Financing the U.S. Trade Deficit

Order Code RL33274 Financing the U.S. Trade Deficit Updated July 22, 2008 James K. Jackson Specialist in International Trade and Finance Foreign Affairs, Defense, and Trade DivisionFebruary 5, 2010 Congressional Research Service 7-5700 www.crs.gov RL33274 CRS Report for Congress Prepared for Members and Committees of Congress Financing the U.S. Trade Deficit Summary The U.S. merchandise trade deficit is a part of the overall U.S. balance of payments, a summary statement of all economic transactions between the residents of the United States and the rest of the world, during a given period of time. Some Members of Congress and other observers have grown concerned over the magnitude of the growing U.S. merchandise trade deficit and the associated increase in U.S. dollar-denominated assets owned by foreigners. The current slowdown in global economic activity has reduced global trade flows and, consequently, reduced the size of the U.S. trade deficit. This report provides an overview of the U.S. balance of payments, an explanation of the broader role of capital flows in the U.S. economy, an explanation of how the country finances its trade deficit or a trade surplus, and the implications for Congress and the country of the large inflows inflows of capital from abroad. The major observations indicate that: !• Foreign official and private investors sharply increased their purchases of U.S. Treasury securities in 2007 as they also increased their purchases of U.S. corporate stocks and bonds. At the same time, foreign official purchases of U.S. Treasury securities rose slowly in 2007 as foreign governments curtailed their purchases of such securities. !2008 in response to uncertainty associated with disruptions in global financial markets. During the same period, foreign private investors sharply reduced their purchases of U.S. corporate stocks and bonds compared with 2007. • The inflow of capital from abroad supplements domestic sources of capital and likely allows the United States to maintain its current level of economic activity at interest rates that are below the level they likely would be without the capital inflows. !• Foreign official and private acquisitions of dollar-denominated assets likely will generate a stream of returns to overseas investors that would have stayed in the U.S. economy and supplemented other domestic sources of capital had the assets not been acquired by foreign investors. This report will be updated as events warrant. Contents Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Capital Flows and the Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The U.S. Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 The U.S. Net International Investment Position . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 List of Figures Figure 1. Foreign Private and Official Purchases of U.S. Treasury Securities, 1997-2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Figure 2. Net Inflows of Private and Official Sources of Capital, 1997-2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Figure 3. Foreign Official and Private Investment Positions in the United States, 1994-2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Figure 4. U.S. and Foreign Investment Position, By Major Component, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 List of Tables Table 1. Selected Indicators of the Size of the Global Capital Markets, 2006 . . . 2 Table 2. U.S. International Transactions, Selected Accounts . . . . . . . . . . . . . . . . 4 Table 3. Summary of the Net Balances by Major Accounts in the U.S. Balance of Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Table 4. Net Foreign Purchases of Long-Term U.S. Securities . . . . . . . . . . . . . . 7 Table 5. U.S. Net International Investment Position . . . . . . . . . . . . . . . . . . . . . 10 Financing the U.S. Trade Deficit Background By standard convention, the balance of payments accounts are based on a double-entry bookkeeping system. As a result, each transaction that is entered into the accounts as a credit must have a corresponding debit and vice versa. This means that a surplus or deficit in one part of the accounts necessarily will be offset by a deficit or surplus, respectively, in another account so that, overall, the accounts are in balance. This convention also means that a deficit in one account, such as the merchandise trade account, is not necessarily the same as a debt.1 The trade deficit can become a debt equivalent depending on how the deficit is financed and the expectations of those who hold the offsetting dollar-denominated U.S. assets. The balance of payments accounts are divided into three main sections: the current account, which includes the exports and imports of goods and services and personal and government transfer payments; the capital account, which includes such capital transfers as international debt forgiveness; and the financial account, which includes official transactions in financial assets and private transactions in financial assets and direct investment in businesses and real estate. When the basic structure of the balance of payments was established, merchandise trade transactions dominated the accounts. Financial transactions recorded in the capital accounts generally reflected the payments and receipts of funds that corresponded to the importing and exporting of goods and services. As a result, the capital accounts generally represented “accommodating” transactions, or financial transactions associated directly with the buying and selling of goods and services. During this early period, exchange rates between currencies were fixed, and private capital flows, such as foreign investment, were heavily regulated so that nearly all international flows of funds were associated with merchandise trade transactions and with some limited government transactions. Since the 1970s, however, private capital flows have grown markedly as countries have liberalized their rules governing overseas investing and as nations have adopted a system of floating exchange rates, where the rates are set by market forces. Floating exchange rates have spurred demand for the dollar. The dollar also is sought for investment purposes as it has become a vehicle itself for investment and speculation. This means that the balance of payments record not only the accommodating flows of capital which correspond to imports and exports of goods and services, but also autonomous flows of capital that are induced by a broad range of economic factors that are unrelated directly to the trading of merchandise goods. 1 For additional information about the causes of the U.S. trade deficit, see CRS Report RL31032, The U.S. Trade Deficit: Causes, Consequences, and Cures, by Craig Elwell. CRS-2 Capital Flows and the Dollar Liberalized capital flows and floating exchange rates have greatly expanded the amount of autonomous capital flows between countries. These capital transactions are undertaken in response to commercial incentives or political considerations that are independent of the overall balance of payments or of particular accounts. As a result of these transactions, national economies have become more closely linked, the process some refer to as “globalization.” The data in Table 1 provide selected indicators of the relative sizes of the various capital markets in various countries and regions and the relative importance of international foreign exchange markets. In 2006, these markets amounted to nearly $600 trillion, or more than 30 times the size of the U.S. economy. Worldwide, foreign exchange and interest rate derivatives, which are the most widely used hedges against movements in currencies, were valued at $396 trillion in 2006, 50% larger than the combined total of all public and private bonds, equities, and bank assets. For the United States, such derivatives total three as much as all U.S. bonds, equities, and bank assets. Table 1. Selected Indicators of the Size of the Global Capital Markets, 2006 in billions of U.S. dollars Gross Total Domestic Official Product Reserves (GDP) World European Union Euro Area United States Japan Emerging Market Countries Bonds, Equities, and Bank Assets Total Stock Debt Market Securities Capitalization Bank Assets Exchange Market Derivatives Total OTC OTC Foreign Interest Exchange Rate DerivDerivatives atives 48,434.4 5,091.5 194,452.7 50,826.6 68,200.9 74,465.2 395,557.0 48,620.0 211,970.0 13,658.0 10,586.1 252.7 73,983.7 13,068.8 23,192.3 37,736.3 N.A. N.A. N.A. 157.5 54,129.5 8,419.1 18,761.1 26,719.2 145,903.0 18,280.0 81,442.0 13,194.7 4,377.1 54.9 56,822.0 19,569.0 27,050.1 10,202.9 154,799.0 40.488.0 74,441.0 879.7 20,109.5 4,795.8 8,723.7 6,590.0 58,329.0 10,579.0 25,605.0 14,262.9 1,932.0 30,984.4 11,692.4 6,072.7 13,219.4 N.A. N.A. N.A. Source: Global Financial Stability Report, International Monetary Fund, April 2008. Statistical Appendix, Table 3. Quarterly Review, Bank for International Settlements, March 2008, Tables 20b and 21b. Total derivatives does not include equity and commodity-linked derivatives. Another aspect of capital mobility and capital inflows is the impact such capital flows have on the international exchange value of the dollar. Demand for U.S. assets, such as financial securities, translates into demand for the dollar, since U.S. securities are denominated in dollars. As demand for the dollar rises or falls according to overall