Report to Congress on

International Economic and Exchange Rate Policies

April 2004

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

policy, focusing on the second half of 2003. The report is required under the Omnibus Trade and 

Competitiveness Act of 1988, which states that: “The Secretary of the Treasury shall analyze on 

an annual basis the exchange rate policies of foreign countries, in consultation with the 

International Monetary Fund, and consider whether countries manipulate the rate of exchange 

between their currency and the United States dollar for purposes of preventing effective balance 

of payments adjustments or gaining unfair competitive advantage in international trade.” 

For the purpose of assessing whether an economy is satisfying the terms of the Act, Treasury has 

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

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

developments, the state of institutional development, and financial and exchange restrictions. 

Isolated developments in any area do not typically provide sufficient grounds to conclude that 

exchange rates are being manipulated under the terms of the Act. A combination of factors, on 

the other hand, can and has in the past led Treasury to find that certain countries had satisfied the 

terms of the Act. 

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

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

Eurasia, (3) Africa, (4) the Middle East and South Asia, and (5) East Asia. To summarize, the 

report finds that: 

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

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

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

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

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

• A notable trend observed over the past several years is the move by many economies to adopt 

flexible exchange rates, combined with clear price stability goals and a transparent system for 

adjusting monetary policy instruments.

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

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

during the second half of 2003. The report notes that while a number of economies continue 

to use pegged exchange rates and/or intervene in foreign exchange markets, a peg or 

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

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

conclusions. The Administration strongly believes that a system of flexible, market-based 

exchange rates is best for major trading partners of the United States.
2

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

and multilateral discussions, policies for large economies that promote a flexible marketbased exchange rate combined with a clear price stability goal and a transparent system for 

adjusting policy instruments. In this light, the communiqué of the G7 Finance Ministers and 

Central Bank Governors in February of this year stated: “...that more flexibility in exchange 

rates is desirable for major countries or economic areas that lack such flexibility to promote 

smooth and widespread adjustments in the international financial system, based on market 

mechanisms.” 

The United States International Accounts

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

increasing levels of domestic U.S. capital formation. Perceived high rates of return on U.S. 

assets, based on strong productivity growth relative to the rest of the world, combined with an 

efficient U.S. capital market to attract foreign investment. This helped finance U.S. investment 

and worked to increase the current account deficit. 

The current account deficit is conceptually equal to the gap between investment and saving as a 

matter of international accounting. When investment in the United States is higher than 

domestic saving, foreigners make up the difference, and the United States has a current account 

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

account surplus as its people invest abroad. 

In the second half of 2003, for example, the U.S. current account deficit was $503 billion (at a 

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

basis) or 4.5% percent of GDP. This $503 billion deficit equaled the gap between $2,079 billion 

in investment and $1,575 billion in saving1. That is, U.S. domestic investment was $503 billion 

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

Viewed in these terms, the $55 billion increase in the U.S. current account deficit in 2003, 

measured on a NIPA basis, was caused by a $91 billion increase in investment outstripping a $36 

billion increase in saving. The increase in investment was a key factor in the acceleration in U.S. 

economic growth during 2003. Overall, real GDP grew at an 8.2 % annual rate in the third 

quarter and 4.1% in the fourth. Consumer spending increased sharply, but growth became more 

balanced over the second half as business investment in equipment and software increased at 

double-digit rates.

The current account was $526 billion in deficit (at a seasonally adjusted annual rate and on a 

balance of payments basis2) in the second half of 2003. How has the deficit been financed? The 

largest single balance of payments component financing the current account deficit has recently 

been net private foreign purchases of U.S. securities, which reached $335 billion in the second 

half of 2003. (Included in these were net private foreign purchases of U.S Treasuries amounting 

 

1

 Including the relatively small statistical discrepancy.

2

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

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

income and product accounts.
3

to $141 billion.) In addition, foreign official institutions increased their U.S. assets by $219 

billion. 

Viewed over a longer period, the U.S. current account deficit rose, as a percent of GDP, from the 

first quarter of 1991 to reach a temporary peak of 4.4% in the fourth quarter of 2000 before 

beginning to contract as domestic and foreign activity weakened. The current account deficit 

began to widen again in the first quarter of 2002 with the recovery of the U.S. economy although 

it appears to have reached at least a temporary plateau, in the neighborhood of 5% of GDP, over 

the last seven quarters.

