18

Foreign purchases of U.S. securities also rose substantially -- over
50 percent -- compared with 1992. Foreign direct investment inflows, which
declined substantially in 1992, recovered somewhat in 1993, though they remain
well below the very high annual levels of 1987-90.

Table 8
Capital Flows, 1992-93
Selected Transactions, $billion

1992 1993
Direct Investment “31.1 36.5
(Inflows) (+9.9) +21.4)
(Out flows) (741.0) (-57.9)
Securities +21.6 ~15.1
(Inflows) (+66.7) (+104.9)
(Outflows) (-45.1) (120.0)
Official +44.8 +70.2
Foreign (+40.9) (+71.6)
U.S. (+3.9) (-1.4)
Banks, net +38.9 +46.9
Other -6.3 +38.4
TOTAL +67.9 +103.9

Source: Survey of Current Business

Prospects for 1994.

As in 1993, relative growth performance in the U.S. and major foreign
economies will continue to dominate the trade and current account outlook for
1994. The U.S. economy will continue to expand, albeit at a more sustainable
pace, while the prospect is for only modest recovery in Europe, and the timing of a
recovery in Japan remains a question mark. In consequence, the U.S. trade and
current account deficits should continue to widen at least through the remainder of
1994, Data through April are consistent with this outlook. The deficit could
widen further in 1995, though at a slower pace as import growth moderates with
the slower pace of U.S. growth, and exports pick up with stronger demand in
Europe and, perhaps, Japan.


12

On April 26, the U.S., Canadian, and Mexican monetary authorities
announced the creation of the North American Financial Group, a forum for regular
consultation on economic and financial developments and policies in the three
countries. These arrangements had been planned earlier in recognition of the three
countries’ increasingly interdependent economic relationships, particularly NAFTA.

In connection with the creation of the North American Financial Group, the
monetary authorities also announced the establishment of a trilateral swap facility
to expand the pool of potential resources available to each to maintain orderly
exchange markets. The United States and Mexico put in place swap agreements
for up to $6.0 billion. The Bank of Canada and the Bank of Mexico expanded an
existing swap agreement to Canadian $1.0 billion. The Federal Reserve and the
Bank of Canada reaffirmed their existing $2.0 billion swap agreement. Each party
has reciprocal privileges to make drawings of the others’ currencies under this

facility.

Qperations in the Foreign Exchange Market and U.S. Policy

In response to the currency movements in the spring and to market
perceptions about U.S. exchange rate policy, the U.S. monetary authorities, in
cooperation with other major countries, intervened on Friday, April 29 in support of
the dollar. Secretary Bentsen also issued the following statement:

The U.S. monetary authorities intervened today in foreign exchange markets
to counter disorderly market conditions. This is in line with our previously
articulated policy, which recognizes that excessive volatility is
counterproductive to growth. We stand ready to continue to cooperate in
foreign exchange markets.

The U.S. authorities sold $500 million equivalent of marks and $200 million
equivalent of yen on that morning.

On Sunday, May 1, Secretary Bentsen said in a television interview that
"what we’re concerned about is volatility in the market” and that the U.S.
authorities intervene "when we see the market move away from what we think are
the underlying economic realities.”

The April 29 intervention operation was followed on May 4 by a concerted
intervention operation involving the U.S. monetary authorities and the authorities
of 18 other countries. The U.S. monetary authorities sold $750 million equivalent
of marks and $500 million equivalent of yen. These operations were accompanied
by a further statement from Secretary Bentsen:


22

exchange. Such steps would facilitate imports and promote adjustment in China’s
large bilateral surplus with the United States.

Trade and Economic Developments

According to Chinese customs figures, China’s trade balance deteriorated
from a surplus of $4.4 billion in 1992 to a deficit of $12.2 billion in 1993 while
China’s current account deficit was approximately $9.6 billion in 1993. However,
China’s reported current account deficit was more than offset by a net capital
inflow of $20.5 billion. As a result, at end-December 1993, China’s foreign
exchange reserves stood at $49.9 billion (equivalent to 6 months of imports), up
from $38.2 billion at end-June 1993.’ China’s external debt remains modest.
Total external debt stood at $77 billion at the end of 1993 while China’s debt-
service ratio was 12 percent. Chinese trade figures suggest that China’s external
position has improved somewhat in 1994, For January-March 1994, China’s
exports increased faster than imports, resulting in a trade deficit of $1.3 billion.

Table 9
Chinese Balance of Payments Figures
($ Billions)

Qt

1990 1991 1992 1993 1994

Trade Balance 8.7 8.2 4.4 ~12.2 -1.3

Current Account 12.0 13.3 6.4 - 9.6 na

Capital Account 3.3 8.1 -0.2 20.5 na

Net Errors & Omissions -3.1 ~6.8 ~8.3 - 9.1 na

Increase in Reserves -12.0 ~14.5 2.1 - 1.8 na
(- = increase)

Source: Chinese and IMF Statistics

However, China’s trade data are inconsistent with those of its trading
partners. Chinese figures probably significantly underestimate exports as the
requirement that exporters sell foreign exchange to designated banks creates
incentives for exporters to hold foreign exchange offshore. In 1992, for example,
China reported total exports of $85 billion while partner countries reported imports
from China of $134 billion. Some of this discrepancy arises from: 1) valuation
differences (China reports f.o.b. exports while partners report c.i.f. imports); and
2) goods transshipped through Hong Kong and counted as imports by both Hong
Kong and China’s other trading partners. However, even after adjusting for these

' This figure includes reserves of the People’s Bank of China ($23.1 billion) as well as the Bank
of China ($25.8 billion). China does not include the latter in its official reserve figures.


3
PART Il: GLOBAL ECONOMIC DEVELOPMENTS
A. ECONOMIC SITUATION IN THE G-7 COUNTRIES
Growth

Real GDP growth in the G-7 countries continues to show a clear distinction
among patterns of solid expansion in North America and the UK, some signs of
slow recovery in continental Europe, and continued weakness in Japan.

