Until this happens, trade imbalances will persist. This matters especially to the United States because of the role it plays in anchoring global imbalances. Countries that run large, persistent trade surpluses must acquire foreign assets to balance these surpluses. American assets are particularly attractive for this purpose, and the United States allows nearly unfettered access to these assets. As a result, surplus countries prefer to acquire assets in the United States in exchange for their surpluses, which also means that the United States must run the corresponding trade deficits.

This has important implications for U.S. manufacturing, unemployment, and debt. It means that the U.S. share of global manufacturing must decline while that of surplus countries must rise. Because surplus countries are those that subsidize their manufacturing at the expense of domestic consumption, American manufactures are forced indirectly to subsidize U.S. consumption. This is why, during the past five decades, manufacturing has consistently migrated from deficit countries (mainly the United States) to surplus countries (mainly China). Until global rebalances are resolved, this will continue.

It also means that for all the talk of reshoring and friendshoring, the U.S. trade deficits cannot decline as long as surplus economies can continue to acquire assets in the United States with the proceeds of their surpluses. The United States, in other words, has no choice but to run deficits to balance the surpluses of the rest of the world.

What’s more, while many mainstream economists assume that foreign inflows lower U.S. interest rates and finance U.S. investment, as occurred in the nineteenth century, this hasn’t been the case for decades. Foreign inflows instead force adjustments in the U.S. economy that result in lower U.S. savings, mainly through some combination of higher unemployment, higher household debt, investment bubbles, and a higher fiscal deficit.

To rebalance its economy toward manufacturing while reining in debt and generating higher-paying employment, the United States must either transform the global trading regime or unilaterally opt out of its current role. Not only would this benefit the U.S. economy, but it would also benefit the global economy by eliminating the persistent downward pressure on global demand created by the surplus countries.

This won’t be easy, however. Any meaningful resolution of global trade imbalances will be strongly opposed by surplus countries and would result in a diminished global role for the U.S. dollar. 

HOW DOES INTERNATIONAL TRADE AFFECT THE U.S. MANUFACTURING SECTOR?

Last month, Yao Yang, former dean at the National School of Development at Peking University, said on his blog that “America’s industrial base has already been hollowed out. How can it possibly compete [with China]? The United States has obviously made a strategic mistake.”

He’s right, but perhaps not for the reasons he thinks. While manufacturing comprises roughly 16 percent of global GDP, according to the World Bank, the manufacturing share of China’s GDP is 28 percent, among the highest in the world, whereas for the United States it is 11 percent, among the lowest for any major economy. The opposite is true for consumption. While consumption accounts for 75 percent of global GDP, it accounts for 80 percent of the United States’ GDP and only 53 percent of China’s GDP.

To put it another way, while China comprises less than 18 percent of global GDP, it accounts for over 31 percent of global manufacturing and less than 13 percent of global consumption. The United States, which accounts for 24 percent of global GDP, accounts for less than 17 percent of global manufacturing and nearly 27 percent of global consumption.

While the differences in the two countries’ manufacturing and consumption shares of GDP may seem unrelated, it turns out that they are different expressions of the same imbalance. China and the United States are extreme representatives of a common pattern in the global economy. Manufacturing typically represents a disproportionately large share and consumption a low share of the GDP of non-commodity economies with large, persistent surpluses. The reverse is true for advanced economies that run large, persistent deficits.

This clearly isn’t a coincidence, but in which direction does the causality run? Do countries have larger manufacturing sectors because they are surplus countries, or do they run surpluses because they have larger manufacturing sectors? For many years, economists have argued that it is the latter. Surplus economies, they claim, have a comparative advantage in manufacturing that leads them to produce tradable goods more efficiently, and this is why they export more than they import. Deficit countries like the United States, on the other hand, have a comparative disadvantage in manufacturing.

But this misunderstands altogether the meaning of comparative advantage. As I explain below, surplus economies run surpluses mainly because of industrial policies that implicitly or explicitly force households to subsidize the manufacturing sector. Their competitive advantage in manufacturing comes not from comparative advantage but rather from transfers that distort comparative advantage and reduce domestic demand.

