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For Release on Delivery F r i d a y , November 8 , 1968 12 N o o n , E . S . T . CAPITAL FLOWS IN THE U . S . BALANCE OF PAYMENTS SINCE 1965 A Paper Presented By A n d r e w F . Brimmer Member Board of Governors of the Federal Reserve System Before a Joint Luncheon at the A n n u a l Meetings of the Southern Economic Association and the Southern Finance Association W a s h i n g t o n Hilton Hotel Washington, D.C. November 8 , 1968 CAPITAL FLOWS IN THE U . S . BALANCE OF PAYMENTS SINCE 1965 By Andrew F. Brimmer* A l m o s t four years have passed since the U n i t e d States in F e b r u a r y , 1965, adopted programs aimed p r i m a r i l y at the i m p r o v e m e n t of the capital accounts in the U . S . balance of p a y m e n t s . M o r e than five years have passed since the adoption of the Interest E q u a l i z a t i o n T a x (IET) in 1 9 6 3 , w h i c h w a s also focused on a segment of the capital a c c o u n t . G i v e n this passage of time, one m i g h t n a t u r a l l y ask w h a t effects -- if any -- have these programs had on capital flows as r e c o r d e d in the b a l a n c e of p a y m e n t s . In this p a p e r , I w i l l r e v i e w b r i e f l y the m a i n d e v e l o p m e n t s 1965 w i t h r e s p e c t to several key elements in our capital a c c o u n t s . since I will stress p a r t i c u l a r l y the changes in those accounts w i t h w h i c h the Federal R e s e r v e portion of the P r e s i d e n t ' s p r o g r a m is concerned -- the flow of funds from commercial banks and other financial i n s t i t u t i o n s . I w i l l also d i s c u s s foreign b o r r o w i n g in the U n i t e d States through the sale of long-term bonds and securities (most of w h i c h are b o u g h t by U. S. n o n b a n k financial institutions) and foreign investment in this country through the purchase of U . S . s e c u r i t i e s . The general conclusions w h i c h emerge from this assessment of the impact of the balance of payments programs on capital flows can be summarized briefly: C o m m e r c i a l banks (which have n o t fully used the leeway available to them in any year since the v o l u n t a r y foreign credit restraint program began) * M e m b e r , Board of G o v e r n o r s of the Federal R e s e r v e S y s t e m . I am g r a t e f u l to M r . G o r d o n B. G r i m w o o d of the Board's staff for assistance in the p r e p a r a t i o n of this p a p e r . -2by the end of September had reduced their foreign claims by over $700 m i l l i o n b e l o w the amount outstanding at the end of last D e c e m b e r , or by $300 m i l l i o n m o r e than had b e e n requested for all of 1968. D u r i n g the last 3 - 1 / 2 y e a r s , there has been a noticeable shift of b a n k funds to the developing c o u n t r i e s , w h i c h has been matched almost entirely by a decline of bank lending in continental W e s t e r n Europe. Foreign branches of U . S . banks have taken over a substantial part of the foreign lending formerly done by the head offices; the funds from w h i c h these loans are m a d e are acquired m a i n l y in the Eurodollar market. New issues of foreign securities in the U . S . still seem to be influenced to a considerable extent by the IET. A l t h o u g h such issues rose sharply last year and are continuing at a high level in 1968, the d i r e c t i o n of this capital outflow shows clearly the impact of the IET. F o r e i g n purchases of U . S . securities (which have b e c o m e an increasingly important factor in the r e c e n t improvement in the capital account) m a y w e l l exceed substantially the capital o u t f l o w related to U . S . acquisition of foreign issues during 1968. F i n a l l y , a basic improvement in our balance of payments m u s t rest heavily on a sizable improvem e n t in our trade s u r p l u s , which in turn w i l l depend upon how successful we control i n f l a t i o n . In stressing the role of the balance of payments programs on the flow of U . S . c a p i t a l , I do not w i s h to imply that these programs w e r e the only factors at w o r k . Since 1965 many influences have affected these flows, and these other factors may w e l l have been equally s i g n i f i