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■viMnun/MmiL ECONOMIC PERSPECTIVES A review from the Federal Reserve Bank of Chicago Consumer debt and home equity borrowing 1993 Bank Structure Conference program highlights Assessing global auto trends Trends and prospects for rural manufacturing Contents Consumer debt and home equity borrowing............................................................................ 2 Francesca Eugeni Have consumers reduced their debt levels significantly compared to the 1980s? The author suggests that the traditional method for measuring consumer debt fails to take into account changes in consumer borrowing habits. According to the author’s estimates, which do take into account recent borrowing trends, consumers have not significantly reduced their debt levels in the past few years. Assessing global auto trends................................................................ 1 5 Paul D. B atlew and Robert H. Schnorbus The authors discuss global trends in auto sales and production and their significance for U.S. automakers, especially in the Midwest. Trends and prospects for rural manufacturing............................................................................ 27 W illiam A . Testa How are you going to keep them down in the rural factory? The author discusses recent events affecting rural manufacturing, including the rise of flexible manufacturing, the increasing service orientation of manufacturing, and trade negotiations among the U.S., Canada, and Mexico. ECONOMIC PERSPECTIVES Karl A. Scheld, Senior Vice President and Director of Research Editorial direction Carolyn McMullen, editor, David R. Allardice, regional studies, Herbert Baer, financial structure and regulation, Steven Strongin, monetary policy, Anne Weaver, administration Production Nancy Ahlstrom, typesetting coordinator, Rita M olloy, Yvonne Peeples, typesetters, Kathleen Solotroff, graphics coordinator Roger Thryselius, Thomas O’Connell, Lynn Busby-Ward, John Dixon, graphics Kathryn Moran, assistant editor M arch/A p ril 1993 V o lum e XV II, Issue 2 ECONOMIC PERSPECTIVES is published by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and do not necessarily reflect the views of the management of the Federal Reserve Bank. Single-copy subscriptions are available free of charge. Please send requests for single- and multiple-copy subscriptions and back issues to Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois 60690-0834, or telephone (312) 322-5 111. Articles may be reprinted provided source is credited and The Public Information Center is provided with a copy of the published material. ISSN 0164-0682 Consumer debt and home equity borrowing Francesca Eugeni Consumer debt ratios are im portant analytical tools because they allow economists and business people alike to evalu ate households’ financial con ditions and forecast consumer spending, which is a crucial component of our economy. Be cause consumer spending represents two-thirds of the United States’ gross domestic product, fluctuations in households’ consumption affect the economy’s output. Typically, rising levels of personal consumption expenditures stimulate the economy, while slower growth or declines in this component have a dampening effect on economic growth. In general, individuals base their spending decisions on several factors, including the level of their existing indebtedness and their dispos able income. Therefore, we need to measure household debt appropriately in order to forecast consumer spending behavior. To evaluate con sumer indebtedness and consumer liquidity, analysts often use debt to income ratios, which measure the ability of consumers to cover out standing obligations with income. The analyst’s most difficult task when cal culating debt to income ratios is to choose the debt measure that can best reflect the full weight of consumer indebtedness. If the measure of debt is too narrow, the resulting debt to income ratio will understate the true magnitude of con sumer debt, while a debt measure that is too broad will inflate the real level of indebtedness. In either case, the resulting forecast of consumer spending behavior will be inaccurate. 2 For example, the most commonly used measure of consumer indebtedness, the ratio of consumer installment credit to disposable per sonal income, has been declining consistently since the beginning of 1990, reaching a seven year low in the second quarter of 1992. It has been widely suggested that the recent decline in this commonly used ratio indicates that consum ers finally have strengthened their balance sheets by lowering the level of their indebtedness, and will be able to sustain rising levels of spending in the future. However, a close look at the major components of household debt indicates that, over the last six years, consumers have been substituting home equity borrowing for other types of credit. Moreover, a recent increase in auto leases suggests that consumers also have been replacing traditional automobile loans with less costly auto leasing agreements. One of the results of these substitution trends is a decline in consumer installment credit outstanding which, in turn, causes the ratio of installment credit to disposable personal income to overstate the true change in consumer indebtedness. Because consumer borrowing behavior has changed over time, we need to adjust our gauging tools ac cordingly and find a debt measure that can best reflect such changes. This article proposes more comprehensive debt to income ratios that take into account the Francesca Eugeni is an economist at the Federal Reserve Bank of Chicago. The author is especially grateful to Steven Strongin for his guidance and insightful comments. The author would also like to thank Anne Marie Gonczy and Carolyn McMullen for helpful comments. ECONOMIC PERSPECTIVES substitution of home equity borrowing for con sumer installment credit. The analysis indicates that, when total home equity lending is included in the measure of consumer indebtedness, the consumer debt ratio has not declined consistent ly during the last two years, and it is much high er than the ratio of consumer installment credit to disposable personal income. Moreover, the analysis indicates that the substitution of auto leasing for automobile loans causes an under statement in the real magnitude of automobile credit outstanding. The evidence presented in this article sug gests that the recent restructuring of consumers’ balance sheets may not have been as significant as the traditional debt ratio indicates, and that the apparent improvement mostly reflects a reclassi fication of consumer liabilities among the differ ent components of household debt. Further more, although the rate of growth of household debt has slowed in the early 1990s, the analysis indicates that the more appropriate measure of consumer credit has not declined dramatically since 1989, which also suggests that households might not be able to sustain higher levels of spending in the near future. T h e c o m p o n e n ts o f h o u se h o ld d ebt The two major components of household debt are consumer credit and home mortgage debt. As of the third quarter of 1992, consumer credit represents approximately 19.3 percent of total household debt, and it consists of install ment credit and noninstallment credit. Nonin stallment credit represents only 7 percent of total consumer credit and consists mostly of short term credit, such as charges on credit cards that require payment in full within the billing cycle. Because noninstallment credit is such a small component of consumer debt, it is normally excluded when calculating debt to income ratios. Clearly more important, consumer installment credit represents 93 percent of total consumer credit, and it is comprised of automobile loans, revolving credit, and “other” installment credit.1 Total household debt as measured by the Federal Reserve Board2 also includes “all other” debt (tax exempt debt, other mortgages, bank loans n.e.c., and other loans) which currently repre sents 10.3 percent of total household debt. In the remainder of this article, household debt will include only its two major components, home mortgages and consumer credit. FEDERAL RESERVE BANK OF CHICAGO Home mortgage debt currently represents 70.4 percent of total household debt, and it con sists of all loans secured by one-to-four family residential properties, including home equity loans and home equity lines of credit, which are loans secured by the equity in the borrower’s primary residence. Home equity loans are tradi tional closed end loans that require scheduled monthly repayments of principal and interest for a predetermined period of time. Home equity lines of credit are revolving accounts (open end lines) that allow borrowers to make withdrawals against an approved dollar amount. Separate data on total home equity lending are not available, as loans secured by residential property are all grouped together in the all inclu sive category of home mortgages. However, data on home equity lines of credit outstanding at commercial banks and thrifts are available in the Report o f Condition, which summarizes balance sheet data of insured depository institu tions.3 Moreover, because of the increased pop ularity of home equity lines of credit during the last six years, different entities have been pub lishing survey data on home equity lending since 1987.4 Nevertheless, none of these sources offers complete historical data on both home equity loans and lines of credit for the lending industry as a whole. Therefore, the data on home equity lending used in this article to calcu late adjusted debt to income ratios are estimated. T h e sh ift to hom e e q u ity b o rro w in g As shown in Figure 1, during the last ten years, household debt (consumer credit and home mortgages) grew rapidly until 1990, when the rate of growth, although still positive, started to slow down. However, from the second half of 1983 to the end of 1985 total debt growth was boosted mainly by sharp increases in consumer installment credit, while from 1986 to the present the growth in total debt has been fueled mostly by home mortgages. In fact, home mortgages, including home equity lending, grew at an average seasonally adjusted annual rate of 15 percent from 1986 through 1987, compared to 11 percent in 1984. On the other hand, the growth in consumer in stallment credit slowed to an average 8 percent rate from 1986 through 1987, compared to 19 percent in 1984. In the early 1990s, the accumulation of both home mortgage debt and consumer installment credit slowed down considerably compared to 3 the 1980s. Installment credit actually declined 0.9 percent in 1991, and 1.2 percent in 1992.5 On the other hand, home mortgage debt continued to rise during the last three years, although at an average annual rate of approximately 6.5 percent. Typically, when the level of home mortgage debt increases, we expect home sales to rise ac cordingly, especially when nominal mortgage interest rates are declining. However, home sales were relatively weak from 1987 to 1991. Part of this anomaly can be explained by the fact that home mortgage debt does not consist exclusively of acquisition mortgages. Other components, such as home equity borrowing, are included in home mortgage debt and changes in these items are not correlated with changes in home sales. Home equity lending, and especially lines of credit, became extremely popular between 1986 and 1988, soon after the enactment of the Tax Reform Act of 1986. “Surveys of Consumer Attitudes,” conducted in 1987 and 1988 by the University of Michigan, show that 11 percent of homeowners had home equity loans in the second half of 1988, compared to 6.8 percent in 1983. Moreover, 76 percent of all the lines of credit in existence at the time of the surveys were opened in 1986 or 1987, compared to only 3 percent in 1983.6 The Tax Reform Act of 1986 phased out personal interest expense on nonmortgage loans as a tax deduction over a five year period (reach ing zero deductibility in 1991). This meant that the tax deductibility of personal interest on credit cards, auto loans, and personal loans disappeared 4 gradually while mortgage interest remained deductible. Because home equity loans (closed end loans) and lines of credit (open end lines) are secured by a lien on residential property, they are clas sified as mortgage loans, therefore allowing almost full deductibility of interest expense. The only restriction is that the amount of home equity debt on which the interest is deductible may not exceed the lesser of the home’s true equity (home’s fair market value less acquisition debt) or $ 100, 000 . It is clear, therefore, that most of the initial surge in home equity lending, from 1986 through 1988, occurred as consumers were trying to take advantage of the interest deductibility on mortgage loans, and were using home equity borrowing as a substitute for other types of cred it and as a source of funds to repay more expen sive outstanding debt. This view is also support ed by the fact that the initial slowdown in con sumer installment credit coincided with the first surge in home equity lending in 1986. In 1987, total consumer installment credit outstanding grew at one-third the average pace of 1984 and 1985. The growth in automobile loans started to slow down in 1987, and “other” credit was nega tive at the end of 1986 and remained consider ably weak thereafter. At the same time, survey data show that the median debt outstanding under home equity lines of credit at the typical lender rose from $6.8 million in 1986 to $15.6 million in 1987, a jump of 130 percent. Debt outstanding under closed end loans rose from a median of $7.4 million in 1986 to $10.7 million in 1987, a gain of 44 percent (see Figure 2).7 Although mortgage interest expense re mained deductible on both closed end loans and open end lines of credit, the Tax Reform Act of 1986 initially had a stronger impact on home equity lines of credit, as shown in Figure 2. This phenomenon can be attributed to the way homeowners originally used these two forms of home equity borrowing. Because home equity lines of credit are structured as simple revolving ac counts, initially they were considered the closest substitute for more expensive types of consumer credit, while traditional closed end loans contin- ECONOMIC PERSPECTIVES to indicate that consumers recently have been using home equity loans also as a substitute for traditional consumer loans. As Table 1 shows, in 1991,43 percent of closed end loans were used for debt consolidation, and 26 percent were allocated to expenditures on goods and services. In the same year, 36 percent of open end lines were used for debt consolidation, and 32 percent were allocated to expenditures on consumer goods and services. Overall, home equity lines of credit have become extremely popular over the last six years for the many tax and nontax advantages they offer to consumers compared to other forms of credit. For example, the interest rate charged on open end lines (approximately 2 percentage points over the prime rate) is usually much lower than interest rates on credit cards, car loans, and personal loans. Also, borrowers can use lines of credit on a need-only basis by means of checks, credit cards, and automatic teller machines. ued to be used mostly for home improvements. Usually, the amounts approved under open end As Table 1 shows, in 1987, of the amounts bor lines are larger than closed end loans and are rowed under open end lines, 53 percent were based on loan to value ratios ranging from 70 used for debt consolidation, 19 percent for ex penditures on consumer goods and services, and percent to 90 percent. For example, in 1991, the most common loan amount approved at the 25 percent for home improvements. In the same typical lender was $28,000 under a revolving year, of the amounts borrowed under closed end account, and $19,000 under a closed end loan loans, only 35 percent were allocated to debt consolidation, 16 percent were used for expendi commitment.8 Finally, repayment methods under lines of credit are more flexible than the tures on goods and services, and 45 percent for monthly repayment schedules of principal and home improvements. While the difference be tween the uses of closed end loans and open end interest under closed end loans. Although mini mum monthly payments usually are required lines was very pronounced in 1987, this differ under lines of credit, lenders offer different ence narrowed somewhat in 1991, which seems methods of repayment. Some lend ers require minimum monthly pay TABLE 1 ments calculated as a fixed percent age of the outstanding balance. Uses of home equity debt Other lenders require only interest (percent of totals) payments for the duration of the 1987 1991 loan, which typically is between 5 Open Open Closed Closed and 10 years, and one “balloon” end end end end payment when the loan matures. After the initial surge from Debt consolidation 53 35 36 43 1986 through 1988, home equity 29 Home improvements 25 45 28 4 5 11 10 Autos lending, and especially lines of Education 1 9 7 3 credit, continued to increase steadi 4 4 Investments 3 2 ly. As shown in Figure 2, in 1991, Other 12 10 12 9 the typical lender had a median of $79 million open end lines outstand NOTE: "O th e r" includes m edical expenses, vacations, tax paym ents, m ajor purchases, and business expenses. ing, and $52 million closed end SOURCE: C onsum er Bankers Association, Home Equity Loan loans, compared to approximately Study, 1989 and 1992; Canner, et. al., Federal Reserve Bulletin, 1988 and 1989. $7 million in 1986 for each type of FEDERAL RESERVE BANK OF CHICAGO 5 home equity lending.9 At the same FIGURE 3 time, as shown in Figure 1, growth Selected household debt components in consumer installment credit percent percent slowed considerably from 1987 to 19 1990 and declined in 1991 and 1992. 