1996 Issue # 9

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Copyright September 1996 PEI All Rights Reserved

Volume III Issue #9 Published by Princeton Economic Institute September 1996214 Carnegie Center, Princeton, NJ 08540

(609)-987-9522 Fax (609)987-0726 HTTP://WWW.PEI-INTL.COM

Copyright 1996 All Rights Reserved

he financial markets arebecoming extremely vola-

tile and choppy this year for the mostpart as they try desperately to guessthe next direction of the Federal Re-serve. Several Fed members in earlySeptember cautioned that inflation

could start to breakout while FedChairman Greenspan continues toargue that the CPI significantly over-states inflation. So what is going onhere? Is inflation going higher orlower?

To begin with, Greenspan iscurrently laying the foundation forthe post-election deal you will des-perately find absent from the politi-cal media as well as the politicaldebate. The CPI will be cut virtually

in half following the elections in anattempt to deal with entitlementswithout having to confront voters. Inother words, entitlement programsare automatically increased fromone year to the next according to therate of inflation as expressed by theCPI (Consumer Price Index).If thebudget, less interest expenditures,is in excess of $1 trillion annually,

chopping the CPI in half willsave at least $12.5 billion annually.On a compounded basis, this singleact would save almost $70 billionover the next 5 years - an amounttoo tempting forDemocrats or Re-publicans alike. Thereal beauty of thisscheme is that social

security will be cutwithout having to callit a cut since only theCPI will be reviseddirectly - not entitle-ments.

The financialmarkets remain in astate of constantconfusion largely be-cause what we all

can see, touch andfeel on the street isfar from theGreenspans virtual-reality of low infla-tion. Just in the past8 years (postReagan era)wherethe Fed and the me-dia have proclaimedvictory in the war

against inflation, the national debthas risen from $2 to $5.2 trillion.State and local budgets (as well astaxation)are up in many cases bymore than 300% in the past 8 years.

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Providing Economic & Market Analysis Worldwide

ur World WideW e bsite is up and

running providing ac-cess to back issuesand research paperson selected issues andmuch more including

our daily forecasting ofthe world capital mar-kets.

Perhaps the most ex-citing coming attractionto our Web site will beour Direct ComputerAccess system. Hereyou can gain accessdirectly into our com-

puter database whereyou will be able to run a study on just about any market in the world. If you ever wanted to seeif there was a correlation between stocks and interest rates, you can run that study yourself andlearn the truth about this market myth.

Another dynamic addition to our Web site will be the Natural Language Interface. Here youwill be able to present a question to our computer such as where do you see support in theDow?For the first time, you will be able to run the PEI Artificial Intelligence Computer Modelsyourself and watch how it understands spoken English.

Another exciting service is our Market Alerts. Here we do a lot of the work for you monitoringUS, European and Asian markets. If we see a big move about to happen, our special alertservice will draw your attention to an opportunity you may otherwise miss. This service isavailable on Bloomberg, but now it is coming to the Internet as well via email.

So go ahead and explore what we have constructed so far. You will always be able to checkour worldwide schedule of upcoming seminars and tap into back issues covering the world.Our address is http://WWW.PEI-INTL.COM.

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Sticking with just the federalnumbers, we have witnessed a 20%annual increase in the cost of gov-ernment since 1988. This is a far cryfrom 2.5% inflation as reported bythe CPI and Greenspans virtual-re-ality of 1.25%. Total federal spend-ing is currently rising at 4.5% annu-

ally and starting in 1997, the growthrate begins to explode. By thegovernments own projections (as-suming no increase in interestrates or decline in economicgrowth), the growth rate in govern-ment expenditures will pass 20%annually just beyond the year 2000!

This is part of the root causebehind the growing confusion in thefinancial markets. We stand silently

like a bunch of fools watching everytreasury auction increase in sizewhile the media tells us otherwise.To understand how we can be go-ing in two directions simultaneously,we need to look at the design of theCPI a bit closer. The major cause ofthis aberration is generated by thelittle known fact that the CPI is ex-actly what it states - a consumerprice indexand NOTa cost ofliving indexnor is it a purchas-ing power index. If the CPI re-

flected either of the two latter pur-poses, then it would require the in-clusion of taxation since the aver-age American now spends more ontaxes than on housing, food andclothing combined! The CPI is inten-tionally lacking any governmentcosts to the consumer insofar asproperty, income and social secu-rity taxes are concerned. Simply put,taxation isNOTpart of anyones costof living - it is your obligation.

Because of this major inten-tional design flaw of ignoring the costof government in the CPI index, itthen becomes possible for inflationto appear in the government sectorbut not in the private sector in theform of goods and services. There-fore, the economic reality can bequite different from the virtual-real-ity as reflected by the CPI.

There is one point that is abun-dantly clear - Perot is right when itcomes to the mess we have gottenourselves into. Washington looks atevery issue as if it were a single iso-lated problem. There is not only aninability to see the entire forest, butWashington has lost all sense of

what it has even passed the yearbefore.

There are two key mistakesthat have had a dramatic impactupon the decline and fall of theAmerican economy.

1) LBJs commingling of theonce separate and independent trustfunds with the general budget wasour first big mistake. LBJ simplywanted to hide the cost of the VietNam war from the American publicby offsetting those costs againstSocial Security surpluses. Thissingle budget trick served to under-mine the entire entitlement processand set in motion a national debt thatcould rise faster even when the an-nual netbudget deficit declined.For example, in 1995 the budgetsurplus for Social Security wasabout $50 billion. This is commingledin the general budget according to

LBJ practices. Thus, the reportednetdeficit declines while the ac-tual realdebt rises by $50 billionmore than the fictitious netdeficitas reported by the media.

2) Jimmy Carter took theUnited States off the annual zero-based budget system and indexedall programs to inflation. Thus, as in-flation rose dramatically during hislast year in office, the budgets ofmost programs and departments

were automatically increased by therate of inflation. This single factorcontributed greatly to the explosionin spending under Reagan. You canimagine with a CPI greater than10%, government spending ex-ploded even though there may nothave been a real demand for anincrease in spending on a parity ba-sis with the CPI. Ever since, spend-ing rises by the CPI on an automatic

pilot basis even when not needed.Departments then strive to spendevery last dime or face losing fund-ing the following year. Worse still,Congress may have passed a pro-gram 20 years ago which is con-stantly funded automatically insteadof being scrutinized year after year

on a zero-based budget system.

These two subtle yet majorchanges to the budget process,have led us down the garden pathto the point that our entire economyis at risk. Entitlements are in dangerof moving into default prompting fur-ther tax increases starting in 1997.Our national debt has risen from $1trillion in 1980 to over $5 trillion by1996 not because of Reagan taxcuts, but because of uncontrolledspending. Revenues increased un-der Reagan proving that it was theuncontrolled spending that led to ourproblems not a lack of taxation rev-enue. Consequently, like debt on acredit card, the annual growth ratefor the national debt has beenover 10% for the past 16 years!

The debate over whether ornot inflation exists is further compli-cated by those who love to use the

computer example. Here we find thatthose who constantly argue that in-flation is declining, point to the samemodel computer and how it has de-clined by 50% in less than 2 years.This, they argue, is evidence that in-flation is declining. However, thisanalogy is like following a 1990 Fordin price down to 1996. Even if thecar is never driven, the value of thatcar still declines due to outdatedtechnology. What is important tonote is the constant price of a com-

puter for the latest top-of-the-lineproduct. Here we have actually seenlittle inflation between 1983 to 1990as the top-of-the-line seemed to bepriced at about $7,000. After 1990,the price of the top-of-the-line modelhas actually risen to about $10,000.Yesterdays model quickly falls inprice due to advancements in tech-nology - not due to declining de-mand.

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The low inflation crowd alsolikes to point out that people are re-sourceful. They shop looking forsales or travel to discount sales forpurchases. Unfortunately, the levelof such discount stores as a percentof total sales is not significantenough to warrant cutting the CPI in

half. The majority do NOTtravel todiscount outlets. The majority mightshop for the best price, but they donot buy goods off the back of a truck.

This latest major proposed re-vision to the CPI is also nothing new.Over 14 major revisions have beencarried out on this index just in thepast 30 years. ALLrevisions to theCPI show one clear purpose - tobring down the appearance of infla-tion, NOTto reflect true changes inour cost of living. The 1983 revisionto the CPI illustrates how Congressdeals with each issue as if it werean isolated problem. Prior to 1983,housing (real estate) accounted for40% of the CPI. Due to the fact thatreal estate was rising sharplythroughout the late 1970s and early1980s, it was then decided that realestate wasNOTactually part of yourcost of living - it was an invest-ment. Therefore, since a home

was aninvestmentand NOTac-tually part of your living costs, this40% component was removed fromthe CPI and replaced by rents. Whatlittle real estate influence remainedwithin this new component was thendetermined by the FHA data. Thismeant that the real estate compo-nent was limited to a maximum con-sideration of $100,000. Therefore,during the late 1980s when real es-tate exploded going into 1987, theCPI rate of inflation remained com-

paratively steady leading many toproclaim that inflation had been van-quished forever. Well if you take40% of what used to be in the CPIout, it is hard NOTto create a falseimpression of victory.

