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a n e c o n o m ic re v ie w b y th e F e d e ra l R eserve B a n k o f Chicago Global interdependence and energy 3 Concern for growing farm debt 8 The energy crisis brought some fundam ental inter national problem s to the forefront. The m ost obvious were widespread disruptions in trade patterns and balanceof-paym ents accounts. The alm ost 25 percent in crease in farm debt over the pa st two years—the largest two-year increase since the early 1950s—could lead to repaym ent problem s for m any individual farm ers. Banking developments 14 Subscriptions to Business Conditions are available to the public free of charge. For information concerning bulk mailings, address inquiries to Research Department Federal Reserve Bank of Chicago, P. 0. Box 834, Chicago, Illinois 60690. Articles may be reprinted provided source is credited. Please provide the bank’s Research Department with a copy of any material in which an article is reprinted. 3 Business Conditions, June 1 9 7 4 Global interdependence and energy Despite the trauma o f the energy crisis, the world econom y in early 1974 continued to show vitality and vigor. The international flow o f goods and capital continued to in crease and the production o f goods and ser vices remained near record levels—an im pressive dem onstration o f the resiliency o f the world econom y to the problems created by the energy crisis. However, not all problems have been resolved. The oil em bargo and the sharp rise in o il p rice s accentuated such chronic problems as worldwide inflation, and created new problems. This article focuses on some o f these problems and on the w ay nations are preparing to deal with them. The impact of the energy crisis In early 1974, the balance-of-payments accounts o f industrial countries reflected the im pact o f the increased cost o f oil im ports. The m agnitude o f the problem faced by oil-im porting countries can perhaps best be appreciated by com paring the amounts paid for oil imports in previous Value of oil imports to major industrial nations 1973 1974 Increase Estimated Projected1 1974/1973 (b illio n U S. dollars, c .i .f .) Total United States Western Europe Of which: West Germany France United Kingdom Italy Japan Canada Others 46.2 9.3 22.2 120.0 25.0 55.5 73.8 15.7 33.3 5.2 3.9 3.8 3.4 6.6 1.3 6.8 12.0 10.7 9.5 9.1 18.0 4.0 17.5 6.8 6.8 5.7 5.7 11.4 2.7 10.7 1Assuming that the volume of oil imports will be the same in 1974 as in 1973 and that average prices in 1974 will be the same as present prices. years with the current estimates. In 1970, for example, oil-importing countries paid about $13 billion to oil exporters; in 1973, the bill rose to about $46 billion; the 1974 oil bill has been estimated at about $120 billion assum ing that the volume o f oil im ports will be the same in 1974 as in 1973 and that the average prices in 1974 will be the same as present prices. Thus, in 1974, the oil-importing coun tries are collectively facing an import bill some $75 billion larger than they faced in 1973. Given the likelihood that the oil exporting countries will not increase their imports from the rest o f the world by a like amount, this m eans that virtually all oil im porting countries will experience a deterioration in their trade accounts. For some, this m ay mean sharply reduced sur pluses; for others—for the great m ajority— it will mean deficits in their trade accounts. The expected sw ing to deficits in the trade accounts o f oil-importing countries will not mean that their overall balance-ofpaym ents position will deteriorate propor tionately. Indeed, for the importers as a group, no changes in the balance o f payments will take place. This is simply because the balance-of-paym ents accounts (as opposed to the balance-of-trade ac counts) measure both the flow o f goods and services and o f paym ents for these in what is essentially a double-entry accounting framework. In that context, international transactions are recorded both as debits and credits; a transfer o f m oney is always the other side o f the coin o f a transfer o f goods. Thus, just like a m erchant who ac quires a financial asset, say a commercial bank deposit that w as previously held by the buyer o f the goods, so the oil-exporting countries will acquire financial assets— deposits at com m ercial banks o f oil 4 importers—in the precise amount o f the oil exports. This, in the balance-of-paym ents sense, simply m eans that at the first stage o f the transaction, the increased oil im ports o f consum ing countries as a group will be precisely offset by “ short-term capital in flow ” i.e., acquisition o f short term financial assets by the oil exporters. Does the unquestionable validity o f this accounting proposition mean, then, that the “ energy crisis” actually poses no problems for the oil-importing w orld? U n fortunately, several problems o f a rather serious econom ic nature are im plicit in this situation once we look beyond the very in itial stage o f the oil paym ents cycle. The oil exporters, just like an individual acquiring a short-term financial asset such as a de mand deposit, will w ant to use their newly acquired wealth in a w ay that will m ax imize their ow n welfare: they will use it either to buy goods and services (largely from industrial nations), or invest it in the form o f return-yielding assets. How the split will be m ade between consum ption and investment, and further, w hat direc tion the investm ent will take, is o f crucial importance to how severely the world econom y will be affected by the “ oil crisis” in the immediate future. Consequences to world production In the m onths to come, consumers in oil-importing countries will be diverting a larger proportion o f their incom es to pay for oil. That portion o f incom e (which otherwise would have been spent on purchases o f