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R V May/June 1990 Vol. 72, No. 3 3 E ighth D istrict Banks in 1989: In th e E ye o f a Storm ? 18 T h e Eighth D istrict Business E c o n o m y in 1989: E xitin g the E ighties w ith V ig o r 31 T h e U.S. and E ighth D istrict A g r i cu ltu ral E con om ies in 1989: B uilding on Past S tren gth THE FEDERAL RESERVE RANK of sr.ijoris 1 F e d e ra l R e s e r v e B ank o f St. L o u is R eview May/June 1990 In This Issue . .. In this Review's first article, “Eighth District Banks in 1989: In the Eye of a Storm?" Michelle A. Clark compares the performance of Eighth District commercial banks in 1989 with that o f their national peers. Because District banks w ere largely untouched by some o f the major problems facing the industry in 1989, especially losses from real estate and foreign loans, they were able to outperform their U.S. counterparts in measures o f profitability, asset quality and capital adequacy. Clark finds that differing asset and liability compositions at District and U.S. banks explain much o f the difference in performance ratios between the two groups of banks. The author points out that both District and U.S. banks are experienc ing increases in problem real estate loans which pose a threat to prof itability in 1990. Clark concludes, however, that banks should be able to weather the economic and regulatory challenges of the next decade. * * * In the midst o f national recession, the Eighth District’s business economy weakened in the early 1980s, with employment declining and unemployment rates rising to double-digit levels. In this issue’s second article, Thomas B. Mandelbaum points out that, as we exited the 1980s, the region's unemployment rate had declined to its lowest level since 1979, and income and employment continued to expand in the longest peacetime recovery on record. Mandelbaum describes economic conditions in 1989 in the Eighth District’s business economy, placing the year’s developments in the con text of the District’s and the nation’s economic growth during the 1980s. The author observes that, despite the general strengthening o f the region’s economy in 1989, some of the District’s sectors, such as residen tial construction, weakened, and the economic performance o f the region’s states varied widely. Furthermore, employment growth slowed in 1989 in each of the four primary states of the District. To the extent that projections of economic activity are accurate, employment growth will slow further in Kentucky, Missouri and Tennessee in 1990. * * * As the U.S. agricultural economy rebounded from the 1988 drought, 1989 real net farm income rose to its highest level since 1975. In the third article in this Review, "The U.S. and Eighth District Agricultural Economies in 1989: Building on Past Strength,” Jeffrey D. Karrenbrock MAY/JUNE 1990 2 describes how strong livestock returns and more normal crop produc tion helped boost the financial positions o f both U.S. farmers and agricultural financial institutions in 1989. Karrenbrock cautions, however, that since the Eighth District’s farm income was not as severely affected by the 1988 drought as other regions of the nation, District farm income growth in 1989 may not have paralleled the income rebound induced by the drought recovery in the rest o f the nation. The author concludes by briefly discussing how technological change and environmental concerns may affect agriculture in the new decade. ERRATA Alison Butler’s article in the March/April 1990 issue o f the Review contained several printing errors. In the numerator o f equation 4 on page 39, a dot was inadvertently omitted above the variable N(t). The correct version o f equation 4 should read: Chiang, Alpha C. Fundamental Methods of Mathematical Economics, 3rd ed. (McGraw-Hill Book Company, 1984). Day, Ft. H., and Wayne Shafer. “Keynesian Chaos,” Journal of Macroeconomics (Summer 1985), pp. 277-95. De Grauwe, Paul, and Kris Vansanten. “Deterministic Chaos in the Foreign Exchange Market,” Discussion Paper Series No. 370, Centre for Economic Policy Research, 1990. Deneckere, Raymond, and Steve Pelikan. “Competitive Chaos,” Journal of Economic Theory (October 1986), pp. 13-25. Devaney, Robert L. An Introduction to Chaotic Dynamical Systems (Addison-Wesley Publishing Company, Inc., 1989). Ellis, Jennifer M. “Are Exchange Rates Chaotic?” mimeo, University of Oregon, 1990. Frank, Murray, and Thanasis Stengos. “Chaotic Dynamics in Economic Time-Series,” Journal of Economic Surveys (Vol. 2, 1988), pp. 103-33. Gleick, James. Chaos: Making a New Science (Penguin Books, 1987). Grandmont, Jean-Michel, ed. Nonlinear Economic Dynamics (Academic Press, 1987). Grandmont, Jean-Michel. "On Endogenous Competitive Business Cycles,” Econometrics (September 1985), pp. 995-1045. Haavelmo, T. A Study in the Theory of Economic Evolution (Amsterdam: North-Holland Publishing Company, 1954). Hinich, Melvin J., and Douglas M. Patterson. “Identification of the Coefficients in a Non-Linear Time Series of the FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis N(t)/N(t) = C - D/A. A substantial share o f the references also was omitted from her article. The missing references are printed below. W e apologize for any incon venience these errors may have caused for our readers. Quadratic Type,” Journal of Econometrics (November 1985a), pp. 269-88. ________ “Evidence of Nonlinearity in Daily Stock Returns,” Journal of Business and Economic Statistics (January 1985b), pp. 69-77. Kelsey, David. “The Economics of Chaos or the Chaos of Economics,” Oxford Economic Papers (March 1988), pp. 1-31. Li, Tien-Yien, and James A. Yorke. “Period Three Implies Chaos,” American Mathematical Monthly (December 1975), pp. 985-92. Mandelbrot, Benoit B. The Fractal Geometry of Nature (W. H. Freeman and Company, 1983). May, Robert M. “Simple Mathematical Models With Very Complicated Dynamics,” Nature (June 10, 1976), pp. 459-67. Melese, Francois, and William Transue. “Unscrambling Chaos Through Thick and Thin,” Quarterly Journal of Economics (May 1986), pp. 419-23. Poincare, Henri. Science and Method, translated by Francis Maitland (Dover Publications, Inc., 1952), pp. 67-68. Ramsey, James B. “Economic and Financial Data as Non linear Processes,” in Gerald Dwyer and R. W. Hafer, eds., The Stock Market: Bubbles, Volatility, and Chaos (Kluwer Academic Publishers, 1989). Stewart, Ian. Does God Play Dice?: The Mathematics of Chaos (Basil Blackwell, Inc., 1989). Stutzer, Michael J. “Chaotic Dynamics and Bifurcation in a Macro Model,” Journal of Economic Dynamics and Control (November 1980), pp. 353-76. 3 Michelle A. Clark Michelle A. Clark is an economist at the Federal Reserve Bank of St. Louis. Thomas A. Pollmann provided research assistance. Eighth District Banks in 1989: In the Eye of a Storm? A -£ A -F T E R REBOUNDING sharply in 1988, most commercial banks in the Eighth Federal Reserve District experienced modest increases in prof itability in 1989 and continued to outperform their national counterparts.1 With few excep tions, Eighth District banks were largely un scathed by the rough weather which battered some segments of the industry, especially losses from real estate loans and loans to lesser-devel oped countries (LDCs), which depressed earn ings at many of the nation’s largest banks. The performance o f Eighth District commer cial banks in 1989 vs. their national peers is analyzed in this paper.2 Conventional perfor mance measures, including bank earnings, asset quality and capital adequacy, are examined to assess the financial condition and operating soundness of the District’s banking industry. In addition, the compositions of assets and liabili ties at District and U.S. banks are compared to explain why District bank performance ratios differ from those of their national peers. 'The Eighth Federal Reserve District comprises the follow ing: Arkansas, entire state; Illinois, southern 44 counties; Indiana, southern 24 counties; Kentucky, western 64 coun ties; Mississippi, northern 39 counties; Missouri, eastern and southern 71 counties and the City of St. Louis; Ten nessee, western 21 counties. EARNINGS Eighth District banks earned $1.14 billion in 1989, an increase of 1.7 percent from 1988 earnings o f $1.12 billion. Earnings for all U.S. banks of comparable size were $14.54 billion in 1989, up 7 percent from 1988. Earnings for the entire banking industry fared poorly in 1989, however, because o f the subpar performance of the 43 banks with total assets greater than $10 billion; including these 43 banks, 1989 earn ings totaled $15.86 billion, down 35.4 percent from 1988 earnings o f $24.56 billion. The number of District banks reporting losses for the year fell again in 1989: just 50 banks, or 4 percent of the District total, incurred losses in 1989 compared with 79 banks (6.1 percent) in 1988 and 88 banks (6.7 percent) in 1987. Na tionally, 11.3 percent of commercial banks with assets of less than $10 billion—banks compar able in size to Eighth District banks—reported losses in 1989, down from 14.4 percent in 1988 and 18.5 percent in 1987; slightly more than 25 $10 billion, as there are no District banks of that size. See Karrenbrock (1990) for a detailed analysis of District agricultural bank performance in 1989. For bank perfor mance statistics on each Eighth District state, see Clark (forthcoming). 2Unless otherwise noted, performance ratios for all U.S. banks exclude those banks with assets of more than MAY/JUNE 1990 4 percent of banks with assets greater than $10 billion reported net losses in 1989, up dramati cally from 5.1 percent in 1988. Substantial in creases in loan loss provisions were primarily responsible for the increase in the proportion of large banks incurring losses in 1989.3 Return on Assets and Equity When examining bank earnings, two standard profitability measures generally are employed: the return on average assets (ROA) ratio and the return on equity (ROE) ratio. ROA, calcu lated by dividing a bank’s net income by its average annual assets, indicates how successful ly bank management employed the bank’s assets to earn income. ROE, the ratio o f a bank’s net income to its equity capital, provides share holders with a measure o f the institution’s re turn on their investment.4 As table 1 indicates, Eighth District banks recorded an average ROA of 0.88 percent and an average ROE o f 11.26 percent in 1989. Both measures w ere down from their 1988 levels because of a sharp drop in profitability among the District’s largest banks. Average ROA and ROE for the District’s 13 banks with assets of $1 to $10 billion fell from 0.82 percent to 0.61 percent and from 12.46 percent to 9.53 percent, respectively, over the period. District banks in asset categories of less than $1 billion, however, generally experienced small average increases in ROA and ROE from 1988 to 1989. District banks in the $25 million to $300 million asset range, which comprise about two-thirds of all District banks, did somewhat better, experiencing an average 5 percent in crease in ROA in 1989 and a 3.4 percent in crease in ROE. For the nearly two-thirds of U.S. banks in this same asset category, the improve ments in ROA and ROE from 1988 to 1989 were even more substantial: 20.2 percent and 17 per cent, respectively. The smallest U.S. banks, those 3lt should be noted that increases in provisions for loan losses by the nation’s largest banks in 1989 largely reflect problem loans to LDCs and more recent problems with real estate lending. These losses will not necessarily affect future profitability. 4Equity capital consists of common and perpetual preferred stock, surplus, undivided profits and capital reserves and cumulative foreign currency translation adjustments. 5U.S. banks with assets greater than $10 billion had an even rougher year in 1989, with average ROA of just 0.11 FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis with assets o f less than $25 million, experienced a 100 percent increase in ROA and a 97.9 per cent increase in ROE in 1989; ROA and ROE for District banks in this asset category changed lit tle from their 1988 levels. Even though most U.S. banks showed stronger earnings improvement than their District coun terparts, District banks continued to outperform their national peers in 1989: the national aver ages o f 0.74 percent ROA and 10.25 percent ROE remained below the levels achieved by District banks. Across asset categories, only District banks in the $1 billion to $10 billion range registered average ROA and ROE below that of their national counterparts. Earnings were depressed or negative for some District banks in that asset category because o f large additions to loan loss provisions associated with commercial real estate loans and loans to LDCs.5 Components o f Earnings As with any business entity, a bank’s financial success is determined by how much revenue its activities generate over and above the costs in curred in generating that revenue. In assessing the earnings performance o f banks, analysts typically examine the three major components o f income and expense: net interest income, net noninterest income and the loan loss provision. These components, like net income, are typically adjusted by average assets to ease comparison among banks. An analysis of these individual items permits a more precise determination as to why an institution experienced a profit or a loss in any period. Net Interest Margin— The net interest mar gin is calculated by dividing the difference be tween interest income (what a bank earned on loans and investments) and interest expense (what it paid its depositors) by average earning percent compared with 0.94 percent in 1988 and ROE of 2.20 percent compared with 18.84 percent in 1988. 5 Table 1 Return on Average Assets and Return on Equity R etu rn on A v e ra g e A s se ts (R O A ) 1989 Asset category All banks1 Eighth District 1988 United States Eighth District 1987 United States Eighth District 1986 United States Eighth District United States 0.88% 0.74% 0.92% 0.72% 0.80% 0.54% 0.87% 0.65% Less than $25 million 0.81 0.58 0.81 0.29 0.68 0.14 0.68 0.02 $25-$50 million 0.98 0.74 0.94 0.59 0.89 0.45 0.84 0.44 $50-$100 million 1.06 0.88 1.01 0.76 0.93 0.64 0.92 0.60 $100-$300 million 1.02 0.92 0.96 0.78 0.94 0.74 0.87 0.69 $300 million-$1 billion 1.03 0.83 1.01 0.61 1.07 0.57 0.66 0.59 $1-$10 billion 0.61 0.65 0.82 0.77 0.51 0.48 0.98 0.75 United States Eighth District R etu rn on E q u ity (R O E) 1989 Asset category All banks1 Eighth District 1987 1988 United States Eighth District United States Eighth District 11.26% 10.25% 11.68% 10.04% 10.24% 1986 7.54% 11.25% United States 9.11% 8.30 5.74 8.27 2.90 7.17 1.39 7.33 0.17 $25-$50 million 10.67 8.11 10.43 6.69 10.05 5.14 9.76 5.09 $50-$100 million 11.82 10.09 11.52 8.90 10.74 7.75 10.89 7.44 $100-$300 million 12.65 11.50 11.82 9.97 11.71 9.65 11.08 9.26 $300 million-$1 billion 12.97 11.40 12.95 8.78 13.67 8.15 8.81 8.44 9.53 10.16 12.46 12.08 7.96 7.59 14.59 11.73 Less than $25 million $1-$10 billion 'Because all banks in the Eighth District have assets of less than $10 billion, “ all banks” includes only those banks in the United States with assets of less than $10 billion to allow for a meaningful comparison. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 assets.6 As specified in table 2, District banks in 1989 posted their lowest net interest margin of the four years shown. The net interest margin fell 3 basis points from 1988 to 1989 for all District banks, largely because of the 15 basispoint decline for banks in the $1 billion to $10 billion asset category. 6More precisely, interest income comprises the interest and fees realized from interest-earning assets and includes such items as interest and points on loans, interest and dividends from securities holdings, and interest from assets held in trading accounts. Interest expense includes the interest paid on all categories of interest-bearing In contrast to other performance indicators, the net interest margin is one area in which U.S. banks consistently outperform their District peers. For U.S. banks with assets of less than $10 billion, the average net interest margin in 1989 was 4.44 percent, up 2 basis points from 1988 and 31 basis points higher than the Dis- deposits, the expenses incurred in purchasing federal funds and selling securities under agreement to repur chase and interest paid on capital notes. Average earning assets rather than average assets are used in the net in terest margin because they are the only assets from which a return in the form of interest is generated. MAY/JUNE 1990 6 Table 2 Net Interest Margin 1989 Asset category 1988 1987 1986 Eighth United District States Eighth United District States Eighth United District States Eighth District United States 4.13% 4.44% 4.16% 4.42% 4.27% 4.48% 4.40% 4.49% Less than $25 million 4.27 4.55 4.28 4.51 4.45 4.61 4.68 4.73 $25-$50 million 4.22 4.55 4.22 4.49 4.34 4.59 4.56 4.75 $50-$100 million 4.14 4.52 4.12 4.49 4.33 4.59 4.56 4.77 $100-$300 million 4.20 4.60 4.17 4.51 4.39 4.59 4.45 4.68 $300 million-$1 billion 4.42 4.57 4.37 4.46 4.55 4.56 4.46 4.65 $1 -$10 billion 3.89 4.32 4.04 4.35 3.97 4.36 4.14 4.25 All banks1 1 banks includes only those banks with assets of less than $10 billion. All NOTE: Interest income has been adjusted upward by the taxable equivalence of tax-exempt state and local securities. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 trict average of 4.13 percent. U.S. banks posted higher net interest margins than District banks in every comparable asset category for all four years shown in table 2.7 Interest Incom e and Expense—Differences in net interest margins among banks in differ ent asset classes and geographic areas can be explained by looking at the income and expense components of the ratio. As figure 1 illustrates, interest income as a percent o f average earning assets for District banks averaged 10.25 percent in 1989, up sharply from the 1988 ratio o f 9.53 percent. District banks with assets of less than $100 million posted increases in interest income margins ranging from 4.5 percent to 6.3 per cent; those with assets of more than $100 mil lion posted increases of 7.8 percent to 9.1 percent. As in 1988, interest income as a percent of average earning assets was positively related to bank size in 1989. The greater interest incomeearning ability of larger banks can be explained by their tendency to hold less o f their assets in H'he story is different for the large U.S. banks. The average net interest margin for banks with assets greater than $10 billion fell 9.5 percent in 1989 to 3.43 percent. This 36 basis-point decline pulled down the net interest margin for the U.S. banking industry in 1989 to 4.07 from 4.19 in 1988. FEDERAL RESERVE BANK OF ST. LOUIS relatively low-return securities than in relatively high-return loans compared with the smaller banks. The relative proportions o f securities and loans in their asset portfolios also account for much of the margin differences between Dis trict banks and their U.S. counterparts. Across all asset categories, District banks held a larger proportion o f their assets in the form o f secu rities than did their national peers over the 1987-89 period. Figure 1 also indicates that interest expense increased more than interest income in 1989. While interest income as a percent of average earning assets increased 7.6 percent at District banks in 1989, the interest expense ratio ad vanced 14 percent. Most of the increase in in terest expense occurred in the first part of 1989, when rates paid on deposits and other interest-bearing liabilities were higher because of relatively restrictive monetary policy and competition from troubled thrifts that were of fering high rates to meet their funding require ments. Because the average maturity of bank 7 Figure 1 Interest Income and Interest Expense as a Percent of Average Earning Assets Percent Percent U.S. Income [District Income is ~] District Expense U.S. Expense 11 10 8 -L 1986 1987 1988 1989 SOURCE: FFIEC Reports of Condition and Income for Commercial Banks, 1986-1989 assets tends to be longer than that o f their de posits, rising interest rates impose increasing in terest expense at a time when interest income tends to be constant or increasing more slowly, thus exerting downward pressure on net in terest margins. Every asset category o f District banks except for one had higher interest expense ratios than their U.S. counterparts in 1989. Moreover, of the four years shown in figure 1, 1989 was the only year in which the overall District average was lower than the national one. The interest expense differentials among District banks and their national peers can be explained by looking at the composition o f their interest-bearing lia bilities. As illustrated in column 1 of table 3, deposit interest expense made up a greater share o f total interest expense for most catego ries of District banks than for comparable U.S. banks in 1989. These greater shares can be at tributed to the higher proportion o f interest- MAY/JUNE 1990 8 Table 3 Composition of Interest Expense and Related Liabilities, 1989 DIE/TIE Asset category All banks1 Eighth District 88.31% Less than $25 million 98.99 United States IBD/TL Eighth District Avg DR Eighth District United States 71.29% 6.98% United States 84.38% 75.44% 99.10 84.72 6.95% 83.88 6.69 6.65 83.91 6.80 6.76 FFE/TIE Eighth District United States 9.62% FFP/TL Eighth District United States 7.04% 7.73»/ 0.70 0.57 0.46 0.34 0.81 0.80 0.56 0.50 11.31% $25-$50 million 98.91 98.79 86.07 $50-$100 million 98.26 97.79 85.95 82.99 6.89 6.80 1.23 1.51 0.91 1.00 $100-$300 million 95.48 95.28 82.87 80.25 6.86 6.78 3.56 3.29 2.63 2.19 $300 million-$1 billion 88.85 87.41 74.12 73.85 6.84 6.89 9.90 9.14 7.42 6.05 $1-$10 billion 73.93 75.76 61.19 63.64 7.36 7.13 21.41 17.61 15.80 12.31 DIE TIE IBD TL Avg DR FFE FFP = = = = = = = deposit interest expense total interest expense interest-bearing deposits total liabilities average deposit rate (DIE/IBD) federal funds purchased and securities sold under agreements to repurchase expense federal funds purchased and securities sold under agreements to repurchase 'All banks include only those banks with assets of less than $10 billion. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 bearing deposits to total liabilities held by Dis trict banks (column 3) and the higher average rate paid on those deposits (column 5). In addition, most District banks paid a higher share o f total interest expense for federal funds than their national peers (column 7).8 The ma jority of District banks held a higher proportion o f federal funds purchased and securities sold under agreements to repurchase to total liabili ties than U.S. banks overall (column 9). The federal funds rate for 1989 averaged 9.21 per cent, approximately 2.2 percentage points higher than the average deposit rate, making federal funds a significantly more expensive source of 8Federal funds expense as a percent of total interest ex pense and federal funds purchased as a percent of total liabilities appear lower for District banks overall than for U.S. banks. This total figure is skewed, however, by the larger proportion of federal funds held by U.S. banks in the $1 billion to $10 billion asset category and by the larger proportion of U.S. banks in this asset class relative to District banks. These different distributions further il lustrate why it is necessary to break down banks by asset category to assess bank performance more accurately. FEDERAL RESERVE BANK OF ST. LOUIS funding. The higher concentrations o f interestbearing deposits and federal funds in their liabilities portfolios and the higher average rates paid by District banks on deposits together ac counted for much of the differentials in interest expense ratios between District and U.S. banks from 1986 to 1989. Net Noninterest Margin—The net nonin terest margin is an indicator of a bank's opera ting efficiency and its ability to generate fee in come. The net noninterest margin is calculated by subtracting noninterest expense (overhead) from noninterest income and dividing by aver- 9 age assets.9 Because noninterest expense usually exceeds noninterest income, the calculation yields a negative number; it is common practice, however, to report the noninterest margin as a positive number. Smaller net noninterest mar gins, therefore, indicate better bank perfor mance, all else equal. Because the net noninterest margin usually is negative and thus depresses earnings, and the income and expense components o f this margin tend to be items that banks have more control over than interest income and expense, bank managers increasingly are seeking ways to re duce the net noninterest margin. Excessive overhead frequently is mentioned by banking executives as a barrier to maintaining accep table profitability levels. Consolidation of opera tions and increased automation are just two ways the industry is seeking to control the largest portion of overhead, employee salaries and benefits. In 1989, as in previous years, all asset catego ries of Eighth District banks recorded lower net noninterest margins than their national peers. District banks recorded a net noninterest mar gin of 1.93 percent in 1989 vs. 2.12 percent for U.S. banks of comparable size. Despite lower ratios o f noninterest income for most categories of banks, District banks continue to record lower net noninterest margins than their U.S. peers because of their consistently lower overhead ratios. Noninterest Incom e and Expense—As il lustrated in table 4, District banks generated a noninterest income to average assets ratio of 1 percent in 1989 compared with 1.22 percent for U.S. banks overall. The pattern of noninterest earnings across asset categories over the last three years continued in 1989, as U.S. banks with assets of less than $300 million once again generated more noninterest income relative to average assets than their District peers, while 9Noninterest expense is the sum of the costs incurred in the bank’s day-to-day operations, which includes employee salaries and benefits, expenses of premises and fixed assets, as well as legal and directors’ fees, insurance premiums and advertising and litigation costs. Noninterest income includes income from fiduciary (trust) activities, service charges on deposit accounts, trading gains (losses) from foreign exchange transactions, gains (losses) and fees from assets held in trading accounts, and charges and fees from miscellaneous activities like safe deposit rentals, bank draft and money order sales, and mortgage servicing. District banks with assets greater than $300 million outperformed their national peers. The lower ratios for smaller District banks relative to larger District banks can be partially attri buted to a lesser demand for trust activities and foreign currency transactions in most parts of the District as well as the large number o f rural banks that charge no or low fees for many bank services. Low er ratios o f off-balance-sheet items to total assets also explain lower noninterest in come margins at District banks.1 0 Overall, noninterest expense fell from 1988 to 1989 at both the District and the U.S. level, as many banks were successful in their cost-cutting efforts. Across all asset categories, District banks maintained lower overhead ratios than their national counterparts for all four years shown in table 4. For District banks, the over head ratio o f 2.93 percent was approximately 13 percent lower than for U.S. banks of compar able size in 1989. These consistently lower over head ratios can be explained by a number of factors: lower average salaries and benefits in the District; a lack o f extensive branching, which keeps overall operating expenses down; and the large proportion o f District banks located in nonmetropolitan areas where building, land, rental and maintenance costs are relatively low. Loan and Lease Loss Provision —In sharp contrast to 1988, when loan and lease loss pro visions dropped substantially from their 1987 levels, total loss provisions rose substantially in 1989 for District banks and their U.S. peers. The District loan loss provision totaled $595 million in 1989, up 30.5 percent from the 1988 provision o f $456 million. For U.S. banks of comparable size, the provision rose 21.7 percent to $13.53 billion. As table 5 reveals, much of the reversal was concentrated at the largest District and U.S. banks. The loan loss provision to average assets ratio increased 16.7 percent for District banks with assets o f $300 million to $1 billion, but 56.5 percent for the 13 banks 1“Off-balance-sheet items represent obligations by a bank to acquire certain assets or liabilities at a future date provid ed contractual conditions are met. They include such diverse financial instruments as loan commitments, letters of credit, interest rate swaps and loan sales. Banks usually earn fee income from providing such services, but do not have to hold capital or funding liabilities against the assets until they are actually booked. Off-balance-sheet activities still subject a bank to risks, which is why these items will be included in the new risk-based capital requirements banks will have to meet by the end of 1990. MAY/JUNE 1990 10 Table 4 Noninterest Income and Noninterest Expense as a Percent of Average Assets N o n in te re s t In c o m e Asset category 1987 1988 1989 Eighth United District States Eighth District United States Eighth District 1986 United States Eighth United District States 1.00% 1.22% 0.98% 1.20% 0.99% 1.16% 1.01% 1.13% Less than $25 million 0.57 1.25 0.58 0.90 0.57 0.95 0.55 0.85 $25-$50 million 0.58 0.77 0.55 0.75 0.53 0.70 0.52 0.70 $50-$100 million 0.55 0.81 0.55 0.79 0.52 0.74 0.52 0.74 $100-$300 million 0.80 0.92 0.74 0.88 0.77 0.88 0.73 0.89 $300 million-$1 billion 1.17 1.13 1.23 1.12 1.39 1.10 1.25 1.11 $1-$10 billion 1.50 1.47 1.51 1.49 1.52 1.44 1.69 1.39 All banks1 N o n in te re s t E xp e n s e (O v e rh e a d ) 1989 1988 1987 Asset category Eighth District United States Eighth United District States 1986 Eighth United District States Eighth District United States 2.93% 3.34% 2.97% 3.37% 2.98% 3.36% 2.98% 3.34o/o Less than $25 million 3.08 3.93 3.07 3.78 3.08 3.83 3.09 3.77 $25-$50 million 2.75 3.33 2.72 3.30 2.69 3.28 2.65 3.28 $50-$100 million 2.52 3.18 2.57 3.19 2.57 3.19 2.59 3.21 $100-$300 million 2.77 3.27 2.77 3.25 2.80 3.23 2.74 3.24 $300 million-$1 billion 3.20 3.31 3.32 3.40 3.37 3.38 3.46 3.45 $1-$10 billion 3.18 3.38 3.27 3.42 3.27 3.42 3.30 3.35 All banks1 1All banks includes only those banks with assets of less than $10 billion. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 with assets o f $1 billion to $10 billion; U.S. banks in those categories made more modest additions to their provisions, 1.7 percent and 37.5 percent, respectively.1 1 The substantial increases in the provision ratios for the large District banks were primar ily the result o f large provisions taken by Ten nessee banks to cover the nonperforming real estate loans of a local developer as well as a large provision at another big District bank to 11The loss provision ratio for the 43 U.S. banks with assets greater than $10 billion almost tripled in 1989, rising from 0.43 percent to 1.28 percent. FEDERAL RESERVE BANK OF ST. LOUIS cover remaining exposure to LDC debt. Deterio rating commercial real estate and foreign loan portfolios led to provision increases nationwide as well. Some analysts have suggested that banks that made large increases in provisions in 1987 to cover nonperforming foreign loans w ere not as vigilant in assessing their growing real estate loan portfolios in 1988 and 1989. Rather than recognizing potential losses in 1988, which would have depressed profits for a second 11 Table 5 Loan and Lease Loss Provision as a Percent of Average Assets Asset category 1987 1988 1989 Eighth District United States Eighth United District States Eighth District 1986 United States Eighth District United States 0.46% 0.69% 0.38% 0.59% 0.60% 0.79% 0.59% 0.77% Less than $25 million 0.28 0.49 0.30 0.62 0.49 0.83 0.68 1.15 $25-$50 million 0.27 0.45 0.34 0.55 0.44 0.73 0.67 0.97 $50-$100 million 0.28 0.42 0.30 0.49 0.41 0.61 0.62 0.85 $100-$300 million 0.37 0.43 0.36 0.49 0.45 0.56 0.64 0.75 $300 million-$1 billion 0.42 0.60 0.36 0.59 0.42 0.72 0.68 0.85 $1-$10 billion 0.72 0.88 0.46 0.64 0.97 0.93 0.46 0.67 All banks1 1All banks includes only those banks with assets ot less than $10 billion, SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 straight year, many banks delayed making these large additions until 1989.1 2 It is important to note, however, that District provision ratios w ere still well below those of their national counterparts in 1989. In addition, provision ratios declined again in 1989 for Dis trict and U.S. banks with assets of less than $100 million. District banks in these asset cate gories, which make up more than 80 percent of total District banks, experienced an average decline in the provision ratio of 11.4 percent; U.S. banks in these categories, which represent just over 75 percent of U.S. banks, experienced an 18.2 percent decline. fallen, reflecting in part banks’ volatile earnings pattern of the past few years and the riskaversion o f many investors. Regulators, too, are concerned and have refined the tools used to assess loan portfolios. They have also adjusted minimum capital ratios to reflect the riskiness o f a bank’s asset portfolio.1 3 Asset quality may be gauged by examining the nonperforming loan ratio and the ratio o f net loan losses to total loans. The nonperforming loan ratio indicates the current level of problem loans as well as the potential for future loan losses. The ratio of net loan losses to total loans specifies the percentage o f loans actually w rit ten o ff the bank’s books for a given period. ASSET QUALITY Asset quality was a major determinant in the pattern of earnings for banks nationwide in the 1980s, and 1989 was no exception. The major area of concern, however, has shifted from the quality o f foreign loans to the performance of real estate loans. The substantial losses already incurred from foreign lending and the mounting losses from real estate lending have not escaped the notice of shareholders or regulators. Bank stock prices in many parts of the country have 12See Rose (1990). 13The new risk-based capital requirements are discussed briefly in a later section. Nonperforming Loans and Leases Nonperforming loans comprise loans and lease financing receivables that are 90 days or more past due or in nonaccrual status.1 The level of 4 nonperforming loans and leases at District banks totaled $1.21 billion at year-end 1989, a 5.5 percent increase from the level at year-end 1988. Nationally, banks of comparable size ex perienced a 9.1 percent increase in the level of nonperforming loans. 14Restructured loans and leases that fall into the 90 days or more delinquent status or in nonaccrual status are includ ed as well. MAY/JUNE 1990 12 Table 6 Nonperforming Loans and Leases as a Percent of Total Loans 1989 Asset category Eighth District All banks1 1988 United States Eighth District 1987 United States 1986 Eighth United District States Eighth District United States 1.60% 2.20% 1.62% 2.10% 2.10% 2.40% 2.16% 2.40% Less than $25 million 1.71 2.31 1.80 2.65 2.12 3.16 2.66 3.76 $25-$50 million 1.70 2.15 1.72 2.43 2.14 2.75 2.61 3.19 $50-$100 million 1.47 1.98 1.65 2.19 2.04 2.45 2.46 2.93 $100-$300 million 1.67 1.92 1.70 1.89 1.95 2.20 2.04 2.53 $300 million-$1 billion 1.42 2.36 1.25 2.71 1.47 2.28 2.33 2.51 $1-$10 billion 1.65 2.27 1.65 1.92 2.44 2.41 1.81 2.06 1All banks includes only those banks with assets of less than $10 billion. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 Despite the rise in the absolute level o f nonperforming loans at District banks, the ratio of nonperforming loans and leases to total loans declined from 1.62 percent in 1988 to 1.60 per cent in 1989. As table 6 indicates, the 1989 nonperforming loan ratio for District banks was the lowest of the four years shown. In 1989, only District banks with assets o f $300 million to $1 billion experienced an increase in the nonperforming loan ratio; nonetheless, this category of banks recorded the lowest nonperforming loan ratio (1.42 percent) among District asset categories in 1989. In contrast to District banks, U.S. banks ex perienced an increase in the absolute level of nonperforming loans and the nonperforming loan ratio in 1989. For U.S. banks with assets of less than $10 billion, the nonperforming loan ratio increased from 2.10 percent in 1988 to 2.20 percent in 1989. Although the nonperforming loan ratio fell substantially across most asset cate gories, an 18.2 percent increase in the ratio for banks with assets of $1 billion to $10 billion was large enough to boost the ratio for all banks.1 5 15The nonperforming loan ratio for the nation’s largest banks registered its second straight year of improvement in 1989, declining to 4.41 percent from 4.47 percent in 1988 and 5.26 percent in 1987. FEDERAL RESERVE BANK OF ST. LOUIS The distribution of nonperforming loans by loan type for District banks over the past four years is illustrated in figure 2. For the second straight year, real estate loans made up the largest share of nonperforming loans, almost 50 percent at year-end 1989, up from 43 percent in 1988. The rise in the share of nonperforming real estate loans was almost completely offset by a fall in the proportion of nonperforming commercial and industrial loans, from 41 per cent of nonperforming loans in 1988 to 35 per cent in 1989. The share o f nonperforming agri cultural loans to total nonperforming loans fell again in 1989 to approximately 4 percent, less than half the percentage recorded at year-end 1986. The ratio of nonperforming consumer loans to total nonperforming loans held steady at District banks in 1989. Net Loan and Lease Losses A more direct measure of loan problems than the nonperforming loan ratio is the percentage of loans and leases actually written o ff a bank’s books. Net loan and lease losses are calculated 13 Figure 2 District Distribution of Nonperforming Loans by Loan Type Percent I Percent I Agriculture Consumer Ml □ 50 - | Real Estate | Commercial 50 40 40 30 30 20 20 10 10 _L -L JL 1986 1987 1988 1989 NOTE: Percentages may sum to greater than 100 because agricultural loans are included in other categories as well. SOURCE: FFIEC Reports of Condition and Income for Commercial Banks, 1986-1989 by totaling loan and lease charge-offs and sub tracting recoveries over a given period. Net loan and lease losses totaled $505 million at District banks in 1989, down almost 2 percent from 1988 net charge-offs. Net charge-offs at U.S. banks o f comparable size rose 0.8 percent in 1989 to $10.4 billion. 16Bank management will adjust the loan loss provision in the current year to reflect nonperforming loans; those loans may be carried on a bank’s books for years before a deci sion is made to write them off. Bank supervisors also help decide when to write off loans, and in fact can force a bank to write off a loan that is still performing by the The ratio o f net loan and lease losses to total loans is an indicator o f problem lending in the current year as well as prior years, because of bank management’s partial discretion in deter mining when a loan is deemed uncollectible and is thus written off.1 As table 7 indicates, the 6 net loan loss ratios for District and comparable bank’s standards. Net loan and lease losses do not affect current earnings as the loan loss provision does; rather, they just alter the allowance for loan losses (or loan loss reserve), a contra account on the asset side of a bank’s balance sheet. MAY/JUNE 1990 14 Table 7 Net Loan and Lease Losses as a Percent of Total Loans 1988 1987 Eighth United District States Eighth United District States 1989 Asset category Eighth District United States 1986 Eighth District United States 0.67% 0.83% 0.73%i 0.87% 0.70% 0.89% 0.88% 0.97% Less than $25 million 0.45 0.84 0.60 1.14 0.95 1.50 1.33 2.03 $25-$50 million 0.42 0.74 0.53 0.88 0.74 1.18 1.16 1.61 $50-$100 million 0.44 0.64 0.47 0.74 0.70 0.96 1.07 1.35 $100-$300 million 0.53 0.60 0.50 0.66 0.67 0.78 0.99 1.02 $300 million-$1 billion 0.51 0.78 0.42 0.78 0.71 0.87 0.92 0.99 $1-$10 billion 1.00 0.96 1.18 0.95 0.68 0.86 0.57 0.73 All banks1 1AII banks includes only those banks with assets of less than $10 billion. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 U.S. banks declined from 1988 to 1989.1 District 7 banks wrote o ff 67 cents for every $100 in loans on the books at year-end 1989, compared with 83 cents for U.S. banks of comparable size. Ex cept for banks in the $1 billion to $10 billion asset category, District net loan loss ratios re mained well below those of their national coun terparts in 1989, as they had for the previous three years. The net loan loss ratio for District banks declined in 1989 across all but two asset cate gories; paralleling the rise in the nonperforming loan ratio, the net loan loss ratio rose 21 per cent for banks with assets of $300 million to $1 billion. District banks with assets of $1 bil lion to $10 billion experienced a 15.3 percent decline in their net loan loss ratio, as banks that had taken large provisions for LDC loan losses in 1987 wrote o ff comparatively more of those loans in 1988 than in 1989. For District banks with assets of less than $50 million, the net loan loss ratio declined dramatically again in 1989, reflecting the continuing rebound from agri cultural loan losses in the mid-1980s. 17lncluding the nation’s largest banks, however, the U.S. net loan loss ratio rose almost 13 percent in 1989, reflecting LDC loans written off by money center banks and commer cial real estate loans written off by some of the country’s largest regional banks. FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis The distribution of loan losses by loan type for District and U.S. banks is illustrated in table 8. The data are further separated into two asset categories to illustrate the lending patterns of small vs. large banks, as agricultural loan losses have been primarily concentrated at small banks while foreign loan losses have been incurred by large banks. For banks with assets of less than $300 million, losses on commercial and industrial loans once again made up more than 50 percent of total loan losses at both the District and na tional levels. The share of commercial loan losses at small District and U.S. banks has fallen steadily since 1986, while losses from consumer lending have increased substantially since 1986 at District and U.S. banks of comparable size. After making up nearly a quarter o f District and 20 percent of U.S. loan losses in 1986, the share of agricultural loan losses has dropped dramatically over the past four years, reflecting the rebound in the farm economy and the in crease in losses from other types of lending, such as real estate. In contrast to the results at U.S. banks, the share of real estate loan losses 15 at small District banks actually fell from 1988 to 1989, although the real estate loss share was roughly the same at both sets o f banks. Once again, there were no losses from foreign len ding at small District banks in 1989 and minimal losses at the national level. The largest District banks, with assets of $300 million to $10 billion, experienced a large increase in the share o f commercial and indus trial loan losses in 1989, climbing above the 50 percent level for the first time since 1986. Such loan losses at U.S. banks made up less than a third of total loan losses in 1989, as the ratio continued its steady decline from its 1986 level. Consumer loan losses accounted for the largest share of total loan losses at U.S. banks in 1989, and the second largest share at District banks. The share of real estate loan losses rose approx imately 50 percent at both the District and na tional level in 1989, and may well surpass con sumer and commercial loan loss shares in 1990. The share of agricultural loan losses more than doubled at large District banks in 1989, but still made up the smallest proportion o f loan losses at 0.38 percent. After comprising almost a third of loan losses in 1988, foreign loan losses declin ed to less than 2 percent of total loan losses at large District banks in 1989. Most District banks with outstanding foreign loans wrote o ff in 1988 the loans for which they took provisions in 1987. The 1989 share of foreign loan losses at U.S. banks of comparable size also fell from 1988, but was twice the District's share. CAPITAL ADEQUACY The volatile earnings pattern o f banks in re cent years, the problem loan portfolios in vari ous parts of the country and the growth of offbalance-sheet items have prompted bank regu lators to redefine measurements of the ade quacy of financial capital. Banks maintain capital to absorb losses, provide for asset expansion, protect uninsured depositors and promote public confidence in the financial soundness of the banking industry. Since 1985, banks have been 18Primary capital is the sum of common stock, perpetual preferred stock, surplus, undivided profits (retained earn ings), contingency and other capital reserve, qualifying mandatory convertible instruments, loan and lease loss reserves, minority interests in consolidated subsidiaries, less intangible assets excluding purchased mortgage ser vicing rights. (For the purposes of this paper, only the goodwill portion of intangible assets was deducted.) Secondary capital is limited to 50 percent of primary Table 8 Distribution of Loan Losses_______ Banks with assets of less than $300 million Loan type 1989 1988 1987 1986 District Agriculture Commercial Consumer Real estate Foreign1 3.70% 53.72 26.31 19.84 N.A. 6.17% 56.16 20.15 23.50 N.A. 14.17% 61.20 16.23 22.17 N.A. 23.60% 66.14 12.73 20.95 0.12 United States Agriculture Commercial Consumer Real estate Foreign1 3.20% 54.76 24.21 20.41 0.10 4.71% 58.60 21.21 19.72 0.04 10.51% 62.52 18.45 18.52 0.02 19.13% 69.26 15.43 14.84 0.01 Banks with assets of $300 million to $10 billion Loan type 1989 1988 1987 1986 District Agriculture Commercial Consumer Real estate Foreign1 0.38% 51.36 21.17 19.24 1.78 0.15% 38.34 16.39 12.65 27.20 1.48% 40.68 31.10 15.61 3.82 2.80% 55.23 28.88 10.18 0.23 United States Agriculture Commercial Consumer Real estate Foreign1 0.30% 31.32 38.15 24.02 4.13 0.29% 36.67 32.96 16.38 9.28 1.22% 38.71 35.51 14.51 6.40 3.44% 46.91 36.09 10.63 0.47 'Loans held in foreign offices, Edge and Agreement subsidi aries and International Banking Facilities (IBFs). N.A.