Financing the U.S. Trade Deficit
Released: 2017-02-10T00:00:00

Background

By standard convention, the balance of payments accounts are based on a double-entry bookkeeping system. As a result, each transaction entered as a credit must have a corresponding debit and vice versa. This means that a surplus or deficit in one part of the accounts necessarily will be offset by a deficit or surplus, respectively, in another account so that, overall, the accounts are in balance. This convention also means that a deficit in one account, such as the merchandise trade account, is not necessarily the same as a debt. The trade deficit can become a debt equivalent depending on how the deficit is financed and the expectations of those who hold the offsetting dollar-denominated U.S. assets. The balance of payments accounts are divided into three main sections: the current account, which includes the exports and imports of goods and services and personal and government transfer payments; the capital account, which includes such capital transfers as international debt forgiveness; and the financial account, which includes official transactions in financial assets and private transactions in financial assets and direct investment in businesses and real estate. In these accounts, exports are recorded as a positive amount even though they represent an outflow of goods and services from the economy, because they represent a credit for which there is a specific obligation of repayment. Similarly, although imports represent an inflow of goods and services to the economy, they are recorded as a negative amount, because they represent a debt that must be repaid.

When the basic structure of the balance of payments was established, merchandise trade transactions dominated the accounts. Financial transactions recorded in the capital accounts generally reflected the payments and receipts of funds that corresponded to the importing and exporting of goods and services. As a result, the capital accounts generally represented "accommodating" transactions, or financial transactions associated directly with the buying and selling of goods and services. During this early period, exchange rates between currencies were fixed, and private capital flows, such as foreign investment, were heavily regulated so that nearly all international flows of funds were associated with merchandise trade transactions and with some limited government transactions.

Since the 1970s, however, private capital flows have grown markedly as countries have liberalized their rules governing overseas investing and as nations have adopted a system of floating exchange rates, where the rates are set by market forces. Floating exchange rates have spurred demand for the dollar. The dollar also is sought for investment purposes as it has become a vehicle itself for investment and speculation and it serves as a major trade invoicing currency. This means that the balance of payments records not only the accommodating flows of capital which correspond to imports and exports of goods and services, but also autonomous flows of capital that are induced by a broad range of economic factors that are unrelated directly to the trading of merchandise goods.

Capital Flows and the Dollar

Liberalized capital flows and floating exchange rates have greatly expanded the amount of autonomous capital flows between countries. These capital transactions are undertaken in response to commercial incentives or political considerations that are independent of the overall balance of payments or of particular accounts. As a result of these transactions, national economies have become more closely linked, the process some refer to as "globalization." The data in Table 1 provide selected indicators of the relative sizes of the various capital markets in various countries and regions and the relative importance of international foreign exchange markets. In 2013, these markets amounted to over $900 trillion, or more than 50 times the size of the U.S. economy. Worldwide, foreign exchange and interest rate derivatives, which are the most widely used hedges against movements in currencies, were valued at $655 trillion in 2013, more than twice the size of the combined total of all public and private bonds, equities, and bank assets. For the United States, such derivatives total more than three times as much as all U.S. bonds, equities, and bank assets.

Another aspect of capital mobility and capital inflows is the impact such capital flows have on the international exchange value of the dollar. Demand for U.S. assets, such as financial securities, translates into demand for the dollar, since U.S. securities are denominated in dollars. As demand for the dollar rises or falls according to overall demand for dollar-denominated assets, the value of the dollar changes. These exchange rate changes, in turn, have secondary effects on the prices of U.S. and foreign goods, which tend to alter the U.S. trade balance. At times, foreign governments intervene in international capital markets to acquire the dollar directly or to acquire Treasury securities in order to strengthen the value of the dollar against particular currencies. In addition, various central banks moved aggressively following the Asian financial crisis in the 1990s to bolster their holdings of dollars in order to use the dollars to support their currencies should the need arise.

