-~18-

in 1989. In the last 6 months for which U.S. data are available
(September 1988~February 1989), the average monthly trade
deficit with Taiwan (excluding U.S. gold exports) has fallen 21
percent from the same period a year ago. Nonetheless,
annualizing these data results in a trade deficit larger than
last year’s, or $13.9 billion. Clearly, this is still an
unsustainable imbalance.

The New Taiwan (NT) dollar has strengthened by 49 percent
against the U.S. dollar since the Plaza Agreement in September
1985, compared to 83 percent for the yen, 53 percent for the
German mark, and 34 percent for the Korean won. However, in
1988 the NT dollar depreciated through October. Since the
October report, the exchange rate has appreciated by 6-1/2
percent, mainly in 1989. Such currency appreciation is a
positive development. Nonetheless, given the still large trade
imbalance and the lack of currency appreciation throughout most
of 1988, it appears that a continuation of the recent
appreciation is required to advance the adjustment process.

During our recent negotiations with Taiwan (under the
auspices of the American institute in Taiwan and Coordination
Council for North American Affairs) regarding its exchange rate
policy, Taiwan agreed to take a number of important measures,
including liberalizing its foreign exchange system and reducing
capital controls. This liberalization could represent a
potentially important step toward the establishment of a more
market-based system of exchange rate determination.

It remains, however, too early to assess fully the effects
of these measures. The effectiveness of the liberalization will
depend importantly on how it is implemented and, specifically,
on satisfactory resolution of uncertainties concerning: the
extent of central bank intervention in the market; the continued
free flow of trading information; the removal of remaining
controls on capital inflows; and the potential for
discrimination between Taiwanese and’ foreign banks. If these
potential difficulties are promptly and fully addressed, the
jiberalization could be a major advance. If not, the new system
could regrettably involve little real progress toward exchange
rate liberalization.

o Description of New Exchange Rate System

Taiwan began to implement the new exchange rate system on
April 3. Formerly, the NT dollar's value against the U.S.
dollar was determined by the "middle rate" of interbank
transaction rates on the previous business day, with a limit on
fluctuation. The most important aspect of the new system is
that all NT dollar-U.S. dollar transactions of $30,000 and above
will now be freely determined. The exchange rate for small
retail transactions under $30,000 will be determined by rotating


~12-

PART IV: ASIAN NEWLY INDUSTRIALIZED ECONOMIES. (NIEs)

Overview

The U.S. merchandise trade deficit with the Asian NIEs -—
Korea, Taiwan, Hong Kong, and Singapore -~ was $29.2 billion in
1988, 16 percent below 1987. This development reflected decreases
in the bilateral deficits with Hong Kong (down 21 percent to $4.6
billion) and Taiwan (down 26 percent to $13 billion). As a share
of the total U.S. trade deficit, the trade deficit with the NIEs
increased slightly from 22 percent to 23 percent.

However, as noted in the last report, if the imbalance with
Taiwan is adjusted to account for $2.5 billion (customs value) in
gold Taiwan imported from the United States in the early part of
1988 for the purposes of diversifying official international
reserves and reducing the imbalance, then the trade deficit with
Taiwan fell by only 11 percent to $15.5 billion.

under Section 3004 of the 1988 Trade Act, the Secretary of
the Treasury is required to "consider whether countries manipulate
the rate of exchange between their currency and the U.S. dollar
for purposes of preventing effective balance of payments
adjustments or gaining unfair competitive advantage in
international trade." It was concluded in the October 1988 report
that Taiwan and Korea engaged in such “manipulation,” within the
meaning of the legislation. Pursuant to Section 3004, the
Treasury was required to initiate bilateral negotiations with
Taiwan and Korea for the purpose of ensuring that these two
economies regularly and promptly adjust the rate of exchange
between their currencies and the U.S. dollar to permit effective
balance of payments adjustment and to eliminate the unfair
advantage.

Below is a summary of economic and exchange rate developments
in Korea and Taiwan and the negotiations which have taken place
with them since October. (See Table 5 on U.S. trade with Asian
NIEs and currency changes.)

Korea

o Recent Exchange Rate Developments

The October report to the Congress and subsequent
initiation of exchange rate negotiations with the Korean
authorities stimulated a period of more intense appreciation of
the won in late 1988.

o In the fourth quarter of 1988, the Korean authorities
allowed nominal appreciation of the won to total 5.1
percent, compared with 2.5 percent and 1.3 percent in
the second and third quarters.


~22-

exchange rate. With full implementation of the new system and
further sufficient exchange rate appreciation, we may well be in
a position to review this judgment. Negotiations in the period
ahead will aim at prompt resolution of the problems that could
limit the effectiveness of the new system as well as obtaining
further sufficient appreciation of the NT dollar.


_3-

In addition to being stronger than initially anticipated,
industrial country growth in 1988 was also better balanced
internationally and therefore more supportive of global current
account adjustment. In the United States, domestic demand
growth was more moderate (3.0 percent) than in the earlier years
of the current expansion, thus helping reduce the growth rate of
nominal imports and making domestic productive capacity
available to meet substantially higher foreign demand for U.S.
products. The sharp improvement in_U.S. net export performance
last year accounted for nearly 1 percentage point of last year’s
3.9 percent total GNP growth rate. .

The Japanese economy, conversely, was led by a sharp
increase in domestic demand while the external side exerted a
strong net contractionary effect. Despite tax cuts in Germany,
domestic demand growth was only slightly above GNP growth, and
external developments had an essentially neutral impact. In the
remaining major industrial countries, the difference between
domestic demand and GNP growth was somewhat larger than was the
case for Germany, particularly in the United Kingdom.

