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MONTHLY REVIEW, JULY 1970
150
T h e B u sin e ss Situation
The economy has apparently eased somewhat further.
Thus, industrial production, employment, working hours,
and private wage and salary payments all declined in
May. Although the unemployment rate dropped back to
4.7 percent in June, employment fell again, resulting in
the first three-month decrease in seven years. Despite the
evidences of weakness, the prospects remain reasonably
good for renewal of growth in the economy in the nottoo-distant future. Contrary to widespread reports of
consumer pessimism, the available sales data suggest that
consumers have in fact responded to recent Government
measures bolstering incomes. An additional boost to
spendable income occurred on July 1, when the remaining
5 percent tax surcharge expired. Similarly, housing permits
have been rising of late and, with an improved flow of
funds into savings institutions, some strengthening in resi
dential construction outlays seems likely in the last half of
the year. Moreover, state and local spending will almost
certainly continue upward in the coming months. According to the latest Government survey, business plans for an
increase in plant and equipment spending this year have
been cut back somewhat. This was to be expected, how
ever, and the cuts reported have not been drastic, with
spending plans outside manufacturing holding up quite
well. Inventory spending has been reduced sharply in
1970 and, while there are still some areas of excess in
ventory, the greater part of the adjustment in this sector
may have been completed. Finally, the policy actions taken
by the Federal Reserve earlier in the year have resulted
in moderate growth in the money supply and bank credit
so far this year, in contrast to little or no growth in the
last half of 1969. The recent decision to suspend Regu
lation Q ceilings on short-dated large certificates of
deposit1 will also help to maintain an adequate overall flow
of credit. Inflation remains a most serious problem. There
have been a few encouraging signs here and there, but the
major price indicators have not as yet shown convincing
evidence of a more moderate trend.
P R O D U C T IO N A N D O R D E R S
Industrial output in May recorded one of the larger
declines in the downtrend that began last July. The
Federal Reserve Board’s index of industrial production
dropped by 0.8 percent to 169.0 percent of the 19571959 average (seasonally adjusted). This was the lowest
level since December 1968 and was 3.2 percent below
last July’s high. The downtrend had been interrupted last
February and March by a small recovery, which had led
some observers to believe that the production slump had
bottomed out. Recent production data have been difficult
to interpret, since the figures have been heavily influenced
by labor disputes. The February settlement of the General
Electric strike helped boost production in March, and in
both April and May work stoppages by truckers caused
shortages of some component parts used in production
lines. Strikes in the rubber industry also dampened produc
tion in May. However, the May decline in the overall
production index was widespread.
The big drop in the index occurred among equipment
producers. Output among defense industries fell again,
reaching a level almost 20 percent below last year’s
average. Production of business equipment also dropped in
May, falling to a level about 6 percent below last October’s
peak. Iron and steel output eased in the month, although
steel ingot production, which accounts for about half the
iron and steel index, moved up in June. Recent levels of
iron and steel output have run almost 10 percent below
last year’s peak, and there have been newspaper reports
that some price concessions are being made.
In contrast to the general easing, auto output jumped
15 percent in May to a seasonally adjusted annual rate of
8 million units. This uptrend continued in June, when out
1 See “Money and Bond Markets in June”, this Review, page 154.
151
FEDERAL RESERVE BANK OF NEW YORK
put rose further to 8 V2 million units. The recent strength
in auto production followed several months of slackening.
In the second quarter, assemblies averaged 73A million
units, compared with 6 3A million units in the first three
months of the year and 13A million units in the final quarter
of last year. The recent uptrend largely parallels the recov
ery in auto sales. After bottoming at a seasonally adjusted
annual rate of 6 3A million units in January, the sales pace
for domestically produced cars has risen rather steadily,
reaching 13A million in May. In June, sales advanced
sharply to an annual rate of 8 V2 million units. Better auto
sales have led to a reduction in dealers’ inventories. By
May, the inventory-sales ratio for dealers had fallen back
to the 1969 average.
The volume of new orders for durable goods, a leading
indicator of industrial activity, rose $0.9 billion to a sea
sonally adjusted rate of $29.6 billion in May, as orders
for transportation equipment—which are often erratic—
surged. Durables orders have generally been weak since last
fall, however, and even the strong May advance left orders
at a level $2.5 billion under the September 1969 peak.
C h a rt I
INVENTORY SALES RATIOS AND
INVENTORY ACCUMULATION
S e a so n a lly ad justed
M onths of sales
M onths of sales
IN V E N T O R IE S , S H IP M E N T S , A N D
R E S ID E N T IA L . C O N S T R U C T IO N
Business inventory accumulation apparently continued
at a slow pace during the first two months of the second
quarter. In April, total business inventories rose by $700
million. While this was above the average gain of the first
quarter, it was well below the $1 billion average monthly
increase of last year. Moreover, a part of the April rise
apparently resulted from the truckers’ strike which inter
rupted shipments that month. May data, which are
available for manufacturing only, indicate that manufac
turing inventories did not rise at all that month. Despite
the small advance in inventory spending this year, there
are some areas where stocks still appear to be high in rela
tion to sales. As has generally been the case in past slow
downs, this problem is centered in durables manufacturing,
where the inventory-sales ratio in May was only slightly
improved from the first-quarter level shown in Chart I.
Residential construction activity continued sluggish in
May, but there were some indications that the situation
might improve. The volume of private housing starts re
mained at April’s seasonally adjusted annual rate of 1.2
million units, compared with 1.5 million units started last
year. While the starts rate continued low, the volume of
building permits issued by local authorities rose for the
second month in a row, reaching the highest level in a year.
The recent strength in this series suggests some pickup
in building activity in the coming months. Underlying
Note: Shaded areos represent recession periods, according to the National
Bureau of Economic Research chronology.
Source: United States Department of Commerce.
demand for new housing— as shown by near-record lows
in vacancy rates and by the rapid growth of household
formations in recent years— remains very strong. More
over, the outlook for home building has been improved
by higher deposit inflows to thrift institutions and also by
the likelihood of increased Federal assistance to the home
mortgage market.
E M P L O Y M E N T , IN C O M E , A N D
CO N SU M ER D EM AND
The economic slowdown has been very evident in the
labor market (see Chart II). Over the first six months
of the year the unemployment rate increased from 3.5
percent to 4.7 percent, according to the household survey
of employment. A part of this increase reflected declines
MONTHLY REVIEW, JULY 1970
152
in employment, but an unusually rapid expansion in the
civilian labor force also added to the pool of those un
successfully seeking work. This acceleration in the labor
force was rather unexpected, since a softening in job mar
kets generally leads to a slowdown or an outright reduc
tion in labor force growth as many persons, particularly
women and teen-agers, simply leave the labor force after
losing a job. (To be included in the civilian labor force,
as officially defined, a person must be employed or have
actively sought employment within thirty days prior to the
survey date.) While the explanation for the labor force
acceleration earlier this year is not completely clear, the
labor force did revert to more normal behavior in May
and June, dropping on a seasonally adjusted basis by a
sharp 750,000 in the two months and wiping out better
than half the 1.3 million gain registered in the JanuaryApril period. The two-month decline was almost entirely
accounted for by adult women and teen-agers. In June,
C hart II
THE CIVILIAN LABOR FORCE,
EMPLOYMENT, AND UNEMPLOYMENT
S e a so n a lly a d ju ste d
M illio n s of p e rso n s
Source: United States Department of Labor.
M illio n s of p e rso n s
teen-agers evidently entered the job market in substantially
less than usual numbers, perhaps discouraged by wide
spread reports that summer employment would be scarce
this year. (Spokesmen at the Bureau of Labor Statistics,
however, have warned that seasonal factors are particu
larly difficult to assess in June.) Also in June, seasonally
adjusted employment of adult women rose; as a result, total
employment did not drop as fast as did the labor force.
Thus the unemployment rate fell back 0.3 percentage point
from its five-year high of 5.0 percent registered in May.
The payroll series on employment, which is a survey
of employers rather than of households, also pointed to
large employment declines in May and June. The total
decrease in those two months amounted to 0.5 million,
with over 0.3 million of that taking place in manufacturing.
Since manufacturing employment peaked last September,
the number of persons on manufacturers’ payrolls has
dropped by 0.8 million, with most of the decline accounted
for by durables industries. The workweek of production
workers in manufacturing also eased 0.2 hour in May to
39.8 hours, almost a full hour below last year’s high, and
remained unchanged at this level in June.
Declines in employment and the workweek led to de
creases in private wage and salary payments in April and
May (June data are not yet available). However, this
weakening has been offset by Federal Government actions
which have maintained the overall growth of personal
income. Total personal income rose by a record $18
billion in April, and declined by $8 billion in May to a
seasonally adjusted annual rate of $794 billion. April
income had been given a tremendous boost by the
6 percent Federal Government pay raise and the 15 per
cent social security hike, both of which were retroactive to
January. The social security increase alone had added
$12V2 billion to April incomes, and $8 billion of that rep
resented nonrecurring makeup payments. These makeup
payments were absent in May and accounted for the
April-to-May decline in total personal income. (The retro
active portion of the 6 percent Government pay raise
granted in April was divided equally between April and
May and amounted to $3 billion in each month.) The
pay raise and the hike in social security payments were
large enough so that they not only masked the decline
in private wage and salary disbursements, but they even
brought the recent growth of personal income to nearly
the same rate as last year. Over the first five months of
the year total personal income rose at a 7.1 percent
annual rate, only a shade below last year’s 7.6 percent
advance.
Federal actions underpinning personal income were
generally expected to stimulate consumer buying, and the
FEDERAL RESERVE BANK OF NEW YORK
limited figures so far available are at least consistent with
this view. Retail sales in April climbed by $0.6 billion and
in May backed off only slightly from that high level. The
fragmentary evidence so far available for June, including
the strong performance of auto sales noted earlier, sug
gests that overall sales may have been rather well main
tained in the month.
R E C E N T P R IC E D E V E L O P M E N T S
There has been little solid evidence to date of a general
slowdown in the rate of price advance. The consumer price
index climbed at a 6.3 percent seasonally adjusted annual
rate in May, virtually the same as the rate of increase for
all of 1969 and for the first four months of this year.
To be sure, without seasonal adjustment the index in
May increased from the April level at a more moderate
5.4 percent annual rate, but this statistic is less meaningful
than the adjusted figure since some prices, such as those
for food, are normally a bit lower in May than in April.
Industrial wholesale prices have also continued to gain
rapidly despite wide expectations of easing. In May in
dustrial prices rose at a 4.1 percent annual rate, compared
with a 4.2 percent rate in the first four months of the year
153
and a 4.0 percent hike in 1969. A good part of the May
rise occurred in prices of fuels, lumber, and iron and steel
products. There was a slowing in the rate of advance in
industrial prices in June, but this apparently reflected little
more than a normal seasonal development. In contrast to
the uptrend in industrial prices, the total wholesale price
index has risen slowly so far this year, as declines in
agricultural prices— which make up a quarter of the total
index— have offset most of the advance in industrial costs.
The agricultural declines suggest some letup in the rise of
consumer food prices, but the current inflation is rooted
in developments clearly outside the farm sector.