other goods and services produced at hom e or in other countries) will be transferred to the oil producers in pay ment for oil. I f the oil producers were to spend their entire new incom e on goods and s e rv ice s p rod u ced b y the oil consum ing nations, the initial reduction in demand for—and production o f—these goods and services by the residents o f oil importing countries would be exactly Federal Reserve Bank of Chicago offset by the increase in demand by the oil importers. However, given the magnitude o f the new incom e accruing to the oil producers, it will be virtually im possible for them to spend the entire sum on con sumption. A t least for the time being, most o f it will be saved—held on deposit or in vested in securities. The inability o f the oil exporters to use their oil revenue on consum ption will create a gap between w hat is produced and what is going to be purchased in and from the industrial world. This gap in the cir cular flow o f consum ption and payments will have a definite contractionary effect on the world econom y. For some countries already suffering from excessive inflation this effect m ight be welcome. Others, however, m ight find it necessary to develop policies to offset the contrac tionary effects to avoid a recession. Such p olicies, however, must be carefully developed so they do not im pinge on other nations’ efforts. For example, a policy to in crease demand for dom estic goods—and to engage domestic resources in production o f such goods—by restricting imports would limit the ability o f other nations to export. Similarly, policies designed to increase ex ports as a means o f stimulating domestic production would not only entail increased imports elsewhere in the world but a reduc tion in production as well, other things equal. Retaliation against such measures could ensure a vicious circle o f competitive actions with potentially disastrous conse quences for the world econom y. Recycling oil investments A n important element in policies designed to offset the contractionary effects o f the higher oil paym ents will be putting back into productive circulation oil revenues withheld as saving and invest ment by the oil producing countries. Clear ly, there is no a priori reason w hy oil exporting countries would invest the funds Business Conditions, June 1 9 7 4 they will not spend on consum ption in each country from w hich the funds cam e as paym ents for oil. To the extent the oil ex porters fail to invest “ surplus” funds in the country o f origin, that country will ex perience an immediate shortfall in its purchasing power, in its balance o f payments, and a deterioration in its ex change rate. The shortfalls in the domestic purchasing power can be readily offset by expansionary domestic monetary and fiscal policies. However, the depressing shortfalls in the balance o f payments can not be so readily offset unless a country has sufficient international reserves, or unless a w ay is found to recycle investment inflow s from countries that will receive such deposits to countries that will ex perience shortfalls. There are several channels through w hich such “ recycling” can take place. There are the com m ercial channels— the m oney and capital markets o f the in dustrial world. In the “ short end” o f reflow, the receipts o f the oil-producing countries will m ost likely be deposited with banking institutions in Europe and elsewhere as interest-bearing deposits until more per manent, long-term investment outlets are found. In this “ short end” o f the recycling process, the Eurodollar market will no doubt play an im portant role. This market, in w hich dollar-denominated deposits are received and dollar-denominated loans are made by banks in Europe and other areas o f the world, has served for m any years as an im portant channel o f intermediation between short-term lenders and borrowers. In recent years, the market has grown to a size estimated at near $100 billion. The ex perience and efficiency o f the institutions participating in the market, as well as its breadth and scope, provide assurance that a large volum e o f funds can be handled and channeled to creditworthy borrowers in response to interest rate incentives. Parallel with the “ m oney market” short-term investm ent function, the Eu 5 rodollar market has developed a longerterm investm ent instrument, so-called Eu robonds. T his instrument, too, m ay be counted upon to perform an important role in the recycling o f oil revenues. O f course, there are the capital markets o f individual nations and the direct investment oppor tunities that individual econom ies offer. Purchases o f stocks and bonds o f the in dustrial countries w ill ultimately represent an im portant channel o f recycling. H ow ever, all th ese com m ercial channels have one com m on characteristic: the flow o f funds through them takes place in response to com m ercial incentives—the interest rate or return potential that the un derlying instruments offer the investors. In the recycling process, the needs o f in dividual oil-consum ing countries for funds m ay not coincide with their ability to qual ify for access to the com m ercial market. This is particularly true o f the developing countries w hose ability to compete for investment funds is severely limited. But it is also true o f some developed countries where interest rate levels necessary to attract funds m ay conflict with domestic econom ic policy objectives. Thus, it has be come increasingly clear that to meet these problems, the facilities o f existing inter national institutions must be strength ened and new facilities developed. In the early m onths o f 1974, there was some progress in meeting the anticipated challenges in both o f these institutional areas. In the com m ercial markets area, the elimination or reduction o f restrictions on international capital