LOCAL currency proceeds (“counterpart funds”) are the proceeds derived by a government or a central bank from (a) the sale of foreign goods or foreign exchange received as a gift, grant, or loan to the national authorities, or (b) the use of exchange reserves. Thus they are the financial counterpart of the import surplus so financed. When supplies are given by one country to another in order to assist in reconstruction or development after some major disturbance (such as a war), the recipient government may, quite appropriately, sell the supplies to its nationals in exchange for local currency, however improper it may seem at first sight that what has been received as a gift or grant should be sold. Presumably the donor country intends the gift or grant for the general benefit of the recipient country, not for particular individuals, and presumably the public has adequate funds in local currency with which to buy the goods. Indeed, if there is active or latent inflation in the recipient country, the public has more than enough money. The sale of the goods for local currency and the accrual of the proceeds to the government are simply means of distributing the goods among users and at the same time retaining the benefit of the gift for the nation as a whole. In the past, certain UNRRA and Lend-Lease supplies (especially food) have been disposed of in this way, and the same is now being done with the supplies provided under the European Recovery Program.
The situation is unchanged in all essentials if, instead of selling the goods, the government uses them directly for its own purposes—for example, food and clothing for the armed forces (as in Lend-Lease), hydroelectric machinery for installation in public power projects, or rolling stock for a government-owned railway. In effect, gifts so used relieve the government of the necessity of making equivalent purchases, so that the gain appears in the first instance as a reduction in outlay rather than as an additional receipt. Sound accounting practice, nevertheless, requires that the transaction be recorded as a receipt of the gift and an equal expenditure for the armed forces, public works, railways, or whatever service was involved. The recorded receipt would be equivalent in all respects to the local currency proceeds of the sale of goods to the public, though it would be less likely to give rise to misunderstanding, since it would be associated only with a public benefit and not at all with any expense to a domestic national.
If the gifts are in foreign exchange rather than in kind, the situation is no different. The recipient government may sell the foreign exchange to its nationals (typically, to importers) in the same way as it might sell goods received, and obtain local currency for it. Or it may sell the foreign exchange to the central bank, again for local currency; the central bank would then presumably in turn sell the foreign ex-change to importers, and the situation would be in all respects identical with that in which the government sells the exchange to importers directly. Finally, the recipient government may use the foreign exchange to purchase abroad goods and services without the expenditure of other resources, and there would be a saving of outlay in local currency, which is equivalent to a local currency receipt. Indeed, as with gifts in kind, sound accounting practice would require that the receipt of the exchange be recorded at the equivalent in local currency, and that its expenditure be charged to the appropriate account.
The mechanics of the accrual of local currency proceeds from a loan are exactly the same as when a grant is received; the only differences arise from the fact that equivalent value is subsequently to be returned to the donor country. The future liability which the government has to meet on account of the goods financed with the loan should prevent any misunderstanding from arising over the fact that the goods are not given free to the public, and the accounting procedures called for in order to record this liability may differ somewhat from those used in a grant. These matters do not, however, affect the accrual of the local currency proceeds arising from the sale or use of the goods.
Finally, it should be noted that local currency proceeds also arise when the authorities allow a country’s exchange reserves to be depleted. If the reserves are sold to private importers and others having payments to make abroad (including the government), obviously the monetary authorities receive domestic currency in exchange. Thus the monetary authorities receive either local currency proceeds or equivalent value from the depletion of the exchange reserves. There is indeed a slight technical difference in the accounting procedure; the local currency proceeds will appear not as the accumulation of an asset in the hands of the government (e.g., by additions to bank balances), but rather as the elimination of a liability of the monetary authorities.1 Specifically, purchasers of exchange must pay in either the currency notes of the monetary authorities, drafts on their deposits with the same authorities, or drafts on their deposits with other banks. The first two types of payment obviously reduce the liabilities of the monetary authorities, and the third will have a similar effect since, in the absence of other offsetting transactions, such as borrowing from or rediscounting with the monetary authorities, the other banks can honor their drafts only by drawing on their balances with the authorities.