The one thing that is clear isthe fact that all these continual revi-sions to the CPI are creating twoentirely different perceptions of re-

ality. It has totally politicized the CPIindex forever eliminating the useful-ness it once had to business and in-vestors alike. This is being reflectedin the wage settlements particularlyamong government employeeunions. School teacher contractsright now are demanding a 15% pay

increase over the next 3 years onaverage. That is a wage demandlevel twice that of the CPI. Clearly,the CPI is starting to have little im-pact in wage settlements. This islargely due to the fact that taxes areup significantly rising to nearly 40%of total earnings for the averageAmerican family. In the end, thesetax increases will continue to placepressure on wages in both the pub-lic and private sectors.

The consequences of under-stating inflation can be much moreserious to the economy in the finalanalysis. Instead of constant gradualincreases in prices, the danger be-comes more of a shock experiencein price movement. In other words,the inflation that would have other-wise taken place in a more gradualmanner is replaced by surges inprice movement within a com-pressed period of time. For example,

the national debt has risen by morethan 500% since 1980. The DowJones Industrials have also risen alike amount from 964 at the close of1980 to 5,800 going into 1996. How-ever, there were two bursts in up-ward price movement between 1984and 1987 (1211 to 2596) and againbetween 1994 and 1996 (3834 to5800). The majority of the remain-ing periods between 1980 and 1996were reflected by a steady gradualadvance more in a linear manner as

compared to the non-linear burstsout of 1984 and 1994.

When one analyzes the priceadvance of the Dow for the 1980 to1996 time period, we can easily seethat there is a very good correlationbetween the rise in the national debt(money supply) and the value of theDow. In effect, the rise in the nationaldebt represents a decline in the pur-

chasing power of the dollar vs as-sets. Consequently, the Dow rosein nominal terms NOT because itwas in the midst of a raging bullmarket in 1929 terms, but rather theprice advance in nominal terms re-flected assets trying to maintain par-ity with the rising debt and ultimate

depreciation in the purchasingpower of the dollar.

This is an important distinctionto understand. A bull market iswhere that particular instrumentrises in value against all others. Con-sequently, if one were to sell thatinstrument at the peak in prices, youwould be able to take that moneyand buy significantly more assetsthan you would have been able todo before the bull market. An instru-ment which rises in nominal termsin harmony with all other assets isNOTa bull market at all. Instead, thistype of price increase reflectsONLYa depreciation in the purchasingpower of the underlying unit of mon-etary value (money). Therefore, ifthe value of the Dow is 1,000 and ahome is 1,000, then if the Dow risesto 5,000 but the home is also now5,000, then this has been a depre-ciation in the value of the dollar - not

a bull market in realterms. Thisis the ultimate definition of realin-flation that prevailed throughout thecenturies prior to the floating ex-change rate under the paper moneystandard.

Since the system is neverequal and fair, what often happensis that there are leaders and lag-gards within the entire process dur-ing the early stages of a deprecia-tion in the value of a currency. Some

sectors in asset values begin to risein advance of others. Soon, this be-havior begins to spread like a virusuntil virtually all sectors are affectedfrom wages, real estate, equities andultimately raw commodities. Thedanger that we now face is in factthat we are on the verge of one ofthese bursts in price activity.

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Looking at crude oil for ex-ample, we can see how there is areal potential problem that crude oilwill simply begin to explode to theupside. If we take the 1980 price ofoil at the peak in inflation ($40)andwe use the watered-down version ofthe CPI to adjust that level into cur-

rent dollars ($82), we suddenly findthat oil prices are incredibly cheap.In fact, oil is running at about 25%of 1980 levels within the pricemechanism of the economy as awhole. This suggests prices willburst higher within a compressedperiod of time largely due to themassive depreciation in the pur-chasing power of the dollar.

Adjusted for inflation, taxes areup by more than 100% since 1980.In nominal rate terms, federal taxesare up by at least 30% since 1980.Automobile prices in nominal termsare more than double. Even the costof running Congress is up by nearly

500% since 1980. In the face of al-most everything being significantlyhigher since 1980, it is ridiculous toexpect raw commodities fromagriculturals to crude oil being main-tained at levels well below every-thing else within the economy. Even-tually, this entire sector will explode

in a burst of price activity.

Therefore, Greenspans vir-tual-reality world where inflation isbeing overstated is nothing morethan a political attempt on his partto try to get government spendingdown. It has NOTHING to do withreality as illustrated by Greenspansown actions for the past two years.The Fed has raised interest rates 7times while the CPI has not moved.The press, confused as they usu-ally are, have portrayed the ratehikes of the past several years aspre-emptive strikes aimed atkeeping future inflation undercontrol while maintaining the current

lies that there is no inflation. This oddscenario painted by the media isconfusing and disruptive to the finan-cial marketplace as a whole. Everyminor economic statistic is scruti-nized so closely in an attempt to seeif inflation exists or not, this uncer-tainty is now creating violent price

swings that are so regular, our com-puter can forecast when a statisticwill hit the market without knowingthe schedule or what that statisticeven reflects! The regularity of vio-lent price swings are simply becom-ing a routine part of the financial mar-ketplace. This cannot be explainedin any other way other that the mar-ketplace senses a problem betweenreality and Greenspans virtual-real-ity. This can only lead to higher vola-tility and greater risks to theeconomy as a whole.

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There is always the accompa-

nying hype surrounding new tech-nologies. The Netscape story is cer-tainly at the top of the list of recentboom stories. However, technologydevelopments have always been thelife-blood of the stock market sincethe very dawn of organized market-place investment. Todays boom,however, is often tomorrows bust.That bust can come at a momentsnotice or more along the lines of aslow dragged out affair often goingunnoticed by the best of analysis.

Technology stocks are a veryinteresting case study by them-selves. As the progress of technol-ogy has passed through time, we of-ten forget those stocks which werethe technology boomers of decadeslong past. Such prior rising starshave survived to become todaysinstitutional conservative blue chipstocks while others are mere faintshadows of former glories long

since past.

The two stories of former glo-ries are railroads and the inventionof radio. The railroads burst on thescene during the middle 19th cen-tury on the heels of the industrialrevolution and the invention of thesteam engine. Railroads were thebackbone of American millionaireswhose family names still live on to-day. As the railroads soared in price,they too had the booms and busts

during the countless panics duringthe second half of the 1800s. Thatera of the iron horse actually cameto an end with the Panic of 1907. Itwas the famous panic where thetransportation stocks were the bluechips that fell like a stone during thatfateful crash. The industrial stockswere not the favored group of inves-tors during that period. A compari-son of the Dow Transportation In-

dex vs the Dow Jones Industrial In-dex bares out this often over-lookedfact.

The technology boom of thelate 19th century not only peaked in1907, it was usurped by an evenmore exciting new technologyknown as the automobile. Since au-tos were a durable good which couldbe sold to the consumer rather thana service purchased by the con-sumer, the auto stocks entered theDow Jones Industrial Index. As aresult, it was the Industrials thatboomed going into 1929 far outpac-

ing the then overshadowed rail-roads. What is interesting is that forthe Panic of 1907, the railroadsstocks dropped by as much as 90%.In the 1929 Panic, it was the indus-trials which dropped by as much as90%.

There was a third technologythat soared in price even during thedarkest hours of the Great Depres-sion. That technology was radio and

the stock was RCA. In fact, RCAsoared in price so much during thisperiod, that a few very smart inves-tors were able to ride out one of theworst depressions in modern his-tory.

No matter how gloomy thingsmay have appeared during the GreatDepression, radios were sellingrather briskly. People at least wantedto sit around and listen to what wasgoing on. Perhaps many were look-

ing for a broadcast of hope announc-ing the end of the Depression whileothers simply passed the time by.FDR even made a radio address thenight before the presidential elec-tions in 1933. Truly, RCA was a tech-nology stock that shined in themiddle of a dark economic storm.

The importance of these tech-nology shifts provides a good les-

son for todays investor. Railroadsonce appeared to be the blue chipsfor the 20th century. All the hype how

they would last for centuries provid-ing endless streams of cash was noteven questioned by the best ana-lysts of the day. Railroad companieswere able to issue 100 year bondsat the start of the 20th century dueto such an endless vision of the fu-ture that dominated the times. Butall those visions soon disappearedwith the Panic of 1907.

The final blow to the railroadswas certainly the automobile. This

was a product that the consumercould not only purchase, but use togo anywhere instead of being re-stricted to time tables and miles ofpre-laid track. That technology shiftbrought the age of the railroads toan end and the centuries of profitsenvisioned quickly turned into de-faulted bonds.

As we approach yet anothernew century, there is a technology

in its infancy poised to reshape theentire world before us, humbling theformer technology boomers of dayslong since past. At risk are the tech-nology companies we think of as in-vincible. These are AT&T, Sprint,MCI and other long distance carri-ers worldwide. With the invention ofthe Internet and the combination ofsound-cards (multimedia), it is nowpossible to talk toll-free between NYand London via the Internet. Whilethis technology is still far less than

the standards acceptable by busi-ness, it is a field that could shakethe very foundations of how we viewthe future.

As technology improves, usingthe Internet for telephone calls overlong distance could cut deeply intothe revenues of long distance phonecompanies in the next 10 to 20years. We could be facing yet an-

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other major technology shift whichperhaps sounds as impossible to ustoday as the collapse of the railroadsto the bond investors who stood inline in 1899 to buy 100 year bonds.Things change and as they do tech-nology shifts as well reshaping thefuture we thought would be into

something the majority neverdreamed possible.

