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Economic Outlook 2005

Moderate growth & major challenges


January 27, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

Puerto Rico’s performance in a global economy

Outlook for 2005 promises moderate growth and plenty of challenges

The first 100 days of the administration of Aníbal Acevedo Vilá will likely be the most critical of his four-year term, as budget deficits, tax reform, massive government bureaucracy, the higher salaries demanded by police officers and other public employees, an estimated $8.1 billion unfunded pension liability, and a negative outlook for government bonds and the Government Development Bank demand immediate attention.

What will happen with the redevelopment of Roosevelt Roads; the plans for the train all around Puerto Rico; and the island’s infrastructure (energy, water, solid, waste management), must also be addressed in 2005.

Add to these the increase in the cost of petroleum, cuts in federal spending predicted to impact Puerto Rico, a bipartisan government, the end of economic tax incentives for the island, high unemployment, thousands without health insurance, high poverty levels and increased competition from emerging economies, and the outlook for 2005 is, at best, cautiously optimistic.

Puerto Rico’s government structure as well as its economic model, designed over half a century ago, has been showing clear signs of obsolescence for decades now. To meet these challenges, government officials must think creatively, act boldly, and move quickly to address them.

Although Puerto Rico’s economy is expected to grow moderately, the projected real growth remains between 2.2% and 2.5%, less than the expected expansion in the U.S. mainland, which is estimated to be about 3.5%.

Economist and tax expert Ramón Cao and Luis Benítez, president of the Puerto Rico Association of Economists, concur in predicting modest growth for the island in 2005. Cao predicts the local economy will grow in the range of 2.2% to 2.5%. Benítez believes oil prices and, more importantly, the political transition may slow growth to 2.4% for the fiscal year ending on June 30, 2005.

Economist Benítez also points out the political uncertainty surrounding Puerto Rico’s bipartisan government may generate a limit on growth for the time being, further emphasizing that a lot depends on the government’s performance during its first 100 days in office.

As we go into 2005, the Standard & Poor’s (S&P) outlook on Puerto Rico’s General Obligation bonds (GOs) and the Government Development Bank (GDB) has been downgraded from stable to negative. As a result, tax reform is inevitable this year, according to Cao, because the government has informed the credit-rating agencies it will be in place by 2006. The rating agencies also are calling for the government to address the estimated $8.1 billion unfunded pension liability in 2005.

Benítez also expressed his concerns regarding the current public deficit and government spending in Puerto Rico, which is growing faster than the gross product, adding that tax reform is needed. The Acevedo Vilá administration took office with $38.8 billion public debt and at least a $1 billion budget deficit that was left by the Sila Calderón administration.

Although most of the economists interviewed agree Puerto Rico must take steps to implement a complete tax reform, they doubt there will be the political willingness to eliminate obsolete agencies, reinvent others and, in general, reduce the size of the Commonwealth government. Gov. Acevedo Vilá publicly has stated that he will reduce the budget without reducing the number of government employees, which is now approximately 320,000, 42,700 more than when the Calderón administration took office. Currently, one out of three salaried employees in Puerto Rico works for the government.

According to economist José Joaquín Villamil of Estudios Técnicos, there are, for example, anywhere from $1.5 billion to $2.0 billion in subsidies embedded in the budget. "As far as I know, there have been no analyses made on the need for such subsidies and, when needed, whether the manner in which the subsidies are structured is effective," said Villamil. Short-term relief in the fiscal situation must not be a substitute for the major restructuring in government that is urgently needed.

However, economist Benítez is concerned not only about the commonwealth’s deficits, but about federal deficits as well. "Puerto Rico’s federal aid isn’t expected to increase this year as a consequence of the federal government’s budget constraints and, more worrisome yet, it may even be reduced," said the president of the Puerto Rico Association of Economists. The U.S. Office of Management & Budget reported a reduction in federal grants to the Commonwealth government for fiscal year 2004 to FY 2005.

President Bush’s economic agenda also could bring radical changes for Puerto Rico, although they may not all have a negative impact on the island. Among the president’s major economic issues are: making permanent the dividend and capital-gains tax cuts pushed through the states during the president’s first term and set to expire in 2008 and 2010, estimated to cost $1.9 trillion over a decade; overhaul of the federal tax code; the reform of Social Security, allowing younger workers to set up individual investment accounts to finance their retirement (the transition is projected to cost $2 trillion); Bush’s goal to reduce the federal deficit in five years by almost 50%; the expansion of the No Child Left Behind Act; and Medicare reform.

