The record-breaking US current-account deficit has prompted calls from protectionists to slow the flood of imports. This response may be understandable, but it is still misguided, given that a large and growing share of the deficit simply reflects the international reach—and success—of the strongest US companies.

Research by the McKinsey Global Institute (MGI) shows that roughly one-third of today's current-account deficit results from trade with US-owned subsidiaries abroad—an automaker importing cars assembled in Mexico, for example, or a bank using call centers in India.¹ These activities may add to the nation's trade imbalance, but they also create significant value for US customers, companies, and shareholders.

Trade between foreign affiliates (as offshore subsidiaries are called) and US companies and customers can, in fact, increase or decrease the current-account balance. When a US carmaker manufactures vehicles in Mexico, it sells many of them to Mexican consumers; the resulting profits appear in the current account as a positive income flow.² In addition, these companies use technologies and components produced in the United States, thereby lifting US exports. At the same time, vehicles assembled abroad and shipped back to the United States count as imports, despite the fact that they are produced by US companies.

This intricate web of global trade demonstrates why traditional interpretations of the current-account deficit are outdated. Any negative net impact that corporate activities abroad have on the US trade balance must be weighed against the overall economic value they create. Today, foreign subsidiaries account for nearly 25 percent of the profits of US multinational corporations and add roughly $2.7 trillion in market capitalization for their parent companies. These revenues promote investment in technologies and business opportunities that will eventually create new jobs, both at home and abroad. Far from reflecting the weakness of the US economy, at least a third of the current-account deficit is actually evidence of its strength.

Instead of adopting protectionist legislation to "correct" trade imbalances, it would make more sense for the government to update the way it calculates the trade balance. This is not to say that the rest of the current-account deficit shouldn't be addressed: policy makers should work toward more equitable trade agreements and get the fiscal budget deficit under control. They should also ensure that the fruits of globalization are shared more broadly across the population and help ease the transition for workers who lose jobs. The openness and flexibility of the US economy are two of its greatest strengths; policies that compromise these qualities are the real danger.

The role of foreign-affiliate trade

The current account takes a residency-based view of trade—that is, it measures the physical flow of goods and services across a nation's borders, regardless of the nationality or the ownership of parties on either side of the transaction. In the 1940s, when national balance-of-payments accounting methodologies were created, few companies had operations outside the home country—imports were goods produced by foreign companies, exports by domestic ones.

This categorization no longer holds true. A growing number of companies have expanded abroad, setting up foreign affiliates. In the national balance of payments, any exchange of goods, services, or income between a foreign affiliate and its parent company, other US companies, or consumers is counted as an export, an import, or an income flow.

Foreign affiliates are a growing part of US trade activity—and their trade has gone sharply into deficit. From 1983 to 1995, the foreign-affiliate trade balance was only slightly negative, with imports from US foreign affiliates roughly equal to the exports of foreign-owned subsidiaries in the United States. Since 1995, however, foreign-affiliate trade has fallen sharply into the red (Exhibit 1).

The reason is the changing nature of multinational investment. Until the early 1990s, just about all foreign direct investment was channeled to the rich industrialized areas—Europe, Japan, and the United States. (The major exception was oil investments in some developing countries.) The expansion of GM into Europe, Citibank's branches in the United Kingdom, and the US auto plants of Honda Motor and Toyota Motor are a few examples. These investments were made to produce goods and services for local consumers, not for export; therefore, the impact on the current account was minimal.

Since the early 1990s, however, there have been two important changes. First, foreign-direct-investment flows have more than doubled, from 0.7 percent of the global GDP in 1992 to 1.5 percent in 2003. Second, the removal of trade barriers and technological developments in communications and transportation have led to novel forms of trade, particularly with emerging markets. Foreign direct investment in emerging markets is still less than half of the worldwide total, but their share is expanding rapidly.

As in industrialized countries, the majority of foreign investment in developing countries is market seeking—that is, aimed at expanding into new markets.³ A small but fast-growing portion, however, is efficiency seeking: motivated by a desire to take advantage of low-cost labor and other inputs to produce cheap goods and services for export (often called offshoring). The examples include a North American bank's customer service call center in the Philippines, a computer manufacturer's motherboard assembly operation in China, and an automaker's factory in Mexico. This efficiency-seeking foreign investment generates large trade flows between foreign subsidiaries and US companies and customers—and has had profound implications for the US current account.

The same trends are affecting the current accounts of other developed countries, such as Japan, where 31 of the 50 largest companies are multinationals. As in the United States, imports from Japanese foreign affiliates increased rapidly during the 1990s and now account for roughly 10 percent of the country's imports. But this share is only half that of US foreign affiliates, mainly because the global expansion of Japanese multinationals and their European counterparts has been slower. We expect European and Japanese imports from foreign affiliates to continue to grow, however.

