[Economic Report of the President (2004)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

Chapter 14

The Link Between Trade
and Capital Flows

Movements of goods and services across borders are often thought of as
distinct from international capital flows. For example, an individual
who allocates part of his or her retirement savings to a mutual fund
that invests in an international portfolio might not think that this
cross-border transaction has an impact on the price of imports, such as
foreign cars or food at the supermarket. Yet, for important but subtle
reasons, trade flows and capital flows are closely intertwined-indeed,
they are two sides of the same coin.

This chapter explores the linkages between trade and capital flows.
The key points in this chapter are:

 Changes in a country's net international trade in goods and
services, captured by the current account, must be reflected in equal
and opposite changes in its net capital flows with the rest of the
 The United States has experienced a large net inflow of
foreign capital in recent years. Any such inflow must be accompanied
by an equally large current account deficit.

 The size and movement of current and capital accounts reflect
fundamental economic forces, including saving and investment rates,
and relative rates of growth across countries.

The Basic Accounting Identity

The balance of payments is the accounting system by which countries
report data on their international borrowing and lending, as well as
on the flow of goods and services in and out of the country. The
balance of payments includes a number of different accounts (Box 14-1).
The central relationship of the balance of payments is that the net
flow of capital into a country, as measured by the financial and
capital accounts, must balance the net flow of goods, services,
transfer payments, and income receipts out of the country, as measured
by the current account.

When the current account balance is negative, this means that
purchases of foreign goods and services (and other outflows) exceed
sales of goods and services to foreigners (and other inflows). This
situation is referred to as a current account deficit. The trade
balance is generally the largest component of the current account and
captures the net inflows of goods and services. A positive net flow of
capital into the United States means that foreigners are purchasing
more U.S. assets than U.S. citizens are purchasing foreign assets.
According to the balance of payments, a positive net flow of capital
into the United States must be balanced by a current account deficit.


Box 14-1: A New Look for the Balance of Payments

Just as a country's national accounts keep track of macroeconomic
variables such as GDP, saving, and investment, a country's balance of
payments accounts serve as the bookkeeping for its international
transactions, such as exports, imports, and international investment
flows. In 1999, the Bureau of Economic Analysis announced that it
would adopt new terminology to be consistent with international best
practices for balance of payments accounting, as outlined by the
International Monetary Fund.

The old balance of payments system used two accounts: the capital
account and the current account. The new system uses three accounts
(Chart 14-1). The new current account includes the trade balance in
goods and services, net income receipts, and the balance of most
unilateral transfers (one-way transfers of assets, such as pension
payments to foreign residents). Some unilateral transfers, including
debt forgiveness and the transfer of bank accounts by foreign citizens
when immigrating to the United States, have been removed from the old
current account and are now in a separate account, the new capital
account. The new capital account represents a very small portion of
overall capital flows. Private capital flows and changes in foreign
and domestic reserves (formerly in the old capital account) are now
in the financial account. This new treatment preserves the balance of
payments identity that the sum of all the accounts is zero.

To simplify terminology, this Economic Report of the President refers
to the new capital and financial accounts as net capital flows- that
is, inflows of capital from foreign countries minus outflows from the
United States. Positive net capital flows indicate that more capital
is flowing into the United States than out.


To understand how the balance of payments works in practice, consider
a consumer in the United States who purchases a scarf from a foreign
seller for one dollar. This transaction is recorded as an import and
reduces the U.S. current account balance by one dollar. The foreign
seller could spend the dollar on U.S. goods or on U.S assets, such as
stocks or bonds. If the foreigner purchases U.S. goods, this would be
recorded in the balance of payments as a U.S. export in the current
account. The U.S. purchase of the foreign scarf and the foreign
purchase of U.S. goods would cancel each other out, so there would be
no change in the current account and no change in net capital flows.
Alternatively, if the foreigner decided to purchase U.S. assets, this
would be recorded as a capital inflow into the United States. The
increase in net capital flows would balance the decrease in the U.S.
current account. In both examples, the resulting change in the current
account, if any, exactly balances any change in net capital flows.

Trade in goods can lead to changes in financial balances (such as
with the payment for the scarf in the example above), or financial
transactions can lead to changes in trade balances. The latter case
would occur if a foreigner purchased a U.S. asset, such as a bond, and
the American seller of the bond used the proceeds to purchase foreign
goods. In both cases, the balance between the current account and net
capital flows still holds.

