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September-October 1966 The Changing Structure of Rural Banking ••• page 3 Measuring a Deficit or Surplus in the U. S. Balance of International Payments •• page 11 FEDERAL RESERVE BANK OF KANSAS CITY Subscriptions to the Mo THLY REVIEW are available to the public without charge. Additional ropies of any issue may be obtained from the Research Department, Federal Reserve Bank of Kansas City, Kansas City, Missouri 64106. Permission is granted to reproduce any material in this publication. The Changing Structure of Rural Banking By Raymond ]. Doll within both the commercial D banking and agricultural industries during EVELOPME TS the past 15 years have had a sharp impact on rural banks. During and immediately after World War II, commercial bank investment portfolios were highly liquid. Loans generally were relatively low and investments in Government securities were high. Beginning in the early 1950's, a number of developments have brought about significant changes in the financial sector of the economy, including the Treasury-Federal Reserve Accord, changes in rates commercial banks were permitted to pay on time and savings deposits, abandonment of the ''bills only" policy, and, until recently, use of a generally stimulative credit policy to encourage a fully employed and stable economy. In addition to experiencing the developments within the financial sector of the economy, rural banks also felt the impact of sharp adjustment problems that occurred in rural areas. The agricultural industry literally passed through a technological revolutionwith the number of farms declining at an average annual rate of about 3 per cent-during the period that the financial developments mentioned above took place. This revolution is continuing unabatedly. Total capital requirements of the industry have about doubled Monthly Review • September-October 1966 -making capital requirements per farm currently about 3J~ times as large as requirements 15 years ago. These changes have caused the average amount of credit used per farmer to increase roughly 5 times in this period. Demands for farm credit have increased sharply, and since rural banks are a major source of this credit, the impact of these activities has been reflected in rural bank portfolios. This situation is particularly important since such banks are heavily dependent on farm income for their deposits, and farm income increased only at a modest rate during this period. The result is that the structure of most enterprising rural banks is substantially different now as compared with 1950. This article will show some of the changes that have occurred, evaluate these changes, and show the wide variability that prevails from bank to bank for rural banks in the Tenth Federal Reserve District. Before proceeding with the analysis, it is appropriate to define a rural bank and briefly discuss the relative importance of such banks. A rural bank is defined as any bank that had 50 per cent or more of its total loan volume in agricultural loans on both December 31, 1950, and December 31, 1965-the beginning and end of the period being evaluated. There were 3 The Changing Structure 231 member and 329 nonmember banks in the T enth District that met this definition , so 560 banks , or about 30 per cent of all commercial banks in the Tenth District, were rural banks . . ot included in the definition of a rural bank were 227 banks that had .50 per cent or more of their total loan volume in agricultural loans in 1950, hut dropped below the figure in 1965, and 329 hanks that were above this figure in 1965, but were below it in 1950. It is interesting to note that a substantially larger number of banks had .SO per cent or more of their loan volume in agricultural loans in 1965 than in 1950. rn the s11hseq11cnl analysis, the evaluations "'ill he hascd 11pon changes occurring between the hc12;i1111inl!; and end of the 1.5-year period. \lajor reasons for using this comparative method are: ( 1) ~Jany of the factors responsible for major changes in bank assets and liabilities during the period were discontinuous in nature. ( 2) In evaluating credit problems, such as those facing commercial b a nks and the agricultural industry today, there are good reasons for using the most recent data rather than projecting from time series regression curves. Such estimates are influenced by information from some banks that, for various reasons, may not be making an effort to pro- Chart 1 DEPOSIT GROWTH OF MEMBER BANKS Tenth District Index (December 1950 = 100) 4 Chart 2 LOAN-TO-DEPOSIT RATIO OF MEMBER BANKS Tenth District Per Cent 60 50 40 30 ZOl.~9~5~1---'---''--7•5~ 5:-'-_L____L__L______l'L6_0L_...J__J__L____L'6_5_.1_~ ,·ide for the credi t r quirements of their communities. ( 3) The general trends influencing capital and credit requirements in agriculture were persistently in the same direction and occurred at rapid, even though not consistently stable, rates. Before proceeding with an analysis of the 1950-65 change for rural banks, it is of interest to compare year-to-year changes for several broad c1assifications of data for all member hanks. Because bank deposits are influenced by such factors as changes in rates commercial banks are permitted to pay on time a nd savings deposits, open market operations, and variability of economic conditions among the different areas, it is important to have some idea of year-to-year changes in deposits for the banking system in the District. Member bank data only are used, since they are more readily available, account for a large proportion of all deposits in th e District, and indirectly influence nonm mber bank deposits. It is of interest to note in Chart 1 that demand deposits of these banks increased at a persistent, but slow, rate throu ghout most of the period. Time and savings deposits, on the other hand, increased rather slowly at first but, with the increasing demand for credit and the of Rural Banking Table 1 STATISTICAL DATA ON RURAL BANKS Tenth Federal Reserve District Member Banks Dec. 31 Dec. 31 Per Cent Change 1950 1965 (Millions of dollars) Total Deposits Demand deposits Time deposits Other deposits•:, Total Loans Agricultura l loans Nonmember Banks Dec. 31 Dec.31 Per Cent Change 1950 1965 (Millions of dollars) All Banks Dec. 31 Dec. 31 1950 1965 (Millions of dollars) Per Cent Change 493 840 +70 385 674 +75 878 1,514 +72 388 44 62 445 274 121 +15 +523 +95 313 26 46 386 192 96 +23 +638 +109 701 69 108 831 465 217 +19 +574 +101 162 466 +188 131 355 +17 1 293 821 +180 133 323 +186 92 245 +166 205 568 + 177 Cash, balances with other banks, and cash items in process of collection 143 157 +10 104 116 +11 247 273 +10 U. S. Government securities 199 219 +10 163 218 +34 362 437 + 21 22 73 +23 2 15 53 + 253 37 126 +240 Obligations of states and political subdivisions ,:, Deposit,; of U. S. Government, states and political subdivisions, and of other banks. NOTE : Member and Nonmember Bank f ig ures may not odd to All Bank fig ure because of rounding. changes in rates commercial banks were permitted to pay on them, these deposits commenced to increase at an accelerating rate in the late 1950's and were roughly 6 times as large in 1965 as in 1951. The average loan-to-deposit ratio of all member banks in Chart 2 shows that this ratio has increased rather persistently throughout the period, indicating that total loans made by District member banks have trended upward throughout the period at a more rapid rate than have deposits. The ratio almost doubled, increasing from 30 in December 1950 to 57 in December 1965. RURAL BANKS General statistical data for rural banks included in Table 1 show total deposits of these banks increased 72 per cent during the period being evaluated. This growth compares with an increase of 45 per cent in cash receipts from farm marketings and Government payments to farmers in Tenth District states during the same period. Even though deposits of these banks grew at a noticeably more rapid rate than farm income, two observations are pertinent. ( 1 ) Deposit growth in the rural Monthly Review • banks was not as large as for all member banks in the Tenth District. ( 2) Changes in rates banks were permitted to pay on time and savings deposits probably had a substantial impact on deposit growth, since the higher rates enabled aggressively managed banks to pull funds in from outside the area and from other financial institutions. Changes in these rates did have an impact on deposits of rural banks as is shown by the impressive 574 per cent increase in time deposits versus the 19 per cent increase in demand deposits. Without the change in rates banks were permitted to pay, these banks might have had a difficult time maintaining a rate of deposit growth equivalent to that of gross farm income. There was wide variation in the increase of total deposits and deposits by type among banks. In many of the rural banks, time deposits increased from a relatively minor part of total deposits at the beginning of the period to where they were more important than demand deposits by the end of the period. At the other extreme, a significant number of banks either had no time deposits or suffered substantial declines in time deposits between the beginning and end of the period. More September-Octobe r 1966 5 The Changing Structure Table 2 CHANGES IN DEPOSITS OF RURAL BANKS FROM 1950-65 CLASSIFI ED BY LOAN/ DEPOSIT RATIO IN 1965 Tenth Federal Reserve District Loan/ Deposit Ratios (Per Cent) Number of Banks Demand Time and Savings Other Dec. Dec. Dec. Dec. Dec. Dec. 31 31 Per Cent 31 31 Per Cent 31 31 Change 1950 1965 1950 1965 Change 1950 1965 (Millions of dollars) (Millions of dollars) (Millions of dollars) Total Dec. Dec. 31 Per Cent 31 Change 1965 1950 (Millions of dollars) Per Cent Change All Banks Up to 40 40-49 50-59 60-69 70 and up 98 117 159 121 65 116 139 209 160 76 133 164 259 184 90 14.6 17.9 23.9 15 .0 18.4 10 14 19 20 7 Total 560 701 831 18.S 69 62 83 143 125 52 520.0 492.8 652 .6 525 .9 642.8 17 22 34 24 11 33 43 68 52 22 94.1 95.4 100.0 116.6 100.0 144 175 261 204 94 229 290 469 362 164 59.0 65.7 79.6 77.4 74.4 465 573.9 108 2 17 100.9 878 1,514 72.4 Member Banks Up to 40 40-49 50- 59 60-69 70 and up Total 33 41 75 53 29 59 63 116 104 46 64 73 143 117 49 8.4 15 .8 23 .2 12.S 6.5 7 6 11 14 5 231 388 445 14.6 44 38 39 84 82 31 442.8 550.0 663 .6 485.7 520.0 11 21 15 6 9 17 20 40 34 JI 88.8 81.8 90.4 126.6 83.3 75 80 149 133 56 118 131 149 232 92 57.3 63.7 79.1 74.4 64.2 274 522.7 62 121 95.1 493 840 70.3 8 12 13 9 5 16 23 28 18 10 100.0 91.5 115.3 100.0 100.0 70 95 113 71 37 111 159 202 130 72 58.5 67.3 78.7 83.0 94.5 96 108.6 385 674 75.0 Nonmember Banks Up to 40 40-49 50-59 60-69 70 and up 65 76 84 68 36 58 76 93 57 30 70 92 116 68 41 20.6 21.0 24.7 19.2 36.6 4 7 7 6 2 25 45 58 43 21 Total 525 .0 542.8 728.5 616 .6 950.0 329 313 386 26 192 638.4 46 23.3 NOTE : Member and Nonmember Bank figures may not add to All Bank figure because of rounding. than a fourth of the member banks and a fifth of the nonmember rural banks suffered declines in demand deposits ranging up to 49 per cent. Increases in demand deposits ranged upward to 147 per cent for member banks and 191 per cent for nonmember banks. There was considerably more variability in deposit change from December 1950-65 among nonmember banks than among member banks. Five per cent of the nonmember banks lost deposits during this period and, almost without exception, these banks were small. On the other hand, 4 per cent of the nonmember banks more than tripled their deposits during the period-with one bank increasing total deposits .5½ times . Only 1 per cent of the member banks lost deposits, but less than 1 per cent tripled total deposits during the period; the largest increase in total deposits of a member bank was about 3¼ times. Even though a larger proportion of nonmember banks lost deposits, a 6 larger proportion of nonmember banks also showed greater rates of deposit growth. The larger average size of member banks, plus the fact that more member banks had only moderate rates of growth, combined to cause the rate of growth in total deposits of member banks to be somewhat lower than for nonmember banks. Data in Table 2 indicate that there was substantial variability among rural banks in their loan-to-deposit ratios. There were more banks, with a larger dollar volume of deposits, with ratios oJ up to 40 per cent, than there were banks with ratios of 70 per cent and up. The ratios varied from 21 to 83 per cent for member banks and from 9 to 93 per cent for nonmem her banks. In checking through the data by individual banks, it is interesting to note that, with four exceptions, all member banks with loan-to-deposit ratios of up to 40 in December 1965 also had ratios of less than of Rural Banking 40 in December 1950. Three of the four exceptions dropped from ratios of slightly above 40 to slightly below 40, and one bank's ratio dropped from 60 to 39 during the period. The same general situation prevailed for nonmember banks. Banks with high ratios at the end of 1965 varied widely in their changes from December 1950, but generally, banks with high ratios in December 1965 also had relatively high ratios at the end of 1950. The latter point can be verified by noting that the banks with loan-to-deposit ratios of 70 and up in December 1965 had total deposits of $94 million in December 1950 and total loans of $42 million, making an aggr gate ratio of 4.5 in 19.50. The banks with ratios of up to 40 at the end of 1965 had total deposits of $144 million at the end of 19.50 and total loans of $37 million. Thus, their aggregate ratio in 1950 was only 26. Rural banks with