Order Code RS21951
Updated July 5, 2006
CRS Report for Congress
Received through the CRS Web
The U.S. Trade Deficit: Role of Foreign
Governments
Marc Labonte and Gail Makinen
Government and Finance Division
Summary
The nation’s trade deficit is equal to the imbalance between national investment
and national saving. National saving is the sum of household saving, business saving,
and public sector saving (a budget deficit equals public sector borrowing). In the 1990s,
this imbalance was largely due to a private investment boom and decline in private
saving. In the 2000s, private investment fell and private saving rose. All else equal, this
should have led to a smaller trade deficit. However, all else was not equal — the public
sector budget moved from a surplus of 2.4% of GDP in 2000 to a deficit of 2.6% in
2005. Thus, while the borrowing needs of the private sector declined, the public sector
borrowing needs increased, and the national saving-investment gap continued to be
filled by foreign lending. The composition of capital inflows also changed. During
2002-2004, they came increasingly from official rather than private sources, as a few
Asian countries purchased U.S. assets to moderate or prevent their currencies from
appreciating against the dollar. During 2005, the 1990s pattern returned. If net capital
inflows should decline sharply, the dollar and trade deficit would decline, U.S. interest
rates would rise, and U.S. spending on capital investment and consumer durables would
fall, all else equal. This report will be updated as events warrant.
By accounting identity, the U.S. current account balance (which consists primarily
of the trade balance) must equal the financial (formerly the capital) account balance or the
net international flow of capital. That is because a country borrows from abroad only if
it imports more than it exports.1 Capital outflows represent foreign assets purchased by
Americans, whereas capital inflows are U.S. assets purchased by foreigners. Also by
identity, U.S. spending on capital goods (investment) must equal national saving plus net
capital flows. National saving consists of private saving (household and business saving)
and public sector saving (federal, state, and local government saving). When the public
sector runs a budget deficit, it has a negative saving rate, which reduces national saving.
1 For more information, see CRS Report RL30534, America’s Growing Current Account Deficit,
by Marc Labonte and Gail Makinen, and CRS Report RL31032, The Trade Deficit: Causes,
Consequences, and Cures, by Craig Elwell.
Congressional Research Service ˜ The Library of Congress

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These identities are useful when attempting to provide a proximate explanation for
why the U.S. trade deficit has stayed at very high levels from the late 1990s, a period of
rapid economic expansion, through the recession of 2001, and to the present.
The 1990s Experience
In the late 1990s, the United States experienced an investment boom and a decline
in the private saving rate. As can be seen in Figure 1, there was a widening gap between
the private saving and investment rates as the decade progressed. The result was a
growing trade deficit to fill that gap — from 1.3% of GDP in 1997 to 4% of GDP in 2000.
Although the public sector budget balance improved as the decade progressed, moving
to surplus in 1998, this shift was not large enough to offset the growing private saving-
investment imbalance, and the trade deficit continued to grow. So paradoxically for
some, the budget deficit and trade deficit did not move in the same direction, as had
occurred in the 1980s. The reason was that all else did not remain constant — spending
on capital goods (investment) rose and private saving fell.
Figure 1: U.S. Saving, Investment, Budget Balance, and Trade
Balance
25%
private
20%
saving
15%
domestic
P 10%
D
investment
5%
f G
government
0%
%o
saving
-5%
trade
-10%
balance
1991 1994 1997 2000 2003
Source: Bureau of Economic Analysis (BEA), U.S. Department of Commerce.
Notes: Private saving equals household and business saving. (Net) government saving equals
the combined budget balance of the federal and state and local sector. Domestic investment
includes private and public investment. The trade balance measure used in this chart is measured
as the current account deficit in the BEA saving and investment tables. BEA measures
government saving on a calendar year basis using a different definition than in budget documents.
Why did the 1990s investment boom lead to a growing trade deficit and an
appreciating dollar? The substantial acceleration in productivity growth that began in the
last half of the 1990s undoubtedly increased the real rate of return on U.S. capital. Since
this rise in productivity was largely an American phenomenon, real rates of return in the
U.S. rose relative to those abroad and this served to increase the attractiveness of U.S.
assets. The response of foreigners (and Americans) was to substitute American assets for

