18

depreciation with respect to the yen and EU currencies has increased the dollar value of
imports but will only gradually slow the growth of import volumes (“the J-curve effect").
According to Korean statistics, the value of imports from the EU and Japan grew at 22.8 and
21.9 percent, respectively, during the first half of 1994, This is more rapid than the rate of
growth reported for imports from the United States, whose currency remained comparatively
stable relative to the won. Despite government promotion of 1994 as "Visit Korea" year, the
deficit in the tourism account during January-June more than tripled to $655 million
compared to the same period in 1993.

Korea’s trade with the United States has also undergone significant adjustment.
During January-September 1994, Korea’s trade surplus with the United States amounted to
$1.4 billion, down from the $1.9 billion surplus recorded in the first nine months of 1993
according to U.S. statistics. The decline in Korea’s surplus with the United States is
attributable to the surge in Korea’s economic growth and the consequent increase in
aggregate demand for imports. Korea’s imports from the United States during January-
September 1994 grew by roughly 18 percent over the same period in 1993. By comparison,
the value of Korean exports to the United States grew by 11.5 percent.

Overall, the Korean economy surged ahead in the first two quarters of this year. Real
GNP grew by an estimated 8.5 percent, with average growth for the entire year predicted to
be around 8 percent. Facility investment and exports led the second quarter growth, as in
the first quarter, but the second quarter also saw an acceleration in private consumption
spending, which rose 7.6 percent over 1993 levels. Korea seems destined to overshoot its
target of 6 percent inflation for 1994. The government has focused its 1995 budget on price
stabilization, however, and the Bank of Korea will attempt to keep monetary growth in the
14-15 percent range.

Despite the depreciation of the won relative to the yen, Korea’s trade deficit with
Japan has widened. While Korean exports to Japan have risen 13.2 percent, the value of
Korean imports from Japan have grown even more rapidly -- possibly due to the J-curve
effect mentioned earlier and inelastic demand for imported capital equipment and inputs from
Japan. The chronic trade deficit with Japan is a concern for Korean officials, with the gap
widening 32 percent from $4.4 billion during the first half of 1993 to roughly $5.9 billion
during the same period in 1994.

At the same time, the decline of the won relative to the yen has apparently also made
Korea more competitive in some export markets in which it competes with Japan. Exports to
the developing nations, for example, grew by 16.4 percent during the first half of 1994,
while exports to the developed nations (the United States, Japan, and the European Union)
grew by only 8.9 percent during the same period.


(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)  areport 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 Govemnors.--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.


12

Subsequently, the dollar recovered following foreign exchange market intervention by
the U.S. monetary authorities in early November and an increase by the FOMC in short term
interest rates on November 15. Over the course of this period, short-term interest
differentials favoring dollar placements widened further. Also, recent months’ data have
provided evidence that the Japanese trade surplus has probably peaked and is on a declining
trend.

Exchange Rate Policy

The Administration supports a strong dollar. A strong dollar is good for the U.S. and
world economies:

it supports confidence in the financial markets;

- it enhances the attractiveness of U.S. assets;

- it gives an incentive for longer-term investment in the United States; and
- it helps to keep inflation low.

In early November, Secretary Bentsen stated that a decline in the dollar would be
inconsistent with the fundamentals of a strong, investment-led recovery in the United States
and with the greatly enhanced ability of U.S. firms to compete around the world, and that a
continuation would be counterproductive for the U.S. and world economies. The U.S.
position is shared generally among the G-7 authorities, who agree that, in prevailing
economic conditions, a decline of the dollar is neither justified nor desirable.

As we have emphasized since early 1993, the Administration’s position on exchange
rate policy rests on two basic points. First, exchange rates should reflect economic
fundamentals, as they evolve, and the policies that help shape the fundamentals. Second, the
U.S. monetary authorities are prepared to cooperate with other G-7 authorities in the foreign
exchange market when appropriate. As we have demonstrated in the past year, we believe
that intervention can be a valuable policy instrument in the right circumstances.

Foreign Exchange Market Intervention

During the period under review, the Administration intervened in the foreign
exchange market on five days. The first three episodes, occurring on April 29, May 4, and
June 24, are detailed in the July report. On November 2 and 3, the U.S. monetary
authorities intervened in the foreign exchange market, purchasing dollars against sales of
Japanese yen and German marks.


22
TAIWAN (figures in U.S. dollars)

Taiwan continues to register an overall current account surplus and a bilateral trade
surplus with the United States. However, it is the judgement of the Treasury Department
that Taiwan is not at this time manipulating the rate of exchange between the New Taiwan
(NT) dollar and the U.S. dollar for purposes of preventing effective balance of payments
adjustment or gaining unfair competitive advantage in international trade.

Notwithstanding this determination, the Treasury Department remains concerned that
restrictions maintained by Taiwan on foreign exchange transactions and capital flows
continue to reduce market demand for the NT dollar and thereby deter market generated
appreciation.

During several rounds of negotiations during 1994 concerning a draft Special
Exchange Agreement as part of Taiwan’s accession to the World Trade Organization (WTO),
Taiwan showed a willingness to undertake that it will not impose exchange restrictions on
current account transactions. Despite this progress, however, Taiwan has been unwilling to
remove key restrictions that can constrain demand for the NT dollar for capital account
transactions. Permitting the full range of market forces to determine the level of demand for
the NT dollar would likely contribute to further adjustment of the existing bilateral trade

imbalance,
i lopmen

Taiwan’s current account surplus fell from $8.2 billion (3.9 percent of GDP) in 1992
to $6.7 billion (3 percent of GDP) in 1993. This decline was mainly attributable to a smaller
overall merchandise trade surplus, which declined $1.4 billion from $12.8 billion in 1992 to
$11.5 billion in 1993 -- the lowest surplus since 1983. A slightly larger deficit in services
and income ($4.6 billion in 1993 compared to $4.4 billion in 1992) and an increase in the
deficit in private unrequited transfers from $168 million in 1992 to $957 million in 1993 also
contributed to the reduction of the current account surplus.

According to recent estimates, Taiwan registered a current account surplus of $2.4
billion in the first six months of 1994. Taiwan’s trade surpluses continued to shrink in 1994,
The continuing decline in Taiwan’s trade surpluses stems from the slow recovery in Taiwan’s
export markets and from increasing competition posed by nations such as the PRC and
Thailand. Taiwan’s global trade surplus for the first eight months of 1994 was $3.9 billion,
compared to $5,1 billion in the corresponding period in 1993.

Taiwan's bilateral trade surplus with the United States was $8.8 billion in 1993, down
from $9.4 billion in 1992. Adjustment in Taiwan’s bilateral trade surplus with the United
States, has stalled so far this year. Taiwan’s surplus with the United States during January-
September 1994 registered roughly $7 billion, a small increase over the $6.8 billion seen in
the same period in 1993. As the New Taiwan dollar/U.S. dollar exchange rate has remained


3
PART I: GLOBAL ECONOMIC DEVELOPMENTS

The global recovery is on track. The overall outlook appears to be the most favorable
in years, and the International Monetary Fund expects that global growth in 1995 will be the
highest since 1988.

The recovery which began in the United States, Canada and the UK has now spread
to continental Europe, and signs of an upturn are appearing in Japan. Aggregate G-7 growth
for 1994 should reach close to 3 percent, and could exceed that rate in 1995. (The IMF
growth forecasts published in October and noted below may now be somewhat conservative,

especially regarding European growth, in light of recent indicators.)

