1 

Report to Congress on 

International Economic and Exchange Rate Policies 

December 2006 

This report reviews developments in international economic and exchange rate policies, focusing 

on the first half of 2006,1

 and is required under the Omnibus Trade and Competitiveness Act of 

1988 (the “Act”).2, 3 This report also updates the special Appendix to the May 2006 Report on 

International Economic and Exchange Rate Policies and includes two additional appendices 

highlighting key issues in the evaluation of currency misalignment and foreign exchange reserve 

accumulation. 

Major Findings: 

• The U.S. economy has continued to grow at a healthy pace, although moderating in the most 

recent quarters. The Administration’s economic forecast for the FY2008 budget projects 

continued moderate growth over the next four quarters, and the labor market is expected to 

remain strong with little change in employment growth or the unemployment rate. The 

Administration forecast is similar to the consensus of private economic forecasters. 

• The world economy grew by 4.9 percent in 2005, and the IMF projects growth of about five 

percent in 2006 and 2007, which would make the 2004 to 2007 period the fastest growing in 

over 30 years. Growth in developing Asia has been particularly strong, exceeding 8.5 

percent this year. 

• Global imbalances remain a key issue on the international economic agenda. They arise 

because of large growth disparities in major countries, differences in the relative 

attractiveness of investment in their economies, and divergent patterns of saving and 

investment. Reducing global imbalances, in a manner that sustains global growth, is a shared 

responsibility requiring complementary actions by a large number of countries. 

• Europe and Japan each need to achieve higher rates of growth of domestic demand on a 

sustained basis. The pace of domestic demand growth in the Euro-area has firmed over the 

last year. However, the pace of domestic demand growth in Japan has slowed sharply in 

2006, and was negative in the third quarter. For a global rebalancing of growth to occur, 

higher rates of domestic demand growth are needed on a sustained basis. 

• The largest oil exporters can help ensure that robust global growth is sustained in several 

ways, such as: (1) by increasing expenditure on oil production capacity, (2) by judiciously 

increasing expenditure that enhances their economic potential and diversifies their 

 

1

 More recent significant developments are also discussed if information is available. 

2

 The Act states, among other things, that: “The Secretary of the Treasury shall analyze on an annual basis the 

exchange rate policies of foreign countries, in consultation with the International Monetary Fund, and consider 

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

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

trade.” 

3

 The Treasury Department has consulted with IMF management and staff in preparing this report. 
2

economies, and (3) where appropriate, strengthening their macroeconomic tools and 

monetary policy implementation including by moving toward more flexible exchange rates. 

• The United States already has made substantial progress to reduce the federal fiscal deficit, 

which has fallen from 3.6 percent of GDP in FY 2004 to 1.9 percent of GDP in FY 2006, a 

net improvement of 1.7 percent of GDP in two years. But further progress is needed. 

Personal saving, which moved into negative territory in 2005, needs to rise as well. 

• China is the world’s third largest trading nation and a global economic leader. It also has a 

very high saving rate, a growing dependency on exports to drive economic growth, and a 

very large and growing current account surplus. China’s economy needs a more balanced 

pattern of growth that is more consumption-based, with a flexible exchange rate regime and a 

modernized financial sector. 

• Secretary Paulson and China’s Vice Premier Wu Yi, chaired the first Strategic Economic 

Dialogue in Beijing on December 14 and 15. The agreed goals of the dialogue include 

balanced, sustainable growth in China, without large trade imbalances, which will aid China's 

successful integration into the global economy. Important pieces of that equation include 

exchange rate flexibility, intellectual property rights protections, increasing the role of 

consumption in the economy and opening up the service sector. China's currency policy is a 

core issue in the China - United States economic relationship. 

• In the first half of 2006, China continued with modest capital account liberalization, inter 

alia, of the programs that allow Chinese investors to make portfolio investments overseas 

and foreign investors to make portfolio investments in China. In addition, China has taken 

further steps to strengthen and reform its financial sector to accommodate currency and 

interest rate fluctuations. 

• During the first half of 2006, the authorities took further steps to reform the currency market 

and RMB flexibility increased compared to the last six months of 2005. This increased 

flexibility, however, is considerably less than is needed. 

• China’s cautious approach to exchange rate reform continues to exacerbate distortions in the 

domestic economy and impede adjustment of international imbalances. Clamping down on 

exchange rate fluctuations has increased pressures in other parts of the economy. 

• The Department of the Treasury concluded that no major trading partner of the United States 

met the technical requirements for designation under the terms of Section 3004 of the Act 

during the period under consideration. 
3

U.S. Macroeconomic Trends

The U.S. economy continued to grow at a healthy pace during the four quarters ending in the 

third quarter of 2006, although growth slowed somewhat in the most recent quarter. Job gains 

also moderated through the first 11 months of 2006, but the unemployment rate remained low by 

historical standards. Inflation – both in the headline numbers and in core measures – has started 

to ease. Energy prices dropped significantly in the late summer and early fall, and there were 

associated declines in retail gasoline prices. The Federal Reserve held its short-term interest rate 

target unchanged from July through December after raising the federal funds rate at every 

policymaking meeting since mid-2004. With the economy moderating and inflation stabilizing, 

yields on longer-term securities eased, and in the third quarter of 2006, the yield on 10-year U.S. 

government securities was noticeably below the Federal Reserve’s policymaking rate. The 

Administration’s economic forecast for the FY2008 budget projects continued moderate growth 

over the next four quarters, and the labor market is expected to remain strong with little change 

in employment growth or the unemployment rate. The Administration forecast is similar to the 

consensus of private economic forecasters. 

Real GDP grew at an annual rate of 3.4 percent over the first three quarters of 2006, matching 

the pace recorded over the three years ending in 2005. Growth moderated in the third quarter of 

2006 to a 2.2 percent seasonally adjusted annual rate after rising at a 2.6 percent annual pace in 

the second quarter of the year. The pace of expansion was restrained by a sharp decline in 

residential investment. However, consumer spending growth rose to 2.9 percent in the third 

quarter of 2006 from 2.6 percent in the second quarter. A jump in purchases of durable goods, 

chiefly motor vehicles, contributed to the pickup. Nonresidential investment also strengthened 

notably in the third quarter. 

Housing starts fell about 15 percent in October of 2006 to a seasonally-adjusted annual rate of 

1.486 million, and were 27.4 percent below October 2005. Building permits issued for future 

construction also declined, and were down 5.2 percent in October 2006 to 1.553 million units. 

That was the weakest permits figure in six years. New home sales were off 25.4 percent in 

October from a year earlier and readings on housing market sentiment on the part of 

homebuilders as reported by the National Association of Home Builders are weaker. As 

measured in the GDP accounts, residential investment decreased 11.1 percent at an annual rate in 

the second quarter of 2006 and fell an additional 18.0 percent in the third quarter. 

Other types of investment have strengthened, however. Real business investment in equipment 

and software rebounded in the third quarter of 2006, rising at an annual rate of 7.2 percent after 

dipping by 1.4 percent in the previous quarter. Real business fixed investment in structures rose 

at a 16.7 percent pace on top of a rapid 20.3 percent annual rate gain in the second quarter 2006. 

Nonfarm payroll employment increased by 132,000 in November, and job growth so far this year 

is averaging nearly 150,000 per month, down from 165,000 in 2005. Since the employment 

trough in August 2003, the economy has generated more than 6.2 million jobs, or 160,000 per 

month. The unemployment rate edged up from a 5-1/2 year low of 4.4 percent in October to 4.5 

percent in November, and the labor force participation rate rose slightly to reach its highest level 

in nearly 3-1/2 years.
4

Consumer price inflation started to slow following large energy-led increases earlier in the year. 

Headline consumer prices fell for a second straight month in October, bringing the twelve-month 

change to 1.3 percent – the smallest year-over-year increase since mid 2002. Energy prices, 

which were largely responsible for recent declines, were down 11.3 percent in October 2006 

compared to October 2005. Core consumer prices (excluding the volatile energy and food 

categories) have also started to ease but still increased 2.7 percent over the twelve months ended 

in October 2006 compared to 2.1 percent a year earlier. 

At its most recent meeting, in December 2006, the Federal Open Market Committee (FOMC) 

maintained the federal funds target interest rate at 5.25 percent, its highest level since March 

2001. The pause occurred after 17 straight hikes of 25 basis points each in the current cycle of 

monetary tightening, which began in late June 2004 when the federal funds rate was at one 

percent. Despite the magnitude of that tightening, the level of the Treasury ten-year yield 

remained relatively stable over this period. After dipping slightly below four percent in June 

2005, the yield fluctuated in a slightly higher range of about 4.5 percent through the remainder of 

2005 and into early 2006. It rose to as high as 5.25 percent in late June, and has since trended 

lower, to about 4.5 percent currently. 

 

The federal budget deficit in FY2006 was $248 billion, about $71 billion less than in FY2005. 

The July 2006 Mid-Session Review Budget projects the deficit will continue to shrink, down to 

$127 billion in FY2011, or 0.7 percent of GDP. 

The Administration’s most recent economic outlook, prepared in November, is close to the 

consensus economic forecasts of professional forecasters and shows continued strength in the 

economy in the coming year. Real GDP is projected to rise 3.1 percent and 2.9 percent during 

2006 and 2007, respectively. That is similar to the U.S. historical average over the last 20 years. 

More recent private forecasts also suggest moderating growth in the near term. 

World Economic Conditions 

The world economy grew by 4.9 percent in 2005, and the IMF projects growth of about 5 percent 

in 2006 and 2007, which would make the growth from 2004 through 2007 period the fastest 

growing three-year period in over 30 years.4

 The IMF also expects some rebalancing of growth 

across advanced countries, even though growth rates in developing and emerging market 

economies are expected to remain above seven percent. In developing Asia, the IMF expects 

economic growth to exceed 8.5 percent this year and next. Against this positive backdrop in 

emerging countries, U.S. growth is expected to moderate, as discussed above, while growth in 

Europe rises from its relatively low level over the last few years. This modest rebalancing of 

growth, to the extent it materializes, would represent a favorable development that would likely 

stimulate U.S. export growth and help maintain strong global growth in the coming year. 

However, it is not certain that the growth acceleration in Europe will be maintained beyond 

 

4

 See the IMF’s World Economic Outlook, http://www.imf.org/external/pubs/ft/weo/2006/02/index.htm; forecasts of 

aggregate GDP growth use PPP weights. 
5

2006. Japan is already decelerating in 2006. Some recent forecasts project modest deceleration 

in both Japan and the Euro Area in 2007.5 

Core inflation measures, which exclude food and energy prices, are running at less than three 

percent, and recent declines in oil prices have pushed headline inflation below core inflation. 