Growth prospects for the industrial countries remain
favorable for 1989. GNP growth is projected to return to a more
moderate and sustainable 3 to 3-1/2 percent range as private
consumption growth moderates slightly and fixed investment slows
from last year’s exceptional pace. Japan will again be the G-7
growth leader for both GNP and domestic demand. In Europe, the
growth slowdown is expected to be ‘particularly evident in
Germany and the United Kingdom.

The basic composition of industrial country growth outside
of the United States this year (i.e., domestic demand growth in
excess of GNP growth) is expected to be qualitatively similar to
1988. However, the projected slowdown of consumption and
investment implies a more measured pace of domestic demand
growth, which will narrow the amount by which it exceeds GNP
growth.

o External Adjustment at More Measured Pace

One of the most favorable aspects of global economic
developments in 1988 was the sharp increase in world trade
growth, which both resulted from and contributed to the stronger
and more balanced overall growth performance. The latest IMF
estimates indicate that world trade volume increased by .
9.3 percent in 1988 after a healthy 6.1 percent gain in 1987.
This strong advance largely reflected developments in the
industrial countries, which account for nearly 75 percent of
total world trade.


~19-

groups of nine foreign exchange banks (including foreign banks)
based on the prevailing free market rates. Banks can then
decide the exchange rate for small transactions based on this
"reference rate." If the transacted rates fluctuate in excess
of a certain level, then a new “reference rate" is determined
with a wider band.

Given that the central bank could still intervene in the
foreign exchange market through proxy state-owned banks, a
significant reduction of central bank direct and indirect
intervention will be essential to allow adequate scope for
market forces. However, as announced and initially implemented,
the new system does not permit openly ascertaining the level of
official intervention. The Central Bank is using five local
banks for intervention and information regarding transaction
amounts and transaction banks will no longer necessarily be made
available as it was in the past. Although the need for some
discretion by the Central Bank is understandable, given the
relatively small size of Taiwan’s foreign exchange market, it
need not have come at the expense of a normal degree of
transparency for the system.

There are other operational problems with the new system.
First, limits have been retained on banks "short" foreign
exchange positions. Moreover, additional new limits were
imposed on "long" foreign exchange positions. Initially these
limits discriminated against foreign banks. Moreover, although
foreign banks are to participate in the committee that
determines the "reference" exchange rate, this has not yet
appeared to be the case. We have indications that Taiwan
intends to correct these problems, and will monitor the
situation.

We are encouraged by the new foreign exchange system, which
could potentially limit intervention. But, as noted above, its
significance depends on its implementation. While we also
welcome the appreciation of the NT dollar since the beginning of
our negotiations, this appreciation, if not continued, will be
insufficient against the backdrop of the lack of appreciation
throughout most of 1988, which impeded the adjustment process.
Therefore, further appreciation, of a sufficient magnitude, will
be necessary this year.

Therefore, at this time, we are not yet able to alter our
basic judgment that Taiwan, within the meaning of the
legislation, "manipulates" its exchange rate. With full
implementation of the new system, however, and further adequate
exchange rate appreciation, it would be possible to review our
position on this matter. Our negotiations in the period ahead
will be aimed at prompt resolution of the problems that could
limit the effectiveness of the new system as well as obtaining
further sufficient appreciation of the NT dollar. It is
important that Taiwan’s currency more accurately reflect market
forces and its external surpluses.


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balance of payments adjustment or gain unfair competitive
advantage in international trade. In accordance with that
section, the Treasury initiated bilateral negotiations with
Korea and Taiwan for the purpose of ensuring that they regularly
and promptly adjust the rate of exchange between their
currencies and the U.S. dollar to permit effective balance of
payments adjustment and eliminate the unfair trade advantage.

The appreciation of the Korean won since 1988 has been
significant, and coupled with inflation and some trade
liberalization, may have begun to contribute to a welcome
structural reduction in Korea’s external surpluses. Cumulative
appreciation of the won, however, remains insufficient in view
of Korea’s overall economic performance and the large gap that
exists between the appreciation of the won and that of the
currencies of its major competitors. Korean authorities have
slowed the won’s rate of appreciation so far this year on the
belief that first quarter trade data for 1989, showing a
substantial decline in Korea's global trade surplus, portend a
drastic reduction for the year as a whole.

In our judgment, these trade data are too limited and
preliminary to indicate a clear irreversible trend towards a
structural reduction in Korea’s surpluses. Although, the
Treasury Department's bilateral negotiations with Korea have
produced some results, assurances of further adequate exchange
rate appreciation are lacking. Moreover, Korea shows virtually
no willingness to move to a market-based system of exchange rate
determination over the medium-term nor to engage in broader
discussions on financial market liberalization. Thus, within
the meaning of the legislation, Korea continues to "manipulate"
the won. Continued bilateral negotiations with Korea in the
period ahead will be aimed at assuring adequate exchange rate
cooperation in the near-term, Also, Korean authorities will be
encouraged over the medium term to dismantle the comprehensive
capital and exchange controls that prevent market forces from
asserting themselves in exchange rate determination. :

Taiwan's bilateral trade surplus with the United States and
global current account surplus have declined. The NT dollar
depreciated in 1988 through October, but has since appreciated
somewhat. While this appreciation is welcome, further
appreciation of a sufficient magnitude is required to advance
the adjustment process, given the continued large trade
surpluses and the lack of appreciation throughout most of 1988.

Taiwan's new foreign exchange system is an encouraging
development, which could potentially limit intervention. The
significance of the new system will, however, depend on its full
implementation, and uncertainties exist as to the prospects for
continued heavy central bank intervention to limit appreciation.
Therefore, the basic judgment cannot yet be altered that Taiwan,
within the meaning of the legislation, "manipulates" its


~16-

o Korean importers, for their part, delayed clearing goods
through customs in anticipation of the January 1, 1989,
tariff cuts.

o Together, these factors helped swell the 1988 fourth
quarter trade surplus and produce an abnormally low
surplus in the first quarter of 1989.

o The increased level of labor disturbances so far this
year is also temporarily suppressing Korea’s export
performance.

