Compass Points

Economic Commentary

Economic Commentary

by Robert W. Bradford

The big story in the economy this fall is, of course, the Asian debt crisis. We call it the debt crisis because, absent the questionable lending practices in several Asian countries, there would likely have been no crisis. The sequence of events leading up to the precipitous devaluation of many Asian currencies started with the devaluation of the Chinese Yuan in late summer. This devaluation was intended to bolster Chinese exports, but coincidentally reduced the value of Yuan-denominated debts to foreign corporations. This started a domino effect, as lenders called in shaky loans to limit exposure to even more shaky Chinese entanglements of their borrowers. The critical problem with Asian currencies had its start with these loans, rather than with currency speculators (which is what some government officials in Asia would have us think). Many of the loans were dollar, rather than local currency denominated, so the borrowers had to trade large amounts of local currencies for dollars to satisfy their obligations. This selloff of local currency was so widespread that it caused local currencies to plummet. The effect of this was exacerbated by two factors: first, the economies affected were highly export-dependent, and second, the government oversight of lending is much less stringent in those countries than it is in the U.S. One silver lining to the clouds brought on by the Asian crisis is that there is now significant impetus to reform those problems in the democracies most dramatically affected. Of course, the less democratic countries involved may end up with entirely different pressures towards reform.

The big question for us, of course, is how does this affect our planning for the next few years? Economists as a whole are varied in their perspectives on this question (for a good overview of differing views on Japan’s economy, see the Wall Street Journal, December 31, 1997 page A7), though few see a great 1998 for the U.S. economy, and fewer still see 1998 as an impending disaster. There are four main areas where Asia’s economic woes can affect the currently cheery picture in the U.S.

First, Asian markets for U.S. exports are likely to shrink significantly. As Asia has been a rapidly growing market for some U.S. companies, there is likely to be a slight impact from this effect. Exports to the entire world make up about 11% of GDP currently, with Asia accounting for less than 20% of that, so a complete elimination of Asian exports (which is very unlikely) would drag down GDP by about 2%. If you export much to Asia, you should already be figuring out how to replace or stomach the loss of that business.

The second strategic impact is likely to be increased price competition from desperate Asian companies. In this scenario, Asian muddling-through will likely cause worse damage than a total collapse because it will leave more desperate survivors. The effect of this problem could be more widespread, however, as even U.S. companies that do not export products or services might be affected. Strategically, it is important to remember that Asian industrial capacity is finite and unlikely to sustain its current growth rates (would YOU finance a plant in Asia right now?). This means that price pressure from Asia has a limit. Currently, imports from the whole world to the U.S. make up a little over 12% of GDP. Asia accounts for about one third of this total, or 4%. It is in this area that trade pressure is likely to cause the greatest harm, but the harm could be greatly exacerbated by overreaction. If U.S. companies react rationally to this threat, it could dampen their profits significantly, but it should not kill companies in otherwise healthy positions. If the prospect of Asian price-cutting is a major threat in your markets, you should already be preparing to deal with it.

“If you export much to Asia, you should already be figuring out how to replace or stomach the loss of that business.”

The third strategic impact would be that of capital flight from the U.S. as Asian investors pull dollars from North America to bolster their domestic economies. There is strong consensus among both economists and bankers that this is an extremely remote possibility, as most such investors are currently very glad to have offshore assets. Indeed, many have pointed out that quite the opposite is true - that Asian investors may be seeking to invest more in the U.S., much as many American investors rushed to invest in Asia in the 1980’s. If you have significant chunks of capital provided by Asian investors, be aware that they will expect good returns on that investment in the coming year. You may also want to assess the likelihood that those investors will pull out, leaving you desperate to find other sources of financing.

