tures abroad, and offsetting sales of military equipment were increased sharply; these improvements were sufficient to offset the net increase in Government grants and capital outflows. Moreover, such grants and capital outflows are now almost completely tied to the export of U.S. goods and services.

Growth of private capital outflows

The outflow of U.S. private capital rose from $3.9 billion in 1960 to $6.5 billion in 1964. Through this outflow, the United States was acquiring a large volume of foreign assets and adding rapidly to its net international ownership position as well as to its future receipts of interest, dividends, and remitted profits. But the assets acquired through this investment were largely illiquid, and were obtained by parting with liquid assets that added to both private and official claims against us. The U.S. reserve position declined continually.

The growth of U.S. private capital outflow is not difficult to explain. As market integration has progressed and as individuals and businesses have become increasingly familiar with international financial operations, there has been a natural tendency for capital to become more more mobile, and more responsive to market forces.

U.S. corporations have shown an increasing interest in business operations overseas and have been sending a rising flow of funds abroad to build and equip new plants and distribution facilities. The extremely rapid growth of incomes, particularly in Europe, Canada, and Japan, has greatly expanded consumer demand, especially for manufactured goods. Wage rates generally are lower abroad, and when American management and technology are exported the productivity of foreign labor is frequently brought close to the U.S. level, making American enterprises in other countries often extremely profitable. The virtual disappearance of internal tariffs in the EEC and EFTA, while external tariffs are retained, has created a large and expanded market which can be readily served by large-scale production in Europe. Of course, direct investment abroad is also made for the purpose of developing or expanding sources of raw materials, often for use in the firm's operations in the United States or elsewhere.

With few exceptions, U.S. money and capital markets are much better developed and freer from restrictions than those abroad, and this attracts foreign borrowers. In part because of this better organization, interest rates and flotation costs are considerably lower in this country. Consequently, there is a tendency for foreigners seeking capital to look to U.S. markets and for interest-sensitive funds to move abroad in search of higher returns.

Long-standing interest rate differentials, and the growing mobility of capital, were important factors in the spurt of long-term portfolio lending that occurred in 1962 and 1963. New foreign security issues in the U.S. market doubled from 1961 to 1962, and the acceleration continued in early 1963. This growth was arrested by the introduction in mid-1963 of the Interest Equalization Tax (IET), which raised the effective interest rate for most foreign borrowing here. Meanwhile, other capital flows began to accelerate, offsetting much or all of the gains from the IET. Bank loans rose sharply, from $1.5 billion in 1963 to $2.5 billion in 1964. Direct U.S. investment abroad also accelerated in 1963 and 1964.

The February 1965 program

At the beginning of 1965, it was evident that the rapid rise in capital outflows was creating growing problems for the U.S. balance of payments. Accordingly, the program announced by the President on February 10 applied the IET to most bank loans with a duration of a year or more to borrowers in developed countries, asked for a 2-year extension of the IET, and attempted in other ways to stem the outflow of private capital through the voluntary cooperation of American business.

U.S. banks and other financial institutions were asked to observe appropriate "guidelines" with respect to their foreign operations in 1965. Banks were asked by the Federal Reserve System to limit the increase in their claims on foreigners in 1965 to 5 percent of the value of their outstanding foreign credits as of December 31, 1964. Top priority was to be assigned to bona fide export credits, and second priority to credits to less developed countries. A related program was applied to credits and investments abroad by nonbank financial institutions.

Under the part of the program administered by the Department of Commerce, about 500 large nonfinancial corporations were asked to make a maximum effort to expand the net balance of (a) their exports of goods and services plus (b) their repatriation of earnings from the developed countries less (c) their capital outflows to such countries. They were also asked to bring liquid funds back to the United States. Although considerable skepticism was initially expressed-particularly abroad-regarding the effectiveness of a voluntary program, it is now clear that the response was excellent. The net outflow of U.S. private capital declined from $6.5 billion in 1964 (and an annual rate of $8.9 billion in the fourth quarter) to an annual rate of $3.6 billion in the first three quarters of 1965. Short-term capital-both bank and nonbank-accounted for a great part of this dramatic shift: the movement of such funds changed from a net outflow of $2.1 billion in 1964 to a net inflow at an annual rate of $1.0 billion in the first three quarters of 1965. The success of the voluntary program in shifting the movement of short-term funds was reinforced by the intensified demand for funds in the domestic market, as a result both of sharply rising activity and some tightening of monetary policy.

The U.S. payments deficit in 1965 was adversely affected by certain unusual transactions of the United Kingdom. As a part of the U.K. program to protect the pound, the British authorities converted certain holdings of U.S. securities. Together with the deferment of payments on intergovernmental debts, these transactions reduced U.S. net receipts by well over $2 billion, on both the official settlements and the liquidity basis.

Despite good over-all results of the payments program, the volume of U.S. direct investment outflows were at a record high in 1965. In the first three quarters, they reached an annual rate of $3.4 billion, compared with a 1964 total of $2.4 billion. However, they declined substantially during the course of 1965. Since such outflows are usually planned long in advance, and businesses were not asked to interrupt projects already underway, a lag in the response to the February program was expected. Nevertheless, there was disquieting

evidence that plans for direct investment in 1966 remained at a high level. With the sharp reversal in the trend of bank lending abroad, direct investment became the primary area of concern.