Recent trends in labor compensation and productivity
suggest labor costs will continue to exert pressure on the
price level. When increases in compensation per man-hour
are not matched by equal gains in productivity (output per
man-hour), the labor cost per unit of output rises. Since
1965, gains in compensation per man-hour have out
stripped productivity increases and have pushed up unit
labor costs. These advances have been major factors in
the current inflation. So far this year the situation has
shown little improvement, except in the manufacturing
sector where layoffs and reductions of expensive overtime
work have helped to hold down costs.
154
MONTHLY REVIEW, JULY 1970
T h e M o n ey and Bond M a rk e ts in Ju n e
The nation’s financial markets coped successfully with
a heavy volume of new private securities flotations in June
despite widespread concern about developments in the
Middle East and Cambodia and new apprehensions related
to the commercial paper market. Although most securities
markets had rallied strongly near the end of May, the bond
markets during most of June remained under the strong
pressure of heavy borrowing demands which pushed yields
on new corporate and municipal issues to new highs dur
ing the month. Earlier fears of a general shortage of liquid
ity faded, as the Federal Reserve continued to insure that
the money markets would function smoothly with minimal
stress during the period of seasonal tax-date pressures.
Further indications of a slowing of the economy contrib
uted to strong investor and dealer demand for bonds. As
the period drew toward the close, investors were appar
ently becoming more hopeful that the slowdown would
smother the inflationary fires and interest rates would
decline.
Against this background the financial markets hardly
faltered when the Penn Central Transportation Company,
the nation’s largest railroad, filed a petition in the third
week of the month for reorganization under the Federal
Bankruptcy Act. Market participants recognized that this
event could lead many investors to reexamine the quality
and volume of commercial paper in their investment port
folios, but prompt action by the Federal Reserve Board
gave reassurance that the banking system would be in a
position to deal with any credit strains that might emerge
as this reassessment proceeded. Effective June 24 the
Board suspended Regulation Q interest rate ceilings on
large certificates of deposit (CD’s )—those in denomina
tions of $100,000 or more— for 30- to 89-day maturities.
The Board stated that it was taking the action in recogni
tion that unusual demands upon commercial banks for
short-term credit could arise as a consequence of current
uncertainties in the financial markets. The atmosphere in
the bond markets continued to improve in the wake of this
action, with yields on most debt securities tending to de
cline further.
BANK R ESERVES AND THE M ONEY M ARKET
Relatively comfortable conditions prevailed in the
money market during June. Cognizant of market con
cerns, the Federal Reserve System was careful to provide
amply for the liquidity of the money market, but System
actions did not lead to rapid growth in the monetary
aggregates. Lenders in the money market were able to
accommodate smoothly the buildup of short-term bor
rowing pressures around the June corporate tax date.
The Federal funds rate declined slightly to about 7%
percent from 8 percent in late May, and bank reserve
positions changed little (see Table I). Average mem
ber bank borrowings declined to $907 million from $924
million in May, while the average basic reserve deficit of
the forty-six large money center banks rose slightly to a
level of $5.3 billion in the four weeks ended on June 24
(see Table II).
The daily average money supply declined in June fol
lowing a rapid expansion in April and moderate growth
in May. The level of the daily average money supply for
the four weeks ended on June 24 contracted at a season
ally adjusted annual rate of 5X
A percent from the level
recorded in May. On a week-to-week basis, the money
supply changed little in June until the week ended on
June 24, when there was a marked decline (see Charts I
and II). The June performance contrasted with the revised
V /2 percent growth rate posted in May, and was largely
accounted for by a moderate decline in demand deposits.
The currency component, which had experienced an espe
cially large increase in May, continued to expand in June
but at a less rapid pace.
The volatile character of the monetary aggregates often
makes interpretation of weekly or monthly movements
difficult. Because longer term movements are calculated
from daily average figures for the first and last months
of the period under consideration, these values can also be
exaggerated by the choice of particularly high or low
months for comparison. If, for instance, the month of
February, when the money supply was at a relatively low
155
FEDERAL RESERVE BANK OF NEW YORK
level, is used as the first month of the comparison, the
average rate of growth through June is about 6V4 percent.
On the other hand, the growth rate would be about 3 3A
percent if the first month were December, when the aver
age money supply level was little affected by a sharp
increase at the end of the month.
During June, time deposits held at commercial banks
expanded at a I V 2 percent annual rate, which approximates
the average rate of growth achieved on balance thus far
in 1970. The change in Regulation Q should lead to further
increases in this aggregate, as reintermediation occurs and
banks issue a larger volume of the shorter term CD’s.
The adjusted bank credit proxy moved upward in June
at a 7 percent seasonally adjusted annual rate as contrasted with a IV 2 percent rate of decline experienced in
May. Most of the strength in this aggregate resulted from
continuing rapid time deposit growth and an upsurge of
United States Government deposits held at commercial
banks. Over the past six months, the adjusted bank credit
proxy has grown at an annual rate of 3 V2 percent, or
C h a rt !!
THE MONEY SUPPLY AND SEASONAL EFFECTS
B illions of d o llars
M a rc h
B illions of d o lla rs
A p r il
M ay
Ju n e
♦This line is the average of the s e a so n a lly adjusted weekly figures for February
multiplied by sea so n al factors for March, A p ril,M a y ,a n d June, b eginning with
the week of March 4. It indicates w hat the unadjusted money supply would
have been if just the influence of the seasonal factors — which are drawn
from the behavior of the money sup p ly during comparable w eeks of previous
ye a rs — had been operative.
C h a rt I
CREDIT AND MONETARY AGGREGATES
Se a so n a lly ad ju sted w e e k ly a v e r a g e s
M a rc h -Ju n e 1 9 70
B iliio ns of d o llars
B illio ns of d o llars
slightly less than the rate of growth of the money supply
during the same period.
T H E G O V E R N M E N T S E C U R IT IE S M A R K E T
Note: Data for June are prelim inary.
^ Total member bank deposits subject to reserve requirements plus nondeposit
liabilities, including Euro-dollar borrowings and commercial paper issued by
bank holding companies or other affiliates.
^ At all commercial banks.
The market for United States Government securities
stabilized in June, although participants remained some
what uneasy. Market sentiment improved at midmonth,
when President Nixon gave a reassuring address on the
state of the economy. This improvement continued with
the growing belief that the Federal Reserve would not
allow a liquidity crisis to develop and impair the func
tioning of the markets. Yields on Government notes and
bonds fluctuated in a narrow range during the early part
of the month, but declined after midmonth (see Chart
III). The ability of the money and capital markets to
withstand heavy corporate demands for funds appears
to have had a salutary effect on this market, especially
in the longer term area. During the month, most bill rates
experienced sizable declines, as heavy demand pressed
against a rather thin market supply. Part of the demand
for bills was apparently from investors switching from
commercial paper.
Yields on coupon securities which had declined m
156
MONTHLY REVIEW, JULY 1970
Table I
TABLE H
FACTORS TENDING TO INCREASE OR DECREASE
MEMBER BANK RESERVES, JU N E 1970
RESERVE POSITIONS OF MAJOR RESERVE CITY BANKS
JU N E 1970
In millions of dollars; (+ ) denotes increase
(—) decrease in excess reserves
In millions of dollars
Daily averages—-week ended on
Changes in daily averages—
week ended on
Factors
June
3
June
10
June
June
17
24
Factors affecting
basic reserve positions
Net
changes
June
3
June
10
June
17
Averages of
four weeks
ended on
June 24
June
24
Eight banks in New York City
“ Market” factors
58
97
34
140
1,508
2,540
1,032
1,447
2,544
1,096
—1,547
—1,554
445
37
394
19
13
306
2S6
_
— 151
— 258
— 69
+ 54
— 15
— 137
4- 97
4 - 25
— 192
4-431
— 11
— 135
— 99
— Ill
4-37 1
— 169
— 12
— 447
+ 250
_ 66
- f 200
— 162
— 50
— T9
4—
44—
—
97
410
310
154
88
798
Other Federal Reserve liabilities
Total
Reserve excess or deficiency (—)* ........
54 — 22
47
Less borrowings from Reserve B a n k s ...
269
195
Less net interbank Federal fun da
purchases or sales (— ) ..........................
947
1,564
1,770
Gross purchases ....................................
2,174
2,818
2,643
Gross sales ............................................
1,227
1,048
1,078
Equals net basic reserve surplus
or deficit ( ) ............................................ —1,163 —1,988 —1,517
Net loans to Government
securities dealers ......................................
428
381
321
Net carry-over, excess or deficit (—) f . . —
3
85
5
factors
— 90
__ 69
4 - 147
4 - 26
-f-
— 409
4-122
— 210
4 -1 8 4
— 31S
14
Thirty-eight banks outside New York City
Direct Federal Reserve credit
transactions
Open m arket operations (subtotal)
O utright holdings:
Government securities
Repurchase agreements:
Government securities .................. ..
Federal agency obligations ................
Other Federal Reserve assetst ..................
Excess reserves ................................................
- f 348
4 -154
+ 423
— 678
+
+ 255
__ 7
4 - 143
— 2
4-5 3 9
_ 3
— 678
+ 259
— 12
+
+
+
4—
4- J-- 15
J.O
4- 4
102
— 369
4- 86
—
—
—
—
4-
16
198
143
4-229
4 - 53
— 44
4 - 130
4- 540
— 179
-j-368
— 396
4 - 333
4- 131
— 57
4-158
— 212
4-
71
7
22
204
_
6
247
86
11
20
70
Reserve excess or deficiency (— )* ..........
349
Less borrowings from Reserve B anks----Less net interbank Federal funds
purchases or sales (— ) ..........................
3,262
5,247
Gross purchases ....................................
1,985
Gross sales ..............................................
Equals net basic reserve surplus
or deficit ( ) ............................................ —3,541
Net loans to Government
securities dealers ......................................
191
25
Net carry-over, excess or deficit {—) t - .
—
3
237
97
251
3,637
5,732
2,096
3,849
5,845
1,996
3,401
5,278
1,877
3,537
5,526
1,989
—3,877
—4,004
—3,720
—3,786
109
15
10
101
13
46
103
25
—
38
Note: Because of rounding, figures do not necessarily add to totals.
* Reserves held after all adjustments applicable to the reporting period less required
reserves,
t Not reflected in data above.
Monthly
Daily average levels
averages
TABLE m
AVERAGE ISSUING RATES*
AT REGULAR TREASURY BILL AUCTIONS
Member bank:
27,613
27,438
175
Excess reserves ........................................ ..
1,225
Free, or net borrowed (—), reserves........ —1,050
26,288
Nonborrowed reserves .............. .
82
Net carry-over, excess or deficit (—) § . . . .
Total reserves, including vault cash..........
27,459
27,341
118
856
— 738
26,603
27,680
27,440
276
658
— 382
27,022
122
87
27,254
27,190
64
887
— 823
26,367
175
Changes in Wednesday levels
27,502?
27,352$
158*
907*
— 748*
26,595*
117*
In percent
Weekly auction dates—June 1970
Maturities
Net
changes
System Account holdings of Governmenl
securities maturing in:
June
S
June
15
June
22
|
6.824
6.858
6.785
6.895
6.733
6.947
6.626
6.929
|
j
June
29
6.421
6.603
Monthly auction dates—April-June 1970
4- 501
4 - 82
— 333
4 - 187
4-271
4- 583
— 146
+ 271
Note: Because of rounding, figures do not necessarily add to totals.
