JS-2308: Report To The Committees On Appropriations on Clarification Of Statutory Provisions Addressing Currency Manipulation

Report To The Committees On Appropriations on Clarification Of Statutory Provisions Addressing Currency Manipulation

Introduction
This report was prepared pursuant to Section 221 of Title II of Division H of the Consolidated Appropriations Act, 2005 (Public Law 108-447). This Section states that: "Not later than 60 days after the enactment of this Act, the Secretary of the Treasury shall submit to the Committees on Appropriations a report describing how statutory provisions addressing currency manipulation by America's trading partners contained in, and relating to, Title 22 U.S.C. 5304, 5305 and 286y can be better clarified administratively to provide for improved and more predictable evaluation, and to enable the problem of currency manipulation to be better understood by the American people and the Congress."

Title 22 U.S.C. 5304 requires, inter alia, that the Secretary of the Treasury 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 adjustment or gaining unfair competitive advantage in international trade. Section 5304 further requires that: "If the Secretary considers that such manipulation is occurring with respect to countries that (1) have material global current account surpluses; and (2) have significant bilateral trade surpluses with the United States, the Secretary of the Treasury shall take action to initiate negotiations with such foreign countries on an expedited basis, in the International Monetary Fund or bilaterally, for the purpose of ensuring that such countries regularly and promptly adjust the rate of exchange between their currencies and the United States dollar to permit effective balance of payment adjustments and to eliminate the unfair advantage."

Title 22 U.S.C. 5305 requires, inter alia, the Secretary of the Treasury to provide reports on international economic policy, including exchange rate policy. Among other matters, the reports are to contain the results of negotiations conducted pursuant to Section 5304.

Title 22 U.S.C. 286y requires the Secretary of the Treasury, inter alia, to initiate discussions with countries regarding economic dislocations which result from structural exchange rate imbalances; and to instruct the United States Executive Director of the International Monetary Fund to work for adoption of policies in the Fund that promote conditions contributing to the stability of exchange rates and avoid the manipulation of exchange rates between major currencies.

Summary
The assessment of whether an economy is manipulating the rate of exchange between its currency and the U.S. dollar for the purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade is inherently difficult. The determination of exchange rates reflects the interplay of macroeconomic and microeconomic forces throughout every corner of the world. Assessments under Section 5304 require a comprehensive review of significant international economic developments and an evaluation of the factors that underlie those developments. In making such assessments, Treasury is guided by the following considerations:

Manipulation
There are many inherent difficulties in rendering assessments of when a currency is being manipulated to prevent effective balance of payments adjustments or gain unfair competitive advantage in international trade. However, the authorities of an economy could be said to "manipulate" the exchange rate in terms of Section 5304 if they intentionally act to set the exchange rate at levels, or ranges, such that for a protracted period the exchange rate differs significantly from the rate that would have prevailed in the absence of action by the authorities. A significant difference between a market rate and an underlying "equilibrium" rate could also arise from the interplay of economic forces or other factors.

There are many reasons why the authorities might seek to influence the exchange rate. For example, they may wish to counter disorderly market conditions; or use the exchange rate as an anchor for monetary policy; or build up international reserves to reduce vulnerability to possible currency crises. If an economy manipulates its exchange rate in order to prevent effective balance of payments adjustments or achieve an unfair advantage in international trade, however, this can be very harmful to other economies and the global financial system.

In order to render assessments on foreign economic and exchange rate policies, Treasury staff monitors economic and financial developments in countries across the globe on a real-time basis.

The International Monetary Fund also conducts surveillance over members' exchange rate policies as required by the Articles of Agreement. The IMF Executive Board adopted general principles in 1977 that continue to provide guidance with respect to these obligations.[1] Treasury consults regularly with the International Monetary Fund on what constitutes exchange rate "manipulation" as discussed above, both in the context of the reports required under Section 5304 and on an ad hoc basis.

Further, the United States has urged the IMF to strengthen its surveillance of exchange rate issues in its regular Article IV consultations. In particular, the IMF has been urged to make candid discussions of exchange rate policy a routine exercise, particularly when a fixed peg is involved. The United States has also emphasized that further work on exit strategies from managed exchange rate regimes (involving direct official intervention or indirect intervention such as through the banking system) is a priority. Engagement with the IMF is continuing on many levels so that the IMF undertakes a thorough, clear, and analytically rigorous assessment of exchange rate issues in its surveillance, even when the country authorities' views diverge with those of IMF staff.