These seasonal or temporary factors notwithstanding, the
preliminary data for early 1989 probably also reflect the
beginning of a reduction in the underlying imbalance -- perhaps
a significant reduction. Previous appreciation of the won,
coupled with inflation and some trade liberalization, may have
begun to contribute to a welcome structural reduction in Korea’s
external surpluses.

° Evaluation of Recent Developments

The won’s appreciation against the U.S. dollar in 1988 was
significant and reflected Korea’s recognition of the need for
the exchange rate to play a role in the adjustment process. The
accelerated appreciation of late 1988, after negotiations were
initiated, and more recently in the last few weeks, was a
welcome response to our concerns. Nevertheless, cumulative won
appreciation remains insufficient, judged against the magnitude
of Korea’s external surpluses in the past 3 years and the much
greater appreciation of the currencies of Korea’s competitors in
the same period.

Korea's exchange rate policy this year appears to be based
on the assumption that the trade data for the first quarter of
1989 foreshadow a drastic reduction in Korea's surpluses for the
year as a whole. The indications that structural reduction in
these surpluses may have begun are both welcome and hopeful.
Nevertheless, the data are too preliminary and limited to
indicate clearly such a trend, and in our judgment, do not
justify the sharp deceleration in the pace of appreciation in
most of the period since early December 1988. While some
moderation in the pace of appreciation relative to the fourth
quarter of 1988 appears understandable in the circumstances,
continued appreciation of the won during the period ahead is
nonetheless required to reinforce recent trade developments and
ensure that the preliminary, first-quarter reduction in Korea's
external surplus is, indeed, the first stage in a structural and
lasting correction of the imbalance. If final trade data for
the period ahead also show significant reductions in Korea’s
external surplus, the need for further won appreciation would be
diminished.


and reducing external imbalances. The G-7 agreed at their April
meeting that a rise of the dollar which undermined adjustment
efforts, or an excessive decline, would be counterproductive and
reiterated their commitment to cooperate closely on exchange
markets.


- 28 -

Table 5

U.S. TRADE WITH ASIAN NIES AND CURRENCY CHANGES

U.S. Trade Deficit with Asian NIEs [1]
(U.S. $ Billions)
T9B80[2] 198712] 1988{2] %Changel[3]

Hong Kong -2.1 -5.8 ~4.6 121%
Korea 0.2 -9.4 9.5 nea.
Singapore 1.1 -2.1 2.2 Nea.
Taiwan -2.8 ~17.5 713.0 369%
TOTAL NIEsS 73.6 -34.8 -29.2 722%
Total U.S. -25.5 7160.3 -126.5 397%
% Total
U.S. 14% 22% 23%

{1] Totals may not equal sum of components due to rounding.
[2] U.S. balance of payments adjusted data.
{[3] From 1980 to 1988.

Cumulative Change against USS as of April 11, 1989 [1]

from: 7732780 9720785 end-87 10/14 88(2) |Rate on 4/711
HKS -37.88% 0.41% -0.30% 0.40% HKS 7.78
Won -11.87% 34.018 8.70% 6.41% W 667.5
SinqaporesS 8.04% 12.49% 1.92% 3.28% S$ 1.96
NTS 32.72% 49.399 5.26% 6.55% NTS 27.12
¥ 66.02% 82.51% -6.84% 4.72% ¥ 132.68
DM -7.89% 53.07% -15.32% 4.30% DM 1.89

{l] This table is calculated in terms of the movement of the
foreiqn currency against the U.S. dollar, as this is the
way the Asian NIEs measure their foreign currency movements.
Thus, foreign currency appreciation is represented by a (+)
and depreciation by a (-)-

[2] Date of last foreign exchange report to Congress.


First, slower GNP and domestic demand growth this year will
ease some of the demand-side pressure that may have been
emerging last year. Second, and related to this, monetary
authorities in the key countries have been pursuing policies of
restraint. Third, despite some recent increases, unit labor
cost developments have been quite moderate. Fourth, the
OECD-wide surge in investment last year should help ease
production bottlenecks that may be emerging in particular
sectors.

U.S. Trade and Current Account Developments

© Developments in 1988

The U.S. trade deficit peaked in real terms in late 1986,
and a year later in value terms. It then declined markedly in
1988.

The improvement in the U.S. trade deficit (nominal terms) in
1988 was broadly~based in geographical and product terms, and
involved substantial increases in exports and slower import
growth. For 1988 as a whole, the trade deficit declined by
roughly $34 billion, from $160 to $127 billion, as exports grew
strongly (28 percent in value terms), while imports grew less
than one-third as fast. In volume terms, exports were up 23
percent, while imports increased 7 percent.

The trade deficit in 1988 decreased with every major
geographic area, with the strongest declines vis-a-vis Western
Europe, Latin America, and Japan. The improvement also covered
a wide range of products. Only consumer goods, among major
product groupings, failed to show a reduced defict in 1988.

Strong export growth was broadly-based in terms of both
product categories and geographic regions. Past exchange rate
changes played a major role in enhancing U.S. competitiveness in
1988. Our export competitiveness was complemented by strong
domestic demand growth in industrial countries -- especially
Japan -- and a revival of exports to Latin America, particularly
to Mexico.

The more subdued rate of import growth for the United States
in 1988 reflected in part the lagged effects of past exchange
rate changes and lower average oil prices.. Auto and consumer
goods imports increased only slightly in 1988; a surge in these
two categories had been a major contributor to the widening of
the trade deficit during 1983-87. Capital goods was the one
product category registering strong import growth in 1988,
reflecting strong capital equipment spending by U.S. firms.