* Includes changes in Treasury currency and cash,
f Includes assets denominated in foreign currencies.
% Average for four weeks ended on June 24.
§ Not reflected in d ata above.
June
1
— 818
— 818
— 379
4 -2 6 9
April
23
May
26
6.844
6,814
7.352
7.277
j
June
23
S
j
i
7.069
7.079
— 110
* Interest
rates on bills are quoted in terms of a 360-day year, with the discounts from
par as the return on the face amount of the bills payable at m aturity. Bond yield
equivalents, related to the amount actually invested, would be slightly higher.
FEDERAL RESERVE BANK OF NEW YORK
157
SELECTED INTEREST RATES
P e rce n t
M O N E Y M A R K ET R A TES
A p r il
M ay
A p r .l-J u n e 1 9 7 0
Ju n e
bq n d
A p r il
m a R k e T Y !E L D $
M ay
P e rce n t
Ju n e
Note: Data are shown for b usiness d ays only.
M O N EY MARKET RATES Q U O TED : Bid rates for three-month Euro-doilars in London; offering
rates for directly p laced finance com pany pap_er; the effective rate on Fed e ral funds (the
rate most representative of the transactions executed ); closing bid rates (quoted in terms
of rate of discount) on newest outstanding three-month and one-year Treasury bills.
BOND MARKET YIELDS Q UO TED : Yiolds on new A a a - and A a -rate d public utility bonds
(arrows point from underwriting syndicate reotfering yield on a given issue to market
yield on the sam e issue im m ediately after it has been released from syndicate restrictions);
the late-May rally continued to move to generally lower
levels during the first days of June, although yields on a
number of intermediate-term securities tended to rise. Sub
sequently, yields on all coupon securities moved higher,
partly reflecting the near-term outlook for interest rates,
which was affected by the heavy calendar of long-term
corporate offerings and the anticipated shorter term financ
ing needs around the June 15 corporate tax date. By mid
month. yields on most securities were higher than levels
set at the end of May, although below the peak values
posted in that month. Yields on longer term Govern
ment securities began to decline, however, with the mid
month improvement in the capital markets, but yields on
intermediate-term issues were less affected. The announce
d aily averag es of yield s on season ed A a a-ra ted corporate bogds; daily av e rag e s of
yield s on long-term G overn m ent securities (bonds due or c a lla b le in ten years or more)
and on Governm ent securities due in three to five ye a rs , computed on the basis of closing
bid prices; Thursday av e rag e s of yie ld s on twenty sea so n ed twenty-ye a r tax-exem pt bonds
(carrying Moody's ratings of A a a , A o , A, and Baa).
Sources: Fed eral Reserve Bank of New York, Board of G overnors of the Fed e ral R eserve System,
M oody’s Investors Service, and The W e e k ly Bond Buyer.
ment of Penn Central’s plans for reorganization benefited
both notes and bonds, as investors sought and acquired
higher quality issues. Yields continued to fall for the re
mainder of the month.
Rates on most Treasury bills moved sharply lower
in June. Rates initially declined in a continuation of the
late-May rally and then fluctuated at lower levels until
after midmonth, with shorter term bills generally register
ing further improvements and longer term bills experienc
ing some increases in rates. Later in the month, following
the Penn Central petition for reorganization, the shift in
investor preference toward higher quality issues and the
demand from holders of the $4.5 billion of tax anticipation
bills (TAB’s) maturing on June 22 moved rates lower on
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MONTHLY REVIEW, JULY 1970
all maturities. Rates continued to fall until the end of the
month, and closed the month about 60 to 20 basis points
lower than those at the end of May. The average issuing
rates set at the weekly and monthly Treasury bill auctions
also declined, as indicated in Table III.
On June 26, the Treasury announced plans to auction
$2.5 billion of TAB’s maturing on March 22, 1971. The
bills were to be auctioned on July 2 for payment on July 8
and qualified depositories were permitted to make full
payments for subscriptions through credit in their Treasury
Tax and Loan Accounts. At the same time, the Treasury
also announced plans for an additional cash offering in
the neighborhood of $2 billion to be scheduled prior to
the refunding of the August 15 maturities.
O T H E R S E C U R IT IE S M A R K E T S
The strong pressures that affected the market for
corporate and municipal securities in May moderated
somewhat in June. Early in the month yields fell on
most new issues, but apprehension over the very heavy
calendar of corporate offerings scheduled for the latter
half of June led to a subsequent deterioration in rates
until midmonth. As it became evident that the large vol
ume of new issues would be placed successfully, market
conditions improved. The announcement of the Penn Cen
tral’s financial difficulties did not impair the performance
of the markets for high-grade debt issues.
Attention in the corporate market before midmonth
continued to be focused on the heavy schedule of new
corporate offerings. After a modest improvement early in
the month, apprehension of participants over the up
coming flotations was associated with a significant deteri
oration in market conditions. The turnaround came on
the eve of President Nixon’s June 17 economic address.
On June 16, a $100 million 40-year Aaa-rated telephone
company bond issue was offered at a record yield of 9.35
percent, 25 basis points higher than any previous toprated telephone company offering. At this high yield, the
bonds met an excellent reception, as did most of the
other issues marketed on the same day. Yields moved
lower thereafter in a revival of demand, particularly among
institutional investors. At the end of June, another Aaarated telephone company flotation consisting of $150 mil
lion of 33-year debentures was successfully offered at a
yield of 9.05 percent, 30 basis points below the slightly
longer term issue marketed on June 16.
In the market for tax-exempt securities, yields fell
moderately early in June when new issue activity was
light. The Weekly Bond Buyer's index of tax-exempt
securities, which had hit a record 7.12 percent in the
week ended on Thursday, May 28, fell 20 basis points
in the week ended on June 4. Subsequently, however,
yields again moved upward and remained at higher levels
until midmonth. On June 16, the state of California re
entered the market after voters there approved a new 7
percent interest rate ceiling. California had been unable
to float new securities for more than a year under the
previous 5 percent ceiling. After midmonth, the successful
completion of the especially heavy flotations in the cor
porate market was accompanied by a decline in taxexempt securities yields as well. At the end of the month,
yields on new issues were being set below levels common
in May and earlier in June.
FEDERAL RESERVE BANK OF NEW YORK
159
In terp retin g th e M o n eta ry In d icato rs *
By R ichard G. D avis
Adviser, Research and Statistics Function
Federal Reserve Bank of New York
Your Chairman has asked me to present a brief descrip
tion of some of the key monetary statistics and their use
in interpreting credit market conditions and the direction
of monetary policy. This is a very large order given the
time constraints, and so my presentation will have to be
both quite selective and highly condensed. I will in fact
briefly describe some of the major monetary and money
market statistics and their significance. I will also have
something to say about their use in interpreting policy. I
will mention some recent modifications in the modus
operandi of Federal Reserve open market policy, but I
will have nothing at all to say about current policy itself,
nor will I attempt any interpretation of recent movements
in the monetary data.
The monetary statistics I want to discuss can conve
niently be divided into three groups: the reserve aggregates,
the monetary aggregates, and the money market indica
tors. Turning first to the reserve aggregates, there are four
concepts that are widely discussed. The first is total re
serves of Federal Reserve System member banks. This
figure consists of member bank deposits at the Federal
Reserve Banks plus their vault cash. The size of this
reserve aggregate is determined in part by the volume of
Federal Reserve open market operations, in part by cer
tain technical market factors (such as Federal Reserve
float), and in part by the member banks themselves as
they make decisions on whether and how much to borrow
at the Federal Reserve discount window— subject of course
to the Fed’s rules regulating such borrowings. A closely
related reserve concept is the so-called “monetary base”
or, as it is known in some of the older money and bank
ing textbooks, “high-powered money”. The monetary base
*A talk delivered before the New York Society of Security An
alysts, New York City, June 4,1970.
is simply total reserves of member banks plus cash held
by nonmember banks and by the nonbank public. Both
these measures, total reserves and the monetary base, are
also often presented in the form of variants that subtract
borrowings of member banks at the discount window. In
this guise they are called, obviously enough, nonborrowed
(or sometimes unborrowed) reserves and the nonborrowed
monetary base.
All these reserve aggregate measures are of intense in
terest to the monetary specialist. They are obviously key
factors in determining the volume of the money supply
and bank credit. In my view, however, the nonspecialist
can profitably economize on the use of his time by work
ing directly with the money and bank credit aggregates
themselves. Consequently I shall have little further to say
about the reserve aggregates.
As you may know, arguments rage interminably as to
just what statistical concept best captures the abstract,
textbook notion of the “money supply”. Henry Wallich,
the Yale professor, Government adviser, and Newsweek
columnist, claims to have discovered at least ten definitions
in actual use. There are really only two definitions with
widespread acceptance, however. The first treats as
“money” the nonbank public’s holdings of coin and cur
rency plus demand deposits other than interbank deposits
and United States Treasury deposits. This definition is
often called the “narrowly defined” money supply or,
simply, “M1”. The second definition of money in common
use (“broadly defined” money, or “M2” ) adds time and
savings deposits at commercial banks to the narrowly de
fined money supply.
As in the case of the reserve aggregates already men
tioned and of bank credit, which I am about to mention,
both the money supply series have strong seasonal pat
terns and as a rule should be looked at in seasonally ad
justed form—this is true despite the fact that seasonal
adjustment procedures often raise some real problems. It
should also be noted that meaningful analysis of the
160
MONTHLY REVIEW, JULY 1970
money supply series involves the rates of growth in these
items rather than their absolute levels. These rates of
growth are almost always measured in terms of annual
percentage rates of change.
Turning to the concept of bank credit, this is simply
total loans and investments of commercial banks with some
minor adjustments. Unfortunately, data on total bank
credit at all commercial banks are available only on a
last-Wednesday-of-the-month (or call date) basis. The
Federal Reserve System in fact makes use of a so-called
“bank credit proxy” for member banks, which is available
on a daily average basis week by week. Very briefly, this
uses total deposit liabilities of member banks to approxi
mate total loan and investment assets (or bank credit) on
the other side of the balance sheet. Total deposits are by
no means a perfect proxy for total loans and investments
since there are many other, often volatile, items on both
sides of the banking system’s balance sheet. Thus for many
purposes it is desirable to try to make adjustments for
some of these items. In recent years, movements in mem
ber bank borrowings from their own foreign branches have
been a particularly important consideration. Also, an ad
justment is usually made to add back the bank credit that
disappears from the statistics when banks sell off loans to
the parent one-bank holding companies, which, in turn,
finance their loan purchases by issuing commercial paper.