Table 1

G-7: Real GDP Growth
(% change y/y)

1993 1994F 1995F
IME = Consensus = IME Consensus
United States 3.1 3.7 3.8 25 28
Japan 0.1 0.9 0.6 25 19
Germany* “11 2.3 25 2.8 2.9
France “1.0 1.9 2.2 3.0 3.8
Italy 0.7 1.5 21 2.8 2.8
United Kingdom 2.0 3.3 3.5 3.0 2.9
Canada 2.2 41 4.1 3.8 3.8
Total G-7 1.4 2.8 2.8 2.7 27

* All Germany; F=Forecast

Sources: IMF, World Economic Outlook, October 1994, and Consensus Economics,
Consensus Forecasts, November 1994,

The recovery in Europe began with the export sector. Domestic demand --
consumption, business investment and housing -- is now strengthening, and should carry the
advance into 1995. In Japan, consumption rose sharply in the third quarter. Business
investment -- though weak -- registered its first uptick in three years, suggesting that 1995
should see greater strength on the investment side and a gradually building acceleration in
growth. The overall picture suggests that recovery will grow to encompass more and more
countries in a broad, non-inflationary upturn. Economic conditions and policies are oriented
to making the expansion sustainable.


APPENDIX 1: OMNIBUS TRADE AND COMPETITIVENESS ACT OF 1988
LR. 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

(®) 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 Representatives of his determination.


19
Exchange Rate Developments

The value of the Korean won relative to the U.S. dollar has not changed significantly
since the last report in July 1994. Between December 31, 1993 and November 18, 1994, the
won appreciated 1.9 percent relative to the dollar.

Korea’s exchange rate system has acted to keep the won’s value against the dollar
virtually steady while the dollar has declined against most other major currencies. Asa
result, the won has captured the competitive benefits of the dollar’s depreciation against the
yen, declining from 629 won per 100 yen in early 1993 to a record low of 818 won per 100
yen at the end of June.

Exchange R i Financial S

Korea’s exchange rate system is characterized by thin trading and an extensive set of
capital controls. Treasury believes that the maintenance of foreign exchange and capital
controls, rather than direct intervention by the Bank of Korea, is the more important factor in
deterring upward pressure on the won.

Under the present system, the won’s exchange rate is determined by a weighted
average of the interbank won-dollar exchange rates applied in spot transactions on the
previous day. The won is allowed to fluctuate +1 percent relative to the dollar on a daily
basis. In July, the Minister of Finance stated that the government intends to widen the
exchange rate fluctuation band to +1.2 - 1.5 percent sometime before year-end 1994, In
October, the new Minister of Finance announced that the limit would be increased to 41.5
percent effective November 1.

Korea continues to maintain a broad array of controls on foreign exchange and capital
account transactions. These controls inhibit market forces from fully determining the
exchange rate, prevent the free flow of capital both into and out of Korea, and constitute a
potential means by which Korean authorities may influence the exchange rate. Foreign
exchange banks, for example, have been required to obtain and review documentation of
underlying commercial transactions for most foreign exchange transactions. Effective
November 1, 1994, the MoF relaxed these regulations to some degree by increasing the
minimum value of forward foreign exchange contracts subject to underlying documentation
requirements to $10 million, up from $3 million. Despite this recent move, however, these
restrictions remain an impediment to foreign exchange transactions. Korea's restrictive terms
for deferred import payment, although recently eased by means of expanding the payback
period to 150 days, still lag far behind international norms and continue to be a key concern.
Offshore financing is also restricted. Some progress was made in this area during the
summer, but the easing of access to offshore financing was selectively focused to maximize
the importation of high-tech or capital equipment while leaving other sectors untouched.


25

China has raised the ceiling for aggregate foreign institutional investment from $5 billion to
$10 billion, and increased the limit for a single institutional investor from $100 million to

$200 million.
Financial Policy Negotiati

While not citing Taiwan as an exchange rate manipulator, Treasury nonetheless
continues to urge Taiwan to move more rapidly to reduce restrictions on foreign exchange
transactions and capital flows. Taiwan's aim of achieving the status of a regional financial
center will require significant liberalization of these restrictions, as well as further movement
toward opening its financial markets. Progress has been made in this regard during WTO
accession negotiations, but foreign exchange restrictions remain a particularly troublesome
area.

Of particular note since the last report, bilateral negotiations conducted in July
resulted in a draft Special Exchange Agreement for use by the GATT Working Party in its
discussions on Taiwan’s accession to the WTO. The Special Exchange Agreement outlines
disciplines on the use of foreign exchange restrictions once Taiwan joins the WTO. The
draft agreement has strong commitments prohibiting exchange restrictions on the current
account, and also requires Taiwan to seek to avoid capital controls.

Assessment

The present determination maintains the assessment contained in the July 1994 report
that Taiwan is not at this time engaging in practices which constitute manipulation of the
exchange rate between its currency and the U.S. dollar. Two factors support this conclusion.
First, there has been no significant change in the value of the New Taiwan dollar relative to
the U.S. dollar since the last report. Second, adjustment continues to occur in Taiwan’s
current account and trade surpluses.

Treasury will continue to use bilateral and multilateral discussions to press for further
elimination of restrictions on foreign exchange transactions and capital movements which
constrain demand for the NT dollar.


21

transactions, import/export payments and the foreign exchange market structure -- including
transition to a floating rate system for the won in 1996-97.

This latest package of reforms will, when fully implemented, represent an important
liberalization of Korea’s foreign exchange system. However, the plan delays many of the
more important reform measures until the end of the reform schedule. Treasury will closely
monitor implementation of the plan and encourage Korean authorities to accelerate its pace.

Assessment

The present determination, like the assessment contained in the July 1994 report, is
that Korea is not at this time engaging in practices which constitute manipulation of the
exchange rate between its currency and the U.S. dollar. Two factors support this conclusion.
First, the won/dollar exchange rate has remained relatively unchanged since the July report.
Second, Korea’s current account and trade balance are now in deficit.

_ However, Treasury will continue to urge Korean authorities to make greater progress
in lifting exchange and capital controls in the context of bilateral financial policy talks and in
the extended Uruguay Round financial services negotiations. Removal of these controls is
essential to promote the freer flow of goods, services, and capital, to facilitate Korea’s
integration with global financial markets, and to permit the won to respond to market forces.


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--

qa

@)

@G)

@)

6)

©

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

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;

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

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;

@) 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;

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

the results of negotiations conducted pursuant to section 3004;


16

labor costs and export market shares, show that U.S. goods are highly competitive in world
markets.

Table 9
FORECASTS OF CURRENT ACCOUNT BALANCE
1994 1995
Source Sbillion %GDP Sbillion GDP
L. Meyer & Assoc (12/94) 155 (-2.3) -172 (-2.4)
DRI (12/94) -158 (-2.3) +200 (-2.8)
Consensus Econ, London (11/94) 7143 (2.1) -141 (-2.0)
OECD (12/94) +154 (2.3) “173 (2.4)
IMF (10/94) -149 (2.2) ~168 (2.4)

The timing of a possible turn-around is very difficult to predict, but, if activity in the
U.S. moderates as expected and there is robust recovery in Europe and Japan, at some point
during the course of 1995 or 1996 the U.S. current account deficit should stabilize or begin
to decline -~ at least as a share of GDP, and probably in absolute terms as well.

The degree, and longevity, of such a turn-around will depend on improvements in the
U.S. saving performance. At current levels of private saving, even if the progress made to
date in reducing the budget deficit can be sustained, domestic saving will continue to be
inadequate to finance desired levels of investment, and the United States will continue to
need to borrow abroad to finance the difference -- or cut investment and future growth.
Substantial further progress in improving U.S. saving performance will be needed to produce
long-term reductions in the current account deficit.


