Report to Congress on International 

Economic and Exchange Rate Policies

U.S. Department of the Treasury

Office of International Affairs

April 15, 2014

This Report reviews developments in international economic and exchange rate policies and is submitted 

pursuant to the Omnibus Trade and Competitiveness Act of 1988, 22 U.S.C. § 5305 (the “Act”).1

 

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The Treasury Department has consulted with the Board of Governors of the Federal Reserve System and 

International Monetary Fund management and staff in preparing this Report.
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Table of Contents

KEY FINDINGS ........................................................................................................................... 2

INTRODUCTION......................................................................................................................... 6

U.S. MACROECONOMIC TRENDS......................................................................................... 6

THE DOLLAR IN FOREIGN EXCHANGE MARKETS ..................................................... 11

ANALYSES OF INDIVIDUAL ECONOMIES....................................................................... 12

ASIA........................................................................................................................................... 12

China..................................................................................................................................... 12

Japan ..................................................................................................................................... 17

South Korea .......................................................................................................................... 19

Taiwan................................................................................................................................... 21

EUROPE...................................................................................................................................... 22

Euro Area .............................................................................................................................. 22

Switzerland ........................................................................................................................... 23

United Kingdom.................................................................................................................... 25

WESTERN HEMISPHERE.............................................................................................................. 26

Brazil..................................................................................................................................... 26

Canada................................................................................................................................... 26

Mexico .................................................................................................................................. 27

ANNEX 1: FINANCIAL VOLATILITY IN EMERGING MARKET ECONOMIES ................................... 28

GLOSSARY OF KEY TERMS IN THE REPORT ................................................................................ 32
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Key Findings

The Omnibus Trade and Competitiveness Act of 1988 (the “Act”) requires the Secretary of

the Treasury to provide semiannual reports on the international economic and exchange rate 

policies of the major trading partners of the United States. Under Section 3004 of the Act,

the Report must consider “whether countries manipulate the rate of exchange between their

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

payments adjustment or gaining unfair competitive advantage in international trade.” 

This report covers developments in the second half of 2013, and where pertinent and available, 

data through end-March 2014. This report reviews the macroeconomic and exchange rate 

policies of economies accounting for 71 percent of U.S. foreign trade and of global economic 

developments more broadly in the second half of 2013. The Report concludes that although 

global growth prospects are improving, much more needs to be done to foster strong, sustainable 

and balanced growth, including through bolstering domestic demand growth in countries with 

external surpluses, and by making greater strides in allowing freely flexible exchange rates. 

Progress on rebalancing global demand continues to remain inadequate and may, in fact, have 

worsened in the second half of 2013. In addition, foreign exchange intervention and reserve 

accumulation in some countries increased notably in the second half of last year. 

The Administration’s policies continue to promote growth and jobs. Real GDP grew at a 3.4 

percent annual rate in the second half of 2013, accelerating notably from the 1.8 percent pace in 

the first half. A consensus of private forecasters is projecting a 2.7 percent increase in real GDP 

in 2014, and domestic demand is expected to accelerate. Export growth accelerated in late 

2013, increasing at an annual rate of 6.6 percent, more than double the 3.2 percent gain posted in 

the first half. Nonfarm payrolls increased by 183,000 per month on average over the nine 

months through March 2014 and between December 2012 and December 2013, the 

unemployment rate fell by 1.2 percentage points to 6.7 percent. The federal deficit narrowed 

sharply in FY 2013 to 4.1 percent of GDP from 6.8 percent of GDP in FY 2012. The 

Administration’s proposed FY 2015 Budget would trim the deficit further and put publicly held 

debt on a declining path as a share of the economy.

Global growth is expected to strengthen in 2014, led by the advanced economies. But significant 

risks remain and global demand is inadequate. In the euro area, weak domestic demand growth, 

high output gaps and high unemployment have left inflation significantly below the ECB’s 

target. This has reinforced deflationary pressures on the periphery and made the needed 

adjustment in relative prices and costs in the euro area more painful. Domestic demand growth 

in Japan is likely to be muted by Japan’s shift to fiscal consolidation. The IMF projects that 

growth will strengthen in many emerging market economies compared to 2013 amid a mixture of 

weaker currencies, higher domestic interest rates, and stronger foreign demand; but decelerate in 

others where important policy adjustments are needed. 

Given the changing global investment environment, with growth strengthening in the advanced 

economies and downshifting in emerging markets, there has been some re-pricing of global risk. 

The size of the adjustment has varied across countries according to domestic economic 

conditions and the strength of their respective policy frameworks (see Annex 1). Volatility has 
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been more severe and more frequent in those emerging markets whose current accounts deficits 

are wider and inflation is higher, while in many other markets prices rebounded from earlier 

declines as it became clear that domestic policy frameworks were more robust. Recent geopolitical tensions and certain one-off events in some emerging markets exacerbated volatility in 

the early months of 2014, following a period of general differentiation and relative calm over the 

fall, but conditions have since steadied. 

The key global imperative is to foster strong, sustainable and balanced growth. Finance 

Ministers and Central Bank Governors of the G-20 agreed, in February 2014, to develop new 

growth strategies with the objective of increasing collective G-20 GDP by more than two percent 

above the trajectory implied by current policies over the coming five years. A key part of the 

agreement is that the policies must also contribute to more effective global rebalancing.

Two key ingredients have been missing or inadequate in the global adjustment process. The first 

is the need for the pace of domestic demand growth in the surplus economies to be faster than 

GDP growth. For example, in Germany, domestic demand has grown faster than GDP only three 

times in the past ten years. Most of the adjustment thus far has been by deficit economies 

increasing national saving which has held back global growth. Second, considerably more 

progress is still needed to at last achieve market-determined exchange rates and refrain from 

currency intervention and excessive reserve accumulation. 

This report therefore highlights the need for concerted progress on global rebalancing, including 

boosting domestic demand in surplus countries and greater exchange rate flexibility, most

notably in China. It also emphasizes the need for greater transparency on exchange rate 

management, much less official intervention in foreign exchange markets, and stronger 

restraints over actual and verbal intervention.

In Germany, the current account surplus remains well above 7 percent of GDP, increasing 

relative to GDP in the second half of last year. One sign of the subdued pace of German demand 

growth is that German goods imports were 1.0 percent weaker for the year. The euro-area’s 

collective surplus expanded as well, as large current account deficits in peripheral countries 

continued to shrink and, in some cases, moved into surplus largely through demand compression. 

In China, the RMB appreciated during 2013 on a trade-weighted basis, but not as fast or by as 

much as is needed, and large-scale intervention resumed. The RMB appreciated by 2.9 percent 

against the dollar in 2013. However, as a result of the depreciation of the yen and many 

emerging market currencies, the RMB strengthened more on a trade-weighted basis, with the 

RMB’s nominal and real effective exchange rates rising 7.2 and 7.9 percent, respectively. For 

most of 2013 the RMB exchange rate was at, or very near, the most appreciated edge of the daily

trading band, suggesting continuous pressure for greater RMB appreciation. During 2014, 

however, the exchange rate has reversed direction, depreciating by a marked 2.68 percent year to 

date.

There are a number of continuing signs that the exchange rate adjustment process remains 

incomplete and the currency has further to appreciate before reaching its equilibrium 

value. China continues to generate large current account surpluses and attracts large net inflows 
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of foreign direct investment; China’s current account surplus plus inward foreign direct 

investment in 2013 exceeded $446 billion. The reduction in the current account surplus as a 

share of China’s GDP has largely been the reflection of the unsustainably rapid pace of 

investment growth. Finally, China has continued to see rapid productivity growth, which 

suggests that continuing appreciation is necessary over time to prevent the exchange rate from 

becoming more undervalued. All of these factors indicate a RMB exchange rate that remains 

significantly undervalued. Further exchange rate appreciation would help to smoothly rebalance 

the Chinese economy away from investment toward consumption.

The Chinese authorities have been unwilling to allow an appreciation large enough to bring the

currency to market equilibrium, opting instead for a gradual adjustment which has now been 

partially reversed. The expectation that the RMB would continue to appreciate over time 

resulted in large and increasing capital inflows in 2013. The PBOC’s policy of gradual 

adjustment triggered expectations of continued appreciation, and resulted in large-scale foreign 

exchange intervention. China’s foreign exchange reserves increased sharply in 2013, by $509.7 

billion, which was a record for a single year. China has continued large-scale purchases of 

foreign exchange in the first quarter of this year, despite having accumulated $3.8 trillion in 

reserves, which are excessive by any measure. This suggests continued actions to impede market 

determination. 

On March 17, the PBOC widened the RMB's intra-day trading band to +/- 2.0 percent around its 

midpoint fixing against the dollar from the previous +/- 1.0 percent. In the month prior to the 

band widening, the PBOC took measures, including reported heavy intervention, to significantly 

weaken the RMB and push it away from the most appreciated edge of the previous band. The 

RMB has seen periods of depreciation before, such as mid-2012 when the RMB fell 1.5 percent 

against the dollar over a three-month period. However, the pace and the size of the recent 

decline was unprecedented. From February 17, 2014 to March 20, 2014, the RMB weakened 2.6 

percent against the dollar. 

The widening of the band gives China an opportunity to reduce intervention and allow the 

market to play a greater role in determining the exchange rate. To realize this opportunity, China 

should refrain from intervention within the band and should allow market forces to permit the 

reference rate to adjust if market pressures push the exchange rate to the edge of the band. 

Recent developments in the RMB exchange rate would raise particularly serious concerns if they 

presage renewed resistance to currency appreciation and a retreat from China’s announced policy 

of reducing intervention and allowing the exchange rate to reflect market forces. We will 

continue to monitor these issues closely going forward. In line with the practice of most other G20 nations, China should disclose foreign exchange market intervention regularly to increase the 

credibility of its monetary policy framework and to promote exchange rate and financial market 

transparency.

Japan has not intervened in the foreign exchange markets in almost two years. Japan’s goods 

trade balance fell into deficit in 2011 for the first time since 1980, and reached a deficit of 2.6 

percent of GDP in 2013. The current account surplus has narrowed substantially from almost 4.0 

percent of GDP in 2010 to 0.7 percent in 2013. As Japan takes policy steps to bring about a 

durable recovery and escape deflation, it is imperative both for the success of those measures and 
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for the global economy that Japan’s economic policies work primarily through an increase in 

domestic demand. In this respect, it is important that Japan carefully calibrate the pace of overall 

fiscal consolidation. Monetary policy cannot offset excessive fiscal consolidation nor can it 

substitute for necessary structural reforms that raise trend growth and domestic demand. 

