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Thursday April 7, 2005 - 13:30:04 GMT

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US trade position precarious

A combination of measures will be required to narrow the US trade deficit gradually, including dollar depreciation in Asia, a lower US budget deficit and higher long-term US interest rates. Some progress on these fronts is realistic over the next year.

There is, however, a growing risk that the markets, politicians and investors will lose patience, especially if the deficit fails to respond this quarter. In this context, current indicators are worrying and point to a further near-term deficit widening due to subdued overseas growth, strong US import demand and high energy prices.

If the deficit rises further in the second quarter, there will be an increasing risk of escalating US trade protectionism pressure, a disorderly decline in the dollar and a US recession.

Deficit fails to respond

The dollarís recovery over the past two weeks has lessened the immediate focus on the US trade deficit, but the issue will return to focus with the release of the February US trade data next week.

The January data remained weak with the deficit widening to US$58.27bn for the month, the second highest shortfall on record and a 4.5% monthly increase.

The US has a serious and long-standing problem in the manufacturing sector. Exports of manufactured goods rose to just over US$50bn in January, an increase of 11.3% over the year. Imports, however, increased 18.6% over the year. The US deficit with China also increased to US$15.2bn for the month.

The fact that the trade deficit has not narrowed despite the weak dollar will cause further surprise. An important factor to note is that the dollar has remained fixed against the Chinese yuan and there has also been only limited depreciation against the yen. Asia has, therefore, been successful in retaining the bulk of its competitive position.

J-curve effect

Currency depreciation always acts with a delayed impact on the trade account as it takes time for prices to adjust and for trade patterns to respond. The initial impact of a weaker currency is to push up import prices which tends to inflate imports while it takes longer for exports to respond to the change in competitiveness. It is, however, uncertain how much value traditional theory has in the case of the US trade deficit, especially as much of the trade deficit is related to transactions between US multinationals based overseas and within the US. Their international transactions and shipments will have a significant impact in distorting the US trade balance and the net impact is probably to inflate the deficit.

Near-term deficit widening?

There will be serious short-term concern that many important indicators are pointing in the wrong direction for the US trade deficit. US demand is still strong with consumer spending robust. The evidence on overseas growth suggests that demand may be weakening, with disappointing data from Japan and the Euro-zone over the past month. Energy costs are high which will widen the deficit and there has been no move on the Chinese currency peg. These factors combined could accelerate the near-term trade deterioration.

Energy prices still high

The high level of oil prices will continue to put upward pressure on the US trade deficit, especially as it is very difficult to reduce energy demand in the short term. Prices have been stuck above the US$50 p/b level this year and recently scaled 2005 highs above US$58 p/b. There will be particular concern if prices do not fall to below the US$50 p/b level within the next few weeks as there will start to be a serious impact on the US trade account as energy imports increase.

Weak overseas demand.

There will be serious concern over the level of demand in Europe and Japan. The latest PMI figures reported weak activity in the Euro-zone area, with manufacturing activity particularly weak. The Japanese demand figures have also been disappointing over the past few weeks. In this environment it will be very difficult for US manufacturers to boost exports as demand for US goods will not be strong enough. Conversely, the latest US growth figures have remained buoyant with strong ISM data for March.

It is possible to put a positive interpretation on this data as it could suggest that import substitution is finally taking effect. Under this scenario, increased demand for US-made goods is boosting US output and hurting the manufacturing sectors in Europe and Japan. This combination would start to narrow the US deficit.

Conversely, if Europe is facing difficulties because of weak internal demand, the implications are much less benign for the US trade account. US exporters will struggle as overseas demand falters. The trade figures over the next 2-3 months will be important in determining whether an optimistic view can be justified.

Limits to market patience

Expectations of higher US interest rates have offered dollar support. It is also the case that high interest rates will be an important element in curing US domestic demand and easing the upward pressure on the trade deficit. There will, however, be an increasing risk that confidence in the dollar will deteriorate sharply again before the trade account shows a significant improvement. A sharp dollar decline and upward pressure on interest rates would increase the risk that the US deficit imbalances will be reduced through a US recession rather than stronger overseas demand and rising exports.

Protectionist pressures

On current trends, there will be a growing risk of protectionist measures. In January, for example, there was a 39% increase in Chinese apparel imports. In part this reflected the ending of world-wide limits on textile trade and there will be intense pressure for US manufacturers to impose new import quotas. The US political pressure for protectionist measures is likely to increase. Members of the US Senate and House of Representatives have already called for legislation to restrict imports from China and to impose import tariffs if China fails to revalue the yuan within the next six months.


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