Rise i ng-term.

Long-term interest rates have risen substantially in all industrial countries over the
past twelve months, although the size of the increase varies across countries. While the
measurement of "real" (i.e., inflation-adjusted) interest rates is subject to a wide range of
uncertainty, there appears to be a roughly one percentage point increase in the real ten-year
bond rate which is common to all countries that have closely linked markets. This rise in
real rates is due to the increasing strength of the global recovery, which has focussed
attention on the large structural budget deficits in many countries. Increases in bond yields
over and above the higher real rate reflect a mixture of concerns about future inflation and
uncertainties about the future path of price increases that differs among countries. For
example, the additional rise is lowest in Japan, where current and likely future inflation rates

are lowest.
Policy Requi

In the United States, where the expansion is now in its third year, monetary policy
has been directed toward sustaining recovery with low inflation. The substantial increase in
short-term rates since February 1994 (2-1/2 percentage points for Federal funds and over 3
percentage points for three month CDs) has begun to show some signs of slowing demand.
The combined effects of the deficit reduction program and strong recovery brought the U.S.
federal budget deficit down to only $203.4 billion (3.1 percent of GDP) in FY94, the lowest
in five years. There will be another sizeable cut in the deficit in FY95, for the third
consecutive year.

In continental Europe, it will be important to continue the process of fiscal restraint.
In addition to improving fiscal positions, this process will ensure continuing anti-inflation
effects as the recovery accelerates. In this context of fiscal tightening -- and given declining
inflation and substantial remaining gaps between actual and potential output -- there is no
evident need for a tightening of monetary policy. Recovery also provides an opportunity to
address structural obstacles to job creation more vigorously.

Japan needs to ensure that macroeconomic policy continues to support demand, so
that the recovery which appears finally to be underway does not falter. In the fiscal policy
area, it is essential to avoid a premature withdrawal of stimulus from the tax side, as well as
expenditure cuts in the normal budget process that might undo the positive impact of the tax
cuts on domestic demand and growth. In addition, the Bank of Japan should resist tightening
monetary policy until the recovery is more assured. Real short-term interest rates are high,
the financial system is still under strain, inflation is nil and the yen has been very strong. As
the OECD remarks in its latest Economic Outlook, "the appropriate time for moving rates to
an upward path appears to be some way off."


31

At the moment, SAEC approval of foreign exchange purchases for foreign firms is
not difficult to obtain. This liberal implementation stems from favorable market conditions --
ample foreign exchange availability and strong demand for the renminbi. However, as in the
past, the SAEC could withhold approval. It is clear that the rationale for maintaining the
approval system is to maintain the government’s capability to ration foreign exchange.

Thus, Treasury has determined that China is not currently manipulating its exchange
system to prevent effective balance of payments adjustment or gain unfair competitive
advantage in international trade. However, it is essential that China commit to liberalizing
access to foreign exchange for current account transactions, as is required under Article VII
of the IMF’s Articles of Agreement. The United States continues to seek such commitments
from China in bilateral negotiations and in multilateral negotiations regarding China’s
accession to the WTO.


28

accelerating in the second half of this year. Industrial sector value added grew 18.1 percent
in the third quarter, 2.3 percentage points higher than in the first half.

China’s inflation figures reflect this acceleration in demand and monetary growth.
Urban prices were 27.5 percent higher in September 1994 compared to September 1993.
Inflation rates have shown an upward trend in recent months, rising from an average of 25
percent in the first quarter. China’s authorities blame the upward trend on rising food prices
resulting from price decontrol and supply problems. Nevertheless, consumer demand is also
likely playing an important role as urban wages have risen 30-40 percent in the first three
quarters of the year. Under these circumstances, the need for renewed emphasis on
monetary restraint is evident.

i ixch

China’s current foreign exchange system operates as a highly managed float. The
daily exchange rate is set according to the median price for foreign exchange on the
preceding day. An interbank market for foreign exchange, the foreign exchange trading
center (FETC), was established in April 1994, The headquarters are located in Shanghai
with additional, satellite-linked centers in 19 cities.

Foreign-funded enterprises (FFEs) may, with the approval of the State Administration
of Exchange Control (SAEC), buy and sell foreign exchange in the interbank market using a
member institution as agent. (Member institutions currently comprise 278 domestic banks
and non-bank financial institutions and designated foreign banks.) A FFE agent bank must
submit the purchase request to the SAEC for approval. With SAEC approval, the agent bank
executes the transaction at the FETC. FFEs, unlike domestic firms, can retain their foreign

exchange earnings.

Domestic enterprises may not trade foreign exchange in the interbank market.
However, those domestic companies that have trading rights are allowed to purchase foreign
exchange automatically from designated members of the interbank market upon presentation
of: (1) an import contract; (2) a request for payment from a foreign institution; and (3) an
import license (if required). The spreads applicable to domestic firms are reportedly slightly
wider than those in the interbank market, providing a small profit margin for the banks.
Domestic firms are required by the government to sell their foreign exchange earnings to a
designated bank at the prevailing exchange rate.

The important distinction between the treatment of FFEs and domestic firms is that
FFEs cannot purchase foreign exchange without the approval of the SAEC, whereas domestic
firms may purchase foreign exchange automatically for permitted transactions. @omestic
firms must still obtain SAEC approval for capital account transactions and some invisible
current account transactions.) In this context, it is important to note that China continues to
impose requirements on FFEs to balance foreign exchange receipts and expenditures. The


Table 3
-7: Out

% of potential GDP

1993 1994 1995
United States 0.9 +0.2 +0.2
Japan 3.8 5.6 55
Germany* 1.6 °1.7 “1.5
France 3.0 3.1 -2.3
Italy 3.8 4.2 35
United Kingdom 48 3.7 2.8
Canada 43 2.9 19
Source : IMF, World Economic Outlook, October 1994
* All Germany

ici Fiscal Polici

Monetary policy is being employed to bear on inflation risks in a timely fashion.
Monetary tightening has been underway in the countries leading the recovery. Fiscal policy
has also become more restrictive in all G-7 countries except (appropriately) Japan. This
fiscal restraint will continue in 1995.

The restrictive movement in fiscal policy is indicated by the reduction in “structural”
budget balances (j.e., the fiscal position estimated by abstracting from the normal cyclical
movements in revenues and expenditures). Since the upturn will also reduce budget deficits
by the revenue-increasing action of cyclical forces, the reduction in actual budget deficits will
be even greater -- from 4.0 percent of G-7 GDP in 1993 to 3.2 percent in 1995, according
to IMF projections. The tightening outside Japan will be even greater.

This generally optimistic picture should not obscure some very real problem areas. In
addition to the continuing large high Japanese current account surpluses noted below, these
problems include high fiscal deficits in many European countries, despite the reductions now
in train. Both the IMF and the OECD estimate that the United States will have the lowest
G-7 government sector budget deficit to GDP ratio again in 1995. Continuing efforts over
the medium term will be needed to correct these deficits.

External Account Developments

While Japan’s trade and current account surpluses remain high, they have started to
come down. The current account surplus measured in yen peaked in 1992. Because of the
rise of the yen against the dollar, however, the surplus in dollar terms continued to rise for
some time, but may now be turning around. For the first ten months of 1994, the surplus in
yen terms was down 9.2 percent relative to the same period in 1993, while the surplus in
dollar terms fell 1.6 percent.


