Foreign Affairs

May/June 2001

 

The U.S. Trade Deficit: A Dangerous Obsession
By Joseph Quinlan And Marc Chandler

 

The Wrong Scorecard

Every U.S. president over the past quarter-century has confronted an annual trade deficit. But the cavernous trade gap inherited by President George W. Bush dwarfs those faced by his predecessors. America's current-account deficit (which measures the cross-border exchange of goods, services, and investment income) averaged more than $1 billion a day last year, reaching a record 4.4 percent of GDP. Many economists worry that the huge trade deficit, which must be financed by foreign investors, could lead to a full-blown financial crisis if and when those investors become unwilling to fund the imbalance. Something as benign as stronger economic growth in another country, for instance, could attract a larger share of the world's savings, leading to higher U.S. interest rates, a weaker dollar, and a grimmer economic outlook for the United States and the world.

Economists offer various explanations for the persistent U.S. trade deficit. Some argue that America buys more from the world than it sells because its companies are growing less competitive. Others blame the "unfair" trade restrictions and labor policies of other countries. Still others point to the underlying strength of the dollar, which makes American goods and services more expensive for foreign buyers.

Whatever the proper explanation, a simple and important fact is absent from the debate: the trade balance is no longer a valid scorecard for America's global sales and competitiveness. Given a choice, U.S. firms prefer to sell goods and services abroad through their foreign affiliates instead of exporting them from the United States. In 1998, U.S. foreign-affiliate sales topped a staggering $2.4 trillion, while U.S. exports -- the common but spurious yardstick of U.S. global sales -- totaled just $933 billion, or less than 40 percent of affiliate sales. How U.S. firms compete in world markets, in other words, goes well beyond trade.

Still, trade erroneously remains the standard benchmark of global competitiveness. More worrisome, it is the most important factor shaping U.S. international economic policy. Overblown concern about the swollen trade deficit, combined with a slowing economy and the expectation of rising unemployment, could ignite a new round of trade protectionism in Washington, which could spark similar responses around the globe. The greatest danger on America's trade front, therefore, is not the size of the deficit but the nation's obsession with it.

Insider Trading

The rule "make where you sell" increasingly governs the way American companies do business. It explains, for example, why Ford Motor Company and General Motors have long owned affiliates in Europe and have recently entered promising emerging markets such as Brazil and China. The principle also underlies Dell Computer's direct-investment positions in Europe and Latin America, as well as those of Cisco Systems and Microsoft in China. And because of the increased globalization of services, U.S. service giants such as American International Group, Citigroup, FedEx, and Yahoo have also set up foreign affiliates, leading the boom in U.S. foreign direct investment (FDI) over the last decade.

American companies simply cannot afford the luxury of staying at home. Multiple market opportunities, incessant technological advances, blurred industrial boundaries, and unrelenting global competition all demand that U.S. firms compete not just through trade but also through FDI. Being an "insider" is increasingly critical in markets around the world.

Numerous factors explain this trend. Contrary to popular perception, foreign consumers' demands vary according to location, requiring firms such as Procter & Gamble, Gillette, and Coca-Cola to be close to their customers. For example, China's vastly diverse cultures, dialects, and above all else, living standards demand that U.S. companies adapt their products to local tastes -- that they follow Coca-Cola's mantra, "think local, act local." Chinese consumers, whether buying soft drinks, computers, or automobiles, are very brand-sensitive -- which means that a local presence is crucial for success in the Chinese market.

Moreover, fierce competition for global market share compels U.S. firms to be close to their foreign competitors. How else can Eastman Kodak successfully compete in China against Japanese rival Fuji Photo Film? Wal-Mart cannot let its global competitor Carrefour of France enter key markets such as Brazil and Japan uncontested; neither can Citigroup, which battled Germany's Commerzbank for market supremacy in Poland last year. At stake for all these companies are new customers, new resources, new opportunities -- and by extension, long-term success.

