- 18 -

the United States was primarily due to causes other than exchange
rate manipulation. However, the reports noted that China's foreign
exchange controls were of serious concern. The Treasury Department
began discussions with the Chinese authorities on liberalizing
these controls.

In the spring 1992 report, the Treasury Department again found
no basis for concluding that Korea was manipulating its exchange
rate within the meaning of the legislation. But the Department did
find that pervasive Korean exchange and capital controls
significantly constrain market forces in the currency market. The
report concluded that liberalization of these controls, the subject
of ongoing bilateral Financial Policy Talks, is imperative to
achieve truly market-oriented exchange rates and trade and
investment flows.

In the case of Taiwan, the spring 1992 report noted the 1991
rise in the overall current account surplus, the slow pace of
adjustment of the bilateral trade surplus with the United States,
and the country's extremely large foreign exchange reserves. The
Treasury Department also noted Central Bank intervention to
moderate upward pressure on the New Taiwan dollar and continued
restrictions on capital flows. In this context, the Department
concluded that Taiwan was manipulating its exchange rate within the
meaning of the legislation. Treasury stated its intention to
negotiate specific measures to help achieve a more market-
determined exchange rate and substantial adjustment in Taiwan's
external imbalances.

For China, the spring 1992 report found a large overall
current account surplus for 1991, very substantial foreign exchange
reserves, and a sharp 1991 increase in the country's bilateral
trade surplus with the United States. The Department determined
that a principal cause of China's large external surpluses was its
network of pervasive administrative controls over external trade
which severely inhibit China's imports. But, in addition, Treasury
found that China was manipulating its exchange rate to help attain
its balance of payments objectives. The basis for this judgment
was the continued devaluation of the administered exchange rate,
despite growing external surpluses, and the significant control
exercised by the authorities over foreign exchange swap center
rates which had also depreciated since the emergence of the large
surpluses. The Treasury Department stated its intention to
negotiate with the Chinese authorities on reforms to bring about a
market-oriented system of exchange rate determination and foreign
exchange allocation in order to help permit substantial balance of
payments adjustment.

The remainder of this chapter provides an update of balance of
payments and exchange rate developments in Korea, Taiwan, and
China, and the Treasury Department's current assessment of the
applicability of Section 3004 to these economies. (See Table 5.)


~ 39 -

United States, the authorities should take steps that would allow
the exchange rate to reflect market forces fully. In addition to
intervention in exchange markets, the limitations on foreign
exchange transactions and capital flows are far too restrictive and
impede the full operation of market forces in exchange rate
determination. Specifically, the authorities should cease direct
and indirect intervention in the exchange market for the purpose of
dampening pressures for appreciation, eliminate foreign exchange
liabilities ceilings for foreign banks, remove other limitations
that restrict the scope of the forward foreign exchange market, and
reduce controls on capital inflows and outflows, while making a
commitment to phase out the controls completely. The Treasury
Department will continue to engage the Taiwan authorities in
negotiations aimed at implementation of these reforms.

China's large trade and current account surpluses,
particularly its rapidly growing bilateral trade surplus with the
United States, remain developments of major concern. China's
surplus with the United States reached $11.2 billion in the first
eight months of 1992, an increase of 56 percent over January-August
1991. Surpluses of this magnitude create serious trade tensions
and must be reduced. A principal cause of China's surpluses is the
network of pervasive administrative controls over external trade,
which severely inhibit China's imports, including those from the
United States. In Treasury's view, the Chinese authorities also
employ exchange rate and foreign exchange policies to attain their
balance of payments objectives.

Despite continued large external surpluses which first emerged
in 1990, the administered rate of the renminbi, 5.55 yuan per
dollar in mid-October, remains significantly devalued below its
level at end-1989 when it stood at 4.72 yuan per dollar. However,
the administered rate has changed very little since the time of the
spring 1992 exchange rate report. That report recommended that
"China should suspend further devaluation of the administered rate
until far-reaching reform of China's trade, exchange, and domestic
price regimes has been undertaken...." In this regard, Treasury
recognizes and welcomes the fact that there has been no further
devaluation. Until far-reaching reform of China's trade and
domestic price regimes has been implemented, Treasury continues to
find that no further devaluation of the administered rate is
warranted.

The Chinese authorities also influence the exchange rate in
the nation's swap centers by controlling both the demand for, and
supply of, foreign exchange. The average swap center rate has not
appreciated over the past two years, notwithstanding the large
current account surpluses and resulting build-up of foreign
exchange reserves. The limited response of exchange rates to
market forces impedes China's balance of payments adjustment.

In the spring 1992 report, the Treasury Department recommended
that the Chinese authorities take a number of concrete measures to


- 35 -

of China's external payments surpluses and the level of its foreign
exchange reserves, continued use of the administered exchange rate
and of regulated swap center rates must be viewed as an effort by
the authorities to frustrate effective balance of payments
adjustment.

Subsequent to the issuance of the spring 1992 report, the
Treasury Department has held two sessions of negotiations with the
Chinese authorities to seek substantial progress toward a more
market-oriented system of exchange rate determination and foreign
exchange allocation, which will contribute to a reduction in large
Chinese external imbalances.

The Treasury will continue to engage the Chinese authorities
in negotiations aimed at implementation of specific actions to
achieve these objectives in the near future.


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-12-

between 1987 and 1991, was the major factor in the decline in the
trade deficit during that period.

While exports have stagnated so far in 1992, imports -- which
actually declined in 1991, due to lower oil prices in the wake of
the Gulf War -- have showed signs of renewed growth despite the
very modest pace of recovery in the domestic U.S. economy. Imports
(both total and non-oil) rose during the first half to $514.3
billion at an annual rate, up $25 billion or 5.1% compared with
full-year 1991. Most of the increase came in the second quarter,
and was sustained in the third quarter.

On an area basis, the 1992 trade balance has deteriorated
(larger deficit or smaller surplus) vis-a-vis most of the
industrial countries, but improved (smaller deficit/larger surplus)
vis-a-vis Latin America, OPEC, and the Asian NIEs. Export growth
has been particularly weak with respect to the other industrial
countries, especially Europe, reflecting the very weak demand
growth in their economies. This coincidence of weak export growth
and trade balance deterioration mirrors the pattern in the overall
balance.

Current account balance: The current account for the first
half of 1992 was in deficit at an annual rate of $48 billion,
roughly the same as 1991's $46 billion if the one-time receipts of
Desert Storm support are disregarded. The current account
typically reflects swings in the trade balance, since trade is
still the largest single component -- though the importance of
services has increased substantially in recent years.

However, there was a sharp increase in the current account
deficit in the second quarter -~- to $17.8 billion, from $5.9
billion in the first quarter -- only part of which represented a
rising trade deficit. In addition, there was a sharp drop ~~ over
$3 billion -- in net investment income receipts. Foreign direct
investments in the U.S., which had been registering losses, shifted
to small profits in the second quarter. Like the second quarter
pick-up in merchandise imports, this development may reflect the
gradual U.S. recovery and thus could represent initial signs of a
cyclical deterioration in the current account in coming quarters.

Capital account: In principle, the capital account balance
constitutes the mirror-image of the current account balance, and
the net capital flow should equal the opposing current account flow
(i.e., a current account deficit would have as its counterpart a
net capital inflow). However, measurement problems mean that the
two balances can be quite different.

So far in 1992, the recorded net capital inflow is over twice
as large as the current account deficit -- that is, there is a
"statistical discrepancy" of $28 billion, compared with the $23.7
billion current account deficit. U.S. investors have continued to


~22-

financial sector. Treasury welcomed the commitment to formulate
such a blueprint as a positive step.

However, concerns remain about the approach of the initial
workplan. In particular, the pace of implementation of later
stages is determined by macroeconomic preconditions, including a
balance or surplus in the current account, lower inflation, and a
narrowing of domestic and international interest rate
differentials. Treasury has pointed out to the Korean government
that financial sector liberalization will be required to reduce
interest rates and domestic costs in order to attain the macro
preconditions laid out in the plan. Expedited action by the Korean
authorities in modifying these policies will be necessary for the
Korean economy to remain competitive internationally.

Stages I and II of the blueprint have been completed and
implementation of some initial measures has begun. Although the
short and medium term measures already announced address to some
extent a few of the individual issues facing U.S. and other foreign
financial institutions operating in Korea, they do not constitute
significant liberalization of the market. The fundamental areas
needing attention (and that have impeded market forces in the
foreign exchange market), such as lifting pervasive foreign
exchange and capital controls, accelerating interest rate
liberalization, and developing capital and money markets, are being
addressed in the third and final stage of the blueprint, currently
scheduled for implementation in 1997 and beyond.

Stage III is now under preparation and is expected to be
completed by the end of 1992. The Korean government is consulting
with experts from the International Monetary Fund, the
International Bank for Reconstruction and Development, and various
research institutes as it formulates Stage III. These institutions
can provide detailed advice on formulating a tightly integrated
blueprint with more timely implementation of the entire range of
needed liberalization measures.

Through the Financial Policy Talks, Treasury will continue the
dialogue with the Korean Ministry of Finance as the blueprint is
finalized. These issues are also addressed in the financial
services negotiations underway in the Uruguay Round of world trade
talks.

Assessment

There is no basis at this time for the Treasury Department to
conclude under Section 3004 that Korea is manipulating its exchange
rate for purposes of preventing effective balance of payments
adjustments or gaining unfair competitive advantage in
international trade. This assessment is based on the following
factors: the continuance of significant global trade and current
account deficits, the lack of evidence that the Bank of Korea is


- 40 -

permit the exchange rate in swap centers to reflect market forces
more fully. These include: eliminating the foreign exchange quota
system and moving to a complete foreign exchange cash retention
system; removing restrictions on access to the foreign exchange
swap centers and on use of foreign exchange for specific trade and
other purposes; eliminating restrictions on foreign exchange flows
among swap centers around the country; and publishing all laws and
regulations pertaining to foreign exchange, as well as making any
proposed changes available to the public in advance for review.

Chinese officials have expressed support for general reform
objectives, but have not yet indicated the specific nature and
scope of the measures they are contemplating to achieve these
objectives, or the timing of such measures. Therefore, Treasury
has insufficient basis to change its previous determination.

It is Treasury's judgment that China is manipulating its
exchange rate within the meaning of Section 3004. Given the size
of China's external payments surpluses and the level of its foreign
exchange reserves, continued use of the administered exchange rate
and of regulated swap center rates must be viewed as an effort by
the authorities to frustrate effective balance of payments
adjustment.

