The Balance of Payments: Meaning and Significance

Report for Congress
The Balance of Payments:
Meaning and Significance
Updated April 30, 2003
Gary J. Wells
Visiting Fellow
Foreign Affairs, Defense, and Trade Division

Congressional Research Service ˜ The Library of Congress

The Balance of Payments:
Meaning and Significance
This report provides a basic discussion of the U.S. balance of payments (BOP).
The BOP is a systematic accounting of the U.S.’s international transactions for a
specified period of time. It is an economic indicator that is followed closely by
Members and Committees concerned with international trade and financial flows.
The BOP measures flows between U.S. and non-U.S. residents. Transactions
involving items capable of directly satisfying economic needs and wants are recorded
in the BOP’s current account. These are further distinguished as goods and services
trade, receipt or payment of income from investments, and one-way (unilateral)
transfers. The capital and financial accounts capture transactions involving asset
transfers (e.g., ownership transfer of equities between residents and non-residents).
The BOP is organized as a double-entry bookkeeping system. As a result, credits
(i.e., inflows of funds) are, in principle, offset by debits (i.e., outflows of funds).
However, difficulty in gathering accurate information creates a statistical
discrepancy. To ensure credits and debits sum to zero the statistical discrepancy is
calculated as the sum of all BOP transactions with the opposite sign.
A key element of the BOP is the balance of trade (BOT). The BOT equals
exports minus imports of goods and services. The BOT is used to quantify the trade
deficit (i.e., imports exceeding exports). From the early 1990s until the third quarter
of 2002 the U.S. trade deficit grew from less than 1% of U.S. gross domestic product
(GDP) to more than 4%. Because of the BOP’s dual entry bookkeeping organization,
the trade deficit must be offset by other transactions. Typically, a net investment
inflow into the United States provides the bulk of the required offset. That is, in
order to purchase U.S.-based assets foreign investors acquire the net outflow of
dollars generated by the trade deficit.
Many analysts believe the trade deficit is not sustainable and that the
attractiveness of foreign investments will gain ground relative to U.S. investments.
This will encourage domestic investors to send more investment funds out of the
country while also encouraging foreign investors to send less to the United States.
Both would make it more difficult to fund U.S. imports at current levels. Two
possible scenarios have been formulated to explain how the trade deficit might
fall–soft and hard landings. With a soft landing the trade deficit gradually falls
allowing exchange rates and other economic measures to adjust; the adverse impact
on the economy is thought to be minimal. A hard landing, on the other hand, would
entail a dramatic fall in the value of the dollar and insufficient time for the economy
to adjust. A recession may ensue.
The terrorists events of September 11 and the weakening economy had the
potential to trigger a hard landing, but the data do not indicate that this is happening.
The exchange value of the dollar relative to widely-traded currencies has steadily
weakened since the beginning of 2002, but at the same time its value has
strengthened relative to less widely-traded currencies.

The Balance of Payments Defined.....................................1
The Current Account...........................................3
The Capital/Financial Accounts...................................4
The Capital Account.......................................4
The Financial Account......................................5
The Statistical Discrepancy..................................6
The Nature of Balance of Payments Transactions.........................6
The Trade Deficit..................................................7
Possible Causes of the Trade Deficit...............................7
Characteristics and Consequences of the Trade Deficit.................8
Sustainability of the Trade Deficit/Financial Surplus.................11
The Impact of Recent Events....................................12
Conclusion ......................................................13
Appendix .......................................................15
List of Figures
Figure 1. Flowchart of the Balance of Payments..........................2
Figure 2. Measures of the U.S. Trade Deficit as a Percent of
Gross Domestic Product–1992:Q1-2002:Q3.........................4
Figure 3. Balance of Trade and Inflation Adjusted Trade Weighted
Exchange Rate (Monthly January 1992-November 2002)..............11
Figure 4. Monthly Inflation-Adjusted, Trade-Weighted Dollar
Exchange Rate Indexes (January 2001-January 2003).................13
List of Tables
Table 1. The Balance Between the Current Account
and Capital/Financial Accounts...................................9
For questions regarding this report, contact James Jackson, CRS Foreign Affairs,
Defense, and Trade Division, at 707-7751.

The Balance of Payments:
Meaning and Significance
Some Members of Congress have voiced concerns regarding the persistent and
growing trade deficit the United States has experienced since the 1990s. A
significant manifestation of this concern was the formation of the U.S. Trade Deficit
Review Commission in 1998 (19 U.S.C. 2213 as amended). This commission was
charged with exploring:
!The causes and consequences of the merchandise trade and current
account deficits and specific bilateral trade deficits.
!The impact that United States monetary and fiscal policies may have
on U.S. merchandise trade and current account balances.
!The relationship of the merchandise trade and current account
balances to the overall well-being of the United States economy, and
to wages and employment in various sectors of the U.S. economy.
!The extent to which the coordination, allocation, and accountability
of trade responsibilities among federal agencies may contribute to
the trade and current account deficits.1
To get a sense of the trade deficit’s importance, this report will place the trade
deficit into the larger context of the balance of payments (BOP). Specifically, the
report will define the balance of payments, illustrate it via a diagram, provide
examples of BOP transactions, and discuss the trade deficit generally and in light of
recent events.
The Balance of Payments Defined
The U. S. balance of payments (BOP) is a systematic accounting of the U.S.’s
international transactions for a specified period of time, typically a quarter or a year.2
Transactions take place between U.S. residents and residents of other countries.
Residents include individuals, businesses and governmental units (federal, state and