Another important way theInternet is impacting our lives is taxa-tion. I recently testified before theHouse Way & Means committee ofCongress on July 18th (see testi-mony on our Internet site). Onequestion that surprised me wasHow do we deal with the Internetand its impact upon our ability to taxincome?

Government knows only twoaspects: 1) Revenue collection 2)How to control the people. Virtuallyevery law passed has to deal witheither the raising and methods ofcollecting revenue or how to restrictbehavior by controlling the popula-tion. What I was surprised to findwas how quickly the Internet tech-nology has captured the concernsof Congress from a revenue collect-

ing perspective. With the ability toencrypt transactions that the govern-ment cannot gain access to, the veryability to determine taxation basedupon income is at risk in the yearsahead. Income can be easily hiddenand cash easily transferred withoutever being in a position where thegovernment will know about what istaking place. As far out as this mightseem, some would argue that themajority of people could not use theInternet to hide their wages. That is

correct. But what Congress is wor-ried about are the rich who wouldbe in a position to hide income thatis NOT derived from a salary.

What if overseas banks beginto tap into the Internet allowing cus-tomers in any country to open anumbered account. Transactionsmade via the Internet in encryptedformat could be transferred from one

place to another without even goingthrough the Federal Reserve sys-tem. There wouldnt be any way thegovernment could trace that type oftransaction.

There is another aspect thathas Congress really concerned.

While encryption attacks their firstpower to tax, the second threat at-tacks their ability to control. TheInternet is an open world wide net-work. It is impossible for Congressto simply pass a law and say that itis illegal to accept encrypted trans-action over the Internet. How couldsuch a law be enforced? Any at-tempt to control the Internet wouldlead to countless offshore banksgaining all the business causing de-posits to decline domestically thusimpacting interest rates overall. Alaw passed in the US cannot be le-gally applied to a business in anothercountry. The only way out would beto outlaw the Internet altogether forAmerican citizens and residents.That would then raise the Constitu-tional problem of restricting freedomof speech. After all, not all transac-tions over the Internet have to dowith hiding income.

To my surprise, Congress isvery smart when it comes to under-standing an infringement upon theirrights. They may be very slow to actwhen it comes to their impact uponus, but when you attack their rev-enue collection ability and their abil-ity to write laws to control society,they become very worried.

We are indeed on the verge ofa new technology. Some come andmany more go as quickly as they

arrived. But this technology has theability to reshape the world we livein because it also has the ability toundermine government in the twoareas it has up to now maintainedan unquestionable monopoly.

Tax reform in the US will leadinto a move to abolish the incometax. Transactions will no longer be

possible to follow in 10 to 20 yearsfrom now. However, a vendor is avendor and if he sets up shows any-where in the US, he must deal witha distributor. This is the realizationon Capitol Hill and why the retailsales tax is coming whether youbelieve it or not.

In the end, the two biggest vic-tims of this technology shift will belong distance carriers and govern-ment. Your Baby Bells and localphone companies who provide thecable, the hook up and the lines tothe new technology age will be thebig benefactors. So when you lookat technology stocks for the long-term investment, look to see who willbe in the position to produce a hard-ware service, not just software whoslife-cycle at best may prove to bethat of a fly.

Available in Japanese

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We cant go on like thisscreamed the front page headlines

of The Independentearlier this month- one of the serious national UKnewspapers. The government isliterally bankrupt - with net wealthdeclining from nearly 20 bn in1979 to minus 179 bn at the endof last year, according to officialfigures.Had Fleet Street at lastwoken up to the government debtcrisis? The article summarised 17years of financial decline under theConservative government. Interestpayments on government debt havenearly quadrupled to make up thefourth largest category of expendi-ture after social security, educationand health out of the total govern-ment expenditure of 303.9 billionlast year. Windfalls such as the taxon North Sea oil and privatisationreceipts (77 bn and 64 bn respec-tively over the period) have not beenenough to cover the spending spreeof ever bigger government. The na-tional debt finished the year at 385.5

bn having doubled under Prime Min-ister John Majors time in office.

Well, it has all gone quiet again.Perhaps, there was just no othernews to report that day.

IMF Watch

The IMFs annual report has re-vealed the strain of record lendingto Russia and Mexico. The IMF com-mitted $26 billion during its last finan-cial year compared with $22 billionin the previous year. Although in realterms this is still less dramatic thanthe $20 billion during the 1982-83debt crisis, the Funds uncommittedusable resources are 90% of its liq-uid liabilities and its liquidity ratio isexpected to deteriorate further. Agroup of 33 countries from the 181members has agreed in principle to

extend a $50 billion credit line foranother Mexico style financial cri-sis (Canada?) but this has not beenratified yet. Beyond this the IMFneeds to raise fresh money to put

its Enhanced structural adjustmentfacility (Esaf) program on a perma-nent basis and find funds for its par-ticipation with the World Bank in thejoint debt relief initiative for poorercountries.

Of course the Fund will try toincrease subscriptions from itsmembers (an international tax rise!)in the longer term to alleviate its po-sition, but a curious turnaround wasreported. Mr. Philippe Maystadt, theBelgium finance minister, who pre-viously was driving the proposal tosell some of the IMF gold reservesshort term, is now suggesting theextra cash might be provided by bi-lateral contributions from govern-ments instead. The official view ex-pressed by the first deputy manag-ing director of the Fund, Mr. StanleyFischer, is that the IMF is closer toagreement on gold sales despitecontinued German opposition.

Let us hope they are a littlemore efficient than the TripartiteGold Commission set up in 1946 bythe US, UK and France to restoreEuropean countries central bankreserves taken by Germany duringthe war. After 50 years they still haveover five tons of gold in the Bank ofEngland awaiting final distribution tothe claimant countries.

EU Watch

EMU is not just about eco-nomics, it is fundamentally about

politics.- Eddie George, Governor

of the Bank of England.

Britain is ready to spar onceagain with the European Union overthe BSE (Mad Cow disease) pro-

gram. Agreement had been reachedin Florence earlier this year that theexport ban on British beef would belifted over time following a cull of125,000 British cattle. Fresh scien-

tific evidence forecasts the epidemicwill die out by the year 2001 with orwithout the large scale slaughter ofcattle. Germany and France insistthe cull must go on to increase con-sumer confidence at home whichhas devastated their own beef indus-try. The British government is ex-pected to tell the EU the cull shouldbe abandoned.

Dunn & BradstreetSchimmelpfeng forecast bankrupt-cies should rise 5% this year to200,000 in the 15 member states ofthe EU citing governments cost cut-ting to achieve a common currencyby 1999 as a contributing factor.Germany is expected to be worst hitwith a rise of 17%.

Germany and the Europeancommission have started legal pro-ceedings against each other follow-ing the German state of Saxony con-

tinuing with illegal subsidiesgranted to Volkswagon to build anew car plant. Without the state aid,VW would not go ahead with theplant which will bring with it muchneeded new employment in the re-gion. The commission has takenaction against Germany as it couldnot legally file a suit against Saxony.

Rogue dealers? - Itcouldnt happen to us.

Deutsche Bank, the Germanparent of the UK based MorganGrenfell Asset Management, is nowcounting the cost of supporting the90,000 investors in three MGAMfunds (market value of 1.1 bn)which have been suspended afterthe discovery of irregularities andbreaches of investment rules. It isreported that a fund manager in the

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Made in Germany -

and the Fear ofUnemploymentcorporate profits surgeand jobs disappear.

Structural problems, laborcosts, taxation and social expendi-tures are the words used most inGermany these days. What theyimply, however, is quite abstract andfeeds anxiety throughout theeconomy. What actually happens is,

that corporations announce recordearnings as the Arbeitsamt an-nounces record unemployment. TheArbeitsamt published the numberof unemployed at the end of Augustat a record high with a total of3,901,700 - 323,500 more than lastyear, while companies increasedtheir profits and improved their bal-ance sheets.

True, if Germany does notchange its course it is heading for a

big bang and it is also true, share-holders check their returnon capital - but what isgoing to happen, if simul-taneously the number ofthe workforce is falling?

Currently 10.2% ofthe workforce is reportedto be without a job. Theofficial number does notinclude all those whogave up registering withthe Arbeitsamt. The IAB(Institute for Job Re-search) estimates thatthis number of unregis-tered unemployed is atleast 1,900,000. If onewould add also those whoretired early, those whoattend public sponsoredcourses for job training

and those who attend governmentsponsored work schemes one wouldend up with a figure of 3,100,000 un-reported unemployed.

In a recent poll the questionwas:

Do you think your childrenwill be better off than you as faras living standard and job pros-pects are concerned?

17% think yes, but 48% be-lieve their children will have a worselife than they are having or had and34% believed there will be nochange.

Traditional theories would sim-ply argue with supply and demandfactors of the labor market. The costfor labor should fall. A very wellknown economist for the DeutscheBank, Professor Walter, suggestedrecently that everybody should re-linquish 20% of his salary. - Butthats where the problem started. Ifyou share two apples among two,you are doing fine, but you dontsolve the problem of starvation by

sharing one apple among 36. It is avicious circle:

The more unemployed, thehigher the social costs, the lower thetax revenues, the lower the domes-tic demand and that leads to lower

sales, leads to lower profit, leads toausterity, leads to redundancies,leads to more unemployed, leads tohigher social costs . And leads tobig trouble.