demand for dollar-denominated assets, the value of the dollar changes. These exchange rate changes, in turn, have secondary effects on the prices of U.S. and foreign goods, which tend to alter the U.S. trade balance. At times, foreign governments have intervened in international capital markets to acquire the dollar directly or to acquire Treasury securities in order to strengthen the value of the CRS-3 dollar against particular currencies. In addition, various central banks moved aggressively following the Asian financial crisis in the 1990s to bolster their holdings of dollars in order to use the dollars to support their currencies should the need arise. Furthermore, the dollar is heavily traded in financial markets around the globe and, at times, plays the role of a global currency. Disruptions in this role have important implications for the United States and for the smooth functioning of the international financial system. This prominent role means that the exchange value of the dollar often acts as a mechanism for transmitting economic and political news and events across national borders. While such a role helps facilitate a broad range of international economic and financial activities, it also means that the dollar’s exchange value can vary greatly on a daily or weekly basis as it is buffeted by international events. A triennial survey of the world’s leading central banks conducted by the Bank for International Settlements in April 2007 indicates that the daily trading of foreign currencies through traditional foreign exchange markets2 totals more than $3.2 trillion, up sharply from the $1.9 trillion reported in the previous survey conducted in 2004. In addition to the traditional foreign exchange market, the over-the-counter (OTC)3 foreign exchange derivatives market reported that daily turnover of interest rate and non-traditional foreign exchange derivatives contracts reached $2.1 trillion in April 2007. The combined amount of $5.3 trillion for daily foreign exchange trading in the traditional and OTC markets is more than three times the annual amount of U.S. exports of goods and services. The data also indicate that 86.3% of the global foreign exchange turnover is in U.S. dollars, slightly lower than the 88.7% share reported in a similar survey conducted in 2004.4 The U.S. Balance of Payments Table 2 presents a summary of the major accounts in the U.S. balance of payments over the last six quarters. The data indicate that in 2007 and the first quarter of 2008 the U.S. current account, or the balance of exports and imports of goods, services and transfers, was in deficit, or the United States imported more than it exported. According to the accounts, the United States experienced a deficit in the merchandise trade goods accounts in all four quarters in 2007 and the first quarter of 2008 and a surplus in the services accounts during those five quarters. In the income accounts, which represent inflows of income on U.S. assets abroad relative to 2 Traditional foreign exchange markets are organized exchanges which trade primarily in foreign exchange futures and options contracts where the terms and condition of the contracts are standardized. 3 The over-the-counter foreign exchange derivatives market is an informal market consisting of dealers who custom-tailor agreements to meet the specific needs regarding maturity, payments intervals or other terms that allow the contracts to meet specific requirements for risk. 4 Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in 2007. Bank for International Settlement, September 2007. pp. 1-2. A copy of the report is available at:[http://www.bis.org/publ/rpfx07.pdf] CRS-4 outflows of income earned on U.S. assets owned by foreigners, the net balance of the accounts was in surplus in all four quarters of 2007 and the first quarter of 2008. Table 2. U.S. International Transactions, Selected Accounts (in billions of U.S. dollars) 2006 Current account Balance on current account Balance on goods and services Balance on goods Exports Imports Balance on services Exports Imports Balance on income Income Receipts Income Payments Unilateral current transfers Capital account Capital account transactions Financial account Balance on financial account U.S.-owned assets abroad, net U.S. official reserve assets, net U.S. Government assets, net U.S. private assets, net Foreign-owned assets in the U.S. Foreign official assets, net U.S. Treasury Securities Foreign private assets, net U.S. Treasury Securities Financial derivatives Statistical discrepancy 2007 -788 -731 -753 -700 -838 -819 1,023 1,148 -1,861 -1,968 85 119 434 497 -349 -378 57 82 685 818 -628 -736 -82 -113 2007 II I III IV 2008 I -197 -180 -203 270 -474 24 115 -91 13 187 -174 -30 -194 -179 -206 279 -485 27 120 -93 10 202 -192 -25 -173 -168 -201 295 -497 33 129 -96 23 214 -191 28 -167 -174 -209 303 -512 35 132 -97 36 215 -179 30 -176 -175 -211 318 -529 36 136 -100 30 199 -170 -31 -2 -1 -0 -1 -1 -1 839 774 -1,252 -1,290 2 -0 5 -22 -1,259 -1,267 2,061 2,058 488 411 209 59 1,573 1,647 -58 157 30 6 -47 -41 265 -442 -0 0 -442 693 163 40 529 43 15 -68 194 -524 0 -1 -523 718 89 2 629 -14 -1 1 102 -170 -0 1 -171 266 13 -26 253 67 6 72 213 -154 -0 -23 -131 380 145 43 235 60 -13 -46 124 -287 -0 3 -290 411 174 89 237 69 0 53 -4 Source: Sauers, Renee M., and Kristy L. Howell, U.S. International Transactions: First Quarter of 2008. Survey of Current Business, July, 2008. P. 67. The data also indicate that the U.S. financial accounts were in substantial surplus, because they represent the opposite and offsetting transactions to deficits in the current account. Indeed, the accounting of the balance of payments is such that the surplus in the financial accounts is equivalent to the deficit in the combined balance in the capital account, the statistical discrepancy, and the balance on the current account. The balance in the financial accounts represents the difference between the capital outflows associated with U.S. investments abroad, which are recorded as a negative value, and the capital inflows associated with foreign investment in the United States, which are recorded as a positive value. This investment is a combination of both private and official investments, or investments by private individuals and institutions and investments by governments and governmental institutions, respectively. Data for 2007 indicate that foreign official purchases of U.S. Treasury securities were down substantially from similar purchases in 2006 and private foreign purchases of Treasury securities in 2007 rose sharply CRS-5 from the negative amount recorded for 2006. Data for first quarter of 2008, however, show a strong increase in foreign official purchases of U.S. Treasury securities, while foreign private purchases of U.S. Treasury securities increased slightly over the previous quarter. The data in Table 2 also indicate that private capital flows account for the largest share of both U.S. capital inflows and outflows. Another way of viewing the data is presented in Table 3 which shows the net amount of the flows in the major accounts, or the difference between the inflows and outflows. In 2007, for instance, total net capital inflows representing the net balance on the current account, the capital account, and the statistical discrepancy, were a negative $774 billion, markedly less than the record deficit of $839 set in 2006. This decrease in the overall net capital inflows occurred in part because of a slight decrease in the deficit in trade in manufactured goods and an increase in the surplus in trade in services. Table 3. Summary of the Net Balances by Major Accounts in the U.S. Balance of Payments (in billions of U.S. dollars) Total Net Capital Inflows Total Net Goods Total Net Services Total Net Income Total Net Transfers Total Net Capital Account Statistical Discrepancy Total Net Financial Account Total Net Official Total Net Private Direct Investment Portfolio Investment Other Private (Banks) Financial Derivatives 2000 2001 2002 2003 2004 2005 2006 2007 $-477 $-416 $-570 $-546 $-585 $-777 $-839 $-774 -452 -427 -483 -548 -665 -787 -838 -819 74 64 61 51 48 73 85 119 21 24 7 33 30 48 57 82 -56 -47 -59 -67 -81 -89 -92 -113 -1 -1 -1 -3 -2 -4 -4 -2 -63 -29 -95 -12 85 -18 -47 -41 477 416 570 546 585 777 839 774 42 23 111 251 399 279 496 389 436 393 460 295 186 498 314 379 162 25 -62 -134 -145 117 1 -96 268 295 402 292 374 386 260 442 6 74 120 137 -43 -4 53 33 n.a. n.a. n.a. n.a. n.a. n.a. 30 6 Source: Data developed by CRS from data published by the Department of Commerce. Commerce Department data indicate that foreign private purchases of Treasury securities turned negative between 1998 and 2001 as foreign private investors experienced net sales of Treasury securities, as indicated in Figure 1. By 2002, foreign private investors returned to acquiring Treasury securities, but the amount they acquired remained relatively level at $100 billion per year from 2002 to 2005. In contrast, foreign official net acquisitions of Treasury securities trended slightly upward between 2000 and 2002, but such net acquisitions more than doubled over the 2002 to 2004 period, rising to $261 billion in 2004. In 2005, though, official purchases of Treasury securities plummeted to less than $100 billion and were less than private purchases. In 2006, private foreign investors again reduced their net holdings of Treasury securities. This action was offset by a