6. Volcker Group Paper1



Question: What steps toward relaxation of the control programs might be taken and what might this cost?

I. Balance of Payments: Position and Outlook

1969 balance-of-payments projections present a bleak picture. The anticipated gain in the trade balance and the current account in general is more than offset by an anticipated reduction in foreign private capital inflow.

The trade projection assumes continuation of the 10% surtax and of current monetary policy; a GNP growth (current dollars) of 7.1% as compared with 9% last year; and less pressure on productive capacity.

The projected growth of total imports from 1968 to 1969 is only 5.2% (at mid-point of range). But, excluding autos and parts imports from Canada, exceptional food imports in 1968, and strike-induced imports in 1968, the growth is projected at about 8%.

The export projection assumes an 8% increase in industrial production in other advanced countries, compared with an 8.8% increase last year. The projected growth of total exports from 1968 to 1969 is 9.3% (at mid-point of range). But, excluding autos and parts exports to Canada, commercial aircraft, and agricultural products, it is 11.9%.

The capital projections assume no change in the IET, or in the Commerce and Federal Reserve programs beyond the changes already announced.

Finally, no substantial change in expenditures in connection with the Vietnam conflict is assumed.

1969 Projected Over-All Balance of Payments

The major items projected for 1969 by an interagency working group are shown in the following table. Most of the 1968 figures are still estimates.

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1968 (est.) (bils. of $’s) 1969 (proj.) Improve or Deterioration (-)
Exports 33.4 35.7-37.3
Imports 33.3 34.5-35.5
(a) Trade balance (at mid-point of 1969 range) 0.1 1.5 1.4
(b)Services bal. (incl. private remittances and govt. pensions) 0.8 1.1 0.3
of which
(Direct investment income, fees & royalties) (6.3) (7.0)
(c) Current account bal. (a) + (b) 0.9 2.6 1.7
(d) Direct investment (before deduction for funds borrowed abroad) -3.3 -3.6 -0.3
(use of funds bor. abroad) (2.2) (1.5) (-0.7)
(Net) (-1.1) (-2.1) (-1.0)
(e) Bank claims 0.3 -0.3
(f) Other private U.S. capital -1.7 -1.2 0.5
(g) U.S. Gov’t. capital (incl. economic grants) -4.3 -4.2 0.1
(h) Foreign private capital inflow:
Direct investment in U.S. 0.4 0.2 -0.2
Loans to finance U.S. direct invest. abroad 3.1 1.3 -1.8
Stock purchases (excl. $210 mil. Shell pur. in U.S. sub) 1.7 1.0 -0.7
(i) Errors and omissions* 0.1 -0.1
Subtotal -2.8 -3.9 -1.1
(j) Receipts from Foreign Gov’ts: (or internat’l. instit., other than IMF) 2.9 not est. for last two items.
Military advance payments(- means run-off). (-0.1) (-) (0.1)
Purchases of U.S. agency bonds by internat’l. instit. (0.1) (-) (-0.1)
Debt prepayments (0.3) (-) (-0.3)
German pur. of special Treasury issues, incl. $125 mil. by German commercial banks in 1968 (0.6) (0.5) (-0.1)
Other Gov’t. purchases of special Treas. issues (1.4) (not est.)
Purchase of medium-term U.S. bank CD’s (0.6) (not est.)
“Liquidity” Balance 0.1 -$3.9 less total receipts obtained under (j)

Some of the above projections such as foreign stock purchases here this year are obviously not much more than “guesstimates.” But the projections clearly indicate that given the assumptions, a major adverse swing in our balance of payments this year is very likely.

With regard to foreign government investment in special Treasury issues and medium-term U.S. bank CD’s, it should be noted that $911 million of the former mature in 1969 ($800 million held by Canada and $111 million held by Switzerland). About $2.4 billion of long-term bank CD’s held by various foreign governments mature in 1969. Even if all these were rolled-over in the same amount, as assumed in the above projections, there would be a deterioration of that amount in the 1969 position relative to 1968 when such foreign government investments showed a net increase.

While no formal projection of the U.S. balance of payments beyond 1969 has been made, the probability of a continued deficit of a worrisome size is high.

II. Alternatives in Revising the Balance-of-Payments Program

Steps to move away from the restrictive aspect of the present program may need to be commenced promptly. This might involve a relaxation—beginning [Page 12] soon—which would entail some risks and the likelihood of an increased capital outflow. It might also involve the need, for balance-of-payments protection, of a continued tight money policy, even if there is some easing in domestic inflationary pressures. A relaxation of controls would be a clear step in the direction of removing them, without throwing caution to the winds.

