- 18 -

foreign securities branches in Korea when they are allowed to begin
operating in 1992.

The Korean Government has also done little to address the need
for broader liberalization of its tightly controlled financial
markets, including deregulation of interest rates and elimination
of credit allocation schemes.

The Department of the Treasury views these issues as evidence
that the Korean Government is unwilling in certain important areas
to address the fundamental concerns of the United States. We will
continue to pursue them with the Korean Ministry of Finance through
the bilateral Financial Policy Talks, and the Uruguay Round
financial services negotiations.

Assessment

At this time, there is no basis for concluding that Korea is
directly "manipulating" its exchange rate, within the meaning of
the 1988 Trade Act, for the purposes of competitive gain, or that
the Government is using the array of exchange and capital controls
at its disposal to "manipulate" the rate indirectly. This
assessment is based on the following factors: the reemergence of
modest trade and current deficits in 1990, the likelihood that
Korea will again post small external deficits in 1991, the decline
in Korea's foreign reserves in the first quarter of 1991, the lack
of evidence that the Bank of Korea is intervening directly in the
exchange market, and the modest role of other government-owned
foreign exchange banks in the market.

Nonetheless, we remain seriously concerned that pervasive
Korean exchange and capital controls significantly constrain supply
-and demand in the currency market. The exchange rate determination
system in place, while an improvement over the previous regime, is
far from a truly market-determined exchange rate system.
Liberalization of these controls is imperative to strengthen the
role of market forces in exchange rate determination and in trade
and investment flows, and would contribute significantly to the
prospects for sustaining Korea's recent external adjustment.

Therefore, in the period ahead, the Treasury Department will
continue to monitor developments in Korea's external accounts and
the operation of the new market-average exchange rate system. In
particular, with a return to external surpluses likely in 1992, we
would expect to see a renewed trend toward appreciation of the won.
We will also continue to press for liberalization of Korea's
financial, capital, and exchange markets, as well as to seek
improved treatment for U.S. financial institutions in Korea.




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12

Furthermore, other important changes in the world economy with
significant medium-term implications have been occurring. In this
context, the Ministers and Governors welcomed the critical reform
efforts underway in Eastern Europe, Latin America, and other
developing countries, and agreed that a strong global economic
recovery and open markets in the major industrial countries will
provide necessary support for these efforts.

At their meeting, the G-7 noted the hopeful signs of
recovery in some quarters. In particular, there were indications
of a prospective economic recovery and lower inflation in those
countries which were in recession. Adjustment of structural fiscal
deficits was underway in the United states and a number of other
countries which would strengthen public savings. External
imbalances have been further reduced. Interest rates in the United
States, in particular, have declined.

But a recovery of world economic activity is by no means
certain. High real interest rates persist in Many countries,
dampening investment and growth prospects, and economic activity is
slowing in those countries which until recently had been
experiencing strong expansion.

Fostering an open, growing world economy is the most effective
tool to meet the challenges of the world economy. The Ministers
and Governors therefore emphasized the importance of monetary and
fiscal policies which provide the basis for lower real interest
rates and a sustained global economic recovery with price’
stability. They agreed that such a medium-term strategy was the
best way to reduce the potential risks and uncertainties in the
current outlook. And they reaffirmed their commitment to cooperate
Closely on exchange markets. In the period ahead, it will be
important to take concrete actions to strengthen prospects for
sustained growth with price stability.


- 22 -

is welcome. Tightening the limit on outflows, however, was not a
positive action, although it was probably instituted out of concern
for the large movement of capital overseas in 1990. The Central
Bank claims that the lower outflow limit will have little practical
effect since over the last three years, the amount of outward
remittances averaged only $26,000, with just 4 cases out of 10,000
exceeding $3 million. It is our expectation that the Central Bank
will raise both limits in tandem as the market continues to be
stable and it gains confidence.

The maintenance of restrictions on "long" and "short" foreign
exchange positions and the method of calculating the foreign
exchange positions of a bank effectively prevent a forward foreign
exchange market from functioning. The cash or spot basis Taiwan
uses to calculate a bank's foreign exchange position is contrary to
normal international practice. Taiwan instituted a cash basis
method in 1987 to deter pressure for NT dollar appreciation and to
prevent foreign banks from doing forward foreign exchange
transactions. That is, on a cash basis, forward foreign exchange
positions are not counted. Taiwan should, thus, return to the
Generally Accepted Accounting Practice norm of using an "accrual"
basis in calculating foreign exchange transactions and allow the
operation of a forward market.

The ceilings on foreign exchange positions also discriminate
against foreign banks. For example, the limit on forex liabilities
varies by bank, depending on the average outstanding balance over a
certain period of time. In all likelihood domestic banks were
forewarned of changes in the ceiling, allowing them to build up
their outstanding balances beforehand. Moreover, the ceiling on
overbought forex position is $50 million per bank for the five
large domestic banks and $20 million per bank for all other banks,
including the foreign banks. Finally, the limits on forex
positions are based on local assets. The assets of foreign banks,
however, are relatively small since Taiwan has restrictions, on
their operations “and branches. -

° Assessment

We are encouraged by the fall in Taiwan's external surpluses
over the past year and the continued liberalization of the exchange
rate system, which now more accurately reflects market forces. We
have no evidence of direct exchange rate "manipulation" for unfair
competitive purposes. There is still reason to be much concerned,
however, about Taiwan's persistently large external surpluses,
especially relative to GNP. As such, there is a need for a more
rapid decline in these surpluses. Exchange rate appreciation will
likely need to play a role in this process. Indeed, with continued
strong growth, sizable external surpluses, and greater domestic
political stability, a renewed trend toward broad appreciation of
the NT dollar would be expected. Limitations on foreign exchange
transactions and capital flows, while less pervasive than in
Korea's case, remain too restrictive and impede the full operation


Among the G-7 (Summit) countries, the United Kingdom
recorded the highest 1990 inflation rate (9.5 percent). This
rate was particularly affected by special factors such as the
introduction of the community charge (poll tax). Inflation rates
in Italy (6.5 percent) and the United States (5.3 percent) also
exceeded the Summit country average for the year. The lowest
rates were recorded in Germany (2.7 percent) and Japan (3.1
percent). The rise of many currencies against the dollar during
1990 helped to limit the impact of higher world oil prices
(denominated in dollars) on their domestic prices.

Trade and current account developments in 1990 were quite

favorable for the goal of reducing external imbalances. The U.S.
trade deficit fell once again, despite an $11 billion increase in
petroleum imports (mainly from higher oil prices, but also from
an increase in the volume of oil imported). The deficit dropped
to $108.7 billion on a balance of payments basis, down $6 billion
from 1989. The U.S. current account deficit fell to $99.3
billion, the lowest level since 1984. The current account
deficit was equal to 1.8 percent of GNP, one half the 1987 peak
of 3.6 percent of GNP ($162.3 billion).

Japan's external surpluses also fell, with the current
account surplus declining from $57 billion in 1989 to $35.8
billion in 1990. This $21 billion reduction -- about $6 billion
of which was attributable to higher oil prices -- brought Japan's
current account surplus down to 1.2 percent of GNP from the 1987
peak of 3.6 percent of GNP ($87 billion).

Germany's current account surplus fell to $44.5 billion (2.7
percent of GNP), after a peak of $55.3 billion (4.6 percent of
GNP) in 1989. While higher oil prices played a role, the
principal factor was strong demand for imports (both in the west,
where real total domestic demand grew 5.1 percent last year; and
in the eastern states, as one effect of reunification).

Germany's $50.3 billion trade surplus with its EC trading
partners fell by a third, after tripling between 1985 and 1989.

Current account deficits for both the United Kingdom and
Canada remained sizeable (2.4 percent) in relation to GDP last
year. But the United Kingdom's deficit fell by $8 billion, to
$22.8 billion, as the economy moved into recession. Canada's
deficit was little changed in dollar terms, at $13.7 billion.
France and Italy again recorded deficits of moderate size.