large increase in acquisitions of Treasury securities by foreign governments, directed at least in part to slow the decline in the international exchange value of the dollar. In 2007, CRS-6 however, foreign private investors accumulated more than $157 billion in Treasury securities, as foreign governments sharply reduced their net purchases of Treasury securities from$209 billion in 2006 to $59 billion in 2007. Figure 1. Foreign Private and Official Purchases of U.S. Treasury Securities, 1997-2007 Billions of dollars $300 $250 Official $200 $150 $100 Private $50 $0 -$50 -$100 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Department of Commerce The deficit in the net capital inflow account was financed by an offsetting net inflow in the financial account. One striking feature of the financial flows is the recent change in the composition of the balances in the net financial account. Except for 2004, total net private inflows were greater than total net official inflows. This trend was reversed in 2004, when net official inflows were nearly double that of the net private inflows, as indicated in Figure 2. In 2006 and 2007, net official inflows exceeded net private inflows. In 2007, foreign private inflows of capital increased by more than 2%, but similar private outflows by U.S. citizens increased by more than 11%, so that the overall net private flows fell in 2007, or were sightly more than half of those received in 2005. The decline in net private inflows in 2007 reflects a higher level of U.S. direct investment abroad, rising to over $335 billion in 2007, from $241 billion in 2006, which is entered into the balance of payments accounts as a negative amount and lower holdings of foreign assets by U.S. banks. Data for 2007 also indicate that the United States again experienced a net positive income inflow from U.S. assets held abroad as U.S. investors received more in income on their investments held abroad than foreign investors received from their investments in the United States. CRS-7 Figure 2. Net Inflows of Private and Official Sources of Capital, 19972007 Billions of dollars $600 $500 Private $400 $300 $200 $100 Official $0 -$100 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: Department of Commerce The data in Table 4 show the total net accumulation of U.S. securities, or the amount of securities purchased less those that were sold, by foreign private and official sources from 2000-2007. The data indicate that in 2007, the net accumulation of U.S. securities fell in 2007 from the amount recorded in 2006, largely due to reduced official purchases of U.S. Treasury securities and corporate stocks. Private foreign investors operating in Asia and through financial centers in the Caribbean increased their net purchases of corporate stocks, while European investors sharply reduced their net accumulations of corporate bonds, which experienced a 40% drop in the net accumulation of such securities. In addition, foreign investors, both private and official reduced their net accumulation of other U.S. government agency bonds. Table 4. Net Foreign Purchases of Long-Term U.S. Securities (in billions of dollars) 2000 2001 2002 2003 2004 2005 2006 2007 Total private and official net purchases of U.S. $437.3 $430.3 $428.3 $520.5 $767.8 $875.7 $982.5 $807.4 securities Total private purchases 394.6 370.7 361.7 311.7 455.6 598.3 542.5 528.4 Corporate stocks Europe United Kingdom Canada Caribbean financial centers 192.5 181.6 71.8 7.7 -20.7 119.5 86.8 37.3 11.7 -5.8 56.1 31.5 14.4 12.9 -17.1 34.3 22.1 0.2 11.5 -2.3 59.5 35.3 28.9 3.9 3.1 88.3 44.0 24.2 21.0 14.8 142.8 94.2 74.8 12.8 34.3 183.4 91.6 68.8 9.3 47.4 CRS-8 Latin America Asia Of which: Japan Africa 2000 2001 2002 2003 2004 2005 2006 2007 3.5 6.8 0.8 0.5 -0.4 -0.4 1.9 1.3 20.0 20.2 23.0 2.8 5.5 8.7 -1.1 29.1 1.9 6.6 12.2 -2.3 4.9 -0.1 -0.8 -5.1 0.4 -0.4 -0.1 0.2 -0.1 0.3 0.1 -0.3 Corporate bonds Europe United Kingdom Canada Caribbean financial centers Latin America Asia Japan Africa Other 166.4 111.7 95.2 3.0 25.0 191.6 108.4 84.1 3.3 49.6 145.4 78.9 55.8 -0.0 35.5 223.2 130.9 89.0 5.2 54.0 254.6 126.3 69.6 6.0 47.1 312.3 199.8 144.7 1.9 40.2 412.3 242.1 192.4 7.9 91.1 246.7 111.2 121.4 12.6 41.4 4.3 21.4 15.6 0.1 0.9 5.0 24.2 6.1 0.3 0.9 4.6 22.7 10.8 0.1 3.6 6.7 24.2 10.5 0.4 1.7 20.2 51.9 33.5 0.6 2.6 7.3 54.4 25.6 0.6 8.1 9.3 53.9 12.3 0.2 7.7 4.6 71.1 38.5 -0.4 6.2 U.S. Treasury bonds Europe Canada Caribbean financial centers Latin America Asia Africa Other -65.3 -54.9 2.1 -5.1 -23.2 -30.2 0.2 1.0 78.4 38.7 -5.0 14.8 91.0 18.1 11.4 6.2 74.1 38.2 16.3 22.1 147.9 65.2 21.8 44.9 -49.5 -37.8 14.7 -10.6 136.5 153.4 -2.9 3.8 -1.2 -7.2 -0.0 1.1 -3.3 8.1 0.0 1.0 3.1 22.3 1.1 3.6 3.0 46.4 -0.2 6.1 -3.4 1.0 0.7 -0.8 10.4 1.3 1.7 2.5 5.5 -20.3 1.1 -2.1 24.5 -42.8 1.5 -1.1 Federal agency bonds Europe United Kingdom Canada Caribbean financial centers Latin America Asia Japan Africa Other 101.0 36.8 28.5 7.6 17.5 82.8 29.6 33.4 -0.7 6.4 81.8 4.7 22.4 -1.9 23.2 -36.8 -29.4 14.6 -4.0 6.0 67.4 13.3 31.4 5.0 11.3 49.8 -11.9 -1.3 12.1 3.0 36.9 11.6 13.6 9.6 29.8 -38.2 53.0 81.0 2.2 -21.9 5.7 33.0 21.3 0.1 0.3 4.6 45.3 12.6 0.2 -2.6 7.5 49.3 16.8 0.3 -1.2 4.9 -11.9 -16.4 0.2 -2.7 1.8 36.4 16.5 -0.1 -0.3 7.1 40.2 15.6 -0.3 -0.4 3.4 -17.7 -5.4 -0.2 0.5 1.9 -73.7 -22.4 -0.1 0.3 Total official purchases U.S. Treasury bonds Other U.S. Government securities Corporate bonds Corporate stocks 42.8 -1.3 40.9 59.6 32.9 20.9 66.5 32.4 30.5 208.7 163.5 39.9 312.2 256.8 41.7 277.4 156.9 100.5 440.0 214.1 191.6 279.0 30.3 182.0 2.0 1.1 3.8 2.0 5.6 -2.0 5.6 -0.3 11.5 2.2 19.1 1.0 28.6 5.8 51.6 15.1 Source: Sauers, Renee, and Kristy L. Howell, U.S. International Transactions: First Quarter of 2008. Survey of Current Business, July 2008. Table 8a. CRS-9 The U.S. Net International Investment Position As indicated above, the data in Tables 2 and 3 show that the trade deficit is accompanied by an equal capital inflow that represents an accumulation of dollardenominated assets by foreigners. Some observers have equated the trade deficit and the associated accumulation of foreign-owned dollar-denominated assets as a debt that the U.S. economy owes to foreigners that will have to be repaid. This characterization, however, is not entirely appropriate. The debts owned by foreign investors represents claims on assets, rather than loans where payments on the principle and interest are specified according to a fixed schedule and where failure to meet the repayment schedule can result in the loans being called in and made payable in full. While foreign investors have expectations of a positive return on their dollar-denominated assets, returns, except for Treasury securities, are not guaranteed, but are subject to market forces. An important feature of claims by foreign investors on U.S. assets is that some or all of the profits or returns on the assets can be repatriated to the home country of the foreign investor, thereby reducing the returns that would otherwise remain in the U.S. economy. According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, and the overall stability of the U.S. economy. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses. While this exchange of assets is implicit in the balance of payments, the Department of Commerce explicitly accounts for this broad flow of dollardenominated assets through the nation’s net international investment position. The U.S. net international investment position represents the accumulated value of U.S.owned assets abroad and foreign-owned assets in the United States measured on an annual basis at the end of the calendar year. Some observers refer to the net of this investment position (or the difference between the value of U.S.-owned assets abroad and the value of foreign-owned assets in the United States) as a debt, or indicate that the United States is a net debtor nation, because the value of foreign-owned assets in the United States is greater than the value of U.S.-owned assets abroad. In fact, the nation’s net international investment position is not a measure of the nation’s indebtedness similar to the debt borrowed by some developing countries, but it is simply an accounting of assets. By year-end 2007, the latest year for which data CRS-10 are available, the overseas assets of U.S. residents totaled $17.1 trillion, while foreigners had acquired about $20 trillion in assets in the United States, with direct investment measured at historical cost. As a result, the U.S. net international investment position was about a negative $2.6 trillion, with direct investment measured at historical cost, as indicated in Table 5. Table 5. U.S. Net International Investment Position (in billions of dollars) Type of Investment 2004 Net international investment position of the United States: With direct investment at current cost -2,245.4 With direct investment at market value -2,355.8 With direct investment at historical cost -2,470.7 Financial derivatives U.S.