Report to Congress on 

International Economic and Exchange Rate Policies 

May 2006 

Summary

This report reviews developments in international economic and exchange rate policies, focusing 

on the second half of 2005,1

 and is required under the Omnibus Trade and Competitiveness Act 

of 1988 (the “Act”).2

 This report also updates the special Appendix to the November 2005 

Report on International Economic and Exchange Rate Policies and includes a second Appendix 

highlighting the key issues in countries’ choice of exchange rate regimes. 

The global economy is strong, but global imbalances have grown, the result of disparate 

economic growth rates, saving rates, and investment climates of larger economies. Rising 

petroleum prices have rapidly increased the current account surpluses of major oil exporters, 

enlarging global imbalances. Addressing global imbalances is a shared responsibility and should 

occur in an orderly manner that maximizes sustained global growth. Members of the 

international community need to implement sound economic policies and remove distortions 

impeding an orderly adjustment of imbalances. They must resist protectionism and maintain 

open trade and investment regimes. The United States cannot be expected to resolve these 

imbalances by itself. 

This report expresses particular concern about the international economic and exchange rate 

policies of China and reaches the central conclusion that far too little progress has been made in 

introducing exchange rate flexibility for the renminbi. In the final analysis, however, the 

Treasury Department is unable to determine, from the evidence at hand, that China’s foreign 

exchange system was operated during the last half of 2005 for the purpose (i.e., with the intent) 

of preventing adjustments in China’s balance of payments or gaining China an unfair 

competitive advantage in international trade. Thus, the technical requirements for China to be 

designated under the terms of the Act have not been met. In reaching this conclusion, the 

Treasury Department took into account a number of factors: 

• On July 21, 2005, China abandoned its eight-year peg to the dollar and moved to a managed 

floating exchange rate regime. Since that time, the renminbi has further appreciated, though 

slightly, against the dollar. The examination period for this Report, the second half of 2005, 

is the first that includes the Chinese exchange rate policy change.

• The renminbi has risen to a significant degree on average against China’s trading partners. 

While strengthening by 2.6 percent against the dollar in the last half of 2005, against the 

 

1

 The Treasury Department has consulted with the IMF in preparing this report. This report focuses on the period 

July 1, 2005, through December 31, 2005. 2

 The Act states, among other things, that: “The Secretary of the Treasury shall analyze on an annual basis the 

exchange rate policies of foreign countries, in consultation with the International Monetary Fund, and consider 

whether countries manipulate the rate of exchange between their currency and the United States dollar for purposes 

of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international 

trade.” 
2

currencies of all of China’s trading partners (JP Morgan index) the renminbi appreciated by 

4.9 percent in the second half and more than nine percent during 2005 as a whole.

 

• China continues to take steps to create market infrastructure and financial instruments for a 

floating currency. China introduced interbank foreign currency trading and allowed banks to 

act as market-makers in foreign currency in early January. China reached agreement with the 

Chicago Mercantile Exchange to develop and trade currency futures to allow renminbi 

hedging. And China has further reduced restrictions on capital flows to create a deeper, more 

liquid foreign exchange market. 

• China’s commitment to move to a flexible exchange rate is clear, and has been repeated at 

the highest levels of the Chinese leadership. President Hu Jintao, when he came to the 

United States in April, said that China will continue to develop the foreign exchange market 

and increase the flexibility of the exchange rate. Premier Wen Jiabao, in his policy speech to 

the National People’s Congress on March 14, 2006, stated that China will expand the foreign 

exchange market and allow more flexibility and fluctuation of the Chinese currency. 

• China’s leaders have also begun a fundamental realignment of the Chinese economy to 

reduce its balance of payments surplus, boost domestic consumption, and reduce domestic 

inequality. China’s most recent five-year plan places strong emphasis on consumption and 

rural development to spur domestic demand. 

• The Governor of China’s central bank, Zhou Xiaochuan, announced a five-point plan on 

March 20, 2006, to reduce China’s current account surplus and raise domestic consumption. 

This plan involves actions to boost domestic demand, reduce Chinese saving, accelerate 

removal of trade barriers, grant greater market access for foreign firms, and achieve greater 

exchange rate flexibility. 

• China's leadership has made a clear commitment to rebalance the sources of growth in the 

Chinese economy. President Hu Jintao, in his meeting with President Bush on April 20, 

2006, stated that China does not want a large current account surplus and would take steps to 

reduce it, relying on domestic demand to boost growth.

• China is acting to implement this strategy. A flexible exchange rate is an essential 

component of this rebalancing program, and China’s leaders recognize that flexibility is 

essential. 

• China’s ongoing efforts to modernize its financial sector are also part of a commitment to 

spur consumption and achieve long-term reversals in recent trade and current account trends. 

Progress on this front increased during the reporting period, but massive challenges remain. 

While these developments suggest that progress is being made, China’s advances are far too 

slow and hesitant given China’s own needs, and its responsibilities to the international financial 

community. The delay in introducing additional exchange rate flexibility is unjustified given the 

strength of the Chinese economy and the progress in China’s transition. China needs to move 

quickly to introduce exchange rate flexibility at a far faster pace than it has done to date. With a 

still rigid exchange rate, China lacks effective monetary policy tools to avoid the boom-bust 
3

cycles it has experienced in the past. Given our strong disappointment and the importance of 

China to the world economy, the Treasury Department will closely monitor China’s progress in 

implementing its economic rebalancing strategy, remain fully engaged at every opportunity with 

China, and continue actively and frankly to press China to quicken the pace of renminbi 

flexibility. 

It is also important that reforming China’s exchange rate regime be part of an international effort. 

China’s exchange rate policies affect the entire world. Increased renminbi flexibility would 

greatly facilitate increased flexibility in other Asian currencies. In this regard, the G-7, IMF, and 

Asian Development Bank have all called for greater flexibility in China’s exchange rate. The 

Treasury Department is supportive of the IMF Managing Director’s commitment to strengthen 

IMF exchange rate surveillance, both bilaterally and multilaterally, as a means to assist 

materially this process. 
4

Domestic Macroeconomic Conditions 

The U.S. economy remained on a sustained upward growth track in 2005, with real GDP 

increasing by a solid 3.2 percent over the four quarters of 2005, despite modest growth in the 

fourth quarter. Growth rebounded at a strong 4.8 percent annual rate in the first quarter of 2006 

– the largest quarterly increase in two and a half years. 

The outlook for consumption growth remains sound. The fourth quarter slowdown in consumer 

spending was importantly influenced by reduced purchases of motor vehicles following strong 

increases in prior quarters when generous sales incentives were in play. However, consumer 

balance sheets are sound, with net worth up $2.3 trillion during the second half of 2005 – the 

highest in nearly five years in relation to disposable personal income. 

Improved labor markets (with one million new payroll jobs added during July-December and a 

decline in the unemployment rate to an average of 5.0 percent in those six months compared to 

5.2 percent in the first half of 2005), as well as the rise in household net worth, also continue to 

provide support to consumer spending. 

Business fixed investment grew at a 4.5 percent annual rate in the fourth quarter, with equipment 

and software investment up at a 5.0 percent pace. That was lower than the 10.6 percent gain at 

an annualized rate in the third quarter, as spending on selected transportation and equipment 

goods declined. Growth in equipment and software investment performed well over the entire 

year, increasing by 8.7 percent Q4/Q4. 

The advances in the economy in the second half of 2005 occurred even as energy prices 

continued to rise. From June 2005 to December 2005, the overall consumer price index 

increased by 4.0 percent at an annual rate. Energy prices rose at a 23.7 percent pace over that six 

month span. Food prices and the core CPI (excluding food and energy) both grew at a benign 

2.2 percent annual rate in the second half of 2005. The CPI increased 3.4 percent in December 

2005 from a year earlier, while the core CPI increased 2.2 percent. 

The Federal Open Market Committee (FOMC) – the Federal Reserve’s monetary policy-making 

body – raised the Federal funds target rate by 25 basis points at each of its four meetings in the 

second half of 2005. That brought the federal funds target (the rate that banks and other financial 

institutions charge each other for overnight loans) to 4.25 percent at its December 13, 2005, 

meeting. The target rate has since been raised twice in 2006 and at the end of March 2006 stood 

at 4.75 percent. 

The 10-year Treasury yield rose to about 4.7 percent in May 2004 in anticipation of faster 

growth and monetary tightening, then trended lower through much of the rest of the year and into 

2005. After dipping slightly below four percent in June 2005, the rate fluctuated in a slightly 

higher range of about 4.5 percent through the rest of 2005 and into the first two months of 2006. 

Mortgage interest rates have generally followed changes in the 10-year Treasury rate and have 

fluctuated in a fairly narrow band around a low level for more than two years. Low mortgage 

rates have contributed to record home sales, but also to mortgage refinancings, which have 

helped to free additional cash for consumption. Mortgage rates started trending upwards in the 
5

second half of 2005, with the rate for a thirty-year, fixed-rate mortgage reaching an average of 

6.22 percent in the final quarter of 2005, its highest level since the third quarter of 2002. 

The Administration’s FY2007 Budget contains policies that promote economic growth (low 

taxes, investment in research and development, and education incentives) and restrain federal 

spending (eliminating unnecessary programs and operating others more efficiently). In 

February, the Administration projected the FY2006 deficit to rise to $423 billion, or 3.2 percent 

of GDP from 2.6 percent last year reflecting higher costs for reconstruction in the aftermath of 

hurricanes and funding to prosecute the war on terror. More recently, a Congressional Budget 

Office report estimates that the deficit will be significantly less than originally anticipated due to 

a surge in federal tax receipts, which will hold the deficit to around 2.5 percent of GDP. 

The FY2007 Budget projects that the deficit will trend down further after 2006 and meet the 

President’s goal of cutting the deficit in half by 2009, when it is projected to fall to $208 billion, 

or 1.4 percent of GDP. The deficit is reduced because of continued economic growth, which 

supports revenues, and because of tight controls on non-security, discretionary spending. 

World Economic Conditions 

The world economy expanded an estimated 4.8 percent in 2005, the third consecutive year of 

better than four percent growth and well above the most recent eight-year average growth rate of 

3.9 percent. Most forecasts for 2006 indicate strong growth momentum will carry forward into 

the current year. Solid growth is more widely distributed than has been the case in decades, but 

there are significant differences among economies. As noted above, U.S. growth remains robust. 

Developing Asia had by far the strongest performance in 2005 with growth of nearly nine 

percent. Growth amongst oil exporters also picked up, averaging better than six percent. The 

Japanese recovery remains on track, although the potential growth rate remains low. However, 

growth in the Euro-zone was only 1.3 percent. Among economically advanced countries, which 

comprise 52 percent of total world output (PPP-based), growth was 2.7 percent in 2005. 

Developing and emerging market economies, which account for the other 48 percent of global 

output, had growth of 7.1 percent. 

This excellent overall global performance was underpinned by favorable financial conditions. 

Notwithstanding the rise in energy prices, with oil averaging $55 bbl in 2005 (average of WTI 

and Brent), core rates of inflation remained generally low in most economies. Long-term real 

interest rates also remained unusually low for this stage of the business cycle, and spreads 

between corporate and government bonds and between emerging market external fixed-income 

issues and U.S. Treasuries were low and even declining (the EMBI+ spread fell to a historical 

low of 173 basis points on May 1, 2006). Above-average economic growth has, in general, 

enabled business balance sheets to strengthen. Balance sheet improvements mean businesses 

and economies are in better position to withstand and adapt to economic shocks. 

