-18-

our trade imbalance with Taiwan at $3.4 billion is lower by 18
percent from the same period in the previous year and by 29
percent from the preceding three-month period. If this latest
quarter were annualized, it would still lead to a large
bilateral trade imbalance of $11.3 billion.

o Exchange Rate System

Taiwan instituted a new exchange rate system at the time of
the April 1989 report that significantly reduced the
authorities’ ability to manipulate the rate. The system allowed
for most foreign exchange transactions to be freely determined.
Thereafter, Taiwan took a number of measures to further
liberalize the system and reduce capital controls.

Currently there is no evidence that the Central Bank has
been substantially intervening directly in the market to gain
competitive advantage. In fact, as noted earlier, the Central
Bank has recently intervened in the market to control downward
pressure on the NT dollar.

In the October 1989 report, a number of remaining
impediments to liberalization of the Taiwanese financial system
were identified. Since the October 1989 report, Taiwan has
addressed several of these impediments. The ceiling on a
foreign exchange bank’s short (oversold) position in spot
transactions was doubled in December. Taiwan also raised the
limit on foreign liabilities of foreign exchange banks by
30 percent, effective March 10. This should permit banks to
increase their foreign exchange activities.

Taiwan also established the Foreign Exchange Development
Foundation in late February to operate the interbank foreign
exchange market and the new U.S. dollar call market, which
reduces the cost of short-term foreign exchange funds.

Taiwanese authorities are developing a plan to introduce foreign
exchange dealers into Taiwan in one or two years.

In another positive step, the limit on annual foreign
exchange inflows was raised to $1 million per entity in
November. This limit, however, is still one-fifth the size of
permissible capital outflows and impedes market forces. Given
that there has been no surge in capital inflows and the NT
dollar is stable, there is little justification for not soon
raising the limit to at least the level of that for outflows.

Despite the recent relaxation of ceilings on “long" and
"short" foreign exchange positions, their existence, plus the
method of calculating the foreign exchange positions of a bank,
effectively prevents a forward foreign exchange market from
functioning. Contrary to international practice, Taiwan shifted
from an accrual to a cash basis for calculating a bank's foreign
exchange position in 1987 to discourage speculation on an


Table 4

Measurements of Dollar Movements (for key dates)
Versus G-7 Currencies
Percent dollar appreciation (+) or depreciation (-)

As of April 10, 1990

Since Since Since

Dollar Plaza Dollar Over Previous
Value of the Peak Accord Lows Last Year Report
Dollar in 26-Feb-85 20-Sep-85 31-Dec-87 10-Apr~89 13-Oct-89
Terms of: to date to date to date to date to date
Japanese yen 39.6 ~34.8 +30.0 +19.0 +926
German mark -51.3 “41.4 +7.1 -9.9 ~ll.1
British sterling 36.2 -17.2 +14.5 +3.7 -4.9
French franc -46.5 -35.5 +661 -10.4 -12.0
Italian lira 42.7 ~36.0 +6.4 -9.9 -10.6
Canadian dollar -17.1 -15.6 -10.6 -1.8 -1.0

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


-12~

In early March, President Bush and Prime Minister Kaifu
reaffirmed cooperation on exchange rates. Later, market
participants concluded that a meeting between U.S. Treasury
Secretary Brady and Japanese Finance Minister Hashimoto did not
produce commitments to support the yen. However, reports that
the G-7 would meet on April 7 instilled caution into the

markets.

The G-7 Ministers and Governors stated at their April 7
meeting that the decline of the yen against other currencies was
having undesirable consequences for the global adjustment
process. After appreciating slightly immediately following the
G-7 announcement, the yen eased back to levels slightly below
those prevailing prior to the meeting.

During the February through April period, the DM has traded
narrowly against the dollar. Despite market concerns over the
implications of GEMU in this period, participants felt GEMU
would also support German growth. They also reacted favorably
to the mid-March election outcomes in East Germany.


-22-

Wages increased 21 percent on average for the 30 ‘largest
manufacturing companies through end-October, compared with
increases of 12 percent and 20 percent in 1987 and 1988,
respectively. Labor-management unrest lowered productivity
gains to 7.1 percent in 1989, compared with 12 percent in 1987
and 1988, and resulted in production losses equal to an
estimated 3.1 percent of GNP.

External Accounts

The current account surplus dropped 64 percent to $5.1
billion (2.5 percent of GNP), compared with $14.2 billion
(8.4 percent of GNP) in 1988. The trade surplus also fell --
61 percent to $4.5 billion, compared with $11.4 billion in 1988.
Exports grew only 2.7 percent in value and declined 5.4 percent
in volume. Footwear, toys, and especially automobiles accounted
for most of the volume decline. Textiles, machinery and
electronics, which account for more than half of exports, showed
volume growth -- about 7 percent in the latter case. It is
estimated that labor-management disputes were responsible for
export losses of $1.4 billion. Imports expanded 17.8 percent in
value and 14.3 percent in volume. Consumer goods, however,
accounted for only 14 percent of the total import growth, with
raw materials (54 percent) and capital equipment (32 percent)
accounting for the rest of the import growth.

According to U.S. customs data, the U.S. trade deficit with
Korea has shown no significant growth since the first quarter of
1988. In 1989, it declined 30 percent to $6.3 billion. This
decline reflects a 19 percent increase in U.S. exports to Korea
(compared with 39 percent in 1988) and a 3 percent drop in U.S.
imports from Korea (compared with a 19 percent increase in

1988).

Korea’s gross external debt declined to $29.4 billion in
1989, equal to only 14 percent of GNP, compared with 28 percent
of GNP as recently as 1987 and 52 percent of GNP in 1985. Total
interest and amortization payments as a ratio of exports of
goods and services declined from 14 percent in 1988 to only
10 percent in 1989, Excluding Korea's voluntary prepayments of
principal, the 1989 debt service ratio was only 8 percent.

With the increase in international reserves to $15.2

billion (3.2 months’ import coverage) and in other foreign
assets, Korea’s net external debt declined to only $3.0 billion

by end-1989.

o Trade and Economic Developments in 1990

Preliminary BOK data indicate that Korea registered a $646
million current account deficit in January-February 1990,
compared with an $888 million surplus in the same period in
1989. This included a $722 million trade deficit for the two
months ($694 million trade surplus in January-February 1989).


-3-

Two major factors accounted for the bulk of last year's
domestic demand slowdown. First, while investment activity
remained generally strong, there was a fairly widespread easing
from the unexpectedly high growth rates in 1988. Contributing
to the slowdown were a moderate scaling back of investment plans
in the wake of the large increases in recent years, narrowed
profit margins, and anticipation of a period of somewhat weaker
demand growth ahead. second, private consumption growth
declined in each of the G-7 countries in 1989, pulling the
aggregate growth rate from 3.7 percent in 1988 to about 3
percent; among the contributing factors were the limiting
effects of selected tax and social payment increases and higher
inflation on real disposable income gains, as well as, in some
cases, higher household saving.

Aggregate macroeconomic developments in the United States
and Japan continued to provide solid support for the current
account adjustment process. In the United States, domestic
demand grew more slowly than GNP for the third consecutive year,
and improving net exports once again provided a significant
growth impetus. The reverse was the case in Japan, where
domestic demand growth again substantially exceeded GNP growth
and net exports declined significantly. In Germany, however,
domestic. demand growth weakened appreciably (due in part to
fiscal tightening), and lagged GNP growth by a considerable
margin; rising net exports were thus an important source of
overall growth. Macroeconomic developments in the United
Kingdom (with a very large current account deficit) moved
strongly in the direction of adjustment in 1989 as domestic
demand growth cooled from its unsustainably high rate in 1988.
Nevertheless, domestic demand growth in the United Kingdom (as
well as in Canada) remained in excess of GNP growth.