The pace of improvement in the trade balance, however,
slowed in the last half of 1988. After remaining essentially
flat at fourth quarter 1987 levels through the first three


~4-

These trade developments were reflected in significant
shifts in the current account positions of major countries and
country groups. The U.S. current account deficit declined about
$20 billion, while Japan's surplus declined $7.5 billion and the
combined surplus of the four Asian NIEs by about $4-1/2 billion,
despite sharp growth in Korea’s surplus. Europe's aggregate
current account surplus was reduced by roughly $20 billion,
though this was accounted for almost entirely by a very sharp
increase in the deficit of the United Kingdom; Germany’s current
account surplus rose nearly $4 billion to a large record high of
around $48-1/2 billion.

External adjustment in the major countries can also be
gauged by considering current account imbalances as a percent of
GNP, which eliminates valuation problems associated with
exchange rate changes and takes into account the differing sizes
of national economies. By this measure, the U.S. current
account deficit declined from its 1987 peak of 3.4 percent of
nominal GNP to 2.8 percent last year; Japan’s surplus dropped
from 3.6 to 2.8 percent (vs. its 1986 peak of 4.3 percent).
Germany’s surplus remained unchanged at 4.0 percent of GNP,
though this was down somewhat from its 1986 peak of 4.4 percent.

Two emerging trends suggest, however, that while global
current account adjustment is expected to continue this year,
the pace of adjustment may slow somewhat. First, the projected
narrowing in the difference between domestic demand and GNP
growth in the major surplus countries will tend, ceteris

aribus, to reduce the macroeconomic impetus for Targe
additional shifts. Second, while U.S. export growth
strengthened substantially in 1988, so too did export growth
rates in most of the other major industrial economies, including
the major surplus countries.

o Inflation Remains Modest and Contained

Consumer.price inflation in the major industrial countries
averaged about 3.1 percent in 1988, only slightly higher than
the 2.8 percent recorded in 1987. Rates in Japan and Germany
were exceptionally low, even by historical standards, averaging
around 1 percent. France continued its impressive progress,
holding its inflation rate below 3 percent. Rates in the United
States and Canada both averaged near 4 percent, and around 5
percent in Italy and the United Kingdom.

Inflation rates in the major industrial countries have
increased somewhat during the past 6 months, generating concern
in some quarters about a potential serious deterioration on the
price front. Average inflation in the industrial countries is
expected to rise only modestly this year, however, probably
remaining below 4 percent. While the situation bears close
attention in some countries, some factors suggest that there is
not now a serious risk of a general acceleration of inflation.


-17-

The Treasury Department's negotiations with the Korean
authorities since the October report appear to have produced
some results. Cumulative exchange rate appreciation, however,
remains insufficient and assurances of further appreciation that
could be considered sufficient in the circumstances are lacking.
In addition, Korea has not provided indications that it intends
to move to a market-based system of exchange rate determination
over the medium-term. Nor is Korea willing to engage in broader
discussions on financial market liberalization. Thus, our
judgment is that, within the meaning of Section 3004 of the
Omnibus Trade and Competitiveness Act, Korea continues to
“manipulate” its currency.

Our negotiations in the coming months will be aimed at
obtaining assurances that exchange rate policy during the period
ahead will reinforce the direction of recent trade developments.
We will also seek to encourage the Korean authorities to
dismantle the comprehensive capital and exchange controls that
prevent market forces from asserting themselves in exchange rate
determination.

Taiwan

Taiwan's external imbalances have undergone further
positive adjustment since the last report. This is due, in
large part, to the effects of currency appreciation, further
reductions in trade barriers, and rising inflation and wages.
If all of these elements, particularly further appreciation,
continue this year, we would anticipate an additional reduction
in Taiwan’s current account surplus and its bilateral trade
surplus with the United States in 1989.

Taiwan’s global current account surplus also decreased by
43 percent in 1988 to $10.2 billion. Asa proportion of GNP,
this translates into a sizeable decline from 18.4 percent in
1987 to 8.3 percent in 1988. At the same time, Taiwan's overall
trade surplus, excluding official gold imports from the United
States, fell 26 percent in 1988 to $13.8 billion ($10.9 billion,
including U.S. gold).

In the first 3 months of this year, compared with the same
period last year, Taiwan's overall trade surplus was lower by 23
percent, excluding U.S. gold, but up 9 percent including U.S.
gold. Moreover, domestic demand has replaced exports as the
main source of growth for the economy. Real GNP growth was 7.3
percent in 1988, down from 11 percent in 1987.

Large U.S. exports of gold to Taiwan through August 1988
accounted for more than half of the reduction in the U.S.
bilateral deficit with Taiwan, These exports have ceased and
need to be replaced with an even greater value of other
sustainable exports if the adjustment process is to be furthered


Economic Policy Coordination

The major industrial countries are continuing their efforts
to coordinate economic policies to achieve shared objectives.
The coordination process has now become an accepted feature of
the international economic landscape with regular meetings of
finance officials from the Group of Seven countries (United
States, Japan, Germany, France, United Kingdom, Canada, and
Italy). A sign of the growing maturity and acceptance of the
G-7 process, for example, was demonstrated by the meeting in
February where no communique was issued and without the market
instability that would have followed such a development in the
past.

The recent meetings of the G-7 in February and again on
April 2 have focused on efforts to maintain the substantial
progress achieved in 1988 in dealing with global economic
problems, Last year represented a notable success for the
coordination process, as documented in the October report.
Economic growth exceeded expectations and inflation remained in
check. External imbalances were reduced substantially and
exchange markets were generally stable.