To understand how financial flows can affect trade balances, suppose
that at the prevailing rate of return, investors in the United States
seek to undertake $200 billion worth of projects. If U.S. savers were
willing to provide only $150 billion in capital through saving, then
the other $50 billion could come from the rest of the world as $50
billion in capital inflows. If the U.S. investors choose to spend this
capital inflow on foreign goods (perhaps imports of new computers),
then net purchases of foreign goods would increase by $50 billion.
The resulting $50 billion current account deficit would balance the
$50 billion capital inflow. If investors in the United States were
not able to obtain the initial $50 billion from abroad, both net
capital flows and the current account would equal zero. There would
be no current account deficit. Would this be good or bad? One
immediate effect would be that the $50 billion gap between desired
investment and saving would need to be closed by scaling back
investment projects or raising national saving. These changes should
be evaluated on their own merits; there is nothing particularly
beneficial about having a trade balance or net capital flows exactly
equal to zero.

A country's saving and investment decisions are critical to evaluating
the implication of any given level of its current account balance. In
a world without capital flows, the only funds available for investment
come from domestic saving. Capital flows allow a country to finance
higher levels of investment by drawing on funds from abroad. This net
inflow of funds corresponds to greater net purchases from the world
and a decline in the current account balance.

The desirability of positive net capital flows and a current account
deficit depend on what the capital inflows are used for. Household
borrowing-an excess of household spending or investment over saving-
provides a useful analogy. Household debt could reflect borrowing to
finance an extravagant vacation, a mortgage to buy a home, or a loan
to finance education. Without knowing its purpose, the appropriateness
of the borrowing cannot be judged. Similarly for countries, borrowing
from abroad can be productive or unproductive. Borrowing from abroad
can be justified if it raises the potential output of the economy and
this, in turn, generates the resources needed to repay the foreign

This entire discussion has focused on trade balances and net capital
flows with the world as a whole, and not with any individual country.
There is no economic basis for concern about trade deficits and the
corresponding net capital flows with an individual trading partner
when there are many countries in the world (Box 14-2).


Box 14-2:  Bilateral Versus Multilateral Balances

A country's aggregate trade deficit matters only to the extent that
it reveals information about underlying economic forces, such as
relative international growth rates or national saving and investment
patterns. In contrast, bilateral deficits, such as the U.S. trade
deficit with China, reveal nothing about underlying economic forces
in either country. While trade barriers are a cause for concern,
there is no economic sense in which a bilateral deficit is either
good or bad. It would be an extraordinary coincidence if all countries
had balanced trade with each of their partners. One of the benefits
of the international financial system is that it frees countries from
these bilateral constraints.

For example, imagine a simplified world that consisted of only the
United States, Australia, and China. Suppose the United States ships
$100 billion of machine tools to Australia and imports no goods in
return. Australia ships $100 billion of wheat to China with no
reciprocal goods imports, and China ships $100 billion of toys to
the United States. Each country would have $100 billion of exports
and $100 billion of imports, so that each would have balanced trade
overall. Yet some Americans might complain about their bilateral
deficit with China. Some Chinese might complain about their deficit
with Australia, and some Australians about their deficit with the
United States. All of these complaints would be unfounded; bilateral
deficits and surpluses are a natural consequence of a trading world
composed of many countries.

Domestic transactions provide a useful analogy. A plumber who spends
no more than he earns can still run a bilateral deficit with the local
grocer. The plumber can earn money from other sources to pay the
grocer and is not constrained to buying only from grocers who have
plumbing problems. The bilateral imbalance that exists between the
plumber and the grocer is an entirely natural feature of a well-
functioning economy with a strong payments system and specialization.


Trends in the U.S. Balance of Payments

The decrease in the U.S. current account balance, from nearly zero
in the early 1990s to a deficit of about 5 percent of GDP in the
first three quarters of 2003, has been mirrored by a similar increase
in net capital flows (Chart 14-2). (The two series in Chart 14-2 are
not exact mirror images due to imprecision in the measurement of trade
and capital flows.)