Macroeconomic trends are expected to be broadly supportive
of external adjustment within the G-7 again this year. As
domestic demand growth eases further in the largest deficit
countries (the united States, the United Kingdom and Canada),
net exports should also improve. Although domestic demand
growth in Japan is not likely to be as strong as in 1989, it
should again exceed GNP growth, with net exports contracting
further. Modest real external adjustment is likely in Germany
as well this year, as a tax cut and economic integration with
the German Democratic Republic boost domestic demand. Over the
longer term, German economic and monetary union should have a
positive and substantial effect in reducing Germany's external

imbalances.

o Trade _and Current Account Developments

World trade in 1989 largely reflected the macroeconomic
developments discussed above: trade volume growth was not quite
as robust as in 1988 (at 9.1 percent, the best year of the
decade), but nevertheless remained quite strong (about 7.5
percent). Thus, the relationship between trade and output
growth continues to track well with historical experience

(roughly a 2:1 ratio).


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~19-

appreciating NT dollar. Ona cash basis, forward foreign
exchange positions are not calculated. In addition, although
the ceilings have not been reached they also discriminate
against foreign banks since they are based on local assets.
These assets are relatively small since Taiwan has restrictions
on foreign banks’ operations and branches.

° Assessment
We are encouraged by the fall -- albeit modest -- in

Taiwan's external surpluses (adjusted for the 1988 gold
purchases) over the past year and the continued liberalization
of the exchange rate system, which more accurately reflects
market forces. On balance, we are of the view, as expressed in
the October 1989 report, that there is no evidence of direct
exchange rate manipulation for competitive purposes.

We remain concerned, however, about the persistence of
Taiwan’s large external surpluses. Moreover, it can be argued
that, despite the lack of evidence of direct exchange rate
"manipulation," Taiwan's remaining exchange and capital controls
—~ recent liberalization notwithstanding ~- constitute a
mechanism for indirect "manipulation" by distorting supply and
demand in the market. These factors underscore the importance
of continued liberalization of remaining exchange and capital
controls and, more generally, of exchange rate policy in
contributing in the months ahead to the necessary further
reduction of Taiwan’s unsustainably large external surpluses.

Korea

The Korean won has depreciated about 6 percent in nominal
terms against the U.S. dollar since the won’s strongest point in
April 1989, but remains some 27 percent stronger against the
dollar than it was at the time of the Plaza Agreement in
September 1985. In 1988, the won began to strengthen
significantly against other G-7 currencies, particularly the
yen, resulting in broad appreciation on a trade-weighted basis.
These currency movements, aided by wage and other developments,
contributed to a substantial decline in Korea’s external
surpluses in 1989. A further, but smaller, decline is possible

this year.

Notwithstanding the decline in Korea's external surpluses
in 1989, exchange rate policy continues to have an important
role to play in Korea’s external adjustment, including the
needed further reduction of the trade imbalance between the
United States and Korea. In this context, the steady
depreciation of the won against the U.S. dollar since April 1989
raises some concerns. Introduction of the new "market average
rate” system of exchange rate determination on March 2, 1990, is
an important development. The eventual success of this system,
however, depends on how it is implemented. In particular,
liberalization of pervasive foreign exchange and capital
controls is necessary to give greater scope to the forces of
supply and demand in the exchange market.


-25-

o Assessment

Korea has achieved a large and welcome reduction in its
current account surplus, from 8.4 percent of GNP ($14.2 billion)
in 1988 to 2.5 percent of GNP ($5.1 billion) in 1989. Also, the
U.S. bilateral trade deficit with Korea declined by 30 percent
in 1989 to $6.3 billion. These imbalances, although sharply
reduced, remain large and there is room for further reductions.
In this regard, it is noteworthy that Korea’s current account
registered a deficit for the first two months of this year,
although a surplus is expected for the year.

The won has depreciated 5 percent against the dollar since
the October report, and by 1.8 percent since the introduction of
the new exchange rate system on March 2. The depreciation
against the dollar in the latter period, however, appears
largely attributable to Korea's trade and current account
deficits in the first two months of this year and capital
outflows associated with concerns about the possible
introduction of the "real name" financial system (now
indefinitely postponed). Moreover, on a trade-weighted basis,
the won’s value has not significantly changed in this period.
There is no evidence of the government conducting transactions
in the inter-bank market for the purpose of directly influencing
the exchange rate.

In view of these developments in Korea's external accounts
and in its exchange markets, there are no clear indications at
this time that the Korean won continues to be directly
"manipulated," within the meaning of the legislation, by the
authorities to gain unfair competitive advantage.

Nonetheless, exchange rate policy continues to have an
important role to play in fostering external adjustment.
Introduction of the "market average rate" system of exchange
rate determination was a positive step forward. The real
significance of this step, however, will depend on the
government's willingness to ‘ease the pervasive controls on
capital flows and the types and amounts of permissible foreign
currency transactions that give it effective tools for
indirectly "manipulating" supply and demand in the currency
market and, thus, the exchange-rate itself. In this regard, the
recent liberalization of controls on certain foreign currency
transactions by large Korean corporations and on overseas
investments of Korean financial institutions should increase
pressure for the won to depreciate. Controls on capital inflows
should be liberalized to offset this effect. It is not clear,
however, that the net impact of the allowable $2 billion in
foreign borrowing by Korean banks will accomplish this. If the
proceeds of these borrowings are on-lent in foreign currencies
for the overseas expenses of Korean corporations, there may be
little effect on the exchange rate.


~21-

Since late April 1989, when the won reached its strongest
point at 665/U.S. dollar, the won has depreciated nearly
6 percent against the U.S. dollar, 2-8 percent against the
British pound and Canadian and NT dollars, and 15-16 percent
against the German mark, French franc, and Italian lira. In the
same period, however, the won has appreciated 13 percent against
the yen, reflecting the generalized depreciation of the yen.
Thus, on a trade-weighted basis, the won is virtually unchanged
from its April 1989 level.

Given these developments, the won's cumulative nominal
appreciation against the U.S. dollar since the Plaza Agreement
in September 1985 has fallen to 27 percent. For the same
period, the won’s cumulative nominal appreciation now totals 6
percent against the Canadian dollar and 4 percent against the
British pound. The won remains roughly 18-20 percent weaker in
nominal terms than the yen, the French franc, Italian lira, and
NT dollar, and 26 percent weaker than the German mark in nominal
terms than it was in September 1985. Taking these various
currency movements into account, the won is estimated to be
roughly equal to its September 1985 level in trade-weighted
terms.

Recent Changes in Foreign Exchange Controls

The government eased some foreign currency and capital
controls as of March 1 to: allow certain Korean companies to
purchase and hold up to $10 million in foreign currencies; raise
the limits on overseas investment by Korean securities firms
from $30 million to $50 million and by Korean insurance and
investment and trust companies from $10 million to $30 million;
and allow Korean banks for the first time since 1987 to obtain
up to $2 billion of long-term capital from foreign banks or from
the issuance of bonds in foreign markets.

o Trade and Economic Developments in 1989

GNP Growth

Economic performance in 1989 was weak by Korean standards,
but strong by any other. Real GNP grew 6.7 percent. This
compares with over 12 percent-in each of the three previous
years and was the lowest rate since 1981's 5.9 percent.
Construction boomed (up 15.4 percent), but manufacturing was
weak (up 3.7 percent) and agriculture declined (- 0.7 percent).
On the expenditure side, consumption was up 9.5 percent,
surpassing for the first time in several decades the rate of
growth of GNP. Investment remained healthy, increasing 16.2
percent, including a 12.3-percent increase in plant and
equipment. Inflation eased from 7.1 percent to 5.7 percent.
Unemployment remained virtually unchanged at 2.6 percent.


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~16-

meaning of the legislation. We also indicated, however, that we
would continue to monitor Taiwan's exchange rate policy closely,
in view of the importance of such policy in furthering the
adjustment of Taiwan’s large external surpluses. Regarding
Korea, the Treasury determined that there were indications of
continued exchange rate "manipulation."

