Report to Congress on

International Economic and Exchange Rate Policies

May 2005

This report reviews developments in international economic policy, including exchange rate 

policy, focusing on the second half of 2004. The report is required under the Omnibus Trade and 

Competitiveness Act of 1988, which states, among other things, that: “The Secretary of the 

Treasury shall analyze on an annual basis the exchange rate policies of foreign countries, in 

consultation with the International Monetary Fund, and consider whether countries manipulate 

the rate of exchange between their currency and the United States dollar for purposes of 

preventing effective balance of payments adjustments or gaining unfair competitive advantage in 

international trade.” 

This report reviews the effects that significant international economic developments have had on 

the United States and foreign economies and evaluates the factors that underlie those 

developments. For the specific purpose of assessing whether an economy is manipulating the 

rate of exchange between its currency and the U.S. dollar according to the terms of the Act, 

Treasury has traditionally undertaken a careful review of the trading partner’s exchange rates, 

external balances, foreign exchange reserve accumulation, macroeconomic trends, monetary and 

financial developments, institutional development, and financial and exchange restrictions 

among other things. Attention is given to both the changes and the interactions of significant 

variables. Isolated developments in any one area do not typically provide sufficient grounds to 

conclude that exchange rates are being manipulated under the terms of the Act. A combination 

of factors, on the other hand, can and has in the past led Treasury to find that certain countries 

had satisfied the terms of the Act1. 

After reviewing developments in the United States, the report examines exchange rate policies in 

major economies across five regions of the world: (1) the Western Hemisphere, (2) Europe and 

Eurasia, (3) Sub-Saharan Africa, (4) the Middle East and North Africa and (5) South and East 

Asia. 

To summarize, the report finds that: 

• Economies around the world continue to follow a variety of exchange rate policies, 

ranging from a flexible exchange rate with little or no intervention to currency unions and 

full dollarization. For example, Canada follows a flexible exchange rate regime with no 

intervention, twelve countries are members of the European Monetary Union, and El 

Salvador, Ecuador and Panama use the U.S. dollar as their “domestic” currency. 

• The report finds that no major trading partner of the United States met the technical 

requirements for designation under the Omnibus Trade and Competitiveness Act of 1988 

during the second half of 2004. A number of economies continue to use pegged 

 

1

These issues are discussed more completely in Treasury’s March 11, 2005, Report To The Committees On 

Appropriations on Clarification Of Statutory Provisions Addressing Currency Manipulation.
2

exchange rates and/or intervene in foreign exchange markets. A peg or intervention, 

though, does not in and of itself satisfy the statutory test. Treasury has consulted with the 

IMF management and staff, as required by the statute, and they concur with these 

conclusions.

• Nevertheless, Treasury has engaged, and will continue to engage, with several 

economies, including some in Asia, to promote the adoption of market-based exchange 

policies and regimes. Most notable among these is China. Current Chinese policies are 

highly distortionary and pose a risk to China’s economy, its trading partners, and global 

economic growth. Concerns of competitiveness with China also constrain neighboring 

economies in their adoption of more flexible exchange policies. If current trends 

continue without substantial alteration, China’s policies will likely meet the statute’s 

technical requirements for designation. 

• While China’s ten-year-long pegged currency regime may have at times contributed to 

stability, it no longer does so. The peg blocks the transmission of critical price signals, 

impedes needed adjustment of international imbalances, attracts speculative capital flows 

and is a large and increasing risk to the Chinese economy. Indeed, Chinese officials have 

publicly acknowledged the need to move to a more flexible system, have repeatedly 

vowed to do so and have undertaken the necessary and appropriate preparations. It is 

widely accepted that China is now ready and should move without delay in a manner and 

magnitude that is sufficiently reflective of underlying market conditions. Treasury will 

continue to engage with China and closely monitor changes in its foreign exchange 

policy over the coming weeks and months.

• Treasury is continuing to engage actively with economies to encourage, in both bilateral 

and multilateral discussions, flexible market-based exchange rate regimes combined with 

a clear price stability goal and a transparent system for adjusting policy instruments. In 

this light, the communiqués of the G-7 Finance Ministers and Central Bank Governors in 

October of 2004 and February and April of 2005 stated: “...that more flexibility in 

exchange rates is desirable for major countries or economic areas that lack such 

flexibility to promote smooth and widespread adjustments in the international financial 

system, based on market mechanisms.” 

The United States International Accounts 2

The current account deficit is conceptually equal to the gap between domestic investment and 

domestic saving, as a matter of international accounting. When investment in the United States 

is higher than domestic saving, foreigners make up the difference, and the United States has a 

 

2

 The IMF annually reviews U.S. economic performance and policies through the so-called IMF Article IV 

surveillance process. The last Article IV surveillance review took place in July 2004. The IMF staff paper and the 

results of the IMF Executive Board’s discussion of the U.S. Article IV review can be found at 

http://www.imf.org/external/pubs/ft/scr/2004/cr04230.pdf. In addition, the IMF discusses U.S. economic policies 

and performance in the context of its twice yearly World Economic Outlook reports. These can be found at 

http://www.imf.org/external/pubs/ft/weo/weorepts.htm. 
3

current account deficit. In contrast, if saving exceeds investment in a country, then that country 

has a current account surplus as its people invest abroad. 

The growth of the U.S. current account deficit over more than a decade has been linked to high 

levels of domestic U.S. capital formation compared to domestic U.S. saving. Perceived high 

rates of return on U.S. assets, based on sustained strong productivity growth relative to the rest of 

the world, sound U.S. economic performance and the attractiveness of the U.S. investment 

climate, attract foreign investment. Sustained external demand for United States assets has both 

supported the dollar in the foreign exchange markets over the years and allowed the United 

States to achieve leve ls of capital formation that would have otherwise not been possible. 

Robust growth in investment is critical to the non-inflationary growth of production and 

employment.