How multinational corporations affect the current account

The net effect of foreign investments by multinational corporations on the current-account balance can be either positive or negative: it depends on the exports, the imports, and the income flows these activities create (Exhibit 2). Consider the impact on the US current account of foreign investments by US companies in three industries.

Personal-computer manufacturers in China

China has one of the world's largest and fastest-growing personal-computer markets, along with a low-cost labor force and a well-developed supplier base. It is no surprise that foreign computer makers, including Dell, HP, and IBM, have invested heavily there. By 2001, these three companies alone had captured roughly 12 percent of the market, with estimated total profits of about $20 million a year.⁴

The foreign affiliates of these companies, like other market-seeking investments, have had a small positive impact on the US current account.⁵ Since the computers made in China are mostly sold there or exported to other countries, US imports are not affected. Some US companies ship raw materials, technology, and other inputs to their Chinese affiliates, however, boosting exports as a result.

At the same time, the estimated $20 million earned by these foreign affiliates counts as a positive income flow to the US current account—regardless of whether it is repatriated to the United States.⁶ And just as important, operating in China has helped Dell, HP, and IBM sharpen their competitiveness. Moreover, we estimate that the earnings of their Chinese affiliates added roughly $400 million to their market capitalization. US households, which own 80 to 90 percent of US equities, reap the benefits.

Automakers in Mexico

Sometimes a company that starts with market-seeking investments begins to export from its foreign location as well. Consider US automakers in Mexico: by the 1930s, Chrysler (then an independent company), Ford Motor, and GM all had production facilities in Mexico, primarily to get around the country's trade barriers. In the 1980s, however, they started building new plants in Mexico City to produce autos for export. By 2003, 77 percent of the vehicles foreign carmakers produced in Mexico were for export, up from 52 percent a decade earlier.

This combination of market-seeking and efficiency-seeking foreign investment has had a mixed impact on the US current account. In 2003, Chrysler, Ford, and GM sold an estimated 483,000 vehicles in Mexico, generating about $360 million in income. This amount was dwarfed, however, by the much larger negative impact from cars being exported to the United States: in the same year, the Big Three imported 697,000 vehicles assembled in Mexico, worth an estimated $11.6 billion. Some $4.8 billion of components was exported from the United States to Mexico to assemble the cars, but, even after deducting these exports, the net effect on the US current account from vehicles assembled in Mexico was a loss of more than $6.8 billion.

This example illustrates why efficiency-seeking foreign direct investment will almost always have a larger impact on the US current account than market-seeking investment. Imports from foreign affiliates are recorded at their full sale price, while income flows are counted only as the profit margin on the underlying sales. This discrepancy is the reason the growth in efficiency-seeking investments in emerging markets has had such a large impact on the US trade balance.

But any negative impact of foreign investment on the trade balance must be weighed against the economic value foreign investment creates. US customers benefit from lower prices, which in turn boost demand. And in the highly competitive global auto market, there is no guarantee that if the vehicles produced in Mexico had instead been produced in the United States by better-paid US workers, and had therefore carried a higher price, those vehicles would have found US buyers.

IT and business process offshoring in India

The newest trend in globalization is not moving manufacturing overseas but, rather, shifting business services to low-wage countries. These are purely efficiency-seeking investments, generating services that will be imported to the company's home market or sent to other countries. Because such investments require very few inputs from the United States, they have an even more negative impact on the current-account balance than the offshoring of production capabilities does. Previous research by MGI estimated that US-produced inputs amounted to just 12 percent of offshore service costs.⁷ In contrast, US exports of auto components to Mexico constituted 40 percent of the cost of finished vehicles.

In 2001, US imports of business services from India alone totaled an estimated $1.5 billion—all of which counted as imports. This figure was offset only slightly by the $200 million that foreign affiliates of US companies earned on these sales. For those who worry about the growing US current-account deficit, it is understandably alarming that the revenues of India's IT- and business-process-outsourcing industries are projected to grow from $8 billion today to more than $200 billion by 2008.⁸

The economic advantages created by the offshoring of services must also be considered, however. As with other forms of foreign investment, a company moves its business processes offshore to increase its competitiveness, lower its cost structure, and offer new products and services to customers at home and abroad. In the long run, offshoring preserves employment at home. From 1991 to 2001, US multinationals added five jobs in the United States for every three jobs created overseas.⁹ Moreover, a 2003 MGI report showed that for every dollar spent on offshoring, nearly $1.50 of value is created, with the vast majority—$1.14—going to the United States.¹⁰

A new perspective on the current-account deficit

In the light of these factors, the view that today's record current-account deficit reflects a weak economy and spells doom for the nation is simplistic. The revenues of the foreign affiliates of US companies totaled some $2.7 trillion in 2002—roughly three times the value of exports from the United States.¹¹ The US Bureau of Economic Analysis estimates that these sales generated $134 billion in income for their US parent companies, adding $2.7 trillion in market capitalization—fully 25 percent of the total (Exhibit 3).