Following is a summary of the economic and exchange rate
developments in Taiwan and Korea since our October 1989 report.

Taiwan

The appreciation of the NT dollar since 1985 has been a
central element in the decline of Taiwan's external trade
surpluses. In the past year, the NT dollar’s appreciation has
stalled, although other factors -~ rising wages, inflationary
pressures, and reduction of trade barriers -- have contributed
to lowering the external surpluses. We expect this adjustment

process to continue.

° Exchange Rate Developments

Since the October 1988 report, Taiwan's exchange rate has
appreciated by 10 percent, more than that of any other major
trading partner. Much of this appreciation occurred in a short
period following the April 1989 report. The NT dollar thereupon
fluctuated within a narrow range from May 1989 until early March
of this year. At that time, the exchange rate depreciated by
1 percent. It has since rebounded slightly and stabilized.

The recent depreciation of the NT dollar was the result of
a number of factors. Most importantly, there has been
widespread attention in the local foreign exchange market to
political uncertainties, especially prior to the March
Presidential election. As such, large net capital outflows were
reported in the first quarter of this year. The depreciation of
the NT dollar was slowed by sizable sales of U.S. dollars by

Taiwan’s Central Bank. -

There is some domestic pressure in Taiwan to depreciate the
NT dollar. This view, however, ignores the fact that the recent
depreciation was mostly due to-speculators seizing on factors
that may be short term. In this regard, the Central Bank has
rightly noted that depreciation may not reflect Taiwan’s still
strong economic fundamentals and would have some adverse
consequences. For one, the external surpluses, although
declining, are still at unsustainably high levels. Real GNP
growth also remains strong. Moreover, any potential benefit to
exporters from devaluation would likely be negated by a fueling
of inflation. Inflation, which has climbed primarily due to the
build-up of excess liquidity generated by the large external
surpluses, currently may pose the greatest threat to the
economy. In addition, depreciation would send the wrong signals
to producers by not encouraging the move toward higher
value-added goods and weakening the role of domestic demand in

economic growth.


-8-

Despite our view that positive factors are at work in
encouraging medium term external adjustment and that these
factors are not captured by conventional models, it would appear
that further improvement in the U.S. current account position in
1990 is likely at best to be very modest. Furthermore, the
possibility of deterioration in the current account cannot be

excluded.


1.

3.
4.

~31-

APPENDIX

TABLES

Economic Performance of Major Industrial Countries
Summary of U.S. Trade and Current Account

Summary of U.S. Capital Account

Measurements of Dollar Movements Versus G-7 Currencies

Asian NIEs: Trade and Currency Changes


~28-

-- The depreciation of the Japanese yen has occurred in
the context of a significant adjustment in Japanese
equity prices as weil as a correction in other Japanese
asset values. This depreciation is a matter of
concern, with undesirable consequences for the
adjustment process. The G-7 will keep these
developments under review.

-- ‘The restructuring of Eastern European economies towards
a market basis and the reunification of the German
economies should contribute to improved global growth
and to a reduction of external imbalances. This will
be a most welcome development, especially in light of
Germany's massive and growing external surpluses.

Other economies have @ clear and complementary
responsibility in promoting sustained non-inflationary world
growth and adjustment of external imbalances. In the October

1988 and April 1989 reports on International Economic and
Exchange Rate Policy, it was determined that Taiwan and Korea,
within the meaning of Section 3004 of the Omnibus Trade and
Competitiveness Act of 1988, were “manipulating” their exchange
rates against the U.S. dollar to prevent effective balance of
payments adjustment or gain unfair competitive advantage in
international trade. In the October 1989 report, it was
concluded that there were no clear indications Taiwan was
"manipulating" its currency within the meaning of the
legislation, but that there were indications of continued
exchange rate "manipulation" by Korea.

Taiwan, last April, instituted an exchange rate system that
allowed for most foreign exchange transactions to be freely
determined. Since last October, a number of impediments to
liberalization of the Taiwanese financial system have been

addressed.

The appreciation of the NT dollar since 1985 has been a
central element in the decline of Taiwan's external surpluses in
recent years. Last year, however, Taiwan's global current
account surplus rose by 9.5 percent to $11.2 billion and as a
share of GNP it declined slightly to 8 percent. The U.S.
bilateral deficit with faiwan-also rose in 1989. The rise in
Taiwan's external surpluses in 1989 in part reflected the
effects, of extraordinary purchases of $2.5 billion of gold from
the United States in 1988. Excluding these one-time purchases,
Taiwan's current account surplus fell 15 percent and our
bilateral deficit with Taiwan fell 14 percent. Nonetheless,
these surpluses, whether including or excluding the 1988 gold

purchases, remain excessively high.


to question. In the United States and Japan, where adjustment
has been the greatest in recent years, additional progress is
likely to be much smaller and a modest widening of nominal
imbalances cannot be excluded. Basic developments have
brightened the adjustment prospects for Germany, but the very
large existing imbalances suggest that substantial imbalances

will remain.

However, developments in Eutope could provide substantial
impetus to the industrial country adjustment process over the
next few years, with early signs perhaps beginning to emerge
later this year. The unification of the two German economies is
likely to be especially significant. The large population
inflow into West Germany is already raising German domestic
demand, due in part to the fiscal stimulus associated with
higher transfers and infrastructure outlays. The additional
demand can be met without undue inflationary consequences by
diverting West German exports to domestic uses and by increasing
imports. The net effect, over time, could thus be a significant
reduction in the German surplus and a substantial increase in
trade opportunities for non-German suppliers.

o Inflation

The increase in average inflation rates in the industrial
countries in 1989 reflected the combined impact of several
developments, including higher oil prices, excise tax increases
in various countries, and generally higher capacity utilization
rates. However, the bulk of the price runup occurred during the
first half of the year, and for most countries inflation rates
have tended to level off or subside since then.

A number of other factors appear likely to reinforce this
more recent trend, which should push inflation moderately lower,
on average, this year. Slower output and demand growth, coupled
with the vigorous investment activity of the past few years,
should ease pressures arising from higher capacity utilization
and wage demands; and, the monetary and fiscal authorities are,
for the most part, likely to continue to pursue a fairly

restrictive course.

As a result, consumer price inflation is forecast to ease
somewhat in each of the major industrial countries this year and
to decline to slightly below 4 percent in the industrial
countries in aggregate. Japan, Germany and France are expected
to remain at the lower end of the G-7 group, with the United
States and Canada in the middle, and Italy and the United
Kingdom at the upper end.


The external imbalances of the two largest economies, the
United States and Japan, declined substantially in 1989. Latest
available data indicate that the U.S. current account deficit
fell about an additional $21 billion in 1989, from $126.5
billion to $105.9 billion (2.0 percent of GNP); the trade
deficit fell to $113.2 billion (2.2 percent of GNP). Japan's
current account surplus declined from $79.6 billion in 1988 to
$57 billion in 1989 (2.0 percent of GNP), and its trade surplus
from $95 billion to $77.1 billion (2.7 percent of GNP). The
aggregate current account surplus of the European Community (EC)
fell to nearly zero last year after having been as high as $51

billion in 1986.

However, the overall external adjustment of the EC conceals
some major imbalances that have developed among Community
members. In particular, Germany's trade and current account
surpluses continued to rise in 1989; at $72 billion and $53
billion, respectively, the German imbalances represent 6.5 and
4.4 percent of GNP, the largest such ratios in the G-7. The
bulk of the increase in German surpluses has come in trade with
other EC member countries, with which Germany’s surplus has more
than tripled since 1985. However, the impact of the growing
German surpluses on the overall external position of the EC has
been essentially offset by rising deficits in other member
countries, especially the United Kingdom and Spain. The trade
and current account deficits of the United Kingdom increased
somewhat further in 1989, to $37 billion (4.5 percent of GNP)
and $33 billion (4 percent of GNP), respectively.