In the second half of 2004, for example, the U.S. current account deficit was $679 billion (at a 

seasonally adjusted annual rate and on a national income and product accounting, or NIPA, 

basis) or 5.7 percent of GDP. This $679 billion deficit equaled the gap between $2,369 billion in 

investment and $1,690 billion in saving3. That is, U.S. domestic investment was $679 billion 

more than domestic saving with net foreign investment making up the difference.

The U.S. economy performed well over the second half of 2004. Real GDP increased at an 

average annual rate of 3.9 percent in the final two quarters, led by rapid gains in both business 

fixed investment and personal consumption. Improved labor markets (with almost one million 

new payroll jobs added during July-December and a decline in the unemployment rate to an 

average of 5.4 percent), as well as a rise in household net worth, contributed to increased 

consumer spending and favorable balance sheets despite low saving. Public saving is expected 

to improve, as solid economic growth and tight controls imposed by fiscal policies are expected 

to cut the Federal budget deficit by more than half, from 3.6 percent of GDP in FY 2004 to 1.5 

percent by FY 2009. 

The U.S. current account was $708 billion in deficit (at a seasonally adjusted annual rate and on 

a balance of payments basis4) in the second half of 2004. A major item financing the current 

account deficit has been net private foreign purchases of U.S. securities, which reached an 

annualized $552 billion in the second half of 2004. (Included in these were net private foreign 

purchases of U.S. Treasury securities amounting to $26 billion.) In addition, foreign official 

institutions increased their U.S. assets by $308 billion.

Viewed over a longer period, the U.S. current account balance declined, as a percent of GDP, 

from a one percent surplus in the first quarter of 1991 to a four percent deficit in the fourth 

quarter of 2000, to a six percent deficit in the second half of 2004. 

Due to the current account deficit the net investment position of the United States (with direct 

investment valued at the current stock market value of owners’ equity) fell to a negative $2.7 

 

3

 Including the (relatively small) statistical discrepancy.

4

 Although the current account measures are conceptually the same, balance of payments statistics are compiled on a 

slightly different basis from national income statistics. Saving includes the statistical discrepancy between the 

income and product accounts.
4

trillion as of December 31, 2003, the latest date for which data are available, from a negative 

$2.6 trillion at the end of 2002. A $398 billion valuation adjustment due to exchange rate 

changes offset much of 2003’s financial outflow. Despite a large negative position, U.S.

residents earned $30 billion more on their foreign investments in 2004 than foreigners earned on 

their U.S. investments. These positive net income receipts are the result of large net inflows of 

income from direct investment offsetting net outflows of income on portfolio investment. 

The U.S. current account deficit is the counterpart of the aggregate surplus of other economies in 

the world. The policies of all countries affect the global pattern of current account balances. It is 

important that policies that the United States follows keep the United States and the world 

economy strong. The adjustment of global imbalances is a shared responsibility. First, in the 

United States, policies aimed at increasing saving of the public sector and the private sector 

should contribute to global adjustment and reinforce the continuing stability of the international 

financial system. Second, in Europe and Japan, policies for further structural reforms are needed 

to boost sustainable growth. Third, greater flexibility of exchange rates is needed, particularly in 

emerging Asia economies that lack such flexibility. 

The U.S. Dollar 

The Federal Reserve Board’s “broad” nominal dollar index decreased 6.7 percent during the 

second half of 2004. The dollar depreciated 8.9 percent against the “major” foreign currencies 

(seven other industrialized economy currencies) and 3.8 percent against the currencies of “other 

important trading partners” of the United States (largely currencies of emerging market 

economies). The broad index declined 16.9 percent from February 27, 2002, when it reached its 

recent peak, through December 31, 2004. Over this latter period the dollar depreciated 29.5

percent against the major currencies while appreciating 1.8 percent against the currencies of 

other important trading partners.

The consumer price index (CPI) rose 2.0 percent annualized rate from July through December 

and in the final month of the year was 3.3 percent higher than a year earlier. Excluding food and 

energy, the core CPI rose 2.2 percent during the 12 months ending in December 2004. With the 

economy expanding and underlying inflation modest, the Federal Reserve continued to remove 

monetary accommodation, increasing its federal funds target rate four times, by a total of 100 

basis points, in the second half of the year to reach to 2.25 percent on December 14. The yield 

on 10-year Treasury notes fluctuated during the latter half of the year, but finished the year at 

about 4.2 percent in December, essentially unchanged from the end of 2003 and 50 basis points 

lower than in June despite the rise in short term interest rates.

As discussed below, the currencies of different economies showed varying degrees of flexibility 

relative to the dollar, as some monetary authorities sought to dampen or prevent movements of 

their exchange rates against the dollar while others did not intervene at all. The United States did 

not intervene in foreign exchange markets during the second half of 2004.
5

Western Hemisphere

Nominal exchange rates in the region on average appreciated against the U.S. dollar in the 

second half of the year, as Latin America posted nearly 6 percent real GDP growth in 2004, the 

highest regional growth rate in a quarter-century. Interest rate spreads between the Latin 

American Emerging Market Bond Index (EMBI+) and U.S. Treasury securities decreased from 

569 basis points in end-June to 434 basis points by end-December 2004.

Argentina

Argentina has had a flexible exchange rate since the end of 2001 when it abandoned its 

convertibility law, which pegged the peso one-to-one to the U.S. dollar. Argentina’s currency 

remained relatively steady in the second half of 2004, depreciating 0.5 percent from 2.96 pesos 

per dollar to 2.97 pesos per dollar. Argentina’s trade surplus was $6.2 billion in the second half 

of 2004, with exports rising 20 percent and imports rising 53 percent compared to the same 

period the previous year. The seasonally adjusted current account fell from 2.2 percent of GDP 

in the first half of 2004 to 1.9 percent of GDP in the second. The U.S. trade deficit with 

Argentina was $334 million in the second half of 2004. 

Argentina’s gross foreign exchange reserves grew by $2.2 billion during the second half of the 

year to $19.6 billion at the end of December 2004 as Argentina’s central bank accumulated 

international reserves during periods of peso strengthening. The economic recovery continued 

after the severe contraction in the first half of 2002, with real GDP growing 14.0 percent at a 

seasonally adjusted annualized rate in the third quarter of 2004 and 11.4 percent in the fourth 

quarter. Consumer prices accelerated, with a net increase of 5.2 percent in seasonally adjusted 

terms from June 2004 to December 2004. 