The German Debt andthe Emu

It was not good timing. Justbefore the Bundesrat (FederalCouncil), which is controlled by the

opposition, could decide on the aus-terity program it was rumored thatthe ruling party has already a Sav-ings-plan II in the making. Plan IIshall help to reduce the effect of theincreasing number of unemployedon the budget. A week ago, the la-bor department received an in-crease of its budget by 162% percent, from 4.3 to 11.3 bn. The netincrease in the national debt will nowincrease by almost 70 bn. (see Capi-tal Market Report July, at that timethe planned increase was 50 bn).

* Source: Statische Bundesamt

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Todays new debt will be thetax for tomorrow under the assump-tion that the debt shall be repaid. Notonly does an increased demand onthe capital market by the govern-ment bear the danger of an increasein interest rates but it also dampensthe enthusiasm as far as invest-

ments are concerned. It remains tobe seen how these problems can besolved. The ruling party diverts theattention of the public to the tax re-form instead of tackling the realtrouble.

The Maastricht single currencycriteria of the net deficit ceiling of 3per cent of gross domestic productmight not be achievable by Ger-many. Mr. Welteke, president of thestate central bank of Hesse, said theGerman public was being misled intobelieving that the government couldprevail with a strict interpretation ofthe criteria, when the EU leadersdecide the issue in 1998.

Mr. Kohl and Mr. Waigl face aparadox here: hard public line on the

Emu criteria when it is apparent thatseveral of the founding members(including Germany and France)are not able to meet the net deficitceiling of 3 per cent of GNP.

Telekom part 2

Telekom wants to receive 15bn DM through the sale of its sharesin November (see Capital MarketReport 8). They are now targetingthe private investor because the in-stitutional investors have alreadyenough telecommunication sharesin their pockets. The marketing bud-get for going public is estimated at60 mn DM. Only ten percent of theinvestors in Germany own shares -so far.

The deal to sell the shares tothe average Mr. Mueller on thestreet is twofold.

Private investors do re-

ceive a discount for the first 300shares between 1 and 5 percent.

Investors who hold the

shares until the 30th of September1999 will receive a 10% stock divi-dend.

The lead underwriters in Ger-many also agreed, not to charge theirminimum commissions to small in-vestors. So, everything is all right.The institutions hold the shares, be-cause they are an important part ofthe DAX Index and the small guysget their discounts.

You wont find too much of acritical press in Germany despitesome concerns which are obvious.Telekom has to pay around 8 bn DMon taxes in 1996. In order to remainprofitable, Telekom has to be quitesuccessful in:

a) cost cutting;b) financing of old pension

schemes and;c) keeping market share when

the competitors attack the market in1998.

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The potential crisis precipi-

tated by Yeltsins ailment is drownedout by optimistic economic reviews.Many have hailed the Presidentsdisclosure of heart-surgery as reas-suring by putting all the cards on thetable - further strengthening the po-litical process and the economy. Itis difficult to dismiss the seriousnessof heart surgery for 65 year-oldPresident Yeltsin. The critical issueis what if the President were to be-come incapacitated or suffer fatalcomplications? The Presidents ill-health may be the catalyst for politi-cal meltdown.

Fallout from a political and eco-nomic disaster in Russia should because for concern to Europe. Thecatastrophe in Chechnya is the po-tential crisis put into motion. An es-timated 17,000 refugees have fledthe region of Chechnya to the sur-rounding areas. Many of the villageswere unable to absorb the refugees

worsening the shortages of food,housing and energy.

Historically, Chechnya is notan anomaly in the Russian Federa-tion. Numerous enclaves of ethni-cally and culturally diverse peoplesare spread throughout this region inaddition to the 21 recognized au-tonomous republics. If conditionsdeteriorate at an accelerated rate,heads of regional or autonomousgovernments may be more likely to

risk policies conflicting with Moscow,increasing the potential for militaryconflict and spillover. In Chechnyaalone, an estimated 30,000 casual-ties of soldiers and civilians havebeen reported while some estimateshave gone much higher. The Rus-sian military may not measure up towhat it once was, but its ability tolevel destruction is clear while whoexactly is calling the shots is not. A

political meltdown could result inmilitary action or a complete bust inthe economy - sending millions ofrefugees into Europe.

The catalysts for Russia topolitically implode are present in

number and intensity. A successfulsurgery or recovery for Yeltsin is notguaranteed. Heading off growingpressure from the Parliament andwithin his government last week,Yeltsin responded to a public call byhis Security Chief Alexander Lebedand promised to transfer powers ofthe presidency to the Prime Minis-ter Viktor Chernomyrdin. Only veryrecently were remaining powers re-

lating to nuclear weapons trans-ferred. The constitution directs thatpower be granted to the Prime Min-ister and that elections be held withinthree months of a presidents deathor incapacitation. It is expected thatwhen the President recovers those

holding power will also recognizethis recovery.

The ability of the opposition tocreate an opportunity to gain con-trol of the government increasedwith Yeltsins illness. Constitutionalvagueness opens the door to asticky confrontation between theCommunist majority in the Dumaand the Yeltsins government. The

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results of such a situation are badto worse. If Yeltsin does not recoverquickly, the three month time periodmay encourage the CommunistParty to force elections by countingthe time elapsed from hospitalizationor the promise to transfer power toViktor Chernomyrdin - giving the

president until mid-December. Thiscould create a chance for anotherround of presidential elections.Without a clear front runner for re-form, the opposition is likely to havean advantage.

In the fall of 1993, Yeltsin dis-banded the regional legislative bod-ies and replaced by appointmentmany of the executive officials.These officials also sit in the upperhouse of Parliament. Regional ex-ecutives in 52 of Russias 89 regionsmust now face the electors so an-other political campaign season isunderway - giving the oppositionanother shot to gain control.

Although Anatoly Chubais -Yeltsins Chief of Staff and formerarchitect of Russias economic re-forms - was brought back into thegovernment to assist with theseelections, his hands will be full bal-

ancing his interests against those ofLebed and Chernomyrdin. A major-ity in both houses of Parliament incombination with a weakened gov-ernment could produce votes of noconfidence forcing the governmentto dissolve. As head of the govern-ment, Prime Minister Chernomyrdincould stand to substantially gainfrom this situation - filling the minis-tries with allies while disposing ofAlexander Lebed who is also a presi-dential hopeful.

Yeltsins illness has placedmany of his regional appointees andsupporters out on a limb. The Presi-dent will be unable to help direct orcoordinate forces to get out the votefor the incumbent or more reform-minded challengers. Many regionalofficials got out the vote for Yeltsinin the July elections for promises ofeconomic subsidies for their con-

stituents. With Yeltsins return to thehead of government in doubt, pre-vious supporters and appointees willbe reassessing their risks and re-wards. The political promises fromYeltsin and his government - particu-larly during his campaign - are nowunlikely to be fulfilled if they ever

were. Furthermore, the budget-busting campaign and expectedeconomic decline make it moredoubtful that money will flow fromMoscow to the regions. Hard cur-rency reserves are down as theCentral Bank has tried to support theruble while gold production is downover 13% from this time last year.However, many of these promiseshave yet to be fulfilled and a back-lash could be in the making, particu-larly in Yeltsins absence.

The carrot and stick offered tothe regional bosses to tow Moscowsline will not be as strong, particularlyas the socio-economic conditionsare often far worse in the outer lyingregions than those immediately sur-rounding Moscow or industrializedareas. This could especially stokeup the political fires and provokeeconomic panic as strikes are be-ing threatened by workers unions -

particularly in the energy sectors.The presidential elections showedpro-Yeltsin support to the north andin urban areas while the pro-Com-munist vote was strongest in thesouth and rural areas. A decreaseddependence on Moscow couldstimulate regions or autonomousdistricts to pursue policies directlyopposed to the Kremlin. In the FarEastern region of Primorskii, thegovernor flat-out ignored a govern-ment decree to raise energy prices.

With no clear leader in the Kremlin,the risks and rewards of politicalbrinkmanship and power playing onthe federal level as well as on theregional level are dramaticallyraised.

Even if the regional districtsvote in favor of reformers and theirrepresentatives resist rogue activi-ties to consolidate their power base,the politics within the Yeltsin govern-

ment threaten stability. Yeltsin haspursued a political strategy that isnow threatening the stability of thegovernment in his absence. Instru-mental to retaining his power, Yeltsinhas sought an environment wherehis key ministers must build coali-tions and leverage their influence

against one another in order to gainand maintain power. This protectedYeltsin from unified attacks by hisown ministers. Key players are po-sitioning themselves for the next-in-line front runner. Certainly, the rapidpace with which Yeltsin has beenchanging ministers within the pastyear or so may indicate a failingstrategy in the face of a weakeningPresident.

Political uncertainty is intensi-fied by an unstable economy. In themix is a recession that has yet toevade the usual fall/winter bust.Unemployment has continued togrow, gross domestic production isdown 6% from last year, and theenergy sectors are failing. Outputof oil and coal is down 2% while re-ports show a 4% decline in refining.Wage arrears are on the rise. Un-paid wages are reported to be at ahigh of $7.4 billion with nation-wide

strikes being threatened. Growingenergy shortages are expected toget worse as colder weather sets inon top of the usual high prices andfood shortages. Expectations ofgreater IMF aid or a World Bank bail-out of the economy if it goes bust -on top of the $10 bn already pledged- is a big if in light of recent disclo-sures of declining institutional liquid-ity. Yeltsins failing health, mixedwith a faltering economy, is a com-bustible mixture for a political melt-

down that would prove disastrous tothe surrounding regions.