However, sustained noninflationary growth -- which remains
the central objective of the coordination process -- will
require continued efforts. The success of these efforts depends
on continued progress in controlling inflation and gradually
reducing external imbalances. While reductions in external
imbalances were achieved last year, further progress in this
area is required.

o Countries with large fiscal and trade deficits,
especially the United States, but also Canada and Italy,
need to make further reductions in budget deficits to
complement monetary policies. Implementation of the
recent bipartisan budget framework agreement between the
President and the joint Congressional leadership will be
crucial to achieving further reductions in the U.S.
budget deficit.

o The major surplus countries should pursue economic and
structural policies that will sustain domestic demand
growth without inflation and facilitate external
adjustment; and

o All countries need to pursue structural reforms.

The coordination process has resulted in more effective
arrangements to deal with exchange market pressures. As
discussed in the next part of the report, exchange markets have
been more stable over the past year, thus contributing to and
benefitting from the progress in sustaining the global expansion


~ 23 -

APPENDIX

TABLES

Economic Performance of Key
Industrial Countries

Summary of U.S. Current Account
Summary of U.S. Capital Account Flows

Measurements of Dollar Movements Versus
G~-7 Currencies

U.S. Trade with Asian NIEs and Currency
Changes


DEPARTMENT OF THE TREASURY
Report to the Congress

on

International Economic and Exchange Rate Policy

April 1989


-10-

moderating, remained robust. Dollar demand quickened on the
market’s belief that the Federal Reserve would tighten its
monetary stance further. At mid-month, the Federal funds rate
rose from under 8-1/2 percent to near 9 percent. However, in
view of coordinated interest rate hikes in Europe, interest
differentials favoring dollar placements against European
currencies initially narrowed. There was no appreciable change
in interest differentials against the yen.

Toward mid-January, the market turned increasingly bullish
on the dollar. There was growing optimism regarding the United
States’ willingness to tackle its fiscal deficit. Also, "safe
haven" demand related to tensions in the Mediterranean was
appreciable. Meanwhile, comments from various G-7 officials
were interpreted as indicating a tolerance for further dollar
appreciation. Reports of concerted intervention sales of
dollars during January and early February braked the dollar’s
upward momentum.

Subsequently, additional data interpreted as suggesting
that inflationary momentum may have increased in the United
States encouraged further expectations of monetary tightening by
the Federal Reserve. Chairman Greenspan said that the Federal
Reserve would err on the side of monetary restraint. The
Federal Reserve progressively tightened the Fed funds to levels
over 9 percent and, in late February, raised its discount rate
by 1/2 percentage point to 7 percent. Meanwhile, Germany and
Japan signalled that they would avoid further tightening of
their monetary stances. Interest differentials against the
German mark and the Japanese yen then began to widen
significantly and, by late March, were approximately 1/2
percentage point higher than in late February.

Since End-March

After reaching its highs for 1989 in late March, the dollar
eased back in early April. Following the G-7's statement of
April 2 and subsequent reports of intervention sales of dollars
against yen as well as marks, the market perceived that the G-7
monetary authorities would regard further dollar appreciation as
counterproductive to global adjustment of external imbalances.
Also, prospects for a further widening of interest differentials
in favor of the dollar were viewed by market participants as
mixed, given that U.S. economic indicators were seen as pointing
tentatively to moderating U.S. economic activity.

Effects of Exchange Rate Changes on External Positions

Despite recent movements, the dollar remains roughly at
1980 levels in real terms. On average, the appreciation of the
dollar in the early and mid-eighties against our major trading
partners has been reversed.


-9-

PART III: FOREIGN EXCHANGE MARKET DEVELOPMENTS

Overview

During the last 6 months, exchange markets have been
generally stable. The dollar appreciated by about 5 percent
against the Japanese yen and 4 percent against the German mark,
but on a trade-weighted basis in nominal terms is little changed
against major currencies. (See Table 4.)

Trends in exchange markets over this period can be
subdivided into three distinct periods: 1) from October through
mid-December when the dollar experienced selling pressure; 2)
from mid-December through March when the dollar strengthened;
and 3) since the beginning of April when the dollar eased from
its end-March highs, but continues to be in good demand.

Trading conditions throughout the period were influenced
primarily by developments and market expectations regarding U.S.
economic growth, inflation, monetary policy, and interest rates.

In market intervention, the U.S. monetary authorities made
net purchases of about $0.7 billion from October through
January. They purchased about $2.6 billion ($2.0 billion
against yen and $0.6 billion against marks) to support the
dollar against selling pressure during October-December, and
sold about $1.9 billion against German marks in January as the
dollar rose.

October through Mid-December

The dollar started declining in early October following
evidence of slowing U.S. economic activity, which the market
regarded as reducing the likelihood of monetary tightening. By
mid-October, selling pressure on the dollar had emerged in
response to diminishing prospects for higher dollar yields and
market perceptions that U.S. monetary authorities might tolerate
a gradual easing of the dollar ahead of the election,
particularly because of concerns that adjustment of world trade
imbalances was slowing. Furthermore, private analysts suggested
that it would take a further dollar decline to narrow the U.S.
external deficit. After the election, market attention shifted
to concerns about the U.S. budget deficit, stimulating further
dollar selling. Concerted intervention purchases of dollars by
G-7 monetary authorities during the period made the market
cautious about selling the dollar aggressively.

Mid-December through March

In December market sentiment changed, with participants
taking the view that the G-7 monetary authorities would
concentrate more on adopting anti-inflationary policies.
Economic indicators showed that U.S. economic activity, though




quarters of 1988, import growth picked up in the fourth quarter
of 1988, largely in finished manufactures. Export growth,
though still robust, moderated somewhat in the latter part of
1988. Exports in the first half of 1988 were up over 32 percent
in value terms from the first half of 1987, while second half
exports were up 24 percent from the same period in 1987.