—not applicable NOTE: Percentages may sum to more than 100 because some agricultural loans are included in more than one category. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 required by regulators to maintain minimum standards o f 5.5 percent primary capital to total adjusted assets and 6 percent total capital to total adjusted assets.1 By year-end 1990, these 8 capital and includes subordinated notes and debentures, limited-life preferred stock and that portion of mandatory convertible securities not included in primary capital. Each bank’s qualifying secondary capital is added to its primary capital to obtain the total capital level for regulatory pur poses. The primary and total capital ratios are obtained by dividing through by average adjusted assets (average assets plus the allowance for loan losses less goodwill). MAY/JUNE 1990 16 Table 9 Primary Capital Ratio Asset category All banks1 8.71% 1987 1988 1989 Eighth District United States Eighth District 8.25% United States 8.72% 8.12% 1986 Eighth United District States 8.72% 8.11% Eighth District 8.47% United States 7.97®/ 10.38 11.00 10.43 10.80 10.11 10.58 9.97 10.36 $25-$50 million 9.84 9.92 9.68 9.65 9.52 9.48 9.27 9.30 $50-$100 million 9.67 9.49 9.48 9.26 9.35 9.06 9.08 8.82 $100-$300 million 8.85 8.76 8.85 8.63 8.71 8.51 8.50 8.26 $300 million-$1 billion 8.72 8.23 8.55 7.86 8.50 7.85 8.30 7.81 $1 -$10 billion 7.53 7.53 7.66 7.45 7.89 7.48 7.52 7.31 Less than $25 million 1All banks includes only those banks with assets of less than $10 billion. SOURCE: FFIEC Reports of Condition and Income for Insured Commercial Banks, 1986-1989 standards will be replaced by a new core capital to total assets ratio (leverage ratio) and capital ratios based on risk-adjusted assets, standards designed to adjust capital requirements to the credit risk o f assets and off-balance-sheet items.1 9 Both District banks and their national counter parts continued to register average primary capital ratios well above the minimum standard in 1989. As table 9 indicates, District banks averaged a primary capital ratio o f 8.71 percent in 1989, just slightly lower than that achieved in 1987 and 1988. All District bank categories ex cept for the smallest (assets of less than $25 million) and the largest ($1 billion to $10 billion) experienced increases or no change in their primary capital ratios from 1988 to 1989. The District’s smallest banks, like their national peers, once again recorded an average primary capital ratio well above the total bank average in 1989. Unlike the previous three years, when 19The risk-based capital guidelines establish a systematic framework in which differences in risk profiles among banking institutions can be assessed in defining regulatory capital. Assets as well as off-balance-sheet items will be assigned weights of 0, 20, 50 or 100 percent based on their riskiness as determined by regulators. Through 1990, banks have the option of meeting the 5.5 percent primary capital and 6 percent total capital ratios, or the transition capital requirements effective at year-end 1990 of 7.25 percent qualifying capital to risk-adjusted assets, 3.625 http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS FEDERAL Federal Reserve Bank of St. Louis they had an average ratio substantially higher than that o f their national counterparts, the largest District banks in 1989 averaged the same rate as their national peers, 7.53 percent. As of December 1989, 11 banks, or 0.9 per cent o f all District banks, registered primary capital ratios below the regulatory minimum, an increase from 1988 when 0.5 percent failed to meet the requirement. Nationally, 358 or 2.9 percent of U.S. banks of comparable size re corded deficient primary capital ratios at yearend 1989, compared with 498 banks or 3.9 per cent of such banks at year-end 1988. CONCLUSION Despite some trouble spots, Eighth District banks once again outperformed their national peers in measures of profitability, asset quality and capital adequacy in 1989. Most District percent Tier 1 capital to risk-adjusted assets and 3 percent Tier 1 capital to total assets (leverage ratio). By year-end 1992, all banks will be required to meet the 3 percent leverage ratio, an 8 percent capital to risk-adjusted assets ratio and a 4 percent Tier 1 capital to risk-adjusted assets ratio. 17 banks registered higher profitability ratios than their U.S. peers, even though the major deter minant of ROA, the net interest margin, remain ed lower in the District in 1989. Lower loan loss provision ratios and net noninterest mar gins at District banks more than compensated for lower net interest margins, resulting in higher ROA and ROE. In contrast to comparable U.S. banks, asset quality continued to improve at District banks in 1989, as both the nonperforming loan ratio and the net charge-off rate declined. Both Dis trict and U.S. banks, however, are experiencing increases in problem real estate loans and a substantial decline in asset quality could materi alize in 1990. In addition to imposing new risksensitive capital requirements on banks, regula tors will be keeping a close eye on real estate portfolios. Most District and U.S. banks had capital ratios substantially in excess o f current minimum stan dards in 1989, and the majority of small banks should have no trouble meeting the new riskbased capital requirements and leverage ratio. Larger banks with substantial off-balance-sheet exposure may have considerably more trouble meeting the new requirements, as those items are being added to the asset base o f banks and are being assigned higher risk rates than some traditional assets like home mortgages and U.S. government securities. As the 1990s begin, bankers across the coun try will be faced with economic uncertainty, a changing regulatory environment and growing problem loans, a climate not unlike that o f the early 1980s. Eighth District banks, with solid profitability ratios, good asset quality and strong capital positions, are poised to weather the changes o f this decade as they did the changes o f the last. REFERENCES Clark, Michelle A. “Bank Performance in 1989: The Pluses and Minuses,” Pieces of Eight, Federal Reserve Bank of St. Louis (June 1990). Karrenbrock, Jeffrey D. “The U.S. and District Agricultural Economy: Continued Strength in 1989,” this Review (May/June 1990). Rose, Sanford. “Mounting Loan-Loss Provisions Weaken Regional Bank Profits,” The American Banker; (February 6, 1990). MAY/JUNE 1990 18 Thomas B. Mandelbaum Thomas B. Mandelbaum is an economist at the Federal Reserve Bank of St. Louis. Thomas A. Pollmann provided research assistance. The Eighth District Business Economy in 1989: Exiting the Eighties with Vigor J j i NTER1NG the 1980s, the business economy o f the Eighth Federal Reserve District was weak ening, employment levels w ere declining and un employment rates w ere rising sharply. As we exited the 1980s, however, District economic conditions contrasted sharply with the early part o f the decade. In 1989, the District’s unem ployment rate was at its lowest level of the de cade while employment and income continued a long rise, albeit at a moderate pace.1 Despite this general good news at the close of the decade, not all sectors o f the region’s econo my fared well in 1989. While District employ ment rose, its rate o f increase slowed from the pace o f the previous two years. Building activity was flat, as declines in residential building offset gains in nonresidential building. Furthermore, the economic performance o f the District’s in dividual states and sectors varied widely. 1The Eighth Federal Reserve District includes the entire state of Arkansas and parts of Illinois, Indiana, Kentucky, Mississippi, Missouri and Tennessee. This article uses data for the entire states of Arkansas, Kentucky, Missouri and Tennessee, where the bulk of District economic activi ty is concentrated, to represent the District. 2Growth rates for all indicators compare the average for 1989 with the average for previous years. FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis INCOME AND CONSUMER SPENDING District real nonfarm personal income rose moderately in 1989; as it has over the entire decade, however, it trailed the national average.2 As table 1 shows, District real nonfarm income in 1989 rose 2.3 percent compared with 2.7 per cent nationally. The slower-than-national region al growth last year reflected a relatively slow expansion o f both nonfarm earnings and divi dends, interest and rent. The District’s 2.3 percent gain in real nonfarm income was a slight deceleration from a 2.7 per cent increase in 1988. Although income growth from transfer payments and dividends, interest and rent picked up last year, the expansion of nonfarm earnings—the largest source of incomewas sluggish. From a longer-run perspective, 19 Table 1 Growth Rates of Selected Economic Indicators1 Indicator United States 1979-89 1989 District 1979-89 1989 Real nonfarm personal income 2.4% 2.7% 1.9% 2.3% Real retail sales2 Durables Nondurables 2.7 4.6 1.6 1.4 2.6 0.6 2.2 3.8 1.3 2.0 4.8 0.2 1.9 - 0 .3 -0 .7 1.7 - 2 .8 2.7 2.5 4.6 1.1 2.8 1.5 1.0 3.5 0.2 3.3 2.7 5.1 2.0 1.6 -0 .3 -0 .2 0.0 -4 .4 2.4 2.3 4.4 0.7 2.9 1.6 2.0 1.0 - 4 .8 3.4 3.0 5.1 2.2 3.2 2.1 2.4 0.3 1.1 2.8 1.5 3.5 1.1 0.5 2.0 - 0 .9 -4 .1 3.2 -0 .1 -1 .2 1.2 0.1 -4 .1 4.8 Payroll employment Goods-producing Manufacturing Construction Mining Services-producing Wholesale/retail trade Services Government Finance, insurance and real estate Transportation and public utilities Real value of building contracts3 Residential Nonresidential 11979-89 growth rates are compounded annua! rates of change. 1989 rates are percent changes from 1988. 2Retail sales data are from DRI/McGraw-Hill. 3Excludes nonbuilding construction. Growth rates are based on current-dollar data from F.W. Dodge Construction Potentials, which were deflated by the author. the District’s income growth in 1989 was slight ly above the average for the decade, as shown in table 1. Retail sales grew slower at the District than the national level in the 1980s, reflecting the region’s slower population and income growth.3 District retail sales growth also trailed well behind the U.S. average in the middle years of the decade: District sales rose at a 2.6 percent annual rate between 1984 and 1988, after ad justing for inflation, compared with the nation’s 3.9 percent rate. District real retail sales, however, rose 2 per cent in 1989, exceeding the nation's 1.4 percent rate. While sales o f nondurable goods showed only marginal increases in both the District and the nation, sales of durable goods rose 4.8 per- cent in the District, more than tw o percentage points higher than the U.S. rate o f increase. One reason for weak durable goods sales in the nation was the sharply slower sales o f automo biles; U.S. consumers purchased few er autos in 1989 than in any year since 1983. Among Dis trict states, sales o f durables w ere particularly strong in Arkansas where even auto sales were up moderately, according to tax revenue data. LABOR MARKETS Payroll employment increased in the 1980s at a 1.6 percent annual rate in the District, reach ing almost 6.8 million workers by 1989. In com parison, U.S. payroll employment rose at a 1.9 percent rate. The District's slightly slower job 3District population grew at a 0.6 percent annual rate bet ween 1979 and 1989 compared with 1 percent nationally. MAY/JUNE 1990 20 Figure 1 Annual Percent Change in Payroll Employment P e rc e n t — P e rc e n t U n ited S tate s A rkansas □ H K e n tu ck y | □ - - E ig h th D istrict M issouri |T e n n e s s e e -1 -1 -2 -2 1983 84 85 86 87 88 1989 m growth resulted mainly from a downturn in the decade's early years that was considerably more severe than at the national level. Between 1979 and 1982, District nonfarm employment drop ped more than a quarter o f a million jobs, or nearly 5 percent, while changing little national ly. The cyclically sensitive goods-producing in dustries — manufacturing, mining and construc tion — accounted for 94 percent of the region’s job losses during this period. As employment weakened, the District’s unemployment rate doubled, rising from 5.4 percent in 1979 to 10.8 percent in 1983. Figure 1 shows that District job growth was slightly stronger than its national counterpart in FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis every year except 1985 of the current recovery. In 1989, District employment growth slowed, but remained above the national average. Dis trict employment gains since 1982 allowed its unemployment rate to fall to 5.8 percent in 1989, the lowest value since 1979. In 1989, payroll employment rose 2.9 percent in the District and 2.8 percent in the nation. As figure 2 shows, the District's largest economic sectors—wholesale/retail trade, services, manu facturing and government—expanded as fast or faster than at the national level. The following sections discuss factors that contributed to the performance o f the Eighth District’s goods-producing and services-producing sectors last year. 21 Figure 2 Eighth District and U.S. Employment Change by Sector, 1988-89 Percent 7.5 Percent 7.5 ^ E ig h th District T] United States 5.0 5.0 2 .5 2.5 0.0 0.0 2.5 -2 .5 -5 .0 -5 .0 -7 .5 _L _L JL _L _L Total Payroll C onstruction M anufacturing M ining T ra d e 1 G overnm ent Services -7 .5 TPU3 FIR E2 'W h o le sale and retail trade 2Finance, insurance and real estate tr a n s p o r ta tio n and public utilities GOODS-PRODUCING SECTORS Mining Following four years o f decline, District goodsproduction employment has risen for the last six years, resulting in an employment figure ap proaching the 1979 level. As the 1979-89 growth rates in table 1 indicate, 1989 levels o f manufac turing and construction employment w ere not substantially different than 1979 levels, while mining employment declined substantially over the decade. In 1989, mining employment declined while manufacturing