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

investment valued at the current stock market value of owners’ equity) fell to a negative $2.6 

trillion as of December 31, 2002, the latest date for which data are available, from a negative 

$2.3 trillion at the end of 2001. Despite a large negative position, U.S. residents earned $22 

billion more on their foreign investments in 2003 than foreigners earned on their U.S. 

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

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

The U.S. Dollar 

The Federal Reserve Board’s “broad” nominal dollar index declined 3.9% during the second half 

of 2003. The dollar declined 7.9% against the “major” foreign currencies (the currencies of 

seven industrialized economies) while rising 1.2% against “other important trading partners” 

(largely currencies of emerging market economies). The broad index declined 12.9% from 

February 27, 2002, when it reached its recent peak, through December 31, 2003. 

Inflation remained subdued during this period. The consumer price index rose 1.9% over the 12 

months of 2003 and the core inflation rate (excluding food and energy items) was 1.1%, the 

smallest increase in core consumer prices since 1966. The Federal Reserve has held the target 

federal funds rate at 1.0% since June. 

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

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

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

not intervene in foreign exchange markets during the second half of 2003.

Western Hemisphere

Interest rate spreads between the Latin American component of the JPMorgan Emerging Markets 

Bond Index (EMBI+) and U.S. Treasury securities continued their downward trend, falling from 

662 basis points at the end of June 2003 to 518 basis points by year end. The Latin American 

economies appear to be undergoing a recovery, with regional real GDP growth estimated at 

around 1.5% in 2003. The region’s current account turned to an estimated surplus of 0.2% of 

GDP in 2003. Canada’s economy slowed in 2003 with real GDP growth of 1.7%, while its 

current account remained relatively unchanged at a surplus of 2.1% of GDP. 
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Argentina

Argentina abandoned its convertibility law, which pegged the peso one-to-one with the U.S. 

dollar, at the end of 2001 and has had a flexible exchange rate since that time. Argentina’s 

currency remained relatively steady in the second half of 2003, depreciating 4% from 2.81 pesos 

per dollar to 2.93 pesos per dollar. Argentina’s trade surplus was $7.2 billion in the second half 

of 2003, with the value of exports rising 12% and the value of imports rising 68% compared with 

the same period the previous year. Argentina’s bilateral trade surplus with the United States was 

$226 million during the second half of 2003. Argentina’s gross foreign exchange reserves grew 

$1.9 billion during the second half of the year to $14.1 billion at the end of December as 

Argentina purchased foreign currency during periods of peso strengthening to rebuild reserves. 

The economic recovery continued after the severe contraction in the first half of 2002, with real 

GDP growing at an annual rate of over 10% in the fourth quarter of 2003. Consumer prices 

were nearly stable, with an increase of 1.6% from end-June 2003 to end-December 2003.

Brazil

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

policy. Following a 35% nominal depreciation in 2002, and a 24% nominal appreciation in the 

first half of 2003, the real depreciated 2% in the second half of 2003 and ended the year at 

BRL2.89/US$. Market sentiment continued to improve and Brazil’s sovereign risk, as measured 

by the Brazilian component of the EMBI+, declined 325 basis points in the second half of the 

year to 463 basis points over U.S. Treasuries at year-end. Monetary tightening in the fourth 

quarter of 2002 and the first half of 2003 helped lower inflation in the second half of 2003; year 

on year inflation through December fell to 9.3% from 16.7% in June. However, full year 

inflation of 9.3% exceeded the revised inflation target of 8.5%. The Central Bank began to ease 

monetary policy in the second half of 2003, cutting the monetary policy interest rate by 10 

percentage points from June through December to 16.5%. Brazil registered a seasonally adjusted 

current account surplus of $3.14 billion (1.1% of GDP) for the second half of the year following 

a $862 million (0.4% of GDP) surplus in the first half of the year. The 2003 full-year current 

account surplus of $4.0 billion (0.8% of GDP) was driven by a $24.8 billion merchandise trade 

surplus. This performance compares with a $7.7 billion (1.6% of GDP) current account deficit 

and a $13.1 billion merchandise trade surplus in 2002. Brazil’s bilateral merchandise trade 

surplus with the United States for the second half of the year was $3.4 billion. The Central Bank 

increased international reserves (net of IMF disbursements) to $17.4 billion at year-end from 

$14.6 billion in June 2003 and $14.2 billion at year-end 2002. 

