Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy
Period Covered: November I, 1996 to October 31, 1998

Page 14

(8) a report on the size and composition of international
capital flows, and the factors contributing to such flows,
including, where possible, an assessment of the impact
of such flows on exchange rates and trade flows.

(c) Report by Board of Governors.-Section 2A(1) of the Federal
Reserve Act (12 U.S.C. 225a(1)) is amended by inserting after
“the Nation” the following:”, including an analysis of the impact
of the exchange rate of the dollar on those trends”.

SEC. 3006. DEFINITIONS.
As used in this subtitle:

(1) Secretary.-The term “Secretary” means the Secretary of the
Treasury.

(2) Board.-The term “Board” means the Board of Governors of
the Federal Reserve System.


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered’ November 1, 1996 to October 31, 1998
Page 5

Asian Financial Crisis

During the period of this report, a financial crisis developed in
Asia that directly impacted Korea, Indonesia, Philippines,
Malaysia, and Thailand and indirectly affected the other
economies in the region. This financial crisis was precipitated
by a variety of factors, some common to all the nations affected.

© The depth and severity of the crisis was partially
attributable to weak financial systems in the crisis
© countries, weaknesses that were exacerbated by close
links between governments, banks, and corporations
that led to fundamentally unsound investments.

In the years preceding the crisis, the emerging economies in Asia
experienced a period of rapid growth. This growth was fueled
by a variety of factors, including high domestic savings as well
as even higher levels of investment supported by large foreign
capital inflows. In general, governments implemented either de
facto or explicit fixed exchange rate regimes.

It is now clear, however, that throughout much of the region the
essential underpinnings of a moder financial system were either
weak or did not exist. Financial regulation and supervision were
inadequate, and financial systems lacked transparency and did
not have appropriate mechanisms to analyze and manage risk.
Furthermore, among the problems evident in some of the Asian
economies were an unsustainable combination of large current
account deficits, fixed exchange rates, and inconsistent monetary
policies. Significant amounts of capital flowed into unproduc-
tive areas.

e Large amounts of capital flowed into these flawed
financial systems — from 1990 to 1997, foreign capital
flows quadrupled in the region — from foreign
investors who failed to adequately assess the risks
involved,

The Thai baht came under pressure in early 1997, due in part to
falling export growth and the failures of financial institutions.
Thailand’s government responded by aggressively intervening in
foreign exchange markets and imposing capital controls, but
with the depletion of nearly all of its reserves was nonetheless
forced to abandon the currency peg in July 1997.

The devaluation of the baht put pressure on other currencies in
the region as the depth of the region's problems were gradually
revealed and there was market contagion, with hedging and de-
leveraging exacerbating initial exchange rate pressures. As the
crisis began to unfold, banks and foreign investors withdrew
capital; local companies sought to hedge hard currency
exposures; exporters ceased converting their earnings into
domestic currency; and citizens shifted their savings to hard
currencies.

Thailand, Indonesia, Korea, Malaysia, Hong Kong and the
Philippines came under the most intenSe pressure. With the
exception of Hong Kong, all these countries experienced sharp
declines in currency values. Stock and land prices also fell
steeply in all these countries, Asian banks and companies faced
severe financial constraints, and affected economies have
suffered from recessions and sharp reversals of current account
positions.

Authorities from both Hong Kong and China have repeatedly
stated their intentions to not devalue their currencies. Hong
Kong authorities took steps to strengthen their linked exchange
rate system, and although China has experienced weaker export
growth as a result of the crisis, their external position remains
strong, with a large balance of payments surplus and a high level
of foreign reserves.

The approach of the international community to the Asian
financial crisis emphasized programs designed in conjunction
with the IMF that require nations to take concrete steps to reform
their economies. New programs were initiated for Korea,
Thailand, and Indonesia while an existing program for the
Philippines was strengthened. The goal of these reforms was to
restore financial stability, promote stronger and more stable
exchange rates, attract new capital, and restore economic
growth. Programs, designed to address issues specific to each
nation, were based around strengthening financial systems,
opening markets to both capital and trade, and following
appropriate monetary and fiscal policies. These programs have

Currency Movements: NIEs
Domestic curreny units per dollar, Oct 1996 = 100

100 ,
& 200 -
2
& i
2 i |
E5001 ences Singspore Korea |
&
8 Taiwan = =m Hong Kong |
1000 |

Oct_96 Feb_97 hm_97 Oct_97 Feb 98 Jun_98 Oct_98

Currency Movements: ASEAN-4 Nations
Domestic currency units per dollar, Oct 1996 = 100
100

——— Indonesia
Malaysia
Phillipines
. Thailand

1000 3 . ——.
Oct_96 Feb_97 Jum_97 Oct_97 Feb_98 Jum_98 Oct_98



Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November 1, 1996 to October 31, 1998
Page 10

U.S. Exchange Rate Policies

G-7 Statements on Exchange Rate Policies

During the reporting period, November 1, 1996 to October 31,
1998, G-7 Finance Ministers and Central Bank Governors
reaffirmed their standing commitment to reduce imbalances and
cooperate closely in the exchange rate markets.