Korea’s current account surplus further increased to 6.1 percent of GDP in 2013 – the highest 

since 1999 – compared to 4.2 percent in 2012. Korea is one of only a few surplus economies 

with a significantly larger external surplus now than before the crisis. Net exports accounted for 

over half of Korea’s growth in 2013, highlighting the economy’s continued dependence on 

external demand and the weakness of domestic demand. Although Korea does not publish data 

on its foreign exchange intervention, during the second half of 2013 the Korean authorities are 

believed to have intervened to limit the pace of won appreciation. Korea’s foreign exchange 

reserves rose from $315.6 billion at end-June 2013 to $335.6 billion at end-December and 

$341.0 billion at the end of February 2014. The Korean authorities also increased their net 

forward position by $4.9 billion to $50.5 billion over the second half of 2013. The magnitude of 

these changes is larger than can be reasonably expected from simple interest earnings on the 

existing stock of reserve assets or valuation changes. The Korean authorities should limit 

foreign exchange intervention to the exceptional circumstances of disorderly market 

conditions and increase the transparency of their interventions in foreign exchange. 

The Korean government has laid out ambitious plans to promote the development of the services 

sector and to reduce dependence on exports. Exchange rate appreciation is an important tool for 

supporting this rebalancing.

Based on the analysis in this report, Treasury has concluded that no major trading partner of the 

United States met the standard of manipulating 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 as identified in Section 3004 of the 

Act during the period covered in the Report. Nonetheless, Treasury is closely monitoring 

developments in economies where exchange rate adjustment is incomplete and pushing for 

comprehensive adherence to recent G-7 and G-20 commitments. Treasury will continue to 

monitor closely exchange rate developments in all the economies covered in this report, with 

particular attention to the need for greater RMB appreciation, and press for further policy 

changes that yield greater exchange rate flexibility, greater transparency on intervention, a more 

level playing field, and support for strong, sustainable and balanced global growth.
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Introduction

This report focuses on international economic and foreign exchange developments in the second 

half of 2013. Where pertinent and when available, data and developments through end-March 

2014 are included.

Exports and imports of goods to and from the ten economies analyzed in this report accounted 

for 71 percent of U.S. merchandise trade in 2013.

U.S. Macroeconomic Trends

U.S. Economic Growth Accelerated 

The U.S. economic recovery strengthened in the second half of 2013, as private demand firmed. 

Real GDP grew at a 3.4 percent annual rate in the second half of 2013, accelerating notably from 

the 1.8 percent pace in the first half. Growth of private domestic demand – the sum of 

consumption, business fixed investment, and residential investment – accelerated to a 2.9 percent 

pace from 2.1 percent in the first half of 2013. Over the entire year, real GDP advanced 2.6 

percent, faster than the 2.0 percent pace recorded during 2012. The economy is expected to 

strengthen further this year. A consensus of private forecasters is projecting a 2.7 percent 

increase in real GDP over the four quarters of 2014.

Stronger growth in consumption, business fixed investment, as well as a marked build-up of 

private inventories, contributed to the faster pace of expansion in the third and fourth quarters of 

2013, helping offset the negative effects of declining government spending. Consumer spending 

rose at a 2.6 percent annual rate over the final two quarters of 2013, faster than the 2.0 percent 

pace over the first two quarters. Business fixed investment rose 5.3 percent, a marked 

improvement following a 0.1 percent decline in the first half of 2013. Inventory accumulation 

picked up in the latter half of 2013, with a particularly large build-up in the third quarter. On 

average, the change in private inventories contributed 0.8 percentage point to real GDP growth in 

the second half of the year, slightly more than the 0.7 percentage point contribution averaged in 

the first two quarters of 2013. 

Export growth also accelerated in late 2013, reflecting somewhat better global economic 

conditions. During the second half of the year, exports rose at an annual rate of 6.6 percent, 

more than double the 3.2 percent gain posted in the first half. At the same time, growth of 

imports slowed to a 1.9 percent pace from 3.7 percent in the first half of 2013. Accordingly, net 

exports contributed an average of 0.6 percentage point to real GDP growth in the third and fourth 

quarters of 2013, after subtracting nearly 0.2 percentage point on average from growth in the first 

two quarters of the year.

The recovery in the housing market moderated in the latter half of 2013, as higher mortgage rates 

weighed on housing demand. The benchmark interest rate for a 30-year fixed mortgage rose 

almost a full percentage point between May and December – from an average of 3.5 percent to 

an average of 4.5 percent, contributing to slower growth of both new and existing home sales. 

Altogether, single-family home sales declined 5.6 percent during the last six months of 2013 
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compared with growth of 6.5 percent during the first six months of the year on a seasonally 

adjusted basis. In addition to higher mortgage rates, a still restricted supply of mortgage credit, 

and relatively tepid income growth have also held down housing demand. Housing supply 

continued to expand through the end of 2013, but the pace of new home building has moderated 

recently. In the final quarter of the year, residential investment declined for the first time since 

the third quarter of 2010, and during the entire second half of 2013, residential investment rose 

just 0.8 percent at an annual rate, compared with growth of 13.4 percent during the first half of 

the year. 

Fiscal consolidation weighed a bit more heavily on the economy during the latter half of 2013, as 

real federal government spending fell more rapidly, declining by 7.3 percent at an annual rate in 

the third and fourth quarters compared with a decline of 5.1 percent during the first two quarters 

of the year. The drop in real federal outlays was particularly pronounced in the fourth quarter, 

partly reflecting the effects of the partial government shutdown in October. Altogether, the drop 

in federal spending during the second half of 2013 reduced GDP growth by an average of 0.6 

percentage point per quarter compared with an average quarterly subtraction of 0.4 percentage 

point in the first half of the year. In contrast, fiscal conditions at the state and local level 

generally improved in 2013. State and local government outlays rose by 0.8 percent at an annual 

rate in the second half of the year after declining 0.4 percent in the first half. 

Labor Market Conditions Continued to Improve, and Inflation Remained Moderate

The economy continued to create jobs at a moderate pace in late 2013 and early 2014, and the 

unemployment rate moved lower. Nonfarm payrolls increased by 183,000 per month on average 

over the nine months through March 2014, somewhat slower than the 204,000 monthly average 

during the first half of last year. Nearly 8.3 million jobs have been created since February 2010, 

including 8.9 million in the private sector. As of March, the level of private employment had 

surpassed its pre-recession peak, but total payrolls remained more than 400,000 lower due to job 

losses in the public sector. Between December 2012 and December 2013, the unemployment 

rate fell by 1.2 percentage points to 6.7 percent and in March 2014 remained at 6.7 percent. The 

unemployment rate has fallen by 3.3 percentage points from its October 2009 peak but is still 

1.7 percentage points higher than at the start of the recession in late 2007. The share of the 

unemployed out of work for 27 weeks or more, at 35.8 percent, is more than double the 

17.5 percent share averaged in 2007, but it has declined from an all-time high of 45.3 percent in 

April 2010.

Headline and core inflation have generally remained low in recent months. The consumer price 

index rose 1.1 percent during the year ending in February 2014, down from 2.0 percent a year 

earlier. Core consumer inflation (which excludes the volatile food and energy categories) 

moderated to 1.6 percent over the year ending in February 2014 from 2.0 percent over the yearearlier period. Slower growth in medical care costs along with labor market slack and the low 

level of capacity utilization have helped contain inflationary pressures. 
8

Putting Public Finances on a Sustainable Path Remains a Priority

The federal deficit narrowed sharply in FY 2013 to 4.1 percent of GDP from 6.8 percent of GDP 

in FY 2012. Since peaking in 2009, the deficit has fallen by 5.7 percentage points – the most 

rapid pace of fiscal consolidation for any four-year period since the demobilization following 

World War II. The Administration’s FY 2015 Budget would trim the deficit substantially further 

and put publicly held debt on a declining path as a share of the economy. By the end of the 

forecast horizon in FY 2024, the deficit is projected to fall to less than 2.0 percent of GDP. The 

primary deficit (non-interest outlays less receipts) is projected to become a primary surplus in FY 

2018 and grow through the end of the forecast horizon. The debt-to-GDP ratio, as measured by 

debt held by the public, is projected to peak at 74.6 percent in FY 2015 and then begin to decline, 

falling to 69.0 percent of GDP by FY 2024.

The Global Economy

Global growth is expected to be stronger 

in 2014 than in 2013. The International 

Monetary Fund (IMF) projects an 

acceleration of 0.6 percent to 3.6 

percent, mostly reflecting a pick-up in 

growth in the advanced economies as the 

United States strengthens further and the 

euro area continues to emerge from 

recession. In contrast, growth is 

projected to moderate in Japan, driven in 

large part due to planned fiscal 

consolidation. Despite a projected 

moderation of growth in China (from 7.7 

percent in 2013 to 7.5 percent in 2014) real GDP is projected to expand by 4.9 percent in the 

emerging market and developing economies, up from 4.7 percent in 2013 led by stronger growth 

in Mexico, the Middle East, Africa, and Asia. The strength of U.S. private demand growth has 

been a pillar of support to the global economy, and the expectation of increasing U.S. growth 

over the coming year is a major factor in the IMF’s more optimistic outlook for 2014. 

Despite these recent improvements, the global economy still faces weaknesses in some areas of 

demand, and growth in many countries is still below the rates needed to foster strong job 

creation. With the intention of fostering strong, sustainable and balanced growth, G-20 Finance 

Ministers and Central Bank Governors agreed in February 2014 to develop policies to boost

collective G-20 GDP by more than 2.0 percent above the trajectory implied by current policies 

over the coming five years. This would represent over $2 trillion more in global economic 

activity and would lead to significant additional job creation.

The past year has seen periods of increased financial market volatility, especially in emerging 

markets. In some respects this has reflected a changing global investment environment in which 

the advanced economies, the United States in particular, have seen their growth rates increase 

relative to those of emerging markets with implications for the path of monetary policy and asset 
9

prices. Volatility rose in the late spring months of 2013, with a strong initial correlation between 

the rise in the interest rate on longer-term U.S. Treasuries and a broad retrenchment in emerging 

market asset markets. But investors increasingly differentiated according to countries’ economic 

fundamentals, the strength of countries’ policy response, and signs of balance payments 

adjustment. A number of idiosyncratic factors, including disappointing data releases, renewed 

signs of slower growth in large emerging markets, and geo-political developments, prompted a 

new round of volatility in the early months of 2014. Those economies with stronger fiscal 

frameworks, more subdued inflation, and more robust external positions were less affected. By 

late March 2014 volatility had subsided, although risks to growth in certain economies still 

remained elevated.