TABLE 1

Economic Performance of
Major Industrial Countries

GNP 1/ Domestic Demand 1/

1989 1990 1991 1989 1990 1991
U.S. 2.5 1.0 0.2 1.9 0.5 -0.5
Japan 4.7 5.6 3.6 5.7 5.8 3.6
Germany 3.8 4.5 2.8 2.7 5.1 2.4
France 3.7 2.8 2.1 3.3 3.1 2.3
U.K. 1.8 0.6 -2.1 2.9 0.1 2.9
Italy 3.2 1.9 1.7 3.3 1.9 1.7
Canada 3.0 0.9 rid 4.2 0.0 71.3
G-7 2/ 3.1 2.6 1.3 3.1 2.4 0.9

Inflation 3/ Current Account 4/

1989 1990 1991 1989 1990 1991
U.S. 4.8 5.3 4.9 “2.1 “1.8 -0.7
Japan 2.3 3.1 4.0 2.0 1.2 1.3
Germany 2.8 2.7 3.5 4.6 2.7 0.6
France 3.5 3.4 3.2 -0.4 -0.6 -0.5
U.K. 7.8 9.5 6.0 “3.9 ~2.4 “1.5
Italy 6.3 6.5 6.2 ~1.2 1.4 -1.5
Canada 5.0 4.8 5.6 72.6 72.4 71.7
G-7 2/ 4.5 5.0 4.6 -0.5 -0.6 -0.2
*Data for 1989 and 1990: national sources and International
Monetary Fund. Forecasts for 1991: International Monetary Fund,

World Economic Outlook (May 1991).

1/ Annual average rates in real terms.

2/ Average of individual country rates, weighted by GNP.
3/ Consumer prices; annual average.

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


Taiwan

Since the October 1990 report, Taiwan's external surpluses
have continued to fall, while the NT dollar has fluctuated within a
small range. Factors such as the relocation of lower, value-added,
export industries overseas; rising wages and production costs; and
inflationary pressures have continued to play an important role in
the decrease in the external trade surpluses over the past year.
The expected slow growth over the near-term in Taiwan's major
export markets, particularly the United States, in addition to the
above elements, should lead to a further reduction in Taiwan's
external surpluses this year. However, Taiwan's current account
surplus, in nominal terms and relative to GNP, will still be
unsustainably large.

° Exchange Rate Developments

Since the October 1988 report, Taiwan's cumulative exchange
rate appreciation against the dollar has been only 6 percent in
nominal terms. The NT dollar began 1990 at NT$26.17/U.S.$1 and
depreciated by less than 1 percent during the first four months of
the year. In mid-May 1990, the NT dollar depreciated by 4 percent
to NT$27.40/U.S.$1 due to substantial net capital outflows caused
by political uncertainties and slower economic growth. In June,
the Central Bank sold U.S. dollars and imposed severe deposit
requirements on foreign exchange accounts, inducing a firming of
the NT dollar to NT$27.20/US$1. This, along with an improvement in
the political situation, led to a reversal in capital flows in the
second half of the year. Since mid-1990, the NT dollar has
fluctuated within a small range against the U.S. dollar. The NT
dollar depreciated against all other major currencies through 1990
as a whole. As of April 12, the exchange rate stood at
NT$27.28/US$1.

Given the strength of Taiwan's economic fundamentals, the
expectation of increased growth, a still large current account
surplus, and a more stable political environment, there is every
reason to expect strengthening of NT dollar ‘in the months ahead.

° Trade and Economic Developments

Taiwan's global current account surplus decreased by
4.6 percent in 1990 to $10.9 billion. As a proportion of GNP, this
was a fall to 6.7 percent from 7.5 percent in 1989. Taiwan's
overall trade surplus (cif basis) was down 10 percent last year
from 1989 to $12.5 billion.

The U.S. trade deficit with Taiwan in 1990 was 14 percent
lower than in 1989 at $11.2 billion. This reflects a 7 percent
fall in U.S. imports from Taiwan. However, U.S. exports to Taiwan
only increased by 1 percent.

According to Taiwan's data, our bilateral trade imbalance
contracted by 24 percent to $9.1 billion in 1990. Exports to the
United States dropped by 9 percent, the steepest decline in 16
years. The U.S. share of Taiwan's exports fell 4 percentage points


~25 -

At the same time, the exchange rates in the swap centers and
black market are weaker than the administered rate, typically by 20
percent and 30 percent, respectively. This gap has narrowed
recently, however. For example, in early 1991, the exchange rate
in the swap centers was close to Yuan 5.7/US$1, or approximately 9
percent below the value of the administered rate.

Given the large and growing external surplus, the apparent
unwillingness to abolish export subsidies fully, and lack of reform
of the trade system, there is certainly no justification for
further devaluations. At the same time, while an appreciation of
the administered official exchange rate could dampen external
demand for China's exports, it would probably have little effect on
the flow of imports given the number and complexity of other
barriers to imports.

° Trade and Economic Developments

China has characteristically had overall trade and current
account deficits in recent years. In 1990, however, China's
merchandise trade balance moved to a $9 billion surplus from a
deficit of $5.6 billion in 1989. The current account also went
from deficit in 1989 to an estimated $10.2 billion surplus in 1990,
equal to 2.8 percent of GNP. This year, these surpluses are
expected to increase by sizable amounts.

China: Current Account and Trade Balance ($ Bn.)

1985 1986 1987 1988 1989 1990
Current Account ~11.4 -7.0 0.3 3.8 ~4.3 10.2
% of GNP -3.9 2.6 O.1 -1.0 -1.0 2.8
Global Trade Bal. “13.1 “9.1 -1.7 -5.3 ~5.6 9.0
% of GNP 4.4 -3.2 ~0.6 “1.4 -1.2 2.5
Trade Surplus w/U.S. 0 1.7 2.8 3.5 6.2 10.4
(U.S. data)
% of GNP oO 0.6 0.9 0.9 1.3 2.9

According to U.S. customs value data, China has a large and
growing trade surplus with the United States. China's bilateral
trade surplus with the United States grew 67 percent to
$10.4 billion in 1990. This trend stems largely from a significant
increase in Chinese exports -- especially clothing, toys, sporting
goods, footwear, and consumer electronics -- to the United States.
China's export capacity has benefitted greatly from foreign
investment, particularly from Hong Kong and Taiwan, as production
of labor intensive goods in those economies has become
uncompetitive. Before being transferred to China, much of this
production was targeted for export to the United States and this is
still the case.


-21-

Taiwan continued to take a number of measures to liberalize
the system further and reduce capital controls over the past year
and since the October 1990 report.

All foreign exchange transactions can now be freely
determined, beginning with the announcement at end-1990 that
authorized foreign exchange banks are permitted to set their own
exchange rate for small foreign exchange transactions (less than
$10,000) that had formerly been fixed by a committee of banks.

The breadth of the foreign exchange call loan market (maturity
ranges from overnight to six months) has been expanded in terms of
eligible participants and tradable currencies. As such, daily
turnover has risen dramatically to approximately $1.2-1.5 billion.
Fifty foreign exchange banks were permitted to participate at the
establishment of the call loan market in August 1989. Since August
1990, headquarters and affiliated institutions of foreign banks in
Taiwan, overseas branches of local banks, and all financial
institutions in Singapore, New York, and London have been allowed
to participate in the market. The tradable foreign currencies have
been increased from only the U.S. dollar to all other 12 currencies
listed on the foreign exchange market. The foreign exchange call
loan market also signed a linkage agreement with Singapore early
this year, on top of linkages already with Hong Kong, Tokyo, and
Seoul.

In addition, the minimum one-month holding period for fixed-
term foreign exchange deposits was eliminated in January 1991. The
foreign exchange reserve requirement instituted in June 1990 to
stem capital outflow was also rescinded in late-November.

The limit on foreign exchange (forex) liabilities of each
foreign exchange bank was increased twice in 1990, by 30 percent in
March and by 50 percent in August. The aggregate level for all
foreign exchange banks was, thereby, raised to $30 billion. The
limit on the short (oversold) position of each foreign exchange
bank was doubled to $6 million in early August. These relaxations
should broaden foreign exchange activities and make the NT dollar's
value more open to market forces.

