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154 MONTHLY REVIEW, JULY 1972 Am endments to Regulations D and J On June 22, 1972, the Board of G overnors o f the Federal Reserve System announced amendments to its Regulations D and J which are designed to restructure on a more equitable basis the reserve requirements o f member banks and to modernize the nation’s check collection system. The changes are basically the same as proposals the Board published on M arch 28 for public com ment, but they have been modified in detail and method o f application in the light o f com ments received. The change in Regulation D , which governs member bank reserves, will restructure requirements against net demand deposits so that the same requirement ratio will apply to all m em ber banks o f equal size regardless of their location. M oreover, all banks with demand deposits o f more than $400 m illion will be considered “reserve city banks”. This m ethod o f classification is in contrast to the current one in which the “reserve city” designation is generally applied to larger banks in larger cities, with all others com m only called “country banks”. At the present time, reserve city banks are required to hold reserves o f 17 percent against net dem and deposits under $5 m illion and of 17 Vi percent on net demand deposits over that amount, while the corresponding required reserve per centages for country banks are H V2 percent and 13 percent, respectively. W hen the scheduled changes becom e effective, a more graduated scale will apply and requirement ratios for m ost categories will be lowered. The re structuring will apply the follow ing ratios to member banks: A m o u n t of net demand deposits Reserve percentages applicable First $2 m illion or less Over $2 m illion-$10 m illion Over $10 m illion-$100 m illion Over $100 m illion-$400 m illion Over $400 m illion 8 percent 10 percent 12 percent 13 percent MVi percent The new reserve requirements are to take effect in two steps. Beginning in the statement week o f September 21 to September 27, the first three ratios— 8 percent, 10 percent, and 12 percent— will apply to net demand deposits of $100 m illion and less, based on the average level of deposits during the week ending September 13. At the same time, the 17Vi percent ratio that now applies to demand deposits between $100 m illion and $400 m illion at present reserve city banks will be reduced to 16!/2 percent. During the statement week from September 28 to October 4, the latter ratio will be reduced to 13 percent based on the average level o f deposits during the week ending September 20. Beginning September 21 an amendment to Regulation J, covering collection of checks and other items by Federal Reserve Banks, will becom e effective. From then on, all banks served by the System ’s check collection m echanism will be required to pay for checks drawn on them with funds im m ediately available on the day that the Federal Reserve presents the checks for payment. Currently, m ost banks outside cities with Federal Reserve facilities or paym ent areas served by the newly created Regional Check Processing Centers pay for checks in funds collectible one day or more after presentation. This change will result in a reduced volum e o f Federal Reserve float to such banks, although this effect will be offset in part by more rapid payment o f funds to these banks. The Board is giving high priority to accelerating the developm ent o f additional Regional Check Processing Centers so that these banks can also have facilities for overnight check gathering, processing, and clearing. The Board established conditions under which it will be appropriate for a Reserve Bank temporarily to waive penalties for member bank reserve deficiencies resulting from the impending changes in Regulations D and J. In this connection, the Board set the follow ing guidelines: — A waiver will be granted initially only for penalties on reserve deficiencies equal to a reduction in avail able funds that exceeds 2 percent o f a member bank’s net demand deposits. — The amount o f deficiency eligible for waiver o f penalties will decrease 1 percent o f net demand deposits for each quarter beginning January 1, 1973. — N o further waivers will be granted under this authority after June 30, 1974. The net effect o f these regulatory changes is expected to amount to a release of about $1.5 billion o f reserves to the banking system. There will be a total release o f about $3.5 billion from the restructuring of reserves and the waiver o f penalties, offset in part by the $2 billion reduction in float resulting from the change in Regulation J. It is intended that open market operations will be adapted as needed, when the amendments go into effect, to neutralize the impact on monetary policy. FEDERAL RESERVE BANK OF NEW YORK 155 Th e Business Situation Recent data indicate that economic activity has con tinued to expand briskly. Retail sales rose markedly in May but then dropped in June, according to preliminary information. Sales were probably held down in June by the storm which affected much of the East. Industrial production posted a moderate, though broadly based in crease in May. Over the first five months of the year, output has risen at a rapid 9 percent annual rate. In May, personal income climbed at roughly the pace of the first four months of the year and the volume of residential housing starts increased after easing off in the two previous months. Moreover, there are tentative signs of some strengthening in inventory spending. The unemployment rate fell to a seasonally adjusted 5.5 percent in June, as employment increased and the civilian labor force de clined by nearly 100,000 workers. The latest price information suggests that inflationary pressures persist. Seasonally adjusted consumer prices, boosted by a rapid rise in prices of some nonfood com modities, increased at an annual rate of 4 percent in May. Retail food prices declined for the second consecutive month, but this improvement is not expected to be main tained. Wholesale prices of farm products and processed foods and feeds rose rapidly again in June, and industrial wholesale prices advanced at a disappointing 5 percent an nual rate. June data reveal only a modest increase in wages for the second consecutive month, although over the Phase Two period as a whole wages have climbed considerably. PRODUCTION, ORDERS, AND INVENTORIES The Federal Reserve Board’s index of industrial pro duction rose in May by 0.5 percent on a seasonally ad justed basis, and the readings for the preceding three months were revised upward slightly. Thus, in recent months output has resumed rapid growth after the decline and subsequent stagnation associated with the recession of 1969-70 (see Chart I). Since the beginning of the year, industrial production has climbed at a fast 9 percent seasonally adjusted annual rate, roughly the pace of ex pansion registered between early 1961 and mid-1969, to reach a level only 0.3 percent below its peak of Sep tember 1969. The May increase in output was widespread, including gains in the production of consumer goods, busi ness equipment, and intermediate products. On the other hand, output of defense and space equipment and of materials edged down a bit following sharp advances in April. The May rise in production of consumer goods was 10 percent at an annual rate. Output of most appliances, fur niture, and consumer nondurable goods increased, while automobile assemblies declined somewhat from their April pace despite the strength of automobile sales. Since De cember 1971, consumer goods output, seasonally adjusted, has advanced at an annual rate of 6.7 percent, with the increase concentrated largely in durable goods. Output of business equipment climbed at an annual rate of 8.3 per cent in May, after an upward revised increase of nearly 17 percent in April. Over the first five months of 1972, pro duction of business equipment has risen rapidly at an annual rate of 12 percent and, in May, stood at 7.5 per cent above its level of a year earlier. Orders placed with manufacturers of durable goods edged up by about $0.1 billion in May. Excluding the volatile transportation equipment sector, bookings rose by a healthy $0.7 billion, or 2.8 percent, to a seasonally adjusted $26.6 billion (see Chart II). This series, along with manufacturers’ shipments, unfilled orders, and inven tories, has recently been revised to reflect new bench marks derived from the annual Survey of Manufacturers and new seasonal adjustment factors. As a result, there have been substantial downward revisions in the orders and shipments series, while inventory levels, and therefore inventory-sales ratios, were revised upward. In any event, in May new orders for electrical machinery and primary metals rose, while bookings for transportation equipment fell more than $0.6 billion after posting a gain of similar magnitude in the previous month. Bookings for nonde fense capital goods, a new category which replaces pro ducers’ capital equipment, were off slightly in May but 156 MONTHLY REVIEW, JULY 1972 C hart I INDUSTRIAL PRODUCTION S easonally a d ju s te d ; 1967=100 Note: Shaded areas represent recession periods, according to the National Bureau of Economic Research chronology. The dates of the 1969-70 recession are tentative. Source-. Board of Governors of the Federal Reserve System. were still about 21 percent above the level of May 1971. Shipments of durable goods climbed modestly to a new record, while the backlog of unfilled orders increased for the eighth consecutive month. There are tentative indications of some pickup in in ventory spending after a prolonged period of sluggishness. During April, the book value of total business inventories increased at an $8.3 billion annual rate following an up ward revised March gain of $6.2 billion. Trade stocks rose substantially, particularly at the wholesale level, but manufacturers’ holdings declined slightly. However, pre liminary May manufacturing data suggest a strength ening in inventory spending in this sector, as seasonally adjusted holdings climbed $4.9 billion at an annual rate. This gain occurred entirely in the durable goods sector. In 1972 thus far, manufacturers’ inventories have risen at a $2.8 billion annual rate after remaining virtually flat throughout 1971. For all manufacturers, the ratio of in ventories to sales was 1.69 in May, the same as April’s upward revised level. R ETAIL SALES, PERSONAL INCOME, AND R ESID EN TIA L CONSTRUCTION Recent data provide impressive evidence of continued strengthening in consumer spending. In May, seasonally adjusted retail sales climbed $0.6 billion above the up ward revised April level to a record $36.9 billion. Sales of both durables and nondurables increased, with auto motive sales accounting for much of the strength in durables. Among nondurables, sales of general merchan dise and food rose sizably. Preliminary June data indicate a drop in retail sales from the May peak, but spending was still a healthy $36.4 billion. Moreover, June sales were 157 FEDERAL RESERVE BANK OF NEW YORK undoubtedly held down somewhat by the tropical storm which affected much of the East Coast. Nevertheless, over the second quarter retail sales were a substantial 2.8 per cent above the first-quarter average. In June, sales of new domestic-type automobiles moderated somewhat from their very rapid May pace to a 9 million unit seasonally adjusted annual rate, still a strong showing. Over the April-June period, sales of new domestic-type autos averaged 9.2 million units at an annual rate by com parison with an 8.7 million unit pace in the first quarter. Meantime, sales of imported cars were at an annual rate of 1.6 million units in June by comparison with 1.5 mil lion units in both April and May. Personal income posted a $4.8 billion increase in May, reaching a seasonally adjusted annual rate of $915.9 bil lion. It should be noted that month-to-month fluctuations in this series have been affected recently by retroactive payments of wage increases approved by the Pay Board, as well as by other special factors. After adjustment for these influences, the May gain in personal income was $5.3 billion, roughly in line with the adjusted increases of the past several months. Further, over the January-May period, personal income averaged $905.4 billion, 8 per cent above the average of the first five months of 1971. Wage and salary disbursements were up moderately in May, with a rise in manufacturing payrolls providing about half of the overall gain. The durable goods sector, particularly primary and fabricated metals and machinery, accounted for most of the rise in manufacturing payrolls. After declining for two consecutive months, the pace of private housing starts increased by 221,000 units in May to a volume of 2.3 million units at a seasonally ad justed annual rate. While this was below the extra ordinarily strong performance of the first quarter, it never theless represented a healthy total by most other stan dards. The May advance was concentrated in starts of single-family units, which climbed to their highest level in four months. Newly issued building permits increased slightly in May as well. Recent information suggests a modest tightening in mortgage market conditions. The average interest cost on conventional new home mort gages inched higher in May as did the effective rate on loans for existing homes. Moreover, the secondary-market yields of Federal Housing Administration-insured loans edged up for the second consecutive month. LABOR M A R K ET DEVELO PM EN TS consequence, the unemployment rate fell to 5.5 percent after holding steady at 5.9 percent over the previous three months. In June, the rates of unemployment for most major labor force groups declined, with a particularly pro nounced drop in joblessness among teen-agers. This de cline stemmed, in part, from a smaller than seasonal influx of young people into the labor force. At the same time, the unemployment rate for adult men dipped to 4 percent, compared with 4.3 percent in both April and May, and the rate of unemployment for adult women fell to 5.5 per cent in June from 5.9 percent in May. On balance, these data suggest that the rather substantial increases in em ployment in recent months have begun to have an impact on joblessness. Over the April-June period, civilian em ployment averaged a sizable 589,000 above the level of the first quarter, an annual rate of increase of 2.9 percent. Expansion of the labor force was also rapid' in the second quarter, amounting to 2.5 percent at an annual rate. After several months of sizable gains, the most recent survey of establishments indicates only a small increase in nonfarm payroll employment in June. With this advance, Chart II NEW ORDERS FOR DURABLE GOODS Seasonally adjusted Billions of dollars 34 r 32 - 30 - 32 - K, Total 28 i 30 28 / 26 26 / i / 24 — Total excludii "9 transportation equipment /V'AJ 22 / 18 M / 4 y / _ 24 - 22 - 20 niiiiiiiii 18 | V 1 1 20 V V / niiiiiiiii Illllllllll 1968 According to the monthly survey of households, civilian employment, seasonally adjusted, rose by 273,000 workers in June, while the labor force decreased by 91,000. As a Billions of dollars 34 1969 Illllllllll 1970 Illllllllll 1971 1972 Source: United States Departme nt of Commerce, Bureau of the Census. 