© April 15, 1998. “We discussed developments in our
exchange and financial markets. We reaffirmed our
view that exchange rates should reflect economic
fundamentals and that excess volatility and significant
deviations from fundamentals are undesirable. We
emphasize that it is important to avoid excessive
depreciation where this could exacerbate large external
imbalances. In light of this, we support appropriate steps
by Japan aimed at stimulating domestic demand led
growth and reducing external imbalances, thus also
correcting the excessive depreciation of the yen. We
will continue to monitor developments in exchange
markets and to cooperate as appropriate.”

* October 3, 1998. “We discussed developments in our
exchange and financial markets reaffirming the views we
expressed in our April statement. We will continue to
monitor developments in exchange markets and to
cooperate as appropriate.”

Currency Intervention

On June 17, 1998, the U.S. monetary authorities intervened in
the foreign exchange markets, purchasing a total of $833 million
worth of Japanese yen. This operation was the first currency
intervention by U.S. authorities since August 1995 and the only
intervention during the period covered by this report.

Throughout the 2TM quarter of 1998, the yen was pressured by
anticipation of renewed capital flows out of Japan following the
March 31 conclusion of the Japanese fiscal year, the beginning
of Japan’s liberalization of its foreign exchange laws, and
continued weakness in the Japanese economy and financial
system. In late May Japan’s April unemployment rate was
reported at 4.1 percent, its highest level since World War II and
the yen subsequently declined to a seven-year low of ¥139.25
and the Japanese benchmark bond yield established record lows.
The yen continue its decline and on June 15 fell to a multi-year
low of ¥146.13 (New York close).

During the June 17 New York morning session, the New York

Federal Reserve’s foreign exchange desk intervened on behalf of

the U.S. monetary authorities, selling dollars and buying yen.
As the operation began, Japanese Prime Minister Hashimoto
issued a statement in which he pledged to “make every effort to

restore [the Japanese] banking system to health [and] to achieve
domestic demand-led growth...”

Later, Secretary Rubin issued the following statement:

"This moming, the Prime Minister of Japan outlined his
Government's plans to restore the health of the Japanese
financial system and to strengthen domestic demand...

In the context of Japan's plans to strengthen its economy,
the U.S. monetary authorities operated in the exchange
market this morning in cooperation with the monetary
authorities of Japan. We are prepared to continue to
cooperate in exchange markets, as appropriate.”

Daily Currency Movements: April ~ June 1998
Japanese Yen per Dollar
150

145
140
135

130 Intervention
125 June 17, 1998

120

y_ 98
y_98
y_98
y_98

21_May

17_Apr_98
08_Jun_98
16_Jun_98
24_Jun_98 |

O1_Apr_98
09_Apr_98

27_Apr_98
05_May
13_May
29_May


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November I, 1996 to October 31, 1998
Page7

U.S. Economy

Overview of the U.S. Economy

The continuing U.S. economic expansion was characterized
by a combination of strong growth and low inflation during
the period covered by this report (November 1, 1996 to
October 31, 1998). Between the 4" quarter of 1996 and the 3"
quarter of 1998, U.S. real GDP grew at an average rate of 3.9%,
while the inflation rate (CPI) fell from an annual rate of 3.2% in
November 1996 to 1.5% in October 1998. The U.S.
unemployment rate fell significantly over this period from 5.4%
in November 1996 to 4.3% in April 1998 ~ a 28 year low —
before rising to 4.6% in October 1998. .

GDP growth in the 2TM and 3 quarters of 1998 was 1.9%
and 3.9%, respectively, compared to 5.5% in the Ist quarter.
Falling exports, however, illustrated the impact of slowing
economies abroad and reduced GDP growth by 0.9% and 0.2%
in the 2TM and 3” quarters of 1998, respectively. In comparison,
rising exports contributed 1.1 percentage points to GDP growth
in 1997. While strong domestic demand compensated for weak
demand abroad, it is clear that economic weakness among some
of our major trading partners had a negative impact on U.S. GDP
growth

© On the other hand, foreign economic weakness
reduced the demand for key commodities, including
oil, which helped to lower import prices and maintain
low inflation.

IMF Article [V Consultation

The underlying strengths of the U.S. economy were
recognized by the IMF Executive Directors in the conclusion
of the IMF Executive Board’s 1998 consultation with the
United States on August 3, 1998 (in accordance with Article
IV of the IMF's Articles of Agreement). The IMF Executive
Directors attributed the balance of strong growth and low
inflation to the combination of sound macroeconomic policies as
well as flexible labor markets.

The Executive Directors cautioned that the potential for inflation
remained a concern given low unemployment rates and high
levels of capacity utilization. Furthermore, conditions that
helped maintain low inflation, such as low commodity prices,
are temporary in nature. An easing of monetary policy may be
appropriate, however, should a significant slowdown in the rest
of the world sufficiently slow the U.S. economy.

The Executive Directors noted that the appreciation of the dollar
in 1997 and the first half of 1998, accompanied by a rise in the
U.S. current account deficit, eased demand pressures within the
U.S. economy and aided the short-term external adjustment of
nations affected by the Asian financial crisis.

