U.S.: A Silver Lining's Menacing Cloud

Higher demand will lead to a rising trade deficit -- even with a lower dollar

"Think globally." That has been a key business mantra over the past decade. However, globalization offers both opportunities and challenges. And in the coming year, ever-increasing competition from attractively priced imports will continue to force many U.S. companies to rethink their production strategies, their use of labor, and even their product lines. The imperative to boost productivity will remain great.

Intense import competition and the strategies businesses are adopting to deal with it are some of the unique features of this business cycle. For consumers, the increased presence of cheap imports means paychecks stretch further. And low inflation has enabled the Federal Reserve to keep interest rates low, making borrowing and mortgage refinancing a bargain. But for businesses, foreign competition saps pricing power, forcing companies to improve efficiency and cut costs.

Foreign trade seemed less of a problem in August when the trade gap narrowed. But the deficit will widen again soon. Demand by U.S. consumers and businesses is accelerating, and about 30 cents of every dollar spent in the U.S. on nonoil goods goes to foreign-made products. And businesses must soon rebuild inventories, which will bring in even more foreign goods.

True, export growth will pick up in coming quarters, but the woeful trade outlook is a case of simple arithmetic. The trade deficit is the value of exports minus imports, and the volume of U.S. imports of goods and services is 50% greater than that for exports. If exports, adjusted for inflation, grow 10% in the coming year, as most economists project, imports can grow by only 6.6% if the trade deficit is to remain at its current level, let alone shrink. Given that U.S. spending is picking up, import growth in the mid-single-digits seems highly unlikely. In 2002, a period of tepid U.S. demand, imports still managed to rise by 10%.

As a result, net exports, the trade component of real gross domestic product, will deteriorate again in the fourth quarter and beyond, subtracting from total real GDP growth, while pressing against the recovery in the factory sector and limiting the growth of new jobs.

MOREOVER, THE DECLINE in the U.S. dollar won't be the panacea it once was. In theory, a weaker currency helps a nation's trade deficit by making imports more expensive and exports cheaper. But in today's world where some currencies are pegged to the dollar and where some regions are grappling with deflation, the theory is not translating into reality.

Since its recent peak in February, 2002, the dollar has fallen 9% on a trade-weighted basis. But import prices, excluding oil, are only beginning to show any inflation. The gain over the past year has been a mere 0.9%. Prices of imported consumer goods are still down 0.2%, and prices of capital goods are off by 1.3%.

Imports Rule the Trade Balance
The problem is that the U.S. imports 60% of its merchandise from either developing nations, including China, which has tied its yuan to the dollar, or from Japan, where domestic prices are falling. Over the past year, U.S. import prices from nonindustrialized countries are down 0.7%, while prices of Japanese imports are off by 1.3%.

Plus, the prices of foreign-made goods are still about where they were 12 years ago. That means that in real terms, after adjusting for overall U.S. inflation, imports are now more than 20% cheaper than they were in the early 1990s. The dollar would have to come down quite sharply to significantly improve the price differential between imports and American-made goods.

That's why U.S. businesses, especially manufacturers, are looking for other ways to compete. Outsourcing jobs and establishing overseas units enable American companies to increase their profitability and make inroads into global markets. It is those business decisions that will limit how much companies expand production facility and payrolls in the U.S. Another 10% drop in the dollar in the next year won't radically alter those long-term business strategies.

WHERE THE DOLLAR WILL HELP is in exports. The weaker dollar improves export competitiveness and it lifts foreign earnings when they are converted into dollars. Thanks in part to the dollar's decline, exports are already off their lows hit in late 2001.

And they will continue to gain now that economic growth around the world is set to pick up. The latest readings of global sentiment -- from German factory orders to Japanese business expectations -- indicate the worst is over for Europe and Japan. And emerging Asia is already growing strongly.

Indeed, growth, not the dollar, will be the major driver of exports in the coming year. Yet even with signs of a global pickup, the U.S. economy is still outpacing the rest of the world. Real GDP appears to have grown at an annual rate of about 6% in the third quarter.

Last quarter's growth spurt came primarily from a surge in consumer spending, but it also reflects an unusual narrowing in the trade deficit. The August gap shrank by $800 million from July, to $39.2 billion. Exports dropped by $2.3 billion, but imports fell by a greater $3.1 billion. The July-August average in the deficit compared with the second-quarter pace suggests that a smaller net-export gap may have contributed as much as a percentage point to the quarter's growth rate of real GDP. But that was a one-shot boost.

TO A GREAT EXTENT, import weakness last quarter reflects business caution in rebuilding inventories. This is typically the time of year when retailers lay in stockpiles of goods for the holiday season. This year, though, merchants are being more careful, staggering their ordering to cut down on potential excesses and discounting that robs from the bottom line.

And it's not just retailers. Monthly data suggest that, economywide, stockpiles actually shrank for the second quarter in a row. That means in the fourth quarter inventories are insufficient to meet rising demand. Rebuilding those inventories will trigger a combination of increased U.S. production and a resurgence in imports in coming months.

Cautious Inventory Building Curbs Imports
The flow of imports into U.S. markets will continue the pressure on American business to hold down costs. And the wider trade deficit will also focus attention on the U.S. current account deficit, which is fast hurtling toward a record 5.5% of GDP next year.

Some economists think of this imbalance as "the last bubble" in the economy. The danger in the coming year is that foreign investors will become less willing to finance the massive U.S. trade deficit. At the same time, Washington politicians, either by design or neglect, are abandoning the strong-dollar policy that has helped keep the greenback's decline orderly. That double whammy could push the dollar down too far, too fast. Currency chaos would be an unwelcome wrinkle in the outlook because it would come at a great cost to the economy, whether in the form of more inflation, higher interest rates, or slower growth.

By James C. Cooper & Kathleen Madigan

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