The Economics of Foreign Exchange: The Capital Account

The Capital Account The balance on current account represents the relationship between current earnings of dollars from international trade and current payments of U.S. dollars to acquire foreign exchange to settle payments to foreigners. When the current account is in deficit, as it was in 1988, the United States has to pay more dollars out in international transactions than it earns from international transactions during the year. In 1988 the United States had to borrow and sell assets to finance the deficit on current account. The increase in foreign assets in the United States on line 11 in Box 8 represents borrowing from foreigners to balance the current account deficit. This represents foreign saving in the United States. Lines 12 through 14 represent purchases and sales of assets by individuals, the U.S. government, and the Federal Reserve System. When the data gathered for the capital account don't exactly match, there is a statistical discrepancy, shown on line 15. The statistical discrepancy in 1988 was $10.6 billion. This sum represents foreign payments of dollars in the United States that the data gatherers estimate existed but could not track down by source. For example, a portion of the $10.6 billion obtained in this way may have resulted from smuggling and other illegal transactions involving exports of U.S. goods and services. Line 16 of the table in Box 8 shows the capital account balance, which is + $126.5 billion. The capital account balance is a surplus that is exactly equal to the deficit on the balance on current account. Whenever the current account is in deficit, there must be a net increase in real and financial assets held by foreigners over the foreign assets acquired by Americans during the year. You learned this earlier in the circular flow analysis in the chapter on the GNP. Whenever net exports are negative, net foreign saving in the United States increases by an amount equal to the excess of imports over exports. Similarly, if net exports were positive, the balance on the current account would be a surplus, which would be offset by a net increase in U.S. saving abroad. As was pointed out earlier in this chapter, foreign saving in the United States increases the supply of loanable funds in U.S. credit markets, thereby putting downward pressure on real interest rates in the United States. The way the capital account is related to the current account points out an important long-term implication of chronic deficits on the current account. A deficit on the current account implies that the United States must borrow from foreigners or sell foreign assets. As this occurs, the United States in the aggregate becomes more indebted to foreigners or reduces its holdings of foreign assets. The deficits on the current account since 1975 have resulted in a sharp increase in foreign ownership of U.S. assets. In the future foreigners will earn more U.S. interest and investment income each year, which, in turn, will force the United States to export more or import less to avoid a deficit on the current account. Similarly, by reducing its holdings of assets abroad, the United States will have less income from abroad to offset import purchases. The long-term implication of chronic balance of trade deficits for the United States is, therefore, that more of the real income from capital in the United States will be paid out to foreigners in the future and less of that income will go to U.S. citizens. For example, net investment income (the difference between U.S. earnings abroad and foreign earnings from investment in the United States) in the balance of international payment accounts for the United States was $25.2 billion in 1985. By 1988, mainly as a result of increased foreign ownership of U.S. assets, net investment income had fallen to a mere $2.2 billion. Causes of the Balance of Trade Deficit Earlier in the chapter we showed how changes in real interest rates can affect the balance of trade and net exports for the United States. In reality the causes of the trade deficit are quite complex and cannot be attributed to any single factor, such as an upward movement in the real exchange rate of the dollar. In the preceding chapter we suggested that one possible reason for decreased U.S. exports and increased import demand has been lagging productivity growth in certain manufacturing indus-tries. However, there are other factors that have contributed to growing trade imbalances between the United States and the rest of the world in the 1980s. The table in Box 10 shows growth rates of real GNP and real domestic demand from 1982 to 1985 for the United States and some of its key trading partners. As you can see, growth in demand and real GNP in the United States was stronger than in the other nations. Growth of real GNP for less developed nations in the Western Hemisphere, Africa, and the Middle East averaged less than 1 percent per year from 1980 through 1986. The slow growth in these nations dampened their demand for U.S. exports. In addition, high real interest rates and increased profitability of U.S. businesses from 1982 to 1985 contributed to increased demand for dollars by foreigners who wanted to invest in the United States. The competition for investment dollars put upward pressure on the price of the dollar in terms of foreign currencies. This higher real exchange rate of the dollar made U.S. goods more expensive abroad, which further decreased foreign demand. Because of the appreciation of the dollar during the early 1980s, foreign currencies depreciated relative to the dollar, causing imports to become cheaper, and further increasing the balance of trade deficit. The U.S. trade balance has worsened against its major trading partners. For example, the U.S. balance of trade deficit with Japan increased from $19 billion in 1982 to more than $55 billion in 1986. The U.S. trade balance with Western Europe went from a surplus of $5 billion in 1982 to a deficit of more than $30 billion in 1986. The U.S. trade balance with nations of the Far East and Latin America also worsened over the same period.