158 MONTHLY REVIEW, JULY 1972 Chart III CHANGES IN EMPLOYMENT Seasonally adjusted M illions of persons June - December 1971 S o u rc e : M illions of persons December 1971June 1972 U n ite d S ta te s D e p a r tm e n t o f L a b o r, B u re a u o f L a b o r S t a tis tic s ; s u r v e y o f e s ta b lis h m e n ts . nonfarm employment reached a level 2.7 percent above that of a year earlier. Growth has been more rapid since the end of 1971, proceeding at a 3.9 percent seasonally ad justed annual rate over the first half of this year. Manu facturing employment declined in June, but over the January-June period manufacturing payrolls have risen by a healthy 342,000 workers, or 3.7 percent at an an nual rate. In contrast, during the last half of 1971, factory employment dropped by more than 40,000 workers (see Chart III). About 75 percent of the gain in manufacturing jobs over the last six months has occurred in durable goods industries. The rise has been widespread within the du rables sector, as there have been sizable employment increases in primary and fabricated metals, machinery, electrical equipment, and transportation equipment. The average factory workweek and hours of overtime both were essentially unchanged in June. Most other areas of the economy have experienced gains in employment in recent months, which surpassed the increases in the last half of 1971. For example, over the first six months of this year, employment in trade and services rose by 336,000 and 270,000 workers, re spectively, whereas the corresponding advances between June and December 1971 were less than 200,000 workers in each case. Total government employment, including Federal, state, and local but excluding the armed forces, rose slightly in June to a level 3.7 percent above that of a year earlier. Thus far in 1972, government employment has increased at an annual rate of 4.3 percent. All of this increase has been at the state and local government levels, as such employment rose by 317,000 workers over the six months ended in June. In contrast, reductions were or dered in Federal employment as part of the package of new economic policies instituted in August 1971 and, over the past ten months, Federal civilian employment declined in addition to the sizable reduction in the armed forces. This pattern of growth in government employment has prevailed for some time. Between June 1969 and June 1971, Federal civilian employment dropped by about 140,000 workers while employment at the state and local levels climbed by nearly 760,000. As a result, state and local governments have accounted for an increasing por tion of overall government employment. In June 1972, state and local employment constituted more than 80 percent of civilian government employment, whereas in June 1969 it made up about 77 percent of the total. The recent declines in Federal civilian employment have cen tered on the Department of Defense, as jobs in most other areas have held relatively steady. Seasonally adjusted average hourly earnings of produc tion and nonsupervisory workers in the private nonfarm economy, adjusted for overtime hours in manufacturing and for shifts in the composition of employment among industries, increased at a 1.8 percent annual rate in June. This marked the second consecutive month of modest growth in earnings. Over the seven months since the end of the wage freeze last November, the index has climbed at a considerably more rapid 7 percent rate, about the pace of 1970 and the first eight months of 1971. However, excluding the sharp advances of December and January which may have resulted from a post-freeze bunching of increases, earnings have advanced at an annual rate of only about 4.5 percent over the five months ended in June. RECENT PRICE D EVELO PM EN TS The latest price statistics suggest that serious inflation ary pressures still persist. The consumer price index rose at a 4 percent seasonally adjusted annual rate in May, despite the second consecutive monthly decline in retail food prices. Moreover, food prices advanced sharply at the wholesale level in May and June, and it is likely that consumer food prices will soon reflect these increases. FEDERAL RESERVE BANK OF NEW YORK Reportedly, retail prices of meats and some other products increased considerably in the last half of June. Because of the timing of the survey, these rises probably will not affect the consumer price index until July. To help slow the advance of food prices, the President recently removed quota restrictions on imported meats and, shortly there after, controls were extended to cover prices of some unprocessed foods at the wholesale and retail levels. In any event, over the past three months, consumer prices have advanced moderately at an annual rate of 2.1 per cent, while over the Phase Two period as a whole they have moved up at a 3.5 percent rate, modestly below the pace of the first eight months of 1971. Food prices have climbed at a 4.4 percent pace over the six months ended in May, somewhat slower than the 5 percent annual rate of gain registered in 1971 before the price freeze. The May rise in the consumer price index stemmed from a rapid advance in prices of some nonfood com modities; in contrast, service charges increased moder ately. Nonfood commodity prices rose at a 6.2 percent seasonally adjusted annual rate in May, the fastest pace in a year. Prices for used cars and gasoline climbed par 159 ticularly sharply. With the large May increase, the index for all commodities less food has now risen at an almost 3 percent annual rate since the termination of the price freeze, the same pace as during the first eight months of 1971. Nevertheless, this still represents considerable im provement relative to the increases experienced in non food commodity prices in 1970 and 1969. At the wholesale level the advance of prices has con tinued to be disappointingly rapid. In June, such prices, seasonally adjusted, climbed at a 5.7 percent annual rate. With this increase, wholesale prices have risen at a 5.2 percent rate following the termination of the price freeze, the same pace experienced over the first eight months of 1971. Wholesale prices of farm products and processed foods and feeds increased at nearly a 6 percent annual rate in June while, at the same time, industrial wholesale prices advanced at a 5 percent rate. Prices of hides, skins, leather, and related products and prices of lumber and wood products rose very sharply again in June. In Phase Two thus far, industrial wholesale prices have increased at a 4.3 percent annual rate by comparison with the 4.7 percent pace of the first eight months of 1971. MONTHLY REVIEW, JULY 1972 160 Th e M oney and Bond Markets in June Interest rates rose in the money and bond markets dur ing June. Short-term rates began to rise early in the month, and the general consensus seemed to be that these rates might increase somewhat further, along with expanding economic activity. There were, in fact, several upward adjustments as the month progressed and, by the close, yields on most money market instruments were from XA to V2 percentage point higher than when the month opened. Substantial investor resistance emerged to the lower rate levels established in the bond market during May but, even after prices were marked down on several issues in June, only modest and sporadic interest was displayed much of the time. There were several news developments during the month which apparently contributed to a fairly pervasive feeling that pressures in the long-term markets were also increasing, and investors tended to remain on the sidelines in anticipation of yet higher rates. These de velopments included announcements of accelerated rises in wholesale and consumer prices during May and dis cussions in the press that the Treasury’s need for new cash during the fiscal year 1973 might be higher than previ ously estimated. The turmoil in the foreign currency mar kets during the latter part of the month was an additional factor depressing securities prices. Indicative of the trend in the long-term markets during the month, The Bond Buyer index of yields on twenty municipal bonds climbed by 28 basis points to a level of 5.43 percent at the end of the month. In addition, the backlog of unsold tax exempts measured by inventories advertised in the Blue List mounted to the highest levels since mid-January before declining toward the end of June. Rates on new Aa-rated utility bonds rose to 7.60 percent from 7.25 percent at the start of the month. Yields on long-term Treasury bonds, on the other hand, were relatively steady, ranging for the most part from 4 to 13 basis points higher over the period. BANK RESERVES AND T H E MONEY M AR K ET The increases in interest rates on most short-term in struments occurred in several steps during June. Yields on most maturities of dealer-placed prime commercial paper rose by 3/s to V2 percentage point, while those on paper placed directly ranged from XA to V2 percentage point higher. A rise in rate of V2 percentage point was also posted on bankers’ acceptances. Anticipating runoffs of negotiable certificates of deposit (CDs) around the mid-June corporate dividend and tax payment dates, major banks began raising CD rates early in June and continued to post increases throughout the month. Simi larly, rates on CDs trading in the secondary market rose about 3/s to V2 percentage point during June. Largely in response to the rise in money market rates, most major banks raised their prime rate to 5lA percent from 5 per cent effective the final week in June. Two large banks with “floating” prime rates increased these even further to 5% percent on June 30. Rates on Euro-dollars shot upward after midmonth, as tensions mounted in the foreign ex change markets leading up to the floating of the British pound. Euro-dollar rates subsequently fell back but re mained above their levels at the beginning of the month (see Chart I). The effective rate on Federal funds in June averaged 4.46 percent, 19 basis points above the May level. Mem ber bank borrowings at the Federal Reserve discount window declined slightly to $86 million on average, how ever (see Table I), as excess reserves increased. The forty-six major money center banks were particularly restrained in their use of the discount window. Prelim inary data indicate that total reserves of member banks grew at a seasonally adjusted annual rate of about 8 V2 percent in June, while “reserves available to support private nonbank deposits” (RPD) grew at about a 9 percent rate, a slightly more rapid pace for RPD than in May (see Chart II). According to preliminary estimates based on data for the four weeks ended June 28, the narrow money supply (M O— adjusted demand deposits and currency held by the public— rose at about a 5 percent seasonally adjusted annual rate in June, up somewhat from its in crease of 3.6 percent in May. Over the second quarter as a whole, the annual rate of growth of M 1 also amounted to some 5 percent. For the first six months of the year, Mx grew at an annual rate of slightly over 7 percent. 161 FEDERAL RESERVE BANK OF NEW YORK The broader money supply (M2) also advanced some what more rapidly in June at a rate of about 9 V2 percent, compared with 8.4 percent in May. The recent acceleration resulted from a faster rise in both components of M2, consumer-type time and savings deposits as well as Mx. For the three months ended in June, however, the growth in this measure was at a seasonally adjusted annual rate of 8 V2 percent. Over the January-June period, M2 has grown at an 11 percent annual rate. In contrast to Mx and M2, the growth of the adjusted bank credit proxy decelerated in June to an annual rate of 5 percent, down from 14.4 percent a month earlier. Both time and private demand deposits expanded sub stantially during June, but United States Government de posits at commercial banks declined by $2 billion on average from the May level, in spite of a buildup in these balances in the second half of June. It is estimated that the proxy expanded at an 11 percent annual rate in the latest quarter and at about the same rate over the first six months of 1972. On June 22 the Board of Governors of the Federal Re serve System announced its unanimous approval of two regulatory changes designed to restructure the reserve requirements of member banks on a more equitable basis and to modernize the nation’s check collection system. The changes, which will begin to go into effect on September 21, C hart I SELECTED INTEREST RATES Percent M O N E Y MARKET RATES A p r il M ay A p n l-J u n e 1972 June B O N D MARKET YIELDS A p r il M ay Percent June Note-. Data are shown for business days only. MONEY MARKET RATES QUOTED: Bid rates for three-month Euro.dollars in London; offering rates (quoted in terms of rate of discount) on 90- to 119-day prime commercial paper quoted by three of the four dealers that report their rates, or the midpoint of the range quoted if no consensus is available; the effective rate on Federal funds Ithe rate most representative of the transactions executed); closing bid rates (quoted in terms of rate of discount) on newest outstanding three-month Treasury bills. BOND MARKET YIELDS QUOTED: Yields on new Aa-rated public utility bonds (arrows point from underwriting syndicate reoffering yield on a given issue to marketyield on the same issue immediately after it has been released from syndicate restrictions); daily averages of yields on seasoned Aaa-rated corporate bonds; daily averages of yields on long-term Government securities (bonds due or callable in ten years or more) and on Government securities due in three to five years, computed on the basis of closing bid prices; Thursday averages of yields on twenty seasoned twenty-year tax-exempt bonds (carrying Moody's ratings of Aaa, Aa, A, and Baa). Sources: Federal Reserve Bank of New York, Board of Governors of the Federal Reserve System, Moody’s Investors Service, and The Bond Buyer. 162 MONTHLY REVIEW, JULY 1972 Table I FACTORS TENDING TO INCREASE OR DECREASE MEMBER BANK RESERVES, JUNE 1972 In millions of dollars; (+ ) denotes increase (—) decrease in excess reserves Changes in daily averages— week ended Net changes Factors June 7 June 14 June June 28 Member bank required, reserves . . . Operating transactions (subtotal) Federal Reserve float .................. Treasury operations* .................... Gold and foreign a c c o u n t ........... Currency outside b a n k s .................. Other Federal Reserve liabilities + 380 — 123 + 346 — + + + + 217 — 784 — 355 + 189 — 195 + — — — — and capital ........................................ — 109 Total “ market” factors ................ + 257 21 “ Market” factors 37 360 316 27 4 — 248 82 555 728 189 — 12 — 313 — 4 + 251 + 235 — 37 — — 2'22 — 735 + — + — + — 552 712 536 928 169 505 73 + 473 Direct Federal Reserve credit transactions Open market operations (subtotal) Outright holdings: Treasury s e c u r itie s ............................. Bankers’ a ccep ta n ces........................ Federal agency o b lig a tio n s ............. Repurchase agreements: Treasury s e c u r itie s ............................. Bankers’ a c c ep ta n c e s........................ Federal agency o b lig a tio n s ............. Member bank b o rro w in g s.................. Other Federal Reserve assetsf . . . Total ................................................... Excess reserves + 111 + 214 — 1 + 39 — 138 — 1 2 — + 78 + 8 + 1 + 100 — — 7 — + 131 + 243 — + S 35 18 + 323 — 3 + 9 11 + 1 — 2 + + + 120 + 142 10 + 139 21 —. 190 + 71 14 — 403 — + 341 — 36 + 45 + + 2 — 119 + 195 + 481 + 197 + 72 37 Monthly averages Daily average levels Member bank: Total reserves, including vault c a s h ........... 32,677 Excess reserves ..................................................... Borrowings ........................................................... Free, or net borrowed ( — ), reserves ----Nonborrowed reserves ..................................... 331 58 273 N et carry-over, excess or deficit (— )§ . . . . 