A very lively debate has existed for a long time within
the Federal Reserve System and among economists in gen
eral as to which of the three main monetary aggregates—
M v M2, or bank credit— is the best indicator of the bank
ing and monetary system’s impact on the subsequent course
of the economy as a whole. In fact, the actual behavior of
these three aggregates tends to be broadly similar, so that
the debate is perhaps not as consequential as it sometimes
seems. Again broadly speaking, these three aggregates tend
to have roughly similar cyclical turning points and have
roughly equal correlation with movements in gross national
product and other economic measures. Under present cir
cumstances, I— and perhaps at least a plurality if not a
majority of economists— tend to prefer M1? the narrowly
defined money supply, to the other two measures. Bank
credit has the disadvantage of being a total of some very
heterogeneous items, ranging all the way from bank invest
ments in Treasury bills to twenty-year home mortgages.
To me, it seems hard to say anything very meaningful
about the market demand for such a hodgepodge. Sec
ondly, the significance of movements in both bank credit
and M2 tends at times to be distorted, in my view, by the
effect of Regulation Q on time and savings deposit interest
rates and thus on the ability of banks to market such de
posits. The argument back and forth on this matter is very
complicated and I simply don’t have time to go into it.
In any case, I would opt for following M1 on balance as
against the other two aggregates, but I doubt that the mat
ter is of really first-class importance.
As I noted a moment ago, interpretations of movements
in the monetary aggregates almost always concentrate on
seasonally adjusted percentage changes computed at annual
rates. In using these data, it is absolutely vital to understand
that they contain a tremendous amount of statistical “noise”
— that is, random short-run movements tend to be large
relative to trend and cyclical movements. (Actually, of
course, the time paths of first differences of most economic
series contain substantial amounts of noise even when
levels in the same series show a fairly regular behavior.)
A second and related point to keep in mind about
growth rates in money and bank credit is that, contrary
to the impression often given in undergraduate economics,
the Federal Reserve System does not have the tools to con
trol movements in money and bank credit growth rates with
any very high degree of precision in the short run. The
System can of course exert a powerful influence through
its open market operations. Nevertheless, the monetary
aggregates are very importantly influenced by other factors
not under direct Federal Reserve control. Since the be
havior of these other factors may be highly unpredictable
in the short run, it may be impossible to know how to
adjust day-to-day or week-to-week open market opera
tions to offset their effect. Moreover, incoming preliminary
data may at times prove highly inaccurate, making it dif
ficult to know what actions need to be taken. Finally, there
are many short-run influences on the money supply that
the System may be simply powerless to offset— again in
the short run— even if it knows about them. For example,
an increase in the demand for bank credit in a given state
ment week will tend to raise bank deposits and credit and,
within that week, there will be virtually nothing the Fed
eral Reserve can do about it. I hope these comments on
the difficulties of precise short-run control of the monetary
aggregates will not appear as a “cop out”. Actually, they
simply reflect a fact of life that interpreters and users of
monetary statistics would do well to keep in mind.
The practical moral to be drawn from the fact that the
monetary aggregates may be dominated by erratic and
often uncontrollable movements in the short run is that
users of these data must avoid the pitfall of overinterpret
ing short-run developments. Under the circumstances, it
will be a wise strategy to adopt some sort of longer run span
or moving average technique to force the raw data into a
reasonably interpretable form.
There are, to be sure, some problems involved in using
devices such as moving averages or moving spans. If the
FEDERAL RESERVE BANK OF NEW YORK
length of the moving span or moving average is too short,
it will not filter out enough of the noise in the data. On
the other hand, if it is too long, it will filter out funda
mental movements along with the noise and will tend to
distort the timing of significant turning points. I will not
try to pinpoint precisely an optimal time span for examin
ing growth rates in the money supply and bank credit.
Nevertheless, some suggestions are in order. Thus I would
think data for a single week are absolutely useless for the
analyst. Indeed I would think even data for a month are of
very dubious significance. Measurements taken over a
quarterly span or in terms of three-month moving averages
may be about the minimum length of time for which mean
ingful readings of these data can be obtained.
Actually, even three-month spans present problems.
Data constructed on this basis still display a fair degree of
noise. Moreover, even on a three-month basis, the rela
tionship between the amount of reserves the Federal Re
serve supplies or permits to be supplied bears a by-nomeans airtight relationship to the volume of deposits and
credit created. Thus it may also be useful to look at devel
opments over longer periods of. say, four to six months.
The third set of measures I want to mention briefly are
the measures of money market conditions. These measures
include the so-called “marginal reserve measures” : they
are the levels of member bank excess reserves, member
bank borrowings at the discount window, and net free
reserves, i.e., excess reserves less borrowed reserves. (To
complicate matters further, free reserves are usually called
“net borrowed reserves” when borrowings exceed excess
reserves.) These various marginal reserve measures can be
thought of (somewhat loosely) as reflecting the balance be
tween supply and demand in the market for bank reserves.
As a result, movements in them have tended historically to
show a rough parallelism with movements in short-term in
terest rates, such as the Federal funds rate, the rates on call
loans to Government securities dealers posted by banks, and
Treasury bill rates. The often-discussed concept of money
market “tone” may be thought of as representing some sort
of weighted average of all these various marginal reserve
and short-term interest rate measures.
Over much of the 1950’s and 1960’s, the Federal Open
Market Committee (FOMC) tended to rely on money
market tone as a focus of short-run operating decisions
by the Open Market Account management. The precise
money market tone aimed at was of course varied by the
FOMC from time to time in line with its broader objectives
regarding rates of growth in the monetary aggregates and/
or broader measures of credit market conditions, and its
ultimate objectives with respect to real growth, employ
ment, prices, etc. To detect changes in the money market
161
tone sought by the Federal Reserve, analysts tended to
concentrate their attention on the behavior of free reserves
and some of the other money market measures just men
tioned. In recent years, there has been an evolution to
ward a more direct role for the monetary aggregates as
targets influencing the short-run conduct of open market
operations. The increased stress on monetary aggregates
is evident in the published report of the January 15, 1970
meeting of the FOMC.
The Committee concluded that in the conduct of open
market operations increased stress should be placed
on the objective of achieving modest growth in the
monetary aggregates, with about equal weight being
given to bank credit and the money stock. It was
agreed that operations should be directed at main
taining firm conditions in the money market, but that
they should be modified if it appeared that the ob
jective with respect to the aggregates was not being
achieved.
Note that the Committee report does not pick out a single
aggregate but mentions both bank credit and the money
supply. The report speaks of giving “about equal weight”
to these two aggregates, but presumably the weights could
be altered from time to time if conditions seemed to favor
use of one or the other aggregate. Note also that the Com
mittee makes reference to the money market conditions (or
tone) it expects to be compatible with its objectives as re
gards the aggregates. However, it instructs the Account
Manager to modify these conditions, if such modification
is needed to approach the objectives concerning the mone
tary aggregates.
The procedure adopted by the FOMC at its January
meeting suggests that the growth rates of the money sup
ply and bank credit should prove more directly sensitive
to the intent of policy makers than was sometimes the
case in the past. Having said this, however, I want im
mediately to remind you again of the extent to which the
short-run behavior of the aggregates reflects factors other
than the influence of Federal Reserve actions. It remains
true that reasonably meaningful statements about the trend
of monetary and bank credit growth rates can only be
made over reasonably long periods.
A second implication of the FOMC’s new approach is
that somewhat greater variability might be expected in
some of the traditional measures of money market condi
tions, such as free or net borrowed reserves and the Fed
eral funds rate, than was true in much of the 1950’s and
1960’s. Again, however, I think a qualification is in order.
It is important to note that increased room for short-run
162
MONTHLY REVIEW, JULY 1970
flexibility in money market conditions does not mean that
the Federal Reserve has ceased to be concerned about the
condition of the money market. There is no disposition to
allow large short-term fluctuations in money market con
ditions.
To summarize briefly, the task of interpreting monetary
data unfortunately has major inherent difficulties. There
are a large number of these measures; as a group they are
quite capable of widely divergent movements in the short
run; taken singly, many of them are equally capable of
very erratic movements in the short run. I have noted that
the System has moved toward increased attention to the
money supply and bank credit aggregates, but that it has
retained its interest in the state of the money market. Since
these objectives may at times conflict in the short run, at
tempts to read changes in policy into weekly movements
in the data are perhaps even more dangerous now than
they may have been in the past. Thus the moral would
seem to be: for heaven’s sake, don’t try to overinterpret
short-run movements in any of these figures. To measure
the Federal Reserve’s intentions, look, instead, to the longer
run trend of money and bank credit growth rates.
F R E E P U B L IC A T IO N S
The following publications are now available free
on request:
Central Bank Cooperation: 1924-31 (1967) by
Stephen V. O. Clarke. 234 pages. A documented dis
cussion of the efforts of American, British, French,
and German central bankers to reestablish and main
tain international financial stability between 1924
and 1931.
Money, Banking, and Credit in Eastern Europe
(1966) by George Garvy. 167 pages. A review of the
characteristics, operations, and recent changes in the
monetary systems of seven communist countries of
Eastern Europe and the steps taken toward greater
reliance on financial incentives.
FEDERAL RESERVE BANK OF NEW YORK
163
Fo reign Dem and fo r United S t a t e s Equities —
T h e R ole of O ffshore M utual Funds
By F r e d H. K lo p s t o c k
Manager, International Research Department
During recent years, one of the major developments in
the evolving international financial scene has been the
massive shift of foreign portfolio capital to Wall Street.
In the brief span of two and three-quarter years, begin
ning in the spring of 1967, approximately $4.5 billion of
foreign money has been placed in United States equities—
surely the largest and one of the most protracted trans
fers of outstanding securities across national borders in
the history of international capital movements.1 This
heavy capital inflow was attributable in large part to the
evolution of new financial institutions, notably internation
ally oriented mutual funds— mostly of the so-called “off
shore” type— and the investment management and sales
organizations associated with their operations. An incidental
benefit of the surge of foreign purchases of American
equities was a much needed fillip to the United States
balance of payments.
The severe price erosion in the United States stock
market during much of the first half of 1970 and the reemergence of net sales of American stocks by foreigners
during this period have cast considerable doubt on
whether investors abroad will soon again begin to acquire
substantial amounts of American equities. In fact, in
some prognostications the dire specter of a massive liqui
dation of foreign-held American equities has been raised.
These doubts and questions about the near-term future of
foreign investments in the United States stock market have
been compounded by the much publicized reversal in the
fortunes of Europe’s largest mutual fund management and
sales organization, the Geneva-based Investors Overseas
Services (IOS) group of companies that has sponsored
several mutual funds which have been heavy investors in
American securities.
Against this somber background, which holds impor
tant implications for the United States balance of pay
ments, this paper tries to identify the sources and deter
minants of the foreign demand for American stocks. An
other purpose of the article is to describe the institutional
pattern of the demand for United States equities, notably
the important role of offshore mutual funds whose future
may well have been unfavorably affected by the recent
IOS events. The article also examines the significance of
the increasing role of professional management of for
eigners’ investable funds in the international movement of
outstanding American and other foreign common stocks.
It then explores the economic implications of the largescale transfer of foreign savings to Wall Street. In the final
section, the longer run prospects for foreign purchases of
American equities will be considered.