US. Real Gross Domestic Product
% change over previous quarter
6.0

40

204

00

Q4_96 QI_97 Q2_97 Q3_97 Q4_97 QI_98 Q2_98 Q3_98
Source: Bureau of Economic Analysis

US. Civilan Unemployment Rate
%
5.5

5.0

45

40 -
Oct_96 Feb_97 Jum_97 Oct_97 Feb_98 Jun_98 Oct_98

Source: Bureau of Labor Statistics

US. Consumer Price Inflation
% change over a year ago
4

3

2

0
Oct_96 Feb_97 Jum_97 Oct_97 Feb_98 Jun_98 Oct_98

Source: Bureau of Labor Statistics

US. Interest Rates
% (10 year Treasuries)
8

7
6
5

|
|
|

4
Oct_96 Feb_97 Jun_97 Oct_97 Feb 98 Jun_98 Oct_98

Source U.S. Treasury



Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November I, 1996 to October 31, 1998
Page 6

been supported by temporary financial assistance from intern-
ational organizations, led by the IMF, providing nations with

room to establish the conditions necessary to restore economic
confidence as weil as prevent a deeper, more prolonged crisis.

The impact of the crisis varied widely among the affected
economies. Growth has slowed in Taiwan, a mild recession is
occurring in the Philippines and Singapore, while Indonesia,
Malaysia, Korea, Thailand, and Hong Kong are experiencing
severe recessions.

e The recession in Japan, which reduces the demand
for Southeast Asian exports, slowed recovery in the
region. Jan.-Oct. 1998 Japanese imports from the NIEs
and ASEAN-4 were down 13.4% from the same period
in 1997, implying that Japanese imports from the region
may fall by $10.2 billion in 1998 (120 yen/$).

Signs of improvement, however, are evident in both interest
rates and currency values. Interest rates throughout the region
fell significantly from their recent highs, and currency values
throughout the region stabilized and generally appreciated
significantly relative to their lowest levels. As the crisis
evolved, international financial institution (IFI) programs for
Korea, Thailand, Indonesia, and the Philippines focused on
stimulative fiscal policies, including the expansion of social

Short Term Interest Rates
%
100

Thailand

~ = » «Indonesia

(Logarithmic Scale)

cesses South Korea Malaysia

Oct_96 Feb_97 Jun_97 Oct_97 Feb_98 Jun_98 Oct_98
Source: JP Morgan

Consumer Prices
% change over a year ago

100
Thailand -

50 --+++ South Korea aa

= + = -lndonesia a

Malaysia

Sot

Oct_96 Feb_97 Jun_97 Oct_97 Feb_98 Jun_98
Source: JP Morgan

safety nets. Furthermore, trade balances within the region have
improved, mostly as the result of falling imports. Current policy
prescriptions emphasize the continued adherence to the IFI
programs and implementation of necessary structural reforms,
especially in the banking sector, efforts to accelerate the pace of
corporate and financial restructuring, and the expansion of social
safety nets to protect the poor and unemployed.

Real GDP Growth
% change over a year ago
15

Indonesia

. ww Thailand
8 Malaysia

gySouth Korea

Q4_96 Q1_97 Q2_97 Q3_97 Q4_97 QI_98 Q2_98
Source: IMF (Q4_96 data not available for Thailand)

Merchandise Imports
5 Billion
20

South Korea
Malaysia

0 — -
Oct_96 Feb97 Jum_97 Oct_97 Feb_98 Jun_98

Source: JP Morgan

Merchandise Exports
$ Billion
20
Thailand _
15 = = = «Indonesia Malaysia
10 .
5
0

Oct_96 Feb_97 um_97 Oct_97 Feb_98 Jun_98
Source: JP Morgan


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November 1, 1996 to October 31, 1998
Page 9

Capital Flows

During the period covered by this report, the weakness of many
foreign economies contrasted sharply with the solid economic
performance of the U.S. economy. Furthermore, uncertainty in
global financial markets heightened investors’ sensitivity to risk.
Investors responded to these changes in the global economy
by purchasing U.S. assets in general, and U.S. Treasury
securities in particular. This trend in asset allocation illustrates
investors’ confidence in the U.S. economy and the fact that U.S.
Treasury securities are an essentially risk-free asset.

Rising capital inflows have two immediate effects on the U.S.
economy. First, the demand for dollars generated by the capital
inflows results in an appreciation of the dollar. The appreciation
of the dollar lowers the price of U.S. imports and raises the price
of U.S. exports. This, in tum, causes a deterioration in the
current account balance, but helps maintain low inflation.

© The U.S. capital account is the mirror image of the
U.S. current account. A current account deficit implies
a capital account surplus.

Second, capital inflows lead to lower interest rates in the United
States. Both of these effects were evident in the period covered
by this report.

In the long-run, a rising capital account surplus implies that
the stock of U.S. assets owned by foreigners is increasing.
This means that a larger amount of the return generated by US.
assets will be payable to foreigners in the future. Furthermore,
increased capital flows, along with increasing trade deficits,
create greater vulnerabilities to changes in global financial
markets views towards investment in the United States as well as
greater sectoral dislocations in the U.S. economy. It is
important to recognize that the United States is currently
experiencing record levels of business investment, part of
which is supported by foreign investors. It is vital that this
investment is employed productively to support both future
repayments to foreigner investors and increased standards of
living in the United States.

Capital Flows into the United States

Policy Priorities

The most important policies in responding to the present
challenges include the following objectives:

© Maintain sound domestic policies to offset the impact
of the rising current account deficit. An adjustment of
the U.S, external imbalance would be eased by policies
designed to raise the level of national savings.
Maintaining a balanced budget is essential to this goal.

© Pursue policies that promote strong growth and low
inflation in the G-7 countries. It is important to
encourage the Japanese authorities to follow through on
their recent efforts to restore economic growth in Japan.