32,619 43 32,448 32,309 139 93 46 32,355 32,602 32,391 211 57 154 32,299 32,174 125 135 — 10 32,545 32,164 32,507 + 32,305 + 202 + 86 + 116 + 32,421 + 1S7 10<S in s 111 + N ote: Because of rounding, figures do not necessarily add to totals. ^Includes changes in Treasury currency and cash, tIncludes assets denom inated in foreign currencies. JAverage for four weeks ended June 28. §Not reflected in data above. were first proposed in late March when the Board invited comments from interested parties during the next month and a half. The major effects of the changes will be that reserve requirements on demand deposits will be TH E GOVERNM ENT SECUR ITIES M AR KET — 150 78 61 + + based upon size of bank rather than location and that all banks using the System’s check collection facilities must make payment in immediately available funds (see box on page 154 for details). The Board received comments from less than 5 percent of the nation’s banks, and the main modifications suggested had to do with minimizing the effects of the new check collection procedures upon funds available for loans and investments. Taking these suggestions into account, the Board modified the regula tions somewhat further. Thus, it reduced the new reserve requirement for one size category of banks which will lose a large amount of reserves as a result of the new check collection rules and set up conditions under which it will be appropriate for a Reserve Bank to waive penalties for certain member bank reserve deficiencies resulting from these changes. The waiver of penalties will be granted for a maximum of twenty-one months. More over, to equalize competitive conditions among banks and ease adjustment to the new check collection proce dures, the Board is assigning high priority to extending Regional Check Processing Centers for clearing services. Yields on most Treasury securities advanced during June, in response to slackened investor demand and an expectation on the part of many participants that interest rates will rise as the economy continues to expand and as the Treasury’s demand for funds places additional pres sure on the credit markets in months to come. This expec tation was fueled somewhat further by May increases in wholesale and consumer prices which surpassed those in April. Rates on Treasury bills and short- and intermediateterm coupon issues rose substantially, while relatively modest increases were posted in yields on long-term Treasury bonds. The increases in rates occurred in spite of the retirement by the Treasury of $3 billion of tax antic ipation bills (TABs) and $1.2 billion of maturing bonds. There was some tightening in the Federal funds market at the start of the month, and a cautious atmosphere hung over the bill market resulting from concern among par ticipants that some firming of monetary policy might be under way. Modest investor demand developed, however, and bidding in the first weekly auction was relatively ag gressive though rates did rise somewhat from the levels set during the final auction in May. Investor interest soon waned, however, and despite some professional demand rates trended higher over the next several days. Market sentiment brightened at the beginning of the next week, reflecting some modest investor demand prior to the weekly auction and the expectation of sizable reinvestment FEDERAL RESERVE BANK OF NEW YORK demand from persons holding Treasury bonds maturing June 15 and TABs coming due six days later. As a result, at the auction on June 12 the average issuing rates on three- and six-month bills were down slightly from the week earlier (see Table II). Buoyed by the potential re investment demand and additional moderate investor pur chases, the market steadied briefly but then began to falter when demand proved less than expected. Substantial pay ments of corporate income taxes on June 15 were met through the runoff of liquid assets including TABs, while borrowing was relatively light, thereby reducing the cor porate reinvestment demand for Treasury bills. Some modest investor demand once again appeared C h a r t II MONETARY AND RESERVE AGGREGATES S e a s o n a lly a d ju s t e d B illio n s o f d o lla r s B illio n s o f d o lla r s 388. 304. 205. 28. 25. 1970 1971 1972 N o te : D a ta fo r Ju n e 1972 a re p r e lim in a r y e s tim a te s . M l = C u r r e n c y p lu s a d ju s te d d e m a n d d e p o s its h e ld b y th e p u b l ic . M 2 = M l p lu s c o m m e r c ia l b a n k s a v in g s a n d tim e d e p o s its h e ld b y th e p u b lic , le ss n e g o tia b le c e r tific a te s o f d e p o s it is s u e d in d e n o m in a tio n s o f $ 1 0 0 ,0 0 0 o r m o re . A d ju s te d b a n k c r e d it p r o x y = T o ta l m e m b e r b a n k d e p o s its s u b je c t to re s e rv e r e q u ir e m e n ts p lu s n o n d e p o s it s ou rc es o f fu n d s , s uch as E u r o - d o lla r b o r r o w in g s a n d th e p ro c e e d s o f c o m m e r c ia l p a p e r is s u e d b y b a n k h o ld in g c o m p a n ie s o r o th e r a f filia te s . RPD = T o ta l m e m b e r b a n k re s e rv e s less th o s e r e q u ir e d to s u p p o r t U n ite d S ta te s G o v e r n m e n t a n d in te r b a n k d e p o s its . S o urce-. B o a r d o f G o v e r n o r s o f th e F e d e ra l R e s e rv e S y s te m . 163 after several days of rising bill rates and improved the market’s tone. Participants once again bid rather aggres sively in the regular auction on June 19, and a better atmosphere prevailed in the market for the next several sessions. An additional lift was provided by the possibility that, in the international currency uncertainty surrounding heavy selling of the British pound and the dollar, some demand for bills might be forthcoming from foreign cen tral banks. Demand again proved disappointing following the floating of the pound early on June 23, and in the unenthusiastic monthly auction held that day, average issuing rates on the new nine- and twelve-month bills reached their highest levels since last September. A better tone emerged over the next few days in re sponse to some investor demand for bills for quarterly financial statement purposes. Dealers were concerned about the reversal of this demand following the end of the quarter, however, and bidding was restrained in the final weekly auction which was advanced to Friday, June 30, because many participants were expected to take a long Fourth of July holiday weekend. In this second auction for the week, average issuing rates on the threeand six-month bills were set at 4.138 percent and 4.688 percent, respectively, their highest levels since late in 1971. Over the month as a whole, most bill rates rose by some 20 to 60 basis points. Treasury coupon issues came under many of the same pressures affecting the bill market during June, and yields on most issues maturing within five years were also about 20 to 60 basis points higher over the month. Modest investor demand and some dealer short covering limited price changes on longer term notes and bonds to a some what narrower range. A cautious tone emerged in this market early in June when buying interest was sluggish and participants pon dered the implications of a firming Federal funds rate for near-term monetary policy. The possibility of renewed inflation, given the percent (annual rate) rise in the wholesale price index during May, and the corporate bond market’s inability to sustain lower yields despite a reduced calendar were further depressants to the market, and prices of most issues eased over the first week in June. The lower price levels attracted some investor interest, as well as the opportunity for dealer short covering, and the market began to firm. Prices fluctuated narrowly over the next several days and then drifted lower amid predictions by some analysts that the Treasury’s cash needs in the fiscal year 1973 would be somewhat greater than estimated earlier. In the face of renewed buyer apathy, dealers marked prices lower in an attempt to elicit some interest but to no avail. There was no selling pressure on the mar- MONTHLY REVIEW, JULY 1972 164 Table II AVERAGE ISSUING RATES* AT REGULAR TREASURY BILL AUCTIONS In percent Weekly auction dates— June 1972 Maturities June 12 June June June 5 19 26 30 3.861 4.243 3.798 4.187 3.924 4.328 4.023 4.484 4.138 4.688 June Three-month . Six-m onth . .. Monthly auction dates— April-June 1972 April 25 Nine month . One-year . . . 4.234 4.362 May 23 4.367 4.465 June 23 4.754 4.854 ^Interest rates on bills are quoted in terms of a 360-day year, w ith 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. ket, however, as investors seemed content with their cur rent holdings, and prices of coupon issues drifted steadily lower over the remainder of the month. OTHER SECURITIES M AR K ETS Considerable investor resistance was evident in both the corporate and municipal bond markets during much of June after rates had fallen early in the month to their low est levels since January. The announcement of larger in creases in the wholesale and consumer price indexes dur ing May as compared with April contributed to an expec tation of higher interest rates, and investors remained on the sidelines a good part of the time. On May 31 underwriters were able to sell only about 10 percent of a $100 million issue of new Aa-rated utility bonds which were aggressively priced to yield 7.29 percent, the lowest return since mid-January. Despite this experi ence, on the following day, June 1, an additional $50 mil lion of similarly rated power company bonds was marketed at an even lower yield of 7.25 percent, and by late Friday, June 2, only about $30 million of these two issues had been bought by investors. Although the calendar of scheduled offerings was relatively light, substantial retail demand failed to materialize at the beginning of the next week. As a result, on Tuesday, syndicate restrictions were removed from the unsold balances of these two issues together with two others, and yields on these bonds adjusted as much as 12 basis points higher. Recognizing the fact that rates had already been pushed beyond their currently acceptable levels, underwriters be gan pricing new offerings at progressively higher yields over the next several days but with only moderate success. Then, faced with a somewhat heavier schedule than there had been in recent weeks, several syndicates disbanded on the following Monday in advance of the sale of $125 mil lion of New Jersey Bell Telephone securities the next day. This two-part Aaa-rated offering of $75 million of fortyyear bonds and $50 million of six-year notes, yielding 7.45 percent and 6.53 percent, respectively, sold out quickly. The return on the bonds matched that placed on a slowselling Aa-rated offering three days earlier. Immediately following the successful sale of the New Jersey Bell issues, however, underwriters priced two Aa-rated utility bond offerings to yield little more than the Aaa-rated Bell bonds and investors once again balked. Finally, early in the week of June 19, returns on new Aa-rated utility bonds were placed at l l/i percent. Investors responded favorably to this higher rate structure and the corporate bond market tended to stabilize over the next few days, albeit with yields on Aa-rated utility bonds some 25 basis points higher than at the start of the month. In reaction to the uncertainties in the international money market, rates moved higher as the month drew to a close, and a sub sequent issue sold slowly at a yield of 7.60 percent. Confronted with an increased supply of scheduled new issues, investors displayed little interest in the lower yields available on tax-exempt bonds at the start of June. There was a sizable buildup in the Blue List of inventories ad vertised for sale, as dealers made preparation for the heavier calendar which included $209 million of Aaa-rated local housing bonds guaranteed by the Department of Housing and Urban Development (HUD). Providing yields of 2.60 to 5.08 percent, the HUD bonds were marketed on June 7 and, even though many analysts be lieved they were not aggressively priced, only about one half were sold during the first three business days. Some additional sales resulted from a markdown in the price of these bonds on the fourth day, but a sizable balance re mained. The tax-exempt market registered a short-lived improve ment just before midmonth, when investors bought heavily of several new issues, but faltered again in response to the somewhat restrained reception to a $90 million offering of Aaa-rated Connecticut securities. Two business days later, the unsold portion of the thirty-year term bonds was released from syndicate with an upward yield adjust ment to 5.40 percent from an initial 5.25 percent. On the following day, other recent issues were also released from pricing restrictions with increases in yields of as much as FEDERAL RESERVE BANK OF NEW YORK 25 basis points. Despite such adjustments, buyers re mained quite hesitant and showed very little interest in the new offerings which were marketed later in the month. For example, the unsold HUD bonds were reduced in price a second time on June 22 and, despite some sales, an estimated $20 million remained in dealers’ hands; at the same time a one-day-old issue was released from syndicate after first-day sales of less than 50 percent. While the corporate bond market was stabilizing tem porarily, tax-exempt securities had difficulty finding a viable level of rates, and that market continued under pressure until late in the month. Reflecting developments in this area over the period, The Bond Buyer index of yields on twenty municipal bonds rose steadily from 5.15 percent on June 1 to 5.43 percent on June 22. Fol lowing postponement of a $151 million issue scheduled for June 27, however, pressures abated somewhat and rates stabilized. Subscriptions to the m o n t h l y r e v i e w are available to the public without charge. Additional copies of recent issues may be obtained from the Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. Persons in foreign countries may request that copies of the m o n t h l y r e v i e w be sent to them by “air mail-other articles”. The postage charge amounts to approximately half the price of regular air mail and is payable in advance. Requests for this service and inquiries about rates should be directed to the Public Information Department, Federal Reserve Bank of New York, 33 Liberty Street, New York, N.Y. 10045. 165 166 MONTHLY REVIEW, JULY 1972 Impact of Direct Investm ent Abroad by United States Multinational Companies on the Balance of Payments By S usan The persistent and distressingly large deficits in the United States balance of payments during the past decade have aroused considerable interest in the overall impact on the payments balance of direct investment abroad by United States multinational companies.1 This paper sum marizes the measurable balance-of-payments flows associ ated with American firms’ operations overseas and at tempts to place these flows in an appropriate theoretical framework. The principal balance-of-payments flows associated with overseas investment can be separated into two major blocks: (1) those affecting the capital and related ser vices accounts (principally investment income), referred to in this article as financial flows, and (2) those relating to the merchandise trade account. The preponderance of evi dence indicates that the balance-of-payments impact of the financial flows has been favorable when viewed in a long-run context. Over the decade of the 1960’s these flows cumulated to a net positive item of $35 billion. Analysis of the financial flows within a theoretical frame work which explicitly takes account of the relationship between investment outflows in one period and income inflows in subsequent periods suggests that their balanceof-payments contribution will remain favorable. Conclusions about the impact of United States direct investment on the merchandise trade balance, on the other hand, must be considered tenuous for several rea sons. First, the data available on trade flows related to direct investment activity are very limited. Second, to as *Econom ist, Balance of Payments D ivision. 