A. The Direct Investment Program

A revised program involving a relaxation of direct investment controls has three basic alternatives: (1) modification and relaxation of the existing program; (2) shifting to a voluntary program; (3) abandonment of the investment controls.

Options available in each of these general alternatives are discussed below. (It should be noted that an FDIP report to be filed by direct investors by February 28 will give the first complete projection of 1969 direct investment plans, including projected capital outflow, use of foreign borrowing, earnings, and dividends to U.S. parents. Results from this report will not be available until sometime in March.)

1. Modifying and Relaxing the Existing Program

There are four primary areas in which this may be done:


Increase the level of minimum authorized investment.

This is presently proposed as $300,000 for 1969, compared with $200,000 in effect in 1968. We would estimate that the balance-of-payments cost of increasing the level to $500,000 would amount to approximately $60 million and would relieve some of the burden of the Foreign Direct Investment Program for approximately 200 companies. Should the level be increased to $1 million, the additional balance-of-payments cost (over the $300,000 level) would amount to $160-200 million, with about 350 companies benefiting.


Increase the elective earnings allowable from its present proposed 20 percent level to 30 percent. (The 20% proposal differs in several respects from the automatic exemption for a certain minimum level of direct investment described in (a) above. It is an optional method of determining a company’s allowable direct investment in all cases where the minimum exempt amount is exceeded; hence, it is an alternative to the base-period investment method. This optional method would allow a firm to make direct investment in 1969 not less than 20% of its direct investment earnings in 1968. Data on the latter for the fourth quarter, 1968 are not due from direct investors until February 14 and some time will be required for processing, so that the figures below must be regarded as preliminary estimates.)

The net additional cost of a 30% earnings allowable would be an estimated $220 million, and approximately 85 companies would benefit. [Page 13] Raising the percentage to 40% would cost $530 million over the announced 1969 program cost and 160 companies would benefit. Increasing the percentage to 50% would involve additional payments costs of approximately $1 billion over the announced 1969 Program level, with over 230 companies benefiting.

Exemption from the program of transactions with affiliated foreign nationals solely involved in a selling capacity. We do not have trading company data, but crude estimates based on available information suggest balance-of-payments costs on the order of $100 million. Companies with which this idea was floated expressed no interest in it, presumably because they feel the pressure of the present ceilings much more with respect to investment in their production affiliates than in their trading affiliates abroad. Also, they believed accounting and definitional problems would be unsurmountable.
There has been a great deal of discussion about the possibility of collapsing Schedules A, B and C into a single schedule. This would do a great deal to simplify the regulations, reporting requirements, and administration of the program, and would be widely acclaimed by the business world. Data for estimating the payments cost of such a move will not be available until March. However, we would guess that the cost would be substantial—say, $1 billion—for the following reason. Many companies find their present quotas partially unusable because these are locked into area schedules where the companies have no specific investment plans.

The attached tables summarize the effects of the above proposals and provide a rough projection of the direct investment situation.2

We have not attempted to assess the incidental balance-of-payments costs, or benefits, that might attend a liberalization of the direct investment program-for example, the effects on foreign government and exchange market confidence in the dollar, and on U.S. exports and imports. These effects could, of course, be substantial.

2. Voluntary Program

Shifting to a voluntary program would depend upon the cooperation of a few hundred companies.

Information gathered this past year greatly increases the capacity to choose those companies which would most appropriately be included in a voluntary program. But a 1969 projection of direct investment by U.S. companies and a sources-and-uses-of-funds forecast with respect to their foreign affiliates would be needed to conceive a voluntary program adequately. This material will be gathered, hopefully, by the end of April; and a proposal could be in shape for announcement some weeks later.

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Among the basic questions which would have to be covered are:

In case borrowing costs in the U.S. decline relative to Europe, would companies be willing to maintain their existing outstanding indebtedness in Europe rather than refinance it in the U.S.? Would they be willing to do a large portion of new borrowing in Europe, rather than in the U.S. for direct investment purposes? Would they insist on counting exports as an offset to their direct investment outflows?

3. Abandonment of Direct Investment Controls

Abandoning controls would cost $2 billion or more—compared to what it was in 1968—depending upon the extent to which companies would refinance in the U.S. foreign debt created in prior years and where they would raise funds for new direct investment.