Brazil

Brazil has a flexible exchange rate regime and relies on inflation targeting to guide monetary 

policy. The real appreciated 16.9 percent against the dollar during the second half of 2004 from 

BRL3.11/US$ to BRL2.66/US$. Brazil’s sovereign risk spread stood at 383 basis points over 

U.S. Treasuries at end-2004 versus 646 basis points at the end of June. Year-on-year inflation 

stood at 7.6 percent in December, above the central bank’s 5.5 percent target for 2004 but within 

the target band. Brazil had a $6.3 billion, or 2.0 percent of GDP, current account surplus in the 

second half of 2004 compared to $5.4 billion, or 1.9 percent of GDP, in the first half. The 

United States had a trade deficit with Brazil of $4.9 billion in the second half of 2004 compared 

to a $3.4 billion deficit in the second half of 2003. Foreign direct investment increased to $14.1 

billion in the second half of 2004 compared with $4.0 billion in the first half. The central bank 

increased net international reserves to $27.5 billion by end-December 2004 compared to $24.9 

billion at end-June, as the central bank purchased international reserves at the end of the year.

Real GDP (saar) increased 4.4 percent and 1.7 percent in the third and fourth quarters 

respectively. For the full-year 2004, GDP posted a 5.2 percent increase—the highest growth rate 

in ten years.
6

Canada

Canada has a flexible exchange rate regime. It has not intervened in the foreign exchange 

market since 1998, except to make a small contribution to the brief G-7 intervention in support 

of the euro in September 2000. Its central bank targets an inflation rate of 2 percent with a +/- 1 

percent band. During the second half of 2004, the Canadian dollar appreciated against the U.S. 

dollar by 11.4 percent, from 1.34 C$/US$ to 1.20 C$/US$. The J.P. Morgan broad real tradeweighted index for the Canadian dollar appreciated by 8.3 percent while the J.P. Morgan narrow 

nominal trade-weighted index for the Canadian dollar appreciated by 9.5 percent. Canada’s 

current account surpluses during the third and fourth quarters of 2004 were $6.4 billion, or 2.6 

percent of GDP, and $5.2 billion, or 1.9 percent of GDP, respectively. The merchandise trade 

surplus with the U.S. during the period was $33.6 billion. Canada’s international reserves 

declined in second half of 2004 to $34.5 billion from $35.4 billion in the first half. Year-on-year 

headline inflation in December 2004 was 2.1 percent. The economy expanded in the second half 

of 2004, with annualized real GDP growth of 3.4 percent and 3.0 percent in the third and fourth 

quarters, respectively. 

Mexico

Mexico has a flexible exchange rate regime. Its central bank targets an inflation rate of 3 percent 

with a +/-1 percent band. The Bank of Mexico also follows a transparent rule for selling foreign 

reserves accumulated by state enterprises. During the second half of 2004 the Mexican peso 

appreciated by 3.5 percent against the dollar, from 11.54 pesos/dollar to 11.15 pesos/dollar. The 

J.P. Morgan narrow nominal trade-weighted index for the peso depreciated by 0.4 percent, while 

the J.P Morgan broad real trade-weighted index for the peso appreciated by 0.4 percent. 

Mexico’s current account deficits during the third and fourth quarters of 2004 were $2.3 billion, 

or 1.4 percent of GDP, and $2.9 billion, or 1.7 percent of GDP, respectively. Mexico’s 

merchandise trade surplus with the U.S. during the period was $22.8 billion. Foreign direct 

investment in the second half of 2004 was $5.4 billion, versus $11.2 billion in the first half of the 

year. International reserves grew by $2.4 billion during the second half of the year, reaching 

$61.5 billion by the end of December. Year-on-year headline inflation was 5.1 percent in 

December. The economy grew robustly in the second six months of 2004, with real seasonally 

adjusted GDP increasing at annual rates of 3.8 percent and 5.6 percent during the third and fourth 

quarters, respectively.

Europe and Eurasia

The Euro-zone

During the second half of 2004, the euro remained relatively stable through mid-October, but 

appreciated sharply thereafter, gaining 9 percent from mid-October, or 11.2 percent from endJune, to year-end. The index of the real effective exchange rate of the European Central Bank 

(ECB) appreciated 4.9 percent over the second half of the year. The ECB did not intervene in 

foreign exchange markets during 2004.
7

The countries in the Euro-zone taken together had a current account surplus during the second 

half of 2004 equal to $11.3 billion (sa), or 0.2 percent of GDP, down from $38.4 billion, or 0.8 

percent of GDP, in the first half of the year. Goods exports increased 8.4 percent while goods 

imports increased 12.9 percent in the second half of 2004 over the same period in 2003. The 

trade surplus of the Euro-zone vis-à-vis the U.S. was $44.2 billion in the second half of 2004 

compared to $39.7 billion in the second half of 2003.

Euro-zone growth was an estimated 0.8 percent (annualized) in the second half of 2004. 

Germany and Italy have held back Euro-zone growth while France had annualized growth of 1.5 

percent in the second half led by strong domestic demand. For the region, final consumption 

expenditure rose 1.0 percent in the second half of 2004 while investment increased 2.5 percent. 

Core inflation was 1.9 percent yr/yr in December 2004 compared to 2.0 percent yr/yr in June 

2004. Headline inflation – which includes energy and other volatile prices excluded in the core 

index – was 2.4 percent yr/yr at the end of the second half of 2004, the same rate as at the end of 

the first half.

Central Europe & Ukraine

The currencies of the major central European economies appreciated sharply against the dollar 

during the second half of 2004. This partly reflected the dollar’s depreciation against the euro 

during the period, but each of the currenc ies also strengthened against the euro, their main 

reference currency, supported by attractive domestic interest rates. 