Prospects for Low Inflation are Bright

The G-7 can look forward to a continuation of inflation rates that are among the
lowest in nearly 30 years. On average, G-7 inflation is expected to be around 2.2 percent in
1994, and 2.5 percent in 1995.

Table 2

G-7: Consumer Price Inflation
(% change y/y)

1993 1994F 1995F
IME Consensus IMF Consensus
United States 3.0 2.7 27 3.4 3.4
Japan 1,3 0.7 0.6 0.7 0.6
Germany* 4.6 3.1 3.0 2.2 2.4
France 21 1.8 1.8 1.8 21
Italy 4.2 3.8 3.9 3.1 3.8
United Kingdom 1.6 2.5 2.5 3.1 3.4
Canada 1.8 0.2 0.3 1.6 19
Total G-7 2.7 2.3 2.2 2.5 27

* All Germany for IMF; F=Forecast
Sources: IMF, World Economic Outlook, October 1994, and Consensus Economics,
Consensus Forecasts, November 1994.

The optimistic outlook for inflation is well grounded. The moderate pace of the
expansion and the shift of momentum from the countries recovering earlier to the Continent
and Japan have helped to prevent undue pressure on supply in any one country, thereby
containing inflation pressures. The normal rise in global commodity prices associated with
an industrial country upturn has been moderate.

In addition, the gap between actual and estimates of potential output remains sizeable
in most countries. Hence, economies at a relatively early stage in their expansion can
continue to grow for some time at above their long-run potential without experiencing
inflationary pressures, and the recovery should not be cut short by the need to restrain
inflation. Furthermore, G-7 policy measures are consistent with the goal of non-inflationary
growth with higher employment.


17
PART I: 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, which in some past reports have been designated as manipulating the rates of
exchange between their currencies and the U.S. dollar.

KOREA

Korea currently has a global current account deficit, but maintains a small bilateral
trade surplus with the United States. It is the judgement of the Treasury Department that
Korea is not at this time manipulating the rate of exchange between the won and the U.S.
dollar to prevent effective balance of payments adjustment or to gain unfair competitive
advantage in international trade.

Notwithstanding this determination, the Treasury Department remains concerned that
Korea’s continued use of foreign exchange and capital controls reduces market demand for
the won and thereby tends to deter upward pressure on the won.

Trade and Economic Developments

Korea’s external accounts continued to shift in 1994. Korea’s current account was
nearly balanced in 1993, recording a small surplus of $500 million compared to a deficit of
$4.5 billion in 1992. Korea’s trade balance registered a surplus of $1.9 billion in 1993.

This year, according to statistics provided by the Bank of Korea, the current account
balance in January-June registered a deficit of roughly $2.7 billion. A small second-half
surplus is expected to lower the annual deficit to $2.5 billion. Trade flows accounted for
most of the increased deficit. Imports, reflecting the recovery in aggregate demand as Korea
pulled out of last year’s recession, jumped roughly 14.5 percent in the first half of 1994
compared to the same period in 1993. Korea’s exports, on the other hand, grew by 11.9
percent during January-June 1994, compared to 5.9 percent during the same period in 1993.
Overall, Korea registered a trade deficit of $1.6 billion during the first six months of this
year. Korea ended 1993 with $20.7 billion in gross reserves (excluding gold), equivalent to
over two months of imports. By May 1994, this figure had risen to an estimated $21.4

billion.

While Korea’s economic recovery has been the driving force in widening the overall
deficit in dollar terms, exchange rate developments may also be playing a role. Won


Table 4

G-7: Current Account Balances
billions; % of GDP in parentheses)

1993 1994F 1995F
Consensus IME
United States 1041.6) -149((-2.2) -143 16700 ((-2.4) 141
Japan +131 (43.1) +136 (42.9) +130 +129 (42.6) +115
Germany* 20 1.0) 16 (0.8) 25 “14 (0.6) -16
France +10 (40.8) +10 (+0.7) +8 +12 © (+0.9) +5
Italy +11 (1.2) #31 (43.0) +20 +38 (43.4) +23
United Kingdom “16 (1.6) 0-13 1.3) 8 1B (-1.6) 9
Canada 24 (4.3) 21 3.9) -22 19 (3.3) -20
Total G-7 ll @.) 2B (0.1) -39 39 = (0.2) 44

* All Germany for IMF; F=Forecast

Sources: IMF, World Economic Outlook, October 1994, and Consensus Economics, Consensus Forecasts.
November 1994,

Unemployment and Structural Adjustment

The recovery has produced substantial employment gains in the United States. Since
January 1993, 5.2 million new payroll jobs have been added, mostly in the private sector.
The unemployment rate dropped to 5.6 percent in November. Job gains are now spreading
to other countries, although unemployment remains high, particularly in Europe.

Reduction in unemployment rates normally lags uptums in production. The year 1995
should see a reduction in unemployment on the Continent, although the decline may be too
small to reduce the aggregate European unemployment rate much below 10 percent before
1996. Thus, while it is likely that some gradual improvement in the unemployment rates
will occur, and there is some evidence that G-7 labor markets are becoming more flexible,
rates will remain at historically high levels in Europe even into the latter part of the decade.
More progress in the structural policy area, supported by appropriate macroeconomic
policies, is essential.

Other structural changes in the industrial economies have made product markets more
competitive and reduced price-raising power. Among these changes is a more open
international trade regime, which may reduce the power of capacity constraints in any one
country to accelerate inflation.


23

relatively steady, the small increase in the bilateral trade deficit with Taiwan is probably
attributable to increased economic growth in the U.S.

In 1992, Taiwan ran its first overall balance of payments deficit in twelve years.
Since that time, however, Taiwan’s position has improved, despite a steady decline in the
current account surplus. Taiwan registered an overall surplus of $1.5 billion in 1993, which
grew to $3.8 billion in the first six months of 1994, The principal reasons for this
improvement in the balance of payments are: 1) a substantial increase in the inflow of
foreign direct and portfolio investment; 2) a steady fall in Taiwan’s direct and portfolio
investment abroad; 3) a drop in Taiwan’s purchases of foreign real estate; and 4) a net
inflow of short-term capital in 1994. Because of these factors, Taiwan’s long- and short-
term capital accounts together ran a surplus of $2.1 billion in the first half of 1994,
compared to a deficit of $4.8 billion for all of 1993. Taiwan ended 1993 with $83.6 billion
in foreign exchange reserves, equivalent to over one year of imports. By August 1994, this
figure had climbed to $91 billion.

Taiwan's real GDP grew 6.2 percent during 1993, continuing the pattern set in recent
years of more moderate growth. Annual growth rates below the seven percent rate which
prevailed over the last several decades reflect both Taiwan's economic maturation and
weakness in the world economy. Economic growth in the first half of 1994 registered only
5.7 percent, but an increase in exports and private sector investment has led to an upward
adjustment of Taiwan’s economic forecast to 6.2 percent growth for all of 1994.

Inflation in Taiwan ran at roughly 2.9 percent for 1993, but indicators for 1994 are
mixed. The consumer price index jumped to 7.1 percent in August and 6.7 percent in
September over previous year levels. These rates are far above the Central Bank’s target of
3.8 percent for the full year. Inflation may have been distorted, however, by poor weather,
which has significantly increased prices for basic commodities. The growth of broad money
(M2) during the first eight months of 1994 slightly surpassed the Central Bank’s target of 15
percent.