1 See the Report of the U.S. Trade Deficit Review Commission. November 14, 2000. For
more information on this report see Trade Deficit Review Commission by Dick K. Nanto
(CRS Trade Briefing Book. April 12, 2001.)
2 For BOP purposes the U.S. economy consists of the 50 states, the District of Columbia, the
Commonwealth of Puerto Rico, American Samoa, Guam, Midway Island, the Virgin Islands,
Wake Island, and all other U.S. territories and possessions. For more information see The
Balance of Payments of the United States: Concepts, Data Sources, and Estimating
Procedures. U.S. Department of Commerce. May 1990.

local). A place of residency is the country where a resident ordinally lives.3 A
transaction is defined as “the transfer of ownership of something that has an
economic value measurable in monetary terms from residents of one country to
residents of another.”4 The balance of payments measures transactions between
domestic and foreign residents, but only if the transactions occur during the specified
measurement period. That is, the BOP captures flows of transactions. It is organized
as a double-entry bookkeeping system with each transaction, in principle, having an
offsetting entry. As a consequence the BOP should always balance–that is sum to
zero. However, individual components (i.e., accounts and sub accounts) may not
balance. The Department of Commerce’s Bureau of Economic Analysis (BEA)
maintains the balance of payments for the United States. BEA reports the BOP
Figure 1. Flowchart of the Balance of Payments.
Balance of Payments
Capital and Financial
Current Accounts
Capital Financial Statistical
Account Account Merchandise discrepancy
Services U.S.-owned assets abroad
Official reserve assets
Income receipts Government assets
and payments Private assets
Unilateral transfers
Foreign-owned assets in the United States
Foreign official assets
Other foreign assets
BOP transactions are grouped by type. Figure 1 illustrates BOP transaction
categories in a flowchart. The two primary headings are the current account and the
capital/financial accounts. Merchandise (goods) trade, services trade, income from
ownership of assets (e.g., income from stocks, securities, and businesses), and
unilateral transfers are recorded in the current account, and asset flows are recorded
in the capital/financial accounts. The general distinction between current account
and capital/financial account transactions is that the items involved in the former are
available to satisfy economic needs or wants in and by themselves, whereas the latter
transactions involve assets that would first need to be exchanged for resources

3 For details see ibid. p. 3.
4 Ibid. p. xiii

capable of satisfying these needs or wants. For example, stock certificates would
first need to be sold to satisfy economic needs or wants. As a matter of convention
the statistical discrepancy, which arises because of the complexity in gathering the
required data, is placed on the capital/financial account side of the BOP.
The Current Account5
Merchandise or goods trade includes all raw materials and manufactured
goods bought, sold, or given away. Services trade includes tourism, transportation,
engineering services, and business services (e.g. banking, insurance, law,
management consulting and accounting services). Patent and copyright fees that
cross international borders are also included in the services category. As a matter of
practicality, the distinction between goods and services sometimes becomes blurred
(e.g., gifts purchased by travelers are classified as services).
A good or service transaction is classified by the direction of the flow of funds.
For example, an exported good or service generates an inflow of funds and is
recorded as a credit with a positive sign in the BOP. An import is accompanied by
a funds outflow and is recorded as a debit with a negative sign. Typically, the United
States imports more goods than are exported, while just the opposite is the case for
If imports exceed exports, a trade deficit occurs; and when exports exceed
imports, a trade surplus occurs. The balance of trade (BOT) is used to quantify
a trade deficit or surplus. To reflect the growing importance of services in the U.S.
economy the balance of trade measure in this publication includes goods and
services. However, as a result the trade deficit as measured by the BOT is lower than
had merchandise trade been used exclusively.6 As stated above, this is the case
because the United States typically exports more services than are imported. To
show the balance of trade in the context of the size of the U.S. economy, Figure 2
presents the BOT as a percent of U.S. gross domestic product (a measure of national
income). As Figure 2 illustrates the United States has had a trade deficit over the
period since 1992, and this deficit has generally grown.

5 For further information on items included in the current account see America’s Growing
Current Account Deficit: Its Cause and What it Means for the Economy by Gail E. Makinen
and Marc Labonte (CRS Report RL30534, Updated April 19, 2001) and U.S. International
Trade: Data and Forecasts by Dick K. Nanto and Vivian C. Jones (CRS Issue Brief
IB96038, July 25, 2001.) In addition to discussing trade generally, IB96038 discusses
bilateral trade flows and the alternative methods used to calculate current account items.
The data in this current report utilizes the balance of payments method.
6 Even though a balance of trade deficit is a negative number, it is discussed as if it were
positive. That is, a growing deficit is moving from a negative number closer to zero to one
further away.