Canada

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

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

of the euro in September 2000. During the second half of 2003 the Canadian dollar appreciated 

4.9% from 1.36 C$/US$ to 1.29 C$/US. The J.P. Morgan trade-weighted real effective exchange 

rate for Canada appreciated 1.1%. During this time, Canada ran a current account surplus of 

2.4% of GDP. The United States ran a US$28.6 billion bilateral merchandise trade deficit with 
5

Canada during the second half of 2003. Economic conditions remained soft in the middle of 

2003, but accelerated to 3.8% (saar) growth in the fourth quarter. 

Mexico

Mexico has a flexible exchange rate and targets inflation at 3% with +/-1% band. The Bank of 

Mexico also follows a rule-based mechanism whereby half of the foreign reserves acquired in the 

previous quarter are auctioned in the foreign exchange market. During the second half of 2003 

the Mexican peso depreciated 6.9% from 10.46 pesos/dollar to 11.23 pesos/dollar. The J.P. 

Morgan trade-weighted nominal effective exchange rate depreciated 7.8%, and the J.P. Morgan 

trade-weighted real effective exchange rate depreciated 4.4%. During this time, Mexico’s 

current account deficit was 1.3% of GDP. Mexico’s bilateral merchandise trade surplus with the 

United States was $19.6 billion during the second half of 2003. International reserves grew $3.2 

billion during the second half of the year, reaching $56.1 billion by year-end. Economic 

conditions strengthened during this period with real GDP growing at an annual rate of 2.1% 

between the first and second half of 2003 compared with the 0.5% growth between the second 

half of 2002 and the first half of 2003. 

Europe and Eurasia

The European Monetary Union

The euro appreciated 9.5% against the dollar in the second half of 2003 although, according to 

the Eurostat index, the real effective exchange rate appreciated only 2.0%. The European 

Central Bank did not intervene in exchange markets during this period.

The countries in the Euro-zone as a whole had a current account surplus during the second half 

of 2003 equal to $26 billion (sa), or 0.6% of GDP, up from $6.8 billion, or 0.2% of GDP, in the 

first half of 2003. Goods exports increased 1.4% in the second half of 2003 from the first half 

of 2003, and goods imports fell 0.6%. For the year, the surplus was 0.4% of GDP. The strong 

euro appeared to moderate the increase in the current account surplus in fourth quarter of 2003. 

The trade surplus of the Euro-zone vis-à-vis the U.S. was relatively constant at $31.4 billion in 

the first half of 2003 and $32.2 billion in the second half. 

Euro-zone growth was an estimated 0.6% in 2003. The largest economies have been a drag on 

overall Euro-zone growth. Growth was strongest in the area of government consumption, as 

private consumption growth remained at 1%. Year-end inflation was 2.0% (yoy), near the 

ECB’s 2% ceiling. 

Central Europe

After exhibiting nominal weakness against the dollar in the first half of 2003, the currencies of 

the major Central European economies appreciated in the second half of the year. However, 

several currencies continued to exhibit nominal weakness against the euro (the most important 

currency for trade) and saw a decline in their respective trade-weighted real exchange rates. 
6

In Poland and the Czech Republic, continued large budget deficits and declining export 

competitiveness contributed to currency weakness. Despite the nominal appreciation against the 

dollar, the zloty and the koruna depreciated 5.5% and 2.6%, respectively against the euro. In 

Hungary, the forint strengthened both in nominal (12% against the dollar and 1.5% against the 

euro) and real trade-weighted (2.3%) terms as the National Bank raised interest rates by 6 

percentage points. 

In Slovakia, the koruna appreciated 0.2% against the euro in nominal and 7.4% in real terms. 

Separately, the Bulgarian lev continued to appreciate against the dollar as its value was fixed to 

the euro as part of Bulgaria’s successful currency board arrangement.

Russia

The trend of large net inflows of foreign exchange resulting from high oil prices and high foreign 

borrowing by Russian corporations witnessed in the first half of 2003 continued during the 

second half. Russia’s current account surplus in the second half of 2003 was 6.7% of GDP 

($15.3 billion) compared with 10.0% in the first half ($20.5 billion). This led to a 3.1% 

appreciation of the ruble against the U.S. dollar in July-December compared to a 5.3% 

appreciation in January-June. The Russian monetary authorities intervened to moderate the 

appreciation of the ruble against the dollar, and foreign exchange reserves increased $12.5 billion 

to a record high of $76.9 billion.