The U.S. current account deficit also declined in 1988,
though less dramatically than the trade deficit, falling by
roughly $20 billion, from $154 to $135 billion. This outcome
reflected the net effect of the trade balance improvement
discussed above, and a switch from surplus to deficit on trade
in services. The adverse shift on the services account reflects
the fact that the traditional U.S. surplus on investment income
has been eroded, along with the U.S. international investment
position, as borrowing from abroad has been needed to finance
continued U.S. external deficits. (See Table 2.)

With respect to capital flows, the recorded net inflow in
1988 declined by about $17 billion, roughly equal to the
decrease in the current account deficit. This was accompanied
by a substantial shift from official to private net inflows.
Official net inflows declined in 1988, while overall private
inflows were unchanged. Within private capital, direct
investment and securities transactions registered an increased
net inflow, while banking inflows declined. By category, the
largest changes in non-official flows were: increased foreign
purchases of U.S. Treasury securities, more than offsetting a
decline in purchases of other U.S. securities; a substantial
decline in U.S. direct investment outflows; and a significant
increase in net lending abroad by U.S. banks. (See Table 3.)

o Prospects for 1989

In view of recent developments, including higher oil prices
and other factors, improvements in the U.S. trade deficit for
1989 which had earlier been expected may be partly offset. The
outlook for trade and current account adjustment through the end
of this year will be influenced by a number of major factors, in
addition to oil prices. These factors include the prospects for
sustained growth abroad, especially in Europe; exchange rate
developments; progress with Korea and Taiwan on market opening
and exchange rate adjustment; and sustained growth in major LDC
export markets.

At home, success in reducing the budget deficit will be a
critical counterpart to progress in these other areas. The
recent bipartisan agreement on a budget framework for Fiscal
Year 1990 between the President and the joint leadership of the
Congress represents an important step in meeting the deficit
reduction targets of the Gramm-Rudman-Hollings law.


-20-

PART V: CONCLUSION

This report has provided an update of developments since
October 1988, when the first report on international economic
and exchange rate policies was submitted to the Congress.

Global economic performance has remained favorable in the
intervening period. The economic expansion is continuing in the
major countries, with the seventh year of consecutive growth
following an extremely robust performance in 1988. Furthermore,
in 1988, the lagged effects of exchange rate changes in 1986 and
1987 and the composition of demand in the major countries were
conducive to significant reductions in external imbalances.

The pace of external adjustment has slowed, however. In
view of recent developments, including higher oil prices and
other factors, improvements in the U.S. trade deficit for 1989
which had earlier been expected may be partly offset. While
inflationary pressures bear close watching, there is little
concern that a general acceleration of inflation is developing.

The economic policy coordination process has contributed
importantly to the improved performance of the global economy in
the current expansion. Sustained noninflationary growth remains
the central objective of the coordination process and will
require continued efforts in reducing fiscal deficits,
controlling inflation and gradually reducing external
imbalances. In the United States, the recent bipartisan budget
framework agreement between the President and the joint
leadership of the Congress represents an important step forward
in these efforts.

During the past 6 months, exchange markets have been
generally stable. The dollar has appreciated slightly against
some major currencies, but has been broadly stable on a trade
weighted basis. These exchange market developments have, at
most, had only a marginal impact on U.S. trade performance and
would not be sufficient to change the outlook. The relative
stability of exchange rates has made a welcome contribution to,
and been supported by, the progress in sustaining global
expansion and reducing external imbalances. The G-7 major
industrial countries have agreed that a rise of the dollar which
undermined adjustment efforts, or an excessive decline, would be
counterproductive, and they have reiterated their commitment to
cooperate closely on exchange markets.

In the October report, it was determined that Taiwan and
Korea, within the meaning of the Section 3004 of the Omnibus
Trade and Competitiveness Act of 1988, were "manipulating" their
exchange rates against the U.S. dollar to prevent effective


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PART II: WORLD ECONOMIC PERFORMANCE AND OUTLOOK

Global Economic Developments

o Overview

The economic expansion in the industrial countries that has
been underway for six consecutive years strengthened
substantially in 1988, contributing to a very strong increase in
world trade growth and helping the Less Developed Countries
(LDCs) record their highest growth rate of the decade. In
addition, the pattern of growth both within and among the seven
largest industrial economies last year provided essential
support for global current account adjustment. The U.S. current
account deficit was reduced considerably in 1988 while the
surpluses of Japan, the European Community and the four Asian
Newly Industrialized Economies (NIEs) also declined. Consumer
price inflation in the industrial countries picked up slightly
again in 1988, albeit to a rate that was only slightly above the
20-year low reached in 1986. (See Table 1.)

The basically favorable macroeconomic trends that were
evident in 1988 have generally persisted thus far this year,
promoting confidence that industrial country growth will
continue, albeit at a more moderate pace, at least into 1990.
Partly as a result, the LDC economies and world trade should
return to their more moderate 1987 growth rates.

However, the international pattern of growth will probably
be somewhat less favorable for current account adjustment than
was the case last year. Thus, while the external adjustment
process is expected to continue in real terms in key countries,
further large reductions in major current account imbalances are
not anticipated this year.

The available evidence suggests that, while inflationary
pressures bear close watching in some countries, the average
industrial country inflation rate will pick up only modestly
this year, to just below 4 percent. There is little evidence
that a serious general acceleration of inflation is developing.

o Expansion Continuing at a Sustainable Pace

Real GNP rose 4.2 percent (annual average) in the seven
largest economies in 1988. Expectations earlier in the year
that the stock market break of October 1987 would have serious
negative repercussions on industrial country macroeconomic
performance were not borne out by events. Indeed, consumer and
business sentiment improved substantially and generally remains
good.


i
i
|

-13-

o Most of this fourth quarter movement occurred in October
and November, with the pace of appreciation slowing
substantially in December.