Resident Commissioner Luis Fortuño, will have his work cut out for him in Congress during 2005 trying to extend the applicability of Section 30A to Puerto Rico, and seeking inclusion of the island in the Enterprise Zone Act when it is presented again during the 109th Congress. Fortuño will also be challenged to improve relations between Washington and Puerto Rico and help bring greater funds to the island.

Economist and university Prof. Elías Gutíerrez states the biggest challenge Puerto Rico will face this year will be the end of federal tax incentives for manufacturers with both Section 936 and 30A scheduled to expire in December.

Need to control public sector

Recognizing the serious fiscal condition of the Commonwealth government as 2005 gets underway and the warnings from the rating agencies arising from that situation, some measures undoubtedly will be approved that will generate more resources. Nevertheless, what is really needed is a major transformation of the government itself and its role in Puerto Rico’s society.

The trend toward a continuously bigger government must not continue in 2005 and efforts must be redirected toward job creation in the private sector. For example, during the Calderón administration, according to the Establishment survey conducted by the Puerto Rico Department of Labor, the private sector lost 51,000 salaried (nonagricultural) jobs while the government’s payroll increased by over 42,000 between December 2000 and December 2004. The growth in Puerto Rico’s government employment must be addressed during 2005, as well as the island’s structurally high unemployment rate of over 10%.

Regarding the challenges ahead, Villamil asserts Puerto Rico’s recent history is one of lost opportunities because we either lacked the will and capability to execute (the Technology Corridor and the Transshipment Port) or we lacked the imagination and courage to be innovators (the last two tax reforms). "We should make certain we don’t lose out once gain," he stresses.

Outlook for the global economy

Continued growth is projected for the global economy although the price of fuel may dampen it somewhat. In 2004, the global economy grew substantially and, as a result, the world probably has turned in its strongest growth performance in almost three decades. Puerto Rico didn’t join the party as the island seems to have grown complacent with its limited economic performance and state affairs of the last few decades.

According to the International Monetary Fund (IMF), world output is likely to have grown about 5% in 2004, well in excess of the 4% historical trend rate and the fastest pace of global expansion since the mid-1970s. Global growth has been powered by the economic recovery on the U.S. mainland, some increase in the Japanese economy, extremely rapid growth in China, and a solid contribution from India.

The global economy is at an interesting crossroads as 2005 unfolds. The dynamism of China as a world-class manufacturer and the successes of India’s Information Technology service sector have created seismic shifts in the global economic landscape.

In 2005, the U.S. is projected to continue being the dominant growth engine in the global economy as it still accounts for close to 30% of the world’s economy. Nonetheless, several factors are likely to lead to some moderation in the pace of global activity in the coming year. These include continued withdrawal of fiscal and especially monetary stimulus, particularly in the mainland U.S.; a slowdown in China in response to a series of moves to tighten economic policies; and the dampening effect of higher commodity prices, especially oil prices, on global demand.

A reasonable baseline forecast for next year is for a moderate decline in the pace of world economic growth. As a result, growth in global Gross Domestic Product during 2005 is likely to move back down to 4.5%, somewhat closer to trend, according to IMF estimates.

According to projections prepared by Dr. Jorge Sicilia, chief economist for Mexico and the U.S. for BBVA Group, 2005 will be the third-consecutive year the world economy will grow above 3.4%, the average established since 1980.

China and the U.S. will dominate the global economic platform again, even though both share vulnerability factors such as oil prices and inflation. The Council on Foreign Relations believes as the new year unfolds, there will be some tendency for growth to taper off in these countries because in both countries central banks are in the process of gradually removing a high degree of monetary accommodation that helped to fuel rapid growth. Instead, rising interest rates in the U.S. and more restrictive credit rules in China will have a moderately constraining effect.

An end-of-the-year survey conducted by The Economist among a selected group of forecasters, which calculates the average of their predictions for economic growth, indicates the euro area will grow by 1.7% this year. It also predicts Japan will grow by 1.9% and the mainland U.S. by 3.5%.

On the mainland U.S., the Council of Economic Advisers to President Bush forecasts the economy will continue to grow in 2005, with inflation and unemployment expected to decline. Growth is projected to slow to 3.5 % in 2005, down less than 0.5% from 2004. Inflation is expected to remain low, dropping to 2% as oil prices decline. Forecasts indicate unemployment will average 5.3%, down from 5.5% in 2004. An average of 175,000 jobs are expected to be added each month and the Bush administration also is pledging it will cut the budget deficit and exercise fiscal discipline.