WHAT IS THE RELATIONSHIP BETWEEN COMPETITIVE MANUFACTURING AND WEAK DOMESTIC DEMAND?

In these persistent surplus economies, weak domestic demand is simply the flip side of policies that result in manufacturing competitiveness. The manufacturing sector is subsidized directly or indirectly by households, which leaves them more competitive and leaves households less able to purchase a substantial share of what they produce.

But in order to balance these surpluses, the opposite transfers must occur in the deficit countries. Just as consumers are forced to subsidize producers in the surplus countries through various explicit and implicit transfers, producers are effectively forced to subsidize consumers in the deficit countries.

There are many forms these transfers can take, but the easiest one to understand is through currency values. An undervalued currency, typical of surplus countries, affects trade imbalances by raising the cost of imports and increasing the profits of exporters. It results, in other words, in an implicit transfer from importers to exporters. Because households are all net importers, and because net exporters are mostly manufacturers, these implicit transfers subsidize the manufacturing sector at the expense of households. This makes the manufacturing sector in that country more competitive while reducing the capacity of households to consume.

The opposite happens in the deficit countries. An undervalued currency for one country is the obverse of an overvalued currency for its trade partner, and this overvaluation also represents an implicit transfer, in this case from net exporters (manufacturers) to net importers (households as consumers). Just as manufacturers are subsidized by consumers in the former, so are consumers subsidized by manufacturers in the latter, making their manufacturing sectors less competitive globally.

It is not surprising, then, that global manufacturing naturally migrates from deficit countries to surplus countries, while global consumption migrates in the opposite direction. This has nothing to do with comparative advantage. Manufacturers in both economies are simply responding to the direction of subsidies.

Although I use undervalued and overvalued currencies as an easy illustration of how these transfers between producers and consumers affect trade, they are not the only, nor even the most important, of such transfers. Repressed interest rates, for example, have often been far more important, along with overinvestment in infrastructure, wage repression, and several other implicit or explicit transfers that subsidize manufacturers at the expense of households. (See appendix 1 for a list of such transfers and how they subsidize manufacturing at the expense of households.)

CAN TRADE INTERVENTION BE USED TO MAKE TRADE FREER?

There is no meaningful difference between trade-oriented policies and most forms of industrial policy. Any economic, monetary, or fiscal policy that affects the balance between a country’s domestic savings and its domestic investment must necessarily affect that country’s trade balance, and through its trade balance, it must necessarily affect the balance between the domestic savings and domestic investment of its trade partners. In a closed global economy, where savings must equal investment, any policy that forces up the savings rate in one sector must be balanced by either higher investment or lower savings elsewhere.

That’s where trade intervention can lead to freer trade. Trade surpluses that are caused by beggar-thy-neighbor industrial policies—designed to improve international competitiveness by suppressing domestic demand—can only exist to the extent that they are matched by trade deficits in other countries. In that case, if the deficit countries implement interventionist trade or capital polices directed at reducing their deficits, these will automatically force surplus countries to reverse their own beggar-thy-neighbor policies. This in turn will force an adjustment in the global trading regime such that global trade is once again based on comparative advantage and contributes to expanding global production, not to suppressing global demand.

The point is that there are a wide range of policies that can cause global trade distortions, and while some of these policies can target trade, many of them don’t do so explicitly. That’s why in the interests of a well-functioning global trade environment it is better to target overall trade imbalances, as John Maynard Keynes proposed at the Bretton Woods Conference in 1944, than it to target specific trade violations.

While the World Trade Organization and other existing trade regulatory entities have focused on the latter, they have left us with a world of massive, persistent trade imbalances and perverse capital flows. These conditions are prima facie evidence that existing trade regulatory entities have failed to manage global trade appropriately. That’s why the United States, and most of the rest of the world, would be better off with a radical reorganization of the global trading system.