Figure 2. Measures of the U.S. Trade Deficit as a Percent of Gross
Domestic Product–1992:Q1-2002Q3.
9 2 .Q1 93. Q1 94. Q1 95 .Q1 9 6.Q1 97. Q1 9 8 .Q1 99. Q1 00. Q1 0 1 .Q1 0 2 . Q1
-2tBalance of Trade
-2.5rcenCurrent Account Balance
-4.5SOURCE: Bureau of Economic Analysis
A measure closely related to the balance of trade is the current account
balance. As can be seen in Figure 2, the BOT and current account balance track
similar paths. This is the case because the BOT is a significant component of the
current account balance. However, in addition to goods and services trade, the
current account balance also includes income payments and receipts and unilateral
transfers. In this regard, the current account balance is more complete because it
encompasses all international transactions of items available to satisfy economic
needs or wants.
International income receipts and payments derive from ownership of assets.
Stock dividends are an example. An outflow results from income earned in the
United States being repatriated by foreign asset holders, and an inflow results as
American residents repatriate foreign generated income. Unilateral transfers are
one-way transfers of funds. Worker remittances from abroad (e.g., a foreign worker
sending money back home), direct foreign aid, and pension payments involving
residents and non-residents are examples. The Bureau of Economic Analysis does
not individually report inflows and outflows of unilateral transfers, but, instead,
reports only the net flow.
The Capital/Financial Accounts
The capital/financial accounts actually include three accounts–the capital
account, the financial account, and the statistical discrepancy.7 Each will be
discussed in turn.
The Capital Account. In order to comply with International Monetary Fund
suggested guidelines the Bureau of Economic Analysis reorganized the balance of

7 The capital and financial accounts are distinct asset accounts. They are grouped together
in this report for ease of exposition.

payments in June 1999. Several transaction categories were moved from the
unilateral transfer account into a newly formed capital account. “The newly defined
capital account consists of capital transfers and the acquisition and disposal of non-
produced, non-financial assets. The major types of capital transfers are debt
forgiveness and migrants’ transfers (goods and financial assets accompanying
migrants as they leave or enter the country).”8 Non-produced, non-financial asset
transactions include transfers of the rights to natural resources, patents, copyrights,
trademarks, franchises, and leases. Other transactions recorded in the new capital
account include the transfer of title to fixed assets, gift and inheritance taxes, death
duties, uninsured damage to fixed assets, and legacies.
For the United States, these transactions typically comprise a relatively small
portion of the balance of payments (see the appendix), but a significant debt
forgiveness program could increase the importance of this account. Prior to the
introduction of this new account, the fundamental division of the balance of
payments was between the current account and what was then called the capital
account. With the introduction of this new capital account the capital account that
existed prior to the change was renamed the financial account.
The Financial Account. International transactions involving assets that are
not recorded in the capital account are reported in the financial account.9 Financial
account transactions may involve financial assets such as loans, bank deposits, drafts,
government and private debt and equities. Assets may also encompass physical or
real assets held for the production of income such as manufacturing facilities and
controlling interest in a business enterprise.
The financial account is further divided into U.S. assets abroad (claims) and
foreign assets in the United States (liabilities). U.S. assets abroad are classified either
as U.S. official reserve assets, other U.S. government assets, or U.S. private assets.
Only the net of each of these transactions is reported in the balance of payments.
Official reserves, as opposed to other government assets, are used for currency
support and to ensure smooth operation of the international transactions system.10
The Statistical Discrepancy. Collection of BOP data is very complex and
involves numerous government agencies, international organizations, and industry
and trade associations. As a result, there is significant potential for data collection
error. For example, merchandise trade valuation is dependent on the paperwork

8 See “Upcoming Changes in the Classification of Current and Capital Transactions in the
U.S. International Accounts.” Survey of Current Business. February, 1999. pp. 10-11.
9 A few transactions that should be included in the capital account are inadvertently
classified as current account transactions because of the difficulty in disentangling these
transactions from other current account transactions.
10 Reserve assets include foreign currencies, gold, and special drawing rights (SDRs). SDRs
were created as part of the International Monetary Fund to help stabilize international
transactions. For more information see The Balance of Payments of the United States:
Concepts, Data Sources, and Estimating Procedures. U.S. Department of Commerce. May
1990. (Because this publication pre-dates the revision of the U.S. BOP, the discussion of
the financial account is conducted in the capital account section.)