-owned assets abroad: With direct investment at current cost 9,340.6 With direct investment at market value 10,204.6 With direct investment at historical cost 8,893.3 Financial derivatives U.S. official reserve assets 189.6 U.S. Government assets, other 83.1 U.S. private assets: With direct investment at current cost 9,068.0 With direct investment at market value 9,932.3 With direct investment at historical cost 8,620.7 Direct investment abroad: — At current cost 2,498.5 — At market value 3,362.8 — At historical cost 2,051.2 Foreign securities 3,545.4 Bonds 985.0 Corporate stocks 2,560.4 U.S. claims by US nonbanking concerns 793.6 U.S. claims reported by US banks 2,230.5 Foreign-owned assets in the United States: With direct investment at current cost With direct investment at market value With direct investment at historical cost Financial derivatives Foreign official assets in the United States Foreign private assets: With direct investment at current cost With direct investment at market value With direct investment at historical cost Direct investment in the United States: — At current cost — At market value — At historical cost U.S. Treasury securities U.S. other securities — Corporate and other bonds — Corporate stocks 2005 2006 2007 -1,925.1 -1,850.9 -2,129.9 57.9 -2,225.8 -1,849.3 -2,399.4 59.8 -2,441.8 -1,727.5 -2,653.6 83.5 11,961.6 12,947.8 11,445.3 1,190.0 188.0 77.5 14,381.3 15,900.0 13,900.0 1,239.0 219.9 72.2 17,640.0 19,455.1 17,098.4 2,284.6 277.2 94.5 10,506.0 11,492.2 9,989.7 12,850.3 14,368.9 12,369.0 14,983.7 16,798.8 14,442.1 2,651.7 3,638.0 2,135.5 4,329.3 1,011.6 3,317.7 1,018.5 2,506.5 2,936.0 4,454.6 2,454.7 5,604.5 1,275.5 4,329.0 1,163.1 3,146.7 3,332.8 5,148.0 2,791.3 6,648.7 1,478.1 5,170.6 1,176.0 3,826.2 2,011.9 13,886.7 14,798.7 13,575.2 1,132.1 2,306.3 16,607.1 17,749.2 16,299.4 1,179.2 2,825.6 20,081.8 21,182.6 19,752.0 2,201.1 3,357.0 9,574.2 10,548.8 9,352.2 10,448.3 11,360.3 10,136.8 12,602.3 13,744.4 12,294.6 14,543.7 15,644.5 14,214.0 1,742.7 2,717.4 1,520.7 561.6 3,995.5 2,035.1 1,960.3 1,906.0 2,818.0 1,594.5 643.8 4,353.0 2,243.1 2,109.9 2,151.6 3,293.7 1,843.9 567.9 5,372.4 2,824.9 2,547.5 2,422.8 3,523.6 2,093.0 734.8 6,132.4 3,299.3 2,833.1 11,586.1 12,560.7 11,364.1 CRS-11 Type of Investment 2004 2005 2006 2007 U.S. currency 272.0 280.4 282.6 272.0 U.S. liabilities by U.S. nonbanking concerns 600.2 658.2 797.5 959.5 U.S. liabilities reported by U.S. banks 2,402.2 2,606.9 3,430.3 4,022.2 Source: Nguyen, Elena L., The International Investment Position of the United States at Yearend 2007, Survey of Current Business, July 2008. p. 9. Foreign investors who acquire U.S. assets do so at their own risk and accept the returns accordingly, unlike the debt owed by developing countries where principle and debt service payments are guaranteed in advance. While foreign investors likely expect positive returns from their dollar-denominated assets, the returns on most of the assets in the international investment position, except for bonds, are not guaranteed and foreign investors stand to gain or lose on them similar to the way U.S. domestic investors gain or lose. As Table 5 indicates, the investments in the international investment position include such financial assets as corporate stocks and bonds, government securities, and direct investment5 in businesses and real estate. The value of these assets, measured on an annual basis, can change as a result of purchases and sales of new or existing assets; changes in the financial value of the assets that arise through appreciation, depreciation, or inflation; changes in the market values of stocks and bonds; or changes in the value of currencies. The Department of Commerce also uses three different methods for valuing direct investments that yield roughly comparable estimates for the net position, although the three methods do provide estimates on U.S. direct investment abroad and foreign direct investment that can be considerably different at times.6 The foreign investment position in the United States continues to increase as foreigners acquire additional U.S. assets and as the value of existing assets appreciates. These assets are broadly divided into official and private investments reflecting transactions by governments among themselves and transactions among the public. While the foreign official share of the overall amount of capital inflows has grown sharply as indicated in Table 3, the overall foreign official share of foreign-owned assets in the United States has remained relatively modest. As Figure 3 indicates, official asset holdings were valued at about $3.4 trillion in 2007, or about 17% of the total foreign investment position, a share that has remained relatively stable over the 13-year period of 1993 to 2007. Official assets 5 The United States defines foreign direct investment as the ownership or control, directly or indirectly, by one foreign person (individual, branch, partnership, association, government, etc.) of 10% or more of the voting securities of an incorporated U.S. business enterprise or an equivalent interest in an unincorporated U.S. business enterprise. 15 CFR § 806.15 (a)(1). Similarly, the United States defines direct investment abroad as the ownership or control, directly or indirectly, by one person (individual, branch, partnership, association, government, etc.) of 10% or more of the voting securities of an incorporated business enterprise or an equivalent interest in an unincorporated business enterprise. 15 CFR § 806.15 (a)(1). 6 For additional information, see CRS Report RL32964, The United States as a Net Debtor Nation: Overview of the Net International Investment Position, by James K. Jackson. CRS-12 include such monetary reserve assets as gold, the reserve position with the International Monetary Fund (IMF), and holdings of foreign currency. An important component of foreign official holdings in the United States is the acquisitions of U.S. Treasury securities by foreign governments. At times, such acquisitions are used by foreign governments, either through coordinated actions or by themselves, to affect the foreign exchange price of the dollar. Foreign currency holdings account for a relatively small share of the total foreign investment position.7 Figure 3. Foreign Official and Private Investment Positions in the United States, 1994-2007 Trillions of dollars $16 $14 $12 $10 $8 $6 $4 $2 $0 1994 1996 1998 2000 Foreign official assets 2002 2004 2006 Foreign private assets Source: Department of Commerce Private asset holdings are comprised primarily of direct investment in businesses and real estate, purchases of publicly traded government securities, and corporate stocks and bonds. As indicated in Figure 4, the composition of U.S. assets abroad and foreign-owned assets in the United States differ in a number of ways. The strength and uniqueness of the U.S. Treasury securities markets make these assets sought after by both official and private foreign investors, whereas U.S. investors hold few foreign government securities. As a result, foreign official assets in the United States far outweigh U.S. official assets abroad. Both foreign private and official investors have been drawn at times to U.S. government securities as a safe haven investment during troubled or unsettled economic conditions. 7 For additional information, see CRS Report RL32462, Foreign Investment in U.S. Securities, by James K. Jackson. CRS-13 Figure 4. U.S. and Foreign Investment Position, By Major Component, 2007 US Assets Foreign Assets Total = $17.1 trillion Total = $19.8 trillion Official assets Direct invest. Govt. securities Bonds Stocks Nonbanks US banks $5 $4 $3 $2 $1 $0 Trillions $1 $2 $3 $4 $5 Trillions Source: Department of Commerce Implications The persistent U.S. trade deficit raises concerns in Congress and elsewhere because of the potential risks such deficits may pose for the long term rate of growth for the economy. In particular, some observers are concerned that foreigners will become saturated with dollar-denominated assets and will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded. Another concern is with the outflow of profits that arise from the dollardenominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represent a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital. CRS-14 Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar’s international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions within the domestic economy and an attempt to address the issue of the trade deficit without addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness. In addition, the nation’s net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case. foreign investors. Congressional Research Service Financing the U.S. Trade Deficit Contents Background ................................................................................................................................1 Capital Flows and the Dollar .......................................................................................................1 The U.S. Balance of Payments ....................................................................................................3 The U.S. Net International Investment Position ...........................................................................9 Implications .............................................................................................................................. 14 Figures Figure 1. Foreign Private and Official Purchases of U.S. Treasury Securities, 1997-2008.............6 Figure 2. Net Inflows of Private and Official Sources of Capital, 1997-2008................................7 Figure 3. Foreign Official and Private Investment Positions in the United States, 19942008 ...................................................................................................................................... 