Michael Pettis is a nonresident senior fellow at the Carnegie Endowment for International Peace. An expert on China’s economy, Pettis is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.

To read the full analysis as it is posted on the Carnegie Endowment for International Peace’s China Financial Markets blog, click here.

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The memos below contain the Climate 21 Project’s recommendations for 11 White House offices, federal departments, and federal agencies, as well as cross-cutting recommendations on personnel and hiring.

Importantly, the Climate 21 Project is not offering a policy agenda. Rather, the memos below contain recommendations that can help the President hit the ground running and build the capacity of his administration to tackle the climate crisis quickly with the existing tools at hand.

The recommendations are focused in scope on areas where the contributors have the most expertise. An all-of-government mobilization on climate change will require important work by additional federal departments and agencies that were not examined by the Climate 21 Project.

To view the recommendations, please click the links below:

Transition Recommendations for Climate Governance and Action

Executive Office of the President

Office of Management and Budget

Environmental Protection Agency (EPA)

Department of the Interior

Department of Energy

United States Department of Agriculture (USDA)

Department of Transportation

Department of State

Department of Justice

National Oceanic and Atmospheric Administration (NOAA)

Department of the Treasury

Attracting and Hiring Climate Change Talent

© 2020 Nicholas Institute for Environmental Policy Solutions.

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The impact of the crisis has not been consistent across sectors or geographies, of course. Travel and entertainment, which had been among the most advanced e-commerce sectors, was hit particularly hard and faces an uncertain path to recovery. Payments providers in regions that have lagged in digitization, meanwhile, in many cases possess greater potential for revenue increases in the new environment. On the other hand, a protracted period of low interest rates, which began before the current crisis, will pressure payments revenues, as will a persistent slowdown in economic activity.

This is the context in which we release our annual report on the global payments industry. As always, these insights are informed by McKinsey’s Global Payments Map and by continuing dialogue with practitioners throughout the payments ecosystem.

Given the impact of the changes and challenges in 2020, however, we are taking a different lens to our analysis, focusing more on the current moment and on the future, than on examining past growth. Our first chapter briefly tells the story of 2019—a solid year with broad-based revenue growth—but focuses primarily on current developments and takes a forward-looking view of the payments landscape. It also details the actions we believe payments providers will need to take to weather the pandemic and position themselves for the “next normal.”

Our “now-cast” analysis of 2020 paints a contrast between the first and second halves of the year— namely, an estimated 22 percent payments revenue decline in the first half will be softened somewhat by stronger performance in the second half. Still, we expect full-year 2020 global payments revenue to be roughly 7 percent lower than it was in 2019—a $140-billion decline roughly equal to recent years’ annual gains, and 11 to 13 percent below our prepandemic projection. Beyond this, in some countries and segments, the likely sustained increase in digital penetration could result in a recovery of revenue pools to levels matching our pre-COVID-19 expectations for 2021.

In following chapters, we explore four areas of payments we consider critical to achieving success in the context of accelerated change. Like many aspects of payments, the merchant-acquiring business was already undergoing significant transformation. Consolidation had driven scale economy imperatives, and non-bank market entrants were gaining inroads with underserved verticals. Our experts detail the need to redefine acquiring offerings to encompass a full suite of value-added services extending well beyond payments settlement—including fraud controls and cart optimization for the fast-growing e-commerce segment. In a separate chapter we look at the specific opportunity for small- and medium-size enterprises, a segment that has historically been expensive to serve for large incumbents, but which has been the focus of many fintech attackers and is well overdue for a closer look.

Supply chain finance has long been considered to be a source of untapped value, but unlike other payments sectors, has struggled to develop enough momentum to address its structural challenges.

Given an expected increased focus on working capital, a step change in digital adoption at scale, and the potential geographic re-shuffling of roughly $4 trillion of cross-border supply chain spending in the next five years—the value embedded in supply chain finance will become even more attractive. The question is whether it will be enough to spur a long anticipated transformation.