Non-energy commodity prices remain at or near all-time highs, with October metals prices rising 

by 80 percent y/y, but the IMF expects these price increases to moderate going forward.6

Financial conditions have tightened this year with the Federal Reserve, European Central Bank 

(ECB), and Bank of Japan (BoJ) raising short-term interest rates. But conditions remain 

generally supportive for continued global growth. For example, after the recent volatility in 

emerging markets in May and June, the spread that emerging market countries paid on their 

external debt over 10-year U.S. Treasuries temporarily rose to 240 basis points in late June 

before retreating to 200 basis points in late November.7

 Also, many successful emerging market 

countries have used benign global liquidity conditions to reduce debt generally, relying more on 

local currency debt, and increasing reserve holdings (reserves covered about 70 percent of yearly 

imports in 2005 compared to 50 percent in 2001).8

 Moreover, financial markets expect further 

tightening by the ECB and BoJ to be gradual and contingent on inflation developments going 

forward. 

Nevertheless, some analysts remain concerned that the benign global liquidity conditions 

described above will subside, and that greater risk aversion will cause a global economic 

slowdown. The moderation in the U.S. housing market is attracting attention overseas because 

analysts question whether U.S. consumers will spend less generally, and whether slower 

consumption growth will negatively impact other countries’ exports and slow economic growth 

overseas. At this point, it is difficult to determine how much of any slowdown in U.S. 

consumption growth will be offset by higher growth in investment spending and exports, thus 

sustaining overall U.S. economic growth, and how much reduced consumption growth will lead 

to reduced imports from other countries. 

Global Imbalances 

Much has been written about the large U.S. current account deficit, which through the first three 

quarters of 2006 totaled $656 billion or 6.7 percent of GDP.9

 The U.S external deficit has been 

growing since 1991, with about half of the increase occurring in the 1990s (3.6 percent of GDP) 

and the other half occurring since 2000 (3.1 percent of GDP). 

A variety of views has been put forth as explanations for the growth in the current account 

deficit, including: the persistence of more rapid growth of domestic demand in the United States 

 

5

 For example, OECD Economic Outlook, November 28, 2006. 

6

 CRB metals index (sub-index of five markets): copper scrap, lead scrap, steel scrap, tin and zinc 7

 As measured by JP Morgan EMBIG+ spread. 

8

 See Table 35, page 248 in the Statistical Annex of the IMF’s World Economic Outlook, and see also Annex 1.1 of 

it’s the IMF’s Global Financial Stability Report that discusses the nature of financial flows to developing countries. 9

 The U.S. current account deficit for all of 2005 was $791.5 billion or 6.4 percent of GDP. 
6

than in major trading partners and other G7 economies;10 weak consumption and high saving 

rates in Asia with the excess of saving over investment channeled mainly to the United States; 

the comparative attractiveness of U.S. financial markets with respect to instrument depth and 

liquidity and market execution which has influenced the behavior of asset prices and 

consumption/saving patterns; and rising oil and other commodity prices which have resulted in 

large wealth transfers. Throughout the 1990s and the current decade, the U.S. current account 

deficit has risen during times of both an improving and a deteriorating fiscal situation. 

The counterpart to a growing U.S. current account deficit is growing current account surpluses in 

other parts of the global economy. The economies with the largest external surpluses in 2005 

were the oil exporters11 ($325 billion), followed by Japan ($167 billion), China ($161 billion), 

and Germany ($ 113 billion). The surpluses of oil exporters and China continued to rise in 2006, 

while those of Japan and Germany stabilized. A reduction in the U.S. current account deficit, by 

definition, implies an equivalent reduction in one or more countries’ external surpluses or an 

increase in one or more countries’ external deficit. There cannot be change in the United States 

without a corresponding change elsewhere. For this reason, the United States and G7 partners 

have emphasized the “shared responsibility” for the adjustment of global external imbalances, as 

well as the importance of ensuring that global growth is not jeopardized in the adjustment 

process. 

 

10 Over the period 1995-2005, domestic demand grew an average 3.7 percent annually in the United States. 

Average growth of domestic demand in Japan over the same period was 1.2 percent and in the Euro-area was 2.0 

percent. Average growth of domestic demand in key U.S. export markets, weighted by export shares, was 3.2 

percent. 

11 Defined as the top seven oil exporters: Saudi Arabia, Russia, Norway, Iran, Venezuela, the UAE, and Kuwait. 

Major Current Account Balances

(Billions of Dollars)

-1200.0

-800.0

-400.0

.0

400.0

800.0

1200.0

1999 2000 2001 2002 2003 2004 2005

Australia Germany Japan U.K. U.S.

Switzerland Russia Saudi Arabia China Other Emerging Asia

Other Oil Exporters Euro Zone ex Germany Norway
7

With respect to “shared responsibility”, Europe and Japan each need to achieve higher rates of 

growth of domestic demand on a sustained basis. The good news is that over the past year the 

pace of domestic demand growth in the Euro-area has firmed. However, for a global rebalancing 

of growth to occur, rates of domestic demand growth in Japan and Europe need to be elevated 

and sustained. Current projections for 2007 or 200812 raise questions about whether this is 

happening. Doubts also remain over how much, if at all, past structural reforms in Europe and 

Japan have translated into meaningful changes in their respective long-term potential growth 

rates. One key will be Germany’s future investment pattern. Germany’s investment/GDP ratio 

fell from 22 percent in the early 1990s to 17 percent in 2005 – the fall in the ratio translates into 

a very large $140 billion difference in current German investment.

China is the world’s third largest trading nation and already a global economic leader. It also has 

an extremely high saving rate, near 50 percent, and a growing dependency on exports to drive 

economic growth. In the first six months of 2006 China’s current account surplus reached $92 

billion, or around eight percent of GDP compared to 7.1 percent of GDP in 2005 as a whole. 

China needs a more balanced pattern of growth. A more consumption-based growth model that 

includes a modernized financial sector and a flexible exchange rate regime would contribute 

significantly to a global rebalancing. 

The largest oil exporters have been significant beneficiaries of the robust pace of global growth 

the last several years. They have a large interest in helping to ensure that robust global growth is 

sustained. They can do so in several ways: (1) by increasing expenditure on oil production 

capacity, (2) by judiciously increasing expenditure that enhances their economic potential and 

diversifies their economies, and (3) where appropriate, by strengthening their macroeconomic 

tools and monetary policy implementation including by moving toward more flexible exchange 

rates. 

And finally, the United States must continue to do its part, especially with respect to increasing 

national saving. The national saving rate reflects both corporate and household saving rates as 

well as government claims on saving (sometimes called “dissaving” when government budgets 

are in deficit). The United States already has made substantial progress on reducing government 

claims, with the federal fiscal deficit having fallen from 3.6 percent of GDP in FY 2004 to 1.9 

percent of GDP in FY 2006, a net improvement of 1.7 percent of GDP in two years. But further 

progress is needed. Personal saving moved into negative territory in 2005, following a steady 

decline from a post-war peak of 11.2 percent in 1982.13

The United States is well positioned to participate in an upswing in foreign global growth, should 

it be sustained. Studies of absolute and comparative productivity growth show the U.S. 

manufacturing sector to be very competitive internationally, with exports increasing 18.5 percent 

in the 12 months through September 2006. Overall, the ratio of U.S. exports to U.S. GDP is 

nearing its historical high, set in 1998. 

 

12 See OECD Economic Outlook, November 28, 2006. 

13 The average personal saving rate over the period 1950-2005 was 7.3 percent. The rate peaked in 1982 at 11.2 

percent, then fell by four percent in 1982-87. It leveled off in 1987-92, and then resumed declining in 1993, falling 

eight percent further over the next 13 years. 
8

The United States International Accounts14

• U.S. Balance of Payments Data 

The U.S. current account deficit was $863 billion (at a seasonally adjusted annual rate, or 

“saar”), or 6.6 percent of GDP, in the first half of 2006, compared with $813 billion, or 6.4 

percent of GDP, in the second half of 2005. Viewed over a longer period, the U.S. current 

account balance declined, as a percent of GDP, from a one percent surplus in the first quarter of 

1991 to a four percent deficit in the fourth quarter of 2000. Then, after a cyclically induced 

narrowing in 2001, it resumed its decline to reach a seven percent deficit in the fourth quarter of 

2005, before easing from this peak in the first three quarters of 2006. 

Although services constitute around 30 percent of U.S. exports of goods and services and around 

15 percent of U.S. imports of goods and services, the balance of trade in services is relatively 

small, being around a $5 billion a month surplus over the past several years, and is relatively 

 

14 The IMF annually reviews U.S. economic performance and policies through the IMF Article IV surveillance 

process. The last Article IV surveillance review took place in July 2006. The IMF Article IV Staff Report and the 

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

http://www.imf.org/external/pubs/ft/scr/2006/cr06279.pdf. In addition, the IMF discusses U.S. economic policies 

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

http://www.imf.org/external/pubs/ft/weo/2006/02/index.htm. 

2004 2005

Q1 Q2 Q3 Q4 Q1 Q2 Q3

Current Account:

 Balance on goods -665.4 -782.7 -183.3 -188.2 -198.7 -212.5 -208.0 -210.6 -218.6

 Balance on services 54.1 66.0 15.2 16.2 17.0 17.7 16.8 17.5 18.3

 Balance on income 1/ 27.6 11.3 3.6 2.0 7.8 -2.2 -2.5 -2.2 -3.8

 Net unilateral current transfers -81.6 -86.1 -27.2 -23.2 -9.5 -26.2 -19.5 -21.9 -21.5

Balance on current account -665.3 -791.5 -191.7 -193.3 -183.4 -223.1 -213.2 -217.1 -225.6

 Current Account as % of GDP -5.7 -6.4 -6.3 -6.3 -5.8 -7.0 -6.6 -6.6 -6.8

Major Capital Flow Components (financial inflow +)

 Net Bank Flows 44.4 -8.9 -32.5 13.0 -7.0 17.6 -48.4 41.1 -3.8

 Net Direct Investment Flows -111.0 100.7 -.7 -25.7 74.8 52.3 -16.0 -.9 -19.0

 Net Securities Sales 656.6 669.2 148.7 120.5 186.3 213.8 203.6 116.1 165.4

 Net Liabilities to Unaffiliated Foreigners by Non Banking Concerns -26.8 -14.1 13.0 37.2 -9.2 -55.1 28.8 -6.1 30.2

Memoranda:

 Statistical discrepancy 85.1 10.4 57.7 44.0 -72.2 -19.1 43.4 64.9 49.7

 Change in Foreign official assets in the United States 387.8 199.5 19.0 74.6 34.0 71.9 75.7 75.9 80.8

Trade in Goods 

Balance -665.4 -782.7 -183.3 -188.2 -198.7 -212.5 -208.0 -210.6 -218.6

Total Exports 807.5 894.6 214.2 222.6 224.9 232.9 244.5 252.8 262.1

 of which:

 Agricultural Products 62.9 64.9 15.6 16.5 16.3 16.5 17.4 18.3 na

 Capital Goods Ex Autos 331.6 362.7 85.9 90.1 90.6 96.1 100.1 102.3 na

 Automotive Products 89.2 98.6 23.6 23.7 25.2 26.1 26.4 26.2 na

 Consumer Goods Ex Autos and Food 103.1 115.7 28.2 28.4 29.1 30.0 31.2 31.5 na

 Industrial Supplies and Materials 2/ 204.0 233.1 56.4 58.9 58.8 59.0 63.9 68.9 na

Total Imports 1472.9 1677.4 397.5 410.8 423.7 445.4 452.5 463.4 480.7

 of which

 Petroleum and Products 180.5 251.9 53.2 58.3 67.3 73.2 72.1 79.3 na

 Capital Goods ex Autos 343.5 379.2 90.7 95.3 95.8 97.5 101.1 103.9 na

 Automotive Products 228.2 239.5 57.9 58.7 60.3 62.6 64.6 64.6 na

 Consumer Goods Ex Autos and Food 373.1 407.3 100.8 101.8 101.0 103.8 106.1 107.7 na

1/ Including compensation of employees

2/ Including petroleum and petroleum products

Source: BEA, Bureau of Census

2005

U.S. Balance of Payments and Trade

($ billions, SA, unless otherwise indicated)

2006
9

stable. As a consequence, movements in the trade balance reflect in the main movements in the 

balance of trade in goods. 