13 Figure 4. U.S. and Foreign Investment Position, By Major Component, 2008............................ 14 Tables Table 1. Selected Indicators of the Size of the Global Capital Markets, 2008 ...............................2 Table 2. U.S. International Transactions, Selected Accounts ........................................................4 Table 3. Summary of the Net Balances by Major Accounts in the U.S. Balance of Payments .................................................................................................................................5 Table 4. Net Foreign Purchases of Long-Term U.S. Securities .....................................................8 Table 5. U.S. Net International Investment Position................................................................... 10 Contacts Author Contact Information ...................................................................................................... 15 Congressional Research Service Financing the U.S. Trade Deficit Background By standard convention, the balance of payments accounts are based on a double-entry bookkeeping system. As a result, each transaction that is entered into the accounts as a credit must have a corresponding debit and vice versa. This means that a surplus or deficit in one part of the accounts necessarily will be offset by a deficit or surplus, respectively, in another account so that, overall, the accounts are in balance. This convention also means that a deficit in one account, such as the merchandise trade account, is not necessarily the same as a debt.1 The trade deficit can become a debt equivalent depending on how the deficit is financed and the expectations of those who hold the offsetting dollar-denominated U.S. assets. The balance of payments accounts are divided into three main sections: the current account, which includes the exports and imports of goods and services and personal and government transfer payments; the capital account, which includes such capital transfers as international debt forgiveness; and the financial account, which includes official transactions in financial assets and private transactions in financial assets and direct investment in businesses and real estate. When the basic structure of the balance of payments was established, merchandise trade transactions dominated the accounts. Financial transactions recorded in the capital accounts generally reflected the payments and receipts of funds that corresponded to the importing and exporting of goods and services. As a result, the capital accounts generally represented “accommodating” transactions, or financial transactions associated directly with the buying and selling of goods and services. During this early period, exchange rates between currencies were fixed, and private capital flows, such as foreign investment, were heavily regulated so that nearly all international flows of funds were associated with merchandise trade transactions and with some limited government transactions. Since the 1970s, however, private capital flows have grown markedly as countries have liberalized their rules governing overseas investing and as nations have adopted a system of floating exchange rates, where the rates are set by market forces. Floating exchange rates have spurred demand for the dollar. The dollar also is sought for investment purposes as it has become a vehicle itself for investment and speculation. This means that the balance of payments record not only the accommodating flows of capital which correspond to imports and exports of goods and services, but also autonomous flows of capital that are induced by a broad range of economic factors that are unrelated directly to the trading of merchandise goods. Capital Flows and the Dollar Liberalized capital flows and floating exchange rates have greatly expanded the amount of autonomous capital flows between countries. These capital transactions are undertaken in response to commercial incentives or political considerations that are independent of the overall balance of payments or of particular accounts. As a result of these transactions, national economies have become more closely linked, the process some refer to as “globalization.” The data in Table 1 provide selected indicators of the relative sizes of the various capital markets in various countries and regions and the relative importance of international foreign exchange 1 For additional information about the causes of the U.S. trade deficit, see CRS Report RL31032, The U.S. Trade Deficit: Causes, Consequences, and Cures, by Craig K. Elwell. Congressional Research Service 1 Financing the U.S. Trade Deficit markets. In 2008, these markets amounted to nearly $700 trillion, or more than 30 times the size of the U.S. economy. Worldwide, foreign exchange and interest rate derivatives, which are the most widely used hedges against movements in currencies, were valued at $486 trillion in 2008, 50% larger than the combined total of all public and private bonds, equities, and bank assets. For the United States, such derivatives total nearly three times as much as all U.S. bonds, equities, and bank assets. Table 1. Selected Indicators of the Size of the Global Capital Markets, 2008 (in billions of U.S. dollars) Exchange Market Derivatives Bonds, Equities, and Bank Assets Gross Domestic Product (GDP) Total Official Reserves World 60,917.3 6,787.8 European Union 17,037.4 Euro Area United States Japan Emerging markets Stock Market Capitalization Debt Securities 214,424.0 33,513.1 278.4 46,802.4 13,538.4 167.7 14,441.4 OTC Foreign Exchange Derivatives OTC Interest Rate Derivatives Bank Assets Total 83,529.6 97,381.4 485,973.0 48,775.0 437,198.0 7,262.8 29,137.0 46,802.4 N.A. N.A. N.A. 32,510.8 4,984.7 23,793.3 32,510.8 160,646.0 20,653.0 160,646.0 66.6 56,391.8 11,737.6 30,657.7 13,996.5 194,904.0 40,737.0 154,167.0 4,910.7 1,009.4 24,714.4 3,209.0 11,478.4 10,027.0 68,889.0 11,438.0 57,451.o 20,605.9 4,286.8 34,394.2 8,558.9 7,815.4 18,020.0 N.A. N.A. N.A. Total Source: Global Financial Stability Report, International Monetary Fund, December 2009. Statistical Appendix, Table 3. Quarterly Review, Bank for International Settlements, December 2009, Tables 20b and 21b. Total derivatives does not include equity and commodity-linked derivatives. Another aspect of capital mobility and capital inflows is the impact such capital flows have on the international exchange value of the dollar. Demand for U.S. assets, such as financial securities, translates into demand for the dollar, since U.S. securities are denominated in dollars. As demand for the dollar rises or falls according to overall demand for dollar-denominated assets, the value of the dollar changes. These exchange rate changes, in turn, have secondary effects on the prices of U.S. and foreign goods, which tend to alter the U.S. trade balance. At times, foreign governments have intervened in international capital markets to acquire the dollar directly or to acquire Treasury securities in order to strengthen the value of the dollar against particular currencies. In addition, various central banks moved aggressively following the Asian financial crisis in the 1990s to bolster their holdings of dollars in order to use the dollars to support their currencies should the need arise. The dollar is also heavily traded in financial markets around the globe and, at times, plays the role of a global currency. Disruptions in this role have important implications for the United States and for the smooth functioning of the international financial system. During the decade preceding the current financial crisis, banks and other financial institutions expanded their global balance sheets from $10 trillion in 2000 to $34 trillion in 2007. These assets were comprised primarily of dollar-denominated claims on non-bank entities, including retail and corporate lending, loans to hedge funds, and holdings of structured finance products based on U.S. mortgages and other underlying assets. As the crisis unfolded, the short-term dollar funding markets served as a major Congressional Research Service 2 Financing the U.S. Trade Deficit conduit through which financial distress was transmitted across financial markets and national borders, according to analysts with the Bank for International Settlements (BIS).2 When these short-term dollar funding markets collapsed in the early stages of the crises, the U.S. Federal Reserve had to engage in extraordinary measures, including a vast system of currency swap arrangements with central banks around the world, to supply nearly $300 billion. After initially expanding the then-existing reciprocal currency arrangements (swap lines) with the European Central Bank, the Bank of England, the Swiss National Bank, and the Bank of Japan, the Federal Reserve made an unprecedented announcement in October 2008 that it would provide swap lines to “accommodate whatever quantity of U.S. dollar funding is necessary” to stem the dollar shortage. 