Finally, in this overview of global payments, we look at a challenge many established payments providers are facing—the need to transform the operating model to meet the growing imperatives for efficiency, scale, modularity (e.g., Payments-as a-Service), and global interoperability. With many banks likely unwilling to commit the hundreds of millions of investment dollars needed to modernize existing payments infrastructure, we outline various paths worth considering before more focused players can establish an insurmountable advantage.

We hope you find the insights in these pages thought-provoking and valuable as you navigate these uncertain times.

To download the full report, please click here.

Alessio Botta is the Leader of the Europe Payments Practice at McKinsey & Company. 

Philip Bruno is the Co-leader of the North America Payments Practice at McKinsey & Company.

Reet Chaudhuri is the Leader of the Asia Payments Practice at McKinsey & Company.

Marie-Claude Nadeau is the Co-leader of the North America Payments Practice at McKinsey & Company.

Gustavo Tayar is the Leader of the Latin America Payments Practice at McKinsey & Company.

Carlos Trascasa is the Leader of the Global Payments Practice at McKinsey & Company.

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Despite these reasons for optimism, the promise remains unfulfilled. Growth in Africa has stalled; both the IMF and the World Bank have cut their 2019 economic growth projections for sub-Saharan Africa (SSA) to 3.5% and 2.8%, respectively, with growth in 2018 at 2.3%. Poverty has increased — 437 million of the world’s extreme poor are in SSA — and 10 of the 19 most unequal countries in the world are in SSA. The World Bank projects that if poverty reduction measures and growth remain sluggish, Africa could be home to 90% of the world’s poor by 2030.

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The international foreign exchange market is a vast, complex assortment of globally dispersed actors and transactions that comprise millions of transactions daily, valued at trillions of dollars. On a daily basis, the value of global foreign exchange transactions eclipses the total global value of economic output and the value of all traded stocks and bonds. These markets are highly liquid as a result of extensive global communications systems and electronic trading venues that operate on a 24-hour basis. Foreign exchange markets respond rapidly to political and economic events and instantaneously transmit market signals across national borders. Governments are adopting or considering regulations to curtail some aspects of the foreign exchange derivatives market and are examining challenges posed by digital currencies.

Unexpected or abrupt disruptions in the foreign exchange market, and the global economy more broadly, can roil financial markets and economies around the globe with broad implications for economic activity. For instance, in January 2015, Switzerland removed the cap it had placed on the foreign exchange value of its currency; in August 2015, China depreciated its currency; and in June 2016, British voters endorsed a referendum to pull the United Kingdom out of the European Union. In 2018 and 2019, swings in financial markets reflected concerns over on-again, off-again trade talks between the United States and China. In each case, global financial markets experienced large shifts in positions over a short period of time.

Foreign Exchange Transactions

Foreign exchange (FX) markets facilitate international commerce by making it possible for firms to exchange currencies for exporting and importing goods and services. The markets also supply currencies for foreign investment, for purchases of financial instruments, and to currency traders attempting to gain profits from short-term fluctuations in exchange rates. Some governments also hold foreign currencies as reserves to protect against fluctuations in currency exchange rates.

Trading in the foreign exchange market occurs in both traditional markets with organized exchanges and standardized products and in the over-the-counter (OTC) market that is informal with uniquely crafted products. Through international efforts, governments are attempting to standardize reporting and transactions in the OTC market. Traditional foreign exchange transactions consist of four kinds: spot transactions, forward transactions, swaps, and options. Spot and forward transactions are agreements that involve trading currencies immediately at the market exchange rate (spot transactions) or at some pre-arranged time in the future and at a pre-arranged rate of exchange (forward transactions). A swap is a contract to exchange currencies and to pay or receive interest payments over the duration of the contract. An option is a flexible forward transaction that allows the owner of the option to buy or sell a specific amount of foreign currency at a certain price before the pre-determined expiration date of the option contract. Over-the-counter foreign exchange derivative market transactions consist largely of interest rate contracts (primarily interest rate swaps and forward rate agreements in a single currency that are designed to manage exposure to changes in interest rates over the duration of the swap).