In Hungary, short term yields of 10.0 percent helped the forint appreciate 2.1 percent against the 

euro (14.0 percent against the dollar), despite continued concern about large fiscal and current 

account deficits. The National Bank of Hungary’s index of the real value of the forint rose by 

slightly less, 1.8 percent, as inflation slowed. 

In Poland, the zloty rose 10.5 percent against the euro during the second half of 2004 (an 

appreciation of 23.4 percent against the dollar). Zloty appreciation reflected the differential 

between domestic interest rates and Euro-zone yields, as well as increased political stability and 

improved macroeconomic performance. The National Bank of Poland’s index of the zloty in 

real terms rose 8.1 percent. 

In Ukraine, the hryvnia rose 0.3 percent against the dollar during the second half as the central 

bank continued to manage the bilateral exchange rate against the dollar heavily. 

Russia

The large net inflows resulting from high oil prices continued during the second half of 2004. 

Russia’s current account surplus in the second half of 2004 was $33.8 billion (nsa), or 10.5

percent of GDP, compared to $15.8 billion, or 6.6 percent of GDP, in the second half of 2003. 

The ruble appreciated 4.9 percent against the U.S. dollar in the second half of 2004 compared to 

0.6 percent in the first half. However, because of the relative strength of the euro, J.P. Morgan’s 

Broad Real Effective Exchange Rate Index appreciated just 0.6 percent in the second half of 

2004 compared to 5.1 percent in the first half. Russian monetary authorities continued to 
8

intervene to moderate the appreciation of the ruble against the dollar, and official reserve assets 

increased $36.3 billion to a record high of $124.5 billion. Consumer prices rose 11.9 percent in 

the year through December 2004 compared to 10.2 percent in the year through June 2004.

Sub-Saharan Africa

Overall, Sub-Saharan African’s current account deficit narrowed to an estimated 1.6 percent of 

GDP in 2004 from 2.4 percent in 2003. An improvement in the current account balances of the 

region’s main oil exporters drove the overall change. The growth in the U.S. trade deficit to $27 

billion, from $19 billion in 2003 with sub-Saharan Africa reflects higher U.S. oil imports, which 

accounted for 73 percent of all U.S. imports from the region. 

Roughly half of sub-Saharan African countries officially peg their currencies to other currencies, 

primary the Euro. Most sub-Saharan African currencies appreciated in nominal terms against the 

U.S. dollar in the second half of 2004. The South African Rand, which floats relatively freely 

appreciated about 10 percent against the U.S. dollar during the second half of 2004, benefiting 

from higher prices of South Africa’s commodity exports. However, the value of the currencies 

of six countries with managed or independently floating exchange rate regimes changed little 

against the U.S. dollar over the six month period, most notably the Nigerian Naira, despite 

significant increases in oil receipts. Of the countries for which reliable data is available, the 

Democratic Republic of the Congo’s currency depreciated the most in nominal terms (11 

percent). 

Middle East and North Africa

Strong economic growth continued across the Middle East and North Africa, supported by high 

oil prices. GDP growth in the oil-exporting countries of the Gulf Cooperation Council countries 

(Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE) remained robust. Mainly due to 

higher oil prices, current accounts across the Gulf remained largely in balance or surplus, having 

increased significantly, along with holdings of official reserves. Oil-exporting GCC countries tie 

their currencies directly to the U.S. dollar. 

Many other countries in the region, such as Jordan and countries in North Africa, also maintain 

pegged exchange rate regimes. Changes in current account balances largely reflected changes in 

terms of trade, with balances rising in large oil exporters like Algeria and falling in importers 

like Morocco. In Egypt, exchange rate flexibility increased considerably following the launch of 

an interbank foreign exchange market in December 2004. The current account surplus rose due 

to higher oil prices and increased receipts from tourism and the Suez Canal (reflecting robust 

global trade). This, along with a small but growing net increase in capital inflows due to tighter 

monetary policy, growing inve stor confidence in the reform-oriented economic team, and an 

expected surge in privatizations, led to upward pressures on the pound and virtually eliminated 

the spread between official and parallel markets. In the six months ending December 2004, the 

pound appreciated 1.9 percent in nominal terms against the dollar, and the current account 

registered a $2.9 billion surplus, a $900 million increase over the same period in 2003. Net 

international reserves increased from $14.8 billion end-June 2004 to $15.4 billion end-December 

2004.
9

Turkey maintained its floating exchange rate regime. Overall, the Turkish lira appreciated by 

10.4 percent in nominal terms against the U.S. dollar in the second half of 2004, as capital 

inflows increased in anticipation of a European Union decision to begin accession negotiations 

and high real interest rates. However, during this period, the central bank’s index of the real 

trade-weighted lira rose 4.1 percent, reflecting 1.7 percent nominal depreciation against the euro. 

Inflation fell from 12.7 percent in 2003 to 9.4 percent in 2004, its lowest level in decades. The 

current account deficit widened in 2004 to 5.1 percent of GNP ($15.4 billion), from 3.4 percent 

in 2003, on the back of strong domestic demand, as GNP grew 9.9 percent over the first three 

quarters of 2004, compared to the same period in 2003. Imports and exports increased 39.1

percent and 30.8 percent, respectively, compared with 2003, driving the trade deficit to $23.8

billion, up 70 percent from $14.0 billion in 2003. Reserves stood at $37.6 billion at end-2004, up 

from $35.2 billion at end-2003, still only 75 percent of short-term external debt.

In Israel, which also maintains a floating exchange rate, the shekel appreciated 4.4 percent in 

nominal terms aga inst the dollar during the second half of 2004, while remaining constant in real 

trade-weighted terms due to significant trade weights of the euro and sterling. Capital inflows 

surged in 2004 as the decline in foreign direct investment in 2004 was more than offset by strong 

portfolio investment throughout the year (reversing the general trend of positive FDI and 

negative portfolio investment). While posting a small deficit in the second half of 2004 as 

private consumption rose, the current account registered a slight surplus for the year (0.4 percent

of GDP) due to strong growth in goods and services exports. GDP growth increased in 2004 to 

4.3 percent for the year, up from 1.3 percent in 2003, with an acceleration in the second half of 

2004. Foreign exchange reserves rose 3.6 percent in the second half of 2004, reaching $26.6 

billion at end-December, after remaining unchanged in the first half of 2004. 