Program for 1966

By the autumn of 1965, it was clear that the February program had been successful and that a substantial improvement in the balance of payments had been achieved. Nevertheless, even further improvement was necessary if payments equilibrium was to be attained. Consequently, decisions were announced in December to reinforce and renew the existing programs for 1966. Further attention was placed on encouraging U.S. exports, on promoting foreign tourism and foreign investment in the United States, and on minimizing the effect on the balance of payments of Government transactions. But the principal focus of the supplementary steps had to be on the further containment of direct investment outflows.

Consequently, new guidelines for direct investment were developed for nonfinancial corporations. Each of about 900 individual corporations was asked to hold its combined 1965 and 1966 direct investment outflows (plus earnings retained abroad) in specified advanced countries and mineral exporting nations to no more than 90 percent of the total of these items in the years 1962-64. This will permit an increase of about 35 percent in the average annual outflow of direct investments in 1965-66 over the average annual rate in the 1962-64 base period. A joint target was set for the years 1965 and 1966 in order not to penalize firms which had cut back in 1965, and in order to seek greater restraint by those which had invested more heavily last year. Direct investment in 1966 under the program would be lower than in 1965, though it would remain high relative to outflows. of earlier years.

Financial institutions were given guidelines for 1966 that permitted about the same outflow as had been suggested for 1965. The guidelines provided for nonbank institutions were somewhat more detailed than those for 1965. New arrangements with the Canadian authorities were announced on the understanding that continued exemption from the IET would not threaten the goals of the U.S. program.

Efforts to reduce even further the impact of Government activities on the balance of payments will continue in 1966. Net overseas defense expenditures have been quite successfully reduced since 1960. Unfortunately, expanding defense needs will prevent further reduction in 1966. The bulk of Government aid will continue either to be given "in kind," with no dollar flows, or tied to procurement in the United States.

U.S. trade position

The outstanding performance of U.S. trade in the 1960's has been strongly supported by our excellent price record, as well as by the rapid expansion of output and incomes abroad. However, the slowdown of economic expansion in Europe and Japan contributed to a reduced trade surplus in 1965. The January-March dock strike not only redistributed the time pattern of sales (somewhat inflating the 1964 level), but also caused a sizable loss of export sales.

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goods and raw materials rose substantially. Only agricultural impor declined, primarily because of lower prices for such commodities coffee, sugar, and cocoa. Many U.S. firms, fearing a possible st strike, turned in part to foreign suppliers in 1965, raising steel impor to about $1.2 billion-an all-time high. In addition, the rapid e pansion of the U.S. economy in 1965 brought a larger rise in o imports than in previous years. The boom in the home market m also in some cases have reduced the interest of American produce in finding or serving markets overseas, particularly where their produ tion made full use of existing capacity or labor.

The 1965 decline in the trade surplus was not the result of any bas deterioration in our competitive position. Our price performance 1965 continued to match that of our major trading partners, so th we retained the relative advantage achieved in earlier years. Conclusion

Over the longer run, the policies required to assure equilibrium in t U.S. balance of payments will be influenced by many factors, i cluding among others the growth rate of our major trading par ners throughout the world, the extent to which European natio learn to rely actively on fiscal as well as monetary policy as a mea of adjusting over-all demand, the development of capital markets Europe, changes in the indispensable foreign exchange costs of n tional security, our rate of technological innovation, our record productivity growth and price stability, and the progress of improv ments in international financial machinery.

If our current account surplus continues to expand, a renew growth of capital outflows could be compatible with over-all paymen equilibrium. For the present, however, the volume of capital ou flows likely to occur in the absence of any measures to modera them would clearly be inconsistent with equilibrium in our extern payments. Given that private capital outflows must be containe the selective measures currently in use seem, for the present, an sential component of our policy. Compared with reliance solely a restrictive general monetary measures that might conceivably ho down capital flows to the same extent, the selective credit techniqu have the obvious advantage of allowing monetary policy to respor to the needs for domestic credit, as well as to affect the 5-10 perce of total credit that flows abroad.

The selective approach is consistent with an appropriate compositi of the private capital outflow. The exemptions in the IET and t priorities established in the voluntary programs protect the access less developed countries to U.S. capital. The Federal Reserve pr gram, moreover, gives priority to export financing, which could

e 1960's squeezed under a highly restrictive monetary policy. By increasi Ter, the slot escape valve; countries in urgent need of new U.S. capital issues & buted to are still free to enter our markets, the less urgent needs are screened ou ell as by the the cost of borrowing in the United States, the IET contains its o

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The guideline approach of the voluntary programs tends to pern the business firms and banks themselves to select the most attracti investment opportunities; the investments foregone would yield. smaller return than the average for all new U.S. foreign investmen

The voluntary program continues to permit growth in both the ownership of U.S. productive facilities abroad and of the U.S. loans outstanding abroad. But it keeps that growth within the bounds permitted by the U.S. current surplus and the cost of essential defense and aid. The voluntary program remains the foundation of improve- | ment in the U.S. balance of payments this year.

Out efforts to achieve full equilibrium in 1966 should also benefit from the improved situation for sterling; in 1965, special transactions by the United Kingdom accounted for roughly half of our deficit. Prospects are also strengthened by recent understandings established with Canada on the handling of its capital needs from the United States. Strong domestic expansion will continue to increase imports this year, and defense expenditures abroad will have to rise in 1966. Nevertheless, the United States has the determination and the means to continue the sharp improvement effected last year in bringing its balance of payments into equilibrium.