[Economic Report of the President (2006)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]



 
Chapter 6

The U.S. Capital Account Surplus


The United States conducts a large number of trade and financial
transactions with other countries. These transactions are recorded
in the U.S. balance of payments accounts. The balance of payments
consists of two subaccounts. One subaccount is the current account.
The current account consists largely of the trade balance, which
records U.S. imports and exports of goods and services. The second
subaccount is the capital and financial account (hereafter called
the capital account), which records U.S. net sales or purchases of
assets--stocks, bonds, loans, foreign direct investment (FDI), and
reserves--with other countries during the same time period.
In 2004 (the most recent calendar year for which data exist), the
United States ran a current account deficit of $668 billion. This
deficit meant the United States imported more goods and services than
it exported. The counterpart to the U.S. current account deficit was
a U.S. capital account surplus. This surplus meant that foreign
investors purchased more U.S. assets than U.S. investors purchased
in foreign assets, investing more in the United States than the
United States invested abroad. By economic definition, a country's
current and capital account balances must offset one another.
Therefore, the U.S. current account deficit was matched by a capital
account surplus of $668 billion (including $85 billion in net
statistical discrepancies within the capital account, which are
included in part to ensure the accounts sum to zero).
Because foreigners invested more in the United States than the
United States invested abroad, the United States received net foreign
capital and financial inflows (hereafter called net capital inflows).
Countries like the United States that run capital account surpluses
and current account deficits receive net foreign capital inflows.
In contrast, countries that run capital account deficits and current
account surpluses experience net foreign capital outflows.
Between 1980 and 2004, the United States ran a capital account
surplus and a current account deficit in all but three years. More
recently, net capital inflows to the United States have risen sharply
(Chart 6-1). The $668 billion in net inflows received in 2004 was
nearly $300 billion greater than the level of net inflows received
only three years earlier. As a percent of U.S. Gross Domestic Product
(GDP), net capital inflows rose from 1.5 percent in 1995 to 4.2
percent in 2000 to 5.7 percent in 2004. In 2005, U.S. net capital
inflows are likely to have exceeded 6 percent of GDP and ranged from
$700 to $800 billion in dollar terms.



Recent growth in U.S. net capital inflows has sparked debate about
the causes of these inflows. As this chapter discusses, a variety of
factors explain recent trends in U.S. capital inflows. One of these
factors is the pattern of national saving (hereafter called domestic
saving) and domestic investment in the United States and other
countries. This perspective on foreign capital flows--linking domestic
saving and investment balances--is consistent with, but somewhat
different from, analyses that explain U.S. capital inflows by focusing
narrowly and exclusively on the U.S. trade deficit. In a view that
emphasizes trade flows, U.S. net capital inflows result directly from
the excess of U.S. imports over U.S. exports. In contrast, a view that
emphasizes domestic saving and investment balances highlights a wider
range of factors within countries that can lead them to experience net
capital inflows or outflows. Key points of this chapter are:
 The size and persistence of U.S. net capital inflows
reflects a number of U.S. economic strengths (such as its
high growth rate and globally competitive economy) as well
as some shortcomings (such as its low rate of domestic
saving).
 The recent rise in U.S. net capital inflows between 2002
and 2004 in part reflects global economic conditions (such
as a large increase in crude oil prices) as well as
policies (such as China's exchange rate policy) and weak
growth in several other large economies (such as Germany)
that led to greater net capital outflows from these
countries.
 The United States is likely to remain a net foreign
capital recipient for a long time. However, the magnitude
of future U.S. net capital inflows is likely to moderate
from levels observed in recent years.
 Encouraging greater global balance of capital flows would
be helped by steps in several countries. The United States
should raise its domestic saving rate. Europe and Japan
should improve their growth performance and become more
attractive investment destinations. Greater exchange rate
flexibility in Asia, including China, and financial sector
reforms could increase the role of domestic demand in
promoting that region's future growth.
In addition, the chapter makes two broader points. First, global
capital flows--the flow of saving and investment among countries--
should be analyzed from a global perspective and not by considering
U.S. economic policies alone. Global capital flows are jointly
determined by the behavior of many countries. To understand why the
United States receives large net capital inflows requires understanding
why countries like Japan, Germany, China, and Russia experience large
net capital outflows.
A second point is the need to distinguish between market-driven and
policy-driven capital flows. For example, recent capital outflows from
Germany have largely reflected market forces and private sector
behavior. In contrast, China's recent net capital outflows largely
reflect policy decisions. In the United States, capital inflows have
reflected a combination of market forces and policy behavior.
Separating market from policy-related sources of capital flows is
important for understanding capital flow patterns and to consider how
these flows may change in the future. This chapter is structured
in five parts. The first part explains
the distinction between countries that are net capital importers
(receiving net capital inflows) and countries that are net capital
exporters (experiencing net capital outflows). One key theme is the
link that exists between saving and investment balances within
countries and capital flows among countries. The second part of the
chapter examines recent trends in global capital flows. Next, the
chapter examines four countries that were the world's largest net
capital exporters in 2004--Japan, Germany, China, and Russia--to
understand some of the factors driving their capital outflows.
The chapter then examines recent U.S. capital inflows and their
determinants. The final section discusses whether the United States
can continue receiving net capital inflows indefinitely.
Global Capital Flows--Principles
Global capital flows reflect the matching of saving and investment
opportunities in the global financial system. In any given period,
countries can be classified as net capital exporters or net capital
importers. Net capital exporters have supplies of domestic saving
(which includes households, firms, and the government) that exceed
domestic investment opportunities that are expected to be profitable.
Because of their excess saving, these countries export some portion of
their saving to other countries through net purchases of foreign
assets--stocks, bonds, loans, FDI outflows, and reserves. In contrast,
countries that are net capital importers have more domestic investment
opportunities that are expected to be profitable than they can fund
with their supply of domestic saving. These countries have excess
demand for saving and import foreign saving through net sales of
assets to foreign investors. Broadly speaking, therefore, global
capital flows reflect the interaction between countries that are net
capital importers and net capital exporters.
Stated differently, countries that are net capital exporters run
capital account deficits and current account surpluses. Conversely,
countries that are net capital importers run capital account
surpluses and current account deficits. A country's capital account
balance reflects its net sales or purchases of assets with other
countries. Its current account balance reflects its net sales or
purchases of goods and services with other countries along with net
flows of income and transfer payments. The current account and
capital account must exactly offset one another. This means the
value of a current account surplus will be mirrored by the value of
a capital account deficit, and a current account deficit will be
mirrored by a capital account surplus of equal value.
Capital
flows provide benefits to both groups of countries. For
capital exporters, net outflows allow them to earn a higher return on
their savings by investing abroad than they expect to earn by investing
in their own countries. For capital importers, drawing on foreign
savings allows domestic investment to be maintained at a higher level
than would otherwise be possible given their level of domestic saving.
Maintaining a high level of capital investment is critical for
promoting future growth.
Changes in the rate of domestic saving or
domestic investment will
cause changes in a country's capital and current account balances.
For example, a rise in domestic investment relative to saving will, all
else equal, cause the capital account surplus to rise and the current
account balance to fall. In this case, net capital inflows will
increase (or, for countries already experiencing net capital outflows,
net outflows will decrease). Conversely, an increase in domestic saving
relative to investment will cause the capital account balance to
decrease and the current account balance to increase. In that case, net
foreign capital outflows will increase (or net capital inflows will
decrease). Therefore, one way of assessing changes in current and
capital account balances is to examine changes in domestic saving and
investment rates (see Box 6-1).
______________________________________________________________________
Box 6-1: Analyzing the Current and Capital Account Balances