A R E V IE W O F F O R E IG N P U R C H A S E S O F
A M E R IC A N E Q U IT IE S
1 Foreign investors desirous of adding to their American securi Heavy flows of foreign funds into American equities
ties portfolios also purchased in this period $2.5 billion worth of have occurred before, but the nature and institutional pat
convertible debentures issued in the Euro-bond market by United tern of the recent surge differs in several important re
States corporations* affiliates set up to finance direct investment
operations abroad. The inflow to Wall Street would have been even spects from those of earlier times. In two periods prior to
larger had many such investors not sold sizable amounts of Ameri World War II, foreigners poured money into American
can common stocks to finance these purchases. On the other hand,
the sales of such convertible debentures and the publicity associ securities. During the 1928-29 speculative boom, foreign
ated with their issuance may have widened foreign investors’ in funds worth approximately $1 billion flowed to New
terest in American equities and therefore contributed to the surge
York for investment in common stocks, and about the
of foreign purchases in the New York stock market.
164
MONTHLY REVIEW, JULY 1970
same amount was invested in the two years ended in
March 1937. The desire of foreign investors to cash in
on rapid advances in New York stock exchange prices
explains, of course, much of this 1928-29 inflow. In the
midthirties, the speculative element appears to have been
less prominent, though by no means absent. Currency
uncertainties in Europe and war fears contributed to the
desire of many wealthy foreigners to add to their
American equities portfolios at that time. In the thirties,
net purchases were large enough to become an important
element in the United States balance of payments; in
this respect the recent experience resembles that of the
thirties. Another element of similarity is that in the mid
thirties and again in the recent period foreign purchasers
bought heavily on price rises but, on balance, did not
sell to any significant degree during price declines.
The most recent surge in foreign purchases of American
equities began in April 1967 rather suddenly and unex
pectedly. The beginning was somewhat less abrupt than
conveyed by the published United States Treasury statis
tics tabulated in the table. These data are misleading on
this score because they reflect the net liquidation of equi
ties holdings by the British government that occurred in the
midsixties. After adjustment for these official sales, it be
comes apparent that private investors abroad engaged in
modest net purchases rather than net sales in 1966 and
early 1967. Foreign net purchases rose slowly in the second
quarter of 1967 and gathered momentum in the fall of that
year. September 1967 witnessed for the first time in sev
eral decades monthly net purchases substantially in excess
of $100 million.
FOREIGN PURCHASES AND SALES OF
UNITED STATES STOCKS
1964-April 1970
In millions of dollars
Period
Purchases
Sales
Net purchases (-{-)
or sales (—)
1964.....................................
3,076
4,425
-
349
1965......................................
3,720
4,133
-
413
333
1966......................................
4,740
5,074
-
1967: January-M arch.........
1,557
1,604
-
47
April-December .....
6,476
5,672
+
804
1968.......................................
13,118
10,848
1969.......................................
12,429
10,942
1970: January-April*..........
3,109
3,199
* Preliminary.
Source: United States Department of the Treasury.
-4-2,270
+1,487
-
90
By March 1968 the previous steady net flow of for
eign capital into American equities had turned into an
avalanche. The student disorders in France and the Rus
sian occupation of Czechoslovakia represented additional
factors which induced foreigners to shift funds into the
United States stock market in that year. The surge of for
eign net purchases carried into 1969, reaching an all-time
record in January of that year ($361 million) and remain
ing at a very high level the following month. Subsequently,
net purchases diminished, and in June and July actual net
sales were recorded for the first time in two and onequarter years. In the August-October period, substantial
net purchases resumed, but they subsided again toward the
end of the year. Altogether, foreigners acquired almost
$1.5 billion of American equities in 1969.
In the early months of 1970, foreigners sold United
States securities again but net sales were relatively modest.
During the first four months, they were approximately
$100 million. In May as a result of the precipitous decline
of stock market quotations net sales rose sharply, accord
ing to preliminary and incomplete data. Shifts between
net purchases and sales are reflected in the chart.
The persistence of relatively heavy capital inflows dur
ing most of 1969 and the relatively small amounts of net
sales during the first few months of 1970 were contrary
to widespread expectations. As stock prices began to
weaken toward the end of 1968, and New York money
market rates rose to ever-higher levels, a common predic
tion was that foreigners would lose interest in American
equities and that they would unload substantial portions
of earlier accumulations. In fact, it was widely believed
that the high rates for short-term money would exert a
perverse effect on our balance of payments. The “stan
dard forecast” was that, as stock prices fell in response
to tighter money, foreigners would become net sellers of
American equities, thus offsetting much of the beneficial
effect of interest-rate-induced short-term inflows on the
dollar’s international position. Notwithstanding the poor
performance of the New York stock market through much
of 1969, this did not occur. In contrast to flows of almost
$4 billion into Wall Street during the April 1967-May
1969 period, aggregate net liquidations of American equi
ties in June and July 1969 added up to no more than
$157 million, a minuscule fraction of the aggregate for
eign stake in American equities estimated at close to $20
billion as of mid-1969. During the 1969 period of sharp
price declines in Wall Street, foreigners in the aggregate
not only retained their holdings but as a group actually
added to their commitments, except for rather brief pe
riods. During the first four months of 1970 the amount of
liquidation was surprisingly modest, considering the extent
FEDERAL RESERVE BANK OF NEW YORK
FOREIGN NET PURCHASES AND SALES OF
UNITED STATES STOCKS
TH REE-M O N TH M O V IN G A V E R A G E S
M illio n s of d o iia rs
M illio n s of d o lla rs
165
vation of the buying of United States common stocks by
foreigners. Reluctance of investors to realize the severe
losses on their holdings was, of course, another factor.
Little is known regarding the ultimate geographical
origin of foreign purchases of American equities. The
available statistics indicate that a major portion of net
purchases originate in Switzerland. But such purchases are
in large part for account of clients of Swiss banks residing
in Europe, the Middle East, and Latin America. And per
haps an equally large part of Swiss-reported purchases
originated in orders from mutual funds resident in Switzer
land but whose shares are sold virtually worldwide. Large
net purchases are shown in the statistics for such countries
as the Netherlands, the Bahamas, and Bermuda, and in
1969 Belgium-Luxembourg. Again, operations of institu
tional investors, notably Netherlands-based investment
companies and similar organizations set up by British and
United States interests in various tax havens, most likely
account for increases shown by these countries.
T H E P A T T E R N O F F O R E IG N D E M A N D F O R
A M E R IC A N E Q U IT IE S
Note:
Three-month moving average for Mcy 1970 is preliminary.
Source: United States Deportment of the Treasury.
of price erosion.
It would appear that the desire of foreigners to reap
short-term profits from rapidly rising prices on the
New York Stock Exchange was not the sole and perhaps
not even the major factor in the massive investment by
foreigners in American equities during the 1967-69
period. This is not to say that the hope for quick capital
gains did not play an important role in the inflows in
1967 and 1968. During this period, large amounts of for
eign money seeking quick capital appreciation moved into
aggressively managed mutual funds. Some of these funds,
both domestic and foreign, showed outstanding perform
ance records; as a consequence, many investors abroad
became highly performance conscious. Nevertheless, the
continuation of relatively large inflows during the 1969
period of declining quotations for American equities and
the absence of heavy liquidation in early 1970 would seem
to indicate that the desire to participate in the long-term
growth of the American economy has been a major moti
Purchases by institutional rather than directly by indi
vidual investors have indeed become the dominant element
in the foreign demand for American equities. This
relatively recent phenomenon has resulted primarily
from the very rapid growth during the last half of
the past decade of internationally oriented foreign in
vestment companies, notably the so-called offshore mutual
funds.2 The fast-growing and well-sustained purchases of
the shares of these foreign-based investment companies by
individual investors in many parts of the world has had an
important bearing on the demand abroad for American
equities. In addition, the foreign demand for American
equities has received substantial impetus from the increas
ingly international investment orientation of a great many
2 Investment companies are corporations or trusts set up for the
purpose of investing the proceeds of sales of their shares to the
public in a diversified assets portfolio. They may be open ended,
i.e., they may have no fixed number of shares outstanding and
the company will continuously sell new shares and redeem shares
of those shareholders who wish to liquidate their holdings. In the
United States, open-end investment companies are usually referred
to as “mutual funds”. In the United Kingdom, they are called
“unit trusts”. Closed-end investment companies or investment
trusts, on the other hand, have a fixed capitalization. Unlike mu
tual funds, they do not offer additional shares to the public on a
continuous basis, nor do they redeem their outstanding shares. In
vestment companies are designated “offshore” if they are chartered
under the laws of countries other than those where most of their
shares are sold.
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MONTHLY REVIEW, JULY 1970
mutual funds and closed-end companies abroad that con
fine the marketing of their shares primarily or entirely
to the residents of their own countries. These various types
of foreign investment companies have become the most
important channel for cross-frontier portfolio capital
movements.
u n i t e d s t a t e s o f f s h o r e f u n d s . In recent years, Ameri
can financial interests have established abroad substan
tially more than two hundred mutual funds. The major
groups responsible for their organization were first of all
American financial executives and lawyers in Europe,
some without any ties to United States financial institu
tions while others have been associated with American
mutual funds. The investment advisers of these funds in
the United States, New York securities dealers and
brokers, and investment and commercial banks have also
played a prominent role in the establishment of these
funds. It is no exaggeration to say that several of these
investment companies, usually referred to as United States
offshore funds, have revolutionized the savings and invest
ment habits of the burgeoning middle classes in many
parts of the world and created new and important markets
for equity capital in countries where stock ownership by
small investors was virtually unknown. Much of the heavy
movement of foreign capital into Wall Street in the 196769 period was ascribable to the purchases by Americanmanaged offshore companies. Their aggregate American
equities portfolio, virtually all purchased during the late
sixties, may well have been close to $1.3 billion at the end
of 1969. In addition, these companies at that time may have
held close to $900 million in the Euro-dollar market.
The phenomenal growth of the offshore mutual funds
industry and the proliferation of offshore funds through
1969 owed much to the spectacular expansion—prior to its
recent crisis— of the IOS group of mutual fund manage
ment and sales and other financial service companies head
quartered in Geneva, Switzerland. In terms of assets under
management, which amounted at the end of 1969 to
approximately $2 billion, this group had developed into
the largest mutual fund organization outside the United
States. Of the other investment company managements
operating offshore funds established by American interests,
not even the largest has under its control more than a
small fraction of the assets controlled by IOS. Much of
the rapid growth of this organization was due to an imagi
native system of sales incentives, including stock options,
which inspired highly aggressive marketing of fund shares.
The success of this group until early 1970 as measured
by the rapid growth of the assets held by its affiliated
mutual funds and other financial service organizations ex
plains to a considerable extent the entry of numerous other
American (and European) financial interests into the in
ternational mutual funds industry. Whether the recent re
versal of this group’s fortunes will adversely affect the
longer run future of the offshore industry cannot be pre
dicted with any assurance at this point in time.