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As 1997 approaches, specu-lation that political uncertainty willbreak the Hong Kong dollar peg is

mounting. After rumours last monththat George Soros was shorting theHong Kong dollar, financial secre-tary Donald Tsang has even goneto the lengths of officially disclosingthe considerable reserves backingthe peg. However we expect the pegis destined to become a relic of abygone era, and destined to the his-tory books along with British sover-eignty.

Up until now Hong Kong finan-cial assets have been a proxy for USdollar assets. Property and bankingassets in fact, have acted like a calloption on movements in US interestrates. Under the certainty of the or-thodoxy that has maintained thepeg, investors have generallyviewed Hong Kong dollar assets asrisk free. However by definition achange of sovereignty createsgreater uncertainty than mainte-nance of the status quo. The popu-

lar proposition that Hong Kongspolitical risk factor will diminish after1997 is therefore flawed.

There are many explanationsfor Hong Kongs success - the Brit-ish legal system, minimal govern-ment intervention and Chinese en-trepreneurs. It was not having com-munist China as a neighbour - butin spite of it. As Hong Kongseconomy is absorbed into greaterChina, closer political integration

becomes necessary and inevitable.Eventually investors will demand apremium for the increased politicaland economic risk of Hong Kong,when at almost no cost they couldhold US dollars. Even if the peg doesnot break immediately, ultimately itwill be undermined by the cost ofmaintaining it.

Politically the peg will also be-

come untenable. After waiting 150years to get Hong Kong back fromBritain, is China willing to surrendersovereignty on monetary policy tothe US? Hong Kongs economy is

now far less geared to the US thanwhen the peg was founded - con-flicts are inevitable and domesticself interest will prevail. Both Chi-nese and Hong Kong Central Bankofficials have vowed to defend thepeg with their war chests, US$60bnand US$90bn of foreign currencyrespectively. However while theseamounts are undoubtedly impres-sive, they are no answer to the $1trillion traded daily in currency mar-kets. Traders are looking at a winwin situation. If the peg goes youwin, if it doesnt you need only waitas you hold your US dollars.

Confidence is obviously thekey. For an estimated 1.5mn to 2mnHong Kong inhabitants with foreignpassports, it is necessary to hop ona plane to escape if life in the newSpecial Administrative Region. For-eign capital requires a mere switchof a button. As yet no specific de-

velopment has created any over-whelming evidence that thehandover will cause the peg tobreak. Rather it will be a series ofactions, that little by little will causelasting change in Hong Kongs po-litical economy. Corruption may in-crease, along with press censorship- we will need only a high profilecase of a connected individual ap-pearing to be above the law to raisedoubts on the legal system.Progress remains slow on arrange-

ments between Beijing and Londonfor the handover, although therehave been some positive develop-ments. Beijing has signalled it willtalk to Hong Kongs elected leadersand Xinhua recently went as far ashaving a formal audience with mem-bers of the previously labelled sub-versive Democratic Party.

There has also been an appar-

ent increase in transparency on theselection procedure for the first ChiefExecutive of the SAR. Beijing is re-ported to be dropping its leftist poli-cies towards Hong Kong and Taiwanand embracing capitalism. ClearlyBeijing wants Hong Kong to be aneconomic success, but more signifi-

cantly for the communist leadership,it will want political control. A difficultbalancing act and, if a choice has tobe made, the communists will inevi-tably opt for political control. Despiteconciliatory gestures, we are seeingevery now and again worrying com-ments emerge; Hong Kong courts willapparently have no jurisdiction overPLA officers who commit crimes inthe territory. It is this kind ofunpredictability that will ultimatelydetermine confidence in the territory

and its currency, rather than the sizeof currency reserves.

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If passed in its current form the96-97 Federal Budget, broughtdown on August 20th, should delivera headline surplus of A$474 millionand an underlying deficit of A$5.6billion. That Federal Treasurer Pe-ter Costello has taken the trouble tomake a distinction between headlineand underlying figures is a refresh-ing break with the past. In recentyears Labor governments have of-

ten bragged about budget surplusesor low deficits which in reality werebased entirely upon the proceeds ofasset sales - Qantas Airways, Com-monwealth Bank of Australia, etc. -or the bringing forward of companyor provisional tax payments. In otherwords rather than cut governmentspending and broaden the tax baseto avoid going into debt the countrywas living off its capital.

In placing the real budgetary

position clearly on the table the gov-ernment plans to enshrine this as aprinciple of a proposed Charter ofBudget Honesty to be enacted vialegislation. The Charter among otherthings will require a Budget updatesigned off by both the secretaries tothe Treasury and the Department ofFinance at the commencement ofeach Federal election campaign.These measures will dovetail with

the governments intention to moveall federal government departmentsto full accrual accounting and sug-gestions that all off balance sheetactivities of government via govern-ment owned entities be detailed inthe budget.

The Budget was generally trueto the governments core electioncommitments and will see the Com-monwealth with an underlying bal-anced budget in 3 years. Most com-mentators were surprised to see the

main beneficiaries being low tomiddle income families with childrenand owners of small business. Thestruggling private health insurancesystem has been put on a betterfooting via tax rebates for low tomiddle income earners who take outprivate health insurance and tax lev-ies on higher income earners whodont. This may help alleviate someof the pressure on the public hospi-tal system and Medicare with theirrising costs and patient queues.

Although heartened by an im-proved deficit, bigger businesswasnt to any extent a beneficiary ofthis Budget with cuts in R&D taxconcessions from 150% to 125%hurting the hi-tech sector. Employ-ment programmes also were se-verely curtailed with the Common-wealth Employment Service to becorporatised and private employ-

If the government continues tobe frustrated, then an early doubledissolution of the House and Sen-ate and federal election is increas-ingly on the cards. The one greathope in many quarters if this hap-pens is that reform and simplifica-tion of the taxation system will beback on the agenda. This is the onearea that disappointed most with theBudget and despite feeling held to

election promises not to raise anytaxes or to introduce new ones (andtherefore being unable to abolish oldtaxes and preserve the existing rev-enue base) there are signs that theHoward government is starting tohear calls for a broadbased con-sumption tax and a lower flattenedpersonal and company tax system.

ment agencies contracted to per-form some of its roles. The govern-ment has emphasised that it seesmost potential for delivery of gainsto business and unemployed via

passage of its Workplace RelationsBills which will deliver far-reachingreform of the labour market. TheSenate has to continue to obstructthis bill along with the bill to privatisea third of Telstra Corp.

The Senate and Reform

The Howard governmentsposition in the grid-locked Senateimproved somewhat on Budget night

with a Labor Senators resignationfrom the Labor Party. The Senatorsstatement that he believed the gov-ernment had a mandate on certainissues combined with his friendshipwith another socially conservativeindependent Senator could makethese two the key to negotiating leg-islation through the chamber. Up tothis point Senate leaders have beenfrustrated and held to ransom bymoon- beam, left-wing, nominallygreen, Democrat and Green Sena-

tors siding with the Labor Party.

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Helms-Burton Update

As we reported in our July is-sue, Canada was one of the mostoutspoken opponents of new USlegislation aimed at curbing interna-tional trade with Cuba and prom-ised legislation to combat Helms-Burton. Canada has made good onits pledge. The Liberals in Ottawaintroduced an antidote law to com-bat the US legislation. The law wouldblock US court judgements againstCanadian firms, allow Canadianfirms to countersue Americans to

recoup penalties and court costs andallow Canadian companies facingUS law suits to sue for US courtcosts even before the case is over.However, the law will not be neededif the existing six-month suspensionof Helms-Burton is extended inJanuary. The promised challenge ofthe law under NAFTA has yet to goforward.

Meanwhile, President Clintonis trying to get Canada and other

countries to soften their stance onHelms-Burton. Stuart Eizenstat,special envoy on Cuba, will urgeCanadian companies to adopt theSullivan principles - used during theembargo against South Africa. TheSullivan principles call on corpora-tions to pay their employees directly(instead of through the government)and allow them to organize unions.Eizenstat will also be asking Canadaand other countries to adopt fiveprinciples aimed at toppling theCastro regime. These principles askcountries to pledge not to help Cubadevelop a nuclear reactor, makestatements calling for democracy inCuba, funnel government aid moneythrough Cuban non-governmentagencies, increase support for inde-

pendent journalists, and end anygovernment subsidies to Cuba. Forthis first effort to launch a multi-lat-eral effort, Eizenstat is askingCanada and Mexico to drop their

plans to challenge Helms-Burtonthrough NAFTA.

Inter-Provincial TradeFriction

The new interprovincial tradeagreement, AIT (Agreement on In-ternal Trade) is on the verge of col-lapse after only three months of ex-istence. The deal was finally signedin June after years of negotiating

between the provinces and the fed-eral government. It is now about tocrumble before resolving its first dis-pute. At issue is UPS Canada con-solidating its operations in NewBrunswick, thus taking 900 jobsfrom British Columbia, Manitoba andOntario. British Columbia wants totake this dispute to the AIT, howeverNew Brunswick claims UPS agreedto move its operations to NewBrunswick in 1994 - before theagreement came into effect. There-fore, the rules of the trade pact donot apply. It appears as if NewBrunswick will not participate in theresolution process - which couldbring down the whole interprovincialtrade pact.