loan-to-deposit ratios of up to 40 per cent in December 1965 had a slower rate of growth in total deposits than did any other group. For nonmember banks, the rate of growth in total deposits tended to increase directly with loan-to-deposit ratio, while for member banks, the rate of deposit growth was the highest for the group of banks with loan-to-deposit ratios from 50-59. A comparison of all rural banks shows that total deposits tended to grow with increase in loanto-deposit grouping until the 50-59 group was reached and did not change significantly beyond that point. Comparing growth rates by loan-to-deposit ratio grouping by type of deposit, illustrates the general tendency for the growth rates of member banks with both relatively low and high ratios to be below average for demand deposits, with the greatest rate of growth for the intermediate-ratio range. Growth rates for demand deposits for nonmember banks did not vary significantly with change in ratio grouping, except for the 70 and up group, which showed a substantially greater rate of Monthly Review • growth than did the other groupings. Growth rates in time deposits from December 1950-65 tended to be positively correlated with loanto-deposit ratios at the end of 1965 for nonmember banks, but were erratic for member banks. For deposits of various types of Government units and interbank deposits, growth rates were relatively stable for banks in the different ratio groupings. Total loans of rural banks increased 180 per cent and agricultural loans 177 per cent, as compared with the 72 per cent increase in deposits. Agricultural loans accounted for 69 per cent of the total loans outstanding at these banks at the nd of 1965. Despite their relative importance at these banks, farm loans increased at approximately the same rate as total loans. It also should be pointed out that farm loan growth at these rural banks did not match the 204 per cent increase in farm loans held by all commercial banks in the United States. This difference indicates that the portion of the agricultural industry financed by the rural banks relied increasingly on other banks and other sources of credit for financing during this period. Agriculture probably relied heavily on other banks b ecause of the slow rate of deposit growth in rural banks and current correspondent banking mechanisms, which tend to funnel a substantial volume of funds out of agricultural areas and return part or all of them through such devices as participation loans. Correspondent banks probably are returning a larger proportion of country bank deposits in the form of overlines and purchase of country bank notes today than 15 years ago. In the case of both total loans and agricultural loans, there was substantial variability among banks in the changes that occurred from December 1950-65. Changes in total loans varied from a -49 per cent to a + 889 per cent. Nine member and 36 nonmember banks either had decreases or increases of 50 per cent or less, while 36 member and 37 nonmember banks had increases of 300 per cent September-October 1966 7 The Changing Structure Table 3 LOANS OF RURAL BANKS BY PER CENT CHANGE FROM 1950-65 Tenth Federal Reserve District Member Banks Dec. Dec. Nonmember Banks Dec. Dec . Number 31 1950 31 1965 Per Cent Change 9 26 51 46 29 34 36 6 23 41 35 17 22 18 7 38 92 97 56 84 92 16.6 65.2 124.3 177 .l 229.4 281.8 41 l. l 36 52 68 54 35 27 57 231 162 466 187.6 329 - - (Millions of dollars) Num ber 31 1950 All Banks Dec. Dec . Num31 31 Per Cent· 1965 Change ber 1950 - - ( Millions of dollars) 31 1965 Per Cent Change 16 24 28 25 13 10 16 20 42 62 67 43 36 83 25.0 75.0 121.4 168.0 230.7 260.0 418.7 45 78 119 100 64 61 93 21 46 68 59 31 32 34 27 80 154 164 99 120 175 28.5 73 .9 126.4 177.9 219.3 275.0 414.7 131 355 170.9 560 293 821 180.2 18.l 75.0 125 .0 178.5 218.1 240.0 408.3 48 100 108 80 70 48 106 18 39 44 33 25 18 28 22 69 99 88 80 66 144 22.2 76.9 125.0 166.6 220.0 266.6 414.2 166.3 560 205 568 177.0 - -(Millions of dollars) Total Up to 50 50-99 100-149 150-199 200-249 250-299 300 and up Totol Agricultural Up to 50 50-99 100-149 150- 199 200-2 49 250-299 300 and up Total 13 34 40 36 31 30 47 7 19 24 18 14 13 17 9 34 54 49 45 49 83 28.5 78.9 125.0 172.2 221.4 276.9 388.2 35 66 68 44 39 18 59 11 20 14 11 5 12 13 35 45 39 .35 17 61 231 113 323 185 .8 329 92 245 20 NOTE: Member and Nonmember Bank figu res may not odd to All Bonk figure because of rounding . or more. It also is of interest to note that the rise in dollar volume of total loans for the banks having 50 per cent increases or less was only $6 million, while for the banks with 300 per cent increases or more the growth in dollar volume of total loans was $141 million. Some interesting evaluations can be made if the changing asset structure of rural banks is observed by loan-to-deposit groupings. By definition, loans should be relatively low in the low-ratio grouping, and it also would be expected that loan growth from December 1950-65 would tend to be positively related to loan-to-deposit groupings at the end of 1965. This relationship did prevail throughout all groupings for nonmember banks and for all groupings of member banks, except for the 70 and up group. Loans in the 70 and up group of member banks grew more slowly from December 1950-65-than loans in all other member bank groupings, except the up to 40 group. This slow growth is explained partly by the relatively slow rate of growth in deposits at this group of banks. Starting with a relatively high loan-to-deposit ratio at the end of 1950 and being confronted with the slower-than- 8 average rate of growth in deposits, these banks were unable to maintain a rate of growth in loans comparable to that for most other groupings. The second most important asset held by the rural banks was Government securities. An inverse relationship with loan - to - deposit grouping would be anticipated in change in Government securities investment from 19506.5. This relationship did prevail for all ratio groupings for both member and nonmember banks. For all banks, the largest change-an increase of 60.6 per cent-was in the up to 40 grouping, while the largest decrease-29 per cent-was in the 70 and up grouping. Changes in bank investments in Government securities tend to reflect a difference in the degree of conservatism and aggressiveness of bank management. Bank investment in Government securities became routine during the World War II period. Since the procedure for investing in these securities is well established and such investments are considered as good risks-particularly if held until maturity - a number of banks have more funds invested in Government securities than in loans. of Rural Banking Cash, balances with other banks, and cash items in process of collection were ranked third in importance as rural bank assets at the end of 1965. These