Africa

Nearly all major currencies in Africa appreciated against the U.S. dollar on a nominal basis 

during the second half of 2003. The South African rand posted the largest gain, appreciating 

12.1%, as a result of favorable interest rate differentials, strong commodity prices, sound 

economic fundamentals, and improved investor sentiment toward emerging markets in general. 

The currencies of the CFA zone also strengthened against the dollar, in line with the euro, to 

which these currencies are pegged. The Zimbabwe dollar was the continent’s weakest 

performer, reflecting the country’s severe economic crisis.

Real GDP growth in Africa rose to 3.8% in 2003 from 3.5% in 2002. The continent’s overall 

current account deficit narrowed slightly to 0.5% of GDP in 2003, though a number of subSaharan countries experienced much larger deficits. Net capital inflows, including from private

sources, increased, leading to a $13.3 billion increase in foreign exchange reserves. North Africa 

accounted for two-thirds of this reserve accumulation, due mainly to higher oil prices.

Middle East and South Asia

Growth in the Middle East and South Asia was robust in 2003, supported by high oil prices and a 

quick resolution of economic uncertainties stemming from the conflict in Iraq. Oil exporting 

countries account ed for much of the growth, although non-oil exporting countries also 

experienced modest growth. With the substantial increase in the average oil price and export 

production volume for 2003 relative to 2002, current account surpluses skyrocketed in the oil 

exporting nations. Saudi Arabia’s current account surplus, for example, more than doubled from 
7

2002 to 2003 to reach close to 13% of GDP. The majority of countries in the region maintain 

pegged exchange rate regimes, with many, including the Gulf Cooperation Council countries, 

explicitly tying their currencies to the dollar.

The Indian rupee appreciated 1.9% in nominal terms against the dollar and 1.3% on a real tradeweighted basis in the second half of 2003. India’s overall economy grew by an estimated 8.1% 

in 2003, compared to 4.2% in 2002, while inflation remained low at 5.4%. Despite a significant 

trade deficit, the current account showed a small surplus of $1.7 billion (0.4% of GDP) in the 

first three quarters of 2003, due to robust services earnings and transfers, compared to a surplus 

of $4.3 billion (1.3% of GDP) during the same period in 2002. The U.S. bilateral merchandise 

trade deficit with India for the second half of 2003 totaled approximately $4 billion – matching 

the trade deficit for the first half of the year. Foreign exchange reserves continued to increase. 

Foreign exchange reserves were $96.5 billion at the end of 2003, up from $78.2 billion at the end 

of June 2003. Indian authorities have also taken a number of steps to reduce upward pressures 

on the currency. In February 2004, Reserve Bank controls on capital outflows were loosened to 

allow resident individuals to invest up to $25,000 per year abroad without prior approval. 

Authorities also used growing reserves to prepay over $3 billion in external debt in 2003.

Turkey and Israel have flexible exchange rates. The Turkish lira was relatively flat between the 

end of June 2003 and the end of December 2003, but appreciated 17.9% in nominal terms against 

the U.S. dollar and 6.4% in real trade-weighted terms in 2003, due primarily to large capital 

inflows as confidenc e in the government’s economic program increased. Real GNP grew 5.9% in 

2003, and inflation fell to 18.4% from 29.7% in 2002. The current account deficit in 2003 

increased to 2.9% of GNP from 0.8% of GNP in 2002, with the strong real appreciation of the 

Lira helping import growth in intermediate and capital goods outpace strong export growth. 

Gross foreign exchange reserves grew $4.5 billion in the last six months of 2003, reaching $33.6 

billion by end-December (or 79% of short-term external debt, residua l maturity basis) as the 

lira’s strength gave the central bank an opportunity to build up reserves.

The Israeli shekel was relatively stable against the dollar in nominal terms, but depreciated 5.8% 

in real trade-weighted terms, during the second half of 2003, following 8.9% nominal dollar and 

1.9% real trade-weighted appreciation in the first half of the year. GDP in Israel grew only 1.2% 

in 2003, following a slight contraction in 2002. Meanwhile, prices contracted 1.9%. Foreign 

exchange reserves climbed steadily in the same period, up 4.9% to $25.6 billion by endDecember (or 88.6% of short-term external debt) from $24.4 billion at end-June. The increase in 

reserves was largely a result of an improved current account position and the issuance of dollardenominated bonds guaranteed by the U.S government. The current account ended the year 

nearly balanced for the first time since 1990.