A Wall Street Journal survey of 56 economists suggests the U.S. economy will grow at a healthy pace while generating only subdued inflation, but many also worry about the low household-saving rate and increasing budget and trade deficits.

The growth rate on the U. S. mainland, even at 3.5%, is outpacing the economic growth of many other developed economies and Puerto Rico. Even the best assessments in Europe predict about 2% growth. The economic forecast prepared by the Council of Economic Advisers, the U.S. Treasury, and the Office of Management & Budget, is used by the government to generate revenue and spending figures as part of the budget process.

On the mainland U.S., corporate savings have moved to near-record levels, a situation likely to prove unsustainable throughout 2005; companies likely will decide in the year ahead to step up capital spending or distribute more cash to shareholders through dividends, buybacks, and mergers & acquisitions activity. The U.S. also may benefit from a one-time dividend-received deduction on repatriated earnings of foreign subsidiaries that should help spur investment and job growth within the U.S. mainland. The deduction results in an effective 5.25% tax rate on the earnings returned to and invested in the U.S.

The land of the euro

The euro economy is growing much more slowly than the U.S. economy, and short- and long-term interest rates on the mainland U.S. are higher than euro interest rates. If the euro continues to appreciate much further in 2005 it would likely abort the economic recovery in the euro nations by hitting both export growth and the blossoming revival of capital spending.

It shouldn’t come as a surprise if there is a monetary intervention in 2005 by the European Central Bank (ECB). The euro area’s GDP growth rate is expected to remain around 1% during the first half of the year before accelerating to 2.5% in the second six months. This will depend, however, on whether tensions in oil markets ease sufficiently and if the euro loses some ground on a trade-weighed basis.

Weak Eurozone demand and homegrown lack of fiscal discipline continue to hamper the progress of new central European members toward the euro. Growth is expected to slow across the region in 2005.

The Asian powerhouse

Asia’s economic borders are blurring, uniting the financial and technological power of Japan and the ex-tigers with China’s low costs and work force, resulting in an informal "Asian Union." For the first time, China’s work force and low costs are united with the money and technology of Japan, Korea, Taiwan, Hong Kong, and Singapore.

China’s emergence as the U.S.’ most visible source of goods thus reflects a structural change in the Asian economy more than it reflects new Chinese trade or labor policies. This development offers economic and security opportunities, carries with it potential sources of risk and financial instability, and also means a powerful new competitive challenge.

The emergence of China in the late-1990s as a viable production entity will continue to reshuffle the production patterns in 2005, not only within Asia but also around the globe. China accounts for at least one-third of the increase in global oil demand, according to Morgan Stanley’s Asian economist Andy Xie.

China’s GDP is projected to grow around 8% in 2005, which represents an appreciable drop from the estimated 9.3% in 2004 but is nonetheless still substantial growth. However, it isn’t expected this slower pace of growth will significantly dampen China’s appetite for commodities.

Modest growth in the Organization of Economic Cooperation & Development (OECD) economies and a soft landing in China should translate into slower but still buoyant growth in developing countries.

Latin America and the Caribbean

The return to growth in Latin America and the Caribbean (LA&C) is projected to continue, with only Argentina experiencing a significant slowdown as the competitive advantage from its depreciation in 2002 wears off. Elsewhere growth should remain strong with Brazil expanding steadily between 3.7% and 3.9%. In LA&C country-specific conditions and the degree to which fiscal consolidation programs are maintained will play an important role. Some Latin American countries that are rich in resources should continue to benefit during the year from China’s appetite for commodities although at a slower growth rate.

In Latin America, regional growth should be moderate, with GDP growth slowing to 3.7% by 2006. The OECD predicts Mexico will see strong recovery in 2005, fueled by an upswing in the mainland U.S. manufacturing sector and high oil prices for the oil-producing country.

Major challenges for Puerto Rico

In 2005, Puerto Rico will have to come up with a game plan for economic improvement and expansion or it will continue to grow more slowly than the mainland U.S. and other developed economies. The island’s mounting structural challenges not only threaten the sustainability of Puerto Rico’s economic expansion, they also pose substantial risks as the economic gap, even with the poorest state of the nation, continues to widen. Puerto Rico’s government officials must take these challenges seriously.

Economic leaders agree the time has come for a complete economic reform, not just a fiscal reform, and to focus on developing efficient public institutions and entities that would strengthen the links between economic growth and social progress. There is, of course, no quick and painless fix to all that ails Puerto Rico, but the sooner we begin to work on these the better. Political leaders have waited too long to tackle these problems. The "blame game"–the inclination of politicians and bureaucrats to blame others for the problems they have themselves created–must end.

