<B>Key factors to the economy and the outlook for 2005</B>

Juan Carlos Martínez Lázaro. Professor Economic Environment. Instituto de Empresa

29 March 2005

Last year was a good one for the economy, marred only by the rise in oil prices. Predictions for 2005, thanks to contributions from the emerging economies, look rosy, too. Effects of higher oil prices seem to have been absorbed.

Uncertainties remain however, including evolution of the dollar, and consequently, behavior of the North American economy. Experts plot growth in the United States at around 3.5 percent (higher than the European Union and Japan). Despite creation of over two million jobs in 2004, giant twin deficits (public and current account) are generating huge debts and keeping the dollar below minimum levels. Nothing seems to indicate these deficits will be put right in the near future.

This is because the crisis in Iraq shows no short-term solution, which means it will continue to draw on public finance; also since the new Republican administration will probably not raise taxes. The current account deficit has done nothing but grow, despite the calculated weakness of the dollar compared to the euro and Asian currencies. This involves a risk of inflation and could force the Federal Reserve to tighten its monetary policy more than anticipated. This has led it to increase interest rates five times since last summer, taking them to 2.25 percent, a quarter-point higher than rates in the Euro zone. Rates will likely jump a further 25 basic points early this year, to hit three percent by summer.
Europe, including Spain

Europe faces a key year. After integration of 10 new member states last May, the political element will focus on ratifying the Constitution. On the economic side, the European presidency, held by Luxembourg for the first half of 2005, must solve two tough questions: defining the budgetary framework for the period 2007-2013 – which involves serious reduction of funds received by Spain; and reforming the Pact on Stability and Growth.
While larger countries such as Germany, France and Italy seek modification or a rereading of the Pact, the Commission and other members seem to lean toward a more flexible application without loss of its essence. This means keeping the allowed limit of a three-percent deficit. The European economy is not expected to emerge from the period of lethargy in which it has wallowed since 2000. Growth figures for the EU are disappointing (just over two percent).

Which direction will monetary policy take? Voices are calling for the Central European Bank to reduce interest rates - once oil prices return to reasonable levels - to boost growth and weaken the euro. Although a strong euro reduces the foreign sector’s competitive capacity, it shields against oil-price increases, avoiding inflationary tendencies. However, Europe’s monetary authority has already issued warnings that it will stick to its policy, which means no change until at least after the summer.

Meanwhile, Spain’s situation has its ups and downs. Our economic leaders may admit that the price of oil and lack of our partners’ recovery means 2005 budgetary forecasts will not be met. If so, the economy could grow by 2.6 percent. This is not bad news, especially if we compare it with other economies in the Union.

Though we have yet to see how public finance fared in 2004, last year’s fall in unemployment was a welcome surprise. Three possible problems could surface, however: a burst in the property bubble, the persistent differential of inflation with our European partners and the enormous commercial deficit. They cannot be justified solely by the dynamism of Spain’s economy. They are both cause and consequence of the loss in competitiveness that has appeared in recent years.

Asia, again

Led by China and India, Asia will once again be the planet’s most dynamic region, despite the recent tsunami catastrophe.

Two closely-watched issues will be whether Japan leaves behind its deflationary period and consolidates a recovery, and the behavior of China’s economy. China’s growth should be more moderate this year, around seven percent, after slightly restrictive measures were enforced in 2004. Still, it will boost other Asian economies, and its high demand will help maintain steep prices of raw materials, including oil.

After more than five percent growth in 2004, this year could see Latin America’s recovery. The healthy progress of the world economy, increase in the price of raw materials and return of foreign investment have brought stable macroeconomic figures to most nations, together with improvement to fiscal and commercial balances. Consequently, the rise in U.S. interest rates is being observed with concern, since it could lead to reduction of the savings stock that flows into the region, as well as increase the cost of foreign debt.

Finally, Africa. Although the IMF expects that, as a whole, it will grow by over five percent - thanks to increases in the price of oil and other raw materials - political instability, corruption, endless regional conflicts and AIDS will once again keep the continent a permanent guest at the world economy’s table.

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