18 Although replacing other kinds of consumer loans with home equi - 17 ty borrowing might have no effect on the total stock of household debt, 16 it causes consumer installment credit outstanding to decline. For 15 example, expenditures on automo biles, consumer goods, and services 14 that are made with funds borrowed under home equity programs in 13 crease the home mortgage compo SOURCE: Federal Reserve Board, Flow of Funds; nent of household debt instead of U.S. Department of Commerce. consumer installment credit. Simi larly, the use of home equity loans debt, some might conclude that consumers final for debt consolidation might cause consumer ly have restructured their balance sheets by credit outstanding to decline as existing liabili appreciably reducing their liabilities. ties are reclassified on the balance sheets of However, other broader measures of house consumers. In fact, when consumers repay their hold debt clearly show that, although the overall outstanding debts with home equity loans and accumulation of debt has slowed down since lines of credit, they do not reduce the total level 1990, the true weight of consumer debt has not of their liabilities. Instead, the amount of the declined considerably during the same period. original debt is shifted from consumer install In fact, the debt to income ratio calculated using ment credit outstanding to home mortgages, home mortgages continues to increase in the where home equity borrowings are included. early 1990s (see Figure 3). In the third quarter Although the total amount of household debt has of 1992, the ratio stood at 64.3 percent, which is not changed on the balance sheets of consumers (assuming that the new home equity loan equals almost 20 percentage points above its level in the original debt), we understate the true magni 1980. Therefore, while the debt measure using tude of consumer indebtedness if we continue to installment credit fell 2.3 percentage points from use only consumer installment credit to calculate the third quarter of 1989 to the third quarter of debt ratios. 1992, the ratio of home mortgages to disposable personal income increased approximately 4 C o n s u m e r d ebt ra tio s points over the same period. The end result is an Consumer installment credit as a percent of increase of 1.1 percentage points in the ratio of disposable personal income is the debt ratio household debt (consumer credit plus home most often used to assess consumer liquidity, as mortgages) to disposable personal income over it matches disposable personal income with short the same time period. and medium term obligations. As Figure 3 However, we have to be careful in the shows, this debt to income ratio increased con choice of a more comprehensive measure of siderably throughout the 1980s, reaching an consumer indebtedness. Including home mort unprecedented level of 18.9 percent in the sec gages in our measure of debt would actually ond quarter of 1989. However, from the peak in cause the debt to income ratio to overstate the 1989, the ratio has declined consistently, falling real magnitude of consumer liabilities. This is to a seven year low of 16.7 percent in the second because home mortgage debt includes acquisi quarter of 1992, and to 16.6 percent in the third tion mortgages, which are long term commit quarter of 1992. After over two years of de ments where only a small portion of the total clines in the most popular measure of household debt has to be repaid each month. For example, 6 ECONOMIC PERSPECTIVES if we were to divide the entire amount outstand ing of a 30 year mortgage loan by annual amounts of disposable personal income, clearly we would be inflating our debt measure. On the other hand, although home equity borrowing is classified as mortgage debt, it differs from acquisition mortgages for two main reasons: 1) its uses, which are mostly debt con solidation and expenditures on consumer goods and services, and 2) its maturity, which is typi cally much shorter than the average life of first mortgages. Because these differences increase comparability between home equity borrowing and disposable personal income when calculat ing debt to income ratios, debt outstanding under home equity loans and lines of credit should be included in measures of consumer debt. H om e e q u ity le n d in g e stim ate d Before introducing adjusted consumer debt measures that take into account the substitution of home equity borrowing for consumer install ment credit, it is useful to discuss the methodolo gy used in this article to estimate the data on home equity loans and lines of credit. Estima tion of the data was necessary for several rea sons. First, although data on home equity lines of credit are available starting with the 1988 Report o f Condition of most depository institu tions (commercial banks, savings and loans, savings banks, and credit unions), data on home equity loans are often grouped together with first mortgages. Second, separate data on home equity lending at investment banks and finance companies are not available in the Report o f Condition, and third, data on home equity lend ing at depository institutions are somewhat un derstated due to the recent increase in securitiza tion of home equity loans and lines of credit. In general, securitization is a transaction whereby assets of an institution, such as residen tial mortgages, credit card receivables, automo bile loans, and, recently, home equity loans and lines of credit, are pooled together and repack aged into securities which are then sold to inves tors. When the seller of the securities transfers all risks and benefits associated with the assets to the purchaser, the sale is said to be without re course, and the assets are removed from the balance sheet of the loan originator. Because securitization is almost always without recourse, home equity loans and lines of credit outstand ing reported by depository institutions are under stated by those amounts that are securitized and FEDERAL RESERVE BANK OF CHICAGO eliminated from the balance sheets of the finan cial institutions. Although securitization of home equity loans and lines of credit is a fairly recent phe nomenon, it has been growing at a very rapid pace since 1989. In 1991, new issues of securi ties backed by home equity loans and lines of credit reached an unprecedented $10 billion, with 37 percent of home equity lines of credit securitized. This compares to $2.7 billion in 1989, and $5.6 billion in 1990.1 In 1992, ana 0 lysts estimate another $10 billion in total new issues, with 42 percent of home equity lines of credit securitized." Available depository institution data on home equity lines of credit were first collected1 2 and then total debt outstanding under home equity loans and lines of credit was estimated for the entire lending industry. The estimating process starts with the following findings from the 1987 and 1988 “Surveys of Consumer Atti tudes:”1 1) insured domestic commercial banks 3 had 40 percent of the home equity lending mar ket at the end of 1987, and 2) home equity lines of credit represented approximately 30 percent of the total home equity loan portfolio of the typical lender in 1988. The 40 percent market share was applied to home equity lines of credit outstanding at com mercial banks to calculate a total for the industry in the first quarter of 1988 ($32 billion/.40=$80 billion). Then, data on lines of credit outstand ing at commercial banks and thrifts were used to calculate a new market share ($52 billion/$80 billion=.65) which was used to estimate total lines of credit outstanding from 1988 to 1992. Then, since survey data show that lines of credit represented approximately 30 percent of total home equity lending in 1988, this proportion was used to calculate home equity lending for the industry as a whole from 1988 to 1992. The estimated total home equity lending was then adjusted for the amounts of home equi ty loans and lines of credit securitized from 1989 to 1992. Finally, it is important to note that the understatement in depository institution data cannot be completely eliminated as information on whole loan sales and private placements of home equity loans and lines of credit are not available at this time. As shown in Figure 4, the estimated total home equity lending increased 75 percent from 1988 to 1992, with increases of 110 percent for 7 open end lines and 60 percent for closed end loans during this same period. In the third quarter of 1992, total home equity lending reached an esti mated $469 billion, with 36 percent in home equity lines of credit. This compares to an esti mated total of $268 billion at the beginning of 1988, with 30 percent in open end lines of credit. A d ju ste d c o n su m e r d ebt ratios The three adjusted debt to income ratios shown in Table 2 all have disposable personal income (DPI) as the denominator, while each ratio has a different measure of consumer debt as the numerator. HE1CI/DPI uses the sum of total estimated home equity lines of credit and consumer installment credit. HE2CI/DPI uses the sum of consumer installment credit, total estimated home equity lines of credit, and the portion of estimated home equity loans that is used for expenditures on goods and services that typically are purchased with consumer credit. Finally, HE3CI/ DPI uses the sum of total estimated home equity borrowing (total debt outstanding under loans and lines of credit) and consumer installment credit. Table 2 also shows CI/DPI, which is the traditional unadjusted ratio of consumer installment credit to disposable personal income. The three adjusted ratios are graphed in Figure 5 together with the traditional consumer debt ratio (CI/DPI). HE 1CI/DPI is the least in clusive of the adjusted measures of debt, account ing only for the substitution of home equity re- The foregoing analysis and survey data on home equity loans and lines of credit clearly show that home equity lending increased dramatically during the mid-1980s TABLE 2 and continues to increase in the Adjusted consumer debt ratios early 1990s. Because the substitu (percent of disposable personal income) tion of home equity borrowing for other types of credit causes the (1) (2) (3) (4) traditional consumer debt ratio CI/DPI HE1CI/DPI HE2CI/DPI HE3CI/DPI (installment credit to disposable 1989-Q1 18.7 21.3 22.3 26.6 personal income) to understate the 1989-Q2 18.9 21.6 22.8 27.3 true magnitude of consumer indebt 1989-Q3 18.9 21.9 23.1 27.9 edness, this article proposes three 1989-Q4 18.9 21.9 23.0 27.6 debt ratios that take into account 1990-Q1 18.6 21.7 23.2 27.5 this substitution trend. To develop 1990-Q2 18.5 21.7 27.7 23.3 an accurate formula for measuring 18.4 1990-Q3 21.7 23.4 28.0 1990-Q4 18.1 21.6 23.2 27.9 debt, it is helpful to aggregate dif ferent components of debt and look 1991-Q1 23.2 27.9 18.0 21.6 at different ratios. For this reason, 1991-Q2 17.7 21.3 23.0 27.8 1991-Q3 17.5 21.2 23.0 28.0 each of the three adjusted ratios 1991-Q4 17.3 21.1 22.8 27.8 presented in this article uses a dif ferent level of the estimated debt 1992-Q1 17.0 20.7 22.6 27.3 1992-Q2 20.4 16.7 22.3 27.1 outstanding under home equity 20.4 1992-Q3 16.6 22.3 27.2 loans and lines of credit, ranging from a very conservative measure SOURCE: Column (1), U.S. Department of Commerce and Federal Reserve Board. Columns (2), (3), and (4) are calculated by the author. to a more inclusive one. 8 ECONOMIC PERSPECTIVES Therefore, both HE 1CI/DPI and HE2CI/DPI, which account for Adjusted consumer debt ratios only part of the substitution of percent home equity borrowing for other types of consumer credit, indicate that even with very conservative debt measures, consumer debt ratios have not declined signifi cantly in the 1990s. Finally, HE3CI/DPI, which is the most comprehensive adjusted measure of consumer debt, ac counts for the substitution of all forms of home equity borrowing for consumer installment credit, and it shows a more complete picture of consumer indebtedness. SOURCES: Federal Reserve Board and U.S. Department of Commerce. Recall that evidence on the uses of home equity borrowing shows that consumer credit recently has been volving accounts for consumer credit, and it replaced with both home equity loans and lines represents a very conservative adjustment of the of credit. Therefore, the inclusion of both forms traditional debt ratio. As shown in Figure 5, of home equity borrowing in our measure of while CI/DPI fell 2.3 percentage points from the debt is not likely to overstate the full weight of third quarter of 1989 to the third quarter of 1992, consumer indebtedness. HE 1CI/DPI fell only 1.5 points over the same The debt to income ratio adjusted for total period and has not declined since March 1992. home equity lending (HE3CI/DPI) clearly shows Therefore, although HE 1CI/DPI still is a very that consumers have not been considerably re conservative measure of consumer indebtedness, ducing the true magnitude of their indebtedness, it shows that the recent restructuring of the bal as the traditional debt ratio indicates. In fact, ance sheets of consumers has not been as dra HE3CI/DPI has ranged between 27 percent and matic as CI/DPI indicates, since HE 1CI/DPI has 28 percent for the past three years and stood at not declined as much. Moreover, it is important 27.2 percent in the third quarter of 1992, which to remember that HE 1CI/DPI recently edged is only 0.7 percentage points below its peak level down because it accounts only for a portion of in 1989 (see Figure 5). Moreover, in 1990 and the total substitution of home equity borrowing 1991, HE3CI/DPI averaged 27.7 percent and for consumer credit. The most comprehensive 27.9 percent, respectively, compared to an aver adjusted measure of consumer leverage, HE3CI/ age of 27.4 percent in 1989. For the three quar DPI, will account for this phenomenon in its ters of 1992, the ratio averaged 27.2 percent, entirety. which is virtually unchanged from 1989. HE2CI/DPI adds to home equity lines of All of the adjusted debt measures discussed credit that portion of home equity loans that is in this section show that the recent restructuring allocated to the purchase of consumer goods and of consumers’ balance sheets has not been as to expenditures on services, such as education, dramatic as the traditional measure suggests. vacation, and medical services, that typically are HE3CI/DPI, the most inclusive ratio and conse purchased with consumer credit. This portion quently a more accurate representation of con represented 26 percent of total closed end loans sumer debt, is the most dramatic, indicating that in 1991, compared to 16 percent in 1987 (see the true measure of consumer credit remains Table 1). As Figure 5 shows, in the third quarter virtually unchanged in the 1990s. of 1992, HE2CI/DPI stood at 22.3 percent, which is much higher than the 16.6 percent level D e b t se rv ice p aym en t ra tio s of CI/DPI, and only 0.8 percentage point below Another important debt ratio used to evalu its level in the third quarter of 1989. ate consumer liquidity is the ratio of debt service FEDERAL RESERVE FIGURE 5 BANK OF CHICAGO 9 payments to disposable personal income, which measures the ability of consumers to meet sched uled repayments of principal and interest on their outstanding debts. One measure of this consumer debt service burden, estimated by staff of the Federal Reserve Board, indicates that the ratio of debt service payments on total outstanding debt to disposable personal income has been declining