.6 0.6
0.4 0.4
0.2 0.2
0.0 0.0
-0.2 -0.2
-0.4 -0.4
Q1 02 Q2 02 Q3 02 Q4 02 Q1 03 Q2 03
New estimates Previous estimates

Source: National Statistics and HSBC

4 Where does that leave us? July’s rate cut was a mistake (as, probably, was
February’s). However the key depends on whether MPC members are comparing now
with July or September. As the September minutes stated, only "some members

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perceived July’s rate cut as being precautionary...now the risks had been eased, the need
for that additional stimulus was to those members no longer so clear".

4 That is a clear signal that a minority of members are making the direct comparison
between now and July and they may vote for a hike in the forthcoming meetings.
However for the majority on the Committee, October’s decision will depend on what has
changed relative to their September decision - taking each meeting one-at-a-time. Since
then the slowdown in consumer spending and doubts over the sustainability of global
recovery means there is little here to hang a rate hike on.

4 In "Turn in the UK rate cycle?" (World Economic Watch, 25 Sept) we described our short
term rate outlook in detail. The bottom line is that the chance of a rate hike has increased
primarily because Q2 GDP growth is stronger. However, weaker domestic demand and
unchanged output gap mean that on balance a hike is still unlikely.

3. Are we still concerned about the consumer?

4 The level of consumer spending as well as real personal disposable income has been
revised down, primarily in 2001 - which was contrary to my expectation. In contrast, retail
sales were revised up to show year-on-year growth of around 10% during the first half of
last year.

4 Over the past 6 months consumer spending is now estimated to have fallen in Q1 and
grown by 0.7% in Q2 compared to the previous estimate of 1.3%. Year-on-year growth is
now just 2.4%, compared to the previous estimate of 3.3%. That seems to provide
evidence that the boom in consumer spending may well have already ended.

+RXVHKROGVUHPDLQLQGHILFLW )LQDQFHDYDLODEOHIRUVSHQGLQJKDVVORZHGVKDUSO\
% disposable income % disposable income % Yr % Yr
10 10 Real finance available for consumer spending
12 7
8 8 10 6

6 6 8
5
6
4 4 4
4
2 2 3
2
0 0 2
0
-2 -2 1
-2

-4 -4 -4 0
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 94 95 96 97 98 99 00 01 02 03
Household deficit: net acquisition of financial assets (4qma) Deflated by Tax Price Index (LHS) Deflated by RPIX (LHS) Retail sales (RHS)

Source: Financial Statistics and HSBC Source: National Statistics, Financial Statistics, Bank of England and HSBC

4 In terms of the household balance sheet, debt-servicing costs remain low and financial
assets of households remain high. The latter is cold comfort as it probably reflects the
fact mortgage equity withdrawal gets transferred directly into bank accounts - just like the
boost in financial assets that was evident in the late 1980s. That implies that there is a

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risk that spending may be stronger short term as households have cash in their accounts,
ready to spend.

4 Nevertheless, the key is that the vulnerability of the consumer remains as high as ever.
First, the savings ratio has fallen sharply over the past 2 years and at 4.8% is near a
cyclical low. Second, households remain in financial deficit, a deficit that has been
almost as large and certainly more persistent than in the late 1980s (chart 4). Third, the
downward revisions to income mean that debt-to-income ratios are now even higher
than had been presumed, at 120%. And fourth, despite the rise in debt, the finance
available for consumer spending - a measure that adds disposable income with MEW
and consumer credit - has fallen sharply (chart 5).

4 Overall, the boom in consumer spending has been less stark, as was the rise in real
income. The revisions raise the risk that the consumer continues to support growth short
term as they spend the debt they have accumulated. However, the vulnerability of the
consumer to any adverse shock - say global stagnation or persistent weakness in income
growth or a rise in unemployment - remains as high as ever.

4. Is the corporate sector in better shape?

4 In real terms the correction in business investment has been less severe. The ratio of
investment to GDP is now back to the levels recorded in 2000 whereas the previous
estimates had suggested the ratio had returned to its 1997 level (chart 6). The correction
in nominal investment spending over the past few years has been as severe as
previously estimated. Hence the upward revision to real investment reflects a sharper fall
in the price of capital goods than previously expected (chart 7).