The U.S. recovery is flourishing, led by investment which will expand
capacity and extend the duration of that expansion. Canada continues firmly on an
expansionary path. The International Monetary Fund (IMF) now projects (see Table
1 below, which also shows the broadly similar average forecast by the June edition
of Consensus Forecasts) U.S. real GDP growth for 1994 of 3.9 percent on a year-
over-year basis (3.2 percent over the year to the fourth quarter of 1994), slowing
to 2.6 percent in 1995. Canada’s growth is expected to accelerate to 3.5 percent
this year and 4.1 percent in 1995.

Table 1
G-7_ Real GDP Growth
(% change y/y)

1993 1994F 1995F
IMF Consensus IMF Consensus
United States 3.0% 3.9% 3.7% 2.6% 2.9%
Japan 0.1 0.7 0.7 2.3 1.9
Germany* -1.2 0.9 1.6 2.1 2.5
France “1.0 1.2 1.8 2.6 2.7
United Kingdom 1.9 2.5 2.8 2.8 2.8
Italy . ~0.7 1.1 1.6 2.5 2.4
Canada 2.2 3.5 3.5 4.1 3.8
Total G-7 1.5 2.5 2.6 2.5 2.7

* All Germany

F=Forecast; source:IMF, World Economic Outlook, April 1994;
Consensus Economics, Consensus Forecasts June 1994

Growth in Japan has been very weak, although there have recently been
some signs of recovery. The current slowdown is the worst since the end of
postwar reconstruction, taking into account the very low growth also recorded in
1992 (1.1 percent) and projected for this year. Even the 1995 projections would
suggest a very weak recovery, and may be on the optimistic side.


19

The evidence from data on costs and export performance indicates that the
competitive position of U.S. goods remains solid, so that U.S. exports should
respond well to stronger growth abroad. There has been substantial progress
made in reducing the federal budget deficit, which should be reflected in improved
national saving performance and a smaller external deficit than would otherwise be
the case. However, sustained declines in the external deficit, beyond the reversal
of cyclical effects in prospect, will require further improvements in U.S. saving
performance.


25

On January 1, 1994, China’s dual exchange rates were unified at the rate of
8.72 yuan/dollar. The unification represented an effective depreciation of 7.2
percent as enterprises previously importing goods at the administered rate were
forced to use the more depreciated swap rate. As of end May, the unified
exchange rate had appreciated slightly to 8.68 yuan/dollar. After dropping for
several years, China’s real effective exchange rate against the dollar has remained
steady in the last two years. Nominal depreciation of the renminbi was offset by
higher inflation in China than in the United States.

Table 10
China: Nominal Exchange Rate Index
(End of Period)

1990 1991 1992 1993

United States 100 96.4 80.2 68.9

Japan 100 88.7 73.7 56.7

EC 100 98.9 91.1 84.8
Table 11

China: Real Exchange Rate Index
(End of Period)

1990 1991 1992 1993

United States 100 97.2 83.9 82.4
Japan 100 99.9 78.8 70.5
EC 100 98.6 93.8 101.3

Exchange Rate Negotiations

On April 21, 1994, the Treasury Department held negotiations with the
People’s Bank of China in the context of the Exchange System Reform Working
Group of the Joint Economic Committee.? Treasury welcomed the unification of
China’s exchange rate and moves to make the renminbi convertible for trade and
trade-related transactions. However, Treasury noted that certain measures
appeared to be a step backward from China’s initial reform plans. In particular, the
exclusion of foreign-funded enterprises from the interbank market and the
enforcement of foreign exchange balancing requirements could restrict access to
foreign exchange. The requirements that foreign-funded enterprises use swap

3 The Joint Economic Committee is a forum for the U.S. and Chinese governments to exchange
views on economic issues of mutual concern. After a lapse of seven years, the Joint Economic
Committee was revived in modified form in a meeting chaired by Treasury Secretary Bentsen and
Minister of Finance Liu in Beijing on January 21, 1994. Both sides agreed to the formation of new
working groups to discuss monetary and banking issues, exchange system reform, and investment.


21

markets. Treasury will continue to engage in negotiations with the Korean
Government to achieve satisfactory results in these areas.

Taiwan

The New Taiwan dollar also remained roughly constant against the U.S.
dollar since Treasury’s November report. Adjustment in Taiwan’s external
surpluses continued. Taiwan's overall current account surplus fell to $5.8 billion in
1993 from $8.2 billion in 1992. The shrinkage stems from slow recovery in
Taiwan’s export markets as well as increasing competition from other exporting
economies in the region. Taiwan's trade surplus with the United States declined
slightly from $9.4 billion in 1992 to $8.9 billion in 1993.

While Taiwan has incrementally relaxed certain limitations on foreign
exchange transactions and capital flows, the pace of reform has been very slow.
Key restrictions on Taiwan’‘s financial markets, which constrain pressure for NT
dollar appreciation, remain in place. Of particular concern in recent months has
been the ceiling on foreign institutional investment inflows. By December 1993,
foreign institutional investment was nearing the $5 billion ceiling. Talwan’s
authorities waited until March 5 before raising the ceiling to $7.5 billion, but, at
the same time, they set a new limit of $2.5 billion for capital raised on foreign
stock markets by local securities investment trust companies (these funds were
not previously subject to any limit).