There are two ways to analyze the current account balance. The more
widely used perspective measures a country's imports and exports of
goods, services, net income flows, and net current transfer payments.
Net capital flows, which are recorded in the capital account, reflect
financing from foreigners needed to pay for net import purchases on
the current account. By accounting necessity, the current account and
capital account must sum to zero. Therefore, a current account deficit
will be matched by a capital account surplus of equal magnitude.
The table below shows the U.S. current and capital accounts in 2004.
The current account deficit of $668 billion was offset by an equivalent
capital account surplus (including net statistical discrepancies,
previously noted). Line items within the capital account specify the
ways that foreigners invested in the United States. The largest net
capital inflow component was portfolio investment ($763 billion in
gross inflows and $103 billion in gross outflows, equaling $660 billion
in net inflows). Because the United States has a floating exchange
rate, changes in its official reserve assets were small. For countries
with fixed exchange rates, changes in reserves are typically much
larger because reserves are bought or sold through foreign exchange
intervention that is undertaken to manage the value of their exchange
rate.

Current Account (billion dollars)

Goods                -$665
Services              +$48
Net income            +$30
Net current transfers -$81
_____
Total                -$668

Capital Account (billion dollars)

Net capital transfers           - $2
Net foreign direct investment - $145
Net portfolio investment      + $660
Net banking and other flows    + $67
Net statistical discrepancies  + $85
Net change in official reserve  + $3
assets                         ______
Total                         + $668






Source: Bureau of Economic Analysis,  International Monetary Fund,
International Financial Statistics

Another perspective on the
current account compares domestic saving
with domestic investment. When domestic investment exceeds domestic
saving, a country has excess demand for saving that is met by drawing
on other countries' saving. Foreign capital inflows may reflect
expectations by foreign investors that they will realize a higher
return by investing in other countries than they will earn by
investing in their own countries. In this case, capital inflows
broadly reflect the attractiveness of investing in one economy
relative to other economies.
The table below shows U.S. domestic
saving and domestic investment
in 2004. Because domestic investment exceeded saving, a current
account deficit and capital account surplus resulted. The total
sums to the same amount regardless of whether the current account
is looked at through trade flows or through saving and investment
flows.
U.S. Savings and Investment--2004 (billion dollars)

Gross domestic saving      +$1,572
Gross domestic investment  +$2,301
Net other flows            +   $61
_______
Total                      $   668
Source: Bureau of Economic Analysis