Country Examinations
Although a broad range of economies in all regions of the world are routinely examined, in light of the requirements of Section 5304, those countries with large overall current account surpluses or large bilateral surpluses with the United States are reviewed more thoroughly. The term "material global current account surpluses," used in Section 5304, is taken to mean large current account surpluses, measured as a percent of an economy's GDP. The term "significant bilateral trade surplus," used in Section 5304, is taken to mean a large bilateral trade surplus with the United States, relative to the size of U.S. trade.

In measuring bilateral trade surpluses, the Treasury uses Bureau of Census statistics on trade in goods. Foreign official statistics are typically used in the examination of global current account balances, which includes global trade balances. China's global trade surplus (a major component of the current account surplus) as reported in aggregate by China's trading partners, however, differs markedly from what is reported by Chinese official statistics. Treasury is undertaking an investigation to see how this arises and what, if any, of the difference can be reconciled.

The discrepancy between the estimate of China's trade surplus reported by Chinese authorities and by China's trading partners has been investigated in a number of studies.[2] One difficulty that arises is that much trade to and from China travels via Hong Kong. Importing countries usually accurately determine the source of their imports through certificates of origin. But exporters (both Chinese and partner country exporters) often record the destination of their exports as Hong Kong, even though the goods go on to other markets. This explains a significant part of the discrepancy between Chinese and partner country trade estimates of China's trade surplus, since a significant part of the trade between China and partner countries is recorded as trade with Hong Kong. (It is worth noting that the discrepancy between Chinese and partner country trade data is mirrored in partner country data with Hong Kong. In 2003 Hong Kong reported a global trade deficit of $8 billion, while partner country data showed a $121 billion surplus with Hong Kong.)

Correction for exports reported to Hong Kong but destined elsewhere, and for the addition of cost, insurance, and freight to exports substantially reduces, but does not completely eliminate, the discrepancy between Chinese and partner country trade data. Treasury considers both Chinese and partner country data in analyzing the size of China's global current account surplus.

Analysis of Foreign Exchange Rate Policies
In making its assessments, Treasury undertakes a careful review of trading partners' exchange rates, external balances, foreign exchange reserve accumulation, macroeconomic trends, monetary and financial developments, state of institutional development, and financial and exchange restrictions. Developments in any one area do not typically provide sufficient grounds to conclude that exchange rates are being manipulated. A combination of factors can lead, and has in the past led, Treasury to find that certain economies were manipulating their currencies consistent with the terms of Section 5304. China, Taiwan, and South Korea were each considered to be manipulating its currency in terms of Section 5304 during different periods in the years 1988 through 1994 (see Attachment II).

Many formal models, as well as a great deal of informal reasoning, have been used over the years to attempt to explain exchange rate determination.[3] These efforts have helped enhance understanding of exchange rate trends and issues. But no approach or model has been fully able to describe observed market-determined exchange rate behavior. The results of any analysis of exchange rate behavior can vary substantially depending on the approach used.

To assist in the identification of exchange rate manipulation, analysts examine indicators that are consistent with official actions to manipulate currencies for the purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade. Though potentially helpful, these indicators are generally not dispositive in and of themselves in determining that a specific economy has manipulated its exchange rate under the terms of Section 5304. In addition to standard macroeconomic and microeconomic analysis, these indicators include, inter alia: (1) measures of undervaluation; (2) protracted large-scale intervention in one direction; (3) rapid foreign exchange reserve accumulation; (4) capital controls and payments restrictions; and (5) trade and current account balances. These indicators are described in detail below.

A large "undervaluation" of a market exchange rate may exist relative to an "equilibrium exchange rate," calculated using a specific model. However, calculating such an "equilibrium" exchange rate is quite difficult given that the given methodological approach may not capture observed market behavior.