In the first half of 2006, the United States exported $995 billion (saar) in goods and imported 

$1,832 billion, with a resulting $837 billion deficit on trade in goods.15 Exports of goods 

increased 13.9 percent in the first half of 2006 compared to the first half of 2005, while imports 

increased 13.3 percent. As strong as export growth has been, it has not been sufficient to narrow 

the gap between imports and exports. As highlighted in the May Report to Congress on 

International Economic and Exchange Rate Policies, U.S. exports must grow more than 50 

percent faster than imports just to keep the trade deficit unchanged. 

Non-automotive capital goods constituted 40.7 percent of merchandise exports in the first half of 

2006. Consumer goods constituted 23.3 percent and non-automotive capital goods constituted 

22.4 percent of merchandise imports. Petroleum and petroleum product imports accounted for 

16.5 percent of merchandise imports. The value of petroleum and petroleum product imports as 

a percent of total imports of goods has risen from 10 percent in the second half of 2003. The rise 

in the U.S. oil bill is an important factor in the growth in the U.S. trade and current account 

deficits. 

Canada, Mexico, China, Japan, Germany and the U.K. remain the largest trading partners of the 

United States. Canada purchased 23.0 percent of U.S. exports, Mexico 13.3 percent, Japan 6.0 

percent, China 5.0 percent, and the U.K. 4.3 percent in the 12 months through June 2006. 

Canada accounted for 17.3 percent of U.S. imports, China 14.7 percent, Mexico 10.4 percent, 

Japan 7.9 percent, and Germany 5.9 percent in 2005. 

Prices of imported goods (nsa) increased 7.3 percent in the year through the second quarter of 

2006. Non-petroleum import prices rose 1.5 percent over this period, while petroleum import 

prices increased 37.5 percent. Export prices rose 3.4 percent over this period. The most recent 

 

15 Sums may not be exact due to rounding. 

Country Exports 

Jul05-Jun06 Country Imports Jul05-Jun06

Total, All Countries ($Bil) 967.0 Total, All Countries ($Bil) 1781.2

Percent of 

Total

Percent of 

Total

Canada 23.0 Canada 17.3

Mexico 13.3 China 14.7

Japan 6.0 Mexico 10.4

China 5.0 Japan 7.9

United Kingdom 4.3 Federal Republic of Germany 4.9

Federal Republic of Germany 3.8 United Kingdom 3.0

South Korea 3.1 South Korea 2.5

Netherlands 2.9 Venezuela 2.1

France 2.4 Taiwan 2.0

Taiwan 2.3 Malaysia 2.0

Singapore 2.2 France 2.0

Memo Memo

 Euro Area 15.0 Euro Area 13.4

 OPEC 3.8 OPEC 7.9

Source: Bureau of the Census
10

trough in import and export prices occurred roughly at the beginning of 2002. Since then nonpetroleum import prices have risen 8.2 percent and export prices 13.3 percent. 

Foreign demand for U.S. financial assets remains strong. A major item financing the U.S. 

current account deficit has been net private foreign purchases of long-term U.S. securities, which 

totaled $884.1 billion in the twelve months ending October, 2006. (Included in these were net 

private foreign purchases of long-term Treasury securities amounting to $146.5 billion and net 

private foreign purchases of U.S. corporate bonds amounting to $435.0 billion.) Net purchases 

by foreign official institutions were $175.2 billion over the same period. 

Foreign investors owned $2.1 trillion of Treasury securities at the end of June 2006, or 51.9 

percent of the public debt not held in Federal Reserve and U.S. Government accounts. This 

compares with $2.0 trillion, at the end of December 2005. Foreign official institutions held $1.3 

trillion in Treasury securities at the end of June 2006, as they did at the end of June 2005. There 

are around $20 trillion in U.S. securities of all kinds outstanding. 

Net International Investment Position 

The U.S. net international investment position (NIIP) widened (with direct investment valued at 

the market value of owner’s equity) to a minus $2.5 trillion (20.4 percent of GDP) at the end of 

2005, the latest date for which data are available, from $2.4 trillion (20.9 percent of GDP) at the 

end of 2004. A $1.1 trillion valuation adjustment, reflecting strong appreciation of foreign 

stocks relative to U.S. equity, offset almost all the $785 billion widening attributable to financial 

flows and the $394 billion widening due to exchange rate changes. The NIIP (with direct 

investment valued at current cost) was a negative $2.7 trillion (21.6 percent of GDP) at the end 

of 2005 compared to a negative $2.4 trillion (20.2 percent of GDP) position at the end of 2004. 

The United States continues to earn approximately the same amount on its foreign investments 

that it pays out on foreigners’ investments in the United States, even though the value of 

foreigners’ investments in U.S. assets is around $2.5 trillion greater than the value of the U.S. 

investment in foreign assets. Net earnings on direct investment have been large enough to offset 

outflows of income payments on other forms of international investment. U.S. residents earned 

$18 billion more on their investments abroad than they paid out on foreign investments in the 

United States in 2005. Net payments have turned into marginal outflows in the four quarters 

ended September 2006. 

The NIIP is a critical measurement in analyzing the sustainability of the current account deficit. 

A growing negative NIIP must stabilize as a percent of national output in the long run or it would 

become impossible to service the external debt out of current or future production. It is generally 

believed that a stable NIIP as a percentage of GDP requires that the balance on trade in goods 

and services be close to zero.16

 

16 The magnitude of the balance depends, among other things, on relative rates of return. For example, U.S. 

residents earn a higher rate of return on their foreign assets than residents of foreign countries earn on their U.S. 

assets. If this were to remain the case through the indefinite future, then the NIIP could stabilize with the United 

States running a deficit on trade in goods and services. There is, however, no clear reason for this interest rate 

advantage to continue indefinitely. 
11

• The U.S. Current Account in Historical Perspective 

A surplus on the capital and financial accounts is, by balance of payments accounting definition, 

the counterpart to a current account deficit. These flows finance the net capital formation that is 

equal to the excess over domestic saving. The growth of the U.S. current account deficit over 

more than a decade has been linked to high levels of domestic U.S. capital formation compared 

to domestic U.S. saving. Perceived high rates of return on U.S. assets, based on sustained strong 

productivity growth especially relative to that of the rest of the world, sound U.S. economic 

performance, a welcoming U.S. investment climate, and the deepest and most liquid capital 

markets in the world have all combined to attract foreign investment. In turn, sustained external 

demand for United States assets has allowed the United States to achieve levels of capital 

formation that would have otherwise not been possible, and robust growth in investment has 

been critical to non-inflationary growth of production and employment. 

The U.S. Dollar 

The dollar ended the first half of 2006 7.4 percent lower vs. the euro at $1.2795 and 2.8 percent 

lower vs. the yen at ¥ 114.45 than at the start of the year. For most of the first half of 2006, the 

exchange rates of the dollar vs. the euro and the dollar vs. the yen moved similarly. 

• Initially, the market focused on interest rate differentials that remained favorable to the 

dollar. 

• The Bank of Japan ended its quantitative easing policy and returned to its Zero Interest 

Rate Policy (ZIRP) in March, setting the stage for an eventual move toward removal of 

monetary accommodation. The European Central Bank (ECB) also raised interest rates 

in March. 

• By mid-April, market participants increasingly looked toward the prospect of an end to 

the Federal Reserve’s tightening cycle and an erosion of the dollar’s interest rate 

advantage. Some took the view that adjustment of global imbalances would require 

substantial exchange rate changes. 

In late May and early June the market’s focus then shifted back to interest differentials, and talk 

of global imbalances faded. The euro retained much of the gains it had made in late April and 

early May, but the yen depreciated back to levels seen in late 2005. 

• Some higher than expected U.S. economic indicators, notably on inflation, led to a 

resurgence in market expectations of higher interest rates. The FOMC raised interest 

rates at both its May and June meetings. 

• Also concerned about inflation risks in the Euro area, the ECB raised it key policy rate in 

June, August, and October, narrowing the dollar’s yield advantage vs. the euro. A 

number of other central banks, including some in emerging market countries, raised 

interest rates. 
12

• Market concerns about the withdrawal of liquidity by central banks prompted a 

liquidation of risk positions globally in late May and June. 

• The Bank of Japan maintained the ZIRP through the end of the first half and made clear 

that further removal of monetary accommodation would be very gradual. 

 

On balance, the dollar largely traded in narrow ranges against the euro and yen, with low 

volatility, throughout most of this year, despite changing fundamentals. In recent trading (i.e., 

late November), however, the dollar depreciated beyond the limits of its trading range vs. the 

euro 

The Federal Reserve’s nominal trade-weighted dollar index declined by 3.2 percent in the first 

half of the year. The dollar depreciated by 5.4 percent vs. the major currencies component of the 

index and by 0.6 percent vs. the currencies of other important trading partners (OITP). 

Country Analyses

Argentina

 

Pursuit of Argentina’s goal of increasing its foreign exchange reserves to reduce external 

vulnerabilities has resulted in a de facto managed float. 

The peso depreciated 1.8 percent nominally against the dollar during the first half of 2006, from 

3.03 to 3.09 pesos to the dollar. The peso depreciated 6.9 percent from end-June 2005 to endJune 2006, from 2.89 to 3.09 pesos to the dollar. However, given current high inflation rates, in 

real terms, the peso appreciated by 0.8 percent from end-2005 through June 2006. 

Argentina repaid its entire $9.9 billion in IMF obligations in January of 2006. Since then, the 

central bank has been able to rebuild its stock of foreign reserves back to pre-IMF repayment 

levels. At the end of June 2006, central bank reserves stood at $25.5 billion, down from $28.0 

billion at end-2005. Argentina’s access to international capital markets has been reduced as a 

Nominal Trade Weighted Dollar

Feb 27, 2002 = 100

65

70

75

80

85

90

95

100

105

110

Feb-02Aug-02Feb-03Aug-03Feb-04Aug-04Feb-05Aug-05Feb-06Aug-06

Broad

Majors

OITP
13

result of its 2005 debt restructuring, and reserves are currently being accumulated to give the 

country a cushion against external shocks. 

Argentina’s reserve accumulation has fueled monetary growth and inflationary pressures. 