accompanying a transaction. If this paperwork is inaccurate, then a statistical
discrepancy might arise. The only transactions that are thought to generate few
discrepancies are those involving U.S. official reserve assets. In contrast, private
financial transactions are difficult to track, and therefore may substantially contribute
to the discrepancy. It should be noted, if both the credit and debit entries of a
transaction are omitted, then no statistical discrepancy is recorded in spite of the fact
that the individual components of the BOP that are affected would be inaccurate.
Also, many errors and omissions may offset each other. In short, the statistical
discrepancy underestimates the magnitude of errors and omissions. The statistical
discrepancy is calculated as the sum of all other BOP transactions but with the
opposite sign.
The Nature of Balance of Payments Transactions
The nature of balance of payments transactions becomes clearest when more
than one currency is involved. For example, consider a U.S. importer purchasing
goods manufactured in Japan. In this case, it is likely that the U.S. importer desires
to make payment in dollars and the Japanese manufacturer desires to receive payment
in yen. To complete the transaction a third party willing to exchange yen for dollars
at the current exchange rate needs to be located.11 The third party can be a bank, a
business enterprise, a government or an individual, and the third party does not have
to be from Japan or the United States. The critical aspects are that the third party is
willing to exchange yen for dollars for a reason and this reason is not likely to have
anything to do with the transaction between the U.S. importer and Japanese
manufacturer. For example, the yen supplier may want to purchase U.S. goods for
shipment to Japan, or he or she may want to purchase U.S. stocks, bonds or other
assets. Regardless, all of the possible transactions are captured in the U.S. balance
of payments. The transaction between the U.S. importer and the Japanese
manufacturer is captured as a U.S. import, and the third party transaction is captured
as either a U.S. export or as a transfer of U.S. assets to foreign-ownership.
It should be noted that the dollar-yen exchange rate plays a critical role in both
transactions. In the first transaction the U.S. importer judges the wisdom of the
transaction based on the dollar value, and the Japanese exporter passes judgment
based on the yen value. These two valuations are linked by the exchange rate.
Likewise, the exchange rate influences the third party’s willingness to make yen
available to complete the exchange.
Thus far, the third party has been portrayed as reacting to the initial transaction
between the U.S. importer and the Japanese exporter. However, the third party is not
likely to be aware of the other transaction. One or more banks are probably acting
as intermediaries to complete the two transactions. In reality, both transactions are

11 Of course, it is possible that the U.S. importer has yen from a previous transaction or the
Japanese manufacturer desires dollars for an upcoming transaction. In either of these cases,
the U.S. importer or the Japanese manufacturer is playing the role of the third party
described in this example.

occurring in a somewhat independent manner. The connecting links are the exchange
rate and financial intermediaries.
If the exchange rate is allowed to find its own value, then the number of dollars
flowing into the foreign exchange market in search of yen and yen flowing into the
market in search of dollars determine the rate. If U.S. importers are attempting to
purchase a growing amount of Japanese products, yen holders may have to be enticed
into exchanging their yen for dollars by a more favorable yen-dollar exchange rate
(i.e., they may require more dollars for a yen than was previously the case). If, on the
other hand, yen holders are bringing increasing numbers of yen for exchange into
dollars, the dollar-yen exchange rate may begin to swing the other way. Hence, the
question that needs to be answered is, “Are dollar holders’ desire for yen driving
changes in the exchange rate or is the driving force yen holders’ desire to have
dollars?” This question will be explored in the next section.
Another key aspect of balance of payments transactions is that they likely
interact with every part of the domestic economy. Hence, every domestic market, be
it for final goods or services, inputs or financial instruments, is impacted to some
degree by BOP transactions, and, in turn, the BOP is influenced heavily by these
domestic markets. Any strength or weakness in the domestic economy is, in part,
shaped by international transactions.
The Trade Deficit
As shown in Figure 2, the U.S. trade deficit steadily grew during the latter part
of the 1990s and during 2000. During the first half of 2001 the trade deficit began
to shrink, but resumed growing again in the second half of the year. In 2002 the
deficit grew to more than 4 percent of gross domestic product. This section of the
report will consider the possible causes of the persistent and growing trade deficit,
explore its characteristics and possible consequences, and its likely sustainability.
Possible Causes of the Trade Deficit
The U.S. Trade Deficit Review Commission identified several potential causes
of the U.S. “large and growing” trade deficit. They are:
1.“...(T)he more rapid expansion of the U.S. economy compared to the economies
of our trading partners...” (According to the Commission report this is the most
widely held reason for the trade deficit.)
2.“...(T)he American economy’s strength has encouraged foreigners to invest in
and lend to Americans and that has led to a real appreciation of the U.S. dollar,
which has lowered import prices and raised prices abroad of our exports.”
3.“...(T)he belief that foreign trade barriers that hinder U.S. exports can contribute
to trade deficits (specialists in international economics tend to discount this last