South and East Asia

South and East Asia contributed to the global economy’s strong growth in 2004. Developing 

East Asia grew at 7.3 percent in 2004. Japan grew at 2.7 percent, its highest rate since 1996. 

Strong external demand, particularly in the United States, and the revival of the global IT 

industry supported growth in the region. But a revival of domestic investment in economies of 

the region also underpinned economic growth. The growth of domestic demand in China, in 

particular, is contributing significantly to the global growth. Although imports into the region 

grew rapidly with improving economic performance, export growth was also strong and current 

account surpluses increased in most major economies of the region. 

Within the year, growth was strongest in the first quarter. By the third and fourth quarter growth 

rates had dropped significantly in a number of East Asian countries – Japan in particular. This 

was in part due to excessive inventory buildups in the IT sector, but also reflected a moderate 

slowing of U.S. growth and rising oil prices. Solid growth within the region and rising oil prices 

also marked the end of concerns about deflation in a number of countries outside Japan, and the 

beginning of a shift in monetary policy to avoid inflation. In some cases, notably Korea, 

exchange rate appreciation was viewed as a way of containing imported inflation.
10

Capital flows into the region went through two broad cycles. After slowing significantly in the 

second quarter of 2004, capital inflows picked up sharply in the last half of the year, and were 

especially strong in the fourth quarter. As a result, private capital flows into the region rose for 

the fourth straight year in 2004 and may be nearing pre-Asian Crisis levels. Net inward foreign 

direct investment increased by more than 30 percent to an estimated $72 billion. Net portfolio 

and other capital inflows increased as well. Monetary authorities faced growing foreign demand 

for domestic currency assets and upward pressures on their currencies over the year as a whole, 

particularly in the second half. 

Trade flows among East Asian economies have increased sharply in recent years, reflecting 

increased integration of economies in the region. But increased intra-regional trade also reflects 

the increasing diffusion of component production among economies in the region, often for 

products that are exported outside East Asia. As a result, monetary authorities of economies 

with more flexible exchange rates appear to be increasingly concerned about the effect of 

currency appreciation on their competitiveness relative to other economies in East Asia. While 

noting these concerns, the Administration has encouraged increased exchange rate flexibility for 

East Asian economies generally, both in bilateral discussions and in regional fora such as APEC. 

APEC Finance Ministers made a significant move in this direction in their statement of 

September 3, welcoming steps taken by member economies to facilitate the move to greater 

exchange rate flexibility.

India 

Faced with strong financial inflows and rising inflation, the central bank allowed greater 

flexibility in the managed floating exchange rate regime and liberalized controls on capital 

outflows. The Indian rupee appreciated against the U.S. dollar by 6.3 percent during the second 

half of 2004. Foreign institutional investors poured $5 billion into Indian equity markets in the 

second half of 2004 compared with $3.5 billion in the first half, as investor concerns that the 

newly elected government would slow market oriented reforms receded. Income from 

remittances also remained strong. The U.S. bilateral merchandise trade deficit with India was 

steady at $4.7 billion in the second half of 2004, compared to $4.8 billion for the first half. 

Despite increases in exports of services, a sharp rise in commodity imports due to higher prices 

pushed the current account into a deficit of 0.1 percent of GDP in 2004, from a surplus of 1.3 

percent of GDP in 2003. Foreign exchange reserves increased to $125 billion at year end from 

$114 billion at the end of June. 

Japan

Japan’s economic recovery, which began in the second quarter of 2002, stalled in the second half 

of 2004. Japan’s economy contracted slightly in the second and third quarters of the year and 

grew marginally in the fourth quarter. Japan also appeared to lose some ground in its long fight 

to eliminate deflation, as core consumer prices (the Japanese CPI less fresh foods) fell by 0.2 

percent year-on-year during the second half of 2004, after falling 0.1 percent on a year-on-year 

basis in the first half of the year. However, other price measures, such as the deflators for private 

consumption and GDP, showed continued progress toward price stability.
11

Japan has had a persistent current account surplus and capital outflows to the rest of the world, a 

consequence of a surplus of Japanese savings over domestic investment. Rates of return on 

domestic investment have been generally low, although the Prime Minister’s program of 

structural reform and deregulation and the recent acceleration of corporate restructuring and 

mergers and acquisition activity hold out the prospect of higher returns. Japan’s global current 

account surplus remained steady at about 3.5 percent of GDP (or $83.1 billion) in the second half 

of 2004. Japan’s bilateral merchandise trade surplus with the United States totaled $39 billion in 

the second half of 2004, up from $36.2 billion in the first half. Capital continued to flow out of 

Japan in the second half of 2004 reportedly in response to changing expectations of U.S. growth 

relative to Japanese growth and higher U.S. interest rates. 

During the June 30 to December 31, 2004 reporting period, the yen appreciated 5.6 percent 

against the dollar, reaching a level of 103.8 at year-end. At the same time that the Japanese 

economy appeared to weaken, economic releases from the United States showed continued 

strength. This differential was reflected in currency values during the first three months of this 

year. The yen hit a peak value of 101.9 to the dollar on January 17, 2005, but by March 31 was 

trading at 107.0 to the dollar, a depreciation of 3.1 percent from its end-year level. Over a more 

extended period, since early February 2002 through the end of March 2005, the dollar has 

depreciated by 20 percent against the yen, less than its 29.5 percent depreciation against the 

major currency component of the Federal Reserve Board’s Broad Nominal Index of the dollar 

over the same period. 

Japanese authorities have not intervened in the foreign exchange market since March 16, 2004.5

Japanese foreign exchange reserves rose by $25.7 billion in the second half of 2004 to $824.3 

billion, due to interest earnings and a depreciation of the dollar against other currencies held as 

Japanese reserves. This contrasts with an increase in Japanese foreign exchange reserves of 

$145.8 billion in the first half of 2004, a period in which the authorities did intervene.