The limits on foreign exchange inflows and the amount of cash
an individual can carry in and out of Taiwan were relaxed. (The
cash maximum was raised 400 percent to a still small NT$40,000 or
$1466.) The annual limit on non-trade related capital inflows was
raised from $2 million to $3 million per entity in July. (Capital
flows for trade purposes are unlimited.) At the same time,
however, the annual limit on capital outflows was tightened from $5
million to $3 million, or the same limit for inflows.

The easing of the inflow restriction was, in part, a response
to U.S. criticism in previous reports that the uneven limits on
inflows and outflows distorted the operation of market forces and
constituted a bias against appreciation. In that sense, the change

ase


Table 2
Measurements of Dollar Movements (for key dates)

Versus G-7 Currencies
Percent Dollar Appreciation (+) or Depreciation (-)

As of April 12, 1991

en

Since Since

Dollar Plaza Louvre | Over Last | Previous

Peak Accord Accord Year Report
Value of the Dollar | 26-Feb-85 | 20-Sep-85 | 20-Feb-87 | 12-Apr-90 | 12-Oct-90
in Terms of: to Date to Date to Date to Date to Date
Japanese yen 48,2 -43.8 11.7 14.4 +5.2
German mark 51.9 415 8.5 -0.2 +9.8
British sterling 419 -23.8 -14.6 8.2 +10.1
French franc 46.7 -35.2 71 +04 +10.9
Italian lira 42.8 35.4 44 +0.8 +89
Canadian dollar 18.1 -16.4



-~16-

of foreign companies located in Korea to obtain investment and
working capital and even import finance.

° Trade and Economic Developments

Domestic Economy

Korea's real GNP is estimated to have grown 9 percent in 1990,
compared with 6.7 percent in 1989 and over 12 percent annually in
1986-88. Growth in 1990 was led by private consumption and fixed
investment, with the construction and manufacturing sectors
registering particularly strong performances. Inflation is
estimated to have reached 8.6 percent in 1990. Unemployment
remained low at 2.4 percent. In 1991, the real GNP growth rate is
expected to remain strong at about 8 percent. Inflation is a
growing concern, with the consumer price index rising at an
annualized rate of nearly 20 percent in the first quarter of 1991.

External Accounts

Korea's external accounts have undergone substantial
adjustment since 1989 largely because of the substantial real
appreciation of the won in 1988-89. Other factors in the
adjustment include: the strong growth of the domestic economy
(drawing in greater imports); rising wage demands and other factors
adversely affecting Korea's export competitiveness; and rising oil
import prices and lost export opportunities in the wake of the
Persian Gulf crisis.

For the first time since 1985, the current account fell into
modest deficit in 1990, by $2.1 billion (0.9 percent of GNP). This
included a trade deficit of $1.9 billion on a balance of payments
basis, compared with a trade surplus of $4.5 billion in 1989.
Merchandise exports were up 4.2 percent in value terms from the
previous year, while imports rose 13.6 percent. The current
account deficit in the first quarter of 1991 reached $3.9 billion.
However, with exports recovering strongly and import growth
slowing, the Bank of Korea projects that the deficit for all of
1991 will narrow to $2 billion, implying a return to monthly
current account surpluses later this year. This in turn suggests
that, notwithstanding the Korean Government's earlier projection of
a current account deficit in 1992, external surpluses are likely to
reemerge from next year.

According to U.S. customs data, the U.S. bilateral trade
deficit with Korea in 1990 fell to $4.1 billion, down 38 percent
from 1989. This was based on a 7 percent increase in U.S. exports
to Korea and a 6 percent decline in imports from Korea. In the
first two months of 1991, the United States ran a small trade
surplus of $13.5 million with Korea.


PART IV: U.S. BALANCE OF PAYMENTS

Developments in 1990

The U.S. trade deficit continued to decline gradually in
1990, to $109 billion from $115 in 1989 (balance of payments
basis). This represents a decline of $51 billion, or nearly one-
third, from the peak deficit of $160 billion in 1987. (See
Tables 3 and 4.)

Total 1990 exports, at over $389 billion, were up nearly $29
billion or 8 percent (9 percent in volume) from their 1989 level.
Export growth, though still robust, slowed substantially from the
double-digit rates of 1988 (28 percent in value terms; 24.5
percent in volume) and 1989 (12.5 percent and 11.4 percent,
respectively). However, a major portion of the extremely rapid
export increases during 1988-89 constituted "catch-up" of market
share lost during the earlier period of extreme dollar strength.
More recently, sustaining U.S. export growth has involved the
challenging task of increasing market share beyond previous peak
levels. In this light, the continued growth of U.S. exports at
rates well above the growth of major markets abroad has confirmed
that the competitiveness of U.S. products remains strong.

As in 1989, roughly one-half of the increase in 1990 exports
was accounted for by capital goods. Consumer goods and
industrial supplies and materials each contributed about one-
quarter of the increase; other categories showed little change
year-over-year. On a geographic basis, nearly one-half of the
increased exports went to Europe, With the remainder spread
across other geographic areas. Robust demand growth, and
sustained U.S. export competitiveness, led to double-digit growth
in the value of exports to Europe, registering a 13 percent
increase compared with a 6 percent increase to all other areas.

Imports for 1990 were $498 billion, up $23 billion, less
than 5 percent in value terms, from their 1989 level. Half the
increase was in oil imports, partly though not entirely due to a
sharp run-up in oil prices late in the year, related to the Gulf
crisis. The remainder was in imports of capital and consumer
goods. Imports from Japan and the Asian NIEs actually declined
slightly, with the bulk of the increase in imports coming in
trade with OPEC. Continued moderation in import growth will be
an essential element in further trade deficit reduction.


-31-

Fundamental denials of national treatment for foreign
financial institutions in Korea remain. The Korean Government has
done little to address the need for broader liberalization of its
tightly controlled financial markets, including deregulation of
interest rates and elimination of credit allocation schemes. The
Treasury Department views these issues as evidence that the Korean
Government is unwilling in certain important areas to address the
fundamental concerns of the United States. We will therefore
continue to monitor developments in Korea's exchange rate and
external adjustment, to press for liberalization of Korea's
financial, capital, and exchange markets, and to seek improved
treatment of U.S. financial institutions in Korea.

Taiwan's global current account surplus decreased by 4.6
percent in 1990 to $10.9 billion, which included a 10 percent drop
in its trade surplus to $12.5 billion. Taiwan's bilateral trade
surplus with the United States also fell by 14 percent to $11.2
billion. With the decline in Taiwan's external surpluses and the
continued liberalization of the exchange rate system, we have no
evidence of direct exchange rate "manipulation" for purposes of
unfair competitive gain. But Taiwan's persistent external
surpluses remain too large, and their decline needs to be
accelerated. Exchange rate appreciation will likely need to play a
role in this process. In addition, Taiwan's exchange restrictions,
while less pervasive than Korea's, impede the full operation of
market forces in exchange rate determination. The Treasury
Department will continue to monitor developments and to urge the
authorities to liberalize exchange restrictions further.

China's current account, which had been in deficit in recent
years, moved dramatically into a surplus of $10.2 billion in 1990,
2.8 percent of GNP, with a trade surplus of $9 billion. China's
large and growing trade surplus with the United States rose 67
percent to $10.4 billion in 1990. These developments chiefly
reflect China's generalized and pervasive controls over the
external sector, including both import restrictions and the
allocation of foreign exchange. These controls, in conjunction
with China's administrative determination of its exchange rate and
sustained real effective depreciation in 1990, raise concerns and
indicate a shift in policy may be occuring aimed at reinforcing
China's attempts to generate significant external surpluses. The
Treasury Department intends to discuss China's exchange policies,
including exchange rates and exchange allocation, with its
authorities with a view toward promoting a more market-oriented and
less distorted exchange rate and exchange allocation system.


- 28 -

There are a number of practical steps that China should
consider taking to permit its exchange rate to reflect more fully
market forces. First, China should make foreign exchange
allocation automatically to companies which either have import
licenses or are authorized to import without licenses, thus,
removing foreign exchange allocation as another administrative
barrier to imports. Second, China should liberalize foreign
exchange transactions by permitting more transactions in the swap
markets and the unofficial market. China should also eliminate
other barriers to obtaining foreign exchange such as the
requirement for explicit authorization.