These external account trends in 1989 partly reflect
developments in the relative growth rates of exports and imports
in individual countries. In the United States, real exports of
goods and services (measured on the national accounts basis)
increased nearly 11 percent (the third consecutive year of
double digit growth) while import growth was 6.4 percent.

Import growth of 21 percent in Japan again exceeded export
growth (about 15 percent), though the latter strengthened
substantially last year. In Germany, however, export growth
accelerated to just over 10 percent, exceeding import growth of
about 7 percent; and while import growth in the United Kingdom
slowed and export growth strengthened, the former still exceeded

the latter by about 7 percent to 4 percent.

phus, underlying trade flows present a mixed picture of
adjustment. U.S. trends continue to favor adjustment, though
the pace of export growth has cooled; in Japan, import growth
remains strong, but export growth has revived considerably;
export growth revived strongly as well in Germany, but imports
picked up only marginally.

Against the background of these underlying trends, and in
light of the macroeconomic projections reviewed above, further
external adjustment in the industrial countries is expected this
year, but the composition and extent of the adjustment is open


~17-

° Trade and Economic Developments

In absolute terms, Taiwan's global current account surplus
rose 9.5 percent in 1989 to $11.2 billion. Asa proportion of
GNP, this surplus translated into a decline to 8 percent from
8.5 percent in 1988 and 18.1 percent in 1987. Taiwan's overall
trade surplus (cif basis) increased by 27 percent to $14
billion. Our bilateral trade deficit with Taiwan grew 3 percent

last year to $13 billion.

The above data include extraordinary purchases of $2.5
billion of gold from the United States by Taiwan’s Central Bank
in 1988. If these one-time purchases are excluded, the trend in
the external accounts continued downward in 1989. For example,
the current account surplus fell 15 percent last year, if the
1988 gold purchases are excluded, and the U.S. bilateral trade
deficit with Taiwan declined by 14 percent.

These surpluses, whether including or excluding the 1988
gold purchases, are excessively high.

The appreciation of the NT dollar from 1985 to 1989 has had
an overall positive impact on the restructuring of the economy.
Appreciation has encouraged the production of higher value-added
goods and the movement of lower value-added production offshore.
In addition, domestic demand has replaced exports as the main
source of growth for the economy, with Taiwan’s consumers
benefiting from years of high savings. At the same time,
unemployment, at 1.7 percent, is at an historical low.

Following years of very rapid growth, real GNP growth has
been at a more sustainable level since 1988. Last year growth
fell slightly to 7.2 percent. Inflation climbed from 1.3
percent in 1988 to 4.4 percent last year. Despite credit
tightening measures and capital outflows, inflationary pressures
continue to be a serious problem.

As a result of a rise in net capital outflow, Taiwan posted
its first overall balance of payments deficit since 1977 last
year. This led to a slight fall in foreign exchange reserves to
$73 billion, the world’s second largest stock at the end of

1989.

In the first three months of this year, Taiwan’s overall
trade surplus declined by 35 percent over last year to $1.8
billion. In February there was an overall trade deficit of $300
million, although this owed much to special factors including
imports delayed during end-January’s Chinese New Year holiday
and the delivery of a passenger airplane.

According to Taiwan's data, the trade surplus with the
United States was down by 23 percent to $1.9 billion in the
first quarter of this year. Over the last three months for
which U.S. data are available (November 1989 to January 1990),


-T-

The difference between the trade balance and the balance on
current account largely reflects U.S. performance in services.
The surplus on service transactions had peaked in 1981 a
billion; until 1986, the balances generally indicate an
underlying deterioration in these accounts. However, in 1988
and 1989, the services surpluses were $15.4 and $22 billion
respectively. Last year, services trade shifted from
approximate balance in the first half to a surplus of almost $22
billion in the second. But that shift incorporated a swing from
capital losses (some $8 billion) in the first half to capital
gains (also $8 billion, for a total swing of $16 billion) in the
second. Those losses and gains reflect the effects of exchange
rate changes on the conversion of U.S. foreign investors’
foreign currency profits to dollars. Whether, therefore, the
full-year figure for 1989 services trade suggests some reversal

of the previous declining trend in that position remains
uncertain.

The recorded net inflow of capital in 1989 was $125.7
billion; unrecorded transactions {the statistical discrepancy)
were $34.9 billion. Major contributors to the gross inflow were
a record amount of inward direct investment ($61.3 billion, up
from the previous high of $58.4 in 1988), and foreign private
purchases of U.S. securities ($40.3 billion). On the outflows
side in 1989, there was a substantial increase ($25.3 billion)
in U.S. official reserve assets, reflecting exchange market
intervention activity; direct investment outflows rose strongly
(by $14.8 billion) to $32.3 billion, while purchases of foreign
securities nearly trebled to $22.6 billion. (See Table 3.)

Prospects for 1990

As has been discussed, the U.S. trade deficit continued to
decline in 1989, following its significant fall in 1988 from its
1987 peak. However, the pace of external adjustment slowed.

The outlook for 1990 is difficult to project with
certainty. Most model-based forecasts project a modest widening
in the U.S. current account deficit, although some project
little change or even a slight improvement. These projections,
however, are influenced by assumptions such as no policy
changes, constant exchange rates, and unchanged structural
characteristics of the u.S. and other major economies.

while conventional models provide very important
information, they cannot capture the full range of factors at
play ina dynamic world economy. For example, these models for
the most part do not take into account the structural
implications of recent developments in Eastern Europe and the
prospective reunification of the two German economies. Also,
they do not take into account the most recent exchange market
developments, nor do they explain the strong role foreign direct
investment may be playing in producing longer term and
continuing adjustment of the current account. Furthermore,
important developments that have taken place in the performance
of the U.S. services account are less well understood than the

merchandise trade accounts.


-23-

Exports fell 12 percent in value in January but rose 6 percent
in February, compared with the same months in 1989, while
imports grew 6 percent and 23 percent, respectively. Further
trade and current account deficits appear likely in March.

According to U.S. customs data, the U.S. bilateral trade
deficit with Korea declined a further 33 percent to $455 million
in January 1990 (the latest month for which data are available).
This was based on a 23 percent increase in U.S. exports to Korea
to $1.2 billion, while U.S. imports from Korea were unchanged at
$1.6 billion. For the latest three months (November 1989 to
January 1990), the U.S. trade deficit with Korea stands 44
percent lower than it did in the same period in 1988-89.

Wage demands in the first quarter were less than half the
level in the first quarter of 1989. The number of strikes is 79
percent lower so far this year. These developments should have
a favorable impact on both growth and the external accounts.
Indeed, production and export losses are only 3-4 percent of
what they were in the first quarter of 1989. On the downside,
inflation is creeping up to a 12-13 percent annual rate. The
government is forecasting stronger economic performance in the
Second half of the year, and has not changed its projections for
6-7 percent real GNP growth and a $2 billion current account
surplus for 1990 as a whole. The government also expects that
Korea will be a net international creditor by end-1990.

The recent merger of three leading political parties to
create the new, ruling Democratic Liberal Party and the
subsequent changes in leadership at the economic ministries
have created public expectations in Korea that "growth-first"
measures to stimulate the economy, and exports in particular,
will be reemphasized. It is also expected that policies
designed to improve social welfare and income and wealth
distribution, while not neglected, will receive correspondingly
less attention.

The new economic policy package announced on April 4, which
builds on measures adopted in December 1989, bears out these
expectations. To stimulate investment and exports, the package

includes:

-- Subsidized interest rates, higher credit ceilings, and
tax incentives for investment and R&D in manufacturing
and, particularly, exports; lower corporate income tax
rates for manufacturing, as compared with services;
streamlined government approval procedures for new
manufacturing/export investments; and funds for
technology development and training, especially aimed
at small and medium-sized enterprises.