Because of financial conditions, some concerns have arisen that investors may be increasing their 

risk exposure in search of higher returns. At the same time, however, many emerging market 

economies used 2005 to improve their fiscal and external payments positions and boost reserves 

– both absolutely and relative to short-term foreign currency debt obligations. Gross new 

issuance of sovereign and corporate emerging market bonds (debt issuance of $182 billion in 
6

2005) rose steeply in 2004 and 2005, reflecting in part the low-interest rate environment.3

 New 

borrowing and gross issuance of bonds and equities by emerging markets and developing 

countries rose to $406 billion in 2005, more than twice the level of 2003. 

Some analysts believe that valuations, however, may be compressed and the favorable financial 

conditions that have supported declining spreads and increased investor positioning could 

change, especially if short-term policy interest rates continue to increase in certain markets. 

Current conditions may thus reflect exceptional financial circumstances. 

Higher oil prices resulted in the oil export revenues of the 10 largest oil exporters increasing to 

more than $600 billion in 2005, up from $256 billion in 2002.4 The cumulative current account 

surpluses of oil exporters (Middle East, Russia, and Norway) rose 68 percent to $331 billion. By 

comparison, the cumulative external surpluses of Asian economies (developing, emerging 

market, and Japan) rose 13 percent to $399 billion.5

 Non-oil commodity prices rose 10 percent, 

led by a 26 percent increase in metals. In general, the volume of global trade expanded seven 

percent in 2005, faster than the five percent average gain for 2001-04 but below 2004’s trade 

volume expansion of nearly 11 percent. The external debt positions of developing countries and 

emerging markets, relative to their exports of goods and services, also continued to narrow and 

are now half their relative levels of 1998/99. IMF balance of payments data indicate that 

emerging market and developing country economies added reserves of $535 billion in 2005, with 

developing Asia and the oil exporters accounting for 80 percent of the total increase.6

An important challenge to sustaining global economic momentum in 2006 and beyond is in 

getting better balanced growth of the global economy. There have been too few engines of 

growth and too few centers of economic dynamism over the last several years. For the period 

2001-05, for example, average yearly growth of domestic demand of the U.S. economy was 3.1 

percent. China also contributed importantly to robust global growth. But G7 partners had a 

considerably smaller economic expansion with domestic demand expanding a weighted-average 

of only 1.7 percent per year. A key feature of adjusting global imbalances will be expanding 

demand relative to output in Europe, Japan, and many parts of developing Asia. 

The Euro currency zone is the world’s second largest economic area. Over the last ten years, 

domestic demand in the Euro-area has expanded annually a full 1.8 percentage points more 

slowly than that of the United States. This gap in relative domestic demand growth rates turns 

out to be substantial, the equivalent to the U.S. adding an economy the size of France or the 

United Kingdom in just a little over 10 years.7

 

 

3

 Table 1, page 51, of Annex on Emerging Market Financing Flows, of Global Financial Stability Report, April 

2006. 

4

 McCown, T. Ashby, Plantier, L. Christopher, Weeks, John, Petrodollars and Global Imbalances,Department of the 

Treasury/Office of International Affairs Occasional Paper No. 1, February 2006. 

5

 Derived from Tables 26 and 28, World Economic Outlook, Statistical Annex, April 2006 

6

 Table 1.2 of World Economic Outlook, April 2006 

7 The rate of real domestic demand growth for the United States over the period 1996-2005 was 3.8 percent and for 

the countries that comprise the current Euro-area it was 2.0 percent. Applying the 1.8 percent differential to 1995 

real U.S. GDP (2000 U.S.$) over 10 years yields an increase of $1,578 billion. Real GDP of the French economy in 

2005 (in 2000 dollars at the 2000 exchange rate) is calculated at $1,438 billion. For the United Kingdom, the 

calculation is $1,622 billion. 
7

Although the Euro-area’s current account position is in near balance, this is in part due to 

suppressed demand reflecting underemployment of existing resources. It has been argued that 

structural reforms to reduce this underemployment of resources would not only increase real 

income and imports but would also, by raising productivity in the tradeable goods sector, lower 

unit costs in the external sector and spur exports. There is some merit in this analysis, but there 

are additional factors that influence the current account position. 

In the Euro-area, in particular, the services sector – which is largely a non-tradeable sector – 

plays a strong and significant role in economic activity. Structural reforms that boost the 

efficiency of the large services sector would undoubtedly raise European incomes and in turn, 

imports. In addition, investment growth in Europe has been weak, notwithstanding a period of 

low – if not negative – real interest rates in the Euro-area as a whole. This weakness in 

investment growth is associated with a range of country-specific economic factors, but has 

important implications for the pattern of global capital flows. Raising European productivity and 

strengthening European capital markets are critical steps for boosting growth and investment in 

Europe. Doing so would clearly affect Europe’s external position and contribute to global 

adjustment. Europe is not only a part of the global current account equation, improved European 

economic performance is a part of the solution. 
8

The United States International Accounts8

• U.S. Balance of Payments Data 

The U.S. current account deficit was $821 billion (at a seasonally adjusted annual rate, or 

“saar”), or 6.5 percent of GDP, in the second half of 2005. Viewed over a longer period, the 

U.S. current account balance declined, as a percent of GDP, from a one percent surplus in the 

first quarter of 1991 to a four percent deficit in the fourth quarter of 2000. Then, after a 

cyclically induced narrowing in 2001, it resumed its decline to reach a seven percent deficit in 

the fourth quarter of 2005. 

In the second half of 2005, the United States exported $912 billion in goods (saar) and imported 

$1,732 billion, with a resulting $819 billion deficit on trade in goods.9

 Exports of goods 

 

8

 The IMF annually reviews U.S. economic performance and policies through the so-called IMF Article IV 

surveillance process. The last Article IV surveillance review took place in July 2005. The IMF Article IV Staff 

Report and the results of the IMF Executive Board’s discussion of the U.S. Article IV review can be found at 

http://www.imf.org/external/pubs/ft/scr/2005/cr05257.pdf. In addition, the IMF discusses U.S. economic policies 

and performance in the context of its twice yearly World Economic Outlook reports. These can be found at 

http://www.imf.org/external/pubs/ft/weo/2006/01/index.htm. 

2004 2005

Q1 Q2 Q3 Q4

Current Account:

 Balance on Goods (SA, Balance of Payments Basis) -665.4 -781.6 -185.7 -186.3 -197.3 -212.4

 Balance on Services 47.8 58.0 13.5 13.6 15.9 15.1

 Balance on Income 1/ 30.4 1.6 .6 -1.6 4.9 -2.4

 Net Unilateral Current Transfers -80.9 -82.9 -26.3 -22.6 -8.9 -25.1

Balance on Current Account -668.1 -804.9 -197.7 -196.9 -185.4 -224.9

 Current Account as % of GDP -5.7 -6.4 -6.5 -6.4 -5.9 -7.0

Major Capital Flow Components (financial inflow +)

 Net Bank Flows 36.8 -18.1 -34.3 12.3 -28.4 32.3

 Net Direct Investment Flows -145.2 107.1 7.6 -6.9 73.7 32.7

 Net Securities Sales 698.3 727.3 159.0 130.2 209.0 229.2

 Net Liabilities to Unaffiliated Foreigners by Non Banking Concerns -24.6 -56.3 19.0 10.1 -11.8 -73.6

Memoranda:

 Statistical Discrepancy 85.1 9.6 40.7 46.6 -68.0 -9.7

 Change in Foreign Official Assets in the United States 394.7 220.7 25.3 82.6 38.2 74.6

Trade in Goods (SA)

Balance -665.4 -781.6 -185.7 -186.3 -197.3 -212.4

Total Exports 807.5 892.6 213.4 223.1 224.8 231.3

 of which:

 Agricultural Products 62.9 64.8 15.3 16.9 16.6 16.0

 Industrial Supplies 2/ 204.0 231.8 55.7 58.8 58.9 58.4

 Capital Goods Ex Autos 331.5 361.8 85.5 90.2 90.9 95.3

 Automotive Products 89.3 97.8 23.6 23.4 24.6 26.1

 Consumer Goods Ex Autos and Food 103.1 115.5 28.2 28.5 29.0 29.9

Total Imports 1472.9 1674.3 399.1 409.4 422.1 443.7

 of which

 Petroleum and Products 180.5 251.6 53.0 57.4 67.5 73.7

 Capital Goods Ex Autos 343.5 379.5 90.6 95.7 95.9 97.2

 Automotive Products 228.2 240.0 58.1 58.0 60.5 63.3

 Consumer Goods Ex Autos and Food 373.1 407.1 101.7 101.7 100.7 103.0

1/ Including compensation of employees

2/ Including Petroleum and Petroleum Products

Source: BEA, Bureau of Census

U.S. Balance of Payments and Trade

($ billions, SA, unless otherwise indicated)

2005
9

increased 10.3 percent in the first half of 2005 compared to the first half of 2005, while imports 

increased 13.4 percent. 

The challenge of external adjustment for the United States is highlighted by two characteristics 

of the U.S. trade accounts. First, as noted, the level of U.S. imports is twice that of U.S. exports. 

Even if U.S. exports and imports grew at the same pace, due to this base effect the trade gap 

would continue to widen. Second, statistical studies suggest that for every percentage point that 

U.S. GDP grows, imports grow somewhat less than twice as fast, while for every percentage 

point that foreign economies grow, U.S. exports grow only a little more than a percentage point. 

Non-automotive capital goods constituted 40.8 percent of merchandise exports in the second half 

of 2005. Consumer goods constituted 23.5 percent and non-automotive capital goods constituted 

22.3 percent of merchandise imports. Petroleum and petroleum product imports accounted for 

16.3 percent of merchandise imports. The value of petroleum imports as a percent of total 

imports of goods has risen from 10 percent in the second half of 2003. The rise in the U.S. oil 

bill is an important factor in the growth in the U.S. trade and current account deficits. 

Canada, Mexico, China, Japan, and Germany remain the largest trading partners of the United 

States. Canada purchased 23.4 percent of U.S. exports, Mexico 13.3 percent, Japan 6.1 percent, 

China 4.6 percent, and the U.K. 4.3 percent in 2005. Canada accounted for 17.2 percent of U.S. 

imports, China 14.6 percent, Mexico 10.2 percent, Japan 8.3 percent, and Germany 5.1 percent in 

2005. 

Prices of imported goods (nsa) increased 11.5 percent (q4/q4) in 2005. Non-petroleum import 

prices rose 4.2 percent, while petroleum import prices increased 60.0 percent. Export prices rose 

4.0 percent over the year. The most recent trough in import and export prices occurred roughly 

at the beginning of 2002. Since then non-petroleum import prices have risen 8.2 percent and 

export prices 10.7 percent. 

Foreign demand for U.S. financial assets remains strong. A major item financing the U.S. 

current account deficit has been net private foreign purchases of U.S. securities, which reached 

$914 billion in 2005. (Included in these were net private foreign purchases of U.S. Treasury 

 9

 Sums may not be exact due to rounding. 

Country Exports 

2005 1/ Country Imports 2005 1/

Total, All Countries ($Bil) 904.3 Total, All Countries ($Bil) 1671.1

Percent of 

Total

Percent of 

Total

Canada 23.4 Canada 17.2

Mexico 13.3 China 14.6

Japan 6.1 Mexico 10.2

China 4.6 Japan 8.3

United Kingdom 4.3 Federal Republic of Germany 5.1

Federal Republic of Germany 3.8 United Kingdom 3.1

South Korea 3.1 South Korea 2.6

Netherlands 2.9 Taiwan 2.1

France 2.5 Venezuela 2.0

Taiwan 2.4 France 2.0

Singapore 2.3 Malaysia 2.0

1/ Bureau of the Census
10

securities amounting to $289 billion.) In addition, foreign official institutions increased their 

holdings of U.S. assets by $112 billion. 