_____________________________________________________________________

Global Capital Flows--Recent Patterns
What is the current pattern of net capital inflows and outflows
across countries? How has this pattern changed in the past decade?
Chart 6-2 shows the United States was the largest net capital
recipient in 2004. Spain, Great Britain, Australia, and Turkey were
also net capital recipients. Japan, Germany, China, Russia, and Saudi
Arabia were the largest net capital exporters.
Between 1995 and 2004,
global saving and investment patterns changed
in a number of respects. Some of the more important changes were:
 Declining concentration among net capital exporting
countries. Falling concentration means that a wider
range of countries experienced net capital outflows.
In 1995, the world's largest net capital exporter
(Japan) accounted for 39 percent of global net capital
outflows and the five largest net capital exporters
accounted for 70 percent of net outflows. In 2000, the
largest net capital exporter accounted for 24 percent
of net outflows while the five largest net exporters
accounted for 48 percent of net outflows. In 2004, the
largest net exporter accounted for 20 percent of net
outflows while the five largest net exporters accounted
for 52 percent of net outflows.
  Rising concentration among net capital importing
countries. Rising concentration means that a smaller
number of countries received a larger



share of total net capital inflows. Most of this change
reflected higher U.S. net capital inflows. The United
States received 33 percent of global net capital
inflows in 1995, 61 percent in 2000, and 70 percent
in 2004. The five largest net capital recipients
received 57 percent of global net capital inflows
in 1995, 78 percent in 2000, and 86 percent in 2004.
  A change in net capital flow positions for
some large countries. Germany experienced the largest
change in its net capital flow position. In 1995 and 2000,
Germany received $30 billion in net capital inflows
but had $104 billion in net outflows in 2004. Saudi
Arabia also went from small net capital inflows in
1995 ($5 billion) to large net capital outflows in
2004 ($52 billion).
  A change in the regional composition of
capital flows. Developing Asian and Middle Eastern
countries also became large net capital exporters.
In 1995, developing Asian countries had net inflows
of $42 billion, but had net outflows of $93 billion
in 2004. China had $2 billion of net capital outflows
in 1995, $21 billion of net outflows in 2000, and $69
billion in net outflows in 2004. Rising crude oil
prices also caused many oil-producing countries to
become large net
capital exporters. Middle Eastern
countries had net
capital inflows of $1 billion in
1995 and $103 billion
of net
outflows in 2004.
  Net capital outflows from developing countries.
In 1995, developing and emerging market countries as a
whole received $84 billion in net capital inflows. In
2000, they experienced $91 billion in net outflows. In
2004, they experienced $367 billion in net outflows.
While these countries remained net recipients of
foreign direct investment (FDI) inflows, they became
larger net purchasers of foreign reserve assets. These
purchases, made primarily by central banks, represent
a capital outflow because domestic resources are being
invested abroad rather than within these countries.
  Rising global foreign reserve levels. The
value of global foreign reserves (held primarily by
central banks) rose from roughly $1.5 trillion to
$3.9
trillion between 1995 and 2004--a 160 percent
increase in a period when the value of global GDP
increased by roughly 40 percent. Global reserves
increased by more than $1.3 trillion in 2002-04 alone.
Three countries accounted for nearly 60 percent of this
reserve increase--Japan, China, and South Korea.