c a n t . I refer particularly to the restrictive m o n e t a r y policy w h i c h was adopted in -3the fourth quarter of 1965 and followed during m o s t of 1 9 6 6 , and w h i c h w a s adopted again in the fourth quarter of last y e a r . Other important d e v e l o p m e n t s w e r e a slowdown in economic activity in the industrial countries of W e s t e r n E u r o p e during 1967 (which still m a y n o t have been completely r e v e r s e d ) and several major international financial disturbances. F i n a l l y , the rapid development of the E u r o d o l l a r m a r k e t , w h i c h w a s itself stimulated by our balance of payments m e a s u r e s , has provided alternative sources of f i n a n c i n g , both through b a n k s , including foreign branches of U . S . b a n k s , and through the growth of the E u r o b o n d m a r k e t . These d e v e l o p m e n t s u n d o u b t e d l y have tended to reduce the demand for capital from U . S . s o u r c e s , p a r t i c u l a r l y by foreign subsidiaries of U . S . corporations. Flow of C o m m e r c i a l Bank C a p i t a l Bank lending to foreigners was included in the b a l a n c e of payments programs of 1 9 6 5 , in part at least, because of a v e r y rapid increase in the foreign assets of banks during 1964. After increasing at an average annual rate slightly above $1 b i l l i o n in the previous five y e a r s (which w a s itself high from an h i s t o r i c a l standpoint and w h i c h was focused m a i n l y on J a p a n ) , b a n k claims on foreigners w e n t u p by $2.5 billion in 1 9 6 4 . T h i r t y per cent of the o u t f l o w in that year w e n t to countries of W e s t e r n E u r o p e , e x c l u d i n g the U.K.; 25 per cent w e n t to Latin A m e r i c a n and other countries in the Western Hemisphere (excluding Canada); and 25 per cent w e n t to J a p a n . The p r i n c i p a l objective of the 1965 p r o g r a m , t h e n , w a s to reduce the rate of increase in b a n k lending to foreigners to a m o r e m a n a g e a b l e figure. A t the same time, another main goal was to insure sufficient credit to finance our e x p a n d i n g exports and to m e e t the n e e d s of the d e v e l o p i n g -4countries. To achieve the latter o b j e c t i v e s , the F e d e r a l R e s e r v e requested the banks to give an absolute priority to bona fide export c r e d i t s , and the h i g h e s t p r i o r i t y in the nonexport category to credits to m e e t the needs of developing countries. Banks also were asked to avoid action that m i g h t place an u n d u e burden on the United K i n g d o m , C a n a d a , or J a p a n . Term loans to these n a t i o n s as w e l l as to other developed countries w e r e inhibited in any event by the extension of the IET to b a n k credits w i t h m a t u r i t i e s of one year or l o n g e r . The p r o g r a m announced in 1965 has been extended three times b e c a u s e the d e f i c i t in our balance of payments has p e r s i s t e d . The form of the b a n k p r o g r a m remained essentially unchanged u n t i l J a n u a r y 1 , 1 9 6 8 . For the first time on that date the banks w e r e requested to achieve a n e t inflow of funds d u r i n g the year through a r e d u c t i o n in outstanding loans. The m o r e r e s t r i c t i v e program (which w a s focused e s p e c i a l l y on those countries w h o s e surpluses mainly reflected our d e f i c i t ) requested the b a n k s to m a k e n o new nonexport credits to developed countries of continental Western Europe. F i n a l l y , due to an extremely d i f f i c u l t financial situation in C a n a d a early this y e a r , that country was exempted completely from all U . S . balance of payments programs on February 29, 1 9 6 8 . The Federal Reserve Board constantly monitors progress u n d e r the programs for financial institutions to assure that the objectives are being a c h i e v e d . M y purpose here is not to give a progress report on the Federal Reserve program (for which I have administrative on delegation from the Board). responsibility R a t h e r , m y objective is to look at U . S . -5capital flows over the last 3 - 1 / 2 years as influenced by the b a l a n c e of payments programs and by the other factors m e n t