Building on its existing bilateral talks with Taiwan, Treasury has raised these
issues in the context of Taiwan’s current GATT accession negotiations. In
particular, Treasury is engaging in negotiations with Taiwan’s authorities regarding
liberalization of Taiwan's financial markets. Treasury will participate in GATT
negotiations regarding a special exchange agreement, which is aimed at ensuring
that Taiwan’s foreign exchange regime does not impede trade and investment.
Treasury hopes that these issues can be addressed expeditiously in the GATT
accession process. -

China

Treasury welcomes China’s decision to unify its dual exchange rates as of
January 1, 1994. Nonetheless, further reforms implemented on April 1, 1994
excluded foreign enterprises from the interbank foreign exchange market and
imposed restrictions that limit their access to foreign exchange. Based on China’s
continued reliance on foreign exchange restrictions that could limit imports, it is
Treasury’s judgement that China manipulates its exchange system to prevent
effective balance of payments adjustment and gain unfair competitive advantage in
international trade. Treasury urges the Chinese authorities to eliminate the
segmentation of the foreign exchange market and restrictions on access to foreign


16
Cyclical Influences.

The 1993 goods trade balance reflected a continuation of the primarily
cyclical factors noted in the November 1993 Report. The U.S. goods deficit for
the full year (balance-of-payments basis) was $132.6 billion, up from $96.1 billion
for 1992. Exports totalled $456.9 billion, up $16.5 billion (under 4 percent) as
weak demand in Europe and Japan was only partially offset by strong export
growth to Latin America and East Asia, which avoided recession. Reflecting the
solid U.S. expansion during 1993, imports rose $53 billion (nearly 10 percent) to
$589.4 billion. Import growth was broadly based across a range of manufactures
and industrial materials. Capital goods, including computers, accounted for roughly
one-third of the increase.

Growing Role of Developing Countries.

Table 6 shows shifts in the geographic pattern of goods trade since 1991,
when the United States had its lowest annual trade deficit since 1983. The solid
competitive position of U.S. goods meant that exports could keep pace as long as
the market itself was growing. In developing economies where growth was strong
-- notably in Asia and certain countries in Latin America -- the goods trade deficit
was flat or declining. In those industrial regions where growth was weakest,
notably in Europe and Japan, the deficit widened. The notable exception to this
pattern, of course, was China, where exports rose substantially (albeit from a low
base) but imports rose by nearly two-thirds.

Table 6
U.S. Goods Trade with Selected Areas: 1991, 1993
($billion; data from Survey of Current Business)

Country Exports to Imports from Balance

or Region 1992 1993 1991 1993 1991 1993
W. Europe 116.8 111.3 102.0 121.0 +14.8 -9.7
Japan 47.2 46.9 92.3 107.3 ~45.1 -60.5
China 6.3 8.7 19.0 31.5 -12.7 -22.8
Asian NIEs 44.4 50.1 59.2 64.5 714.90 14.5
L. America 63.3 78.2 63.0 75.2 +0.3 +3.0
Canada 85.9 101.2 93.0 113.0 -7.1 -12.1
OPEC* 13.8 14.2 25.3 24.2 711.4 -10.1
Rest of Wid 39.2 46.3 37.1 $2.8 71.9 ~5.9
TOTAL 416.9 456.9 491.0 589.4 ~74.1 -132.6

*excl. Venezuela, which is included in Latin America



8
B. DEVELOPMENTS IN THE FOREIGN EXCHANGE MARKET

Fluctuations of the Dollar agai Individual Currencies

The dollar appreciated against the German mark and Japanese yen in the
first half of the period covered in this report. From mid-October until end-
December, the dollar rose in nominal terms by six percent against the mark and by
four percent against the yen. Meanwhile, the mark depreciated by two percent
against the yen. Against other currencies, the results were mixed. The dollar
depreciated very slightly against the Canadian dollar and the Mexican peso. Latin
American currencies generally tracked dollar movements, with some exceptions
such as Brazil. Key Asian currencies also followed the dollar, although the floating
Singapore dollar depreciated.

Flows out of yen were attributed to continued economic weakness in Japan
and political uncertainty related to the new coalition government. Demand for
dollars vs. marks was related to expectations that interest rate differentials would
move in favor of dollar assets. During the final quarter of 1993 and first quarter of
1994, acceleration of the U.S. economic recovery contrasted sharply with
continued weakness in the real economy in Europe.

In the early months of 1994, however, these exchange rate trends reversed
course. Over the period from end-1993 until end-June the dollar declined in
nominal terms by nine percent against the mark and by 13 percent against the yen.
Over this same period, the mark depreciated by 4 percent against the yen.

However, the dollar appreciated by 4 percent against the Canadian dollar
and by almost 10 percent against the Mexican peso. Other Latin American
currencies were steady, with the exception of Brazil’s and Venezuela’s. After the
Venezuelan Government introduced exchange rate and price controls on June 27,
the Venezuelan bolivar took a third large step in its depreciation since mid-April.

On July 1, Brazil introduced a new currency. linked to the dollar as part of a broader
price stabilization policy. The dollar depreciated by 4 percent against the
Singapore dollar, but showed little change against other Asian currencies. Table 5
shows the percent change in the dollar against various currencies since

October 15, 1993.


SEC. 3005. REPORTING REQUIREMENTS.

(a) Reports Required.--In furtherance of the purpose of this title, the
Secretary, after consultation with the Chairman of the Board, shall submit to the
Committee on Banking, Finance and Urban Affairs of the House of Representatives
and the Committee on Banking, Housing, and Urban Affairs of the Senate, on or
before October 15 of each year, a written report on international economic policy,
including exchange rate policy. The Secretary shall provide a written update of
developments six months after the initial report. In addition, the Secretary shall
appear, if requested, before both committees to provide testimony on these
reports.

(b) | Contents of Report.-- Each report submitted under subsection (a) shall
contain--

(1) an analysis of currency market developments and the
relationship between the United States dollar and the currencies
of our major trade competitors;

(2) an evaluation of the factors in the United States and other
economies that underlie conditions in the currency markets,
including developments in bilateral trade and capital flows;

(3) a description of currency intervention or other actions
undertaken to adjust the actual exchange rate of the dollar;

(4) an assessment of the impact of the exchange rate of the United
States dollar on--

(A) _ the ability of the United States to maintain a more
appropriate and sustainable balance in its current account
and merchandise trade account;

(B) production, employment, and noninflationary growth in
the United States;

(C) the international competitive performance of United
States industries and the external indebtedness of the
United States;

(5) recommendations for any changes necessary in United States
economic policy to attain a more appropriate and sustainable
balance in the current account;

(6) the results of negotiations conducted pursuant to section 3004;


5

Particularly notable in these projections are essentially stable U.S. inflation
rates; continued very low inflation in Japan and Canada; Italy’s remarkable
achievement in reducing inflation to very moderate levels; and the sharp decline
forecast for German inflation. Measures of German inflation have been distorted
by the impact of some increases in value added and other consumption taxes that
enter the consumer price index. As the impact passes from the index, and as tight
German monetary policy achieves success in reducing the rate of wage and price
increases, German inflation has declined. Consumer prices in western Germany
were up only 3.0 percent in the year to June; the IMF projections indicate a
significant decline in the rate of increase over the course of this year and into
1995.

