London, 12 April 2010

Much of the spare industrial capacity in the United States is concentrated in the sectors most exposed to competition from China and other lower-cost Asian economies. It is not really spare as much as stranded and gone forever.

If much of this industrial capacity has now been rendered effectively obsolete, the total amount of cyclical slack may be much lower than is commonly assumed. It may not provide as much of a cushion against renewed inflationary pressures as the expansion matures in 2011. It is consistent with the view that interest rates will need to begin a sustained rise sometime towards the end of H2 2010 or in H1 2011.

According to estimates published by the Federal Reserve, U.S. manufacturers were using 69.4 percent of their maximum capacity in February, 9.6 percentage points below the two-cycle average of 79.0 percent. But the capacity gap varies widely by industry:

* Miners, oil and gas producers, pulp and chemicals firms are operating at 86 percent of rated capacity, almost exactly in line with the two-cycle average. Any capacity gap in this sector is negligible.

* Makers of finished consumer goods, computers and business machines are working at 71 percent, about 6 percentage points lower than normal (77 percent). The capacity gap is significant but should be closed by end of Q4 2010 or Q1 2011 if the expansion continues on current trends.

* In contrast, producers of semifinished raw materials and industrial inputs (eg steel, glass, cement and components) are operating at just 70 percent, a massive 13 percentage points lower than normal (83 percent). The enormous gap in this area is unlikely to close for more than two or even three years. In fact it may never really "close" fully. Much of the gap for intermediate industries may reflect structural decline rather than cyclical slack.

Table 1 (download below) shows a full list of current utilisation rates compared with the average over the last two business cycles (Jul 1990-Dec 2007) for all the industrial groups surveyed by the Federal Reserve. Table 2 shows more detail on rates for the hardest-hit industries producing semifinished raw materials and other industrial inputs:

The worst affected industries include forest products, motor manufacturing and parts, non-metallic minerals, iron and steel, other non-ferrous metal producers, semiconductors and textiles, as well as fibres, plastics, textiles and paper. With the exception of the auto industry, almost all these industries are located in the middle of the supply chain -- sandwiched between raw materials extractors upstream and makers of branded consumer goods and business equipment downstream.

They produce generic commodity-like products competing more on price than quality or brand. These are precisely the sectors that have been most vulnerable to offshoring by U.S. manufacturers and increasing competition from lowercost producers in China and the rest of Asia.

Capacity utilisation began to fall in this part of the manufacturing system well before the downturn hit the rest of the economy. At an aggregate level, midstream utilisation peaked in December 2005, and was falling for a year and a half before the subprime crisis erupted in August 2007 and two and a half before the crisis intensified and turned into a global depression with the failure of Lehman Brothers.

These sectors have been the focus of most of the antidumping and countervailing duty (anti-subsidy) complaints by U.S. manufacturers (usually backed by unions) against imports from China (including the steel safeguards in the early 2000s, and more recent actions against oil field tubular goods and coated paper).

They will continue to be plagued by downward pressure on margins, and capacity closures, even if the rest of the economy experiences a sustained upswing.

In theory, they could benefit from a more competitive exchange rate, if China's yuan is revalued by a significant amount the dollar and other major currencies, since these are some of the most price-sensitive and heavily traded sectors.

But any revaluation is likely to be far too small (5-10 percent at the very most in the first two years) to provide much relief or lead to widespread plant reactivations. Much of this capacity has been stranded for good.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now

The views expressed are his own.

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