Global Capital Exporters

To understand global capital flow patterns, we can
examine in more
detail saving and investment patterns
in some of the largest capital
importers and exporters.
The world's four largest net capital
exporters in 2004
were Japan, Germany, China, and Russia. In total,these
countries exported more than $400 billion of domestic
savings to other countries through their net purchases
of foreign assets. Net capital outflows from these four
countries represented 46 percent
of outflows among all
net capital exporting countries in 2004.
While these countries exported large amounts of their
saving to other countries, they also differed in several
respects.
Recent
capital outflows from Japan and Germany, for
example, have been
associated with weak growth while
Russia and China have experienced
rapid growth. Germany's
capital outflows largely reflect private
sector,
market-driven behavior whereas China's outflows reflect
policy behavior. Japan and Germany have run fiscal deficits
while
Russia has had a fiscal surplus. Japan and Germany
have had falling
rates of domestic investment while China
has had a rising rate. What these countries have had in
common, however, were supplies of
domestic saving that
exceeded their domestic investment.
Japan--Deflation and a Falling Investment Rate  With net
capital outflows of $172 billion, Japan was the world's
largest net capital exporter in 2004. Between 1995 and 2004, Japan
was the world's largest net capital exporter every year, ``pushing''
more than $1.1 trillion in excess saving into the global financial
system.  Moreover, the level of Japan's net capital outflows
increased each year from 2001 to 2004.
Recent growth in Japan's net capital outflows has resulted
primarily from a falling domestic investment rate rather than a
higher saving rate. Between 1995 and 2004, Japan's domestic saving
rate fell from 30 percent to 28percent of GDP. During this same
period, Japan's domestic investment rate fell from 28 percent to 24
percent of GDP. This widening gap between saving and
investment--Japan's excess supply of saving--led to higher net
capital outflows and a corresponding rise in its current account
surplus. Japan's current account surplus rose from 2.1 percent of
GDP in 1995 to 2.5 percent of GDP in 2000 to 3.7 percent of GDP in
2004.
Japan's investment rate has fallen for several reasons.
A declining population and slowing growth in its labor force has
reduced Japan's
need for physical capital. Japan also arguably
suffered from a large excess of capital investment in the late 1980s.
This previous experience with overinvestment, growth in bad loans
among Japan's banks, and the slow growth Japan has experienced since
the early 1990s following the collapse of its ``bubble economy'' have
made Japanese firms more cautious about undertaking new domestic
investment. Deflationary pressures (a decline in the overall price
level) have also weakened private investment since firms are often
more reluctant to initiate new investment when future prices are
expected to fall.
The key source of Japan's rising saving-investment imbalance has
been its corporate sector. Between 1995 and 2004, Japan's corporate
sector went from being a net borrower of funds (investing more than
it saved) between 2 percent to 3 percent of GDP to a net lender of
funds (saving more than it invested) equivalent to nearly 15 percent
of GDP. During this same period, the rate of net saving in Japan's
household sector fell by roughly 70 percent (from 10 percent to about
3 percent of GDP) while Japan's public sector was a large net
borrower of funds. Therefore, rising net savings by Japanese firms
explain much of the recent growth in Japan's net capital outflows.
After a long period of slow growth, Japan's economy showed some
signs of improvement in 2005. Financial ratios among firms improved,
and growth prospects appeared to improve. Japan's central bank
forecast that deflation is likely to end in 2006. Business
confidence strengthened and commercial bank lending began to
resume. Japan's labor market also showed some signs of strength.
The re-election of Prime Minister Koizumi strengthened prospects
for future economic reform. To the extent Japan can achieve sustained
growth, its future net capital outflows are likely to slow. Stronger
growth in Japan will encourage a larger share of its savings to
remain at home rather than being invested abroad.Germany--Structural
Rigidities and a Falling Investment Rate
With $103 billion in net capital outflows, Germany was the world's
second largest net capital exporter in 2004. Between 1990 and 2000,
Germany received total net foreign capital inflows of $175 billion.
Between 2001 and 2004, in contrast, Germany experienced net capital
outflows of more than $200 billion. Germany's rising net capital
outflows have been mirrored by its rising current account surpluses.
Between 2001 and 2004, Germany's current account surplus rose from
0.2 percent to 3.8 percent of GDP.
Like Japan, Germany's rising saving surpluses and net capital
outflows have stemmed from a falling rate of domestic investment
rather than a rising rate of domestic saving. At 21 percent of GDP,
Germany's saving rate has been broadly stable over most of the past
decade (though it did rise from 2003 to 2004).  Domestic investment
during this period, however, fell from 22 percent to 17 percent of
GDP--the second lowest investment rate among G8 countries
(the world's most advanced economies).
Why has Germany's investment rate declined? One factor has been
structural rigidities in its economy that have slowed Germany's rate
of growth and opportunities for profitable investment. These
rigidities result in part from legal and microeconomic barriers that
limit economic flexibility.  Inflexibility can prolong periods of
slow growth because an economy is less able to adjust effectively to
changing conditions in its labor and product markets and achieve full
levels of employment. According to the Organization for Economic
Cooperation and Development (OECD), barriers to new business
formation and investment are higher in Germany than the OECD average.
A World Bank ``employment rigidity index'' scored Germany's labor
market at 55 (scaled from 0-100, with higher scores implying greater
rigidity) compared to 17 for Australia, 14 for Great Britain, and 3
for the United States. Germany's standardized unemployment
rate is high (9.5 percent in 2005) and its long-term unemployment
rate (measuring workers unemployed for a year or more) was more than
50 percent higher in 2004 than the average OECD rate.
Germany has taken some recent steps to reduce unemployment and
accelerate its growth. Laws limiting temporary and part-time work
have been relaxed.  Passage of ``Hartz IV'' labor reforms in 2004
was aimed at reducing long-term unemployment by requiring unemployed
workers to seek work more actively. Unit labor costs, which are one
widely used indicator of competitiveness, have recently fallen
relative to several other European countries. It is also hoped that
Germany's new government, which took office in November 2005, may
strengthen other growth incentives. Like Japan, stronger growth in
Germany will encourage a larger share of its domestic savings to be
used at home rather than invested abroad.China--Exchange Rate
Management and a Rising Saving Rate  With $69 billion in net
outflows, China was the world's third largest net capital
exporter in 2004. China's role as a net capital exporter may
seem surprising given the large foreign investment
inflows it experiences. While China does receive substantial foreign
investment, it experiences even larger capital outflows due to
foreign reserve accumulation by its central bank that results from
its foreign exchange regime. As China's reserves have risen in recent
years, its capital account balance has moved toward larger deficits
and its current account toward larger surpluses. In 2004, China's
current account surplus was equivalent to 4 percent of GDP (note
that in December 2005, China increased the estimate of its 2004 GDP,
which is likely to reduce the size of this current account surplus
relative to GDP). Current projections indicate China's current
account surplus is likely to have exceeded 6 percent of GDP in 2005.
China's reserves have increased due to its rising current account
surpluses, net private capital inflows, and tightly managed pegged
exchange rate system. China first adopted its currency peg in 1994,
linking its currency (the renminbi) to the U.S. dollar at a rate of
8.3 renminbi-per-dollar. To maintain this peg, China's central bank
has purchased large amounts of foreign currency assets in recent
years to prevent its currency from appreciating. Even after
modifying its exchange rate peg in July of 2005, however, (linking
the renminbi to a basket of currencies rather than the U.S. dollar
alone) China's foreign reserves have continued to rise. By the end
of 2005, China's foreign reserve level exceeded $800 billion and
may rise to $900-$1000 billion by the end of 2006. Between 2000
and 2005, China's foreign reserves increased by more than $600
billion.
In terms of its saving and investment balance, China's net capital
outflows  have resulted primarily from a rising saving rate. While
China's rate of domestic investment has also been rising (projected
46 percent of GDP in 2005 prior to its GDP revision), its saving rate
has risen even more rapidly. At roughly 52 percent of GDP, China's
saving rate is the highest in the world.
Several factors contribute to China's high saving rate.
China's ``one child'' policy, enacted to control its population growth, has contributed to its aging
population by reducing the share of younger groups within its
population. Because older workers typically earn and save more than
younger workers, China's saving rate has increased as its workforce
has aged. The absence of a strong social safety net (including
adequate public pensions and health care) increases the need for
precautionary household saving. The absence of well-developed
financial markets and consumer credit mechanisms contribute to high
saving by forcing many people in China to save large amounts of cash
before making purchases rather than by taking consumer loans that
can be repaid gradually. China's tightly managed exchange rate and
foreign exchange intervention to limit currency appreciation also
contribute indirectly to its high saving rate. Saving is encouraged,
in effect, because consumption is discouraged by China's exchange
rate policy. With a stronger currency, the global purchasing power
of China's currency would rise, raising its income (in global terms)
and consumption share, and thus reducing its rate of domestic saving.
Greater exchange rate flexibility would encourage China's
productive resources to move toward domestic rather than export
production. Greater financial development would help to raise
consumption spending (and reduce saving) by providing credit
mechanisms for purchases that are currently paid for with cash. A
reduction in China's saving rate and greater reliance on domestic
demand are essential for China to sustain its future growth. At
roughly 45 percent of its GDP, China's domestic investment rate
could create future risks for its economy (see Box 6-2).