Table 3
G-7 Consumer Price Inflation
(% change y/y)
1993 1994 1995

IMF Consensus IMF Consensus
United States 3.0% 2.8% 2.7% 3.2% 3.3%
Japan 1.3 0.9 0.7 0.9 0.8
Germany* 4.7 3.0 2.9 2.2 2.2
France 2.1 1.9 1.8 2.1 2.1
United Kingdom** 3.0 3.2 2.6 3.0 3.5
Italy 4.3 3.8 3.9 3.1 3.7
Canada 1.9 0.5 0.7 1.7 1.8
Total G-7 2.8 2.4 2.3 2.5 2.7
* All Germany for IMF; western Germany for Consensus
+ For UK , consumer prices excluding mortgage interest in

IMF projections

Global Rise in Long-term Interest Rates

Yields on long-term government bonds increased during the first half of
1994. For the United States, the rise was about 150 basis points. Increases of
between 100 to 200 basis points were recorded on ten-year benchmark issues in
Japan, France, Germany and Italy, and by over 200 percent in Canada and the
United Kingdom. During the first part of this period, the rise was largely
synchronized across national markets. In the latter part, movements were more
divergent.

A number of factors underlay the rise in long-term rates. Expectations
regarding future developments in real economic growth and inflation were affected


4

The sharp rise in public sector investment in 1992 and 1993 under the fiscal
expansion programs has compensated only in part for the weakness in private
consumption and the two-year decline in private plant and equipment investment.
_The February fiscal package -- which includes income tax cuts as well as additional
public infrastructure spending -- will be helpful, but will not fully compensate for
other sources of weak domestic demand.

The outlook for continental Europe is slightly more encouraging, but the
recovery forecast for this year is still quite modest for this stage of the business
cycle and too weak to prevent further increases in unemployment. For the
European Union (EU) countries other than the UK, the IMF projects only 1.0
percent aggregate growth this year, after an 0.8 percent decline in GDP in 1993.

Qutput Gap

The gap between actual and potential output has been growing in Japan,
France, Germany and Italy, and declining in the United States, Canada and the UK.
Table 2 below shows IMF estimates of this gap for the major countries. While
these calculations are crude and the precise numbers somewhat questionable, the
relationships and directions are indicative. These gaps are expected to remain
sizeable outside the United States, despite narrowing in 1995.

Table 2

G-7: Output Gaps
% of potential GDP

1993 1994 1995
Canada -5.2% ~4.68 3.6%
France ~3.5 ~4.5 74.4
Germany -1.8 -3.2 3.2
Italy -3.9 -4.7 -4.2
Japan “3.5 -5.3 “5.6
UK -5.3 4.9 ~4.2
us 0.9 +0.1 +0.2
Source: IMF

Inflation

Inflation has been declining in most G-7 countries, and low inflation for the
G-7 group is likely to continue. IMF and Consensus projections for consumer price
increases (see Table 3 below) show inflation at the lowest aggregate rates since
the early 1960s, excepting only the year 1986, when world petroleum prices were
cut in half.


17
Current Account Follows Trade Deficit

The widening trade deficit was reflected in the current account balance, as
trade is by far the largest and most volatile component. Table 7 shows data for
the peak deficit year of 1987, for 1991 (post-1987 low point) and for 1993.

Table 7
U.S. Current Account: 1987; 1991; 1993
($billion; data from SCB)

Balance 1987 1991 1993
Goods and
Services 7-152 -28 -76

Investment

Income +8 +15 +4
Transfers -23 ~35% -32
Current Account -167 -49% 104
* Excludes $42 billion in one-time

transfers from allies to support Desert
Storm. Totals do not add due to rounding.

The succession of large current account deficits -- which began in the early
1980s and is not expected to be broken in the near future -- has eroded the U.S.
net investment position abroad and, inevitably, our net investment earnings. In
consequence, the surplus on net investment income which has been characteristic
of the U.S. balance of payments throughout the post-WWII period has disappeared,
leaving services as the only offset to adverse swings in the goods deficit.

Turning to the capital account, U.S. investors substantially increased their
purchases of foreign assets in 1993, in the form of both portfolio and direct
investments. U.S. purchases of foreign securities were about 2-1/2 times total
equivalent purchases for 1992; direct investment outflows were about 40 percent
above 1992 levels. Net flows of U.S. official capital were negligible.


7

Relative national growth rates are a key to understanding these changes in
current account balances. For Japan, the IMF currently is projecting (see Table 1)
real GDP growth of only 0.7 percent for 1994, after 0.1 percent in 1993. In
contrast, growth in important export markets for Japan is projected to be far above
these rates: 3.9 percent in the United States (after 3.0 percent in 1993); 3.5
percent in Canada (vs. 2.4 percent in 1993); and 7.5 percent in Asian developing
countries (vs. 8.4 percent in 1993). It should not be surprising that, under these
conditions, the volume of Japan’s imports grew only 1.4 percent in 1993, while
export volume grew 1.6 percent despite the sharp rise of the yen (12 percent in
real trade-weighted terms over the course of 1993).

In the United States, strong growth in imports in the face of relatively weak
export performance, especially to Europe and Japan, contributed to rising trade and
current account deficits. Strong export growth to Japan and Western Europe had
been a major factor in the 1987-91 decline in our deficits. Despite a continued
solid U.S. competitive position, the weak outlook for growth in Europe and Japan
will hamper U.S. export growth until recovery strengthens, and the U.S. recovery
will continue to pull in imports.