outflow s by the U n ited States and capital inflow s by Ger many, the Netherlands, Belgium, and France was an im portant step toward opening the channels through which private funds can move. A s the first payments reflecting sharply higher oil prices were m ade to the oil producers in ear ly April, the world m oney markets re sponded smoothly. Anticipating shortfalls in the inflow o f 6 funds, a number o f governm ents tapped the commercial markets for loans early in 1974. The French floated a $1.5 billion Eu rodollar loan with the bulk o f the proceeds to be parceled out to the country’s com m er cia l b a n k s to increase their dollar holdings, and with the balance added to the central bank’s reserves. The British negotiated a $2.5 billion, ten-year Eu rodollar loan underwritten by 25 com m er cial banks in the private markets and decided that the proceeds will be drawn upon by the governm ent as needed to meet the shortfalls in fund inflows. The Italian governm ent not only negotiated borrow ing in the Eurodollar market but also made arrangements for official borrow ing with the International M onetary Fund (IMF). As concerns strengthening o f inter national official institutional arrange ments through w hich reflows o f funds can be effected, the International Monetary Fund (IMF) has developed a plan that boosts the Fund’s resources available for lending to member countries, both in dustrial and developing. Under the pro gram, the oil-exporting countries will lend part o f their oil revenues at 7 per cent interest to the IMF, and the Fund, after due consultation, will make loans to oil-importing nations in proportion to the size o f the adverse oil price im pact for a m aximum term o f seven years. The International Bank for Reconstruction and Development (IBRD) has increased its efforts to float bonds in the oil-producing countries to obtain funds to boost its lending capability to developing countries. The Shah o f Iran proposed the establish ment o f a new international institution that would loan funds received from oil producers and other nations, channeling between $2 and $3 billion annually to developing countries. Other proposals that emerged in 1974 and are currently under consideration are an Islam ic Development Bank with capitalization at $1.2 billion; an Arab Oil Federal Reserve Bank of Chicago Fund for A frica capitalized at $200 million; OPEC Development Bank (between $1 and $2 billion); an Arab Bank for Agricultural and Industrial Development in A frica ($200 million); and other similar proposals designed to deal with the energy problems o f the developing countries. To meet the possible needs o f the developed countries for short-term credits on an ad h oc basis, the mutual currency swap lines (developed in the Sixties by the Federal Reserve System) stand ready to provide $20 billion in mutual assistance am ong 14 cooper ating central banks. The swap limits o f the Banks o f England and o f Italy were boosted earlier this year by $1 billion to $3 billion each to provide for anticipated con tingencies. All o f these commercial, governm ent al, and central bank arrangem ents— bilateral and multilateral—should go a long w ay toward reducing the problems associated with deficits in the balance o f payments o f individual countries in the aftermath o f the energy crisis. But it can hardly be expected that they will eliminate the problem completely. At best, they will postpone and spread over time the problem o f real transfers, i.e., transfers in the form o f goods and services from the oil consum ing to the oil-producing nations. Sooner or later, more basic adjustments must be made in the balance o f paym ents o f individual countries to effect the transfer. Moreover, despite the broad scope o f the financial facilities that are available to handle the problem o f recycling, some countries m ay be confronted with im mediate payments problems that will re quire immediate adjustments. The role of the monetary system The IM F N airobi meeting last year set July 31, 1974 as the target date for agree ment in the negotiations for the reform o f the international monetary system. In the words o f former U. S. Treasury Secretary 7 Business Conditions, June 1 9 7 4 George Shultz, the center o f gravity o f the exchange rate system would be a regime o f stable but adjustable par values. The energy crisis has radically altered the cir cu m s ta n c e s su rrou n d in g the negotiations. In principle, a fixed ex change rate system o f stable but ad justable par values would possess the hoped-for stability only if the balance-ofpaym ents positions o f individual countries participating in the system are roughly in equilibrium. But, as pointed out, the un predictability o f distribution o f investment reflows raises great uncertainties about the balance-of-paym ents positions o f in dividual countries for m onths to come. Im balances will necessarily emerge, and they will put pressure on the exchange rates. Under a regime o f fixed exchange rates, this would no doubt precipitate speculative flow s o f funds that could prove very disrup tive to the prim ary function o f the inter national m onetary system—to facilitate international com m erce and productive in vestment flows. R e c o g n iz in g th is p rob lem , the Ministerial Committee o f Twenty (C-20), charged with the responsibility o f develop ing the blueprint for the reformed system, focused its attention away from a unified reform package and concentrated on in dividual com ponents on the assumption that com ponents could be put in place as circum stances permit. In an effort to work out agreements on various components, the C-20 settled on a code o f conduct to be followed by individual countries in respect to the floating exchange rate system that, as has been generally agreed, best meets the needs o f trading nations in the current period