Foreigners owned $2.2 trillion in Treasury securities at the end of December 2005, or 55 percent 

of the public debt not held in Federal Reserve and U.S. Government accounts. This compares 

with $2.0 trillion, at the end of June 2005. Foreign official institutions held $1.3 trillion in 

Treasury securities at the end of December 2005, compared to $1.2 trillion at the end of June 

2005. 

Net International Investment Position 

The net international investment position of the United States (with direct investment valued at 

the current stock market value of owners’ equity) was a negative $2.5 trillion as of December 31, 

2004, the latest date for which data are available. This was only $170 billion wider than the 

negative $2.4 trillion position at the end of 2003, as a $272 billion valuation adjustment due to 

exchange rate changes and a $147 billion valuation adjustment due to other price changes offset 

much of the financial outflow associated with the 2004 current account deficit of $665 billion.10 

Despite the large negative net investment position, U.S. residents earned $36 billion more on 

their investments abroad than they paid out on foreign investments in the United States in 2004 

and $7 billion more in 2005. Net earnings on direct investment in those years were slightly 

larger than net payments on other investment. Net investment earnings continued to decline, 

however, and were marginally negative in the second and fourth quarters of 2005 

• Perspectives on the Financial Account

The autumn 2005 Report to Congress on International Economic and Exchange Rate Policies 

described different perspectives on the current account and showed that the characteristics of 

each perspective affect the interpretation of the factors influencing the current account and the 

implications of current account deficits. This section extends the analysis to the capital and 

financial accounts. 

A surplus on the capital and financial accounts is, by balance of payments accounting definition, 

the counterpart to a current account deficit. These net inflows finance the excess of net domestic 

capital formation over net domestic saving. To the extent foreign investors acquire U.S. 

financial assets, it represents the foreign investors’ assessment of the relative appeal of investing 

in U.S. assets versus investing in alternative assets, including assets in the home economy of the 

foreign investor as well as third countries. This perspective leads to a focus on broad economic 

and financial factors – such as prospective relative growth rates of output and productivity, the 

relative attractiveness and openness of investment environments, prospective inflation, the 

flexibility of factor markets, and exchange rates. 

According to this perspective, the growth of the U.S. current account deficit over more than a 

decade has been linked to high levels of domestic U.S. capital formation compared to domestic 

U.S. saving. Perceived high rates of return on U.S. assets, based on sustained strong productivity 

 

10 In principle the net financial and capital account flows should equal the current account balance, but in fact there 

was a statistical discrepancy of $10 billion in 2005. 
11

growth, especially relative to the rest of the world; sound U.S. economic performance; a 

welcoming U.S. investment climate; and the deepest and most liquid capital markets in the world 

have all combined to attract foreign investment. Portfolios worldwide are also becoming 

increasingly internationalized, and some studies point to the conclusion that the home bias of 

foreign investors is eroding and that they are underweight in U.S. dollar holdings.11 In turn, 

sustained external demand for United States’ assets has allowed the United States to achieve 

levels of capital formation and future growth potential that would have not been possible in the 

absence of net financial inflows into the United States. The robust growth in fixed investment 

has been critical to the non-inflationary growth of production and employment in the United 

States. 

Some analysts have raised concerns about different features of international financial flows, 

suggesting that the financing of the U.S. current account deficit rests on precarious grounds. 

Below, these concerns are addressed. 

• While the large negative international investment position of the United States will 

probably generate outflows on investment income in the near future, these outflows are 

not likely to be massive.

For 2005 as a whole, U.S. residents continued to receive slightly more income on their foreign 

investments than foreigners receive on their U.S. investments. This is surprising on its face, 

given that the value of foreign investment in the United States exceeds U.S. investment abroad 

by $21⁄2 trillion. As noted earlier this positive net inflow has, however, been declining. 

Balance of payments data indicate the positive flow to the United States from net investment 

income is the result of relatively high earnings on U.S. direct investments abroad compared to 

foreigners’ income from foreign direct investment in the United States. Net inflows of direct 

investment income have been sufficient to offset outflows of other investment income. These 

other investment income flows have also recently been affected by temporary factors, such as 

relatively low interest rates in the United States, which have risen in the last year. Most analysts 

generally believe that U.S. net income payments will become a net outflow as the negative U.S. 

net investment position widens. Direct investment income will probably, however, continue to 

cushion the growing outflow of portfolio investment income, in part because U.S. investment 

abroad is large and appears to be maintaining a relatively superior rate of return. 

This has led some observers to argue that the U.S. net international investment position is in 

considerably better shape than the available data suggest – that there is some kind of “dark 

matter” in U.S. direct investment abroad. They use this argument to throw doubt on common 

inferences about the future sustainability of U.S. current account deficits. This analysis is based 

on an assumption that, if every country earned the same underlying rate of return on its assets 

and then using this rate of return to capitalize the value of assets, it would be “as if” the U.S. net 

international investment position is positive rather than the negative $2.5 trillion that the official 

data record.12 There is some suggestion that this makes the U.S. current account deficit 

 

11 Bertaut, Carol C. and Griever, William L., “Recent Developments in Cross-Border Investment in Securities”, 

Federal Reserve Bulletin, Winter 2004. 

12 Hausmann, Ricardo and Sturzenegger, Federico, ‘Dark matter’ makes the US deficit disappear, The Financial 

Times, Thursday December 8, 2005. 
12

disappear and that there are no serious global imbalances. While this view of the U.S. 

international investment position is interesting, it has not gained acceptance with most analysts 

of the U.S. balance of payments. This line of thinking would require that national income 

accounting definitions of saving be revised since U.S. spending does exceed U.S. income, under 

current definitions, and this difference is equal to the current account balance. Moreover, even if 

unidentified assets had existed in the past, that would not mean that they could be counted on to 

keep the international investment income balance positive in the future, since the relatively high 

rates of return on U.S. foreign direct investment could ease in time. 

• The current account deficit is being financed predominantly by private sources, and not 

by official sources or by Asian reserve accumulation.

Much of the information in the financial account of the U.S. balance of payments is from data 

collected by the Treasury International Capital Reporting System (the “TIC”). The TIC reports 

that net purchases of long-term U.S. securities by foreign official institutions declined to $111.5 

billion in 2005 from $235.6 billion in 2004. The decline coincided with the cessation of 

Japanese intervention in the foreign exchange markets in the first quarter of 2004. The TIC data, 

albeit imperfect (see below), indicate that nearly 90 percent of the long-term securities that 

foreigners purchased in 2005 came from non-official foreign investors. Net private purchases of 

long-term securities in 2005 totaled $914 billion. These percentages should be read with some 

perspective on the accuracy of the data. As described below, there are well known qualifications 

that need to be made in assessing the relative size of foreign official and private net purchases of 

long-term securities. The percentage for private purchases might well be lower, but the 

description of trends continues to be valid. 

The current account deficit is financed by many items other than purchases of long-term 

securities. Sources of financial inflows include, among other things, net foreign purchases of 

short-term U.S. securities, increased liabilities to foreigners of banking and non-banking 

enterprises, and increased foreign direct investment in the United States. Financial outflows in 

the form of such items as U.S. acquisition of foreign securities, increased claims on foreign 

Foreigners' Net Purchases by Domestic Long-term Securities

1990-2005, quarterly data

-50.0

.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

1990-031990-091991-031991-091992-031992-091993-031993-091994-031994-091995-031995-091996-031996-091997-031997-091998-031998-091999-031999-092000-032000-092001-032001-092002-032002-092003-032003-092004-032004-092005-032005-09

$ billions

official private
13

banking and non-banking enterprises and increased U.S. direct investment abroad offset some of 

the inflows. 

The Department of Commerce’s Bureau of Economic Analysis (BEA) makes some adjustments 

to the TIC data on official purchases of long-term securities and combines these adjustments 

with other information (e.g., on short-term securities and U.S. banking liabilities) before 

publishing the data in the U.S. balance of payments accounts. However, taking these 

adjustments and additions into account, the balance of payments accounts indicate that the 

increase in foreign official assets in the United States, of all kinds, was only slightly more than a 

quarter of the U.S. current account deficit in 2005, down from over half in 2004. 

• While the TIC data face limitations, they provide a good picture of U.S. portfolio 

capital flows. 

It has been asserted, from an examination of a limited set of published data, that the TIC only 

presents data on foreign transactions in long-term securities.13 The monthly press notice issued 

by Treasury announcing the release of TIC data only discusses transactions in long-term 

securities. A much more complete data set is, however, posted on the TIC web site concurrent 

with the press notice. These data include, among other things, statistics on international banking 

assets, holdings of short-term Treasury securities, estimates of unrecorded prepayments of 

principal on asset-backed securities, and estimates of foreign holdings of Treasury securities. 

These statistics do not include information on direct investment since the BEA is responsible for 

collecting those data. As the BEA presentation of official capital flows cited above 

demonstrates, the qualitative conclusions derived from an analysis of transactions in long-term 

securities are the same when account is taken of all of these other factors. 

There are documented limitations to the Treasury data.14 TIC reports on transactions in longterm securities can, in particular, misclassify the country of residence of a foreign purchaser and 

mistakenly identify official transactions in long-term securities as private transactions. 

Misclassification of a foreign investor’s residence, often called a “geographical bias”, typically 

arise when transactions take place in foreign financial centers, and the TIC attributes the 

transaction to the country where the financial center is located instead of the country where the 

investor resides. However, the TIC system carries out annual surveys of custodians of securities 

that correct for many of these misclassification errors and help verify the accuracy of the data. 

Recently released preliminary results of the survey of foreign holdings of U.S. securities as of 

June 200515 illustrate the geographical bias in transactions data as well as some corrections. 

Before the new survey results were available, estimates of foreign holdings of Treasury securities 

were calculated by adding accumulated net transactions in Treasury securities to data derived 

from the June 2004 survey. Using the results of the June 2005 survey means that net 

transactions, with their geographical bias, are accumulated only since June 2005 instead of since 

June 2004. There is only a modest difference between using the two benchmarks in calculating 

 

13 For example Martin Feldstein, “Why Uncle Sam’s bonanza might not be all that it seems”, The Financial Times, 

January 10, 2006. This was a small part of the article. 

14 A more complete discussion can be found in FAQ numbers 4 and 7 on the TIC web site. 

15 Preliminary data from an annual survey of foreign portfolio holdings of U.S. securities at end-June 2005 were 

released April 28, 2006. They are posted on the U.S. Treasury web site at (http://www.treas.gov/tic/fpis.html). 
14

total foreign holdings of Treasury securities. The old estimate indicated that foreign investors 

held $2.2 trillion in Treasuries, compared with the new estimate of $2.1 trillion. As the 

following table illustrates, individual countries show greater differences.16 

There are, of course, gaps in the survey data as well that arise from the ability of investors both 

to carry out transactions and to place securities in custody overseas, beyond the reach of the TIC 

data collection system. These gaps will affect estimates of individual country holdings rather 

than overall foreign holdings of U.S. securities. Although there are limitations to TIC data, 

particularly in their ability to identify the precise geographic origin and destination of portfolio 

flows, the overall picture that private investors, rather than official foreign investors, dominate 

net purchases of U.S. securities remains valid. 