The Egyptian pound depreciated 23% in nominal terms against the dollar from January to June 

2003, following the Egyptian government's announcement that the pound would float. The 

pound has remained close to LE6.2/$ since June. The differential between the official and 

parallel market rates reported in the press widened by 10 percentage points to approximately 

15% by year-end. The current account surplus continued to expand during the second half of 

2003, reaching 1.9% of GDP in the third quarter compared to 0.1% in the same quarter the year 

before. The growing current account surplus was due to a strong upswing in tourism receipts 
8

and the narrowing of the trade deficit, which resulted from increased oil and gas revenues and 

the depreciation of the Egyptian pound.

East Asia

After a sluggish start at the beginning of 2003, East Asian GDP growth accelerated sharply in the 

latter half of 2003. Several factors were behind the ratcheting up of growth rates. The economic 

impact of SARS proved to be short-lived, and affected economies rebounded in the second half. 

The quick resolution of oil market uncertainties stemming from the conflict in Iraq also raised 

confidence in the economic outlook. Finally, strengthened external demand, principally from the 

United States and China, bolstered growth throughout the region.

These factors have also led to increased current account surpluses and foreign direct investment 

inflows into East Asia. This has been most striking in Korea and Thailand. But the greater effect 

on flows in the foreign exchange market have come from a sharp rise in net portfolio capital 

inflows – especially into China and Japan, as well as Korea and Taiwan. Portfolio capital 

inflows have been lured by and fueled equity market rallies in the region, but they also reflected 

expectations of exchange rate appreciation in selected economies.

Monetary authorities in these economies intervened, purchasing foreign exchange, in order to 

limit upward pressure on their currencies, often citing speculative capital inflows and, in Japan 

and Taiwan, concerns about deflation. Intervention did not prevent appreciation in several 

economies over the review period.

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

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

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

products that are exported outside East Asia. As a result, monetary authorities appear to be 

increasingly concerned about the effect of currency appreciation on their competitiveness 

relative to other economies in East Asia. While noting these concerns, the Administration has 

encouraged increased exchange rate flexibility for East Asian economies generally, both in 

bilateral discussions and in regional fora such as APEC. 

Japan

Japan’s economic recovery, which began in the second quarter of 2002, gathered momentum in 

2003. GDP grew 2.7% in 2003, and at an annual rate of 6.4% in the fourth quarter. In the 

second half of 2003, personal spending picked up slightly, and business investment grew 

strongly (notably in the fourth quarter). Net exports played an important role in the recovery, 

both directly, and through increased investment in many export industries. 

Japan’s current account surplus grew to $75.5 billion (3.4% of GDP) in the second half of 2003, 

up from $62.8 billion (3.0% of GDP) in the first half. Japan’s bilateral merchandise trade 

surplus with the United States was $33.8 billion in the second half of 2003, up from $32.2 billion 

in the first half of 2003, but below its level a year earlier ($36.8 billion in the second half of 

2002). 
9

The persistent Japanese global current account surplus reflects the high rate of Japanese domestic 

saving relative to domestic investment, and the transition of Japan from being one of the fastest

growing economies in the industrial world to one of the slowest. Slower growth over a longer 

period has meant lower investment, and the share of private investment in GDP has fallen from 

26% in the 1960s, to 22% in the 1980s, to 19% in the last 3 years. Notwithstanding a decline in 

personal saving to cushion consumption in the downturn and in view of the aging of the 

economy, excess private saving has been partially absorbed by larger government deficits and by 

persistent capital exports to the rest of the world.

A net outflow of private capital throughout 2002 and in the beginning of 2003 partially offset 

Japan’s current account surplus. But, starting in May 2003, net private capital moved into Japan 

in large amounts, with particularly large flows at the end of the year and into 2004. Two factors 

were behind this shift. The first was large foreign flows into the Japanese equity market, as the 

recovery increased confidence in Japan’s near-term prospects. The second was sales of foreign 

bond holdings by Japanese residents after the rise in Japanese domestic interest rates in the 

summer of 2003. Expectation of yen appreciation may have also added to net capital inflows.