Subsequent to the issuance of the spring 1992 report, the
Treasury Department has held two sessions of negotiations with the
Chinese authorities to seek substantial progress toward a more
market-oriented system of exchange rate determination and foreign
exchange allocation, which will contribute to a reduction in large
Chinese external imbalances.

The Treasury will continue to engage the Chinese authorities
in negotiations aimed at implementation of specific actions to
achieve these objectives in the near future.


Growth

The G-7 economies are still experiencing slow aggregate
growth, but considerable disparities in economic performance
remain. In the aggregate, real GDP/GNP is expected by the IMF in
its October forecasts to increase about 1.7 percent in 1992 ona
year-over-year basis. This would be an improvement over last
year's performance -- when real growth was only 0.6 percent -- but
is, nonetheless, substandard compared with the long expansion
following the 1982 recession. (See Table 1 for detailed IMF
projections.)

Recent slow growth appears to be related to imbalances which
arose during the economic expansion of the 1980s. During this
period, asset prices in some countries escalated to inappropriate
levels; corporate and household debt rose to uncomfortable heights;
and stocks of some real assets increased beyond current need. The
adjustment process necessary to reduce these imbalances has slowed
recovery from recession in the United States, Canada, and the
United Kingdom. In Japan and Germany, where growth had not
initially faltered, weakness is now clearly evident. In addition,
developments in European currency markets and questions surrounding
the Maastricht Treaty have increased economic uncertainties in
Europe and may have contributed to weaker growth.

For 1993, the IMF has projected 3.0 percent aggregate G-7
growth. However, this forecast is subject to considerable
uncertainty, and substantial downside risk exists. Latest data
suggest, for example, that consumer confidence remains weak,
industrial output is below earlier peaks, and business investment
is sluggish. Consequently, a number of forecasters, including the
international financial institutions, have been revising downward
their projections for next year.

Growth in 1992 is projected by the Fund to be strongest in
France, Canada, Japan, and the United States. France has been able
to maintain modest growth in 1992 (projected at 2.2 percent),
reflecting exports to other EC countries, despite high interest
rates; Canada's economy is projected to achieve nearly comparable
results (2.1 percent growth) by a recovery in interest sensitive
construction and by exporting to the growing U.S. economy.

Growth in Japan is likely to be very disappointing by
historical standards (around 2.0 percent in 1992 according to the
IMF) because domestic demand has been restrained by the adverse
effects on consumption and investment of falling real estate and
equity prices, by previous very high levels of private investment,
and by contractionary fiscal policies. Mitigating the effect of
these policies is Japan's success in exporting to rapidly growing
Asian markets. The recently announced fiscal stimulus program
should help to strengthen the economy, although the effects of the
program may not be visible until next year. Given the hindrances


- 33 -

Having narrowed to less than 10 percent by the beginning of
1992, the spread between the official and swap rates has again
widened to about 25 percent.

Controls on Foreign Exchange Allocation and External Trade

China's foreign exchange regime must be viewed in conjunction
with its direct controls over imports. The two sets of controls
are often overlapping and redundant.

For example, an importer wishing to obtain foreign exchange
for non-priority imports must obtain not only approval from the
exchange authorities but also an import license from the trade
ministry and explicit approval from the ministry responsible for
enterprises producing domestic substitutes. The various approval
processes do not necessarily operate consistently. Possession of
an import license does not guarantee that an importer will be
allocated foreign exchange, nor does approval of foreign exchange
use automatically entitle the importer to a license. In practice,
it appears that the strict import licensing system is often the
most significant obstacle to the importer's ability to obtain
foreign exchange. Thus an effort to remove foreign exchange
controls without a complementary effort to address direct trade
restrictions is unlikely to result in a significant adjustment in
China's trade flows.

Assessment

China's large trade and current account surpluses,
particularly its rapidly growing bilateral trade surplus with the
United States, remain developments of major concern. Surpluses of
this magnitude create serious trade tensions and must be reduced.

A principal cause of China's surpluses is the network of
pervasive administrative controls over external trade, which
severely inhibit China's imports, including those from the United
States. On October 10, 1992, under authority provided by Section
301 of the Trade Act of loge, the United States and China signed a
Memorandum of Understanding (MOU) which commits China to remove a
substantial number of China's external trade barriers. The MOU
calls for China to: progressively remove the majority of its
nontariff trade barriers such as quotas, import licensing
requirements, and other restrictions on imports; enhance the
transparency of its trade regime by publishing all trade laws,
regulations, and policies; reduce tariffs on a range of products
exported by U.S. firms; and eliminate standards and testing
requirements as barriers to trade. When fully implemented, the MOU
will have achieved a major step toward eliminating China's direct
trade controls and should contribute to external surplus reduction.


-~ 19 -
KOREA

The Korean won has depreciated slightly against the U.S.
dollar since the spring 1992 report. The nominal depreciation
reflects in part the continued adjustment in Korea's external
accounts, as well as higher Korean inflation. However, the
exchange rate continues to be influenced by pervasive foreign
exchange and capital controls in Korea. These controls constrain
the forces of supply and demand in the exchange market, distort
trade and investment flows, and continue to position the
authorities to manipulate the exchange rate through indirect means.
The Korean government is currently formulating a comprehensive
blueprint for financial sector liberalization, expected to be
completed by the end of 1992.

Trade and Economic Developments

The Korean economy is stabilizing in 1992 in line with
government objectives. Real GNP growth is expected to be held by
the government to 6.6 percent this year, compared to 8.4 percent in
1991. Private consumption and exports are leading growth.
Inflation, which reached 9.3 percent at end-1991, is improving in
1992 == consumer prices rose 3.8 percent in the first half of 1992,
compared to 6.2 percent during the same period last year. The
central bank projects end-1992 inflation to reach 6.5 percent.
Unemployment remains low at just over 2 percent of the labor force.

Korea's external accounts have undergone substantial
adjustment since 1989. This adjustment -~ which moved the current
account from a surplus of 2.4 percent of GNP in 1989 to a deficit
of 3.1 percent of GNP in 1991 -- has resulted largely from an
increase in imports caused by strong growth of the domestic
economy; rising wage demands and other factors adversely affecting
Korea's export competitiveness; and rising oil import prices and
the longer term impact of the Persian Gulf crisis.

A current account deficit of $2.1 billion emerged in 1990, and
grew to a record $8.7 billion in 1991. Korean authorities project
the current account deficit will fall to roughly $5 billion in
1992. Korea's trade deficit, which reached $7 billion on a balance
of payments basis (2.5 percent of GNP) at the end of 1991, is
expected to shrink to $2.5 billion in 1992. Notably, first half
exports outpaced imports for the first time in four years. Korea's
external deficits do not appear to be structural in nature;
authorities anticipate external surpluses by mid-decade.

According to U.S. data, the U.S. bilateral trade deficit with
Korea in 1991 fell to $1.5 billion, down 63 percent from 1990. In
the first eight months of 1992, U.S. data showed a trade deficit
with Korea of $1.0 billion, compared to a deficit of $869 million
during the same period in 1991.


- 25 -

cover 18 months of imports), compared to $83 billion at the time of
the spring 1992 report. For purposes of comparison, the industrial
countries on average hold non-gold reserves equivalent to 2-3
months of import cover.

Based on data for the first half of 1992, which show a decline
of 27 percent, Taiwan's current account surplus is likely to
decrease in 1992 due to a reduction in the overall merchandise
trade surplus and an increase in the services deficit. The economy
should continue to grow rapidly; real GDP is expected to expand by
roughly 7 percent in 1992, following 7.3 percent growth in 1991.
Inflation averaged 3.5 percent in 1991 and increased to an average
of 4.9 percent over the first three quarters of 1992.

Exchange Rate Developments

The NT dollar has depreciated by 0.7 percent since the last
report; the exchange rate stood at NT$25.27/US$1 on October 16.
The cumulative appreciation of the NT dollar since the end of 1991
is 1.9 percent.

Since the last report, the Central Bank reportedly continued
to intervene directly and indirectly in the exchange market. In
addition, market pressures for appreciation have been resisted
through continuing controls over capital flows, tight ceilings on
the foreign exchange liabilities of all banks, and limitations on
the scope of the forward foreign exchange market. The dampening
role these measures play in the exchange market are in the
judgement of the Treasury Department significant and serve as
continued evidence of the unwillingness of the Taiwan authorities
to rely on a market-determined exchange rate.

Given the strength of Taiwan's economic fundamentals -~- strong
economic growth, continued large trade and current account
surpluses, large and growing foreign exchange reserves, and a
stable political environment -- the depreciation of the NT dollar
since mid-July cannot be fully explained by the decline in Taiwan's
overall trade and current account imbalances during 1992.

In this regard, the monetary authorities have been forced to
formulate exchange rate and monetary policies against the
background of political pressure from powerful exporters
complaining of declining competitiveness. However, the evidence
does not seem to support fears that the nominal appreciation of the
NT dollar has seriously damaged the competitiveness of Taiwan's
economy. Though the NT dollar appreciated more than 16 percent
between September 1987 and September 1992, the real exchange rate
has depreciated over the same period, indicating that Taiwan has
become slightly more competitive in global markets. In 1992,
Taiwan's global exports through September have increased by 7.5
percent over the comparable period in 1991. According to U.S. data
through August, Taiwan's exports to the U.S. market have increased


- 21 -

One of the most onerous controls is the requirement that
foreign exchange banks obtain and review, prior to entering into
most foreign exchange transactions, original documentation of an
underlying commercial transaction. This "real demand" rule
seriously hampers the development of Korea's foreign exchange
market, reflects the government's continued controlling hand in the
foreign exchange market, and its unwillingness to let market forces
fully play their role in the economy. Such restrictions are
inappropriate for a country at Korea's stage of development.

Other exchange and capital controls severely impede the use of
short-term trade finance, such as stringent terms for deferred
payments for imports. Direct portfolio investment in Korea was
opened to foreigners for the first time in January 1992, but a
number of restrictions -- including a 10 percent limit on total
foreign investment in most Korean stocks and a 3 percent limit on
investment by individual foreigners -- continue to act as
disincentives to foreign investment in the market.

The Korean government revised the Foreign Exchange Control Act
(FECA) -- renamed the Foreign Exchange Management Act (FEMA) -~ in
the fall of 1991 to adopt a "negative list" approach to the
regulation of foreign exchange transactions. According to the
negative list approach, all foreign exchange transactions are to be
permitted in principle, with exceptional restrictions explicitly
listed in the regulations.

The revised regulations under the new FEMA went into effect
September 1, 1992. Treasury's preliminary analysis of the
regulations indicates that the list of restricted foreign exchange
transactions remains extensive, with little or no relaxation in key
areas such as underlying documentation requirements and deferred
payments for imports. In some areas, restrictions may have been
tightened.