asset items are held to service community needs or to obtain services from city correspondents, and are largely nonearning assets. Consequently, the growth in this category of assets would be expected to be held to a minimum regardless of loan-todeposit ratio . The data in Table 4 indicate that growth in this category of asset items was relatively small during the 19.50-65 period and fluctuated erra tically among ratio groupings for both mcmb r and nonmember banks . Finally, rural banks had a ubstantial dollar volume of their invcstm 'nts in obligations of states and other political subdivisions. Because of changes in rates banks were permitted to pay on time and savings deposits and tax considerations, investment in this category of assets increased rather sharply in recent years. There did not appear to be any significant variation in rate of growth in this category of assets by loan-to-deposit ratio grouping or b y member and nonmember banks. The average rate of increase from 1950-65 was 240 per cent for all banks with an average rate of increase of 232 per cent for member banks and 253 per cent for nonmember banks. SUMMARY AND CONCLUSIONS The preceding analysis emphasizes that rural bank structure has changed substantially during the past 15 years. It also indicates that there was a high degree of variability in the kinds and d egree of change from bank to hank, with some of th rural banks showing substantial d ecreases in the dollar volum of assets in loans, while others showed hug increases. The average increase in dollar volume of loans outstanding for the rural banks in the Tenth District was 180 per cent. The fact that total farm debt outstanding increased 227 per cent from December 1950- Table 4 MAJOR ASSETS OF RURAL BANKS BY LOAN/DEPOSIT RATIOS IN 1965 Tenth Federal Reserve District Loan/Deposit Rat ios ( Per Cent) Up to 40 40-49 50-59 60-69 70 and up Total Up to 40 40-49 50-59 60-69 70 and up Total Up to 40 40-49 50-59 60-69 70 and up Total Cash, Balances with Other Banks, and Cash Items Total Loans Dec . 3 1 Dec . 31 Per Cent Dec. 3 1 Dec. 3 1 Per Cent Change ~ 1965 ~ ~ Change (Millions of dollars) (Millions of dollars) Governments Dec.3 1 Dec. 31 Per Cent 1 9 5 0 ~Change (Millions of dollars) States and Political Subdivisions Dec. 3 1 Dec. 31 Per Cent 1950 ~ Change (Millions of dollars) 44 51 71 56 25 49 52 84 60 27 11.3 1.9 18.3 7.1 8.0 37 53 87 75 42 73 131 257 235 124 All Banks 97.2 147.1 195.4 213.3 195.2 66 77 109 79 31 106 101 133 75 22 60.6 31.1 22 .0 -5 .0 -29.0 6 7 12 8 4 19 29 36 30 11 216.6 314.2 200.0 275 .0 175.0 247 273 10.5 293 821 180.2 362 437 20.7 37 126 240.5 33 36 62 53 16 50 41 71 3 3 7 5 3 11 15 22 19 6 266.6 400.0 214.2 280.0 100.0 24 24 41 37 16 25 24 51 41 15 4 .1 0 24.3 10.8 -6.2 18 22 48 47 26 143 157 9.7 162 20 26 30 19 9 24 28 33 19 12 20.0 7 .6 10.0 0 33.3 18 30 39 27 16 104 116 11.5 131 Member Banks 39 116.6 172.7 60 146 204.l 221.2 151 70 169.2 466 187.6 Nonmember Banks 88 .8 34 71 136.6 184 .6 Ill 211.1 84 237.5 54 355 170.9 12 51.5 13.8 14.5 -16.9 -25 .0 199 218 9.5 22 73 231.8 34 41 47 27 15 55 59 62 31 10 61.7 43 .9 31.9 14.8 -33.3 2 3 5 3 1 8 14 14 11 6 300.0 366.6 180.0 266.6 500.0 163 218 33 .7 15 53 253.3 44 NOTE : Member and Nonmember Bank figures may not add to All Bonk figure because of rounding . Monthly Review • September-October 1966 9 The Changing Structure of Rural Banking 65, while rural banks with loan-to-deposit ratios of up to 40 per cent-more than one sixth of the banks-increased their loans only 97 per cent may indicate either conservative management or a relative lack of loan demand for these banks. If the rural banks are plotted by loan-to-deposit ratio by geographical area, no particular pattern is detected. Rural banks with high ratios and low ratios tend to be mixed and frequently one or more of each are found in the same town or rural community. Since the low ratio banks tend to have relatively high investments in Government securities, the analysis suggests that a significant number of rural bankers, for one reason or another, prefer to retain a large investment in Government securities. It also should be emphasized that large numbers of rural bankers are making an intensive effort to adapt to the 10 changing structure both in the banking and agricultural industries. These rural banks are finding it increasingly difficult to adapt to the dynamic economic situation that prevails and are finding it necessary to innovate in their efforts to serve their communities. To be able to innovate within the prevailing institutional environment frequently requires a high degree of managerial ability and aggressiveness. To maintain this type of managerial ability in a large number of isolated, rural banks is a difficult bank-management task Many rural banks have been able to meet the challenge reasonably well, as indicated by the changes that have just been evaluated. However, it appears that some rural banks are in need of additional managerial assistance if they are to do the most effective job of adapting to prevailing economic developments. Measuring a Deficit or Surplus in the U.S. Balance of International Payments By Thomas E. Davis THE QUESTION of the best way to measure a d ficit or surplus in the U. S. balance of payments has been the object of considerable discussion during recent years. Interest in this question has been due to the importance attached to the concept of a deficit or surplus as an indicator of our international economic position, and to the significant influence that the large U. S. balance of payments deficits have had on economic policy decisions since 1958. Last year, after careful review and study,1 the U. S. Government decided to place primary emphasis on two measures of our balance of payments performance-the "liquidity" balance and the balance on "official reserve transactions." In view of this decision, it is important when speaking of a deficit or surplus in the U. S. balance of payments to have a clear understanding of the meaning, as well as the limitations, of the particular concept being used. To aid in this understanding, this article examines some of the problems associated with measuring a deficit or surplus in the balance of payments, and attempts to explain and compare the two concepts now 1 Review Committee for Balance of Payments Statistics, The Balance of Payments Statistics of the United States -A Review and Appraisal (Washington: U. S. Government P~inting O!fice, 1965), and U. S., Congress, Joint Economic Committee, The Balance of Payments Statistics, 89th Cong ., 1st Sess., 1965. Monthly Review • being used to measure the U. S. international payments position. PROBLEMS IN MEASURING A DEFICIT OR SURPLUS A major source of difficulty in measuring a deficit or surplus in a country's balance of payments is that the balance of payments statement as a whole