3 At the same time, the U.S. Treasury announced a money market guarantee program to stop the withdrawal of funds from the money markets and to offset the withdrawals by providing public funds. The prominent role of the dollar means that the exchange value of the dollar often acts as a mechanism for transmitting economic and political news and events across national borders. While such a role helps facilitate a broad range of international economic and financial activities, it also means that the dollar’s exchange value can vary greatly on a daily or weekly basis as it is buffeted by international events. A triennial survey of the world’s leading central banks conducted by the Bank for International Settlements in April 2007 indicates that the daily trading of foreign currencies through traditional foreign exchange markets4 totals more than $3.2 trillion, up sharply from the $1.9 trillion reported in the previous survey conducted in 2004. In addition to the traditional foreign exchange market, the over-the-counter (OTC)5 foreign exchange derivatives market reported that daily turnover of interest rate and non-traditional foreign exchange derivatives contracts reached $2.1 trillion in April 2007. The combined amount of $5.3 trillion for daily foreign exchange trading in the traditional and OTC markets is more than three times the annual amount of U.S. exports of goods and services. The data also indicate that 86.3% of the global foreign exchange turnover is in U.S. dollars, slightly lower than the 88.7% share reported in a similar survey conducted in 2004.6 The U.S. Balance of Payments Table 2 presents a summary of the major accounts in the U.S. balance of payments over the last seven quarters. The data indicate that in 2008 and in the first three quarters of 2009 the U.S. current account, or the balance of exports and imports of goods, services and transfers, was in deficit, or the United States imported more than it exported. On a quarterly basis, the deficit in the current account declined from the second quarter of 2008 through the second quarter of 2009, 2 McGuire, Patrick, and Gotz von Peter, The US Dollar Shortage in Global Banking and the International Policy Response, BIS Working Paper No. 291, the Bank For International Settlements, October 2009; McGuire, Patrick, and Goetz von Peter, The U.S. Dollar Shortage in Global Banking, BIS Quarterly Review, March 2009. 3 Ibid., p. 76. 4 Traditional foreign exchange markets are organized exchanges which trade primarily in foreign exchange futures and options contracts where the terms and condition of the contracts are standardized. 5 The over-the-counter foreign exchange derivatives market is an informal market consisting of dealers who customtailor agreements to meet the specific needs regarding maturity, payments intervals or other terms that allow the contracts to meet specific requirements for risk. 6 Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in 2007. Bank for International Settlement, September 2007. pp. 1-2. A copy of the report is available at:http://www.bis.org/publ/rpfx07.pdf Congressional Research Service 3 Financing the U.S. Trade Deficit reflecting the slowdown in global trade. According to the accounts, the United States continued experiencing deficits in the merchandise trade goods accounts in all four quarters in 2008 and in the first three quarter of 2009 and a surplus in the services accounts during those seven quarters. In the income accounts, which represent inflows of income on U.S. assets abroad relative to outflows of income earned on U.S. assets owned by foreigners, the net balance of the accounts was in surplus throughout the period. Table 2. U.S. International Transactions, Selected Accounts (in billions of U.S. dollars) 2008 2008 I 2009 II III IV I II III Current account Balance on current account -706 -179 -188 -184 -155 -104 -98 -108 Balance on goods and services -696 -183 -183 -186 -144 -92 -81 -97 Balance on goods -840 -219 -221 -221 -179 -124 -115 -132 Exports 1,277 316 333 338 291 249 245 284 Imports -2,117 -534 -554 -559 -469 -373 -362 -396 Balance on services 144 36 39 35 34 32 34 35 Exports 550 136 140 140 134 123 125 129 Imports -405 -00 -102 -105 -99 -91 -91 -94 Balance on income 118 37 26 34 21 18 17 24 Income Receipts 765 203 199 195 168 135 135 140 Income Payments -646 -166 -173 -161 -148 -117 -118 -117 Unilateral current transfers -128 -33 -31 -32 -32 -30 -33 -34 0 0 0 0 0 0 0 0 505 167 107 143 88 35 63 38 0 -252 107 29 115 95 37 -294 -5 0 -1 0 -3 -1 -4 -49 -530 3 -42 -226 -265 244 194 58 534 -254 150 255 383 -148 -153 -303 Foreign-owned assets in the U.S. 534 428 2 118 -12 -68 15 332 Foreign official assets, net 487 209 179 116 -16 71 124 124 U.S. Treasury Securities 478 106 76 116 179 118 124 124 Foreign private assets, net 47 217 -177 2 4 -139 -110 209 U.S. Treasury Securities 197 16 19 80 81 54 -23 -9 Financial derivatives -29 -8 -2 -4 -15 8 11 0 Statistical discrepancy 200 13 81 38 67 70 35 70 Capital account Capital account transactions Financial account Balance on financial account U.S.-owned assets abroad, net U.S. official reserve assets, net U.S. Government assets, net U.S. private assets, net Congressional Research Service 4 Financing the U.S. Trade Deficit Source: Weinberg, Douglas B., U.S. International Transactions: Third Quarter of 2009. Survey of Current Business, January, 2010. P. 18. The data also indicate that the U.S. financial accounts were in surplus throughout the period, because they represent the opposite and offsetting transactions to the deficits in the current account. Indeed, the accounting of the balance of payments is such that the surplus in the financial accounts is equivalent to the deficit in the combined balance in the capital account, the statistical discrepancy, and the balance on the current account. The balance in the financial accounts represents the difference between the capital outflows associated with U.S. investments abroad, which are recorded as a negative value, and the capital inflows associated with foreign investment in the United States, which are recorded as a positive value. This investment is a combination of both private and official investments, or investments by private individuals and institutions and investments by governments and governmental institutions, respectively. Data for 2008 indicate that foreign official purchases of U.S. Treasury securities nearly quadrupled from similar purchases in 2007 and private foreign purchases of Treasury securities in 2008 more than doubled from the amount recorded for 2007. Foreign official purchases of U.S. Treasury securities remained strong through the first three quarters of 2009, while foreign private purchases of such securities turned negative in the second and third quarters, The data in Table 2 also indicate that official capital flows at times accounted for the largest share of both U.S. capital inflows and outflows in 2008. Another way of viewing the data is presented in Table 3 which shows the net amount of the flows in the major accounts, or the difference between the inflows and outflows. In 2008 for instance, total net capital inflows representing the net balance on the current account, the capital account, and the statistical discrepancy, were a negative $505 billion, markedly less than the deficit of $664 in 2007. This decrease in the overall net capital inflows occurred in part because of an increase in the surplus in the services account and in the income account. These totals may change, however, since they are subject to periodic revisions. Table 3. Summary of the Net Balances by Major Accounts in the U.S. Balance of Payments (in billions of U.S. dollars) 2001 2002 2003 2004 2005 2006 2007 2008 -$400 -$501 -$533 -$532 -$701 -$809 -$664 -$505 -430 -483 -549 -672 -791 -847 -831 -840 Total Net Services 64 61 54 62 76 87 130 144 Total Net Income 32 27 45 67 72 48 91 118 -64 -65 -72 -88 -106 -91 -116 -128 12 -1 -3 1 11 -4 -2 1 -14 -40 -8 97 37 -2 65 200 $400 $501 $533 $532 $701 $809 $664 $505 Total Net Official 23 113 280 402 279 496 459 -47 Total Net Private 378 388 253 130 422 313 205 553 Direct Investment 24 19 11 13 8 2 -11 29 289 335 165 305 331 260 306 131 Total Net Capital Inflows Total Net Goods Total Net Transfers Total Net Capital Account Statistical Discrepancy Total Net Financial Account Portfolio Investment Congressional Research Service 5 Financing the U.S. Trade Deficit 2001 2002 2003 2004 2005 2006 2007 2008 65 34 77 -188 82 51 -90 393 0 0 0 0 0 30 6 -29 Other Private (Banks) Financial Derivatives Source: Data developed by CRS from data published by the Department of Commerce. Commerce Department data indicate that foreign private purchases of Treasury securities turned negative between 1998 and 2001 and in 2006 as foreign private investors experienced net sales of Treasury securities, as indicated in Figure 1. By 2002, foreign private investors returned to acquiring Treasury securities, but the amount they acquired remained relatively level at $100 billion per year from 2002 to 2005. In contrast, foreign official net acquisitions of Treasury securities trended slightly upward between 2000 and 2002, but such net acquisitions more than doubled over the 2002 to 2004 period, rising to $273 billion in 2004. In 2005, though, official purchases of Treasury securities plummeted to $112 billion and were less than private purchases. In 2006, private foreign investors again reduced their net holdings of Treasury securities. This action was offset by a large increase in acquisitions of Treasury securities by foreign governments, directed at least in part to slow the decline in the international exchange value of the dollar. In 2008, foreign private investors accumulated $197 billion in Treasury securities, as foreign governments sharply increased their net purchases of Treasury securities, which rose from $98 billion in 2007 to $478 billion in 2008. Figure 1. Foreign Private