2

 

Progress to reduce global current account 

imbalances remains mixed. The euro area's 

overall current account, which was close to 

balance in 2009-2011, increased to a surplus 

of 2.2 percent of GDP in 2013, from 1.3 

percent in 2012. The current account surplus 

of Germany widened to 7.4 percent of GDP in 

2013 and widened further in the second half 

of 2013, rising to 8.1 percent of GDP by the 

fourth quarter. Essential to external 

adjustment and the rebalancing of global 

demand is that in surplus countries the pace of 

growth of domestic demand must exceed that of GDP, a condition that has been met in Germany 

only three times over the past ten years. For the year, German goods imports contracted slightly 

in 2013 relative to 2012, which was indicative of weak domestic demand.

China registered a moderate current account surplus at 2.1 percent of GDP in 2013 according to 

preliminary data. The appreciation of China’s real effective exchange rate has been an important 

factor in reducing the current account surplus. At the same time, cyclical factors, such as 

weakness in demand from advanced economies, and shifts in terms of trade have also played a 

role. As discussed later in the report, the renminbi (RMB) remains significantly undervalued. 

Notably, Korea’s current account surplus rose significantly, reaching 6.1 percent of GDP in 

2013, up from 4.2 percent of GDP in 2012. Taiwan’s surplus was over 11 percent of its GDP in 

2013, increasing from 10.6 percent of GDP in the first half of 2013 to 12.6 percent in the second 

half. 

Achieving strong, sustainable, and balanced global growth will require a much more focused 

follow-through than achieved heretofore. Stronger commitments are needed to close current 

output gaps, increase jobs, rebalance global demand, and boost long-term growth potential. In 

this respect, economies with large external surpluses and sound fiscal positions have a key role to 

play in adding incrementally to global demand. In addition, a stronger follow-through is needed 

 

2

See Annex 1 for a fuller explanation of recent volatility developments in emerging markets.
10

on past G- 20 commitments to move more rapidly to market-determined exchange rates, where 

such exchange rate regimes do not exist. 

Global foreign-currency reserve accumulation continued 

to be large in 2013. China accounted for two-thirds of 

the increase, as shown in the table. Saudi Arabia saw its

reserves rise at an average monthly pace of $6.6 billion. 

However, many other countries reduced their pace of 

reserve accumulation in 2013 relative to previous years, 

as some engaged in defense of their currencies. 

U.S. International Accounts

The U.S. current account deficit was 1.9 percent of GDP 

in the fourth quarter of 2013, its lowest level since 1997. 

For the year, the deficit was 2.3 percent of GDP, a 3.5 

percent of GDP decline from its peak in 2006 of 5.8 

percent of GDP. Increased domestic oil production 

helped reduce the oil deficit from a peak of 3 percent of 

GDP in 2008 to 1.2 percent of GDP in 2013. Since the

recession’s trough in the June of 2009, the value of U.S. 

exports has increased by about 53 percent, while 

the value of imports has increased by almost 51 

percent through the fourth quarter 2013. As of the 

fourth quarter of 2013, the U.S. net international 

investment position was -$4.6 trillion, or -26.8 

percent of GDP. The value of U.S.-owned foreign 

assets was $22 trillion, and the value of foreignowned U.S. assets was $26.5 trillion.
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The Dollar in Foreign Exchange Markets

The nominal trade-weighted value of the U.S. 

dollar appreciated by 3.0 percent in 2013. The 

dollar rose by 4.5 percent against advanced 

economy currencies and by 2.0 percent against 

emerging market currencies. In the first three

months of 2013, the dollar’s path against the 

major and emerging market currencies 

diverged, as the dollar rose by 3.9 percent 

against major currencies, driven in large part 

by the yen’s depreciation, while remaining 

generally stable against emerging market

currencies. From May 2013 through October

2013, the dollar appreciated versus many 

emerging market currencies, particularly the 

Brazilian real, but depreciated against the currencies of major economies, particularly the 

U.S. Balance of Payments and Trade

($ billions, seasonally adjusted unless indicated) 2012 2013 Q4-12 Q1-13 Q2-13 Q3-13 Q4-13

Current Account

 Balance on goods (for details, see lower half of table) -741.5 -703.9 -182.4 -178.7 -175.0 -178.4 -171.8

 Balance on services 206.8 229.0 55.0 56.7 57.5 56.9 57.9

 Balance on income (including employee compensation) 223.9 228.8 57.0 50.1 55.2 59.1 64.4

 Net unilateral current transfers -129.7 -133.2 -31.9 -33.1 -34.5 -34.0 -31.6

Balance on current account -440.4 -379.3 -102.3 -105.0 -96.8 -96.4 -81.1

Balance on current account as % of GDP -2.7 -2.3 -2.5 -2.5 -2.3 -2.28 -1.9

Capital and Financial Account (financial inflow = +)

 Net official assets 474.8 288.8 87.7 125.5 -3.3 66.9 99.6

 Net bank flows -6.9 461.8 -23.9 98.7 281.7 -55.4 136.6

 Net direct investment flows -221.9 -166.3 -53.1 -53.3 -55.2 -38.9 -18.8

 Net sales of securities 208.5 -142.4 104.0 -94.0 -128.6 150.5 -70.2

 Net liabilities to unaffiliated foreigners by nonbank concerns -65.2 -126.6 -4.1 -43.3 -40.9 -61.0 18.6

 Other * 57.0 35.5 26.5 8.9 12.8 5.9 7.9

Balance on capital and financial account 446.3 350.8 137.1 42.6 66.5 68.2 173.7

Memo Items

Statistical discrepancy** -5.9 28.5 -34.7 62.5 30.3 28.3 -92.6

Change in foreign official assets in the United States 393.9 283.7 84.4 126.9 -6.6 66.1 97.4

Current Account Detail: Trade in Goods

Exports of goods

 Agricultural products 132.8 135.9 33.3 34.1 30.8 33.3 37.8

 Industrial supplies and materials (including petroleum) 518.9 525.3 128.6 130.9 128.8 132.1 133.4

 Capital goods except autos 527.7 534.5 131.6 130.8 134.9 134.2 134.6

 Automotive products 146.1 152.1 36.2 36.6 38.4 38.7 38.3

 Consumer goods except autos and food 181.7 188.5 46.0 45.6 49.0 46.3 47.6

 Other goods 54.0 53.3 14.7 13.2 13.2 13.3 13.7

Total exports of goods 1,561.2 1,589.7 390.3 391.3 395.2 397.8 405.4

Imports of goods

 Agricultural products 111.1 116.0 27.9 28.7 29.2 29.0 29.1

 Industrial supplies and materials (including petroleum) 752.3 702.5 183.2 181.8 173.2 175.8 171.7

 Capital goods except autos 551.7 557.3 137.7 137.1 137.3 139.6 143.2

 Automotive products 298.5 309.7 75.3 72.9 76.9 80.0 79.8

 Consumer goods except autos and food 519.6 535.8 131.7 131.8 134.4 133.7 135.9

 Other goods 69.5 72.3 17.0 17.8 19.1 18.0 17.4

Total imports of goods 2,302.7 2,293.6 572.7 570.0 570.2 576.2 577.2

Balance of trade in goods -741.5 -703.9 -182.4 -178.7 -175.0 -178.4 -171.8

Source: Bureau of Economic Analysis (BEA) via Haver Analytics.

Notes: *Latest quarter calculated by inference; this line contains items with a longer reporting lag than other lines.

 **Amount needed to make the current account balance with the capital and financial account; by definition,

 current account + capital and financial account + statistical discrepancy = 0.
12

Australian dollar. Since October 2013, the dollar has appreciated against the currencies of both 

groups of countries, though more strongly against the majors – notably versus the yen and 

Canadian dollar. 

On a real effective basis, which takes into 

account relative domestic price adjustments,

the U.S. dollar appreciated 2.0 percent in 

2013. The euro appreciated the most in 

2013 in real terms among the currencies 

covered in this Report, followed by the 

RMB and the won. However, the won 

remains the most depreciated of the 

currencies in this report since end-2007. 

The yen weakened the most during 2013, 

after a sharp drop in the first half of the year 

following the Bank of Japan’s marked 

easing of monetary policy and the

introduction of an explicit two percent inflation target in January 2013, and following a 

commitment in early April to aggressive monetary easing to support the inflation target. The 

Canadian dollar and Brazilian real weakened in 2013, with the Canadian dollar’s decline 

persisting into 2014. 

Analyses of Individual Economies

Asia

China

China’s GDP grew 7.7 percent in 2013, the same rate as 2012, although momentum decelerated 

in the second half of the year and into early 2014. Quarterly GDP growth fell from 2.2 percent 

in the third quarter to 1.8 percent in the fourth quarter, on a quarter over quarter seasonally 

adjusted basis. At the National People’s Congress in March 2014, China’s leaders announced a 

GDP growth target of 7.5 percent for 2014, unchanged from their 2013 target. Subsequent data 

on industrial production, fixed asset investment, and retail sales for the first two months of 2014 

suggest a further slowdown in growth, posing a 

challenge to the Chinese Administration to maintain 

economic growth while pursuing reforms 

announced at November’s Third Party Plenum. 

However, growth supporting measures announced 

in early April 2014, including railway construction 

and social housing development, should help 

stabilize the economy in the near term. 

Rebalancing the Chinese economy to rely more on 

household consumption, and less on exports and 

investment for growth is a longstanding goal of the 

Chinese leadership. However, China has made only 
13

limited progress to date. According to preliminary 2013 data, investment’s contribution to GDP 

growth rose and consumption’s contribution declined. With investment accounting for about 50 

percent of GDP, and consumption still too weak to drive overall growth, China’s economy 

remains highly vulnerable to a slowdown in investment. 

China has reduced its reliance on net exports subsequent to the global crisis. China’s current 

account surplus declined to 2.1 percent of GDP in 2013, according to preliminary data, down 

from 2.3 percent of GDP in 2012 and from a peak of over 10 percent in 2007. China’s current 

account surplus has also declined as a share of global GDP, but not as dramatically, since China 

now makes up a larger share of the world economy. According to IMF projections, assuming no 

further real effective appreciation of the RMB and a moderate pace of reform implementation, 

China’s current account surplus would begin to expand this year as a share of China’s GDP and 

nearly double in size as a share of global GDP in five years.