Russia--Growth in ``Petrodollars'' and a Rising Saving Rate
With $60 billion in net outflows, Russia was the world's fourth
largest capital exporter in 2004. Russia's net capital exports have
been closely linked to higher export revenues resulting from rising
oil and natural gas prices. Oil export revenues are sometimes
referred to as ``petrodollars.'' With oil sales accounting for over
40 percent of its exports, Russia's export revenues rose by more
than 50 percent between 2002 and 2004 ($107 billion to $183 billion)
while its current account surplus rose to more than 10 percent
of GDP.
In terms of its domestic saving and investment balance, Russia's
growing net capital outflows have resulted primarily from higher
saving. Between 2002 and 2004, domestic saving rose from 29 percent
to 31 percent of GDP. A higher saving rate has been reflected by
rising fiscal surpluses. Between 2002 and 2004, Russia's fiscal
surplus rose from 1 to 5 percent of GDP while its rate of net
private sector saving declined from 8 to 5 percent of GDP.
Large petrodollar increases have also occurred in other oil
producers. Chart 6-3 shows current account surplus levels among 12
of the world's largest oil exporters, whose combined current account
surplus and net capital outflows rose by 134 percent between 2002 and
2004.
The United States and Net Capital Inflows
Overview
The United States received $668 billion in net foreign capital
inflows in 2004 (including $85 billion in net statistical
discrepancies recorded in its capital account). This capital account
surplus was the counterpart to the U.S. current account deficit. This
section examines four questions about the U.S.

____________________________________________________________________

Box 6-2: High Saving and Financial Sector Inefficiency

Can a country save too much? While a higher saving level might
always seem beneficial, higher saving can create costs if those
savings are poorly used.  Excess saving can sometimes lead to
overinvestment that reduces the quality and efficiency of new
capital investment and can sometimes create problems in a
country's banking system by increasing the share of non-performing
loans (NPLs).
An NPL is a loan that cannot be fully repaid by a borrower. Higher
NPL ratios imply that investment spending may be inefficient because
loans are not being fully repaid. High NPLs can create a number of
problems. One problem is that banks often become more cautious about
new lending as NPL ratios rise.  New loans are unlikely to be approved
if previous loans are not being repaid. Slower bank lending, in turn,
can slow economic growth more broadly.
Another more direct problem can result when NPL ratios become so
high that banks themselves face bankruptcy due to widespread loan
defaults and falling bank capital adequacy ratios. In this case,
governments must sometimes recapitalize weak banks or pay off insured
depositors of banks they close.  The cost of closing U.S. savings and
loan institutions that failed in the 1980s was $150 billion, or
roughly 3 percent of GDP. In Chile, bank failures in the early 1980s
cost more than 40 percent of GDP. Spain paid costs equivalent to
nearly 20 percent of its GDP following a banking crisis in the late
1970s and early 1980s.
High saving rates can increase NPLs by encouraging banks to take
imprudent risks.  For example, lending standards may be reduced.
Loans for weak borrowers that otherwise lack creditworthiness are
more likely to be approved when saving is high and interest rates
are low. If interest rates later rise, however, borrowers whose
rates rise may not repay their loans, causing NPL ratios to rise.
If in contrast interest rates that borrowers pay remain fixed,
then banks can again suffer losses because they must pay higher
rates to their depositors but cannot charge higher interest rates
on loans to their current borrowers.
Japan arguably experienced a large capital overhang in the 1990s
after a long
period of high saving and investment as well as the emergence of its
"bubble economy" in the late 1980s. Average saving and investment
rates in Japan were roughly 35 percent of GDP in the 1970s and 30
percent of GDP in the 1980s. China, however, likely has even higher
saving rates. Not surprisingly, China's NPL ratio is also believed
to be high. While China's official statistics report NPLs are
roughly 10 percent of outstanding loans, unofficial estimates
suggest China's NPL ratio may be closer to 25 percent (by comparison,
NPLs among U.S. banks are less than 1 percent).
_____________________________________________________________________








capital account: (1) How do U.S. capital inflows compare with other
countries? (2) Has the U.S. share of global capital inflows changed?
(3) Has the composition of U.S. capital inflows changed? (4) What
factors encourage foreign capital flows into the United States?
Most of this section focuses on the final question. One
conclusion is that a high rate of growth relative to many other
advanced economies has contributed to U.S. net capital inflows.
Among advanced economies, capital flow patterns in the past decade
have tended to be positively correlated with growth performance.
Countries with higher rates of growth have tended to run current
account deficits (and received net capital inflows), while countries
with lower growth rates have tended to run current account surpluses
(and experience net capital outflows--Chart 6-4).