Global Heavyweights

Corporate America now has some 23,000 majority- and minority-owned affiliates strategically positioned around the globe. Together they rank among the world's largest economic producers, boasting a combined gross output of $510 billion in 1998 -- greater than the GDPS of most nations, including Mexico, Sweden, Taiwan, and South Korea. U.S. affiliates also contribute significantly to the GDPS of their various host nations. In 1998, they accounted for more than 16 percent of the GDP in Ireland, more than 9 percent in Singapore and Canada, and more than 6 percent in the United Kingdom.

The strategic objective of most U.S. foreign affiliates is to produce and deliver goods and services to the host market. In 1998, roughly two-thirds of total affiliate sales were made to customers in the host nation -- virtually unchanged from the level in the early 1980s. Yet as U.S. multinational corporations increasingly disperse different stages of production among different countries, their affiliates have also become world-class exporters of intermediate goods and components. In 1998, the exports of U.S. affiliates totaled $623 billion. That figure not only matched the total value of U.S. goods exports but also easily surpassed the export levels of Germany, Japan, and China.

Critics often claim that U.S. multinationals export cheaper products from their overseas affiliates back to the United States, thereby contributing to the U.S. import bill and undermining American jobs and income. But in fact, most U.S. affiliate exports do not go to the United States. In 1998, only 30 percent of them went to the United States; the bulk of the rest went to regional markets close to the host nations. Moreover, the majority of affiliate exports do not emanate from low-wage nations such as Brazil, China, or India. Rather, nearly three-fourths of total affiliate exports in 1998 came from high-wage industrialized nations such as Canada, the United Kingdom, and Germany.

U.S. affiliates also stand among the world's top employers, collectively employing more than 8 million people in 1998 -- a workforce greater than that of most countries. Most Americans assume that the bulk of this workforce toils in developing nations under extreme and unfair conditions. But in fact, corporate America's global workforce is concentrated in the high-wage developed nations. In Europe alone, U.S. affiliates employed some 3.5 million workers in 1998 -- more than the combined U.S. workforce in Latin America and developing Asia. In Canada, some 935,000 workers were on U.S. payrolls in 1998 -- more than four times the number employed by U.S. affiliates in China.

Location, Location, Location

Not only are U.S. affiliate sales significantly larger than U.S. exports, but they are also dispersed differently across the globe. Since the end of World War II, America's FDI levels have soared, and Europe, notably the United Kingdom, has emerged as the favorite destination for U.S. multinationals. As Europe recovered from the ravages of war and moved toward creating a common market, U.S. firms seized the new commercial opportunities presented by its peace and economic stability. By the 1960s, Europe accounted for almost 40 percent of total U.S. foreign direct investment. The following decade, the tilt toward Europe became even more pronounced: the region accounted for nearly half the value of American FDI, largely at the expense of Latin America and Canada. In the 1970s, meanwhile, Asia remained among the least favored destinations for U.S. multinationals.

The first half of the 1980s proved an unpropitious time for U.S. multinationals. Courtesy of the 1979 oil shock, the global economy stumbled into recession. After reaching a postwar peak of $13 billion in 1980, U.S. direct investment in Europe plunged to just $3.5 billion in 1982. Investment flows to Canada turned negative in 1981-82 due to that country's adoption of restrictive policies such as the Natural Energy Program, which prompted U.S. companies to sell their existing assets in the politically charged petroleum and mining sectors. Meanwhile, Latin America's debt crisis and subsequent economic recession sharply curtailed U.S. multinational participation in that region.

Across the Pacific, talk of an "Asian miracle," set against debt-ridden Latin America, protectionist Canada, and slumping Europe, inspired a friendlier view of Asia among U.S. firms. As a consequence, cumulative U.S. direct investment in Asia rose 71.5 percent from the previous decade, well ahead of the pace in Europe (64 percent), Latin America (37 percent), and Canada (-13.2 percent). More impressive still was the surge in U.S. investment to the developing nations of Asia, which rose to $14 billion in 1980-89 from $6.1 billion in the 1970s. Still, the region attracted only 8.1 percent of total U.S. outflows in the 1980s -- less than half the amount invested in trouble-prone Latin America.

