It's easy to blame the weak yuan for the huge US current account deficit, but MGI research finds it's not the real problem.
As it raced to begin its summer recess, the US Congress seemed determined to take some sort of action to punish China for allegedly manipulating its currency. Only a stronger yuan, says the conventional wisdom on Capitol Hill, will allow the US to balance its growing current account deficit, which reached a record $857 billion last year.
Hard numbers have played little role, so far, in the debate. No wonder: If lawmakers had paused to consider the facts, they might recognize the flaws in the conventional wisdom. New research by the McKinsey Global Institute (MGI) adds some clarity to the economic issues at stake, and shows that China's currency is not at the heart of the problem.
Even a 45% depreciation of the dollar against the yuan would not result in balanced US bilateral trade with China. The cost advantage of most Chinese exports is simply too great to be eliminated by currency movements alone. Moreover, many of the goods that the US imports from China are not manufactured domestically. Nor are they available in sufficient quantities—at least at the moment—from other low-cost markets.
Taking Into Account What Really Matters
At the same time it ponders the US trade deficit, Congress is also focused on fairness toward American workers. An undervalued yuan, it is argued, effectively subsidizes China's exports to the US and costs Americans jobs. But the jobs that US workers have lost over the past decade are not coming back: Under no scenario is the US going to start producing more toys, textiles, shoes, and other goods that China exports, nor should it. If those goods from China became more expensive, the new research finds that in the short run the US trade deficit with China would grow larger, since imports would cost more. In the long term, production would move to the next low-wage nation, such as Vietnam, Laos, Kenya, or Tanzania.
Before Congress acts, it must consider what really matters in reducing the trade deficit. The numbers are sobering. Looking across countries and export categories, our research finds that over the next few years, the US has ample opportunity to boost service and manufacturing exports, by as much as $450 billion by 2012. The US could also over time reduce oil imports by increasing energy efficiency and developing alternative fuel sources. But the analysis shows that these measures would at best reduce the US current deficit only very modestly, leaving it at 6.3% of gross domestic product in 2012.
To reduce substantially or eliminate the US deficit would require a 25% to 30% dollar depreciation from the level that prevailed in January, 2007. This would put the dollar at a 30-year low against the other major currencies. The US would still run a trade deficit with China, even with a balanced current account, but there would be other issues facing US policymakers.
A Lower Dollar Would Hurt Canada and Mexico
The US trade balance with its NAFTA partners—Canada and Mexico—would face a major adjustment. With no further currency interventions, the current deficit of $109 billion would swing to a surplus of $100 billion or more. The cost advantages now enjoyed by Canada and Mexico in the production of many goods would disappear altogether. This would create a new set of competitive and employment challenges for our neighbors, and would prompt all three NAFTA partners to think about how to help ease the transition and how to enhance their collective competitive advantage.
Although trade with China should not be the scapegoat in US policy circles, Asia clearly does have an important role to help reduce global imbalances. Greater appreciation of Asian currencies—not just the yuan—would help spread the needed adjustment more evenly among US trade partners. Should China and other Asian countries continue to peg their currencies to the dollar, the greenback would need to fall by nearly 40% against the rest of the world's currencies to close the current account deficit. Should Asian countries allow their currencies to strengthen, however, the required dollar depreciation against the rest of the world would be much less dramatic: an estimated 25%.
Whatever the outcome in the currency markets, Congress should consider that economic pragmatism, not impulsive action, is surely the wisest course. Emphasizing those areas in which the US has genuine potential to improve its trade and current account position is the right course of action.
Diana Farrell is director of the McKinsey Global Institute, McKinsey's economics research arm
This article originally ran in Businessweek.