Foreign direct investment in Taiwan, measured on an approval basis, has declined
steadily in recent years. The most likely causes for this drop include the earlier appreciation
of the NT dollar against the U.S. dollar, an increase in labor costs and an increase in land
costs. Inward foreign investment showed a surprising increase during the first six months of
1994, however, totalling $465 million during January-June of this year, an increase of 72
percent over the same period in 1993. Further, it is estimated that Taiwan received $1.5
billion of portfolio investment in the first half of 1994, compared to $433 million during the
same period in 1993.

h: lopmen

The NT dollar depreciated nearly 5 percent against the US dollar in 1993, largely due
to strong capital outflows from the island during the first three quarters of that year:


DEPARTMENT OF THE TREASURY
SEVENTH ANNUAL
REPORT TO THE CONGRESS
ON

INTERNATIONAL ECONOMIC AND EXCHANGE RATE POLICY

DECEMBER 1994

Embargoed for release until
5:00 p.m., January 3, 1995


10

Dollar vs. Yen and DM
October 1993 to November 1994

4195

7
4 a
3 ee
6
a 6
g Ws
» pi diss?

96.
Oci3 Nbv Dee Jao Feb Apr Mey Jt Jel Aug «Sep Ort) = Nov
Yen peg Dollar] DM pe Dolls

Chart 3

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

Change:
Currency October 1, 1993-November 30, 1994
Japanese Yen 46.7%
German Mark 3.9%
British Pound 4.3%
French Franc 5.4%
Ttalian Lira 1.6%
Canadian Dollar 3.4%
Swiss Franc 46.8%
Mexican Peso 10.3%
Korean Won 2.2%
Taiwanese Dollar 2.3%

hin nt Foreign Exch: M: Developmen

The depreciation of the dollar over the period can be attributed to two sets of factors.
First, there was a renewed focus in the market on external imbalances and the associated


9
B. Developments in the Foreign Exchange Markets
Ini jon

Between October 1, 1993 and November 30, 1994, the dollar experienced a moderate
decline of approximately 4 percent on a nominal trade-weighted basis. The decline was
widespread, including against many currencies which customarily follow dollar movements in
the exchange markets. The dollar ended the period at a level 3.5 percent below its average
over the past seven years in trade-weighted terms.

Real Trade-Weighted Exchange Rate Indices
October 1993 to September 1994
(Monthly)

z

100
,

3
8

,
Sette enee

3s
8

index October 1993
©
8

£ 8

L L 1 1 n 1 1
‘Oct-93 Nov-93 Dec-93 Jan-94 Feb-94 Mar-94 AprS4 May94 Jun-94 JubS4 Aug-94 Sep-S4 Oct-94 Nov-94

Dollar Yen DM

Source: JPMorgan index, using OctS3 = 100.

Chart 2

The downward movement in the dollar was first evidenced in January against the yen,
reversing a trend of appreciation that had begun in August 1993. Over the next two months,
the dollar also began to decline against the German mark and other European currencies.
The following table shows the percent change in the dollar against various currencies from
October 1, 1993 through November 30, 1994. The peak-to-trough decline from early 1994
to the dollar’s lows in October was 14.6 percent vs. the yen and 5.0 percent vs. the DM.


30

While accepting these objectives as long-term goals, China’s position in these
negotiations is that reforms undertaken this year are very significant; that access to foreign
exchange is already nearly unrestricted; and that China needs to maintain a system which
provides the capability of regulating foreign exchange availability.

Table 11
China: Nominal Bilateral Exchange Rate Indices
(End of Period)
Sept
1990 1991 1992 1993 1994
United States 100 96.4 80.2 68.9 65.5
Japan 100 88.7 73.7 56.7 47.8
EU 100 98.9 911 84.8 72.7
Ching: Real Bilateral Exchange Rate Indices
(End of Period)
Sept
1990 1991 1992 1993 1994
United States 100 97.2 83.9 82.4 92.2
Japan 100 89.9 78.8 70.5 70.2
EU 100 98.6 93.8 101.3 102.6

Sources: IMF and Treasury Department Data

Decline of Index = Depreciation of Chinese Currency
September Real Exchange Rate Indices Are Based on Estimated Inflation Rates for China, Japan, and
the European Union

Assessment

Treasury acknowledges that major strides in reforming China’s foreign exchange
system have been made this year. However, China maintains significant restrictions on
foreign exchange transactions. Domestic firms are required to sell foreign exchange to
designated banks, and, while FFEs may use the foreign exchange earned through exports,
they must receive prior approval from the SAEC for all purchases of foreign exchange in the
interbank market. Moreover, China continues to require SAEC approval for certain current
account transactions, including repatriation of profits.



29

SAEC approval system can be used as a means to enforce foreign exchange balancing
requirements.

If a domestic firm wishes to purchase foreign exchange for permitted current account
transactions, the request is not submitted to the SAEC. The firm needs only the required
documentation cited above. With such documentation, the domestic firm can buy the foreign
exchange directly from a designated bank.

Exchange rate management in the interbank market comes in two forms: (1) limiting
trading to within a particular range of the daily determined rate (+0.25 percent); and (2)
intervention through buying or selling foreign exchange by the People’s Bank of China
(PBOC) to stabilize rates.

Outside the 19 cities linked to the interbank market in Shanghai, foreign firms must
trade foreign exchange in the previously existing swap centers. These swap centers are not
part of the integrated foreign exchange market in Shanghai but still must balance the local
supply and demand for foreign exchange according to the exchange rate set in Shanghai.
Local authorities often have been unwilling to allow foreign-funded enterprises to trade
foreign exchange outside the local swap center.

Exchange Rate Developments

On November 4, 1994 China’s exchange rate (unified in January of this year) stood at
8.53 yuan/dollar, a nominal appreciation of 2 percent from its end-1993 value of 8.71
yuan/dollar. Most of this appreciation has come in recent months and is likely the result of
increased demand for renminbi stemming from domestic credit controls and the increased
availability of foreign exchange resulting from large investment inflows and China’s
improved trade balance. Large accumulation of foreign currency by the People’s Bank of
China, as evidenced by the large increase in official foreign exchange reserves, prevented
greater nominal appreciation of the exchange rate.

Nonetheless, China’s inflation rate greatly exceeded that of the United States. Asa
result, China’s yuan/dollar exchange rate appreciated an estimated 12 percent in real terms
over the period end-1993 to end-September 1994.

xch jation:

In the context of bilateral negotiations between Treasury and Chinese authorities, as
well as in China’s WTO accession negotiations, Treasury and other U.S. Government
agencies have pressed China to: (1) give domestic and foreign firms equal access to a unified
foreign exchange market; (2) eliminate all requirements for government approval of foreign
exchange purchases for goods and services transactions (i.e., move to current account
convertibility); and (3) eliminate foreign exchange balancing requirements.


6

Trade volume figures show a substantial rise in imports, although exports have also
risen somewhat. For 1994 as a whole, it is entirely possible that Japan’s current account
surplus measured in dollars could be the same as or slightly higher than its $131 billion level
in 1993. But the cumulative impact of the past yen rise (which took place mainly in the first
half of 1993) and the gradual strengthening of domestic demand in Japan should produce a
small reduction in the 1995 surplus even in dollar terms.

depen: import Volunes Continue To Incresee, But
Export Vokunes Up As Well Due to Overseas Growth

a. .
vo 1.8 1: rene

on cameo =o
ote: Derived wating OD Yur basen Inport ard beport Wirctanabe Pie cow. ed

Chart 1

Even in 1995, however, Japan’s external surpluses will remain sizeable, both in
absolute terms and in proportion to GDP. It will therefore remain urgent that Japan continue
to open its markets and avoid premature monetary and fiscal policy tightening, so that the
recovery can gather strength and produce an expansion of domestic demand large enough to
make a sizeable reduction in Japan’s external imbalances. (For a discussion of U.S. trade
and current account prospects, see section IIB.)