RMB appreciation continues to be critical if China is to meet its goals of rebalancing the Chinese 

economy and ensuring stable growth. A stronger RMB would support domestic consumption by 

increasing the purchasing power of households, and encourage a shift from tradable goods

production to production of domestically-oriented goods and services. A market-determined 

exchange rate would allow China to reduce its intervention in the foreign exchange market and 

give Chinese authorities greater control over liquidity creation and domestic monetary policy. 

China’s new leadership has 

expressed a strong desire for 

exchange rate reform. China’s 

November 2013 Third Plenum 

decision document underlines the 

goal to “perfect the market-based 

renminbi exchange rate formation 

mechanism.” In an article 

explaining the Third Plenum 

reforms, People’s Bank of China 

(PBOC) Governor Zhou said that 

China will “basically exit from 

normal foreign-exchange market 

intervention.” China has also 

made a number of bilateral and 

multilateral commitments to 

reform its exchange rate. At the 

July 2013 Strategic & Economic Dialogue (S&ED) in Washington, DC, China pledged to 

“continue exchange rate reform, increase flexibility of the RMB exchange rate, and let [the] 

market play a more fundamental role in exchange rate formation.” 

The RMB appreciated 2.9 percent against the dollar in 2013. This modest strengthening stood in 

contrast to the large depreciations in the yen and many emerging market currencies. As a result, 

the RMB strengthened more significantly on a trade-weighted basis, but not as fast or by as 

much as is needed. While the RMB nominal effective exchange rate (NEER) and real effective 
14

exchange rate (REER) rose 7.2 and 7.9 percent, respectively, for most of this period the RMB 

exchange rate was at or very near the most appreciated edge of the daily trading band, suggesting 

continuous pressure for RMB appreciation (see graph). During 2014, however, the exchange 

rate has reversed direction, depreciating by a marked 2.68 percent year to date.

China faced increasingly large capital inflows in 2013 and, given the PBOC’s policy of gradual 

adjustment, resumed large-scale foreign exchange intervention. Foreign exchange inflows were 

particularly sizeable in the first quarter of 2013, but slowed in the second quarter after the 

government clamped down on false trade invoicing used to channel “hot money” onshore for 

speculation, and introduced stricter requirements for managing the net open foreign exchange 

positions of domestic banks. Foreign exchange accumulation resumed again in the second half 

of the year, increasing to $98 billion and $131 billion in the third and fourth quarters of 2013, 

respectively.

For more than a year, market participants – particularly Chinese firms operating in both the 

onshore and offshore markets – had been able to profit from the combination of high domestic 

RMB interest rates, low dollar borrowing rates, and a steady and predictable pattern of RMB 

appreciation.3 In fact, China’s exchange rate volatility declined last year, with inter-day and 

intra-day movements of the RMB getting significantly smaller during the third and fourth 

quarters of 2013. Expectations of continued low volatility created a clear incentive for firms to 

borrow dollars at low interest rates and invest the funds in China, which fueled the large capital 

inflows. 

The Recent China Carry Trade:

During 2013 and into early 2014, market participants––particularly firms with onshore and 

offshore operations––sought to profit from the combination of relatively high domestic RMB 

interest rates, relatively low dollar borrowing rates, and a steady, predictable appreciation of the 

RMB. Even the modest positive carry available to offshore investors through the nondeliverable forward (NDF) market was highly profitable on a volatility-adjusted basis, especially 

if currency positions were highly leveraged. The RMB’s attractiveness as a carry trade currency 

has been partly a function of the PBOC’s unwillingness to allow the exchange rate to adjust to 

appreciation pressures stemming from China’s large current account surplus and foreign direct 

investment inflows. Limited movements in the daily reference rate and persistent foreign 

exchange intervention to keep the spot rate within the trading band allowed market participants 

to be reasonably confident that appreciation would continue in a predictable way. The

introduction of RMB volatility in February 2014 has led to an unwinding of carry trade positions 

in the short-term.

As noted above, mounting inflows in 2013 increased the amount of foreign exchange 

intervention necessary to keep the RMB within the trading band. China’s headline foreign 

exchange reserves increased $509.7 billion during 2013, a record for a single year. China’s 

 

3 One result of Chinese efforts to encourage greater use of the RMB in settling trade transactions is that firms that 

operate in both the Chinese domestic market and Hong Kong have considerable flexibility to move funds on- and 

off-shore, despite Chinese capital controls.
15

balance of payments data, which removes the impact of valuation changes from China’s 

reserves, indicates $433 billion in underlying reserve growth. The central bank’s “other foreign 

assets” increased by $56 billion, for a combined increase of $489 billion.

At the end of 2013, China’s total holdings of foreign exchange reserves came to $3.8 trillion, 

equivalent to 41 percent of China’s GDP, or $2,808 for every Chinese citizen. This is an 

exceptionally large amount compared to other economies, and well beyond established

benchmarks of reserve adequacy. China’s stock of reserves is more than the total amount of 

foreign exchange reserves held by all advanced economies combined, and accounts for nearly 

half of all of foreign exchange reserves held by emerging and developing economies. Evidence 

that China continued large-scale purchases of foreign exchange during the first quarter of this 

year as well, despite having accumulated $3.8 trillion in reserves, which are substantial by any 

measure, is suggestive of continued actions to impede market determination. 

The events of the past year highlight a fundamental problem that China’s policy makers have 

faced since the end of the dollar exchange rate peg in 2005. In the recent past the authorities 

have been unwilling to allow an appreciation large enough to bring the currency to market 

equilibrium, opting instead for a gradual adjustment. The expectation that the RMB would 

continue to appreciate over time resulted in capital inflows in 2013. The PBOC’s policy of 

gradual adjustment triggered expectations of continued appreciation, and resulted in large-scale 

foreign exchange intervention. China’s capital controls have provided a degree of insulation, but 

these have weakened as a result of increasing opportunities to move capital created by China’s 

large trade volumes and greater opportunities for RMB settlement through on- or off-shore 

affiliates. 

In what was initially interpreted as an effort to introduce two-way volatility and discourage carry 

trade inflows after large inflows over the past 15 months, China appears to have recently taken 

measures to weaken the RMB. After 18 months of sustained appreciation, the RMB depreciated 

significantly from late-February 2014 through March. Over the course of 30 trading days, the 

onshore spot rate fell 2.5 percent against the dollar, and the PBOC lowered the daily “reference 

rate” – the exchange rate that defines the center of the RMB’s permitted trading band – by 0.7 

percent. The RMB has seen periods of depreciation before, such as mid-2012 when the RMB 

fell 1.5 percent against the dollar over a three-month period, but the pace and the size of the 

recent decline was unprecedented. 

According to market analysts, 

the immediate trigger for the 

depreciation in late February

was the PBOC’s decision to set 

sequentially lower reference 

rates, combined with PBOC 

intervention in the spot market 

to weaken the RMB. These 

actions pushed the spot price 

below the reference rate for the 

first time since May 2012 on 
16

February 25, 2014. On March 17, 2014, the PBOC widened the RMB’s trading band with the 

dollar from +/- 1 percent to +/- 2 percent, and RMB depreciation extended into the newlywidened weak side. The widening of the band gives China an opportunity to reduce intervention 

and allow the market to play a greater role in determining the exchange rate. To realize this 

opportunity, China should refrain from intervention within the band and should allow market 

forces to permit the reference rate to adjust if market pressures push the exchange rate to the 

edge of the band. 

Although the RMB exchange rate may be more volatile than it has been in the recent past, the 

core factors that have long driven RMB appreciation remain. There are a number of signs that 

the exchange rate adjustment process remains incomplete and the currency has further to 

appreciate before reaching its equilibrium value. China continues to generate large current 

account surpluses and attracts large net inflows of foreign direct investment; China’s current 

account surplus plus inward foreign direct investment in 2013 exceeded $446 billion, or 4.8

percent of China’s GDP. The reduction in the current account surplus as a share of China’s GDP 

over the past few years has largely been the reflection of the unsustainably rapid pace of 

investment growth. Finally, China has continued to see rapid productivity growth, which 

suggests that continuing appreciation is necessary over time to prevent the exchange rate from 

becoming more undervalued. All of these factors indicate a RMB exchange rate that remains 

significantly undervalued. Rebalancing the Chinese economy will require further exchange rate 

appreciation so that consumption rather than investment drives domestic demand.

Although incentives for capital inflows may have been blunted in the near term by the PBOC’s 

recent actions, the fundamental problem referred to above – that the authorities have only 

allowed a part of the necessary appreciation to take place – will continue to drive expectedappreciation-based capital inflows in the future. Therefore it is very much in China’s interest to 

fulfill its own commitment to move more rapidly to a market-determined exchange rate, with 

intervention only in the case of disorderly market conditions.

 

While the desire to introduce two-way volatility in the RMB foreign exchange market is clear,

recent developments in the RMB exchange rate raise particularly serious concerns, if they 

presage a retreat from China’s announced policy of allowing the exchange rate to reflect market 

forces, reducing exchange market intervention, and moving toward a market-determined 

exchange rate. We will continue to monitor this issue closely going forward. 

The RMB’s recent depreciation underlines the importance of a significant increase in the 

transparency of China’s actions in the foreign exchange market. Because China still does not 

provide transparent disclosure of its activity in the currency market, market participants and 

other observers must resort to estimating China’s intervention using published reserve levels and 

changes in the central bank balance sheet. In line with the practice of most other G-20 nations, 

China should disclose foreign exchange market intervention regularly to increase the credibility 

of its monetary policy framework and to promote exchange rate and financial market 

transparency. Other large emerging market countries – including India, Russia, and Brazil –

disclose their monthly intervention in the foreign exchange market, with several publishing daily 

intervention data.
17

China is currently one of only two G-20 members that do not report reserves under the IMF’s 

Special Data Dissemination Standard (SDDS) template, the international standard for public 

reporting of reserves data. Participation in the SDDS and the IMF’s aggregate Currency 

Composition of Foreign Exchange Reserves (COFER) database would be consistent with 

China’s commitment at the 2012 G-20 Los Cabos Summit to increase the transparency of its 

exchange rate policy. China stated at the 2013 S&ED that it is “actively considering” 

subscription to the SDDS. 