China

China kept its fixed exchange rate of 8.28 to the U.S. dollar throughout the reporting period, a 

rate it has maintained since 1995, through periods of both upward and downward pressures on 

the exchange rate. While the benefits of China’s ten-year-long pegged currency regime may 

have at times served well the Chinese economy, this is no longer the case for the large, 

increasingly market-based economy that China has become. China’s fixed exchange rate is now 

an impediment to the transmission of price signals and international adjustment, and imposes a 

risk to its economy, China’s trading partners, and global economic growth. China has clearly 

stated that it intends to move to a market-based flexible exchange rate, and has undertaken the 

necessary and appropriate preparations. It is now widely accepted that China is now ready and 

should move without delay in a manner and magnitude that is sufficiently reflective of 

underlying market conditions.

 

5

The Japanese Ministry of Finance announces its total foreign exchange intervention at the end of each month, and 

publishes the dates and amounts of intervention at the end of each quarter. See 

http://www.mof.go.jp/english/e1c021.htm
12

To maintain the fixed exchange rate the Chinese authorities supplied renminbi for net inflows of 

foreign exchange, accumulating foreign exchange reserves in the process. This accumulation of 

foreign reserves accelerated in second half of 2004. China’s official foreign exchange reserves 

grew by a net $139 billion to $610 billion during the second half of 2004, with over two-thirds of 

the increase taking place in fourth quarter.

China’s fixed exchange rate regime and the large amount of renminbi the monetary authorities 

supply in maintaining the fixed exchange rate made effective macroeconomic policy 

management more difficult during the second half of 2004 and into 2005. To soak up 

(“sterilize”) the additional renminbi created by purchasing foreign exchange, China’s central 

bank sells bonds to domestic banks. Net issuance of central bank sterilization bonds has risen 

sharply since September 2004. Chinese policymakers also took a series of administrative 

measures over the last year to curb lending, and raised domestic interest rates slightly in October 

2004 in order to constrain investment and contain consumer prices.

These macroeconomic policy measures had some effect in cooling off the economy during the 

second half of 2004. However, economic growth remained quite strong in the fourth quarter of 

last year, and 2005 data suggest that China’s growth rate and inflation risks are rebounding. In 

the first quarter of 2005, real GDP, driven by trade and investment, grew by 9.5 percent. 

Industrial output and investment growth also remained brisk. China’s exports grew rapidly on 

sharp increases in textile and apparel exports following the end of quotas and increased 

electronics shipments. After a 3.9 percent year-over-year increase in consumer prices in March, 

inflation moderated in April, but still remains higher than at the end of 2004. Real interest rates 

fell as a result, countering the authorities’ efforts to contain the increase in bank lending. 

China’s experience over the reporting period illustrates some of the difficulties of maintaining 

the fixed exchange rate. Rapid growth in exports, increased liquidity, and low real interest rates 

continue to support China’s economic growth, and concerns remain about overinvestment and 

inflationary pressures. In this regard, China needs to rely more on domestic demand growth, 

particularly consumption growth. The central bank has had to work hard to counteract the 

growth in domestic liquidity from foreign exchange intervention. It is also very limited in its 

ability to raise interest rates since this would spur greater capital inflows. The rapid growth of 

credit and very high rate of investment in turn risk undermining the progress China has made in 

reforming its banking system by creating new flows of non-performing loans.

China’s global trade surplus increased in the second half of 2004 to a (seasonally unadjusted) 

total of $40 billion (4.2 percent of GDP), up from a $21 billion surplus (2.6 percent of GDP) in 

the same period in 2003. The trade surplus in the second half of 2004 offset a deficit during the 

first half, bringing China’s reported trade surplus to $32 billion for all of 2004.6 The increase in 

 

6

 These trade figures are on an FOB-CIF basis. Several studies have noted that China’s global trade surplus (one 

component of its current account surplus) as reported in aggregate by China’s trading partners differs markedly from 

what is reported by Chinese official statistics. One difficulty that arises is that much trade to and from China travels 

via Hong Kong. Importing countries usually accurately determine the source of their imports though certificates of 

origin. But exporters (both Chinese and partner country exporters) often record the destination of their exports as 

Hong Kong, even though the goods go on to other markets. This explains a significant part of the discrepancy 

between Chinese and partner country trade estimates of China’s trade surplus, since a significant part of the trade 

between China and partner countries is recorded as trade with Hong Kong.
13

China’s global trade surplus is partly due to recovery in the global IT market and the increase in 

Chinese shipments of components. But there are also reports that trade transactions are also 

being used to move capital into China for domestic investment or in anticipation of a revaluation 

of the renminbi. This could occur either through accelerating the collection of payments due for 

Chinese exports while delaying payment for imports, or by over-invoicing exports and underinvoicing imports. Both responses are common in countries with capital controls. China’s 

bilateral surplus on trade in goods with the United States also expanded in the second half of 

2004 to $93.5 billion compared to $70.2 billion for the last half of 2003. U.S. trade in both 

directions continued to expand at a faster rate than total U.S. trade. While total U.S. exports to 

all destinations grew by 13 percent in 2004, U.S. exports to China grew 22 percent during the 

same period. 

China’s balance of payments surplus amounted to $206 billion in 2004, up 76 percent from 2003 

(China’s balance of payments data are available only on an annual basis). China’s current 

account surplus increased sharply in 2004 to $68.7 billion, or 4.2 percent of GDP. This surplus 

has increased in recent years from $17.4 billion in 2001 (1.5 percent of GDP), to $45.9 billion 

(3.1 percent of GDP) in 20037. China’s capital and financial account saw a net inflow of $111 

billion in 2004 (compared to $53 billion in 2003). Reserve accumulation figures suggest that 

private financial inflows surged in the second half of 2004, as speculation on an appreciation of 

the renminbi increased and as property markets in major urban areas heated up. Despite recent 

liberalization, China maintains greater controls on capital outflows than inflows, which 

contributes to upward pressure on reserves and the balance of payments.

In the context of an economy with large and dependable capital inflows, large prospects for 

productivity gains, and unsustainably high rates of investment, China’s current account surplus is 

large. 