Net Capital Importers--International Comparisons
Since 1995, three countries have been consistent recipients of
net capital inflows--the United States, Australia, and Great
Britain. Average annual net capital flows to Australia have been
largest (4.6 percent of GDP), second largest for the United States
(3.3 percent of GDP), and third largest for Great Britain (1.6
percent of GDP). Spain also received average annual net capital
inflows (2.5 percent of GDP) during this period. Australia has
the longest




record of capital account surpluses (and current account deficits),
receiving net foreign capital inflows every year since 1974.
Between 2001 and 2004, net capital inflows increased for most of
these countries.  Spain's net inflows rose by 1.4 percent of GDP
(to 5.3 percent of GDP). U.S. inflows rose by 1.9 percent of GDP
(to 5.7 percent of GDP). Australia experienced the largest
increase, where net inflows rose by 4.1 percent of GDP (to
6.4 percent of GDP). Net inflows to Great Britain slowed
slightly (to 2.0 percent of GDP).

U.S. Share of Global Flows and the Asset Composition
of U.S. Capital Inflows
The U.S. share of net global capital inflows has
risen over the past decade. The United States received 33 percent
of global net capital inflows in 1995, 62 percent in 2000, and
70 percent in 2004. The composition of net foreign capital inflows
to the United States has varied. Between 1995 and 2004, foreign
official sector holdings of U.S. assets averaged 14 percent of
foreign asset holdings (ranging from a high of 16 percent to a
low of 11 percent). Gross foreign direct investment (FDI) inflows
to the United States, representing larger foreign equity purchases,
averaged 26 percent of foreign holdings in this period
(ranging from a high of 33 percent to a low of 22 percent).
Foreign holdings of U.S. Treasury securities averaged 15 percent
of foreign holdings (ranging from a high of 21 percent to a low
of 11 percent).

Causes of U.S. Capital Inflows
What factors encourage large and persistent U.S. foreign capital
inflows? Several factors, which reflect U.S. economic strengths,
encourage these inflows. In particular, a high rate of U.S. growth
encourages foreign capital to be ``pushed'' toward the United
States. In contrast, one U.S. shortcoming that ``pulls'' foreign
capital to the United States is its low rate of domestic saving.

Low and Declining U.S. Saving
At 13 percent of GDP, the U.S. domestic saving rate is the lowest
among the advanced economy countries (Chart 6-5). Moreover, the
U.S. domestic saving rate has declined in recent years. With a
domestic investment rate equivalent to 20 percent of GDP, low U.S.
saving requires the United States to draw on foreign saving to fund
a part of its domestic investment. This excess U.S. demand for
saving is reflected by the U.S. current account deficit.




When we disaggregate the decline in U.S. domestic saving into its
three parts--personal saving, corporate saving, and public
saving--we see the personal saving rate has declined from 3.4
percent of GDP in 1995 to 1.3 percent of GDP in 2004 (for more
discussion, see Chapter3 in this report on Saving for Retirement).
This decline in personal saving is mirrored by a rise in personal
consumption spending, whose share of GDP has risen from 67 percent
to 70 percent of U.S. GDP. U.S. corporate saving has remained
relatively stable at between 18
and 19 percent of GDP.
Public sector saving also declined. Between 2000 and 2004, the
federal budget balance went from a surplus
equivalent to 2.4 percent
of GDP to a deficit equivalent to 3.6 percent of GDP. Fiscal deficits
represent dissaving, or net
borrowing, which requires the public
sector to draw on domestic
private sector resources (firms and
households) and the foreign sector. While a growing fiscal deficit
has contributed to U.S. demand for foreign saving, and thus affected
the U.S. current account deficit, the extent to which it has done so
is unclear (Box 6-3).
_____________________________________________________________________
Box 6-3: The Link Between Fiscal and Trade Deficits

Most economists agree that fiscal deficits will, all else equal,
lead to an increase in a country's trade and current account
deficits.  Fiscal deficits are a form of "dissaving," so fiscal
deficits reduce the availability of domestic saving to fund
investment.  Unless this decline is matched by an equal decline in
domestic investment, net demand for foreign saving will rise. Fiscal
deficits will thus cause net capital inflows to increase.
However, the effect of fiscal deficits on trade and current account
deficits may be considerably less than dollar-for-dollar. For example,
one study by the Federal Reserve has estimated that each dollar
change in the fiscal deficit leads to a change in the trade deficit
of approximately 20 percent. This means that reducing the U.S. fiscal
deficit by $100 billion would reduce the trade deficit by only $20
billion.
The relationship among fiscal deficits, the current account, and the
capital account is complex because the current and capital accounts
also depend on private sector behavior. In Japan and Germany, for
example, recent current account surpluses and capital outflows have
been associated with large fiscal deficits because private saving
balances in those countries have been large and outweighed public
sector dissaving.
As the chart below indicates, U.S. fiscal and current account
balances have sometimes moved in the same direction and other times
in different directions. For example, between 1997 and 2000 the U.S.
Federal public sector balance moved from a deficit of 0.3 percent
of GDP to a surplus of 2.4 percent of GDP. During this same period,
the current account deficit widened from 1.7 percent to 4.2 percent
of GDP. In the early 1980s and early 1990s, the United States came
close to current account balance even though the public sector ran
arge fiscal deficits because a large private sector saving surplus
existed then.