Japan

Japan maintains a floating exchange rate regime. As of February 2014, Japan’s foreign exchange 

reserves were $1.2 trillion, the second-largest in the world. The yen foreign exchange market 

accounts for about 23 percent of the roughly $5 trillion in daily global foreign exchange 

transactions, according to surveys by the Bank for International Settlements (BIS).4 

Japan has not intervened in the foreign exchange markets in over two years, although the 

authorities did issue numerous public statements regarding their desire to “correct the 

excessively strong yen” in the weeks following Prime Minister Abe’s election on December 16, 

2012. Shortly thereafter, in the G-7 statement of February 2013, Japan joined the other G-7 

countries in pledging to base its economic policies on domestic objectives using domestic 

instruments, and to avoid targeting exchange rates. Japan was also part of the subsequent G-20 

consensus and statement at the February 2013 Finance Ministers and Central Bank Governors 

Meeting in Moscow that countries would not target exchange rates for competitive purposes. 

These statements were affirmed by G-20 Leaders in September 2013 at the St. Petersburg

Summit. Since the February 2013, G-7 and G-20 statements, Japanese officials have clearly 

ruled out purchases of foreign assets as a monetary policy tool, and public comments by 

Japanese officials on the exchange rate have notably diminished. 

The yen started to depreciate against the dollar in October 2012 as market expectations built for 

more aggressive monetary easing by the Bank of Japan (BOJ). After the April 4, 2013,

announcement of “Quantitative and Qualitative Easing” in which the Bank of Japan committed 

to double the monetary base to achieve a 2.0 percent inflation target, the yen depreciated as far as 

¥103.2 per dollar on May 17, 2013, representing a 32 percent depreciation from the beginning of 

October 2012. The yen depreciated again between October and December 2013, reaching 

¥105.3 per dollar, on widening interest rate differentials between the United States and Japan and

growing market expectations of additional monetary easing by the BOJ in early 2014. Since 

December 2013, the yen has appreciated against the background of renewed emerging market 

volatility, trading in a range of ¥101-105 per dollar in the first quarter of 2014. On a real tradeweighted basis, the yen has depreciated by 25 percent since the beginning of October 2012 

through February 2014. In its last Article IV Consultation Report for Japan (August 2013), the 

IMF assessed the yen’s real effective exchange rate to be moderately undervalued, while noting 

 

4 The 2013 BIS Triennial Central Bank Survey, released in September, showed that a significant expansion in yen 

trading between October 2012 and April 2013 was driven by expectation of a regime shift in Japanese monetary 

policy. In the last triennial BIS Central Bank Survey of Foreign Exchange Turnover, the yen foreign exchange 

market accounted for 19 percent of the roughly $4 trillion in daily global foreign exchange transactions.
18

the very large uncertainty about its assessment given the major changes to Japan’s economic 

fundamentals. 

Japan’s nominal goods trade balance fell into deficit in 2011 for the first time since 1980 as 

exports slowed following production disruptions stemming from the tsunami, while imports 

increased due to higher commodity prices and rising demand for reconstruction materials. The 

deficit continued to rise in 2012 and 2013, due in large part to the rise in import prices driven by 

the weaker yen and increased demand for fossil fuel imports following the shutdown of most of 

Japan’s nuclear power generators. The trade deficit reached 2.6 percent of GDP in 2013. The 

current account has remained in surplus due to positive net income flows, but narrowed 

substantially from almost 4.0 percent in 2010 to 0.7 percent in 2013 and posted a deficit on a 

monthly basis from October 2013. Japan’s bilateral trade surplus with the United States totaled 

$73.4 billion in 2013, down slightly from $76.4 billion in 2012. The IMF is projecting that 

Japan’s current account surplus will rise in 2014 and 2015, to 1.2 and 1.3 percent of GDP, 

respectively, as growth in Japan slows, foreign demand growth increases, and past yen 

depreciation begins to have an effect.

For over a decade and a half, Japan has struggled to establish sustained economic growth and to 

escape from persistent price deflation. The “three arrows” of Prime Minister Abe’s economic 

program are the most forceful attempt to meet these challenges. Aggressive monetary policy and 

initially-stimulative fiscal policy have contributed to the recovery in the Japanese economy in the 

short term, and GDP grew by 2.5 percent year-on-year as of the fourth quarter 2013. Over the 

four quarters of 2013, domestic demand has contributed 3.0 percentage points to growth on a 

cumulative basis, compared to a negative 0.2 percent point contribution from net exports. 

Fiscal policy will turn contractionary in 2014, as Japanese authorities seek to put their public 

finances on a more sustainable footing, with net debt of 140 percent of GDP and gross public 

debt of 250 percent of GDP. An increase in Japan’s consumption tax, with an initial stage from 

5 to 8 percent on April 1, 2014, and a second stage to 10 percent scheduled for October 2015, is 

a large part of the authorities’ deficit-reduction strategy. However, Japan also needs to take care 

that the overall fiscal position, inclusive of expiring fiscal stimulus and reconstruction spending, 

does not result in too rapid a consolidation that prevents escape from deflation, stalls Japan’s

growth, and undermines the success of its reform program. The short-term, negative impact of 

consumption tax increases should be moderated through temporary fiscal measures calibrated to 

support domestic demand. In December 2013, the Japanese government approved a ¥5.5 trillion 

($54 billion) supplemental budget to help offset the drag on growth from the consumption tax. 

The government plans to front-load this spending to support growth at the time the consumption 

tax hike takes effect. The authorities also plan to accelerate regular budgetary spending, but 

should be prepared to provide additional fiscal support if growth slows more than authorities 

forecast. As fiscal consolidation sets in, and support from the weaker yen abates, the IMF 

projects GDP growth will slow to 1.5 percent in 2014 with a further slowdown to 1.0 percent in 

2015. 

As Japan takes policy steps to bring about a durable recovery and escape deflation, it is 

imperative both for the success of those measures and for the global economy that Japan’s 

economic policies work primarily through an increase in domestic demand. Sustaining domestic 
19

demand growth will depend on sustained rises in business and residential investment, household 

consumption, and wage increases that exceed inflation. In this respect, it is important that Japan 

carefully calibrate the pace of overall fiscal consolidation. Monetary policy cannot offset 

excessive fiscal consolidation nor can it substitute for structural reforms needed to raise trend 

growth and domestic demand.

Ambitious and effective structural reforms to durably increase domestic demand would include 

measures to raise household income through greater labor force participation and higher 

earnings. They would also include measures to facilitate new domestic opportunities for activity 

and investment, by opening up domestic sectors – particularly services – to new products and 

new competition through deregulation, as well as measures to encourage more effective use of 

land, especially land now classified as agricultural. In March 2013, Prime Minister Abe 

announced Japan’s intention to join the Trans-Pacific Partnership (TPP) trade negotiations, and 

Japan joined the negotiations in July 2013. The TPP could also lead to internal reforms such as 

deregulation in areas like agriculture and medical services that support growth.

South Korea

South Korea officially maintains a market-determined exchange rate, and its authorities intervene 

with the stated objective of smoothing won volatility. In February 2013, Korea joined the rest of 

the G-20 in committing to refrain from competitive devaluation and resolving not to target its 

exchange rate for competitive purposes. Korean authorities appear to intervene on both sides of 

the market but, on net, they have intervened more aggressively to resist won appreciation. 

Korea’s current account surplus further increased to 6.1 percent of GDP in 2013 – the highest 

since 1999 – compared to a surplus of 4.2 percent in 2012. Korea is one of only a few surplus 

economies with a significantly larger external surplus now than before the crisis. Net exports 

accounted for 1.6 percentage points of Korea’s 3.0 percent growth in 2013, highlighting the 

economy’s continued dependence on external demand. Korea’s goods and services trade surplus 

was 5.6 percent of GDP in 2013, and Korea’s bilateral trade surplus in goods with the United 

States totaled $20.7 billion, around 2 percent of Korean GDP, up from $16.6 billion in 2012. 

The rise in the current account and trade surpluses can be only partly explained by an 

improvement in Korea’s terms of trade due to falling commodity prices, as energy imports 

constitute around 40 percent of total imports. Domestic demand growth remains sluggish, 

although supported somewhat last year by incremental fiscal stimulus of 0.4 percent of GDP and 

a pick-up in business investment. Personal consumption growth lagged overall GDP growth. 

Korea’s elevated household debt – currently at 136 percent of disposable income – and general 

government fiscal surplus have weighed on domestic demand and consumer spending. 

In February 2014, President Park announced a sweeping economic reform agenda that targets a 

potential growth rate of 4.0 percent, an employment rate of 70 percent of the population, and per 

capita income of $40,000 (compared with approximately $24,000 at present). This ambitious

reform plan seeks to reduce Korea’s dependence on exports and largely targets for improvement 

the services sector, where productivity growth has lagged the export sector. Exchange rate 

appreciation is an important tool for supporting this rebalancing, as it would encourage 

reallocation of production resources to the non-tradables sector, which includes most services. 
20

The won’s real effective exchange rate remains about 11 percent weaker than its 2007 level. The 

won appreciated 1.4 percent against the dollar during 2013. Although Korea was less affected 

than other emerging markets by financial turbulence, the won depreciated by 9.1 percent in the 

first half of 2013, from 1064 won per dollar on December 31, 2012 to 1161 on June 24, 

2013. Thereafter, the won appreciated 9.6 percent by year-end to 1050 won per dollar as market 

participants took stock of the relative strength of Korean fundamentals.

Korea has intervened in the market to resist appreciation within the context of a widening current 

account surplus. During the second half of 2013 the Korean authorities are believed to have 

intervened to limit the pace of won appreciation, with market speculation of intervention 

increasing as the won approached key levels. Unfortunately, Korea does not publicly report 

foreign exchange market intervention, unlike many other major emerging markets and 

industrialized economies.5 Instead, market participants derive estimated intervention from 

changes in Korean foreign exchange reserves and forward positions. Korea’s foreign exchange 

reserves rose from $315.6 billion at end-June 2013 to $335.6 billion at end-December and 

$341.0 billion at the end of February 2014. The Korean authorities also increased their net 

forward position by $4.9 billion to $50.5 billion over the second half of 2013. The magnitude of 

these changes is larger than could be reasonably expected from simple interest earnings on the 

existing stock of reserve assets or valuation changes, leaving little doubt that Korea has been 

active in the market. 