These controls and the surpluses to which they contribute are
a matter of concern for the United States Government. Treasury,
therefore, intends to discuss China's foreign exchange policies
with its authorities with a view to seeing China move toward a more
market-oriented exchange rate determination and allocation system.


PART III: DEVELOPMENTS IN FOREIGN EXCHANGE MARKETS

Overview

Since the October 1990 report, the dollar has appreciated
5.2 percent against the yen and 9.8 percent against the
deutschemark. Continental European currencies followed the
movement of the dollar versus the deutschemark. The Canadian
dollar, the currency of the United States! largest trading
partner, remained roughly unchanged against the dollar. (See
Table 2.)

On a real, trade-weighted basis, measured against the
currencies of 40 developed and developing country trading
partners, the dollar's March 1991 value was 4 percent above its
October 1990 level. Measured on this basis, the dollar was about
at the same level as in early 1980, prior to the 1980-84
appreciation. (See Chart.)

Demand for the dollar increased somewhat in the last quarter
of 1990 as a hedge against uncertainty about the Gulf crisis and
the Soviet Union. A brief shift out of the dollar occurred in
mid-January to mid-February due to movements in interest rate
differentials against the dollar and as the favorable conduct of
the Gulf War dampened safe haven demands for the dollar.

However, market confidence in the dollar returned in the wake of
the quick conclusion of the Gulf War, optimism about the outlook
for the U.S. recovery, and selling pressures on the deutschemark.

Late 1990

During the final quarter of 1990 and into early January
1991, the dollar driited upward, boosted by occasional surges in
demand for dollar liquidity prompted by market concerns over the
risk of war in the Gulf and instability in the Soviet Union. The
upward trend was tempered, however, by the slowdown in U.S.
economic activity compared to that abroad, and the risk of
adverse economic effects from a prolonged Gulf war. Moreover,
short-term interest differentials moved further against the
dollar during this period, particularly between the United States
and Germany. Divergent movements in interest rates resulted in a
differential of more than a percentage point between rates for
U.S. and German short-term (3~month) assets.

On balance, events in the Gulf at times prompted dollar
demand. But as concerns over economic fundamentals reasserted
themselves among participants, the lower returns on dollar assets
began to depress demand for dollars.


4

The year 1991 is likely to record very low aggregate real
GNP growth in the industrial countries -- perhaps in the 1 to 1.5
percent range. A significant slowdown in growth is projected in
Germany and Japan. Growth is also projected to be lower in the
major continental European countries. The slow average growth
projection for the year also reflects recession in the United
States, Canada and the United Kingdom in the early months of
1991.

While there are some encouraging signs of prospective
economic recovery, the global outlook contains substantial risks,
given the persistence of high real rates which generate
uncertainties about the strength and timing of increased growth.
For example, real short term interest rates in 1990 were 4.5
percent and 5.8 percent in Japan and Germany, respectively,
compared to 2.4 percent in the United States.

Inflation prospects for the G-7 countries in aggregate, on
the other hand, are favorable. With the passing of last fall's
temporary rise in world petroleum prices, slower growth
encouraging price and wage moderation, and some special
statistical factors in consumer price indices no longer present,
inflation rates are expected to decline this year. Ona year
average basis the decline is likely to be small, but average G-7
inflation is expected by the IMF to fall from 5.5 percent in the
year to the fourth quarter of 1990 to about 4 percent in the year
to the fourth quarter of 1991.

A further decline in current account imbalances is in
prospect for this year. Slower growth in the U.S. will hold down
import levels, while the more moderate slowdown abroad will help
sustain U.S. exports. There will also be a large temporary
reduction in the U.S. deficit as transfers are received from
foreign governments in connection with international cooperation
in the Persian Gulf. (The effect of these transfers on the
balance of payments depends in part on whether they are received
in cash or in kind -- only the former would be recorded in the
current account.) The current account surpluses of Japan and
Germany are also likely to fall, the latter by a considerable
margin as imports by the eastern states continue to rise.


-17 -

After declining steadily since 1985, Korea's gross external
debt rose to $31.7 billion by the end of 1990, compared with $29.4
billion at the end of 1989. The 1990 gross debt figure is equal to
only 13.5 percent of GNP, compared with 52 percent of GNP in 1985.
Total interest and amortization payments declined from $8.1 billion
in 1989 to $6.9 billion in 1990. As a ratio of exports of goods
and services, debt service declined from 11 percent in 1989 to 9
percent in 1990. Gross official reserves at the end of 1990
totaled $15 billion, representing 2.8 months of import coverage.
With the negative trends in the current account, reserves fell to
$13 billion by the end of March 1991, about the same level as at
end-1988, when Korea experienced its peak current account surplus.

Policy Developments

In the last report, we noted with concern that the Korean
Government had strengthened its controls over various aspects of
the economy during 1990 and postponed earlier plans to deregulate
and liberalize. Responding to foreign expressions of concern about
the direction of economic policy, senior Korean officials issued a
series of public statements in the early part of 1991 affirming the
Korean Government's commitment to free trade and calling on
government ministries to alleviate economic tensions with other
countries.

The Ministry of Finance has taken some concrete measures over
the past year to improve the treatment of foreign financial
institutions in Korea. These steps include an increase in the
ceiling on issuance of certificates of deposit (CDs) by foreign
banks in June 1990, elimination of the ceiling on foreign banks!
paid-in capital in Korea, and extension of the operating hours of
cash dispenser machines.

However, fundamental denials of national treatment for foreign
financial institutions in Korea remain. These denials of national
treatment manifest themselves in several areas. Notwithstanding
the increase in CD limits, U.S. banks report severe and growing
difficulties in meeting the local financing needs of their
traditional clients. Swap lines, the chief source of local
currency for foreign banks, have been cut several times since
December 1987 without deep, viable alternative sources of funding
being made available. Discrimination against foreign banks in the
setting of interest rates in the interbank call money market has
not abated. At the same time, the regulatory environment for
foreign banks in Korea has been tightened, in a manner that lacks
both transparency and consistency.

In the securities area, the Ministry of Finance has imposed
stiff criteria for foreign branch establishment, including
burdensome and discriminatory minimum capital requirements. These
criteria are all the more onerous because the Ministry of Finance
has not yet specified the range of permissible activities for


7

Demand for dollars during this period was reinforced as the
view took hold that the U.s. economy would likely begin its
recovery around mid-year. There was still a note of caution,
however, in that market participants expected the recovery to be
moderate. Also, many participants believed that the U.S.
monetary authorities would view a further rapid rise of the
dollar with some concern, given the potential risks to U.S. trade
competitiveness.

A major factor in the strength of the dollar during this
period was a slackening of demand for deutschemark assets. While
many had expected German reunification to produce rapid growth of
investment in east Germany, the productive capacity and
investment appeal of east Germany proved weaker than initially
expected. The market regarded the tax increases in Germany --
announced early in the year -- as an admission by the German
government that it had underestimated the cost of integrating
west and east Germany.

In addition, demand for German assets declined in light of
deteriorating political and economic conditions in the USSR.
Many participants were concerned about Germany's ability to cope
with both the costs of unification and the possibility of large-
scale immigration into Germany from the Soviet Union.


~ 23 -

of market forces in exchange rate determination. Given Taiwan's
advanced state of economic development, such limitations should be
significantly relaxed. We will continue, therefore, to monitor
carefully the situation and urge the authorities to further
liberalize controls on capital and foreign exchange transactions.

China

In the October 1990 report, we noted China's tendency to run
global current account and trade deficits since experimentation
with economic and trade liberalization began in 1979. At the same
time, we observed that China's bilateral trade surpluses with the
United States had grown rapidly since 1985. China's exchange rate
had been devalued periodically, but apparently not to the extent
that the fall in the yuan had matched the pace of increase in
Chinese inflation, thereby causing China to lose competitiveness.
Since that report, however, there are mounting indications that
China may seek to run significant current account and trade
surpluses by combining devaluations of the yuan and tight controls
over foreign exchange allocation with severe restrictions on
imports.