and construction employ ment continued to expand. District mining employment fell sharply in 1989, the fifth consecutive year o f decline. Meanwhile, nationally, slight gains w ere re ported for the second successive year.4 The diverging employment trends stem from the dif ferent compositions o f mining in the District and the nation. Oil and gas extraction account for most U.S. mining jobs; however, coal mining, centered in Kentucky, dominates the District’s workforce. The District's mining employment losses last year partially reflect productivity 4See Karrenbrock (September 1989) for a discussion of the Eighth District’s mining industry. MAY/JUNE 1990 22 gains. In Kentucky, for example, coal production rose 1.6 percent last year, while mining employ ment levels dropped 5.4 percent. This produc tion rise was mostly due to increased demand by electrical utilities in Virginia and the Carolinas, as well as by those within Kentucky’s own boundaries. Manufacturing The Eighth District economy is more sensitive to manufacturing’s ups and downs than is the U.S. economy. Manufacturing employed 22 per cent of Eighth District nonfarm workers last year compared with 18 percent for the nation. Furthermore, manufacturing produced 27 per cent o f the District's real output in 1986 com pared with 22 percent nationally.5 Given manufacturing’s comparatively large size in the District, last year’s slowdown in manufacturing activity had a relatively severe impact. Manufacturing employment rose 2.0 percent in 1989, down from 3.2 percent in 1988. While employment growth slowed in several o f the District’s major industry groups, the most severe deceleration, as table 2 shows, occurred in the chemicals and fabricated metals industries. Despite frequent temporary layoffs o f auto workers throughout the region, the 1989 level of District transportation equipment employ ment was 4 percent higher than in 1988. Many of the new jobs in this sector were due to gains in Kentucky, especially in Louisville and Lex ington, where motor vehicle assembly plants and their suppliers have expanded. Employment gains in aircraft and parts plants in St. Louis ac count for many of the other new jobs in this sector. As table 2 shows, job growth was slowest in the food processing and electrical equipment in dustries. Although employment in food process ing exhibited little change in Kentucky, Missouri and Tennessee last year, it rose moderately in Arkansas, where poultry processing plants ex 51986 is the most recent year for which output data are available. The output figures are based on Gross State Product data from the U.S. Department of Commerce, Bureau of Economic Analysis. See Mandelbaum (September 1989) for a comprehensive comparison of the industrial structures of the Eighth District and U.S. economies based on this data. 6See Karrenbrock (December 1989) for a discussion of the Eighth District’s food processing industry. http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS FEDERAL Federal Reserve Bank of St. Louis Table 2 Employment Growth in the Eighth District’s Largest Manufacturing Industries Industry 1988 1989 Manufacturing Durables Fabricated metals Electrical equipment Nonelectrical machinery Transportation equipment Nondurables Food and kindred products Textile mill and apparel Printing and publishing Chemicals and allied 3.2% 2.0% 5.3 0.4 3.0 5.5 3.3 0.8 3.8 4.0 0.7 1.1 2.4 3.9 0.6 1.6 2.7 2.0 panded.6 The sluggish employment expansion in electrical equipment production, in part, was due to weak demand for home appliances which reflected a decline in homebuilding. Construction After plunging 30 percent between 1979 and 1982, Eighth District building activity rebounded strongly in 1983 and 1984 (see figure 3). The real values (1982 prices) o f building contracts in 1988 and 1989, however, w ere slightly below those in 1984.7 District contracts fell 8.6 percent in 1988 before stabilizing in 1989 at $7.8 billion. District residential construction has been weakening since 1987. This decline, which also occurred nationwide is due in part to revisions in the federal income tax code that eliminated provisions that had previously stimulated con struction.8 In 1989, the real value o f District residential contracts fell 4.1 percent, while the number o f housing units authorized by permits fell 4.9 percent to approximately 79,200 units, their lowest level since 1982. Permits for single7Building contracts exclude those for so-called non-building projects, such as roads, bridges and public utilities. 8For a discussion of housing trends in the Eighth District’s largest metropolitan areas, see Mandelbaum (December 1989). 23 Figure 3 The Real Value of Building Contracts In d e x 1 9 7 9 = 1 00 120 60 19 79 family dwellings, which represented more than three-fourths o f all District permits, declined by 4.5 percent in 1989. Although mortgage interest rates fell in the second half of 1989, they were relatively high during the critical home sales period in spring and early summer.9 After falling 7.3 percent in 1988 from its 1987 peak, the real value o f District nonresidential contracts recovered in 1989, rising by 4.8 per cent to almost $3.9 billion. Much o f this gain stemmed from growth in Arkansas, where a In d e x 1 9 7 9 = 1 00 120 60 1 9 89 $283 million contract to build a paper plant north o f Texarkana in Little Rock County and a number of smaller contracts caused the state’s nonresidential contracts to more than double. SERVICES-PRODUCING SECTORS For several decades, consumers have spent an increasing proportion o f their rising incomes on services. This consumption shift, in conjunction with slower productivity gains in services-pro- 9Effective rate on conventional mortgages (primary market), for example, rose from 9.78 percent in the first quarter of 1989 to 10.26 percent in the second quarter, peaked at 10.48 percent in July, then declined slightly to 10.09 per cent in the fourth quarter. This series, published by the Federal Housing Finance Board, reflects fees and charges as well as the contract rate. MAY/JUNE 1990 24 Table 3 Annual Percentage Change of Selected Economic Indicators for 1989 Indicator U.S. District Arkansas Kentucky Missouri Tennesse Real nonfarm personal income 2.7% 2.3% 1.8% 2.4% Real retail sales Durables Nondurables 1.4 2.6 0.6 2.0 4.8 0.2 7.0 6.5 7.3 2.1 3.2 1.5 -0 .3 4.9 -3 .9 2.5 4.7 0.7 Payroll employment Goods-producing Manufacturing Construction Mining Services-producing Wholesale/retail trade Services Government Finance, insurance, and real estate Transportation and public utilities 2.8 1.5 1.0 3.5 0.2 3.3 2.7 5.1 2.0 2.9 1.6 2.0 1.0 - 4 .8 3.4 3.0 5.1 2.2 3.0 1.0 1.6 - 2 .6 - 2 .5 3.9 3.9 5.6 2.7 3.8 2.9 3.6 4.7 -5 .4 4.1 4.1 5.7 3.0 2.2 1.0 1.2 0.2 - 2 .5 2.6 2.5 4.1 1.9 3.0 1.6 1.9 0.7 -4 .6 3.5 2.4 5.7 1.8 2.1 0.3 0.5 1.9 -0 .5 0.4 2.8 3.5 4.4 3.4 1.8 5.4 -0 .9 -4 .1 3.2 0.1 -4 .1 4.8 55.7 13.2 118.3 4.5 2.2 7.0 - 9 .2 -1 0 .8 -7 .2 -7 .4 -6 .3 -8 .6 Real value of building contracts1 Residential Nonresidential 2.0% 2.9% ’Excludes nonbuilding construction. Growth rates are based on F. W. Dodge Construction Potentials. ducing than in goods-producing sectors and the increasing tendency o f manufacturers to pur chase business services rather than produce them internally, has resulted in steadily rising employment levels in services-producing sectors. Table 1 shows that employment in all District services-producing sectors rose in 1989, as well as over the decade. Each sector grew more slowly in 1989 than it had in 1988. The services subsector, which includes per sonal, business, legal, repair and health services, experienced the most rapid job growth o f any sector in 1989, as it has throughout the decade. Its 5.1 percent growth in 1989 approaches its rapid 5.2 percent annual growth rate over the preceding six years. The strong expansion of most types o f services continued, including health services. The aging o f the population has contributed to this expansion and most likely will continue to do so. 10Berger (1989) found, after controlling for a number of structural, demographic and institutional factors, a statisically significant, positive relationship between a FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis DIFFERENCES IN ECONOMIC PER FORMANCE AMONG STATES Descriptions of economic trends in the Eighth District obscure considerable differences among its individual states. For example, as figure 1 and table 3 show, the 1989 growth o f payroll employment varied from 2.2 percent in Missouri to 3.8 percent in Kentucky. As figure 4 il lustrates, unemployment rates have fallen in all District states since 1983; however, jobless rates in Kentucky and Arkansas remained well above the national average in 1989. These high jobless rates may reflect the com paratively low educational achievement o f these states’ residents that limits the job opportunities o f many potential workers.1 In 1989, for exam 0 ple, just 22.6 percent and 22.2 percent of adults in Arkansas and Kentucky had one or more years o f college education compared with 31.8 state’s educational achievement levels and the proportion of its population that is employed. Educational attainment figures are from DRI/McGraw-Hill. 25 Figure 4 Annual Unemployment Rates in the 1980s P e rc e n t P e rc e n t 12 Kentucky Arkansas United States Missouri 1979 percent nationally. The corresponding figures for Missouri and Tennessee, 27.6 percent and and 25.1 percent, respectively, w ere closer to the national average, as were their unemploy ment rates. As figure 5 shows, construction activity was another sector that varied substantially across states. Most notably, building activity in Arkan sas declined sharply for four years before re bounding in 1989, while such activity in Ten nessee remained well above 1979 levels until last year. Arkansas Posts Solid Job Gains The Arkansas economy, which expanded mod erately in the 1980s, continued to grow substan 1 9 89 tially in 1989. As figure 1 shows, Arkansas’ non farm employment growth slightly exceeded the national and District rates in 1989, allowing a sharp drop in the state’s unemployment rate. Despite this healthy job growth, real nonfarm personal income grew somewhat slower last year than in the other states for two reasons. First, many of Arkansas’ new jobs last year were in low-paying sectors: miscellaneous ser vices, wholesale/retail trades and food and kin dred products. Annual earnings in Arkansas food processing, for example, averaged approx imately $14,400 last year, about four-fifths of Arkansas’ all-industry manufacturing average. Second, income rose comparatively slowly in Arkansas because transfer payments and divi dends, interest and rents showed modest growth last year. MAY/JUNE 1990 26 Figure 5 The Real Value of Building Contracts Ind ex 1979 = 100 130 In d ex 1979 = 100 130 Manufacturing employment in Arkansas, show ing growth in nearly every major industry, rose 1.6 percent in 1989. Almost 1,100 of the 3,708 new manufacturing jobs were in the food and kindred products sector, mostly in poultry pro cessing. Poultry processors have expanded rapidly in Arkansas for several years. Some have recently announced plans for further ex pansion, so continued gains are likely. On the other hand, employment declined in electrical equipment production. Some of the losses, such as those in home appliance production, reflect the nation’s homebuilding slump and relatively high interest rates for much of 1989. building contracts rose 55.7 percent in 1989 as building in both residential and nonresidential sectors expanded. Contracts for nonresidential projects more than doubled last year. As noted previously, a contract for a paper manufactur ing plant in southwest Arkansas accounted for much of this increase; however, the FayettevilleSpringdale, Fort Smith and Pine Bluff metropoli tan areas also reported strong nonresidential building growth. After declining sharply between 1984 and 1988, construction contracting in Arkansas re bounded in 1989 (see figure 5). While construc tion employment continued to fall, reflecting the earlier decline in contractings, the real value of Heavily dependent on goods production, the Kentucky economy was severely affected by the early-1980s recession. State payroll employment fell 7.5 percent between 1979 and 1983, and the state unemployment rate rose to more than 11 http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS FEDERAL Federal Reserve Bank of St. Louis Kentucky's Cyclical Expansion Continues 27 percent in 1983 (figure 4). As figure 1 indicates, employment did not begin rising until 1984, one year after the other District states. Since 1983, however, nonfarm employment has grown slightly faster than the national rate, and rose 3.8 percent last year. More than half o f the state’s 52,600 new jobs last year were in the wholesale/retail trade and services sectors. Many new jobs were generated in department stores, grocery stores, eating and drinking establishments, and firms providing business and health services. Manufacturing employment’s strong 3.6 per cent expansion last year was fueled by wide spread gains across most industries. The trans portation equipment industry generated the most new manufacturing jobs last year, despite temporary layoffs at some motor vehicle as sembly plants. Most of the state’s new transpor tation equipment jobs were related to motorvehicle and parts production concentrated near assembly plants in Louisville, Bowling Green and near Lexington. Workers producing major home appliances in Louisville, that area’s largest industry, experi enced temporary layoffs during the year, con tributing to the state’s slow job growth in the electrical equipment industry. Projected strengthening in appliance sales in the second half of 1990, however, may lead to job gains. Real nonfarm income received by Kentuckians has risen at just a 1.2 percent annual rate since 1979, considerably slower than the District or national averages. In 1989, however, real nonfarm income rose 2.4 percent, compared with the national average of 2.7 percent, as income from earnings and dividends, interest and rent rose moderately. As figure 5 indicates, the real value o f build ing contracts awarded in Kentucky has trended slowly upward since 1983. In 1989, both resi dential and nonresidential building expanded, allowing total building contracts to rise 4.5 per cent. Moderate gains in the Louisville and Owensboro metropolitan areas contributed to the state’s growth in 1989, while building activi ty weakened in the Lexington-Fayette area. Missouri’s Growth Trails the Nation’s With its diversified economy, Missouri’s eco nomic growth paralleled the nation's for most of 1980s. State unemployment rates, shown in figure 4, followed the U.S. rates throughout the decade. The growth o f income and employment, however, fell below the national average in re cent years. Real nonfarm income rose 2 percent in 1989, reflecting the comparatively sluggish expansion o f employment. Nonfarm payroll employment rose 2.2 percent last year, the state’s slowest job growth since 1983. Employment growth in all service-producing sectors slowed in 1989 from 