Notably in the last published Article IV Consultation Report on Korea, released in September 

2012, the IMF noted that foreign exchange reserves were adequate and that there was “no need 

for further reserve accumulation beyond what would be needed to keep pace with rising foreign 

liabilities over time.” The Korean authorities have not yet authorized publication of their latest 

IMF Article IV review, which the IMF Executive Board concluded in January 2014.

Prior to the global crisis, the Korean banking system relied heavily on wholesale funding, much 

of it external. The Korean government has subsequently taken a number of useful steps to 

reduce short term external liabilities. However, it is important that Korea’s macroprudential 

measures continue to target financial vulnerability and not the level of the exchange rate. 

Throughout 2013 and early this year, in periods of won appreciation, the Korean authorities have 

publicly warned they were contemplating further tightening of macroprudential measures on the 

foreign exchange exposure of the banking system in periods of won appreciation. During 

periods of won depreciation, no additional macroprudential measures were signaled. 

The Korean authorities should limit foreign exchange intervention to the exceptional 

circumstances of disorderly market conditions, increase transparency of foreign exchange 

intervention, approve the timely publication of the IMF’s recent Article IV surveillance report,

and ensure that macroprudential measures clearly focus on reducing financial sector risks – in 

design, timing, and description – rather than alleviating upward pressure on the exchange rate. 

 
21

Taiwan

Taiwan has a large and rising current account surplus, which reached a record level of $57.4 

billion in 2013. The surplus was 11.7 percent of GDP, the highest since 1988. Taiwan’s goods 

and services trade surplus totaled $46.3 billion in 2013, up 22 percent from 2012. The current 

account and trade surpluses reflect both the recovery of the global economy and sluggish 

domestic demand. Weak private consumption and business investment held overall GDP growth 

to 2.2 percent in 2013, below the 2001-2008 average of 3.8 percent. The IMF currently projects 

overall GDP growth of 3.1 percent in 2014 and 3.9 percent in 2015. Policies to stimulate 

consumption and investment, further liberalize the services sector, and remove trade and 

investment barriers would help rebalance the Taiwanese economy.

Taiwan has a largely open capital account, but maintains some restrictions to avoid large inflows 

or outflows of capital, including measures to discourage foreign investors from holding local 

currency deposits. Taiwan was less affected by capital outflows than other emerging markets in 

2013. While the financial account showed a net outflow of $41 billion in 2013, this largely 

reflected greater investment abroad by Taiwanese insurance companies.

Taiwan’s foreign exchange reserves grew by $13.6 billion (3.4 percent) in the second half of 

2013, and stood at $418 billion as of end-February 2014. Taiwan’s foreign exchange reserves 

are well in excess of adequate levels by any metric. They are equivalent to 85 percent of GDP, 

19 months of imports, and 2.8 times the economy’s short-term external debt.

Taiwan maintains a managed float exchange rate regime, and the central bank states that the New 

Taiwan Dollar (NTD) exchange rate is determined by the market, except when the market is 

disrupted by seasonal or irregular factors.6 The NTD appreciated 1.1 percent against the dollar 

in the second half of 2013, and has depreciated 1.9 percent against the dollar in the first three 

months of 2014. The real effective exchange rate, as calculated by the Bank for International 

Settlements (BIS), was unchanged over the course of the year, while the BIS nominal effective 

exchange rate appreciated 0.2 percent during 2013. 

Taiwan does not disclose its foreign exchange market intervention. However, looking at 

publicly available statistics, Taiwan appears to intervene on both sides of the market but, on net, 

much more to resist appreciation than depreciation. On a balance of payments basis, reserve 

assets increased every quarter since 2008 except one. The change in foreign assets on the central 

bank’s table “Factors Responsible for Changes in Reserve Money” (which excludes valuation 

changes resulting from foreign exchange fluctuations) also has been positive since 2011 every 

month but two. The magnitude of these changes is larger than could be reasonably expected 

from simple interest earnings on the existing stock of reserve assets, leaving little doubt that 

Taiwan intervened in the market.

 

6

In December, Central Bank Governor Perng issued a report to the legislature as well as an open letter to the public 

stressing the limits on the ability of the central bank to influence the exchange rate, the need for the central bank to 

balance competing domestic interests (including those of importers and consumers) in its monetary and foreign 

exchange policy, and the need for structural reforms to promote investment, increase competitiveness, and move 

Taiwan up the value-added product ladder.
22

Taiwan uses the IMF’s Special Data Dissemination Standard (SDDS) framework to provide data 

on many aspects of its economy, including the real sector, and fiscal, financial and many external 

accounts. But Taiwan does not publish data on international reserves that conforms to the SDDS 

reserves template, nor does it publish intervention data. Taiwan is the only major emerging 

market in Asia not to be either currently subscribing, or publicly considering subscription, to the 

SDDS reserves template. 

Given the size of Taiwan’s economy and its importance in international trade flows, Taiwan 

should move toward a more fully market-determined exchange rate, Taiwanese authorities 

should limit their foreign exchange interventions to the exceptional circumstances of disorderly 

market conditions, and increase the transparency of reserve holdings and foreign exchange

market intervention.

Europe

Euro Area

The euro area has a freely floating exchange rate. The euro has experienced large fluctuations 

since the financial crisis resulting from ebbs and flows in risk aversion associated with financial 

stresses in the euro area. In the second half of 2013, the euro appreciated by 5.3 percent against 

the dollar and has been relatively stable through the first three months of 2014. On a real 

effective basis, the euro depreciated by 0.7 percent in the second half of 2013.

The euro area’s recovery has substantially lagged other developed countries, leaving economic 

activity at a low level. Euro area GDP is 2.7 percent below its peak in the first quarter of 2008.

Private demand is more than five percent below pre-crisis levels, and unemployment is running 

at a near-record high of 12 percent. Following six consecutive quarters of contraction, the euro 

area economy returned to growth in the second quarter of 2013, with GDP expanding by 1.0

percent, on a seasonally adjusted, annualized basis, over the last three quarters of 2013. 

However, significant macroeconomic and financial headwinds persist. While the pace of fiscal

consolidation has eased, the region’s fiscal stance remains contractionary, and bank 

deleveraging, low real wage growth, and weak investment continue to weigh on economic 

activity. Moreover, growth was driven primarily by net exports in 2013. With inflation in the 

euro area dropping to new record lows in recent months and the risk of further financial volatility 

in emerging markets having an adverse impact on global demand, Europe faces the risk of a 

prolonged period of substantially below-target inflation or outright deflation. This would slow 

Europe’s return to growth, further hinder the internal rebalancing that is still needed between the 

core and periphery, and increase the real burden of public and private debts. The European 

Commission forecasts that the euro area economy will grow by around 1.0 percent in 2014. 

The euro-area’s collective current account surplus expanded to 2.2 percent of GDP in 2013, as 

large current account deficits in peripheral countries continued to shrink, in some cases moving

into surplus largely through demand compression, while surplus countries have not reduced their 

current account surpluses. Both in dollar terms and as a share of GDP the euro area’s surplus

now exceeds China’s surplus. Previous current account deficits in Italy, Spain, and the smaller 

economies in the periphery have turned into small surpluses in recent quarters, primarily as a 
23

result of a collapse of domestic demand and falling wages. The Netherlands and Germany, 

meanwhile, have continued to run substantial current account surpluses since 2011, with 

Germany’s surplus rising to 7.4 percent of GDP in 2013. 

To ease the adjustment process within the euro area, countries with large and persistent surpluses

need to take action to boost domestic demand growth and shrink their surpluses. For example, in 

Germany, domestic demand has grown faster than GDP only three times in the past ten years. 

German domestic demand picked up in the third quarter of 2013, but weakened in the fourth 

quarter, leaving domestic demand just 0.4 percent larger in the second half of 2013 than in the 

first half. One sign of the subdued pace of German demand growth is that German goods 

imports were 1.0 percent weaker for the year. Stronger domestic demand growth in all surplus 

European economies is needed to help facilitate a durable rebalancing of imbalances in the euro 

area. 

The European Union’s (EU) annual Macroeconomic Imbalances Procedure, developed as part of 

the EU’s increased focus on surveillance, recently identified Germany’s current account surplus 

as an imbalance which requires monitoring and policy action. Notably, the EU stated that, given 

the size of the German economy, action was particularly important to reduce the risk of adverse 

effects on the functioning of the euro area. While identification of Germany is a welcome step,

as are the EC’s recommendations for measures to bolster investment and demand growth, it 

remains to be seen whether the procedure can produce robust recommendations or policies aimed 

at the euro area aggregate fiscal stance and symmetric rebalancing.

A key priority for the euro area moving forward is to solidify and accelerate the recovery in 

growth, which will support a reduction of heavy debt burdens, lower high unemployment rates, 

and help maintain political support for the adjustment process within the core and periphery. 

While structural reforms are a necessary part of the European policy mix, a more balanced 

approach that couples such reforms with measures to boost investment, job creation, and demand 

is needed. Continued flexibility with respect to fiscal targets will allow countries with more 

fiscal space to support growth and better align the euro area’s aggregate fiscal stance with the 

economic cycle. Measures to increase domestic demand, particularly in surplus countries like 

Germany, can help further European and global rebalancing. Germany’s recent agreement to 

implement the country’s first economy-wide minimum wage represents incremental progress 

towards this goal. Appropriate monetary accommodation to move inflation back toward target 

could accelerate healing in Europe’s labor markets and also support rebalancing, as higher 

domestic inflation in strong economies like Germany would provide more headroom for 

periphery countries to improve their competitiveness without outright deflation. Finally, 

deepening euro area financial, economic, and fiscal integration – more centralized risk sharing, 

greater resource pooling, enhanced cost sharing – would facilitate the ongoing adjustment and 

make the monetary union more resilient to future shocks.

Switzerland

Switzerland is a small open economy surrounded by the euro area, and has been 

disproportionally affected by the financial stresses in Europe, resulting in disorderly movements 
24

in the exchange rate. The Swiss authorities faced a constrained policy environment as external 

forces pushed the economy into deflation in the summer of 2011. In September 2011, after a 

number of alternate policy measures failed to achieve the Swiss National Bank’s (SNB) 

monetary policy objectives, it established a minimum exchange rate (“floor”) of 1.20 Swiss 

francs per euro, temporarily changing the exchange rate regime from a floating to a managed 

rate. Through 2012 the SNB intervened repeatedly to prevent the franc from appreciating. 