Financial Policy Talks

Capital and exchange controls and other financial policy
issues are the subject of the ongoing Financial Policy Talks
between the Treasury Department and the Korean Ministry of Finance.
The purpose of the talks is to provide a mechanism for addressing
specific market access problems that U.S. banks and securities
firms face in doing business in Korea, and for encouraging broader
liberalization of Korea's financial, capital, and exchange markets.
The importance of financial issues to the U.S.-Korean economic
relationship was reflected by President Bush's and President Roh's
agreement in January 1992 to resolve differences in this area.

In recent sessions with senior Ministry of Finance officials,
they have presented an inter-agency workplan for developing a
three-staged blueprint for comprehensive liberalization of the


~ 34 ~

In Treasury's view, the Chinese authorities also employ
exchange rate and foreign exchange policies to attain their balance
of payments objectives.

Despite continued large external surpluses which first emerged
in 1990, the administered rate of the renminbi remains
significantly devalued below its level at end-1989 when it stood at
4.72 yuan per dollar. However, the administered rate has changed
very little since the time of the spring 1992 exchange rate report.
(The rate was 5.48 yuan per dollar in mid-April 1992.) That report
recommended that "China should suspend further devaluation of the
administered rate until far-reaching reform of China's trade,
exchange, and domestic price regimes has been undertaken...." In
this regard, Treasury recognizes and welcomes the fact that there
has been no further devaluation. Until far-reaching reform of
China's trade and domestic price regimes has been implemented,
Treasury continues to find that no further devaluation of the
administered rate is warranted.

The Chinese authorities also influence the exchange rate in
the nation's swap centers by controlling both the demand for, and
supply of, foreign exchange. The average swap center rate has not
appreciated over the past two years, notwithstanding the large
current account surpluses and resulting build-up of foreign
exchange reserves. The limited response of exchange rates to
market forces impedes China's balance of payments adjustment.

In the spring 1992 report, the Treasury Department recommended
that the Chinese authorities take a number of concrete measures to
permit the exchange rate in swap centers to reflect market forces
more fully. These included: eliminating the foreign exchange
quota system and moving to a complete foreign exchange cash
retention system; removing restrictions on access to the foreign
exchange swap centers and on use of foreign exchange for specific
trade and other purposes; eliminating restrictions on foreign
exchange flows among swap centers around the country; and
publishing all laws and regulations pertaining to foreign exchange,
as well as making any proposed changes available to the public in
advance for review.

Chinese officials have expressed support for general reform
objectives: a phasing-out of the administered exchange rate,
unification of the dual exchange rate system, liberalization of
access to the swap centers, and making foreign exchange regulations
more transparent. However, the Chinese authorities have not yet
indicated the specific nature and scope of the measures they are
contemplating to achieve these objectives, or the timing of such
measures. Therefore, Treasury has insufficient basis to change its
previous determination.

It is Treasury's judgment that China is manipulating its
exchange rate within the meaning of Sections 3004. Given the size


-16-

of the deductibility of mortgage interest. Spending cuts proposed
by the IMF include: reduced farm price supports, cutbacks in
Medicare and Medicaid, and further reductions in defense
expenditures.

The United States shares the objective of reducing the budget
deficit but believes the Fund's proposed remedies, which seek a
correction in the fiscal balance of five percent of GDP by 1997,
would exert strong downward pressure on the U.S. economy at a time
of already sluggish growth. Job creation would suffer and output
would remain subdued over an extended "adjustment" period.

In contrast, the United States has stressed the overriding
importance of strengthening the recovery and establishing
sustainable growth with low inflation. There is broad agreement on
the need to address the major structural aspects of the current
fiscal imbalance, particularly the rapid increase in outlays for
various mandatory programs. However, the more measured approach
advocated by the United States envisages a balanced set of policies
designed to ensure a more robust upturn in growth in the near term
while offering credible prospects for a substantial reduction in
the budget deficit over the medium-term.

Such an approach is also consistent with ensuring the U.S.
external position remains "sustainable" and does not risk an
excessive accumulation of external indebtedness. Although
"sustainability" encompasses a variety of factors and market
perceptions that cannot be quantified in any meaningful way, the
U.S. external position does benefit from a number of strengths and
positive trends.

U.S. export competitiveness has increased dramatically in
recent years, aS was discussed previously. The growth in services
exports is expected to continue despite the slowdown in some major
overseas markets. Due to the sustained improvement in U.S.
competitiveness across a broad range of sectors, U.S. authorities
expect a more modest deterioration in the U.S. current account
deficit than does the IMF over the medium term, particularly as
cyclical factors converge among the major economies.

Further contributing to the stability of the U.S. external
position are the size and openness of the U.S. economy and the size
and liquidity of U.S. capital markets. These attributes will
continue to attract foreign investment to the United States in the
foreseeable future. The United States is committed to an open and
growing multilateral trade and payments system to facilitate the
continued expansion of trade and investment flows. Recent
successes in confirming the new consensus on growth among the G-7
countries as well as ongoing efforts to strengthen the economic
policy coordination process should contribute further to the smooth
functioning of the international economic system.


-g-

PART III: DEVELOPMENTS IN FOREIGN EXCHANGE MARKETS

Overview

Over the past year (ending mid-October), the dollar
depreciated by 7 percent against the Japanese yen and 14 percent
against the German mark. On a trade weighted basis, however, the
dollar's decline was only about 2-1/2 percent, reflecting an
appreciation of more than 10 percent against Canada, our largest
trading partner.

The main factors behind the exchange rate movements were
changes in interest rates in the United States and abroad which
reflected differences in economic conditions, particularly growth,
and resulted in large interest differentials unfavorable to dollar
assets. Towards the end of the period, serious strains developed
among European currencies, which triggered large short-term capital
flows. On balance, however, these flows did not appear to have a
significant lasting effect on the dollar's exchange value.

The dollar reached record lows of DM 1.3865 and ¥ 118.60 in
September 1992 but was recovering toward the end of the reporting
period as the U.S. economy showing increased signs of recovery
while growth in Europe and Japan slowed.

Dollar

The dollar trended downward against most other major
currencies through much of the year, apart from a brief period in
early 1992 when the U.S. economic recovery briefly seemed to pick
up speed. As noted above, the decline primarily reflected a
further widening of large differentials between European and U.S.
interest rates. Subsequently, declining consumer and business
confidence and weakening employment in the United States
discouraged any expectation that the differentials would narrow
significantly over the near term. Also, the U.S. monetary
authorities were perceived as unconcerned about dollar depreciation
so long as it was orderly.

Yen

The yen appreciated modestly against the dollar but declined
against European currencies. This mixed picture reflected several
factors, including a decline in Japanese interest rates as the
authorities responded to growing signs of an economic slowdown and
increased strains in domestic financial markets. As a result,
interest differentials on dollar/yen narrowed somewhat but widened
on yen/DM. Moreover, Japanese capital flows reversed from recent
years as financial institutions reduced their foreign exposure at a
time of increased strain in domestic financial markets. The sharp


-31-

explains the widening of the bilateral trade gap. Toys, sporting
goods, clothing, and footwear led the rapid growth in U.S. imports
from China. If these rates of growth were to continue throughout
1992, the bilateral gap would approach $17 billion by the end of
the year, compared to $12.7 billion in 1991.

The pattern of China's trade with other major trading partners
differed substantially. In the first 5 months of 1992, China's
trade surplus with the EC grew by 8 percent, after surging 78
percent in 1991. China's surplus with Japan fell 21 percent in
January-May 1992, while its surplus with Hong Kong rose 4 percent.
Thus, the expansion in the U.S. trade imbalance with China was very
large compared to the changes in China's trade balances with other
partners. The growth in Chinese exports to the U.S. was much
faster than export growth to other destinations, and the growth of
China's imports from the U.S. was slower than import growth from
other sources.

It is important to note that there are large discrepancies
between Chinese and U.S. trade data, including differences in
treatment of re-exports through Hong Kong and other countries.

(The United States counts Chinese exports through Hong Kong as
products of China if they are not substantially transformed in Hong
Kong or elsewhere, while China apparently does not include some
portion of these products in its export figures.) China itself
continues to claim a small trade deficit with the United States
through the first half of 1992. However, Chinese statistics reveal
trends in bilateral trade flows similar to those of U.S. data:
according to Chinese figures, exports to the United States rose 32
percent in the first half, while imports grew 21 percent.

In other economic developments, boosted by a renewed reform
drive beginning early in the year, China's real GNP grew at an
estimated annual rate of nearly 12 percent in the first half of
1992. Growth is likely to top 10 percent for all of 1992, greatly
exceeding the original target of 6 percent in the current Five-Year
Plan. Accelerated growth has raised concerns about renewed
inflation, although the rise in the retail price index (a weighted
average of administered, guided, and market prices) in the first
half of 1992 was running at only a 5 percent annual rate.

Exchange Rate System

China's administered exchange rate, set daily by the central
exchange authorities, generally applies to trade transactions under
the State Plan. There is also a second rate determined in foreign
exchange adjustment ("swap") centers, where joint ventures and
other enterprises with foreign participation, domestic entities
that are allowed to retain rights to their foreign exchange
earnings, and certain individuals may buy and sell foreign exchange
or foreign exchange quotas at rates established through a regulated
auction system. Outside the official dual rate system, there is a


- 28 -

trade surplus with the United States has increased in 1992,
reversing the reductions achieved in 1990 and again in 1991.
Taiwan's immense and growing foreign exchange reserves are
excessive, especially given the investment needs of the economy.
The existence of continued large external surpluses indicates a
continued need for substantial adjustment, and for significant
appreciation of the NT dollar to bring this adjustment about.

In the present context, the continuation of official actions
and controls that impede market adjustment of the exchange rate are
factors which are considered in the Treasury Department's
assessment of the adjustment process. In addition to official
action, the array of limitations on foreign exchange transactions
and capital flows is far too restrictive and impedes the full
operation of market forces in exchange rate determination. Given
the advanced state of economic development on Taiwan, and the oft-
stated desire of the authorities to develop Taipei as a regional
financial center, such limitations should be completely lifted.

As noted in Treasury's spring 1992 report, to encourage a
continued decline in Taiwan's overall surpluses and promptly effect
an appropriate adjustment in its bilateral trade surplus with the
United States, the authorities should take steps that would allow
the exchange rate to reflect fully market forces. Specifically,
they should cease direct and indirect intervention in the exchange
market for the purposes of dampening pressures for appreciation,
eliminate foreign exchange liabilities ceilings for foreign banks,
remove other limitations that restrict the scope of the forward
foreign exchange market, and reduce controls on capital inflows and
outflows, while making a commitment to phase out the controls
completely.