Policy Implications for the Country’s Economy
For the sake of simplicity and concreteness, let us discuss the matter in terms of international grants and loans, such as those under the European Recovery Program. In its essence this program is an under-taking by the participating European Governments, with outside (mainly United States2) assistance in the form of grants and loans, to expand their own productive capacity according to an agreed program. The beneficiaries undertake to make the fullest possible use of their own resources, including efforts to achieve internal financial stability and to expand international trade. On the basis of this program, the needs of Europe for outside aid are calculated.
Expressed in real terms the objective is relatively simple to under-stand, however difficult it may be to achieve: it is to use the economic aid made available so as to raise the productivity of the recipient nations in the most effective manner. Fundamentally, ERP is a plan to provide a net addition to the real resources available from current production in the recipient countries, thus making it possible to expand either private consumption, current governmental services, government (or government-controlled) investment, or private investment.3 In general, the greater part of the additional resources should be used for investment, since the purpose of the program is to assist the recipients to reach a high level of production more rapidly than would otherwise be possible. In practice, however, it is quite impossible to determine the actual net effect of the import surplus, because in all likelihood every aspect of the community’s use of real resources is affected by ERP aid. Without this assistance it would undoubtedly have been necessary to reduce the volume of imports, perhaps by as much as the amount of ERP aid. In some countries, investment would have had to be sharply contracted; in others, consumption would have probably suffered further restriction. On the whole, however, it is not unreasonable to assume that the volume of investment is being sustained at a level that exceeds, by the amount of ERP aid, what it would otherwise have been.
While the policy implications of ERP aid are clear enough in real terms, the proper integration of local currency proceeds into general financial policies must be given careful attention. The first and most important point to recognize is that the accrual of counterpart funds does not make possible the undertaking of new projects that were not part of the original program; they are simply the financial reflection of real resources already received and integrated into the economy. Secondly, when goods are received from abroad as a result of foreign aid and are sold within the country for local currency, a net deflationary (or anti-inflationary) effect is produced; for, unlike the case of an additional flow of goods arising from expanded local production, no equivalent sum is added to the income of the public in the form of wages, rents, etc. Local currency proceeds thus have a direct bearing on the inflationary situation, and their use must therefore be continuously coordinated with budgetary, monetary, and price policies.4 Obviously the beneficial effects of the import surplus in eliminating inflation can be offset by undesirable policies affecting government expenditure and investment. Nevertheless, this policy integration should not prove difficult as long as the central fact about local currency proceeds is kept in mind, namely, that they are simply the financial counterpart of foreign aid already received and incorporated in production and therefore do not constitute a resource for additional expenditure. Nor should aid received under ERP be used by the recipients as a means for relaxing their own efforts at self-help; on the financial side, this means that they should not reduce their efforts to finance government expenditure and normal investment by taxation and saving. In general, however, a country cannot pursue a really aggressive reconstruction program without generating some inflationary pressures, and the proper use of local currency proceeds can be of material assistance in combating them.
The most effective integration of local currency proceeds with other financial policies in any given country will depend to some extent on the nature of the inflationary situation. If there is still continuing inflation (whether it is allowed to work itself out at once in the form of rising prices, or is kept latent by economic controls), the obvious use for local currency proceeds is to substitute them for inflationary financing. If the government is responsible for the inflationary finance, it should use the local currency proceeds directly, in replacement of new bank borrowing. If the government’s budget (ordinary, investment, and state enterprise account combined) is already being covered by taxes and by borrowing from the public, and if it is the private sector of the economy that is resorting to inflationary methods of finance (the expansion of bank credit), the local currency proceeds should be transferred directly or indirectly from the government to the private sector. The government might lend the money to the industries in question, thus relieving them of the need to borrow from the banks; this would have the advantage of letting the government channel the funds to the most essential projects, and reduce the danger that less essential uses might intercept them. Or the government might allow the private sector to continue borrowing from the banks, but offset this by repaying government debt held by the banks. Or, finally, it might use the local currency proceeds to repay debt held by the public, in the expectation that funds would then become available through the capital market for financing private industry, though there is the danger that the public would use some of the funds for increased consumption instead.