and Official Purchases of U.S.Treasury Securities, 19972008 $500 Billions of dollars $400 $300 Official $200 $100 $0 Private -$100 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Department of Commerce The deficit in the net capital inflow account was financed by an offsetting net inflow in the financial account. One striking feature of the financial flows is the way the composition of the balances in the net financial account have changed over the period since 2002. Net private and net official capital inflows have changed abruptly since the period prior to 2002, when private Congressional Research Service 6 Financing the U.S. Trade Deficit inflows were greater than official inflows, as indicated in Figure 2. In 2004, 2006, and 2007, net official inflows exceeded net private inflows. In 2007, foreign private inflows of capital increased by more than 2%, but similar private outflows by U.S. citizens increased by more than 11%, so that the overall net private flows fell in 2007. In 2008, however, private capital flows by U.S. citizens shifted from a net outflow of $1.4 trillion in 2007 to a net inflow of $500 billion in 2008. During the same period, U.S. official outflows increased from $22 billion in 2007 to $530 billion in 2008. In contrast, foreign private inflows of capital dropped from $1.6 trillion in 2007 to $47 billion in 2008. During the same period, foreign official inflows increased slightly from $481 billion in 2007 to $487 billion in 2008. As a result of these changes, net official flows, or the combination of U.S. and foreign officials flows dropped from a net outflow of $458 billion 2007 to a net inflows of $47 billion in 2008. In addition, net private flows increased from a net inflow of $199 billion in 2007 to a net inflow of $581 billion in 2008. Figure 2. Net Inflows of Private and Official Sources of Capital, 1997-2008 $600 Billions of dollars $500 Private $400 $300 $200 $100 $0 Official -$100 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: Department of Commerce The data in Table 4 show the total net accumulation of U.S. securities, or the amount of securities purchased less those that were sold, by foreign private and official sources from 2001-2008. The data indicate that in 2008, the net accumulation of U.S. securities fell sharply from the amount recorded in 2007, largely due to a shift in net private purchases from a net accumulation in 2007 of $644 billion to a net sales of $114 in 2008. Private foreign investors operating in every area but Asia reduced their accumulation of U.S. corporate stocks, Similarly, foreign private investors reduced their accumulation of corporate bonds, reflecting the deteriorating economic and profit conditions of most U.S. firms in 2008. In addition, both private and official investors reduced their net accumulation of other U.S. government agency bonds. Congressional Research Service 7 Financing the U.S. Trade Deficit Table 4. Net Foreign Purchases of Long-Term U.S. Securities (in billions of dollars) 2001 2002 2003 2004 2005 2006 2007 2008 $430.3 $428.3 $520.5 $767.8 $875.7 $1,099.1 $989.6 $245.6 Total private purchases 370.7 361.7 311.7 455.6 598.3 611.4 644.8 -113.7 Corporate stocks 119.5 56.1 34.3 59.5 88.3 139.7 230.5 57.1 Europe 86.8 31.5 22.1 36.3 44.0 92.6 90.5 4.3 United Kingdom 37.3 14.4 0.2 28.9 21.2 73.2 67.9 28.5 Canada 11.7 12.9 11.5 3.9 21.0 12.6 9.8 6.7 Caribbean financial centers -5.8 -17.1 -2.3 3.1 14.8 34.4 95.4 3.0 6.8 0.8 0.5 -0.4 -0.4 1.8 1.1 3.7 20.2 23.0 2.8 5.5 8.7 -2.2 27.9 44.0 6.6 12.2 -2.3 4.9 -0.1 -1.2 -5.6 20.7 -0.4 -0.1 0.2 -0.1 0.3 0.0 -0.4 -4.7 Corporate bonds 191.6 145.4 223.2 254.6 312.3 517.8 383.7 1.0 Europe 108.4 78.9 130.9 126.3 199.8 332.1 225.9 -62.5 84.1 55.8 89.0 69.6 144.7 203.6 130.5 -38.0 3.3 -0.0 5.2 6.0 1.9 7.9 12.4 7.0 49.6 35.5 54.0 47.1 40.2 106.9 61.9 22.2 5.0 4.6 6.7 20.2 7.3 9.3 4.7 1.7 Asia 24.2 22.7 24.2 51.9 54.4 53.7 72.8 32.3 Japan 6.1 10.8 10.5 33.5 25.6 12.2 39.5 21.6 Africa 0.3 0.1 0.4 0.6 0.6 0.2 -0.4 -0.4 Other 0.9 3.6 1.7 2.6 8.1 7.7 6.4 0.7 U.S. Treasury bonds -23.2 78.4 91.0 74.1 147.9 -71.9 39.2 13.0 Europe -30.2 38.7 18.1 38.2 65.2 -61.9 57.8 -65.9 Canada 0.2 -5.0 11.4 16.3 21.8 14.7 -1.9 -5.7 Caribbean financial centers 1.0 14.8 6.2 22.1 44.9 -10.9 -6.2 17.6 -3.3 3.1 3.0 -3.4 10.4 -2.1 9.8 -5.1 Asia 8.1 22.3 46.4 1.0 1.3 -10.7 -20.8 69.3 Africa 0.0 1.1 -0.2 0.7 1.7 1.1 1.5 7.1 Other 1.0 3.6 6.1 -0.8 2.5 -2.1 -1.1 -4.3 82.8 81.8 -36.8 67.4 49.8 25.8 -8.6 -184.8 Total private and official net purchases of U.S. securities Latin America Asia Of which: Japan Africa United Kingdom Canada Caribbean financial centers Latin America Latin America Federal agency bonds Congressional Research Service 8 Financing the U.S. Trade Deficit 2001 2002 2003 2004 2005 Europe 29.6 4.7 -29.4 13.3 -11.9 United Kingdom 33.4 22.4 14.6 31.4 Canada -0.7 -1.9 -4.0 Caribbean financial centers 6.4 23.2 Latin America 4.6 Asia 2006 2007 2008 -8.1 42.3 0.9 -1.3 -8.8 70.9 59.2 5.0 12.1 9.7 3.0 4.9 6.0 11.3 3.0 31.3 -21.6 -100.1 7.5 4.9 1.8 7.1 3.4 2.8 0.8 45.3 49.3 -11.9 36.4 40.2 -10.8 -34.6 -87.8 Japan 12.6 16.8 -16.4 16.5 15.6 2.9 -14.9 -37.2 Africa 0.2 0.3 0.2 -0.1 -0.3 -0.3 -0.6 -2.8 Other -2.6 -1.2 -2.7 -0.3 -0.4 0.6 0.1 -0.8 Total official purchases 59.6 66.5 208.7 312.2 277.4 487.7 344.8 359.3 U.S. Treasury bonds 32.9 32.4 163.5 256.8 156.9 233.5 76.6 205.2 Other U.S. Government securities 20.9 30.5 39.9 41.7 100.5 219.8 171.5 65.8 Corporate bonds 3.8 5.6 5.6 11.5 19.1 28.6 51.6 35.0 Corporate stocks 2.0 -2.0 -0.3 2.2 1.0 5.8 45.1 53.4 Source: Weinberg, Douglas B., U.S. International Transactions: Third Quarter of 2009. Survey of Current Business, January, 2010. Table 8a. The U.S. Net International Investment Position As indicated above, the data in Tables 2 and 3 show that the trade deficit is accompanied by an equal capital inflow that represents an accumulation of dollar-denominated assets by foreigners. Some observers have equated the trade deficit and the associated accumulation of foreign-owned dollar-denominated assets as a debt that the U.S. economy owes to foreigners that will have to be repaid. This characterization, however, is not entirely appropriate. The debts owned by foreign investors represents claims on assets, rather than loans where payments on the principle and interest are specified according to a fixed schedule and where failure to meet the repayment schedule can result in the loans being called in and made payable in full. While foreign investors have expectations of a positive return on their dollar-denominated assets, returns, except for Treasury securities, are not guaranteed, but are subject to market forces. An important feature of claims by foreign investors on U.S. assets is that some or all of the profits or returns on the assets can be repatriated to the home country of the foreign investor, thereby reducing the returns that would otherwise remain in the U.S. economy. According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, the overall stability of the U.S. economy, and the generally held view that U.S. securities, especially Treasury securities, are high quality financial instruments that are low risk. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount Congressional Research Service 9 Financing the U.S. Trade Deficit of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses. While this exchange of assets is implicit in the balance of payments, the Department of Commerce explicitly accounts for this broad flow of dollar-denominated assets through the nation’s net international investment position. The U.S. net international investment position represents the accumulated value of U.S.-owned assets abroad and foreign-owned assets in the United States measured on an annual basis at the end of the calendar year. Some observers refer to the net of this investment position (or the difference between the value of U.S.-owned assets abroad and the value of foreign-owned assets in the United States) as a debt, or indicate that the United States is a net debtor nation, because the value of foreign-owned assets in the United States is greater than the value of U.S.-owned assets abroad. In fact, the nation’s net international investment position is not a measure of the nation’s indebtedness similar to the debt borrowed by some developing countries, but it is simply an accounting of assets. By year-end 2008, the latest year for which data are available, the overseas assets of U.S. residents totaled $19.4 trillion, while foreigners had acquired about $23 trillion in assets in the United States, with direct investment measured at historical cost. As a result, the U.S. net international investment position was about a negative $3.6 trillion, with direct investment measured at historical cost, as indicated in Table 5. Table 5. U.S. Net International Investment Position (in billions of dollars) Type of Investment 2005 2006 2007 2008 Net international investment position of the United States: With direct investment at current cost -1,925.1 -2,225.8 -2,139.9 -3,469.2 With direct investment at market value -1,850.9 -1,849.3 -1,506.6 -4,006.9 With direct investment at historical cost -2,129.9 -2,399.4 -2,334.2 -3,638.1 57.9 59.8 71.5 159.6 With direct investment at current cost 11,961.6 14,381.3 18,278.8 19,888.2 With direct investment at market value 12,947.8 15,900.0 20,055.3 19,260.6 With direct investment at historical cost 11,445.3 13,900.0 17,744.3 19,351.4 1,190.0 1,239.0 2,559.3 6,624.5 188.0 219.9 277.2 293.7 77.5 72.2 94.5 624.1 With direct investment at current cost 10,506.0 12,850.3 15,347.8 12,345.8 With direct investment at market value 11,492.2 14,368.9 17,124.3 11,718.2 With direct investment at historical cost 9,989.7 12,369.0 14,813.3 11,809.0 Financial derivatives U.S.