Financial Policy Talks

Taiwan's exchange rate policies are just one source of the
discriminatory treatment faced by foreign banks and securities
firms. The exchange rate negotiations with the authorities
initiated as a result of the spring 1992 report supplement ongoing
financial policy talks between the Treasury Department and Taiwan's
authorities under the auspices of the American Institute in Taiwan
and the Coordinating Council on North American Affairs. These
talks provide a forum for addressing specific market access
problems encountered by U.S. banks and securities firms in Taiwan,
and for encouraging Taiwan's authorities to undertake further
liberalization of its financial and exchange markets, and of
restrictions on capital flows.

Since the spring 1992 report, and following a round of
discussions in Taipei earlier in the year, Taiwan moved to allow
all banks, including foreign banks, to process credit card
transactions and to deal in short-term money market instruments.
These measures directly address concerns raised by the Treasury


-5-

The United Kingdom and Italy have both been successful in
reducing inflation thus far in 1992 compared with 1991. Inflation
in the United Kingdom is expected to fall on a year-over-year basis
from 5.9 percent in 1991 to 3.8 percent in 1992. Similarly,
inflation in Italy is expected to fall from 6.3 percent in 1991 to
5.6 percent in 1992. The IMF expects further small improvements in
1993, but the recent depreciation of the pound and lira against the
DM may increase import prices and limit further progress on the
inflation front. Inflation in Japan is expected to be a bit more
than a 2 percent rate in 1992 and 1993. Wages have been rising
slowly and land prices have been falling. Appreciation of the yen
has also had the effect of reducing the prices of imported goods.

External Account Developments

The most important recent development in the external accounts
of G-7 countries is the continuing sharp rise in Japan's trade and
current account surpluses (to a current account surplus of $110
billion for 1992 according to IMF projections). In the United
States there has been some leveling off in the reduction of the
current account deficit. For other G-7 countries, nothing dramatic
is anticipated. Germany's deficit should rise somewhat to about
$22 billion in 1992 and then fall by a substantial amount to about
$9 billion in 1993. The United Kingdom's deficit is expected to
deteriorate from $11 billion in 1991 to $19 billion in both 1992
and 1993, while the IMF forecast shows deterioration in Italy's
current account deficit to $25 billion in 1992 and $33 billion in
1993. However, the recent depreciations of the pound and lira vis-
a-vis the DM could alter these projections.

In 1991, the U.S. current account showed a deficit of $3.7
billion, down $87 billion from the 1990 result. Only about $45
billion of the decline reflected ordinary economic factors; the
remainder (about $42 billion) reflected Desert Storm-related
transfers. Without the transfers, the 1991 deficit would have been
about $46 billion. The merchandise trade and current account
deficits are likely to deteriorate this year, as higher growth
leads to a pickup in imports, and disappointing growth in Europe
and Japan limits export expansion.

Japan's current account surplus declined during the late
1980s, but this trend stopped in 1990, and the Japanese current
account surplus rose once again to nearly $73 billion in 1991.

The IMF projects that the surplus will reach about $110 billion in
1992. About 80 percent of the projected increase is due to a
growing trade surplus. Imports have not changed much in yen terms
since 1989, while exports, particularly to countries in Asia, have
grown rapidly. Total Japanese exports are expected to increase
nearly $25 billion in 1992. The surplus is not expected to change
much in 1993.


-4-

to strong growth, the IMF's October projection of 3.8 percent
growth for 1993 appears quite optimistic.

The greatest uncertainties are in Europe. Germany's economy
faltered in the second quarter after an aberrantly strong first
quarter. While consumption may respond positively to the removal
of the income tax surcharge last July, and some types of investment
~- especially in eastern Germany -- should show moderate growth,
growth in 1992 is projected by the IMF to reach 1.8 percent for
Germany as a whole. The Fund's forecast of 2.6 percent growth for
1993 assumes that current obstacles to strong recovery --
particularly high real interest rates -- will be overcome.

The United Kingdom apparently remains in recession; lower
interest rates and the September devaluation may not have much
impact until next year, and growth for 1992 is expected to be
negative (-0.8 percent). France should experience modest growth in
1993, but this economy will have to overcome the improved
competitiveness of goods produced in the U.K., Italian, and Spanish
economies, as well as the adverse effect of high domestic interest
rates.

Price Trends

Inflation has been declining in most G-7 countries, and should
continue to slow next year. The IMF projects a decline in
aggregate G-7 consumer price inflation from 4.3 percent in 1991 to
3.1 percent in 1992 and 3.2 percent in 1993. These will be the
best aggregate inflation rates since the late 1960s (excluding the
1986-88 period following the collapse of world petroleum prices),
and indicate a major improvement in economic performance after the
high inflation of the 1970s. Last year, France registered the
lowest inflation rate, with an increase of just 3.1 percent in
consumer prices. This year, Canada is likely to be most successful
in approaching practical price stability by limiting inflation to a
rate of only 1.6 percent.

The IMF projects consumer price inflation in the United States
of 3.1 percent in both 1992 and 1993, about the same as the Mid-
Session Budget Review estimates. Among other factors, availability
of manufacturing capacity, reasonably good productivity growth, and
low raw material prices have allowed output to grow while price
performance improves. Alone among the G-7 countries, Germany will
record higher year-over-year inflation in 1992 than in 1991, mainly
because of the impact of consumption tax increases that went into
effect in July 1991. Once the influence of these measures had been
eliminated from the CPI (in July 1992), inflation fell. Favorable
influences on Germany's medium-term outlook include the downward
impact on import prices of recent DM appreciation and a more
moderate pattern of wage settlements.


-17 -

PART V: ASTAN NEWLY INDUSTRIALIZED COUNTRIES
AND CHINA

Background

Under Section 3004 of the Omnibus Trade and Competitiveness
Act of 1988, the Secretary of the Treasury is required to
",.,..consider whether countries manipulate the rate of exchange
between their currency and the United States dollar for purposes of
preventing effective balance of payments adjustment or gaining
unfair competitive advantage in international trade. If the
Secretary considers that such manipulation is occurring with
respect to countries that (1) have material global current account
surpluses and (2) have significant bilateral trade surpluses with
the United States, the Secretary of the Treasury shall take action
to initiate negotiations...on an expedited basis...for the purpose
of ensuring that such countries regularly and promptly adjust the
rate of exchange between their currencies and the United States
dollar to permit effective balance of payments adjustments and to
eliminate the unfair advantage."

It was concluded in the October 1988 exchange rate report that
Taiwan and Korea "manipulated" their exchange rates, within the
meaning of the legislation. Pursuant to Section 3004, Treasury
initiated bilateral negotiations with Taiwan and Korea for the
purpose of ensuring that these two economies regularly and promptly
adjust the rate of exchange between their currencies and the U.S.
dollar to permit effective balance of payments adjustment and to
eliminate unfair competitive advantage.

Treasury concluded that Taiwan in fall 1989 and Korea in
spring 1990 were no longer directly "manipulating" their currencies
within the meaning of the legislation. These findings were
reaffirmed in fall 1990, spring 1991, and fall 1991. However, it
was noted that Taiwan's external surpluses remained large and that,
in both Taiwan and Korea, exchange rate policy would continue to
have an important role to play in promoting economic adjustment.

In addition, the reports concluded that, in Korea,
liberalization of remaining exchange and capital controls was
required to improve the functioning of the exchange markets and
assure the full operation of market forces in exchange rate
determination. In Taiwan, foreign exchange and capital controls
were cited as impediments to the operation of market forces in
exchange rate determination.

China's large external surpluses, including its growing
bilateral surplus with the United States, depreciation of the
renminbi, and administrative controls over foreign exchange
allocation and trade have led the Treasury Department to consider
the applicability of Section 3004 to China. The three reports from
fall 1990 to fall 1991 concluded that China's trade surplus with


-7-

this regard, Summit participants agreed on the importance of an
early conclusion to a successful Uruguay Round in order to
reinforce growth in the major economies as well as to support
reforming countries elsewhere in the world.

Actions have been taken to implement the new G-7 consensus and
strengthen the economic recovery. Japan has announced the largest
fiscal stimulus package in its history and Germany has cut interest
rates for the first time in five years. Reduced price pressures
and lower interest rates in a number of countries have established
the basis for a pick-up in investment and growth.

G-7 measures to increase growth occurred amid turmoil in
European exchange markets and disruptions in the EMS (see Part
III). At their September meeting, G-7 Ministers and Governors
expressed concern over the volatility in exchange markets and
agreed that recent measures to increase growth would foster greater
stability in exchange markets.

Recent events have demonstrated anew the consequences of
incompatible and inconsistent policies in an integrated world
economy with global financial markets. The fundamental premise of
the G-7 process has been reaffirmed, but there must be a continued
willingness to consider measures to improve economic policy
coordination in order to respond to the significant changes in the
world economy.

Global capital markets have undergone particularly significant
change. The speed and size of international capital flows have
grown enormously and the channels for their transmission have
increased in complexity with the development of new instruments and
technologies. As a result, foreign exchange transactions have
increased substantially -- to nearly $1 trillion daily according to
some estimates.

At the U.S. initiative, the Group of 10 is now considering the
implications of developments in international capital markets for
the exchange rate system and economic policy coordination. This
analysis will assist G-7 Finance Ministers leading up to the Tokyo
Summit as they examine methods of cooperation that will permit the
international monetary system to adapt to changing circumstances
while ensuring internationally responsible policies.


-23-

intervening directly in the exchange market, and the modest role of
other government-owned foreign exchange banks in the market.

Nonetheless, although the exchange rate determination system
in place in Korea is an improvement over the previous regime, it is
far from a truly market-determined one. In particular, Treasury
remains seriously concerned that pervasive foreign exchange and
capital controls significantly constrain supply and demand in the
currency market and provide the potential for manipulation.
Liberalization of these controls -- especially the "real demand"
rule for foreign exchange transactions -- is imperative to
strengthen the role of market forces in exchange rate determination
and in Korea's trade and investment flows. In this regard, the
extensive list of restricted foreign exchange transactions embodied
in the regulations implementing the revised FEMA is disappointing.

Therefore, in the period ahead, the Treasury Department will
continue to monitor developments in Korea's external accounts and
the operation of the MAR exchange rate system. The Department will
also continue to press for liberalization of Korea's financial,
capital, and exchange markets, as well as to seek improved
treatment for U.S. financial institutions in Korea.