______________________________________________________________________



High U.S. Economic and Productivity Growth
Other factors that attract foreign capital inflows to the United
States reflect strengths of the U.S. economy. One factor is the
high rate of U.S. growth. Between 1995 and 2004, annual real GDP
growth in
the United States averaged 3.2 percent compared to 1.1
percent in Japan, 1.4 percent in Germany, and 2.3 percent among
Eurozone economies (the group of 12 European countries with a common
currency).  In the most recent years within this period, these growth
differentials widened further.
Higher growth tends to attract foreign capital for two reasons.
First, higher growth leads to a higher rate of import growth. All
else equal, higher import growth will lead to a decline in a
country's trade balance and increase its demand for foreign saving.
Second, higher growth attracts foreign capital inflows because growth
contributes to higher potential corporate earnings and investment
returns.

High Productivity Growth  High
U.S. growth and capital inflows are supported by high
productivity growth. The broadest measure of productivity is
multi-factor productivity (which broadly measures the efficiency with
which capital and labor inputs are used). OECD data comparing
multi-factor productivity across countries for the period 1995-2003
indicate that the United States and Australia had relatively high
rates of productivity growth, Canada, Great Britain, and Germany had
more modest rates of growth, while Japan had a low rate of
productivity growth.

Favorable U.S. Business Climate and Global Competitiveness

A sound business climate can also support high growth and foreign
capital inflows.  A sound business climate can enhance efficiency
by strengthening competition. It can reinforce profit maximizing
incentives and effective corporate governance. A sound business
climate can also encourage entrepreneurship by reducing the
administrative burdens of new business formation. It can enhance
the flexibility of industries through laws that facilitate rapid
restructuring or liquidation of bankrupt firms. In addition, it can
promote efficiency and specialization by reducing international
trade barriers.
Several organizations compare business climates across countries.
The World Bank publishes an annual ``Doing Business'' survey that
compares legal frameworks and business practices.  Countries are
ranked in part by an ``ease of doing business index.'' Results from
the World Bank's most recent survey ranked New Zealand 1st, the
United States 3rd, Australia 6th, Great Britain 9th, Japan 10th,
Germany 19th, Spain 30th, Russia 79th, and China 91st. Another
competitiveness survey is published by the World Economic Forum
(WEF). In the WEF's most recent survey, the United States ranked
second in overall competitiveness (Finland was first).  The report
ranked Japan 12th, Great Britain 13th, Germany 15th, China 49th,
and Russia 75th.
Financial Market Size
The size of U.S. financial markets also attracts foreign capital
by encouraging investors to hold dollar-denominated assets. Large
and efficient financial markets reduce transaction costs and
liquidity risk (the risk that assets cannot be sold at fair value
on short notice) and increase the ability to diversify asset
holdings. In 2004, U.S. financial markets comprised 32 percent
of global financial markets compared to 26 percent for
Eurozone countries and 15 percent for Japan. U.S. stock market
capitalization represented 44 percent of global equity markets
compared to 16 percent for Eurozone countries. U.S. bond markets
represented 39 percent of global bond markets compared to 27
percent for Eurozone countries.

Global Role of the U.S. Dollar
Widespread use of the dollar in the global economy also contributes
to U.S. capital inflows.  The dollar's role can be seen in terms of
the three classic functions of money. First, the dollar serves as a
medium of exchange. Private firms in different countries use dollars
to settle transactions. Second, the dollar serves as a unit of
account. Globally traded goods like oil are denominated in dollars.
Many global debt securities are also dollar-denominated.  A number
of countries also use the dollar either as their own currency or as
an exchange rate peg to which their own currencies are tied. Third,
the dollar is a store of value. Private firms hold dollars to help
hedge financial risks. Central banks hold dollars as reserves to
intervene in foreign exchange markets, meet foreign currency demand
for debt servicing payments, or help maintain general financial
confidence.
In recent years, the dollar's future role as a global
reserve currency has been debated.  Some have argued this role
may diminish. One argument is that the dollar will face competition
from the euro.However, recent estimates indicate the dollar's role
as a reserve currency has been broadly stable over the past decade.
In 1995, 59 percent of global reserve holdings consisted of
dollar-denominated assets. In 1999, this figure rose to 71 percent
and then declined to 66 percent in 2004.