Foreign Exchange Market

Market Activity. According to a triennial survey of the world’s leading 53 central banks and monetary authorities conducted by the Bank for International Settlements (BIS) in April 2019, spot transactions and foreign exchange swaps dominate the traditional foreign exchange markets, as indicated in Table 1. Daily turnover in these foreign exchange markets totaled more than $6.6 trillion in the survey, while daily turnover in the OTC market totaled $6.5 trillion, primarily in interest rate instruments (swaps). In total, daily foreign exchange turnover was $13.1 trillion, nearly double the value of daily transactions recorded in the previous survey in April 2016. 

The BIS indicated that the sharp increase in the daily OTC turnover in interest rate derivative contracts in 2019 compared with 2016 reflects increased hedging and shifting of positions associated with concerns over monetary policy and global economic growth prospects, more comprehensive reporting, and the increased use of shorter term contracts.

In the United States in April 2019, the outstanding daily turnover in notional amount of traditional foreign exchange contracts totaled $800 billion, while the comparable daily turnover in interest rate contracts totaled $3.3 trillion. The combined U.S. daily foreign exchange market turnover activity amounted to $4.1 trillion, about one-third the total daily global foreign exchange market turnover activity. Notably, the total daily foreign exchange turnover in the U.S. market was more than double the annual amount of U.S. exports of goods and services. Similarly, the daily global foreign exchange market turnover was more than five times the annual amount of U.S. exports of goods and services.

Markets by Geographic Region. Foreign exchange trading activity is dominated by a few geographic locations, as indicated in Figure 1. London is the largest trading center, accounting for 41% of global volume. This share, however, may change as a result of Brexit (the British exit from the European Union), The United States (New York) accounts for less than half the U.K. share, or 17% of global trading. The next six countries—Singapore (7.6%), Hong Kong (7.6%), Japan (4.5%), Switzerland (3.3%), and France (2.0%)—combined with the U.K. and U.S. shares— account for about 85% of all daily foreign exchange market turnover.

The Role of the Dollar. The U.S. dollar is the most heavily traded currency in FX markets, as indicated in Figure 2. It accounts for 88% of daily foreign exchange market turnover. (Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%.) In comparison, the euro accounts for 32% of trades, the Japanese yen accounts for 17%, and the British pound accounts for 13%. Other currencies account for smaller shares: Australian dollar (7.0%), Canadian dollar (5.0%), Swiss franc (5.0%), and Chinese renminbi (4.3%).

As the dominant global reserve currency, the dollar is used to fund an array of financial transactions, including: Serving as an invoicing currency to fund commercial activities in international trade, even among countries that do not use the dollar as their national currency.

• Accounting for two-thirds of global central bank reserves, which central banks can use to intervene at times to protect their currencies from the spillover effects of global crises.
• Accounting for more than half of non-U.S. banks’ foreign currency deposits.
• Accounting for almost two-thirds of non-U.S. corporate borrowings from banks and the corporate bond market. Regulatory reforms that require financial institutions to hold safe and liquid assets as a buffer against adverse financial shocks have added to the global demand for dollars.

Issues for Congress

Through the Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203), Congress moved to regulate parts of the foreign exchange derivatives (swap) markets by: (1) registering and regulating swap dealers and major swap participants; (2) implementing clearing and trade execution requirements for certain foreign exchange swaps; and (3) establishing record keeping and reporting requirements. Congress may choose to use its oversight role to ensure that the new requirements promote transparency and greater stability in the foreign exchange derivatives market and to determine if new laws or regulations are necessary. The emergence of digital currencies and the increased role in international markets of currencies such as the Chinese renminbi may pose challenges for the dollar over the long run as the global economy’s dominant reserve currency. Also, Brexit may shift some foreign exchange trading from London to other locations in Europe, but may affect trading activity in New York. Congress may choose to assess and evaluate the continuing role of the dollar as the dominant global reserve currency and possible implications for U.S. economic and financial policies.

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