° Exchange Rate System

China officially has a dual exchange rate system. There is an
administered ("managed float") exchange rate which applies to
transactions under the state trade plan. There is also a
"floating" rate determined in the "foreign exchange adjustment
(swap) centers" where foreign investment corporations and all
domestic entities which are allowed to retain foreign exchange can
conduct foreign exchange transactions based on rates agreed by the
buyer and seller. This foreign exchange, however, can only be used
to purchase "priority" products and transactions must be approved
by the State Administration of Exchange Control. The swap centers
were instituted in 1986 and have since then grown significantly in
number (100) and breadth of transactions. There are also various
internal settlement rates used to conduct transactions; for
instance, between factories and foreign trade corporations. In
addition to the official dual system, there is an active black
market for foreign exchange trading.

o Exchange Rate Developments

There has not been a consistent pattern of nominal yuan
devaluations against the dollar since the yuan (administered rate)
was devalued by 15 percent in 1985 and another 17 percent in 1986.
In December 1989, however, the administered rate was devalued in
nominal terms by 21 percent to Yuan 4.72/US$1 due mainly to a
desire to reduce state subsidies to exporters who lose money on
sales of products with higher domestic production costs than
prevailing international prices. This depreciation was instituted
in anticipation of eventual import liberalization, which has not,


DEPARTMENT OF THE TREASURY

Report to the Congress
on

International Economic and Exchange Rate Policy

May 1991


10

Exports should continue to show steady growth, similar to
the 1990 performance. The U.S. competitive position remains
solid: despite recent dollar fluctuation, on a trade-weighted
basis against a basket of currencies, it remains within the +10
percent or so band observed since its 50 percent decline in 1985-
87. In addition, growth in markets abroad remains solid,
although there are emerging concerns that growth in Europe and
Japan may slacken over the course of this year.

Non-oil import growth in 1991 should remain low, though it
should pick up somewhat during the course of the year from the
very low 3 percent value growth for 1990 as part of the normal
part of a cyclical recovery. The value of oil imports is likely
to decline in 1991, reflecting lower average oil prices. While
the volume of oil imports may rise, as depleted stocks are
rebuilt in the early part of the year and demand picks up in the
latter part of the year, the oil price decline is likely to be
larger than the volume increase.

These trends point to a 1991 trade deficit in the $90
billion range, below $100 billion for the first time since 1983.
In addition, further underlying progress is being made in
reducing the current account deficit. Thus, the current account
deficit may fall to around $75 billion, excluding the one-time
impact of Desert storm contributions. Including these
contributions, the current account deficit could even be below
$40 billion.


9

Reflecting these import and export developments by product
and area, the trade balance vis-a-vis Western Europe switched
from a $4 billion deficit in 1989 to a modest surplus of over $2
billion in 1990. The balance vis-a-vis Japan and the Asian
NIEs -- though remaining in deficit -- also improved, although
about one-half of the improvement reflected lower U.S. imports
rather than export gains, as was the case for the balance with
Western Europe.

The 1990 current account deficit, at $99 billion, was under
$100 billion for the first time since 1984. Roughly one-half ($6
billion) of the $11 billion improvement from 1989's $110 billion
deficit reflected the trade balance improvement, discussed above.
The remaining $5 billion came from an increase in the net inflow
for all other components of the current account combined:
investment income, services, and transfers.

The increase in net investment income was extremely large,
over $8 billion. In large part, this reflected a decline in U.S.
earnings of foreign direct investors, which, in turn, was related
to the more moderate pace of activity in the U.S. economy. Net
receipts on services other than investment income registered a
modest increase of over $2 billion, continuing the gradual upward
trend of recent years. Offsetting these increased inflows was an
increase in the net outflow for unilateral transfers of over $6
billion, principally reflecting forgiveness of debt owed by
Egypt. (The impact of the grant to Egypt was partly offset by
receipts of cash support from coalition partners for Operation
Desert Shield.)

Financing of the 1990 current account is obscured by the
extremely large ($73 billion) statistical discrepancy, which is
thought generally to reflect unrecorded capital flows. The
recorded inflow of capital from net investments by private
foreigners was exceeded by the recorded outflow of investments
abroad by U.S. investors. Aside from the statistical
discrepancy, the other source of net capital inflows was an
increase in foreign official holdings of U.S. assets.

Prospects for 1991

The prospect for 1991 is for a substantial further decline
in the trade deficit. The current account should show a similar
underlying trend, but, in addition, contributions by allies in
support of Operation Desert Storm will give a one-time, dramatic
increase in invisible receipts producing a very large one-time
decline in the current account deficit in 1991.


- 30 -

In this context, they emphasized the importance of monetary
and fiscal policies which provide the basis for lower real interest

rates and a sustained global recovery with price stability.

They

reiterated the importance of policies aimed at increasing global
savings and reaffirmed their commitment to cooperate closely on

exchange markets.

Also, all countries must maintain open markets

to meet the challenges of the world economy, and the G-7 Ministers
emphasized the importance of bringing the Uruguay Round to a

successful conclusion.

Though the major industrial

countries bear a special

responsibility for the smooth functioning of the world economy, all

countries have a role to play in

stable prices and adjustment of external imbalances.

promoting sustained growth with
In this

context, it was determined in the October 1988 and April 1989
reports 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.

it was concluded that there were

In October of 1989,
no clear indications Taiwan was

"manipulating" its currency, though there were continued

indications of such "manipulation" by Korea.

was concluded that there were no

In April of 1990, it
indications of currency

"manipulation," within the meaning of the legislation, in either

Taiwan or Korea.

This report has analyzed economic and exchange rate
developments in Korea, Taiwan, and China.

Korea's external accounts have undergone substantial
adjustment, following the substantial real appreciation of the won

in 1988-89.
fell into modest deficit in 1990

GNP), which included a trade deficit of $1.9 billion.

For the first time since 1985, the current account

of $2.1 billion (0.9 percent of
The

bilateral surplus with the United States fell to $4.1 billion in

1990, down 38 percent from 1989.

There continues to be no basis

for concluding that Korea is directly "manipulating" its exchange

rate for purposes of competitive
Korea is using exchange controls
indirectly for several reasons.

will likely persist in 1991; its
first quarter of 1991; and there
Korea is intervening directly in

gain, nor does it appear that
to "manipulate" the exchange rate

’ Korea's small external deficit

foreign reserves declined in the
is no evidence that the Bank of
foreign exchange markets.

We remain seriously concerned, however, that pervasive Korean
exchange and capital controls significantly constrain supply and
demand in the currency market and distort the exchange rate.

Liberalization of these controls

is imperative to allow market

forces to govern Korea's exchange rate and trade and investment
flows, and to enhance the prospects for sustaining Korea's recent

balance of payments adjustment.

This is particularly important in

view of the likelihood that current account surpluses will re-
emerge in 1992, generating natural pressures for appreciation of

the won.


- 29 -
PART VII: CONCLUSIONS

Substantial changes have taken place in the world economy

since the autumn report on International Economic and Exchange Rate
Policy.

The Gulf War and its aftermath have highlighted the increasing
interdependence of our nations and the world economy. Throughout
the world, in Eastern Europe, Latin America, and many other
developing countries, fundamental market-oriented reforms are being
pursued with vigor.

At the same time, world economic growth has slowed markedly.
Since last autumn, the IMF has marked down its growth projection
for the major countries in 1991 by over a full percentage point to
1.3 percent. Several countries are experiencing recession.

There are encouraging signs of recovery in some quarters.
Inflation is projected to decline significantly this year in the
major countries, reflecting the reversal of the run-up in oil
prices and the more moderate pace of economic activity. Interest
rates have declined sharply in some countries, especially the
United States. Current account imbalances have been further
reduced, and the adjustment process is continuing in the major
countries. Adjustment of structural fiscal deficits is underway in
the United States, and this should strengthen national savings.