¢ Maintain financial assistance for strong programs,
anchored with IMF support, designed to promote
recovery in emerging market economies and limit the
spread of financial contagion.

* Continue efforts to open foreign markets to U.S.
exports,

© Continue to lead efforts to create an international
financial architecture as modern as the markets. The
reform of the international financial system should be
based on increasing financial transparency, strengthening
domestic economic institutions, and creating mechan-
isms so that creditors and investors more fully bear the
consequences of their actions.

Foreign Holdings of U.S. Treasury Securities
5 Billion
1300

1200

1100

Q4_96 QI_97 Q2_97 Q3_97 Q4_97 QI_98 Q2_98 Q3_98
Source: US. Treasury

1000

§ Billion. sa
Q4.96 Q197 Q297 Q397 Q497 QI Q298  Q3.98
Net Portfolio Flows 3 85 69 84 46 106 66 6
U.S. acquisition of foreign assets* -72 ~53 -33 -66 -56 -14 ~42 3
Foreign acquisition of U.S. assets 150 138 102 150 102 120 108 3
Foreign Official 38 27 5 21 -27 at -10 ~46
Private** 112 Wl 107 129 129 109 118 49
Net Banking Flows +16 ~46 1 -17 62 47 13 54
Assets 61 ~64 -27 -30 -28 3 25 -28
. Liabilities 45 18 28 13 90 50 38 83

Source: Bureau of Economic Analysis

* Net private claims on foreigners by nonbanks plus net private U S. purchases of foreign securities
+» Net purchases of U S. Treasury securities, net nonbank liabilities to foreigners, net purchases of govt. non-Treasury securities, and net US currency flows


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy
Period Covered: November 1, 1996 to October 31, 1998

Real Value of the Dollar
JP Morgan Broad Real Dollar Index (1990=100)
1200
115.0
1100
1050
100.0
95.0
8, 5, 5 5, 5, &, &, &, 5,
ZSEPZRERS

This report reviews developments
in U.S. international economic
policy, including exchange rate
policy, during the period from
November 1, 1996 through
October 31, 1998. This report is
required under Section 3005 of the
Omnibus Trade and Competitive-
ness Act of 1988 (“the Act”).

EMBARGOED FOR RELEASE
UNTIL:

4:30 p.m., January 22, 1999

Summary and Polic:
Analysis of Currency Mark
~ Developments -
U.S. Economy

U.S. Exchange Rate Policie:
Foreign Exchange ] Rate! Policies

Append :

1
1

oNN

Summary and Recommendations

Major Findings

The U.S. economy performed strongly over the period November
1, 1996 to October 31, 1998, despite the financial crisis in
emerging markets and the weakness of some of the industrial
countries. The U.S. economy over this period experienced a
combination of strong growth, low inflation, and strong employment
growth not seen in nearly three decades.

However, as the financial crisis resulted in economic contractions
or declining growth rates across emerging markets and Japanese
weakness continued, U.S. exports declined sharply and the U.S.
current account deficit rose significantly.

For most of the period covered by this report, the relative
strength of the U.S. economy and a growing aversion to risk
fueled strong capital inflows into the United States, causing an
appreciation of the dollar. Global investors showed a preference for
USS. assets in general, and U.S. Treasury securities in particular,
reflecting their confidence in the U.S. economy. In September, how-
ever, the dollar retreated against most major currencies as financial
markets reacted with growing concern to losses stemming from the
global financial turmoil.

Treasury determined that none of our major trading partners has
manipulated exchange rates under the terms of Section 3004 of
the Act during the period under consideration.

Policy Priorities

Encourage policies that promote strong growth and low inflation
in the G-7 nations, with a particular focus on fiscal stimulus and
banking reform in Japan and structural reform in Europe.

Remain prepared to support financial assistance, led by the IMF
and the IFIs, in support of strong programs to promote recovery
in emerging market economies and limit the spread of financial
contagion.

Continue efforts to open foreign markets to U.S. exports.

Continue to monitor the policies and practices of our trading
partners for evidence of currency manipulators.

Develop and implement proposals to strengthen the international
financial architecture and reduce the risk of future financial
crises.


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy
Period Covered: November 1, 1996 to October 31, 1998

Page 12

GDP fell from 4.0% GDP in 1996 to an estimated 2.7%
GDP in 1997 and, according to private sector forecasts,
will fall further to 0.6% GDP in 1998. While recently
imposed restrictions on financial markets (e.g., banning
the use of New Taiwan dollar forward contracts for
domestic companies, closing Taiwan’s bond market to
foreign issues, and jaw-boning of foreign banks not to
“speculate") represent a reversal in progress made
towards financial liberalization, these actions have been
taken in order to defend a stronger NID and not to
promote the competitiveness of Taiwan exports

© Malaysia. The Malaysian government imposed broad
capital and exchange controls on September 1, 1998.
The government's stated reasons for imposing capital
controls appeared to be to induce the retum of ringgit
capital that had been accumulating offshore and to
preserve the value of the ringgit while providing more
freedom for monetary policy to address domestic
conditions. The government fixed the ringgit exchange
rate at RM3.8/$1 on September 2", a rate that was 10%
higher than the rate prevailing in the market at the time
and 23% higher than the lowest rate reached this year.
On a trade-weighted basis, the ringgit has appreciated
6% since the end of 1997. Although Malaysia’s current
account balance improved dramatically (the current
account balance is expected to swing to a surplus of
8.3% of GDP this year from a deficit of 4.9% of GDP in
1996), and Malaysia has both a current account surplus
and a bilateral trade surplus with the United States, this
is primarily a result of the collapse in import demand
driven by the economic slowdown. Exports were
actually down 18% year over year in dollar terms during
August. While it is the opinion of the Treasury
Department that Malaysia is not using currency controls
to gain a competitive advantage in trade, Treasury
believes that the Malaysian government’s goal of
defending the ringgit could be achieved more efficiently
through appropriate macroeconomic policies

Policy Priorities

¢ Treasury intends to continue monitoring the markets
for evidence of currency manipulation.