o f uncertainty. The proposed code o f conduct includes commitments that in dividual countries will intervene in order to m aintain an orderly foreign exchange market, but will refrain from intervention that would: (1) accelerate movements in exchange rates; (2) prevent a small and gradual appreciation o f its currency if a country holds large reserves; and (3) pre vent a small and gradual depreciation o f its currency i f a country’s reserves are low. It is clear that orderly exchange rate movements within a loosely structured in ternational m onetary system, buttressed by a judicious use o f official reserves, will play an im portant role in the adjustments to the balance-of-paym ents consequences o f the energy crisis. The outlook The success with w hich the O rganiza tion o f Petroleum Exporting Countries (OPEC) implemented price-raising ar rangements in late 1973 has encouraged new or renewed cartelization attempts by producers o f such com m odities as copper, bauxite, iron ore, phosphate, coffee, and bananas. The developing countries have expressed their intention to organize “ new O PECs,” and a number o f these countries have set up ministries o f resources to pur sue this end. This is “ resources diplom acy.” It threatens to add to inflationary pressures and, in some cases, create bottlenecks in supplies. It highlights the dependence o f the United States and other developed countries on prim ary product imports, and the associated need for stability in supplier relationships. T o achieve this stability, the United States, in cooperation with other nations, is seeking to supplement existing international trading rules on access to markets for producing countries with new rules on access to supplies for consum ing countries. Such a development would facilitate the international flow o f goods that benefits producing and consum ing countries alike. Joseph G. K vasnicka 8 Federal Reserve Bank of Chicago oncern for growing farm debt Farm debt rose by record amounts during the past two years and another record in crease is expected in 1974. Outstanding farm debt totaled $82 billion at the end o f 1973, up nearly $9 billion from a year earlier and more than $15 billion above the ending 1971 level. In percentage terms, the growth in farm debt exceeded 23 percent during the past two years, the largest twoyear gain since the early Fifties. The boom in farm debt continues unabated in the current year as reflected in the U. S. Department o f Agriculture’s projected in crease o f nearly $11 billion in 1974. Overall, the rise in farm debt during the past two years, plus the projected 1974 gain, would be twice as large as the 1969-71 increase in farm debt and equal to total out standings in 1961. Both real estate and non-real estate farm debt registered strong advances dur ing the past two years. Outstanding real estate debt totaled $39.5 billion at the end o f 1973, up $8.2 billion from two years earlier. Non-real estate debt (usually shortand intermediate-term credit), on the other hand, rose to $42.8 billion by the end o f 1973, m arking a two-year increase o f $7.2 billion. Current projections o f the Depart ment o f Agriculture portend increases o f about $6 billion for real estate and $5 billion for non-real estate farm debt during the current year. The expanding use o f debt capital coin cides with unparalleled prosperity in the farm sector that has also boosted equity capital. Net realized farm incom e rose to $17.6 billion in 1972, 35 percent above the year-earlier level and 3 percent over the previous record set a quarter o f a century earlier. Last year, net farm incom e soared another 83 percent to $32.2 billion. Cur rent forecasts o f net farm incom e for 1974 vary widely due to a number o f uncer tainties. Nevertheless, m ost estimates in dicate net farm incom e in 1974 will be well above all historical com parisons excepting perhaps for last year. The surge in farm borrow ing reflects shifts in a number o f factors w hich affect both the demand for, and the supply of, loan funds. Factors inducing lenders to provide a larger volume o f farm loan funds included a sharply higher level o f loan repayments, more com petitive yields on farm loans, lower risks on farm loans, strong deposit inflow s, and an increase in b on d a n d d eb en tu re sales. Factors boosting the demand for farm borrow ing included a shift in agricultural policy toward all-out production, larger pur chases o f capital and operating inputs, higher prices paid for virtually all farm in- Farm debt registers a record increase billion dollars Business Conditions, June 1 9 7 4 puts, and renewed optimism for continued prosperity in agriculture. Institutions pace increased lending Holders o f farm debt typically are classified as institutional lenders, in dividuals and others, and the Com m odity Credit Corporation (CCC). Non-recourse CCC loans are available to farmers who participate in the various governm ent farm program s. Such loans permit farmers to obtain low cost inventory financing if they prefer to store, rather than market, their harvested crops. The amount o f CCC loans outstanding is com paratively small and has declined steadily since 1971. In d iv id u a ls a n d o th e r s represent a broad category o f lenders who hold rough ly two-fifths o f all non-real estate and real estate farm debt outstanding.1The bulk o f non-real estate debt held by individuals and others represents short-term credit ex tended by m erchants and dealers o f agricultural supplies, often in prom otional efforts to boost sales. On the other hand, in dividual sellers account for the m ajority o f farm real estate debt held by individuals and others. A s o f the end o f 1973, non-real estate debt held b y individuals and others totaled an estimated $15.9 billion, 3.5 per cent above the year-earlier level and 16 per cent greater than two years