i o n e d above. A n Over-all V i e w Foreign assets held by c o m m e r c i a l b a n k s that are covered by the Federal R e s e r v e program increased during 1965 by about $170 m i l l i o n , compared w i t h a p e r m i s s i b l e increase of almost $500 m i l l i o n under the ceiling for that y e a r . In 1966, d e s p i t e an increase in the aggregate c e i l i n g , covered assets fell by $160 m i l l i o n , leaving the banks almost at their base d a t e p o s i t i o n of D e c e m b e r 3 1 , 1 9 6 4 . During 1967, covered assets increased by $370 m i l l i o n , b u t the banks at the end of that year still had an aggregate leeway of $1.2 b i l l i o n . The program announced last N e w Years Day in e f f e c t requested that banks reduce their covered foreign assets by at least $400 m i l l i o n d u r i n g 1968. By last September 3 0 , as I m e n t i o n e d a b o v e , the banks had reduced their claims by over $700 m i l l i o n , or by $300 m i l l i o n m o r e than had b e e n requested for all of 1 9 6 8 . A t the end of S e p t e m b e r , the banks w e r e $328 m i l l i o n b e l o w the D e c e m b e r , 1 9 6 4 , base f i g u r e , and they had an aggregate leeway for the r e m a i n d e r of the year of $629 m i l l i o n . attached.) (Table 1 H o w e v e r , I do not e x p e c t that all of that leeway w i l l be u s e d . M o r e o v e r , I am confident that the b a n k s w i l l m o r e than achieve the o b j e c t i v e of a n e t inflow of $400 m i l l i o n -- even if w e e x p e r i e n c e in the fourth quarter the seasonal outflow of funds that u s u a l l y occurs d u r i n g the closing m o n t h s of the y e a r . o G e o g r a p h i c a l D i s t r i b u t i o n of Bank Capital Flows A s I stated at the o u t s e t , a striking change has occurred in the last 3-1/2 years in the geographic pattern of b a n k lending abroad. The data on which we m u s t rely to trace the regional flows of bank capital are n o t exactly comparable w i t h the aggregate figures given a b o v e . For this p u r p o s e , the analysis m u s t be based on data supplied on T r e a s u r y Foreign E x c h a n g e forms from w h i c h the balance of payments statistics are derived. In g e n e r a l , the coverage of fo reign assets reported on the Treasury forms is broader than that of the foreign credit restraint program because the former include collections and other claims held for account of c u s t o m e r s , and also include claims held by the U . S . agencies and branches of foreign b a n k s . The Treasury data show that on December 31, 1964 (the base d a t e ) , the d e v e l o p i n g countries accounted for 38 per cent of all bank claims on foreigners; Japan for 26 per cent; developed countries of continental W e s t e r n E u r o p e for 18 per cent; C a n a d a for 11 per cent, and the U n i t e d K i n g d o m for only 3 per cent. Broken down between short and long-term claims, C a n a d a and Japan accounted for higher percentages of short-term claims, w h i l e the percentages of long-term claims on the d e v e l o p i n g countries and the developed countries of continental W e s t e r n E u r o p e were higher than the relative positions of those areas with respect to total bank claims. Developing Countries In the period December 31, 1964, to A u g u s t 31, 1968 (the latest date for which data are a v a i l a b l e ) , over-all banks claims on foreigners -7declined by 3.3 per c e n t . On the other h a n d , bank claims on the develop- ing countries increased by 28 per cent. The shift in the d i r e c t i o n of flow of b a n k credit w a s m o s t m a r k e d with respect to l o n g - t e r m l o a n s , w h i c h are m o s t important to economic development. L o n g - t e r m claims on develop- ing countries rose by 33 per c e n t , and by the end of last A u g u s t they accounted for 63 per cent of a total that itself had d e c l i n e d by 16 per cent over the same p e r i o d . Developed C o u n t r i e s of C o n t i n e n t a l W e s t e r n Europe The shift of funds to the developing countries w a s m a d e almost entirely at the expense of the developed countries of c o n t i n e n t a l W e s t e r n Europe. Bank claims on these countries declined almost d o l l a