The developments in external imbalances, however, are not by themselves a
significant cause of concern. Indeed, the large capital inflows associated with the
external deficit enable the United States to maintain a higher level of investment
than it could do if solely dependent on domestic saving, helping to strengthen our
recovery. The U.S. current account deficit is expected to stabilize as the negative
forces associated with growth differentials recede. Moreover, given the strength
of U.S. investment, the buildup of debt associated with our current account
deficits should not pose a problem.


23

factors, partner countries report $9 billion more in Chinese exports than China
reports as exports.

According to U.S. data, China’s trade surplus with the United States
increased from $18.3 billion in 1992 to $22.8 billion in 1993. U.S. exports to
China rose 18 percent to $8.8 billion while U.S. imports from China rose 23
percent to $31.5 billion. U.S. consumption of low cost, labor intensive goods
produced by China continues to grow rapidly. Footwear, toys, apparel, and plastic
goods constituted the fastest growing categories of U.S. imports from China. On
the export side, U.S. exports of capital goods are increasing most rapidly.
Automobiles, telecommunications equipment, aircraft, and specialized industrial
machinery constituted the fastest growing categories of U.S. exports to China.

In 1993, China continued to grow rapidly. China’s GDP grew 13.4 percent
in real terms while real industrial production rose 30 percent and retail sales rose
35 percent in nominal terms. Rapid growth was caused by high fixed investment
and accommodating monetary policy. Nominal fixed investment by state
enterprises increased 58 percent in 1993 while broad money increased 24 percent.
Loose monetary policy led to high domestic demand and increasing inflation. The
retail price index rose 18 percent for the year ending in December 1993 while the
cost of living in 35 cities rose 24 percent.

The authorities attempted to slow the economy in July 1993 with a 16-point
austerity program. This program achieved some initial results as real industrial
production fell from 30 percent for the year ending June 1993 to 16 percent for
the year ending October 1993. However, credit problems in state enterprises
forced the central government to ease credit. The People’s Bank of China
reportedly increased base money by 150 billion yuan in September and October.

In the first quarter of 1994, economic activity moderated somewhat but
nonetheless remained strong. Real GDP rose at a 12.7 percent annual rate.
Industrial production was up 19 percent in real terms for the year ending in March
1994 while nominal retail sales increased 24 percent. The nominal growth of fixed
investment by state enterprises declined to 36 percent for the same period. While
production has slowed, inflation continues to rise. For the year ending in March
1994, retail prices rose 24 percent while the cost of living in 35 cities rose 25
percent. The government is now attempting to tighten the money supply, largely
through administrative measures. The government has also resorted to price
controls on basic commodities and services in an attempt to slow inflation.

China’s Foreign Exchange System

On January 1, 1994 China unified its dual exchange rates at the more
depreciated swap center rate and announced it would abolish swap centers in


DEPARTMENT OF THE TREASURY
INTERIM REPORT TO CONGRESS
ON

INTERNATIONAL ECONOMIC AND EXCHANGE RATE POLICY

JULY 1994

Embargoed for release until
10:00 a.m., July 21, 1994


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Table 5
Change in Dollar vs. Selected Currencies
(Percentage Change)

Change from Change From

10/15/93 to 12/31/93 10/15/93 to 6/30/94
Japanese Yen 4.4% 7.4%
German Mark 6.5 1.3
British Sterling 2.1 71.8
French Franc 2.5 4.5
Italian Lira 6.7 0.4
Canadian Dollar 0.7 4.1
Swiss Franc 3.3 75.9
Mexican Peso -0.2 9.0
Korean Won ~0.6 ~0.7
Taiwan Dollar 0.3 0.2

The most important factors behind the rise of the yen and the mark this year
were a reassessment of the pace of economic activity in Europe and a renewed
focus on the external imbalances of the United States and Japan. Emerging
indications of economic recovery in Germany dampened market expectations about
the extent of monetary easing there and about prospects for declines in German
yields relative to U.S. yields. Japanese political uncertainties raised questions as to
whether Japan’s external surplus would be addressed. The widening of the U.S.
current account deficit and continued diversification by U.S. investors into foreign
assets raised questions about prospects for financing the deficit.

In addition to these underlying fundamental factors, market participants
remained sensitive to progress in discussion of trade issues between the United
States and Japan and to the reception of U.S. officials to the stimulus measures
announced by Japan in early February. Dollar movements also were affected at
times by market dynamics and volatility in other asset markets.




{7) key issues in United States policies arising from the most recent
consultation requested by the International Monetary Fund
under Article IV of the Fund’s Articles of Agreement; and

(8) a report on the size and composition of international capital
flows, and the factors contributing to such flows, including,
where possible, an assessment of the impact of such flows on
exchange rates and trade flows.

(c) Report by Board of Governors.--Section 2A(1) of the Federal Reserve
Act (12 U.S.C. 225a(1)) is amended by inserting after "the Nation”

the following: ", including an analysis of the impact of the exchange
rate of the dollar on those trends”.

SEC. 3006. DEFINITIONS.

As used in this subtitle:

(1) Secretary.--The term "Secretary" means the Secretary of the
Treasury.

(2) Board.--The term “Board” means the Board of Governors of the
Federal Reserve System.


6

by adjustments of monetary policy in the United States and Europe and by new
economic data. Also, the willingness of market participants to hold long positions
in bonds decreased as yields rose, prompting additional sales that augmented the
rise. It is generally thought that the substantial decline in yields during 1993,
reflecting the build-up of long positions by a variety of market participants, created
the potential for a substantial correction.

It is not possible to specify with precision the relative importance of the
various factors; however, the generalized rise in yields is consistent with the
improved outlook for economic growth in the United States and in most other
major countries. Stronger growth is associated with greater demand for credit,
and thus with higher interest rates in real terms. Although faster growth also
tends to be associated with rising inflationary expectations, there is no evidence to
date of accelerating price increases in the United States, and inflation also remains
under control in other countries.

External Account Developments

The pattern of recovery in the industrial world has been accompanied by
some deterioration in the U.S. external deficit and by pressures that have limited
the extent of adjustment of Japan’s external surplus. Japan’s trade and current
account surpluses have remained high as a result of the continued stagnation of
demand in Japan combined with strength in Japan’s export markets in North
America and Asia. U.S. external deficits are rising once again, as the U.S.
expansion continues to pull in imports while growth in our export markets in
Europe and Japan remains slack. IMF and Consensus projections for the G-7 are
shown in Table 4.

