What businesses need to know about the US current account deficit Based on the article By Diana Farrell and Susan Lund The McKinsey Quarterly, 2007 No. 3

Introduction The US current account deficit has crossed $ 850 billion. It is still growing. The credibility of US government policies is under attack. The need to restore balance has been widely articulated. The Economist magazine has repeated this point again and again in recent years.

Adjustment mechanisms The US needs to export more and import less. This implies reducing domestic consumption & increasing savings. That is not very likely. The most likely adjustment mechanism will be dollar depreciation. Depreciation of the dollar → US exports will become cheaper → US imports will become expensive But this adjustment is likely to be gradual than abrupt.

Implications of slide in Dollar European demand for business and financial services from the US would increase. The US would become a more attractive location for European companies to set up manufacturing & R&D facilities. The US trade deficits with Japan, South Korea and Taiwan may become surpluses. The US trade deficit with China will not be affected significantly. - China exports five times as much to the US as it imports - Prices of Chinese exports to the US are far too low to erode China’s comparative advantage. Canada & Mexico might lose their manufacturing cost advantage resulting in new dynamics in the North American Free Trade region.

Two scenarios The deficit grows over the next 5 years. The deficit is eliminated over the next 5 years.

Continued growth of the US current account deficit The US current account deficit will increase to $1.6 trillion by Net foreign debt would increase from $2.7 trillion at the end of 2006 to $8.1 trillion in 2012 or 46% of GDP. This is nothing alarming as Australia, Ireland and Mexico carry similar external debt relative to GDP. Since debt is denominated in its own currency, repayment will not be all that difficult for the US. The US has historically earned higher returns on its foreign assets than it has paid to overseas investors. Net interest payments may still be less than 1% of GDP.

Elimination of deficit A 30% depreciation of the dollar from January 2007 levels would fully balance the US current account deficit by The US would become a significant net creditor with claims equal to 28% of GDP. The US would run a large trade deficit but more than make up through services exports and income from overseas investments.

US strengths Better returns on financial assets and business investments compared to Europe & Japan. Lower earnings volatility compared to emerging markets. Better institutional protection compared to emerging markets. But the US will have to learn to consume less and save more. This as mentioned earlier, is easier said than done.

Conclusion Getting ready for a dollar depreciation and reduction of US current account deficit makes sense for companies all over the world. European companies will find it more difficult to export to the US. But they will find the US an increasingly attractive place to make investments. The US trade deficit with Japan, South Korea and Taiwan may become a surplus if the dollar depreciates significantly. The US trade deficit with China may continue.

Meanwhile, the US must not bet too heavily on a currency depreciation to boost its competitiveness. The US must further build on its high tech sector. The US must continue to encourage competition and innovation. The US must encourage investments by foreign companies. The US must continue to welcome skilled immigrants.