4.“...(T)he huge imbalance between domestic savings and domestic investment
as the fundamental cause of the major inflows of foreign funds that, as they are
respent, are the basic source of the excess of imports over exports.”12
These causes reflect the fact that balance of payments transactions touch every
aspect of the domestic economy. The first two relate to the strength of the U.S.
economy relative to other economies. The second and fourth are related in that
foreign investors are filling the gap between domestic savings and domestic
investment. The third plays a role in shaping U.S. trade policy, and is indirectly a
factor determining where firms locate their operations.
Characteristics and Consequences of the Trade Deficit
The growing trade deficit/financial surplus led the U.S. Trade Deficit Review
Commission to conclude:
In our strongly held view, trade deficits are a part of the recent ‘virtuous
circle’ of the U.S. economy, contributing to low interest rates (with the net
inflow of funds from foreign investors increasing the overall supply of
investment funds) and to low inflation (with imported products meeting domestic
demand for goods and services that exceeds domestic production). The huge
trade deficits have helped to make possible a period of high employment and
rapid economic growth. By enabling U.S. investment to exceed U.S. saving and
U.S. consumption to exceed U.S. production, trade deficits have contributed to
higher American living standards.
Others see trade deficits as a measure of the problems that international
trade causes our society, particularly the jobs and business lost to import
competition. Most egregiously in this view, persistent trade deficits between the
United States and several other nations represent the impact of unfair foreign
trade barriers. U.S. businesses are seen as unable to sell their products in those
nations because of their restrictions on U.S. imports while, at the same time,
businesses from those nations have easy access to our markets. But, the positive
feedback effects of some of our imports on jobs in U.S. export industries should
not be forgotten. The competitiveness of U.S. producers is enhanced by their
ability to source globally the lowest cost and highest quality parts and13
These paragraphs of the commission report capture the multifaceted nature of
the trade deficit/financial surplus.
The double-entry bookkeeping nature of the balance of payments captures the
fact that parties to all transactions enter them for a reason. The end result is that
balance of payments outflows are offset by inflows of like amount. However, the
trade deficit represents an imbalance with more dollars flowing out to purchase

12 See page vi of the Commission Report.
13 This was in the “Searching for Common Ground and Areas of Basic Agreement” section
of the U.S. Trade Deficit Review Commission report (page iv). The Republican members
submitted this portion of the report, but the Democratic members assisted in its preparation
and acknowledged that it represented common ground.

imports than flow in to pay for exports. To maintain overall balance a trade deficit
necessitates a surplus in the remainder of the BOP, but because the U.S. trade deficit
is not offset by the remainder of the current account it is necessary that the
financial/capital accounts run a surplus to provide the offset. Table 1 illustrates this
for the year 2001 and the first three quarters of 2002.
Table 1. The Balance Between the Current Account and
Capital/Financial Accounts
DateCurrent Account BalanceCapital, Financial and Statistical
(millions of dollars)Discrepancy Account Balances
(millions of dollars)
2001-$393,371$826 + $381,844 + $10,701 = $393,371
2002:Q1-$112,454$208 + $87,578 + $24,668 = $112,454
2002:Q2-$127,611$200 + $73,228 + $54,183 = $127,611
2002:Q3-$127,041$223 + $172,430 - $45,612 =$127,041
Source: Bureau of Economic Analysis. (See the appendix.)
Because trade in goods and services dominate the current account and financial
account transactions dominate the asset side of the BOP, many analysts view a trade
deficit as being accompanied by a financial account surplus. The data support this14
Some believe the trade deficit is an opportunity for domestic residents to have
a wider variety of goods and services available without having to give up the same
value of goods and services via exports as are received via imports. In this context,
the growing trade deficit enriches consumers.
At the same time, many view the trade deficit as a sign of weakness for our
economy that is due, in part, to the unfair trade practices of our trading partners.
Proponents of this view point to the growing anxiety many workers have experienced
even during recent prosperous times as an argument counterbalancing the consumer
gain discussed in the proceeding paragraph.15
Additionally, some view the growing financial account surplus as the United
States becoming more indebted to foreign investors. Technically, a growing financial
account surplus simply means that foreigners hold a growing value of U.S. assets.
These assets include the nation’s loan portfolio (public and private) as well as other

14 Because of the double-entry nature of the BOP a current account deficit must be offset by
a surplus in the capital/financial accounts (i.e., an identity is formed), but with subsets of
the current account and the capital/financial accounts (in this case the balance of trade and
the financial account) the necessity of an identity is broken.
15 See Globalization and the Perceptions of American Workers by Kenneth F. Scheve and
Matthew J. Slaughter (Institute for International Economics, March 2001) for a discussion
of the growing worker anxiety.

assets of every type (e.g., equities, real estate, and productive capacity). The use of
the term “more indebted” or the United States increasingly becoming a “debtor”
nation in this context refers to foreign residents owning a growing number of
domestic assets, and reflects a growing loss of domestic control of the country’s
productive base.
However, others view attracting foreign private investment into the United
States as a vote of confidence for our economy and a sign of strength, and foreign
direct investments are viewed as an even stronger statement of confidence because
of their more permanent nature. Hence, as stated above, strong investor interest in
U.S. opportunities may be viewed as a signal of the relative strength of the U.S.
economy vis á vis other economies. This raises the question, is the trade deficit
driving the financial account surplus or is the financial account surplus driving the
trade deficit? The exchange value of the dollar holds some clues in making this
If the growing U.S. trade deficit were the driving force, the increasing outflow
of dollars required to pay for the imports not offset by exports should have put
downward pressure on the dollar’s exchange value relative to the currencies of U.S.
trading partners. That is, to entice a third party to accept the dollars offered to pay
for the imports not offset by exports a more favorable exchange rate was likely
needed. If this were the case, the dollar should have weakened against the currencies
of our trading partners during the period of our growing trade deficit. If, on the other
hand, foreign investors’ desire to invest in the United States was the driving force,
the dollar should have strengthened. Figure 3 shows the balance of trade and the
inflation adjusted trade-weighted exchange value of the dollar.16 In 1995, the dollar
began to strengthen relative to U.S. trading partners currencies. During this same
period the trade deficit was growing. This indicates that the financial account surplus
was likely having more influence during this period than the trade deficit (i.e., driving
the process). It should be noted that in the months following September 2001 the
dollar’s strength has not been as robust. This will be investigated below.