1 The phrase “m ultinational com panies” has been defined in a variety o f ways by different analysts o f this subject. The termi nology is used in its br:adest ssnse in this paper to refer to the activities of all United States firms with direct investments abroad. B. F o s t e r * sess the impact of overseas investment on trade flows, one ideally should compare the flows that took place given the existence of the overseas affiliates with the flows that would have occurred in their absence, and the data nat urally do not permit such a comparison. Only by making explicit assumptions about the behavior of firms can any inferences be drawn. The assumption considered most reasonable is that multinational firms are operating in fairly competitive environments, which implies that most of the observed changes in exports and imports would have occurred even in the absence of United States foreign investment, at least in the long run. In other words, if United States companies had not exploited the overseas opportunities as they appeared, foreign companies eventu ally would have. Therefore, these export and import changes should be viewed more as reflections of adjust ments to changes in international competitiveness rather than as a direct result of United States investment abroad. More data are required, however, before this conclusion on trade effects can be demonstrated empirically. FRAMEWORK FOR ANALYZING DIR ECT IN V E S TM E N T IM P A C T The balance-of-payments flows associated with the ac tivities of United States multinational companies arise in the following manner. The value of United States direct investment in foreign enterprises2 can be augmented either 2 In the official statistics on the U nited States foreign invest ment position published by the United States Departm ent o f Com merce, the book value o f United States direct investment abroad is defined to include, not only the parent com pany’s share o f the capital stock and surplus o f the affiliate, but also the net indebted ness o f the affiliate to the parent plus any long-term debt o f the affiliate held by nonaffiliated United States residents. FEDERAL RESERVE BANK OF NEW YORK through additional contributions of capital from the United States— a long-term capital outflow in the balance of payments— or through the reinvestment of a portion of the direct investors’ share of the foreign affiliates’ earn ings. The latter does not appear in the balance-ofpayments statistics if the foreign affiliate is incorporated but, if the affiliate is unincorporated, reinvested earnings are included as inflows of direct investment income offset by capital outflows. The stock of assets abroad generates a stream of earnings into the future, some portion of which is returned to the United States in the form of dividends, branch profits, and interest payments and recorded as balance-of-payments inflows of “income from direct invest ment”. In addition, United States parent firms receive pay ments from the affiliates of royalties and fees for the use of patents, managerial services, etc., which are also balanceof-payments inflows. Since the inception in 1968 of the mandatory capital control program on American corporations’ overseas in vestments,3 United States firms have relied to a significant extent on foreign sources of funds to finance their direct investment, principally by borrowing either through bond issues or directly from financial institutions overseas. These foreign borrowings are recorded as positive balance-ofpayments inflows, offset by corresponding capital outflows when utilized to increase United States direct investment in foreign concerns. United States companies’ interest pay ments on these foreign borrowings, of course, are also balance-of-payments entries and are included as a part of the figure recorded for United States private payments of income on foreign investments in the United States. In addition, there are a variety of possible merchan dise trade flows associated with United States direct in vestment abroad. Exports of capital goods may be gener ated by the establishment or expansion of facilities abroad, and there may be a continuing stream of such capital equipment shipments to meet replacement demands. There may be exports of intermediate goods for further pro cessing and assembly abroad, and some goods may be shipped to affiliates for immediate resale, with the affiliate acting principally in a distributing or warehousing capac ity. On the other hand, United States exports may be dis placed by production and sale by the foreign subsidiary of goods which would otherwise have been shipped from this country. United States imports may also be affected 167 by United States direct investment abroad, as intermediate or final goods produced by the affiliate in a lower cost en vironment overseas are imported back to the United States. Before proceeding to attempt to measure these flows, a brief exposition of the theoretical context appropriate to the analysis of the real balance-of-payments effects stem ming from direct investment is in order. The first impor tant point which clearly emerges from the mere listing of possible effects is that there is a dynamic process in volved and time must explicitly be taken into account in any attempt to establish a causal relationship between out flows of investment funds and resultant income and net trade receipts. Any addition to the stock of productive assets abroad yields a flow of income as well as exports and imports in subsequent periods. The balance-ofpayments impacts of a direct investment outflow in period t, then, are the increments in periods t+ 1 , t+ 2 , etc., of income and net trade receipts associated with that addition to productive capacity. Alternatively, one can say that the income and trade flows in any given year are attributable, not to the capital outflow in that year, but to the cumula tive outflow in all previous years, i.e., to the outstanding stock of investment in that year. Thus, matching inflows and outflows on a year-by-year basis or cumulated over several years must be regarded as purely a descriptive method and not as an analytical tool. The number of years required for an initial capital out flow to generate a return stream of income and net trade receipts equal to it is frequently referred to as the recoup ment period, which several studies have attempted to cal culate.4 For purposes of illustrating the time pattern of balance-of-payments impacts, which is implicit in the re coupment estimate procedure, the relationship between capital outflows and related income flows will be exam ined, ignoring the trade effects for simplicity. The basic model employed in these studies assumes that the invest ment base which produces the earnings stream is aug mented either through capital outflows from the United States or through retained earnings. Then, given a constant rate of earnings, a constant ratio of repatriated to total 4 For exam ple, Philip Bell, “Private Capital M ovem ents and the U.S. Balance-of-Paym ents P osition”, F actors Affecting the U.S. Balance o f P aym en ts (W ashington, D .C .: U nited States G overn ment Printing Office, 1962); N . K. Bruck and F. A . Lees, Foreign Investm ent, C apital C ontrols, and the Balance o f P aym en ts (N ew York University Graduate School o f Business Administration, In stitute o f Finance, Bulletin N o . 4 8 -4 9 ), April 1968; G. Hufbauer 3 This program is administered by the Office o f Foreign Direct and F. Adler, O verseas M anufacturing In vestm en t and the Balance o f P aym en ts (W ashington, D .C .: United States Departm ent of the Investments o f the Departm ent o f Com m erce and is usually re Treasury, 1 9 6 8 ). ferred to as the O FD I program. 168 MONTHLY REVIEW, JULY 1972 earnings, and a constant rate of growth of new direct in vestment outflows, the number of years necessary to achieve a cumulative positive balance-of-payments effect can be calculated. The inflows will ultimately match and then exceed the outflows, both on an annual and on a cumulative basis, so long as some earnings are repatriated and the rate of return is larger than the rate of growth of outflows.5 This approach may be used to analyze two relevant problems. In the first instance one can calculate how long it will take for a single once-and-for-all capital outflow to have positive balance-of-payments consequences. Clearly, in the year it occurs the outflow will be a negative balanceof-payments entry which will not be offset by any inflows, assuming that the investment does not earn a return until the next period. On the other hand, in every subsequent year the annual balance-of-payments effect will be positive and equal to the remitted earnings. This income stream will not be constant, however, but will grow because the investment base is being augmented in each period by the amount of reinvested earnings. As an example, if the earn ings rate equals 20 percent and the repatriation rate is 60 percent, it can be calculated that a single outflow of $100 will be totally recovered in terms of cumulated income in flows in the seventh year after the initial outflow. For the purposes of analyzing the impact of aggregate direct investment flows on the balance of payments, how ever, it is more appropriate to examine the situation where there is a continuous, and probably growing, stream of new capital outflows. As noted above, as long as the rate of return on investment exceeds the rate of growth of capital outflows and as long as some earnings are repatri ated, the balance-of-payments effect will ultimately turn positive although the recoupment period will be longer than in the example of a single nonrecurrent outflow. Us ing the same earnings and repatriation rates as in the ear lier case but allowing capital outflows to grow at 10 percent per year, the annual balance-of-payments effect (i.e., yearly income inflows minus annual outflows) does not become positive until year 10 and the cumulated in flows exceed the cumulated outflows only beginning in year 16. The length of the recoupment period is quite sensitive to the assumptions made regarding the rate of return and the rate of growth of outflows; in general, the larger the excess of rate of return over the rate of growth of outflows, the shorter the recovery time. Thus, whether one judges the balance-of-payments impact of direct investment as posi tive or negative depends critically on the time horizon one chooses. In the short run, the impact is likely to be nega tive, while in the long run the reverse is the case.6 It should be emphasized that, as illustrated by the numeri cal examples, the short run in this context covers a period of several years. The second fundamental question which must be con fronted in any attempt to assess the overall balance-ofpayments impact of direct investment is what would have happened in the absence of United States direct invest ment abroad. This question is not relevant in estimating income flows associated with direct investment since there would obviously be none in the absence of the initial in vestment, but it is critical in estimating trade effects.7 There are a variety of explicit motives leading to the investment decision. While the explanations may appear different on the surface, they generally share the notion that there are competitive advantages in producing abroad—frequently in the form of lower costs. These lower costs could arise in the production process itself because of lower costs of labor or materials. Alternatively, savings could arise in the dis tribution process where local production allows lower transport costs, or lower costs of delivery to final market because of tariff barriers. Other less tangible benefits might also accrue from local production, such as establishing brand consciousness in the market or being better able to tailor products to specific national tastes. In some instances, the decision to produce abroad could be based primarily on a defensive motive— to protect an 6 The length of the overall recoupment period w ill also be af fected by the size and direction of the net trade receipts generated by the investment base. The larger and more positive these flows, the shorter w ill be the pay-back period, whereas the recoupment period will be lengthened the larger and m ore negative the net receipts. Indeed, if the net trade balance effects were sufficiently large and adverse, they could swamp the positive incom e inflows and the net balance-of-paym ents effect w ould be negative. This outcom e does not seem likely, however, for a variety o f reasons discussed later. 7 Under certain conditions, other kinds o f capital flows, e.g., portfolio investment or bank lending, could arise in the absence 5 These conditions are sufficient to ensure that the rate o f o f direct investment. The existence o f such substitution might growth o f the stock o f assets abroad (which equals the rate at m odify the conclusions of a study such as this. But for the pur which incom e inflows grow ) will be sufficiently larger than the poses o f evaluating the balance-of-paym ents impact of direct in rate o f growth o f outflows— because o f the reinvestment o f earn vestment by itself, the most m eaningful approach was to leave ings— so that the balance-of-paym ents inflows w ill ultimately ex aside the possibility of substitute capital flows in the absence of ceed the outflows. direct investment. FEDERAL RESERVE BANK OF NEW YORK existing market share against the emergence of potential rivals. Underlying this explanation is still the presumption that there are advantages in producing abroad rather than in the United States, however. If such advantages did not exist, then the United States exporter could continue to maintain his market share through exports and would not be induced to begin production abroad in an attempt to forestall the emergence of potential rival firms. Another hypothesis about the behavior pattern of United States direct investors has been propounded by Vernon and is known as the product or industry cycle theory.8 This thesis suggests that new products are first developed and tested in the large and relatively high-income United States market. Production remains in the United States during a trial period when a variety of production processes and product characteristics are tested, and during this period a market abroad may be initiated through export. As the market reaction both here and abroad is assessed, some standardization occurs and the emphasis in the productionlocation decision shifts to cost minimization. At some point during the expansion of the foreign market, costminimizing criteria may dictate shifting the locus of pro duction abroad. Vernon carries the argument one step further and suggests that, in some instances, the cost of production may be sufficiently lower overseas to offset transport costs and the product may ultimately be pro duced abroad entirely, with some of it imported back to the United States. All of the foregoing explanations—by no means a com prehensive listing—have in common the basic premise that there are advantages in producing in the foreign market, which would suggest that the foreign-produced goods could outcompete the comparable United States product. Given relatively free markets in which the basic technology of production is known and in which there are no significant barriers to entry, such as prohibi tive start-up costs, competitive forces would suggest that in the absence of United States firms establishing produc tion facilities abroad, other non-United States firms would seize this profitable opportunity. Consequently, to the ex 169 tent that foreign-sourced goods displace United States exports or lead to United States imports replacing domestic production, these effects would be likely to occur anyway even without the United States firms producing abroad, and therefore it would be wrong to attribute any export loss or import creation to United States direct investment. Rather these changing trade patterns merely reflect world production adjusting to relative cost advantages. Once again, however, it should be emphasized that the time frame becomes an important consideration in this evaluation. There may be a considerable lag between the emergence of profitable production possibilities and the perception and seizing of these opportunities. It seems quite possible that United States firms