DEPARTMENT OF THE TREASURY

REPORT TO THE CONGRESS
ON

INTERNATIONAL ECONOMIC AND EXCHANGE RATE POLICY

DECEMBER 1992


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Following the French referendum on September 20 approving the
Maastricht Treaty by a narrow margin, pressures in the EMS shifted
largely to the French franc. However, the French authorities were
successful in defusing the situation through increases in domestic
interest rates and large scale joint French-German intervention.
The relatively strong performance of the French economy in recent
years also contributed to the credibility of the authorities'
efforts to convince the markets that the current exchange rate was
sustainable. French market interest rates eased, and the French
were able to recover DM reserves spent defending the franc, in
subsequent weeks.

Subsequent to the September events, interest rates in Europe
declined somewhat as German and other European authorities
responded to growing evidence of the economic slowdown and as
exchange market pressures eased. The dollar has recovered some of
its earlier declines and, by the end of the reporting period, had
moved into a DM 1.45-1.50 range.


~“9 =|

rise in Japan's external surplus may also have provided underlying
support for the yen. Finally, the announcement of a fiscal
stimulus package and_ measures to prop up financial markets eased
pressure on the yen and contributed to some appreciation toward the
close of the reporting period.

European Currencies

European currencies appreciated steadily against the dollar
for most of the year. U.S. monetary easing to stimulate the
economy produced the lowest interest rates in more than 25 years.
In contrast, German interest rates rose to historically high levels
as the rising cost of German unification was financed primarily
through borrowing and monetary policy was tightened to deal with
the inflationary effects of increased public and private
expenditures. As a result, short-term dollar/DM interest rate
differentials widened to an unprecedented 6 3/4 percent. A similar
increase in interest differentials occurred with other European
currencies as they followed German monetary policies through most
of the period, despite weaker economic situations, in order to
maintain exchange rates under the EMS.

Initially, the exchange rate pressures within Europe were
contained as market participants believed that economic policies
and performance would converge under the requirements of the
Maastricht Treaty for economic and monetary unification. However,
the Danish vote rejecting Maastricht weakened this market view and
focused attention on the ability of governments to maintain EMS
exchange rates in the face of disparate economic conditions. As
uncertainties regarding the future of European unification
increased in the period leading up to the French referendum on the
treaty, speculative pressures intensified.

The authorities sought to combat these pressures through a
combination of large scale intervention, increases in interest
rates by countries whose currencies were under downward pressure,
and statements reaffirming the commitment to Maastricht, including
maintenance of the exchange rate arrangements. On September 14,
however, the Italian lira's bilateral central rate was devalued by
7 percent. At the same time, Germany reduced the Lombard rate by
1/4 percent. Nevertheless, the markets considered these actions
insufficient; massive speculative capital flows out of the lira and
into German marks continued and heavy selling pressures also
developed against the sterling. Despite very heavy intervention
and sharp interest rate rises, the U.K. authorities were forced to
suspend sterling from the EMS, and it subsequently depreciated by
more than 15 percent. The Italian lira was also suspended from the
EMS, and it depreciated by about 15 percent, while the Spanish
peseta's bilateral central rate was devalued by 5 percent but
remained in the EMS. In addition, Spain, Ireland, and Portugal
introduced temporary measures to restrict capital flows.


Table 1

ECONOMIC PERFORMANCE
OF MAJOR INDUSTRIAL COUNTRIES

I. Real GNP/GDP (percent change; annual average)

1991 1992 1993
United States 1.2 1.9 3.1
Japan 4.4 2.0 3.8
Germany* 0.9 1.8 2.6
France 1.2 2.2 2.7
United Kingdom 72.2 -0.8 2.1
Italy 1.4 1.3 1.5
Canada -1.7 2.1 4.4
Total G-7 0.6 1.7 3.0
IIT. Consumer Prices (percent change; annual average)
United States 4.3 3.1 3.1
Japan 3.3 2.2 2.4
Germany* 4.5 4.9 4.2
France 3.1 2.9 2.8
United Kingdom 5.9 3.8 3.0
Italy 6.3 5.6 5.1
Canada 5.6 1.6 2.0
Total G-7 4.3 3.3 3.2

IIL. Current Account ($ billions and percent of GDP)

United States -4f -35 -55
(0.1) (0.6) (0.9)
Japan 73 110 101
(2.2) (3.0) (2.6)
Germany* -20 _ 722 -9
(1.2) (1.1) (0.4)
France -6 -1 -0
(0.5) (0.1) (0.0)
United Kingdom -11 -19 -19
(1.1) (1.7) (1.6)
Italy -21 25 33
(1.8) (1.9) (2.4)
Canada 26 -20 -21
(4.3) (3.4) (3.3)

SOURCE: IMF World Economic Outlook. Comparable Administration
forecasts for 1992 U.S. growth and inflation are 2.0% and 3.0%
respectively, and for 1993, 3.0% and 3.2% respectively.

* All of Germany

t Reflects extraordinary Desert Storm receipts of $42 billion.


- 30 -
CHINA

China's substantial external surpluses remain a source of
serious concern. These surpluses result in large part from
pervasive administrative controls maintained by the Chinese
authorities on imports and on foreign exchange allocation. In
addition, balance of payments adjustment in China has been hindered
by an exchange rate system which encompasses a government-
determined official exchange rate and an exchange rate determined
in the nation's foreign exchange swap centers, where both the
supply of, and the demand for, foreign exchange are substantially
controlled by the government.

Since the spring 1992 report, the Treasury Department has
negotiated with the Chinese authorities on China's system for
determining foreign exchange rates and foreign exchange allocation.
The goal has been to seek a more market-oriented system and
exchange rate, and to promote significant adjustment in China's
overall external surplus and its bilateral trade surplus with the
United States.

Trade and Economic Developments

China's global trade and current account surpluses remain
large but have fallen from their record levels in 1990 and 1991.
According to Chinese data (which are not consistent with U.S. trade
data -- see below), the merchandise trade surplus in the first 9
months of 1992 fell to an estimated $5.4 billion from $6.1 billion
in the same period of last year. Imports increased 21 percent in
the January-September period, supported by higher economic growth
in China, while exports have also remained strong, rising some 17
percent. China's overall trade surplus for 1992 is expected to be
around $7 billion, compared to $8.7 billion in 1991.

China's current account surplus will likely remain large in
1992, although, in line with the smaller trade surplus, it is
expected to decline from its 1991 level of $13.8 billion. The
continuing surpluses have contributed to a build-up of China's
official reserves, which totaled about $47 billion, or about 8
months! import cover, in July of this year. China's large current
account surpluses have allowed China to meet its debt service
obligations. While debt service as a percentage of export earnings
has increased slightly in recent years, the ratio still remained a
modest 8.7 percent in 1991.

In contrast to the narrowing of the global trade gap, China's
bilateral trade surplus with the United States continues to grow at
a rapid pace. According to U.S. data, China's bilateral surplus in
the first 8 months of 1992 totaled $11.2 billion, an increase of 56
percent over the same period of 1991. A 41 percent surge in U.S.
imports from China, despite relatively slow U.S. growth, combined
with a slowdown to 15 percent in U.S. export growth to China,


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- 29 -

Department, and will expand the scope of opportunities available to
foreign banks in Taiwan. Nevertheless, U.S. financial services
firms continue to face significant denials of national treatment in
addition to the constraints imposed by Taiwan's controls on foreign
exchange transactions and capital flows. From a broader
perspective, Taiwan has approved several other measures that will
further modernize the financial sector. Foreign exchange licenses
are now available to a wider range of domestic banks, legislation
to establish a futures market has been approved by the Legislative
Yuan, and gold trading has been deregulated.


-6-

Between 1990 and 1991, there was strong shift in Germany's
external accounts from a current account surplus of $47 billion to
a deficit of $20 billion. This shift reflected the impact of
unification between an advanced industrial area in the west and a
much less advanced developing region (the former GDR) in the east.
The balance of payments consequences occurred in two phases.
Initially, exports of both east and west Germany fell, and imports
of both areas rose. The main factors were a diversion to the
eastern area of west German goods that might have been exported;
the collapse of east German exports to COMECON; and the substantial
transfers by west Germany that allowed east Germans to finance a
consumption boom. This situation persisted until the second
quarter of 1991, when policy changes were made that cut the growth
of imports and mildly stimulated exports. These policies are still
largely in place, and should produce a current account deficit of
about $22 billion in 1992 and a deficit of $9 billion in 1993.

The G-7 Response

Since 1991, the overriding U.S. priority in the G-7 has been
to build a consensus around a growth-oriented strategy designed to
assure a strong recovery, create jobs, and provide a supportive
global economic environment for the reforming countries of East
Europe, the former Soviet Union, and elsewhere.

U.S. efforts have been complicated, however, by divergent
economic conditions among the major economies. When the economic
slowdown took hold in the U.S., Canada, and the U.K. in the second
half of 1990, strong growth rates prevailed in Germany and Japan.
cyclical differences in economic performance gave way to broader
policy divergences as high German budget deficits associated with
unification costs and the Bundesbank's tight monetary policies
resulted in steadily rising German interest rates. The commitment
of other EC countries to the EMS required them to pursue high
interest rates in order to maintain fixed exchange rates -- despite
weakening economic conditions.

G-7 countries began to coalesce around the U.S. growth
strategy, however, as the downturn in economic growth persisted and
prospects for a strong recovery appeared increasingly uncertain.

At the Munich Summit, a new consensus on the priority of growth was
endorsed by Heads of State, who expressed particular concern over
the hardship created by unemployment and pledged to adopt policies
aimed at creating jobs and growth.

The new G-7 consensus was reflected in Munich Summit
guidelines committing countries to pursue sound fiscal and monetary
policies in order to create the scope for lower interest rates and
support for the upturn without rekindling inflation.

There was also agreement to reduce structural rigidities that
posed obstacles to private initiative and employment creation. In


- 20 -

Reflecting the rise in the external deficits, Korea's gross
and net debt figures rose in 1991. After declining steadily since
1985, Korea's gross external debt rose to $39.3 billion at the end
of 1991 (14 percent of GNP), from $31.7 billion at the end of 1990.
Net external debt reached $12.5 billion at the end of 1991, up from
$4.9 billion in 1990. However, the debt service ratio has fallen
significantly over the last 5 years, registering roughly 6 percent
in 1991, and is expected to decline further to 5 percent in 1992.

Reflecting the recent improvement in Korea's external
accounts, Korea's foreign exchange reserves have shown an upward
trend in recent months, rising from $13.7 billion at end~-1991 to
$15.2 billion at end-July 1992, representing 2.5 months of import
cover.