steadily since the beginning of 1991, reaching a six year low of 16.6 percent in the third quarter of 1992. As estimated by the Federal Reserve Board staff, debt service payments on both consumer installment credit and home mortgages relative to disposable income also declined over this period. The recent reduction in these debt service ratios appears to conflict with the above conclu sion that consumers have not substantially re duced their indebtedness and strengthened their balance sheets considerably. However, debt ser vice payments on consumer installment credit outstanding do not include repayments on home equity loans and lines of credit, causing this ratio to understate the true size of consumers’ current liabilities. Moreover, although debt service pay ments on home mortgages include servicing of home equity borrowings, most of the recent de cline in mortgage repayments reflects heavy refi nancing and repricing of outstanding mortgages at lower nominal interest rates. After the Federal Reserve Board lowered the discount rate to 3.5 percent on December 20, 1991, and to 3 percent on July 2, 1992, borrowers started replacing their outstanding mortgages with new loan commitments at lower nominal mort gage rates, thereby reducing their monthly pay ments. In January and July 1992, mortgage appli cations for refinancings represented approximate ly 70 percent of all originations in both months, compared to about 30 percent for all of 1991.1 4 In summary, the recent reduction in debt service payments on consumer installment credit outstanding relative to disposable income seems to overestimate the apparent restructuring of con sumers’ balance sheets, as this debt measure does not include monthly disbursements on home equi ty borrowings. Moreover, although the ratio of total household debt service payments to dispos able income is calculated using the most compre hensive measure of debt (including home equity borrowings), part of the recent decline in this ratio was due to lower nominal interest rates. There fore, although this reduction in debt servicing obligations lessened the repayment burden of 10 consumers, it cannot be attributed entirely to a retrenchment of household debt. T he sh ift to auto lea sin g Another recent trend in consumer spending behavior is the substitution of auto leases for traditional automobile loans. In this case, the substitution phenomenon also causes an under statement in the real measure of consumer credit and should be taken into account when we eval uate the full weight of consumer indebtedness. Auto leasing has become extremely popular during the last six years mostly because it allows consumers to lower their monthly payments of principal and interest on a new vehicle. This is possible because the individual who leases the vehicle (lessee) finances only a portion of the total value of the car. Then, at the end of the lease, the lessee can either purchase the car for a set residual price or simply return the vehicle to the lessor. Moreover, because of the favorable lease terms and rates, consumers often can lease a more expensive vehicle without considerably increasing their monthly disbursements. Automotive leasing data collected by CNW Marketing/Research1 show that 24 percent of 5 total passenger cars delivered were leased in 1992. This compares to 12 percent in 1986, and to a projected 28 percent in 1997. Moreover, as Table 3 shows, the total value of the consumer lease fleet of passenger cars went from $13.1 billion in 1986 to $27.7 billion in 1992, an in crease of over 100 percent. During the same period, the amount paid by consumers for new auto leases rose from $8.3 billion to $12.7 bil lion, a gain of 53 percent. This increase is re markable especially if we consider that, in 1992, consumers financed only 46 percent of the total value of the lease fleet, compared to 63 percent in 1986. This decline in the lessee’s debt expo sure is mostly due to shorter maturities on new car leases in 1992 compared to 1986. The increase in auto leasing during the last six years coincided with a slowdown in the growth of automobile credit. From 1987 through 1989, automobile credit outstanding grew at an average annual rate of 6 percent, while it fell at an average of 4 percent during the last three years. This compares to average annu al increases of approximately 20 percent from 1984 through 1986. The earlier analysis of recent changes in consumer borrowing habits indicated that the use of home equity borrowings ECONOMIC PERSPECTIVES TABLE 3 Automobile leasing (1) (2) Lessee's debt exposure Value of lease fleet (3) Value of lease fleet cum ulated ( ...................... .... billion $ .......... ............ ; 1986 1987 1988 1989 1990 1991 1992 8.3 10.7 13.2 11.5 10.0 10.7 12.7 13.1 17.3 21.0 20.2 17.8 20.5 27.7 13.1 27.1 40.5 47.9 47.8 49.2 57.0 (4) Ratio of consum er installm ent credit/D P I (5) Ratio adjusted for auto leases ( ............. percent............. ) 18.3 18.2 18.4 18.9 18.1 17.3 16.6 18.7 19.0 19.5 20.1 19.3 18.5 17.9 NOTES: A m o unts in colum n (3) are first am ortized over four years and then cum ulated. Th e ratio in colum n (5) is the sum of consum er in stallm ent credit and the cum ulated value of the lease fleet in colum n (3) as a percent of disposable personal incom e. SOURCE: Colum ns (1) and (2), C N W M arketing/R esearch, Lease Trak Reports/8, A ugust 1992. Colum ns (3) and (5) are calculated by the author. C olum n (4), U.S. D ep artm ent of C om m erce and Federal Reserve Board. to purchase new autos and pay off more expen sive automobile loans outstanding contributed in part to the recent slowdown in the growth of automobile credit. Here, the effects of the sub stitution of auto leases for traditional auto loans are evaluated and a measure of debt adjusted for such phenomenon is estimated. First of all, it is necessary to express the value of the lease fleet in terms comparable to outstanding amounts of consumer installment credit. Table 3 shows the annual value of the lease fleet and the lessee’s debt exposure from 1986 to 1992. For example, if the same cars were financed with traditional auto loans instead of leases, then consumers’ debt exposure would equal the value Of the lease fleet (assuming 100 percent financing of the vehicle total cost for a purchase). Moreover, the value of the leased vehicles should be cumulated, since auto loans typically are repaid in approximately four years. Also, only a portion of the total value of the lease fleet should be cumulated each year to allow for amortization of the auto loans over the four years. Therefore, the value rolled over each year is gradually reduced by one-fourth of its original amount to reach full amortization by the fifth year. Because at this time data on the value of leased vehicles are not available before 1986, the cumulated value of the lease fleet from 1986 to 1989 is not exactly comparable to the num bers cumulated for later years. However, the FEDERAL RESERVE BANK OF CHICAGO purpose of these calculations is to give a general indication of the significance of the increase in auto leasing. At this point, the cumulated value of the lease fleet is added to consumer installment credit outstanding to obtain an estimated measure of debt adjusted for the shift to auto leases. As shown in Table 3, the new estimated measure is then used to calculate an adjusted debt to in come ratio. As Table 3 shows, although the ratio adjust ed for auto leases has declined since 1989, it is much higher than the traditional ratio of install ment credit to disposable personal income at any point. Moreover, the adjusted debt ratio does not take into account the substitution of home equity borrowing for other types of consumer credit, which causes installment credit to decline. Final ly, if automobile loans outstanding are adjusted for the increase in auto leases, automobile credit fell only 7 percent from the third quarter of 1989 to the third quarter of 1992, compared to a 12 percent drop in the unadjusted measure of auto mobile credit during the same period. The above analysis, once again, highlights the importance of choosing a measure of debt that takes into account the changes in consumer financing behavior and further suggests that even the most comprehensive adjusted debt ratio dis cussed earlier in this article (HE3CI/DPI) may still understate the full weight of consumer in debtedness. 11 C o n c lu s io n The evidence presented in this article shows that consumer borrowing patterns have changed during the last six years, as households have been taking advantage of less costly sources of credit. The substitution of home equity borrow ing for other types of credit and the replacement of traditional auto loans with auto leases are clearly two important changes in consumer borrowing behavior. One of the results of these substitution trends is a decline in consumer installment credit outstanding, which, in turn, causes the most commonly used debt ratio (consumer installment credit to disposable personal income) to under state the full weight of consumer indebtedness. Therefore, to appropriately gauge consumer liabilities, we need to use a debt measure that is more inclusive, but not too broad, and more responsive to changes in consumer borrowing patterns. This article has proposed three con sumer debt ratios that take into account the sub stitution of home equity borrowing for other types of credit. These adjusted debt to income ratios indicate that, although the rate of accumu lation of total household debt has slowed down since 1990, the real magnitude of consumer indebtedness has not been consistently declin ing during the last two years, as the traditional measure of consumer debt suggests. Moreover, the recent substitution of auto mobile leases for traditional auto loans also causes an understatement in the true level of automobile credit, and its effects should be taken into account in assessing consumer in debtedness. Finally, a fundamental result of this analy sis is to suggest that the choice of an appropri ate measure of debt can turn an overstated decline in consumer indebtedness into a virtual ly unchanged reality. In fact, in light of all the findings presented in this article it is reasonable to conclude that, although the burden of debt servicing has declined due to lower nominal interest rates, consumers have not significantly reduced their debt levels. This, in turn, seems to indicate that, after all, households might not be able to appreciably increase their level of spending in the near future. FOOTNOTES '"Other” installment credit includes mobile home loans, and secured and unsecured loans for education, boats, trailers, and vacations. 2Federal Reserve Board, Flow o f Funds Accounts. 3The Report o f Condition contains balance sheet and income statement information o f insured commercial banks and thrifts. In general, insured depository institutions must file statements o f condition and income with their respec tive federal government regulatory agencies on a quarterly or semiannual basis. 4The Consumer Bankers Association publishes annual Home Equity Loan Studies, and the American Bankers Association publishes annual Home Equity Lines o f Credit Reports. 5Data for 1992 are through the third quarter, unless other wise noted. 6Data from the 1987 and 1988 “Surveys of Consumer Attitudes” o f the University o f Michigan are from Canner, et. al. (1988) and (1989). extreme observations. Moreover, Figure 2 seems to indi cate that the typical lender maintains a higher portfolio of open end lines than closed end loans. Note, however, that Figure 2 plots only the middle results of the studies and that all o f the respondents in the CBA ’s surveys offer both home equity lines and loans. Data from the Report of Condition indicate, however, that only 60 percent o f com mercial banks offer home equity lines o f credit and that, overall, closed end loans represent a much larger share of the real estate loan market than open end lines. 8Consumer Bankers Association (1992). 9Ibid. l0Dean Witter Reynolds Inc. (1992); D uff & Phelps Credit Rating Co. (1992); and American Banker Bond Buyer (1992). "Estimated total issues for 1992 are from David Olson Research Co., Columbia, MD. 12Federal Reserve Board database. "Canner, et. al. (1988) and (1989). 7The data are from the 1987 and 1989 Consumer Bankers Association’s (CBA) Home Equity Loan Studies. Although the CBA’s studies report both the mean and the median as measures o f central tendency, in this article only the medi an will be used, as mean results can be at times skewed by 12 "Mortgage Bankers Association (1992). I5CNW Marketing/Research, Lease Trak Reports/8 , (1992). ECONOMIC PERSPECTIVES REFERENCES American Banker Bond Buyer, Asset Sales Report, October-December 1992. Duff & Phelps Credit Rating Co., AssetBacked Monitor, 1991 and 1992. American Bankers Association, Home Equity Lines o f Credit Report, 1990 and 1992. Federal Reserve Board, Flow o f Funds Ac counts, various years. Boemio, Thomas R., and G.A. Edwards, Jr., “Asset securitization: a supervisory perspec tive,” Federal Reserve Bulletin, October 1989, pp. 659-669. Mortgage Bankers Association, Real Estate Finance Today, November 14, 1991 and July 20, 1992. Canner, Glenn B., and C.A. Luckett, “Pay ment of household debts,” Federal Reserve Bulletin, April 1991, pp. 218-229. Canner, Glenn B., C.A. Luckett, and T. A. Durkin, “Home equity lending,” Federal Re serve Bulletin, May 1989, pp. 333-344. Canner, Glenn B., J.T. Fergus, and C.A. Luckett, “Home equity lines of credit,” Federal Reserve Bulletin, June 1988, pp. 361-373. CNW Marketing/Research, Lease Trak Re ports/8, Bandon, OR, May, August, and Novem ber 1992. Consumer Bankers Association, Home Equity Loan Study, 1986-1992. Pavel, Christine A., The Analysis and Develop ment o f the Loan-based/Asset-backed Securities Markets, Probus Publishing, Chicago, IL, 1989. _________________ , “Securitization,” Econom ic Perspectives, Federal Reserve Bank of Chica go, July/August 1986, pp. 16-31. Pozdena, Randall J., “Home equity lending: boon or bane?,” Weekly Letter, Federal Reserve Bank of San Francisco, June 2, 1989. Swonk, Diane C., “Consumer debt: hitting a wall in the 1990s,” Trend Watch, First National Bank of Chicago, August 1992. United States Banker, “HELs in heaven,” May 1992, pp. 20-23. Dean Witter Reynolds Inc., Asset Backed Se curities Reference Guide, first half 1992. FEDERAL RESERVE BANK OF CHICAGO 13 The 2 9 th A n n u a l Conference on B ank Structure a n d Competition, M ay 5-7, 1993 FDICIA A n Appraisal The Federal Reserve Bank of Chicago will hold its 29th annual Conference on Bank Structure and Competition at the Westin Hotel in Chicago, Illinois, May 5-7, 1993. Attended each year by several hundred academics, regulators, and financial institution executives, the conference serves as a major forum for the exchange of ideas regarding public policy toward the financial services industry. This year’s conference will provide a broad based assessment of the merits and shortcomings of the Federal Deposit Insurance Corporation Improve ment Act (FDICIA) of 1991. Among the highlights of this year’s program will be: I The keynote address by Federal Reserve Board Chairman Alan Greenspan. I A panel discussion on the topic, “FDICIA: Renaissance or Requiem?” Prominent members of the academic, regulatory, and banking communities will discuss the impact of the new legislation. I A luncheon address on banking reform by John G. Heimann, chairman of the Global Financial Institutions Group of Merrill Lynch & Company, Inc. and former superintendent of banks for New York State and Comptroller of the Currency. 