• There is little evidence of significant foreign central bank reserve diversification out of 

dollars. 

The best available information indicates that significant aggregate diversification is not 

happening. The IMF publishes data on the currency composition of official reserves on a 

quarterly basis. These data were just released through the end of 2005. The data are affected to 

some degree by valuation adjustments in translating foreign currencies into dollars. Nonetheless, 

according to official IMF data the share of the U.S. dollar in official foreign exchange reserves 

has remained constant for the last few years at around two thirds, a figure similar to that in the 

mid-1990s.17

 

• There is also little evidence to support the argument that foreign central banks might 

sell off their stock of dollar holdings, that such sales would result in substantial upward 

pressure on U.S. interest rates, or that foreign official purchases of dollars are 

substantially holding down the U.S. yield curve. 

The record is not supportive of either a sell off or substantial upward pressure on U.S. interest 

rates. In the first instance, to give some perspective on flows, total net official purchases of longand short-term Treasury securities averaged around $11⁄2 billion per month in 2005. 

Further, in considering this issue, it is worthwhile to distinguish between the existing stock of 

foreign official holdings, and newly accumulated dollars and the earnings on the stock. Many of 

 

16 There are, of course, other reasons to revise estimated geographical allocation of foreign holdings besides 

correcting for the geographical bias. 

17 The data cover reserves for which the currency of denomination is known. See 

http://www.imf.org/external/np/sta/cofer/eng/index.htm. 

Old Estimates New Estimates

All Countries 2,232.3 2,081.7

 U.K 250.8 162.7

 Japan 673.1 658.3

 China 265.2 319.8

 Caribbean Banking Centers 94.1 54.4

Foreign Official Institutions 1,282.0 1,326.4

Select Foreign Holdings of Treasury Securities

(end-February 2006, $ billions)
15

the largest official holders of U.S. dollar portfolios (China, Korea, and Japan) have repeatedly 

emphasized that they do not intend to sell the stock of their U.S. dollar portfolios. 

Notwithstanding much discussion over past years about the potential for diversification, as well 

as a rising current account deficit, the U.S. dollar has remained well bid in foreign exchange 

markets. 

Some analysts have suggested that foreign central banks, even if they do not sell their stock of 

dollar assets, may pare back at the margin the percentage of newly acquired reserves allocated to 

dollars. But assume that foreign official holders hypothetically accumulated $500 billion next 

year, and decided to hold 50 percent rather than 65 percent of these accumulations in dollars. 

This would imply that, over a year's time, $75 billion less in foreign official holdings would be 

placed into dollar assets and instead into non-dollar assets. Although there would be marginally 

less demand for dollars in the foreign exchange market, this would be a very small amount 

compared to the market's $2 trillion a day turnover. Similarly, although the demand for 

Treasuries, or other U.S. securities, might ease, the decline would be small compared to the $11 

trillion monthly trading volume in the Treasuries market. Moreover, demand for Treasuries is 

only a part of the total credit demand in the U.S. financial market. 

• There is little evidence suggesting that oil-producing countries are less willing to hold 

their assets in US dollars. 

A review of TIC data and investment patterns shows no anomalies in the pattern of investment 

activity in U.S. assets on the part of oil exporters. Although the Bank of International 

Settlements (BIS) is only able to identify thirty percent of the investable funds of OPEC, the data 

that are available show that oil exporter deposits with BIS reporting banks continue to be 

predominantly in dollars. 

The U.S. Dollar 

In the second half of 2005, the dollar traded in a moderate range against the euro and appreciated 

against the yen. In terms of the euro, the dollar moved from $1.20898 to $1.1842 over the 

second half. That is, there was a euro depreciation of 2.1 percent. During that period, the 

dollar/yen rate moved from ¥111.7 to ¥ 117.9, a yen depreciation of 5.3 percent. Although the 

direction of euro and yen movements diverged after mid-summer 2005, the two currencies have, 

on balance, moved in a broadly similar manner since the dollar’s most recent peak in February 

2002. 
16

Dollar movements in the second half of 2005 were influenced by a range of factors: 

• Market participants were particularly focused on the rise in short-term U.S. interest rates and 

widening global interest rate differentials, and expressed little day-to-day concern about the 

financing of the large U.S. current account deficit, although the deficit tempered overall dollar 

demand. Changing market perceptions of U.S. economic growth prospects in light of Hurricanes 

Katrina and Rita and fluctuations in energy prices, and their implications for the outlook for U.S. 

monetary policy, also impacted trading. In particular, in the wake of the hurricanes, perceptions 

that underlying U.S. growth remained strong, notwithstanding the fourth quarter slowdown, 

added to expectations that the FOMC would raise the Fed Funds rate more than previously 

thought and supported dollar demand. 

• The yen’s depreciation reflected in part the so-called “global carry trade.” Given Japan’s very 

low interest rates, global investors increasingly borrowed yen to fund investments in higheryielding assets. Also, even though foreign inflows, especially into Japanese stocks, have 

increased as the Japanese recovery has taken hold, Japanese investors have stepped up their 

overseas investment in light of increased global risk appetite. The yen was subject to upward 

pressure at times when market participants anticipated further Chinese renminbi appreciation, but 

this factor diminished in the latter months of the year. Yen trading, more generally, was affected 

by the Japanese monetary policy outlook, as the Bank of Japan began to end its quantitative 

easing policy and consider the future of its zero-interest rate policy. 

• After depreciating substantially in the first half of 2005, the euro generally fluctuated within 3-4 

cents of $1.20 for the remainder of the year. Toward the end of the year, the euro received some 

support from increased market expectation that the European Central Bank would raise Eurozone interest rates by up to 50 basis points during the first half of 2006, around a time when 

participants also felt the cycle of FOMC rate hikes may reach an end. 

The Federal Reserve’s broad nominal trade-weighted dollar index was little changed in the 

second half of the year – the dollar appreciated by 0.9 percent vs. the major currencies and 

Euro/dollar (inverted) and Dollar/yen Since End-2001 [Professional] 12/31/2001 - 4/14/2006 (GMT)

JanMar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan Mar

2002 2003 2004 2005 2006

Inv

USD

0.74

0.76

0.78

0.82

0.84

0.86

0.88

0.92

0.94

0.96

0.98

1.02

1.04

1.06

1.08

1.12

1.14

0.8

0.9

1

1.1

Price

/USD

102

104

106

108

112

114

116

118

122

124

126

128

132

110

120

130

Yen per dollar (left axis)

Euros per dollar (right axis)
17

depreciated by 1.3 percent against the currencies of other important trading partners of the 

United States. The major currencies portion of the index accounts for 53 percent of the broad 

index. The other important trading partner (OITP) portion of the index accounts for the 

remaining 47 percent; roughly two thirds of this portion is accounted for by emerging Asian 

economies. 

Between its peak in early 2002 and the beginning of 2004, the dollar fell 25 percent against 

major currencies measured by the Federal Reserve Board’s nominal trade-weighted index. Since 

then, the dollar has risen less than three percent against the major currencies. The economies 

comprising this portion of the index grew over the last four years by a weighted-average of only 

1.6 percent. The dollar appreciated against the OITP index by four percent from early 2002 to 

the beginning of 2004 and has since declined by a similar amount. Though the exchange rate 

movement against the currencies of these economies was much less than that against the major 

currencies, the countries comprising the OITP index grew a weighted average of 6.6 percent over 

the last four years. These developments underscore the importance of the call for greater 

flexibility in exchange rates, particularly in emerging Asian economies. 

Movements in the foreign exchange value of the dollar reflect a wide range of factors in 

extremely large and deep international financial markets. The latest BIS-coordinated central 

bank survey of activity in the global foreign exchange market, undertaken in April 2004, 

estimated that average total daily turnover in the market was nearly $2 trillion dollars equivalent 

per day. A large majority of these trades involve the dollar, either as one of the two currencies in 

the underlying transaction or as the vehicle currency in a trade between two foreign currencies. 

Although current account transactions are an important factor affecting currency markets, these 

transactions are often small by comparison to global capital flows. 

The United States has not intervened in foreign exchange markets since September 2000. 

Nominal Trade Weighted Dollar

Feb 27, 2002 = 100

65

70

75

80

85

90

95

100

105

110

2/1/02 8/1/02 2/1/03 8/1/03 2/1/04 8/1/04 2/1/05 8/1/05 2/1/06

Broad

Major

OITP

1`
18

Country Analyses

Brazil

Brazil has a flexible exchange rate regime and relies on inflation targeting to guide monetary 

policy. The real appreciated 1.0 percent during the second half of 2005 from BRL 2.36/US$ to 

BRL 2.33/US$. Brazil’s sovereign debt traded at 305 basis points over U.S. Treasuries at end2005 versus 411 basis points at the end of June. Year-on-year inflation stood at 5.7 percent in 

December, above the center of the central bank’s 5.1 percent target for 2005 but within the target 

band of two percent to seven percent. Brazil had a seasonally adjusted $7.3 billion current 

account surplus in the second half of 2005 compared to $6.9 billion in the first half. The United 

States had a trade deficit with Brazil of $4.4 billion in the second half of 2005 compared to a 

$4.7 billion deficit in the first half. Foreign direct investment fell to $6.6 billion in the second 

half of 2005 compared with $8.6 billion in the first half. The Central Bank increased net 

international reserves to $53.7 billion by December 2005 compared to $40.5 billion in June, in 

part due to central bank purchases of foreign exchange for reserve accumulation in November 

and December. In December, Brazil announced that it would pre-pay its entire remaining 

obligations to the IMF totaling $15.5 billion. Real GDP decreased 3.4 percent at a seasonally 

adjusted annualized rate and increased 3.4 percent at a seasonally adjusted annualized rate in the 

third and fourth quarters, respectively. For the full-year 2005, GDP posted a 2.3 percent increase 

over the previous year. 

Mexico 

Mexico has a flexible exchange rate regime. Its central bank targets an inflation rate of three 

percent with a +/-1 percent band. The Bank of Mexico also follows a transparent rule for selling 

foreign exchange accumulated by state enterprises. During the second half of 2005 the Mexican 

peso appreciated by 1.4 percent, from 10.8 pesos/dollar to 10.6 pesos/dollar. The J.P. Morgan 

trade-weighted effective exchange rate index for the peso appreciated by 1.7 percent. Mexico’s 

seasonally adjusted current account deficit was 0.4 percent of GDP during the second half of 

2005. Mexico’s merchandise trade surplus with the U.S. from July through December 2005 was 

$25.7 billion. Foreign direct investment in the second half of 2005 was $9.0 billion, versus $8.8 

billion in the first half of the year. International reserves grew by $6.9 billion during the second 

half of the year, reaching $68.7 billion by the end of December. Year-on-year headline inflation 

was 3.3 percent in December, compared to 4.4 percent in June. Real GDP increased at 

seasonally adjusted annual rates of 8.7 percent and 2.4 percent during the third and fourth 

quarters of 2005, respectively. For the full-year 2005, GDP posted a 2.7 percent increase over 

the previous year. 