However, as European authorities implemented measures to reestablish financial stability, and 

concerns about tail risks subsided, pressures on the Swiss franc subsided and SNB interventions 

ceased. The SNB continues to reaffirm its commitment to a managed rate, noting that it is 

prepared to buy foreign currency in unlimited quantities to enforce the 1.20 exchange rate floor. 

Since establishing the exchange rate floor, the SNB’s foreign reserve assets have increased by 

$172 billion on a headline basis, and now total $492 billion as of February 2014. In 2013, 

foreign reserve assets increased $20.6 billion to $488.6 billion (72 percent of GDP). Given the 

lack of foreign exchange intervention in 2013, the change is attributable to valuation effects. 

While the currency composition of reserves fluctuates on a monthly basis as a result of 

interventions and valuation changes, the SNB rebalances its portfolio over time to keep the euro 

share around 50 percent of reserves and the U.S. dollar share between 25 and 30 percent.

After remaining close to the 1.20 exchange rate floor through the end of 2012, the franc 

depreciated by 1.3 percent against the euro in 2013. Against the U.S. dollar the franc appreciated 

by 1.8 percent in 2013 and on a real trade weighted basis the franc has appreciated 0.9 percent in 

2013 (based on BIS data). 

Preliminary data indicates that the 2013 the current account surplus was 13.0 percent of GDP. 

The large current account surpluses traditionally run by Switzerland must be interpreted with 

caution. The IMF’s 2013 Article IV staff report notes that (a) the activities of international 

commodity trading companies could add up to 4.0 percent of GDP to the surplus even though 

some have limited operations in Switzerland; (b) Swiss multinationals partly owned by 

foreigners artificially raise the surplus and are estimated to have added 2.0 percent of GDP to the 

surplus in 2011; and (c) cross-border shopping direct purchases and deliveries may not be 

reflected in import statistics and overstate the current account by non-trivial amounts. Finally, 

Switzerland’s role as an international banking center generates fee and investment income that 

contribute to the overall current account surplus but cannot be attributed to Swiss citizens.

In the IMF’s 2013 Pilot External Sector Report, the Swiss external position is assessed to be 

“moderately stronger than the level consistent with medium-term fundamentals and desirable 

policy settings.” The real effective exchange rate is assessed to be “moderately overvalued 

because of safe-haven capital inflows, but the overvaluation is eroding over time given negative 

inflation differentials with trading partners.”

Economic growth in Switzerland is slowly reviving and deflationary pressures appear to be 

subsiding. Switzerland’s economy expanded by 1.9 percent in 2013, up from 1.2 percent in 

2012; and the SNB forecasts 2.0 percent growth for 2014. Consumer prices increased 0.1 

percent year-on-year in December 2013, but have subsequently fallen back into deflation –

declining 0.1 percent year-on-year in February 2014. With low unemployment (3.2 percent) and 
25

high capacity utilization (around 81 percent in the third quarter 2013) there appears to be little 

“slack” in the economy. The SNB estimates the negative output gap in the fourth quarter of 

2013 at around 1.0 percent of potential GDP. 

The exchange rate floor has contributed to the reduction of deflation and overall economic 

stability. Once economic conditions normalize, a return to a freely floating currency would be 

desirable.

United Kingdom

The UK economy expanded by 1.8 percent in 2013, its highest rate of annual growth since 2007. 

Growth was driven by household consumption growth of 2.6 percent, which makes up 62 percent 

of economic output. Gross fixed capital investment decreased by 0.5 percent in 2013 and real 

net exports increased by 0.1 percent. 

The fiscal deficit fell from its post-war peak of 11.0 percent of GDP in fiscal year 2009-10 to 7.3 

percent of GDP in 2012-13, excluding one-off factors. On a cyclically-adjusted basis, the fiscal 

deficit decreased from 8.7 percent of GDP in 2009-10 to 5.3 percent of GDP in 2012-13. As of 

March 2014, the Office of Budget Responsibility projects that the headline fiscal deficit will fall 

further in 2013-14, to 5.0 percent of GDP.

Monetary policy remains accommodative. The Bank of England (BOE) has maintained its

historically low policy rate at 0.5 percent and, since October 2011, increased the size of its 

quantitative easing program three times – each time by £50 billion – to reach £375 billion at its 

July 2012 meeting. In July 2012, BOE launched its Funding for Lending Scheme (FLS), which 

is designed to incentivize banks to increase their lending by reducing the cost of BOE funding in 

response to commercial banks’ lending performance. In November 2013, BOE reoriented FLS 

toward business lending. Consumer price inflation peaked at 5.2 percent in September 2011 on 

year-on-year basis, but has fallen to 1.8 percent as of February 2014. 

The United Kingdom (UK) has a freely floating exchange rate. The pound appreciated by 1.9 

percent against the U.S. dollar on a nominal basis in 2013, and continued to appreciate by 0.4

percent through end-March of 2014. On a real effective basis, the pound appreciated by 1.5 

percent in 2013. The UK real effective exchange rate has appreciated 13.3 percent from its 

trough in early 2009, but remains 19 percent below its pre-crisis peak. However, in July 2013, as 

part of the UK’s Article IV consultation, the IMF assessed the pound to be moderately 

overvalued. 

The current account deficit in 2013 widened to 4.4 percent of GDP – the largest deficit since 

1989 – reflecting a widening of the income and transfers deficits. The goods and services trade 

deficit remained more modest at 1.6 percent of GDP in 2013, narrowing from 2.1 percent of 

GDP in 2012. In the IMF’s 2013 Pilot External Sector Report, the UK’s external position is 

assessed to be “moderately weaker than implied by medium-term fundamentals and desirable 

policy settings.” 
26

Western Hemisphere

Brazil

Brazil’s economy expanded by 0.7 percent quarter-on-quarter on a seasonally adjusted basis in 

the fourth quarter of 2013 after contracting by 0.5 percent in the previous quarter. The fourth 

quarter expansion helped Brazil’s real GDP increase 2.3 percent for the year in 2013. The IMF 

projects a moderation of growth to 1.8 percent in 2014. Annual inflation reached 6.5 percent 

year-on-year in the first half of 2013, at the upper limit of the central bank’s target band of 4.5 

percent ± 2 percent, and decelerated to 5.7 percent year-on-year by February 2014. Market 

participants surveyed in the Brazilian central bank’s weekly market survey expect inflation to 

remain in the upper end of the central bank’s target band through 2015.

Brazil maintains a floating exchange rate regime, although over the past few years there have 

been, at times, increased official efforts to manage the real. The authorities have used foreign 

exchange market intervention – primarily through foreign exchange derivatives markets – as well 

as verbal guidance and capital flow management measures to dampen directional movements of 

the currency. Brazil’s real effective exchange rate depreciated substantially over the past year, 

weakening 7.6 percent year-on-year as of March 2014. In nominal terms, the real depreciated by 

17.3 percent against the dollar over that period. In Brazil’s July 2013 Article IV review, IMF 

staff assessed the real to be 10-15 percent overvalued.

In response to sharp depreciation pressures on the real, in August 2013, the Brazilian Central 

Bank (BCB) announced a formal intervention program, with a stated objective of providing 

hedging and liquidity to the foreign exchange market. From August through December 2013, the 

BCB sold a minimum of $2 billion in swap contracts per week, along with $1 billion in USD in 

the spot market through repurchase contracts. The repurchase operations will cause a temporary 

fall in foreign exchange reserves until the operations are reversed, whereas dollar swaps are 

settled in local currency. As a result of this activity, the BCB has built up a short dollar position 

in the foreign exchange forward market, which reached $86 billion as of end-March 2014. In 

addition, on net, the BCB has sold $14.5 billion in the spot market using repurchase contracts 

through end of February. The BCB announced a reduction in the size of the intervention 

program starting in January 2014, but stated that the program will continue at least through June 

2014. Brazil’s headline foreign exchange reserves totaled $363 billion as of end-February 2014, 

equivalent to 14 months of import cover.

Brazil’s current account deficit increased to 3.7 percent of GDP in 2013, up from 2.4 percent in 

2012, reaching its largest deficit since 2001. Brazilian export growth was flat in 2013, while 

imports increased about 7 percent. 

Canada

Canada saw growth of 2.0 percent in 2013, underpinned by private consumption and a marginal 

pickup in exports. The IMF projects growth to increase to 2.3 percent in 2014, driven by 

stronger external demand. Canada’s current account deficit narrowed slightly from 3.4 percent 
27

in 2012 to 3.3 percent in 2013, and the IMF forecasts it will continue to narrow, albeit slightly,

over the next few years as external demand for Canada’s exports, particularly from the United 

States, recovers. 

Canada maintains a flexible exchange rate and employs an inflation-targeting monetary policy 

regime. The Canadian dollar fluctuated against the dollar throughout 2013 but was on a 

depreciating trend for the year. In nominal terms, the Canadian dollar depreciated by 8.4 percent 

against the U.S. dollar from March 2013 through March of this year. On a real effective basis, 

the Canadian dollar depreciated 9.0 percent over the course of 2013. Inflation remained low at 

just above 1.0 percent for the year. 

Canada had foreign exchange reserves of $63.7 billion as of the beginning of March 2014, 

representing 3.5 percent of GDP and about 1.6 months of imports. Canada recently took steps to 

diversify its foreign exchange reserves, and will begin to add pound sterling-denominated assets

to its Exchange Fund Account (EFA). The EFA also holds U.S dollar-, euro-, and yendenominated assets.

Mexico

After rebounding strongly following the financial crisis, the Mexican economy lost momentum 

in 2013, growing by just 1.1 percent. Government spending was weak in 2013 as the new 

government took time to execute its spending priorities, and softness in the residential housing 

sector also contributed to low overall growth. Continued soft global demand throughout 2013

also contributed to a challenging external environment, weakening Mexican exports and 

manufacturing, with negative second-order effects on consumption. The IMF forecasts growth 

increasing to 3.0 percent in 2014, as government spending and investment rebound and stronger 

growth in the United States boosts Mexican manufacturing and exports. Mexico’s current 

account deficit was 1.8 percent of GDP in 2013 and the IMF forecasts it to remain relatively 

stable at 2.0 percent of GDP in 2014, reflecting higher imports associated with stronger 

economic activity offset by higher exports due to the strengthening global economy.

Mexico has a flexible exchange rate and employs an inflation-targeting monetary policy regime. 