Trade barriers between prov-inces are hurting the Canadianeconomy. According to a study re-leased by the Canadian Chamber ofCommerce, existing trade barriers

between the provinces cost theeconomy C$7 billion a year - aboutone percent of domestic product.While NAFTA, the free trade pactwith the US and Mexico has helpedCanadian exports surge to a C$4.58billion annualized rate in the secondquarter, interprovincial exports have

declined in seven out of ten prov-inces.

Unity and NAFTA

The US Congress will holdhearings on Quebecs potential se-cession and the impact it would haveon NAFTA. The House InternationalRelations Committee will hold hear-ings centering on the economic is-sue, on the possibility of NAFTA fall-ing, if in fact, one of the main signa-tories to the contract isnt an entityanymore, according to Joel Starr,a spokesman for committee mem-ber Representative Tom Campbell.

Starr also said that an InternationalRelations sub-committee on theWestern Hemisphere will be look-ing at the issue of minority rights,specifically in the bilingual area. Thehearings, scheduled to begin Sep-tember 25th, send a clear messageto separatists in Qubec that theworlds capital markets are indeedwatching.

Notes

Toronto ranked the highest incity taxes in North America for thefourth year in a row. The CB Com-mercial Real Estate Canada/Madi-son Advisory Group survey alsoplaced Montreal, Calgary, London,Ont., and Edmonton in the top 10.

The VSE launched a new, two-hour night session called VISTA(Vancouver International SecuritiesTrading Access) for securities that

are either Asian-based or activethere. The session starts at 5:30 PMPacific time and runs Sunday toThursday.

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UNITED STATES

JOBS GROWTH: Figuresfrom the Labor Department showed

an increase in nonfarm employmentof 193,000, less than many econo-mists had projected. The joblessrate edged up to 5.4 percent, from5.3 percent in June. Average earn-ings fell slightly, reducing worriesabout upward pressure on inflation.

The employment increase fellwell short of an average monthlygain of 273,000 in the second quar-ter, suggesting an easing of growth.The length of the average factory

work week also declined, suggest-ing output gains will be more mod-est than in the second quarter whengross domestic product grew at anannualized rate of 4.2 percent.

WHOLESALE PRICES: USwholesale prices were flat in July.The labor department said the pro-ducer price index for finished goodswas unchanged last month, after a0.2 percent rise in June. Most WallStreet economists had expected a

gain of about 0.2 percent. The an-nual rate of producer price inflationfell to 2.6 percent from 2.7 percentin June.

Excluding the volatile food andenergy components, core producerprices were up 0.1 percent after a0.2 percent gain in June. Prices forintermediate and crude goods(which give advance warning ofprice trends for finished goods) fell.

HOUSING STARTS: Con-struction starts on new homes andapartments in the US dropped for athird straight month in July as cost-lier mortgages put a drag on thehousing market, the CommerceDepartment said.

Total starts dropped 1.3 per-cent to a seasonally adjusted annual

rate of 1.46m in July, after a revised0.3 percent fall in June and a 2.2percent decline in May.

Interest-rate rises that began

in the spring appear finally to beslowing down the housing industryby boosting monthly payments tolevels that are eliminating some buy-ers.

Construction starts on single-family homes dropped 5.7 percentin July to a rate of 1.13m the big-gest monthly fall since 12 percentplunge in January 1995 after a 5percent rise in June. But starts onapartments were up 17.9 percent toa rate of 322,000 in July, largely re-versing an 18.3 percent drop inJune.

Previously, the departmentsaid June housing starts had risen1.3 percent to 1.48m but it revisedthat estimate down sharply. The lasttime housing starts fell for threemonths in a row was over a year agofrom January to March 1995, thedepartment said.

The National Association ofHome Builders said recently itshousing market index fell for a thirdstraight month in August.

Total starts in July were 0.3percent higher than in July 1995,when they were running at a rate of1.45m a year. While the market maybe leveling off, there was no indica-tion it was in sharp decline. Appli-cations for building permits rose 2.6

percent in July to a seasonally ad-justed annual rate of 1.45m.

DURABLE GOODS: Thecommerce department reported thatthe US durable goods figure for Julyclimbed by 1.6 percent from the pre-vious month compared with econo-mists consensus forecast of a 0.5percent increase.

Wall Street is concerned thatif the pace of US economic growthseen in the first half of this year con-tinues unchecked, the Federal Re-serve will have to push up interest

rates to contain the threat of infla-tion.

The rise in orders was broadbased apart from weakness in de-fense orders, which fell 36.5 percent.Excluding the volatile transportationsector, July orders would have beenup by 2.1 percent, compared with0.2 percent in June and 1.1 percentin May.

LEADING INDICATORS: Akey gauge of US economic activitystrengthened in June, according tothe Conference Board, a businessanalysis group, despite providing ad-ditional signs of slowing in the indus-trial sector.

The index of leading indicators,designed to forecast economictrends six to nine months ahead,rose by 0.5 percent in June after arevised 0.2 percent increase in May.

Higher prices for commoditieshelped drive the index up, but ordersreceived by factories for durablegoods were lower than in May.

The overall monthly gain in theindex during June was moderatelystronger than anticipated by WallStreet economists who had forecasta 0.3 percent rise.

The leading index measures abasket of economic indicators from

unemployment benefit claims tobuilding permits. Six of its 11 com-ponents were higher in June whilefive weakened. The signals of ris-ing activity in June were led by in-creased commodity prices, slowervendor deliveries, rising consumerexpectations and a higher moneysupply. The average working weekwas longer and stock prices werehigher.

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The negative indicators werefewer new orders in June for durablegoods and reduced orders for newplant and equipment. Order back-logs also fell.

CONSUMER PRICES: Con-sumer prices rose 0.3 percent in July

reflecting large increases in the costof food and hotel accommodation.Economists had expected a gain ofabout 0.2 percent. In the pat sixmonths, consumer prices have risenat an annualized 3.5 percent, upsharply from 2.5 percent during 1995as a whole.

However, the core consumerprice index, which excludes food andenergy, shows little sign of accelera-tion. Core prices were up 0.3 per-cent last month and at an annual-ized 3 percent in the past six months,in line with last years increase.

RETAIL SALES: Retail salesrose 0.1 percent, against projectionsof a 0.2 percent contraction. But fora sharp fall in car sales, which arevolatile on a monthly basis, saleswould have been up 0.3 percent.Figures for June were revised downto show a fall of 0.5 percent, rather

than 0.2 percent.

CONSUMER CONFIDENCE:Consumer confidence in the US hita six-year high in August. The USConference Boards Confidence In-dex rose 2.4 points to a high of 109.4in August. This sustained growth,following an increase of seven pointsin July, was a surprise to manyAmerican economists, who had ex-pected a decline to about 105 points.

Optimism about current condi-tions climbed two points, and con-sumers expectations for the com-ing six months rose by three points.Nearly 29 percent described currentbusiness conditions as good an in-crease from less than 28 percent inJuly.

ECONOMIC GROWTH: TheUS economy grew at an annualized

rate of 4.2 percent in the secondquarter, its fastest for two year, theCommerce Department said. The4.2 percent growth rate exceededWall Street expectations and fol-lowed revised estimates of 2 percentand 0.3 percent in preceding quar-ters.

The expansion was broadlybased, with consumer spendinggrowing at an annualized rate of 3.7percent, up from 3.5 in the first threemonths. Growth was also boostedby a rebuilding of corporate inven-tories and a rapid rise in governmentspending. The increase would havebeen faster but for a slowdown inbusiness capital spending and a wid-ening of the trade deficit.

PURCHASING MANAGERSREPORT: The Purchasing Manag-ers index fell to 50.2 percent from54.3 percent in June, indicating aslowdown in manufacturing lastmonth. Readings of about 50 per-cent indicate zero growth in factoryoutput.

PERSONAL CONSUMPTIONSPENDING: The Commerce De-partment said personal consumption

spending fell 0.2 percent in realterms in June, following a gain of 0.6percent in May. New orders formanufactured goods were also re-ported down 0.9 percent in June,after a gain of 2.3 percent in May.

JAPAN

OVERSEAS INVESTMENT:Japanese companies are boostinginvestment abroad despite the re-cent weakening of the yen againstthe dollar and fears that the domes-tic economy will hollow out as aresult, a survey shows.

Companies surveyed by theNihon Keizai Shimbun daily saidthey would boost capital investmentoverseas 11.6 percent in the yearto March 1997, exceeding a planned8.9 percent rise in domestic capital

spending.

This compares with a 14.5 per-cent rise for overseas investmentand a 21.9 percent rise in domesticspending in the fiscal year to March1996. The percentage of the com-panies total production done over-

seas is expected to rise to 13.1 per-cent 1996-97 (12.1 percent the pre-vious year). Southeast Asia toppedthe list of sites for planned Japanesecorporate investment.

RAIL DEBT: Japans trans-port ministry has drawn up a plan todispose of debts incurred by Japa-nese National Railways (JNR), thestate-run railway group which wasbroken up into seven companies in1987.