U.S. Capital Flow Sustainability
In principle, the United States can continue to receive net capital
inflows (and run current account deficits) indefinitely provided it
uses these inflows in ways that promote its future growth and help
the United States to remain an attractive destination for foreign
investment. The key issue concerning U.S. foreign capital inflows
is not their absolute level but the efficiency with which they are
used. Provided capital inflows promote strong U.S. investment,
productivity, and growth, they provide important benefits to the
United States as well as to countries that are investing in the
United States.
To evaluate the sustainability of these inflows, economists often
evaluate a country's external debt burden. This debt burden can be
seen in terms of a stock and a flow burden.  One stock measure that
is sometimes examined is a country's net foreign asset position.
Net foreign assets measure the value of a country's foreign assets
relative to the liabilities it owes to foreigners. When foreign
assets exceed liabilities, a country is a net foreign creditor. When
foreign liabilities exceed foreign assets, it is a net foreign
debtor. Net capital inflows contribute to net foreign debt because
some share of these inflows reflect foreign purchases of debt
instruments. A rising level of net foreign debt may be a warning sign
that debt could become unsustainable in the future.
U.S. current account deficits in recent years have caused its level
of net foreign debt to rise from negative 4 percent of GDP in 1995 to
negative 22 percent in 2004. Other countries vary in their net
foreign asset or debt positions. For example, Japan is a net foreign
creditor (foreign assets exceeding foreign liabilities) with net
foreign assets equivalent to 38 percent of its GDP. In contrast,
Australia is a net debtor with net foreign debt equivalent to 64
percent of its GDP. Great Britain's net foreign debt is equivalent
to 13 percent of its GDP. While net foreign debt or asset positions
can be a useful indicator, however, these figures must be interpreted
cautiously since what constitutes an ``excessive'' amount of net
foreign debt is far from clear.
One flow measure of the external debt burden is a country's net
foreign income. Countries either receive or pay foreign income
depending on their foreign asset and liability levels as well as
the rate of return they earn and pay on these assets and liabilities.
When a country receives more in interest, dividends, profit
remittances, and royalties on its foreign assets than it pays on its
foreign liabilities, it is a net foreign income recipient. When
payments exceed receipts, a country makes net foreign income
payments.
One striking feature of the U.S. balance of payments accounts is
that the United States has continued to earn net foreign income
despite its rising level of net foreign debt. For example, the United
States earned $30 billion in net foreign income in 2004 despite a
stock of net foreign debt equivalent to $2.5 trillion. By comparison,
Japan received $86 billion in net foreign income payments in 2004
despite the fact that it held $1.8 trillion in net foreign assets.
Between 1995 and 2004, the United States earned over $200 billion
in net foreign income despite current account deficits that totaled
more than $3 trillion during this period.  Therefore, U.S. external
debt has not appeared burdensome by this measure because its net
foreign income flows have remained positive.
While U.S. capital inflows can continue indefinitely, recent
levels of net inflows received are likely to moderate in the future.
At more than 6 percent of GDP, U.S. net capital inflows are
unusually high by historical standards. While no specific ``critical
value'' exists beyond which a country can no longer necessarily
receive net foreign capital inflows, recent growth in U.S. net
inflows has attracted substantial attention. The key questions
concern the rate and magnitude by which U.S. net inflows moderate
in the future. In one scenario, U.S. net capital inflows might
drop quickly. In another ``soft landing'' scenario, the adjustment
process would occur in a more gradual manner. While a large share of
U.S. net capital inflows reflects foreign private sector
investment that believes a higher risk-adjusted return can be earned
by investing in the United States than can be earned by investing
elsewhere, some policy adjustments (see below) in the
United States and abroad could nonetheless help to increase the
likelihood of a soft landing.

Conclusion
This chapter has emphasized the interdependent nature of the
global financial system. To understand U.S. net capital inflows,
one must also understand factors that underlie net capital
outflows from countries like Japan, Germany, China, and oil-producing
and exporting countries like Russia. Global capital flows reflect a
wide array of conditions in many countries rather than developments
in the United States alone. In some instances, global capital flows
reflect expectations among market participants who invest in
countries where they expect to earn the highest level of
risk-adjusted returns. In other instances, capital flows reflect
policy decisions by central banks to manage their exchange rates.
In both instances, global capital flows provide important benefits
for net capital importers as well as net capital exporters. Net
capital importers like the United States benefit because they
can maintain a level of domestic investment they would otherwise have
to reduce given their levels of domestic saving. Net capital
exporters benefit because they can earn higher returns on the saving
they invest abroad than they expect to earn by investing in their own
countries.
The interdependence of the global financial system
implies that no one country can reduce its external imbalance through
policy action on its own. Instead, reducing external imbalances
requires action by several countries. Specifically, at least four
steps may help to reduce these imbalances.
First, the United States must work to raise its domestic saving
rate. Higher U.S. saving will reduce U.S. demand for other countries'
savings. To increase saving, the United States should continue its
efforts to reduce its fiscal deficit and raise its personal saving
rate. Sections of the U.S. tax code that discourage saving should be
reformed as appropriate. Health care, social security, and other
entitlement programs will require reforms given their large projected
impact on future public spending.
Second, China and other Asian countries should reduce their excess
saving through policies and reforms that promote higher domestic
demand. Financial systems can be reformed and modernized to help
expand consumer credit and reduce the need for high levels of
precautionary saving.  Managed exchange rate regimes should be
liberalized more fully. Greater exchange rate flexibility would
provide China with a useful policy tool to help stabilize its
business cycle.  It would also help China to reorient its future
growth away from net exports and toward higher domestic demand.
Third, Japan, Germany, and several other large countries should
reduce their supplies of excess saving by promoting higher private
domestic demand and improving their economic growth performance.
Raising private domestic demand will require the implementation of
further structural reforms in these countries that strengthen
incentives for private consumption and private investment. In turn,
higher consumption and investment will help to reduce their external
surpluses. While structural reforms are often politically difficult
to enact, they are essential if long-term growth performance in these
countries is to improve.
Finally, oil producing and exporting countries could increase their
domestic investment levels. At least some of this spending could be
used to expand oil sector production that would reduce excess
saving in these countries, enhance the future productive capacity of
these economies, and help to ensure adequate future supplies of oil
for the global economy.