Argentina 

Argentina intervenes frequently in the foreign exchange market to manage the value of the peso 

and build international reserves. The peso depreciated five percent during the second half of 

2005 from ARS2.89/US$ to ARS3.03/US$. Over the full 2005 the peso depreciated two percent 

from, ARS2.97/US$ to ARS3.03/US$. The stock of Central Bank international reserves 

increased to $28.1 billion by end-December compared to $23.0 billion at end-June and $19.6 
19

billion at end-2004. In December, Argentina announced that it would tap Central Bank reserves 

to pre-pay its entire remaining obligations to the IMF totaling $9.9 billion. Annual inflation 

reached 12.3 percent at end-2005 compared to 6.1 percent at end-2004. The Central Bank's 

monetary policy response remained accommodative in the face of the rise in inflation; while 

nominal interest rates on Central Bank repo transactions rose by 200-300 basis points in 2005 to 

5-6 percent, the increase was outpaced by the acceleration in inflation, producing a decline in the 

real interest rate. Argentina’s sovereign debt traded 498 basis points over U.S. Treasuries at endDecember versus 464 basis points at end-June. Argentina had a $3.5 billion current account 

surplus in the second half of 2005, equivalent to 3.7 percent of GDP, versus 2.1 percent of GDP 

in the first half of 2005. Argentina’s current account surplus for the full 2005 was $5.4 billion, 

equivalent to 3.0 percent of GDP. For the full 2005 the U.S. trade deficit with Argentina 

increased to $472.2 million, compared to $357.4 million the year prior. During the second half 

of 2005 the U.S. trade deficit with Argentina was $374.3 million compared to $97.8 million in 

the first half of the year. Real GDP increased at seasonally adjusted annual rates of 10.7 percent 

and 8.8 percent during the third and fourth quarters of 2005, respectively. For the full-year 2005, 

GDP posted a 9.2 percent increase over the previous year. 

The Euro-zone 

The euro depreciated 2.1 percent against the dollar in the second half of 2005. The European 

Central Bank’s broad index of the euro’s real effective exchange value declined 1.1 percent over 

the period. The Bank did not intervene in foreign exchange markets during the second half of 

2005. The harmonized consumer price index rose 2.2 percent year-on-year as of December 2005 

while the index excluding energy, food, alcohol, and tobacco rose 1.4 percent. Broad money 

(M3) grew 8.0 percent annualized in the second half of 2005. 

The countries in the Euro-zone taken together had a current account deficit during the second 

half of 2005 equal to $39.5 billion (sa) or 0.8 percent of GDP, down from a surplus of $6.2 

billion and $19.6 billion in the first half of 2005 and second half of 2004, respectively. Goods 

exports increased 10.6 percent while goods imports increased 15.6 percent in the second half of 

2005 over the same period in 2004. The trade surplus of the Euro-zone vis-à-vis the United 

States was $48.6 billion in the second half of 2005, which is about $4.9 billion higher than in the 

same period of 2004. 

Euro-zone growth was an estimated 2.0 percent (annualized) in the second half of 2005. Final 

consumption expenditure rose 1.5 percent (annualized) in the second half of 2005 while gross 

fixed capital formation increased 2.6 percent (annualized). 

Germany 

Germany had a current account surplus during the second half of 2005 equal to $50.3 billion (sa), 

or 3.4 percent of GDP. Goods exports increased 9.8 percent while goods imports increased 10.4 

percent in the second half of 2005 over the same period in 2004. The trade surplus of Germany 

vis-à-vis the U.S. was $26.2 billion, which is $2.0 billion higher than the same period of 2004. 

German growth was 1.6 percent (annualized) in the second half of 2005. Consumption and 

investment grew 0.2 percent and 9.3 percent (annualized), respectively, in the second half. 
20

Germany’s fiscal deficit is expected to exceed the three percent of GDP Stability and Growth 

Pact limit for the fourth straight year in 2005. German inflation was 2.2 percent yr/yr in 

December 2005 while core inflation was 1.1 percent. 

Netherlands 

The Netherlands had a current account surplus during the second half of 2005 equal to $19.0 

billion (sa), or 6.2 percent of GDP. The current account surplus for 2004 was 8.9 percent of 

GDP (with a five percentage point upward revision late in the year), with a substantial 

contribution from increased earnings of foreign subsidiaries of Netherlands companies. Goods 

exports increased 9.6 percent while goods imports increased 10.4 percent in the second half of 

2005 over the same period in 2004. The trade deficit of the Netherlands vis-à-vis the U.S. was 

$5.0 billion, which is $717 million lower than the same period of 2004. 

Dutch growth was an estimated 3.6 percent (annualized) in the second half of 2005, driven by 

domestic demand. Consumption and investment grew 2.9 percent and 6.7 percent (annualized), 

respectively, in the second half of 2005. Dutch CPI inflation was 2.1 percent yr/yr in December 

2005 while core inflation was 0.9 percent. 

Spain 

Spain’s current account deficit was $43.3 billion, or 7.8 percent of GDP, in the second half of 

2005. Goods exports increased 5.9 percent while goods imports increased 11.1 percent in the 

second half of 2005 over the same period in 2004. The trade surplus of Spain vis-à-vis the U.S. 

in the second half was $940 million, which is $615.7 million higher than in the same period of 

2004. 

Spanish growth was an estimated 3.6 percent (annualized) in the second half of 2005, driven 

entirely by domestic demand. Consumption and investment increased 4.9 percent and 5.7 

percent (annualized), respectively, in the second half. Spanish CPI inflation was 3.7 percent 

yr/yr in December 2005 while core inflation was 2.8 percent. 

Switzerland 

Switzerland’s current account surplus in the third quarter of 2005 was $10.9 billion or 12.1 

percent of GDP. Goods exports increased 8.1 percent while goods imports increased 10.0 

percent in the second half of 2005 over the same period in 2004. The trade surplus of 

Switzerland vis-à-vis the U.S. in the second half of 2005 was $1.1 billion, which is $24.3 million 

lower than in the same period of 2004. 

Swiss growth was an estimated 3.1 percent (annualized) in the second half of 2005. 

Consumption and investment increased 1.8 percent and 2.3 percent (annualized) respectively in 

the second half while net exports increased by 12.0 percent (annualized). The Swiss franc 

depreciated 2.5 percent against the dollar in the second half and declined 0.8 percent against the 

currencies of Switzerland’s trading partners. JP Morgan’s index of the real effective exchange 

rate of the Swiss Franc declined 2.3 percent over the second half. Broad money (M3) increased 
21

1.8 percent over the second half. Inflation remained low at 1.0 percent yr/yr as of December 

2005. Core inflation was 0.3 percent. 

Norway 

Norway’s current account surplus in the second half of 2005 was $27.4 billion or 18.3 percent of 

GDP. Goods exports increased 22.9 percent while goods imports increased 9.4 percent in the 

second half of 2005 over the same period in 2004. The trade surplus of Norway vis-à-vis the 

U.S. was $2.3 billion, which is $438.7 million lower than in the same period of 2004. 

After 3.0 percent growth in the first half of 2005, Norway’s GDP grew 3.1 percent (annualized) 

in the second half of 2005. Consumption grew 3.9 percent (annualized) while investment 

increased 24.6 percent. The Norwegian Kroner depreciated 3.2 percent against the dollar in the 

second half. The trade-weighted exchange rate increased 0.5 percent. Broad money (M2) 

increased 2.3 percent over the second half. Inflation was 2.0 percent yr/yr as of December 2005. 

Core inflation was 1.3 percent. 

Russia 

High oil prices continued to contribute to strong growth as well as large external and fiscal 

surpluses. Russia’s current account surplus in the second half of 2005 was an estimated $42.7 

billion, or 10.7 percent of GDP, compared to $25.9 billion, or 9.9 percent of GDP, in the second 

half of 2004. The bilateral trade surplus with the U.S. was $5.4 billion in the second half of 2005 

compared with $5.4 billion in the second half of 2004. 

 

The fiscal surplus for 2005 was a record 7.5 percent of GDP which helped raise the balance of 

the oil stabilization fund to $43 billion at end-2005. Foreign exchange market intervention by 

the Central Bank resulted in a slight easing of the ruble vis-à-vis the dollar in the second half (0.4 

percent). Official reserve assets increased 20.2 percent from $151.6 billion at end-June 2005 to 

$182.2 billion at end-December 2005. Russia’s current account surpluses and foreign exchange 

reserve accumulation have been very large over recent years. The ruble’s bilateral exchange rate 

with the dollar has, however, not varied greatly. From the end of 1999 to the end of 2005, the 

ruble depreciated on net 4.1 percent against the dollar. On the other hand, the real value of the 

ruble, measured by the JP Morgan broad index of the real effective exchange rate, appreciated 75 

percent consonant with the high levels of Russian inflation over most of this period. 

Inflation decelerated marginally with consumer prices rising 11.3 percent yr/yr at end-December 

2005 compared to 11.7 percent at end-December 2004. Inflation has been running in the low 

teens for over three years. M2 grew 38.6 percent over the twelve months through December 

2005 compared to 35.8 percent in the comparable period through December 2004. A more 

flexible exchange rate would allow better control over monetary conditions and assist materially 

in controlling inflation. 
22

Ukraine 

The hryvnia depreciated by 0.7 percent against the dollar during the second half of 2005. This 

followed an appreciation of 5.9 percent during the first half of the year, resulting in a cumulative 

appreciation of 5.2 percent for the year as a whole. 

Downward pressure on the exchange rate during July-December reflected a sharp slowdown in 

export growth that shifted the current account to a deficit of $0.4 billion in the second half of 

2005 from a surplus of $2.9 billion in the same period of 2004. For the year as a whole, the 

surplus narrowed to $1.4 billion (two percent of GDP) in 2005 from $6.8 billion (10.5 percent of 

GDP) in 2004. 

Foreign exchange reserves rose from $12.9 billion at the end of June to $19.1 billion at the end 

of December. This reflected in large part receipts from the privatization of a major steel mill 

(Kryvorizhstal, sold to Mittal) for $4.8 billion. In addition, after allowing the exchange rate to 

appreciate in the first half of the year, the central bank resumed intervention to maintain an 

informal exchange rate peg of UAH5/$ during July-December. Most of this intervention was 

unsterilized, contributing to acceleration in broad money growth to 54 percent in December 

(yr/yr) from 37 percent in June. 

Real GDP growth continued to slow in the second half of 2005, falling to 1.1 percent yr/yr from 

four percent yr/yr in January-June. For the year as a whole, real GDP growth fell to 2.4 percent 

in 2005 from 12.1 percent in 2004, as weaker steel demand contributed to a marked decline in 

exports. 

Sub-Saharan Africa 

Overall, Sub-Saharan Africa’s current account deficit narrowed to 0.7 percent of GDP in 2005 

from 1.8 percent in 2004. An improvement of more than six percentage points of GDP, on 

average, in the current account balances of the regions main oil exporters drove the overall 

change. The U.S. merchandise trade deficit with Sub-Saharan Africa continued to widen in 2005 

to $40 billion, from $27 billion in 2004, due to a large increase in the value of crude oil imports. 

Roughly half of Sub-Saharan African countries officially peg their currencies to other currencies, 

primarily the euro. The currencies of the United States’ two largest trading partners in subSaharan Africa, Nigeria and South Africa, both appreciated about five percent in nominal terms 

against the U.S. dollar in the second half of 2005. The IMF classifies Nigeria’s foreign exchange 

rate regime as a managed float. The South African Rand floats relatively freely. 

