The Cutting Edge™ June2004

Business Briefing

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China: While China's trade surplus with the U. S. is high and rising, in total, the world's sixth largest economy is running a trade deficit. In February, their trade shortfall was $7.9 billion following up on a $30 million deficit in January. Imports in January rose 77% year-on-year while exports gained 40%. The country is importing three times more goods and services per month than in the late 90's.

This balance of trade deficit bodes ill for the U. S. Treasury and our economy. Till now the dollars China has earned by exporting to the U. S. has been converted into massive purchases of U.S. government debt. Now with these dollars being used to pay for increasing imports, China will have fewer greenbacks to support the U.S. bond market. Keep your eyes on this situation as well as the Japanese Ministry of Finance's program to keep the yen cheap vis-à-vis the U. S. dollar. Japanese purchases too have been critical to keeping our interest rates low.

In the meantime the U.S. is exporting more goods and services to China. The Chinese are building cities the size of Houston, TX, each month to house the migration of its population to urban areas. As a result the U.S. is shipping industrial commodities, food/agricultural products, machinery, telecommunications equipment, airplanes, and cars to China in record numbers.

Another Chinese risk is their financial system. The ratio of non-performing loans, i.e., bad debt, at the biggest banks in China is running at a staggering 21%. At U.S. banks, this performance metric is about 0.75-1%, 20 times better than its Chinese counterparts. A recent pronouncement by Chinese banking regulators aims to improve the ratio by expanding lending rather than fixing the bad loans. This ploy is akin to making up the loss on an unprofitable product by selling more product!

The rising trade deficit may, in fact, force the Chinese to revalue their currency, a move long encouraged by U.S. authorities. By increasing the purchasing power of their currency, such a move would make its imports cheaper. But often these maneuverings produce unintended consequences. Who knows? Maybe a floating renminbi falls in value and generates more exports - another way to balance trade.

Economic Factoid - Since 1978, the Chinese economy has averaged 9% annual growth, expanded foreign trade by 15% annually, and generated a trade surplus with the U.S. twice that of Japan's. The economy needs to generate nearly 15 million new jobs every year to keep pace with population growth.

The impact of China on the global economy is huge and growing. The risks to the world of an economic downturn starting in China are high. The U.S. is walking a thin tightrope by relying on China to prop up our economy. But the remedies are complicated and, in many cases, untested. Stay tuned to this critical story.

For more information on the Chinese economy, get a copy of the March 20 survey in The Economist www.economist.com/surveys.

And here at home...

The job-creating machine that's the U.S. economy remained at full throttle in April, as 288,000 new jobs were generated. Added to the 377,000 rise in payrolls in March, this two-month job growth was the strongest in four years. In total, the economy has produced 867,000 new jobs in 2004. And 64% of private companies have hired new workers in the past three quarters. The trend is clearly upward for employment.

Companies hire when additional production is required. And they add capacity when demand outruns supply. The Federal Reserve estimates that manufacturing capacity utilization stands at 76% or so. At this rate, companies have little incentive to expand their factories. Today's rising prices are an indicator of tight supply - the need for more capacity. If so, perhaps capacity utilization is higher than the Fed's data shows. In fact, the Institute of Supply Management's capacity indicator is reporting utilization at 85.6%, up from 80.1% last December. Keep your eyes open for an uptick in capital investment on new plant and equipment. Cash flow, a key source of capital for investment, is strong at many companies as the economy has moved from recovery to expansion. As advisers on facilities design, our company is seeing more projects involving new plants and expansions than in three years. That's a great sign. Planning always precedes major equipment purchases.

Of course higher interest rates mean a slower economy. But will rates really increase enough to endanger the economy? Some economists will tell you that a central bank's interest rate should approximate an economy's growth rate. If rates are lower than growth, money is easy. If higher, money is tight. Easy money leads to inflation, a condition we can see in today's economy.

At the moment the natural rate of growth in the U.S. is around 2%, and the Fed's 'federal funds rate' is 1%. On this theory, the Fed has room to increase rates by about one percentage point. But the lower tax on investment income provided by last year's dividend tax reduction may also influence any rate increase. This incentive will drive capital into the market and keep rates down.

If these funds are wisely invested, the result will be more technological advances, higher productivity, higher wages, and rising profits. All these factors are great for the economy. Buckle up.

Solid growth is on the horizon for the U.S. unless outside influences derail the current momentum. Many say that influence could be the price of oil. The talking heads are hammering us with reports that the world is running out of oil and present higher prices will be permanent. Ignore the media and think again. War, especially in the Middle East, can and will push up prices. But the world is drowning in oil. Back in 1982 the best guesstimate of global oil reserves - crude that's still in the ground - was around 600 billion barrels. Oddly, since that time, the world has used about that much oil, but we now have reserves of 1.05 trillion or so. In fact recent news from Saudi Arabia indicated that their reserves might be as much as 1.2 trillion rather than the 261 billion previously reported. Russia, too, is a growing resource having recently tripled their reserve estimate. In oil as with other commodities, rising prices usually mean rising supply. And don't forget that our economy is twice as energy-efficient as in the late 1970's.

Bottom Line: Keep your fingers crossed. The world is crazy at the moment, and our economy is fragile. One thing is certain however - an increasingly intertwined world means everyone is a stakeholder in the global economy. If common sense prevails, everyone may experience the benefits of a strong economy.

Page 2 - Sector Situation Report

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