Foreign Relations of the United States, 1969–1976, Volume III, Foreign Economic Policy; International Monetary Policy, 1969–1972

15. Memorandum From Secretary of the Treasury Kennedy to President Nixon¹

Washington, April 1, 1969.

SUBJECT

• Relaxation of Balance-of-Payments Controls

It is important that this Administration signal at an early date and in a concrete way its intention to reverse the trend toward controls and restrictions on international payments. To that end, we propose a limited but significant relaxation of the present controls on capital movements. This recommendation is being made following a series of consultations just undertaken in Western Europe by my Under Secretary for Monetary Affairs, Paul Volcker. The reactions he received ranged from unenthusiastic to cautionary.² It was particularly pointed out that these proposed steps will not make things any easier on an early and sizeable activation of the Special Drawing Rights. This reaction was anticipated, and emphasizes the necessity in European eyes for accompanying relaxation of controls with evidence of restrictive monetary and fiscal policies. European reservations are not, however, a compelling reason for delay.

I am joined in this recommendation by Secretary Rogers, Secretary Stans, Chairman Martin, Chairman McCracken, and Director Mayo.

In making this recommendation, we are running a risk in terms both of weakening our balance-of-payments position this year and of adverse reactions abroad. In particular, we are proposing this relaxation in face of staff projections of a substantial balance-of-payments deficit in 1969 on the liquidity basis and the absence of evidence that the deterioration in our trade accounts has yet been reversed. In fact, a February trade deficit has just been announced.

The more widely used definition of our balance of payments, the so-called liquidity measure, showed a small surplus of $158 million in 1968. However, this surplus was achieved only by virtue of an unprecedented inflow of private capital stimulated by controls, tight money, and the attraction of our stock market. In addition, there was an element of “statistical window-dressing” (mainly foreign governments’ buying medium-term securities at our behest rather than investing in short-term Treasury bills and time deposits). The less familiar official settlements measure (not ordinarily affected by our “window-dressing”) showed a substantial surplus of $1,600 million.

The first quarter of 1969 will show a very large deficit on the familiar liquidity basis. The official settlements measure, on the other hand, will show a surplus—still reflecting our tight monetary policy.

Attachment A³ tells the story for 1968, and shows the 1969 forecast of a further deficit of around $3 billion on the liquidity measure. The official settlements outcome is more difficult to forecast but it is not likely to be so bad. While balance-of-payments forecasts have particularly wide margins of error, there is good reason to believe that deterioration in the capital accounts will more than offset an anticipated gradual increase in the trade surplus later this year.

These projections make no allowance for the relaxations we are proposing. Potentially, these relaxations could add almost $1 billion to the deficit. However, we would expect the net cost to be considerably less—perhaps no more than $500 to $600 million—if money remains tight in the U.S.

Aggravation of the already difficult balance-of-payments problem carries important economic and political risks. The result could be to intensify pressures for maintenance of restrictive monetary policies to protect the balance of payments, even if that would be less appropriate than at present in terms of the domestic economy.

A further danger is psychological. Some financial officials abroad view the action as premature, and may reduce their willingness to cooperate with the U.S. in other areas. In particular, it will make more difficult our objective of obtaining an early activation, in appropriate size, of SDR’s. Moreover, we must guard against any lessening of the sense of urgency in the U.S. about dealing with the balance-of-payments problem, including efforts to economize on net government spending abroad.

On balance, we think these risks are acceptable. The main advantage is to indicate, early in your Administration, a firm intent to reject “creeping restrictionism” as an answer to our problems; also to demonstrate that the philosophy of achieving solutions consistent with market forces should carry over into the trade area.

The potential losses entailed, while significant, may not themselves be the critical margin in the viability of the present monetary system. Properly presented, the moves proposed should suggest confidence and prudence, rather than a willingness to throw caution to the winds.

To maximize the benefits with minimal risk, it is essential that this relaxation be accompanied by an expression of your broad balance-of-payments strategy and objectives. Therefore, we propose an announcement along the lines of Attachment B.⁴

This announcement would express your determination to create over time a viable balance-of-payments picture without a mass of controls, reversing the restrictionist trend of the past. But it would also highlight the actions you are taking to strengthen our economy and the dollar, to develop an effective export program, and to work toward monetary reforms.

The question of whether this action now implies that a second installment, and maybe a third installment, is due at a predictable time in the future is one upon which we believe judgment should be reserved. Developments in our domestic economy later on this year, for example, may raise a serious risk of a substantial capital outflow if our Interest Equalization Tax is down too low. We would contemplate that the Interest Equalization Tax could be utilized in a flexible manner in the future. However, any relaxation in the Commerce or Federal Reserve programs should be considered as a decision that would be very difficult to reverse in the future.