r - f o r - d o l l a r by the amount that claims on developing countries i n c r e a s e d . The m a j o r part of this shift w a s in the long-term area, w h e r e claims on d e v e l o p i n g countries increased by $568 m i l l i o n while claims on W e s t e r n E u r o p e (mainly b e c a u s e they b e c a m e subject to the IET in F e b r u a r y , 1965) w e n t down by $1.1 b i l l i o n . United K i n g d o m , C a n a d a , and J a p a n Bank claims on these countries -- w h i c h w e r e e s p e c i a l l y m e n t i o n e d in the g u i d e l i n e s after export credits and credits to d e v e l o p i n g countries -fluctuated during the period u n d e r review but changed only m o d e r a t e l y overall. 1968.) (Canada, as has been n o t e d , was exempted from the p r o g r a m on F e b r u a r y 29, Total claims on the United Kingdom and C a n a d a d e c l i n e d 22 per cent and 32 per c e n t , r e s p e c t i v e l y , while over-all claims on J a p a n , after declining slightly in the last half of 1966, increased again by the end of 1967 to a level slightly above December 31, 1964. -8W i t h i n these over-all totals both short and long-term claims on the United K i n g d o m declined, the short-term relatively m o r e . claims on C a n a d a w e r e Short-term reduced by one half but w e r e partially offset by an increase in long-term claims. A slight increase in short-term claims on J a p a n , w h i c h account for about 95 per cent of total claims on that c o u n t r y , w a s offset by a relatively sharp drop in long-term claims o u t s t a n d i n g . (Tables 2 , 2 - a , and 2-b.) Impact of R e s t r a i n t Program on Operations of U . S . Banks w i t h F o r e i g n Branches W h e n the foreign credit restraint program w a s announced in 1965, foreign b r a n c h e s of U.S. banks were exempted from the program provided that "the funds u t i l i z e d (by the branches) are derived from foreign sources and do not add to the outflow of capital from the United States." This exemption was m a d e b e c a u s e the operations of the branches are not reflected in the b a l a n c e of payments statistics of the United States. It also avoided placing the b r a n c h e s in a less advantageous competitive position in the countries in w h i c h they operated. N e v e r t h e l e s s , it was recognized that b r a n c h operations m i g h t have some effects on our balance of payments. Foreign branches of U . S . banks have taken over a substantial part of the foreign lending formerly done by the head o f f i c e s . The funds from which these loans are m a d e are acquired m a i n l y in the Eurodollar m a r k e t . To the extent that these funds represent a shift of dollar liabilities to foreigners from head offices to branches -- or to the extent that dollars are deposited at foreign branches w h i c h otherwise m i g h t have come to the head offices -- it is possible that there w i l l be -9an adverse effect on our b a l a n c e of payments as m e a s u r e d on the official settlements b a s i s . W h e t h e r the adverse e f f e c t occurs depends u p o n the u s e m a d e by the branches of these f u n d s . If they are used for the purpose of m a k i n g advances to the head o f f i c e , there is no effect on our b a l a n c e of payments w h e t h e r m e a s u r e d on the liquidity or the o f f i c i a l settlements b a s i s . How- e v e r , if the funds are u s e d to m a k e loans to foreigners that o t h e r w i s e would have b e e n m a d e by the head o f f i c e s , the official settlements balance may be a f f e c t e d . The b o r r o w e r s m a y u s e the d o l l a r s acquired to purchase local c u r r e n c i e s , or they m a y use the dollars in lieu of d o l l a r s that otherwise would have been acquired from foreign official r e s e r v e s . In either c a s e , our liquid liabilities to foreign official institutions w o u l d be higher than they o t h e r w i s e w o u l d h a v e b e e n . The b u s i n e s s of the foreign b r a n c h e s e x p a n d e d v e r y rapidly after the announcement of the foreign credit r e s t r a i n t p r o g r a m . D o l l a r loans to foreign n o n b a n k customers increased by almost 60 per cent b e t w e e n the end of F