-owned assets abroad: Financial derivatives U.S. official reserve assets U.S. Government assets, other U.S. private assets: Congressional Research Service 10 Financing the U.S. Trade Deficit Type of Investment 2005 2006 2007 2008 Direct investment abroad: —At current cost 2,651.7 2,936.0 3,451.5 3,698.8 —At market value 3,638.0 4,454.6 5,228.0 3,071.2 —At historical cost 2,135.5 2,454.7 2,916.9 3,162.0 Foreign securities 4,329.3 5,604.5 6,835.1 4,244.3 Bonds 1,011.6 1,275.5 1,567.1 1,392.9 Corporate stocks 3,317.7 4,329.0 5,248.0 2,851.4 U.S. claims by US nonbanking concerns 1,018.5 1,163.1 1,239.7 991.9 U.S. claims reported by US banks 2,506.5 3,146.7 3,821.5 3,410.8 With direct investment at current cost 13,886.7 16,607.1 20,418.8 23,357.4 With direct investment at market value 14,798.7 17,749.2 21,561.9 23,267.4 With direct investment at historical cost 13,575.2 16,299.4 20,078.5 22,989.4 1,132.1 1,179.2 2,487.9 6,465.0 2,306.3 2,825.6 3,404.0 3,871.4 With direct investment at current cost 10,446.3 12,602.3 14,526.9 13,021.1 With direct investment at market value 11,360.3 13,744.4 15,670.1 12,931.1 With direct investment at historical cost 10,136.6 12,294.6 14,186.6 12,653.1 —At current cost 1,906.0 2,151.6 2,450.1 2,646.8 —At market value 2,818.0 3,293.7 3,593.3 2,556.9 —At historical cost 1,594.5 1,843.9 2,109.9 2,278.9 643.8 567.9 639.7 885.0 U.S. other securities 4,353.0 5,372.4 6,190.1 4,703.5 —Corporate and other bonds 2,243.1 2,824.9 3,289.1 2,865.9 —Corporate stocks 2,109.9 2,547.5 2,901.0 1,837.6 U.S. currency 280.4 282.6 272.0 301.1 U.S. liabilities by U.S. nonbanking concerns 658.2 797.5 1,000.4 873.2 2,606.9 3,430.3 3,974.6 3,611.4 Foreign-owned assets in the United States: Financial derivatives Foreign official assets in the United States Foreign private assets: Direct investment in the United States: U.S. Treasury securities U.S. liabilities reported by U.S. banks Source: Nguyen, Elena L., The International Investment Position of the United States at Yearend 2008, Survey of Current Business, July 2009. p. 10-18. Foreign investors who acquire U.S. assets do so at their own risk and accept the returns accordingly, unlike the debt owed by developing countries where principle and debt service payments are guaranteed in advance. While foreign investors likely expect positive returns from their dollar-denominated assets, the returns on most of the assets in the international investment Congressional Research Service 11 Financing the U.S. Trade Deficit position, except for bonds, are not guaranteed and foreign investors stand to gain or lose on them similar to the way U.S. domestic investors gain or lose. As Table 5 indicates, the investments in the international investment position include such financial assets as corporate stocks and bonds, government securities, and direct investment7 in businesses and real estate. The value of these assets, measured on an annual basis, can change as a result of purchases and sales of new or existing assets; changes in the financial value of the assets that arise through appreciation, depreciation, or inflation; changes in the market values of stocks and bonds; or changes in the value of currencies. For instance, in 2008, U.S. private holdings abroad declined in value $15.3 trillion to $12.3 trillion due to a large decline in the value of foreign corporate stocks, reflecting the decline in stock market values in nearly all exchanges, combined with a decline in the exchange value of the dollar, which depreciates the value of assets held abroad when translated into dollar equivalents. Similarly, the value of foreign owned corporate stocks in the United States fell sharply in value in 2008, pulling down the overall investment position of foreign investors. The Department of Commerce uses three different methods for valuing direct investments that yield roughly comparable estimates for the net position, although the three methods do provide estimates on U.S. direct investment abroad and foreign direct investment that can be considerably different at times.8 The foreign investment position in the United States continues to increase as foreigners acquire additional U.S. assets and as the value of existing assets appreciates. These assets are broadly divided into official and private investments reflecting transactions by governments among themselves and transactions among the public. While the foreign official share of the overall amount of capital inflows has grown sharply as indicated in Table 3, the overall foreign official share of foreign-owned assets in the United States has remained relatively modest. As Figure 3 indicates, official asset holdings were valued at about $3.8 trillion in 2008, or about 17% of the total foreign investment position, a share that has remained relatively stable over the 14-year period of 1994 to 2008. Official assets include such monetary reserve assets as gold, the reserve position with the International Monetary Fund (IMF), and holdings of foreign currency. An important component of foreign official holdings in the United States is the acquisitions of U.S. Treasury securities by foreign governments. At times, such acquisitions are used by foreign governments, either through coordinated actions or by themselves, to affect the foreign exchange price of the dollar. Foreign currency holdings account for a relatively small share of the total foreign investment position.9 7 The United States defines foreign direct investment as the ownership or control, directly or indirectly, by one foreign person (individual, branch, partnership, association, government, etc.) of 10% or more of the voting securities of an incorporated U.S. business enterprise or an equivalent interest in an unincorporated U.S. business enterprise. 15 CFR § 806.15 (a)(1). Similarly, the United States defines direct investment abroad as the ownership or control, directly or indirectly, by one person (individual, branch, partnership, association, government, etc.) of 10% or more of the voting securities of an incorporated business enterprise or an equivalent interest in an unincorporated business enterprise. 15 CFR § 806.15 (a)(1). 8 For additional information, see CRS Report RL32964, The United States as a Net Debtor Nation: Overview of the International Investment Position, by James K. Jackson. 9 For additional information, see CRS Report RL32462, Foreign Investment in U.S. Securities, by James K. Jackson. Congressional Research Service 12 Financing the U.S. Trade Deficit Figure 3. Foreign Official and Private Investment Positions in the United States, 1994-2008 $16 Trillions of dollars $14 $12 $10 $8 $6 $4 $2 $0 1994 1996 1998 2000 Foreign official assets 2002 2004 2006 2008 Foreign private assets Source: Department of Commerce Private asset holdings are comprised primarily of direct investment in businesses and real estate, purchases of publicly traded government securities, and corporate stocks and bonds. As indicated in Figure 4, the composition of U.S. assets abroad and foreign-owned assets in the United States differ in a number of ways. The strength and uniqueness of the U.S. Treasury securities markets make these assets sought after by both official and private foreign investors, whereas U.S. investors hold few foreign government securities. As a result, foreign official assets in the United States far outweigh U.S. official assets abroad. Both foreign private and official investors have been drawn at times to U.S. government securities as a safe haven investment during troubled or unsettled economic conditions. Congressional Research Service 13 Financing the U.S. Trade Deficit Figure 4. U.S. and Foreign Investment Position, By Major Component, 2008 US Assets Foreign Assets Total = $19.4 trillion Total = $23.0 trillion Official assets Direct invest. Govt. securities Bonds Stocks Nonbanks US banks $5 $4 $3 $2 Trillions $1 $0 $1 $2 $3 $4 $5 Trillions Source: Department of Commerce Implications The persistent U.S. trade deficit raises concerns in Congress and elsewhere due to the potential risks such deficits may pose for the long term rate of growth for the economy. In particular, some observers are concerned that foreigner investors’ portfolios will become saturated with dollardenominated assets and foreign investors will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded. Another concern is with the outflow of profits that arise from the dollar-denominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represent a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital. Congressional Research Service 14 Financing the U.S. Trade Deficit Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar’s international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions within the domestic economy and an attempt to address the issue of the trade deficit without addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness. In addition, the nation’s net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case. Author Contact Information James K. Jackson Specialist in International Trade and Finance jjackson@crs.loc.gov, 7-7751 Congressional Research Service 15