20

Regarding inward capital controls, foreigners have been subject to a 10 percent
general and 3 percent specific limit on investment in Korean stocks. Newly appointed
Finance Minister Park Jae Yoon announced October 5 that, effective December 1, the 10
percent ceiling on aggregate foreign purchases in a listed stock will be increased to 12
percent, with the ceiling going to 15 percent sometime in 1995. The 3 percent limit on
purchases by an individual will remain unchanged. Soon after the announcement, however,
the Stock Market Stabilization Fund reportedly sold its equity holdings to slow the rise in
stock prices. The Fund’s decision to sell equity holdings was viewed by some as
unnecessary intervention in the market. Treasury will closely monitor this issue and continue
to press Korea for more rapid liberalization.

With regard to capital outflows, Koreans and Korean companies are permitted,
effective July 1, 1994, to purchase foreign stocks and bonds, but individual Koreans are
limited to investments of up to $125,000 and companies up to $375,000. However, new
capital controls were introduced early this year in response to a surge in capital inflows.
Foreign investors were required to obtain special identification cards prior to purchasing
Korean shares. Foreign investors were also required to deposit 40 percent of the purchase
price prior to entering the order — a practice prohibited in the United States - thereby
cutting U.S. institutional investors out of Korea’s securities market. Although these
regulations were eased during the course of the year, their imposition had the effect of
slowing capital inflows during the early months of 1994.

The limits on capital inflows and outflows, while they were eased on an incremental
basis, reflect the cautious approach taken by the Korean government and the desire to
insulate the won from the effects of market-determined capital flows. The imposition of new
capital controls earlier this year and more recent actions to depress activity on the Korean
stock exchange are evidence that Korean authorities are still far from the goal of allowing
market forces to determine exchange rates. Moreover, such actions undermine foreign
confidence in Korea’s financial liberalization commitments, and in the longer run can
complicate monetary management. :

Financi, jation:

Treasury has continued to engage Korean authorities in discussions related to
accelerating its financial market and capital account liberalization and will continue to do so
under extended Uruguay Round negotiations and further bilateral contacts. Most recently,
Treasury has focused on the need for the exchange rate to reflect the influence of global
capital markets. Treasury has expressed concern to Korean officials about the consequences
of maintaining an undervalued exchange rate. Of particular note since the last report, the
Ministry of Finance announced on December 7 its Foreign Exchange System Reform Plan - a
package of measures based on the recommendations of a study committee set up earlier this
year. The reforms will loosen some controls on Korea’s foreign exchange and capital
markets, and will be introduced in three stages: 1995; 1996-97; and 1998-99. Specific areas
which will be affected by the reform plan include selected current and capital account


26
CHINA

As noted in the July report, China has taken important steps to reform its foreign
exchange system this year, unifying exchange rates and liberalizing domestic firms’ access to
foreign exchange. Yet, government approval of foreign exchange purchases by foreign-
funded enterprises, which account for a large share of China’s imports, is still required.
Documentation requirements for domestic enterprises wishing to acquire foreign exchange for
current transactions are also burdensome and give authorities the scope to prohibit foreign
exchange transactions. While approval is readily given at the moment, the arrangements can
only be viewed as intended to provide the means to limit imports of goods and services if
government officials wish to do so. The non-transparency of the process and the criteria for
approval allow scope for discrimination in imports.

It is therefore Treasury’s determination that China is not currently manipulating its
exchange system to prevent effective balance of payments adjustment and gain unfair
competitive advantage in international trade, but that it retains the capacity and bureaucratic
means to do so in the future. In the context of bilateral negotiations as well as multilateral
negotiations on China’s entry into the WTO, Treasury continues to urge China to complete
market-oriented reform of its foreign exchange system, give foreign and domestic firms equal
access to the new interbank foreign exchange market, and eliminate all government approval
systems aimed at regulating the level and composition of imports of goods and services.

Indeed, foreign exchange controls are but a part of a multiplicity of formal and
informal trade controls. Restrictions include foreign exchange balancing requirements,
limitations on the trading rights of foreign and domestic firms, and import licenses that
restrict and distort the composition of China’s imports.

Trade and Economic Developments

After deteriorating to a deficit of $12.2 billion in 1993, China’s overall trade balance
returned to surplus in the first nine months of 1994 as exports benefitted from stronger
growth in China’s markets. China’s data indicate that exports were up 30 percent in the first
three quarters of 1994 to $79.4 billion while imports, driven by China’s continued rapid
growth, rose 15 percent to $78.0 billion. China thus reported a trade surplus of $1.4 billion
for January-September 1994. Current account information is not yet available for this year,
but the improvement in China’s trade account should give China a small current account

surplus in 1994.

In this context, it is important to reiterate the caveat noted in previous reports that
China’s trade data are not consistent with those of its trading partners. Specifically, China’s
data significantly understate exports because of the incentives that China’s foreign exchange
surrender requirements generate to underreport export earnings and hold foreign exchange
offshore. For example, while China reported a trade deficit of $12.2 billion for 1993,
trading partner data adjusted for differences in valuation and transshipment through Hong


2

the decline on several occasions and to undertake several rounds of intervention. The
Administration has made clear its desire for a strong dollar.

The main themes of the IMF’s annual Article IV consultation with the United States
Government, completed in August, were the U.S. fiscal outlook -- and its implications for
the U.S. extemal position — and the appropriate monetary policy at this stage of recovery in
the United States.

In this Report, Treasury has re-examined the systems and policies of Korea, Taiwan
and China, which have been identified in some previous reports as having manipulated the
exchange rate between their currency and the U.S. dollar in order to prevent effective
balance of payments adjustment or to gain an unfair advantage in international trade. It is
Treasury’s judgement that, at the current time, neither Korea nor Taiwan is manipulating the
exchange rate between its currency and the U.S. dollar for such purposes. However, both
Korea and Taiwan continue to maintain a number of troubling financial and foreign exchange
policies, capital controls in particular, which discourage investment and hamper the full
effect of market forces in exchange rate determination. Treasury will continue to seek
removal of these impediments in the context of bilateral negotiations and/or discussions.

Treasury acknowledges that major strides in reforming China’s foreign exchange
system have been made this year. However, China maintains significant restrictions on
foreign exchange transactions. Domestic firms are required to sell foreign exchange to
designated banks, and while Foreign-funded enterprises (FFEs) may use the foreign exchange
eared through exports, they must receive prior approval from the State Administration of
Exchange Control (SAEC) for all purchases of foreign exchange in the interbank market.
Moreover, China continues to require SAEC approval for certain current account
transactions, including repatriation of profits.

At the moment, SAEC approval of foreign exchange purchases for foreign firms is
not difficult to obtain. This liberal implementation stems from favorable market conditions --
ample foreign exchange availability and strong demand for the renminbi. However, as in the
past, the SAEC could withhold approval. It is clear that the rationale for maintaining the
approval system is to maintain the government’s capability to ration foreign exchange.

Thus, Treasury has determined that China is not currently manipulating its exchange
system to prevent effective balance of payments adjustment or gain unfair competitive
advantage in international trade. However, it is essential that China commit to liberalizing
access to foreign exchange for current account transactions, as is required under Article VII
of the IMF’s Articles of Agreement. The United States continues to seek such commitments
from China in bilateral negotiations and in multilateral negotiations regarding China’s
accession to the World Trade Organization (WTO).