shows neither a deficit nor a surplus. The method of double entry accounting used in compiling the balance of payments statement implies-by definition-that total debit, or payment, entries must equal total credit, or receipt, entries. Therefore, to obtain a deficit or surplus it is necessary to strike a balance on certain selected transactions within the accounts. In other words, all the transactions in a country's balance of payments must be divided into two groups, with those transactions believed to give rise to a deficit or surplus placed in one group or "above the line," and the remaining transactions thought to be balancing, or settlement, items placed in the second group or "below the line." With all the transactions grouped in this manner, a deficit or surplus in the balance of payments is presumed to exist when the sum of the items above the line shows either a negative or positive balance and, in turn, is presumed to be balanced or settled by the sum of the transactions below the line. September-October 1966 11 Measuring a Deficit or Surplus in the Since a deficit or surplus in a country's balance of payments is determined on the basis of selected transactions only, the crucial problem is deciding which transactions should be selected. Quite clearly, the transfer of one category of transactions from a position above the line to a position below the line, or vice versa, could significantly alter the size and possibly the nature of a deficit or surplus, even though the underlying data in the accounts remain the same. Unfortunately, this selection cannot be made simply on the basis of the data alone because the fi gures themselves never indicate whether a particu1ar type of transaction sho uld b e entered ahove or below the line. Rather, the se1ection must depend upon an analytical interpretation of the data and upon an analysis of the relationships b etween the transactions. Any such analysis, however, is likely to vary with changing circumstances and with the particular problem being analyzed. Therefore, to better understand why certain transactions are selected to measure a deficit or surplus it is necessary to know the purpose for constructing such a measure. Ideally, the purpose of determining a deficit or surplus in the balance of payments is to meas ure the extent of any real disequilibrium in a country's international economic position. And yet, there is general agreement that no measure of the balance of payments, however defined, can be relied upon for this purpose. Numerous adjustments of a qualitative and quantitative nature would have to be made to any such measure to take account of the economic conditions and policies in that country and abroad. For example, the relation between a country's level of employment and the level of its imports and exports wou]d need to be considered. A country may be importing less and exporting more, but at a cost of experiencing a less-than-desired level of emp]oyment and economic growth. Consideration also would have to be given any special controls or restraints imposed on a country's 12 international transactions tending to make them appear more favorable, or possibly more unfavorable, than they might otherwise be. Also, any random or special short-run fluctuations that have occurred in the accounts which do not of themselves reflect a lasting cha~ge in the country's external position would have to be sorted out. Only in this way can the international economic position of a country be determined satisfactorily. The difficulty in constructing such a measure has forced analysts to fall back on secondbest solutions, and thus it is not surprising that differences have occurred in the selection of transactions to b e inc1udcd as a measure of a d eficit or surplus. Th most general approach to the problem, however, has been to consider all international transactions as either "autonomous" or "compensatory." Autonomous transactions are regarded as those occurring independently of balance of payments considerations and are placed above the line, while compensating transactions are regarded as those undertaken to finance, or settle, the sum of the autonomous transactions and are placed below the line. Years ago, und er the strict gold standard, it was a simple matter to distinguish b etween autonomous and compensatory transactions. All transactions except gold movements were considered autonomous, and so a deficit or surplus was measured by changes in a country's gold stock. Today, the distinction between the two is less precise because it is recognized that not only are some international transactions settled by capital flows as well as by gold flows, but that some capital flows are autonomous while others are compensatory. But deciding which capital flows should be considered as compensatory, or balancing, transactions has presented a problem. One approach to the problem has been to focus on those transactions which respond to long-run economic forces. This measure, known as a balance on "basic" transactions, U. S. Balance of International Payments places above the line all transactions on goods, services, transfer payments, and long-term capital movements. All other transactions, including short-term capital movements and changes in official holdings of international reserves, are placed below the line. The rationale for this approach is that it provides a measure of the underlying competitive economic relationships which a country must seek to balance over time if it wishes to maintain equilibrium in its external position. In spite of its apparent simplicity, the analytical usefulness of the basic balance has been questioned on the- grounds that it is difficult to clearly distinguish transactions on the hasis of their sensitivity to short-run or long-nm economic forces. For example, capital movements nominally classified as long-term may, in fact, be of the short-term variety, while capital movements classified as short-term may be repeatedly renewed. Also, certain types of short-term capital movements are closely related to merchandise transactions which they finance, so it cannot be said that the two respond to different sets of economic forces. Hence, it is felt that while the basic balance concept might be a helpful partial measure in the context of a broad analysis of the balance of payments, it does not always serve as a reliable summary indicator of a country's current external position. Another approach to the problem of how to treat capital flows has been to place b elow the line those transactions specifically undertaken by national monetary authorities to settle all other transactions arising in the balance of payments. This approach, which was employed by the International Monetary Fund in the early postwar years, is identified with the balance on "official compensatory finance." According to this