The plan, which is to be sentto the finance ministry, will includethe splitting of debts put atY28,300bn ($262bn) held by JNRSettlement, a special entity createdto dispose of JNR assets. The movecomes amid rising criticism of gov-ernment delays over the disposals.

The transport ministry hadpostponed plans to sell former sta-

tion sites owned by JNR during theasset bubble of the late 1980s,fearful of fueling speculation in theproperty market. Land prices havesince plunged. Under the plan, JNRSettlement will be dissolved nextyear and disposable assets will beshifted to a new fund. Of theY28,300bn debt, more thanY20,000bn is expected to be paidfor by the taxpayer.

PRIVATE CAPITAL SPEND-

ING: Private capital spending inJapan remains on a firmly upwardtrend in spite of figures indicating asharp drop in June, the economicplanning agency said. Private ma-chinery orders, excluding shipbuild-ing and electric power, fell by a sea-sonally adjusted 9.6 percent in Junefrom the previous month, the sec-ond straight monthly fall. But the two

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declines followed a 26 percent in-crease in April, the biggest monthlyjump in nine years.

The falls in may and Juneseem to be just a reaction to thesubstantial increase in April, said anagency official. Orders for the sec-

ond quarter overall were up by 10.8percent on the previous threemonths.

Compared with a year earlier,orders rose by just 3.2 percent.Manufacturing orders were almostunchanged on a year earlier, whilethe figures for non-manufacturingshowed a slight rise. In the thirdquarter, the agency expects an 8.2percent drop in private machineryorders compared with the previousthree months, though that would stillleave the figures on course for anannual rate of increase of about 8percent, the best rate of growth forsix years.

QUARTERLY ECONOMICSURVEY: The Bank of Japansquarterly survey of short-term eco-nomic prospects or tankan, showedthe first decline in confidence for ayear among the countrys large

manufacturing companies. Thetankan is considered by the bank tobe among the most reliable indica-tors of immediate economic pros-pects and is one of the main influ-ences on monetary policy decisionmaking.

The report revealed that themain diffusion index for businessconfidence among large manufac-turers, the difference between com-panies saying their business climate

was improving against those sayingit was deteriorating, dropped fromminus 3 in May to minus 7 thismonth. In May, companies had fore-cast a gap of zero in August, antici-pating rising demand. This hasclearly failed to materialize.

Most other indicators in thereport suggested the economy wascontinuing to improve, albeit slowly.

Non-manufacturers reported an im-provement in confidence, though itwas less pronounced than had beenforecast at the time of the last sur-vey. There were also signs of im-provements throughout theeconomy in labor market conditions,in capital investment plans and in li-

quidity, with little evidence of a re-surgence of inflation.

SPENDING REQUESTS:General account spending requestsfrom Japanese government depart-ments for the fiscal year beginningnext April totaled Y81,400bn($750bn), finance ministry officialssaid, 8 percent higher than the cur-rent years initial planned spendingtotal.

The bulk of the increase is theresult of a sharp rise in debt servic-ing costs and tax grants to local au-thorities. The recession of the early1990s has forced the governmentto increase borrowing in the face ofrising demand for public spendingand falling tax revenues. This yearalone, the central government wasforced to raise about Y22,000bnthrough the issue of deficit-financ-ing bonds.

Total debt service costs areexpected to rise by 11.6 percent toY18,270bn next fiscal year. Grantsto local authorities will be aboutY17,250bn, an increase of 26.8 per-cent. General expenditures, exclud-ing debt service costs and local au-thority grants, are expected to riseby about 3.4 percent to Y44,620bn.

TRADE SURPLUS: Japanstrade surplus fell by 37.7 percent in

July compared with the same perioda year ago, the finance ministry said.It was the 20th consecutive monthof year-on-year decline in the over-all surplus and the 17th consecutivemonth of decline in the surplus withthe US. The surplus with the USshowed only a small decline, 4.5percent to Y316.7bn ($3bn), asJapanese car exports shifted intohigher gear.

The July surplus the small-est surplus for the month in 14 years at Y504bn, reflected strong per-sonal computer and crude oil pur-chases which were the main factorsbehind a 35.6 percent rise in imports.The strength of personal computer

imports highlights the extent to whichmany Japanese manufacturershave shifted production overseas.Companies are moving factories off-shore to countries with cheaper la-bor and then bringing the goodsback into Japan, also boosting im-port numbers.

The rise in imports, which hascontinued for 27 months in a row,has far outweighed a firm increasein exports, which grew for the 12thconsecutive month. Exportsclimbed 17.4 percent on the back ofa rise in car and computer exports.

Car sales were the largest con-tributor to overall export growth, ris-ing 35.5 percent, while exports ofpersonal computers and other officeequipment rose 27.6 percent. crudeoil imports rose 48.9 percent, com-puters 52.7 percent, and scientificand optical products 77.8 percent.

HOUSEHOLD SPENDING:Household spending in June rose3.4 percent from a year earlier forthe first time in three months, indi-cating a recovery in consumer con-fidence. Average monthly house-hold spending in the first half of theyear rose 1.5 percent.

UNITED KINGDOM

INCREASED EXPORTS: Ahint of an upturn in one corner ofBritish manufacturing emerged afterthe machine tool industry reportedincreased exports. The sector,which has been one of the most vi-brant parts of UK manufacturing inrecent years, saw a sharp increasein export turnover in June, the Of-fice for national Statistics said. Thisfollowed several months in which

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export turnover had steadily de-clined.

The increase is likely to fuelhopes that demand in Europeasignificant machine tool marketmay be reviving slightly, after slump-ing in recent months. Measured on

a three-monthly basis, the level ofexports was a seasonally adjusted5.9 percent higher than the sameperiod a year before.

INDUSTRIAL OUTPUT: Brit-ish industry suffered its biggest fallin output for three and a half year inJune. Industrial production fell by1.1 percent in June, the Office fornational Statistics said. It was thebiggest monthly drop since Novem-ber 1992 and included falls in fac-tory output, oil and gas extractionand energy production.

The 0.3 percent drop in factoryoutput in June surprised statisticianswho had assumed there would beno change when they drew up theestimate of economic growth in thesecond quarter, published lastmonth.

Recent surveys had sug-

gested factories might be steppingup production again. But manufac-turing remains in a technical reces-sion: with output stagnated in thesecond quarter following falls in thetwo preceding quarters.

The statistics office estimatedfor the seventh successive monththat the underlying trend in factoryoutput and the broader measure ofindustrial production were flat.

In manufacturing, output rosein the second quarter in the textiles,chemicals, engineering and food,drink and tobacco industries. Butcoke, oil refining, nuclear fuels, met-als and other manufacturing con-tracted.

M0 MONEY SUPPLY: Thevalue of notes and coins in circula-

tion grew by a seasonally adjusted0.6 percent in July, the Bank of En-gland said, following a 0.9 percentrise in June. The annual rate of in-crease has reached 7.1 percent, thehighest since October 1994.

The annual increase in the

narrow money supply measure M0 which also includes banks bal-ances at the Bank of England fellslightly from 7.4 to 7.1 percent.

UNEMPLOYMENT: The fallin Britains unemployment total gath-ered pace in July. The number ofpeople without work and claimingbenefits fell by a seasonally adjusted24,1000 last month, the Office fornational Statistics said. This re-duced the total to 2,126,200, its low-est level since early 1991.

Average earnings growth wasstronger than City of London econo-mists had predicted, but remains inthe 3 to 4 percent band it has occu-pied for the last three and a halfyears. Earnings rose by an under-lying 3.75 percent in the year toJune, with the figure for the previ-ous month revised up by a quarter-point to the same level.

INTEREST RATE INCREASESURGED: The Bank of Englandwarned Mr. Kenneth Clarke, thechancellor, will have to raise inter-est rates and cut government bor-rowing if he is serious about hittinghis inflation target.

In its latest quarterly inflationreport the Bank said Mr. Clarke hadonly about a 40 percent chance ofhitting his inflation target in two years

without a rise in interest rates. It saidthe odds had worsened since its lastreport, largely because the chancel-lor cut rates in June. The Bank isalso worried by the deterioration inpublic finances revealed in theTreasurys summer forecast.

With domestic spending al-ready accelerating, the Bank ex-pects the pace of economic growth

to rise above its long-run trend ofbetween 2 and 2.5 percent a yearthrough the rest of this year and into1997. As a result the economysspare capacity will be eroded andinflation should rise from the middleof next year.

Mr. Mervyn King, the Bankschief economist, said the questionto be asked in the coming monthswas no longer whether interest ratesshould be raised, but when. TheBank expects the underlying rate ofinflation which excludes mortgageinterest payments to fall from 2.8percent to 2.5 percent or below laterthis year and 2.25 percent in mid-1997.

It believes inflation may belower if export markets remain slug-gish and companies continue run-ning down stocks of unsold goods.But inflation should then start risingas the economy gathers momentum.

CBI INFLATION OUTLOOK:Interest rates will not have to riseuntil after the general election nextyear as the governments economicpolicies deliver strong growth butwith low inflation, according to the

Confederation of British Industry.

The CBIs latest economicforecast supports the governmentshopes of fighting the election amida low inflation consumer-led recov-ery. It suggests the CBI believes Mr.Kenneth Clarke, chancellor of theexchequer, will successfully fend offpressure from the Bank of England the UKs central bank forhigher interest rates ahead of the

election, which must be held by theend of May next year.