China has committed to push ahead firmly and steadily to a market-based flexible exchange rate, 

and is taking concrete steps to bring about exchange rate flexibility. Chinese Premier Wen said 

on March 14, 2005 that China would “create a market-based, managed and floating exchange 

rate.” Chinese Central Bank Governor Zhou has said recently that “rigid exchange rates present 

huge risks.”

Since September 2003, when the Treasury began its intensive engagement with China to hasten 

its move to a more flexible exchange rate, the Chinese Government has taken important steps to 

establish the necessary financial environment and infrastructure to support exchange rate 

flexibility. 

First, China has undertaken measures to increase the volume of foreign exchange trading, an 

important step in aiding market development and reducing the volatility of exchange rates. 

China has reduced restrictions on capital flows and allowed its firms and citizens greater scope to 

engage in market transactions. In February, China eliminated the foreign exchange surrender 

requirements for many commercial firms, which can now exchange their export earnings with 

 

7

 In addition to the trade balance, a widening surplus on transfers and a narrowing deficit on investment income are 

significant factors increasing the current account surplus. At this time, trade statistics are the only current account 

items available for 2004.
14

authorized banks rather than the central bank. Domestic Chinese insurance companies and 

China’s national social security fund are authorized to invest in overseas capital markets, thereby 

increasing the volume of renminbi foreign exchange transactions. Recently, China increased the 

amount of foreign currency that business travelers can take out of the country, permitted Chinese 

emigrants to transfer assets overseas, and allowed Chinese students to take more money abroad 

to pay for living expenses. As a result, the volume of foreign exchange market transactions in 

renminbi has expanded rapidly in the past few years. China needs to continue to liberalize its 

exchange regime by increasing the scope for foreign investment in China and allowing its 

residents greater access to foreign exchange. 

Second, China has also taken steps to develop foreign exchange market instruments and to 

increase its financial institutions’ experience in dealing with fluctuating currencies. China has 

introduced, or will introduce soon, financial instruments and systems for trading currencies and 

managing currency risk through hedging. Foreign exchange forward contracts can now be 

offered in China, and foreign exchange futures trading systems and instruments are being 

developed. Domestic and foreign banks can trade non-reminbi currency pairs (such as US 

dollar-yen), and certain Chinese banks will act as market-makers for this foreign currency 

trading. The Treasury and U.S. financial regulators provided substantial technical assistance to 

China in these efforts, through the Technical Cooperation Program (TCP) established with the 

People’s Bank of China.

Finally, China has taken steps to strengthen its financial sector and its financial regulation, 

making the financial sector more resilient to foreign exchange rate fluctuations. In addition to 

raising one-year deposit and lending rates late last year, China’s central bank eliminated a ceiling 

on interest rates on bank loans, giving banks greater scope to price risk. Further market oriented 

reforms in this area are needed. China’s banking regulator tightened loan accounting standards 

by introducing a risk-based loan classification system to track non-performing loans (NPLs) 

more effectively. It also tightened loan supervision by increasing the number and scope of bank 

audits and on-site bank examinations, and by setting more aggressive targets for reducing NPLs 

and increasing capital. The larger banks have upgraded their credit risk management systems, 

centralized and standardized credit extension procedures, and improved corporate governance 

practices following regulatory measures to allow foreign interests to take strategic stakes, to 

define clearly responsibilities for Boards, management and shareholders, and to raise disclosure 

requirements. China needs to continue this progress and to take further steps to allow foreign 

investment in the major commercial banks, show that its tightened NPL classification system is 

yielding results, and strengthen the functioning of its securities markets. To assist the Chinese 

authorities, Treasury provided technical guidance last year on banking supervision, credit 

analysis, international accounting standards, and resolution of non-performing loans. 

In summary, the fixed exchange rate that China now maintains is a substantial distortion to world 

markets, blocking the price mechanism and impeding adjustment of international imbalances. It 

is also a source of large and increasing risk to the Chinese economy. China has completed 

significant preparations over the last two years for adoption of a more flexible, market-oriented 

exchange rate. China is now ready to move to a more flexible exchange rate and should move 

now. Treasury will monitor progress on China’s foreign exchange market developments very 

closely over the next six months in advance of preparation of the fall report. 
15

Korea

In contrast to strong growth in other parts of emerging East Asia, Korean growth in 2004 was 

held back by the continuing effects of a credit card boom and bust. With household spending 

depressed, Korean economic growth during the year was largely driven by increased exports. 

The growth rate decelerated in the second half of 2004 to 3.2 percent (annualized), from 4.7 

percent growth in the first half, largely due to a continued decline in private consumption. 

Export growth slowed in the second half of 2004, but exports were still up 25 percent year-onyear, after growing at 37 percent year-on-year in the first half. Export growth to China was 

particularly strong, up 42 percent for 2004. Total import growth did not keep pace, but still rose 

by 26 percent for the year. The difference in import and export growth rates was reflected in 

Korean external balances. The U.S. bilateral trade deficit with Korea totaled $19.8 billion for the 

full year 2004. For the second half of 2004 the trade deficit totaled $10.8 billion, up 44 percent 

from the same period a year earlier, as U.S. imports from Korea grew by 23 percent and exports 

to Korea by 10 percent. Korea’s current account surplus was 4.0 percent of GDP for the second 

half of 2004, compared to 4.1 percent for the first half of the year.

Total capital and financial flows, exclusive of reserve accumulation, registered a net surplus 

(inflow) of $7.5 billion (n.s.a.) for the second half of 2004, an increase over the small ($0.8 

billion) inflow for the first half. The financial inflows resulted from Korean residents’ increasing 

their foreign borrowings. The Korean authorities continued to intervene in the second half, as 

official foreign reserves increased by $32 billion to $199 billion, equivalent to 112 percent of the 

total external debt of Korea. 

Despite this intervention, the won appreciated 14.8 percent versus the dollar over the course of 

2004; during the fourth quarter alone the won appreciated 10 percent. Citing a slowdown in the 

pace of economic recovery, particularly in domestic demand, the Korean central bank reduced its

benchmark call rate a quarter-point again in November following on a similar cut in August. 