earlier. Farm m ortgage debt held by individuals and 'The most reliable estimates of farm debt held by individuals and others are obtained only periodically which necessitates some method of interpolation in order to estimate annual changes in such debt out standing. Since the method of interpolation is often highly arbitrary, annual estimates of farm debt held by individuals and others should be viewed with some caution. For several years prior to 1973, for example, annual changes in non-real estate debt held by in dividuals and others, were arbitrarily equated with the proportional change in outstandings registered by all institutional lenders. This method of interpola tion was abandoned last year when it became ap parent that widespread shortages and the increased costs of receivables financing had tightened the credit policies of merchants and dealers of agricultural supplies. 9 others totaled about $16.9 billion, 15 per cent above the ending 1972 level and 26 percent larger than two years earlier. In s titu tio n a l le n d e r s have been the dom inant source in accom m odating the farm debt boom . In the farm m ortgage market, the m ost significant strides have been registered by Federal Land Banks (FLBs) and com m ercial banks. In non-real estate lending, com m ercial banks and Production Credit A ssociations (PCAs) have paced the overall advance. New m ortgage m oney extended by FLBs jumped 46 percent above the yearearlier level in 1972 and another 47 percent in 1973. The unprecedented volum e more than offset the sharply higher level o f repayments. A s a result, farm mortgage debt held by FLBs exceeded $10.9 billion at the end o f 1973, up one-fifth from a year earlier and up nearly two-fifths from 1971. The rapid increase in FLB outstandings partially reflects new lending provisions established by the Farm Credit A ct o f 1971, and implemented in the spring o f 1972. Prior to the act, FLB loans were restricted to 65 percent o f the “ agricultural value” o f the supporting real estate collateral. The new act changed this restriction to 85 per cent o f the “ market value” o f the mort gaged real estate. Farm m ortgages held by commercial banks totaled $5.4 billion at the end o f 1973, up 28 percent from the level two years earlier and equivalent to one-fourth o f all institutional farm m ortgages outstanding. Farm m ortgages held by life insurance companies, w hich rank second in in stitutional holdings, totaled $6.1 billion at the end o f 1973, up just 9 percent from two years earlier. The com paratively small in crease by life insurance com panies, w hich have been extremely slow to recover from the declines that occurred during and fo llo w in g the 1969-70 credit crunch, reflects increased em phasis on other in vestment alternatives and, to some extent, an increase in policy loans. 10 Com m ercial banks paced the surge in non-real estate farm loans during the last two years, a distinction long-held by PC As. Non-real estate farm debt held by banks rose 39 percent during the two years end ing in 1973, while such holdings by PCAs rose 29 percent. Nevertheless, the $7.9 billion in P C A outstandings at the end o f 1973 marked a 3.7-fold increase from the level a decade earlier, while the $17.3 billion in bank holdings capped a 2.6-fold increase/ for the decade. Heightened loan demand The expanded volum e o f farm lending reflected an unusually strong demand for borrowing as well as the increased ac tivities o f institutional lenders. A number o f factors were associated with the heightened farm loan demand, but most were related to the follow ing. • The reinstatement o f investment tax credit in late 1971. • The all-out production incentives provided by record-high farm prices and the governm ent’s release o f some 60 million acres held in set-aside under the various farm programs. • The more optim istic expectations for continued prosperity as a result o f record incom e levels achieved by farmers and the surge in foreign de m and for U. S. agricultural products. The strong farm loan demand partial ly resulted from the financial arrange ments necessary to support the boom in capital expenditures. In 1973, higher prices and increased purchases boosted capital expenditures by farmers to $9.4 billion, nearly one-fourth above the year-earlier level and more than two-fifths larger than in 1971. The increases in capital expen ditures were the largest since the late For ties and included purchases o f a wide range o f assets that will enhance the productive capacity o f agriculture for a number o f years. Shortages o f fuels and Federal Reserve Bank of Chicago fertilizers coupled with transportation snarls encouraged m any farmers to boost on-farm drying capacities and to expand storage facilities for both inputs and harvested crops. Record-high farm level prices and incom es encouraged farmers to b oost expenditures on drainage tile, terraces, and irrigation. Such capital ex penditures were no doubt largely directed toward the some 40 m illion acres o f land that came into production follow ing the elimination o f set-aside requirements from the various governm ent farm programs. The surge in capital expenditures is perhaps best reflected in unit sales o f farm tractors and machinery. The weatherplagued and untimely fall harvest in 1972, the availability o f investment tax credit, and the expanded production incentives have encouraged farmers to substantially upgrade their m achinery and equipment. In 1973, unit retail sales o f farm tractors soared 25 percent above a year earlier and 50 percent above the 1971 level. U nit sales o f combines, balers, and m any other large Business Conditions, June 1 9 7 4 items also scored impressive gains. In addition to financing capital expen ditures, farm loan demand w as bolstered by higher prices for, and increased purchases of, operating inputs. By late 