Table 4
G-7 Current Account Balances
($ billions; % GDP in parentheses)

1993 1994F 1995F
IMF nsensus IMF Consensus
United States -104 (-1.6) -140 (-2.1) -130 -166 (-2.3) ~135
Japan #131 (+31) +133 (43.0) +123 +126 (+2.7) +103
Germany* -21 (1.2) 13 (-0.7) 15 =11 (~0.5) “7
France #17 (41.0) +10 (+0.8) +9 #13 (+1.0) +7
United Kingdom ~-16 (~1.7) “19 (-2.0) ~17 20 (-1.9) -19
Italy +8 (+1.1) +26 (+2.7) +15 +31 (43.1) +17
Canada ~24 (~3.5) -15 (-2.6) ~19 “14 (~2.4) 16
Total G~7 -9 (-0.1) “17 (-0.1) 34 -40 (-0.2) -50

* All Germany
F=forecast; source: IMF, World Economic Outlook, April 1994

Consensus Economics, Consensus Forecast



20
PART Ill: ACTIONS UNDER SECTION 3004

Section 3004 of the Omnibus Trade and Competitiveness Act of 1988
requires the Secretary of the Treasury to consider whether countries manipulate
the rate of exchange between their currencies and the U.S. dollar for the purposes
of preventing effective balance of payments adjustment or gaining competitive
advantage in international trade. Section 3004 also requires the Secretary to
undertake negotiations with those manipulating countries that have material global
current account surpluses, and significant bilateral trade surpluses with the United
States. This section summarizes the current status of Korea, Taiwan, and China,
countries that have in past reports been designated as manipulating the rates of
exchange between their currencies and the U.S. dollar.

Korea and Taiwan

It remains Treasury’s judgement that neither Korea nor Taiwan is
manipulating its exchange rate within the meaning of Section 3004 of the Omnibus
Trade Act of 1988. Nevertheless, Treasury remains concerned about certain
financial and foreign exchange policies in both countries, particularly capital
controls, which discourage investment and impede the operation of market forces
in exchange rate determination.

Korea

The Korean won remains roughly unchanged since Treasury’s last report in
November 1993. Korea’s trade surplus with the United States rose slightly from
$2.0 billion in 1992 to $2.3 billion in 1993, while the country’s overall current
account balance moved into a small surplus of $500 million.

Korea’s strong economic performance and initial stock market-opening steps
resulted in large capital inflows in 1993 and early 1994. Concern about the effect
of these inflows on monetary growth and inflation prompted authorities to seek to
stem the capital inflows by imposing exchange controls early in 1994 which placed
onerous requirements on foreign investors and succeeded in dampening these
inflows.

Treasury continues to engage the Korean government as it implements its
five year financial sector liberalization plan. Having set its sights on achieving
OECD membership by 1996, the Korean Government has recently announced that
financial sector liberalization will be accelerated to accomplish that goal. This plan
includes projected steps to liberalize controls on capital flows and current account
payments, including regulations that limit payback periods to only a fraction of
international norms, and access of foreign financial institutions to Korea’s financial


26

centers and that the SAEC must approve access to the centers have the potential
to act as barriers to trade and thus could increase China’s bilateral trade surplus
with the United States. The Chinese authorities were urged to eliminate these
restrictions as soon as possible. Treasury noted that elimination of restrictions
would facilitate China’s move toward current account convertibility, improve the
efficiency of China’s economic system, and promote further reform of the Chinese
economy.

Assessment

Treasury welcomes unification of China’s exchange rates as an important
step that will facilitate China’s GATT accession and movement toward full
convertibility on the current account. At the same, Treasury remains concerned
that restrictions on access to foreign exchange remain. In particular, the denial of
foreign funded enterprises’ access to the interbank market and the enforcement of
foreign exchange balancing requirements could be used to reduce imports,
including those from the United States. Moreover, there are no clear public
regulations stipulating the conditions under which foreign funded enterprises may
purchase foreign exchange. If the Chinese exchange rate comes under pressure,
the SAEC could use its authority to deny foreign funded enterprises’ access to the
swap centers and maintain the stability of the renminbi. Thus, it is Treasury’s
view that China continues to manipulate its foreign exchange system.

Treasury will continue to negotiate with the People’s Bank of China
bilaterally and in the GATT accession context to promote further reform of China’s
exchange system aimed at achieving a market-oriented system of exchange rate
determination and foreign exchange allocation.


2

The pattern of recovery has been associated with some deterioration in the
U.S. current account position, but virtually all the increase in the U.S. deficit during
this period has been cyclical in nature -- the consequence of comparatively rapid
growth in the United States relative to that of our major trading partners. Japan’s
external surplus appears to have peaked, and there is some evidence in recent
volume numbers to suggest that further declines are likely.

Recent developments in the exchange markets have been a cause of
considerable concern. By the end of June, the dollar had declined by 13 percent
against the yen and 9 percent against the mark since the beginning of the year.
Both the pace and the extent of these movements were unusual when set against
the backdrop of a general improvement in the fundamental outlook for the U.S.
economy. Given the rise of the dollar against the currencies of many of our other
major trading partners the dollar has been relatively stable since the beginning of
the year when measured on a trade-weighted basis. Nevertheless, the
Administration has expressed concern over the dollar’s recent movements against
the major currencies, noting that they have not been in line with fundamental
conditions and that a stronger dollar would be desirable.

Treasury has reviewed the foreign exchange systems and exchange rate
policies of China, Taiwan and Korea -- countries with an important role to play in
promoting a healthy, open global economy and adjustment in external imbalances.
This assessment examines whether these countries are manipulating their
exchange rates within the meaning of Section 3004 of the Trade Act, to prevent
effective balance of payments adjustment or gain unfair competitive advantage in
international trade.