14 I A panel discussion on the potential for systemic risk resulting from the rapid increase in over-the-counter trading of derivative and foreign exchange products. The panel will include leading experts on derivatives trading and interbank risk exposures. I A luncheon panel, “The Outlook for Banking: Is the Crisis Over?,” featuring L. William Seidman, former chairman of the Federal Deposit Insurance Corporation and currently chief commentator of CNBC; George M. Salem, first vice president of Prudential Securities; and Edward J. Kane, James F. Cleary Professor of Finance at Boston College. As usual, our Wednesday sessions will showcase a wide array of more technical papers of primary interest to researchers in academia and government. If you are currently not on our mailing list or have changed your address and would like to receive an invitation to the conference, please write or call: Sandy B lazina Public A ffa irs Department Federal Reserve B ank o f Chicago P .0. Box 8 3 4 Chicago, Illinois 6 0 6 9 0 -0 8 3 4 Telephone 3 1 2 -3 2 2 -5 1 1 4 ECONOMIC PERSPECTIVES Assessing global auto trends Paul D. B allew and Robert H. Schnorbus The global automobile indus try has gone through over whelming restructuring during the last twenty years. This restructuring has produced, among other effects, massive downsizing and relocation for the Midwest, the birthplace of the mass production of vehicles. Assessment of current and future changes in the industry pre dict further adjustments, especially within the region. The factors prompting these adjust ments are frequently depicted dramatically as emanating in large part from economic forces endemic to the U.S. market. Although this domestic emphasis is understandable, one sub ject that has received less attention is how the U.S. market has been impacted by the rapidly evolving global environment. For instance, the U.S. market constitutes only 25 percent of new vehicle sales in the world and its growth is slowing relative to the rest of the world. In deed, an expanding portion of future economic growth and increases in consumer spending on autos is likely to originate abroad. A current assessment of the domestic U.S. industry within this global marketplace indi cates that the Big 3 (GM, Ford, and Chrysler) are almost exclusively concentrated in the North American and European markets. A sales dependency ratio for each of the Big 3 of North American sales to worldwide sales is presented in Figure 1. As indicated, Chrysler has the highest concentration in North America with a ratio of .96. This ratio has been increas ing throughout the latter half of the 1980s, although the recent expansion of Chrysler in FEDERAL RESERVE BANK OF CHICAGO Europe should offset part of this concentration. Ford’s North American ratio is .63, while GM’s is slightly higher at approximately .67. Both of these levels are significant improvements over Chrysler. However, their North American and European to world sales ratios provide evidence of the degree of concentration and the depen dency of Ford and GM in these markets collec tively, with GM’s combined ratio over .90 and Ford’s combined ratio almost .95. A major factor in this dependence is the limited presence of the Big 3 in developing markets, with the possible exception of Latin America. Of particular concern is the Big 3’s absence in Asian markets where their combined sales are still less than 500,000 units annually. Eastern and central Europe are two potentially key emerging markets for the Big 3. However, competition from VW, Fiat, and, eventually, Japanese manufacturers will be intense. These markets are unlikely to achieve rapid growth in auto purchases before the end of the decade. In an attempt to achieve an integrated analysis for the auto industry, this article ana lyzes each major and emerging market for Paul D. Ballew is an economist and information coor dinator at the Detroit branch of the Federal Reserve Bank of Chicago. Robert H. Schnorbus is senior businesseconomistand research officeratthe Feder al ReserveBankofChicago. Theauthorswishtothank Professor Don Byrne of the University of Detroit for providing access to much of the data used in this study. The authors would also like to thank David Allardice, Assistant Director of Research atthe Feder al Reserve Bank of Chicago, and Roby Sloan, Senior Vice President of the Detroit branch, for helpful com ments and support in completing this study. 15 FIGURE 1 Dependency ratio— Big 3 sales percent (sales in region/total sales) world’s production and sales of vehicles. Of these markets the U.S., Japan, and Germany are the most important. However, because of the degree of integration between the U.S. and Can ada and among the seventeen major nations of western Europe, these markets have been grouped into U.S.-Canada, Japan, and western Europe. All three major markets are large pro ducers with similar market shares. One differ ence is that Japan is export oriented, while U.S.Canada and western Europe are domestically oriented. Western Europe and U.S.-Canada represent over 60 percent of all vehicle sales in the world, with Japanese domestic sales being significantly less, approximately 15 percent. U.S.-Canada North America North America + western Europe SOURCE: U S. Department of Commerce and Federal Reserve Bank of Chicago. vehicles first individually and then in aggre gate. The purpose of this systematic approach is to reach some comprehensive insights and conclusions into the prospects for the U.S. nameplates in a marketplace where they must compete with foreign nameplates not only in their own backyard but also in markets through out the world, most of which are less than hos pitable. This article will also emphasize how these global developments impact auto produc ers in the Midwest, a region where the domestic industry is still highly concentrated.' G lo b a l d em a n d fo r v e h ic le s in p e rsp e c tiv e Global sales of motor vehicles today are nearly 50 million units annually. In the last few years, sales have been approximately 4 to 5 million units below trend annually, with sales in the U.S. accounting for roughly half of this deficiency. This trend level of roughly 55 million units is well above the ten year average of 41.5 million units; and in fact, growth in the overall vehicle market has been significant in the last ten years, up almost 25 percent during the 1980s. Furthermore, market forecasts antic ipate vehicle sales in excess of 60 million by the turn of the century.2 Currently, the market can be segmented into three mature markets and three important emerging markets. The mature markets collec tively account for over three-quarters of the 16 Among the mature markets, average light vehicle sales in the U.S.-Canada market over the past decade have reflected cyclical patterns as well as trend growth of the U.S. economy. Sales dropped significantly in 1981 and 1982 and rebounded to record levels in the 1984 to 1987 period. Since 1989, sales have declined as the U.S. and Canadian economies have slowed sig nificantly, with combined sales declining to 16 million units in 1990 and bottoming out in 1991 with a decline to 14.5 million units. Further more, the sharp decline since 1989 had been preceded by a slow decline from the peak of 18 million units in 1986 toward a rate below the ten year average of just over 16 million units.3 The U.S.-Canada market has experienced significant competition over the last 20 years as foreign nameplates have eroded the stranglehold that the Big 3 once had on the market.4 The market share for the Big 3 has steadily declined from over 90 percent to its current levels of 70 percent for light truck and cars combined and 65 percent for passenger cars. GM has been the biggest loser in the passenger car market with a loss in market share of more than 10 percent over the last decade. This erosion has been largely the result of market penetration of for eign nameplates, of which the Japanese brands have been most successful, with a market share today of approximately 25 percent in North America. This market share equals approxi mately 4 million units in annual sales. Despite setbacks in the passenger car mar ket, domestic nameplates have done extremely well in the growing light truck segment. This segment, increasingly dominated by Ford and Chrysler, represents, in large part, a shift in con ECONOMIC PERSPECTIVES sumer preference from cars to passenger light trucks, such as minivans and sports utility vehi cles. During the past decade the number of light trucks sold annually has doubled, reaching al most five million in 1992. This growing market, along with product strength, traditional know how of the segment, and trade restrictions, has allowed the Big 3 to maintain a market share of approximately 85 percent (even in 1991). Cur rent vehicle introductions and redesigned ver sions have further stimulated sales at the expense of Japanese producers in particular. However, Japanese and domestic producers are responding to this growing demand with increased product development. For example, the recent introduc tion of Nissan’s minivan, the Quest model, has been well received by auto critics. And Toyota has recently entered the mid-sized pickup truck market, perhaps as a stepping stone to the intro duction of a full sized model.5 Therefore, the continued dominance of even this segment by domestic producers is not guaranteed. Expansion of foreign nameplates into luxury and sport cars as well as minivans and pickup trucks will continue to put pressure on domestic nameplates to retain market share.6 Product development schedules are decreasing in length, price containment pressures are intense, and quality and safety improvements continue to accelerate. The pressure is intense for all pro ducers and significant restructuring is prevalent even for Japanese nameplates. In fact, Isuzu has announced its intention to exit the light truck market in the U.S., and Mazda has delayed its entry into the luxury car segment by cancelling the Amati. The prospects for a North American free trade area or customs union may dampen some external competition due to domestic con tent requirements. However, it should foster intraregional competition, including transplant operations. Therefore, the U.S.-Canada market will likely continue to be one of the most com petitive markets in the world, despite its relative ly slow growth. Western Europe Unlike the U.S.-Canada market, the western Europe market—the second largest in the world—continues to have significant vehicle sales. Although sales declined slightly in the weaker economic environment in 1992, sales have trended steadily upward in the last 5 years. With access to central and eastern Europe, this market is rapidly becoming one of the most FEDERAL RESERVE BANK OF CHICAGO important areas of growth in the industrialized world. With prospects for economic unification strong in the region, the presence of numerous firms, both local and foreign, continues to be a dominant character of the market. Thus, the key question concerns the consequences of economic integration for all auto manufacturers involved in western Europe. Sales in the market, due primarily to a one time boost from German unification, were robust in 1990 and 1991. Sales in 1991 reached 15 million units and, although sales in 1992-93 are being depressed by the economic difficul ties in Germany, the outlook is for sales of more than 15 million units annually into the late 1990s. Continued growth in certain Euro pean Community (EC) countries (notably Spain and Portugal) and the economic stimulus from further integration in the EC are expected to support these sales levels. Some of the demo graphics of a mature market that exist in the U.S., such as an aging population with modest income growth, are also present in Germany, the U.K., and France. However, these factors should be offset by further market integration and stronger economic growth. Current sales in western Europe are divid ed among six major producers, with limited Japanese imports (approximately 12 percent), and a second tier of product or market specific manufacturers. Unlike other major markets, no producer has even marginal dominance of the western European market. Volkswagen, the market leader, comes closest with a western European market share of 17 percent, a strong hold in Germany (over 25 percent market share), and a significant share in every other market in Europe. Fiat and PSA (PeugeotCitroen) are next with market shares of approx imately 13 to 14 percent. Both producers are heavily concentrated in their domestic markets. PSA is more diversified than Fiat, but Fiat has increased its efforts in central Europe in recog nition of this fact. A large portion of Fiat’s dependency on the Italian market is due to the Italian government’s decision to limit foreign imports.7 Ford and GM both have significant sales presences in Germany and the United Kingdom and each has a market share above 12 percent. Both companies have been rapidly expanding in other markets; Ford in Italy and Germany and GM in Spain and the United Kingdom (a long time stronghold of Ford). 17 State owned Renault rounds out the major man ufacturers with a market share of approximately 10 percent. The company focuses almost ex clusively on the French market with only limit ed sales in other European markets. Recently, Renault has attempted to expand its reach through joint operating agreements, especially in Scandinavia. A number of companies with significant market presences in specific markets recently have been acquired wholly or in part by larger firms. For instance, Saab has been partially acquired by GM, and Jaguar by Ford. Japanese manufacturers are also trying to increase their share of the market, but face a quota of 16 percent in the EC. Therefore, transplants have increased, although additional limits on these developments, labor costs, and other concerns may dampen this movement somewhat. Japan Annual vehicle sales in Japan currently constitute the second largest single country vehicle market in the world. Sales in the late 1980s and in 1990 approached almost 8 million units a year. The continued growth of the mar ket throughout the post-war era has resulted in per capita vehicle registration level comparable to the U.S. However, a variety of factors are currently reducing sales growth, including the current economic slowdown, an aging popula tion, low population growth, parking and regu latory difficulties, and a maturing market.8 The domestic Japanese sales market is dominated by Toyota (35 percent), Nissan (20 percent), Honda (10 percent), Mazda (7 to 8 percent), and Mitsubishi (more than 5 percent), with other Japanese producers active in specific market segments. The bulk of the remaining market is comprised of foreign nameplates, although they have not reached any significant market penetration. In the past, trade restric tions limited foreign nameplate penetration. In recent years, other barriers, such as limited distribution networks and adaptation to local customers’ tastes, have limited penetration. Annual sales volumes by foreign producers are still below 250,000 units (approximately 3 percent), and most of this activity is concentrat ed among European nameplates. Overall, the market is currently in flux and the two dominant producers, Toyota and Nis san, have recently experienced significant sales setbacks. The current economic slowdown in a 18 mature and potentially stagnant market will continue to pose problems for these producers, although they will probably continue to domi nate the market for the foreseeable future. Smaller Japanese manufacturers have experi enced greater difficulty because they do not have the financial wherewithal to wage a com petitive battle in multiple market segments. Asia-Pacific region (excluding Japan) Overall sales in 1991 in the Asia-Pacific market, excluding Japan, were slightly less than 4 million units. This level is not significant relative to mature markets. However, the po tential for growth is phenomenal. Sales in South Korea, for instance, are currently in ex cess of 1 million units and have more than doubled in last 15 years. Sales in Taiwan have also experienced strong growth in the 1980s: total vehicle sales annually are almost 500,000 units. Overall in the 1980s, non-Japanese sales in Asia grew in excess of 8 percent annually, a trend which is widely expected to continue in the 1990s. The remaining parts of the region represent an underserved, emerging market with strong income and population growth.9 Additionally, economic reforms in the two most populous countries of the world, China and India, could potentially provide significant growth in consumer product sales. In the early stages of development, con sumers typically do not buy vehicles. Howev er, gains in income eventually produce signifi cant gains in vehicle purchases in underserved markets such as Asia. An estimate of these potential sales gains for China is indicated by Figures 2 and 3, which compare income levels and vehicle sales in South Korea during its phenomenal economic acceleration in the 1970s and 1980s to projected levels for China. As shown, growth in vehicle sales and all con sumer durables in South Korea exploded once per capita income reached approximately $3,500 a year. That is, at this level vehicle sales begin an upward swing which accelerated as income continued to gain. If China mirrors this trend, the gains in vehicle sales in the next twenty years may be surprisingly strong. For instance, if China’s vehicle concentration is similar to the Korean experience, total vehicle registrations in China may approach 40 million units early in the next century. Current vehicle registrations in China are only 5 million. ECONOMIC PERSPECTIVES with this growth in sales the mar