EMBARGOED FOR RELEASE
AT 4:00 P.M. EDT
APRIL 18, 1990

DEPARTMENT OF THE TREASURY
Report to the Congress
on

International Economic and Exchange Rate Policy

April 1990


-10-

"Phe Ministers and Governors considered the rise ‘in
recent months of the dollar inconsistent with
longer-run economic fundamentals. They agreed that
a cise of the dollar above current levels or an
excessive decline could adversely affect prospects
for the world economy. In this context, they
agreed to cooperate closely on exchange markets."

The G-7 monetary authorities intervened aggressively in the
weeks immediately following the Statement.

Following the G-7 Statement and coordinated intervention,
participants anticipated changes in official interest rates that
would reinforce the desired trend in exchange rate movements.
In the event, the Bundesbank raised its official rates by
1 percentage point (discount rate to 6 percent, Lombard rate to
8 percent) on October 5, 1989. The Bank of Japan raised its
discount rate by 1/2 percentage point to 3-3/4 percent on
October 11, 1989, and to 4-1/4 percent on December 25, 1989.
The Federal Reserve eased reserve conditions in successive
steps, with the result that the Fed funds rate fell from 9
percent at the end of September to 8-1/4 percent by the end of

December.

With these changes in the relative stances of monetary
policies, around mid-November, German interest rates neared U.S.
interest rates, and this narrowing of interest rate
differentials supported the mark’s appreciation in late 1989.
Meanwhile, indications of slowing U.S. economic activity
fostered market expectations of moderating growth, diminished
price pressures, and further declines in U.S. yields. (The
October 13 stock market drop only sharpened market participants’
focus on the perceived weakening in U.S. economic fundamentals,
and by early December, the softness in the economy was viewed as
confirmed by the U.S. November employment data.)

Elsewhere, economic activity remained more buoyant, and the
West German economy in particular was thought to be operating
near capacity. The opening of the East German border in early
November was seen as likely to provide a further stimulus to
growth and investment and, consequently to raise real yields on
DM assets. German monetary officials welcomed the DM’s rise
against the dollar. Also, in late October, German monetary
officials reportedly had begun expressing interest in a
revaluation of the DM within the European Monetary System (EMS),
and this contributed to the rise of the DM into early January,
when the Italian lira was realigned in the EMS and Italy joined

the narrower $2-1/4 percent band.

Around mid-January, however, flows from dollars into marks
stalled as the market grew increasingly concerned about the
potential inflationary implications of GEMU. Meanwhile, flows
into dollars were supported by some perceptions of a pickup in
U.S. economic activity. The mark then began trading within a
moderate range, slightly off its January highs, with its
movements against the dollar at times influenced by developments
in Eastern Europe and the Soviet Union.


~9-

PART III: FOREIGN EXCHANGE MARKET DEVELOPMENTS

o Overview

Over the past six months, foreign exchange market activity
was characterized by an appreciation of the German mark in late
1989 and a depreciation of the yen in early 1990.

Since the October 1989 report, the German mark has
appreciated by 10 percent against the dollar, while the Japanese
yen depreciated by 11 percent (as of April 10). Against the
mark, the yen depreciated by 19 percent. Continental European
currencies generally mirrored the movement of the mark against
the dollar. The British pound ended the period little changed.
Early in this period, the market perceived the G-7 as favoring a
lower dollar and remained generally wary of dollar intervention
sales. (See Table 4.)

The period since the October 1989 report can be subdivided
into two parts. The first, from October 1989 to January 1990,
was characterized by appreciation of the mark in the aftermath
of the September 1989 G-7 Statement and in response to
developments in Eastern Europe, including East Germany. The
second, from January through mid-April, was highlighted by a
sharp depreciation of the Japanese yen.

In market intervention, U.S. authorities sold $2.5 billion
between October and January.

October 1989 through January 1990: DM Appreciation

In the October-January period, the exchange value of the
German mark rose in the aftermath of the September 1989 G-7
Statement, in response to changes in monetary policies in
Germany and the United States, and in reaction to favorable
perception of political changes occurring in Eastern Europe,
notably the opening of the East German border and growing
prospects for German unification, which were seen as providing
attractive opportunities for real investment. During this time,
the U.S. economy showed signs of slowing, and participants
anticipated that changes in interest differentials would tend
toward favoring placements in foreign currencies. However,
foreign investor interest in German assets paused after the turn
of the year, as uncertainties regarding German Economic and
Monetary Union (GEMU) raised concerns about its potential
inflationary risks. such concerns moderated somewhat after the

East German election in mid-March.

Foreign exchange markets were impressed by the forcefulness
of the September 23, 1989, Statement of the G-7, which noted:


-30-

Nonetheless, exchange rate policy continues to have an
important role to play in fostering external adjustment. In
particular, the government needs to allow supply and demand to
function more freely in the exchange market. The government's
pervasive controls on capital flows and the types and amounts of
permissible foreign currency transactions give it effective
tools for indirectly influencing supply and demand in the
currency market and, thus, the exchange rate itself. Thus,
these controls should be rapidly liberalized. The recent easing
of controls on certain foreign currency transactions by large
Korean corporations and on overseas investments of Korean
financial institutions, however, could increase pressure for the
won to depreciate. There should be a corresponding
liberalization of controls on capital inflows to offset this

effect.

Although there is a lack of evidence of direct government
"manipulation" of the exchange rate, we remain concerned about
the won’s depreciation. Recent policy measures, aimed at
increasing exports and suppressing domestic demand, add to our
concerns. They are likely to delay the adjustment process,
jeopardizing the encouraging shift that appeared to have began
in 1989 toward greater reliance upon domestic demand as a source

of growth.

In the period ahead, we will continue to monitor Korea's
trade developments and the operation of the new exchange rate
determination system closely. iIn_the Financial Policy talks, we
will continue to encourage liberalization of Korea’s financial,
capital, and exchange markets as well as seek improved treatment
for U.S. financial institutions.


-29-

Between May of 1989 and early March of this year+ the NT
dollar fluctuated narrowly against the U.S. dollar.
Subsequently, it depreciated by 1 percent, before rebounding
slightly. The decline reflected a number of factors, including
significant capital outflows in response to continuing political
uncertainties, and was resisted by the Central Bank. There is
no evidence that the Central Bank has been intervening directly
in the market to gain unfair competitive advantage. Moreover,
the Central Bank has rightly noted that NT dollar depreciation
does not reflect Taiwan’s still strong economic fundamentals and
would have some adverse consequences.

On balance, we remain of the view, as expressed in the
October 1989 report, that there is no evidence of exchange rate
"manipulation" by Taiwan. There is still reason, however, to be
concerned about Taiwan's unsustainably large external surpluses.
The adjustment process must continue. Liberalization of
remaining exchange and capital controls and, more broadly,
exchange rate adjustment need to play a role in this process.
fhe Treasury Department will continue to monitor the situation

carefully.

Korea has achieved a large and welcome reduction in its
current account surplus, from 8.4 percent of GNP ($14.2 billion)
in 1988 to 2.5 percent of GNP ($5.1 billion) in 1989. Also, the
U.S. bilateral trade deficit with Korea declined by 30 percent
in 1989 to $6.3 billion. Korea’s current account registered a
deficit for the first two months of this year, although a
surplus is expected for the year as a whole.

Korea introduced a new "market average rate" system of
exchange rate determination on March 2. Since this system's
introduction, there is no evidence that the government is
conducting transactions in the inter-bank market in order to
directly influence the exchange rate.

The won has depreciated 5 percent since the October 1989
report, and by 1.8 percent against the dollar since the
introduction of the new exchange rate system. But the
depreciation in the latter period appears largely attributable
to Korea’s trade and current account deficits in the first two
months of this year and capital outflows associated with
concerns about the possible introduction of the "real name"
financial system (now indefinitely postponed). In
trade-weighted terms, the won appears to have changed little
since April 1989.