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non-American assets in their portfolios.2 To buy American assets, foreigners had first to
buy dollars. This drove up the price of the dollar on the foreign exchange market (the
dollar appreciated) and, as explained above, this led to a growing trade deficit.
The 2000s Experience (2000-2004)
The American investment boom came to an abrupt halt with the 2001 economic
recession. Domestic investment spending fell from 22% of GDP in 2000 to 18% of GDP
in 2003. Over that period, private saving varied from 13.6% of GDP in 2000 to 15% of
GDP in 2002-2004. Since the trade deficit reflects the imbalance of saving and
investment, one might assume that the change in saving and investment would result in
a smaller trade deficit, all else equal. However, other things were not equal during this
period — the public sector went from being a net contributor to national saving, running
a budget surplus of 2.4% of GDP in calendar year 2000, to a net borrower, running a
budget deficit of 2.6% of GDP in 2005.3 The shift in the fiscal position meant that the
overall shortfall of national saving relative to investment in the 2000s was roughly the
same as the 1990s even though the borrowing needs of the private sector were much
diminished. It also meant that long-term interest rates did not fall as much as they
otherwise would have.4
Investors choose where to buy assets based on the (risk-adjusted) rate of return. The
Federal Reserve had an important influence on interest rates from 2000 to 2003, lowering
short-term interest rates from 6.5% to 1%. It might be expected that the fall in interest
rates that accompanied the investment slowdown and the steep stock market decline of
mid-2000 to 2002 made the U.S. economy a less attractive destination for foreign capital.
As can be seen in Figure 2, this was generally the case. Annual private capital inflows
fell from about $1 trillion in 2000 to $0.6 trillion in 2003. However, at the same time that
the U.S. was experiencing an economic downturn, so was much of the rest of the world,
and American purchases of foreign assets also fell sharply, from $0.6 trillion in 2000 to
$0.3 trillion in 2003. In 2004, however, private inflows increased sharply to $1.0 trillion,
but private capital outflows grew even more rapidly to $0.9 trillion, so that net private
inflows declined to $0.2 trillion.
Based on the decline in net private capital flows, one would have expected the trade
deficit to decline by about $200 billion from 2002 to 2004. This did not occur because
of an increase in official capital inflows — primarily, purchases of U.S. assets by foreign
central banks.
2 For more information on foreign lending to the United States, see CRS Report RL32462,
Foreign Investment in U.S. Securities, by James Jackson.
3 Most of the fiscal shift from 2000 to 2005 came at the federal level, since state and local
governments have balanced budget rules. The federal budget shifted from a surplus of 1.9% of
GDP in 2000 to a deficit of 2.6% of GDP in 2005 (down from 3.5% in 2003 and 2004).
4 This was the same logic behind the “twin deficits” argument made in the 1980s. See CRS
Report RS21409, The Budget Deficit and the Trade Deficit: What Is the Connection? by Marc
Labonte and Gail Makinen.

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Figure 2: Composition of U.S. Private Capital Flows
1200
1000
private outflow
f $
800
o
600
private inflow
ns
400
io
ll
200
bi
net private
0
inflow
-200
1995 1997 1999 2001 2003 2005
Source: Bureau of Economic Analysis.
As seen in Figure 3, net private inflows tracked net total inflows very closely from
1997 to 2001. But between 2002 and 2004, net total inflows kept climbing while net
private inflows first stabilized in 2002 and then declined. The two diverged because of
the sharp rise in net official capital inflows from $0 in 2001 to $353 billion in 2004. Five
countries had very large official foreign exchange reserve accumulations: from 2002 to
2005, official foreign exchange reserves increased by $530 billion in China, $64 billion
in India, $373 billion in Japan, $89 billion in Korea, and $92 billion in Taiwan. (These
increases represent foreign reserve assets originating from all countries; data for assets
from only the U.S. are not available.)
Figure 3: U.S. Net Capital Inflows by Type
1000
800
600
$
net official inflow
400
of
s
net private inflow
200
0
illion
b -200
19951996199719981999200020012002200320042005
Source: Bureau of Economic Analysis.