Cumulative won appreciation in 1988 totalled 15.8 percent.
This exceeded the movement against the dollar in 1988 of the
currencies of Korea’s key trade competitors, Japan and Taiwan.
Thus, in 1988, the Korean won began for the first time to lose
on a broad basis some of the advantage that it had gained for
Korea earlier in the decade, and particularly since 1985.

Despite the won’s strengthening in 1988, cumulative won
appreciation still lagged behind that of the yen and New Taiwan
(NT) dollar in key periods. For example, in the interval from
the Plaza Agreement in September 1985 to end-1988, the won
appreciated 34 percent against the U.S. dollar, compared with 49
percent for the NT dollar and 83 percent for the yen. Thus, the
won maintained an important, albeit diminished, competitive
edge.

In 1989, the authorities have generally maintained the slow
pace of appreciation that they resumed in early December 1988.
Won appreciation in the first quarter of 1989 totalled only 1.8
percent. However, late March and early April saw a brief period
of somewhat more rapid movement of the won as the Treasury
Department intensified its negotiations with Korea and the
deadline approached for this report. Thus, as of mid-April, the
won had appreciated 2-1/2 percent in 1989.

fe) 1988 Bilateral U.S. Trade Deficit with Korea

According to U;:S. customs data, the United States bilateral
trade deficit with Korea increased 1 percent in 1988 to $9.0
billion, reflecting a 39 percent increase in U.S. exports to
Korea and a 19 percent increase in U.S. imports from Korea.

This is significantly slower growth than in 1987 when our
bilateral trade deficit increased 39 percent (from $6.4 billion
to $8.9 billion), based on a 27 percent rise in exports to Korea
and a 33 percent rise in imports from Korea.

In the second and third quarters of 1988, the U.S.
bilateral deficit with Korea was actually somewhat lower than in
the same quarters in 1987. These declines were due primarily to
a drop in the rate of growth of U.S. imports from Korea. This,
in turn, was largely the result of the temporary impact of labor
disturbances in Korea on production and exports. Growth in the
bilateral deficit resumed in the fourth quarter of 1988,
registering an increase of 5 percent over the fourth quarter of
1987.


-15-

{e} Domestic Economic Performance

Korea’s economy continued to boom in 1988. Real GNP growth
exceeded 12 percent for the third consecutive year, bringing
cumulative real GNP growth to 41 percent since end~-1985.
Domestic demand is strengthening -- due to large nominal wage
increases, lower tariffs, and cuts in excise taxes -- but
increased real net exports still accounted for nearly 50 percent
of real GNP growth.

Unemployment averaged only 2.5 percent in 1988, the lowest
annual average in the last three decades. Wages have increased
by about 33 percent in the past 2 years. Cumulative
productivity gains among production workers totalling about 30
percent in the past 2 years have largely offset the higher
wages.

Monetary and price developments are increasingly showing
the negative side effects of Korea’s external imbalance.
Despite tight credit controls and the government’s direct
efforts to sterilize the liquidity resulting directly from
Korea’s massive external surpluses, money supply expanded by
about 19 percent in 1988. This, together with the large nominal
wage increases and emerging capacity constraints, was largely
responsible for the jump in inflation from 3 percent in 1987 to
7.2 percent in 1988.

° Trade Developments in 1989

Preliminary Korean customs data for the first quarter of
1989 show a substantial decline in Korea's global trade surplus
relative to the same period in 1988. These data indicate that
the global trade surplus totalled only $95 million in the first
quarter of 1989, compared with $1.4 billion in the first quarter
of 1988. Moreover, the won value of Korean exports declined by
4 percent in January and by 8 percent in February relative to
the same periods in 1988, although in U.S. dollar terms, Korean
exports increased by 11 percent and 6 percent, respectively,
given the increase in the dollar value of the won in 1988.

For January-February 1989 (the latest period for which U.S.
customs data are available), the U.S. bilateral trade deficit
with Korea declined 28 percent, compared with the same period in
1988. U.S. exports to Korea increased 29 percent, while imports
from Korea declined by 1 percent. ©

It is likely that Korea’s first quarter trade performance
reflects a compounding of seasonal factors (the first quarter is

traditionally the weakest quarter in the trade account) and
other unique influences:

o Korean exporters accelerated shipments in the fourth
quarter of 1988 in anticipation of continued
strengthening of the won.


PART I: INTRODUCTION

Section 3005 of the Omnibus Trade and Competitiveness Act
of 1988 (Pub. L. 100-418) requires the Secretary of the Treasury
to submit to the Committee on Banking, Housing and Urban Affairs
of the Senate and the Committee on Banking, Finance and Urban
Affairs of the House of Representatives a report each October 15
on international economic policy, including exchange rate
policy.

The initial report was submitted in October 1988 and
provided an analysis of exchange market developments, including
the underlying economic factors and the impact on the U.S.
economy; an assessment of which countries were "manipulating"
exchange rates within the meaning of the legislation; and
recommendations for changes in U.S. economic policy to attain a
more appropriate and sustainable current account balance.

Section 3005 also requires the Secretary to provide a
written update of developments 6 months after the initial
report. This report provides such an update. Part II reviews
recent developments in the world economy, including developments
in the U.S. balance of payments and efforts by the major
industrial countries to coordinate economic policies. Part III
analyzes the situation in the foreign currency markets,
including the impact of changes in the exchange rate for the
dollar on the U.S. economy. Part IV provides a status report on
negotiations with Korea and Taiwan, economies which were
considered in the October report to be "manipulating" their
exchange rates, within the meaning of the trade legislation.

The final part provides conclusions on the principal issues
discussed in the report.