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered. November 1, 1996 to October 31, 1998
Page I]

Foreign Exchange Rate Policies

Elements of Manipulation

Section 3004 of the Omnibus Trade and Competitiveness Act of
1988 requires the Treasury to analyze annually the exchange rate
policies of foreign countries, in consultation with the IMF, and
to consider whether countries manipulated the rate of exchange
between their currency and the dollar for purposes of preventing
effective balance of payments adjustments or gaining unfair
comparative advantage in international trade. The Secretary of
Treasury is required to undertake negotiations with those
manipulating countries that have material global account
surpluses and significant bilateral surpluses with the United
States, unless there would be a serious detrimental impact on
vital national economic and security interests.

* Treasury undertook a broad review of the perfor-
mance of major trading partners of the United Stated
and concluded that none of them has manipulated
their exchange rate under the terms of Section 3004
during the period examined.

In evaluating evidence of currency manipulation, Treasury looks
at the following five factors:

e External Balances. Persistent global current account
surpluses are fundamentally a reflection of an excess of
national savings over national investment, but in some
cases may also indicate an attempt to use exchange rate
policy to prevent external adjustment.

e Exchange Restrictions and Capital Controls.
Restrictive exchange regimes and capital controls can be
aconcern, particularly where the restrictions are
designed to maintain an consistently undervalued
exchange rate or prevent the adjustment of an external

surplus.

° Exchange Rate Movements. Large depreciations of
exchange rates, if induced artificially rather than by
market forces responding to fundamentals, could suggest
an attempt to gain a comparative advantage in trade.
Manipulation could also be reflected in the absence of a
significant appreciation of the exchange rate when
justified by fundamentals. Equilibrium real exchange
rates, however, are determined by a number of factors
and are therefore difficult to define.

* Movements in Reserves. Significant and persistent
accumulation of foreign exchange reserves could be a
source of concern if it reflects efforts to maintain an
excessively competitive exchange rate.

*® Macroeconomic Trends. When analyzing these
economies, Treasury looks at the macroeconomic policy
stance and other conditions that are important determi-
nants of exchange rates.

Country Assessments

Economies were closely examined as potential exchange rate
manipulators if they had significant global current account
surpluses and bilateral surpluses with the United States as well
as a fixed or actively managed exchange rate system during
some point of this report.

© Singapore. Singapore’s stated policy in combating the
regional financial crisis has been to reduce business costs
rather than devaluing its currency. Singapore's currency
has depreciated 12% in nominal terms versus the dollar
since 1996, but the Singapore dollar remained stable in
trade-weighted terms since the start of the crisis.
Singapore’s current account surplus is expected to fall
from 14.7% of GDP in 1997 to 13.5% of GDP in 1998.
Following growth of over 7% in each of the past two
years, no economic growth is expected for this year and
a small decline in GDP is forecast by the market for next
year,

¢ China. During the period covered by the report, the
exchange rate of the renminbi was kept fixed to the
dollar. In 1997 China experienced a record current
account surplus (about 3.2% of GDP) and a record
inflow of direct foreign investment (over $44 billion),
which together resulted in a large balance of payments
surplus. These surpluses Jed to a $35.9 billion increase
in China’s foreign reserves in 1997. The large current
account and balance of payments surpluses continued in
1998, although reserve growth slowed significantly.
China’s growth, meanwhile, continued to slow. China
experienced sharp declines in exports to Japan and other
Asian countries, but export growth remained relatively
strong to the United States and Europe. China’s leaders
consistently reiterated their commitment to maintain the
stability of the renminbi.

« Taiwan. Taiwan’s exchange rate policy since the start
of the Asian financial crisis has generally been directed
towards maintaining the value of the New Taiwan Dollar
(NTD) in the face of significant regional financial
turmoil. From July 1997 to mid-October 1997, the
Central Bank of China (CBC) used over $7 billion in
reserves in an effort to support the value of the NID. As
the crisis in Asia intensified and pressures on reserves
continued, the CBC relaxed its support of the currency
on October 17, 1997. Since then, the NTD has
depreciated some 16%, with roughly a 7% real
depreciation from October 1997 through September
1998. Taiwan’s current account surplus as a percent of


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered. November 1, 1996 to October 31, 1998
Page &

Trade Flows

The strength of the U.S. economy, combined with weakness
abroad, generated a rise in both the trade and current
account deficits during the period covered by this report.
The current account deficit rose from $33 billion in the 4" quar-
ter of 1996 to $56.5 billion in the 2" quarter of 1998. Between
the 4" quarter of 1996 and the 3" quarter of 1998, the goods and
services trade deficit increased from $24.2 billion to $44.5
billion.

« The primary factor underlying the rising current
account deficit was the recent fall in U.S. exports.