ket will continue to be under served, given an estimated popu lation of 1.3 billion people by 2010. Consequently, future sales growth may be more rapid, al though other constraints, such as space and regulations, may even tually set limits on the market. Similarly, other nations in the region may achieve substantial growth in vehicle sales in the next few decades. For instance, per capita registrations in India are even lower than in China. Eco nomic reforms are still in their infancy in this country, however, and remain a concern. Other Asian markets, principally Thai land, Indonesia, and Malaysia, Therefore, assuming some replacement, total appear well on their way to reform and should sales could approximate 35 to 40 million units boost sales of vehicles significantly in the years ahead.1 0 over the next 10 to 15 years, resulting in annual sales on average growing at four times their Market concentration is actually higher in current sales rate. some Asian markets than in the more estab lished markets. The Korean market, for in If this growth seems unbelievable, it should be noted that mean income levels in the Guang stance, is dominated by Hyundai Motors (over dong Province in southern China, one of the 50 percent), Kia Motors (over 20 percent), and most successful provinces, are currently esti Daewoo Motors (over 20 percent).1 However, 1 mated at above $2,000 a year. Income growth other markets are more diverse, with foreign is currently projected at more than 7 percent nameplates active in Taiwan, where Ford has a annually, with southern regions experiencing strong market presence, and Thailand, where Toyota and other Japanese automakers are much more rapid growth. Furthermore, even active. One trend affecting mar ket concentration is government FIGURE 3 activity. Besides trade barriers, Projected income and vehicle registrations many Asian markets have govern growth in China ment sponsored companies or partnership programs that discour age market penetration. Japanese manufacturers have been the most successful at entering these mar kets through unconventional means. Partnerships as well as transplant facilities continue to provide Japanese manufacturers access to the market. Eastern and central Europe Perhaps the most important emerging market is in eastern and central Europe. This market cur rently is going through a massive restructuring phase with existing FEDERAL RESERVE BANK OF CHICAGO 19 state owned firms failing and/or being disas sembled and western firms rapidly entering the market. Sales in the last decade have lagged due to limited income growth on the part of individuals. Overall the market is currently underserved with vehicle registrations well below western European levels. Pent up de mand has been exhibited in many product mar kets since liberalization, as indicated by recent rapid sales growth. While the near term sales outlook is some what bleak, with incomes falling and unem ployment rising, the economic transformation is beginning to take shape and, as the recovery begins, higher income levels will result in in creased demand in this underserved consumer market over the long term. Consequently, sales in Hungary, Czechoslovakia, Poland, and the Baltics should accelerate throughout the mid1990s. Furthermore, the 280 million consumers in the Commonwealth of Independent States (CIS), a collection of former Soviet republics, will likely experience significant income gains in the late 1990s and, therefore, provide an added boost. These developments should sig nificantly enhance the overall European mar ket. A conservative estimate of vehicle sales of 6 million units annually seems likely by the end of the first decade of the next century, exclud ing a rapid economic transformation in the CIS. It is important to keep in mind that such a sales level would exceed annual sales in Germany. Furthermore, even given this sales level, the market will not be close to western standards. Latin America Latin America is another emerging market that is experiencing a significant economic transformation. Reform efforts have solidified growth in Mexico, Argentina, Chile, and Vene zuela, and will eventually stimulate demand for durables in a market of 125 million consumers. Successful economic reform in Brazil and the Andean nations, which appears possible if not probable, could further stimulate the market. Although political instability is a major con cern, democratic reforms and trade liberaliza tion have increasingly solidified the gains made to date. Current vehicle sales of almost 2 million units annually reflect the potential in the region. Given the economic hardship of debt restructur ing and economic austerity programs, the cur rent sales levels reflect positively on the de 20 mand for vehicles in the region. The Interna tional Monetary Fund and World Bank estimate that the GDP of the region should continue to accelerate throughout the decade, averaging 4.5 to 5 percent annually. If the economies expand at such a rate, the recent annual sales growth in autos of over 20 percent may not be replicated, but growth should continue. Potential growth in Latin America should boost Big 3 sales as well as European manufac turers’ sales (especially Volkswagen), as these producers have significant presences in Mexico and Brazil. Recently, Japanese nameplates have begun to penetrate the market. However, the efforts have been limited. One wild card is the outcome of the various trade talks ongoing in the region. Modifications in domestic con tent restrictions and other trade barriers could significantly alter production and sales activity for various producers. The general effort to liberalize existing trade policies will likely accelerate investment, export activities, and domestic sales.1 2 C u rre n t and fu tu re p ro d u c tio n a c tiv ity Production activity mirrors sales activity within markets as well as export and relocation activities or producer trends. Changes in pro duction activities in regions and between pro ducers has been relatively dynamic in recent years. There has been continued movement toward lower cost production, an effort to close excess facilities in some market segments and expanded production in others in order to ac cess new and growing markets. These trends are often a response to shifts in sales and com petition among producers. To understand the future implications, it is important to under stand the current production environment. The global marketplace is comprised of 12 major manufacturers with annual production capacity above 1 million units and a second tier group comprised of manufacturers with produc tion capacity below 1 million units, many of them specializing in specific market segments. The top six manufacturers account for over half of global production and the top 12 account for over three-quarters of all production. But in comparison to the 1960s and 1970s, the level of concentration is less and has become more geographically diverse. For example, GM is still the number one automaker, but its market share has fallen below 20 percent, Ford is sec ECONOMIC PERSPECTIVES ond with a 13 percent share, and Toyota is cur rently third with a 11 percent share. Most manufacturers still have a core base in their traditional markets. Although one would not classify this core as stable, it still provides a degree of support and is a major consideration in most decisions affecting company operations. The major question for firms in the future may be whether or not they can maintain their posi tion in their traditional market while at the same time penetrating new markets.1 3 U.S. and Canada Production during the last decade has aver aged approximately 12 million units annually in the combined U.S.-Canada market with signifi cant growth occurring in two primary segments: light trucks and transplants. Light truck produc tion, for instance, has more than doubled since the late 1970s and early 1980s.1 Transplant 4 production in the U.S. and, to a lesser extent, Canada, has also soared. Transplant production in 1982 was only a token level from Honda; by 1991 transplant production exceeded 1.6 million units annually and new capacity continues to be added, especially in light trucks. Within this expansion of production there has been a change in mix of firms, led by the continued downsizing of GM, Ford, and Chrys ler, especially in the U.S. By the mid-1990s, Big 3 employment will be more than 400,000 jobs lower than its level in 1980. Production by the Big 3 exceeded 11 million units in the mid1980s, however, since that time, production has consistently headed downward, and is currently near 8 million units. GM is currently planning to close at least 4 assembly plants totaling over 1 million units of capacity. Gains in market share by foreigners coupled with the general competi tive pressures to do more with less continue to shape the production decisions of the Big 3 as well. Future developments in production of units in North America should reflect the contin ued development of transplants, some additional downsizing of existing domestic nameplate operations in the U.S. and Canada, and some shifting of domestic nameplate production to foreign markets. Western Europe Western European production in the last five years has exceeded 13 million units. Capac ity is currently estimated at more than 14 million units, with new facilities coming online. Current FEDERAL RESERVE BANK OF CHICAGO production is concentrated in four principal countries: Germany, France, Italy, and the Unit ed Kingdom. Germany, where one in six jobs are linked to the auto industry, easily outstrips all other production areas, with production in excess of 5 million in 1991. French and Italian producers generally comprise a second tier of companies and are concentrated heavily in their domestic markets. British production increas ingly involves U.S. and Japanese transplants or wholly owned subsidiaries, and production is mixed between domestic units and products exported to the continent. Western Europe has six large firms and a second tier comprised of specialized and/or market specific firms, transplants, and imports. Volkswagen, PSA, GM, Ford, Fiat, and Renault are the top producers in this market representing 85 percent of production. The second tier is dominated by luxury car makers like BMW and Mercedes and single product firms like Volvo. Recently, mergers and consolidations have re duced the number of independent companies. Furthermore, competition has also redistributed market share among the largest firms, with GM and VW on the ascendancy1 and Fiat and, to a 5 lesser extent, Ford struggling somewhat. NonU.S. transplant production initially involved Nissan’s entry into Britain. However, Toyota and Honda have also recently established facili ties. By the mid-1990s, Japanese transplant production capacity in Europe will exceed 500,000 units annually. A primary concern in these transplant locations is the continuing threat of trade retaliation and a stated EC policy to limit Japanese nameplates to a market share of 16 percent or less. (Current sales levels are still below this target.) The Big 3 have also added capacity due to stronger sales or, in the case of Chrysler, reestablishing a position in the market.1 6 Japan Japan is the largest single country producer in the world in combined car and light truck production. Annual production levels by 1991 exceeded 13 million units annually. Almost 45 percent of this production (over $65 billion a year) is exported and, consequently, Japan is the world’s largest exporter of vehicles. Toyota, Nissan, Honda, Mazda, and Mitsubishi are the primary, but not necessarily the dominant, pro ducers. Altogether, the domestic market actual ly is comprised of 10 manufacturers with pro 21 duction above 500,000 units annually. Of great er significance is the fact that certain manufac turers, like Fuji and Daihatsu, have significant influence in important market niches. In the extended outlook, Japanese produc tion will be influenced by three primary trends. First, production of parts and some finished assembly are becoming more mobile, for exam ple, moving toward offshore sites in Asia and other developing markets. Due to labor shortag es and rising costs in Japan this trend seems inevitable as an alternative to domestic produc tion. Additionally, offshore facilities provide a means of entry into an expanding global con sumer market. Production can then include exports back to Japan, as well as some produc tion for the local market. The potential growth of these non-Japanese Asian markets may be significant in the years ahead, and companies like Toyota and Nissan have attempted to antici pate their development. Second, transplant operations in the U.S., Canada, and western Europe continue to in crease capacity and plans for further expansion are in the works. Concern over political pres sure, trade barriers, and economic considerations continue to push Japanese producers toward local production. As this trend continues, pro duction in Japan will be reduced by falling ex ports which are being replaced by Japanese nameplate production in the States and western Europe. Unless exports from Japan find new markets, the impact on domestic Japanese pro duction may be severe. Finally, domestic Japanese production is evolving technically and moving increasingly toward luxury, mid-size, and sports models to suit the changing preferences of consumers. In an economically mature and aging domestic market, Japanese producers not only must grap ple with sales stagnation but a changing product mix. Their technological gains in these areas also influence their export product mix and will continue to do so in the foreseeable future. Asia-Pacific region (excluding Japan) Non-Japanese Asian production in 1991 was almost 4 million units, a level which has in creased tenfold in the last decade.1 The fastest 7 growing production area has been South Korean facilities, which produce almost 1.5 million vehicles annually. The birth of the Korean in dustry is relatively recent. The industry did not begin in earnest until almost 1980. However, 22 production has grown from 100,000 annually in the 1980s to a projected level of over 1.6 mil lion in 1992. Production in Taiwan has also grown and now approaches half a million units annually. Assembly and parts facilities are also well established in Malaysia, Indonesia, and Thailand. Additionally, major facilities have been and are being added in India and China. Currently, production in these two markets exceeds 1 million units. Recent expan sion in China, in particular, bodes well for production capacity. Overall production in Asia has traditionally had an export flavor, with one-third of the pro duction in this region destined for exportation. The trend is still strong in spite of the establish ment of Japanese nameplate production facili ties in Europe and North America. Non-Japa nese markets are not as export oriented as Ja pan, although they are becoming more so. South Korea may be a reflection of the future; net exports of vehicles for the country are al most 400,000 annually, almost 30 percent of total production. Other nations in the region have not experienced such a share of export orientation. However, there does seem to be a learning curve, and once facilities are estab lished, some export potential will likely exist.1 8 Eastern and central Europe Almost all current production in eastern and central Europe involves inefficient state producers who are or will likely be disbanded. Current annual production has fallen to approx imately 2.5 million units, with the CIS respon sible for over 70 percent of combined vehicle production. The severe economic slump, com bined with the break up of the centralized man ufacturing system, has produced a contraction in production in the last two years that is likely to continue in the near term. The civil war in Yugoslavia and decline of the Yugo has also adversely affected the Yugoslavian economy, which was the second largest producer in the region prior to 1992. Over the long term, pro duction will likely continue its trend away from state owned production to the private sector. One element is the inefficiency and quality concerns with traditional products like the Yugo, Trabants, and Ladas.1 Increasingly, 9 however, private sector production has come from western firms that have established bases in the region. BMW, Volkswagen, and GM all have major expansion efforts in former commu ECONOMIC PERSPECTIVES nist countries and production from these facili ties should maintain or at least partially offset the decline in state companies which are being liquidated and/or downsized. Volkswagen’s presence in Czechoslovakia is indicative of what