tion Tax, which had effectively curbed the excessive outflow of capital into foreign securities, was broadened to include bank lending of one year or more."

Looking back over developments during 1965 and 1966 so far, we feel that the February, 1965, program has been successful. The deficit on a liquidity basis in 1965 was $1.3 billion and, in the first three quarters of 1966, has been at an annual rate just below that figure-both less than half the deficit of the two preceding years.

This improvement, however, has not been evenly distributed throughout the various segments of our international accounts. It has resulted from a very substantial improvement in our capital account, offset, in part, by a deterioration in our trade surplus and by an increase in our deficit on military account.

The improvement in the capital account reflects both a decrease in the outflow of U.S. capital and an increase in the inflow of foreign capital. The major improvement has been in bank lending, which has shown a big swing-from an outflow of about $22 billion in 1964 to an inflow in the first three quarters of this year of $300 million, annual rate. The tight domestic credit situation has sharply reinforced the bank voluntary credit program. At the end of the third quarter, the banks were $1.2 billion below the ceilings suggested by the Federal Reserve program. Banks not only reduced their lending to foreigners but also drew in funds from their branches abroad to supplement domestic sources of funds.

special U.S. subsidiaries established for this purpose. In addition to the $650 million, over $400 million are estimated to have been borrowed by foreign-based affiliates of U.S. companies. The balance of payments impact of foreign direct investment during the first half of this year, $2.7 billion at an annual rate, was $600 million below that of 1965, though still some $300 million worse than 1964. The corporations have also helped the balance of payments by repatriating short-term liquid funds which they held abroad prior to February, 1965.

With respect to foreign capital inflow, the major development has been foreign investment in U.S. agency bonds and in long-term certificates of deposit. Foreign interest in these instruments is comparatively new and reflects the very attractive rates they pay under present circumstances. It remains to be seen to what extent they are a permanent addition to the international financial scene.

While it is too early to observe its effects, we look forward to some favorable long-term impact on our balance of payments from the Foreign Investors Tax Act 18-one of the final measures passed by the 89th Congress. This Act, which seems to have gained more publicity for some of the extraneous matters that were tacked on to it in the final days of the legislative session than for the benefits for which it was initially introduced and supported, removes a number of tax impediments that have tended to limit foreign investor participation in the U.S. capital markets.

In our current account, the major developments over the past year and a half have been the sharp decrease in our trade surplus and the sharp increase in the military deficit as a result of our increased participation in Vietnam. Our military account has also suffered from some lag in payments which we receive from the Federal Republic of Germany under our special offset agreement.1o

U.S. business corporations also have conformed to their voluntary program, which is administered by the Commerce Department. Although gross direct investment continues at a rate well above that of 1964, corporations have responded to the request that they seek financing abroad for such investment. In the first half of 1966, such long-term borrowing abroad by U.S. corporations totaled over $650 million, including security issues and long-term loans from foreign banks and other foreign residents. Of this amount, around $475 million represented security issues by

17 See ibid., pp. 1063-1074.

The effect of Vietnam on our balance of payments has been a good deal larger than most people realize. In the second quarter of 1966, the latest period for which we have data, our net military foreign exchange costs in the Asian countries where most of the impact of the Vietnam ex

18 See supra.

19 See footnote 51 to doc. IV-31, ante.

penditures takes place initially were running at an annual rate about $900 million greater than in 1964. In addition, there are indirect costs in the form of the import content of military procurement here in the U.S.

The decline in our trade surplus comes down to the boom in imports. Our exports have continued to increase fairly well, considering the very high level of domestic demand.

Our analysis suggests that when we get into periods of very high economic growth rates-such as we have had recently-imports increase more than in proportion to GNP growth. When we have been in periods of more moderate growth, such as we anticipated for next year, imports have increased but much less rapidly. If we can stay competitive on the cost side-which is one goal of domestic policy-and maintain a more moderate and sustainable growth rate-which is another goal of domestic policy-we should see continued growth in exports and moderation in the rate of growth of imports.

