>The skeptics at Goldman Sachs say "it doesn't matter
>who is driving the deficit wider. The end result is still that the world is
>awash in dollars and because of that the currency is still prone to sharp --
>and potentially destabilizing -- depreciation."
DAILY FINANCIAL MARKET COMMENT 03/28/05 Goldman Sachs Economics
*Recently, some have suggested that the contribution of US foreign affiliates (FAs) to recent deterioration in the US current account balance makes this deterioration less worrisome. Although we recognize that FAs have enhanced shareholder value by searching out more efficient ways of providing goods and services to US consumers, we register three objections to this line of argument. First, the FA deficit accounts for only about one-fifth of the deterioration from 1997 to 2002. Second, this deficit augments the supply of dollars on foreign exchange markets every bit as much as the rest of the deficit. Third, although basic accounting assures that capital inflows will finance the deficit in the very short run, no assurance is available on the terms of that financing, notably the dollar exchange rate.
The US Current Account Deficit - Foreign Affiliates are Not Special
Everyone, it seems, is talking about the US current account deficit, which surpassed 6% of GDP in the fourth quarter of 2004 for the first time in the nation's modern economic history. The previous cyclical peak, reached in the mid-1980s was barely half this size.
One recent 'what, me worry' suggestion is that the portion of this deterioration attributable to foreign affiliates of US firms should not be a source of concern. This claim appears to be rooted in a white paper issued by McKinsey Global Institute in December 2004, entitled 'A New Look at the U.S. Current Account Deficit: The Role of Multinational Companies.' <http://www.mckinsey.com/mgi/publications/currentaccountdeficit.asp> The essence of the argument presented therein is two-fold. First, a large part of the deterioration in the US current account deficit since the mid-1990s can be traced to the operations of US multinationals, whose operations are increasingly 'efficiency seeking' (i.e., looking for cheaper ways to serve the US market) versus 'market seeking' (the more traditional process of locating production facilities in the foreign markets firms are attempting to penetrate). Second, although this reorientation of US foreign direct investment has exacerbated the trade and current account deficits, it has also enhanced shareholder value.
Our problems with this argument are as follows:
1. Foreign affiliates account for only about one-fifth of the recent deterioration in the US trade deficit. It is factually correct to point out that the foreign affiliate (FA) deficit (a) doubled between 1990 and 1997, (b) doubled again by 2002, and (c) accounted for nearly one-third of the total deficit in 2002. However, these points -- particularly the first two -- just underscore the small base from which the FA deficit has increased. In dollar terms it stood at -$132 billion in 2002 versus -$63 billion in 1997, an increase of $69 billion. This was barely one-fifth the total deterioration over that same period, to -$425 billion from -$102 billion. So while the operations of multinational firms are clearly growing in relative importance, it would be a stretch to conclude that they are the main source of the US trade problem when the other two-thirds is coming from massive deterioration in the more traditional form of international trade.
2. The FA deficit is still a deficit. We grant the point that shareholder value is enhanced by the efforts of US companies to search out the most efficient way to produce and distribute goods and services in an increasingly global economy. We also agree that this overwhelmingly benefits US households and other entities. That said, the contribution of these firms to the US trade and current account deficits represents a net supply of dollars onto foreign exchange markets that is every bit as genuine as the more traditional form of international trade. Put simply, the US vehicle manufacturer that imports a finished automobile back into the United States for sale in the domestic market must convert some portion of the dollars received in that sale into foreign currency to pay its foreign workers and potentially other factors of production. This supply, equal to the difference between the final sales price and the sum of any inputs exported from the United States and the profits earned on the final sale, is the impact on both the reported current account balance and the net supply of dollars. In this sense, a dollar of FA deficit is no different than a dollar of 'other' deficit.
3. The FA deficit therefore affords no special protection against dollar depreciation. We are asked to believe that the activities of foreign affiliates will generate an equivalent demand for US-denominated assets. But there are two problems here. First, while basic accounting assures equivalence between a current account deficit and capital inflows ex post, the process that provides this assurance is the variability of the exchange rate or, in cases where exchange rates are fixed, the willingness of foreign official institutions to hold an overvalued dollar. Second, in this regard there is absolutely no difference between the dollars supplied via FA transactions and those supplied by other transactions.
Ed McKelvey