It remains Treasury’s judgment that neither Korea nor Taiwan is
manipulating its exchange rate within the meaning of this provision. Nevertheless,
Treasury remains concerned about certain financial and foreign exchange policies in
both countries, particularly capital controls, which discourage investment and
impede the operation of market forces in exchange rate determination.

Treasury welcomes China’s decision to unify its dual exchange rates as of
January 1, 1994. Nonetheless, further reforms implemented on April 1, 1994
segmented the foreign exchange market and imposed restrictions that limit foreign-
funded enterprises’ access to foreign exchange. Based on China's continued
reliance on foreign exchange restrictions, it is Treasury’s judgment that China
manipulates its exchange system to prevent balance of payments adjustment and
gain unfair competitive advantage. Treasury urges the Chinese authorities to
eliminate the segmentation of the foreign exchange market and restrictions on
access to foreign exchange. Such steps would facilitate imports and promote
adjustment in China’s large bilateral trade surplus with the United States.


13

"| am concerned by recent developments in the exchange markets. This
Administration sees no advantage in an undervalued currency. The
monetary authorities of the major countries are joining this morning in
concerted intervention. These operations reflect our view that recent
movements in exchange markets have gone beyond what is justified by
economic fundamentals.”

These operations demonstrated that the G-7 are prepared to act quickly, and
in concert, in response to deteriorating conditions in foreign exchange markets.

Subsequently, the Bank of Japan accommodated a decline in market interest
rates to record low levels; the Bundesbank lowered its discount and Lombard rates
by 50 basis points each; and the Federal Reserve raised its presumed Fed funds
rate target and discount rate by 50 basis points each. These actions were
followed by a short period of relative stability of exchange rates.

However, in early June, the dollar’s decline resumed. Political uncertainties
in Japan were growing. The market was increasingly cautious about the end of
the monetary easing cycle in Europe and about upside risk to European growth
forecasts. With market participants’ views growing more bearish, the U.S.
authorities responded with a series of statements reiterating the Administration’s
concern, and on June 24 the U.S. monetary authorities and the authorities of 16
other countries made coordinated intervention purchases of dollars. The U.S.
authorities sold $610 million equivalent of yen and $950 million equivalent of
marks, and Secretary Bentsen said

"Our actions today in cooperation with our G-7 partners and other monetary
authorities reflect a shared concern about recent developments in financial
markets. We look forward to continued cooperation to maintain the
conditions necessary for sustained economic expansion with low inflation.”

On June 28, Secretary Bentsen stated

"We believe a stronger dollar is better for our economy and better for the
world’s economy. The dollar is not a tool of our trade policy. No country
can be indifferent to a fall in its currency.”

The Administration believes that a stronger dollar would have important
economic benefits for the United States. It would restore the confidence in
financial markets that is important to sustaining recovery. It would boost the
attractiveness of U.S. assets and the incentive for longer-term investment in the
economy, and help to keep inflation low. In addition, we believe -- and this view is
shared by other G-7 countries -- that a continuation of recent movements in
exchange markets would be counterproductive to global recovery.


15

C. Balance-of-Payments Developments

Trade Developments in 1993

Services have become a major component of international trade in recent
years, in terms of both size and rapid growth. This development has been
particularly important for the United States, as services are an area where the
United States is a world leader, and trade in services has recorded large and rising
surpluses in recent years while goods trade -- which has received much more
attention -- has recorded large deficits. Thus any complete discussion of U.S.
trade performance has to take account of developments in services as well as

goods.

Measures of the U.S. Trade Balance
(B/P data in $US billions)

189 Lt ! ! n ! | LJ 480
1987 1988 1989 1990 1991 1992 1993

Goods Only Goods & Services

Source: Survey of Current Business, June 1994

The 1993 deficit on goods and services (G&S) trade was $75.7 billion, up
from $40.4 billion in 1992. The widening of the deficit was entirely due to a
larger deficit on goods trade; there was a slight increase in the already large
surplus on services transactions.


PART 1: SUMMARY AND CONCLUSIONS

This Report discusses recent developments in U.S. international economic
policy, including exchange rate policy, since the sixth annual Report to Congress
submitted in November 1993. It is based on information available through May
1994 except for foreign exchange developments, which are described through
June. These reports are required under Sections 3004 and 3005 of the Omnibus
Trade and Competitiveness Act of 1988 (Trade Act).

The outlook for the industrial economies has brightened considerably since
the last report. Recovery is now firmly established in North America and the
United Kingdom. The U.S. economy is flourishing, and Canada and the UK are
expected to show satisfactory growth this year and next. In continental Europe
and Japan, positive real growth is expected this year, though the pace of recovery
remains comparatively weak.

Significant progress has been made on the inflation front. Inflation is under
control throughout the G-7, even in those countries showing the greatest
acceleration in growth. Inflation in the G-7 is expected to average 2.8 percent in
1994, the lowest level since the early 1960s. Particularly notable are essentially
stable inflation in the United States; continued very low inflation in Japan and
Canada; Italy’s remarkable achievement in reducing inflation to very moderate
levels; and the sharp decline forecast for German inflation. In countries where
output remains well below potential, this progress towards price stability provides
room for use of monetary policy to strengthen and sustain the expansion. In
countries where the recovery has matured, policy has to be oriented to preventing
acceleration of inflation that could threaten to curtail the expansion.

Despite the growing sense of optimism about recovery and output growth,
unemployment remains alarmingly high and is still rising in much of Europe,
particularly among the young, and people are staying unemployed longer. There
are over 35 million unemployed in the OECD countries, 22 million of whom are in
Europe alone. Over the past several business cycles, we have seen unemployment
in Europe ratchet ever higher in the slumps and drop less during recoveries. With
each iteration, part of the cyclical joblessness has become structural.

At the Naples Economic Summit, the G-7 reaffirmed their commitment to
take action to sustain the expansion with low inflation. The European participants
committed to further action on the fiscal front to create the conditions that would
permit more flexibility on monetary policy. Japan committed to maintain the recent
income tax cut and not put in place increases in other, offsetting taxes while the
economy remained weak. And, building on the employment conference in Detroit,
the G-7 leaders agreed on an action plan to reduce structural unemployment which
focusses on investment in human capital, reduction of rigidities in labor markets,
fostering innovation and spread of technology, removing barriers to competition
and encouraging opportunities in new areas such as protection of the environment.