1988. Never theless, the services sector, with a 4.1 percent employment increase, continued to grow rapidly with large job gains by firms providing health, business, engineering and management services. State manufacturing employment rose 1.2 per cent in 1989; as a result o f severe losses in the early years of the decade, however, it was 5.5 percent below its 1979 level. Employment in the transportation equipment sector, the state’s largest manufacturing industry, rose by 3 per cent in 1989. Several temporary layoffs o f auto workers dampened the sector's expansion, but rapid employment growth in aircraft manufac turing enabled it to grow moderately. Producers of nonelectrical machinery and fabricated metal products also expanded their workforces mod erately, while makers o f electrical equipment and textile mill and apparel products experi enced employment declines in 1989. Building activity trended upward in Missouri from the trough of the last recession in 1982 until 1987. In recent years, the real value of contracts for both residential and nonresidential sectors declined. In 1989, the real value of building contracts fell 9.2 percent in Missouri. The St. Louis area posted a drop in building contracting last year, but healthy gains were reported in Springfield and Columbia. Tennessee’s Job Growth Moderates Tennessee's economy grew moderately during the 1980s, with annual nonfarm income and employment gains near the national average. Between 1979 and 1989, the state’s real nonfarm income and nonfarm payroll employment rose at 2.5 percent and 1.9 percent annual rates compared with 2.4 percent and 1.9 percent nationally. In 1989, Tennessee payroll employment growth slowed from the approximate 4 percent rate over the previous tw o years to its lowest rate MAY/JUNE 1990 28 since 1983. Despite this deceleration, Tennessee payroll employment rose by 61,700 last year, a moderate 3 percent gain. More than 25,000 of the new jobs w ere in the services sector, while the wholesale/retail trade sector contributed another 12,000. Employment in Tennessee's transportation and public utilities sector grew rapidly, largely due to an expansion in Mem phis. Government employment slowed to a 1.8 percent gain in 1989, partially because o f feder al job reductions by the Tennessee Valley Authority. Manufacturing employment rose 1.9 percent in 1989. Several of the state’s largest durables sectors, including nonelectrical machinery, elec trical equipment and transportation equipment, experienced moderate to strong job growth. Employment declines were reported, however, in the food processing and textile mill and ap parel industries. The decline in the latter sector was partly due to continued technological im provements that, while enhancing the industry’s global competitiveness, have eliminated some jobs. Tennessee’s 2.9 percent growth of real non farm income in 1989 exceeded the nation's rate. Nonfarm earnings grew at the national pace, but income from transfer payments and divi dends, interest and rent rose somewhat faster. Construction activity in Tennessee has declin ed since 1987 because of slowing growth in Tennessee’s metropolitan areas. The 7.4 percent decline in the real value o f building contracts in 1989 stemmed from moderate contractions in both residential and nonresidential building. OUTLOOK FOR 1990: ANOTHER YEAR OF SLOWING GROWTH Projections from various sources shown in table 4 suggest that the state economies o f the District will continue to expand in 1990. Al though the forecasts are based on different methodologies, they do provide a look at the likely future o f the states’ economies as viewed by economists aware of local conditions and possibilities. Projections for the national econo my are provided for comparison. The growth of personal income in 1990 in Arkansas, Kentucky, Missouri and Tennessee is expected to slow from 1989’s pace, following an expected national deceleration. The slower pro FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis jected growth also reflects an anticipated slow down in inflation in 1990. Payroll employment growth is expected to slow from the 1989 rate in all District states but Arkansas. To some extent, the weak employ ment growth projected for Kentucky, Missouri and Tennessee probably reflects the fact that the projections were based on state employment data before it was recently rebenchmarked. The revised data, reflecting 1989 benchmarks and used in this article, show substantially more rapid employment growth than was originally reported in the three states. As job growth slows, unemployment rates are expected to rise in Kentucky, Missouri and Ten nessee, while Arkansas’ more rapid expansion is expected to allow the state jobless rate to fall. The more optimistic outlook for Arkansas par tially reflects its closer relationship with the recovering economies in Texas, Oklahoma and Louisiana, where many Arkansas businesses sell goods and services. Manufacturing job growth in Arkansas also is expected to accelerate be cause of continued strength in nondurables and a pick-up in durables industries, stimulated by anticipated lower interest rates. W ood products industries, currently restrained by the construc tion slowdown, are expected to rebound this year. Manufacturing employment in Kentucky is ex pected to decline slightly in 1990, mirroring the national contraction projected by DRI/McGrawHill. This decline, in conjunction with weakness in mining, is expected to hinder growth in other sectors, resulting in sluggish payroll employ ment growth. Missouri’s economic growth in 1990 is ex pected to start slowly and, like the national economy, strengthen as the year progresses. The state's auto sector is expected to improve after the first quarter, although the planned closing of an auto assembly plant in St. Louis will restrain growth. An improvement of the state’s construction industry is also anticipated later this year, although the number o f residen tial building permits for the year is expected to be few er than last year. Much o f the state’s de fense industry is accounted for by military air craft production by McDonnell Douglas Cor poration in the St. Louis area. McDonnell Doug las announced a shift to the St. Louis area of some aircraft and aircraft parts production cur rently taking place in California, but also plans 29 Table 4 Economic Projections for District States Actual 1989 Civilian unemployment rate United States Arkansas Kentucky Missouri Tennessee Projected 1990 5.3% 7.2 6.2 5.5 5.1 5.4% 6.7 7.2 5.9 5.6 Percent change1 Actual 1989 Payroll employment United States Arkansas Kentucky Missouri Tennessee Manufacturing employment United States Arkansas Kentucky Missouri Tennessee Personal income (current dollars) United States Arkansas Kentucky Missouri Tennessee 2.8% 3.0 3.8 2.2 3.0 Projected 1990 1.9% 3.4 0.8 0.7 0.9 1.0 1.6 3.6 1.2 1.9 -1 .0 2.8 - 1 .2 N.A. 0.7 7.6 6.8 7.4 6.7 7.5 6.7 5.8 5.9 5.6 5.8 1Percent changes compare entire year with previous year. SOURCES: United States: DRI/McGraw-Hill, Review o f the U.S. Economy, March 1990; Arkansas: University of Arkansas at Little Rock, Arkansas Economic Outlook, January 1990; Kentucky: Office of Financial Management and Economic Analysis, Kentucky Finance and Administration Cabinet, March 1990; Missouri: College of Business and Public Administration, University of Missouri-Columbia, Missouri Economic In dicators: December 1989; Tennessee: Center for Business and Economic Research, University of Tennessee, Knoxville, An Economic Report to the Governor of the State of Tennessee On the State’s Economic Outlook, January 1990. to cut several thousand St. Louis workers in the second half of 1990. Tennessee’s nonfarm employment is projected to rise just 0.9 percent in 1990. Some of the weakest sectors o f the state economy, non durables manufacturing and construction, are expected to remain weak in 1990, and further employment declines are anticipated in federal government and mining. One positive develop ment is the planned completion of General Motor’s Saturn plant in Spring Hill, Tennessee. The plant is expected to provide approximately 1,000 new jobs in 1990, raising the plant’s total workforce to 3,000 workers. CONCLUSION In many ways, 1989 was just a continuation of earlier trends for the Eighth District economy. District nonfarm employment and in come grew near the national rate in 1989 as they have for the decade. District employment growth slowed last year, but was sufficient to MAY/JUNE 1990 30 allow unemployment rates to fall to near their 1979 levels. The long-run future of the District’s economic performance is uncertain because of a number of recent developments. These include the pro spects for substantial cuts in federal defense spending, the possibility of further restructuring of the automobile industry and the potential im pact of proposed federal clean-air legislation on regional coal production. To the extent projec tions of economic growth are accurate, however, 1990 will be another year of growth for the District economy. REFERENCES Berger, Mark C. “Why Aren’t More Kentuckians Working?” Kentucky 1989 Annual Economic Report, Center for http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS FEDERAL Federal Reserve Bank of St. Louis Business and Economic Research, University of Kentucky (December 1989), pp.16-20. Karrenbrock, Jeffrey D. “U.S. and Eighth District Food Pro cessing and Tobacco Manufacturing,” Pieces of Eight - An Economic Perspective on the Eighth District, Federal Reserve Bank of St. Louis (December 1989), pp. 1-4. ________“The Changing Role of Mining in the Eighth Dis trict,” Pieces of Eight - An Economic Perspective on the Eighth District, Federal Reserve Bank of St. Louis (September 1989), pp. 1-4. Mandelbaum, Thomas B. “In Search of a Regional Economic Identity,” Pieces of Eight - An Economic Perspective on the Eighth District, Federal Reserve Bank of St. Louis (September 1989), pp. 5-10. ________“The Nation and the Region: Home Building in the 1980s,” Pieces of Eight - An Economic Perspective on the Eighth District, Federal Reserve Bank of St. Louis (December 1989), pp. 5-8. 31 Jeffrey D. Karrenbrock. Jeffrey D. Karrenbrock is an economist at the Federal Reserve Bank of St. Louis. David H. Kelly provided research assistance. The U.S. And Eighth District Agricultural Economies in 1989: Building on Past Strength I h e U.S. AGRICULTURAL economy showed continued strength in 1989 as real net farm in come rose to its highest level since 1975. This article examines the factors behind last year’s agricultural expansion in the United States and analyzes the 1989 agricultural economy in the Eighth Federal Reserve District. Issues o f impor tance to agriculture in the new decade are also discussed briefly. THE U.S. AGRICULTURAL ECONOMY Farm Finances Real net farm income, the difference between gross farm income and total expenses, was estimated to be $39 billion in 1989, its highest level since 1975 when it was $43.1 billion.1 As table 1 shows, the $3.8 billion increase in real 1Forecast values are from the U.S. Department of Agricul ture’s Agricultural Outlook (March 1990). 2Net farm income approximates the net value of agricultural production in a calender year plus government payments, less total expenses. Net farm income is equal to gross farm income less total expenses. Gross farm income in cludes farm receipts from commodity sales, government payments and the value of inventory changes. Farm net farm income over 1988 was the fourth rise in the last six years. The rise in real net farm income in 1989 resulted from a rise in crop and livestock receipts, in conjunction with a build-up in agricultural commodity inventories, that out weighed declining government receipts and higher expenses.2 Increased crop receipts and higher inventory values in 1989 w ere largely due to agriculture’s recovery from the 1988 drought. As the drought reduced crop production in 1988, grain stocks dwindled and crop prices rose. Crop prices re mained relatively strong throughout 1989, while crop production rebounded sharply. U.S. corn production, for example, jumped nearly 53 per cent over 1988 production, while soybean pro duction rose 24 percent. This combination of higher production and relatively high crop prices allowed farmers to take in larger crop receipts. Similarly, increased production allowed receipts represent the value of commodities that are pro duced and sold, while changes in the value of inventories captures the value of commodities that are produced, but not sold. Therefore, a build-up in inventories leads to higher net farm income. MAY/JUNE 1990 32 Table 1 Farm Sector Income Statement (billions of 1982 dollars) 1981 Farm receipts Government payments Gross farm income Total expenses Net farm income2 Net cash income 1982 1983 1984 1985 1986 1987 1988 19891 $153.2 $147.1 $135.5 $136.3 $134.4 $123.6 $124.0 $129.6 $129.7 10.4 2.0 3.5 8.9 7.8 6.9 14.2 12.0 8.8 176.9 163.5 147.1 162.4 150.0 141.0 146.4 146.4 152.8 148.2 140.0 134.9 132.5 120.8 107.6 109.2 111.3 113.8 28.6 23.5 12.2 29.9 29.2 33.4 37.2 35.2 39.0 34.9 37.8 35.4 35.8 42.1 46.5 47.2 45.5 42.0 ’ Values for 1989 are forecasts. 2Net farm income includes the value of inventory changes. Data are rounded. SOURCE: Agricultural Outlook (March 1990). more grain to be stored at higher prices, raising the value o f farm inventories. Adding support to net farm income were higher prices for cattle, hogs, broilers and milk. Milk and livestock production, except for cattle, w ere also higher. Nominal livestock receipts in 1989, it appears, have risen 5.2 percent over 1988 to $83 billion, the highest level of the decade. While real net farm income rose 11 percent in 1989, real net cash income dropped 11 per cent (see table l).3 The difference between the two is this: net farm income represents income largely generated from a given calendar year’s production, whether the commodities are sold, fed or placed in inventory during the year. Net cash income measures the total income that farmers receive from their operation in a given calendar year, regardless of how much they produced or when they actually produced it. It approximates the income stream available to farmers for purchasing assets or paying o ff debt. The $5.2 billion drop in real net cash in come in 1989 was a result of falling government payments and rising cash expenditures, which outweighed increased commodity receipts. 