may accelerate this rationalization of worldwide resource utilization, perhaps because they become aware more rapidly of the market opportunities in certain products as developed through their export trade and perhaps because of an ability to raise the necessary capital more quickly either through internal funds or through access to the larger United States capital market. Thus, in the short run—which may be a matter of several years— the shift of United States produc tion may be conceived to result in actual export loss or import creation for specific products, but as indicated above, given a longer run outlook, many of these exports would probably have been forfeited and the goods im ported anyway. In a long-run time frame, then, theoretical considerations suggest that the relevant criterion for assessing the balance-of-payments impact of United States direct investment abroad is whether or not the income re turns outweigh the associated capital outflows, and on this basis the evidence seems clearly to indicate that the bal ance of payments is favorably affected by direct invest ment activity. EXPANSION OF FOREIGN IN V E S TM E N T AND SALES IN T H E 1960’S The book value of United States direct investment abroad has expanded from less than $32 billion at the end of 1960 to $78 billion by the end of 1970 (see chart), growing at an average rate of 9.4 percent per year. Total affiliate assets, which are larger than the book value of United States direct investment reflecting foreign equity 8 R. Vernon, “International Investm ent and International Trade participation in the affiliates as well as the affiliates own in the Product C ycle”, Quarterly Journal of Economics, Vol. borrowing from foreigners, appear to have grown even L X X X (1 9 6 6 ). A recent exposition o f this hypothesis supported more rapidly at least in the latter part of the decade. by evidence obtained through case studies may be found in a study undertaken by the Harvard Business School under contract Unfortunately, recent data on these total affiliate assets for the United States Departm ent of Comm erce: R. B. Stobaugh are lacking, but a survey conducted by the Office of For and A ssociates, “U .S. M ultinational Enterprises and the U.S. E con om y”, The Multinational Corporation: Studies on U.S. Foreign eign Direct Investments (OFDI) covering the balance Investment, Vol. I (U nited States Departm ent o f Com m erce, Bu sheets of the majority-owned affiliates of 469 United reau o f International Com m erce, March 1972). 170 MONTHLY REVIEW, JULY 1972 States direct investors9 reveals that total assets of these affiliates rose at an approximately constant rate of 13 per cent per year between 1966 and 1969. During this same period, however, the United States direct investors’ share of these total affiliate assets declined from 60.1 percent to 57.2 percent, reflecting the impact of the control program on United States direct investment that was designed to shift the financing of affiliate expansion from United States to foreign sources. Additional supporting evidence pointing to the con tinued expansion of overseas affiliate assets can be derived from actual and anticipated plant and equipment expendi tures of foreign affiliates, which dipped in 1967-68 but rose sharply in 1969-70. These figures indicate clearly 9 Office of Foreign D irect Investments, Foreign Direct Invest ment: Selected Statistics (U nited States Department o f C om merce, July 1971). that there has been no sharp curtailment in expansion plans since the OFDI program was established in 1968. Rather the expenditure pattern seems more probably to reflect cyclical conditions in foreign business and capital markets. GEOGRAPHICAL AND INDUSTRIAL DISTRIBUTION OF FOREIGN In the ten years 1961-70 inclusive, the increase in total book value of United States direct investment abroad was concentrated in the manufacturing sector, where United States-owned assets rose by 190 percent to $32.2 billion (see chart). The bulk of these manufactur ing investments was in Canada and Europe, but the rate of growth in Europe considerably outstripped that in Canada. Undoubtedly the formation of the Common Market at the end of the 1950’s acted as a considerable inducement to American firms to establish production facilities behind the common tariff barrier in order to serve the markets of the member countries. The establishment of such local facilities was encouraged, not only as a means of avoid assets. FEDERAL RESERVE BANK OF NEW YORK ing the external tariff wall, but also to take advantage of the expanded internal market which opened up possibili ties of achieving economies of scale and generated more rapid economic growth in the European Community countries than might otherwise have been achieved. In absolute amount, investment in petroleum affiliates represented the second largest industrial group by the end of 1970, although their proportion of total investment abroad had fallen to 28 percent from 35 percent ten years earlier. The $21 billion of petroleum industry assets, which include refining, distribution, and crude production facilities, was about evenly divided between Canada and Europe on the one hand and Latin America and other areas on the other. Mining and smelting operations, largely representing investments to obtain raw materials, grew at about the same rate as petroleum investments over the ten-year period and amounted to $6.1 billion at the end of 1970, or roughly 8 percent of total investments. As expected, these assets were concentrated in Canada and Latin America. The other category of investments displaying a growth of just over 200 percent during the 1960’s was comprised of trade and other industries, largely financial and other service industries. The most rapid growth in this group of enterprises occurred in Europe, as ancillary service industries moved abroad with the rapid development of manufacturing concerns. Despite the rapid growth in these investments, however, they represented only some 8 per cent of total direct investment assets by the beginning of 1970. Finally, transportation and public utilities invest ment exhibited virtually no growth over the period and represented less than 4 percent of the total investment figure in 1970. p r o d u c t i o n o f f o r e i g n a f f i l i a t e s . Unfortunately for as sessing the importance of the role of American overseas investment in world production, comprehensive statistics on the total output of foreign subsidiaries of American companies located outside the borders of the United States are not available. However, by assuming a constant relationship between affiliates’ assets and their sales, an estimate which is at least indicative of the rough order of magnitude of such output can be derived.10 This proce- 171 dure suggests affiliate sales in 1970 of about $74 billion by manufacturing concerns, roughly $36 billion for petroleum affiliates, $6 billion for mining and smelting subsidiaries, and $16 billion for all other affiliates. Thus, a very rough approximation of total sales by all foreign affiliates in 1970 would be in the range of $130 billion$140 billion, which contrasts with a total sales figure (estimated similarly) of some $50 billion in I960.11 Clearly, then, the operations of United States-affiliated firms abroad—whether measured in terms of asset forma tion or of total sales— exhibited sharp growth in the 1960’s and, by the end of the decade, were a very significant factor in global production. CA P ITA L AND SERVICES ACCOUNT FLOWS To recapitulate briefly the relevant entries in the capi tal and services accounts of the balance of payments as sociated with United States direct investment, the expansion in the book value of United States foreign di rect investment can be achieved either through a capital outflow from the United States or through the reinvestment of a portion of the United States share in the affiliates’ earnings. The first method of financing entails a debit entry in the balance of payments, “direct investment abroad”, whereas, as noted above, the latter does not ap pear in the balance of payments at all if the affiliate is incorporated or it appears as offsetting debit and credit en tries if the affiliate is unincorporated. Direct investment capital outflows rose from $1.6 billion in 1961 to $4.4 billion in 1970 (see Table I), with the bulk of the out flows going to manufacturing and petroleum affiliates. These additions to the stock of investments subse quently generate a return flow of payments in the form of repatriated earnings and interest payments on credit extended by United States residents, all recorded as “income on United States direct investment abroad”. These flows have been a major positive factor in the balance of payments, rising from $2.8 billion in 1961 to $6.0 billion in 1970 and again coming mainly from 11 The 1970 total is probably a conservative estim ate since it is based on an assumed constant relationship between sales and as sets. However, the relationship actually used in the estimation procedure is that between affiliate sales and the United States 10 This estim ation procedure was derived from work done by direct investors’ share o f book value, not gross assets. To the Judd Polk, econom ist for the United States Council o f the Inter extent that the gross investment base o f the foreign affiliates has national Chamber o f Commerce. For the few years when data been augmented by an increased proportion o f foreign capital on both assets and sales are available, the relationship was fairly contributions, either debt or equity, total sales expansion might stable. well have exceeded that suggested above. 172 MONTHLY REVIEW, JULY 1972 Table I NET EFFECT OF CAPITAL AND SERVICES ACCOUNT FLOWS ASSOCIATED WITH DIRECT INVESTMENT OF UNITED STATES MULTINATIONAL COMPANIES In billions of dollars; — denotes outflow Capital and services account flows 1961 1966 1967 1968 1969 1970 United States direct investment abroad ......................................... - 1.6 * - 3.7 — 3.1 - 3.2 - 3 .3 - 4 .4 0.7 0.5 3.4 2.4 3.9 - 0 .1 - 0 .2 -0 .4 - 0 .6 Borrowing abroad by United States direct investors..................... Cumulated 1961-70 - 2 8 .8 11.2 Interest payments to foreigners on borrowing abroadt ............... X X Income from direct investment abroad ...................................... 2.8 4.0 4.5 5.0 5.7 6.0 41.8 Receipts of royalties and fees .......................................................... 0.7 1.3 1.4 1.5 1.7 1.9 12.4 N e t financial flow st .................................................................................... 1.9 2.3 3.2 6.5 6.1 6.8 35.3 - 1.3 * Not available, t Estimated. t Less than $50 million. Sources: United States Department of Commerce, Survey of Current Business (June 1971) and Foreign Direct Investment Program: Selected Statistics (July 1971). manufacturing and petroleum affiliates.12 Receipts from affiliates of royalties and management fees for services rendered by the parent companies comprise another balance-of-payments inflow, and these rose from $0.7 bil lion in 1961 to $1.9 billion in 1970. In response to the OFDI program, United States com panies have borrowed substantial amounts of funds abroad in recent years. These borrowings appear as an inflow of nonliquid foreign capital in the balance of payments and are subsequently counterbalanced by an outflow of direct investment as the proceeds are transferred to foreign sub sidiaries. A survey carried out by the OFDI reveals that borrowing by United States direct investors from foreign ers both in the form of bond issues and directly from banks has been a strongly positive item in the balance of payments, particularly in the 1968-70 period following the institution of the mandatory restraint program. In fact, during this three-year period, the average net posi tive contribution of all financial flows to the balance of payments was $6.5 billion, and foreign borrowings by 12 Since a large number o f petroleum affiliates are branch sub sidiaries, the incom e figures from these affiliates include earnings which in fact are reinvested, and thus the gross incom e inflows overstate the amount o f incom e which remains in the United States. From the overall balance-of-payments point o f view, how ever, this overstatement is canceled out as any branch profits reinvested are counted as capital outflows in the direct investment account. United States direct investors accounted for nearly one half of this— or $3.2 billion, as can be seen in Table I. Finally, this foreign borrowing also gives rise to a balance-of-payments outflow in the form of interest pay ments to foreigners. Estimates of these figures are avail able only for 1967-70 but, since borrowing abroad was relatively insignificant prior to 1965, the absence of earlier figures does not seriously distort the overall picture. On the simplest level of analysis, these debit and credit entries can be matched on a year-by-year basis or cumu lated over a period of years to yield a net positive or negative impact on the balance of payments, as illustrated in Table I. Clearly, on either of these bases, the inflows of income, royalty and fee payments, and foreign borrowing have greatly exceeded the outflow of funds for expanding direct investment assets or for interest payments on foreign debt: the net positive balance-of-payments flows cumulated to over $35 billion in the period 1961-70, nearly one third of which may be attributed to borrowing from for eigners. As stated earlier, this simple comparison of flows is use ful mainly as a descriptive tool, but reveals little about the causal relationship between capital outflows and future in cremental income returns generated by the addition to the investment base. For this, time must be allowed ex plicitly to enter the calculus. When the model described earlier is employed using actual data for the period 196169, the rate of return is found to have exceeded the rate of growth of capital outflows and, therefore, one can con clude that the balance-of-payments effects of new direct FEDERAL RESERVE BANK OF NEW YORK investment will ultimately be positive on both an annual and a cumulative basis. This is consistent with the pres ently observed pattern of positive balance-of-payments contributions of income and capital outflows, and suggests that this pattern will continue in the future if the param eters remain stable.13 To evaluate the overall balance-of-payttients effect of all capital and financial flows, certain other flows must also be considered. The annual stream of receipts of royalties and fees associated with the outstanding stock of invest ment will also increase as the investment base grows. In the base period, each $100 of book value was associated with about $3 of such receipts. This additional stream of inflows enlarges the ultimate net positive balance-ofpayments effect and shortens the length of the recoup ment period. Second, the increase in United States corporate borrowing from foreigners to finance overseas investment will affect the time pattern of net balance-ofpayments effects. The borrowing may be considered as an offset to direct investment outflows in the immediate pe riod, thus reducing net capital outflows, but repayment of the debt in the future will lead to larger net outflows than would otherwise have occurred. In addition, interest pay ments to foreigners on the debt will constitute an annual stream of outflows, partially offsetting some of the posi tive effects mentioned above, and will tend to lengthen the recoupment period. These conclusions must be further tempered by other qualifications. The calculations assume constant param eters— that is, rates of return, repatriation, and growth of outflows— and there are a variety of factors which might lead to a shift in these parameters. For example, there is 173 some evidence of a negative relationship between capital outflows and the age of foreign affiliates.14 As the affiliates mature, they provide for a larger part of