Exchange Market Developments

Under the "market average rate" (MAR) system of exchange
determination, introduced on March 2, 1990, the won/dollar exchange
rate at the beginning of each business day is equal to the weighted
average of transactions in the inter-bank market on the preceding
business day. Inter-bank and customer rates are allowed to float
freely within specified margins, which were expanded in September
1991 and in July 1992. Exchange rates between the won and third
currencies are set in accordance with dollar rates in international
currency markets. Foreign banks have accounted for a large share
of transactions in the inter-bank markets, generally between 40-60
percent of the total. Reportedly, the Bank of Korea has intervened
only occasionally in the market, and other government-owned banks
have accounted for only a small share of inter-bank activity.

Since the inception of the MAR system (through October 16,
1992), the won depreciated 12.8 percent in nominal terms against
the U.S. dollar. Most of the depreciation occurred over the second
half of 1991 and the first half of 1992, with the currency falling
only .8 percent against the dollar on a nominal basis since the
spring 1992 report. In the last four months the won has
appreciated slightly vis-a-vis the dollar due to improvements in
the current account, issuance of overseas bonds, and increased
capital inflows following the partial opening of the stock market
to foreign participation in early 1992.

Foreign Exchange and Capital Controls

The Korean authorities maintain a comprehensive array of
controls on foreign exchange and capital flows. These controls
prevent market forces of supply and demand from playing a fully
effective role in exchange rate determination, distort trade and
investment flows, and provide the Korean authorities with tools for
indirectly manipulating the exchange rate.


-37-

speed of market movements. A better understanding of these changes
and their implications is needed to provide policymakers a sound
basis for developing policies compatible with sustained global
growth.

At Secretary Brady's initiative, the G-10 will undertake a
study of global capital flows and their implications over the next
few months. This analysis will assist G-7 Finance Ministers
leading up to the Tokyo Summit to consider ways in which
cooperation might be intensified and obstacles to growth removed.

In addition to the major industrial countries, major trading
countries like Korea, Taiwan, and China have an important role to
play in promoting a healthy, open global economy and adjustment in
external imbalances. In this report, Treasury has reviewed the
foreign exchange and exchange rate policies of these countries and
has assessed whether they are manipulating their exchange rates,
within the meaning of Section 3004 of the Omnibus Trade and
Competitiveness Act of 1988, to prevent effective balance of
payments adjustment or gain unfair competitive advantage in
international trade.

Korea's current account has undergone substantial adjustment
since 1989, shifting from a surplus of 2.4 percent of GNP in 1989
to a deficit of 3.1 percent of GNP in 1991. Korea's trade deficit,
which reached $7 billion on a balance of payments basis (2.5
percent of GNP) at the end of 1991, is expected to shrink to $2.5
billion in 1992. Notably, first half export growth outpaced import
growth for the first time in four years. Korean authorities
anticipate external surpluses by mid-decade.

According to U.S. data, the U.S. bilateral trade deficit with
Korea in 1991 fell to $1.5 billion, down 63 percent from 1990. In
the first eight months of 1992, U.S. data showed a trade deficit
with Korea of $1.0 billion, compared to a deficit of $869 million
during the same period in 1991.

There is no basis at this time for the Treasury Department to
conclude under Section 3004 that Korea is manipulating its exchange
rate for purposes of preventing effective balance of payments
adjustments or gaining unfair competitive advantage in
international trade. This assessment is based on the following
factors: the continuance of significant global trade and current
deficits, the lack of evidence that the Bank of Korea is
intervening directly in the exchange market, and the modest role of
other government-owned foreign exchange banks in the market.

Nonetheless, although the exchange rate determination system
in place in Korea is an improvement over the previous regime, it is
far from a truly market-determined one. In particular, Treasury
remains seriously concerned that pervasive foreign exchange and
capital controls significantly constrain supply and demand in the
currency market and provide the potential for manipulation.


- 38 -

Liberalization of these controls -- especially the "real demand"
rule for foreign exchange transactions -- is imperative to
strengthen the role of market forces in exchange rate determination
and in Korea's trade and investment flows. In this regard, the
extensive list of restricted foreign exchange transactions embodied
in the regulations implementing the revised FEMA is disappointing.

Therefore, in the period ahead, the Treasury Department will
continue to monitor developments in Korea's external accounts and
the operation of the MAR exchange rate system. We will also
continue to press for liberalization of Korea's financial, capital,
and exchange markets, as well as to seek improved treatment for
U.S. financial institutions in Korea.

Some adjustment in Taiwan's overall trade and current account
imbalances appears likely this year. Data for the first half of
1992 show a decline of 27 percent in Taiwan's current account
surplus. However, Taiwan's bilateral trade surplus with the U.S.,
$9.8 billion in 1991, has increased in 1992, reversing the
reductions achieved in 1990 and again in 1991. Taiwan's immense
and growing foreign exchange reserves are excessive, especially
given the investment needs of the economy. The existence of
continued large external surpluses indicates a continued need for
substantial adjustment, and for significant appreciation of the NT
dollar to help achieve this adjustment.

It is Treasury's judgment that Taiwan is manipulating its
exchange rate within the meaning of Section 3004. In the context
of Taiwan's continued large overall trade and current account
surpluses, a large and increasing bilateral trade surplus with the
United States, and excessive foreign exchange reserves, continued
official action that directly interferes with the role of market
forces in exchange rate determination, such as direct and indirect
intervention in the foreign exchange market, must be viewed as an
effort by the authorities to inhibit effective balance of payments
adjustment.

Subsequent to the issuance of the spring 1992 report, the
Treasury Department has held two sessions of negotiations with the
Taiwan authorities to seek an end to practices that inhibit the
operation of market forces in exchange rate determination, capital
flows, and foreign exchange transactions, and that prevent
substantial appreciation of the NT dollar.

During these negotiations, the Taiwan authorities indicated
that they would review their practices and restrictions to assess
changes that might be necessary. However, Taiwan has not yet
committed to specific measures that would address fully the
concerns raised in the spring 1992 report.

As noted in Treasury's spring 1992 report, to encourage a
continued decline in Taiwan's overall surpluses and promptly effect
an appropriate adjustment in its bilateral trade surplus with the


- 26 -

by 11 percent, outpacing overall U.S. import growth, which is up
8.3 percent. As economic growth improves in the United States and
Europe in coming months, Taiwan's exports should continue to
perform well.

Nor has appreciation of the NT dollar led to a loss of jobs in
the domestic economy. With an unemployment rate under 2 percent,
the labor market remains tight, leading the authorities to permit
an increase in the number of foreign workers in Taiwan. Wages, on
average, are increasing by more than 10 percent annually. Taiwan's
continued competitiveness provides the monetary authorities with
sufficient scope to permit needed exchange rate adjustments without
spurring a decline in exports.

Exchange Rate System

Taiwan has instituted a number of measures over the past
several years to liberalize the exchange rate system and reduce
capital controls. Nevertheless, the system still does not allow
the full effect of market forces to be reflected in the exchange
rate. Although the rate for foreign exchange transactions is
freely determined between buyers and sellers, an array of official
practices and restrictions remains which serves to resist pressures
for appreciation generated by underlying economic fundamentals.

The Central Bank continues to resist pressure for appreciation by
intervening in exchange markets directly and indirectly, setting
ceilings on the foreign exchange liabilities of foreign banks,
limiting the operation of the forward foreign exchange market, and
regulating capital flows. With economic fundamentals enhancing the
stability of Taiwan's markets, the utility of these various
controls and restrictions appears questionable.

The Central Bank needs to increase the transparency of its
operations if it wishes to disprove the widespread view that it
intervenes in the market directly and through proxies (such as
local banks), or that it has on occasion attempted to control the
timing of large-scale NT dollar purchases by local market
participants in order to dampen pressures for appreciation. In
this regard, it appears that the monetary authorities continued to
limit appreciation of the NT dollar on a number of occasions
between the spring 1992 report and mid-July.

As noted earlier, a number of restrictions severely constrain
forward foreign exchange trading and the scope of the forward
foreign exchange market, and thus serve to limit the role of market
forces in exchange rate determination. Most importantly, foreign
exchange Liabilities ceilings, which vary from bank to bank, still
affect forward trading, and constrain the ability of foreign
branches to offer foreign currency loans in Taiwan and to use swap
funding for local currency lending. In place of the quantitative
limits imposed by these ceilings, prudential concerns in this area
could be addressed through other means, such as through risk-based


PART IT: ECONOMIC POLICY COORDINATION
AND THE ECONOMIC SITUATION IN THE INDUSTRIAL COUNTRIES

The increased integration of the world economy has
significantly reduced the economic independence of even the largest
economies and reaffirmed the importance of a strong economic policy
coordination process. A sound world economy requires that the
major countries work closely to formulate compatible policies
necessary for sustained growth with low inflation, sustainable
external imbalances, and greater stability of exchange markets.

The coordination process was intensified in the mid-1980s in
response to divergent economic performances among the major
economies which had resulted in growing external imbalances,
substantial dislocations in the U.S. manufacturing sector, and
rising protectionist pressures. Beginning with the 1985 Plaza
Agreement, the major countries agreed on policy actions to address
these problems and to facilitate balance of payments adjustment and
economic growth.

The broad agreement on policy directions achieved by the G-7
countries through the late 1980s contributed to the longest
peacetime expansion in the post-war period, reductions in external
imbalances, and increased stability in exchange markets.

In the 1990s, however, divergent economic conditions have
emerged and the historic changes in East Europe, the former Soviet
Union, and elsewhere resulted in a loss of consensus on economic
policy priorities. In the United States, declining price pressures
and concern over rising unemployment led authorities to ease
monetary policy and lower interest rates. At the same time,
Germany's mounting unification costs coupled with the Bundesbank's
adherence to price stability goals led to a tight monetary policy
and higher interest rates. Under the fixed exchange rates of the
European Monetary System (EMS), high German interest rates were
transmitted throughout Europe -- at a time of slowing growth.

The resulting disparity in interest rates in Europe and the
United States contributed to strong exchange rate pressures. These
pressures were especially acute in Europe where authorities
struggled to maintain fixed exchange rates despite divergent
economic conditions.

Thus, the challenges confronting G-7 policymakers have been to
1) achieve a new policy consensus oriented toward growth and 2)
strengthen the coordination process to respond to changes in the
international economy. Below is a description of the current
economic situation and prospects in the major countries and the
G-7's response.