If there is only latent inflation in the country, and if it is not increasing—that is, if excess liquid resources exist but are stable or declining—the local currency proceeds may best be used to reduce the money supply by repaying debt held by the banks. Since there is no tendency toward a net expansion of bank credit to finance either the public or the private sector of the economy, there is no question of using the local currency proceeds to obviate such expansion, and no presumption of a need to make them available directly or indirectly to the private sector. By hypothesis, both sectors are adequately financed by taxation and by voluntary current savings. A qualification should be noted, however; in practice it may not be possible to carry out completely the elimination of excess liquid balances. If these balances were fairly widely distributed, and easily transferable through the sale of securities, excess liquidity could be reduced by the full amount of the local currency proceeds not used for public expenditure and investment. Some part of the public will, however, continue to hold excess funds to finance their future consumption and investment. Some friction must therefore be expected, which will mean that, despite excess liquidity of the public as a whole, part of the private investment may have to be financed by new loans from the banking system.
Finally, the country may be free of inflation in any form. In such a case, funds equivalent to the accumulating local currency proceeds must be returned to the community, or the cash balances of the public will fall short of what is needed to finance production and the consumption and investment of the available supply of goods. The local currency proceeds may be handed back directly by the government in income payments, or may be made available indirectly through the creation of alternative funds by the banking system. It is quite conceivable, and even proper, that some of the funds should be used by the government to finance its own investment, including that of state enterprises. It is conceivable, too, that the local currency proceeds would be used from time to time by the government to finance private investment. It does not follow, however, that it is the actual local currency proceeds which must be made available for investment.
In a country in which institutional arrangements provide adequate facilities for financing private investment, there may in fact be distinct advantages in permitting private investment to continue to be financed through the usual channels. The investment bankers are familiar with the problem of raising capital for private enterprises, the commercial banks are familiar with the problem of providing bank credit to the same borrowers, and there is no special reason for superseding these financial agencies in the provision of funds for investment merely because the government has the local currency proceeds at its disposal. Under such circumstances, it would be preferable to place the banking system and the general public in a position to provide the finance requisite for investment. This could be done by using the local currency proceeds to repay government debt in the hands of individuals or the banks. In this way, funds would come into the hands of private investors in return for the bonds they hold, and these funds would be available to purchase new issues of private securities. The lending power of the banking system would also be restored by the repayment of government bonds. While the amount of debt repaid to the banking system and the public, respectively, might not conform precisely to the demands for loans from these two sources, means would be available to establish proper relationships. Individuals might place as bank deposits some of the funds received in return for bonds. The banks, in turn, if they found they had too much cash, might use some of their funds to purchase privately-held government and other bonds. Such adjustments could reasonably be expected in a well-organized financial system.
Thus, while the appropriate monetary policy connected with local currency proceeds differs for countries according to their situation with respect to inflation, the general principles which should deter-mine the disposition of these proceeds are much the same everywhere. In general, the most convenient means of disposing of the local currency proceeds is probably to repay government debt, subject only to the possible need to finance government investment through use of these funds. It is as the debt is retired that the essential differences in policy appear. In countries without inflation of any kind, it will be necessary to restore the cash holdings of the public; in countries working off latent inflation, there may be little need to restore these holdings.
As far as the day-to-day decisions of individual consumers and businessmen are concerned, the existence of local currency proceeds has no direct effect whatever. The consumption and investment of the community are adjusted by the public on the basis of income, the level of output, and other factors, modified perhaps by government policy relating to consumption and investment. The financing of an import surplus by ECA does not act directly to influence the desire of the public to consume and to invest. The flow of imports is continuously integrated into the economy in the usual way, just as if the goods were paid for by exports. Only when the aggregate supply of available goods is considered does it become clear that the behavior of the community would have had to be different without aid such as ECA is now making available to Western Europe.