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The decline in net private capital flows placed downward pressure on the U.S. dollar
since foreigners needed to buy fewer dollars to buy U.S. assets. But the rise in net official
capital inflows tempered that decline, and the dollar has fallen 11% in real terms since its
peak in February 2002. When one examines the depreciation of the dollar since then, it
is due mainly to a decline against the euro (30%), the Canadian dollar (20%), and the
British pound (22%). In all three areas, short-term interest rates during 2002-2004
remained higher than in the United States.5 The dollar declined by 17% in nominal terms
against the Japanese yen and stayed constant with the Chinese yuan. Japan is linked to
the United States with a flexible exchange rate, whereas China formally maintains a fixed
exchange rate.
Although Japan allows its currency to float, it would appear that the government is
committed to a policy of moderating the yen’s appreciation relative to the dollar so as not
to nip Japan’s revival of economic growth in the bud and add deflationary pressures to the
Japanese price level.6 This means that as relative private demand for U.S. goods or assets
in Japan declined, the Bank of Japan entered the foreign exchange market and bought
dollars (and with them dollar-denominated assets) to moderate the yen’s appreciation.
Thus, the bilateral trade deficit between the United States and Japan did not decline as
much as it would have if the Bank of Japan had not entered the exchange market to
support the dollar. A similar story can be told about Taiwan, Korea, and India.
The Chinese role in this situation is more complicated since its government does not
allow the free flow of capital out of China. Thus, lower U.S. interest rates are unlikely
to have had much of an effect on the bilateral flow of capital from China to the U.S.
Instead, the U.S.-China aspect is more directly centered on trade. Many argue that the
exchange value of the Chinese yuan is too low relative to the U.S. dollar and that this
undervaluation is growing. Why this is so is often left unspecified. It could be due to a
variety of factors: inflation is lower in China than in the United States, productivity is
growing more rapidly, a growing number of foreign export-oriented firms are
concentrating production in China, and so on. Regardless, what this means is that, over
time, China has become an increasingly attractive place from which to buy. The result
is a growing trade deficit. This deficit is only possible if the Bank of China buys the
surplus dollars represented by the trade deficit at the fixed exchange rate. And this it has
done: the foreign exchange reserves of the Bank of China have shown a large increase
since 2000. It should be noted that this is in its essence a capital movement from China
to the United States — an official capital movement set in motion by the Bank of China
as opposed to a private capital movement by Chinese citizens.
5 Interestingly, although short-term rates were lower in the United States than in these other
countries, long-term rates were mostly higher. This may be a sign that budget deficits and the
low private saving rate have indeed pushed up long-term interest rates as economists have
predicted. See CRS Report RL31775, Do Budget Deficits Push Up Interest Rates and Is This the
Relevant Question? by Marc Labonte.
6 Traditionally, the effect of shifts in monetary policy is reflected in shifts in market interest rates.
In Japan, this is limited by the fact that short rates are effectively zero while longer term rates are
low. In such a situation, the only available option for monetary policy to stimulate the economy
is for the central bank to buy foreign currency in the foreign exchange market in an effort to
depreciate the home currency or prevent it from appreciating. Currency depreciation should tend
to stimulate exports and discourage imports, thereby stimulating domestic economic activity.

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During 2005, the gap between domestic investment and national saving persisted.
It was, as in the past, filled largely by the net inflow of private capital, whereas the inflow
from official sources declined. The rise in the net inflow of private capital was due
largely to strong investment demand and the sharp increase in short-term interest rates
brought about by the Federal Reserve as it seeks to restrain the growth in aggregate
demand. With the rebound in private capital inflows, the dollar rose in value, reducing
the need for official capital inflows to keep the dollar from falling against local currencies.
What Do These Trends Mean for the U.S. Economy?
Did the shift in net capital inflow to the United States during 2002-2004 from private
to official sources have a different effect on the U.S. economy? The shift meant that net
inflows were based less on private lenders seeking profitable opportunities in the United
States and more on efforts by foreign central banks to keep their currency from
appreciating against the dollar.
Although the motive for the trade deficit has changed since the 1990s, its effect on
the U.S. economy remains the same. When private foreigners buy U.S. assets, they must
first obtain dollars, and this pushes up the value of the dollar. This makes U.S. exports
and import-competing goods less desirable, reducing production and employment in those
industries. On the other hand, the capital inflow increases the supply of saving available
to U.S. borrowers, thereby pushing down domestic interest rates. This has an offsetting
positive effect on the U.S. economy because it increases interest-sensitive spending on
plant, equipment, homes, consumer durables (such as automobiles and appliances), and
the like, thereby boosting employment in those industries. In the medium term, the trade
deficit has no net effect on U.S. aggregate spending or employment, although there may
be transitional effects. It does change the composition of spending and employment,
however, away from the trade sector and toward the capital and durable good sectors.
When the trade deficit results from official capital flows, the outcome is very much
the same. When a country reduces its relative demand for U.S. goods and services, U.S.
exports (and employment within export industries) fall. With a floating exchange rate,
the dollar would depreciate. But if the foreign country has fixed its exchange rate to the
dollar, its central bank must instead purchase dollars (and U.S. assets) to prevent the
dollar from depreciating. This pushes down U.S. interest rates and stimulates interest-
sensitive U.S. spending just the same as if a private capital inflow motivated by relative
rates of return had occurred.
Thus, if the purchase of U.S. assets by foreign central banks (official capital inflows
to the United States) ceased, the composition of output would change. All else equal, the
U.S. dollar would depreciate, increasing the output of U.S. exports and import-competing
industries. But at the same time, less saving would be available for Americans to finance
their spending on capital goods and for the U.S. government to finance its budget deficit.
As a result, interest rates would rise, all else equal.
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