In view of these developments in Korea's external accounts
and exchange market, there are no clear indications at this time
that the Korean won continues to be "manipulated," within the
meaning of the legislation, by the authorities to gain unfair
competitive advantage.


U.S. Balance of Payments Developments and Trends - ‘

o Developments in 1989

The U.S. trade deficit, after declining markedly (by $32
billion) to $127 Billion in 1988, fell further in 1989 to $113.2
billion. The 1989 trade deficit was the lowest since 1984. The
improvement occurred largely in the first half of the year as
the pace of adjustment slowed ovér the course of 1989.

The continued, but slowed decline in the trade deficit
reflected moderation in both export and import growth. In 1989,
exports rose 13.4 percent in value (11.8 percent in volume),
well below the corresponding performance in 1988 when export
values had surged 27.6 percent (23.5 percent in volume). Most
commodities shared in the rather general, small slowing of
export value growth in the latter half of 1989. The largest
changes occurred in foods, feeds and beverages, and in the
typically “lumpy" completed civilian aircraft sector. Import
growth also slowed -- from 8.8 percent (6.5 percent in volume)
in 1988 to 6.4 percent (5.6 percent in volume) in 1989. (See

Table 2.)

{Two on-going phenomena affected 1989 imports, and are
likely to continue to influence U.S. trade data. Petroleum
imports were up by $10.9 billion in value, to $50.2 billion in
1989, their highest level since 1985. Oil prices rose 19
percent; quantities were up 7.75 percent to 8.06 million barrels
per day, a figure not seen since 1979. Total automotive imports
actually declined in 1989; those from Japan declined for the
third consecutive year. Along with a softening of demand for
autos generally, the increases in production and sales by
foreign-owned auto producers in the United States were a major
factor slowing automobile imports.

Geographically, the 1989 decline in the trade deficit was
concentrated in Western Europe; that bilateral trade deficit
dropped $12.1 biilion to $3.6 billion. Deficits with other
countries or regions fell by lesser amounts: the deficit with
the newly industrialized countries of the Far East fell $4.3
billion, to $25 billion; that with Japan dropped $2.9 billion,
to $49.7 billion; and that with Canada by $2.4 billion to $8.5
billion. ‘The only major bilateral trade deficit to increase was
that with OPEC which was up $8.4 billion to $17.1 billion.

The 1989 deficit on the balance on current account was also
the lowest since 1984. It stood at $105.9 billion, down $20.6
billion from $126.5 billion in 1988. For the year as a whole,
the reduction in the trade deficit accounted for about
two-thirds of the current account decline (some $14 billion),
while an improved position on services (see below) accounted for
the remaining third (about $7 billion).


-20-

Another development since the October 1989 report’ was the
initiation of Financial Policy Talks between the Ministry of
Finance and the Department of the Treasury. These talks provide
a possible mechanism for addressing problems that U.S. banks and
securities firms face in gaining access to the Korean financial
services market. The initial round of these talks was held in
late February, but much remains to be done before U.S. banks and
securities firms can compete on an equal footing with their
Korean counterparts.

o Exchange Market Developments

New Exchange Rate System (MAR)

The "market average rate” (MAR) system of exchange rate
determination was introduced on March 2. Under this system, the
won/dollar exchange rate at the beginning of each business day
-is equal to the weighted average rate of transactions in the
inter-bank market on the preceding business day. Exchange rates
between the won and third currencies are set in accordance with
dollar rates in international currency markets.

During each business day, the won/dollar inter-bank rate is
permitted to fluctuate within a band of +0.4 percent. Foreign
exchange banks, including 53 foreign bank branches, are free to
set customer rates within bands of +0.4 percent for won/dollar
telegraphic transfer (TT) transactions and +0.8 percent for
dollar-third currency TT transactions. A +1I.5 percent band is
established for cash customer transactions.

Recent Exchange Rate Movements

During the the first five weeks of operation of the MAR
system:

-- The won depreciated 1.8 percent against the U.S. dollar
in nominal terms and 1 to 4-1/2 percent against most
other G-7 currencies and the new Taiwan (NT) dollar.

~-- The won appreciated 3.6 percent against the yen,
reflecting the weakness of the yen in international
markets, offsetting on-a trade-weighted basis most of
the won's reciation against the other currencies.

-- Foreign banks accounted for the majority of
transactions in the inter-bank market.

-- The Bank of Korea (BOK) was not a direct participant in
the market; and other government-owned banks accounted
for a small share of inter-bank activity.




-26-

Despite the lack of evidence of direct government.
"manipulation" of the exchange rate via transactions in the
market, we remain concerned about the won’s nominal depreciation
against the U.S. dollar since April 1989 (although, in
trade-weighted terms, there appears to be little change). By
raising the cost of Korea's dollar-denominated imports,
including its oil imports, depreciation will add to inflation,
the increase in which is already a concern to policymakers. The
resulting loss of real purchasing power could well lead to
higher wage demands over the long-term, offsetting any
beneficial short-term impact of depreciation on competitiveness.
Moreover, as the United States is Korea's largest export market,
depreciation against the dollar is likely to encourage the
inefficient production of certain lines of exports in which
Korea has already been losing competitiveness relative to lower
wage-cost Asian competitors.

The recent policy measures signal greater government
intervention in the economy and add to our concern. While we
understand the government's concern about the sharpness of the
declines in Korea’s external surpluses in 1989, this reflects
largely the long delay in beginning the adjustment process (the
won did not begin to appreciate significantly against the dollar
and, especially, the major non-dollar currencies until 1988).

On balance, the new policies appear likely to delay the
adjustment process. Aimed at increasing exports and suppressing
domestic demand, the new measures may reinforce Korea's
dependence upon exports as a source of growth and jeopardize the
encouraging shift that appeared to have begun in 1989 toward
greater reliance upon domestic demand as a source of growth.

In the period ahead, we will continue to monitor Korea's
trade developments and the operation of the new exchange rate
determination system closely. In the Financial Policy Talks, we
will continue to encourage liberalization of Korea’s financial,
capital, and exchange markets as well as seek improved treatment
for U.S. financial institutions.


~2-

PART II: ECONOMIC SITUATION IN THE INDUSTRIAL
COUNTRIES AND THE U.S. BALANCE OF PAYMENTS

o Overview

The economic expansion in the industrial countries
continued through its seventh consecutive year in 1989, at an
average rate that was, as expected, somewhat below the very
strong pace of 1988. Aggregate real GNP growth is expected to
ease a bit further this year, to a still satisfactory rate of
about 3.0 percent, with a greater divergence in the performance
of individual countries reflecting both policy measures and
cyclical factors. Prospects for continued steady growth remain

good.

Substantial progress was made last year in reducing the
trade and current account imbalances of the United States and
Japan. However, the external imbalances of other major
countries, such as Germany and the United Kingdom, increased
further in 1989, and the underlying pace of the overall
adjustment process appears to have slowed in some important
respects. Nevertheless, market opening measures in Eastern
Europe and, particularly, the economic integration of West and
East Germany, could provide substantial impetus to the external
adjustment process over time, especially within Europe.

Consumer price inflation in the industrial countries rose
by approximately one percentage point in 1989, to an average
rate of about 4.5 percent. The increase, which was broadly
consistent with expectations, in part reflected the influence of
some special, transitory, factors during the first half of the
year. Since then, however, price pressures have generally
moderated or stabilized, and the average inflation rate is
likely to slip back marginally to slightly below 4 percent in
1990. (See Table 1.)

o Economic Growth

Basic developments in real GNP and its components were
remarkably uniform in the major industrial countries in 1989.
Specifically, after GNP growth-rates picked up strongly in 1988
{to what, for several countries, were decade highs), there was a
broadly shared slowdown in 1989. Japanese growth dipped to 4.9
percent (still the strongest rate in the G-7), and U.S. growth
to 3.0 percent; the largest declines were registered for the
United Kingdom and Canada (to 2.3 and 2.9 percent,
respectively); only in Germany was GNP growth stronger in 1989
than in 1988 (4.0 percent vs. 3.6 percent). Aggregate GNP
growth for the G-7 countries was an estimated 3.4 percent last
year, after 4.5 percent in 1988. Domestic demand followed a
similar course, with G-7 growth easing from 4.7 percent in 1988
to 3.4 percent in 1989.