16 “The broad index (used in Figure 3) is a weighted average of the foreign exchange values
of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The
index weights, which change over time, are derived from U.S. export shares and from U.S.
and foreign import shares.” (See the St. Louis Federal Reserve Web Site
[ h t t p : / / www.f e de r a l r e s e r ve .gov/ r e l e a s e s / H10/ Summa r y] )

Sustainability of the Trade Deficit/Financial Surplus
Figure 3. Balance of Trade and Inflation Adjusted Trade Weighted
Exchange Rate (Monthly January 1992-November 2002)
Many analysts raise the possibility that the persistent trade deficit/financial
surplus is not sustainable over the long run. If investors see the need to begin
realigning their portfolios to include fewer U.S. investments, then the trade deficit
would have to contract because the funding to pay for the excess imports would not
be available. Additionally, if domestic savings did not fill the void, domestic
investment would also have to be curtailed. This would impact the growth prospects
of the United States. Analysts consider two scenarios for a pull back by
investors–soft and hard landings. With a soft landing as investors gradually reduce
their interest in the U.S. economy the dollar’s exchange value relative to our major
trading partners begins to weaken and imports become relatively more expensive on
the domestic U.S. market and U.S. exports become more competitive on the world
market. The end result is an expected reduced trade deficit and lower foreign
investment in the United States.
With a hard landing, the above events are compressed in time. An event such
as a sharp decline in the stock market is put forth as a possible spark to a hard
landing. As foreign investment recedes and domestic investors seek safer
investments outside the United States, interest rates could rise significantly to fund
the trade deficit, or if viewed from the investment side, the rising interest rates could
facilitate closing the gap between domestic savings and investments. The result
could be a recession because the economy would not have adequate time to react to
the rapid change. Relatively liquid portfolio investments would lead the stampede

of funds out of the United States in this scenario.17 The Mexican peso crisis of 1994-
95 and the more recent financial crises in Asia, Latin America, and Russia show the
extreme situation that can arise when there is a sudden drop in confidence in the
prospects of an economy.
The Impact of Recent Events
As Figures 2 and 3 indicate the trade deficit’s growth trend was only briefly
interrupted after September 2001, but the dollar’s strength position is currently more
clouded. Figure 4 shows three indexes of the monthly trade-weighted exchange rate
of the dollar. The first is a broad index of the dollar’s value relative to major U.S.
trading partners.18 This index began and ended the period at almost the same value,
but after a strengthening of the dollar during the first half of the period the recent
trend has been for the dollar to weaken. It remains to be seen if this weakening trend
will continue.
The next index is a subset of the broad index that measures the dollar’s value
relative to the United States’ trading partners having widely traded currencies (e.g.,
the euro, Swiss franc, etc.). With this index the dollar peaked in value in February
2002, but it has fallen by more than 11 percent since that time and is almost 4 percent
lower than the rate at the beginning of 2001. This weakening of the dollar
encourages increased U.S. exports and dampens imports in the United States. Many
analysts have claimed that the dollar has been overvalued for several years and this
gradual downward trend is bringing the dollar back into line with the other major
currencies. Other analysts point to the soft economies and geopolitical tensions as
possible further causes.
The final index measures the dollar relative to major trading partners who do not
have widely trading currencies. These include countries in Latin America, Asia, the
Middle East, and Eastern Europe. While the dollar lost ground against these
currencies in the months after September 2001, it has generally strengthened since
the beginning of 2002 and ended the period up by just over 5 percent. A weakened
investment climate in these countries relative to the United States may explain why
these currencies have not increased in value relative to the dollar. Nonetheless, the
strengthening trend encourages U.S. residents to increase imports from countries
comprising this index and discourages U.S. export increases.

17 The most liquid funds are sometimes referred to as “hot” money. In its broadest usage,
hot money is available for any speculative international transaction. Large hot money flows
may destabilize a currency.
18 According to the Federal Reserve the broad index includes countries or regions “that had
a share of U.S. non-oil imports or nonagricultural exports of at least ½ percent.” (See “New
Summary Measures of the Foreign Exchange Value of the Dollar.” Federal Reserve
Bulletin. October 1998. P 813.)