But a timely recovery of world economic activity is by no
means certain. At this juncture, the hopeful signs of recovery
have yet to be translated firmly into reality. Economic activity
is slowing in those countries which until recently had been
experiencing strong expansion. Furthermore, real interest rates
remain persistently high in a number of other countries, in part
reflecting the influence of regional and international transmission
mechanisms. This confluence of factors is dampening investment and
growth prospects.

Fostering an open, growing world economy is the most effective
tool to meet the challenges of the changing world economy. Against
the background of the increased interdependence of nations,
countries must work collectively to achieve their common objectives
of freedom and prosperity.

In these circumstances, G-7 economic policy coordination will
need to play a central role in the world economy. Recognizing this
basic reality, the Ministers and Governors of the G-7 countries, at
their most recent meeting on April 28, 1991, reaffirmed their
support for policy coordination as essential to achieving their
common objectives.


6

Mid-January to Mid-February 1991

From mid-January to mid-February, the dollar came under
selling pressure as it appeared that the Gulf war would not
generate sustained safe haven demand for dollars, but might act
to depress economic activity. Interest rate differentials
unfavorable to the dollar widened further as many believed that
the land phase of the war would be lengthy and act as a
substantial drag on the U.S. economy.

With military action underway in the Gulf, the G-7 Finance
Ministers and Central Bank Governors agreed at their January 21
meeting to strengthen cooperation and to monitor developments in
exchange markets. The Ministers and Governors stated that they
were "prepared to respond as appropriate to maintain stability in
international financial markets." This statement and subsequent
intervention to support the dollar reassured the market
concerning the G-7 commitment to cooperative action.

The downward pressure on the dollar continued, however,
particularly against the deutschemark. The Bundesbank raised
official German interest rates on January 31 (a move not
generally anticipated in the market) and the Federal Reserve
lowered official U.S. interest rates on February 1. Shortly
thereafter, U.S. monetary and economic officials voiced
dissatisfaction with the dollar's depreciation and optimism about
the prospects for economic recovery. A brief episode of
concerted dollar purchases by G-7 monetary authorities was also
initiated at that time which provided significant support to the
dollar.

These official interest rate actions, in retrospect, may
have marked a turning point in the foreign exchange markets, with
a shift in market psychology in favor of the dollar. This was «=
influenced by an increasingly critical market view of
developments in the German economy, Eastern Europe and the Soviet
Union.

Mid-February through Mid-April 1991

With the end of the war, market optimism about U.S. economic
prospects increased and a period of sustained and rapid
appreciation of the dollar began. The dollar rose at times in
March as many market participants decided that the dollar had
"bottomed out". Moreover, participants focussed on the German
mark, which was influenced by concerns over developments in the
Soviet Union, East Europe, and the reunification of eastern
Germany. Corporate treasurers and institutional investment
managers made previously deferred dollar purchases. At this
time, U.S. monetary authorities intervened out of concern about
the rapidity of the dollar's rise.


- 20 -

to 32 percent. In addition, as a result of Taiwan's efforts to
diversify its export markets and the growing demand from Taiwan's
offshore industries, Asia replaced North America in 1990 as
Taiwan's largest export market for the first time.

In 1990, real GNP growth fell to 5.3 percent from 7.3 percent
in 1988 and 1989. The fall was due principally to the decline in
private investment, inventories, and the trade surplus. However,
given the pick-up in growth beginning in the last quarter of 1990
and strong expansion by the public sector, we expect growth this
year to be close to the level of 1988-89. At the same time,
inflation officially rose by 4.1 percent last year, although this
is probably an understatement. Inflation is unlikely to improve
this year.

Taiwan experienced a substantial rise in net capital outflow
last year, due largely to sizable increases in overseas investment
and short-term flows from NT dollar to foreign currency accounts.
As a result, the overall balance of payments surplus plummeted 98
percent to just $55 million, the lowest level in the past 10 years.
Foreign exchange reserves, consequently, were virtually unchanged
at $72.4 billion, the world's second largest stock at the time.

The current account surplus is expected to continue to fall in
1991. This is the result of a lower merchandise trade surplus and
increased service payments.

In the first quarter of this year, Taiwan's overall trade
surplus fell by 9 percent over last year to $1.6 billion.

The U.S. trade deficit with Taiwan in the first two months of
this year totalled $1.5 billion, a 12 percent decline from the
comparable period in 1990. U.S. exports to Taiwan were up by
8 percent and imports from Taiwan down by 2 percent.

According to Taiwan's data, thé trade surplus with the United
States was down by 29 percent in the first 3 months of this year,
due to a 7 percent decline in exports to the United States and a5
percent increase in imports. The U.S. share of Taiwan's overall
trade surplus fell to 81 percent, compared to 103 percent over the
same period in 1990.

° Exchange Rate System

There is no evidence that the Central Bank has recently been
intervening in the market consistently to gain competitive
advantage. The Central Bank has, however, intervened to control
short-term downward and upward pressure on the NT dollar, although
not with the same dominance before the institution of the new
exchange rate system two years ago. On a net basis, the Central
Bank probably sold more U.S. dollars through intervention than it
bought in 1990, thereby, favoring appreciation of the NT dollar.


TABLE 5

ASIAN NIES AND CHINA: TRADE AND CURRENCY CHANGES

Cumulative Change against USS as of April 12, 1991

(Plaza) (Report)
from: 9/20/85 end-86 end-87 10/14/88 end-89 end-90 Rate on 4/12/91
HKS 0.31% 0.00%  -0.39% 0.30% 0.19% 0.12% HKS 7.79
Won 23.24% 18.67% 9.16% -2.14%  ~-6.49%  -1.30% W 725.80
SingaporeS 25.23% 23.44% 13.45% 14.97% 8.08% 1.11% S$ 1.76
NTS 48.55% 30.15% 4.67% 5.95%  ~-4.07%  ~-0.62% NT$ 27.28
Yen 77.76% 17.16% -9.26%  ~-7.19% 5.45%  -0.42% Y 136.22
OM 71.39% 15.16% 5.18% 7.15% 0.42% -11.18% DM 1.68
Yuan 43.73% -29.43% -29.43% ~-29.43% ~-10.25%  ~-1.01% Yuan 5.27

* [-] signifies depreciation against the U.S. dollar.

U.S. Trade Balance with Asian NIEs and China [1]
(U.S. $ Billions)

1985, 1985 1987 1983 1989 1990 1-2/90 12/91 % Change

Hong Kong -5.6 ~5.9 5.9 4.6 ~3.4 2.6 -0.4 ~0.1 72.6%
Korea 41 6.4 8.9 8.9 6.3 44 -0.7 0.0 101.9%
Singapore ~0.8 1.9 2.1 2.2 1.6 1.8 -0.3 0.1 128.5%
Taiwan 211.7

212.6 713.9 211.2 71.8 -15 212.2%

China to) 1.7 2.8 -3.5 6.2 ~10.4 -1.3 1.7 29.7%

NIEs % Total U.S,

Trade Bal. 17% 18% 22% 24% 22% 20% 20% 14%
China + NIEs
% Total U.S. 17% 19% 24% 27% 28% 30% 28% 28%

{1] U.S. customs value data, not seasonally adjusted.
Totals may not equal sum of components due to rounding.


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- 26 -

In 1990, China's exports to the United States rose by
27 percent, following a 41-percent expansion in 1989. These growth
rates are significantly above those for China's global exports
during the same period (18 percent in 1990 on top of
7 percent in 1989). (NOTE: There is a major discrepancy between
China's calculation of its trade with the United States and U.S.
official statistics. The difference is largely due to China's not
counting its exports that are re-exported, probably with little
value added, primarily through Hong Kong. Because the re-exporter
adds little value, the United States considers these exports (i.e.,
U.S. imports) to be from China. The U.S. data will be used for the
purposes of this analysis.)

China's imports from the United States rose 16 percent in
1989, but contracted by 16 percent in 1990 due to China's desire to
limit overall imports. The increase in 1989 was greater than that
for China's overall imports (7 percent), but the fall in 1990 was
more pronounced than that for total imports (10 percent).