Graph 1

The final strategic impact would be the collapse of U.S. financial institutions that have heavy exposure to Asian debt. It is clear that there will likely be some write-offs in the Asian portfolios of many investment firms. It currently appears that the level of those write-offs will be limited, and that there are no major players on the U.S. scene that will incur unsustainable losses. To gauge the market’s assessment of this risk, take a look at major bank stocks. The coordination of the international banking community and the IMF in staving off default in Korea demonstrates that there is some ability to contain the crisis financially. There is still a question as to whether such heroics might work in the case of Japan’s much larger economy, or whether the IMF will bother with smaller cases like that of Indonesia. Still, since the Latin American debt crisis of the 70’s and 80’s, U.S. banks have been very circumspect overexposure to foreign borrowers. Some of this caution has been voluntary, but some has been enforced by exactly the kind of strict banking regulation that many of the badly suffering Asian countries lack. As a result, most bankers consider the U.S. banking system to have already withstood the greatest strain that Asia will place on it for the coming year. This is a threat that most of us can do little to change. If it happens, a good contingency plan for a major economic downturn will be a valuable tool. Fortunately, it is also the least likely of these four threats.

It is impossible to accurately predict the impact of the Asian crisis on the U.S. economy, but we can assess the individual threats outlined above and take appropriate precautions. In addition, there are some significant opportunities out there. The market value of some major Asian players in many industries has plummeted (Samsung, for example, lost over $4 billion in market value) while the U.S. stock market remains buoyant. If you are optimistic about the economy, look to Asia for some real bargains in the way of plants and entire companies that may come up for sale in the next few months. Also, if you can incorporate Asian intermediate products or services in your operations, you may find your costs in those areas declining significantly in the coming year.

Now, let’s take a look at the domestic picture as of the end of October. Disposable income rose significantly more quickly than consumption in the third quarter, which is good. One would expect the savings rate to increase in the same period, but it did not. This would be puzzling - and disappointing - if we did not know that there is a third thing you can do with money besides consumption and savings: debt reduction, which is good.

Orders for plant and equipment show a strong increase, but the increase was lower than the previous quarter. This may be good news for the economy as a whole, since overbuilding can lead to recession. Still, industrial equipment manufacturers and those in construction should watch closely for a further decrease in growth. The ratio of inventories to sales is still very low, but it is up for the quarter. This number has declined fairly steadily since 1991 (see chart), so a series of increases would be a bad signal. We need to watch this number closely in the coming months. The dollar exchange rates showed a slight decline, but still a major improvement for the year. The fourth quarter is likely to show an increase, as Asian currencies such as the Yuan, Won and the Yen have declined significantly against the dollar. Employment growth is slow, and getting slower. This is probably limited by the number of workers entering the workforce, and may be a limiting factor to GDP growth in the coming years. Unemployment is low and continues to drop. One wonders how low it could get - probably not much lower. Manufacturing hours, at 42.0, are quite strong, but off from the post WWII high of 42.2 set in 1995. Still, this number is pretty close to wartime levels. Private Housing starts showed a nice increase, reversing a decline in the previous quarter.

Graph 2

U.S. Productivity continues to set record highs. U.S. productivity growth is extremely strong both historically and compared to the rest of the world, as both Europe and Japan posted declines in the last quarter. Japan seemed to be getting into a nice recovery in the second quarter, but could not sustain it. Recent currency turmoil in Asia brought on by dangerous debt abuse will likely cause further deterioration in Q4. Manufacturing capacity utilization is very strong. While we are not seeing the peaks that we have in the past (see chart), neither are we seeing the valleys. One can spot most recessions by looking at the down cycles in capacity utilization, but that would leave us thinking that 1996-1997 was a recession! Fortunately, we are not currently seeing big decreases in capacity utilization, despite heavy spending on manufacturing capacity. This may change as Asian manufacturers gain the edge of a favorable exchange rate.

The money supply showed a pretty strong increase, but this was well warranted. Hopefully, it will give the U.S. economy the lift it needs to weather the effects of the Asian debt crisis. Mortgage and business interest rates did a flip-flop. This indicates that the market views long-term risks to be lighter than the short-term ones. The treasury yield curve backs up this assessment.

Crude Materials Prices posted strong growth this quarter, though only slightly higher than a year ago. Watch the impact this may have on producer prices in the coming quarters, as this is where we will get our first warnings of renewed inflation. Producer prices picked up a bit, though producer prices are still down for the year. Consumer prices also moved up, although they are still within a reasonable range. Overall, inflation appears to be in check, but we need to be wary about the strong labor market.

Finally, the leading indicators showed a solid increase, which once again suggests we have six months to a year before we need to start worrying about recession. Overall, the domestic outlook looks moderately good, but not great.

© Copyright 2007 Center for Simplified Strategic Planning

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