The question suggests itself why foreigners interested
in American investment management would buy into
newly established offshore funds rather than existing
American mutual funds. Actually, the shares of the better
known United States funds, notably those with outstand
ing growth records, have been and continue to be bought
by foreign investors. However, offshore funds were easily
able to persuade investors abroad that its particular in
vestment vehicle conveyed certain benefits not obtainable
by the purchase of the United States funds. In fact, some
investment management firms associated with domestic
mutual funds established offshore funds, with a view
to enabling their shareholders to obtain the services
of the same management group and at the same
time reap the benefits that only foreign-based investment
companies can supply. One of the principal benefits to the
foreign investor is that offshore companies are not subject
to the Internal Revenue Code.3 United States investment
companies to meet certain requirements of the code may
not derive more than 30 percent of their gross income for
any taxable year from sales of securities held for less than
three months. Unlike offshore companies, they are subject
to capital gains tax though they are allowed a deduction
to the extent that capital gains are paid out to their stock
holders. Moreover, they are subject to the interest equaliza
tion tax when they buy Japanese, Australian, and certain
other foreign equities. By buying into an offshore fund,
foreign investors can obtain the advantage of American
professional management of an international equities port
folio with a heavy dollar content and at the same time
benefit from the increased investment flexibility that de
rives from the absence of tax considerations in investment
decisions. Offshore investment companies are, moreover,
typically set in jurisdictions where there is no income tax
and where other taxes such as those on the issue and trans
3 Under the Internal Revenue Code, as amended by the Foreign
Investors Tax Act of 1966, offshore investment companies are con
sidered nonresident foreign corporations as long as they do not
have their principal office in the United States and their only busi
ness in the United States is trading in stocks and securities. Their
nonresident status prevails even if such trading is conducted by
investment managers resident in the United States.
FEDERAL RESERVE BANK OF NEW YORK
167
performance bonuses if the investment company out
performs some specified stock market index. In fact, the
attractive emoluments that the advisory and sales organi
zations administering successful offshore companies were
able to reap during the 1967-68 period of rapidly rising
stock prices have been a major motivating factor for
the establishment of “offshores”.
The door-to-door sales concept and advertising ap
proach employed by the IOS-managed mutual funds has
been imitated by other investment companies established
in recent years. Several such companies have built up or
are in the process of developing a highly aggressive sales
force that attempts to place various types of investment
vehicles over the telephone or through personal visits at
the homes of investors. The large majority of investment
companies, however, do not have their own sales force but
place fund shares with international consortiums of Eu
ropean banks and investment firms or through brokerdealers and other financial intermediaries. Even prior to
the recent price erosion in the world’s major stock markets,
their marketing problem had become more difficult, partly
because of alternative investment opportunities but also
because of market congestion and capital outflow restric
tions in several major European countries. As the number
of offshore companies sponsored by American investment
advisers with impressive performance records multiplied
and the market became increasingly saturated, the sales
efforts of the funds’ sponsors have met growing resistance.
In particular, European banks, some of them operating
mutual funds of their own and disposing of considerable
international investment know-how, have found themselves
in a rather strong bargaining position vis-a-vis American
interests trying to place their product. These banks are no
longer satisfied with the once-and-for-all placement fee
or sales commission. As a result, some offshore manage
ment companies have had to offer greater participation in
income to important financial intermediaries in Europe.
European banks and brokers have been offered rights to
buy into the management companies in return for buying
or placing a minimum number of investment company
shares. This gives the banks and brokers an opportunity
4 Most offshore investment companies are incorporated in Pan to share in management fees that are based on the assets
ama, the Bahamas, Bermuda, the Netherlands Antilles, and Lux of the funds. Some investment companies have established
embourg. Each of these jurisdictions has its special attractions.
These relate to ease of organization and communication, tax ad advisory boards abroad, which prominent members of the
vantages, minimal exchange controls, and legal provisions bearing placing syndicate are invited to join and thereby either re
on the right continuously to issue new and redeem existing shares.
Tax liabilities can be minimized by choosing different jurisdictions ceive a share in the fees earned by advisory companies or
for incorporating the investment companies, the investment advis are paid fees directly by the investment companies. Several
ory and sales organizations associated with them, and the holding
companies that in turn own the shares of the investment advisory banks also felt that, by joining management companies or
and sales companies. The operating offices of the companies, advisory boards, they would be able to look after the in
irrespective of where incorporated, are located in most cases in
European countries, notably the United Kingdom, Switzerland, terests of those clients with whom they placed offshore
and Luxembourg.
funds shares.
fer of shares are either minimal or nonexistent.4 Another
fairly important advantage of offshore companies is that in
dividuals holding shares in them are not subject to the
United States estate tax on their holdings, while foreign
owners of shares in American mutual funds, if the indi
viduals’ aggregate direct holdings in the United States
exceed a certain amount, may incur such a liability. Of
equal importance and frequently the decisive consideration
in the minds of sales prospects is the ability of offshore
funds established in tax havens to provide virtually fool
proof guarantees that the prospect’s holdings will remain
completely anonymous. Altogether, much of the success of
offshore funds is attributable to the fact that they have been
especially tailored to offer a variety of legal and tax ad
vantages in the various areas where they are offered.
Generally, offshore investment companies are not subject
to the regulations, designed to protect the investor, that
apply to United States companies. Unless precluded by
their statutes, or the laws of their countries of incorpora
tion, offshore investment companies can sell stocks short
and leverage their assets by incurring debt. They can pur
chase warrants and put and call options. If not permitted
by their statutes to engage in short sales, they may be
authorized to acquire so-called hedge funds that are set
up abroad for the explicit purpose of selling stocks short
in addition to holding a conventional portfolio. Such
funds typically operate on margin accounts. (In the United
States, in order to avoid classification as investment com
panies subject to the registration requirements of the In
vestment Company Act of 1940, hedge funds must have
fewer than one hundred owners and may not make a pub
lic offering of their securities.) Certain offshore companies
also buy and sell commodities and real estate.
Commissions payable to offshore management com
panies often include not only basic management fees but
also so-called performance fees, based on actual or even
unrealized portfolio gains. Sometimes, they provide for
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MONTHLY REVIEW, JULY 1970
Offshore realty companies that sell their shares in sev
eral countries have become fairly important competitors
of foreign investment companies that place their funds
solely in equities. During the last two years, several such
companies have been set up abroad by United States
citizens, and two or three have established remarkable
sales records as a result of providing highly rewarding
incentives for their sales force. For the most part, these
funds invest in corporations that acquire high-incomeproducing office and apartment buildings in United States
metropolitan centers.5 These properties are heavily mort
gaged so that they provide leverage to their owners who
are in a position to take advantage of the favorable de
preciation provisions of the United States Internal Rev
enue Code. The companies managing these funds also act
as real estate agents in the purchase and sale of the
properties and are thus able to add substantially to their
income. Some of these funds are being marketed by offers
of participation in the management companies to the
sponsoring banks.
Toward the end of 1969, the aggregate assets managed
by offshore investment companies organized by United
States financial interests may have reached close to $3
billion. This very rough estimate excludes the portfolios
of the offshore realty companies and of national funds
established by the management companies associated with
offshore funds. (National funds are investment companies
selling their shares predominantly or solely in the coun
tries where they are established.) The estimate also ex
cludes the assets held by a sizable number of “in-house”
offshore funds set up by American investment and other
banks whose shares are placed only with wealthy foreign
clients of these banks. Including the assets of these various
investment companies and also the portfolios of United
Kingdom and Canadian offshore funds, the aggregate
assets of the international offshore industry may have
approached $4.8 billion at the end of 1969.
United Kingdom investment companies. Shares of these
offshore funds may be sold to United Kingdom residents,
while offshore companies established by American inter
ests in an effort to remain exempt from United States securi
ties and tax laws will not sell their shares to United States
citizens. Some of these United Kingdom offshore funds
invest primarily in the sterling area. They serve principally
the needs of sterling-area residents who desire professional
management of British equities portfolios but who are
averse to investing in United Kingdom resident investment
companies because of the companies’ exposure to the
United Kingdom capital gains tax.
The investment orientation of most United Kingdom
offshore funds is, however, the dollar area. Among these
funds, a distinction must be made between those that
sell their shares against sterling and those whose shares
are denominated in dollars. Those whose own shares are
denominated in sterling must acquire dollars at varying
premiums over the official rate in the so-called investment
dollar market except to the extent that they are officially
permitted and able to borrow dollars. The investment
dollar market is a pool of foreign currencies which is fed
mainly by the proceeds from sales, redemptions, or liqui
dations of nonsterling-area portfolio and direct invest
ments by United Kingdom private and institutional in
vestors. British exchange control requires that 25 percent
of such proceeds must be surrendered at the official rate;
the balance is normally eligible for reinvestment in non
sterling-area securities or sale in the investment currency
market. To the extent that United Kingdom offshore com
panies draw on this pool rather than borrow dollars, there
is generally no net addition to the demand for American
equities.
For British and overseas-sterling-area investors inter
ested in obtaining a foothold in American and other
dollar-are a common stocks, funds whose shares are de
nominated in sterling but which purchase dollar securities
are attractive for two reasons: (1) the investor need not
incur the risk of directly entering the dollar premium
u n i t e d k i n g d o m o f f s h o r e f u n d s . In the last year or
two, rather substantial amounts of American equities have market, which is subject to substantial price fluctuations,
been acquired by United Kingdom offshore funds. These and (2) he avoids becoming subject to the 25 percent
are mutual funds that have been established in Bermuda, surrender requirement. Moreover, by reason of the fund’s
the Bahamas, and other tax havens by British merchant residence outside the United Kingdom, there is no capital
banks and other financial institutions engaged in supplying gains tax liability on investment switches within the fund.
investment advisory and other management services to Such funds themselves are subject to the 25 percent sur
render requirement on switches of dollar securities; this re
quirement they are able to avoid, however, either by buying
into, and holding onto, the shares of affiliated or other funds
whose own shares are a dollar security or by borrowing
dollars under exchange control rules governing institutional
5 Our balance of payments records such investments as direct
borrowing of foreign currencies for portfolio investment.
investment by foreigners in the United States.
FEDERAL RESERVE BANK OF NEW YORK
169
companies. The motive was to conform to new laws
and regulations (discussed below) which have thrown
roadblocks into the path of foreign-based investment com
panies. These so-called national funds, established pri
marily in Germany and Italy, cater to the needs of in
vestors in their own countries. While holding substantial
amounts of local stocks, often in response to legal or in
formal requirements of the governments concerned, they
also invest heavily in the United States, Japanese, or other
foreign securities. This trend toward national funds is
likely to continue as an increasing number of countries
seek to restrict the operations of foreign-based investment
companies doing business in their countries.