24

favor of an interbank market for foreign exchange. The new, unified exchange
operates as a managed float, with the People’s Bank of China (PBOC) setting each
day’s exchange rate according to market conditions and relative to the price for
foreign exchange on the previous day. While domestic firms are still required to
surrender their foreign exchange, China announced that government approval
would no longer be required for purchases of foreign exchange for trade and trade-
related current account transactions. Moreover, companies are allowed to
purchase foreign exchange automatically from designated banks upon presentation
of: 1) an import contract; 2) a request for payment from a foreign institution; and
3) an import license (if required).”

On March 26, 1994 the Chinese Government issued new foreign exchange
regulations that went into effect on April 1, 1994. In many areas, the new foreign
exchange regulations are in line with previous announcements. Chinese firms are
permitted to buy foreign exchange for specified purposes upon presentation of
required documents. Permitted transactions include purchase of foreign exchange
to buy imported inputs, to repay foreign debt, and to remit dividends abroad.
However, the Chinese authorities segmented China’s foreign exchange market by
excluding foreign-funded enterprises from the new interbank market for foreign
exchange. While Chinese firms may purchase foreign exchange through
designated banks (which in turn trade through the interbank market), foreign-
funded firms must use the existing swap centers.

The new regulations maintain the requirement that foreign enterprises
balance their foreign exchange earnings and expenditures. Foreign-funded
enterprises that have a deficit or surplus of foreign exchange may trade in the
swap centers but only with other foreign-funded enterprises. The Chinese
authorities have also indicated that the State Administration of Exchange Control
(SAEC) must approve individual foreign exchange transactions and has the
authority to deny access to foreign exchange for purposes that do not accord with
national policy. However, there are no clear public regulations stipulating the
conditions under which foreign-funded enterprises can purchase foreign exchange.

Exchange Rate Developments

In 1993, China’s administered exchange rate depreciated less than one
percent from 5.75 yuan/dollar to 5.80 yuan/dollar. China’s more market-oriented
swap rate depreciated 19 percent, rising from 7.30 yuan/dollar at the end of 1992
to 8.71 yuan/dollar at the end of 1993.

2 In 1992, 53 broad categories of goods accounting for 25 percent of China’s total imports
were subject to licensing.


Part I

Part Il

Part Ill

Appendix

TABLE OF CONTENTS

Summary and Conclusions

Global Economic Developments

A. Economic Situation in the G-7 Countries

B. Developments in Foreign Exchange Markets
Cc. U.S. Balance of Payments Situation
Actions Under Section 3004

- Korea and Taiwan

- China

Text of Sections 3004 - 3006 of the Omnibus Trade and

Competitiveness Act of 1988

15

20

21


APPENDIX 1 - OMNIBUS TRADE AND COMPETITIVENESS ACT OF 1988
(H.R. 3)

SEC. 3004. INTERNATIONAL NEGOTIATIONS ON EXCHANGE RATE AND
ECONOMIC POLICIES.

(a) Multilateral Negotiations.--The President shall seek to confer and negotiate
with other countries--

{1) to achieve--

(A) better coordination of macroeconomic policies of the major
industrialized nations; and

(B) more appropriate and sustainable levels of trade and current
account balances, and exchange rates of the dollar and other
currencies consistent with such balances; and

(2) to develop a program for improving existing mechanisms for
coordination and improving the functioning of the exchange rate
system to provide for long-term exchange rate stability consistent
with more appropriate and sustainable current account balances.

(b) Bilateral Negotiations.--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. If the Secretary considers that such
manipulation is occurring with respect to countries that (1) have material global
current account surpluses; and (2) have significant bilateral trade surpluses with
the United States, the Secretary of the Treasury shall take action to initiate
negotiations with such foreign countries on an expedited basis, in the International
Monetary Fund or bilaterally, for the purpose of ensuring that such countries
regularly and promptly adjust the rate of exchange between their currencies and
the United States dollar to permit effective balance of payments adjustments and
to eliminate the unfair advantage. The Secretary shall not be required to initiate
negotiations in cases where such negotiations would have a serious detrimental
impact on vital national economic and security interests; in such cases, the
Secretary shall inform the chairman and the ranking minority member of the
Committee on Banking, Housing, and Urban Affairs of the Senate and of the
Committee on Banking, Finance and Urban Affairs of the House of Representatives
of his determination.


110

11

The dollar’s depreciation accelerated in April and spread beyond the yen to
encompass European currencies as well. Political uncertainty in U.S.-Japan trade
relations increased following Prime Minister Hosokawa’s resignation. Meanwhile,
the narrowing of interest rate differentials between the United States and Germany
seemed to have run its course after the Bundesbank made an unexpected cut in
interest rates on April 14 and the Federal Reserve hiked rates on April 18.

Fluctuations of Major Currencies on a Trade-weigh Basi

Taken over a time period of two to three years, the dollar and the German
mark have fluctuated moderately on a trade-weighted basis, while the Japanese
yen has greatly appreciated. However, from mid-October 1993 through June
4994 the dollar has registered a decline of some 2 percent, while the mark has
remained little changed and the yen has appreciated by 3.0 percent.

Real Trade Weighted Index
{Monthly)
October 93 - June 94

Dolar

Morgan Real Trade Weightad index

North American Financial Group

Following the March 23 assassination of Mexican presidential candidate
Colosio, the U.S. monetary authorities announced on March 24 the establishment
of a temporary bilateral swap facility at the request of the Mexican authorities.

The assassination had prompted the closing of Mexican financial markets on March
24, giving rise to concern that the reopening of the market on March 25 would be
accompanied by market disorders that could spill over into U.S. financial markets.
However, no drawings on this facility proved necessary.

10


14

The prospects for sustained noninflationary growth in the United States are
more favorable than they have been at any time in a generation, and should be
reflected in a strong and stable U.S. dollar.