e b r u a r y , 1965 (the first date for w h i c h such d a t a are available) and the end of that y e a r . To a c o n s i d e r a b l e e x t e n t , this increase reflected the "sale" of foreign assets to the b r a n c h e s by the head o f f i c e s of some banks that w e r e substantially over the target ceiling w h e n that ceiling w a s announced. Bank loans to foreigners increased by 20 per cent in 1966. This more m o d e r a t e gain partly reflected the adjustment of head offices to the program ceiling. But it m a y also have b e e n the result of tightening m o n e t a r y -10conditions in the U n i t e d S t a t e s . E u r o d o l l a r funds acquired by the branches w e r e advanced to the head offices to m e e t domestic requirem e n t s rather than used to increase branch loans to foreigners. The increase in loans to foreign n o n b a n k customers by the b r a n c h e s w a s 40 per cent in 1 9 6 7 , and in the first eight months of 1968 the rise was 30 per c e n t . As of the end of A u g u s t , U . S . dollar loans outstanding to foreign n o n b a n k customers at foreign branches of U . S . b a n k s (at $2.4 billion) w e r e m o r e than three times the amount of such loans o u t s t a n d i n g on February 28, 1965. It is difficult to m e a s u r e the extent to w h i c h the branch lending activities m a y have resulted in the "substitution" or "shift" of U . S . head office liabilities to foreigners described above. One problem is that our d a t a do n o t go b a c k far enough and in sufficient detail. H o w e v e r , w e m a y d r a w some tentative conclusions from an e x a m i n a t i o n of changes in head offices deposit liabilities c 0 foreigners in the years preceding and in the years since the announcem e n t of the foreign credit restraint p r o g r a m . If we look at U . S . b a n k d e p o s i t liabilities to foreigr b a n k and nonbank customers, adjusted to exclude accounts that are affected by other than m a r k e t forces (see Table 3), we find that the total of such liabilities increased by an average of 7 per cent per annum between the end of 1964 and 1967. Liabilities to foreign -11banks increased by almost a 2 per cent annual a v e r a g e , w h i l e liabilities to foreign n o n b a n k customers w e n t u p by over 10 per cent per a n n u m . Partial data for U . S . banks that had foreign branches prior to December 31, 1 9 6 4 , (the last year-end b e f o r e the inauguration of the V F C R ) indicate that d e p o s i t liabilities of such banks to foreign n o n b a n k customers increased by a l m o s t 40 per cent b e t w e e n end-1964 and e n d - 1 9 6 7 . D a t a for banks that have established foreign b r a n c h e s since December 31, 1964, show the same p a t t e r n . These banks (which accounted for only 6 per cent of total deposit liabilities to foreigners on December 3 1 , 1964) more than d o u b l e d d e p o s i t liabilities to foreign n o n b a n k customers in the following three y e a r s . W e m u s t c o n c l u d e , on the basis of the above statistics, that it is possible that the activity of foreign b r a n c h e s m i g h t have had some adverse effect on our official settlements b a l a n c e . How- e v e r , the data do not provide conclusive evidence that this has been the case. Flows of Funds from N o n b a n k Financial Institutions Total foreign assets of nonbank financial institutions reporting to the Federal Reserve under the foreign credit r e s t r a i n t -12program (insurance companies, finance c o m p a n i e s , trust departm e n t s of b a n k s , pension funds, etc.) w e r e about $14 b i l l i o n at the end of J u n e , 1968. On the same d a t e , total foreign assets of banks amounted to about $12 b i l l i o n . H o w e v e r , of the former a m o u n t , only $1.5 billion is subject to the guidelines; $10 b i l l i o n is exempt as claims on Canada; $1 billion represents claims on international institutions, w h i c h are exempt from the guidelines; and the remaining $1.5 billion consists of claims on developing countries and a small amount of other foreign assets w h i c h are s p e c i f i c a l l y exempted from the g u i d e l i n e s . The nonbank financial institutions w e r e asked on January 1, 1968, to reduce their