Although the 1980s started with a gloomy investment climate for U.S. multinationals, the decade ended on a decidedly different note. In fact, the global investment backdrop at the end of the 1980s and into the 1990s was nearly perfect. Multiple forces -- both cyclical and structural -- converged to produce one of the most powerful booms in global FDI, with American firms leading the way. Falling telecommunication and transportation costs allowed U.S. firms to broaden the geographic dispersion of their operations. The end of the Cold War opened new markets to U.S. firms, as did the proliferation of regional trading blocs such as the North American Free Trade Agreement, Mercosur (which comprises Argentina, Brazil, Paraguay, and Uruguay), and the common market of the European Union (EU). Moreover, low interest rates and surging equity prices around the world provided copious amounts of cash for global mergers and acquisitions.

All of these developments converged in the 1990s to trigger the most robust wave of U.S. foreign direct investment in history. During that decade alone, U.S. firms invested more capital overseas -- $802 billion -- than they had in the prior four decades combined. But the geographic preference of U.S. firms did not change, despite all the hype about new markets in central Europe, economic reform in India, privatization in Brazil, and liberalization in mainland China. The developed nations -- by a wide margin -- remained the biggest recipients of U.S. direct investment.

A number of motives drive the global strategies of U.S. multinationals, but reducing the wage bill tends to be near the bottom of the list. More important are wealthy markets, along with access to skilled labor and technology. These advantages reside in the developed nations, which accounted for two-thirds of total U.S. foreign direct investment during the 1990s. Europe remained the preferred destination, accounting for nearly 55 percent of the total. Canada represented another 8 percent, attracting $2 of U.S. investment for every $1 invested in Mexico during 1994-99. Meanwhile, Asia's total share of U.S. investment during the 1990s (roughly $122 billion) lagged behind other major parts of the world. And even in the Asia-Pacific, the most favored location of U.S. multinationals was neither China nor Japan, the two largest markets in the region, but Australia, whose labor force and consumer markets are smaller than those of most U.S. states.

During the 1990s, Australia accounted for more than 20 percent of total U.S. direct investment in the Asia-Pacific region, placing the nation among the top 10 foreign destinations for U.S. companies. Australia's attractiveness may owe to its technological capabilities and its well-educated, English-speaking labor force. On a per capita basis, Australia is one of the world's heaviest users of computers and the Internet and is therefore a prime location for U.S. technology firms. Industry deregulation in the late 1980s and early 1990s was another draw for U.S. investment.

At the other end of the spectrum lies India. Although it is often viewed as one of the most promising emerging markets in Asia, with a massive and cheap labor force, India attracted a mere $1.1 billion of U.S. investment in the 1990s -- roughly half the level of U.S. investment in Colombia during the same period. Meanwhile, the so-called crisis economies of South Korea, Thailand, the Philippines, Malaysia, and Indonesia together drew only 3.2 percent of U.S. foreign direct investment. Even in Taiwan, one of the region's hottest economies, U.S. direct investment amounted to less than that in South Africa during the 1990s. By the same token, U.S. multinationals invested more capital in tiny Chile than in massive China over the same time frame.

Tunnel Vision

While U.S. multinationals were enjoying their best decade ever, developing countries around the world were suffering successive economic crises. In 1995, Mexico fell victim to a currency meltdown. In mid-1997, it was Asia's turn. Russia rolled over the next year, followed by Brazil shortly thereafter. Each traumatic event set off a mad scramble on Wall Street to determine the collateral damage to the United States, using trade linkages as the standard benchmark.