One highly interesting development-one which causes both concern and satisfaction-is the manner in which the deficit has been financed. Both the deficit on a liquidity basis and the deficit on an official settlements basis have to be financed, but the financing patterns differ.

The reason, of course, is that the official settlements deficit measures the increase in our liabilities to official monetary authorities. Only they have the right to convert dollar holdings into gold. The liquidity deficit includes increases in liquid liabilities to non-monetary entities. While some of these liabilities may come into the hands of monetary authorities over time, as long as they remain in private hands, they represent no immediate potential claim on our gold stock. And with the dollar being the major transactions currency for world trade, some growth in private holdings is perfectly natural as world trade expands.

Let me speak first of the aspect that causes concern. On the official settlements basis, we had a deficit of $1.3 billion in 1965 and, for the first nine months of this year, we had a surplus of $500 million. Last year, we financed the deficit with an outflow of gold of almost $1.7 billion, offset, in part, by a minor improvement in our IMF position. This year, despite an

official settlements surplus, we have had a net outflow of gold of $450 million and a deterioration in our IMF position of about the same amount. So, for the past 21 months, we have financed an official settlements deficit of $800 million with an outflow of gold of about $2.1 billion and a net decline in our IMF position of $400 million-taken together, somewhat more than three times the deficit. The difference reflected a decline in officially-held dollar balances and an increase in our holdings of foreign exchange.

While developments in this period point up this problem more sharply than would be the case over a different time span, they do call attention to a fact of some concern. The United States was called upon to overfinance heavily a moderate official settlements deficit with gold and drawings on the IMF. Such a drain on U.S. reserves imposes an unnecessarily heavy strain on the international monetary system.

The more satisfactory development concerns the reduced outflow of gold this year. In the first three-quarters of this year, the U.S. gold reserve declined by $450 million. However, $600 million was taken by France alone, and Treasury sales of gold for industrial and commercial uses in the U.S. took another $100 million. In our other gold transactions, we had a net inflow. France made a prepayment of $70 million to the United States in September and did not request a conversion of dollars into gold last month. There has been some recent decrease in the large and persistent French surplus, though it is not clear whether this is more than seasonal. We will be watching with interest the unfolding results of measures just announced by France for liberalization of the regulations governing foreign access to the French capital markets and freer participation by French investors in capital transactions originating abroad.

Another interesting development has been the very large part of our over-all deficit which is reflected in short-term liquid holdings by foreign private banks and individuals. In the first three-quarters of this year, the increase in these holdings was actually greater than the over-all deficit measured on the liquidity basis. It is for this reason that, on the official settlements basis, which does not count increases in these holdings as

part of the deficit, we had a surplus. This phenomenon, in great part, is accounted for by the development which I mentioned earlier of U.S. banks borrowing funds from their branches abroad to supplement their domestic source funds. This large movement of funds was also in part due to the pressure on sterling which developed in the Summer and resulted in a shift from sterling claims to dollar claims on the part of foreigners.20

This latter development shows how highly developed and closely knit the Euro-dollar market is. Funds can move quite rapidly between major international financial centers. We would not, in the immediate period ahead, expect to see movements of quite this magnitude, but the fact that there were these large amounts of dollars held abroad, which could be borrowed by the private U.S. market fairly quickly, does indicate, I think, the important role of the dollar as an instrument for financing not only international trade but capital movements as well.

These flows are drawing increasing attention from monetary authorities. In the OECD forums, where we carry on a continuing dialogue on balance of payments problems and capital flows, there has been considerable interest in the cause and effects of the monetary tightness which now prevails generally around the industrialized world. Between September, 1965, and September, 1966, Euro-dollar rates increased from about 4.5 percent to 6.8 percent. Long-term yields on international bond issues increased by about one percent, and long-term government bond rates increased in every major industrial country except Italy.