Higher oil prices buoyed the Nigerian Naira and drove a significant increase in the country’s 

current account surplus to 14 percent of GDP in 2005 from four percent in 2004. Primarily due 

to the large current account surplus, Nigeria’s foreign exchange reserves increased from $24.4 

billion at the end of June 2005 to $28.3 billion at the end of December. Capital inflows benefited 

the South African Rand and financed a widening of South Africa’s current account deficit to 4.2 

percent of GDP in 2005 from 3.4 percent in 2004. Capital inflows also boosted South Africa’s 

foreign exchange reserves from $16.6 billion at the end of June 2005 to $18.3 billion at the end 

of December. 
23

Saudi Arabia 

Saudi Arabia is one of the most oil-dependent economies in the world, with oil accounting for 45 

percent of GDP, almost 90 percent of export revenue, and 85 percent of the government’s 

revenue. With the price of West Texas Intermediate oil averaging $56 a barrel in 2005, real 

GDP growth exceeded six percent, and nominal GDP grew by 25 percent. Despite this strong 

growth, 2005 CPI inflation remained contained at 1.2 percent year over year due to minor price 

changes of imported goods and the large share of administered prices in the CPI basket. 

Oil export revenues continued to increase on the back of high oil prices, rising to $153 billion in 

2005 from $110 billion in 2004. The surge in oil export revenue led to an increase in the current 

account surplus from 20.5 percent of GDP in 2004 to 30 percent of GDP in 2005. Finally, the 

bilateral trade surplus with the United States reached $20.4 billion in 2005, compared with $15.7 

billion in 2004. 

The government’s financial position improved as revenue from oil rose by $43 billion to $131 

billion in 2005. The budget surplus was approximately $57 billion in 2005 (18 percent of GDP), 

and the government used much of that surplus to reduce government debt to 41 percent of GDP. 

Based on historical experience, these surpluses are likely to diminish over time as the 

government increases spending; the government projects domestic spending to rise by 20 percent 

in 2006. 

The Riyal has been unofficially pegged to the dollar since 1986 (officially since 2003), so 

interest rates largely followed recent increases in the United States. The Gulf Cooperation 

Council18 has set a goal of establishing a formal monetary union by 2010. 

 

Due to its large current account surplus and fixed exchange rate, the net foreign assets of the 

Saudi Arabian Monetary Agency rose to $150.3 billion from $108.6 billion during the last six 

months of 2005, providing approximately 30 months of import cover. Gross liquid reserves rose 

by a much smaller amount over the same period, rising to $23.7 billion from $22 billion. 

Singapore

Since 1988, Singapore has had a large and growing current account surplus, which reached about 

31 percent of GDP in the second half of 2005. Primarily due to the large current account surplus, 

official foreign reserves increased $1.4 billion to $116.6 billion in the second half of 2005, equal 

to seven months of imports. Singapore was the 16th largest trading partner of the United States 

in 2005. It had a deficit of $2.5 billion on trade in goods with the United States in the second 

half of 2005, compared to a $1.8 billion deficit a year earlier. 

The current account surplus has risen because investment has fallen while both public saving and 

private saving have remained high. Factors accounting for the decline in investment include the 

slowdown in the technology sector in 2001-02, the 2003 outbreak of Severe Acute Respiratory 

Syndrome (SARS) and Singapore’s declining productivity growth relative to that of other less 

 

18 GCC member countries are Kuwait, Qatar, Oman, Saudi Arabia, Bahrain, and the United Arab Emirates. 
24

developed Asian economies. Gross national saving was 47 percent in 2005, among the highest 

in the world. Despite income tax cuts last year, the government continues to register large fiscal 

surpluses, which it argues are a necessary safeguard against external shocks and to help prepare 

for the costs of an ageing population. 

Private saving makes up about two-thirds of total saving and is dominated by saving of private 

corporations and government-linked corporations, which pay limited dividends. Household 

saving has been boosted by demographic and income changes (an ageing, but not yet old, 

population; declining birth rates; high and volatile GDP growth). The government’s mandatory 

saving program through the Central Provident Fund has also supported household saving, 

although to a lesser extent since the government allows residents to borrow against the fund for 

housing. 

Singapore is a small, open economy, with imports and exports three and a half times GDP. As a 

result, inflation and inflationary expectations are heavily influenced by movements in the 

exchange rate. Singapore uses its exchange rate as the operational policy tool for monetary 

policy by maintaining a heavily managed exchange rate linked to an undisclosed basket of 

currencies of its major trading partners. Since April 2004, the Monetary Authority of Singapore 

(MAS) has had a stated policy of a modest and gradual nominal appreciation against this basket. 

The Singapore dollar appreciated 1.4 percent against the U.S. dollar in the second half of 2005, 

while JP Morgan’s nominal and real trade-weighted indexes of the exchange rate appreciated 2.8 

percent and 2.3 percent, respectively.19 In recent years, MAS has been reluctant to allow for a 

faster appreciation out of concern that this could increase the risks of a deflationary spiral. 

However, in 2005, the strengthening economy and rising oil prices caused consumer prices to 

increase 1.3 percent in December compared to a year earlier and wholesale prices to rise 11.4 

percent. 

In the first quarter of 2006, the Singapore dollar appreciated 2.8 percent against the U.S. dollar 

and its NEER and REER rose 2.3 percent and 7.0 percent, respectively. CPI rose 1.8 percent 

year on year in January 2006 and 1.2 percent in February 2006. Wholesale prices have been 

little changed so far in 2006. 

Under Secretary for International Affairs Tim Adams traveled to Singapore in February 2006 to 

discuss economic issues with officials from MAS and the Finance Ministry. Treasury staff 

continue to discuss economic developments and their implications for the exchange rate regime 

with officials from Singapore. 

India 

India’s current account deficit widened to $20 billion, or 2.5 percent of GDP in 2005, from 0.6 

percent of GDP in 2004, mainly due to stronger domestic demand and deteriorating terms of 

trade due to higher oil prices. The economy grew about eight percent yr/yr in the second half of 

the year. Private investment continued on an upswing dating back to 2004, driven by lower real 

interest rates and ample liquidity in the banking system (credit growth of 30 percent yr/yr and 

 

19 The JP Morgan index of the real value of the Singapore dollar is calculated using the price of manufactured goods 

in Singapore. Indexes for the Singapore dollar that use CPI indexes can give significantly different results. 
25

robust capital expenditures). Saving rose slightly, due mainly to corporate saving from higher 

profits. Public dissaving remained large despite some progress in reducing the public sector 

deficit currently about eight percent of GDP. Capital inflows continued to increase, particularly 

as foreign institutional investors’ assessment of India’s economic prospects improved, and they 

put more funds into stock and bond markets. The U.S. bilateral merchandise trade deficit with 

India climbed to $5.9 billion in the second half of 2005, $1 billion more than the first half. 

The monetary policy of the Reserve Bank of India (RBI) relies on targeting short-term interest 

rates to achieve price stability while monitoring the trade-weighted exchange rates over the 

medium term. The Indian rupee depreciated by about 3.5 percent against the dollar in the second 

half of 2005 and by about two percent in real terms against a basket of the currencies of India’s 

major trading partners, driven largely by a growing current account deficit. Despite this, on a 

real, trade-weighted basis, the rupee is about six percent over its average for the last 15 years. 

Overall, the accumulation of foreign exchange reserves by the RBI slowed considerably from 

previous periods with foreign exchange reserves for the six months almost unchanged at $131 

billion (which, at about seven times external debt on a residual maturity basis, is high). To date 

foreign exchange purchases have risen again in 2006. 

The government in March 2006 announced its intention to move India gradually toward full 

capital account convertibility, which would reduce capital controls significantly, particularly on 

outflows. It could also lead to the liberalization of the financial services sector to allow 

additional foreign participation, providing additional capital and expertise to the Indian financial 

system. Such moves would bolster Indian efforts to extend the yield curve on domestic financial 

assets and attract financing for infrastructure investment. 

Japan 

Japan’s economy appears to finally be exiting its long post-bubble slump after several false starts 

over the past few years. Following disappointing growth during the last three quarters of 2004, 

the Japanese economy grew at 2.7 percent in 2005, with domestic demand contributing 2.5 

percentage points. The financial health of Japan’s major banks has greatly improved, corporate 

restructuring has mostly eliminated large excesses of capacity and workers, and employment of 

permanent fulltime workers has begun rising. Business investment and private consumption 

drove 2005 growth, though net exports picked up in the fourth quarter of 2005. A continued 

economic recovery based on domestic demand should allow Japan to make a greater contribution 

to global growth and the orderly adjustment of global imbalances. 

Japan has struggled with low but stubborn deflation since 1998. Core consumer prices (the 

measure that the Bank of Japan uses as its gauge of underlying inflation) fell by 0.1 percent 

during 2005 as a whole, but increased by 0.1 percent in the last half of 2005 over the previous 

year, raising hopes for an end to deflation. Following three months of positive year-over-year 

growth in core CPI, the Bank of Japan announced on March 9, 2006 that it would change its 

monetary policy from providing substantial excess liquidity (“quantitative easing”) to a policy of 

targeting interest rates. Even with the new policy, interest rates are expected to remain very low 

for some time. The BOJ also announced a non-binding medium-term 0-2 percent CPI inflation 

definition of its target of price stability. 
26

Japan has had a persistent current account surplus and corresponding capital outflows to the rest 

of the world, a consequence of a surplus of Japanese saving over domestic investment. Rates of 

return on domestic investment have been generally low, although the recent acceleration of 

corporate restructuring and mergers and acquisition activity holds out the prospect of higher 

returns. Since the early 1990s, a decline in Japan’s household saving rate and a widening fiscal 

deficit have been offset by rising corporate net saving as firms paid off debt in order to 

strengthen their balance sheets following the collapse of the late-1980s asset “bubble.” The net 

result of these offsetting factors is that Japan’s current account surplus has fluctuated in the three 

percent range in recent years. 

In 2005, Japan’s global current account surplus fell slightly to $166 billion (3.6 percent of GDP), 

from $172 billion (3.8 percent of GDP) in 2004. Japan’s overall trade surplus declined $31 

billion to $79 billion in 2005 as imports grew by 15.7 percent, due primarily to higher prices for 

oil and other commodities, while exports grew by 7.3 percent. Japan’s bilateral merchandise 

trade surplus with the United States totaled $83 billion in 2005, up slightly from $76 billion in 

2004. Increased outward direct investment by Japanese firms and larger portfolio investment 

outflows by Japanese residents seeking higher returns abroad, particularly as interest rates in the 

U.S. and other major economies rose relative to Japanese rates, contributed to a shift in Japan’s 

private net capital flows to net outflows of $123 billion in 2005 from net inflows of $21 billion in 

2004. 

Japanese authorities did not intervene in the foreign exchange market in the second half of 2005, 

and have not intervened in the foreign exchange market since March 16, 2004.20 Japanese 

foreign exchange reserves rose by $5 billion in the second half of 2005 to $829 billion, primarily 

due to interest earnings. This contrasts with an increase in Japanese foreign exchange reserves of 

$146 billion in the first half of 2004. 

During the July 1 to December 31, 2005 reporting period, the yen depreciated 6.3 percent against 

the dollar, reaching a level of 117.88 at year-end. Nominal depreciation of the yen versus the 

dollar was 14.8 percent for the year as a whole. Rising capital outflows from Japan contributed 

to a relatively weaker yen. Since the beginning of 2006, the yen has fluctuated within a 4.3 

percent range, and as of April 25 had appreciated 2.5 percent since end-2005. 

South Korea 

South Korea shares many characteristics with other major Asian emerging markets, a large share 

of trade in GDP, strong links to the global technology market, and a high degree of integration in 

the Asian manufacturing system. Yet South Korea maintains substantial exchange rate 

flexibility, with average daily fluctuations of the won of roughly the same size as the yen and the 

euro. Despite a nine percent nominal effective appreciation of the won over the course of 2005 

and the slowing of Chinese import demand, Korea still managed GDP growth of 4.0 percent for 

the year. Growth for 2006 is expected to be in the five percent range. In addition, the exchange 

 

20 The Japanese Ministry of Finance announces its total foreign exchange intervention at the end of each month, and 

publishes the dates and amounts of intervention at the end of each quarter. See 

http://www.mof.go.jp/english/e1c021.htm. 
27

rate flexibility allowed Korea to direct monetary policy towards stimulating domestic demand, 

while still keeping inflation within its target range. 