As the Asian crisis unfolded, the flurry of attention surrounding U.S.-Asian trade linkages was understandable. Of the top 15 U.S. export markets in the world, 7 were in Asia. Collectively the region accounted for nearly one-third of U.S. exports in the year prior to the crisis, notably higher than the export shares of Europe (22.4 percent) and Latin America (17.8 percent). Using trade as the key variable, then, Asia factored heavily into the U.S. equation. But trade linkages were only half the story -- if even that. Viewed from the lens of affiliate sales, the Asian meltdown was significant but hardly fatal to the U.S. economy, given that developing Asia accounted for only about 10 percent of total U.S. affiliate sales.

In contrast, Europe took credit for more than 50 percent of such sales. The United Kingdom, for example, accounted for $224 billion in U.S. affiliate sales in 1998, versus just $39 billion in goods exports -- a ratio of almost 6 to 1. Similarly, in nearly all developed nations, U.S. affiliate sales surpassed exports by a wide margin. Italy, Spain, and Switzerland, for example, do not even appear on the export radar screen, giving the false impression that U.S. commercial links with these countries are insignificant. But in fact, they are substantial when measured by foreign affiliate sales. Thus, when the euro plunged against the dollar in 2000, so did the overseas profits of U.S. multinationals such as Gillette, IBM, Ford, Heinz, and DuPont. And since a shift in exchange rates has a more immediate impact on affiliate sales and income than on trade, these pains were quickly felt by corporate America.

Just as a myopic focus on U.S. exports can distort the true picture of U.S. global competitiveness, so can a singular focus on imports. Many foreign companies compete in the United States the same way U.S. companies compete abroad -- through affiliate sales rather than exports. Although American firms adopted FDI-led strategies earlier and more aggressively than did their foreign counterparts, many Japanese and European companies have also begun to prefer affiliate sales over exports as their main approach to foreign markets. According to a 1998 report by the Japanese Ministry for International Trade and Industry, Japan's affiliate sales surpassed its exports for the first time in 1996. The same thing happened in Europe in the late 1980s. By the mid-1990s, affiliate sales of European companies totaled almost $3 trillion, or 1.2 times the value of EU exports.

For many foreign multinationals such as Reuters, Daimler-Benz, Royal Ahold, and British Petroleum, the answer to globalization was to plow billions of dollars into the United States, the growth champion and technological leader of the world. As Krish Prabhu, chief operating officer of Alcatel, remarked to the Financial Times in September 1999, "So much company strategy is driven out of the United States today. No serious player can afford not to have a presence there." Indeed, foreign multinationals pumped nearly $900 billion into the U.S. economy in the 1990s, more than the amount invested over the preceding four decades combined.

In 1998, U.S. imports of goods and services totaled $1.1 trillion. But as impressive as that number is, it falls short of the $1.9 trillion in sales by foreign-owned affiliates in the United States that same year. A fixation on imports ignores the extensive presence of foreign-owned affiliates in the United States, which numbered more than 9,700 at last count. It also overlooks the fact that such affiliates contributed nearly $420 billion in output and employed more than 5.6 million Americans in 1998.

Germany, for example, may not be a significant exporter to the United States, but German affiliates here employed nearly 800,000 Americans and racked up sales of roughly $240 billion in 1998 -- nearly five times the value of German exports to the United States in the same year. Similarly, import figures suggest that China has greater stakes in the United States than the United Kingdom does. But that is hardly the case, given the latter's deep and long-standing direct-investment ties with the United States. U.S. imports from the United Kingdom totaled only $36 billion in 1998, roughly half the value of that year's imports from China. But affiliate sales of British firms operating in the United States -- $192 billion in 1998 -- greatly exceed those of Chinese firms.

Goodbye, Adam Smith

Foreign direct investment has changed the face of the international economy. Since the early 1970s, it has grown faster than either world output or global trade and is the single most important source of capital for developing economies.