The dollar is also heavily traded in financial markets around the globe and, at times, plays the role of a global currency. Disruptions in this role have important implications for the United States and for the smooth functioning of the international financial system. During the decade preceding the recent global financial crisis, banks and other financial institutions expanded their global balance sheets from $10 trillion in 2000 to $34 trillion in 2007. These assets were comprised primarily of dollar-denominated claims on non-bank entities, including retail and corporate lending, loans to hedge funds, and holdings of structured finance products based on U.S. mortgages and other underlying assets. As the crisis unfolded, the short-term dollar funding markets served as a major conduit through which financial distress was transmitted across financial markets and national borders, according to analysts with the Bank for International Settlements (BIS). When these short-term dollar funding markets collapsed in the early stages of the crises, the U.S. Federal Reserve engaged in extraordinary measures, including a vast system of currency swap arrangements with central banks around the world, to supply nearly $300 billion. After initially expanding the then-existing reciprocal currency arrangements (swap lines) with the European Central Bank, the Bank of England, the Swiss National Bank, and the Bank of Japan, the Federal Reserve made an unprecedented announcement in October 2008 that it would provide swap lines to "accommodate whatever quantity of U.S. dollar funding is necessary" to stem the dollar shortage. At the same time, the U.S. Treasury announced a money market guarantee program to stop the withdrawal of funds from the money markets and to offset the withdrawals by providing public funds.

The prominent role of the dollar means that the exchange value of the dollar often acts as a mechanism for transmitting economic and political news and events across national borders. While such a role helps facilitate a broad range of international economic and financial activities, it also means that the dollar's exchange value can vary greatly on a daily or weekly basis as it is buffeted by international events. A triennial survey of the world's leading central banks conducted by the Bank for International Settlements in April 2016 indicates that the daily trading of foreign currencies through traditional foreign exchange markets totaled $5.1 trillion, down 5% from the $5.3 trillion reported in the previous survey conducted in 2013, as indicated in Figure 1 . In addition to the traditional foreign exchange market, the over-the-counter (OTC) foreign exchange derivatives market reported that daily turnover of interest rate and non-traditional foreign exchange derivatives contracts reached $2.7 trillion in April 2016. The combined amount of nearly $8.0 trillion for daily foreign exchange trading in the traditional and OTC markets is more than four times the annual amount of U.S. exports of goods and services. The BIS data also indicate that 88.0% of the global foreign exchange turnover in April 2016 was in U.S. dollars, as indicated in Figure 2 . This share was slightly higher than the 87.0% share reported in a similar survey conducted in 2013.

The U.S. Balance of Payments

Table 2 presents a summary of the major accounts in the U.S. balance of payments over the four quarters of 2015 and the first two quarters of 2016. The data indicate that throughout the period, the U.S. current account, or the balance of exports and imports of goods, services and transfers, was in deficit, or the United States imported more goods and services than it exported. The current account balance represents the broadest measure of U.S. trade in goods, services, and certain income flows. The balance worsened by 16% from 2014 to 2015. On a quarterly basis, the deficit in the current account has varied from quarter to quarter, although remaining negative, reflecting a broad range of economic activities.

Most economists argue that, given the current composition of the U.S. economy, foreign capital inflows play an important role by bridging the gap between domestic supplies of and demand for capital, or between the total amount of saving in the economy relative to the total amount of investment. Indeed, economists generally argue that it is this interplay between the demand for and the supply of credit in the economy, rather than the flow of manufactured goods and services, that drives the broad inflows and outflows of capital and serves as the major factor in determining the international exchange value of the dollar and, therefore, the overall size of the nation's trade deficit or surplus. Capital inflows, in turn, place upward pressure on the dollar's exchange rate, pushing the exchange value of the dollar up relative to other currencies. As the dollar rises in value, the price of U.S. exports rises and the price of imports falls, which tends to increase the current account deficit.

The important role capital flows play in determining the overall trade balance is demonstrated in the recent changes that have occurred in the price of oil and its impact on the U.S. trade deficit. Given the prominent role that energy imports play in the U.S. trade deficit, the U.S. trade deficit might be expected to decline along with the drop in the price of oil that occurred in 2014 and 2015, but this was not the case. From 2014 to 2015, the average price of an imported barrel of crude oil fell by nearly half from an average annual price of $91 per barrel to an average annual price of $47 per barrel, although the price of imported crude oil fell below $40 per barrel by the end of 2015. At the same time that the average price in imported crude oil dropped sharply, the quantity of imported crude oil fell by 1.4%. As a result of this drop in crude oil prices and relatively stable quantity of imports, crude oil imports fell from accounting for more than 40% on average of the annual U.S. merchandise trade deficit in 2012 to about 10% on average of the annual U.S. trade deficit in 2015.

Despite the drop in the average annual price of imported crude oil and the decline in the role of imported crude oil in the value of the U.S. trade deficit in 2014 to 2016, the U.S. merchandise deficit increased in 2015 over that recorded in 2014. Instead of seeing the overall trade deficit decline, the composition of the trade deficit changed, with non-petroleum products replacing petroleum products, seemingly affirming the proposition that the overall value of the trade deficit is determined primarily by macroeconomic forces, as indicated in Figure 3 .