GROWTH IN RETAILSALES: The annual growth in re-tail sales fell to 5.4 percent in Julyfrom 7 percent in June because poorweather hit sales of ice cream, softdrinks and summer items, the Brit-ish Retail Consortium reported.

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But the underlying trend re-mains healthy, with the housing sec-tor in particular reporting steadybusiness. The retail consortium saidthat the value of sales for like forlike items remained healthier thanthe average increase of 4.1 percentin the first four months of this year,

and the 2.7 percent annual increasereported since last year. The con-sortium figures are collected from 75big retailers, representing about halfof all sales.

OUTPUT PRICES: The Officefor National Statistics said that out-put prices fell a seasonally adjusted0.1 percent in July the third con-secutive monthly fall. This took theannual rate to 2.2 percent.

Excluding the volatile elementsof food, drink, tobacco and petro-leum, the price level also fell 0.1percent. This was the first monthlydrop for core goods since 1967, andit pushed the annual price increasedown to 1.5 percent also the low-est rate for thirty years. The key fac-tors in the fall were sharp monthlydrops in the price of office equip-ment, base metals, wood productsand pulp, paper and publishing.

The price level of raw materi-als and fuels purchased by industryfell 0.8 percent in the year to July.Excluding volatile items, it fell 6.7percent in the year. This was thelargest fall since 1986. The fall partlyreflected the recent strength of ster-ling. However, the most significantfactor was a sharp drop in commod-ity prices, that has recently reversedthe sudden spiral in these prices lastyear. Goods purchased by the pulp

and waste products industry, forexample, were 40 percent cheaperin July than a year earlier. Mean-while while goods for the metal in-dustry were 12.1 percent cheaper,and chemical inputs were 7.2 per-cent lower.

HOUSE PRICES: Houseprices in July rose for the seventhmonth in succession according to

figures published by nationwide, theUKs second largest building soci-ety.

The figures confirm that thehousing market recovery, unlike inthe previous two years, has contin-ued into mid-summer. According to

Nationwide, prices on average roseby 0.7 percent last month toBP53,589 ($83,062). In previousyears, prices and sales have im-proved ahead of the spring, butfallen away as the summer ap-proached.

RETAIL SALES: Shops re-corded the biggest fall in retail salessince the beginning of the year. Thedrop, which followed a large in-crease in June, was bigger than theCity expected, but most economistsanticipate growth to resume, at asteady, if not spectacular, rate.

FACTORY SPENDING:Manufacturing investment fell backsharply in the second quarter of theyear, official figures showed. Out-side manufacturing, other areas ofbusiness stepped up their capitalexpenditure.

Measured overall, the Officefor national Statistics said that capi-tal expenditure by the manufactur-ing sector was a seasonally adjusted4 percent lower in the second quar-ter of the year than the first quarter.

Compared with the same pe-riod a year before, the spending levelwas 5 percent lower. The last timethat investment was this weak wasat the start of 1995.

Most of the quarterly fallstemmed from lower spending onbuildings and vehicles. Plant andmachinery investment, by contrast,rose slightly in the quarter. But thisquarterly rise in spending still left thelevel of investment in plant and ma-chinery 7.4 percent lower than thesame period a year ago.

CAR PRODUCTION: Car

production jumped by 19 percent inJuly compared with the same montha year ago. While the largest pro-portion of the increase was destinedfor export, a year-on-year rise of 8.7percent in output for the domesticmarket was hailed by the industryas further evidence of a recovery in

the UK new car market.

FACTORY ACTIVITY: Manu-facturing activity strengthened againin July for the second month in a rowas new orders rose to the highestlevel since March 1995, a surveyshowed. But the latest monthly re-port by the Chartered Institute ofPurchasing and Supply painted aless upbeat picture of the manufac-turing recovery than other recentsurveys.

It confirmed manufacturingwas now recovering after recessionearlier this year thanks to rising con-sumer demand by suggested therecovery may be gradual rather thanimmediate.

Companies laid off staff for thethird month in succession. Pricecompetition among supplierscaused the sharpest decline in in-

dustrial goods prices since the sur-vey began in 1991.

GOVERNMENT BORROW-ING: Hopes of UK tax cuts wereboosted after government borrowingfell back in July. The fall, triggeredby a surge in tax revenues, surprisedthe City of London. It is likely to fuelpolitical pressure on the chancellorof the exchequer to deliver big taxreductions in the November Budget.

But the Treasury admitted thatsome of the surge in revenues mayhave been due to a change in thetiming of tax collection. The Officefor national Statistics yesterday saidthe government spent BP1.7bn($2.63bn) less last month than itcollected in taxes. Last July spend-ing overshot tax revenues by

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BP804m. The improvement partlyreflected privatization proceeds.

NEW CAR SALES: Growingsigns that nearly 500,000 new carswith the latest P registration prefixwill be sold in August have raisedconfidence that the market could top

2m this year for the first time since1990. The optimistic forecasts areunderpinned by strong indications ofreturning confidence among privatebuyers. Their absence had contrib-uted significantly to the poor profit-ability of many car makers and de-clining margins among distributors.

INFLATION:A surge in houseprices pushed the rate of inflation upto 2.2 percent in July from 2.1 per-cent the previous month, the gov-ernment announced. But this wasoffset by some encouraging trendsin the retail sector. Although con-sumer spending has risen recently,retailers still show no sign of raisingtheir prices. The clothing and foot-wear sectors reported the sharpestfall in prices for any July sale for fortyyears.

GERMANY

INFLATION: Inflation edgedup again in Germany in July to anannual rate of 1.6 percent, with sea-sonal price rises for package holi-days and hotel accommodation in-fluencing the trend, the federal sta-tistics office said. The July figurecompares with 1.4 percent in June,the lowest since pan-German fig-ures were first compiled at the startof 1992. Economists said the slightupturn was expected. Julys con-sumer price index was 0.3 percenthigher than in June, which showeda 0.1 percent rise on the May level.In west Germany alone, consumerprices rose 1.3 percent in July overthe same month a year ago, against1.2 percent in June. The east Ger-man year-on-year increase was 3percent (2.6 percent in June), stem-ming mainly from higher rents andtourism charges.

INTEREST RATE CUT: TheBundesbank cut one of its key inter-est rates more sharply than ex-pected in an apparent bid to rein-force the German economic recov-ery and help support the shakyFrench franc.

The German central bank low-ered its securities repurchase (repo)rate, through which it influences themoney market, from 3.3 percent toa new low of 3 percent, citing slowergrowth in the money supply as themain reason for the move.

Mr. Hans Tietmeyer,Bundesbank president, said the re-duced July growth rate in the M3,

the broad monetary aggregate, an-nounced this week was decisive inthe rate decision. But low inflation,with no dangers to price stability onthe horizon, had also influenced themove.

DRUG SALES: Pharmaceu-ticals sales in German in the first halfof the year rose to DM12.6bn($8.5bn), 6.5 percent higher than ayear earlier, the VFA industry asso-ciation reported. Germany is

Europes biggest pharmaceuticalsmarket and third largest in the worldafter the US and Japan.

The growth rate is below thatfor Europe as a whole but excludessales through hospitals. Germanhealthcare reforms of 1993 gavegeneral practitioners budgets whichexcluded hospital drug sales.

INDUSTRIAL OUTPUT:Ger-man industrial output rose by a sur-prisingly strong 0.6 percent in June,according to the Federal StatisticsOffice. The increase was under-pinned by a strong performance bythe manufacturing sector. Althoughoverall the rise was higher than ex-pected, it was still lower than gainsin the previous three months.

Ifo, the economic institute,

forecast a rise in economic growthof 0.75 percent for this year, followedby 2 percent in 1997, underlining aconsensus that the economic recov-ery will be slow initially. The 0.6percent increase in June was madeup of a 0.4 percent rise in west Ger-many and a 1.8 percent gain in the

east.

MONETARY RESERVE:German monetary reserves roseDM400m ($270m) to DM119.6bn inthe week to August 7, theBundesbank said. Foreign liabilitiesin the week were down DM100m toDM16.5bn.

BUSINESS CONFIDENCE:Business confidence in west Ger-many increased more than expectedin July, according to the monthly in-dex of the Ifo economic researchinstitute. The Ifo business sentimentindex rose to 94.1 in July from 90.4in June, still leaving it lower than inNovember.

REGIONAL PRICES: Ger-man consumer prices have re-mained stable in August while thereappears to have been a slight ac-celeration in the year-on-year rate

of inflation according to early reportsfrom state statistical offices.

North Rhine/Westphalia andBaden-Wurttemberg reported nochange in consumer price indicescompared with July, while in Hesseprices fell 0.1 percent. However,annual inflation rates quickened to1.6 percent this month from 1.4 per-cent in July in North Rhine/Westphalia and to 1.2 percent from1.1 percent in Hesse and Baden-

Wurttemberg, reflecting falling pricesin August last year.

GROWTH/EMPLOYMENT:The German economics ministrysaid industrial orders had risen by aseasonally adjusted 1.1 percent dur-ing June, well above market expec-tations. The rise derived from do-mestic rather than foreign orders;eastern Germany showed stronger

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growth than western

Documents

1996 Issue # 9