their investment needs through internal funds and rely less on funds from the parent organization. This would suggest that, as the previously noted bulge of investments in the 1960’s matures, the rate of growth of outflows may decline. The stability of the rate of return on investment is also open to question. In particular, it appears that the foreign af filiates have been induced by the OFDI program to in crease their own borrowing to finance investment.15 The impact of this greater leveraging of their assets may be to increase the rate of return in the future. However, in creased leverage can also sharply cut rates of return in periods of slackened demand for their output as the higher interest costs reduce earnings. It is not obvious which type of effect is likely to prevail' Finally, United States ownership of assets abroad and/or the proportion of foreign earnings which may be repatriated are, in some instances, subject to control by host governments, and the possibility of expropriation introduces a further uncer tainty into the long-run outlook. TR A D E ACCOUNT FLOWS e x p o r t s . As outlined in the introduction, there are a vari ety of possible export effects attributable to United States direct investment abroad but, unlike the capital and other financial effects, these cannot readily be isolated from available statistics. There are two types of export effects which it would be desirable to measure. (1) Exports of goods to and through foreign affiliates, which would not have been shipped to other foreigners if the affiliates did not exist, are referred to as associated exports. This category could comprise a variety of goods, such as capital equipment associated with plant expansion, parts and components to be assembled abroad, or final goods 13 The values o f the parameters were estimated to be: rate of destined for immediate resale. (2) Exports which do not return, 12 percent; rate o f growth o f outflows, 9 percent; repatri ation rate, 70 percent. These values were estimated as averages occur because of the competition of goods manufactured over the period and, therefore, must be viewed as only rough and sold by the foreign affiliates are described as dis approximations of the marginal relationships the use o f which would be preferable since we are interested in isolating the incre placed exports. Unfortunately, we cannot directly answer m ental incom e inflows from an addition to the investment base. the question—which is central to these two effects—of These estimates may be used to calculate the recoupm ent period, although the results must be viewed with caution. Such sim ulations what the pattern of United States exports would have suggest that the balance-of-paym ents impact (annual incom e in flows minus annual new direct investment outflow s) associated with these new direct investments w ill becom e positive in the twenty-second year, although the negative annual balances dim in ish in m agnitude after the fourth year. O f course, it should be em phasized that the balance-of-paym ents impact o f total in com e and capital flows in future years will be a com bination of not only these marginal flows associated with the new direct in vestm ent but also the positive flows generated by past investments. On this basis, the calculations show that the net incom e and capital flows associated with both old and new investments will continue to be positive and to expand. 14 F. Cutler, “Benchmark Survey o f U .S. D irect Investment Abroad, 1966”, Survey of Current Business (A ugust 1 9 71). 15 P. Berlin, Foreign Affiliate Financial Survey, 1966-1969 (U nited States Departm ent o f Commerce, Office o f Foreign Direct Investm ents, July 1971). 174 MONTHLY REVIEW, JULY 1972 been in the absence of foreign direct investment. Never theless, very rough estimates of the order of magnitude of such effects are presented below based on the limited amount of available data and, most importantly, on judg mental assumptions about firm behavior. Turning first to the question of estimating associated exports, the only comprehensive data available are provided in a bench-mark survey of direct investors for 1966. In that year, United States companies’ exports to overseas affiliates amounted to $7.8 billion, of which $6.3 billion represented shipments by United States manufac turing concerns, primarily to their manufacturing affiliates with distribution outlets receiving most of the remainder. Several interesting facts emerge from this survey. First, exports to foreign affiliates accounted for roughly one half of the total exports of the direct investors. Second, the total export sales of direct investors accounted for 67 percent of the total United States exports of merchandise goods.16 Thi; i, as noted earlier, one of the associated ex port effects to be expected from United States overseas investment is a demand for capital equipment— both for use in constructing and expanding facilities and to fill the subsequent stream of replacement needs. It has been sug gested that United States affiliates might be more likely than other foreigners to purchase such equipment in the United States, and therefore such exports would be di rectly associated with United States overseas investments. When exports to affiliates are examined in terms of their end use, it is apparent that shipments of capital equip ment for the affiliates’ use are small, amounting to only 9 percent of total exports to affiliates. Of the other exports to affiliates, shipments of parts and components for fur ther processing or assembly accounted for 40 percent of the total, with 51 percent of the goods destined for im mediate resale or lease. The bulk of the shipments of final goods was received by manufacturing affiliates, suggesting that in many cases the manufacturing affiliates themselves act as distributing agents for finished products from the United States. Using these 1966 data as a bench mark and assuming a constant relationship between exports to affiliates and 16 For comparability with the direct investor export figures, this total merchandise export figure as published by the Census Bu reau is adjusted to exclude goods classified by the Census Bureau as special category goods— m ainly military-type goods transferred by the Departm ent o f D efense. For further details, see U.S. DU rect Investm ents A b r o a d , 1966, Part II, a supplement to the Survey of Current Business (U nited States Departm ent o f Com merce, Bureau o f Econom ic Analysis, April 1972). outstanding investments, a comparable figure for associ ated exports in 1970 can be estimated to be about $12 billion. It should be noted that this is only a rough esti mate of the amount of exports which would not have been shipped in the absence of the foreign affiliates because it assumes that all exports of United States firms to their foreign affiliates can be attributable directly to the owner ship of the affiliates. This must be viewed only as an ap proximation because, on the one hand, at least some of the goods sold through affiliates probably would have been exported anyway. On the other hand, the existence of the foreign affiliates may have helped promote the sale — either through the affiliates or directly to other for eigners— of goods produced by their United States par ents that otherwise would not have been exported. This brings us to the key question of displaced ex ports. At the outset, the argument over possible displace ment may be limited to the manufacturing industries since the output of other affiliates, principally petroleum and mining and smelting enterprises, represents develop ment of raw material sources not available in sufficient supply in the United States. The problems of evaluating the magnitude of export displacement render sharply defined estimates impossible. To obtain such estimates, it would be necessary to know to what degree the expan sion of foreign-sourced output by United States firms replaced, not United States exports, but other potential foreign-owned production. In other words, in the absence of United States-owned affiliates abroad, would the for eign demand for the products have been met by United States exports or by production abroad in a foreign-owned facility? Here then, subjective assumptions about behavior become critical. The most reasonable assumptions, as in dicated above, seem to be that markets are relatively com petitive for most of the manufacturing affiliates’ products, that a significant portion of United States investment in overseas facilities is undertaken in response to lower pro duction and distribution costs (including the effect of tariff barriers), and that these cost conditions as well as needed technological knowledge are fairly readily avail able to foreign organizations. These assumptions imply that, on the basis of relative cost considerations, produc tion in the foreign market would eventually replace United States exports and that, in the absence of United States firms abroad, foreign firms would in time come to produce the goods. Thus, some, and probably a large pro portion, of affiliate production should be viewed as a sub stitute for output of indigenous foreign firms without United States affiliation rather than as a substitute for United States exports. Since the process of substitution of foreign production 175 FEDERAL RESERVE BANK OF NEW YORK for United States exports is a dynamic one involving ad justments over time, some insight into the shift of pro duction may be gained by examining the change over time in relative market shares provided by United States ex ports as opposed to foreign affiliate production. For five major categories of manufactured products for which comparable data on exports and affiliate sales are avail able,17 the share of the market provided by United States exports fell from 35 percent in 1962 to 30 percent in 1968.18 (See Table II for detailed sales and export data.) In other words, if the relative market shares had remained constant over this period, United States exports would 17 Affiliate sales data are classified by type o f industry while export figures are by type o f product, so that the two categories are not necessarily com pletely consistent. 18 For this purpose, the total supply to the market is defined as sales by foreign manufacturing affiliates outside the United States plus exports from the United States summed across the five major categories for which we have comparable data. Data for sales and exports o f transport equipment for Canada are excluded from the calculations because the figures are heavily influenced by the m ovem ent across the United States-Canadian border o f autom o tive parts associated with the 1965 A utom otive Agreement. have been about $2 billion higher in 1968 than they actu ally were. It must be emphasized that this is not to be interpreted as a numerical estimate of export loss during the interval attributable to the existence of the affiliates. The “loss” might well have occurred anyway as nonaffili ated foreign producers assumed a larger market share, and might more appropriately be viewed as illustrative of a general loss of competitiveness of United States exports in world markets. In summary, the question of whether there has been export displacement and, if so, of what magnitude essen tially cannot be answered on the basis of existing data. However, when the problem is appropriately viewed as a dynamic adjustment process over time, reasonable as sumptions about firms’ behavior suggest that the amount of export displacement attributable to direct investment is likely to be fairly small. This, of course, in no way contra dicts the possibility that, at any one point in time, there may be substitution of foreign affiliate production for United States exports as the adjustment process works itself orut. i m p o r t s . As with exports, the question of what effect United States direct investment abroad has on United Table n SELECTED DATA ON UNITED STATES EXPORTS AND SALES BY FOREIGN MANUFACTURING AFFILIATES OF UNITED STATES MULTINATIONAL COMPANIES In billions of dollars Commodities 1962 1963 1964 1965 1967 1968 Chemicals: Affiliate sales ...................................................... United States exports ...................................... 4.4 1.9 5.1 2.0 5.9 2.4 6.9 2.4 8.9 2.8 10.2 3.3 Rubber products: Affiliate sales ............................................ ......... United States exports ....................................... 1.3 0.1 1.3 0.1 1.6 0.2 1.7 0.2 2.0 0.2 2.1 0.2 Machinery excluding electrical: Affiliate sales ...................................................... United States exports ....................................... 3.4 4.1 3.7 4.2 4.6 4.8 5.4 5.2 7.4 6.2 8.2 6.5 Electrical machinery: Affiliate sales ....................................................... United States exports ...................................... 2.7 1.4 3.0 1.5 3.6 1.7 4.0 1.7 4.8 2.1 5.3 2.3 Transportation equipment: Affiliate sales ...................................................... United States exports* ................................... 6.7 1.8 8.0 1.9 9.5 2.2 10.7 2.2 12.8 3.1 14.5 3.7 Total for selected goods: Affiliate sales ...................................................... United States exports* ...................................... 18.5 9.3 21.1 9.7 25.2 11.3 28.7 11.7 35.9 14.4 40.3 16.0 * Excludes civilian aircraft. Sources: United States Department of Commerce, Survey of Current Business and Overseas Business Reports, selected issues. 176 MONTHLY REVIEW, JULY 1972 States imports revolves around attempting to differentiate between those imports which would have occurred even in the absence of United States overseas affiliates and those which may be directly ascribable to the existence of these subsidiaries. Once again, the discussion may be limited to imports from manufacturing affiliates since purchases from petroleum and mining affiliates reflect primarily raw materials needed in the United States, which presumably would have been imported even if the United States investors did not own the overseas facilities. Conceptually, the same considerations of exploiting relative cost conditions as enunciated above in the export discussion could lead United States firms, not only to establish production units outside the borders of the United States, but also to import the output of these affiliates for direct sale or further assembly in the United States. The manufacture of electronic components in the Far East, such as Hong Kong, Taiwan, Korea, and the Philippines, by United States producers is a frequently cited example. Other specific examples can surely be found. To the extent that lower production costs arise out of differing relative factor endowments or other mar ket forces, such overseas production can be seen once again as merely a more rational utilization of resources. In other instances, the cost advantages of producing abroad may arise not from market factors but from specific incentives provided by host governments. For example, special concessions are given to United States firms by Mexico to induce them to set up assembly plants on the Mexican side of the border and export the final goods back to the United States. In situations of this sort there are, of course, benefits to the host country in terms, for example, of employment and foreign exchange earnings, but there are also disadvantages to the United States in terms of displacement of United States workers with the attendant loss of income. When the cost ad vantages arise from artificial incentives, it is questionable whether a more efficient pattern of resource use results. The most striking conclusion which can be drawn from data on sales of foreign manufacturing affiliates to the United States is that such shipments represent a fairly small proportion of total affiliate output and a much smaller percentage of total United States imports than the comparable relationship between exports to affiliates and total United States exports. Imports