A. The Direct Investment Program

A modest relaxation of the mandatory Direct Investment Program can be undertaken and we concur in the proposal of Secretary Stans which would involve raising the ceiling $400 million to $3.35 billion.

Two key features are part of this proposal:

(a) Raise the minimum investment allowable for each company from $300,000 to $1 million

• —recommended by industry
• —substantially eases administrative burden
• —substantially reduces number of companies involved in detailed reporting by about 60%
• —helps LDCs as well as other areas.

(b) Raise the alternative earnings base from 20 to 30 percent (giving the companies a more meaningful option in selecting a reference base)

• —strongly recommended by industry
• —introduces more “equity” in the arbitrary base period
• —assists foreign debt servicing through retained foreign earnings.

It is important to note that OFDI’s chance of not exceeding the $3.35 billion ceiling rests on the companies’ carrying forward about $2 billion of unused investment quotas from 1969 to 1970. There is a good chance of this happening only if present tight U.S. monetary policy is continued.

Some thought has been given to raising the ceiling $600 million, rather than $400 million. This would be done by raising the alternative base percentage from 20 to 35 percent. However, this would only benefit about 25 additional companies, and $200 million seems to be too expensive for such a small return.

Beyond this immediate announcement, we are studying additional ways to simplify the Commerce program.

B. The Federal Reserve Program

Chairman Martin advises that the Board of Governors recommends that the Federal Reserve guidelines for restraints on credits to foreigners be modified to reduce the inequities in the position of many of the smaller banks and to give some additional room for export financing. First, the Board would increase the ceiling for bank lending to foreigners by about $400 million. The room for expanding such lending would actually be about double that amount since banks are presently about a half billion dollars below the aggregate ceilings. Virtually all of the increase would be available to the small banks. Second, the Board would also lift the limit on loans by non-bank financial institutions, such as insurance companies, by about $40 million. Banks and non-bank financial institutions would be asked to continue to give top priority to credits to finance U.S. exports.

The Board believes the proposed increase in lending limits takes account of the Commerce direct investment controls, to which the credit restraints are closely related, and would, in fact, lead to no more than a modest outflow of bank credits this year, under prevailing monetary conditions.

C. The Interest Equalization Tax

Reduction of the IET rate by 1/2 percent from its present 1-1/4 percent to 3/4 percent could be undertaken now without risk of a substantial outflow. A smaller reduction would carry the risk of being termed “tokenism.” A larger cut would run counter to the philosophy of gradualism, which must be employed in phasing out these controls, and would sharply increase the risk of an accelerated outflow of United States funds to acquire issues previously placed abroad by American corporations. If this occurred, the IET rate would need to be raised again quickly, and this would reflect on our judgment in reducing the rate too far in the first instance.

The IET expires in July and responsible business groups concur that the legislation should be extended. It is important that we have this tax authority available (with the option of increasing the rate) for the time when our domestic situation might call for an easing of monetary policy. The IET also serves to reinforce both the Commerce and the Federal Reserve programs.

Recommendations:⁵

(1) That you approve the $400 million ceiling increase in the Direct Investment Program.

(2) That you approve lowering the IET 1/2 percent, down to 3/4 percent.

(3) That we seek an extension of the IET, past its July expiry. Particulars of the extension can be considered in the near future.

(4) This announcement should be made on Friday, April 4. It would be desirable for market reasons, if the announcement could occur after the Stock Exchange closes at 2 p.m.

(5) That the announcement of the relaxation be part of a balance-of-payments strategy message.

(6) That the message take the form and strategy of Attachment B (draft message).

David M. Kennedy

1. Source: Washington National Records Center, Department of the Treasury, Office of the Assistant Secretary for International Affairs: FRC 56 76 108, Studies and Reports, Volume 7, 2/68-11/69. Confidential. An earlier draft of the memorandum had been discussed at a meeting on March 11; see Document 8.
2. See Document 14.
3. Not printed. Attachment A gives the balance-of-payments result for 1968 and the projection for 1969. The projection for the liquidity deficit in 1969 was $3 billion compared to an actual deficit of $1.1 billion in 1968.
4. Not found. Attached is the actual statement as released on April 4; see footnote 5, Document 16. An attached April 10 memorandum to the files by Philip P. Schaffner, Director of the Office of Balance of Payments Programs, Operations and Statistics, indicates that the April 4 text was drafted in the White House “using Treasury’s draft.”
5. There is no indication of President Nixon’s approval or disapproval of the recommendations. See also Document 16.