Examining the components of the current and financial accounts
provides information on the causes of these recent trends in the U.S.
balance of payments (Table 14-1). Over the 1990s, a major contributor
to the rise in the current account deficit was the increase in
imports of foreign goods. The trade balance in goods moved from a
deficit of 1.9 percent of GDP in 1990 to a deficit of 4.6 percent of
GDP in 2000. Exports of goods increased from 6.7 percent of GDP in
1990 to 7.9 percent of GDP in 2000, but goods imports increased by
much more, from 8.6 percent of GDP to 12.5 percent of GDP over the
same period. The increase in the current account deficit since 2000
has resulted mainly from lower exports of goods (which fell from 7.9
percent to 6.4 percent of GDP between 2000 and the first three
quarters of 2003), rather than increased imports. Imports as a share
of GDP actually fell 1 percentage point over the same period
(Chart 14-3 and Table 14-1). Most recently, the current account
deficit has narrowed from 5.2 percent of GDP in the first quarter of
2003 to 4.9 percent of GDP in the third, reflecting stronger export

U.S. net capital flows grew from about 1 percent of GDP in 1990 to
over 41/2 percent of GDP in 2000. This resulted from roughly equal
increases in foreign purchases of debt securities, equity securities,
and direct investment. This increase in net capital flows into the
United States largely reflected the desire of foreigners to
participate in higher-return investment opportunities in the United
States. The global economic downturn and the collapse of high-tech
stock prices and broader equity indices that began in 2000
contributed to a shift in the composition of capital flows in the
United States. Foreign investors moved away from foreign direct
investment and private equity assets and toward government and
corporate bonds. In addition, foreign governments increased their
share of these capital flows, although the foreign private sector
still accounts for a far greater proportion.

Over the latter half of the 1990s and the early 2000s, the
counterpart to the rising U.S. current account deficit has been a
growing wedge between U.S. investment rates and U.S. national saving
rates (Chart 14-4). The national saving rate in the United States
began to decline in 1999, but increased capital inflows allowed U.S.
investment rates to remain at a high level through 2000. As discussed
in Chapter 1, Lessons from the Recent Business Cycle, investment fell
substantially after the collapse of the stock market bubble of the
late 1990s. In 2001, the decline in investment outpaced a
contemporaneous decline in U.S. saving, so that the current account
deficit narrowed. U.S. investment has since leveled off while saving
remains low, causing a wider U.S. current account deficit. Over the
entire period, the availability of foreign investment permitted the
United States to maintain higher investment rates than it could have
funded relying solely on domestic financing. These capital inflows
have helped finance U.S. investments, expand U.S. productive capacity,
and strengthen U.S. economic performance.

Factors that Influence the Balance of Payments

A number of underlying economic factors influence the level of and
changes in the balance of payments. One of the most important factors
is the differential rate of GDP growth across countries. During the
late 1990s, the United States grew faster than many of its major
trading partners, such as Japan and a number of major European
countries. As a result, capital flowed into the United States,
leading to a corresponding trade deficit. Even during the recent
business-cycle downturn and recovery, U.S. growth rates have exceeded
those of many of our major trading partners. This has contributed to
the slow recovery in U.S. exports and has helped to maintain continued
capital inflows into the United States.

A second determinant of trade and capital flows is the price of
domestic goods relative to foreign goods. Relative prices are
influenced by a number of factors, including labor and production
costs, labor productivity, and exchange rates. For many manufactured
products, for example, labor and production costs in developing
countries are often below such costs in the United States. As a
result, the prices of these goods produced in developing countries
may be substantially lower than the price of similar goods produced
in the United States. For other products and projects, such as
airplanes and the development of new drugs, the availability of
factors of production such as skilled engineers may be more important
than the availability of low-skilled workers. Exchange rates can also
influence relative prices. A depreciation of a country's currency can
make its products cheaper and thus more competitive abroad, even if
domestic prices do not change. When a country's currency appreciates,
domestically produced goods become relatively more expensive in
foreign markets.

