Contents

• Background
• Capital Flows and the Dollar
• The U.S. Balance of Payments
• The U.S. Net International Investment Position
• Implications

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 U.S. merchandise trade deficit and the associated increase in U.S. dollar-denominated assets owned by foreigners. International trade recovered from the global financial crisis of 2008-2009 and the subsequent slowdown in global economic activity that reduced global trade flows and, consequently, reduced the size of the U.S. trade deficit. Now, however, U.S. exporters face new challenges with an increase in the international exchange value of the dollar relative to other key currencies and the slow rate of economic growth in important export markets in Europe and Asia. 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 of capital from abroad. The major observations indicate that

• the following.The current account balance, the broadest measure of U.S. trade in goods, services, and certain income flows, worsened by 3.3% in 2014, after improving by over 18% in 201318% in 2015 from that recorded in 2014. Foreign-owned assets in the United States continued to outpace U.S. ownership of foreign assets, reflecting the deficit in the current account, but the net amount, or the difference between U.S.-acquisition of foreign assets and foreign acquisition of U.S. assets, dropped by nearly three-fourths in 2014about one-third in 2015 compared with 20132014 and down by over half since 2012. The relative decline in foreign acquisitions of U.S. assets in 2014 reflected a sharp drop in foreign official purchases of U.S. portfolio assets, including a decline of 63%2015 reflected a drop in the net private purchases of U.S. corporate stocks and a decline by one-third in net private purchases of U.S. treasury securities. In addition, foreign official purchases of U.S. portfolio purchases shifted from positive net purchases in 2014 to negative net purchases in 2015, including a 38% decline in purchases of corporate stocks and a 58% decline in official purchases of U.S. Treasury securities. Foreign private net purchases of U.S. Treasury securities in 2014 rose slightly above those in 20132015 fell by one-third from those in 2014, but foreign private purchases of U.S. equities more than tripled in 2014increased by 20% in 2015 compared with 20132014. At the same time, foreign direct investment dropped by more than half, from $287 billion in 2013 to $132 billion in 2014increased by 83% in 2015 compared with 2014, rising from $207 billion in 2014 to $379 billion in 2015; U.S. direct investment abroad in 2014 dropped 10% below2015 rose slightly above the amount invested in 20132014, although U.S. net purchases of foreign equities and debt securities increased 13%in 2015 fell by 75%, compared with net purchases in 2014. 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. In general terms, foreign private holders of U.S. Treasury securities are taxed on their interest income, depending on U.S. tax conventions with other countries.

Background

By standard convention, the balance of payments accounts are based on a double-entry bookkeeping system. As a result, each transaction entered 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. In these accounts, exports are recorded as a positive amount even though they represent an outflow of goods and services from the economy, because they represent a credit for which there is a specific obligation of repayment. Similarly, although imports represent an inflow of goods and services to the economy, they are recorded as a negative amount, because they represent a debt that must be repaid.

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 and it serves as a major trade invoicing currency. This means that the balance of payments records 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 markets. In 2013, these markets amounted to over $900 trillion, or more than 50 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 $655 trillion in 2013, more than twice the size of the combined total of all public and private bonds, equities, and bank assets. For the United States, such derivatives total more than three times as much as all U.S. bonds, equities, and bank assets.

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 intervene 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 recent global 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 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 engageengaged 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 20132016 indicates that the daily trading of foreign currencies through traditional foreign exchange markets⁴ totaled $5.31 trillion, up 35down 5% from the $4.05.3 trillion reported in the previous survey conducted in 2010.2013, as indicated in Figure 1.⁵ In addition to the traditional foreign exchange market, the over-the-counter (OTC)⁵6 foreign exchange derivatives market reported that daily turnover of interest rate and non-traditional foreign exchange derivatives contracts reached $2.7 trillion in April 2013.2016.⁷ The combined amount of nearly $8.0 trillion for daily foreign exchange trading in the traditional and OTC markets is more than four times the annual amount of U.S. exports of goods and services. The BIS data also indicate that 8788.0% of the global foreign exchange turnover in April 20132016 was in U.S. dollars, as indicated in Figure 2.⁸ This share was slightly higher lower than the 84.987.0% share reported in a similar survey conducted in 2010.⁶