In the domestic economy, an austerity program was instituted
in 1988 primarily to counter extreme inflationary pressures and
overly rapid growth. The program also was designed to reduce
China's overall trade deficit and build-up foreign exchange
reserves. The government has, in fact, been especially successful
in reimposing control over the external trade system, where reform
had previously been the most far-reaching. This has enabled it to
reverse the deficits in the external trade account. In addition,
foreign exchange reserves have climbed by over $10 billion, or 38
percent, to $27.3 billion last year. Such a level is equal to
eight months of imports.

In the first quarter of this year, according to China's data,
the overall trade surplus was $2.26 billion, an increase of 183
percent compared to the same period last year. Exports (fob basis)
were up 24 percent, while imports grew by only 12 percent. China
claimed to have a $180 million trade deficit with the United States
in this period. . .

U.S. data, however, reveal a $1.7 billion deficit with China
in the first 2 months of this year, a 30 percent increase over last
year. This was our second largest trade deficit, behind that with
Japan, and bigger than the total deficit with the four Asian NIEs.
u.S. imports from China rose by 19 percent, while U.S. exports to
China grew by only 2 percent during the period compared to last
year.

° Foreign Exchange Allocation and External Trade System

The manner in which foreign exchange is allocated, along with
import licenses and other market access barriers, is an important
means by which China controls the external trade sector. These
pervasive controls are symptomatic of the broader controls which
characterize the command structure of the Chinese economy.


PART II: ECONOMIC SITUATION IN THE INDUSTRIAL COUNTRIES

Overview

After eight years of robust expansion, real GNP growth for
the seven major industrial countries fell to 2.6 percent in 1990,
and will likely fall further to the 1-1.5 percent range in 1991.
The slowdown reflects recession in the United States, Canada, and
the United Kingdom and decelerating growth in Japan, Germany, and
elsewhere. On the bright side, industrial country inflation is
likely to drop significantly in 1991, and external imbalances are
expected to continue to be reduced.

Aggregate real GNP growth in the seven largest (Summit)
countries slowed considerably to 2.6 percent in 1990, down from
3.3 percent in 1989 and 4.6 percent in 1988. Thus, 1990
represented the eighth consecutive year of growth in the G-7.
The temporary run-up in oil prices and the uncertainties
associated with the Gulf crisis contributed, however, to the
overall slowdown. For the 24 members of the OECD as a whole,
real GNP growth was 2.6 percent, compared to an average annual
rate of 3.4 percent during the 1983-90 expansion. (See Table 1
on G-7 economic performance.)

Growth in the United States, Canada, and the United Kingdom
slowed sharply over the course of 1990, with each moving into
recession by the end of the year. Output growth also slowed, but
less dramatically, in France and Italy. In contrast, growth in
Germany and Japan accelerated. Thus the growth disparity between
the United States and the other industrial countries increased,
with U.S. growth of 1.0 percent for the year, and OECD growth
outside the United States of 3.5 percent in aggregate. This
differential contributed to the further reduction in the U.S.
trade and current account deficits.

Inflation in the OECD countries was somewhat higher in
aggregate terms in 1990 than it was in 1989, owing mainly to the
temporary runup in world petroleum prices late last year. In
addition, a number of factors, which affected consumer price
indices but did not boost the underlying rate of inflation,
temporarily raised recorded inflation. These factors included
the temporary effects of bad weather on some crops, the
introduction or increasing of consumption taxes, and higher
mortgage interest rates (with a high weight in the Retail Price
Index) in the United Kingdom.

Taking all these forces into account, consumer prices rose
6.3 percent on a weighted average basis in the OECD countries in
1990, compared to 5.8 percent in 1989. Turkey, Iceland, and
Greece had the highest inflation rates. Inflation in the Summit
countries alone was 5 percent (vs. 4.5 percent in 1989).


13

PART VI: ASIAN NEWLY INDUSTRIALIZED ECONOMIES
(NIEs) AND CHINA

Overview

Since mid-October 1990, Korea's currency has depreciated some
1.5 percent against the U.S. dollar, while Taiwan's has remained
virtually unchanged. Over the longer term, since the Plaza
Agreement in September 1985, the NT dollar has strengthened by 48.6
percent and the Korean won by 23.2 percent against the U.S. dollar
(see Table 5).

The decline in the U.S. merchandise trade deficit with the
Asian NIEs as a group -- Korea, Taiwan, Hong Kong, and Singapore --
continued in 1990. In 1990, the trade deficit with the Asian NIEs
was $19.7 billion, down $4.6 billion or 19 percent from 1989. This
compares to a 7 percent decline in the overall U.S. trade deficit.
As a proportion of the overall U.S. trade deficit, the deficit with
the NIEs fell from 22 percent to 20 percent between 1989 and 1990.
In the first two months of 1991, the trade deficit with the NIEs
was $1.6 billion, 51 percent below the same period of 1990.

At the same time, the U.S. trade deficit with China has risen.
In 1990, the trade deficit with China was $10.4 billion, an
increase of 68 percent over 1989. The bilateral trade deficit with
China is now our third largest, after Japan and Taiwan.

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 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...on an
expedited basis...for the purpose of ensuring that such countries
regularly and promptly adjust the rate of exchange between their
currencies and the United States dollar."

It was concluded in the October 1988 report that 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.


During the first thirteen months of the MAR system (through
April 12, 1991), the won depreciated 4.4 percent in nominal terms
against the U.S. dollar and 6 to 13 percent against most other G~-7
currencies. Foreign banks accounted for a large share of
transactions in the inter-bank market, generally 40-60 percent of
the total. The Bank of Korea (BOK) was not a direct participant in
the market, and other government-owned banks accounted for only a
small share of inter-bank activity.

Since the Plaza Agreement in September 1985, the won's
cumulative nominal appreciation against the U.S. dollar now stands
at 23.2 percent. However, much of that appreciation occurred in
1988 and first quarter of 1989; the won peaked at 665/dollar in
April 1989 and has depreciated roughly 8 percent in nominal terms
against the dollar since then. The cumulative nominal depreciation
against the dollar since the first of these reports was issued in
October 1988 now stands at 2.1 percent.

In real effective terms, i.e., taking into account movements
of the won against major trading partners as well as relative
inflation rates, the picture is somewhat different. On this basis,
we estimate that the won appreciated some 11 percent between
October 1988 and the middle of 1989. Since that time, the won has
steadily depreciated in real effective terms, with the result that
its cumulative real effective appreciation since October 1988 now
stands at only 2.3 percent.

° Foreign Exchange and Capital Controls

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

Foreign exchange banks are required to obtain and review,
prior to entering into spot customer foreign exchange transactions,
original documentation of an underlying trade (or other)
transaction. This requirement makes it virtually impossible for
banks to conduct foreign exchange business over the telephone and
hampers the development of Korea's foreign exchange market. Other
controls severely restrict the use of short-term trade finance, and
there are effective limitations on a variety of current account
transactions such as travel and remittances. Portfolio investment
abroad by Korean individuals is restricted to participation in a
limited number of Korean-managed unit trusts. Direct portfolio
investment by foreigners in Korea is prohibited, although the
Korean Government has announced that a limited, but as yet
unidentified, opening of the domestic capital markets will occur
sometime in 1992. The government also controls capital flows in
connection with foreign direct investment in Korea, as well as
investment abroad or foreign borrowing by Korean residents. These
and other controls limit the ability of branches and subsidiaries


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 1988, 1989, and 1990.
Written updates of developments have been submitted in April of
1989 and 1990. This is the third update of developments to be
submitted to Congress.

Part II of this report reviews the economic situation in the
industrial countries. Part III analyzes developments in the
foreign exchange markets, including the dollar's movement
relative to the currencies of major trading partners and U.S.
foreign exchange market intervention. Part IV examines the U.S.
balance of payments situation and Part V reviews efforts by the
major industrial countries to coordinate economic policies. Part
VI provides a status report on developments in the Asian newly
industrialized economies and China. The final part provides
conclusions on the principal issues discussed in the report.


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however, materialized. The PRC then instituted another substantial
devaluation (9.6 percent) of the administered exchange rate in
late-November 1990, again with the stated purpose of unifying this
rate with the swap market rate and lightening the budgetary burden
of export subsidies. In addition, in early April, the yuan was
devalued by 1 percent without a public announcement.