The effect of the won appreciation in the fourth quarter was to reduce inflation pressures, 

particularly those due to oil price increases. This, in turn, allowed the Central Bank of Korea to 

pursue its more accommodative monetary stance despite inflation coming in at the upper end of 

the 2.5-3.5 percent target range.

Taiwan

Taiwan’s GDP growth moderated to 3.8 percent saar in the second half of 2004 relative to the 

first half of the year. GDP growth in the second half of 2003 reached 9.4 percent due to a sharp 

recovery of domestic demand (in particular business investment) and strong export growth 

(particularly to China). The 2004 slowdown was the result of both a decline in investment and a 

modest slowdown in government consumption. 

Accommodative monetary policy, accompanied by higher oil and commodity prices, halted three 

years of deflation in 2004 with headline consumer price index growing at a rate of 2.9 percent in 

the third quarter and 1.9 percent in the fourth. In the third quarter of 2004, the central bank 
16

raised interest rates for the first time in four years on concerns of inflation, particularly related to 

rising oil prices. It has continued to raise rates in the fourth quarter and first quarter of this year.

Taiwan’s exports increased by 16.5 percent year-on-year in the second half of 2004, while 

imports expanded by 28.8 percent, resulting in a trade surplus of $2.5 billion in the third quarter 

and a trade deficit in the fourth quarter of $0.2 billion. Taiwan’s bilateral trade surplus with the 

United States increased slightly from $6.8 billion in the second half of 2003 to $7.1 billion in the 

second half of 2004.

The current account surplus in the second half of 2004 was 4.8 percent of GDP ($7.5 billion), 

down from a surplus of nearly 7.7 percent of GDP in the first half. The 2004 current account 

surplus of $19.0 billion, 6.2 percent of GDP, was the smallest annual figure in three years. 

Taiwan continued to experience portfolio capital inflows in the second half of 2004, primarily 

due to increased investment in equities. This was more than offset by portfolio outflows during 

that same period; resulting in a net outflow in the capital and financial account. 

Taiwan’s foreign exchange reserve accumulation slowed significantly in the second half of 2004, 

with foreign exchange reserves increasing by $12 billion, compared to a $23 billion in the first 

half of 2004. By year end, total foreign exchange reserves had reached just over $242 billion, or 

79.2 percent of GDP and about four times short-term external debt. 

The New Taiwan (NT) dollar has been on an appreciating trend since the third quarter of 2004, 

increasing 6.0 percent against the dollar in the second half of 2004. Since then the NT dollar 

continued its appreciating trend reaching a peak of NTD30.79/USD in early March. While 

Taiwan’s central bank maintains that “the NT dollar exchange rate is determined by market 

forces,” the Central Bank Governor has also recently stated that it may “enter the foreignexchange market to make adjustments” to maintain stability as the currency strengthens.

Malaysia

Although Malaysia’s economic growth slowed a bit in the second half of 2004, to a 4.4 percent 

annual rate, due in part to moderation in global growth, growth for 2004 as a whole – 7.1 percent 

– was the highest in four years. Private consumption and exports were the primary drivers of 

growth. Fiscal consolidation continued, as public spending on infrastructure was cut and total 

public sector spending grew moderately. Investment grew modestly, but still remained well 

below its levels in the early 1990s.

The current account surplus was $7.8 billion, or 12.7 percent of GDP, in the second half of 2004, 

up from 11.5 percent in the second half of 2003. Large current account surpluses are a striking 

feature of the Malaysian economy in the last few years. After running substantial external 

deficits prior to the Asian Financial Crisis in 1997, Malaysia has had significant and growing 

trade and current account surpluses. The trade surplus in 2004 was $25.2 billion (21.4 percent of 

GDP), up from $21.8 billion (21.0 percent of GDP) in 2003. The current account surplus in 

2004 was $14.9 billion. Malaysia’s current account surplus is in large part the counterpart to a 

sharp fall in domestic investment that took place in the aftermath of the Asian Financial Crisis. 

After rising to over 40 percent of GDP in 1995-97, total investment dropped sharply in 1998, and 
17

has not recovered. Over the last few years, investment as a percent of GDP has declined 

gradually, reaching 20.5 percent in 2004. The decline in private investment has been even more 

striking, falling from over 30 percent of GDP in 1997 to below 8 percent in 2003.

The trade balance is the predominant component of Malaysia’s current account surplus, and was 

$11.4 billion for the second half of 2004, up from $10.6 billion in the latter half of 2003. 

Malaysia’s bilateral trade surplus with the United States totaled $9.8 billion in the second half of 

2004, compared with $7.9 billion in the second half of 2003.

Malaysia has maintained a fixed peg to the dollar (3.80 ringgit to a dollar) since September 1998, 

when it also expanded capital controls. Most of the controls on capital flows have since been 

relaxed. Further liberalization took effect April 1, 2005, to allow: increased investment abroad; 

maintenance of currency export proceeds with licensed banks onshore; and hedging in any 

committed or anticipatory current account transaction or on any committed capital account 

payments. Offshore trading of the ringgit remains, however, prohibited, and foreign portfolio 

investment by residents continues to be limited. 

Malaysia experienced net financial account inflows of $1.73 billion in the last half of 2004, 

versus a net outflow of $0.55 billion in the second half of 2003, reportedly due in part to 

speculation on an upward revaluation of the currency. At the end of 2004, total foreign exchange 

reserves stood at $61.7 billion, almost six times short-term external debt and up from $49.0 

billion at end-June 2004.

Malaysian authorities remain publicly committed to the fixed exchange rate system, and have 

declared that that the peg is supported by strong fundamentals. But the low level of private 

domestic investment and the growing current account suggest opportunities for domestic-led 

growth that Malaysia is not taking advantage of. Although a small open economy such as 

Malaysia can benefit from a pegged exchange rate, increasing imbalances in the economy may 

warrant closer scrutiny and monitoring of the exchange rate regime going forward.