B. The Federal Reserve Program

The announced 1969 program left the bank program ceiling at essentially 103 percent and made no significant changes in the Program. The Fed resisted the general preference to exempt medium-term export credits, as did the OFDI, which would be greatly affected by such an exemption. It was felt that no major change should be made before the new Administration had had an opportunity to review the over-all U.S. balance-of-payments program.

It was announced last December that the Fed would review the Program early in 1969, and Governor Brimmer is now in the process of discussing with banks and other financial institutions their experience under the Program. The main considerations of the Program review are the reduction of inequities among financial institutions covered by the Program, and the methods that might be used to resolve any conflict between the need to stem potential dollar outflows and the need to assure that funds necessary to finance U.S. exports are available. In order to stimulate consideration by the banks of various alternatives, he has mentioned the following as examples:

extending the IET to cover foreign credits and investments now covered only by the VFCR, including short-term bank loans;
establish a special reserve requirement against credits to foreigners;
create an auction system related to the total amount of bank lending to foreigners;
make changes within the present program to minimize inequities, especially for the smaller banks;
making special provisions to facilitate exports.

Suggestions (d) and (3) would overlap to the extent that higher ceilings approved for small banks would be concentrated on export credits.

The meetings of Governor Brimmer with institutions covered by the VFCR extend to March 11, and recommendations will then be made by the [Page 15] Governor to the Board. The range of possibilities for some relaxation and simplification is quite large, and judgments of the balance of payments cost will vary depending on the extent to which additional extensions of credit are expected to stimulate exports that otherwise would not occur. Pending completion of the review by the Board no recommendations are made here.

C. Interest Equalization Tax

The IET rate is presently 18.75 percent on purchase of long-term debt (28-1/2 years or more) and equity securities. This is roughly equivalent to an annual cost of 1-1/4 percent.

The IET has operated as nearly an absolute barrier for American lending to foreign borrowers. Virtually no IET collections have been associated with loans to foreigners or purchases of foreign bonds.

Collection data show that well over half the IET payments in over four years were associated with American purchases of South African gold mining shares. Most of the balance came from purchases of outstanding issues of Canadian mining stocks and a few “special situation” issues. U.S. speculators in foreign mining shares have generally been able to resell “tax-paid” shares in the U.S. market at prices equal to or exceeding what they paid the foreign issuer plus IET.

We cannot predict with any precision what rate constitutes the threshold for substantial outflows based upon interest differentials alone. But an example of the potential for such outflows is the large volume of attractive convertible bonds issued abroad by U.S. companies in recent years to finance direct investment. A substantial reduction of the IET would seem very likely to encourage U.S. private purchases of these issues and thus defeat the purpose of the Foreign Direct Investment Program-that is, the encouragement of use of foreign capital for financing U.S. direct investment.

A reduction to one percent per year would not entail a substantial increase in capital outflow under the existing structure of interest rates here and abroad. A reduction to three fourths of 1 percent would be more risky because a sizeable pent-up U.S. demand for foreign issues probably exists, and a sizeable reduction of the IET could trigger it off, not only because of the reduced tax per se but also because of the psychological impact of a substantial liberalization step.

Also, interest differentials between here and Europe could shift by mid-summer sufficiently to make a three fourths percent rate quite costly and even a one percent rate costly.

The attached tables show IET collections and interest rate differentials. (The collections data suggest that from $850 million to $1 billion of foreign stock was purchased by U.S. investors during the period October, 1964, through October, 1968.)

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The IET has related effects which must be borne in mind in evaluating changes in the rate:

  • —it facilitates the pursuit of an autonomous domestic monetary policy;
  • —it stimulates development of the European capital market;
  • —it facilitates operation of the Federal Reserve Program by relieving the pressure on U.S. banks of foreign demands for credit;
  • —it restrains capital outflow to developed countries through channels not covered by other programs.

Since the need for these related effects may continue well beyond the expiration of the IET in July, 1969, continuation of the IET, at least on a standby basis, should be seriously considered.

  1. Source: Washington National Records Center, Department of the Treasury, Volcker Group Masters: FRC 56 86 30, VG/LIM/31-VG/LIM/50. Confidential; Limited Distribution. Circulated to members of the Volcker Group on March 18 under cover of a routing memorandum from Willis that indicated the paper was discussed at a February 28 meeting.
  2. During 1960-67, the U.S. had consistent deficits in “errors and omissions,” averaging -$600 mil. (-$210 mil. to -$997 mil.). The small estimated surplus in this item for 1968 could turn out to be merely a temporary favorable shift, possibly associated with unusually large capital receipts last year.
  3. None of the attached tables is printed.