A third determinant of the direction and size of capital flows is
the relative return that investors expect to make in one country
compared with another. This return differential can reflect factors
discussed earlier, such as relative output growth, labor costs, or
exchange rates. This differential can also depend on a country's
legal framework, accounting and tax systems,
infrastructure, culture, and institutions. The flow of capital into
the United States likely reflects a view that the expected risk-
adjusted, after-tax return on U.S. assets is higher than the return
on similar foreign investments.
These factors-growth rates, relative prices, and rates of return-all
drive national saving and investment decisions. Those decisions most
directly determine the balance of payments. National saving is the sum
of private saving (saving of households and corporations) and public
saving (the total saving of Federal, State, and local governments, as
reflected in their budget balances). When national saving is less
than domestic investment, a country must be borrowing from abroad.
This borrowing will be reflected in positive net capital flows and a
current account deficit.

Although this suggests that the recent increase in the U.S. budget
deficit may be related to the recent increase in the U.S. current
account deficit, the historical evidence for a relationship between
government deficits and trade deficits is mixed. A number of academic
studies suggest that other domestic and international factors are
more important influences on current account balances than government
deficits. The recent U.S. experience supports this. In the 1990s,
the large increase in the U.S. current account deficit occurred while
the Federal budget surplus was growing (Chart 14-5). From 1997 to
2000, the U.S. current account deficit increased by almost 3
percentage points. Over the same period, the U.S. budget balance
went from a slight deficit to a surplus of 21/2 percent of GDP. Since
2000, the U.S. budget has moved into deficit by several percentage
points of GDP, but the current account deficit has widened by only
about 1 percentage point of GDP. These figures show that the current
account and Federal budget do not move in lockstep, and that the
government deficit is only one of several factors behind the widening
of the current account deficit since the mid-1990s.

Possible Paths of Balance of
Payments Adjustment

The U.S. current account deficit reached about 5 percent of GDP in
the first three quarters of 2003. Historically, many countries with
sizable current account deficits have experienced reductions in capital
flows and corresponding reductions in their current account deficits.
Because the U.S. current account deficit and U.S. capital inflows are
balanced by trade and capital flows in other countries, any change in
the U.S. balance of payments would involve corresponding changes in
other countries' flows of trade and capital. The economic implications
of any adjustments depend on how it occurs.

An adjustment in the U.S. trade balance could involve a number of
domestic and global factors. For example, faster growth in other
countries would be expected to increase demand for U.S. exports and
narrow the U.S. current account deficit. Slower growth in the United
States relative to its major trading partners would dampen U.S. demand
for imports and reduce the U.S. trade deficit. Trade flows could also
adjust through changes in the relative prices of U.S. goods and
services compared to the prices of foreign goods and services. This
relative-price adjustment could occur through changes in nominal
exchange rates or through different inflation rates in different

An adjustment in the U.S. balance of payments would also require a
change in international capital flows. To reduce net capital flows,
foreign investors could buy fewer U.S. assets and/or U.S. investors
could buy more foreign assets. This might occur if U.S. national saving
were to increase, thereby reducing the need for foreign funds to
finance U.S. domestic investment. The U.S. investment rate could also
fall, so that the United States required less capital inflow. Lower
investment is the least desirable form of adjustment for the balance
of payments, however, as it would reduce U.S. productive capacity and
lead to slower growth.

It is impossible to predict the exact timing or magnitude of any
adjustment in the U.S. current account balance. After a large
increase in the U.S. current account deficit in the 1980s, the ensuing
adjustments were gradual and benign.  Public policies can facilitate
changes in the U.S. current account and net capital flows by creating
a stable macroeconomic and financial environment, encouraging foreign
growth, and spurring increased saving in the United States.


Flows of goods and services across borders are linked to
international capital flows through the balance of payments. Changes
in the current account (which includes international trade in goods
and services) must be balanced by equal and opposite changes in net
capital flows with the rest of the world. Similarly, movements in
net capital flows require offsetting movements in the current account.

In recent years, the United States has received large net inflows of
foreign capital, which have been balanced by large U.S. current
account deficits. The U.S. balance of payments is mirrored by trade
and capital flows in other countries. Thus, over the same period,
the rest of the world as a whole has experienced a current account
surplus and capital outflows.

The United States' sizable positive net capital flows and the
corresponding trade deficits are neither good nor bad in and of
themselves. Instead, they represent underlying economic forces,
such as relative GDP growth rates, relative prices of domestic and
foreign goods, relative returns on investment, and national saving
and investment decisions. Changes in these underlying factors would
lead to changes in the U.S. balance of payments and corresponding
changes in the international flows of trade and capital.