the future may bring. The company is adding facilities to expand production to per haps over 200,000 units annually; of this total, a portion will be exported to the West. This trend will likely continue as the relatively cheap skilled labor and the opening of new markets provides a magnet to U.S., European, and Japanese firms. increasing their production capacity in this region in order to breach the local market as well as provide exports to established markets. The potential for future growth also includes Japanese nameplates, which to date have had only a minimal presence (with the possible exception of Nissan). The domestic content provisions of the North American Free Trade Agreement may provide a strong impetus for auto plants locating in Latin American markets, principally Mexico. Latin America Sales data for 1991 indicate the diversity of activities throughout the world and highlight the environment U.S. nameplates face as the decade progresses. In 1991, total vehicle sales in the world broke down as follows: 33 percent of all sales occurred in western Europe, 30 percent in North America, 15 percent in Japan, 8 percent in Asia, 7 percent in eastern and cen tral Europe, 3 percent in Latin America, and the remaining 3 percent in the rest of the world. Prima facie, it would seem that the Big 3 would be well positioned in the world, given that almost two-thirds of all sales occur in North America and western Europe, their two tradi tional strongholds. Unfortunately, such a con clusion ignores developments discussed in this article. The most important concern is the fact that sales growth is accelerating in Asia (ex cluding Japan), Latin America, and eastern and central Europe where the Big 3 generally are not active, and decelerating in traditional Big 3 strengths: the U.S. and western Europe. At the same time the current market standing for firms in traditional markets is under stress from for eign competitors and, with the integration of the EC, competition should accelerate. The prospects of a sluggish domestic vehi cle market with intensifying competition at the same time developing markets are expanding abroad poses many questions for the Midwest. Whether restructuring and downsizing of do mestic operations continue is, of course, at the forefront of these questions, especially if the Big 3 fail to penetrate new markets through expansion programs. Moreover, even foreign market penetration may be insufficient to sup plement U.S. domestic development and em ployment, unless this penetration involves ex ports of U.S. made products. Currently, Latin America is an important producer, both for domestic consumption as well as for exportation. Of course, domestic content restrictions and other trade barriers have produced some distortions in domestic production. However, current production in excess of 2 million units annually generally reflects the comparative advantage of these areas as a low cost production base. Most of these units are produced in two markets, Mexi co and Brazil, with a limited amount of assem bly occurring in other markets. In Mexico, a million units are assembled annually, of which over 500,000 units are exported.2 In Brazil, a 0 combination of vehicle sales and exports are responsible for almost 1 million units annually. Brazilian production is not quite as export ori ented as Mexico, primarily due to a larger do mestic market as well as economic problems in the last twenty years. Current production activity is increasing due to the rapid expansion of facilities. In fact, capacity estimates indicate that future expan sion plans are accelerating, and production should continue to grow, especially in Mexico where a trade agreement with the U.S. should provide a stimulus to the market. Mexican capacity and, therefore, production have dou bled in the last ten years. This expansion re flects the economic reforms in the country as well as the development of Mexico as an export center of certain models to the U.S. market. The competitive position of the Mexican pro duction environment bodes well for expansion of production facilities in North America, espe cially due to the continued importance of the sales market. U.S. and European firms are expected to continue the trend of the last twenty years by FEDERAL RESERVE BANK OF CHICAGO G lo b a l tre n d s and im p lic a tio n s fo r M id w e s t auto p ro d u ce rs 23 same improvement as other manufacturing Of greatest concern is the further employ sectors. As indicated in Figure 4, U.S. mo ment and income erosion in the Midwest as Big tor vehicle wages in 1990 were still one of 3 facilities are streamlined. Current employ the highest in the world and may not be fully ment in auto manufacturing is estimated at offset by productivity differentials. Higher slightly over 800,000 jobs in finished and parts benefit costs push this differential higher, assembly. Projections of white collar support especially health care which is currently staff and retail distribution employees include estimated at 20 percent of overall payroll an additional 500,000 workers. A large portion costs for the Big 3. of these workers are in the Midwest, which is 2) Competitiveness relative to the developing still responsible for nearly 60 percent of the world: as emerging markets reform their assembled U.S. vehicles and is home to the economies and integrate into the internation headquarters of the Big 3. There is a strong al marketplace, competition will intensify, probability of further economic restructuring in especially in the new sales markets. These addition to the overwhelming adjustment which new markets are also a source of competi has occurred already. Since 1979 the domestic tion, and their wage rates may give them a industry has closed numerous U.S. plants, pared competitive advantage compared to the production costs throughout the entire manufac industrialized nations. Overall wages in turing process, and will eliminate more than Mexico are currently one-seventh the U.S. 400,000 jobs by 1995. The impact of this re level for workers in the motor vehicle indus structuring has been especially severe in the try, rates in Korea are still only one-fifth, Midwest. In Michigan alone, the Big 3 reduced and so on. Of course, productivity differen their work force by more than 150,000 between tials and other factors are considerations in 1979 and 1991. GM’s planned job cuts through this environment. However, it is question 1995 will reduce the work force in the state by able whether or not the productivity differ an additional 25,000 jobs. entials can or will account for such a wide A weak sales environment intensifies the difference of compensation.2 1 need to restructure and will likely prompt fur 3) Regional and multilateral trade agreements: ther efforts to speed up the adjustment. This successful completion of the North Ameri factor will also likely encourage all producers, can Free Trade Agreement (NAFTA) and domestic and foreign, to explore new opportu the General Agreement on Tariffs and Trade nities, many of which will be external to the (GATT) round will impact the development U.S. market. Whether or not these opportuni of the industry by shifting some production ties are or will be available is likely to become activities between nations, and also by influa major issue which each manufac turer will have to address. Future prospects resulting in FIGURE 4 adjustment of the current trade Hourly wages in the auto industry— 1990 flow and stimulation of exports will dollars be influenced by a variety of fac 25 tors. Of primary concern are the following: 1) Continued improvements in U.S. manufacturing competitiveness relative to the international mar ketplace: U.S. manufacturing wages relative to the developed world have declined in the last decade. Additionally, productiv ity gains have been strong and, therefore, unit labor costs have improved in relative terms. However, the automotive seg ment has not experienced the 24 20 15 10 Ger. U.S. Can. Japan Italy France SOURCE: U.S. Department of Commerce. ECONOMIC PERSPECTIVES U.K. Korea Taiwan Mex. encing income growth, job creation, and other macroeconomic developments. Of course, the primary concern for workers in the industry is the potential increase of pro duction shifting to Latin America which may be facilitated by NAFTA. Unfortunate ly, the impact of the agreement is not that easy to quantify; for example, the agreement would also open the Mexican market to U.S. exports and remove many of the current trade distortions. It is likely, however, that some labor in certain segments would be adversely affected, especially in the semi skilled categories where the compensation differentials are the greatest. Segments affected may include the assembling of light trucks (which currently face a relatively high barrier) and some parts components. Of course, export potential also exists in more value added components. 4) Other trade developments: from an export standpoint, U.S. growth will be influenced significantly by domestic content rules, tariffs, quotas, and other political restric tions. Developing nations prefer to increase domestic production in lieu of importing significant quantities. The 2-for-1 rule of exports to imports which has been imposed in Mexico is an example of such policy. Future expansion into other non-North American markets, especially in Asia, will have to deal with such policies. Additional ly, U.S. trade policies will influence the degree of competition in the U.S. from abroad. Japanese voluntary export restraints are being bypassed by transplant production, but are such policies mandatory on Korean or other Asian production? These issues will impact nameplate activities in the U.S., especially the Midwest. Over the long run, location of manufactur ing facilities in the Midwest for domestic and/or export production depends on the costs of production, including shipping, trade restric tions, and location concerns, relative to other markets. In a competitive marketplace these pressures are felt much faster and to a greater degree than in insulated markets. Consequent ly, when evaluating further global integration and its impact on the Midwest one should also consider taxation, education and training, regu lation, shipping fees, transaction costs, and overall production costs. These elements deter mine the competitiveness of the firm and will, in the long run, play an important role in deter mining location, production activity, and export growth for any industry. Overall, external growth and domestic restructuring will continue to be the dominant issue for the domestic auto industry, especially in the Midwest. The future for the motor vehicle industry is increasingly a global one, both in terms of production and sales, and hopefully U.S. industry can benefit and get in the game. Otherwise, change and the resulting economic pain for the Midwest in particular may be severe. FOOTNOTES lrThe Midwest is defined as the East North Central census region which includes Illinois, Indiana, Michigan, Ohio, and Wisconsin. 2Among other estimates the University of Michigan, Euro motor, and the Commerce Department all conservatively estimate sales growth at this level. Estimates provided in this analysis have come from these sources. T h e recent sales declines may be a reflection of the general downward adjustment in the trend in auto sales. Dem o graphic shifts, minimal income growth, and price increases may mean that further expansion in the market is unlikely. These factors may cause multiple problems for many producers, especially given the level o f competition that already exists in the market. T h e expression “foreign nameplate” refers to vehicles produced by a company headquartered abroad. Production activity may well, and in fact does, occur in the U.S. For FEDERAL RESERVE BANK OF CHICAGO eign transplants refer to U.S. facilities o f foreign name plates. The initial development o f transplant facilities began in 1982 when Honda established U.S. assembly facilities in Ohio. sDomestic competition is also increasing. For example, Chrysler recently unveiled the first full sized model in two decades to compete with the highly popular Ford (F series) and GM (Chevy truck) models. T ig h t trucks in this discussion exclude vehicles classified as Class 5 and greater. ’Recent EC rulings have encouraged the removal of auto trade restrictions within the community. These revisions are forcing significant changes within the Italian market. ®Regulatory procedures, specifically em ission require ments, do encourage a higher replacement rate for autos than would otherwise be expected in a mature economy. 25 However, reduced prices for slightly used vehicles are beginning to put pressure on new car sales. Along with other adverse trends, one would expect only modest sales gains in the future. ’Conservative estimates o f gross domestic product (GDP) in the dynamic Asian econom ies places growth at approxi mately 7 to 8 percent per year throughout the decade. Southeastern China, with a population equal to the U.S., has an economy growing at a 12 to 14 percent annual rate with industrial production growing in excess of 20 percent per year. 10Other elements are also important to support an expand ing consumer market for vehicles. Infrastructure, especial ly roads and parking facilities, is an important factor. Additionally, there may be constraints on specific markets which will hamper growth. Hong Kong, for instance, because o f space difficulties, has a very small vehicle market in spite o f its relatively high income levels. n One qualification to the claim o f apparent market domi nance by domestic producers to the exclusion o f other manufacturers is that cross ownership stakes are significant and therefore other manufacturers successfully permeated markets through equity stakes. For instance, GM has a 50 percent equity stake in Daewoo, while Ford has a 10 per cent equity stake in Kia Motors. Domestic nameplates’ market share have also been helped by import quotas and the 25 percent tariff levied on import ed light trucks. lsThe expansion by VW and GM has recently added capac ity in excess o f 500,000 units annually. 16Chrysler is building built a facility in Austria and is targeting production o f at least 150,000 units annually. 17Overall, production in this region (including Japan) currently exceeds 17 million units annually and estimates o f additions to current capacity indicate that, by the mid1990s, production will be well in excess o f 18 million units. An increasing portion o f this production originates in more diverse areas, including Japanese transplant facilities in Asia. Additional capacity in mainland China, Thailand, and Indonesia may increase capacity above 18 million units by the mid-1990s. Given the difficulties in measuring existing capacity and additions to capacity, a reasonable forecast would place the level at more than 18 million units by 1995. 18A s illustrated by South Korea, emerging producers may have difficulties in exporting to mature markets due to quality problems, trade restrictions, and other factors. However, low labor and other production related costs are an offsetting factor in export growth to other emerging markets. 12See Ballew and Schnorbus (1992). 13Recent acquisitions have reduced the number o f indepen dent automakers, especially in Europe, where intense restructuring appears to be occurring. These acquisitions have not dampened the degree of competition in the mar ketplace. If anything, competition has become more aggressive recently. 14Note that U.S. nameplates have been relatively aggressive in developing light vehicles that combine the strengths of trucks with the ride and comfort of cars. Minivans and many sports utility vehicles possess these characteristics. '’Production of the Yugo and Trabant has been disrupted by current events. Production o f the Lada is still occurring at the Nizhny Novgorod facility, an industrial behemoth employing 160,000 workers. 20Some Mexican exports are the result o f 2-for-1 import requirements. However, in general the exports reflect the cost effectiveness o f Mexican labor. 