3Net cash income is equal to farm receipts plus government payments less cash expenses. Cash expenses exclude depreciation, perquisites to hired labor, and farm household expenses. http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS FEDERAL Federal Reserve Bank of St. Louis As the number of farms continues to decline, the use of either real net farm or cash income as indicators o f the income position of the average farm can be misleading.4 The reason is that total farm income is being divided among few er farms. Indexes representing real net farm income and real net farm income per farm are shown in figure 1. While real net farm income generally has trended downward since 1950, real net farm income per farm has moved in the opposite direction. Indeed, while real net farm income declined 32 percent between 1950 and 1989, real net farm income per farm in creased 77 percent. Similarly, real net cash in come declined 21 percent between 1950 and 1989, while real net cash income per farm in creased 105 percent. In 1989, real net farm in come per farm rose 12 percent over 1988, while real net farm income rose 11 percent. Real net cash income per farm fell 13.8 percent and real net cash income fell 11 percent below 1988. Farm Balance Sheet The farm sector’s balance sheet improved again in 1989, as exemplified by the lower debtto-asset and debt-to-equity ratios shown in fig4See Karrenbrock (June 1990) for a detailed discussion of some of the problems associated with different farm in come series, 33 Figure 1 U.S. Real Net Farm Income Indexes Index: 1950 = 100 250 Index: 1950 = 100 250 150 0 ----------------------------------------------------------------------------------------------------------------------1950 53 56 59 62 65 68 71 74 77 80 83 86 o 1989 SOURCES: USDA, Econom ic Indicators o f the Farm Sector, National Financial Summary, 1988, and A gricultu ral O utlook. ure 2. A primary reason for this improvement is rising real estate values.5 Strong returns in the agricultural sector over the past several years have encouraged investors to pay more for agricultural real estate. In 1989, farm real estate values rose $40 billion, or 6.6 percent, while real estate debt fell $1.7 billion, or 2.2 percent. The decline in non-real-estate debt ex perienced throughout the 1983-89 period ap pears to be bottoming out. Between 1983 and 1987, non-real-estate debt dropped an average of 7.2 percent per year, but between 1987 and 1989, that same figure fell by an average o f less than 0.1 percent per year. 12 percent, increase in agricultural exports was due to a rise in the value o f grain exports. Al though the quantity o f grain exports increased overall, higher prices also played a significant role in increasing the value of grain exports. In fact, higher wheat prices allowed the value of wheat exports to rise 34 percent, despite a 7 percent decline in the quantity o f wheat ex ports. Also adding to the increase in agricultural exports were meat exports, which rose about $558 million, or 31 percent. U.S. agricultural im ports were up only slightly in 1989, leaving net agricultural exports at $18.1 billion, the highest agricultural trade surplus since 1984. Agricultural Trade Government Support U.S. agricultural exports reached their highest level since 1984, standing at nearly $39.7 billion for fiscal year 1989.6 Most of the $4.3 billion, or Direct government payments to farmers fell $3.5 billion in 1989 to $11 billion. Although down from the record direct government pay- 51989 ratios and real estate figures are forecasted values as reported in USDA’s Agricultural Outlook (March 1990). 6Real agricultural exports for fiscal year 1989 were about $31.4 billion, their highest level since 1984. MAY/JUNE 1990 34 Figure 2 U.S. Agricultural Balance Sheet Ratios Percent 32 1979 Percent 32 80 81 82 14 1989 83 SOURCE: USDA, A gricultu ral O utlook (March 1990). ments o f $16.7 billion in 1987, the $11 billion payments are still relatively high compared to past payments. For example, direct government payments to farmers as a percent o f net farm income averaged 4 percent during the 1950s, 19 percent during the 1960s and 11 percent during the 1970s. In the 1980s, direct government pay ments to farmers as a percent o f net farm in come have averaged almost 28 percent.7 In 1989, this figure was 23 percent, the seventh consecutive year in which it topped 20 percent. The 1989 direct government payments include about $2.1 billion in disaster payments stem ming from the 1988 drought. H'he 1980s figure is skewed by the huge amount of pay ments made to farmers in 1983 during the Payment-InKind program. During 1983, direct government payments to farmers as a percent of net farm income was 73.2 percent. 8The FAMC is similar to other government-sponsored agen cies such as the Governmental National Mortgage Associ- FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis Agricultural Lenders In 1989, the Federal Agricultural Mortgage Corporation (FAMC) moved closer to opening a secondary market for agricultural loans.8 When "Farmer Mac” becomes fully operational, finan cial institutions, such as banks, insurance com panies and the Farm Credit Banks, that choose to become members will be able to originate, pool and underwrite agricultural loans.9 Agricul tural real estate loans and rural housing loans, both with certain restrictions, are eligible to be pooled. Once the loans are pooled, the financial institutions will be able to offer farm mortgagebacked securities. Farmer Mac, owned by its ation (Ginnie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). 9Much of the information in this section was taken from Booth (1990) and various issues of the National Farm Finance News. 35 Table 2 U.S. and District Agricultural Banking Data United States 1988 1989 Return on assets Return on equity Agricultural loan losses/Total agricultural loans Agricultural nonpf loans/Total agricultural loans1 Primary capital ratio 0.91% 9.64 0.60 3.76 10.33 1.03% 10.68 0.35 3.15 10.50 District 1988 1989 1.05% 11.10 0.45 4.99 10.26 1.10% 11.25 0.27 3.76 10.49 NOTE: An agricultural bank is defined as a bank that has at least 25 percent of its loan portfolio in agricultural loans. ’ Nonperforming loans are defined as those loans that are 90 days or more delinquent. SOURCE: Fourth-quarter FDIC Reports of Condition and Income for Insured Commercial Banks. member institutions, will guarantee the timely payment of principal and interest to investors. To obtain this Farmer Mac guarantee, the is suers of the farm mortgage-debt must pay both an initial and an annual fee based on the size of the issue. In addition, issuers must stand ready to cover at least 10 percent of any losses that occur as a result of delinquencies and default on the underlying loans. A final factor, perhaps the most important in allowing it to guarantee its members’ issues, is FAMC’s guaranteed $1.5 billion line of credit at the U.S. Treasury. To limit the U.S. government’s exposure, the amount of loans eligible for Farmer Mac guar antees will be limited and relaxed progressively in the first three years of operation to 2 per cent, 4 percent and 8 percent of the total outstanding supply o f non-FmHA agricultural mortgage loans. Farmer Mac is also establishing underwriting standards for issuing institutions. These standards include such items as a mini mum number o f loans in a pool and guidelines for both geographical and agricultural enter prise diversity. Observers expect the first pool of farm mortgage-backed debt to be issued this year. mercial agricultural banks improved their finan cial performance during the year.1 Selected 0 performance ratios for U.S. agricultural banks are shown in table 2. These banks, on average, increased their return on assets from 0.91 per cent in 1988 to 1.03 percent in 1989 and their return on equity from 9.64 percent to 10.68 percent. Agricultural loan losses as a percent of total agricultural loans fell from 0.6 percent to 0.35 percent. Agricultural non-performing loans (those delinquent 90 days or more) as a percent of total agricultural loans fell from 3.76 percent to 3.15 percent. The primary capital ratio of U.S. agricultural banks improved as well to 10.5 percent, well above the 5.5 percent level re quired by law.1 1 In part, because of the improved performance of the agricultural economy in 1989, U.S. com Finally, the Farm Credit System’s financial position remained relatively stable in 1989.1 Net 2 income for 1989 was $695 million compared with that in 1988 of $704 million. There were significant improvements, however, in two in come components. First, net interest income in creased $219 million in 1988 to a level of $1,006 billion for 1989. This was in part due to the System’s efforts to reduce non-earning assets and improve asset and liability management. Se cond, loan loss reversals played a smaller role in accounting for the System’s profitability in 1989, as the negative provision for loan losses 10See Clark (1990) for a more extensive analysis of the com mercial banking sector. assets. See Clark (1990) for a more detailed discussion of the new capital requirements. "Starting in 1991, banks will be required to meet two new capital requirements. One capital standard will be based on core capital as a percent of total assets and the other based on qualifying capital as a percent of risk adjusted 12The Farm Credit System is a nationwide system of federal ly charted agricultural lending institutions cooperatively owned by their borrowers. MAY/JUNE 1990 36 Table 3 Percentage of Farm Cash Receipts from Commodity Sales United States Eighth District Arkansas Kentucky Missouri Livestock products Cattle & calves Hogs Dairy products Broilers Other 53.0% 23.1 6.9 12.5 4.8 5.8 58.3% 18.7 8.2 8.8 10.2 12.3 62.6% 10.0 2.8 3.0 34.6 12.3 59.6% 19.0 6.6 11.5 0.1 22.4 55.2% 22.8 14.9 9.7 0.0 7.8 54.8% 25.8 7.4 13.8 0.0 7.8 Crops Rice Wheat Corn Cotton Tobacco Soybeans Vegetables Fruits Other 47.0 0.6 3.8 7.3 2.9 1.4 7.4 6.7 5.7 11.2 41.7 3.1 2.6 4.7 4.4 5.5 14.4 0.9 0.4 5.7 37.4 9.6 3.4 0.3 7.6 0.0 12.7 0.6 0.2 2.8 40.4 1.6 8.0 6.4 0.0 19.8 7.0 1.0 0.4 4.2 44.8 0.7 3.0 8.5 2.3 0.2 23.4 0.3 0.4 6.1 45.2 1.9 5.2 11.7 8.4 7.1 10.0 2.4 0.5 11.6 Tenness< NOTE: All figures represent the average percent of total commodity cash receipts for the years 1986-88. Each region is calculated independently of the others. SOURCE: Derived from data obtained from the Economic Indicators of the Farm Sector: State Financial Summary, 1988. USDA, Economic Research Service. of $285 million was $395 million lower than the 1988 negative provision of $680 million.1 3 THE EIGHTH DISTRICT AGRICULTURAL ECONOMY The diversity of the agricultural economy of the Eighth Federal Reserve District, highlighted in table 3, and the uneven effects of the 1988 drought suggest the presence of noteworthy dif ferences in agricultural performance between the Eighth District and the nation, as well as among Eighth District states.1 As in the nation, 4 livestock products account for the majority of farm receipts in District states, with cattle and calves being relatively important to all District states. Hogs are important in Missouri and dairy products are important to all District states, ex cept Arkansas. Arkansas, on the other hand, is 13Loan loss reversals occur when firms lower the amount of money they have set aside to cover loan losses. 14The Eighth Federal Reserve District includes all of Arkan sas and parts of Illinois, Indiana, Kentucky, Mississippi, FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis the nation's largest broiler producer, and most of its livestock receipts are concentrated in that industry. Kentucky’s livestock receipts are dom inated by the horse industry. Soybeans are by far the District’s most impor tant crop. Corn receipts are significant in Mis souri and Tennessee, while cotton plays a key role in Arkansas and Tennessee. Rice is also im portant in Arkansas, while Kentucky’s crop re ceipts are led by tobacco. Fruits and vegetables account for a minor portion of District crop receipts, especially when compared with the roles these crops play in the nation's agricul tural economy. District Weather Despite excellent weather for corn production in most of the District, lingering drought condi- Missouri and Tennessee. The majority of this report, however, focuses only on the entire states of Arkansas, Kentucky, Missouri and Tennessee. 37 tions in northern parts and excessive moisture in southern parts of the District hampered crop and livestock production in 1989. Extreme win ter weather contributed negatively as well. Heavy snows in late winter did extensive dam age to the poultry industry in northwestern Arkansas. Throughout the winter and into sum mer, the drought lingered in northern Missouri, limiting crop growth and straining livestock water supplies. Too much spring rain in some southern parts o f the District delayed planting, forced replantings and prevented planting alto gether in some areas. Fall rains slowed the cot ton and soybean harvests in some southern parts of the District. As the drought in the Plains and upper Midwest continued, low water levels became a problem for commodity move ment on District rivers. In late December, the Mississippi River reached its lowest level in 25 years. The combination of low water levels and ice caused by record cold weather forced the temporary closure of the Mississippi and Arkan sas rivers in December. District Crop Production and Prices District 1989 crop yields, production and prices are shown in figure 3 as a percent of average production and prices during the 198588 period. Corn yields were much higher this year in the District’s three most southern states as Kentucky, Tennessee and Arkansas reported yields that ranged from 13 percent to 27 per cent above the 1985-88 average. Indeed, Ken tucky and Tennessee both posted record corn yields in 1989. Missouri corn yields were slight ly below normal, largely because of the continu ing drought in northern Missouri. Cotton yields in District states w ere below normal, partially because of excessive rain early in the growing season and again in the harvesting season. Rice production in Arkansas and Missouri was up about 12 percent in both states, with planted acreage and yields slightly higher than the average of the previous four crop years. Soy bean production fell throughout the District ex cept in Kentucky. The lingering drought put a damper on Missouri’s soybean yields, while ex cessive moisture at various stages throughout the growing season kept soybean yields in Ar kansas and Tennessee below their normal levels. Tobacco production in Kentucky expanded from its 1985-88 average largely because of increased acreage, while Tennessee's tobacco production fell because o f both decreased acreage and yields. Wheat production jumped in all District states, with increases over the recent years’ average ranging from 39 percent to 93 percent. Average 1989 crop prices w ere above the previous four-year average for all commodities in all District states. The higher crop prices were largely a function o f decreased grain stocks, stemming from the 1988 drought. Wheat and soybean prices ranged from 20 percent to 39 percent above the 1985-88 average. While soy bean prices w ere below their 1988 level in each District state, wheat prices, in contrast, were above the average 1988 price in each state. District Livestock. Production and Prices District livestock production and prices for 1989 are shown in figure 3 as a percent of av erage production and prices during the 1985-88 period. As in the nation, cattle and calf produc tion fell below the previous four-year average in Kentucky, Missouri and Tennessee, while in creasing in Arkansas. Hog production rose above the average in all District states, except Missouri. Broiler production in Arkansas was about 13 percent above