The U.S. Balance of Payments

Table 2 presents a summary of the major accounts in the U.S. balance of payments over the four quarters of 20142015 and the first quarter of 2015two quarters of 2016. The data indicate that in 2013, 2014, and the first quarter of 2015throughout the period, 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 goods and services than it exported. The current account balance, which is represents the broadest measure of U.S. trade in goods, services, and certain income flows,. The balance worsened by 3.3% in 2014, after improving by over 18% in 201316% from 2014 to 2015. On a quarterly basis, the deficit in the current account has varied from quarter to quarter, although remaining negative, reflecting a broad range of economic activities.

Most economists argue that, given the current composition of the U.S. economy, foreign capital inflows play an important role by bridging the gap between domestic supplies of and demand for capital, or between the total amount of saving in the economy relative to the total amount of investment. Indeed, economists generally argue that it is this interplay between the demand for and the supply of credit in the economy, rather than the flow of manufactured goods and services, that drives the broad inflows and outflows of capital and serves as the major factor in determining the international exchange value of the dollar and, therefore, the overall size of the nation's trade deficit or surplus. Capital inflows, in turn, place upward pressure on the dollar's exchange rate, pushing the exchange value of the dollar up relative to other currencies. As the dollar rises in value, the price of U.S. exports rises and the price of imports falls, which tends to increase the current account deficit.¹⁰

The import role capital flows play in determining the overall trade balance is demonstrated in the recent changes that have occurred in the price of oil and its impact on the U.S. trade deficit. Given the prominent role that energy imports play in the U.S. trade deficit, the U.S. trade deficit might be expected to decline along with the drop in the price of oil that occurred in 2014 and 2015, but this was not the case. From 2014 to 2015, the average price of an imported barrel of crude oil fell by nearly half from an average annual price of $91 per barrel to an average annual price of $47 per barrel, although the price of imported crude oil fell below $40 per barrel by the end of 2015. At the same time that the average price in imported crude oil dropped sharply, the quantity of imported crude oil fell by 1.4%. As a result of this drop in crude oil prices and relatively stable quantity of imports, crude oil imports fell from accounting for more than 40% on average of the annual U.S. merchandise trade deficit in 2012 to about 10% on average of the annual U.S. trade deficit in 2015.¹¹

Despite the drop in the average annual price of imported crude oil and the decline in the role of imported crude oil in the value of the U.S. trade deficit in 2014 to 2016, the U.S. merchandise deficit increased in 2015 over that recorded in 2014. Instead of seeing the overall trade deficit decline, the composition of the trade deficit changed, with non-petroleum products replacing petroleum products, seemingly affirming the proposition that the overall value of the trade deficit is determined primarily by macroeconomic forces.

The data in Table 2 also indicate that in 2014, net private inflows increased by more than 50%, while net official inflows, although positive, fell by two-thirds. The flows in direct investment also experienced significant changes from those in 2013, with U.S. direct investment abroad falling by 10% below that reached in 2013 and foreign direct investment in the United States falling by more than half to $132 billion. The decline in foreign direct investment in 2014 likely reflects a $130 billion stock repurchase transaction that occurred between Verizon and the French-owned Vodafone.

Another way of viewing the balance of payments 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 2014 for instance, total net capital inflows representing the net balance on the current account, the capital account, and the statistical discrepancy, were a negative $239.6 billion, which was equivalent to the offsetting recorded in the financial accounts and is about one-third of that recorded in 2013. These totals are subject to periodic revisions.

Commerce Department data indicate that foreign private net purchases of Treasury securities have shifted between positive and negative changes at various times since the late 1990s, as indicated in Figure 1. Foreign official net acquisitions of Treasury securities have also tended to change abruptly on an annual basis. During the midst of the financial crisis in 2009, foreign private investors had net sales of $15 billion in Treasury securities, down sharply from the $197 billion they accumulated in 2008. Foreign governments, however, increased their net purchases of Treasury securities in 2009, which rose from $478 billion in 2008 to $570 billion in 2009. Foreign official purchases of U.S. Treasury securities exceeded foreign private purchases in 2010, 2012, and in 2013. In 2014, foreign official purchases of treasury securities fell to $89 billion, about one-third of the $253 billion in purchases by private investors in 2013. Over the 2001-2014 period, net foreign official purchases of treasury securities were more than twice as large as net foreign private purchases.