1973, the index o f prices paid by farmers for production inputs was 21 percent above a year earlier and 33 percent above the end ing 1971 level. Livestock producers were particularly hard hit with higher prices for feed and feeder stock, while crop farmers experienced particularly large increases in prices paid for seed, fuel, fertilizer, and chem icals. Higher prices com bined with larger purchases boosted 1973 operating expenses to $48 billion, 50 percent above the 1971 level. The vigorous farm loan demand coin cided with a general upward movem ent in interest rates starting in the last h a lf o f 1973. A lthough the expansion in farm debt was acquired at historically high interest costs, interest rates during m ost o f the period were favorable compared both to earlier highs during the 1969-70 credit crunch and to other market interest rates. Interest rates on farm loans tended to decline throughout 1971 before bottom ing out in the first h a lf o f 1972. From mid-1972 to mid-1973, interest rates held steady, but have since turned sharply upward and now exceed 1970 highs. Some reasons for concern Am erican agriculture has experienced recurring cycles o f the “ cost-price squeeze” throughout its history. The cost-price squeeze defines a situation in w hich the prices o f farm com m odities are low relative to the costs o f production inputs. A s a result, cash receipts from farm marketings are largely absorbed by cash outflows, leaving only sm all operating m argins to com pensate the farmer-operator for his equity capital, labor, and m anagem ent skills. In view o f the rapidly rising farm costs and the likelihood that prices o f 11 agricultural com m odities m ay trend lower because o f expanded production, another cycle o f the cost-price squeeze appears to be in the offing. Should this occur, and d ep en d in g upon the severity, m any farmers m ay be hard pressed to meet their rapidly rising debt repayment obligations. Discussions o f the debt repayment ability o f farmers typically center on the debt-to-asset ratio o f the farm sector and the maturity distribution o f outstanding farm debt. The debt-to-asset ratio o f the farm sector has trended upward from a low o f 7.2 in 1947 to 19.6 in 1972.2 Since the current ratio is som ewhat below earlier highs—due to large increases in farmland values during the past two years—and well below that for m ost other industries, m any observers contend there is little reason for concern over the ability o f farmers to meet debt repayment schedules. The debt-to-asset measure, however, m ay be a m isleading indicator o f farmers’ debt repayment capacity. On the one hand, the ratio values assets at current market prices rather than cost. (If assets were valued in terms o f 1967 prices, for example, the debt-to-asset ratio would be 12 percen tage points higher than the present level.) Moreover, the debt-to-asset ratio is a poor indicator o f farm ers’ abilities to retire debt since a high proportion o f farm operators are debt-free. Prelim inary indications from a 1970 survey indicate the proportion o f debt-free operators m ay approach onehalf. These results suggest that farm debt is highly concentrated, that those with farm debt have substantially higher debtto-asset ratios than the industry average, and that the bulk o f the expansion in farm debt over the past few years probably reflects borrow ings by operators who had existing debt rather than by debt-free operators. 2 is interesting to note that the debt-to-asset It ratio exceeded 19 in the early Forties, just prior to the last time farm debt declined for an extended period. 12 A high portion of short-term debt Concern over farm ers’ abilities to retire debt, in conjunction with a possible cost-price squeeze, is perhaps m ost evident in the maturity distribution o f farm debt. A lth ou gh only scattered evidence is available, there are several indications that a high proportion o f the farm debt matures each year and that the scheduled annual cash outflows for principal and in terest repayments are equivalent to an ex tremely high proportion o f cash receipts. The bulk o f the annual debt repay ments reflects the short-term nature o f non-real estate farm debt. A lthough PC As can extend loans with maturities o f up to seven years, the amount o f new loans made annually by P C A s consistently ex ceeds a v e ra g e annual outstandings. Moreover, the am ount o f PC A loans renew ed annually is equivalent to one-half o f a v e ra g e annual outstandings. These measures indicate that the average maturi ty o f P C A loans is substantially less than one year. Other evidence suggests the maturity o f non-real estate farm loans provided by other lenders also averages less than one year. For example, a 1966 survey found that nearly two-fifths o f the dollar volume o f farm loans made by commercial banks—including real estate loans—had maturities o f six m onths or less, while nearly three-fourths had maturities o f 12 m onths or less. I f real estate debt could be subtracted out o f these figures, the maturi ty o f non-real estate farm loans made by commercial banks m ight average six months or less. The large volume o f nonreal estate loans extended by individuals and others, no doubt, also carries relatively short-term maturities. In particular, a large proportion o f the credit extended by merchants and dealers probably matures within periods o f 30 to 90 days. Overall, it is probably reasonable to assume that the maturity o f non-real estate Federal Reserve Bank of Chicago credit extended to farmers averages less than nine months. This would im ply that the annual scheduled repayment o f nonreal estate farm debt m ight total $58 billion in 1974 based on the amount o f such debt outstanding at the start o f this year and adjusting for loans obtained and repaid during the year. The cash outflow for debt retirement