13

Cc. f=) ni velopm
Goods and Services Trade

The U.S. deficit on Goods and Services (G&S) trade continued to widen in 1994,
running at an annual rate of $109.3 billion for the first 9 months, compared with $74.1
billion for the same period in 1993, and a recent low point of $28 billion for the year 1991.

This widening was entirely due to an increased deficit on goods trade. The surplus on trade
in services so far this year is roughly unchanged from the 1993 level.

Mensures of the U.S, Trade Balance
CBI? dete ia BUS DI Iitone)

Chart 4
The goods trade balance was heavily influenced by cyclical factors.

° The robust U.S. expansion, now in its third year, continues to draw in imports, which
are up 12.6 percent in value terms for first 9 months of 1994 over the same period in
1993. Strong import growth is characteristic of such a robust expansion. However,
40 percent of the increase has been accounted for by capital goods, including
computers. Such imports have a positive impact on the U.S. economy, since they
support the strong capital investment expenditures by U.S. firms, which in turn
contribute to the continued strong competitive performance by U.S. exporters in the
face of weak demand in several major export markets.

° Exports are up 9.3 percent in value terms over the first 9 months, despite having been
hampered by sluggish growth in Europe and Japan. The drag of sluggish growth in
major industrial country markets has been partly offset by strong growth in emerging
country markets, and continued improvement in the foreign market share of U.S.
exports, reflecting a robust U.S. competitive position as measured, e.g., by relative
unit labor costs.


15

‘hanging Capital Account Pattern:

The pattern of financing of the U.S. current account has changed somewhat in recent
years. Direct investment recorded net inflows during much of the decade of the 1980s, but
has shifted to net outflows so far during the 1990s. At the same time, there has been a
substantial decline in the net inflow from securities transactions, though changes in the net
have masked much larger swings in gross inflows and outflows. (in particular, there was a
very large surge in U.S. purchases of foreign securities during 1993, which rose to $142
billion annual rate during the second half of the year but dropped back sharply in 1994, to an
annual rate of $42 billion in the second and third quarters.) Banking transactions have
accounted for increased inflows. There have been substantial official inflows in recent years,
in part relating to foreign official intervention in exchange markets by major industrial
countries and in part to the accumulation of dollar reserves by dynamic developing countries,
which are a counterpart of their increased ability to attract private capital.

Table 8
Annual Capital Flows: 1981-85; 1986-90; 1991-93; 1994
(Sbillion; annual averages, selected transactions)

1981-85 1986-90 1991-93 1994"
Direct Invest, net +11 +28 24 “AS
Securities, net +23 +31 +5 +18
Corporate (non-d.i.) +1 +3 +12 +14
Banks, net -l +15 +32 +119
Official, net 5 +28 +5 +52
* Jan-Sept at annual rate

k_ for nt_Accoun’

Relative growth performance by the United States and its major trading partners will
continue to be a major factor driving the U.S. trade and current account during 1995 and
beyond. The U.S. economy should continue to expand, though at a more moderate pace,
and thus imports will continue to grow as well. Renewed expansion in Europe and Japan
will give a boost to U.S. exports, but the improvement will be gradual.

‘We expect the U.S. trade and current account deficit to continue to widen in 1995,
albeit at a declining rate, reflecting this growth pattern. (A range of recent private and
public sector forecasts is shown below.) However, the deficit in 1995 should not exceed
2-1/2 percent of GDP, well short of the peak deficit of 3.7 percent of GDP recorded in
1987. Recent data confirm that a recovery is underway in Europe -- though the likely vigor
of the expansion remains uncertain -- and prospects for a revival of economic activity in
Japan have improved. And various indicators of U.S. competitiveness, notably data on unit


PART I: SUMMARY AND CONCLUSIONS

This seventh annual Report addresses recent developments in U.S. international
economic policy, including exchange rate policy, since the interim Report to Congress
submitted in July 1994. It is based on information available for the most part through
November 1994. These reports are required under Sections 3004 and 3005 of the Omnibus

Trade and Competitiveness Act of 1988 (Trade Act).

Global recovery is now well underway. Recovery is strengthening in continental
Europe, and in Japan there are initial signs of recovery. The Managing Director of the
International Monetary Fund has termed the 1995 outlook for the world economy the most
favorable in seven years.

‘With the momentum now shifting from the United States, Canada and the UK, where
growth first took hold, to the economies in continental Europe (and, more hesitantly, Japan),
the prospects for a sustained and balanced recovery are much improved. G-7 growth in 1995
is expected to average at least 2.7 percent -- about the same as in 1994, and double the
figure recorded in 1993.

Inflation in the G-7 has been held to levels achieved only once since the 1960s,
despite gains in capacity utilization. The inflation outlook for 1995 is only slightly less
favorable, Those that started earlier in the recovery cycle, the United States, Canada and the
UK, will likely see a very modest increase in inflation, but the steady decline of inflation in
Germany and continued progress in Italy will provide a counterbalance.

The growing sense of optimism about recovery and output growth in the industrial
countries is not, however, without blemishes. Unemployment in Europe remains very high,
and the upturn is not expected to be sufficient to bring about a substantial improvement. The
large fiscal deficits in Europe are also troubling, although most European countries have
embarked on strenuous efforts to reduce the underlying structural deficit.

Stronger growth in the United States than in many key trading partners led toa
widening of the U.S. current account deficit in 1994. The current account deficit will likely
continue to widen further during the remainder of 1994 and in 1995, although it will remain
well below peaks recorded in the late-1980s as a percentage of GDP.

Japan's surpluses, though still high, have started to decline. For the first ten months
of 1994, the current account surplus fell 9.2 percent in yen terms relative to the same period
in 1993, and declined 1.6 percent in dollar terms on the same basis. A further modest
reduction is expected in 1995 as domestic demand strengthens in Japan.

‘When measured on a trade-weighted basis, the dollar declined approximately 4
percent between October 1, 1993 and November 30, 1994. However, the peak-to-trough
decline from early 1994 to the dollar’s lows in October was 14.6 percent vs. the yen and 5
percent vs. the DM. The decline against the yen and mark during a period of robust growth
and low inflation in the United States prompted the Administration to express concern about


24

However, between December 31, 1993 and November 18, 1994, the NT dollar has
strengthened moderately, appreciating by roughly 1.2 percent relative to the U.S. dollar.

Exch Finangi: m

Taiwan continues to maintain controls and regulations on foreign exchange
transactions and capital flows. Together, these limit the size of Taiwan’s foreign exchange
market. Principally through negotiations held on accession to the WTO, Taiwan has made
some progress in liberalizing its financial sector during the past year. Certain key ceilings
and restrictions on foreign exchange remain in place, however, and authorities on Taiwan are
reluctant to abolish them in favor of indirect controls.