But America's foreign economic policy still centers on trade at the expense of FDI. A trade spat with the EU over beef and bananas, for example, risks America's large investment stake in Europe. And the suggestion of some in Congress to devalue the dollar to promote U.S. exports would only make it more expensive for U.S. affiliates to do business abroad while making it cheaper for foreign companies to buy American assets. An attempt to improve the trade balance, therefore, would actually end up hurting the FDI balance.

Corporate America risks losing out on the best opportunities of the global marketplace if Washington continues to make trade its top priority in the world economy. With China's entry into the World Trade Organization, for example, many observers will carp on the U.S.-China trade imbalance (which recently surpassed the U.S. trade deficit with Japan), even though the real, more substantial penetration of the Chinese market will likely come through direct investment and affiliate sales. In 1998, U.S. affiliate sales in China totaled $14 billion -- roughly equal to U.S. exports there. This comparison will only grow in favor of FDI. A continued fixation on trade, however, will divert attention from the more promising opportunities of direct investment in China.

Similarly, America's most significant economic imbalance with Japan is not the headline-grabbing U.S. trade deficit but the stark imbalance of FDI. In 1997, Japan's accumulation of direct investment in the United States was worth $64 billion more than the value of U.S. assets in Japan -- a deficit 12 percent greater than the trade gap that year. Thus, in dealing with Japan, the Bush administration should not get bogged down in the all-too-familiar battle over automobile trade.

Instead, it should concentrate on opening the Japanese market in service sectors such as health care, insurance, and financial services, where the potential payoffs are greater. In other words, Detroit should not set the tone for U.S.-Japan commercial relations; rather, Washington should work on expanding investment opportunities in Japan for companies such as Yahoo, General Electric Capital, and Charles Schwab. Moreover, the Bush administration should actively promote another round of global trade negotiations, putting the liberalization of services at the top of the agenda.

Looking south of the border, America's widening trade deficit with Mexico appears increasingly formidable. But both policymakers and the media should realize that in 1999, nearly two-thirds of U.S. imports from Mexico counted as "related-party trade" -- that is, trade between multinational firms and related affiliates. What drives U.S. trade with countries such as Mexico, Canada, and Singapore is the exchange of goods and services within U.S. firms such as ibm, Ford, DuPont, and Motorola. Slamming the door on Mexican imports, then, means slamming the door on corporate America.

U.S. commercial relations with many developing nations are growing more complex as American firms shift from trade-led initiatives to investment-driven strategies. This development should influence how the Bush administration takes up negotiations for the proposed Free Trade Area of the Americas. The initial signs, however, are discouraging. Just when U.S. firms are striving to integrate more developing nations into their global production networks, the Bush administration is proposing broad cuts in the Overseas Private Investment Corporation, which provides insurance and loans to companies investing in developing nations. That proposal must be music to the ears of policymakers in Europe, who are actively promoting their own commercial interests in strategic markets such as China, India, Mexico, and the Mercosur trade group.

In the end, U.S. exports and imports neither represent America's global linkages nor indicate how or where U.S. firms compete. Yet many still view global competition though the 200-year-old eyes of Adam Smith and David Ricardo, who saw trade as the chief form of economic exchange. Others harbor equally archaic mercantilist prejudices, assuming that exports are good while imports are bad. These observers regard a trade deficit as a sign of national weakness, a warning signal that something is amiss. But U.S. global engagement involves far more than just trade. If policymakers continue to interpret a large trade deficit as a loss of global competitiveness or a result of unfair trade practices, protectionist backlash could result, which could trigger retaliations around the globe. Under this scenario, there would be no winners -- only losers.

The United States' obsession with its trade deficit belies the fact that corporate America has never been better positioned to compete in the global marketplace. It is time to say goodbye to Adam Smith's outdated framework of global competition and to embrace instead a more complex understanding of America's economic engagement with the world.

Joseph Quinlan is Senior Global Economist at Morgan Stanley Dean Witter and author of Global Engagement: How American Companies Really Compete in the Global Economy. Marc Chandler is Chief Currency Strategist at Mellon Financial Corporation.