would be boosted further by principal and interest repayments on real estate debt. A lth ou gh only scattered evidence is available, the average maturity on such debt is probably close to ten years.3 Based on the present level o f farm real estate debt outstanding, and assum ing an average an nual interest rate o f 6 percent, this implies a scheduled annual cash outflow o f $6 billion for principal and interest payments on real estate debt in 1974. Overall, the analysis suggests that the scheduled cash outflow for farm debt retirement m ay range from $60 to $65 billion in 1974. For 1975, the scheduled principal and interest repayments m ight exceed $70 billion i f this year’s projected in crease in farm debt materializes. Cash outflows o f these magnitudes for debt retirement are startling when com pared to cash receipts from farm m ar ketings. In 1970 and 1971, cash receipts from farm marketings averaged less than $52 billion. In conjunction with the sharp ly higher farm-level prices o f the past two years, cash receipts from marketings jumped to $61 billion in 1972 and $83 billion in 1973.4 Even i f cash receipts stay q'he portfolio of farm real estate debt held by FLBs probably has as high an average maturity as any of the major holders of farm real estate debt. Nevertheless, based on the past five years, the ratio of annual repayments to outstandings at the beginning of the year implies an average maturity of 14 years for FLBs. The average maturity of such debt held by banks and by individuals and others is probably less. 4 more realistic comparison of farm debt repay A ment with cash receipts from farm marketings would deduct cash receipts received by debt-free operators. While there are little data to compute the appropriate deduction, a reasonable estimate might be 15 percent. Business Conditions, June 1 9 7 4 at the sharply higher level for the next few years, the likelihood o f further increases in the scheduled annual debt repayment leaves only a small m argin for other cash outflows. Moreover, and despite the trend o f cash receipts to rise over time, there would seem to be a reasonable probability that cash receipts from farm marketings could decline from recent high levels, a developm ent that would intensify what already appears to be a narrow margin between cash inflow s and outflows. Some offsetting factors There are a number o f factors that par tially offset the concern over the ability o f fa r m e r s to m e e t s c h e d u le d debt repayments. The im plications o f the com paratively high proportion o f short-term debt is partially alleviated by the fact that m any o f the assets acquired by debt fi nancing provide a sufficient cash inflow, in a sufficiently short period, so that ser vicing the debt is not an undue burden. Crops are produced and marketed within 5 to 12 m onths, generating the receipts necessary to repay debt incurred to finance operating expenses. Similarly, cattle typi cally are marketed four to six m onths after being placed into feedlots. The receipts from the marketings can m ost logically be used to repay the financing needed to ac quire and feed the cattle. A s long as the repayment o f short-term debt is geared to the cash inflow s produced by the assets financed, the com paratively high propor tion o f short-term debt norm ally would not be particularly burdensome to agriculture. Nevertheless, during periods o f a severe cost-price squeeze— such as that experienc ed by livestock producers for the past several m onths—receipts m ay fall far short o f the scheduled loan repayments. A nother m itigating factor is that renewals or extensions o f farm loans appear to be very com m on occurrences. 13 Data on P C A s suggest that the volume o f renewals is equal to over one-half of repayments every year. A 1966 survey o f commercial bank loans to farmers in dicated that nearly one-third o f the amount outstanding at the time o f the survey had been renewed, and that the bulk o f the renewals had been planned. These in dications suggest that agricultural lenders norm ally are w illing to renew loans. But their willingness to do so could be reduced if a cost-price squeeze threatens the repay ment capacity o f the borrower. The im portance o f nonfarm earnings as a source o f incom e to the farm sector is another factor that dilutes the concern for debt repayment. For a number o f years, nonfarm incom es o f the farm population have been equivalent to around threefourths o f the net farm incom e o f farm operators. Should a cost-price squeeze threaten the debt repaym ent capacity of farmers, nonfarm earnings can be used to subsidize the debt servicing capacity o f farm income. A lthough such a relationship would be econom ically unstable over the long run, it could delay the im pact o f a costprice squeeze on debt repayments. While the arguments for and against concern over the repaym ent capacity o f agriculture m ay be at a stand-off, there is little doubt that there will be individual farm operators who will have difficulty repaying the financing obligations entered into during the current boom in farm debt. This could accelerate the continuing shift in the structure and control o f agriculture. This is not to say that farm debt will decline or even that its growth will necessarily slow from the rapid pace o f re cent years. But it does suggest the possibili ty that those rem aining in farm ing will be fewer in number, control a m ore extensive level o f assets, and be the m ost efficient and competitive users o f debt capital. Gary L. Benjam in 14 Federal Reserve Bank of Chicago anking developments Bank loan charges A normal relationship is gradually being restored between the interest rates paid on short-term bank loans by large and small businesses. This relationship was altered as a result o f the “ two-tier prime” concept generally adopted in the spring o f 