During the June 30 to December 31 reporting period, the yen appreciated by 11.9% aga inst the 

dollar, from ¥119.9 to ¥107.1. The yen appreciated nearly 5% in the week of September 15-22 

around the time of the meeting of G7 finance ministers and central bank governors in Dubai and 

then appreciated gradually during the remainder of the reporting period. 

So far in 2004 the exchange rate between the yen and the dollar has swung broadly, against the 

backdrop of strong capital inflows into Japan and large official Japanese intervention. On 

balance, the dollar continued to depreciate against the yen through the first months of 2004, 

reaching ¥104.2 at the end of March. Looked at over a slightly longer period, the dollar – as 

measured by the Federal Reserve’s broad trade-weighed index – reached its peak in late 

February, 2002. Since then through the end of March, 2004, the dollar has depreciated by 22.6% 

against the yen, in line with its 24.4% depreciation against the major currency component of the 

index over the same period. 

Japanese authorities continued to intervene in the foreign exchange market in the second half of 

2003. Intervention totaled $60 billion in the first half of 2003, and $119 billion in the second 

half3. Japan’s foreign exchange reserves grew by 24% to $652.8 billion at the end of December, 

up from $526.6 billion at the end of June 2003 and $451.5 billion at end-December 2002.

The Japanese foreign exchange intervention came at the same time as a shift in monetary policy 

toward more rapid growth in base money in order to overcome persistent Japanese deflation. 

The provision of yen in the course of foreign exchange intervention has been an important 

component of monetary base growth, as it has been only partially absorbed (“sterilized”) by the 

sale of government securities. This shift in monetary policy has had some success, with yearly 

average consumer price deflation moderating to -0.3% in 2003 from -0.9% in 2002.

 

3

 Published Japanese Ministry of Finance data on intervention in all currencies converted to dollars with exchange 

rates as published in Federal Reserve Release H10. 
10

Even though the dollar-yen foreign exchange market is huge, with transactions estimated at $230 

billion per day, the scale of Japanese intervention has been extremely large. Japanese authorities 

have stated that their “intervention is carried out when excess volatility or over-shooting is 

observed in the markets,” and that they do not target particular values of the exchange rate. 

The Treasury is actively engaged in discussions with Japanese authorities on these issues, both 

bilaterally and through the meetings of the G-7 finance ministers and central bank governors. At 

the G-7 meetings in Dubai and more recently in Boca Raton, the Treasury worked with the G-7 

to promote a strong consensus in support of flexible exchange rates. Japan joined the United 

States and other G-7 nations in these declarations. 

China

In the second half of 2003, China’s overall trade surplus (not seasonally adjusted) was $21 

billion (2.6% of GDP), compared with $17 billion (2.5% of GDP) a year earlier. China’s overall 

trade account turned from surplus in 2003 to a deficit in January-February 2004 of $8 billion. 

China’s bilateral merchandise trade surplus with the United States grew to $70 billion in the 

second half of 2003, up from $60 billion in the second half of 2002. 

More than half of China’s exports come from foreign-funded operations in China, many Asianowned. Exports to the U.S. from other Asian economies are increasingly routed through China 

for final assembly and processing before shipment from Chinese ports. In the last three years, as 

the U.S. trade deficit with China has increased, the U.S. trade deficit with the other emerging 

economies of East Asia has fallen.

Given the Chinese exchange rate peg, balance of payments inflows into China are absorbed by 

the Chinese central bank and reflected in an increase in Chinese reserves. China’s official 

foreign exchange reserves grew by a net $57 billion during the last ha lf of 2003, or by 16% of 

end-June foreign exchange reserves, to reach $403 billion. Chinese authorities, however, 

transferred $45 billion of reserves in December to recapitalize two large state-owned financial 

institutions thereby reducing net reserve accumulation over the period. China’s accumulation of 

foreign exchange reserves created monetary pressures that fueled domestic credit growth and 

inflation. China’s real GDP officially increased 9.1% in 2003, with official fourth-quarter 

growth put at 9.9%. Rapid acceleration of China’s import demand growth in 2003 reflects this 

rapid GDP growth and potential overheating and over-investment. 

China maintains controls on capital flows, tariff and non-tariff trade barriers not yet addressed by 

WTO accession, and a variety of export incentive programs. These controls are largely 

asymmetrical, restricting outflows more than inflows, and hence provide upward pressure on the 

currency’s value. 

The renminbi remained pegged to the dollar throughout the reporting period and in the first three 

months of 2004 at 8.28 renminbi per dollar, the same rate that China has maintained since 1995. 