According to the balance of payments accounts, the United States experienced deficits in the merchandise trade goods accounts over the last eight quarters in the range of $113 billion to $123 billion and a surplus in the services accounts during the same period in the range of about $61 to $67 billion, as indicated in Table 2 . In the income accounts, which represent inflows of income on U.S. assets abroad relative to outflows of income earned on U.S. assets owned by foreigners, the net balance of the accounts was in surplus throughout the period.

The data also indicate that the U.S. financial accounts were in surplus throughout the period, because they represent the opposite and offsetting transactions to the deficits in the current account. Indeed, the accounting of the balance of payments is such that the surplus in the financial accounts is equivalent to the deficit in the combined balance in the capital account, the statistical discrepancy, and the balance on the current account. The balance in the financial accounts represents the difference between the capital outflows associated with U.S. investments abroad, which are recorded as a net positive outflow, and the capital inflows associated with foreign investment in the United States, which are recorded as a net positive inflow. These investment flows represent the combined amount of both private and official investments, or investments by private individuals and institutions and investments by governments and governmental institutions, respectively.

The balance on the financial account (the difference between the net U.S. acquisition of foreign financial assets and the net foreign acquisition of U.S. financial assets) in 2015 fell from that recorded in 2014 due to an increase in U.S. net purchases of assets abroad and a drop in foreign net purchases of assets in the United States. The relative decline in foreign acquisitions of U.S. assets in 2015 below those recorded in 2014 reflects a 180% drop in foreign official purchases of U.S. portfolio assets, including a decline of 200% in official purchases of U.S. Treasury securities. Foreign private purchases of U.S. portfolio assets declined by 40%, reflecting a decline by 33% in foreign private purchases of U.S. treasury securities and an increase year-over-year of 75% in private purchases of corporate bonds. During the same period, U.S. purchases of foreign equities and debt securities fell by 75%, year-over-year.

The data in Table 2 also indicate that in 2015, the flows in direct investment, particularly foreign direct investment in the United States, experienced significant changes. U.S. direct investment abroad rose slightly in 2015 to reach $348.6 billion, and foreign direct investment in the United States rose by 83% to reach $379 billion. A lower value for foreign direct investment in 2014 reflected a $130 billion stock repurchase transaction that occurred between Verizon and the French-owned Vodafone.

Another way of viewing the balance of payments data is presented in Table 3 , which shows the net amount of the flows in the major accounts, or the difference between the inflows and outflows. Net inflows are represented by positive numbers; net outflows are represented by negative numbers. In 2015 for instance, total net capital inflows representing the net balance on the current account, the capital account, and the statistical discrepancy, were a negative $195.2 billion, which was equivalent to the offsetting amount recorded in the financial accounts and is below the amount recorded in 2014. These values are subject to periodic revisions.

Department of the Treasury data indicate that foreign private net purchases of Treasury securities have shifted between positive and negative values at various times, as indicated in Figure 4 . Foreign official net acquisitions of Treasury securities have also tended to change abruptly on an annual basis, at times reflecting the role of the dollar and dollar-denominated securities as safe haven assets. During the midst of the financial crisis in 2009 and 2010, for instance, foreign private investors sharply increased their net purchases of Treasury securities, which rose to over $500 billion in 2010. From 2010 to 2013, however, as concerns over financial market stability eased foreign private net purchases of Treasury securities fell to $52 billion in 2013. Similarly, foreign governments increased their net purchases of Treasury securities in 2008 and 2009, which they maintained until foreign official net purchases fell in 2013 and again in 2015 when foreign official entities liquidated more than $200 billion in treasury securities.

As Figure 4 indicates, financial flows over the 2007-2015 net private and net official capital inflows have changed abruptly at times. Private capital flows, representing the combination of net purchases of Treasury securities, corporate stocks and bonds, and other U.S. Government agency bonds, shifted from a net inflow of $1.7 trillion in 2007 to a net outflow in 2008 and 2009, reflecting the contraction in capital flows as a result of the financial crisis. Between 2010 and 2015, net private inflows have varied sharply, often reflecting changes in private net purchases of a broad range of financial assets exclusive of Treasury securities. Net private inflows by U.S. citizens resumed in the 2012 to 2014 period. During the same period, net foreign official accumulations of U.S. financial assets increased from $188 billion in 2007 to $225 billion in 2012, shifting to a net outflow in 2015 of over $200 billion.

