A good year draws to a close

This is my last column for the year and as good a time as any to take a quick look backwards and then turn to the year(s) ahead. The year 2004 has been a year replete with expectations unmet?both for ill and good. Conventional wisdom had it that the US economy would bounce back in great strength and Japan too would strengthen greatly, building on nice output expansion towards the close of 2003. Europe, it was expected, would also emerge from its latest recessionary phase. The mess in Iraq was bad, but a year is a long time. Oil prices would ease as Iraqi crude output rose. There might be devastating terrorist strikes. The growth story in Asia was strong and commodity prices would remain firm, and there was some danger from a hard landing in China. Asset prices would gain as the economic recovery established traction.

It did not quite turn out like that. The US economy has indeed expanded by 3.9% in the first three quarters and is unlikely to be much short of 4% for the full year. That is pretty close to the 4.5% plus, which was the expectation at the beginning of 2004. The euro-zone will have less than 2% growth in 2004, which was more or less what was expected. However, Japan is likely to have seriously underperformed expectation. Iraq of course soldiers on and the course ahead looks long and tough. China has not had a hard landing, and India has done better than most people expected. Oil prices ruled much higher than anybody could ever have imagined, the unexpected nature of the event deriving almost wholly from the size of the increase in domestic oil consumption in China and India. Financial markets were choppy as the major currencies swirled around, commodity funds did better and the US dollar lost further ground.

On the face of it, there might not be much of a gap between expectations and the eventual outcome ? but for some problems in Japan and oil prices running higher than expected. But if we look back not just at 2004, but 2003 as well, we can spot the difference. Markets basically expected that the US economy would come back roaring, the Europeans would be more buoyant, Japan would shine with some health ? and all of the structural problems would give ground in the face of broad-based growth. The structural problems being mainly the US current account and government deficits on one side of the Atlantic and more hopefully the sluggishness of welfare-side adjustment in Europe on the other.

These problems have actually got worse. The US trade deficit continues to rise, as domestic economic growth is driven by an accumulation of household and public debt that is financing consumption growth. Corporate profits have stayed ahead of the race, as productivity gains continue to outstrip employment costs and new hiring remains weak. Business investments have grown pretty smartly, except in the third quarter of 2004, but obviously not on a scale or in a way to significantly impact new hiring. Sustaining the growth then involves adequate demand for US dollar assets which in recent times ?despite the insatiable appetite of Asian central banks?has weakened, leading to a sharp fall in the greenback vis-a-vis the euro. In theory, that ought to settle the issue of relative prices, force the US to compress demand and save more etc. But that of course is not about to happen in a hurry. For America?s trade deficit is mostly with China, Japan and the rest of Asia, and the currencies that matter there choose to walk with the dollar. The US government budget deficit continues to yawn and is unlikely to significantly change course. US interest rates will of course have to rise, and so it has and will continue to. That may not do much to pull the dollar up, since amongst major currencies, other than the euro, interest rates are way higher than it is likely to be for the dollar even at the end of 2005.

Most of the home balance sheets of funds are in US dollar. So the dollar?s weakness seriously overstates prospective gains made in US financial markets in 2004 ? S&P 500 up 10%, Dow by less. That might start changing as investors start getting more hardnosed in the face of sustained dollar weakness. Which will start making investments in distant places more alluring and start pushing dollars out of the US economy, of course, further exacerbating matters.

The world has changed in the past few years. And our place in it too has ? provided we are willing to reach out and accept the challenge, instead of sulking about the loss of yesterday?s certainties. Increasingly more and more of incremental global growth will come out of Asia ? China, India and the neighbourhood. Not just as exporters of cheap consumer goods to the developed world (that too will be there) but potentially huge markets which eventually will start making a big difference to global output. The impact of China and India?s incremental oil consumption on world petroleum prices in 2004 is a foretaste of the morrow.

Growth expands the fabric of our nation. By this it can accommodate many previous problems, but structural imbalances can also become acute and threaten to burst. We know how growth can?by creating more jobs?absorb social tension. By generating more taxes make balancing the book easier. Lack of infrastructure can play a disruptive role, as can unreformed public expenditure that just battens on revenue, instead of returning it to the people in the form of more public services and infrastructure: if we wrestle with these challenges successfully, we can assure our people of a legitimate share in the prospects of a world that is changing, and will change yet further.

The author is economic advisor to ICRA