Here comes the downturn

The outlook for '98: as the fallout from Asia reaches Britain, 'deflation' will be the word on everyone's lips

It won't be a happy or prosperous New Year for the world's big economies and financial markets. 1998 threatens to be one of the most deflationary years since the 1930s as the fall-out from the ongoing financial turmoil in Asia contaminates the rest of the world. It means prices, interest rates, wages and employment will all fall and the danger of a world recession can not be dismissed.

Financial markets in Asia and the US rallied on Friday on the news the International Monetary Fund and the G7 group of industrialised countries were to rush through $10bn (pounds 5.9bn) emergency aid to South Korea. The rally, already exaggerated because of the thin volume of shares traded, will be short-lived. The evidence shows the worst is far from over.

"The downturn in Western economies could be greater than what most people are forecasting," said George Magnus, chief economist at UBS. Even if the Far East Asian economies manage to keep their heads above a fully- blown recession there is a high risk of a devaluation of the Chinese currency in 1998. That would give a second severe shock to the region," Mr Magnus warned.

Mr Magnus's concerns echo those of the International Monetary Fund, which last week cut its forecast for world growth in 1998 by a staggering 20 per cent, to 3.5 per cent, from 4.3 per cent. The IMF warned that if the downturn in the Japanese economy continues, it may have to slash its estimates for world growth even further. The IMF predicts the Japanese economy will grow by just 1.1 per cent next year, compared to a previous IMF forecast of 2.1 per cent. The performance of the Japanese stock market on Friday, where shares fell 3.25 per cent despite the rally elsewhere in the region, highlights investor concern that the country is not out of the woods.

The New Year will begin with an unprecedented wave of corporate and bank bankruptcies in the Far East, especially South Korea and Japan. The withdrawal of Asian money invested in factories abroad - and the ensuing loss of jobs, such as Samsung Electronics' delay of a $450m factory on Teesside - will be just the start of the chill that seems set to blow from Asia to the West.

Exports to the region from Europe and the US will fall sharply, hitting corporate profits here. The collapse of South Korean and Japanese companies will make banks in the West anxious about their positions there and credit lines to the region's corporations could be pulled. UK banks are owed around $6bn from Korean creditors alone, just a fraction of the debt to American, Japanese and other European banks. In a bid to halt the rot, the Bank of England asked British commercial banks on 24 December to extend the length of their loans to ease South Korea's financial crisis.

"Although we can make reasonable judgments about how trade and gross domestic product will be affected we can't measure the effects of the financial gridlock most of Asia is going through," said Mr Magnus. But the trends are clear; and they are depressing.

Decelerating growth in the UK had already been forecast, with the IMF forecasting this year's current rate of economic expansion of 3.5 per cent to fall to 2.4 per cent. A straw poll of City economists by the Independent on Sunday suggests the rate of growth could be much lower, probably around 1.5 per cent. A handful of the most bearish banks actually suggest a technical recession - when the economy actually shrinks for two consecutive quarters - in the second half of the year. Windfall spending will dry up; higher interest rates will take their toll, and the strong pound will have stifled export growth. Retail sales over the Christmas period already reflect a sharp fall in consumer confidence.

All these factors will accelerate the decline in economic growth. Despite the current tightness of the UK labour market this will inevitably lead to a rise in the number of people looking for jobs.

The majority of City analysts polled expect a small quarter of a per cent rise in the base lending rate in the first quarter, after which the cost of borrowing in the UK will come down again by the end of next year or the beginning of next. However, events in Asia could put pressure on Western central banks, including the Bank of England, to sharply lower interest rates in a desperate bid to absorb the shock from the Far East and reverse the decline in growth. That may force sterling downwards on the international markets although foreign investors could buy UK bonds, seen as a safe haven in an unstable global economy.

As world growth shrinks, European governments will find it hard to stay on course with the budget-deficit cutting measures required by the Maastricht treaty for European monetary union. EU leaders are due to decide which countries have reached the convergence criteria to join the single currency in May 1998. If it becomes apparent that the course to monetary union will be less smooth than currently expected, European financial markets could also be in for a shock. You have been warned.