Annual inflation reached 11.0 percent at end-June 2006 compared to 12.3 percent at year end 

2005 and 9.0 percent at end-June 2005. Nominal interest rates on repo transactions rose in the 

first half of 2006 to eight percent from six percent at the end of 2005. The increase was not, 

however, outpaced by inflation, producing some rise in real interest rates. Argentina’s 

benchmark sovereign debt traded 385 basis points over U.S. Treasuries at end-June 2006 versus 

504 basis points at end-2005. 

On an accumulated basis, foreign direct investment into Argentina rose 10.7 percent to $4.7 

billion from the end of 2004 to the end of 2005. Argentina had a $3.2 billion seasonally adjusted 

current account surplus in the first half of 2006, equivalent to 3.1 percent of GDP compared to 

1.8 percent in the first half of 2005. During the first half of 2006, the United States had a trade 

surplus with Argentina of $224 million compared to a deficit of $100 million in the first half of 

2005. This reflected, in part, export supply restrictions of the Argentine government designed to 

control inflation. Export taxes currently in place to boost fiscal performance are also placing 

downward pressures on Argentina’s export performance. 

Real GDP increased at a seasonally adjusted annual rate of 7.2 percent during the first half of 

2006 versus 9.7 percent in the second half of 2005. 

Capital controls remain in effect on currency inflows. Residents are limited in the amount of 

foreign currency they can bring into the country. Non-residents are required to keep dollars in 

the country for a minimum of one year, with 30 percent held on deposit in an interest-free 

account at the central bank. 

 

Brazil 

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

policy. The real continued to strengthen during the first half of 2006, appreciating 7.3 percent in 

nominal terms, from 2.33 to 2.16 reals to the dollar (although the real effective exchange rate 

depreciated by 0.95 percent). The real has appreciated by 82 percent relative to the dollar since 

reaching a low in October 2002, likely reflecting both overshooting during the 2002 crisis and a 

structural improvement in export competitiveness. Although the external accounts continue to 

be in surplus, they have narrowed in 2006 on the back of the real’s continued recovery. On a 

seasonally adjusted basis, Brazil’s current account surplus was $4.3 billion (0.9 percent of GDP) 

in the first half of 2006, down from $7.3 billion (1.7 percent of GDP) in the second half of 2005, 

while the trade surplus fell from $23.4 billion (5.3 percent of GDP) to $21.3 billion (4.7 percent 

of GDP) over the same period. The U.S. trade deficit in goods with Brazil narrowed from $4.6 

billion in the first half of 2005 to $3.8 billion in the first half of 2006. 

Slowing net exports contributed to a deceleration of the Brazilian economy during the second 

quarter of 2006. Beginning in the fourth quarter of 2005, the economy began to pick up steam, 

growing by 4.7 percent at a seasonally adjusted annualized rate. By the first quarter of 2006, the 
14

economy grew by 5.2 percent at an annual rate. However, a slowdown in export volumes and 

continued strong growth of imports resulted in a deceleration in real GDP growth in the second 

quarter of 2006 to 1.8 percent. 

The strong real has aided the disinflation process in Brazil. The inflation outlook improved over 

the past year, with year-on-year inflation at 4.0 percent in June, within the targeted “tolerance 

range” of 2.5 percent to 6.5 percent. The same range has been targeted for 2007. The central 

bank increased net international reserves to $62.7 billion by June 2006 compared to $53.8 billion 

in December 2005. The central bank has a broad objective of increasing reserves in the medium 

run to make the economy less vulnerable to shocks, but it does not commit to a specific 

numerical target. In December 2005, Brazil repaid its $15.5 billion in IMF obligations. 

Brazil has taken several steps this year to liberalize its foreign exchange market. In July 2006, 

Brazil loosened its repatriation requirements for exporters, enabling them to keep up to 30 

percent of their export revenue abroad as long as they wish and the remaining 70 percent for up 

to a year. Previously, exporters were required to repatriate all of their foreign currency earnings 

within seven months of their receipt. Repatriation requirements for foreign exchange generated 

by financial market operations and Treasury purchases were also lengthened to a year. Brazil 

also will now allow the registration of foreign capital not previously eligible for registration, 

enabling foreign companies to remit profits and dividends related to this capital abroad. 

Mexico 

Mexico has a flexible exchange rate regime. During the first half of 2006 the Mexican peso 

depreciated nominally by 5.8 percent, from 10.6 to 11.3 pesos to the dollar. The J.P. Morgan 

trade-weighted effective exchange rate index for the peso depreciated by 5.8 percent during the 

same period. The depreciation during the first half of the year reversed much of the peso’s gains 

since 2004 and reflected uncertainty associated with the presidential elections on July 2 as well 

as narrowing interest-rate spreads with the United States. 

 

Rising oil prices continued to contribute to a rapid accumulation of Mexico’s international 

reserves. Reserves grew by $10 billion during the first half of the year, reaching $79 billion by 

the end of June. Pemex, the state-controlled Mexican oil company, is obligated by law to sell its 

foreign currency earnings to the Bank of Mexico to service the country’s foreign debt. Reserves 

accumulate, therefore, when the foreign currency obtained by the Bank of Mexico is greater than 

foreign debt payments. The Bank of Mexico follows a transparent rule for selling these reserves. 

Every 13 weeks, the Bank of Mexico retains half of the reserves accumulated during that period 

and sells the other half evenly over the ensuing three months. The stated goal of this transparent 

procedure is to prevent uncertainty in the financial markets and minimize discretionary actions 

by the financial authorities. 

Mexico’s seasonally adjusted current account deficit was 0.4 percent of GDP in the second 

quarter of 2006 compared to a deficit of 0.9 percent of GDP in the second quarter of 2005. The 

current account deficit was easily financed by foreign direct investment. Mexico’s trade surplus 

with the United States for the first half of 2006 was $31.3 billion, up from $24.3 billion in the 
15

first half of 2005. Mexico is the second largest supplier of oil to the United States, and the rise in 

the U.S. trade deficit reflects rising oil prices. 

A resurgence of automobile and agriculture exports caused the economy to grow briskly in the 

first six months of 2006. Real GDP increased at annual rates of 6.6 percent and 5.6 percent 

during the first and second quarters, respectively. At the same time inflation approached the 

Bank of Mexico’s three percent target in the first half of 2006, although it has edged up in 

subsequent months. Year-on-year headline inflation was 3.2 percent in June, compared with 3.3 

percent in December 2005. The December reading was Mexico’s lowest year-end inflation since 

the 1960s. 

Mexico does not maintain controls on most external capital inflows and outflows. It does, 

however, maintain some restrictions against certain types of foreign investment, such as the 

establishment of foreign bank branches within Mexico. 

Venezuela

 

Venezuela maintains a pegged exchange rate. The nominal exchange rate was held at 2,147 

bolivars to the dollar at end-June 2006, unchanged from end-December 2005 and end-June 2005. 

The J.P. Morgan trade-weighted real effective exchange rate index for the bolivar appreciated by 

6.4 percent during the first half of 2006. 

Oil accounts for about one third of Venezuelan GDP, roughly 90 percent of the country’s exports 

and close to half of government revenues. High oil prices have not only supported highly 

expansionary fiscal policies, but have accounted for the rising current account surplus and 

foreign reserve accumulation. The stock of central bank reserves increased to $31.2 billion by 

end-June 2006 compared to $29.6 billion at end-2005 and $28.1 billion at end-June 2005. 

Reserve accumulation is contributing to monetary expansion and inflationary pressures. High 

inflation with a fixed exchange rate has contributed to real exchange rate appreciation, eroding 

competitiveness, evidenced by continued strong growth of imports. 

The monetary base expanded by 53 percent from the end of the first quarter of 2005 through the 

end of the first quarter of 2006. Annual inflation was 11.8 percent at end-June 2006 compared to 

14.3 percent at end-2005. Venezuela’s benchmark sovereign debt spread was 228 basis points 

over U.S. Treasuries at end-June 2006 versus 318 basis points at end-2005. 

For the first half of 2006, net FDI inflows were -$3.2 billion versus $0.8 billion for the first half 

of 2005, and net portfolio flows were -$8.1 billion versus $1.6 billion in the first half of 2005. 

Venezuela had a $15.2 billion current account surplus in the first half of 2006 versus a $14.9 

billion surplus in the second half of 2005 and a $10.6 billion surplus in the first half of that same 

year. For 2005, the current account balance was $25.5 billion, or 18.2 percent of GDP. 

Venezuela’s rising current account surplus can be attributed to higher world oil prices. During 

the first half of 2006 the U.S trade deficit with Venezuela was $14.5 billion, up from $13 billion 

in the first half of 2005. The higher U.S.-Venezuela trade deficits primarily reflect increasing oil 

prices; about 11 percent of U.S. oil imports come from Venezuela. Real GDP increased at a 
16

seasonally adjusted annual rate of 6.5 percent during the first quarter of 2006 versus 15.6 percent 

during the fourth quarter of 2005. Real GDP rose by 9.3 percent in 2005. 

Venezuela maintains extensive controls on capital inflows and outflows. These controls require 

exporters to surrender their foreign exchange earnings to the government at the official exchange 

rate. 

The Eurozone 

Eurozone quarterly growth increased to an average annualized rate of 3.0 percent during the first 

three quarters of 2006 from 1.9 percent during the same period in 2005. Domestic demand 

strengthened in the second quarter with a very strong increase in domestic investment. During 

the first half of 2006, imports followed suit, increasing 18 percent from the first half of 2005 

compared to export growth of 13 percent. The combined effect caused the Eurozone’s current 

account deficit to widen slightly from 0.26 per cent of GDP in the first half of 2005 to 0.3 

percent in the first half of 2006. The Eurozone’s trade surplus with the United States increased 

$2.2 billion during the first half of 2006 compared with the same period in 2005 to $45 billion. 

Over the first half of 2006, the euro appreciated 7.8 percent against the dollar to $1.278. The 

Eurozone’s moderate inflation relative to that of its major trading partners, however, helped 

contain real effective exchange rate appreciation to only 3.1 percent. The ECB has not 

intervened in foreign exchange markets since November 2000 and the value of Eurozone foreign 

exchange reserves increased by only $1.7 billion between December 2005 and June 2006 

reaching $169.1 billion. 

Although CPI-measured inflation has fallen below the ECB’s two percent ceiling to 1.6 percent 

in October, the ECB remains hawkish citing inflationary concerns. The ECB has raised its key 

policy rate (the minimum bid rate on main refinancing operations) five times from a December 

2005 level of 2.25 percent to 3.25 percent in December, 2006. 

Germany 

Germany’s GDP increased at an annualized rate of 3.4 percent over the first three quarters of 

2006 compared with 1.9 percent growth during the same period in 2005. During this period, 

investment increased at an average 7.4 percent annualized rate compared to 2.6 percent during 

the same period in 2005. Strong growth induced a healthy, 19 percent, increase in imports 

outpacing a 12 percent increase in exports during the first six months of 2006 compared with the 

same period in 2005, with the current account surplus narrowing somewhat from five percent of 

GDP during the first half of 2005 to 4.2 percent in first half of 2006. Germany’s trade surplus 

vis-à-vis the U.S. increased by $15 million during the first six months of 2006 to $24.4 billion. 