Taiwan’s ceilings on banks’ foreign exchange liabilities limit the ability of banks to
engage in forward trading in the NT dollar, to offer foreign currency loans in Taiwan, and to
use swap funding in order to obtain NT dollars with which to make local currency loans. In
January, the Taiwan authorities again raised the foreign exchange liabilities ceiling for
commercial banks, and the industry as a whole does not appear to be operating up against the
ceilings at present. Nevertheless, the existence of these ceilings may act to restrict the
activities of individual foreign banks. The existing limits force banks to be more selective in
the types of business that they do and have the effect of restricting long-term lending. Also,
although some banks still have excess capacity on their limits, the Gross Business Revenue
Tax on domestic interbank loans makes interbank lending too expensive. Further, while
there currently is excess foreign liability capacity in the market, there is no guarantee that
this will not change. The use of foreign currency borrowing is generally influenced by
interest rate differentials and exchange rate movements. The current limits hinder the ability
of banks to react to market movements and thus raise their costs. Taiwan authorities have
pledged to replace these limits with reserve requirements after passage of a new Central Bank
law. ,

Limits on foreign banks’ short and long foreign exchange positions are also a
concern. Under current regulations, foreign banks are subject to the same ceiling as "small"
domestic banks. That is, foreign banks are limited to a $20 million "long" position
compared to $50 million for large domestic banks; and a $6 million "short" position,
compared to $10 million for large domestic banks. As New Taiwan dollar funding and
liquidity remain areas of concern for foreign banks, raising the long and short ceilings for
foreign banks to a level comparable to that for large domestic banks would be a positive
development.

Non-trade-related capital inflows and outflows by an individual continue to be subject
to a limit of $5 million per year without prior approval. The limit for firms, however, has
been raised to $10 million per year. Foreign individual investors are prohibited from
investing on Taiwan’s stock exchange (the Taiex). The Taiex was opened to foreign
institutional investors in January 1991, but these investors continue to face restrictions on
repatriation of capital and earnings. On the positive side, however, the Central Bank of


Part I

Part II

Part I

Appendix

TABLE OF CONTENTS

Summary and Conclusions

Global Economic Developments

A. Economic Situation in the G-7 Countries

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

- Korea

- Taiwan

- China

13

17
22
26

Text of Sections 3004 - 3006 of the Omnibus Trade and Competitiveness Act

of 1988




27

Table 10
Chinese Balance of Payments Figures
($ Billions)
Jan-Sept
1990 1991 1992 1993 1994
Current Account 11.9 13.3 6.4 -11.9 na
Of which:
Trade Balance* 8.7 8.2 4.4 -12.2 1.4
Capital Account 3.3 8.1 0.2 23.5 na
Net Errors & Omissions - 3.1 -6.8 -8.3 9.8 na
Increase in Reserves -12.0 14.5 21 - 18 -18.6
(- = increase)
Sources: Chinese and IMF Statistics
* Trade Figures on Customs Basis; Other Figures on a Balance-of-Payments Basis

Kong suggest that China’s 1993 trade balance was instead in surplus by approximately $20
billion.

China’s large bilateral trade surplus with the United States will likely continue to
increase this year. Extrapolating from January-September 1994 data, the bilateral surplus is
projected to be $28.7 billion, compared with $22.8 billion in 1993 and $18.3 billion in 1992.
Growth in U.S. exports, largely capital goods, to China rose 15 percent for this period over
last year (compared with 1993 growth of 17 percent), while imports, dominated by consumer
goods, rose at a 23 percent rate (the same rate as 1993).

All sources agree that China’s foreign exchange reserves have increased sharply this
year. Chinese authorities reported that reserves of the People’s Bank of China rose $18.6
billion in the first nine months of 1994, from $21.1 billion at the end of 1993 to $39.8
billion at the end of September 1994, i.e., about five months of imports. This excludes
foreign exchange holdings of the Bank of China that until 1992 were counted as part of

official reserves,

The large increase in China’s reserves and the selective easing of credit to
unprofitable state enterprises in 1994 contributed to rapid growth of China’s money supply.
M1 and M2 expanded by 33 and 37 percent, respectively, in the year ending September
1994. This monetary expansion helped to sustain China’s rapid growth in 1994. Real GDP
growth remains very high -- 11.4 percent for the first 9 months of this year. This pace
represents some moderation of last year’s 13.4 percent growth and is in line with official
forecasts of 11-12 percent growth in 1994. However, indicators suggest that growth is


il

trade tensions between the United States and Japan. Second, there was a change in market
expectations regarding the monetary policy response to the sustained strength of the economic
expansion in the United States and a faster than expected recovery in Europe.

The widening of Japan’s trade surplus in late 1993 and into early 1994 raised market
caution about the need for further adjustment in imbalances. The market showed sensitivity
at times to developments in US-Japan trade negotiations in subsequent months, given their
importance to the adjustment process. Lack of progress in Japan on fiscal and other policy
measures which influence domestic demand led the market to believe that external adjustment
might come about mainly through the yen/dollar exchange rate.

In addition, the deterioration in the U.S. current account deficit that accompanied the
recovery generated some concem in the market. Changes in capital flows, including the
continued diversification of U.S. investors into foreign assets and a period of reduced
demand by Japanese investors for foreign assets were perceived to have exerted pressure on

the dollar.

Market expectations about growth, inflation, and the expected monetary policy
response played a key role. At times, there was downward pressure on the dollar as the
market participants gradually realized that U.S. economic growth was moving along faster
than they had anticipated and became concerned whether the monetary response would be
adequate to keep the economy from quickly reaching employment and capacity constraints.

Over the period, the pace of economic recovery in Germany and throughout Europe
accelerated faster than many market participants had anticipated, raising expectations of
strong relative investment returns in these markets and thereby leading to some adjustment
out of dollar assets. Market perceptions in the summer that the monetary easing cycle in
Europe was over implied that interest rate differentials would not widen sufficiently in the

doliar’s favor.

The dollar stabilized for a short period beginning in mid-July as some of these
concems receded. Optimism spread about the favorable resolution of the framework talks
with Japan. There was a growing feeling in the market that the Japanese trade surplus had
peaked. The August tightening by the Federal Reserve was well received in the markets.
Later, the dollar was supported by encouraging signs that other steps, such as preliminary
Japanese tax reform and other policies to stimulate domestic demand, were being taken to
address external imbalances.

However, starting in September, renewed indications of stronger than anticipated U.S.
economic activity kept U.S. bond prices under pressure. Increases in various indicators of
capacity utilization, of prices of inputs, and of employment pointed to sustained growth at
faster than anticipated rates, which raised the market’s concern about inflation risks. The
dollar temporarily traded lower during the second half of October.


14

Table 6
Goods Exports and Imports by End-Use 1993-4
(§ billion; Jan-Sept at annual rates)
End-Use Category Exports Imports
1993 1994 1993 1994
Foods, Feeds, & Beverages 39.9 39.6 27.5 30.6
Industrial Materials 110.0 118.3 145.4 159.1
Capital Equipment 178.0 201.5 148.4 178.7
Automobiles & Parts 51.4 56.0 101.0 115.7
Misc. Manufactures 71.3 84.2 150.2 164.0
TOTAL, CENSUS BASIS 456.6 499.6 572.4 648.0
TOTAL, BOP BASIS 448.5 490.1 580.7 654.0

The surplus on services, though large, has remained in the $55 billion range for
several years, after rapid growth in the latter 1980s. The factors behind this apparent
levelling-off are not clear, but may in part reflect the same cyclical factors influencing the
goods trade balance, since U.S. competitiveness is as marked in services as in goods.
Recovery abroad should contribute to a renewed widening in the services surplus.

However, renewed growth in the services surplus may well be offset by a widening
deficit on investment income, as a decade of current account deficits has built-up a large net
debt which has to be serviced. In 1994, for the first time, the United States will run a deficit

on net investment income.

Table 7

U.S. Current Account: 1987; 1991*; 1994
($ billion; data from SCB)

jalance 1987 1991" 19948
Goods -160 -74 -164
Services +8 +46 +57
Investment Income +8 +15 10
Transfers 23 -35* 32
Current Account ~167 49" 149

*excludes $42 billion in one-time transfers from allies to support Desert Storm. Totals
may not add due to rounding.
#Jan-Sept at annual rate