Policy decisions must address the root causes of economic and political problems. If decisions address only symptoms, then any economic improvement will be short-lived. As complex and challenging as the task is, Puerto Rico can’t postpone it any longer, as it is an urgent imperative. The future of Puerto Rico is just too important to be left to the self-serving interests of politicians and bureaucrats. It is the wake-up call that can’t be ignored.

In the years ahead, Puerto Rico will live through the highs and lows of the business cycle but, on a structural basis, above-average growth won’t return to the island’s economy unless major decisions are made. Estudios Técnicos projects economic growth for Puerto Rico will remain around 3% into 2008.

In 2005, over 100,000 public employees will renegotiate their collective bargaining agreement contracts with the Commonwealth’s agencies. Most will demand salary and benefits the government is in no condition to provide and some may even threaten to strike. Militant labor strikes, however, not only hurt Puerto Rico’s image but also significantly increase production costs, as walkouts often end in agreement to increase wages and bonus payments. As all political parties argued against privatization, Puerto Rico will continue to see more of the same; the government controlling everything and most of what they control being managed inefficiently.

To avoid being called pessimistic, we wouldn’t join Standard & Poor’s and Moody’s in describing Puerto Rico’s outlook as negative, but it is definitely cloudy. Despite this, there are plenty of opportunities for the island. The financial sector will continue to be a bright spot in Puerto Rico’s economy, although it is expected the Federal Reserve will continue to increase interest rates slightly throughout the year.

The tourism sector also holds great promise, as do the retail and commerce sectors. Auto sales, on the other hand, are expected to slow a bit from the record 2004 but still will be higher than in 2003. On the other hand, the manufacturing sector has a more "wait and see" outlook as increasing fuel prices may continue to impact the cost of operating in Puerto Rico. A closer look at Puerto Rico’s industries and its economic projections for 2005 has been included throughout this issue of CARIBBEAN BUSINESS.

CARIBBEAN BUSINESS consultant Carlos Márquez contributed to this article.

Why the U.S. economy looks good

Historically, the fifth year of each decade has been a good year for the U.S. economy. This has been happening since 1915. In fact, over the past 120 years, no year ending in five has been a bad year. The fifth year always has been the best year of the decade, even during the Great Depression of the 1930s.

Will this be the case in 2005? It probably will be.

One big reason for optimism about the U.S. economy is that there is an enormous amount of liquidity in the U.S. and worldwide economies.

Corporations, not counting financial institutions, have a record $1.27 trillion in liquid assets right now, up from $169 billion a year ago.

Some of this is foreign earnings of U.S. corporations that have stayed abroad mostly to avoid paying U.S. taxes. However, last year, Congress passed legislation that lowered the tax rate on repatriated earnings to only 5.25% instead of the 35% levied up to December 2004. It’s only a one-year window, allowing repatriation in 2005. These undistributed foreign earnings can then be spent in the U.S. to buy equipment, pay dividends, acquire more companies, pay down debt, or in many other ways that will undoubtedly help the U.S. economy.

Another very favorable happening is the very quiet push of lowering the value of the dollar lower and lower by the Bush administration. This is helping manufacturers improve their export sales overseas as U.S. goods become cheaper and cheaper against stronger foreign currency countries and their cost of goods.

China, India, and Japan’s recent economic accelerated growth has created more consumers for U.S. goods. Even though China is starting to have internal problems because of inflationary pressures and overbuilding, it will continue to grow as a consumer powerhouse.

The U.S. economy has created 2.2 million new jobs during the past 14 months. As it continues to grow as an exporter, due to the Bush administration’s unofficial policy of a cheaper dollar, more jobs will be created this year. It’s expected at least two million more jobs will be created in 2005 and two million jobs will continue to be created in the next few years. The cheaper dollar, besides helping the manufacturing industry, is helping the U.S. tourism industry by keeping more people under the U.S. flag where the dollar buys more.

Technology will continue to increase productivity and push living standards for most U.S. residents to new highs.

The lowest taxes since 1960, which President Bush is pushing to make permanent, the lowest interest rates in 50 years, and the lowest inflation since 1960 have contributed to the improvement of the U.S. mainland’s economy.

Of course, there’s always the uncertainty of terrorism and global conflicts but, barring any major happenings, the outlook looks good for continued growth of the U.S. economy through 2005 and a few more years beyond.

This Caribbean Business article appears courtesy of Casiano Communications.
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