The Netherlands 

The Netherlands posted a $25.6 billion current account surplus in the first half of 2006, which 

represented an increase to 10.5 percent of GDP from 6.4 percent of GDP in the second half of 

2005. For the first half of 2006, the current account surplus is largely explained by the trade 
17

surplus (96 percent), balance on services (14 percent), and balance on income (eight percent), 

which offset a deficit on current (outward) transfers (-18 percent). For the full 2005 year, the 

current account surplus was 7.7 percent of GDP. Merchandise exports in the first half of 2006 

grew by 15.3 percent over the same period in 2005 while merchandise imports grew 16.7 

percent. The U.S. trade surplus with the Netherlands grew to $6.8 billion in the first half of 2006, 

up $258 million from the same period in 2005. 

GDP growth was estimated to be 2.7 percent (annualized) over the first half of 2006, driven by 

the growth in investment, government consumption, and net exports. Headline inflation was 1.8 

percent in June (y/y) while core inflation was 0.8 percent. 

Spain 

Spain’s GDP increased 3.8 percent, at an annual rate, in the first half of 2006 from 3.6 percent in 

the second half of 2005. Consumption and investment increased 2.7 percent and 7.3 percent, 

respectively, over this period. Spain faces a risk of overheating given strong domestic demand 

and record low unemployment. Unemployment fell sharply to 5.5 percent in the second quarter 

of 2006 from 12.7 percent in the second quarter of 2005. Spain’s CPI increased 4.0 percent y/y 

in June 2006, which was up from 3.2 percent y/y in June 2005. The IMF estimates the output 

gap to be close to zero. 

Rapid growth of investment over the past decade has sustained growth in domestic demand and 

been the principal factor in a widening current account deficit. Gross fixed capital formation rose 

7.0 percent in the first half of 2006 from the second half of 2005. Investment represented over 

30 percent of GDP and the current account deficit reached $54.7 billion, or 9.3 percent of GDP 

in the first half of 2006. In the first half of 2006, goods imports increased 14.9 percent over the 

same period in 2005 while goods exports increased 12.9 percent. Spain’s bilateral surplus on 

trade in goods with the United States was $11.3 billion in the first half of 2006, $346 million 

higher than during the same period last year. 

 

Switzerland 

Switzerland posted a $31.8 billion current account surplus (15.8 percent of GDP) in the first half 

of 2006, up from $26.3 billion (15.1 percent of GDP) in the same period in 2005. The trade 

surplus declined $1 billion (from $2 billion to $1 billion) in the first half of 2006 compared to the 

corresponding period in 2005, while the surplus in the services account increased $2 billion to 

$13 billion during the same period. The surplus on trade in goods accounted for only 3.5 percent 

of the current account surplus in the first half of 2006. On the other hand, the surplus on trade in 

services, including financial services, accounted for 43.1 percent, while the surplus on net 

income receipts, including net receipts from foreign investment, accounted for 61.1 percent of 

that period’s current account surplus. The net transfers balance was in deficit over the period, 

reducing the current account surplus by 7.7 percent. Goods exports increased by 17 percent in 

the first half of 2006 over the corresponding period in 2005, while imports grew 18.7 percent 

over the same period, but the trade balance contributed only 2.6 percent to the overall current 

account surplus. The U.S. trade surplus vis-à-vis Switzerland was $73.3 million in first half of 

2006, up from a deficit of $1.2 billion from the corresponding period in 2005. 
18

As a small open economy, Swiss economic conditions are heavily influenced by conditions in 

the Eurozone, Switzerland’s major trading partner. Monetary policy was tightened during first 

half of 2006, following the ECB’s policies, and the Swiss Franc appreciated 0.8 percent against 

the euro and 6.2 percent against the dollar; however, its nominal effective exchange rate 

remained unchanged and the IMF’s index for the real effective exchange rate of the Swiss Franc 

appreciated 1.1 percent. Foreign exchange reserves remained relatively stable at $36.2 billion 

during the period. The Central Bank did not intervene in the foreign exchange market during the 

first half of 2006, but does intervene occasionally to “counteract market disturbances.” 

GDP growth was estimated to be 2.9 percent (annualized) during first half of 2006. 

Consumption and (fixed) investment grew 1.6 percent and 5.6 percent, respectively on an 

annualized basis during the same period, while net exports grew 8.1 percent in first half of 2006 

compared to first half of 2005. During the first half of 2006 headline inflation was 1.56 percent 

y/y while core inflation was 0.8 percent y/y. 

Norway 

Norway is a major oil and gas exporter. Its current account surplus during first half of 2006 was 

$29.4 billion (17.5 percent of GDP), up $2.2 billion from $27.2 billion (14.2 percent of GDP) in 

the second half of 2005. Merchandise exports were up 25.2 percent over the same period last 

year while imports increased 15.1 percent. The U.S. trade deficit with Norway in first half of 

2006 was $2.4 billion, down from $2.5 billion in first half of 2005. The Norwegian kroner 

appreciated 7.8 percent against the dollar during the period while the IMF’s nominal and real 

effective exchange rate indices for the kroner appreciated 1.4 percent and 2.4 percent, 

respectively. Foreign exchange reserves grew $2.6 billion to $49.0 billion during first half of 

2006, slightly faster than during the corresponding period in 2005. Norway’s Central Bank does 

not intervene in foreign exchange markets to influence the kroner, but management of the 

Government Pension Fund (GPF) portfolio has some of the characteristics of intervention. In the 

process, it may influence the kroner. 

Most of Norway’s oil and gas revenue is invested overseas through the GPF and, at end-June 

2006, the GPF’s market value was $241 billion (86 percent of 2005 GDP) and growing rapidly. 

The return on the GPF’s investment can be used for current government consumption while the 

principal remains as a retirement fund for future generations. 

GDP increased 1.7 percent (at an annual rate) during the first half of 2006 compared to the 

second half of 2005. Consumption grew by 4.6 percent (annualized) during the same period 

while fixed investment (annualized) declined 1.9 percent Headline inflation was 2.1 percent 

(annualized) during the period while core inflation was 0.9 percent. 

Russia 

Strong growth in exports, boosted by high oil prices, helped increase Russia’s current account 

surplus to $56.5 billion (not seasonally adjusted, or “nsa”) in the first half of 2006 from $42.8 

billion in the first half of 2005. As a share of GDP, the surplus rose to 11.3 percent in the 12 
19

months through June from 11 percent during the comparable period in 2005. The bilateral trade 

balance with the U.S. amounted to a surplus of $7.5 billion in the first half of 2006; this 

compared with $5.9 billion in the first half of 2005. In addition, the shift to net private sector 

inflows that began in the second half of 2005 accelerated in the first half of 2005, as direct 

investment rose sharply and portfolio investment outflows slowed. As a result, the balance of 

payments’ financial accounts, exclusive of changes in reserves, shifted to a surplus of $9.4 

billion during the first half 2006 from a deficit of $2.9 billion in the first half 2005. 

The increase in capital inflows, together with central bank intervention to moderate the pace of 

exchange rate appreciation, boosted total international reserves to $250.6 billion at the end of 

June from $182.2 billion at the end of 2005. Net of valuation changes, reserves rose $62.4 

billion during the first half of 2006, compared with an increase of $61.5 billion for all of 2005. 

In addition, the balance of Russia’s oil stabilization fund rose to $76 billion at the end of June 

from $43 billion at the end of 2005. Limited sterilization of the central bank’s foreign exchange 

market intervention has resulted in continued rapid growth in the money supply, as M2 (using 

the monetary survey definition) rose 38.0 percent in the 12 months through June compared with 

36.3 percent in 2005. 

The central bank continues to manage closely the exchange rate in an effort simultaneously to 

meet inflation targets and to limit real exchange rate appreciation. The ruble appreciated six 

percent against the dollar during the first half of 2006. The IMF’s nominal trade-weighted index 

of the ruble appreciated 3.1 percent in the first half of 2006 while its real trade-weighted index17

appreciated by 4.2 percent. This compared with nominal appreciation of 2.5 percent and real 

appreciation of 9.3 percent for the full-year 2005. The ruble has remained little changed against 

the dollar since the end of June, rising by only 0.2 percent. 

The ruble’s appreciation (together with smaller increases in administered prices) helped slow the 

increase in the CPI from 10.9 percent y/y in December 2005 to 9.0 percent y/y in June. CPI rose 

again to 9.6 percent y/y by August, however, compared with the end-2006 inflation target of 8.5 

percent. Real GDP increased 6.5 percent y/y during the first half of 2006, little changed from 6.4 

percent in 2005. Output growth has been supported by strong household spending and fiscal 

easing as the government is spending a larger share of oil revenues ahead of the 2007-2008 

election cycle. 

South Africa

South Africa’s flexible exchange rate responded quickly to changing economic conditions over 

the first half of 2006. The rand, typically classified as one of the “commodity” currencies, was 

relatively strong against the dollar from January to May. However, from mid-May to mid-June it 

depreciated 22 percent on the heels of a drop in precious metals prices and cooling investor 

interest in emerging markets. Bond and equity prices also fell. The Central Bank believed that 

rand weakness and rising fuel prices pushed inflation expectations above the upper end of the 

inflation target range (3-6 percent), and increased its policy interest rate 50 basis points in both 

June and August. Actual inflation was 4.8 percent in June, within the target range. 

 

17 The IMF’s CPI-based index. 
20

Robust domestic demand, supported by a 25 percent y/y increase in the extension of credit to the 

private sector in the second quarter following a similar increase in the first quarter, contributed to 

above trend real GDP growth of 4.2 percent in the first quarter (q/q, sa), and 4.9 percent in the 

second quarter. 

Strong domestic demand also contributed to a current account deficit that averaged an estimated 

6.1 percent of GDP in the first two quarters of 2006. South Africa’s imports from the United 

States increased 27 percent (about $750 million) in the first half of this year relative to the same 

period in 2005, while South Africa’s exports to the United States were little changed. Portfolio 

inflows financed most of the current account deficit. Foreign exchange reserves rose more than 

$3 billion in the first half of 2006 to almost $24 billion (4.3 months of imports) at the end of 

June. 

Egypt 

Since January 2005, the Central Bank of Egypt (CBE) has used partially sterilized interventions 

in the foreign exchange market to maintain a de facto peg of the Egyptian pound against the 

dollar. In the six months ending in June 2006, the pound-dollar exchange rate stayed within a 

narrow one percent range, while the CBE’s net international reserves increased by five percent, 

to $22.9 billion. Net reserves grew by 20 percent for the year ending in June, contributing to 15 

percent growth in reserve money and 13 percent growth in broad money (M2). 

The CBE has made gradual progress towards the goal of a floating exchange rate regime, 

abandoning the formal peg against the dollar in early 2003, and launching an inter-bank foreign 

exchange market in December 2004. The CBE has announced that it will adopt a formal 

inflation targeting regime to guide monetary policy. 