Table 4 data show the total net accumulation of long-term U.S. securities, or the amount of securities purchased less those that were sold, by foreign private and official sources from 2013 to 2015 and five recent quarters. The data indicate that in between 2013 and 2014, the net foreign private accumulation of U.S. securities tripled from $80 billion to $249 billion, before falling by a third to $155 billion in 2015. According to the Department of the Treasury, the drop in net foreign purchases of U.S. securities reflects adjustments by private investors in their portfolios by reducing their holdings of U.S. corporate stocks and U.S. Treasury securities and increasing their net purchases of corporate bonds and the bonds of U.S. government agencies other than Treasury securities.

The U.S. Net International Investment Position

As indicated above, the data in Table 2 and Table 3 show that the trade deficit is accompanied by an equal capital inflow that represents an accumulation of dollar-denominated assets by foreigners. Some observers have equated the trade deficit and the associated accumulation of foreign-owned dollar-denominated assets as a debt that the U.S. economy owes to foreigners that will have to be repaid. This characterization, however, is not entirely appropriate. The debts owned by foreign investors represent claims on assets, rather than loans where payments on the principal and interest are specified according to a fixed schedule and where failure to meet the repayment schedule can result in the loans being called in and made payable in full. While foreign investors have expectations of a positive return on their dollar-denominated assets, returns, except for Treasury securities, are not guaranteed, but are subject to market forces. An important feature of claims by foreign investors on U.S. assets is that some or all of the profits or returns on the assets can be repatriated to the home country of the foreign investor, thereby reducing the returns that otherwise would remain in the U.S. economy. Depending on the tax convention the United States has with other governments, private foreign investors who own U.S. Treasury securities will owe taxes on the interest income.

According to the most commonly accepted approach to the balance of payments, macroeconomic developments in the U.S. economy are the major driving forces behind the magnitudes of capital flows, because the macroeconomic factors determine the overall demand for and supply of capital in the economy. Economists generally conclude that the rise in capital inflows can be attributed to comparatively favorable returns on investments in the United States when adjusted for risk, a surplus of saving in other areas of the world, the well-developed U.S. financial system, the overall stability of the U.S. economy, and the generally held view that U.S. securities, especially Treasury securities, are high quality financial instruments that are low risk. In turn, these net capital inflows (inflows net of outflows) bridge the gap in the United States between the amount of credit demanded and the domestic supply of funds, likely keeping U.S. interest rates below the level they would have reached without the foreign capital. These capital inflows also allow the United States to spend beyond its means, including financing its trade deficit, because foreigners are willing to lend to the United States in the form of exchanging goods, represented by U.S. imports, for such U.S. assets as stocks, bonds, U.S. Treasury securities, and real estate and U.S. businesses.

While this exchange of assets is implicit in the balance of payments, the Department of Commerce explicitly accounts for this broad flow of dollar-denominated assets through the nation's net international investment position. The U.S. net international investment position represents the accumulated value of U.S.-owned assets abroad and foreign-owned assets in the United States measured on an annual basis at the end of the calendar year. Some observers refer to the net of this investment position (or the difference between the value of U.S.-owned assets abroad and the value of foreign-owned assets in the United States) as a debt, or indicate that the United States is a net debtor nation, because the value of foreign-owned assets in the United States is greater than the value of U.S.-owned assets abroad.

In fact, the nation's net international investment position is not a measure of the nation's indebtedness similar to the debt borrowed by some developing countries, but it is simply an accounting of assets. The Department of Commerce uses three different methods for valuing direct investments that can yield different estimates for the net position, depending on the stock market value of the investments. For example, by year-end 2015 the overseas assets of U.S. residents totaled $22.0 trillion, with U.S. direct investment abroad valued at historical cost, while foreigners had acquired about $28.0 trillion in assets in the United States, with direct investment measured at historical cost. As a result, the U.S. net international investment position was about a negative $5.6 trillion in 2015, with direct investment measured at historical cost, but was valued at negative $7.3 with direct investment valued at current cost, as indicated in Table 5 .

Foreign investors who acquire U.S. assets do so at their own risk and accept the returns accordingly. While foreign investors likely expect positive returns from their dollar-denominated assets, the returns on most of the assets in the international investment position, except for bonds, are not guaranteed and foreign investors stand to gain or lose on them similar to the way U.S. domestic investors gain or lose.

