A variety of forces, including demographics, technological change, and shifts in consumer demand, could cause the United States to export more and import less. But the further depreciation of the dollar is the most direct correction mechanism—and the most widely anticipated one.1 The uncertainty surrounding such a correction complicates efforts to establish priorities for business investment and government policy.
New research from the McKinsey Global Institute (MGI) offers some guidance. Our findings suggest that the depreciation will most likely be gradual—but would have to be very large to eliminate the deficit. This depreciation would lead to significant changes in the current pattern of world demand and trade.
If the dollar were to fall sharply, European demand for many types of financial and business services from the United States would increase, and European companies would find the United States a more attractive location to build manufacturing and R&D facilities. US policy makers should cultivate the open and competitive environment necessary for continued innovation in these sectors.
The US trade deficit with many Asian countries, including Japan, South Korea, and Taiwan, would become a trade surplus. Many Asian companies would have to intensify their efforts to increase exports to non-US markets and would find US companies more competitive in their own domestic markets. In contrast, China would retain both its manufacturing cost advantage and its trade surplus with the United States—suggesting that industry groups should focus less energy on pressuring China to revalue its currency.
As the dollar declined, Canada and Mexico would lose their manufacturing cost advantage, and imports from the United States would increase, particularly in high-tech products and machinery. This would create a new set of employment challenges and opportunities across the entire North American Free Trade Agreement (NAFTA) region. Companies in Canada and Mexico should prepare for the potential depreciation of the dollar—for example, by strengthening their efforts to export to Central America.
MGI reached these conclusions by analyzing two very different five-year scenarios describing the evolution of the US current account. (For more detail, see the full report, The US Imbalancing Act: Can the Current Account Deficit Continue? available free of charge online.) In the first, we assessed whether it could continue to grow over the next five years if exchange rates remained the same and whether the rest of the world could finance an ever-larger US deficit. The second scenario describes a world where the dollar depreciates enough to eliminate the entire US current-account deficit—by some 30 percent from the dollar’s level in January 2007—and the impact on trade patterns. While reality is likely to lie somewhere between these two extremes, understanding them should help business leaders and policy makers better prepare for what lies ahead.
Two views of the future
MGI created two scenarios by using a microeconomic approach2 to analyze the effects of a depreciation of the dollar on demand for 30 different product categories in 100 countries, as well as on US foreign assets and liabilities. The two scenarios paint vastly different pictures of the US current account, trade balance, and net foreign income in 2012.3
Continued growth of the US current-account deficit
If current trends in global savings and investment continued for an additional five years and there were no adjustments in exchange rates, the US current-account deficit would reach $1.6 trillion by 2012, or 9 percent of GDP (Exhibit 1). However, under plausible assumptions, global capital outflows from other countries, reaching $2.1 trillion in 2012, would also grow large enough to finance a deficit of that size.4 Under this scenario, the US deficit would simply resemble a more exaggerated version of the status quo, and the United States would increasingly borrow from abroad to pay for it.
It’s not implausible that the United States could pay for such a large imbalance. Running a current-account deficit of this size would triple today’s net foreign debt, from $2.7 trillion at the end of 2006 to $8.1 trillion in 2012, or 46 percent of GDP. Yet a number of countries, including Australia, Ireland, and Mexico, currently carry a net external debt of a similar size relative to GDP. Furthermore, the United States is likely, at least over the next five years, to retain some unique advantages that help service a large foreign debt. Most obviously, it is denominated in the country’s own currency, the dollar, eliminating the risk of ballooning payments resulting from currency swings.5
What’s more, the United States has historically earned higher returns on its foreign assets than it has paid to overseas investors. One consequence is that the US net foreign debt today is significantly smaller than the sum of past current-account deficits (Exhibit 2). If this pattern continues, interest payments on the large external debt resulting from an even larger current-account deficit would be relatively low, at less than 1 percent of GDP.
Elimination of the US current-account deficit
A variety of economic shocks could spark changed global trade, consumption, and savings patterns that might eliminate the US current-account deficit by 2012. US consumers may be forced to save more as the housing boom ends, for example. Asian countries might boost domestic consumption, perhaps through increased spending on education and health care, and save less in the form of US securities. Such changes would increase the supply of and lower demand for the US dollar, leading its value against other currencies to fall.