Figure 4. Monthly Inflation-Adjusted, Trade-Weighted Dollar
Exchange Rate Indexes (January 2001-January 2003).
As the record of all transactions between domestic and foreign residents, items
in the balance of payments influence all segments of the U.S. economy. This breadth
of activity ensures that the global economy influences all domestic economic
outcomes. As a result, the international economy contributes to all the strengths and
weaknesses observed in the domestic economy. Analysts who emphasize the BOP’s
contribution to the strengths point to items such as lower consumer prices and the
advancements that result from heightened international competition. Analysts who
emphasize the BOP’s contribution to weaknesses point to items such as the widening
income gap between low and high income earners and adverse employment impacts.
In large measure, the controversy international economic transactions create is
centered around the U.S. trade deficit. During the period from the early 1990s until
the third quarter of 2002 the trade deficit grew to more than 4% of U.S. domestic
economic activity. Analysts are concerned that a trade deficit of this magnitude is
not sustainable. With a trade deficit, the imports of goods and services not funded
by exports is, in large measure, funded primarily by non-U.S. residents investing in

the United States. If the U.S. investment climate weakens relative to the rest of the
world, the readily available funding to run a trade deficit could shrink dramatically.
This adjustment is termed a soft landing if the change is gradual enough to allow
markets to adjust. Many analysts believe the U.S. economy can weather a soft
landing without significant adverse consequences. An abrupt adjustment is termed
a hard landing. With a hard landing, the U.S. economy could experience significant
recessionary pressures. Most analysts believe a soft landing is more likely than a
hard landing, but the possibility of a hard landing cannot be eliminated.
The events since September 11 have created the type of pressures many analysts
believe could trigger a hard landing. Fortunately, thus far the evidence does not
suggest that the U.S. is experiencing a hard landing. Typically, with a hard landing
the domestic currency’s value falls significantly and quickly relative to the currencies
of its trading partners. This occurs because the hard landing is being fueled by
investors liquidating their investments and moving their funds to safer investment
destinations. The outflow of funds puts downward pressure on the currency’s value.
In recent months the dollar has lost value relative to major economic powers with
widely-traded currencies, but it appears this decline has been gradual enough not to
cause severe problems. At the same time the dollar has weakened relative to major
currencies, it has strengthened relative to less widely traded currencies. The end
result is a clouded picture as to the impact the dollar’s value is having on the
economy and vice versa. Nonetheless, even in the face of the dollar weakening
against some currencies the resiliency of the U.S. economy appears to be strong
enough to withstand significant stress without eroding investor confidence enough
to trigger a mass outflow of funds.

Table 1.--U.S. International Transactions
[Millions of dollars, quarters seasonally adjusted]
(Credits +, debits -)200120012002IIIIIIIVIIIrIIIp
Current account
1Exports of goods and services and income receipts1,281,793349,040331,612309,477291,667291,348305,262312,881
2 Exports of goods and services998,022266,004256,766242,325232,930233,252244,540249,409
3 Goods, balance of payments basis718,762193,284184,846173,274167,358164,649172,426175,727
iki/CRS-RL312204 Services279,26072,72071,92069,05165,57268,60372,11473,682
g/w5 Transfers under US military agency sales contracts12,2202,8063,2273,0793,1082,9903,0872,922
leak6 Travel73,11920,73519,80317,84514,73617,03817,20017,586
7 Passenger fares18,0075,0074,8494,5223,6294,1714,1724,503
://wiki8 Other transportation28,3067,4957,1706,9686,6746,8056,9867,159
9 Royalties and license fees38,6689,7179,7439,5379,6729,93111,08511,020
10 Other private services108,10926,73826,92726,88627,55927,47329,38530,292
11 US Government miscellaneous services831222201214194195199200
12 Income receipts283,77183,03674,84667,15258,73758,09660,72263,472
13 Income receipts on US-owned assets abroad281,38982,44474,25366,55558,13757,48560,10862,854
14 Direct investment receipts125,99635,27033,07830,21127,43628,67930,95833,763
15 Other private receipts151,83246,28140,39835,49429,65927,99428,48628,231
16 US Government receipts3,5618937778501,042812664860
17 Compensation of employees2,382592593597600611614618
18Imports of goods and services and income payments-1,625,701-445,154-418,930-388,448-373,174-387,786-419,862-426,701

19 Imports of goods and services-1,356,312-363,164-350,090-322,103-320,958-328,744-353,853-360,270
20 Goods, balance of payments basis-1,145,927-306,316-292,565-279,025-268,021-271,073-294,893-298,903
21 Services-210,385-56,848-57,525-43,078-52,937-57,671-58,960-61,367
22 Direct defense expenditures-15,198-3,548-3,512-3,785-4,353-4,488-4,766-5,005
23 Travel-60,117-16,003-16,698-14,468-12,948-14,587-14,454-14,995
24 Passenger fares-22,418-5,810-6,213-5,944-4,451-5,113-5,028-5,352
25 Other transportation-38,823-10,521-10,130-9,178-8,997-8,858-9,739-9,709
26 Royalties and license fees-16,359-4,097-4,038-4,113-4,110-4,764-4,951-5,264
27 Other private services-54,588-16,146-16,208-4,864-17,371-19,120-19,297-20,317
iki/CRS-RL3122028 US Government miscellaneous services-2,882-723-726-726-707-741-725-725
s.or29 Income payments-269,389-81,990-68,840-66,345-52,216-59,042-66,009-66,431
30 Income payments on foreign-owned assets in the U. S.-260,850-79,881-66,727-64,210-50,035-56,803-63,737-64,229
://wiki31 Direct investment payments-23,401-13,021-5,246-6,3031,166-6,610-12,163-14,942
http32 Other private payments-156,784-45,512-40,886-38,156-32,230-31,679-32,943-31,114
33 US Government payments-80,665-21,348-20,595-19,751-18,971-18,514-18,631-18,173
34 Compensation of employees-8,539-2,109-2,113-2,135-2,181-2,239-2,272-2,202
35Unilateral current transfers, net-49,463-11,608-11,916-12,360-13,579-16,016-13,011-13,221
36 US Government grants-11,628-2,419-2,522-2,905-3,782-6,273-3,312-3,147
37 US Government pensions and other transfers-5,798-1,316-1,291-1,305-1,886-1,348-1,356-1,368
38 Private remittances and other transfers-32,037-7,873-8,103-8,150-7,911-8,395-8,343-8,706