approach, official financing includes changes in a country's gold and official foreign exchange position, its net position with the International Monetary Fund, and government grants or loans made for balance of payments reasons . In addition, changes in Monthly Review • the foreign exchange holdings of a country's commercial banks are included to the extent that the authorities exercise control over these holdings. The problem with this approach is that when the principle of official compensatory financing is extended to various types of capital flows , it involves the impossible task of detecting the motive for capital flows from the data alone. As a result, the practical application of this approach has met with great difficulty. The problems involved in treating capital flows have been further complicated b y the close association of deficit and surplus determination with economic policy considerations. This association has increased in importance as governments have adopted policies to protect their domestic economies from fluctuations in international economic activity, and have agreed to maintain the external value of their currencies at relatively fixed rates of exchange. Consequently, governments have become vitally interested in having a measure of their countries' international transactions that can serve as a guideline for their economic policies. Such a measure, it is believed, should concentrate on the country's means of making international payments and, more specifically, on the government's ability to maintain the external value of its currency. In constructing such a measure, the problem is determining which funds should be considered available for this purpose. For most countries, however, this does not present a particularly difficult problem. Their official means of making international payments readily include their official holdings of gold and foreign exchange and their net position with the International Monetary Fund. In addition, to the extent that the foreign exchange holdings of their commercial banks are controlled by the government, any changes in these holdings also are included. For the United States, which is a reserve currency country, special problems exist in de- September-October 1966 13 Measuring a Deficit or Surplus in the Table I U. S. BALANCE OF PAYMENTS, 1965 ( In Millions of Dollars) T ransoctions Balance of Payments Receipts Exports of goods and services-Total Imports of goods and services--Total Remittances and pensions Payments Type of Balance Liquidity Official Reserve Basis Transaction Basis Balancing Net Balancing Net Balance Items Balance Items 32,036 994 38,993 -32,036 -994 38,993 -32,036 -994 U.S. Government grants and capitol flow, net 3,375 -3,375 -3,375 U.S. private capitol flow, net: Direct investment Foreign securities Other long-term claims Short-term claims 3,371 758 322 -3,371 -758 -322 761 -3,371 -758 -322 761 429 -429 -429 443 71 -443 71 -443 97 451 451 38,993 761 Errors and unrecorded transactions Foreibir;~~it~~:~f~e~t: U. S. corporate securities Other U. S. nonliquid liabilities: ~ ~~l~~e~fficial agencies Liquid U. S. liabilities to all foreigners: To foreign commercial banks To other private foreigners To fore ign official agencies f U. S. official reserve assets; increase ( - ) Totol 71 97 451 17 116 34 -17 41,745 1,222 1,355 116 34 1,222 41,745 97 -1,355 116 34 -1,302 -17 1,222 1,302 SOURCE: U. S. Department of Commerce. termining a measure which can serve as a guideline for its economic policies. As an international reserve currency, the U. S. dollar is used widely throughout the world in settling transactions, not only between the United States and the rest of the world but also between third-party countries. As a result, foreign official agencies hold U. S. dollars as part of their international reserves and foreign private parties have accumulated a substantial amount of U.S. dollars as a means of payment in world trade. Moreover, as part of its obligation to the International Monetary Fund to maintain the exchange rate of the dollar, the United States stands ready to convert dollars held by foreign official holders into gold for legitimate monetary purposes. Therefore, it is felt that in determining its international payments position the United States should not only consider its holdings of gold and other official international reserves but also should 14 take into account the large volume of outstanding foreign dollar claims that may be exercised against these reserves. Which of these foreign dollar claims, or U. S. dollar liabilities, should be included as an offset to U. S. official reserves has been a matter of dispute. In recognition of the opposing views in this dispute, the United States recently adopted two measures of its international payments positionthe "liquidity" balance, and the balance on "official reserve transactions." THE LIQUIDITY BALANCE The liquidity balance measures a deficit or surplus in the U. S. balance of payments by any changes in U. S. official reserve assets and in liquid U. S. liabilities to all foreigners ( Table I). U. S. official reserve assets are defined to include U. S. official holdings of gold and convertible foreign exchange, plus the U. S. net position with the International Mone- U. S. Balance of International Payments tary Fund. 2 Liquid U. S. liabilities include all short-term liabilities to foreigners and international nonmonetary institutions reported by U. S. banks, and all foreign holdings of marketable, and nonmarketable but convertible, U. S. Government securities. All other trans-actions recorded in the U. S. balance of payments are entered above the line and presumed to give rise to a change in the U. S. international liquidity position. Thus, according to the liquidity balance, a deficit in the U. S. balance of payments is measured by any decrease in U. S. official reserve assets plus any increase in U. S. liquid liabilities to foreigners. a The rationale for the liquidity balance is that it serves the needs of policymakers who have the final responsibility for maintaining the exchange rate of the U. S. dollar. It does so, it is felt, by focusing on the liquid resources available to the authorities to defend the dollar, as measured by changes in U. S. official reserve assets, and by spotlighting the liquid claims which may be exercised against these reserves, as measured by changes in U. S. liquid liabilities to all foreigners. Such a measure, it is believed, provides the authorities with an indicator of their ability to maintain the external value of the dollar and to determine whether a given pattern of international transactions can be sustained over the long run. While it is generally agreed that the external liquidity of the United States is important in assessing the U. S. payments position, the liquidity measure has not been free from criticism. A major objection to the 2 The U. S. net position with the International Monetary Fund is measured by the U. S. "gold tranche" position. This position represents virtually automatic U. S. drawing rights from the Fund to the extent that the Fund's holdings of U. S. dollars are less than the U. S. quota. 