During the fiscal year ending in June 2006, Egypt’s current account narrowed to a projected 1.7 

percent of GDP, down from 3.3 percent of GDP in the year ending June 2005. Driven by higher 

prices, exports of oil and natural gas increased by 93 percent in the year ending June 2006, to 

constitute 55 percent of total exports. By contrast, non-energy exports declined by four percent, 

and Egypt’s projected trade deficit remained above 11 percent of GDP. The stress of nominal 

appreciation on non-energy sectors would be eased if ongoing structural reforms increased 

productivity growth in these sectors. Egypt had a deficit of $713 million on trade in goods with 

the United States from January through August 2006, down from a deficit of $830 million during 

the same period last year 

Reforms, increased privatizations, and the robust regional economy helped Egypt attract large 

capital inflows for the second straight year. The overall financial account surplus (excluding 

reserve accumulation) was a projected 3.3 percent of GDP in the year ending June 2006, 

compared to 3.8 percent of GDP in the year ending June 2005. Net foreign direct investment 

reached a record $6.1 billion in the year ending June 2006. 

The Egyptian economy, which grew five percent in 2005, has continued to perform strongly in 

2006. Increased economic activity and ample growth in liquidity contributed to consumer price 
21

inflation of 6.4 percent y/y in June, compared to 4.7 percent y/y inflation during the same period 

in 2005. 

Saudi Arabia 

The riyal has been unofficially pegged to the dollar since 1986 (officially since 2003), so interest 

rates largely followed recent increases in the United States. The Gulf Cooperation 

Council (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the U.A.E.) has set a goal of 

establishing a formal monetary union by 2010, although the relationship of the new currency to 

other currencies has not been announced. 

With Saudi Arabia’s large current account surplus and fixed exchange rate, the net foreign assets 

of the Saudi Arabian Monetary Agency rose to $176 billion from $152 billion during the first six 

months of 2006, providing approximately 30 months of import cover. Gross liquid reserves rose 

by a much smaller amount over the same period, increasing to $30 billion from $26 billion. 

Saudi Arabia is one of the most oil-dependent economies in the world, with oil accounting for 

around 50 percent of GDP and almost 90 percent of export and government revenue. With high 

oil prices over the past few years, real GDP growth has averaged close to six percent, with 

average nominal GDP growth just under 20 percent.18 Despite this strong growth, 2005 CPI 

inflation remained below one percent in 2005 and is projected to be about 1.5 percent in 2006, 

reflecting small changes in the prices of imported goods and the large share of administered 

prices in the CPI basket. 

Oil export revenues continued to increase on the back of high oil prices, rising from $110 billion 

in 2004 to a projected $197 billion in 2006. The surge in oil export revenue led to an increase in 

the current account surplus from 20.7 percent of GDP in 2004 to an estimated 31 percent in 

2006. Finally, the bilateral trade surplus with the United States has grown substantially, reaching 

$20.4 billion in 2005, compared with $15.7 billion in 2004, and surplus of $14.4 billion recorded 

in the first eight months of this year. 

The government’s financial position improved as revenue from oil rose by $46 billion to $134 

billion in 2005 and is projected to reach $150 billion in 2006. The budget surplus was 

approximately $57 billion in 2005 (18 percent of GDP) and is projected to exceed $60 billion in 

2006. The government is using much of that surplus to reduce government debt, which is 

expected to be reduced to 17 percent of GDP in 2006. Based on historical experience, these 

surpluses are likely to diminish over time as the government increases spending; the government 

projects domestic spending to rise by 20 percent in 2006. 

Singapore

The Monetary Authority of Singapore (MAS) uses the exchange rate as its operational monetary 

policy tool to control inflation. MAS manages the Singapore dollar (SGD) against an undisclosed 

basket of currencies and since April 2004 has operated on a policy of “modest and gradual” 

 

18 Using actual 2004 and 2005 rates and projected 2006 rates. 
22

appreciation against this basket.19 In the first half of 2006, the SGD appreciated 4.7 percent 

against the U.S. dollar, compared with 1.1 percent appreciation in the second half of 2005. JP 

Morgan’s nominal and real trade-weighted indexes of the SGD appreciated 1.8 percent and 5.2 

percent, respectively, in the first half of this year.20 The faster pace of appreciation of the real 

trade-weighted index in the first half of 2006 reflected a slight pick-up in inflation in the first few 

months of the year. 

CPI inflation was a relatively modest 1.3 percent (y/y) in the first half of 2006, although higher oil 

prices are beginning to have a stronger impact on overall consumer prices. The economy 

expanded by 3.0 percent (saar) in the second quarter of this year, compared with 7.6 percent in the 

first quarter. The second quarter deceleration was largely due to weaker manufacturing sector 

growth, although manufacturing has more recently shown signs of a rebound. 

High savings rates and declining investment have driven large and growing current account 

surpluses in Singapore. In the first half of 2006, the current account surplus reached 31 percent of 

GDP, compared with an overall 2005 surplus of 28.5 percent of GDP. Singapore’s gross national 

savings rate of around 45 percent of GDP is among the world’s highest and reflects an extremely 

high corporate savings rate (estimated by the IMF at 25-30 percent of GDP21). The government 

also records large fiscal surpluses.22 Household savings are on par with international levels. 

Meanwhile, domestic investment, at around 20 percent of GDP, remains well below savings. 

Corporate profits and government savings – including profits from government-linked companies 

– are often invested overseas. Gross capital formation declined markedly in the early part of the 

decade – from 33 percent of GDP in 2000 to 16 percent in 2003 – as a result of several factors, 

including a property market slowdown, the bursting of the IT bubble in 2000-01, and the SARS 

outbreak of 2003. 

Reserves increased by $12 billion in the first half of this year, reaching $129 billion, or about 

seven months of import cover. Singapore has a large bilateral merchandise trade deficit with the 

U.S., which reached $2.7 billion over the first half of the year. This was slightly lower than the 

bilateral trade deficit of $3.0 billion in the first half of 2005. 

India 

India’s economy grew 9.7 percent annualized in the first half of 2006 after 8.5 percent growth in 

2005 due to strong activity in the manufacturing and services sectors. Strong domestic demand 

and increases in fuel prices put upward pressure on wholesale price inflation which was 5.1 

percent y/y in June, up from 4.5 percent y/y in December. In response, the Reserve Bank of 

India (RBI) twice increased its reverse repo policy rate by 25 basis points, in January and June. 

The RBI characterizes its monetary policy as seeking price stability while ensuring adequate 

 

19 MAS manages the exchange rate within an undisclosed band. Its policy options are to (1) change the midpoint of 

the band to allow for a one-off adjustment, (2) change the band’s slope to signal a possible turning point in the 

monetary policy cycle, or (3) widen the band. 

20 The trade weights in the JP Morgan NEER and REER indexes are based on Singapore’s 2000 bilateral trade in 

manufactured goods. 

21 IMF No. 06/150. Singapore: 2005 Article IV Consultation, May 2006 

http://www.imf.org/external/pubs/ft/scr/2006/cr06150.pdf. 22 The IMF projects, however, that its overall surplus of six percent of GDP in 2005 will fall to four percent in 2006. 
23

credit to productive sectors of the economy to support growth. It targets short-term interest rates 

and monitors trade-weighted exchange rates over the medium term. 

The RBI manages the exchange rate without a pre-announced target or a band. The rupee 

depreciated by 2.1 percent against the dollar in the first half of 2006, while in real trade-weighted 

terms the effective exchange rate, as calculated by JP Morgan, depreciated by 3.7 percent. In the 

first half of 2006, foreign exchange purchases by the Reserve Bank of India totaled $15.6 billion 

as compared with $10.9 billion in the first half of 2005. India’s foreign exchange reserves, on 

the other hand, increased more strongly, by $25 billion in the first half of 2006, exceeding the 

$7.2 billion increase in the first half of 2005. Foreign exchange reserves increases reflected 

interest earnings and exchange rate changes as well as net transactions in foreign exchange. 

The current account deficit was $7.6 billion sa (2.0 percent of GDP) in the first half of 2006, 

wider than the $2.4 billion figure (0.7 percent of GDP) in the first half of 2005. The deficit was 

driven by strong growth of oil, steel, and machinery imports associated with robust domestic 

growth. The U.S. bilateral trade deficit with India was $5.7 billion in the first half of 2006, 

which is $764 million larger than in the first half of 2005. Capital inflows continue to finance 

the current account deficit. Net foreign direct investment and portfolio inflows were $7.6 billion 

in the first half of 2006 compared to $7.0 billion in the first half of 2005. Foreign institutional 

investment inflows in the first half of 2006 continued to support net portfolio inflows of $3.8 

billion, while foreign direct investment was also $3.8 billion. 

Japan 

The current economic recovery, which has become the longest in Japan’s post-war history, may 

finally have allowed Japan to escape from a decade of persistent deflation. Economic growth has 

accelerated modestly from less than 0.3 percent in the first year of the recovery (2002) to an 

average of 2.2 percent in the first three quarters of 2006. Growth this year has largely been 

reliant on net exports and business investment, with private consumption contracting in the most 

recent quarter and below year-ago levels. Consumer prices (the CPI less fresh food) were rising 

at a rate of 0.1 percent y/y in October 2006, while other price indices, such as the GDP deflator, 

continued to fall. 

High oil prices have helped contain Japan’s trade and current account surpluses. Over the first 

half of 2006, Japan’s trade surplus fell to $33.8 billion compared to $41.4 billion in the same 

period in 2005 as the value of imports grew by 23 percent, well outpacing export growth (16.1 

percent y/y). The U.S. bilateral deficit with Japan, however, widened by $1.4 billion to $43.1 

billion in the first half of the year compared with the same period of 2005, despite U.S. 

shipments to Japan expanding at a faster rate than imports (8.0 percent y/y versus 5.2 percent). 

As a share of GDP, Japan’s current account surplus through the first three quarters of 2006 is 

running at about the same 3.7 percent level that it did in 2005. 

On July 14, the BOJ raised interest rates to 0.25 percent from effectively zero. This marked the 

start of the first monetary policy tightening cycle in more than 16 years. The lead-up to the 

BOJ’s increase in official interest rates, which began with an exit from quantitative easing in 
24

March, initially contributed to some increased volatility in foreign exchange markets. However, 

volatility has moderated since mid-year. 

Over the January to June 2006 reporting period, the yen strengthened 2.9 percent versus the 

dollar, closing at ¥114.51 on June 30. Persistent Japanese deflation since 1998, which has only 

recently dissipated, has led to a substantial depreciation of the yen in real terms. BOJ data 

indicate that the yen is now at its weakest level in real trade-weighted terms in more than 20 

years. The Japanese authorities, however, have not intervened in the foreign exchange market 

since March 2004 when the yen was around ¥109 per dollar.23 Gold and foreign exchange 

reserves totaled $885.6 billion at the end of October 2006, up from $864.9 billion at the end of 

June and $846.9 billion at end-December 2005. 

South Korea 

South Korea’s economy continues to perform well with real GDP growing at a 4.9 per cent 

seasonally-adjusted annual rate in the first half of 2006, after posting 4.0 percent growth in 2005. 

Private forecasters project real GDP growth in the 41⁄2-5 percent range both this year and next. In 

addition, core consumer price inflation stands below the center of the central bank’s target range 

of about 2.5 -3.5 percent. South Korea’s flexible exchange rate regime, under which the won has 

appreciated steadily since 2003, has contributed significantly to containing inflation. Despite 

substantial real appreciation of the South Korean won over this period, growth of South Korean 

exports has remained strong, expanding in excess of 15 percent over the year through the second 

quarter of 2006. 