China’s effective exchange rate, averaged across its trading partners, has moved with the dollar, 

depreciating by 3.9% in the last half of 2003, and by a further 0.3% in the first three months of 
11

this year. In real terms, the renminbi depreciated by 2.7% in the last half of 2003, but 

appreciated by 2.1% in the first quarter of this year.

Since 1994, when it unified its exchange rates and adopted its current pegged exchange rate 

system, the Chinese economy has grown rapidly, as has China’s participation in world trade. A 

pegged exchange rate policy is not appropriate for a major economy in the global system such as 

China, and the Chinese government has indicated publicly and at senior levels that it will move 

to a flexible exchange rate regime. The Administration has urged China to move as soon as 

possible toward greater flexibility. President Bush, in his meeting with Premier Wen in 

December, raised the issue of China's exchange rate policy as well as liberalization of trade and 

capital markets. At the September 2003 G-7 meeting in Dubai, the ministers and central bank 

governors endorsed flexibility in exchange rates for large economies. This position was 

reiterated at the February 2004 G-7 meeting in Boca Raton. A regular series of talks between 

senior financial officials from the G-7 and senior financial officials from China has been 

established. During discussions last month with the Chinese central bank governor, Secretary 

Snow stressed that a flexible market-based exchange rate regime and reduced controls on capital 

flows are the best system for China and all major world economies. Secretary Snow will meet 

also with Vice Premier Huang Ju in Washington in the next few months on this topic. 

The United States is actively assisting the transition to flexible rates. Treasury has appointed a 

senior financial expert to serve as Secretary Snow’s emissary in Beijing. The financial expert 

will ensure close communications on exchange rate and other pressing financial issues. Under 

the leadership of the Secretary of the Treasury and the governor of the central bank of China, a 

technical cooperation program was launched last year. A Treasury-led delegation was in Beijing 

in February to discuss the creation of market mechanisms necessary for a flexible exchange rate 

regime. Among other subjects, techniques for supervision of banks’ currency risk and for 

regulation of foreign exchange derivative markets under a flexible exchange rate regime were 

discussed. 

China will need to lay the groundwork for a shift to a floating exchange rate. In this regard, 

China has taken many steps to prepare for a flexible exchange rate regime. It has liberalized FDI 

outflows, is preparing for renminbi trading in Hong Kong and has allowed insurance companies 

to invest a portion of their portfolio in foreign assets. China is also preparing to allow, within 

limits and through qualified institutions, investments in securities traded on foreign markets. 

China is also strengthening its financial architecture. China recapitalized two of its four largest 

state-owned financial institutions in December 2003 and has continued to write off nonperforming loans in the banking system. It has introduced new regulations to allow banks to 

raise capital through subordinated debt, and it has announced measures to allow foreign banks a 

greater share in joint venture banks. In addition, in December the central bank announced 

measures to liberalize certain domestic interest rates. 

Treasury will continue its efforts to encourage and assist China to move as soon as possible to a 

flexible exchange rate regime. 
12

Korea

After contracting in the first half of 2003, the Korean economy rebounded in the second half of 

last year. Real GDP increased at a 6.7% annual rate in the third quarter and an 11.4% annual rate 

in the fourth quarter. The first half slowdown was due to both contracting domestic demand and 

slowing external sales; the second half rebound was the result of strong export growth, up 21% 

over the same period in 2002. 

Korea’s current account surplus increased to $11.4 billion (3. 8% of GDP) in the second half of 

2003, up from $0.9 billion (0. 2% of GDP) in the first six months of 2003 and $2.4 billion (1.0% 

of GDP) in the last half of 2002. The U.S. bilateral trade deficit with Korea rose to $7.5 billion 

in the second half of 2003, up from $6.9 billion in the same period of 2002. Net portfolio capital 

inflows also increased sharply, to $15.3 billion in the second half, compared to $2.7 billion in the 

first half and $0.7 billion for all of 2002. Much of this inflow went into the Korean stock market, 

where the broad share price index increased by 31% over the course of the year and 21% in the 

last half alone. 

Korean authorities intervened to counter upward pressure on the won exchange rate over the 

course of the year. Official foreign reserves increased by $23.6 billion in the second half of 

2003, and by $33.7 billion for the year as a whole, to reach $154.5 billion by end-December (or 

more than three times short-term external debt). Reserves have increased another $8.2 billion 

through end-March 2004. 