South Korea’s current account surplus declined substantially during 2005 to $16.6 billion (2.1 

percent of GDP), from $28.2 billion in 2004. The fall in the current account surplus was due in 

part to a sharp deceleration in export growth (12 percent growth in 2005 compared to 31 percent 

in 2004) as a result of decelerating export growth to China. Korean imports also increased 

significantly, due both to higher prices of oil and other raw materials as well as rising domestic 

demand (particularly household consumption and corporate investment) as the effects of a 

household credit boom/bust dissipated. The U.S. bilateral trade deficit with Korea narrowed to 

$7.6 billion for the second half of 2005, down almost 30 percent from the same period a year 

earlier, as U.S. imports from South Korea decreased and exports to South Korea rose by five 

percent. 

Along with other Asian emerging markets, South Korea experienced a reversal of portfolio 

investment flows during the reporting period, due in part to rising U.S. interest rates. Capital and 

financial account outflows, net of increases in official reserves, totaled $4.5 billion in the second 

half of 2005, almost canceling the net inflow of $5 billion in the first half. While officials from 

the Ministry of Finance and the Economy made public statements expressing concern about won 

appreciation, the Bank of Korea reduced its foreign exchange intervention significantly during 

2005. For the year, reserve assets increased by only $20 billion, compared to an increase of 

almost $40 billion in 2004. By end-2005 reserves stood at $210 billion, equivalent to 110 

percent of the gross external debt of Korea. 

South Korea maintains a managed floating exchange rate in the context of an inflation targeting 

monetary policy framework. Finance Minister Han (who is also South Korea’s Deputy Prime 

Minster) has stated that the exchange rate should not be used as a policy tool, and has 

emphasized that exchange rates should be determined in the market. At the same time, he said 

that the South Korean Government may intervene “if abnormal factors such as foreign exchange 

speculation are in action.” Despite the rise in oil prices, the won’s rise of 9.1 percent on a 

nominal trade weighted basis during 2005 enabled the Bank of Korea to lag behind the Federal 

Reserve in raising interest rates, while keeping core inflation within the 2.5 to 3.5 percent target 

band. The won appreciated 2.3 percent versus the dollar over the course of 2005 (1.3 percent 

within the second half of the year), and during 2005 the won/dollar exchange rate varied over a 

range of 6.4 percent. In the three years through end-2005, the won has appreciated about 15 

percent against the U.S. dollar and 12 percent on a nominal effective basis. 

South Korea also implemented a liberalized system for capital transfers starting January 1, 2006. 

The system replaced a permit requirement with a reporting requirement for a number of capital 

transactions. In addition, regulations on cross boarder borrowing were eased, and asset 

management companies are now allowed to issue certain foreign currency-denominated 

investment securities. 

China 

Rapid Chinese economic growth continued during 2005, despite a series of administrative and 

market-based measures imposed by the Chinese authorities in late 2004 to reduce the growth of 
28

investment in order to reduce the risk of overheating and a hard landing. This tightening cycle 

was followed by steps to ease monetary policy following the July 21, 2005 exchange rate 

adjustment. Growth for the year was 9.9 percent, down only slightly from the 10.1 percent 

growth in 2004.21 Investment growth did fall from 2004’s torrid pace, but fixed asset investment 

still grew by 26 percent, well in excess of overall GDP growth. China recorded larger-thanexpected growth in the first quarter of 2006 of 10.2 percent, and the Chinese leadership has once 

more expressed concerns about excessive investment and credit extension, and raised domestic 

lending rates on April 28.

 

Macroeconomic imbalances increased significantly. The growth of net exports in the latter half 

of 2005 brought China’s global trade surplus to $102 billion (5 percent of GDP) for the year, 

three times the $32 billion surplus in 2004.22 The widening of the surplus came from slower 

import growth. After expanding by 36 percent in 2004, imports of goods grew by only 14 

percent year-over-year in the first half, before picking up to 21 percent year-over-year growth in 

the last half of 2005. Chinese imports decelerated due to lower investment growth and the 

displacement of imports by domestic supply in some sectors. In the first quarter of 2006, 

China’s trade surplus widened further by $23 billion (nsa). The U.S. bilateral trade deficit with 

China rose 25 percent to $202 billion in 2005 from $162 billion in 2004. The increase in China’s 

trade surplus drove a sharp increase in China’s current account surplus, which rose to $161 

billion (seven percent of GDP), a more than doubling of the $67 billion surplus in 2004.23 

Net foreign direct investment was lower in 2005 than in the previous year, and net portfolio 

capital inflows slowed sharply during the second half of 2005. After a period of strong net 

portfolio capital inflows, the falloff in the second half of 2005 was likely the result of the change 

in the Chinese exchange rate regime that occurred on July 21, tax measures to discourage 

speculative holdings of property, and wider interest rate differentials favoring U.S. dollardenominated financial assets. The sharp increase in the current account surplus accounted for 

most of the increase in reserves in the balance of payments. The stock of China’s foreign 

exchange reserves rose $209 billion during 2005, a slight increase from 2004.24 As of March 31, 

2006, Chinese foreign exchange reserves totaled $875 billion, about three times its external debt, 

and far in excess of amounts needed to cushion against adverse shocks. 

After maintaining a pegged exchange rate for eight years, the movement to a new exchange rate 

mechanism on July 21, 2005, was a significant event. But the Chinese authorities have been 

very slow in introducing exchange rate flexibility and in allowing the renminbi to adjust to 

 

21 The Chinese government revised upward its official estimates of production-based GDP for the years 1993 to 

2005 in December of 2005 to account more accurately for output attributable to the growing services sector. The 

authorities did not release revised expenditure-based GDP. As a result, we do not yet know by how much it will 

change the investment, consumption, or net exports figures, leading to revisions in the contributions of these GDP 

components to real growth rates. A better counting of the services sector, which tends to be less capital intensive, 

should contribute to a larger estimated consumption share in the economy. 

22 These trade figures are on FOB-CIF basis. If China’s imports were measured on the same basis as its exports 

(fob), China’s adjusted global merchandise trade balance in 2005 would be $134 billion. (This calculation assumes 

a 4.8 percent c-i-f (cost, insurance, and freight) adjustment factor.) 

23 Current account statistics for all of 2005 in China were published by SAFE on May 1, 2006. 

24 The PBOC used $6 billion to execute a swap transaction with local banks – both to establish the swap instrument 

and to soak up renminbi liquidity. The PBOC must mop up (“sterilize”) domestic liquidity created by accumulating 

foreign exchange reserves. The FX swap provides an alternative way to absorb renminbi funds from the market. 
29

market forces. Since July 2005 and through the end of last year, the renminbi appreciated 

gradually against the dollar, closing at 8.011 yuan per dollar as of May 1, an additional 

appreciation of only 1.2 percent since the initial change on July 21, 2005. While appreciating 

only modestly against the U.S. dollar, the renminbi strengthened (along with the dollar) against 

other currencies since last July, rising by about 2.4 percent on a nominal trade-weighted basis as 

of April 30, 2006. Daily fluctuations since the new mechanism was introduced have averaged 

only 0.025 percent, with a maximum one-day change of 0.13 percent, far less that the allowable 

daily movements of 0.3 percent. So far, the role of the reference basket of currencies has been 

extremely limited, as monetary authorities have maintained effectively a tightly managed 

crawling peg against the U.S. dollar. 

Chinese leaders’ statements of their commitment to move to a flexible exchange rate have been 

clear, and repeated at the highest level, most recently by President Hu in Seattle in April 2006, 

when he said China would “continue to develop the foreign exchange market and increase the 

flexibility of the renminbi exchange rate.” But Chinese leaders have consistently expressed a 

strong preference for a gradual adjustment in their exchange rate. This view may reflect the 

caution of the Chinese leadership in adopting fundamental policy changes in an economy 

undergoing rapid transformation and the shedding of millions of workers annually from 

agriculture and state-owned enterprises.25 It may also reflect the diversity of advice that Chinese 

leaders receive.26 

The Chinese authorities continued taking steps to enhance the market infrastructure to support a 

more flexible exchange rate regime. They introduced an interbank foreign currency trading 

system in early January; previously, the State Administration for Foreign Exchange (SAFE) had 

been the counterparty on all foreign exchange transactions. The authorities have also introduced 

new financial products to hedge against currency risk, such as forwards. But the barriers to 

greater foreign exchange rate flexibility are no longer technical. China has the means to 

introduce a much greater degree of exchange rate flexibility. Loosening management of the 

exchange rate will in fact spur the development of the market for hedging instruments when 

participants have greater incentive to hedge their exposure to exchange rate risk, and it will 

facilitate China’s transition to a more market-oriented economy. 

China has taken steps to liberalize controls on capital movements to increase the depth and 

liquidity of foreign exchange markets. Chinese authorities have continued to expand the 

program that allows foreign institutional investors to buy shares in locally listed companies. In 

mid-April, the central bank announced a series of measures to liberalize foreign exchange 

regulations that will allow Chinese residents and institutional investors to acquire more overseas 

assets. These capital account liberalization steps will offer opportunities for higher returns and 

portfolio diversification to Chinese households and thus should contribute to reduced saving. 

Despite this recent liberalization, China still maintains more extensive controls over flows of 

capital out of China than it does on inflows of foreign capital. 

 

25 This fundamental caution is also evidenced by the fact that China maintained a fixed exchange rate throughout the 

Asian Financial Crisis in 1997-98, despite the fact that many Asian currencies depreciated sharply against the U.S. 

dollar, and thus against the renminbi. 

26 At least one prominent economist has argued that China should maintain its fixed exchange rate and risks falling 

into deflation similar to what Japan experienced should its currency appreciate. 
30

China’s leaders have also recognized that the country’s growth cannot be maintained through 

continued reliance on net exports. They have expressed their clear intent and commitment to 

reduce China’s current account surplus and shift the sources of Chinese growth away from 

foreign demand and investment, in particular to increased consumption expenditure. When 

President Hu came to Washington in April, he outlined China’s intent to boost domestic demand 

and reduce China’s trade surplus. To spur domestic demand, China has placed strong emphasis 

on consumption and rural development in its most recent Five-Year Plan. To boost disposable 

incomes of the rural poor, the government has recently decided to cut agricultural taxes and 

eliminate fees for rural primary education. It also plans to direct more capital and social 

spending to the rural sector. 

The counterpart to China’s high investment and its current account surplus is a saving rate of 

roughly 50 percent of GDP, which may be the highest in the world. Household saving reflects a 

weak social safety net and limited access to financing and insurance; households need high 

saving in the event of serious illness, disability, or to pay for children’s education. The “iron rice 

bowl” of cradle to grave wages and benefits has disappeared and a modern social safety net has 

not yet been erected. Chinese state and private firms also save heavily – and re-invest the profits 

they earn rather than paying out dividends. 

There are a number of additional steps that China could take to lower saving and boost domestic 

demand. Policies to encourage China’s state-owned enterprises to distribute some of their 

earnings as dividends to the government would reduce their saving and their inefficient 

investment, and could contribute to greater social welfare expenditure or reduced taxes. 

Strengthening and increasing enrollments in public pension and health insurance systems, 

particularly in rural areas, are also important steps. 