Our analysis suggests that a 30 percent depreciation of the dollar from its January 2007 levels would fully balance the US current account by 2012.6 A smaller decline—of 20 to 25 percent from January 2007 levels—would reduce the deficit to roughly 2 to 3 percent of GDP, respectively, which many economists feel is sustainable.
Notably, even after a depreciation of this magnitude, in 2012 the US trade deficit in goods would remain quite large—around $720 billion, roughly today’s level. However, the United States would export more services and earn more income from overseas investments.7 Indeed, rather than being a large net debtor owing about 46 percent of GDP, the country would be a significant net creditor, with claims equaling some 28 percent of GDP. The factors underlying this dramatic reversal are the same ones that limit the accumulation of net foreign debt today: the positive spread between the interest that the United States earns on its foreign assets and what it pays on its liabilities, as well as the appreciation of US assets abroad, in this case accelerated by a depreciation of the dollar.
Preparing for both scenarios
Which of these scenarios is likely to play out? Since the United States could continue running a large current-account deficit for the next five years, there’s no reason to expect that the dollar will depreciate abruptly. For many years, foreign investors have displayed a growing appetite for dollar assets. The United States has offered better returns on financial assets and business investments than have other mature economies, such as Europe and Japan—along with lower volatility and better institutional protection than can be found in emerging markets.
There’s also no reason to expect that today’s global trade, consumption, investment, and savings patterns will persist indefinitely. Redressing the imbalances will require the United States to save more and consume less, while other regions—especially Asia, Canada, Europe, and Mexico—would consume and import far more than they do today. As imports become more expensive for consumers in the United States, companies around the world will intensify their sales efforts elsewhere and lessen the global focus on the US economy.
The prudent course for business is to prepare for an adjustment of the US deficit, whether that happens gradually or abruptly. Despite the great uncertainty surrounding the deficit’s fate, few companies have developed contingency plans for a significant depreciation of the dollar and the major shifts in trade and investment that would follow. Our analysis describes the implications of these changes.
Europe and the United States
The United States runs a trade surplus with Europe across many service subsectors, including business services (such as consulting, accounting, financial, and computer and information services), education, telecommunications, and travel. If the dollar declined and US services became cheaper for Europeans, these surpluses would more than triple in value.8
After a depreciation of the dollar, the US trade deficit in goods with Europe would shrink but not disappear. Two-thirds of the improvement would come from increased US exports to Europe—particularly of machines and other goods, such as farm and construction equipment. Also, US imports of manufactured products from Europe, such as scientific instruments and consumer goods, would decline.
European companies should prepare for the possibility that they will face new, more cost-competitive US entrants, perhaps by further differentiating their offerings. In general, they would also find the United States a more attractive place to build manufacturing and R&D facilities to serve both it and other markets.
Asia and the United States
The US trade deficit with China will persist for years, even in the unlikely event of a major short-term depreciation of the dollar against the renminbi.9 The reason is that China’s exports to the United States today are five times as large as its imports; moreover, the cost difference in the goods the United States imports from China—such as toys, clothing, and consumer electronics—is too large for even a significant depreciation to erase. What’s more, China imports many components of the goods that it exports, and a stronger renminbi would reduce the cost of those inputs, helping to preserve China’s manufacturing cost advantage. As a result, the preoccupation of business and government leaders with the depreciation of the renminbi seems misplaced.
In contrast, the US trade deficit in goods with Japan, South Korea, and Taiwan would become a trade surplus in the event of a significant depreciation; US imports of automobiles, computers, electrical appliances, and telecommunications equipment from them would decline. These three countries have major trading relationships with many other markets and would need to increase exports to them. And despite lower exports to the United States, Japanese, South Korean, and Taiwanese companies would enjoy lower costs for building and running plants there to serve its domestic market.