Consistent economic growth in the United States, as well as an
appreciating dollar, sustained growth in nominal imports. In
contrast, economic weakness abroad, particularly in Asia,
severely decreased the demand for U.S. exports. Export growth
began to slow in the 4” quarter of 1997, while exports fell
throughout the first three quarters of 1998. From the 4" quarter
of 1996 to the 2% quarter of 1997, nominal imports rose an
average of 2.4% each quarter, while nominal exports rose an
average of 3.8% each quarter. From the 3" quarter of 1997 to
the 2TM quarter of 1998, the period immediately following the
Asian financial crisis, nominal imports rose an average of 1.3%
each quarter, while nominal exports fe// an average of 0.4% each
quarter.

Developments in key bilateral merchandise trade balances
US. External Balances
5 Billion (Balance of Payments Basis)
Q4_96 Q1_97 Q2_97 Q3_97 Q4_97 Q1_98 Q2_98 Q3_98
i)

-60 | pyCurent Account py Trade*

* Balance on goods and services.
Source: Bureau of Economic Analysis, Bureau of the Census

US. Trade in Goods and Services
$ Billion (Balance of Payments Basis)
280

260

240
200 a

—e— Exports —gy— Imports

200

Q4_96 Q1_97 Q2_97 Q3_97 Q4_97 QI_98 Q2_98 Q3_98

Source: Bureau of Economic Analysis. Bureau of the Census

U.S. Bilateral Merchandise Trade Balances

S Billion

Mexico Canada Japan China EU
Q4_96 4.0 5.4 ~13.4 -10.5 4.6
Q1_97 -4.0 4.6 -134 9.7 -0.8
Q2_97 4.3 3.8 -12.6 “112 3.8
Q3_97 34 3.9 -14.8 -15.3 6.5
Q4_97 -2.9 -4.2 +153 -13.2 5.6
Q1_98 +27 3.8 -15.5 “115 “17
Q2_98 4.4 “3.4 -15.6 -13.6 69
Q3_98 4.3 5.8 -15.4 “17.2 8.5

Source: Bureau of Economic Analysis, Bureau of the Census
included the following:

© The trade deficit with Mexico decreased steadily until
the 2TM quarter of 1998, when the deficit rose to $4.4
billion. The appreciation of the dollar against the peso
contributed to a drop in U.S. exports to Mexico.

e The trade deficit with Canada decreased 4.6% in the
first three quarters of 1998 from the same period last
year. The fall in the deficit with Canada was likely the
result of the low prices of Canada’s commodity exports.

© The trade deficit with Japan expanded significantly.
The deepening recession in Japan as well as the
appreciation of the dollar against the yen contributed to a
sharp fall in U.S. exports to Japan. This resulted in a
rising trade deficit with Japan beginning in the 4"
quarter of 1997 and continuing into 1998.

© The trade deficit with China has recently shown signs
of significant expansion. The third quarter 1998
bilateral trade deficit with China was the United States’
largest bilateral trade deficit that quarter.

¢ The trade deficit with the EU increased 54% in the
first 3 quarters of 1998 compared to the same period
last year. This increase is likely the result of the dollar
appreciation and comparatively stronger U.S. growth.

© The trade deficit with emerging Asia widened
considerably as the result of falling U.S. exports to
the region. During the period of this report, nominal
imports from emerging Asia grew only moderately.

US, Merchandise Exports to Emerging Asia
1 Billion

a

| —~@— Exports —gy_- Imports
5)
Oct_96 Feb_97 Jun_97 Oct_97 Feb_98 Jun_98
Source: Bureau of Economic Analysis



Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November I, 1996 to October 31, 1998
Page 4

Latin America

Latin America experienced strong growth in 1997, but appears
to be entering a period of slowdown in 1998. As global investors
have become more risk averse, capital flows into Latin America
have dried up, so that affected nations, in order to finance their
current account deficits, have had to adjust with some
combination of reserve loss, depreciation, and slower growth.
Furthermore, weak commodity prices have hurt Latin American
exporters, further exacerbating external and internal imbalances.
Regional developments include the following:

* Mexico. The Mexican peso depreciated strongly against
the dollar since October 1997, driven by both falling oil
prices (Mexico is a large oil exporter) and reduced
capital inflows to Mexico attributable to general investor
aversion to emerging markets following the Asian crisis
and Russian devaluation. The fall in the value of the
peso added to Mexican inflation pressures, prompting
the Bank of Mexico to tighten monetary policy, which in
tum slowed economic growth: Real GDP growth in
Mexico fell to 4.3% in the 2TM quarter of 1998 from 6.6%
in the 1* quarter of 1998.

* Venezuela. The dollar appreciated against the bolivar
over the period of this report, also driven by lower oil
prices and capital outflows. Since government revenue
is dependent upon oil exports, falling oil prices also
increase the fiscal deficit. High interest rates imposed to
maintain the value of the bolivar are likely to lower
economic growth.

« Argentina. Argentina’s currency board arrangement did
not come under significant pressure and Argentina
posted strong growth in the first half of the year despite
the financial turmoil affecting the emerging markets.
Fiscal discipline and forward-looking external debt
management helped to maintain investor confidence
throughout the first half of 1998, but recent declines in
capital flows to emerging markets in general led to
modestly higher interest rates in the aftermath of the
Russian devaluation.