3 A variant of the liquidity balance, called the balance on "regular" transactions, appeared in official U. S. publications prior to 1965. This variant included below the line those items presently carried by the liquidity balance, plus any receipts from "special government transactions" undertaken mainly to finance a deficit, such as advance repayments on U. S. Government loans. Monthly Review • September-October 1966 liquidity measure is its asymmetric treabnent of short-term private capital flows. According to this measure, changes in U. S. liquid liabilities to private foreigners are placed below the line, while changes in private U. S. capital claims on foreigners are placed above the line. This treatment is criticized because any inflow of short-term private foreign capital tends to worsen the U. S. liquidity position, but any inflow of short-term private U. S. capital does not. The justification given for this treatment is that U. S. liquid liabilities to private foreigners are considered a potential threat to the U. S. gold stock because they are readily transferable to foreign official holders to whom the United Statcs is obligated to sell gold upon demand. Private U. S. capital claims on foreigners, on the other hand, are placed above the line because they are not considered readily available to the U. S. authorities for use in defending the U. S. dollar in foreign exchange markets. Only U. S. official reserves are regarded as available for this purpose. The asymmetric treatment of private short-term capital flows also is said to be justified because it corresponds to the asymmetries of the real world. Since the U. S. dollar serves as an international reserve currency throughout the world, unlike currencies of most other countries, the United States is felt to have a special obligation as banker to the world to weigh its official reserve assets against all its liquid liabilities, both official and private. The view of the liquidity concept that foreign private dollar claims should be put on the same basis as foreign official claims has met with further criticism. This view, it is argued, gives inadequate recognition to the positive motives causing private foreigners to acquire dollar claims, and so underrates the advantages and attractiveness of the U. S. money market as a place for foreigners to invest liquid reserves and to hold working balances. It also is thought that a sizable portion of private foreign claims are linked closely to liabilities 15 M easuring a Deficit or Surplus in the that foreigners have incurred to U. S. residents, and thus are essentially "locked into" dollars and not likely to be withdrawn. A common instance is when a U. S. bank lends money to a private foreigner and requires that the foreigner place on deposit at the bank certain compensatory balances-which in practice are foreign private dollar claims not subject to liquidation or withdrawal. Another instance is when a U. S. resident places funds in a foreign bank, say a Canadian bank, and these funds are then invested by the bank in liquid assets in the United States. These liquid dollar assets are not likely to be converted into for ign currencies in view of the foreign hank's outstanding liability to the U. S. r sidcnt. Hence, it is believed that the effect of treating foreign private capital flows as different from U. S. private capital flows, or as similar to foreign official capital flows, tends to exaggerate the threat to the U. S. gold stock and the deficit in the U. S. balance of payments. Another objection to the liquidity approach is that it lacks precision because liquidity is a relative term. As such, any classification of foreign held dollar assets based on their degree of liquidity is susceptible to change, depending upon changing circumstances and changing points of view. In a larger sense, moreover, all U. S. dollar assets held either by foreigners or by U. S. residents, are in some degree liquid to the extent they are freely exchangeable into foreign currencies. In this sense the liquidity approach may underestimate the potential drain on U. S. official reserves and so provide a misleading picture of the ability of U. S. monetary authorities to maintain the valt1e of the dollar. THE BALANCE ON OFFICIAL RESERVE TRANSACTIONS According to the balance on official reserve transactions, a deficit or surplus in the U. S. balance of payments is measured by any 16 changes in U. S. official reserve assets and in liquid and certain nonliquid U. S. liabilities to foreign official agencies ( Table I). This measure differs primarily from the liquidity balance by excluding U. S. liquid liabilities to foreign private holders and nonmonetary international organizations. A second difference, of less importance, is that changes in certain nonliquid U. S. liabilities to foreign official agencies are included in the official reserve transactions balance, but not in the liquidity balance. These nonliquid liabilities primarily consist of nonmarketable, nonconvertible U. S. Government securities held by foreign official monetary institutions. The hypothesis underlying this approach is that the need for a summary indicator of the balance of payments arises from the nature of the present international monetary system in which the final responsibility for maintaining stable foreign exchange rates rests with national monetary authorities, i.e., central banks and treasuries. In carrying out this responsibility, monetary authorities act to settle the net deficits and surpluses that arise on all other international transactions by gaining or losing international reserve assets and by increasing or decreasing their liabilities to foreign monetary authorities. Therefore, the size of a monetary authority's transactions in international reserves is thought to provide the most useful measure of the market intervention necessary to maintain the exchange rate, and, hence, of any balance of payments disequilibrium. A comparison of this approach with the liquidity approach , for the 6-year period 19606.5, shows that by either measure the United States has incurred balance of payments "deficits" in every year ( Chart I). According to the liquidity approach, however, the annual deficit during these 6 years averaged $2,550 million, $490 million higher than the deficit measured on the basis of official reserve transactions. The primary reason for this differ- U. S. Balance of International Payments Chart I ALTERNATIVE MEASURES OF THE U. S. BALANCE OF PAYMENTS DEFICIT ( In Billions