To the extent that private firms and individuals undertake investments, they have two problems: to acquire the real resources necessary for the investment, and to find financing for the investment. The real resources available to the community for investment are determined by production, the import surplus, the amount of real resources that must be used for consumption and for government outlay, and the country’s policy in restraining aggregate investment to prevent inflation. The import surplus means that more real resources are available to meet these various demands, and therefore makes possible increased real investment. As far as individual persons or business firms are concerned, however, they know only whether or not the goods are to be had, not how they became available. Nor are their financial problems altered, directly at least, by the existence of an import surplus or the accrual of counterpart funds; they must pay for the investment goods in the normal way. If they had previously had government aid (e.g., in connection with war damage), they may expect the financing of such investment to be provided by the government. If they have customarily financed their new investment out of profits, they will expect to continue to do so. If they had ordinarily borrowed from the banking system or from the public, this practice will be continued. In brief, the problem of financing for private firms and individuals appears to them as part of the process of investment and is not directly affected by the existence of an import surplus or the accumulation of local currency proceeds as a consequence of the import surplus. It may be indirectly affected by the monetary effects of accumulating local currency proceeds, but this is only a special case of the rather obvious fact that the financing of investment is always affected by monetary policy.
In the aggregate it is clear that the community can undertake only as much investment as would have been possible without foreign aid, supplemented by the additional investment foreign aid permits. It is easy to assume that the accumulation of funds by the monetary authorities, in the form of local currency proceeds of the import surplus made possible by ECA aid, provides a means of undertaking additional investment, but in fact this is not so. The local currency proceeds are no more than the financial sign of the physical integration of the import surplus into the domestic economy; the aggregate supply of goods and the use of the available supply for consumption and government outlay are what determine the amount of investment that the community can undertake without encouraging inflation. Any attempt to add to the volume of investment determined in this way, by further use of local currency proceeds, could only have the effect of adding to the inflationary pressure.
The banking system (to the extent that it may be considered part of the private sector of the economy) deserves some special comment. The accumulation of local currency proceeds by the government and their use to retire debt held by the central bank, the other banks, or the public may cause temporary shortages of bank reserves and similar disturbances. In general, however, these will be merely technical difficulties; the authorities should be aware of the possibility of trouble of this kind, but normal central banking techniques should be adequate to cope with the matter unless unreasonably large and sudden movements of local currency proceeds are attempted. What will usually be required is a shift of assets among the central bank, the other banks, and the public. Under the circumstances, the banks are likely to have large holdings of government bonds, so that no serious transfer difficulties need arise.
Use of Local Currency Proceeds under ERP
This analysis may conveniently be concluded by a summary statement of the uses to which the local currency proceeds accumulated under ERP have in fact been put. As of October 31, 1949, a sum equivalent to $4,056 million had passed into the local currency accounts subject to the control of the various countries. The total amount re-leased up to the same date was $2,537 million. Of this, $1,069 million was released for debt retirement purposes, $1,307 million for various undertakings that may be regarded more or less as investment—promotion of production, reconstruction projects, and development of strategic materials—and the remainder for other purposes, mainly relief.
The use of these funds for specific investment projects calls for some comment. If these investments are new projects entered into in the belief that the local currency proceeds represented free resources, then they have really been financed by inflationary means, to the extent that by charging them to local currency proceeds the anti-inflationary effect of these proceeds has been offset to an equivalent amount. If, on the other hand, they represent merely an arbitrary linking of certain expenditures properly incorporated in the investment program that ERP was designed to permit, they are merely examples of a relatively harmless but not very meaningful practice sometimes followed whereby particular expenditures are arbitrarily linked to particular receipts.
If the foreign exchange was carried as an unencumbered asset of the government, its expenditure will involve a reduction of the government’s cash holdings in much the same way as the expenditure of local currency.
Aid from the United States is administered by the Economic Cooperation Administration (ECA).
It should be noted that the country’s real income may be increased by more than the equivalent of the ERP aid. For example, production might otherwise be hampered by the lack of certain key materials or equipment obtainable only in return for a currency in particularly short supply in the given country.
In this connection, the magnitude of ECA aid relative to the national income is of special significance (based on a comparison of ECA aid for the year ended April 30, 1949 and national income for the calendar year 1948). In Great Britain, where net ECA aid was of the order of 3 per cent of the 1948 national income, its effect on the inflation situation, while not negligible, is nevertheless limited. In the Netherlands, where net ECA aid was of the order of 6 per cent of the national income, its effect on the inflation situation is much greater.