As Table 5 indicates, investments in the international investment position include such financial assets as corporate stocks and bonds, government securities, and direct investment in businesses and real estate. The value of these assets, measured on an annual basis, can change as a result of purchases and sales of new or existing assets; changes in the financial value of the assets that arise through appreciation, depreciation, or inflation; changes in the market values of stocks and bonds; or changes in the value of currencies. For instance, by year-end 2015, U.S. holdings abroad had risen in value to $22 trillion, with direct investment valued at historical cost, and $23.2 trillion and $21.4 trillion with direct investment valued at current cost and market value, respectively, reflecting an upward revaluation in the values of foreign corporate stocks due to an increase in stock market values. Similarly, the value of foreign owned assets in the United States rose in 2015 to $27.2 trillion with direct investment valued at historical cost and $30.6 trillion with direct investment valued at market cost, with rising stock values pulling up the overall investment position of foreign investors.

The foreign investment position in the United States continues to increase as foreigners acquire additional U.S. assets and as the value of existing assets appreciates. These assets are broadly divided into official and private investments, reflecting transactions by governments among themselves and transactions among the public. While the foreign official share of the overall amount of capital inflows has grown sharply as indicated in Table 3 , the overall foreign official share of foreign-owned assets in the United States has remained relatively modest.

As Figure 6 indicates, foreign official asset holdings were valued at about $6.0 trillion in 2015, or about 20% of the total foreign investment position, a share that rose above 20% in 2008 as foreign official holdings of U.S. Treasury securities rose during the global financial crisis. Official assets include such monetary reserve assets as gold, the reserve position with the International Monetary Fund (IMF), and holdings of foreign currency. An important component of foreign official holdings in the United States is the acquisitions of U.S. Treasury securities by foreign governments. At times, such acquisitions are used by foreign governments, either through coordinated actions or by themselves, to affect the foreign exchange price of the dollar. Foreign currency holdings account for a relatively small share of the total foreign investment position.

Private asset holdings are comprised primarily of direct investment in businesses and real estate, purchases of publicly traded government securities, and corporate stocks and bonds. As indicated in Figure 7 , the composition of U.S. assets abroad and foreign-owned assets in the United States differs in a number of ways. The strength and uniqueness of the U.S. Treasury securities markets make these assets sought after by both official and private foreign investors, whereas U.S. investors hold few foreign government securities. As a result, foreign official assets in the United States far outweigh U.S. official assets abroad. Both foreign private and official investors have been drawn at times to U.S. government securities as a safe haven investment during troubled or unsettled economic conditions.

Implications

The persistent U.S. trade deficit raises concerns in Congress and elsewhere due to the potential risks such deficits may pose for the long-term rate of growth for the economy. In particular, some observers are concerned that foreigner investors' portfolios will become saturated with dollar-denominated assets and foreign investors will become unwilling to accommodate the trade deficit by holding more dollar-denominated assets. The shift in 2004 in the balance of payments toward a larger share of assets being acquired by official sources generated speculation that foreign private investors had indeed reached the point where they were no longer willing to add more dollar-denominated assets to their portfolios. This shift was reversed in 2005, however, as foreign private investments rebounded.

Another concern is with the outflow of profits that arise from the dollar-denominated assets owned by foreign investors. This outflow stems from the profits or interest generated by the assets and represents a clear outflow of capital from the economy that otherwise would not occur if the assets were owned by U.S. investors. These capital outflows represent the most tangible cost to the economy of the present mix of economic policies in which foreign capital inflows are needed to fill the gap between the demand for capital in the economy and the domestic supply of capital.

Indeed, as the data presented indicate, it is important to consider the underlying cause of the trade deficit. According to the most commonly accepted economic approach, in a world with floating exchange rates and the free flow of large amounts of dollars in the world economy and international access to dollar-denominated assets, macroeconomic developments, particularly the demand for and supply of credit in the economy, are the driving forces behind the movements in the dollar's international exchange rate and, therefore, the price of exports and imports in the economy. As a result, according to this approach, the trade deficit is a reflection of macroeconomic conditions within the domestic economy, and an attempt to address the issue of the trade deficit without addressing the underlying macroeconomic factors in the economy likely would prove to be of limited effectiveness.

In addition, the nation's net international investment position indicates that the largest share of U.S. assets owned by foreigners is held by private investors who acquired the assets for any number of reasons. As a result, the United States is not in debt to foreign investors or to foreign governments similar to some developing countries that run into balance of payments problems, because the United States has not borrowed to finance its trade deficit. Instead the United States has traded assets with foreign investors who are prepared to gain or lose on their investments in the same way private U.S. investors can gain or lose. It is certainly possible that foreign investors, whether they are private or official, could eventually decide to limit their continued acquisition of dollar-denominated assets or even reduce the size of their holdings, but there is no firm evidence that such presently is the case.