- 24 -

Table 1

Economic Performance of
Key Industrial Countries 1/

GNP Growth 2/ Domestic Demand Growth 2/
1987 1988 1987 1988

U.S. 3.4 3.9 3.0. 3.0

Japan 4.5 5.7 5.2 7.7

Germany 1.8 3.4 3.1 3.7

France 2.3 3.4 3.4 3.7

U.K. 4.3 4.4 4.3 6.2

Italy 3.1 3.7 4.6 4.1

Canada 4.0 4.2 4.7 5.1

G-7 3/ 3.4 4.2 3.7 4.4
Inflation 4/ Current Account 5/
1987 1988 1987 1988

U.S. 3.6 4.1 —3.4 -2.8

Japan 0.1 0.7 3.6 2.8

Germany 0.2 1.2 4.0 4.0

France 3.3 2.7 -0.5 -0.4

U.K. 4.1 4.9 -0.6 -3.1

Italy 4.7 5.0 -O.1 -0.5

Canada 4.4 4.0 -1.9 -1.5

G-7 3/ 2.8 3.1

1/ All data are latest IMF figures, except for U.S.
2/ Real growth rates, annual average.

3/ Average of individual country rates weighted by GNP in dollar
terms; annual averages.

4/ Consumer prices; annual averages.

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


Part I
Part If
Part IIft
Part IV
Part V

APPENDIX

TABLE OF CONTENTS

Introduction

World Economic Performance and Outlook
Foreign Exchange Market Developments
Asian Newly Industrialized Economies
Conclusion

Tables

12
20
23


-~ 27 -

Table 4

Measurements of Dollar Movements
Versus G-7 Currencies Since Key Dates

Percent dollar appreciation (+) or depreciation (-)

Value of the
dollar in
terms of:

Japanese yen
German mark
Sterling

Prench franc
Canadian dollar
Italian lira

as of April 12, 1988
Since Since Since
Floating Dollar Previous
Began Peak Report
3720/73 2726/85 10/14/88
to date to date to date
749.6 ~49.2 +4.0%
33.2 ~45.7 +3258
+45.8 38.3 +3.3%
+40.8 -40.0 +2.4%
+19.2 15.3 -1.5%
+144.3 ~36.3 +1.8%

Source: London midday rates.


-1l1-

Exchange rate changes since October have, on balance, been
minor, and exchange rate changes in any case tend to influence
the real economy with considerable lags. Thus, exchange rate
developments over the past months probably have not been a
significant factor affecting the U.S. economic situation and
prospects. The influence of such minor exchange rate changes is
extremely small, in comparison with the potential overall impact
of other factors influencing the trade and current account
position.

The October report noted several factors not captured by
conventional models which could contribute to sustained
reduction of the trade deficit over the long term. Strengthened
competitiveness is much broader based than exchange rate
calculations show. Intense competitive pressures during the
period of dollar strength forced U.S. producers to make
fundamental changes resulting in increased efficiency, reduced
costs, and improved quality.

Also, direct investment in the united States should
contribute to the adjustment process over time, especially in
the automotive sector, with Japanese firms in particular
expanding U.S.-based output (for export as well as import
replacement), product lines and value added. However, the
favorable indirect effects of past exchange rate changes on the
trade balance resulting from direct investment activity are of a
long-term nature. The modest exchange rate movements over the
past 6 months have probably not affected these developments.

Finally, most trade models are based on assumptions of no
policy changes. The essence of the G-7 coordination process is
that policies are regularly reviewed,-with an eye to possible
changes in light of developments in the underlying fundamentals.
The G-7 are committed to implementing the policies necessary to
build on the progress that has been achieved.


-14~

° Korean Global Balance of Payments Developments in 1988

Korea's 1988 global trade surplus increased 51 percent to
$11.6 billion on a balance of payments basis. Overall, exports
grew 15 percent in volume terms, down from 24 percent in-1987.
The growth of import volume, however, decreased even more
sharply to 10 percent from 22 percent in 1987.

Toys are the only category of Korean exports that declined
in value terms in 1988 (by 7 percent). Textiles and footwear -~-
other labor-intensive products about whose competitiveness the
government expresses concern ~~ managed increases of 22 percent
and 25 percent, respectively, despite won appreciation and
higher wages. Exports of higher value-added products performed
even more strongly: electronics were up 33 percent, iron and
steel 35 percent, machinery 51 percent, automobiles 20 percent
(despite second quarter labor disturbances), and ships 55
percent.

Korea's 1988 current account surplus increased 44 percent
to $14.3 billion, compared with the government’s $7 billion
target. Thus, for the third consecutive year, the actual
current account surplus was more than double the government’s
initial target for the year. Increases in net services and
transfers -- reflecting declining external interest payments,
Olympics-related tourism revenues, and transfers from Korean
residents abroad -- contributed to the swelling of the current
account surplus.

As indicated in Part II above, the magnitude of external
imbalances is best judged by presenting the amount as a
percentage of GNP. In this context, it is noteworthy that
Korea’s trade surplus increased from 6.5 percent of GNP in 1987
to 7.4 percent in 1988, while the current account surplus
increased from 8.3 percent of GNP in 1987 to 9.1 percent in
i988. In contrast, Japan's 1988 trade surplus was equal to 3.3
percent of its GNP and its current account surplus, 2.8 percent,
both having declined from 1987 to 1988.

With the rapid expansion of its current account surplus in
1988, Korea was able to continue. reducing its external debt and
building its foreign reserves, further strengthening its
international position. Gross external debt fell to $31.2
billion (20 percent of GNP) in 1988, compared with $35.6 billion
(30 percent of GNP) in 1987 and $46.8 billion (55 percent of
GNP) in 1985. In addition, Korea increased its foreign reserves
by nearly $9 billion to $12.3 billion in 1988; although equal to
about 3 months’ imports, this level is not excessive.