Figure 1. Foreign Private and Official Purchases of U.S. Treasury Securities, 1997-2014

Source: Department of Commerce.

As the data in Table 3 indicate, a deficit in the net capital inflow account is financed by an offsetting net inflow in the financial account. One striking feature of the financial flows over the 2006-2014 period is the way the composition of the balances in the net financial account has changed. Net private and net official capital inflows have changed abruptly at times, as indicated in Figure 2.

Figure 2. Net Inflows of Private and Official Sources of Capital, 2006-2014

Source: Department of Commerce.

The data in Table 4 show the total net accumulation of long-term U.S. securities, or the amount of securities purchased less those that were sold, by foreign private and official sources from 2006 to 2013. The data indicate that in 2008, the net foreign private accumulation of U.S. securities dropped by three-fourths from that recorded in 2007 as foreign private investors withdrew funds from the United States during the financial crisis. In 2009, however, total foreign private and official purchases of U.S. securities increased to reach $485 billion, propelled primarily by net foreign official purchases. Total foreign purchases of U.S. securities grew to reach $573 billion in 2010, reflecting increased net purchases of U.S. corporate stocks and U.S. Treasury securities. Such foreign purchases continued to grow in 2012 to reach $726 billion, before falling in 2013 to $435 billion. Similarly, total private purchases of Treasury securities dropped in 2011 and 2012, but rebounded somewhat in 2013, reaching $205 billion. In 2013, private foreign investors decreased their net purchases of U.S. corporate stock, while increasing their net purchases of corporate bonds. Investors in Europe nearly doubled their net purchases of Treasury securities in 2013 from the amount they purchased in 2012.

The U.S. Net International Investment Position

As indicated above, the data in Table 2 and Table 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 represent claims on assets, rather than loans where payments on the principal 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 otherwise would remain in the U.S. economy. Depending on the tax convention the United States has with other governments, private foreign investors who own U.S. Treasury securities will owe taxes on the interest income.

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 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 2013,The Department of Commerce uses three different methods for valuing direct investments that can yield different estimates for the net position, depending on the stock market value of the investments.¹⁴ For example, by year-end 2015 the overseas assets of U.S. residents totaled $21.0 trillion22.0 trillion, with U.S. direct investment abroad valued at historical cost, while foreigners had acquired about $2628.0 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 $5.16 trillion in 20132015, with direct investment measured at historical cost, but was valued at negative $7.3 with direct investment valued at current cost, as indicated in Table 5. , with direct investment measured at historical cost, as indicated in Table 5. Preliminary data for 2014 indicate that the U.S. net international investment position fell to a negative $6.9 trillion, driven by a large increase in the foreign position in financial derivatives and an increase in the market value of foreign direct investment in the United States compared to a decline in the market value of U.S. direct investment abroad.

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 principal 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 investment⁸15 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, by year-end 20132015, U.S. private holdings abroad had risen in value to $17.722 trillion, with direct investment valued at historical cost, and $19.523.2 trillion and $21.4 trillion with direct investment valued at market costcurrent cost and market value, respectively, reflecting an upward revaluation in the values of foreign corporate stocks due to an increase in stock market values. Similarly, the value of foreign owned corporate stocks in the United States rose in 2013, pulling up the overall investment position of foreign investors. The Department of Commerce uses three different methods for valuing direct investments that can yield different estimates for the net position, depending on the stock market value of the investments.⁹

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 35 indicates, foreign official asset holdings were valued at about $5.96.0 trillion in 20132015, or about 2620% of the total foreign investment position, a share that rose above 20% in 2008 as foreign official holdings of U.S. Treasury securities rose during the global financial crisis. 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.¹⁰

Figure 35. Foreign Official and Private Investment Positions in the United States, 1994-2013 2015

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 46, the composition of U.S. assets abroad and foreign-owned assets in the United States differs 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.

Figure 46. U.S. and Foreign Investment Position, By Major Component, 2013 2015

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 dollar-denominated 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 represents 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.

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 of 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.

Footnotes