© Brazil. Global financial market turbulence contributed
to a large loss of foreign exchange reserves in
September, reflecting capital outflows by both domestic
and foreign residents. The government reacted with
steep hikes in interest rates, the announcement of deep
fiscal cuts, and the initiation of discussions with the IMF
on a program of international support. Reserve outflows
slowed sharply in October. Under the Brazilian
government’s 1999 budget program, supported by the
IMF, 1999 GDP growth was forecast to be -1%.

Real GDP Growth
% change over a year ago
Mexico Brazil Venezuela Argentina

Q4_96 71 5.0 1.7 9.0
Q1_97 49 46 0.5 8.0
Q2_97 8.6 48 76 83
Q3_97 79 2.7 73 9.9
Q4 97 6.7 19 49 8.2
Q1_98 6.6 0.9 17 72
Q2_98 4.3 15 0.6 69

Source: Haver Database

Brazil's Foreign Currency Reserves

5 Billion
80

70
60

50 4
40 4
304
20
10
0

Oct_96 Feb_97 Jun_97 Oct_97 Feb_98 Jm_98 Oct_98

Currency Movements

Domestic Currency

Units per Dollar

400

1

Mexico (Peso)

Oct_96 Feb_97 Jm_97 Oct_97 Feb_98 Jum_98 Oct_98

Currency Movements

Domestic Currency
0.90

Units per Dollar

095 foc
1.00
1.05
1.10
1a5
1.20
125

Argentina (Peso)

Brazil (Real)

Oct_96 Feb97 Jun_97 Oct_97 Feb 98 Jum_98 Oct_98


Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November 1, 1996 to October 31, 1998
Page 3

Canada

During the period covered by this report, the dollar appreciated
by 13% against the Canadian dollar. The fall in the Canadian
dollar stemmed from weak external demand combined with a
fall in commodity prices; both factors reduce the demand for
Canadian dollars. The Bank of Canada attempted to halt the
slide of the Canadian dollar through a series of interest rate
hikes, including a 100 basis point rise on August 27, 1998, as
well as interventions in the foreign exchange market. Although
the Bank of Canada matched the recent Federal Reserve interest
rate reductions, the impact of previous interest rate hikes has
been slowing economic growth in Canada.

Currency Movements: Canada
Canadian Dollars per Dollar
1.60

155
1.50
145
140
135

130 -
Oct_96 Feb_97 Jun_97 Oct_97 Feb_98 Jun_98 Oct_98

Russia

Throughout much of the period of this report, until August 1998,

the Russian currency remained stable. Western nations, along

with the IMF, provided a substantial package of financial
support to the Russian government on the condition that the
Russian government stabilize its fiscal position through a
combination of increased tax collection and spending cuts.
These reforms, however, did not fully materialize and the
combination of Russia’s growing fiscal deficit, reduced
confidence in Russia, and the general dollar withdrawal from
emerging markets led to a sharp decline in Russian foreign
currency reserves as Russia intervened to support the fixed
exchange rate. In the face of these falling reserves, on August
17%, 1998, the Russian authorities allowed the ruble to float,
resulting in a sharp fall in the value of the ruble, and intense
pressure on Russian banks. The devaluation was shortly
followed by a government announcement that debt payments
would be suspended and negotiations would be undertaken with
creditors on domestic debt restructuring. Subsequently, the IMF
suspended its July 1998 support package.

Currency Movements: Russia
Rubles per Dollar
20

15

10

5

0 :
Oct_96 Feb97 Jum_97 Oct_97 Feb_98 Ju_98 Oct_98

: On Jemma 1, 1999, eleven European inion 2 (EU) mem!

occur gradually. and it isnot clear that it would have tz

dollar will continue to play a critical Tol in on international financial syste1

macroeconomic policies,

Econo ic and Monetary Uni Europ :

ng as 3s the ‘United States continues to arse sound



Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered’ November 1, 1996 to October 31, 1998
Page 2

Currency Market Developments

Recent Developments

While the dollar appreciated during most of the period from
November 1, 1996 through October 31, 1998, in recent weeks
the dollar fell steeply against some major currencies. An
increase in risk aversion worldwide produced substantially wider
credit spreads, equity market declines, and record-low
benchmark bond yields on flight-to-quality flows. In this
environment, the dollar depreciated as many market participants
rapidly liquidated long dollar positions to offset losses in other
markets and closed out short positions in other currencies in a
widespread effort to de-leverage.

Japan

Between October 1996 and August 1998, the dollar appreciated
strongly against the Japanese yen, rising 19%, primarily
reflecting economic stagnation in Japan and market concerns
about the state of the banking system. The dollar depreciated
sharply against the yen, however, in October 1998 as market
participants covered short yen positions in response to financial
market turmoil. Japan’s economy recorded its fourth
consecutive quarter of negative real GDP growth in the third
quarter of 1998 while the Japanese government continued to
delay implementation of initiatives required to restore growth
and stability to the economy. Of pressing importance are
decisive actions to restore confidence to Japan’s ailing banking
system. Delays in implementing fiscal stimulus packages also
slowed recovery in Japan. The approval by the Japanese
parliament of a significant amount of public funds to strengthen
Japan’s banks is an encouraging development. To ensure
Tecovery, it is crucial that Japan’s banks take action now to use
these funds quickly and effectively, with appropriate conditions,
including stronger disclosure and steps to clean up the banks’
balance sheets and permanently dispose of bad assets.