There are perhaps two interpretations of the latest moves.
Firstly, this could be an indication that China will be pursuing a
policy of more frequent and smaller changes, particularly
devaluations, in the exchange rate to gain competitive advantage in
a quieter fashion. Secondly, China could be responding to the
advice of the international financial institutions to adjust the
exchange rate more flexibly in preparation for convertibility. In
either case, there is reason to monitor China's exchange rate
movements closely.

China: Exchange Rate and Inflation

1985 1986 1987 1988 1989 1990

Exchange Rate

(Yuan/$; end-year) 3.20 3.72 3.72 3.72 4.72 5.22
Nominal Ex. Rate Index

(Yuan/$; end-year) 100 116 116 116 148 163
CPI Index 100 107 116 141 163 167

Real Effective Index
(inflation adj., trade
weighted; end-year) 100 78 73 87 81 61

From 1985 through 1988, nominal devaluation of the yuan
against the dollar was not sufficient to offset the impact of
rising prices in China. Thus, in real terms (i.e., adjusted for
China-U.S. inflation differentials), the bilateral exchange rate
appreciated against the dollar over this period. Since then,
however, as noted above, the yuan has depreciated in real terms.

Against the broader range of currencies of China's trading
partners, and adjusted for differentials between China's inflation
and that of its major trading partners, the picture is somewhat
different. On this basis, the yuan has depreciated significantly
(see real effective index). Since 1985, the yuan had depreciated
by 39 percent in real effective terms. During this period, the
real effective exchange rate did appreciate sharply in 1988, but
has since fallen again. In 1990 alone, the nominal devaluation in
November and lower inflation (3 percent) resulted in a 25 percent
effective devaluation.


Part I

Part II

Part III
Part IV
Part V

Part VI

Part VII

Appendix:

TABLE OF CONTENTS

Introduction

Economic Situation in the Industrial
Countries

Developments in Foreign Exchange Markets
U.S. Balance of Payments
Economic Policy Coordination

Asian Newly Industrialized Economies
(NIEs) and China

Conclusions

Tables and Charts

Page

11

13
29

32


APPENDIX

TABLES AND CHART

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

Summary of U.S. Capital Account Flows

Asian NIEs and China: Trade and Currency Changes

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


-~27 -

An import license is a prerequisite for obtaining a foreign
exchange allocation for non-priority imports at the official
exchange rate. The licenses are, hence, a primary means of
controlling imports. However, even if a foreign trade company has
obtained an appropriate import license, it may not be able to
obtain a foreign currency allocation.

For priority imports, foreign exchange at the administered
rate is allocated to foreign trade companies under the foreign
exchange plans of the central, provincial, and local governments.
The allocation decision, while not affecting exchange rates, does
provide a second control not only on the value of imports, but also
on the supplier of any particular product. This control, to the
extent purchasers are directed away from U.S. suppliers to other
suppliers, increases the U.S. bilateral trade deficit with China.

On the export side, China uses a number of licensing and other
administrative means to influence exports. For example, China
gives exporting firms priority access to raw materials, energy, and
bank loans. An important element in China's export strategy is
efforts to target sales to the U.S. market.

° Assessment

It is our assessment that the principal cause of China's
bilateral trade surplus and external surpluses appears to be
generalized and pervasive administrative controls over external
trade, which inhibit imports, including from the United States, and
promote exports, particularly to the United States, China's largest
market.

The foreign exchange allocation system is a serious problem.
Given the substantial reserves, there is no basis for this
rationing except to restrict imports and control sources.

There is no clear evidence at this time of direct
"manipulation" of the exchange rate itself within the meaning of
the law. However, the recent devaluations, in conjunction with
large external surpluses, raise concerns and indicate that a shift
in exchange rate policy may be occurring aimed at reinforcing
China's attempts to generate sizable external surpluses. Such a
possibility is a matter of concern to the U.S. Government. In
addition, the command nature of China's economy has allowed it to
control the allocation of foreign exchange. This has been clearly
done in a manner that impedes imports. There is, thus, a need to
monitor this situation closely. Certainly, given the substantial
real effective depreciation of the official rate of the yuan to
date and China's reluctance to eliminate export subsidies and
liberalize imports, no case can be made for further real effective
depreciation.


11

PART V: ECONOMIC POLICY COORDINATION

The world economy has become increasingly interdependent in
recent years and, more and more, economic power and responsibility
are shared in view of the greater balance among nations. The
linkages among major economies are being heightened by the
globalization of flows of goods, services, and investment.
Financial markets involve around-the-clock trading. Against this
background, countries continue to pursue their own self interests.
But they increasingly recognize that they must work collectively to
achieve their shared objectives.

The pursuit of international economic policy coordination in
the G-7 has become essential for achieving these shared objectives.
Indeed, over the years, the G-7 have made significant progress in
implementing consistent policies for sustained growth with price
stability, reduced external imbalances, and greater stability of
exchange markets. Furthermore, economic policy coordination has
been extended to a wide range of international economic policy
issues. Thus, the G-7 have in recent years addressed such issues
as cooperation in the Persian Gulf, the transformation of Eastern
European economies, and the international debt strategy, as well as
a range of other international financial issues concerning
individual countries and the international financial institutions.

The meeting of the G-7 Finance Ministers and Governors on
January 20-21, 1991, reflected this reality. The Ministers and
Governors met against the background of the Gulf war, reaffirming
their support for economic policy coordination and agreeing to
strengthen cooperation to maintain stability, as appropriate, in
international financial markets in light of the uncertainties
arising from the Gulf war and developments then taking place in the
Soviet Union.

More recently, the G-7 Ministers and Governors met on April
28, in the context of an economic environment that had
substantially changed during the preceding months. Several major
economies were experiencing recession. Economic activity was
slowing in other industrial countries, including those which had
been experiencing strong expansion. Indeed, the IMF had marked
down significantly its projection for G-7 growth in 1991 to 1-1/4
percent, a full percentage point lower than the October 1990
projection.


14

In April 1990, the Treasury concluded that Taiwan and Korea
were no longer directly "manipulating" their currencies within the
meaning of the legislation. This finding was reaffirmed in
November 1990. It was noted, however, that particularly Taiwan's
external surpluses remained large. In addition, it was noted that
in both Taiwan and Korea, exchange rate policy would continue to
have an important role to play in furthering their economic
adjustment. Furthermore, it was noted that, particularly in Korea,
liberalization of remaining exchange and capital controls was
required to improve the functioning of the exchange markets and
assure full scope for market forces in exchange rate determination.

Qur large and growing bilateral trade deficit with China,
substantial depreciation of the yuan in 1990, and administrative
controls over foreign exchange allocation, have prompted serious
concern as to the applicability of Section 3004 to China. This
issue will be analyzed below.

Following is a summary of economic and exchange rate
developments in Korea, Taiwan, and China.

Korea

The steady depreciation of the Korean won in nominal terms
against the U.S. dollar has continued since the last report. The
won has depreciated by 1.5 percent since mid-October 1990 and
8 percent since its peak in April 1989. In real terms (i.e.,
adjusted for U.S.-Korean inflation differentials), however, the won
has shown little change against the U.S. dollar over the past year
as inflation in Korea has remained high.

The renewed nominal depreciation of the won reflects in part
the adjustment: in Korea's external accounts, which moved intova
modest deficit in 1990. However, the exchange rate also continues
to be influenced by pervasive foreign exchange and capital controls
in Korea. These controls constrain the forces of supply and demand
in the exchange market, distort trade and investment flows, and
position the authorities to manipulate the exchange rate through
indirect means.

° Exchange Market Developments

Under the "market average rate" (MAR) system of exchange
determination, introduced on March 2, 1990, the won/dollar exchange
rate at the beginning of each business day is equal to the weighted
average of transactions in the inter-bank market on the preceding
business day. Inter-bank and customer rates are allowed to float
freely within specified margins. Exchange rates between the won
and third currencies are set in accordance with dollar rates in
international currency markets.