For the future, the Korean government has set an ambitious reform agenda to enhance 

productivity and income growth to offset expected declines in the labor force as Korea’s 

population ages. That agenda includes liberalizing the financial sector and increasing its 

integration into the global financial system and opening the services sector to domestic and 

foreign competition. 

The Bank of Korea tightened monetary policy over the reporting period to limit the risk of 

overheating and to contain the inflationary impact of high oil prices. The Bank of Korea raised 

the call money rate target from 3.25 percent to 3.75 percent from October to December 2005, 

and to 4.5 percent by August 2006. The won appreciated 6.6 percent in nominal terms against 

the dollar over the first half of 2006 and almost 25 percent from the end of 2003 to the end of 

June 2006. The magnitude of average daily fluctuations in the won/$ exchange rate is 

comparable to that of the euro against the dollar. The won has also appreciated in real effective 

terms, strengthening five percent in the first half of 2006 and 24 percent from its end-2003 level. 

Core consumer price inflation remains subdued, rising 2.2 percent y/y in October 2006, below 

the bottom end of the Bank of Korea’s 2.5-3.5 percent target range. Starting in January 2007, the 

Bank will target headline inflation using the same target band. 

 

 

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

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

http://www.mof.go.jp/english/e1c021.htm. 
25

Despite South Korea’s strong export performance, the current account surplus declined during 

the reporting period due to high oil prices and rapid real import growth. The current account 

surplus fell from $7.4 billion (1.9 percent of GDP) in the second half of 2005, to $0.3 billion (0.1 

percent of GDP) in the first half of 2006. Foreign exchange reserves increased $10 billion in the 

first half of 2006, reaching $224 billion, about equal to South Korea’s total foreign debt. 

China24

In the first half of 2006, China’s economic growth accelerated slightly, despite administrative 

measures taken to slow investment. And, despite the Chinese authorities’ stated goal of 

rebalancing growth towards domestic consumption, output growth continued to rely heavily on 

investment and net exports. In fact, despite the goal of reducing the country’s external surplus, 

China’s global merchandise trade surplus rose to $80 billion, or roughly seven percent of GDP, 

in the first six months of this year. The Chinese currency, the renminbi (RMB), appreciated by 

0.94 percent against the dollar in the first half of 2006. Chinese authorities took several steps to 

develop the foreign exchange market, and average daily fluctuations of the RMB were twice as 

large in the first half of 2006 as in the last half of 2005, although the degree of flexibility is still 

low by comparison to other major currencies. Overall, Chinese authorities continue a cautious, 

measured approach toward economic reform with a goal of minimizing the risks of instability. 

Lack of monetary policy autonomy due to limited exchange rate flexibility presents a major 

obstacle to rebalancing growth and improving the efficiency of financial intermediation. 

Unexpectedly high growth numbers in the first half of 2006, despite measures taken to slow 

investment, prompted authorities to impose additional tightening measures to rein in economic 

activity. Real GDP growth accelerated from 9.9 percent in 2005 to a seasonally-adjusted annual 

rate of 10.3 percent in the first quarter of 2006, and 11.3 percent in the second quarter. The 

acceleration in growth was in part spurred by a goods trade surplus in the first half of this year 

that was nearly 50 percent larger than in the corresponding period in 2005, despite the 

revaluation of the RMB in July 2005 and continued modest appreciation through the first half of 

2006. Continued strong growth in investment also contributed to the acceleration in growth, 

with fixed asset investment up 30 percent. 

A burgeoning trade account has given rise to an increasingly large current account surplus. In 

fact, the current account surplus has risen from 1.5 percent of GDP in 2001 to four percent of 

GDP in 2004 and up to seven percent of GDP in 2005. In the first half of 2006, the current 

account balance rose further to around eight percent of GDP. 

 

In response to the acceleration of growth in the first half of 2006, the People’s Bank of China 

(PBOC) implemented a series of tightening measures. Required bank reserve ratios were 

increased twice (by a total of one percentage point) and renminbi-denominated commercial 

lending rates were raised twice (by 0.54 percent overall). The authorities also imposed 

 

24 The latest IMF Article 4 report on China discusses these issues, especially exchange rate issues, in great detail. 

See http://www.imf.org/external/pubs/ft/scr/2006/cr06394.pdf
26

administrative measures aimed at dampening investment including re-evaluation of planned 

projects, restrictions in property markets, and guidance to banks to lend less.25

The authorities have begun to liberalize the exchange rate regime and the operation of exchange 

rate markets. On July 21, 2005, the government ended the RMB’s eight-year peg against the 

dollar, and introduced a new exchange rate regime described as “a managed floating exchange 

rate regime based on market supply and demand with reference to a basket of currencies.” The 

RMB was allowed to fluctuate up to 0.3 percent on either side of a central rate set daily and was 

initially revalued by 2.1 percent against the dollar. 

During the first half of 2006, the authorities took further steps to reform the currency market. In 

January 2006, authorized banks – including some foreign banks – were allowed to act as market 

makers for spot trading of foreign exchange. Previously, all trades had been with the State 

Administration for Foreign Exchange (SAFE), with relatively high fees.26

RMB flexibility with respect to the dollar increased significantly in the first half of 2006 relative 

to the last six months of 2005, although it remains small in comparison with other currencies 

with flexible exchange rate regimes. Measures of flexibility include average daily movement, 

maximum one-day movements, and net value changes over a period of time. In terms of average 

daily movement in the second half of 2005, the RMB fluctuated 0.02 percent around the central 

parity rate in daily trading. This average daily fluctuation increased to 0.03 percent in the first 

half of 2006, and further to 0.05 percent since June 2006. In the second half of 2005, the RMB’s 

largest single intra-day fluctuation from the central parity rate was 0.07 percent, while on 

May16, 2006, the fluctuation reached 0.15 percent. Since June, the most the RMB has diverged 

from the central parity rate in one day is 0.17 percent on August 14. This is the closest that intraday fluctuation has come to the bounds of the 0.3 percent fluctuation band. Finally, the RMB 

gained 0.5 percent against the dollar in the second half of 2005 and gained 1.0 percent against 

the dollar in the first half of this year. In total, starting with the initial revaluation on July 21, 

2005, the RMB has appreciated by 5.88 percent as of December 14, 2006.

 

25 Some banks with overly rapid loan growth were required to purchase $31 billion in below-market rate bonds 

issued by the PBOC. 

26 An additional innovation in January was that the “central parity rate” would be set each morning before market 

opening based on a weighted average of the prices that market makers were offering. This allows further scope for 

daily movement, as the central parity rate can theoretically change by any amount each morning. The 0.3 percent 

band still applies to movements within a day’s trading. 
27

Continued strong investment demand for renminbi means that an inflexible RMB faces 

continued market pressure. In order to maintain the managed float, the central bank intervenes in 

the foreign exchange market, exchanging RMB for foreign currency and accumulating foreign 

exchange reserves. In 2005, the average monthly accumulation was $17.4 billion. Reserve 

accumulation accelerated in the first half of 2006, averaging $20.4 billion monthly. From July to 

September of 2006, reserve accumulation slowed to an average of $15.6 billion per month. On 

October 13, 2006, the PBOC announced that its foreign exchange reserves totaled $987.9 billion 

at the end of September. On November 6, China’s state television reported on an evening news 

program that reserves reached $1 trillion in October. In order to reduce the expansionary impact 

of reserve accumulation on the money supply, the PBOC “sterilizes” foreign currency purchases 

by issuing PBOC bonds, through swaps and repurchase agreements, and by periodic increases in 

the required reserve ratio of banks. In the first half of 2006, PBOC sterilization operations 

averaged $10.8 billion monthly, about 60 percent of foreign exchange purchases for the period. 

2006: Daily RMB-to-US Dollar

7.78

7.83

7.88

7.93

7.98

8.03

8.08

8.13

1/2/2006

1/16/20061/30/20062/13/20062/27/20063/13/20063/27/20064/10/20064/24/2006

5/8/2006

5/22/2006

6/5/2006

6/19/2006

7/3/2006

7/17/20067/31/20068/14/20068/28/20069/11/20069/25/200610/9/2006

10/23/2006

11/6/2006

11/20/2006

12/4/2006

Daily Low

Daily Close

Daily High

Bottom of Band

Top of Band

Intra-Day RMB fluctuations from the Daily Reference Rate

-0.3%

-0.2%

-0.1%

0.0%

0.1%

0.2%

0.3%

7/22/20058/22/20059/22/2005

10/22/200511/22/200512/22/2005

1/22/20062/22/20063/22/20064/22/20065/22/20066/22/20067/22/20068/22/20069/22/2006

10/22/200611/22/2006

Strongest Value

Weakest Value
28 

China’s cautious approach to exchange rate reform continues to exacerbate distortions in the 

domestic economy and impede adjustment of international imbalances. With capital flows 

increasingly mobile into and out of the Chinese economy, limited exchange rate flexibility cedes 

a great deal of control of monetary policy to foreign monetary authorities and international 

investment sentiment. Use of higher interest rates to slow credit growth and enforce bank 

lending discipline is also constrained by the effect that higher interest rates have in spurring 

greater capital inflows. Clamping down on exchange rate fluctuations in the belief that this is 

prudent has in fact increased pressures in other parts of the economy. 

Limited exchange rate flexibility has also become an obstacle to the broader goal of reducing 

economic imbalances enunciated by China’s leaders. Premier Wen’s speech before the National 

People’s Congress in March underscored that among the main goals of the 11th Five-Year Plan 

were rebalancing growth towards domestic consumption and improving investment efficiency. 

Soon after, PBOC Governor Zhou outlined a five-point plan to address the growing current 

account surplus, and President Hu reiterated these points during his visit to Washington in April 

2006. The plan aims to increase domestic demand, reform social security (to reduce required 

saving), increase exchange rate flexibility, widen market access for foreign firms, and boost 

China’s imports (through further trade liberalization). Limited exchange rate flexibility impedes 

the rebalancing of Chinese growth away from exports towards consumption and away from 

coastal areas towards the interior. Failure to let the exchange rate adjust also impedes the 

reduction of China’s current account surplus and foreign reserve accumulation.

Chinese officials have repeatedly stated that the exchange rate will gradually become more 

flexible and that there will not be any surprise adjustments. They contend that greater flexibility 

cannot be achieved overnight and that progress is ongoing. Indeed, Chinese officials continue to 

enact measures that are preconditions for greater exchange rate flexibility, including steps to 

liberalize the capital account, reform the financial sector, enhance the foreign exchange market, 

and develop new financial products. 