adjusted base date holdings of "covered" foreign assets to 95 per cent of the amount outstanding on December 3 1 , 1967. As of June 30, 1968 (the n o n b a n k financial institutions report on a quarterly b a s i s ) , covered assets of all reporting institutions had been reduced by $175 m i l l i o n from the end-1967 figure. As of last June 30, total covered assets out- standing w e r e 93 per cent of the adjusted b a s e date h o l d i n g s . (Table 4.) A s s e t s not subject to the guidelines increased by almost $400 m i l l i o n in the first six months of 1968. Two-thirds of this amount represented increased loans and investments in C a n a d a . -13Transactions In F o r e i g n Securities in the U . S . During the five years ending in 1 9 6 1 , the capital o u t f l o w related to net U . S . transactions in foreign securities a v e r a g e d $760 m i l l i o n a n n u a l l y ; in only one of the five years did the o u t f l o w substantially exceed the a v e r a g e . In 1962, the o u t f l o w increased to $ 9 7 0 m i l l i o n , and in 1963 the figure jumped to $1.1 b i l l i o n , a factor w h i c h led to the p r o p o s a l of the I E T . M o r e o v e r , larger a m o u n t s of n e w issues of E u r o p e a n countries b e g a n to appear in the m a r k e t . (Table 5.) The Interest E q u a l i z a t i o n Tax had features w h i c h tempered its effect on n e w issues of foreign securities in the U . S . , including the exemption of n e w l y issued C a n a d i a n securities as w e l l as the securities of the developing c o u n t r i e s . N e v e r t h e l e s s , the tax did reduce sharply the capital outflow related to these transactions -- at least u n t i l 1967. The outflows for 1 9 6 4 , 1 9 6 5 , and 1966 w e r e $677 m i l l i o n , $759 m i l l i o n , and $481 million, respectively. In 1 9 6 7 , the outflow increased to $1.3 b i l l i o n and w a s running at only a slightly lower annual r a t e in the first h a l f of 1 9 6 8 . The d i r e c t i o n of foreign portfolio investment by A m e r i c a n s w a s influenced by the incidence of the IET and the foreign credit program. restraint The increase in 1967 w a s related entirely to issues exempted from the IET (Canada accounted for 62 per cent of the new issues in 1967). F u r t h e r , w h i l e it is not possible to separate long-term bonds from long term credits in our d a t a , it a p p e a r s that n o n b a n k financial institutions m i g h t have accounted for a p p r o x i m a t e l y 60 per cent of the total increase in -14net purchase of securities of C a n a d a , J a p a n , the developing c o u n t r i e s , and international i n s t i t u t i o n s . Investments in all of these areas are exempted from the guideline ceiling for n o n b a n k financial institutions. P r e l i m i n a r y data for the first half of 1968 indicate a continuation of these trends w i t h the exception of the international agencies. Based on these d a t a , the o u t f l o w related to n e t transactions w i t h C a n a d a and the d e v e l o p i n g countries m i g h t be somewhat higher than in 1967. There was a n e t inflow on account of the international agencies of $35 m i l l i o n in the first h a l f , p r i m a r i l y as a result of large redemptions in the second quarter. H o w e v e r , n e w issues of international agencies are running a little above the 1967 level. Foreign Purchases of U . S . Securities A t this p o i n t , it w o u l d be w e l l to look at the other side of this coin, since foreign purchases of U . S . corporate securities have become an increasingly important factor in the recent improvement in our balance of payments. In the five years ending December 3 1 , 1964, n e t foreign purchases of U . S . corporate securities averaged about $190 m i l l i o n a n n u a l l y . In 1 9 6 5 , there w e r e net sales of $350 m i l l i o n ; h o w e v e r , this amount is m o r e than accounted for by the liquidation in that year of securities owned by the government of the United K i n g d o m . Discounting this t r a n s a c t i o n , net pur- chases w e r e only slightly lower than the average of the preceding five y e a r s . In 1966, net purchases jumped to $900 m i l l i o n , twice the amount in any
@FedFRASER