~13-

PART IV: ECONOMIC POLICY COORDINATION *

In recent years, the major industrial countries have
developed the G-7 economic policy coordination process to put in
place the consistent and compatible economic policies necessary
for sustained growth with low inflation, reduced external
imbalances and greater stability of exchange rates. Under this
process, substantial progress has been made in achieving the

G~7's shared objectives.

The economic expansion has been sustained for eight
consecutive years. Economic growth is slowing in several
countries this year to more sustainable levels. However,
overall growth prospects remain good. Inflation remains
contained, reflecting the vigilance of authorities as well as
the subsiding of temporary factors last year. External
imbalances have been reduced, particularly in Japan and the

United States.

These favorable developments have occurred in part due to
the important role of the coordination process in promoting
greater stability of the international monetary system in the
face of significant changes, at times, in the world economy.
Since the October report, further significant fundamental
changes have taken place, including most notably the efforts of
Eastern European countries to restructure political and economic
life, and developments in global financial markets, particularly
in Japan. Economic policy coordination, including cooperation
in exchange markets, represents the most effective means of
assuring that these profound changes now underway are managed in
an orderly manner that contributes to the G-7’s shared

objectives.

Against this background, the G-7 Finance Ministers and
Central Bank Governors met in Paris on April 7 to take stock of
these changes and to review economic and financial developments
in their countries. They noted that the major countries will
need to continue their close cooperation on macroeconomic and
structural policies and remain vigilant against current
inflation rates. Both surplus and deficit countries have a
shared responsibility to promote an open and growing world
economy. Deficit countries, including the United States, should
further reduce budget deficits and increase private savings.
Surplus countries must contribute to external adjustment by
promoting non-inflationary growth of domestic demand.

The depreciation of the Japanese yen has occurred in the
context of a significant adjustment in Japanese equity prices as
well as a correction in other Japanese asset values. The yen's
weakness is a matter of concern, with undesirable consequences
for the global adjustment process. The G-7 will keep these

developments under review.


-15-

PART V: ASIAN NEWLY INDUSTRIALIZED ECONOMIES (NIEs)

Overview

Since the release of the October 1989 report, both Korea
and Taiwan’s exchange rate have depreciated against the dollar.
The New Taiwan (NT) dollar was stable following the October
report, depreciated in early March, and has since firmed
slightly. On balance, Nr dollar depreciation since October has
totaled 2 percent. The Korean won has steadily depreciated
since the October report by a total of 5 percent against the
dollar. Over the longer term, however, the NT dollar has
strengthened by 54 percent and the Korean won by 27 percent
since the Plaza Agreement in September 1985. (See Table 5.)

The Treasury Department began discussions with the Asian
NIEs in summer 1986 on their exchange rate and related policies
against the backdrop of their rising external surpluses,
particularly their surpluses with the United States. The U.S.
merchandise trade deficit with the Asian NIES as a group ~~
Korea, Taiwan, Hong Kong, and Singapore -- peaked in 1987 at
$34.1 billion and has declined a total of 29 percent since then.
In 1989 alone, the trade deficit with the Asian NIEs fell $3.9
billion to $24.3 billion, a 14 percent decline from 1988. This
compares to an 8 percent decline in the overall U.S. trade
deficit from 1988 to 1989. As a proportion of the overall U.S.
trade deficit, the deficit with the NIEs fell from 24 percent to
22 percent in the same period.

Under Section 3004 of the 1988 Trade Act, the Secretary of
the Treasury is required to "consider whether countries
manipulate the rate of exchange between their currency and the
U.S. dollar for purposes of preventing effective balance of
payments adjustments or gaining unfair competitive advantage in
international trade." It was concluded in the October 1988 and
April 1989 reports that both Taiwan and Korea "manipulated"
their exchange rates, within the meaning of the legislation.
Pursuant to Section 3004, the Treasury was required to initiate
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 the unfair advantage. Subsequently to the October
1988 report, the Treasury Department initiated bilateral
negotiations with poth Taiwan and Korea on their exchange rate
policies, as well as continuing talks with them on their
associated macroeconomic and structural policies.

In October 1989, in view of the change in Taiwan's exchange
rate system that had occurred during the course of the
negotiations, and certain other factors, the Treasury concluded
that there were no clear indications that Taiwan was
"manipulating" its currency for competitive advantage within the


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 the 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 that the
Secretary shall provide a written update of developments six
months after the initial report. Annual reports, pursuant to
Section 3005, have been submitted in October of 1988 and 1989.
The first written update of developments was submitted in April
1989. This report represents the second written update of
developments submitted to Congress.

Part Il of this report reviews the economic situation in
the industrial countries, including the U.S. economic and
balance of payments situation. Part IIT analyzes the situation
in the foreign exchange markets, including the dollar’s movement
in terms of the currencies of major U.S. trading partners and
U.S. foreign exchange market intervention. Part Iv reviews
efforts by the major industrial countries to coordinate economic
policies. Part v provides a status report on negotiations with
Korea, which was considered in the October 1989 report to be
"manipulating" its exchange rate, within the meaning of the
legislation. It also reviews developments in Taiwan. The final
part provides conclusions on the principal issues discussed in

the report.


TABLE 5

ASIAN NIES: TRADE AND CURRENCY CHANGES :

Cumulative Change against US$ as of April 10, 1990

(Plaza) (Report)
from: 9/20/85 end-86 end-87 = 10/14/88 end-89
HKS 0.21% “0.11% 0.50% 0.19% 0.08%
Won 26.59% 21.89% 12.13% 0.52%  -3.95%
SingaporeS 17.16% 15.49% 6.15% 7.57% 1.12%
NTS 54.19% 35.08% B.64% 9.97% 70.44%
Yen 53.69% 1.29%  -21.55% --19.76%  -B.83%
OM 72.20% 15.71% 4.73% 7.66% 0.90%
* [+] signifies depreciation against the U.S. dotlar.
U.S. Trade Balance with Asian NIEs [1]
(U.S. $ Billions)

1985 1986 1987 1988 1989
Hong Kong 5.6 5.9 5.9 4.6 3.4
Korea 74.1 “6.4 “B.9 “8.9 -6.3
Singapore -0.8 “1.3 “2.1 -2.2 “1.6
Taiwan “11.7 “14.3 17.2 712.6 -13.0
TOTAL NIES 722.1 -27.8 “34.1 -28.2 24.3
Total U.S.
Trade Balance 7132.1 +152.7 7152.1 “118.5 -108.6
NIEs as % Total
U.S. Trade Bal. 1% 18% 22% 26% 22%

{1] U.S. customs value data,

not seasonally adjusted.
Totals may not equal sum of components due to rounding.

| Rate on 4/10/90
|

HKS 7.80
W 706.60
S$ 1.88
NTS 26.28
Y 157.56
DM 1.68


-24—

Other recent policy measures include:

~- Indefinite postponement of introduction of the
requirement to use real names in conducting financial
transactions.

-- Higher taxes, tighter credit, and possible economic
and social sanctions to discourage "professional" or
"habitual" real estate speculators.

-- Tax reform to ease the burden on low-income wage
earners along with other measures to increase
incentives for construction of rental or low-income
housing, employee education, and other benefit
programs.

_— Wage guidelines and controls and reductions in charges
on public utilities.