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Table 2

Dollar Exchange Rates
vs. G-7 Currencies
At Key Dates
(units per dollar)

e

Value of the Dollar Plaza Louvre Year Previous Dollar Current
Dollar in Peak Accord Accord Since Report Lows Report
Terms of: 2/26/85 9/20/85 2/20/87 10/18/91 4/17/92 9/2/92 10/15/92
Japanese yen 261.55 241.00 153.60 130.02 133.88 122.20 120.60
German mark 3.4730 2.8575 1.8272 1.6928 1.6682 1.3865 1.4505
British pound 0.9606 0.7326 0.6542 0.5813 0.5726 0.4980 0.5882
French franc 10.6100 8.7150 6.0860 5.7668 5.6400 4.7380 4.9455
Italian lira 2169.50 1924.00 1299.00 1265.55 1254.50 1063.00 1287.50

Canadian dollar 1.4043 1.3763 1.3282 1.1286 1.1818 1.1952 1.2488

Measurements of Dollar Movements
Vs. G-7 Currencies
Percent Appreciation (+) or Depreciation (-)
(through 10/15/92)

Since Since Since Over Since Since
Value of the Dollar Plaza Louvre Year Previous Dollar
Dollar in Peak Accord Accord Since Report Low

Terms of: 2/26/85 9/20/85 2/20/87 10/18/91 4/17/92 9/2/92

Japanese yen -53.9% -50.0% ~-21.5%  ~-7.2% “9.9% -1.3%
German mark ~58.2% -49.2% -20.6% -14.3%  ~-13.0% 4.6%
British pound -38.8% -19.7% ~-10.1% 1.2% 2.7% 18.1%
French franc 53.4% ~-43.3% -18.7% -14.2% 12.38% 4.4%
Italian lira -40.7% -33.1%  -0.9% 1.7% 2.6% 21.1%
Canadian dollar “11.1%  -9.3%  ~-6.0% 10.7% 5.7% 4.5%

Source: New York 9:00 a.m. exchange rates


-13-

acquire substantial amounts of foreign assets in 1992, in the form
of both portfolio and direct investments. Capital outflows in
these two categories totalled $86 billion at an annual rate during
the first half of 1992, compared with $72 billion for 1991.

There was a strong recovery of foreign private investment in
the U.S. in the second quarter of this year, particularly purchases
of U.S. securities. Foreign direct investment inflows, which
showed a mixed pattern in 1991, also picked up somewhat in the
second quarter but remain well below the very high annual levels of
1987-90. There were very substantial (over $21 billion per
quarter) inflows of official capital in the first half of 1992.

Prospects for Full-Year 1992 and 1993

Trade balance: The trade deficit for full-year 1992 is
expected to reflect the modest trend of deterioration noted above,
beginning in mid-1991. Imports should continue to show modest
growth, while exports are likely to remain weak. The net result is
expected to be an increase in the trade deficit on the order of $20
billion, to the $95 billion range.

This contrasts with the projection in the previous Report of a
modest further decline in the deficit. The principal difference is
a less buoyant outlook for exports -- despite a continued strong
U.S. competitive position -- in light of weaker demand than
previously foreseen in Europe and Japan. (The lower dollar, if
sustained, would have significant effects on exports only in the
latter part of 1993, due to lags in the responses of prices and
volumes.) Expected weak demand in foreign markets coincides with
a revival, albeit gradual, in U.S. import demand.

Current account balance: The 1992 current account deficit
will show a substantial increase from the recorded 1991 figure of
$4 billion, which included $42 billion in one-time transfers from
foreign governments in support of Desert Storm. There should also
be some deterioration in the 1992 current account deficit, compared
with the 1991 figure of $46 billion excluding Desert Storm -- a
more appropriate basis for comparison. The deteriorating trade
balance will be only partially offset by the strong positive trend
of recent years in services receipts, where the U.S. is a
competitive supplier of a range of activities such as tourism,
financial services, and advanced education.

Investment income may show a modest decline from 1991, since
the favorable effects of the U.S.-foreign interest rate
differential (lower U.S. rates mean smaller payments on foreign
assets in the U.S., and vice versa) may be offset by the cyclical
effects on direct investment income. (The income of foreign
investors in the U.S. tends to rise with domestic business profits.
Hence a U.S. economic recovery is likely to increase investment


-15-

stimulus, for example, should help shift the engine for growth in
that country from rising exports to increased internal demand.

Third, G-7 measures to increase growth are expected to
contribute to greater exchange rate stability. In this context,
the dollar's value has been reasonably stable in recent years and
broadly consistent with a competitive U.S. position.

To be sure, the dampening of export growth rates achieved in
recent years will be felt. Between 1987 and 1991, the increase in
net exports of goods and services accounted for 40 percent of U.S.
GDP growth and played a critical role in U.S. job creation. For
these reasons, the U.S. assigns critical importance to ensuring
that G-7 efforts to strengthen the global economic recovery take
hold. At the same time, the United States must take actions
domestically to remove impediments to growth and to support
continued progress in reducing external imbalances.

Issues Regarding Medium-Term U.S. Balance of Payments Performance

The U.S. current account mirrors the continued imbalance
between U.S. national savings and investment. This internal
imbalance and U.S. economic performance more broadly give rise to a
number of issues, including the sustainability of the U.S. external
position and measures to improve national savings.

The decline in the U.S. current account deficit in 1991
(abstracting out Desert Storm inflows) was associated with a sharp
drop in private investment (equal to 1-3/4 percent of GDP). At the
same time, the modest increase in personal savings was more than
offset by the increase in federal government dissavings. Over the
medium term, the IMF projects U.S. current account deficits
widening somewhat to 1-1/2 percent of GDP, but stresses that
policies to improve national savings would contribute to a
reduction in the current account deficit.

U.S. economic policies and their implications are reviewed
annually in Article IV consultations by the International Monetary
Fund. During the most recent review, the IMF noted the likelihood
of a strengthening U.S. recovery, but emphasized that medium-term
prospects depended importantly on improvements in national savings
performance -~ particularly regarding the U.S. budget deficit. The
Fund believes that the deterioration in the U.S. fiscal position
along with forecasts of high budget deficits over the medium-term
have major implications for the health and durability of the
economic recovery, domestic investment, and the U.S. current
account.

The IMF's heavy emphasis on restoring U.S. fiscal balances in
the short-term has led it to prescribe a number of revenue and
spending measures to close the budget gap. On the revenue side
these include energy taxes, value added taxes, and the elimination


PART I: INTRODUCTION

Section 3005 of the Omnibus Trade and Competitiveness Act of
1988 (Pub. L. 100-418) requires the Secretary of the Treasury to
submit to the Committee on Banking, Housing, and Urban Affairs of
the Senate and Committee on Banking, Finance and Urban Affairs of
the House of Representatives an annual report each October 15 on
international economic policy, including exchange rate policy.
In addition, Section 3005 requires the Secretary to provide a
written update of developments six months after the initial
report. This is the fifth annual report submitted to Congress.

Part II of this report reviews the economic situation in the
industrial countries and efforts by major countries to coordinate
economic policies. Part III analyzes developments in the foreign
exchange markets, including the dollar's movement relative to the
currencies of major trading partners and U.S. foreign exchange
market intervention. Part IV examines the U.S. balance of
payments situation and assesses issues related to the U.S.
economic and balance of payments situation. Part V, prepared
pursuant to Section 3004 of the Omnibus Trade and Competitiveness
Act of 1988, considers whether countries manipulate the rate of
exchange between their currencies and the U.S. dollar within the
meaning of the legislation. In this connection, a status report
on developments in Taiwan, Korea, and China is provided. The
final part provides conclusions on the principal issues discussed
in the report.


-~ 36 -

PART VI: CONCLUSIONS

Over the past year, the United States has successfully
achieved a global consensus to strengthen the world economy.
Significant measures are now being implemented to ensure the
economic recovery underway gathers strength. At the same time, the
U.S. is initiating a review of developments in international
capital markets with a view toward considering ways to improve
economic policy coordination.

A number of positive developments have begun to emerge in the
major economies. In the United States, which has experienced six
successive quarters of expansion, inflation and short-term interest
rates are at their lowest levels in 25 years, providing a solid
foundation for a pick-up in investment and growth. Interest rates
have been reduced in other major countries, and the scope for
further reductions appears to exist. Recent cuts in German
interest rates represent a significant shift in direction that
could lead to lower rates throughout Europe, stimulating economic
activity in major U.S. export markets.

Japan's announcement of a large fiscal stimulus is a welcomed
step toward reinvigorating growth in that country while providing a
basis for a reduction in its external surplus.

These efforts are steps in the right direction, but more must
be done to assure the recovery gathers strength. A sound and
growing world economy is necessary to create new jobs and economic
opportunity in the major economies and to support the historic
movement to free markets and democracy taking place around the
world. Recent events highlighting the interdependent and rapidly
changing nature of the world economy confirm the need to strengthen
economic policy coordination.

The G-7 process has achieved some considerable successes. In
the latter part of the 1980s, it played a central role in reducing
divergences in policy and performances among the major economies.
As a result, economic expansion was sustained over an extended
period, external imbalances were reduced, price stability was
restored, and exchange markets became more stable.

More recently, the G-7 has achieved a new consensus on
reducing policy differences that have inhibited growth. Solid
measures are being implemented to fulfill the commitment of the
Munich Summit to higher growth and job creation.

Changes in the world economy will require further con-
sideration of ways to ensure strong economic policy coordination in
response to evolving developments and new challenges. As recent
events have made clear, global capital markets have grown
increasingly large, complex, and integrated. New instruments and
channels for capital flows have greatly expanded the scope and


- 24 -
TAIWAN

The Treasury Department continues to be seriously concerned
about the lack of appreciable adjustment in Taiwan's continued
large bilateral trade surplus with the United States. While
Taiwan's overall trade and current account imbalances have declined
during 1992, its bilateral trade surplus with the United States has
increased. Many factors of course contribute to the persistent
surplus that Taiwan has run with the United States during the past
several years. Similarly, as trade barriers in Taiwan have been
modified, it would be expected that market forces would play a
significant role in correcting the bilateral trade imbalance,
including appropriate movement in the exchange rate. However, the
exchange rate has regrettably played only a limited role in the
external adjustment process. The exchange rate does not fully
reflect forces of supply and demand, as appreciation clearly seems
to be impeded by limitations on capital flows and on foreign
exchange transactions.

In the Treasury Department's judgement, intermittent central
bank intervention in the exchange market to dampen the rate of
appreciation and smooth out exchange rate movements have served to
further constrain demand for the New Taiwan (NT) dollar. This
combination of official practices and restrictions contributes
directly to Taiwan's efforts to generate the trade surpluses it
views as essential for reserve accumulation and impedes adjustment
of the bilateral trade imbalance.