of Dollars) Bi 11 ions of Doi Iors 5 Liquidity Basis 4 / Official Reserve / Transactions Basis 3 1960 1961 1962 1963 1964 1965 ence is that the liquidity measure considers any rise in U. S. liquid liabilities to private foreigners, including foreign commercial banks, as adding to the deficit. During this period, U. S. liquid liabilities to foreign commercial banks alone averaged an increase of $440 million and accounted for nearly all of the average difference between the two measures. Thus, much of the debate between the advocates of these two measures has been on how to treat liquid liabilities to private foreigners. The rationale for not including U. S. liquid liabilities to private foreigners in the official transactions measure is that these liabilities usually represent ordinary capital movements and so should be treated like private U. S. capital claims. This treatment, it is felt, recognizes the key distinction between transactions of monetary authorities and private parties, and also is consistent with the concept of a Monthly Review • zero payments deficit since it takes into account the continued need for and the growth of U. S. dollar claims by private foreigners. Under the liquidity approach, however, which considers an increase in liquid U. S. liabilities to private foreigners as adding to the deficit, the concept of a zero deficit is not consistent with a rise in these liabilities unless simultaneously offset by a drop in U. S. official reserves. A fundamental criticism of the official transactions measure is that changes in foreign private dollar claims are related closely to central bank policies and therefore should be treated like reserve-type transactions. This especially is true when a foreign c ntral hank either owns the commercial banks in its country or is able to control the commercial banks' holdings of dollar claims through directives or exchange controls. It also is true when private foreigners have been induced by official exchange operations to alter the size of their dollar holdings. Such operations, mainly in the forward exchange market, frequently are conducted today by official agencies as part of the techniques of international financial cooperation, and, additionally, as part of th e domestic monetary policies of foreign monetary authorities. For instance, a foreign central bank may induce its commercial banks to hold liquid dollar assets by agreeing to exchange local currency for dollars at some future date and at a more favorable rate than is available in the market. Since the effect of these operations is to shift dollar balances from foreign monetary institutions to foreign commercial banks, or vice versa, they tend to blur the distinction between these foreign dollar claims. Thus, it is argued that when these operations cause large short-run variations in foreign official and private dollar claims it is possible to misinterpret the U. S. payments position viewed according to tne official transactions measure. The liquidity measure, it is pointed out, is not similarly affected by such variations because September-October 1966 17 Measuring a Deficit or Surplus in the U. S. Balance of International Payments it places changes in all liquid foreign dollar claims below the line. Advocates of the official transactions measure readily acknowledge that short-run changes in foreign private dollar claims often are related closely to policy actions taken by national monetary authorities. However, they maintain that these changes, whether induced by official exchange operations or by changing credit conditions, serve to underscore the market responsiveness of what is essentially private capital. Moreover, they believe that these short-run changes in foreign dollar claims are not dominant enough to justify placing them below th line, even though occasional distortions in the data may require special analysis and explanation. They further maintain that even though national monetary authorities may influence foreign private dollar claims in the short run, they cannot do so in the long run. In support of this view, they cite the large buildup of foreign private dollar claims over the past 7 years, which is presumed to represent a genuine inflow of private capital related to the investment or financing needs of foreigners. For these reasons, the balance on official reserve transactions is thought by some observers to provide the most useful measure of the long-run market forces affecting the U. S. international payments position. pending upon the problem being analyzed and upon the interpretation given to the underlying data. Also, as indicated earlier, a useful analysis of a country's international position rarely is possible on the basis of balance of payments data alone; domestic economic conditions and policy objectives both in the country and abroad have to be taken into account. For the United States, the problem is particularly difficult because of the key currency status of the U. S. dollar in international trade and finance, and the diversity of U. S. transactions with the rest of the world. Indeed, it was du largely to these difficulties that the United States decided to adopt two measures of its balance of payments performance. Neither of these measures, however, can be said to be unequivocally superior to the other in revealing whether the United States is experiencing a fundamental disequilibrium in its international payments position. The value in having two measures, therefore, is that they may further public understanding of the complex nature of the balance of payments, and also encourage people not to evaluate the U. S. payments position on the basis of a single concept-a deficit or surplus. 'FOREIGN TRADE AND AMERICAN AGRICULTURE" WHICH IS THE BEST MEASURE? In view of the variety of concepts employed to measure a country's balance of payments, and the various arguments presented regarding the two current measures of the U. S. balance of payments, the inevitable question arises as to which measure is best. The answer is simply that there is no one best measure to describe a country's international payments position, any more than there is one best measure to describe the financial position of a government, bank, or corporation. Any one measure may be misleading or revealing de- 18 A special booklet, "Foreign Trade and American Agriculture," has been issued recently by the Research Department of the Federal Reserve Bank of Kansas City. The booklet provides a historical perspective of international agricultural trade, reviews the current status of this trade, and discusses the agricultural implications of current international trade negotiations. Copies may be obtained on request to the Research Deparhnent, Federal Reserve Bank of Kansas City, Kansas City, Missouri 64106.
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