After strengthening steadily during the first four months of 2013, the peso began to reverse 

course in May 2013. In nominal terms, the Mexican peso depreciated by 5.5 percent against the 

U.S. dollar from March 2013 through March 2014, and 7.6 percent from the end of April 2013 

through March 2014. On a real effective basis, the peso, on net, was nearly unchanged over the 

course of 2013, appreciating 0.1 percent.

Mexico has a comfortable level of foreign exchange reserves at $168.2 billion as of the end of 

2013 (equivalent to five months of import cover). Mexico’s reserves continue to be backed by 

the availability of an additional $72 billion from a two-year Flexible Credit Line (FCL) with the 

IMF, which was most recently renewed in November 2012. As of March 2014, Mexico had not 

drawn on this line. 
28

Annex 1: Financial Volatility in Emerging Market Economies7

Over the past year there have been periodic bouts of increased financial market volatility in 

emerging market economies (EMEs). Increased volatility has been manifest in increased capital 

flows (mostly outflows), depreciating currencies, rising domestic interest rates, and declining 

prices of equity assets. Not all periods over the past year have been unusually volatile, in fact 

May and June 2013 and January 2014 account for the bulk of the rapid price adjustments. Nor 

have all emerging market economies experienced the same intensity of volatility; there has been 

considerable differentiation by international investors across emerging markets according to the 

strengths or weaknesses underlying economic activity in the various economies. Idiosyncratic 

factors appear to have played a substantial role in the most recent January episode of volatility. 

With the exception of May 2013, actions by the Federal Reserve do not appear to bear a strong 

correlation with the occasional spikes in volatility in certain emerging market economies. The 

backdrop appears to be that the U.S. economy is gaining economic strength in comparison to 

emerging markets in general and this has had implications for the portfolio decisions of 

international investors.

Emerging Market Economies and Capital Flows

EMEs have long benefitted from, but also 

faced certain challenges posed by, crossborder capital flows. Strong growth 

prospects, financial market development, 

and improved macroeconomic and 

institutional frameworks have made 

investing in EMEs considerably more 

attractive over time, especially as global 

investors have sought both yield and 

diversification. The period following the 

2008/09 financial crisis saw a resumption 

of significant capital flows to EMEs, on the 

order of flows just prior to the crisis. 

These flows helped fuel economic growth 

in EMEs, but also raised concerns about upward pressures on exchange rates. Over this period 

expansionary macroeconomic policies in some EMEs resulted in rapid credit growth, widening 

of external deficits, and inflation rates moving above target. Other economies pursued stronger 

fundamentals and built up larger policy toolkits than in years past, including having more scope 

for implementing countercyclical fiscal and monetary policies as needed, and more flexible 

exchange rate regimes. 

 

7

Prepared by Leslie Hull
29

Volatility

Beginning in May 2013, with the first 

suggestions of eventual Fed tapering as 

the U.S. economy strengthened, assets in 

EMEs began to re-price. Although the 

market selloff was triggered by global 

factors, markets differentiated among 

EMEs according to the strength of their 

policy frameworks and their current 

account positions (see Annex Table 1). 

This differentiation persisted through the 

remainder of 2013, especially with 

respect to exchange rates and credit 

default swaps. On January 22, 2014, a 

new round of volatility occurred amid 

several events, including a disappointing 

flash Chinese purchasing manager index 

data release, weakening EM growth 

prospects, Argentina’s peso devaluation, 

ongoing civil unrest in Ukraine and 

concerns about the sustainability of 

foreign exchange intervention in Turkey, 

rattled investors, highlighting some of 

the broader economic and political 

challenges that many EMEs face. The 

market response included a decline in 

emerging market equities, increases in 

benchmark bond yields, and further 

depreciation of EME currencies. 
30

Potential Drivers of Market Differentiation

Following the initial market 

sell-off last May, financial 

markets began differentiating 

pricing on the basis of various 

countries’ fundamentals. 

Traditional fundamentals can be 

grouped into three broad 

categories: (1) external 

vulnerabilities; (2) domestic 

fundamentals; and (3) policy 

space. No single data point can 

explain fully the market reaction 

in any particular country. Instead, a broad picture of growth prospects, financial stability and 

policy settings is taken into account by market participants (Annex Table 2). 

While investors search for strong returns, 

they also take into account a country’s 

economic and financial stability. Crises can 

arise from fiscal, banking or external 

vulnerabilities. The initial volatility seen 

last summer seemingly correlated with 

indicators of external vulnerability. The 

most basic indicators of external 

vulnerability include current account 

balance, external debt, and foreign exchange 

reserves. Annex Chart 2 shows the strong 

correlation between current account balances 

and exchange rate changes between April 

and June of last year. Larger current account 

deficits have larger financing requirements and at some point can drive market skepticism about 

sustainability.

Strong growth in EMEs has attracted capital inflows over the past few years as growth prospects 

in advanced economies remained tepid. Weakening growth prospects in EMEs, which were seen 

in the second half of 2013 in emerging markets as a whole, coupled with stronger growth 

prospects in advanced economies, can create an environment of repositioning. Indicators of 

domestic fundamentals such as retail sales, purchasing manager indices (PMI), and industrial 

production can therefore drive a market reaction. Indeed, as noted above, weaker than expected 

growth in China, as proxied by its January PMI release, triggered a strong market reaction. 

In the event of a local or global shock, market participants will look to the ability of country 

authorities to take measures to support growth and financial stability. In the context of slowing 

growth, markets will look to the ability of policymakers to implement supportive monetary 

and/or fiscal policies. Indicators of fiscal space typically include budget balances (overall and 
31

primary) and the level of public debt. Indicators of monetary policy space can include the level 

of the policy rate, whether medium and long-run inflation expectations are well-anchored, and 

whether expectations are close to the target. In addition to policy space, sound and credible 

policy frameworks, with demonstrated implementation of appropriate policy settings, support 

sound domestic and external fundamentals, and foster market confidence. 

Monetary Policy Response

EME central bankers face a balancing act with respect to raising interest rates to support their 

currencies: higher interest rates lend support to currencies while withdrawing support to the real 

economy. In some cases, the prolonged period of low interest rates has fuelled a rapid build-up 

of debt which, in the context of a weakening economic outlook, could precipitate a disorderly 

unwinding of financial imbalances as interest rates rise. Balancing these considerations, a 

number of central banks responded with strong policy rate hikes in late January and early 

February with positive results as currencies have stabilized and some have appreciated since 

early February. Specifically, the Central Bank of Turkey hiked rates by a de facto 225 basis 

points, and the South African Reserve Bank hiked rates by 50 basis points. The hikes followed a 

50 basis point rate increase by Brazil on January 15, which was part of a sustained tightening 

cycle in Brazil that began last year. Similarly, the Reserve Bank of India hiked rates by 25 basis 

points between December and February as part of a tightening cycle that began in September. 

Conclusion

Volatility in emerging markets reflects a complex interplay between factors local to EMEs and 

concerns about global growth, structural challenges, and potential shifts in policy. Strong growth 

prospects, financial market development, and improved macroeconomic and institutional 

frameworks have strengthened the fundamentals of a number of EMEs. Accordingly, there has 

been considerable differentiation by international investors across EMEs according to the 

strengths or weaknesses underlying economic activity in the various economies. EMEs can best 

manage potential spillovers through policies that support strong economic fundamentals, 

including flexible exchange rates.
32

Glossary of Key Terms in the Report

Bilateral Real Exchange Rate – The bilateral exchange rate adjusted for inflation in the two 

countries, usually consumer price inflation. 

Exchange Rate – The price at which one currency can be exchanged for another. Also referred 

to as the bilateral exchange rate.

Exchange Rate Regime –The manner or rules under which a country manages the exchange rate 

of its currency, particularly the extent to which it intervenes in the foreign exchange market. 

Exchange rate regimes range from floating to pegged.

Floating (Flexible) Exchange Rate – A regime under which the foreign exchange rate of a 

currency is fully determined by the market with intervention from the government or central 

bank being used sparingly.

International Reserves– Foreign assets held by the central bank that can be used to finance the 

balance of payments and for intervention in the exchange market. Foreign assets consist of gold, 

Special Drawing Rights (SDRs), and foreign currency (most of which is held in short-term 

government securities). The latter are used for intervention in the foreign exchange markets.

Intervention – The purchase or sale of a country’s currency in the foreign exchange market by a 

government entity (typically a central bank) in order to influence its exchange rate. Purchases 

involve the exchange of a country’s foreign currency reserves for its own currency, reducing 

foreign currency reserves. Sales involve the exchange of a country’s own currency for a foreign 

currency, increasing its foreign currency reserves. Interventions may be sterilized or 

unsterilized.

Managed Float– A regime under which a country establishes no predetermined path for the 

exchange rate but the central bank frequently intervenes to influence the movement of the 

exchange rate against a particular currency or group of currencies. Some central banks explain 

this as a policy to smooth fluctuations in exchange markets without changing the trend of the 

exchange rate. 

Nominal Effective Exchange Rate (NEER) – A measure of the overall value of a currency 

relative to a set of other currencies. The effective exchange rate is an index calculated as a 

weighted average of bilateral exchange rates. The weight given to each country’s currency in the 

index typically reflects the amount of trade with that country. 

Pegged (Fixed) Exchange Rate – A regime under which a country maintains a fixed rate of 

exchange between its currency and another currency or a basket of currencies. Typically the 

exchange rate is allowed to move within a narrow predetermined (although not always 

announced) band. Pegs are maintained through a variety of measures including capital controls 

and intervention. 
33

Real Effective Exchange Rate (REER) – The effective exchange rate adjusted for relative 

prices, usually consumer prices. 

Sterilized Intervention – An action taken by the central bank to offset the effect of intervention 

on the domestic money supply. Intervention in which the central bank sells domestic currency 

increases the domestic money supply, and is, in essence, expansionary monetary policy. To 

neutralize the effect of the intervention on the money supply, the central bank will sell domestic 

government securities, taking an equivalent amount of domestic currency out of circulation. If 

the intervention involved the purchase of domestic currency, the central bank will buy 

government securities, placing an amount of domestic currency equivalent to the size of the 

intervention back into circulation. An intervention is partially sterilized if the action by the 

central bank does not fully offset the effect on the domestic money supply.

Trade Weighted Exchange Rate – see Nominal Effective Exchange Rate

Unsterilized Intervention –The purchase of domestic currency through intervention in the 

exchange market reduces the domestic money supply, whereas the sale of domestic currency 

through intervention increases the money supply. If the central bank takes no action to offset the 

effects of intervention on the domestic money supply, the intervention is unsterilized.