$FRUUHFWLRQLQEXVLQHVVLQYHVWPHQW 6KDUSIDOOVLQSULFHRIFDSLWDOJRRGV
% GDP Business investment % GDP % Yr Price of capital goods % Yr
15 15 6 6

14 14
4 4
13 13
2 2
12 12

11 11 0 0

10 10
-2 -2
9 9
-4 -4
8 8

7 7 -6 -6
70 73 76 79 82 85 88 91 94 97 00 03 95 97 99 01 03
Real Nominal Current estimates Previous estimates

Source: National Statistics and HSBC Source: National Statistics and HSBC

4 The corporate sector is still in financial surplus and so are cash rich but that does not
necessarily signal that companies are about to invest. Business investment rose 2% in
Q2 compared to the previous estimate of a drop of 1.1%. Nevertheless investment
intentions, according to the business surveys, remain weak.

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4 Debt to GDP or to profits remains at historically high levels (chart 8). Yet productivity
growth remains low (average of 1.5% over the past few years) and the profit share of
GDP has been revised down to show an even sharper fall over the past few years (chart
9).

'HEWOHYHOVVWLOOKLVWRULFDOO\KLJK EXWSURILWVUHPDLQORZ
% GDP % market valuation of assets % nominal GDP % real GDP
45 45 22 13
Net debt (non-financial private corporations)
40 40
21 12
35 35
30 30 20 11
25 25
19 10
20 20
15 15 18 9
10 10
17 8
5 5
0 0 16 7
87 89 91 93 95 97 99 01 03 84 87 90 93 96 99 02
Share of market value of assets Share of GDP Corporate profits (LHS) Business investment (RHS)

Source: National Statistics, Financial Statistics and HSBC Source: National Statistics and HSBC

4 Overall, the sharp drop in real investment was less severe than previously thought and
the corporate balance sheet has continued to adjust. However, our view remains that
companies are unlikely to launch a new investment surge when they still have all the
costs - high debt - and few of the rewards - low profitability and productivity - of the
previous investment boom. See "UK investment: back to business?" (World Economic
Watch, 21 September) for more details on this issue.

5. Is sterling vulnerable to a sharp correction?

4 The manufacturing recession was less severe than expected as was the contraction in
exports. Indeed, manufacturing has been recovering since the start of the year,
according to the new data. However, over the past 6 months, while there are signs that
the internal imbalances within the economy may be narrowing, the external imbalances
have come to the fore.

4 The current account deficit was GBP8.6bn in Q2, 3.2% of GDP - not yet as bad as the
6% achieved in the late 1980s. The surplus in investment income dropped back (due to
lower oil prices) and that has pushed the attention back on to the large balance of trade
deficit. The deficit in goods and services is currently 4% of GDP, as bad as anything
achieved during the late 1980s (chart 10).

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6KDUSGHWHULRUDWLRQLQWKHFXUUHQWDFFRXQW

% of GDP % of GDP
4 4

2 2

0 0

-2 -2

-4 -4

-6 -6
86 88 90 92 94 96 98 00 02
Current account Trade Deficit

Source: HSBC

4 A vulnerable consumer, stagnant corporate sector and a widening current account deficit
points to downward pressure on sterling. We still expect EUR/GBP to climb to 0.80 by
the end of 2004.

Summary
4 The revisions to the UK’s economic history have altered the emphasis we would place on
some important issues - from the structural relationship between growth and inflation to
the current position of the household and corporate sectors to the subtlety of internal
versus external imbalances. However, the key is that the changes have not
fundamentally altered our view.

1 On interest rates, clearly the Q2 GDP revision and expectation of a strong Q3 means
there is a substantial risk that the MPC hike soon. However, on balance we still believe
the MPC will adopt a ’wait-and-see’ approach.

2 On trend growth, there is little to suggest a change and, indeed, recent measures such
as the rise in National Insurance taxes on employers are more likely to reduce rather than
increase trend growth.

3 Government borrowing looks broadly on track in 2003 with April’s revised budget
projections but net borrowing is still likely to over-shoot in 2004 and 2005.

4 The boom in consumer spending was less stark but the vulnerability persists.

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5 The corporate sector is adjusting, with the level of debt falling and evidence that
investment spending may have turned. However, any investment recovery is unlikely to
be strong.

6 On sterling, the widening current account and switch from internal to external imbalance
should put downward pressure on the currency.

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