Trade and Economic Developments

After declining in 1990, Taiwan's overall external surpluses
rose in 1991. According to its data, Taiwan's overall trade
surplus for 1991 increased to $13.3 billion, a 6.4 percent increase
ever 1990. Taiwan's global current account surplus increased by
11.6 percent in 1991 to $12.0 billion, and remained at 6.7 percent
of GNP. Taiwan's bilateral trade balance with the United States
declined at a modest pace in 1991. According to U.S. statistics,
the U.S. trade deficit with Taiwan in 1991 was, at $9.8 billion,
11.9 percent lower than in 1990.

Taiwan's trade surplus with the United States has increased in
1992, as foreseen in the spring 1992 report. U.S. data indicate
that the bilateral trade surplus increased 12.0 percent to $6.7
billion in the first 8 months of 1992, compared to $6.0 billion in
the corresponding period in 1991. This has occurred despite slow
growth in the U.S. economy, the ongoing relocation of Taiwan's
labor-intensive export industries overseas, and rising wages and
production costs and continued inflationary pressures in Taiwan.

Taiwan's official foreign exchange reserves, already the
world's largest, increased significantly over the last year to
reach $89.5 billion at the end of September 1992 (sufficient to


Part I

Part IT

Part III
Part IV

Part V

Part VI

Appendix:

TABLE OF CONTENTS

Introduction

Economic Policy Coordination and the Economic
Situation in the Industrial Countries

Developments in Foreign Exchange Markets
U.S. Balance of Payments and Associated Issues

Asian Newly Industrialized Economies (NIEs) and
China

- Korea
- Taiwan
- China
Conclusion

Tables and Charts


-32-

black market for foreign exchange, which is apparently diminishing
in significance but is still sizable.

The authorities use a variety of means to control the
allocation of foreign exchange under the dual rate system. Foreign
exchange earned by a state enterprise must initially be surrendered
to the Bank of China in exchange for local currency at the
administered rate. After each sale, the government gives the
enterprise a foreign exchange quota according to a retention ratio
determined by the government. Retention ratios vary greatly among
regions, firms, and products. Domestic firms are permitted to
trade only retention quotas among themselves rather than foreign
exchange itself.

The authorities also restrict access to the nation's swap
centers for prospective buyers and sellers of foreign exchange.
Foreign exchange may be purchased in the swap centers only for the
importation of goods deemed by the state to be "necessary" for
China's development. Swap center purchases of foreign exchange for
non—trade-related foreign exchange transactions are restricted.

And foreign exchange flows among swap centers in different parts of
the country are limited.

These controls on the demand for, and supply of, foreign
exchange in the swap centers clearly affect the swap rate itself,
which therefore cannot be called a market-determined exchange rate.
Moreover, the authorities are positioned to influence the swap rate
more directly by intervening in the market or shutting down trading
if fluctuations in the rate extend beyond set bands.

For a more detailed description of China's dual exchange rate
system, see Treasury's fall 1991 exchange rate report.

Exchange Rate Developments

Administered Rate: On October 16, 1992, the official rate of
the renminbi stood at 5.55 yuan to the U.S. dollar. This
represents a nominal depreciation against the dollar of roughly 5
percent since the adoption of the "managed float" system in April
1991. However, since the start of this year, the Chinese
authorities have held the official rate within a relatively narrow
range, generally between 5.45 and 5.55 yuan per dollar.

Swap Rates: For the week ending October 17, 1992, the average
swap center rate stood at 6.91 yuan per U.S. dollar. This
represents a depreciation of some 20 percent since the start of the
year. Swap rates began to depreciate briskly in the spring, as
demand for foreign exchange -- boosted by the domestic expansion
and resulting growth in imports -- greatly outstripped supply. The
depreciation slowed somewhat in September as state enterprises
began to supply more foreign exchange to the swap centers and as
demand for imports eased slightly.


-41-
APPENDIX

TABLES AND CHART

Economic Performance of Key Industrial Countries
Measurements of Dollar Movements Versus G-7 Countries
Summary of U.S. Current Account

Summary of U.S. Capital Account Flows

Asian NIEs and China: Trade and Currency Changes

Chart: Real Trade-Weighted Exchange Rate Indices for the
Dollar, Yen, and DM


-27 =

capital requirements that apply to the financial institution as a
whole.

The scope of the forward foreign exchange market is further
restricted by a number of rules that prohibit transactions for non-
trade-related purposes, limit trading to authorized banks, impose a
sizeable deposit guarantee, and limit the maximum forward period to
180 days. These restrictions have a particularly adverse effect on
foreign banks and securities firms both in and outside of Taiwan,
as they are prevented from hedging capital in the onshore market.

Until October 1992, Taiwan restricted annual non-trade-related
capital inflows and outflows to $3 million per firm or individual
(capital flows for trade purposes are unlimited). On October 9,
the limit was raised to $5 million, a welcome but marginal
improvement. Taiwan also limits the amount of cash an individual
can carry in and out of Taiwan (NT$40,000 or about $1,600).

Restrictions imposed by the Central Bank have hindered the
ability of foreign institutional investors to make investments in
Taiwan. (In recognition of the strong long-term prospects of
Taiwan's economy, foreign institutional investors wish to make
long-term and large~scale investments in NT dollar-denominated
financial instruments.)

Assessment

It is Treasury's judgment that Taiwan is manipulating its
exchange rate within the meaning of Section 3004. In the context
of Taiwan's continued large overall trade and current account
surpluses, a large and increasing bilateral trade surplus with the
United States, and excessive foreign exchange reserves, continued
official action that directly interferes with the role of market
forces in exchange rate determination, such as direct and indirect
intervention in the foreign exchange market, must be viewed as an
effort by the authorities to inhibit effective balance of payments
adjustment.

Subsequent to issuance of the spring 1992 report, the Treasury
Department has held two sessions of negotiations with the Taiwan
authorities to seek an end to practices that inhibit the operation
of market forces in exchange rate determination, capital flows, and
foreign exchange transactions, as well as substantial appreciation
of the NT dollar. During these negotiations, the Taiwan
authorities provided indications that they would review their
practices and restrictions to assess changes that might be
necessary. However, Taiwan has not yet committed to specific
measures that would address fully the concerns raised in the spring
1992 report.

Some adjustment in Taiwan's overall trade and current account
imbalances appears likely this year. However, Taiwan's bilateral


-i11-

PART IV: U.S. BALANCE OF PAYMENTS

Medium-Term Overview

The U.S. trade and current accounts have experienced very wide
swings since the early 1980s. From a modest deficit on trade ($25
billion) and near balance on the current account in 1980, both
balances had moved into deep deficits (in the $160 billion range)
by 1987. Subsequently, both deficits turned course and have been
on a declining path, at least until quite recently.

The major factors in both episodes were relative growth in the
U.S. and major markets, and the exchange rate. During the 1980-87
period of increasing external deficits, U.S. growth outpaced that
of our major trading partners and the dollar appreciated
substantially. U.S. exports stagnated, while import growth was
robust. Since 1988, U.S. growth has slowed substantially while
Europe and Japan -~ until recently -- experienced strong,
investment-led growth as did the Asian newly industrialized
economies. At the same time, the dollar depreciated, returning to
roughly its 1980 level on a trade-weighted basis. Export growth
rebounded dramatically, while import growth moderated.

Recent developments, and the outlook for the trade and current
accounts, will continue to depend heavily on these factors. In
particular, the recent weakness in demand growth in Europe and
Japan has begun to be reflected in weaker U.S. export performance.
(In addition to the exchange rate, price competitiveness of U.S.
exports will depend on the relative inflation performance of the
United States and the ability of U.S. firms to continue to enhance
competitiveness in terms of both price and quality.)

Developments in 1992

Trade balance: The U.S. trade deficit in the first half of
1992 (balance of payments basis, seasonally adjusted) was $83.3
billion at an annual rate, up from $77.4 billion in the second half
of last year and $73.4 billion for the year as a whole. This
modest deterioration, which apparently began during the course of
1991, represents a reversal of the downward trend which began in
1987 and lasted for roughly four years.

First half 1992 exports (unless otherwise indicated, all data
are seasonally adjusted on a balance of payments basis) reached
$431 billion at an annual rate, up about $15 billion or 3.6% from
the full year 1991. However, the year-over-year increase reflects
growth early in 1991 -- exports have been "stuck" at just under
$108 billion for three quarters, and this apparent flattening-out
is confirmed by the most recent monthly data. Strong export
growth, which averaged roughly 13-1/2% per year in value terms


- 14 -

income payments to foreigners, while sluggish activity abroad will
act as a drag on earnings of foreign investments of U.S. firms.)

For 1993, the cyclical factors influencing the trade deficit
will continue to generate a modest negative trend, with imports
responding to a continued U.S. expansion while foreign demand
growth remains subdued. As a result, the trade deficit could
exceed $100 billion in 1993 unless exports pick up more strongly
than now foreseen.

This further increase in the trade deficit will be only
partially offset by the growing surplus on services transactions.
In addition, the underlying trend in net investment income is
negative due to the growing net U.S. indebtedness resulting from
sustained current account deficits. While a higher rate of return
on U.S. foreign direct investment may continue for a time, foreign
investments in the U.S. should close the gap as they mature.

At the same time, the U.S.-foreign interest differential,
presently favoring the U.S. (i.e., interest rates earned on foreign
assets in the U.S. are low, while those paid on foreign holdings of
U.S. investors are high), should narrow. Thus the medium-term
outlook is for further declines in net investment income, as rates
of return on foreign investments in the U.S. increase relative to
those we earn on our investments abroad. The net effect for 1993
is expected to be a further increase in the current account
deficit, to the $70 billion range.

Analysis of the U.S. External Deficit

U.S. external competitiveness remains fundamentally sound
despite the slowdown in overseas markets and the resulting dip in
U.S. export performance. In contrast to the first half of the
1980s, when U.S. exports were declining as the dollar steadily.
appreciated against other major currencies, the modest
deterioration expected in U.S. current account balances over the
next year is likely to be attributed almost entirely to a rise in
imports. Export performance is expected to flatten out, but a
variety of factors point to the sector's overall resilience.

First, the U.S. competitive position as indicated by a variety
of measures (e.g., U.S. relative unit labor costs, the relative
unit price of exports, and real effective exchange rates) has
improved substantially since the mid-1980s. These factors and
possibly others, such as changes in relative capital costs, will
continue to benefit U.S. exporters. In addition, U.S. performance
on services continues to demonstrate considerable long-run
strength.

Second, the new G-7 consensus on growth-oriented policies and
the implementation of measures in that direction auger well for
further progress in reducing external imbalances. Japan's fiscal