from all foreign manufacturing affiliates increased approximately fourfold between 1962 and 1968 and reached a level of $4.7 billion in the latter year, or approximately 15 percent of total nonmilitary merchandise imports. While the increase over the period is fairly sizable, it is largely a result of the 1965 Canadian-United States automobile agreement. If imports of transportation equipment from Canada are ex cluded, the remaining imports rose by about two and one-half times to only $2.5 billion. These sales to the United States accounted for only some 4 percent of total affiliate sales in both 1962 and 1968. Thus, by far the largest part of affiliate output is designed for sale in for eign markets, not in the United States. Furthermore, the available statistics do not support the claim that there are very significant imports from affiliates in the areas frequently cited as the “low wage” countries, such as Mexico, Taiwan, and Korea, where United States firms are establishing assembly plants and production facilities for parts and components.19 In fact, the bulk of the increase in nonautomotive imports has been from Canada and was principally centered in three categories: paper and allied products, primary and fabri cated metals, and nonelectrical machinery. Thus, on the basis of the available data, it seems rea sonable to conclude that the impact of foreign direct investment on imports is small. Using the relationship be tween imports from affiliates to outstanding investment in 1968, it can be estimated that such imports (excluding Canadian autos) were about $3 billion in 1970. Not only is this absolute magnitude of imports from foreign affili ates fairly small, but additionally it is likely that a signi ficant portion of the goods currently purchased from these overseas subsidiaries would have been imported from other foreign sources if the United States affiliates did not exist. CONCLUSIONS In summation, the empirical evidence available to esti mate the total impact on the trade balance of direct invest ment by United States multinational companies is inade quate to the task. As indicated above, rough estimates can be made from existing statistics of two types of trade effects associated with direct investment. Combining the $12 billion of associated exports with the $3 billion import figure suggests a net positive trade effect in 1970. But even these are only partial estimates of the total trade bal ance effect and must be interpreted with great caution for several reasons. First, they depend very heavily on 19 H owever, it should be noted that there m ay have been some increase in this type o f activity recently which would not be cap tured in these statistics for 1968. FEDERAL RESERVE BANK OF NEW YORK the underlying behavioral assumptions. In particular, both estimates assume that none of these exports to, or imports from, affiliates would have occurred if the affiliates did not exist, while in reality it is likely that some indetermi nate portion of both would have been traded with foreignowned firms in the absence of United States affiliates. Second, these trade balance estimates for 1970 do not take into account any possible export displacement which, as noted above, may be significant in any particular year. Third, and perhaps most importantly, all of these trade effects are more appropriately viewed as part of a dynamic process over time rather than as a specific impact in any given period. On this basis, while there may be some net export gain or loss or import creation in the short run, over a longer time horizon the portions of the observed changes in export and import patterns which can reason ably be ascribed to the direct investment process itself probably tend approximately to balance out or perhaps be a net positive item. Rather, most of the observed alterations in trade patterns should more appropriately be 177 viewed as market responses to shifts in worldwide relative competitive conditions, and would have occurred whether or not the foreign facilities were owned by United States investors. The real balance-of-payments impact of United States direct investment activities, then, hinges on the relation ship between capital account items and related financial flows and, on this basis, the evidence seems clear that United States direct investment is a long-run positive fac tor in the balance of payments. It must be recognized, however, that there are still many unanswered questions about the underlying motivations and the dynamic pro cesses involved in foreign direct investment. There are most likely significant differences among industries and countries which temper the investment decision, and the future outlook could well be affected by changes in inter national economic and political relations.' There is a great need for more and better statistics on the interna tional operations of multinational firms and wide scope for further research on this important topic. 178 MONTHLY REVIEW, JULY 1972 Th e Program for the Automation of the Governm ent Securities M arket By R i c h a r d A . D e b s Vice President, Federal Reserve Bank of New York Editor’s Note: The following is based on a memorandum which was completed on March 21,1972 and which was subsequently submitted by the Board of Governors of the Federal Reserve System to the Subcommittee on Securities of the Committee on Banking, Housing and Urban Affairs of the United States Senate in connection with hearings relating to the clearance and settlement of securities transactions. The author has responsibility for the Government Bond and Safekeeping operations of the Federal Reserve Bank of New York. He is also chairman of a Federal Reserve System Subcommittee on Fiscal Agency Operations, which acts as liaison between the Federal Reserve Banks and the Treasury Department with respect to Reserve Bank operations conducted as agent for the United States Government. This paper outlines the development and current status of the Federal Reserve-Treasury program for the automa tion of the Government securities market, including the book-entry procedure for Government securities. O BJECTIVES AND SCOPE The ultimate objective of the program is a fully auto mated Government securities market, in which the pieces of paper representing Government obligations—including both Treasury and Federal agency obligations— have been eliminated and replaced by computerized book-entries, and in which transactions in such book-entry securities are effected by means of wire messages—including computerto-computer communications— through high-speed lines directly linking computer terminals on the premises of each major market participant throughout the country. In general, the program was designed to improve the efficiency of operations in Government securities. It is in tended to reduce the time, money, personnel, and space required to handle the increasing volume and velocity of transactions in Government securities and, at the same time, to ensure adequate controls and reduce to a mini mum the risk of loss or theft of such securities. The benefits of the program will be available to all owners of Government securities—whether they be pri mary dealers or private individuals— through the member banks, which will be qualified to open book-entry accounts at their Federal Reserve Banks and to deposit any or all of their customers’ securities in such accounts. Thus, all owners of Government securities may, if they so desire, arrange to have their securities converted into book-entry form by depositing them with a member bank, which in turn will deposit the securities in its book-entry account with its Reserve Bank. In this respect, the program pro vides a substitute for the physical custody of Government securities. In addition, and just as important, for those banks and bank customers which are active participants in the Gov ernment securities market— such as the primary bank dealers and the primary nonbank dealers, through their clearing banks—facilities will be available for effecting central market transactions in such securities through Federal Reserve wire systems. In this respect, the program provides a means for moving the book-entry securities throughout all segments of the Government securities market, with the speed and in the volume necessary to en sure the effective functioning of the market. FEDERAL RESERVE BANK OF NEW YORK Historically, the automation program has comprised two separate, but parallel, lines of development. The first was the development of facilities for transferring and clearing securities transactions among the major partici pants in the market, beginning with the New York money center banks and the establishment of the Government Securities Clearing Arrangement. The second was the de velopment of the book-entry procedure itself, which began with the conversion into book-entry form of Treasury securities owned by country member banks and held in safekeeping at their Reserve Banks. More recently, there has been a third related development of significance for the Federal Reserve System—the creation of the Reserve Bank “checklist procedure”, developed as a transitional measure to deal with the immediate problem of Govern ment securities thefts, pending the longer-term solution offered by the automation program. WIRE F A C ILITIE S AND CLEARING ARRANGEM ENTS The basic concept of transferring Government securities by means of wire messages has existed for many years in the “CPD” wire facilities maintained by the Treasury and the Federal Reserve Banks, which permit wire transfers between most Federal Reserve offices. Under this system, the commercial bank sender of a security delivers it to the local Federal Reserve office, which then retires the secu rity and sends an appropriate wire message to another Federal Reserve office, which in turn issues a new security, which is then picked up by the ultimate recipient of the transfer message. The clearing arrangement carries this basic concept further in three important respects: (1) instead of requir ing the delivery and pickup of a physical security for each transfer, the transfers are debited or credited to a bank’s “securities clearing account”—with appropriate cash en tries to its reserve account— and only one delivery of securities is necessary at the end of the day, and only in the net amount due to or due from the bank; (2) the major commercial banks having a large volume of such transactions are linked by wire directly with their Reserve Bank, permitting them to transmit transfer messages from terminals on their premises; and (3) as the final step in a money market center, the major commercial banks are linked with each other, through a Reserve Bank computer switch, permitting them— and their customers, including the nonbank primary dealers— to effect transactions among themselves, thereby providing each of them access to the other major participants in the Government secu rities market through their own terminals. The first experiments with clearing procedures were 179 initiated in New York City in 1965, and resulted in the establishment of the Government Securities Clearing Ar rangement, which now includes twelve participating mem ber banks. Over the years— and particularly since the in stallation of the Federal Reserve System’s Culpeper switch and the Sigma 5 computer switch at the New York Re serve Bank— the arrangement has been expanded to the point where it now handles virtually all types of transac tions in the Government securities market, in any volume that may be required. As an example, during 1971, a year of transition to the use of the new computer equipment, there were about 470,000 transactions effected through the Clearing Arrangement, totaling $710 billion. Last month alone, there were more than 50,000 transactions, totaling $99 billion. Studies are now in progress for developing clearing procedures at other Reserve Banks. The San Francisco Reserve Bank has been operating a net settlement proce dure for CPD transfers with one of its member banks, and the Chicago Reserve Bank has been exploring the possi bility of a similar procedure with its larger member banks. Other Reserve Banks have been considering the possible use of such procedures at some future date, as increasing volume may warrant it. The importance of such proce dures lies not only in their immediate benefits, but even more important, in the potential for integrating a clearing arrangement with the basic book-entry procedure. BO O K -EN TR Y PROCEDURE In essence, the book-entry procedure is a new legal sys tem, created by Federal regulations having the force of Federal law (e.g., Subpart O of Treasury Circular No. 300), under which the piece of paper representing a Gov ernment obligation may be eliminated, and the obligation recorded on the books of a Federal Reserve Bank. The first phase in the development of the procedure began in 1968, when it was established as a substitute for the physi cal custody of Treasury securities in the safekeeping ac counts maintained by the Reserve Banks for country mem ber banks. Although the procedure was made available to all member banks at that time, until last year most of the largest money center banks did not utilize the procedure, primarily because of burdensome tax-reporting require ments. Since 1968, there has been a gradual extension of the procedure to additional types of securities accounts. The process has been gradual because the conversion of each class of security account has presented new and different legal problems, tax questions, and operational complica tions. These are reflections of the fact that for centuries 180 MONTHLY REVIEW, JULY 1972 the law, commercial practices, and traditions governing transactions in securities have been based on the posses sion of a piece of paper having intrinsic value. Under the book-entry procedure, that piece of paper no longer exists. By the end of 1970, most of the different types of safe keeping accounts maintained at the Reserve Banks had been converted to book-entry form. The next phase of the program contemplated an extension to Government securi ties held outside the Reserve Banks, including in particular the securities of the primary dealers in Government securi ties— both bank dealers, which involved certain tax ques tions, and nonbank dealers, which involved in addition the question of their legal status as customers of clearing banks. Beyond that phase, the program aimed at covering all securities held by member banks for any third party. The overall plan for the conversion of these types of securities accounts envisaged a program of several years’ duration. However, the timetable was greatly accelerated by the “insurance crisis” in the Government securities mar ket early last year, which resulted from the abrupt emer gence of the problem of securities thefts. SEC UR ITIES T H E F T S AND C H ECK LIST PROCEDURE The problem of securities thefts is in large part rooted in the difficulties of the financial community in coping with the vast amounts of paper required by traditional methods of operation. During the past year, the matter has been the subject of close study by Congressional committees, the Securities and Exchange Commission, and the financial community itself. The studies continue, and will no doubt result in basic changes in existing procedures in the bank ing system and in the securities markets, some of which will come about as a result of Federal legislation. The Federal Reserve has an interest in many aspects of this problem and its proposed solutions, but for present pur poses it should suffice to note only those relating directly to the Government securities market. The problem of securities thefts first came to public at tention in connection with Government securities. Within a matter of weeks at the end of 1969, $17 million in Gov ernment securities were reported stolen from three New York City banks. By the end of that year, a national total of approximately $30 million in losses had