Economy will beat forecast with 1.8% growth: UK is predicted to become net debtor next year and to run up pounds 80bn debts by 1997

THE ECONOMY will grow by 1.8 per cent this year, outperforming the Government's Budget forecast of 1.25 per cent growth, according to the computer model of the economy that Treasury officials use to advise the Chancellor, Kenneth Clarke.

But the pace of recovery will be flattered by North Sea oil output, according to the Ernst & Young Item Club, a group of independent economists using the Treasury model. Non-oil output is expected to rise only 0.3 per cent between the second and fourth quarters of the year.

At the same time a series of large deficits on the current account of the balance of payments will transform the UK's net overseas assets, worth pounds 110bn in 1986, into net debts by next year. The current account deficit is forecast to expand to pounds 17bn this year and to pounds 25bn by 1997, by which time the UK will have run up net debts of more than pounds 80bn, equivalent to over 10 per cent of gross domestic product.

Britain would have ended 1992 with a net debt had the devaluation of the pound not increased the sterling value of the country's overseas assets by pounds 40bn- pounds 50bn.

Brian Pearce, Item's chief economist, said the balance of payments deficit was the counterpart of the Government's borrowing, creating a 'twin deficits' problem.

'This leaves the UK vulnerable to a gilt buyers' strike, leading to higher long-term interest rates, or a loss of confidence (by) overseas investors, leading to a sterling crisis, both of which could endanger the recovery.'

Tackling the problem of the twin deficits will slow medium-term growth to just over 2 per cent a year. But short-term prospects are brighter as the economy benefits from the post-ERM devaluation and low interest rates by historical standards.

'Recent poor economic data are evidence of an erratic, rather than a faltering, recovery path for the economy,' according to Item.

Growth is expected to accelerate to 2.8 per cent in 1994 and 1995, before slowing to 2.4 per cent in 1996 and 2.3 per cent in 1997 as policy is tightened. Item also forecast that underlying inflation - excluding mortgage interest - will not exceed its 4 per cent target ceiling until the spring of 1995.

Unemployment is now on a gradual downward path, Item believes. The jobless total is expected to be little changed at 2.94 million at the end of the year, falling only another 150,000 during 1994. The total is expected still to be around 2.25 million at the end of 1997.

Item argues that the Chancellor is likely to raise an extra pounds 3bn in taxes in November's Budget to help reduce government borrowing and divert resources from consumer spending to exports. In order to prevent the tax increases from derailing recovery, interest rates are forecast to be lowered by a further half-point to 5.5 per cent.

Item's conclusions are broadly backed up in a paper by Roger Bootle, chief economist of Midland Global Markets. He argues that a further tightening in fiscal policy of 1 per cent of national output - equivalent to further tax increases of pounds 7bn - may be needed to get the public sector borrowing requirement firmly under control, although rapid growth is also essential to revive tax revenues.

'To facilitate this result base rates will at least need to be cut to 5 per cent, and if a really substantial fiscal tightening is undertaken and/or private-sector demand falters, rates may need to be cut to 3 per cent.'

Business activity in the financial services sector has risen in the past three months, led by insurance brokers, securities traders and fund managers, and volumes are expected to grow even more strongly in the next quarter, according to a CBI survey published today.

The only sectors that suffered a fall in business volumes were life insurers and venture capitalists. Business levels are mostly below normal for building societies and banks, and mostly above normal for fund managers and securities traders.