Still, policy makers in the three countries (and others that have traditionally depended on exports to drive economic growth) would find it prudent to foster domestic consumption by liberalizing their service sectors, improving their credit systems and products to facilitate consumer borrowing, and letting their currencies appreciate to improve consumer purchasing power. Although US consumption played an important role in revitalizing these economies after the 1997 financial crisis, it cannot continue to fuel global growth forever.
Canada, Mexico, and the United States
Canada and Mexico, whose trading relationships with the United States make up the majority of their total trading activity, would be significantly affected by a short- or long-term depreciation of the dollar. Because of the relatively low labor costs of these countries, they have enjoyed many production cost advantages over the United States since the creation of NAFTA, in 1993. After a major depreciation, however, those advantages would largely disappear. Instead of increasing investments in offshore-manufacturing facilities in Canada and Mexico, US companies would find it more cost effective to produce goods at home, where labor costs would be comparable and new factories could be built without the complexity and expense of operating abroad.
Exports from Canada and Mexico to the United States could decline as much as their imports from it increased, creating a double shock. Both would have lower exports of manufactured goods there, especially furniture and clothing, and Canada would also export smaller quantities of mineral fuels. At the same time, both would consume more US goods, especially industrial and electrical machinery, medical devices, computers and other high-tech gear, and farm and construction equipment. Canada and Mexico might need to increase their trading with Central America and other parts of the world as a result. To do so, Mexico would have to move more quickly into higher-value-added types of products, since it could no longer rely on low wages to compete.10
Maintaining healthy economies throughout the NAFTA region benefits everyone, so the three members should work together to prepare for the possible effects of any depreciation of the dollar. Even if differences in their production costs narrowed after it, the free-trade area would continue to benefit all member countries; the growth unleashed by the integration of European economies in recent years is a testament to this point. By reducing trade barriers, NAFTA has already allowed low-cost manufacturers, especially in Mexico, to increase their exports to the United States. Increases in other types of cross-border commerce are still possible. All three countries should continue to build the physical and telecommunications infrastructure necessary to facilitate such trade by harmonizing product standards and regulations and streamlining border procedures and red tape.
Lessons for the United States
For US companies and government leaders, economic pragmatism is surely the wisest course. Emphasizing those areas in which the United States has genuine potential to improve its trade and current-account position will have more impact than focusing on some of the red herrings—revaluing the renminbi, for example—in the current public debate. The highly productive and innovative US high-tech sector warrants special attention because of its direct exports and its role in facilitating innovation in other sectors; it produces not only computers and semiconductors but also components for a wide range of goods, such as surgical instruments and medical devices, office equipment, farm and construction machinery and vehicles, and air-conditioning and heating systems.
Fostering the high-tech sector will require the United States to provide an environment that facilitates innovation. Competition is vital, as is the free flow of ideas across companies and borders. Since the terrorist attacks of 9/11, policy changes prompted by national-security concerns may have jeopardized this flow. The current long delays in approving visas for highly skilled foreign workers and graduate students are shortsighted. Policies that discourage investment by foreign companies in the United States also will do more harm than good.
Service businesses in the United States should prepare to increase their exports to Europe by tailoring their offerings to meet local regulatory requirements and consumer preferences. Other companies ought to consider what adjacent services they might provide. US trade negotiators should continue trying to reach global agreement on the removal of tariff and nontariff barriers to trade in services, and policy makers would be wise to initiate broader long-term efforts to break down the language and cultural differences that constrain the growth of service exports. Foreign-language study, for example, should receive more emphasis in US schools.
The US current-account deficit could continue to grow for at least the next five years. When the adjustment does take place, it is more likely to be gradual than abrupt. Still, a major depreciation of the US dollar and large shifts in global consumption and savings are possible. Governments, business leaders, and investors around the world should prepare for the potential effects.
About the Authors
Diana Farrell is director of the McKinsey Global Institute, where Susan Lund is a consultant.
The authors wish to thank team members Alexander Maasry and Sebastian Roemer, both McKinsey consultants. We are also grateful to our academic advisers on this project: Martin N. Baily, senior fellow at the Peter G. Peterson Institute for International Economics; Richard Cooper, Maurits C. Boas Professor of International Economics, Harvard University; and Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy and Professor of Economics at Harvard.
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