Currency Movements: Japan

Yen per Dollar
160.0

150.0
1400
130.0
1200
1100

100.0
Oct_96 Feb_97 Jun_97 Oct_97 Feb_98 Jun_98 Oct_98

Germany

Between October 1996 and August 1997, the dollar appreciated

by 14% against the German mark. This appreciation appeared to
reflect stronger growth in the U.S. compared to Germany plus
uncertainty concerning the implementation of the European
Monetary Union (EMU). Market participants, concerned about
prospects for EMU, chose the safety of both dollars and pounds.
As the outcome of the EMU became more certain Jate in 1997,
and German growth prospects improved, the dollar stabilized
against the mark. In recent months, however, the dollar has
depreciated sharply against the mark. This followed Federal
Reserve actions to loosen U.S. monetary policy, the September
unwinding of long dollar positions, and somewhat weaker U.S.
growth and earnings prospects. Movements of the French franc
and Italian lira against the dollar matched movements in the
mark against the dollar.

Currency Movements: Germany

Marks per Dollar
2.0

19
18
17
16
1s
14
13 - > -

Oct_96 Feb_97 Jum_97 Oct_97 Feb_98 Jm_98 Oct_98

United Kingdom

The dollar remained relatively stable against the pound during
the period covered by this report. Both currencies benefited
from safe-haven flows in response to uncertainty conceming the
implementation of the EMU. Furthermore, both the United
States and the United Kingdom recorded strong economic
growth over this period. The pound was also supported by
interest rate hikes by the Bank of England in response to
inflation concerns in the United Kingdom. In response to
evidence of a slowing domestic economy, however, the Bank of
England cut interest rates by 25 bps. on October 8, 1998.

Currency Movements: United Kingdom
Pounds per Dollar
0.70

0.65

9.60 NDA AA

0.55

0.50
Oct_96 Feb_97 Jum_97 Oct_97 Feb_98 Jm_98 Oct_98



Department of the Treasury

Annual Report to Congress on International Economic and Exchange Rate Policy

Period Covered: November 1, 1996 to October 31, 1998
Page 13

Appendix

OMNIBUS TRADE AND COMPETITIVENESS
ACT OF 1988 (H.R. 3)

SEC. 3004. INTERNATIONAL NEGOTIATIONS ON
EXCHANGE RATE AND ECONOMIC POLICIES.

(a) Multilateral Negotiations.-The President shall seek to confer
and negotiate with other countries-

(1) to achieve-

(A) better coordination of macroeconomic policies of
the major industrialized nations; and

(B) more appropriate and sustainable levels of trade
and current account balances, and exchange rates
of the dollar and other currencies consistent with
such balances; and

(2) to develop a program for improving existing
mechanisms for coordination and improving the
functioning of the exchange rate system to provide for
long-term exchange rate stability consistent with more
appropriate and sustainable current account balances.

(b) Bilateral Negotiations.-The Secretary of the Treasury shall
analyze on an annual basis the exchange rate policies of foreign
countries, in consultation with the International Monetary Fund,
and consider whether countries manipulate the rate of exchange
between their currency and the United States dollar for purposes
of preventing effective balance of payments adjustments or
gaining unfair competitive advantage in international trade. If
the Secretary considers that such manipulation is occurring with
respect to countries that (1) have material global current account
surpluses; and (2) have significant bilateral trade surpluses with
the United States, the Secretary of the Treasury shall take action
to initiate negotiations with such foreign countries on an
expedited basis, in the International Monetary Fund or
bilaterally, for the purpose of ensuring that such countries
regularly and promptly adjust the rate of exchange between their
currencies and the United States dollar to permit effective
balance of payments adjustments and to eliminate the unfair
advantage. The Secretary shall not be required to initiate
negotiations in cases where such negotiations would have a
serious detrimental impact on vital national economic and
security interests; in such cases, the Secretary shall inform the
chairman and the ranking minority member of the Committee on
Banking, Housing, and Urban Affairs of the Senate and of the
Committee on Banking, Finance and Urban Affairs of
Representatives of his determination.

SEC.3005. REPORTING REQUIREMENTS.

(a) Reports Required.-In furtherance of the purpose of this title,
the Secretary, after consultation with the Chairman of the Board,
shall submit to the Committee on Banking, Finance and Urban
Affairs of the House of Representatives and the Committee on
Banking, Housing, and Urban Affairs of the Senate, on or
before October 15 each year, a written report on international
economic policy, including exchange rate policy. The Secretary
shall provide a written update of developments six months after
the initial report. In addition, the Secretary shall appear, if
requested, before both committees to provide testimony on these
reports.

(b) Contents of Report.-Each report submitted under subsection
(a) shall contain-

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

an evaluation of the factors in the United States and
other economies that underline conditions in the
currency markets, including developments in bilateral
trade and capital flows;

@

v

3

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

(4) an assessment of the impact of the exchange rate of the
United States dollar on

(A) the ability of the United States to maintain a more
appropriate and sustainable balance in its current
account and merchandise trade’account;

(B) production, employment, and noninflationary
growth in the United States;

(C) the international competitive performance of
United States industries and the external
indebtedness of the United States;

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

(6

the results of negotiations conducted pursuant to section
3004;

key issues in United States policies arising from the
most recent consultation requested by the International
Monetary Fund under article IV of the Fund’s Articles
of Agreement; and

7