In many cases, these increases were largely the result of the deliberate application of monetary policy in an effort to restrain internal demand. This might be said to be the case for the United States, the United Kingdom, and Germany-probably the Netherlands, Belgium, and Sweden, as well. Elsewhere, interest rate increases appear to have been largely a response to international conditions, which, however, the authorities did not counter by their own actions.

both internal economic conditions and on countries' external positions. Germany has remained a net importer of capital, despite a rapidly rising trade surplus and an outflow of short-term money through the German banks. France has also continued to import capital, despite the fact that the rise of rates in France was somewhat less than those in most other countries. Italy and Japan, where rates remained nearly stable, experienced substantial capital outflows which were stabilizing.

Perhaps, in the initial stages, when inflationary pressures were widespread, not too many industrial countries suffered ill effects from this high level of interest rates, even though particular sectors of some economies did bear an undue share of the burden. As time passes, however, countries are beginning to examine the effects of tight money and high interest rates more carefully, and some concern is developing. For example, some of the smaller countries which are heavily dependent on external funds have come to feel that the impact of reduced availabilities tends to be concentrated on them, just as housing feels the burden on the internal side.

No general easing of interest rates may be possible unless the United States participates. However, in terms of the effect on the balance of payments at least, it would clearly be very important that rate reductions in the United States be accompanied by rate reductions in the surplus European countries.

Document XI-9

Memorandum From the President (Johnson) to the Secretary of the Treasury (Fowler), December 12, 1966

21

Presidential Approval of the 1967 Voluntary Program To Combat the Balance of Payments Problem

I agree with the Cabinet Committee Balance of Payments that our

on

This general tightening of interest rates has had noticeable effects on

20 See footnote 35 to doc. IV-26, ante.

21 White House press release dated Dec. 12, 1966.

overall objective in 1967 should be to continue to move toward balance-ofpayments equilibrium as fast as the continuing foreign exchange costs of Vietnam permit.

I understand that your Committee's appraisal is that we can achieve this objective; but to do so requires a continued determined program to restrain both government overseas expenditures and private capital flows. You therefore propose new Voluntary Programs for the restraint of capital outflows in 1967. I fully agree.

In announcing the Voluntary Program for 1967, you should make it clear that:

1. Our balance of payments has been substantially improved since the Voluntary Program was put into effect in early 1965.23 In the first three quarters of this year the balance-of-payments deficit measured on the liquidity basis was down to an annual rate of $1.2 billion, less than half the deficits of years prior to the inauguration of the program. On the basis of the alternative tabulation, the official reserve transactions basis, our balance of payments was in surplus in the first three quarters of this year at an annual rate of about $750 million.

2. This heartening progress is in great part attributable to the bankers and businessmen of America who responded to my request to join with the Government in a voluntary partnership to help solve a problem which is of concern to all Americans.

3. When the Voluntary Program was initiated, it was hoped that the need for restraint would have passed by this time. Only a few months later, however, it became necessary for us to increase substantially our military participation and expenditures in Southeast Asia in defense of South Vietnam." These expenditures have taken a heavy toll on our balance of payments. After taking account of all the direct and indirect effects, we estimate that the cost of Vietnam to our balance of payments may be well in excess of $1 billion a year.

must continue to make progress toward equilibrium as fast as the continued substantial costs of Vietnam will permit. We will, therefore, call upon American bankers and businessmen to continue their cooperation during this period of difficulties.

5. I pledge that the Government, for its part will continue to exercise all possible efforts to restrain the dollar drain resulting from our military spending abroad. Our foreign economic assistance programs will continue to take account of this requirement.

6. We recognize that continuation of the Voluntary Program will involve some sacrifice. Under the circumstances, however, we feel that the results of the Voluntary Program, along with the other balance-of-payments measures calling for restraint within Government, fully justify whatever sacrifice it may entail.

7. When the hostilities in Vietnam have ended, we will re-examine our balance-of-payments program in the light of the circumstances at that time.