21Note that product quality is a major concern with regard to foreign manufacturing locations. These concerns may offset other competitive disadvantages. REFERENCES Automotive News, 1992 Market Data Book, Crain’s Communications, Detroit, MI, 1992. Ballew, Paul, and Robert Schnorbus, “NAFTA and the auto industry: boon or bane?,” Chicago Fed Letter, Federal Reserve Bank of Chicago, December 1992. Berry, Steven, Vittorio Grilli, and Florencio Lopez-de-Silanes, “Automobile industry and the Mexican free trade agreement,” NBER Working Paper, Cambridge, MA, 1992. Commission of the European Communities, “The European motor vehicle industry: situation, issues at stake, and proposals for action,” Brus sels, May 8, 1992. Economic Strategies Institute, The Future of the Auto Industry, Washington D.C., 1992. Ministry of Trade and Industry, Profde and Prospects for the Mexican Automotive Industry, Mexico, September 1990. Ward’s Communications, 1992 Automotive Year Book, Detroit, MI, 1992. Caldwell, Philip, Berry Eichengreen, and Charles Parry, “International competition in the products of U.S. basic industries,” The United States in the World Economy, NBER, 1988. U.S. Department of Commerce, U.S. Industrial Outlook, Washington, D.C., 1992. 26 ECONOMIC PERSPECTIVES Trends and prospects for rural manufacturing W illiam A . Testa Manufacturing has become the primary economic base for many nonmetropolitan coun ties in both the Midwest and in the rest of the nation. At the same time, services, retail, and other industries are abandoning remote counties and are central izing their operations in urban areas (see Figure 1). While the farm sector’s health has now stabilized following the downslide of the early 1980s, farm jobs—especially those as a full time occupation—continue to disappear as the average size of a farm needed to support to day’s American family continues to grow larg er. In sum, as one writer has put it, “many small rural towns ... have been transformed from farm service centers into minor cogs in the national manufacturing system.”1 Manufacturing’s importance to rural areas has been growing for several decades and it will probably continue to outpace other “basic” industry sectors in the rural Midwest. Howev er, several forces of change, which began or continued to unfold in the 1980s and which are expected to continue into the 1990s, are not so favorable. These changes impacting rural man ufacturing are threefold. First, manufacturing is undergoing a transition from traditional as sembly line modes of production, that is, from “post-Fordism,” to what is being called “flexi ble manufacturing” or “just-in-time.” This change in the organization and mode of produc tion is believed by some to favor urban locales over rural areas as production sites. Secondly, rural manufacturing differs from its urban coun terpart in being more production oriented and FEDERAL RESERVE RANK OF CHICAGO less service oriented in the particular activities that manufacturing companies perform. (Ser vice activities of manufacturing companies include corporate headquarters, general adminis tration, and R&D). However, because U.S. manufacturing companies are becoming more service oriented, it is expected that manufactur ing in rural areas will not fare as well. Finally, ongoing negotiations among Mexico, Canada, and the United States are moving toward a tariff free trading area perhaps as early as 1993. As a result, low skill or low value added jobs (which tend to be found in rural areas) are those that are more likely to flee U.S. borders to Mexico. T h e ch a n g in g e c o n o m ic base o f n o n m e tro p o iita n co u n tie s The primary challenge to rural areas during this century has been to replace jobs lost by the declining labor force needs of natural resource industries. As productivity climbs in farming and mining, or as natural resources are exhaust ed in forests and fisheries, the movement of labor into other sectors or the outright loss of jobs is the result. In many regions, the decentralization of manufacturing from urban areas to rural areas has partly replaced jobs lost in other rural indus tries. Coupled with population decline in rural areas, per capita income in metropolitan and nonmetropolitan counties in the U.S. converged during most of this century.2 On average, per W illiam A. Testa is senior regional economist and research officer at the Federal Reserve Bank of Chicago. Research assistance was provided by Virginia Carlson and David D. Weiss. 27 FIGURE 1 Rural share of the Seventh District’s nonfarm jobs Total Manufacturing percent percent 25 25 23.5 21.5 17 13 21.6 2 1 ^ ^ 2 1 !^ ™ m il Retail Services percent percent 25 13 1969 -------■ ■ ■ ■ ------ 13 1 1974 1979 1984 1989 1969 1974 1979 1984 1989 SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. capita income growth in rural countries outper formed urban counties in the 1970s in the Sev enth District states of Illinois, Indiana, Iowa, Michigan, and Wisconsin. Prosperity in natural resource industries during the 1970s, especially agriculture, was accompanied by stable or slightly growing employment in manufacturing. The convergence of rural and urban per capita incomes in the Seventh District came to a halt during the 1980s as both agriculture and natural resource industries such as mining, energy production, and forestry fell on hard times (see Figure 2). Manufacturing located in urban and rural areas alike also suffered during the 1980s despite the fact that rural perfor mance continued to outpace urban performance in job creation in both the Seventh District and the nation (see Figure 3). Outperformance by rural counties (in the U.S.) in manufacturing job growth has been shown to date back at least to the 1950s and 1960s [Carlino (1985)]. Moreover, the conten tion that rural manufacturing job growth merely represents a urban spillover effect of manufac turing jobs to outlying counties has also been found to be either mistaken, inconclusive, or at least not pervasive from decade to decade 28 [Carlino (1985); Haynes and Machunda, (1987)]. Those rural counties that are not even adjacent to metropolitan areas have been found to be experiencing buoyant or above average manufacturing job growth. This experience was replicated in Seventh District states (see Table 1). From 1969 to 1990, the rate of job growth in nonadjacent nonmetropolitan coun ties exceeded not only growth in metropolitan counties but adjacent job growth as well. The causes of this reorientation of manu facturing from large urban areas to rural areas are not difficult to trace. As U.S. factory pro ductivity increased sharply during this century, manufacturing no longer required as many workers. More modest “factory neighbor hoods” of workers could be gathered on a smaller scale in rural areas than those previous ly needed in large cities. In addition, the as sembly line methods of production which gath ered momentum following Henry Ford’s suc cess in automotive production required more space to organize production efficiently. Ac cordingly, the multistory urban factory increas ingly gave way to one story sprawling produc tion buildings. But this also meant that the cheaper land costs of suburban and rural sites ECONOMIC PERSPECTIVES transportation penalty of remote ness was no longer so severe. The upshot of these changes has been that, as manufacturing job growth in rural counties outpaced growth in the large urban areas, manufacturing has become a staple of the job composition in rural counties. In the Seventh District for example, manufacturing’s share of total employment in non metropolitan counties exceeds its share in metropolitan areas (see Figure 4). Rural counties in the Seventh District states have a larg er share of manufacturing in com parison to their U.S. counterparts; manufacturing employment in rural District counties accounts for 19.2 percent of total employment versus 17.2 percent nationally. Not all nonmetropolitan coun ties have fared well in the 1980s with regard to manufacturing job growth (see Figure 5). This sug gests that active development policies in rural areas may be needed if this growth is to be real ized. This is especially so owing to several trends that may be work ing against the rural edge in manu facturing: the movement toward flexible manufacturing, the further opening of the U.S.-Mexico bor der, and the increasing service orientation of U.S. manufacturing. M a n u fa c tu rin g and se rv ice s became more important in the production cost equation. Finally, the transportation system changed from rail lines converging on a central terminus—for example, Chicago— to a grid of interstate highways reaching deep into remote areas such as Appalachia and Texarkana. Rath er than shipping manufactured goods from a central rail terminal such as Chicago, a remote branch plant could serve wide market areas almost as well. At the same time, the evolution away from producing heavy manufactured goods such as steel (which required bulky in puts of coal and ore), and toward lighter goods such as computers and plastics, also dispersed manufacturing toward rural locales because the FEDERAL RESERVE BANK OF CHICAGO Many of the same forces af fecting the location decisions of service firms— especially the so called business services or producer services—also have a bearing on manufacturing companies. The reasons for this are that, aside from plant production activities, many activities of manufacturing companies are service activities such as research and de velopment, design, management, sales, and distribution [Israilevich and Testa (1989)]. To varying degrees, manufacturing industries and companies can be thought of as an amalgam of service and production activities so that those locational forces that motivate service compa nies will, to varying degrees, also motivate manufacturing companies. By the same token, 29 FIGURE 3 Growth in manufacturing employment in the 1970s and 1980s Seventh District U.S. percent change percent change 18 18 12 12 Nonmetro Metro -12 1969-73 FI 1973-80 Nonmetro J a Metro -12 1980-85 1985-89 1969-73 1973-80 1980-85 1985-89 SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. service activities and production type or plant type activities will respond to differing location pulls. As a result, the service intensity of any particular manufacturing company or industry will help to determine its location preferences. Service industries—especially the rapidly growing (and higher paying) “producer service industries” such as advertising, specialized finance, and management consulting—have thrived and concentrated in large urban areas rather than in rural counties [Testa (1992a)]. Similar to producer service jobs, nonproduction jobs of manufacturing companies have come to favor more urban areas over rural counties. A look at nonmetropolitan counties in the Seventh District shows that, in comparison to the 47 percent nonproduction payroll of manufacturers in the U.S., rural District counties hover at just over 30 percent in nonproduction payroll (see Figure 6). TABLE 1 Job performance in manufacturing in Seventh District states (percent) 1969-79 Metropolitan - Nonmetropolitan Adjacent Nonadjacent 1 2 .8 2 .7 8 .6 1979-90 - 1 7 .8 - 1969-90 - 2 0 .0 1.9 6 .4 1.7 14.7 SOURCE: U .S. D ep artm ent o f C om m erce, Bureau of Econom ic Analysis. 30 According to recent studies, improvements in telecommunications technology such as facsimile machines, teleconferencing, and other fiber optics transmission have probably strengthened the advantages of large urban areas over rural counties. These improvements are proving to be complements rather than substitutes for centralized business service provision, that is, it is now easier to transmit or deliver services to remote locations; and more efficient to do so from a centralized and (usual ly) urban locale. At the same time that producer service activities are growing in stature—especially in urban areas—the actual activities and jobs of manufacturing companies are becoming more service oriented. Production or so called blue collar jobs inside of manufacturing companies continue to dwindle at the same time that jobs such as R&D, clerical, computer programming and data processing, advertising, accounting, and strategic planning are becoming more plen tiful. Nonproduction payroll by manufacturing companies in the United States has increased from 39 to 49 percent over the 1972-90 period. The trend toward greater service orienta tion among manufacturers, coupled with the impetus to concentrate service activities in large urban areas, have exerted a drag on the expansion of manufacturing employment in rural areas during the 1980s. Drawing on data from the Census Bureau from 1980 to 1988, McGranahan (1991) finds that a significant shift in job composition occurred in nonmetro- ECONOMIC PERSPECTIVES FIGURE 4 Job base: 1989 Seventh District District vs. U.S. (nonmetro) percent of total percent of total 0 6 12 18 24 30 0 6 12 18 24 30 Farm Ag. services and forestry Nonmetro Metro Mining h b District U .S . Construction Manufacturing Transportation and utilities Wholesale trade Retail trade Finance, insurance, and real estate Services Government S O U R C E : U.S. Departm ent of Commerce, Bureau of Economic Analysis. politan versus metropolitan areas within the manufacturing sector. Within nonmetropolitan counties, management-research and support type jobs declined while production jobs increased slightly. In contrast, management-research jobs in metropolitan counties soared (by over 30 FEDERAL RESERVE percent) while production jobs fell by over 10 percent. By implication, insofar as such produc tion jobs are becoming a smaller share of em ployment in manufacturing, production activi ties will be less capable of buoying income and employment in nonmetropolitan counties. Fle x ib le m a n u fa c tu rin g Manufacturing industries are reportedly changing their manage ment and production methods towards “flexible manufacturing,” which is also referred to as “flexi ble specialization” or “just-intime” [Piore and Sabel (1983); Scott (1986)]. The U.S. auto in dustry is perhaps the most promi nent industry that has adopted new organizational techniques which are predicated on Japanese innova tions. GM, Chrysler, and Ford have adopted these technologies through joint ventures with Japa nese car makers (Toyota, Mitsub ishi, and Mazda, respectively) and are now adopting many organiza tional changes throughout their firm or at least within divisions (for example, Saturn of GM). In addition, other U.S. industries, BANK OF CHICAGO 31 FIGURE 6 Nonproduction payroll in manufacturing Nonproduction payroll percent of total Seventh District counties, 1987 percent of total payroll 50 U.S.=4 7.0 40 33.0 32.0 30 33.6 3 2 .9 31.6 28.7 20 10 Ml SOURCES: U.S. Department of Commerce, Bureau of the Census, Census of Manufactures, Annual Survey of Manufactures. including photocopiers, cameras, and calcula tors, have changed their relationships with suppliers following the Japanese prototype [Linge (1991)]. Many features have been used to character ize flexible manufacturing, and there is no universally accepted definition. Perhaps the most prominent characteristic is that flexible manufacturing involves smaller production runs and a more varied or customized product. However, the processes by which these results are achieved are equally descriptive of flexible manufacturing. Innovations in the organization of design and production allow this customized small batch production to be carried out quick ly, at low cost, and with high quality. Some of the organizational features include close relations between firms and their suppli ers. In general, flexible firms maintain rela tionships with a smaller number of key suppli ers. In addition, the supplier relationship can be characterized as closely knit and cooperative with regard to capital investment, sharing of technology, and input to design, rather than purely contractual in nature. Another key fea ture is the maintenance of “lean” inventories and the use of “just-in-time” delivery of inputs and parts. With regard to labor, there is less hierarchy and more participatory organization of employ ees, ranging from the production line to man agement and sales activities. Often, employees are trained to perform many jobs rather than the single routinized activity which characterized many assembly lines of yesteryear. There is 32 Wl Seventh District also a technological side to flexible manufac turing. Flexible manufacturing systems equip ment can change the production line set up (including tools and dies) in short order. These systems must be manned by highly skilled and trained workers. Some analysts believe that the adoption of these production methods will work to the disadvantage of manufacturing in rural areas. For one reason, skilled and high wage labor tend to gravitate toward urban areas because skill demands are higher there. In addition, flexible manufacturing implies a smaller scale of operation so that there is a lesser need for cheap and plentiful rural land. Finally, the greater need for communication/innovation among employees in flexible firms, especially those that are highly innovative and technologi cally oriented, may favor urban areas where the flow and exchange of information can be con