1973 at the suggestion o f the Committee on In terest and D ividends (CID). The purpose o f the two-tier prime rate was to hold down the cost o f credit to small borrowers while allowing the banks to increase rates charg ed big borrowers in line with rising money market interest rates. Inform ation on the structure o f bank lending rates is very limited. One source o f inform ation is a Federal Reserve quarter ly survey o f rates charged on new loans made during a seven-business-day period. The survey covers a panel o f 15 district banks that account for a large portion o f the dollar volume o f outstanding com mercial and industrial loans. Average loan rates calculated from the survey responses show that, historically, rates on small loans (presumed to reflect credits to small business) have been higher than those on large loans, reflecting a greater element o f risk. This differential changes over the interest rate cycle, however, with the spread widening as the “ prime” rate declines and narrow ing as the prime rises. (The prime is the rate at w hich m ajor banks lend to their m ost creditworthy customers—principally large national cor porations.) In August o f 1973, for the first time in the history o f the survey, small loans were cheaper, on average, than very large ones. The weighted average rate charged by district respondents on loans under $10,000 was 8.8 percent—one h a lf o f 1 percent below the rate on loans o f $1 million and over. But by November, this negative spread was eliminated, and in M ay 1974 the structure o f rates w as very similar to that prevailing in the latter part o f 1969. Throughout the period o f econom ic co n tro ls that began with the New Econom ic Program in the summer o f 1971 a m ajor function o f the CID w as to hold down the price o f credit. But as rising credit demands, com bined with efforts to reduce the rate o f monetary growth, drove market interest rates higher in early 1973, the banks were flooded with dem ands for loans because bank loans were cheaper than the cost o f obtaining funds in the com mercial paper market. The CID guidelines accom panying the two-tier system allowed adjustments in the rate charged large businesses with access to national m oney and capital markets. (Nevertheless, it was not until fall that a fairly normal rela tionship was restored between the prime and commercial paper rates.) However, the guidelines insisted that increases in other Business Conditions, June 19 7 4 loan rates had to be justified by increases in costs and could not be as large or as fre quent as those involving large firms. The M ay 1973 quarterly survey was conducted shortly after the “ two-tier” criteria were established. Reflecting some adjustment in the large-business prime, the average rate on loans o f $1 m illion and over was 113 basis points higher than in the February survey, while the rate for loans under $10,000 was up only 34 basis points, reducing the spread to 65 basis points. By the August survey, the average rate on the largest loans was 9.29 percent, an increase o f 181 basis points over May, whereas the rate on the smallest loans in creased only 67 basis points to 8.80 percent, producing the reverse spread noted above. While the “ large business prime” in August was 8.75 percent and 9 percent (a lA percent increase occurred within the sur vey period), m ajor district banks reported rates o f 8.50 percent and below on more than h a lf o f the dollar volume o f loans o f less than $10,000 and on 31 percent o f those in the $10,000 to $100,000 loan size. The lag in rate adjustments on small loans was not a development unique to the period o f the CID guidelines. For instance, o f the loans reported in the August 1969 survey, when the prime was at its peak for the last interest rate cycle, 24 percent and 9 percent o f loan volume in the two smallest loan categories, respectively, were made at rates below prime. The differential in average rates between the smallest and largest loans was 26 basis points, com pared with 13 points in M ay 1974. A t the bottom o f the rate cycle in early 1972, with the prime as low as 4.50 percent at some banks, that differential reached a m ax imum 178 basis points. The earlier experience indicates that practices under the guidelines were not greatly different from what m ight have been expected without them. In a period o f rapidly rising rates, small loan charges tend to be sticky. However, the relatively 15 Effective rates on small loans follow “small” prime small increase in average charges on small loans, weighted by the amount loaned, m ay also reflect restrictive lending policies that screen out some high-risk borrowers who would norm ally have to pay a bigger premium over prime for credit. Another indication o f loan rate be havior under the CID guidelines is provid ed by m onthly reports o f a sample o f com mercial banks o f various sizes. This infor mation is collected jointly by the Federal Reserve System and the Federal Deposit Insurance Corporation. Simple averages o f the “ most com m on” effective annual rates reported by these banks on selected types o f loans have been published m onth ly since January 1972. The small business prime, first reported in July 1973, is defined as the rate charged by a bank to its most c r e d i t w o r t h y l o c a l b u s in e s s and agricultural loan customers. A ccording to this evidence, the small prime was a full 2 percentage points below the big prime in M ay 1974 due to the very rapid increases in the latter. However, effective rates most com m only charged on short-term business loans under $25,000 have exceeded the average small prime, w hich is not con verted to an effective rate basis, by 100 to 150 basis points since mid-1973. These rates have follow ed the trend o f the big prime but with smaller swings.
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