Table 1--US International Transactions (Continued)
[Millions of dollars, quarters seasonally adjusted]
(Credits +, debits -)200120012002
Capital and financial account
Capital account
39Capital account transactions, net826208207206205208200223
Financial account
40US-owned assets abroad, net (increase/financial outflow (-))-370,962-215,815-80,03624,978-100,088-25,918-131,07923,920
iki/CRS-RL3122041 US official reserve assets, net-4,911190-1,343-3,559-199390-1,843-1,416
g/w42 Gold
s.or43 Special drawing rights-630-189-156-145-140-109-107-132
leak44 Reserve position in the International Monetary Fund-3,600574-1,015-3,24283652-1,607-1,136
://wiki45 Foreign currencies-681-195-172-172-142-153-129-148
46 US Government assets, other than official reserve assets, net-48677-7837714313342172
47 US credits and other long-term assets-4,431-1,094-1,330-1,011-996-853-565-897
48 Repayments on US credits and other long-term assets3,8731,0715731,1181,1119945661,190
49 US foreign currency holdings and US short-term assets, net72100-26-3028-841-121
50 US private assets, net-365,565-216,082-77,91028,460-100,032-26,441-129,27825,164
51 Direct investment-127,840-23,514-35,131-41,724-27,470-29,280-34,255-27,463
52 Foreign securities-94,662-26,895-51,76410,087-26,0902,047-9,67518,295
53 US claims on unaffiliated foreigners reported by
US nonbanking concerns-14,358-51,7599,670-9,47937,21065-16,693-12,087
54 US claims reported by US banks, not included elsewhere-128,705-113,914-68569,576-83,682727-68,65546,419
55Foreign-owned assets in the U. S., net (increase/financial inflow (+))752,806302,510181,61017,889250,797113,496204,307148,510

56 Foreign official assets in the United States, net5,2244,087-20,83116,8825,0867,64147,2529,319
57 US Government securities31,6652,547-10,86615,59424,3906,71421,74112,309
58 US Treasury securities10,745-1,027-20,79815,81016,760-58215,1931,424
59 Other20,9203,5749,932-2167,6307,2966,54810,885
60 Other US Government liabilities-1,882-676-79189-504-79054999
61 US liabilities reported by US banks, not included elsewhere-30,2781,213-10,202-782-20,50799124,531-4,824
62 Other foreign official assets5,7191,0031,0281,9811,707726926835
63 Other foreign assets in the United States, net747,582298,423202,4411,007245,711105,855157,055139,191
64 Direct investment130,79643,58951,10214,20821,89716,223-2,70411,037
65 US Treasury securities-7,670-4,744-14,685-15,47027,229-7,282-5,12454,691
66 US securities other than US Treasury securities407,653129,990113,55664,78799,32071,095104,40446,647
iki/CRS-RL3122067 US currency23,7832,3112,7728,20310,4974,5257,1832,556
g/w68 US liabilities to unaffiliated foreigners reported by
s.or US nonbanking concerns82,353111,644-5,307-25,1541,17032,34521,05615,961
69 US liabilities reported by US banks, not included elsewhere110,66715,63355,003-45,56785,598-11,05132,2408,299
http70Statistical discrepancy (sum of above items with sign reversed)10,70120,819-2,54748,258-55,82824,66854,183-45,612
M e mo r a nda :
71Balance on goods (lines 3 and 20)-427,165-113,032-107,719-105,751-100,663-106,424-122,467-123,176
72Balance on services (lines 4 and 21)68,87515,87214,39525,97312,63510,93213,15412,315
73Balance on goods and services (lines 2 and 19)-358,290-97,160-93,324-79,778-88,028-95,492-109,313-110,861
74Balance on income (lines 12 and 29)14,3821,0466,0068076,521-946-5,287-2,959
75Unilateral current transfers, net (line 35)-49,463-11,608-11,916-12,360-13,579-16,016-13,011-13,221
76Balance on current account (lines 1, 18, and 35 or lines 73, 74, and 75)-393,371-107,722-99,234-91,331-95,086-112,454-127,611-127,041
r Revised p Preliminary
NOTE:--Details may not add to totals because of rounding Source: U S
Bureau of Economic Analysis