8. The announcement of the Voluntary Program for 1967 at this time is being made to enable banks and corporations to incorporate the suggested guidelines in their plans for 1967. The Government's own economic policy in the year ahead will also be conducted with the balanceof-payments implications kept clearly in mind.

Document XI-10

Letter From the Secretary of Commerce (Connor) to the Chief Executives of American Companies Participating in the Voluntary Program To Improve the Balance of Payments Situation, December 12, 1966 *

"The Vital Significance of Limiting the [United States] Balance of Payments Deficit"

Circumstances, which I believe are fully understood throughout the busi

25 Department of Commerce press release dated Dec. 13, 1966.

ness community, are prolonging and intensifying our balance of payments problems. Although the U.S. deficit has been significantly reduced since the President announced the balance of payments program early in 1965,20 any relaxation of effort at this stage could lead to a rapid reversal of that progress. The continued need for special measures has become increasingly apparent as the U.S. commitments in Southeast Asia are reflected directly and indirectly in our balance of payments. The added drain caused by military expenditures abroad must be offset by more vigorous effort to cut the deficit in other sectors and expand our foreign earnings.

In view of these developments, I asked the Advisory Committee on the Balance of Payments 27 for its recommendations on a course of action for 1967. The Committee expressed support for the continuation of the voluntary program, and outlined the areas where the program is likely to increase balance of payments contributions in 1967. They pointed out that, in 1967, it is reasonable to hope that exports by participating companies, encouraged by the voluntary program, will continue to increase, provided that rising costs and domestic shortages do not prove to be a severely limiting factor. It is likewise reasonable to expect further increases in remitted earnings, royalties, and fees from foreign operations." The Committee indicated, "While we cannot expect that foreign borrowings will increase at the same rate as heretofore, due to limited availability of overseas credit, continuance of the voluntary program should provide an adequate incentive for companies to maintain borrowings substantially above pre-program levels."

On the basis of the Committee's advice and our confidence in the continued support of the leaders of American business, we have decided to appeal once more for your voluntary cooperation in a joint effort to strengthen the nation's balance of payments position. In one sense this is a grateful tribute to the effectiveness of your efforts in the last two years, but it is also a request that you continue to make the sacrifices that have contributed to the success of the voluntary program.

Our confidence that the voluntary program will continue to work effectively is further strengthened by the excellent record of our joint accomplishments since the program was launched in March 1965. An early result was the rapid repatriation of short-term assets held abroad. The 722 companies, included in a tabulation of annual data, reported increases in such assets by more than $400 million in 1964. During 1965, the return flow was slightly larger than the 1964 outflow, providing a net change in this item of more than $800 million. This was a most gratifying response, more than fulfilling our request for reductions to a level not exceeding the amount outstanding on December 31, 1963.

This year, the participants indicate that their total balance of payments contributions on other selected transactions will reach $17.8 billion, or about $2.5 billion more than in the preprogram year of 1964. The largest part of this improvement is the expected increase in exports of $2.2 billion, and nearly all of the remainder is accounted for by increased dividends and other income from foreign investments.

The surplus of direct investment income over capital outflows has been running at about $1.5 billion in each of the two years under the voluntary program, compared to a little over $1.1 billion in 1964. This has been accomplished by preventing capital outflows during the past two years from rising above the level reported for 1964. In spite of mounting capital expenditures by foreign affiliates, their dependence on U.S. funds has not increased. Greater reliance on foreign financing has made this possible. The average level of foreign borrowing in 1965 and 1966 has exceeded the 1964 level by about $1 billion.

Through the special efforts of the participating companies to limit the adverse effects of capital investment programs, the increase in their total net contributions matched their gains in exports and other foreign earnings. In the coming year we must continue to rely upon the business community for a sizeable share of increased contributions needed to meet the growing costs of our obligations in Vietnam.

The operation and form of next year's program will be changed as little as possible in order to minimize administrative problems. The system of reporting will be continued in the

See American Foreign Policy: Current Documents, 1965, pp. 1050-1058, 1074-1082. 27 See ibid., p. 1080.