A rather large number of investment companies organ
ized in Western Europe to meet the needs of domestic
investors and to place their resources primarily in domes
tic investments nevertheless tend to hold at least a part,
and sometimes a sizable portion, of their portfolios in for
eign securities. This is particularly true of several Swiss
and German funds and, in the United Kingdom, applies
with particular force to the Scottish investment trusts,
which have traditionally been heavy investors in Ameri
e u r o p e a n i n v e s t m e n t c o m p a n i e s . European financial
can equities. Toward the end of 1969, almost two fifths
institutions, mostly banks, have established a large num of these trust portfolios was invested in dollar-area stocks.
ber of internationally oriented investment companies, The United States portfolio of all United Kingdom invest
many of which have sizable American equities portfolios. ment trusts was as much as <£1,187 million (after making
Some of them have been set up for the specific purpose allowance for the dollar premium), or 23 percent of their
of providing investors with a vehicle to acquire a stake in total assets at the end of 1969.
a broadly diversified portfolio of shares issued in a great
British institutional investors have often been reluctant
many countries. Others define their investment objective to add to their investment risk by paying the rather high
as seeking capital appreciation or long-term capital growth and volatile dollar premium in the investment dollar mar
through the purchase of the common stock of American ket. To avoid the risk of adverse movements of the
and Canadian corporations. Still others purchase only the premium, as well as to avoid the 25 percent surrender
shares of companies incorporated in specific European requirement, many trusts and other institutional investors
countries or in such regions as the Pacific area. Some of in the United Kingdom have been led to finance an in
these funds have been established by large local banks for creasing portion of American and other dollar-area equities
the explicit purpose of offering the shares to these banks’ purchases with borrowed rather than investment dollars.
international clientele who are often interested in funds Two major avenues have been used: Euro-dollar loans
with a diversified portfolio that contains a sizable dollar and so-called “back-to-back” loans.
content. For instance, the foreign participation in Swiss
Medium-term Euro-dollar loans may be employed with
investment companies has been estimated to be as high as Bank of England approval for financing equities pur
40 to 50 percent.
chases and are known to amount to several hundred mil
At the end of December 1969, twelve large internation lions of dollars, though in 1969 their use fell off because
ally oriented investment companies organized by European of high rates. Back-to-back loans have their origin in the
banks and other financial interests held assets of approxi United Kingdom credit restraint program and the ensuing
mately $1.9 billion, of which about $470 million was in difficulties for United Kingdom affiliates of foreign cor
vested in American equities. More than two thirds of this porations in their search for adequate bank finance. To
amount was accounted for by a prominent group of Dutch help them overcome these difficulties, large institutional
investment companies.
investors in the United Kingdom, including investment
Still another category of European funds has been set trusts and insurance companies, have offered the affiliates
up by the management groups associated with offshore sterling finance at attractive terms on the condition that
The appeal to sterling-area investors of offshore funds
whose shares are denominated in dollars is based on sev
eral grounds: by reason of their external status, the
funds are not subject to the requirement to acquire
dollars through the premium market nor are they subject
to the 25 percent surrender requirement and capital gains
tax on investment switches; moreover, if the sterling-area
investors are institutions, they may be able to expand their
dollar-denominated fund holdings by borrowing dollars
rather than buying them at the premium rate. However,
United Kingdom and, in certain circumstances, other
sterling-area residents become subject to the 25 per
cent surrender rule if and when they sell the dollardenominated shares of offshore funds. The number and
scope of operations of United Kingdom-sponsored dollararea-oriented funds have been increasing at a rapid rate
during the past year and, in the longer run, they may
well be able to mobilize rather impressive amounts of
“free” dollars, i.e., dollars not originating in the dollar
investment pool, for expanding their stake in American
equities.
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MONTHLY REVIEW, JULY 1970
their parent companies advance an equivalent dollar
amount to the investor (a so-called “triangular” financing
arrangement). These loans are kept under surveillance by
the Bank of England; they are also subject to restrictive
requirements administered by the United States Depart
ment of Commerce’s Office of Foreign Direct Investments,
if the supplier of the dollars is a United States direct
investor.
Resort to these loan facilities has failed to prevent net
sales of American equities by United Kingdom residents
in recent years (owing largely to the withdrawal of United
Kingdom tax relief from overseas corporate taxation under
the 1965 Finance A ct), but it has helped to sustain the
United Kingdom demand for American equities and has
made a not unimportant contribution to the net flow of
capital into Wall Street. Moreover, to an indeterminate
extent, sales by British residents of American equities
have been offset by their purchases of shares of offshore
funds that invest heavily in the New York market.
f o r e ig n
b a n k s . Banks in several foreign countries,
notably in Europe, operate on a large scale in American
equities markets. Some of these banks, notably Swiss and
French institutions and a few British merchant banks,
have set up investment affiliates in New York and thus
have established close contacts in the New York market.
For the most part, operations of foreign banks in Ameri
can markets reflect customers’ orders, including those of
institutional investors— such as mutual funds and insur
ance companies—to whom these banks provide substan
tial investment services and on whose portfolio choices
they exercise a great deal of influence. But during the past
decade, an increasing portion of total orders of foreign
banks, the larger part in the case of some private banks,
has been placed for account of customers who have re
linquished investment discretion to these banks. Many
foreign investors, interested in a geographically diversified
portfolio but ill informed about the investment climate
abroad and thus at a loss concerning which foreign stocks
to choose, prefer to let professional investment managers of
knowledgeable banks administer their equities portfolio.
The investment discretion of the banks is usually restricted
by customers’ directives that reflect their particular needs
and preferences. Among the relatively wealthy people who
use banks of two or three European countries to make in
vestment decisions for them are, of course, many investors
who do not wish to use the mails or the telephone for
communicating with their foreign banks of account. Ag
gregate orders for American equities purchases handled
by foreign banks with discretionary authority from their
customers add up to impressive amounts.
t h e r e t a i l d e m a n d . Direct purchases by individuals,
placed either through foreign banks or the local branches
of American brokers, continue to play an important part in
the net foreign demand for American equities. This group
of investors is very heterogeneous. During the 1966-68 pe
riod a great many foreign individuals entered the American
market in the expectation of much more rapid capital
appreciation than in their own markets; these investors
tend to pull out of New York when the market shows signs
of weakness. A minority consists of quite volatile and very
performance-conscious investors, many of them relatively
wealthy, who step into and out of various stock markets
in response to speculative opportunities and currency de
velopments. Another group of fairly well-to-do investors
around the world, not only Europeans but also South
Americans and residents of the Middle and Far East, are
primarily interested in obtaining protection of their wealth
from the effects of local inflation and in some cases from
confiscatory taxation. Being essentially safety oriented
rather than of a speculative bent, they are typically long
term investors. This is also true of many small investors
abroad who are not concerned with day-to-day stock
price fluctuations but are convinced that by acquir
ing American equities they are buying “guaranteed longrun growth”. This type of investor appears to be per
suaded that patience will eventually be rewarded and does
not panic when New York market quotations wilt. For
the most part, however, these small savers buy shares of
investment companies, both American and foreign, rather
than American equities directly. Their general investment
philosophy is well reflected by the fact that gross pur
chases by small investors of offshore funds with large
American portfolios held up quite well at least during the
early phases of the recent period of depressed price con
ditions in the New York stock market; with few excep
tions, share redemptions by investors in offshore funds
remained on the low side, at least in 1969 and early
1970 ° One reason for their inertia is the few alternatives
they have for the employment of funds. Their own mar
kets tend to reflect conditions in the New York stock
exchange, and typically they know even less about basic
conditions, and the shares of individual companies, in
other distant markets than they know about the Ameri-
6 It should be noted that the relatively low redemptions are partly
attributable to the fact that small savers typically purchase ten- or
fifteen-year programs for monthly investments. Since a large part
of the sales commission is collected on the early instalments, re
demption of the shares soon after their purchase is expensive for
the investor.
FEDERAL RESERVE BANK OF NEW YORK
can market. These considerations help to explain the
absence of large-scale foreign liquidation of American
equities in 1969 and early 1970. However, many offshore
funds investors who have hesitated to redeem their shares
at a loss may do so after the value of their shares recovers.
Individuals’ direct purchases in the New York market
have been greatly stimulated by the proliferation of Amer
ican brokerage offices abroad. The branch offices have
done a great deal to bring investment opportunities in the
American market to the attention of individual investors
and have provided institutional investors, notably foreign
banks, with access to available research and other services.
Presently, approximately 250 such offices are operating
in about thirty countries, including more than fifty offices
in Canada and more than forty offices in Switzerland. In
1969, however, various measures have been taken abroad
to restrict purchases of American equities; consequently,
branch offices in several areas may well be closed. In some
countries, American brokers confine themselves to institu
tional business and refuse to handle retail orders, some
times under formal or tacit arrangements with local bank
ing groups which do not look kindly upon foreign securi
ties firms that try to trespass on what they consider their
own preserve.
GLOBAL A SSE T M ANAG EM ENT
International portfolio investment patterns have under
gone significant changes, as rapidly increasing amounts
of individual savings in many countries abroad have come
under professional investment management. There is now
a much higher degree of mobility of such savings among
national stock markets. Surely, the typical small investor
abroad who bought into internationally oriented funds
would not have had the courage, even if he had the desire,
to venture on a large scale and on his own initiative into
unfamiliar investment territories. This is in sharp contrast
to the attitude of professional investment advisers asso
ciated with offshore funds, other major foreign-based in
vestment companies, and large foreign banks. Many of
them have gradually become adherents of a relatively
new concept of investment administration referred to as
“global asset management”. This means that they are now
quite prepared to shift their resources quickly among
stock and even money markets in response to changing
conditions in major countries’ investment climates. As a
result, the portfolios of many foreign-based investment
companies are now much more internationally diversified
than is generally realized. Even among the Americanmanaged offshore funds, which used to put virtually all
their resources into the New York market, there are sev
171
eral important institutions that now hold substantially
less than one half of their assets in American common
stocks. The trend toward international portfolio diversifi
cation and a lower ratio of American stocks in fund port
folios gained additional force during 1969; a few such
funds now hold a rather small fraction of their total re
sources in the United States. On the whole, the declining
ratio of American equities holdings in aggregate portfolios
during 1969 involved little, if any, net liquidation of se
curities in the New York market. In part, it was due to a
relatively sharp decline in the price of some volatile
“glamour” stocks held by a number of the investment
companies. Moreover, many funds employed an increas
ing portion of their continuously growing resources in
other markets rather than New York. In 1969, their pre
ferred outlets were the Euro-dollar market and the Japa
nese stock market.
The Euro-dollar market last year attracted very
large amounts of money destined eventually to enter
or reenter long-term capital markets. The aggregate
amount of long-term portfolio account funds placed in the
market was probably close to $2 billion, including place
ments by individual investors. With three-month rates for
Euro-dollars in the 9 to H V 2 percent range through
much of 1969, portfolio managers, beset by doubts and
hesitations about adding to their stake in the depressed
New York stock market, were easily lured into placing
their investable funds in European banks. Some pur
chased Euro-dollar certificates of deposit from London
banks rather than using ordinary Euro-dollar deposit
facilities. Thus they had a fairly liquid instrument on
hand, if they desired on short notice to reenter equities
markets that showed incipient signs of renewed strength.
Others preferred to take advantage of the somewhat higher
rates for deposits, spacing their maturities in order to
provide them with the necessary liquidity for possible re
entry into securities markets. Sizable funds held for
eventual long-term investment were also placed in localcurrency time deposits with European banks, notably in
Germany.
International diversification of portfolios has involved
greater interest in Japanese equities. Foreign institutional
interest in Japanese equities rose rapidly in 1968 and even
more so in 1969. A few major European mutual funds
now hold a larger amount of Japanese than United States
stocks. Some of the European bank-sponsored funds spe
cializing in Japanese stocks have grown at a rapid rate.