average, and Tennessee broiler production jumped 23 percent. Milk production remained steady across all District states. Three of the District’s four most important livestock commodities experienced higher prices in 1989 relative to the 1985-88 period. Cattle prices were the strongest, averaging 22 percent to 25 percent above years past. Broiler prices ranged from 15 percent to 18 percent above average, while milk prices w ere just slightly above average. Hog producers received prices that were close to 1988 levels, but w ere sub stantially below the average prices received dur ing the 1985-88 period. Higher cattle prices reflected the relatively low number of cattle in the nation, while broil er price increases largely reflected increased consumer demand. Overall, milk market fun damentals in 1989 were not much different than in 1988. A decline in milk cow productivity in the second half o f the year, stemming from drought-induced lower feed quality, however, caused milk production in the second half of the year to decline below levels a year ago. These lower supplies helped push milk prices higher in the last half o f the year. MAY/JUNE 1990 38 Figure 3 State Agricultural Indicators Arkansas Crop Indicators Arkansas Livestock Indicators 1989 as a percent of 1985-88 average 1989 as a percent of 1985-88 average Percent 180 Percent 180 Corn Cotton Rice Soybeans Tobacco Broilers Cattle Wheat Hogs Milk Kentucky Crop Indicators Kentucky Livestock Indicators 1989 as a percent of 1985-88 average 1989 as a percent of 1985-88 average Percent 180 160 | □ | Price Production 140 120 100 80 60 40 20 0 Corn Cotton Rice Soybeans Tobacco Wheat Broilers Cattle Hogs Milk SOURCE: Derived from data provided by the Agricultural Statistical Service of the four states and USDA, Agricultural Prices. FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis 39 Missouri Crop indicators Missouri Livestock Indicators 1989 as a percent of 1985-88 average 1989 as a percent of 1985-88 average Percent Percent 180 i------------------------------------------------------ 2 00 i------------------------------------------------- 180 D Price | | Production 160 Price 160 | Production 140 F I Yield 140 120 120 100 100 80 80 60 60 40 40 20 20 0 Corn Cotton Rice Soybeans Tobacco Broilers Cattle Wheat Hogs Milk Tennessee Crop Indicators Tennessee Livestock Indicators 1989 as a percent of 1985-88 average 1989 as a percent of 1985-88 average Percent 180 Percent 180,------------------------------------------------------ 140 | | Price | 160 | Production 160 □ Price | Production 140 l~l Yield 120 120 100 100 80 80 60 60 40 40 20 20 0 Corn Cotton Rice Soybeans Tobacco Wheat ................ ..... m i i..m Broilers Cattle Hogs Milk H MAY/JUNE 1990 40 Figure 4 U.S. and District Real Net Farm Income Billions of 1982 dollars Billions of 1982 dollars SOURCES: USDA, Econom ic In d ica to rs o f the Farm Sector, N ational Financial Summ ary and State Financial Summary. District Net Farm Income Net farm income figures for District states are available with a one year lag; therefore, 1989 figures are not yet available. Movements in District real net farm income, as shown in fig ure 4, have generally paralleled movements in U.S. real net farm income. The drought o f 1988, however, hit other regions more severely than it did the Eighth District, and the District’s real net farm income actually increased in 1988, while U.S. real net farm income fell. The latest available state farm income data indicate that 1988 real net farm income in Arkansas, Ken tucky and Tennessee rose 28 percent, 3 percent and 17 percent over their 1987 figures, while U.S. real net farm income fell 5.1 percent. Mis souri’s real net farm income fell 10 percent in 1988, as its agricultural production more closely FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis followed the drought-stricken pattern of the rest o f the United States. Since the District was not as severely affected by the drought as other regions of the nation, District farm income growth in 1989 may not have paralleled the income rebound induced by the drought recovery in the rest o f the nation. In fact, it may have fallen in 1989. 1989 cash receipts from commodity sales were down 2 percent, 3.7 percent, and 7.8 percent in Arkan sas, Missouri and Tennessee, respectively, from a year ago. To match the expected 12.4 percent in crease in U.S. net farm income, these states will have to have seen higher government payments, increased their agricultural inventory values, and/or reduced farm expenses in 1989. Kentucky differs from the other District states with cash receipts up 12.7 percent over a year ago. 41 District Agricultural Lenders Technology Agricultural banks in the Eighth District show ed continued strength in 1989.1 As shown in 5 table 2, District institutions, on average, obtained higher returns on assets and higher returns on equity in 1989, although the gains were not as large as those experienced in 1988. Similarly, both agricultural loan losses and non-performing loans as a percent of total agricultural loans declined in 1989. Again, however, the improve ments in 1989 were not as dramatic as those in 1988. Technological change has long been labeled the "treadmill’’ of agriculture. Farmers have adopted new technologies that have expanded agricultural supplies faster than the growth in demand for agricultural products. As a result, real agricultural prices have declined. These fall ing prices pushed farmers to continually adopt new technology in an attempt to lower produc tion costs more rapidly than their product prices were falling. The new technology, of course, would again increase agricultural supplies and the cycle would continue. Such a cycle, despite necessitating adjustments in agriculture, does have the positive benefit o f lower food prices for consumers.1 7 Like the national Farm Credit System, both Farm Credit Banks in the Eighth District reported improved financial conditions in 1989. The Farm Credit Bank of St. Louis reported net earnings at $81.2 million, marking the third consecutive year of positive earnings. The bank’s 1988 earnings stood at $99.8 million. The Louisville Farm Credit Bank posted 1989 earnings of $83.2 million, up from $3.6 million in 1988. Both banks had lower loan-loss reversals in 1989, meaning that the banks are deriving less income from the reversal of loan-loss provisions and more from normal len ding operations. Net interest income was also up at both banks. The St. Louis Farm Credit Bank reported a significant increase in new farm real estate loan volume during the year, and the Louisville Bank’s gross loans outstanding increased for the first time in eight years. AGRICULTURAL ISSUES FOR THE 1990S The initial rounds o f technological advance ment in agriculture began with the adoption of mechanized equipment, then later took the form of hi-bred crops and livestock and increased use of fertilizer. The next wave will be biotechnolo gy, which is broadly defined as applied biologi cal science. One of the benefits of biotechnology is its ability to reduce the amount of time needed to develop more productive crops and livestock. For example, biotechnology has allowed research ers to mass produce hormones that are found naturally in livestock. One such hormone, bo vine somatatropin (BST), increases the output of milk cows. By using this hormone, dairy farmers can increase the output o f their livestock within days by an amount that would have taken sev eral years to accomplish using traditional genet ic breeding. U.S. farmers are leaving the 1980s in better financial condition than they w ere in the first half of the decade. As farmers move into the 1990s, several important issues will affect the profitability of their operations. These issues in clude the adoption o f new technology, environ mental concerns, increased consumer protec tion, agricultural trade and the 1990 farm bill. Perhaps the most important long-term issues are what role technology will play and how envi ronmental concerns will be addressed. This sec tion briefly discusses these two issues.1 6 The rate at which biotechnology is adopted will depend, in part, on consumer acceptance of the products produced under its use. If con sumers are hesitant to consume food produced with biotechnology, farmers will not produce it. Some dairy farmers, for example, are concerned about BST because some consumers have in dicated that they will not drink milk produced using it. Policymakers will also resist the adop tion of new agricultural technology, as it will undoubtedly drive some of their farm consti tuents out o f business. In the long run, how- 15Banking data is for all agricultural banks located within the Eighth District and not just those located in Arkansas, Kentucky, Missouri and Tennessee. 17This, of course, assumes a stable or very slow growing demand for agricultural products. 16See Drabenstott and Barkema (1990) for a more detailed discussion of these and other issues facing agriculture in the 1990s. MAY/JUNE 1990 42 ever, the potential benefits for consumers and the competitive disadvantages for farmers elec ting to use less technologically advanced pro duction methods suggests that the technology will be adopted.1 Farmers who adopt it early 8 are likely to reap the largest profits. Environmental Issues A second agricultural issue o f the 1990s will be how to deal with the declining quality of our natural resources. Environmental issues that will be important to agriculture in the 1990s in clude soil erosion, water quality and conserva tion and chemical use. As technology has advanced, farmers have been able to farm more marginal land by mak ing more intensive use o f tillage, chemicals and irrigation in crop production. These practices have accelerated wind and water erosion and damaged water quality; crop farming, however, has not been the sole cause o f environmental damage. Overgrazing on range land causes soil erosion, and livestock confinement operations sometimes have trouble preventing animal waste from entering the drinking water supply. Soil erosion, in conjunction with chemical and waste run-off, has damaged water quality throughout the country. Some actions are already being taken to re duce environmental damage stemming from ag ricultural production. The Conservation Reserve Program, instituted by the USDA, takes highly erodible land out of production in return for annual payments to farmers. Farmers also have started to use reduced tillage techniques to limit erosion and have made more extensive use of natural predators, now called integrated pest management, to decrease the amount of chemi cals needed to raise a good crop. In the future, biotechnology that makes plants and animals more resistant to insects and diseases may re duce the need for agricultural chemicals. Though some actions have already been taken to reduce the damage to the environment, fur ther action will be implemented in the 1990s. The decade will see a push for tighter control and monitoring o f chemical use in agriculture. As population growth in the West competes 18This, of course, assumes that consumers will readily ac cept biotechnologically produced products. While this may not hold true in the short run, continued consumer educa tion will likely ease the resistance to biotechnology in the long run. FEDERAL http://fraser.stlouisfed.org/ RESERVE BANK OF ST. LOUIS Federal Reserve Bank of St. Louis with agriculture for water, irrigation will per haps decline. Programs also will likely be con tinued or expanded to take highly erodible land out of agricultural production. While these measures will potentially improve the environment, they will also raise the cost of producing food.1 Society will have to decide 9 how much it is willing to pay for food to either improve or limit the damage to the environ ment. Farmers will have to adapt to new re strictions on production techniques and will be forced to decide whether they can adjust to in creasing environmental restrictions and remain profitable. SUMMARY Largely because of continued strong livestock returns and a rebound in crop production from last year’s drought, U.S. net farm income in 1989 reached its highest level since 1975. The farm sector’s balance sheet and agricultural ex ports also improved last year. While fundamen tal measures of the agricultural economy gener ally have improved in recent years, U.S. farmers remain dependent on government payments for a large portion of their income. Buoyed by the strong returns to farmers, agricultural financial institutions also bettered their performance dur ing the year. District farmers received relatively high prices for their crops and livestock in 1989, but some District farmers faced disappointing weather conditions during the year. Although farm returns have been relatively strong during the second half o f the 1980s, it is unlikely that this trend will continue throughout the 1990s. In addition to dealing with the cus tomary challenges of weather, price and income volatility, farmers will face several new chal lenges in the 1990s, including tighter environ mental controls and the adoption of new pro duction technologies. REFERENCES Booth, James R. “Farmer Mac and the Secondary Market,” Federal Reserve Bank of San Francisco Weekly Letter, January 5, 1990. Clark, Michelle A. “Eighth District Banks in 1989: In the Eye of A Storm?" this Review (May/June 1990), pp. 3-17. 19The increased costs associated with tighter environmental controls may be offset somewhat by increased production efficiency stemming from the use of biotechnology. 43 Drabenstott, Mark, and Alan D. Barkema. “U.S. Agriculture Charts a New Course for the 1990s,” Federal Reserve Bank of Kansas City, Economic Review (January/February 1990), pp. 32-49. U.S. Department of Agriculture. Agricultural Outlook, various issues. ________ Agricultural Prices, various issues. Karrenbrock, Jeffrey D. “Potential Pitfalls in Interpreting Farm Income Data,” Pieces of Eight: An Economic Perspec tive on the 8th District Federal Reserve Bank of St. Louis (June 1990), pp. 10-13. ________ Economic Indicators of the Farm Sector: National Financial Summary, 1988. National Farm Finance News. Various issues (Dorset Group, Inc.). ________ Economic Indicators of the Farm Sector: State Financial Summary, 1988. MAY/JUNE 1990 F ederal R eserve Bank o f St. Louis Post O ffice Box 442 St. Louis, Missouri 63166 The R e v ie w is published six times per year by the Research and Public Information Department o f the Federal Reserve Bank o f St. Louis. Single-copy subscriptions are available to the public fre e o f charge. Mail requests f o r subscriptions, back issues, or address changes to: Research and Public Information Department, Federal Reserve Bank o f St. Louis, P.O. Box 442, St. Louis, Missouri 63166. The views expressed are those o f the individual authors and do not necessarily reflect official positions o f the Federal Reserve Bank o f St. Louis or the Federal Reserve System. Articles herein may be reprinted provided the source is credited. Please provide the Bank’s Research and Public Information Department with a copy o f reprinted material.