The nominal dollar/won rate ended 2003 essentially unchanged from a year earlier; although 

over the course of 2003 the rate fluctuated over a range of 8%. On a real trade-weighted basis, 

the won depreciated 0.5% during 2003. In the first three months of 2004 the won has 

appreciated by 4.0% vis-à-vis the US dollar. Over the past five years the won has been more 

stable against the Japanese yen than against the dollar, suggesting that the authorities may be 

more concerned with Korea’s competitiveness with Japan than with the United States. 

Taiwan

After contracting by 0.5% at an annualized, seasonally adjusted rate in the first half of 2003, 

Taiwan’s economy rebounded by 10.2% in the second half. This GDP growth was driven by 

export growth and a strong recovery in household consumption and business investment. 

Total foreign exchange reserves increased by nearly $30 billion in the second half of 2003, twice 

the amount of first half reserve growth, to reach $207 billion (almost five times short-term 

external debt). Rapid reserve growth has continued through the first three months of 2004, with 

an almost $20 billion increase. The current account surplus in the second half of 2003 was 10% 

of GDP (or $14.2 billion), a proportion that has remained relatively constant for the last two 

years. Taiwan’s bilateral trade surplus with the United States decreased from $7.3 billion in the 

first half of 2003 to $6.8 billion in the second half of 2003. The increase in Taiwan’s balance-ofpayments position in the second half, which in turn fueled the reserve growth, was primarily due 

to the strong financial inflows, including a net portfolio inflow of $7.4 billion in the second half 

of 2003 compared with net outflows of $12.6 billion in the first half of 2003. This turnaround 
13

followed a decision by the Taiwan government in July to scrap a rule restricting foreign fund 

investments in Taiwanese shares to $3 billion per fund, and very large net inflows occurred in 

the third quarter of 2003. 

Taiwan has been in deflation since the third quarter of 2001, and prices in June 2003 were about 

0.5% lower than the previous year. Despite falling prices, the authorities let base money contract 

into mid-2002, before reversing course to provide for growth in the monetary base. Money base 

growth continued during the last half of 2003 and into this year, and by early 2004 prices had 

begun to rise again. Foreign exchange intervention, not fully sterilized, provided growth of base 

money during the last half of 2003 and into 2004. 

Deflation abated, but continued during the reporting period, with consumer prices declining 

0.1% in December 2003 compared to the previous year versus 0.5% year over year in June. 

Taiwan continues to pursue an easy money policy. Narrow money grew 21%, year-on-year, in 

2003, and much of the growth was in the second half as a result of reserve accumulation. 

While the Taiwanese central bank maintains that “the NT dollar exchange rate is in principle 

determined by market forces”, the bank also notes that it will respond to “excessive volatility” in 

order to maintain the “dynamic stability of the NT dollar exchange rate.” The nominal Taiwan 

dollar vs. U.S. dollar exchange rate appreciated 1.8% in the second half of 2003 after 

appreciating a slight 0.3% in the first half of 2003. In the first three months of 2004, the Taiwan 

dollar has appreciated by a further 3.0% vs. the dollar. According to JP Morgan’s real tradeweighted index, the Taiwan dollar declined 0.8% during the second half of 2003.

Malaysia

Malaysia’s economy grew 5.2% in 2003 (after growing 4.1% in 2002), with growth accelerating 

to an annual rate of almost 8% in the second half, as personal spending picked up and investment 

growth turned positive. The external contribution to Malaysian growth was negative in the last 

half, due to strong growth in imports. 

The current account surplus decreased slightly to 12.2% of GDP in the second half of 2003 from 

12.3% in the first half (and 9.6% in the second half of 2002). Malaysia’s bilateral trade surplus 

with the United States increased, to $7.9 billion in the second half of 2003, up from $7.7 billion 

in the same period in 2002.

Malaysia has maintained a fixed peg to the dollar since September 1998, when it also expanded 

capital controls. Controls on capital flows have since been relaxed, but offshore trading of the 

ringgit remains prohibited, and foreign portfolio investment by residents continues to be 

restricted. The ringgit depreciated 3.2% over the second half of 2003 on a real trade-weighted 

basis, as measured by the JP Morgan index. At the end of December, reserves stood at $44.9 

billion, about five times short-term external debt, up from $37.1 billion at end-June 2003.