ducted on a greater scale and at lower cost. Close proximity also promotes close and coop erative relations between assembly operations and key suppliers, and cuts down on delivery and inventory costs. Accordingly, manufactur ing activity may tend to concentrate into cen tralized nodes rather than locating in isolated rural areas. Despite these disadvantages, there is also a growing body of argument and evidence to suggest that rural areas will not necessarily wither because of the technological transition toward flexible manufacturing systems. First, the alleged benefits of close and dense proximi ty as it relates to flows of information may not ECONOMIC PERSPECTIVES be universal. Experience in other countries such as the peripheral Jutland area of Denmark [Hansen (1991)] has illustrated that a critical mass of interlinked and cooperating manufac turers who practice flexible methods can be assembled in rural areas.3 Close physical proximity has also been cited as advantageous because it facilitates justin-time delivery of parts and components from suppliers, and thereby economizes on delivery and inventory costs. However, a “growing separation of assembly plants from their sub contractors has also been facilitated by the parallel growth of specialist freight handling firms with national and international multimo dal networks which have considerably reduced the tyranny of distance.”4 In comparison to most other industrialized nations, many rural regions of the Midwest have access to the inter state highway system which greatly shortens the time and distance from rural factories to their markets. With regard to the skilled labor advantages of urbanized areas, the case can be argued that the new (flexible) production and organization al techniques actually favor rural areas over urban counties. That is partly because the need for flexibility in work assignments may be difficult to achieve in urban counties where the influence of strong labor unions may resist flexible work assignments. For example, in the American Midwest, Knudsen, et. al. (1991) report in a series of case studies that unions dislike “flexible labor cells” (where the labor resource is maximized in production) because they are viewed as threatening to the seniority system and are thought to be a device to en courage “speed up” of the work process. In deed, the location decisions of many Japanese manufacturers (who were among the pioneers of flexible methods) such as Honda at Marys ville and East Liberty, Ohio, and especially Toyota at Georgetown, Kentucky, have favored rural (less union oriented) locales. Nor has it been established with certainty that there is any underlying rural skills deficit which would act as a labor supply impediment in the location decision of flexible manufactur ers. Statistics reporting years of education completed do show that the adult population of U.S. nonmetropolitan counties is below the national average; but this does not necessarily reflect a shortage of skilled workers. Rather, the lower stock of educational attainment may FEDERAI. RESERVE BANK OF CHICAGO reflect a historical lack of skilled job opportuni ties in rural areas which has induced a migra tion of younger and educated workers out of rural areas and into large urban areas. McGranahan and Ghelfi (1991) review the evidence of the rural economic stagnation of the 1980s against the backdrop of the increased national demand for educated workers during the 1980s. The authors conclude that lagging rural job growth was not driven by faltering labor supply in rural areas but rather that a surging demand for skilled workers occurred in urban areas which accelerated rural outmigra tion and widened the rural/urban wage gap. Furthermore, the educational gap between nonrural and rural areas is significantly larger for those with a college education than for those with a high school education [Swaim and Teixeira (1991)]; the latter is most likely to be the level of education which manufacturers would tend to demand of prospective produc tion workers. Moreover, the authors report that the shortfall for high school completion rates of adults in rural areas has been falling—from 8.1 percentage points in 1971 to 4.4 percentage points by 1987. Likewise, while national statistics report lagging academic achievements of rural stu dents, there is much variation across regions, with the rural South largely accounting for the smallest percentage number of high school graduates. In the Midwest, Swaim and Teixeira (1991) report that high school drop out rates among 18-21 year olds in nonmetropolitan counties were below both metropolitan and nonmetropolitan counties of the Northeast, West, and South in 1985. High school gradua tion attainment rates for Seventh District states reveal that nonmetropolitan counties are not much different in producing high school gradu ates in comparison to both its own urban areas and to national averages.5 While these arguments suggest that the change toward flexible manufacturing need not be an insurmountable obstacle to continued manufacturing growth in rural areas, formal evidence to date indicates that it has already impeded rural manufacturing growth in selected industries.6 Barkley and Hinschberger (1992) have examined 106 metal working industries over the 1981-86 period. Their findings sug gest that those industries that were restructuring toward flexible specialization were less likely to locate in rural locales, especially among the 33 more high technology or rapidly growing metal working industries. With regard to rural devel opment policy, the authors caution that rural areas with competitive advantages will be those that are more amenable to flexible manufactur ing characteristics such as good transportation, developed communications, high labor skills, and the absence of a labor force culture steeped in older and rigid manufacturing methods. TABLE 2 Average hourly compensation* costs for manufacturing production workers (dollars) _____________ 1982 United States Mexico 1985 1987 1989 1991 11.64 12.96 13.40 14.31 15.45 2.54 2.09 1.57 2.32 2.17 SOURCE: Bureau of Labor Statistics, Report 825. N o rth A m e ric a n Free T rad e A g re e m e n t (N A FT A ) Despite the recent efforts of the aforemen tioned manufacturers to locate state of the art technology plants in rural areas, the particular types of manufacturing activity that have his torically located in rural areas tend toward the lower skilled and production activities. Though it need not be the case, rural areas have been a haven for those manufacturers searching for low production costs [Norton and Rees (1979)]. That is, manufacturing in the U.S. has followed the so called spatial product cycle, which gen eralizes a manufacturing product’s progress from inception to standardization. At incep tion, products are either new or are produced with innovative processes; at this stage, the products are produced initially near large urban areas where innovation allegedly has a strong hold. As the product and its production are routinized, standardized, and generally “de skilled,” and as the scale of production increas es as the product gains wide market acceptance, the location of the production process is shifted out toward more rural locales (or overseas) 34 ‘ Includes all paym ents m ade directly to the w orker, before payroll deductions, but including e m p loyer expenditures for legally required insurance program s and contractual and private benefit plans. where production costs are lower (and needed skills or access to technology are fewer). To the extent that this paradigm is accu rate, it implies that the proposed NAFTA is less favorable for rural areas. Because average wages and labor skills in Mexico are lower, those U.S. jobs most likely to flee to Mexico would be the lower wage, lower skill, nonser vice type jobs—exactly those types that tend to concentrate in rural areas. Table 2 reflects the large wage differences between the nations for production workers (unadjusted for skill differ ences). The hourly wage premium for the U.S as a whole is as large as 6 to 7 times that in Mexico. In all fairness, it should be noted that workers with certain production skills may not be available in Mexico at these lower wages. Moreover, the advantages of lower transporta tion costs and highly developed physical infra structure favor U.S. locales. However, these advantages probably do not favor U.S. rural ECONOMIC PERSPECTIVES locales over Mexico to the same extent as U.S. urban locales. This is not to say that NAFTA will not be a net plus for rural counties, but rather that urban counties may be the greater beneficiaries. Mexico’s tariffs on U.S. exports are two or three times greater than U.S. imports from Mexico so that Midwest manufacturing as a whole may gain from NAFTA passage.7 This is especially true given the surging economic growth and demand for imported capital goods which Mexico has recently displayed. From 1987 to 1991, nonelectrical machinery exports to Mexico from the Seventh District states increased by two and one-half times (to almost $ 1 billion) while exports of electrical equip ment increased by a multiple of 2.25. These capital goods are just the type of goods—ma chinery and electrical equipment—that concen trate in the Midwest and which could experi ence a further growth in demand arising from NAFTA’s spur to Mexico’s growth and devel opment (see Figure 7). A rapidly developing Mexico will undoubtedly require growing ma chinery investments both for factories and for construction. Rural counties in the Midwest would tend to benefit as well, but these benefits would be diluted by the fact that machinery establishments are not highly concentrated in rural counties in the Seventh District, but in stead tend to concentrate within the large met ropolitan areas.8 C o n c lu s io n Despite the possible negatives working to slow rural gains in manufacturing employ ment—increasing service orientation of manu facturing companies, the movement of lower skilled production jobs to foreign countries such as Mexico, and the adoption of flexible manufacturing methods by domestic compa nies—these forces have not been strong enough to hold back the tide of manufacturing growth in rural areas to date. Over the course of the 1980s, rural manufacturing in the Midwest con tinued to outpace urban counties. From 1985 to 1989, metropolitan counties’ manufacturing jobs declined by 1.1 percent while rural counties gained by 8.2 percent. In the face of such a strong growth difference, it is difficult to imag ine any reversal of fortunes. Moreover, increas ing Midwest manufacturing growth in general shows little sign of abating during the remainder of the 1990s as export growth will continue to be strong while the region will suffer little of the fallout from America’s defense reduction. As a result, the continuing stabilization, if not recov ery, in many agriculturally oriented regions in the Midwest should continue to be helped along by rising manufacturing fortunes. However, the experience of Seventh District states in the 1980s also suggests that not all rural counties will realize manufacturing job growth in the 1990s. Those who conduct development policies in rural areas will need to be aware of potential difficulties (such as those discussed above) in assisting the growth and expansion of manufacturing in rural areas. In addition, not all manufacturing industries will find rural areas attractive. The experience of the 1980s shows widely divergent shifts in the Seventh District in the urban versus rural pat terns of growth of establishments by individual manufacturing industries.9 For reasons such as these, some analysts have suggested developing information on the relative costs and productivi ty of individual industries in urban versus rural locations [Martin, et. al. (1991)]. The somewhat less sanguine outlook for rural manufacturing in the 1990s makes this idea more appealing as a way to concentrate scarce development dollars for maximum impact. FOOTNOTES *See John Fraser Hart (1991), chapter 3, p. 32. 4See Linge (1991), p. 327. 2See McGranahan and Ghelfi (1991). sSee Testa (1992b), p. 11. 3See Hansen (1991) for a discussion. Hansen cites Lego Co. (maker o f the plastic toy blocks) and Bang & Olafsen Co. (maker o f consumer electronics products) as examples o f successful firms in Jutland. Also, see “Small, flexible plants may play crucial role in U.S. manufacturing,” Wall Street Journal, January 13, 1993, p .l. 6See also Glasmier (1991). FEDERAL RESERVE 7See U.S. Dept, o f Labor (1990). 8See Testa (1992b), p. 27. ’Ibid. BANK OF CHICAGO 35 REFERENCES Barkley, David L., and Sylvain Hinschberger, “Industrial restructuring: implications for the decen tralization of manufacturing to nonmetropolitan areas,” Economic Development Quarterly, Vol. 6, No. 1, 1992, pp. 64-79. Benjamin, Gary B., “Agriculture and the Great Lakes region,” in William A. Testa, ed., The Great Lakes Economy Looking North and South, Federal Reserve Bank of Chicago, 1991 pp. 97-103. Carlino, G.A., “Declining city productivity and the growth of rural regions: a test of alternative explana tions,” Journal of Urban Economics, Vol. 18, 1985, pp. 11-27. Glasmier, Amy K., The High Tech Potential: Eco nomic Development in Rural America, Center for Urban Policy Research, New Brunswick, NJ, 1991. Hansen, Niles, “Factories in Danish fields: how high-wage, flexible production has succeeded in peripheral Jutland,” International Regional Science Review, Vol. 14, No. 2, 1991, pp. 109-132. Hart, John Fraser, “Population and the labor force,” in William A. Testa, ed., The Great Lakes Economy Looking North and South, Federal Reserve Bank of Chicago, 1991, pp. 28-38. Haynes, Kingsley E., and Zachacy B. Machunda, “Spatial restructuring of manufacturing and employ ment growth in the rural Midwest: an analysis for Indiana,” Economic Geography, Vol. 63, No. 4, 1987, pp. 319-333. ence, U.S. Dept, of Agriculture, Washington, D.C., December 5, 1991. McGranahan, David A., and Linda M. Ghelfi, “The education crisis and rural stagnation in the 1980s,” in Education and Rural Economic Develop ment, Strategies for the 1990s, U.S. Dept, of Agri culture, Economic Research Service, September 1991, pp. 40-92. Norton, R.D., “Reindustrialization and economic development strategy,” Economic Development Quarterly, No. 3, 1989, pp. 188-202. Norton, R.D., and John Rees, “The product cycle and the spatial decentralization of American manu facturing,” Regional Studies, Vol. 13, 1979, pp. 141-151. Piore M.J., and C.F. Sabel, The Second Industrial Divide, Basic Books, New York, 1983. Scott, A.J., “Industrial organization and location: division of labor, the firm, and spatial process,” Economic Geography, Vol. 62, 1986, pp. 215-231. Swaim, Paul L., and Roy A. Teixeria, “Education and training policy: skill upgrading options for the rural work force,” in Education and Rural Econom ic Development: Strategies for the 1990s, U.S. Department of Agriculture, 1991. Testa, William A., “Prospects for producer services in the Seventh District,” Economic Perspectives, May/June 1992a, pp. 19-28. Israilevich, Philip R., and William A. Testa, “The geography of value added,” Economic Perspectives, September/October 1989, pp. 2-12. _____________________ , “Trends and prospects for rural manufacturing,” Federal Reserve Bank of Chicago, working paper, WP-92-12, 1992b. Knudsen, Daniel C., Dennis Conway, F. Robert Jacobs, and Megan Blake, Flexible Manufacturing in the Midwest, Institute for Development Strategies, Indiana University, 1991. U.S. Department of Commerce, Bureau of the Census, County Business Patterns (data base), various years. Linge, G.J.R., “Just-in-time: more or less flexible?,” Economic Geography, Vol. 64, 1991, pp. 316-322. Martin, Sheila A., Richard McHugh, and S.R. Johnson, “The influence of location on productivi ty: manufacturing technology and rural and urban areas,” paper presented at the North American Re gional Science Association Meetings, New Orleans, LA, November 1991. McGranahan, David, “Can the rural economy be competitive?,” Annual Agricultural Outlook Confer 36 ______________________ , Census of Manufac tures and Annual Survey of Manufactures, various issues. U.S. Department of Labor, “Industrial effects of a free trade agreement between Mexico and the U.S.A.,” an INFORUM report to the United States Department of Labor, Sept. 15, 1990. U.S. Department of Labor, Bureau of Labor Statistics, International Comparisons of Hourly Compensation Costs for Production Workers in Manufacturing 1975-89, Report 794, October 1990. ECONOMIC PERSPECTIVES ECONOMIC PERSPECTIVES Public Information Center Federal Reserve Bank of Chicago P.O. 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