been reported to the Treasury, and the losses continued at the same high level in 1970. In view of the magnitude of the problem, it was clear that the Federal Reserve System had a direct interest in the matter. Apart from the responsibilities of the Reserve Banks as fiscal agents of the United States, the System had an immediate concern in the problem as it affected the banking system, and also as it affected the performance of the Government securities market. It was also clear that, while the book-entry program offered a long-term solution as a means of preventing thefts, there was an immediate need to assist in recovering securities already stolen. It was against this background that the “checklist pro cedure” was developed. Under the procedure, which was adopted on a uniform basis by all Federal Reserve Banks through the Conference of First Vice Presidents of the Federal Reserve Banks, a current list of stolen securities is maintained at each Federal Reserve office, based on reports received from banks and other financial institu tions throughout the country, and more recently, from the Treasury. Up-to-date information is promptly circulated to all Federal Reserve offices, by wire, through the New York Reserve Bank, which acts as the coordinating bank under the procedure. With the list, each Federal Reserve office checks the securities received at that office, and also serves as a clearing house for information on stolen securi ties within its own territory. Experience with the checklist procedure since 1970 in dicates that it has been fairly successful in achieving its primary objective— to assist in discovering stolen securi ties. It does not, of course, prevent securities thefts, a longer-term objective that the book-entry program seeks to achieve. INSURANCE CRISIS AND AC CE LE R A TE D BO O K -E N TR Y PROGRAM The problem of thefts led directly to the “insurance crisis” of early 1971, which endangered the continued functioning of the Government securities market. At that time, the Continental Insurance Company had announced plans to terminate its coverage of bearer Government securities held by money center banks, dealers, and brok ers. Since Continental was the predominant carrier in the field, there was a risk ihat if such plans were implemented, the major participants in the market would terminate op erations, and the market would cease to function. The ultimate avoidance of such a result required sev eral months of intensive negotiations involving the Fed eral Reserve, the Treasury, the insurance companies, and the leaders of the banking and securities industries. It also involved the adoption of a contingency plan to attempt to handle essential market operations through the New York Reserve Bank; it required the enactment of Federal legis lation to permit the Treasury to settle claims on stolen securities; and— most important in the long run— it re sulted in the formulation of a greatly accelerated program for the further extension of the book-entry procedure. FEDERAL RESERVE BANK OF NEW YORK The new program was designed to accelerate existing long-term plans for automation as rapidly as possible. The program required action by the Treasury, in amending the governing Treasury regulation; by the Internal Revenue Service, in amending its tax rulings on dealer securities and tax-reporting requirements; and by the Federal Re serve Banks, through the Committee on Fiscal Agency Operations of the Conference of First Vice Presidents of the Federal Reserve Banks, in revising Reserve Bank oper ating rules and procedures. To be successful in averting the complete termination of insurance coverage, the pro gram also required action by the New York City banks affected by the crisis, who were expected to begin promptly the process of converting their securities accounts to the book-entry procedure. By April 1971, all of the necessary legal actions had been completed. In brief, the program contemplated that the book-entry procedure would be extended to cover (a) securities owned by primary dealers—both bank dealers, and nonbank dealers acting through their clearing banks; (b) securities held by member banks in customer ac counts, including the establishment of special book-entry accounts to accommodate collateral loans, repurchase agreements, pledges, and similar arrangements; and (c) eventually, securities held by member banks in trust ac counts, which required the resolution of certain legal questions under state laws. The plan also contemplated the further development and utilization of the Government Securities Clearing Arrangement and the System’s wire network. In addition, plans were made for the extension of the overall program to the securities of Federal agencies. When the program was formulated, it was understood that it would be put into effect in stages; the first stage was limited to the New York City banks participating in the Clearing Arrangement, who were most vulnerable to the problem of insurance coverage. In view of the pres sures under which the program was formulated, such an approach was also deemed desirable as a means of ex perimenting with the new procedures and developing a basic pattern of book-entry accounts that could accom modate the operations of all member banks. During the first six months of the program, nine banks opened new book-entry accounts, including several special accounts in which a limited number of customer securities were gradually deposited. Several banks— particularly the clearing banks, acting as agents for the nonbank dealers— encountered delays because of the need to develop ade quate computer systems to handle the volumes involved. During the period, the capabilities of the Clearing Ar rangement were further enlarged as the computer switch 181 systems came into operation, and all of the new bookentry accounts were integrated into the Clearing Arrange ment. During the same period, New York State enacted legislation, endorsed by the Federal Reserve Bank of New York, to permit the application of the book-entry procedure to Government securities held by banks as trustees. At the end of the six-month period, there was a compre hensive review of operations in the light of experience to date, which indicated the desirability and feasibility of cer tain changes in the basic legal concepts underlying the bookentry procedure— particularly with respect to transfers and pledges of customer securities— that would obviate cer tain operating complexities and result in a much simpler system. Since then, the System Subcommittee of Counsel on Fiscal Agency Operations, working with counsel to the commercial banks and Treasury counsel, have been developing the necessary legal framework to implement the changes. It is expected that the new rules will be pub lished in the Federal Register as amendments to the gov erning Treasury regulation within the next week or two.* CURRENT S TA TU S At this point in time, ten of the participating banks have opened a variety of new book-entry accounts, in cluding separate accounts to hold investment portfolios, dealer inventories, customer securities, and special col lateral accounts. The total amount in these accounts is now about $4 billion, and is continuing to increase. The securities already deposited in these accounts include some or all of the dealer inventories of most of the dealer banks (including dealer banks in the Chicago and San Francisco Districts, through their New York clearing banks), and most of the nonbank dealers. The process of conversion has been gradual and is continuing. All of these book-entry accounts have been integrated into the Clearing Arrangement. This means, in effect, that all transactions in these accounts— including purchases, sales, repurchase agreements, free deliveries, denomina tional exchanges, original issues, redemptions at maturity, and any associated debits or credits to Reserve accounts— are effected through the terminals located on the premises of the member bank depositors, without the need for the existence of any physical security. The overall volume handled through the Clearing Ar * Editor’s note: The am endments were published on April 29, 1972. 182 MONTHLY REVIEW, JULY 1972 rangement continues to increase. In the week of Febru ary 18, during a Treasury refunding operation, 17,285 transactions went through the arrangement, totaling about $32 billion. In terms of the book-entry program as a whole, there are approximately $171 billion in Treasury securities in book-entry form at all Reserve Banks. About $145 billion of that amount is held at the New York Reserve Bank. Of the total amount in book-entry form, approximately $155 billion is in marketable public issues, out of a total of about $262 billion in total marketable public debt out standing. Thus, approximately 60 percent of the out standing marketable public debt is in book-entry form. In addition there are about $84 billion in “special issues” in book-entry form. Including these issues, approximately 70 percent of the outstanding gross public debt, excluding savings bonds, is in book-entry form. In terms of the goals of the program, there remains roughly $95 billion in bearer Treasury securities eligible for conversion into book-entry form. The great bulk of these securities is held by parties which are— or could be— customers of member banks, including trust accounts. FUTURE PLANS At this point, the most immediate goal of the program is to complete the process of conversion of all primary dealers’ securities. Then, as soon as the new amendments to the Treasury regulation are published, the way will be open to continue with the further extension of the pro gram to all customer securities, not only at the participat ing New York banks, but also at the other member banks throughout the country. The basic pattern of accounts and procedures has been worked out in the light of the New York banks’ experience, and the new amendments should facilitate the expansion of the program for all member banks. There are some particular questions that have yet to be resolved— such as agreement on contingency plans in the event of computer failures and other emer gencies, and approval of a form of lending agreement among the major market participants—but these questions will no doubt be resolved soon. As soon as they are settled, and as soon as new uniform operating circulars are formu lated for all Reserve Banks through the Conference of First Vice Presidents, each Reserve Bank should be in a position to make the program available to member banks in its District. All Reserve Bank fiscal agency officers have been preparing for that step; there have been meetings of such officers during the past year to review the operations of the program, and another meeting will be held soon, before the next phase is begun. While the book-entry program will be available to all member banks for their customer securities, the rate at which those securities will be converted will depend upon the capabilities of the member banks themselves. No doubt the process of conversion will continue to be a gradual one. In addition, the laws of many states present legal problems that must be resolved, presumably by legisla tion, before member banks subject to such laws may con vert securities held in trust accounts, which, of course, comprise a large proportion of commercial bank custody accounts. Once the revised Treasury regulation is published, simi lar book-entry regulations can be promulgated by the other Federal agencies, and the next phase of the program will focus on the inclusion of agency securities. In January of this year, the Postal Service became the first Federal agency to promulgate a book-entry regulation and to issue securities in book-entry form, but that was a rather special situation. The inclusion of all of the issues of all Federal agencies will be a gradual process, but it presents no spe cial legal or operational problems that would be difficult to resolve. It is impossible to indicate a timetable for the comple tion of the automation program. Apart from the obvious uncertainties involved, it would be difficult to measure with any precision the point at which the basic objectives of the program will have been achieved. While it may be desirable to attempt to convert all outstanding Treasury and agency securities to book-entry form, the purposes of the automation program will have been fulfilled long be fore that stage is reached. The program will have achieved its ends whenever all— or virtually all—transactions m Treasury and agency securities in the Government securi ties market can be effected by means of wire messages among the major participants in the market, without the need for physical securities. In the light of the experience to date, that time does not seem too far distant. FEDERAL RESERVE BANK OF NEW YORK Publications of the Federal Reserve Bank of New York Distribution and charge policy: The following selected publications are available from the Public Information Department. Except for periodicals, mailing lists are not maintained for these publications. The first 100 copies of the Bank’s general publications and the first copy of its special publications are free on reasonable requests. Additional copies of general and special publications are free on reasonable requests for educational purposes to certain United States and foreign organizations. United States: schools (including their bookstores), commercial banks, public and other nonprofit libraries, news media, and Fed eral Government departments and agencies; foreign: central government departments and agencies, central banks, and news media. (Such additional free copies will be sent only to school, business, or government addresses.) Other organizations are charged for copies exceeding normal limits on free quantities (prices are listed with the publications). Remittances must accompany requests if charges apply. Delivery is postpaid and takes two to four weeks. Remittances must be payable on their faces to the Bank in United States dollars collectible at par, that is, without a collection charge. GENERAL PUBLICATIONS m o n e y : m a s t e r o r s e r v a n t ? (1971) by Thomas O. Waage. 45 pages. A comprehensive discussion of the roles of money, commercial banks, and the Federal Reserve in our economy. Explains what money is and how it works in a dynamic economy. (15 cents each if charges apply) p e r s p e c t i v e . Published each January. 9 pages. A nontechnical review of the major domestic and in ternational economic developments of the previous year. Sent to all Monthly Review subscribers. (6 cents each if charges apply) SPECIAL PUBLICATIONS e s s a y s i n d o m e s t i c a n d i n t e r n a t i o n a l f i n a n c e (1969) 86 pages. A collection of nine articles dealing with a few important past episodes in United States central banking, several facets of the relationship between financial variables and business activity, and various aspects of domestic and international financial markets. (70 cents each if charges apply) t h e v e l o c it y o f m o n e y (1970, second edition) by George Garvy and Martin R. Blyn. 116 pages. A thorough discussion of the demand for money and the measurement of, influences on, and the implications of changes in the velocity of money. ($1.50 each if charges apply) c e n t r a l b a n k c o o p e r a t i o n : 1924-31 (1967) by Stephen V. O. Clarke. 234 pages. A documented discussion of the efforts of American, British, French, and German central bankers to reestablish and main tain international financial stability between 1924 and 1931. ($2.00 each if charges apply) m o n e y , b a n k i n g , a n d c r e d i t i n e a s t e r n e u r o p e (1966) by George Garvy. 167 pages. A re view of the characteristics, operations, and changes in the monetary systems of seven communist countries of Eastern Europe and the steps taken toward greater reliance on financial incentives. ($1.25 each if charges apply)
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