In the first half of 2006, China continued with modest capital account liberalization, including in 

the pilot programs that allow Chinese investors to make portfolio investments overseas and 

foreign investors to make portfolio investments in China. From April to November 2006, the 

China Banking Regulatory Commission (CBRC) granted one asset management company and 15 

banks – including foreign banks – a total of $13.1 billion in quotas to provide overseas 

investment services for Chinese residents, as part of the Qualified Domestic Institutional 

Investors (QDII) program to allow pooling of RMB funds to be invested overseas. However, 

only a small proportion of the allotted QDII quota has been used to date. In August 2006, the 

China Securities Regulatory Commission (CSRC) expanded the number of institutions qualified 

to invest in local shares as Qualified Foreign Institutional Investors (QFII) by reducing the 

minimum size for institutions and shortening the required holding period for investments. Also 

in April 2006, foreign exchange regulations were liberalized to allow Chinese firms and residents 

to buy more foreign assets. Individuals can now convert up to $20,000 worth of RMB to take 

out of China. 

China has taken steps to improve its financial sector to be able to adapt to currency and interest 

rate fluctuations. Since the beginning of 2004, China has promoted foreign investment in its 
29

banking system by selling more than $20 billion worth of strategic stakes to foreign bankers, 

securities firms, and institutional investors. Further, institutional investors have bought $30 

billion worth of stakes in four of China’s five largest banks through public listings in Hong 

Kong. The higher disclosure requirements of listing in Hong Kong and the presence of foreign 

investors will likely increase market pressure for the banks to improve their risk management 

capabilities and corporate governance systems. 

China has expanded the availability of financial instruments for managing and hedging foreign 

exchange and other financial risk. The foreign currency market maker system introduced in 

January allows for deeper spot market trading and increased transactions between banks. In 

March, the Chicago Mercantile Exchange (CME) announced its plan to allow Chinese financial 

institutions to electronically trade CME foreign exchange and interest rate products through the 

China Foreign Exchange Trading System platform27, pending regulatory approval by the 

CFTC. In August, the CME also began selling RMB futures contracts on its U.S. platform. In 

April 2006, 54 foreign and domestic banks operating in China were authorized to trade foreign 

exchange swaps. In September, the China Financial Futures Exchange was established in 

Shanghai, which will start by launching mainland stock futures. However, foreign currency 

hedging opportunities were restricted when the authorities banned onshore banks from trading in 

offshore non-deliverable forwards. 

The Department of the Treasury engages intensively with Chinese economic policy makers on 

economic issues of both bilateral and global importance. China’ exchange rate policy, its effect 

on Chinese domestic and external imbalances, and China’s financial sector are particular focal 

points of that engagement. Recognizing that resolving imbalances in China requires reform 

across many economic sectors, Treasury convenes the Joint Economic Commission with the 

Chinese government as well as a Financial Sector Working Group to promote mutual 

understanding and guidance. 

Additionally, Secretary Paulson was appointed by President Bush to be the U.S. co-chair of the 

newly formed Strategic Economic Dialogue (SED) with China’s top economic leaders, a forum 

for addressing critical economic issues and planning for long-term cooperation. The first SED 

was held in Beijing on December 14 and 15. It was agreed that discussions will be conducted on 

development of efficient innovative service sectors and on ways to improve health care. A 

bilateral investment dialogue will be launched with exploratory discussions to consider the 

possibility of a bilateral investment agreement, enhancing cooperation on transparency issues, 

and launching a joint economic study on energy and environment. The two countries are 

committed to invigorating ongoing work within the U.S.-China Joint Commission on Commerce 

and Trade on high-tech trade, intellectual property rights, and market economy status/structural 

issues. Utilizing other existing mechanisms, both sides agreed to increase bilateral cooperation 

on more efficient and environmentally sustainable energy use, facilitation of personal and 

business travel, development assistance, and multilateral development bank lending. Finally, 

both sides agreed that NYSE and NASDAQ should open offices in China, that China will 

participate in the government steering committee of the FutureGen project, and that the United 

States will support China's membership in the Inter-American Development Bank. Both sides 

 

27This interbank foreign exchange trading platform is a government owned, but technically independent arm of 

SAFE, which is controlled by the PBOC. 
30

concluded an agreement on facilitating financing to support U.S. exports to China and agreed to 

re-launch bilateral air services negotiations. 

China's currency policy is a core issue in the China-United States economic relationship. More 

flexibility in China’s exchange rate will help it achieve more balanced economic growth, 

enhance the effectiveness of monetary policy, safeguard the health of the financial sector and 

promote over time an orderly reduction of external imbalances. 

Taiwan 

Taiwan has experienced sluggish domestic demand growth and low or negative inflation rates 

since a sharp decline in fixed investment spending led to recession in 2001. Strong export 

growth has allowed Taiwan to achieve annual real GDP growth rates between 3-6 percent since 

the recession ended, but at the cost of increased dependence on external demand. 

That pattern persisted in the first half of this year, as slowing exports and continued weak 

domestic demand brought a sharp deceleration in economic growth, from 7.8 percent (saar) in 

the second half of 2005 to just 1.5 percent in the first half of 2006. Net exports, which accounted 

for more than half of all growth since the 2001 recession ended, contributed just 0.3 percentage 

points in the first half of this year. Inflation remained very low, and negative by some measures, 

during the January-June reporting period. Consumer prices excluding food and energy rose 0.3 

percent year-on-year in June and 0.2 percent through September (according to the most recent 

available data), while the GDP deflator declined 1.2 percent year-on-year in the second quarter. 

Taiwan’s current account surplus narrowed slightly to $10.3 billion (5.8 percent of GDP) in the 

first half of 2006, down from $10.7 billion (6.2 percent of GDP) in the second half of 2005, as a 

declining trade surplus outweighed growth in the income surplus and a declining services deficit. 

Net financial outflows from Taiwan totaled $11.9 billion during the first half of 2006, up from a 

$9.4 billion net financial outflow during the second half of 2005. The main component of net 

financial outflows during the first half of 2006 was $14.0 billion in net portfolio outflows, as 

Taiwanese residents increased their purchases of foreign assets and foreign portfolio inflows 

slowed. 

Recent net financial outflows have roughly offset Taiwan’s current account surplus, reducing 

pressure on Taiwan’s managed floating exchange rate regime. As a result, net accumulation of 

foreign exchange reserves, which averaged nearly $29 billion a year from 2001 to 2005 and 

totaled $19 billion the first half of 2005, slowed to $1.1 billion in the second half of 2005 and 

$2.7 billion in the first half of 2006. Taiwan’s reserves totaled $260.4 billion in June 2006, 

rising to $261.6 billion in September. 

The Taiwan dollar (NT$) remained within the 31-35/US$ trading range in which it has fluctuated 

for the past five years. After ending 2005 at 33.29/US$, the NT$ appreciated 2.6 percent to 

32.44/US$ at end-June, but has since depreciated by 2.3 percent to 33.22/US$ as of October 30, 

2006. 
31

Malaysia

Malaysia has begun to edge toward a more flexible exchange rate regime, allowing a modest 

appreciation of the ringgit against the dollar this year and permitting increased volatility in dayto-day currency movements, after abandoning its fixed U.S. dollar peg in July 2005. However, 

Malaysia’s large and growing current account surplus still suggests that macroeconomic 

imbalances in the economy need to be addressed. 

Malaysia, a net oil exporter, has had current account surpluses in excess of eight percent of GDP 

since the late 1990s, even before the run-up in oil prices began. Higher oil prices helped push 

the surplus up to $20.0 billion, or 15.2 percent of GDP, in 2005, and to an annualized $21.0 

billion, or 14.4 percent of GDP in the first half of 2006. Malaysia’s non-oil current account 

surplus has been growing, at least through last year. The current account surplus excluding 

mineral fuel exports came to 1.8 percent of GDP for the first three quarters of 2005 (according to 

the most recent available data), up from 0.4 percent of GDP in 2004. 

The swing in Malaysia’s current account surplus from large deficits in the mid-1990s to large 

surpluses since 1998 reflects a dramatic decline in private investment since the 1997-98 Asia 

crisis. Private sector fixed investment fell from more than 31 percent of GDP in 1996-97, to 7.6 

percent of GDP by 2003 and has only recently begun to recover, to 8.8 percent of GDP in 2005. 

The reasons for the sustained weakness in Malaysian private investment, which fell more sharply 

and rebounded more weakly than in other crisis-hit Asian countries, are not well understood. As 

explanations for the sluggish recovery of private investment, some analysts cite weak Malaysian 

corporate sector profitability, due in part to excess investment during the pre-crisis period, and 

financial market imperfections that limit external financing for smaller firms. Those factors may 

be fading in importance, as Malaysian investment spending has shown signs of recovery over the 

past 21⁄2 years. 

Malaysia has recorded solid economic growth and low-to-moderate inflation over the past 

several years despite weak investment spending. Real GDP grew 5.2 percent in 2005, led by 

consumption and external demand. Growth accelerated to 6.8 percent (saar) in the first half of 

2006, on stronger public and private fixed investment. (Malaysia’s quarterly national accounts 

data do not break out public and private investment.) Higher fuel, transport and food prices 

pushed overall consumer price inflation steadily higher over the course of 2005 and into 2006. 

CPI inflation peaked in March 2006 at 4.8 percent y/y, its highest level since 1998, before 

subsiding to 3.3 percent y/y in August.

After abandoning its fixed exchange rate of 3.8/$ in July 2005 and revaluing to 3.75/$, the 

ringgit gradually weakened over the remainder of 2005 and ended the year at 3.779/$, a net 

appreciation of only 0.6 percent. The ringgit moved over a wider range in the first half of 2006, 

appreciating 5.7 percent to 3.575/$ by May 17. The general sell-off of emerging market assets in 

May and June led the ringgit to weaken to 3.639/$ at the end of June, for a gain of 2.7 percent in 

the first half. The ringgit had been relatively stable since the end of June until recent increases in 

the growth outlook pushed the ringgit up almost three percent in the first week of December. 

Average daily ringgit fluctuations against the dollar have also risen this year, to 0.17 percent 

through September compared to 0.05 percent for the second half of last year. Nevertheless, daily 
32

volatility of the ringgit remains below that of the South Korean won and well below that of such 

major international currencies as the euro. 

Malaysian authorities’ exchange rate policy has been to “lean against the wind” – intervening to 

strengthen the currency when it was depreciating, as in the last half of 2005, and accumulating 

foreign reserves when the currency was appreciating. Malaysia’s authorities intervened heavily 

in the first half of the year in response to upward pressure on the currency. However, this policy 

was relaxed in early December, and the ringgit was allowed to appreciate at a faster pace at a 

time when there was broad appreciation of Asian currencies against the dollar. Foreign 

exchange reserves, which had declined by nearly $10 billion in the fourth quarter as the central 

bank intervened to offset large capital outflows and to limit ringgit depreciation, rose by more 

than $8 billion in the first half of 2006, to $78.7 billion (60 percent of 2005 GDP) at the end of 

June. Attempts to contain upward pressure on the currency may have constrained the central 

bank’s monetary policy. The central bank did raise overnight interest rates modestly from 2.7 

percent to 3.5 percent in three steps starting in December. 

Malaysia has gradually relaxed most of the controls on capital flows imposed when the ringgit 

was pegged in 1998. Remaining controls include: offshore trading of the ringgit remains 

prohibited; limits on foreign portfolio investment by residents are still in place; and restrictions 

on local or foreign currency-denominated credit extended from residents to non-residents or vice 

versa.