The remarkable strength displayed by the Japanese econ
omy in recent years, its impressive growth rate, its rapidly
growing exchange reserves, and the low earnings multi
pliers at which many leading Japanese shares are traded
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MONTHLY REVIEW, JULY 1970
constitute the major factors in the growing foreign interest
in Japanese stocks. The large turnover at the Japanese
stock exchanges, which consequently can absorb substan
tial purchases and sales with relative ease, and the avail
ability of American and European depository receipts for
Japanese stocks are other elements that attract foreign
funds into Japanese stocks. Yet, despite the concerted
efforts of investment companies to add to their expertise
on Japanese industry and the presence in New York and
London of several affiliates of Japanese securities dealers
and brokers, many members of the international invest
ment community continue to feel rather remote from Japan.
On balance, it appears that the New York stock market
has a great deal going for it in the international competi
tion for investable funds handled by professional portfolio
managers. The New York market, more than any other,
can handle large individual stock transactions with relative
ease and absorb very sizable deals without quotations for
the respective stocks being materially affected. This is, of
course, of great relevance to portfolio managers who wish
to buy and sell large blocks of stocks and who must put
great emphasis on portfolio liquidity, considering that
their funds’ shares are subject to redemption by their
holders. In many Continential exchanges, an order to buy
or sell a large block of shares of any one stock typically has
significant price effects. Apart from New York, only the
Japanese and London stock exchanges have the depth that
large institutional investors require.
The New York stock exchange also offers a greater
degree of diversity in stocks listed than virtually any other
market. For fund managers interested in growth stocks, the
large number of technology-oriented stocks makes New
York particularly attractive. Information on industry de
velopments in the United States is ample, and a good deal
of financial disclosure is required by Securities and Ex
change Commission rules. This is in sharp contrast to the
paucity of relevant data issued by corporations in major
foreign countries.
New York has also benefited from the fact that quite
a number of the offshore funds, notably some of those
sponsored by United States banks, are committed under
their statutes only or primarily to invest in common stock
issued by United States corporations. Also, the American
investment advisers of offshore funds have a natural predi
lection for investing in the New York market since they
know the United States market better than any other. But,
as noted before, a strong desire to spread their wings
and look for new investment horizons can be discerned
from the behavior of their portfolios.
IM P L IC A T IO N S F O R T H E
IN T E R N A T IO N A L E C O N O M Y
The emergence of offshore investment funds and the
ensuing accelerated movement of foreign capital into
American equities have left distinct marks in several sec
tors of the international economy. In many countries,
changes have occurred in the allocation of the public’s
savings and new links have been forged among national
capital markets. The balance of payments of some of the
capital-exporting countries, as well as that of the United
States, has been importantly affected.
ALLOCATION OF SAVINGS: NATIONAL AND INTERNATIONAL.
The initial success of the aggressive sales campaign
of the investment company industry has not been without
effect on savings patterns in both less developed and in
dustrial countries even though, in the aggregate, equities
purchases still occupy a relatively modest role as an out
let for savings abroad. Often for lack of satisfactory in
vestment outlets, potential investors in developing nations
have hoarded gold and other valuables or invested in real
estate. Such individuals might find investment in United
States mutual or offshore funds attractive, but a flow of
funds into such investment tends to interfere with devel
opment of domestic capital markets.
In the industrial countries of Western Europe, too,
foreign-based and locally sponsored mutual funds have
produced changes in the investment patterns of the pub
lic. Of course, middle-class savers in these countries have
for decades bought a broad range of securities for long
term investment. But not infrequently the flow of funds
into equities was inhibited by savings banks and even
commercial banks that preferred to put their customers
into time deposits or fixed-interest-bearing securities.
In several Western European countries these institu
tions, though the principal dealers and brokers in securi
ties, did little to promote sales of stocks among people
with moderate means. These institutions became inter
ested in stock ownership only after the large-scale entry
into the European continent of the performance-oriented
American mutual funds and their offshore affiliates and
the emergence of commercial-bank-sponsored funds in
Europe. Thus, even in Western Europe, the intensive
sales effort of the investment company industry, both na
tional and international, has made equities a more impor
tant repository for savings of people in every walk of
life. However, the severe price declines of recent months
in the world’s major stock markets may shift the invest
ment preferences of many individuals abroad back to
fixed-interest-bearing assets.
FEDERAL RESERVE BANK OF NEW YORK
Whether these changes in foreign investment patterns
and the ensuing movement of portfolio capital into the
United States have contributed to an optimal allocation
of financial resources is questionable. It could be said that
it does not appear to make economic sense for as wealthy
and capital-rich a country as the United States to import
large amounts of capital by selling outstanding stocks to
the rest of the world. Very often the movement into Wall
Street involves the shift of funds from capital-poor coun
tries that can ill afford the loss of financial resources. On
the surface, there appears little to be said for such capital
flows. Obviously, however, the sale of financial assets helps
to equilibrate our foreign accounts. In very broad per
spective, the United States capital market can be viewed
as providing intermediary financial services. It may serve
the desire of investors in search of long-term capital appre
ciation, and it may supply in return direct investment
capital, often to the same countries that export portfolio
capital to this country.
For obvious reasons, this view finds little support
among the governments of many capital-poor countries
whose citizens have become heavy buyers of American
equities either directly or indirectly through mutual funds.
In many countries of the less developed world, notably in
Latin America, governments have issued various regula
tions prohibiting or at least making more difficult the sales
of foreign mutual fund shares. Such regulations reflect the
efforts of these governments to channel savings into do
mestic investment and to protect their monetary reserves.
In fact, a not insignificant amount of the aggregate foreign
demand for United States equities comes from individuals
seeking refuge or a safehaven from their revenue and ex
change control authorities.
In industrial countries, as the public’s stake in shares
of foreign-based investment companies grew at a rapid
rate, several governments became increasingly concerned
over the safety of these investments. This concern was en
hanced further by the absence of any supervision and regu
lation of these investment companies in the countries,
mostly tax havens, where they were incorporated. To some
extent, this concern was also prompted by widespread criti
cism of the selling and advertising methods employed by
some offshore funds. Consequently, several governments
felt compelled to adopt new laws to put share sales of
foreign-based mutual funds under a measure of restraint
and supervision. In some countries, there was also concern
over excessive capital exports, but for the most part the
major motive was to protect savers. A case in point is the
law on foreign investment companies adopted last year in
the Federal Republic of Germany. The law imposes farreaching restrictions on the timing of sales charges and on
173
other sales practices; it requires foreign funds desirous of
selling their shares in Germany to establish a legal presence
in Germany, and outlaws the sale of those funds that invest
in other mutual funds. Laws and regulations restricting the
operations of offshore funds have also been adopted or are
in various stages of preparation in several other major Eu
ropean countries. For instance, funds offered in Italy must
have at least 50 percent of their assets invested in Italian
companies. A variety of restrictions on purchases of foreign
funds were also adopted in France and several other Euro
pean countries. The unfavorable publicity surrounding the
operations of some of the mutual funds sponsored by IOS
might well give further impetus to legislative action curb
ing operations of offshore funds. These measures may
inhibit the progress of some of the offshore mutual funds.
On the other hand, the ingenuity of the industry to adapt
itself to whatever regulatory climate it encounters should
not be underestimated.
f i n a n c i a l i n t e g r a t i o n . During the past decade, na
tional financial markets have become increasingly linked
together as close ties have been fashioned between major
money markets and the Euro-dollar market. The banking
systems of several major countries now hold sizable por
tions of their liquid funds in that market. But long-term
financial markets, at least until recently, have remained
largely isolated in the sense that the public’s aggregate
holdings of long-term securities issued in countries other
than those of their own residence have remained a small
fraction of their total holdings of long-term financial
claims. The emergence in the midsixties of the Euro-bond
market, in which interest-bearing securities were sold
simultaneously in a large number of countries by multi
national underwriting syndicates, has made a scant begin
ning in demolishing major barriers between individual
financial markets. This process has been given further
stimulus, as the international investment funds sold United
States shares to foreigners, as newly formed national in
vestment companies in the late sixties placed substantial
portions of their resources abroad, and as American se
curities brokers and dealers increasingly engaged in world
wide operations.
b a l a n c e -o f -p a y m e n t s a s p e c t s . The heavy movement of
equity capital to Wall Street had both equilibrating and
disequilibrating effects on the international accounts of
the countries involved. In several areas of the under
developed world where inflation and exchange rate de
preciation were among the motives for investors seeking
investment outlets abroad, the heavy flow of capital into
foreign equities served to aggravate pressures on monetary
174
MONTHLY REVIEW, JULY 1970
reserves. This was also true of a few European countries.
On the other hand, some countries with large currentaccount surpluses in 1967 and 1968 welcomed the greater
balance in their overall accounts that stemmed from the
heavy movement of domestic capital to New York
(whether via investment company shares or directly into
American equities or Euro-bonds). Germany, one of the
most important markets for American and offshore invest
ment company shares, is a conspicuous example.
In the United States, the flow into stocks has had
an important influence on our international accounts.
Notably in 1968, the $1.4 billion increase in net foreign
purchases of United States stocks over 1967 served to
offset almost half of the current account’s shrinkage dur
ing that year. In 1969, the decline of the inflow was one
of several factors that explain the worsening of our liquid
ity balance. But it should be noted that foreign purchases
of United States stocks in 1969 were still the second high
est on record and made an important contribution to a
much better balance in our capital accounts. Moreover,
many offshore investment companies that ordinarily would
have invested their own net accruals in United States
equities indirectly contributed to the capital inflow by
placing funds in the Euro-dollar market, where they were
acquired by the overseas branches of United States banks
for head-office account. Without these inflows, our official
reserve transactions surplus for 1969 might have been
substantially reduced.
OUTLOOK
Prognostications about the outlook for foreign purchases
of American equities call for great caution, especially in
view of recent changes in the investment environment in
the New York market. The past period of heavy buying
is far too short to permit extrapolation of 1967-69 trends.
The recent problems of the IOS group of companies and
the poor performance of many offshore funds during the
last twelve months will probably militate against effective
sales campaigns of existing funds and make it difficult, if
not impossible, to float new funds in the months ahead.
Considering the huge accumulation of American equities
by foreigners, there is always the possibility of substantial
disinvestment. Nevertheless, a qualified optimism appears
to be in order. The fact that foreigners purchased $1.5
billion of American stocks when the New York market
performed as dismally as in 1969 is significant.
Several long-term forces may contribute to continued
growth of foreign investment in Wall Street. Institutional
investors in Europe, notably insurance companies and
pension funds, are becoming increasingly interested in
foreign stocks. Despite recent setbacks, prospects are
fairly good for growing interest in the direct and
indirect ownership of common stocks among savers in
many areas of the world. Wall Street may well benefit
from this trend. While recent laws and regulations adopted
in many countries may curb the growth of offshore invest
ment companies, national funds associated with the Amer
ican and British management companies that established
the offshores are likely to gain in importance. And, as in
the past, there is good reason to expect that these com
panies will continue to supplement their holdings of United
States corporate shares with superior growth prospects.
In this connection, it is noteworthy that the Japanese gov
ernment has recently authorized Japanese investment com
panies, within certain limits, to buy corporate securities
in the United States and several other countries.
For the United States balance of payments, these
longer term prospects have encouraging implications.
Foreign purchases of American equities hold good promise
for making an important contribution to the eventual
achievement of a greater degree of balance in our inter
national accounts.
FEDERAL RESERVE BANK OF NEW YORK
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