For at least the next decade, we would expect foreign investment by US multinationals to go on adding to the current-account deficit as it is currently measured. After all, globalization is in its infancy. Industries such as consumer electronics and apparel are the furthest along in establishing global production and sales networks, while companies in most other industries are just beginning to tap this potential.¹² We estimate that the global automotive industry, for example, could create an additional $320 billion of value if companies took full advantage of opportunities to offshore production and sourcing.¹³

The good news is that the activities of the foreign affiliates of US companies not only generate higher rates of return but also help attract the foreign savings needed to finance the current-account deficit. During the past decade, flows of private foreign savings into US securities have grown at an annual rate of 17 percent. That figure should reassure observers who worry about the growing dependence of the United States on foreign capital. In fact, we believe it is only natural that foreign savers should help finance the expansion of US multinational companies abroad, since those countries also benefit. The United States acts as the world's financial intermediary, gathering up and allocating global savings to companies that then invest them around the world.

What policy makers can do

The one-third of the US current-account deficit created by the activities of multinational companies will not correct itself soon, even if the dollar continues to lose significant value. Since corporations invest for the long term, even fairly large changes in the dollar's value are unlikely to make a difference—particularly in emerging markets, where land and labor costs are only one-tenth of those in the United States.

Limiting the activities of multinational companies through protectionist legislation, fueled by an outdated view of the world and a misleading interpretation of the data, would be a mistake. Instead the United States should change the way its trade balance is calculated, by taking an ownership-based view of trade and categorizing companies by where they are owned rather than by where their goods are produced.¹⁴ This new metric would count the sales of US foreign affiliates (but subtract imports from them) and would strip out the sales by US affiliates of foreign companies, thus reflecting the full economic activity of US companies no matter where production is based—and result in a much smaller deficit. The US Bureau of Economic Analysis found that the $418 billion current-account deficit in 2002 would have been nearly 25 percent smaller using such an ownership-based view.¹⁵

To tackle the other two-thirds of the current-account deficit, the US government should push for more equitable trade agreements, encourage other countries to open their markets to foreign investment and trade, and urge them not to keep their national currencies artificially weak. The United States runs a significant trade surplus in services, but MGI research has found that it is more successful in some markets than others. In Japan and South Korea, the United States accounts for more than a third of total service imports; in EU countries, that figure is just 15 to 20 percent. US trade negotiators and companies must work to understand why some markets are underpenetrated. If the United States could double its share of service imports to the European Union—matching the European Union's share of service imports by the United States—more than 30 percent of the current-account deficit would disappear.

US policy makers should also tackle the fiscal budget deficit, the part of the global economic imbalance that is directly under US control. The $413 billion deficit in 2004 represents a shortage of US savings—a shortage that must be offset by borrowing from foreigners. This gap boosts the US capital account balance, which, by definition, is offset by downward pressure on the current account. Closing the budget deficit would raise the nation's low savings rate, reduce its current dependence on foreign capital, sustain the attractiveness of the dollar, and ensure that foreign savings are channeled to productive investments in US companies.

At the same time, policy makers should ensure that the fruits of globalization are shared broadly across the population. If US households were encouraged to invest in corporate bonds and equities, people would benefit from the rising wealth of companies. For instance, Reid Cramer of the New America Foundation has proposed the creation of the American Stakeholder Account, an investment account that gives an initial contribution of $2,000 to any child with a Social Security number.¹⁶ These funds would be invested by a custodian in equities, bonds, and other products and then used by individuals to pay for education, housing, or retirement or to start a small business. Workers displaced by trade and offshoring should also be helped through job-retraining programs, generous severance packages, wage insurance,¹⁷ and portable medical and retirement benefits. Such policies can help ease the transition between jobs and, at the same time, help make the US labor force more dynamic and enable the economy's wealth creation engine to flourish. Because the economic dividend to the nation from globalization is potentially so large, these measures are eminently affordable.

Today's debate over the US current-account deficit misses the mark. Roughly one-third of the deficit is caused by foreign subsidiaries that create value for the United States as well as for countries around the world. Focusing on their activities is unhelpful and distracts attention from fiscal irresponsibility in Washington—which poses a far bigger threat to the future economic health of the United States.