Financial sector modernization is a critical element of improving the efficiency of investment 

and facilitating increased consumption. Increasing the range of financial products available to 

households could reduce household precautionary saving for disability and catastrophic illness, 

reduce the need to save in advance to finance education and other major expenses, and make 

higher return investments available to households. All of these would allow households to save 

less and spend more, boosting Chinese domestic demand. 

China has been working to modernize its financial system, tightening its risk classification 

system for bank loans, deregulating bank lending rates, and developing financial-sector 

infrastructure. Foreign entry and expertise is an important part of China’s strategy for 

modernizing the financial system. Foreign strategic investors have invested more than $17 

billion in Chinese banks in the last 18 months. In addition, international institutional investors 

have invested around $11 billion in the public listings of two of China’s five largest banks. 

These investors will subject the management of these institutions to tighter surveillance and 

market forces. In the capital markets, China has made progress converting all shares to tradable 

shares, expanding access to locally listed shares for foreign institutional and strategic investors. 

Despite this progress, much needs to be done to improve China’s financial markets. Deeper 

bond markets would reduce corporate reliance on state-controlled lenders and more active 

derivatives trading would allow firms to manage risk better. On the banking side, the stateowned banks still account for most credit. China needs to increase competition including by 
31

raising foreign ownership caps on securities firms and purchases of existing state-owned 

companies, which would increase competition as well as provide capital, risk management, and 

new products. The more flexible interest rates that would result from a more market-based 

exchange rate would also improve the financial sector’s ability to allocate credit through market 

forces to investment with the highest return. 

Rebalancing the sources of Chinese growth and improving the efficiency of Chinese financial 

markets will be requirements for sustaining future Chinese growth. But greater exchange rate 

flexibility, through changing internal prices of domestic and internationally traded goods will be 

a fundamental part of that rebalancing. While the hesitancy of the Chinese leadership to 

introduce greater exchange rate flexibility may be real; its concerns about the effects of an 

accelerated introduction of flexibility and market determination of the renminbi exchange rate 

are unfounded. Chinese export growth accelerated in the final quarter of 2005 and into 2006, 

despite the strengthening of the exchange rate. In fact, first quarter 2006 GDP growth at over 10 

percent has again raised questions of overheating. The experience of South Korea, described 

above, illustrates that a substantial degree of exchange rate flexibility and an exchange rate 

appreciation far greater than China has experienced can be incorporated in a growing economy. 

Chinese leaders have also expressed concerns about the effects of a fully floating exchange rate 

on the Chinese banking system. However, we are not asking China for an immediate full float of 

the currency with full liberalization of controls on capital movements. China can introduce a 

much greater degree of exchange rate flexibility without risk to its financial system. In fact, the 

current slow pace of moving towards flexibility carries its own risks to the financial system, as 

People’s Bank of China Governor Zhou has noted. It has led to large capital inflows that have 

fueled rapid credit growth and property market speculation. Low real interest rates and rapid 

loan growth in turn weaken bank lending discipline, risking the creation of a new generation of 

non-performing loans. 

China’s tightly managed exchange rate regime has become an increasingly significant systemic 

risk, both in China’s domestic economy and the global economy. Its peg constrains monetary 

authorities’ ability to adjust interest rates and the growth of monetary aggregates and credit at a 

time when credit growth is fueling a re-acceleration of investment. The expanded scope to vary 

interest rates with a more flexible currency regime would promote more efficient and prudent 

financial intermediation, and help avoid credit-fueled investment booms and resulting buildups 

of excess productive capacity and non-performing loans in the banking system. Moreover, as 

China proceeds in its transition toward a market economy, command-and-control tools are losing 

their effectiveness, and exchange rates, interest rates, and other price mechanisms will become 

more important to achieve and maintain macroeconomic stability. The price signals that come 

from a more flexible exchange rate would be a critical part of readjusting China’s economy to 

produce more balanced and sustainable growth and contributing to an orderly reduction of global 

imbalances. Greater exchange rate flexibility in China would make other Asian governments’ 

authorities, concerned about their relative external competitiveness vis-à-vis China, less reluctant 

to allow their exchange rates to adjust. 

Treasury will continue to intensify its bilateral and multilateral efforts to encourage China to 

move more rapidly to a market-based, flexible exchange rate. In what have now become regular 

meetings with the leaders of the People’s Bank of China, the Chinese Ministry of Finance, and 
32

the National Development and Reform Commission, Treasury officials consistently emphasize 

the necessity of more rapid introduction of exchange rate flexibility under China’s new exchange 

rate mechanism. The G7, the IMF, the Asian Development Bank, and the OECD have all called 

on China to introduce greater exchange rate flexibility. Discussions begun under the Technical 

Cooperation Program on foreign exchange market issues have developed into a broader 

discussion of strengthening China’s financial and foreign exchange markets to support greater 

exchange rate flexibility. U.S. and Chinese financial regulators conducted their second Financial 

Sector Working Group talks on April 24. Also in April, Treasury’s Financial Attaché assumed 

full-time permanent residence in Beijing. Treasury will continue to encourage Chinese 

economic leaders to interact with leaders of the major economies that share systemic 

responsibility, with the clear understanding that the role China now plays in global trade carries 

responsibilities for contributing to an orderly reduction of external imbalances and global 

conditions conducive to continued support for open trade and investment. 

Taiwan 

Robust global high-tech demand and an increase in Taiwan’s exports led to stronger growth in 

the second half of 2005. Taiwan’s current account surplus in the second half of 2005 was $10.7 

billion (6.3 percent of GDP), up from a surplus of $5.5 billion in the first half. Even with the 

second half increase, the current account surplus for 2005 as a whole was the lowest annual 

figure since 2000. Taiwan’s bilateral trade surplus with the United States was $7.0 billion in the 

second half of 2005, down very slightly from the same period a year earlier. The U.S. bilateral 

deficit with Taiwan peaked at $16.1 billion in 2000, and has declined since then, to reach $12.8 

billion in 2005. The decline in the U.S. bilateral deficit with Taiwan, in a period in which the 

U.S. global trade deficit rose substantially, reflects increasing Taiwanese investment in China 

and the use of China as a final assembly point for exports destined for the United States and 

other third country markets. 

Portfolio capital outflows in the second half of 2005 offset most of the inflows from the first half 

of 2005, resulting in a very small net inflow with regard to the capital and financial accounts for 

the year. Taiwan residents’ investment in foreign securities in 2005, $36 billion, was a recordhigh, spurred by the gap between the interest rates for New Taiwan Dollar (NTD) deposits and 

U.S. dollar deposits. 

Taiwan maintains a heavily managed exchange rate. However, in the second half of 2005, the 

central bank’s foreign exchange intervention declined significantly. Taiwan’s foreign exchange 

reserves at end-2005 were $253 billion, unchanged from their end-June level. In the first 

quarater of 2006 reserves have risen slightly, to $257 billion at the end of March. Nevertheless, 

by end 2005, Taiwan’s ratio of foreign exchange reserves to GDP (78.2 percent) was the second 

largest in the world and the ratio of reserves to short-term external debt was over four. 

After appreciating by 6.6 percent against the dollar over the course of 2004, the NTD remained 

virtually flat in the first half of 2005, and then depreciated by 3.5 percent by year-end. In the 

first three months of this year, the NTD has appreciated by 2.4 percent against the dollar. 
33

Malaysia

Malaysia’s current account surplus increased to 15.3 percent of GDP ($19.9 billion), from 12.6 

percent of GDP in 2004. Large current account surpluses have been a striking feature of the 

Malaysian economy in the last few years, even before higher oil prices (Malaysia is a net oil 

exporter) expanded the surplus. Malaysia’s current account surplus is driven in large part by the 

low level of domestic investment, which dropped off sharply after the Asian financial crisis and 

continues to decline (20.0 percent of GDP in 2005). Part of this decline was expected after the 

investment boom just prior to the 1997 Asian financial crisis, but Malaysia’s investment rate is 

almost 15 percentage points below its level in the early 1990s, and there have been sharp 

declines in both domestic private and foreign direct investment. The reasons for the sharp fall in 

investment are not clear; reasons that have been suggested include declining competitiveness of 

Malaysia vis-à-vis other Asian economies, shortages of complementary inputs (particularly 

skilled labor), policy efforts to shift towards a more service-oriented economy, and the effect of 

excessive government regulation. 

Despite the rise in the annual current account surplus in 2005, the surplus for the second half of 

2005 was $9.7 billion, or 14.1 percent of GDP, down from the 16.5 percent in the first half of 

2005. This drop in the surplus was due entirely to a fall in investment income; the goods and 

services trade balance rose slightly in the second half of the year (not seasonally adjusted). 

Malaysia’s bilateral trade surplus with the United States totaled $12.8 billion in the second half 

of 2005, compared with $9.7 billion in the second half of 2004. 

Within hours of China’s revaluation on July 21, Malaysia abandoned its peg of 3.8 ringgit per 

dollar and adopted a managed float that is “determined by economic fundamentals.” Over the 

next few days of trading the ringgit appreciated by 1.3 percent. Through the rest of 2005 the 

ringgit exchange rate gradually depreciated slightly, ending the year at 3.78, an appreciation of 

0.5 percent from its previous pegged rate. Since the end of 2005, however, the ringgit has 

appreciated steadily, reaching 3.59 per dollar by May 8, a cumulative appreciation of over 5.4 

percent. The pace of appreciation has accelerated markedly since April 18, with over one third 

of total appreciation occurring since that time. The magnitude of average daily fluctuations, 

around 0.1 percent, is still small, but a marked increase over 2005. 

Speculation leading up to the change in exchange rate policy and a gradual reversal of some of 

the initial appreciation during the remainder of the year strongly influenced Malaysian capital 

flows. After strong net capital inflows prior to the change in exchange rate regime, Malaysia’s 

financial account saw surging outflows in the fourth quarter of 2005. The financial account 

deficit for the second half of 2005 spiked to $10 billion (compared to a surplus of $1 billion in 

the first half of the year). This is due in large part to the unwinding of speculative positions on 

ringgit appreciation. Bank Negara Malaysia intervened to slow the ringgit’s depreciation, and 

foreign exchange reserves declined by about $5.6 billion in the fourth quarter. 

Inflation, while still moderate, rose measurably in 2005 to three percent from 1.4 percent the year 

before. This was due in large part to high global oil prices, cuts in domestic fuel subsidies, and 

increased communications costs. Inflation spiked in March 2006 to 4.8 percent, on the heels of 

another government increase in fuel prices. Bank Negara Malaysia has raised the overnight 

policy rate three times since November, 80 bps to 3.5 percent in an effort to curb rising inflation. 
34

Malaysia had already relaxed most of its controls on capital flows imposed when the ringgit was 

pegged in 1998. There are a few remaining controls: offshore trading of the ringgit remains 

prohibited, and foreign portfolio investment by residents continues to be limited. 

Malaysia’s move to a managed floating exchange rate regime was an important step to address 

the external and domestic imbalances suggested by the large and rising current account surplus. 

Malaysia could benefit from a greater degree of exchange rate flexibility, to better manage 

domestic demand and inflation and to allow changes in internal prices and resource reallocation 

to support growth. Since the last report, Under Secretary Adams and other Treasury officials 

initiated consultations with the Malaysian authorities on exchange rate policy in the context of 

overall Malaysian macroeconomic policy. The additional ringgit flexibility introduced since the 

beginning of 2006, in particular the increased flexibility that has been observed during the past 

month, is welcome.