-- Tight restrictions on consumer credit, higher excise
taxes, income tax assessments based on observed
"standard of living" rather than reported income, and
restraints on overseas travel expenditures (December
1989 policy package).

o Financial Policy Talks

Korea’s impressive economic growth in recent years has not
been matched by comparable development and liberalization of its
financial system. Despite some steps to liberalize controls and
provide national treatment to U.S. and other foreign financial
institutions, the system remains characterized by pervasive
government intervention in financial intermediation and
significant constraints on the ability of U.S. and other foreign
financial institutions to compete on an equal footing with
Korean institutions.

With these problems in mind, the Treasury Department and
the Korean Ministry of Finance initiated a new series of
Financial Policy Talks in late February. These talks will
provide a mechanism for addressing specific market access
problems that U.S. banks and securities firms face in doing
business in Korea and also allow a dialogue on the need for
broader ,liberalization of Korea's financial, capital, and
exchange markets.

In the first round, the Korean government gave positive
signs of its willingness to address some specific issues, but
necessary follow-up actions remain to be taken. We will be
continuing these talks in the period ahead. The October 1990
report on International Economic and Exchange Rate Policy and
the December 1990 report to the Congress on Foreign Treatment of
U.S. Financial Institutions provide target dates for achieving
substantial progress on these matters.


Part I

Part II

Part IIT
Part IV
Part V

Part VI

APPENDIX

TABLE OF CONTENTS

Introduction

Economic Situation in the Industrial Countries
and the U.S. Balance of Payments

Foreign Exchange Market Developments
Economic Policy coordination

Asian Newly Industrialized Economies (NIEs)
Conclusion

Tables

Page

13
15
27
31


TABLE 1

Economic Performance of
Major Industrial Countries

GNP 1/ Domestic Demand 1/
1988 1989 1990 1988 1989 1990
U.S. 4.4 3.0 2.4 3.3 2.4 2.2
Japan 5.7 4.9 4.6 7.6 5.7 4.8
Germany 3.6 4.0 3.2 3.7 2.8 3.1
France 3.4 3.4 3.1 3.9 3.2 3.2
U.K. 4.5 2.3 1.3 7.4 3.9 0.0
Italy 4.2 3.2 3.0 4.3 3.7 3.4
Canada 5.0 2.9 1.6 5.8 5.2 1.6
G-7 2/ 4.5 3.4 2.8 4.6 3.4 2.7
Inflation 3/ Current Account 4/
1988 1989 1990 1988 1989 1990
U.S. 4.1 4.8 4.0 ~2.6 -2.0 -2.0
Japan 0.7 2.3 1.7 2.8 2.0 2.0
Germany 1.3 2.8 2.5 4.0 4.4 4.9
France 2.7 3.5 3.1 0.4 -0.4 ~0.3
U.K. 4.9 7.9 7.2 “3.1 -4.0 -3.1
Italy 5.0 6.3 5.5 -0.6 -1.1 -1.0
Canada 4.0 5.1 4.9 71.7 72.9 72.7
G-7 2/ 3.3 4.5 3.8

* Data for 1988 and 1989: national sources and International
Monetary Fund. Data for 1990: For U.S. - Administration
projections; for other countries ~ International Monetary Fund,
World Economic Outlook (forthcoming) .

1/ Annual average rates in real terms.
2/ Average of indivdual country rates, weighted by GNP.
3/ Consumer prices; annual average.

4/ Calculated as percent of GNP; negative indicates deficit.


~27-

PART VI: CONCLUSION .

This report has provided an update of developments since
October 1989, when the second annual report on international
economic and exchange rate policies was submitted to Congress.

Global economic performance has remained favorable since
the October 1989 report. The economic expansion in the
industrial countries has been sustained for eight consecutive
years. Economic growth is slowing in several countries, but to
more sustainable levels. Strong investment is providing a major
stimulus to the G-7 economies, and the prospects for overall
growth remain good. Inflation remains contained, reflecting the
vigilance of authorities and the subsiding of several temporary
factors, last year, which placed upward pressures on inflation

rates.

Substantial reductions in external imbalances have been
achieved, particularly in Japan and the United States. The U.S.
trade deficit fell further in 1989, by nearly $14 billion to
$113 billion, and the current account deficit fell by some $21
billion to $106 billion. The pace of global external adjustment
has slowed, however. Despite our view that positive factors are
at work in encouraging medium term adjustment and that these
factors are not captured by conventional models, further
improvement in the U.S. current account position in 1990 is
likely at best to be modest. Furthermore, the possibility of
deterioration in the current account next year cannot be
excluded.

The economic policy coordination process has contributed
importantly to the favorable performance of the world economy in
the current expansion. Continued economic policy coordination,
including cooperation in exchange markets, will be essential in
assuring that the profound changes underway in the world economy
=— most notably, the changes in Eastern European political and
economic life and developments in global financial markets -~
are managed in an orderly manner that contributes to sustained
growth, low inflation, and reduced external imbalances.

-- Both surplus and deficit countries have a shared
responsibility in this regard. Surplus countries must
sustain non-inflationary growth of domestic demand.
Deficit countries should further reduce budget deficits
and increase private savings.

-- All countries should promote appropriate structural
reforms.


-li-

February ~ April: Bearishness Toward the Yen

Between October and January, the yen traded in a fairly
narrow range against the dollar. However, the yen had already
declined considerably against the German mark in late 1989, as
market concern about the inflation of Japanese asset values
became evident. Substantial flows from Japan into German
equities were registered at that time, although the effect on
Japanese asset values was masked by the climb of Japanese stock
prices to record levels by end-December.

Since mid-February, the yen has weakened substantially
against other major currencies more generally, including the
dollar, in response to to political uncertainties in Japan,
market perceptions about the stance of official Japanese
interest rate policy, and unease associated with the decline in
Japanese equity markets. The decline of the yen became
particularly pronounced in March. Also, during this period,
U.S. interest rates rose and some participants took the view
that U.S. economic growth might be "bottoming out.”

Sentiment towards the yen in late January and early
February was affected by political uncertainties ahead of the
mid-February elections and the reluctance to tighten monetary
policy further. The depreciation of the yen accelerated after
the Japanese monetary authorities did not hike interest rates in
the wake of the ruling Liberal Democratic Party's February 18
election victory and as Japanese equity markets declined.
Market perceptions that an opportunity to raise official rates
had been missed seemed to crystallize pessimism toward the yen.
Subsequently, bearishness toward the yen increased rapidly in
light of the market’s concerns about Japanese economic policy
and political conditions. Market perceptions of U.S.-Japan
trade tensions were also bearish for the yen.

In this period, expressions of concern about yen
depreciation by leading Japanese monetary officials, and about
attendant risks to Japanese inflation and trade adjustment, were
outweighed in the market’s eyes by the absence of a change in
the discount rate and the political uncertainties. Moreover,
some Japanese monetary authorities repeatedly suggested that,
barring a sharp drop of yen, they would rely on intervention
rather than interest rates to support the yen, At the same
time, however, the market came to believe increasingly that the
yields on yen assets should be adjusted upward. A 1 percentage
point discount rate hike (to 5-1/4 percent on March 20) came
amid active buying of dollar assets that kept the yen, and
Japanese stocks and bonds, under pressure throughout March.

This hike had been largely discounted in advance, and the market
looked for another hike in the near term.


-14-

The restructuring of Eastern European economies away from
central planning towards market-orientation will represent one
of the key challenges of the 1990s. in this regard, the
prospective unification of the German economies should
contribute to improved global growth, to increased investment
opportunities, and to a further reduction of external
imbalances. Strong German domestic demand growth and a reduced
current account surplus would be most welcome, especially in
light of Germany’s extremely large current account surplus and
forecasts suggesting this surplus could widen further this year
to roughly $65 billion, equivalent to nearly 5 percent of GNP.