Further, even if a currency can be identified as "misaligned" in the sense that it deviates substantially from its "equilibrium exchange rate," as determined by a specific model, that does not necessarily mean that "manipulation" is occurring. For example, if a country initiated a contractionary fiscal policy and an expansionary monetary policy, which temporarily lowered real interest rates, the model might be incapable of predicting the amount by which the country's currency would depreciate. In such circumstances, the "misalignment" might reflect problems with the model describing market reaction to the fundamental macroeconomic policy mix, but not "manipulation" of the exchange rate.

Similarly, if there were a large, unexpected surge in private capital outflows from a country, driving down the exchange rate, the exchange rate could appear to be "misaligned" due to inadequate modeling of market behavior. However, this would not be attributable to developments in the current account, and it again would not necessarily imply "manipulation."

Protracted large-scale intervention in one direction also merits attention in any consideration of "manipulation," insofar as such intervention could reflect an effort by the authorities to maintain a given exchange rate level in the face of market pressure for the purposes of Section 5304.

Intervention can be carried out for a number of purposes. IMF surveillance procedures provide that: "A member should intervene in the exchange market if necessary to counter disorderly conditions, which may be characterized inter alia by disruptive short-term movements in the exchange value of its currency. Members should take into account in their intervention policies the interests of other members, including those of the countries in whose currencies they intervene."[4]

Evidence shows that the effectiveness of intervention in influencing exchange rate behavior is, at best, short-lived. Intervention can, however, impact domestic inflation. As a result, most countries "sterilize" their intervention so that the impact of intervention on the monetary base is offset. Although short-term sterilized intervention may be effective in offsetting short-term foreign exchange market shocks, there is little evidence that it has long-term effects on the exchange rate.

The ability of governments to marshal sufficient resources for effective intervention is also often limited by the size of the foreign exchange market – for example, according to the latest Bank for International Settlements survey (2004), average daily turnover is $1.9 trillion in traditional foreign exchange markets (spot transactions, outright forwards, and swaps) and $1.2 trillion in over-the-counter currency and interest rate derivatives markets.

When a country's financial authorities purchase foreign exchange, that country's reserve holdings typically rise. For example, if a country had a large balance of payments surplus and intervened heavily to absorb capital inflows, its foreign exchange reserves could rise rapidly. There are many reasons why a country might wish to increase its reserves, and there is no universally agreed optimum level of reserves. Some countries – for example, countries with a heavy tourist season – experience large seasonality in their balance of payments, which they might wish to smooth to avoid significant swings in their exchange rate. Other countries may need to buy foreign exchange in order to make payments on external debt or to counter disorderly market conditions.

After the Asian financial crisis, many economists came to believe that emerging markets and developing countries needed to raise their reserves in order to take account of volatility in short-term capital flows. U.S. foreign exchange reserves tend to be quite small, reflecting in large measure the dollar's predominant role as a reserve currency in the international monetary system.

Capital controls also warrant attention in making assessments regarding currency manipulation. Capital controls can be applied to inflows (limiting upward pressure on domestic currency) or outflows (limiting downward pressure on the domestic currency). Some countries have used controls on inflows out of concern that large short-term portfolio investment from major financial centers could suddenly reverse – disrupting small domestic capital markets. If controls are placed on outflows, lifting them could result in increased capital outflows that cause the domestic currency to depreciate.

More broadly, capital controls prevent capital from flowing to its most productive uses. They involve significant administrative costs, reduce the pressure on countries to institute needed economic reforms, and can increase the risk to the domestic economy in times of crisis (for example, by limiting sources of funding if there is a shock to domestic credit markets).

Payments restrictions regulate the use of foreign currency to buy goods and services and can be very distortionary. Residents of a country with such restrictions may wish to buy certain foreign goods or services but may be denied the foreign currency necessary to make the purchase even if they are willing to do the transactions at the formal exchange rate. The General Obligations of IMF members severely discourage restrictions on current international transactions[5].

Many analysts focus on the impact of exchange rates on trade flows, often examining developments in bilateral trade balances and current account balances. Bilateral balances, however, reflect unique patterns of demand or comparative advantage and are therefore highly limited in their ability to explain exchange rate movements. For example, it is quite understandable that the United States would have a large bilateral deficit with a country that is a major oil exporter. At the same time, in a multilateral trading system, a bilateral deficit with one country can be offset by a bilateral surplus with another.

Current account positions reflect a country's balance on trade in goods and services (normally the largest component), plus its balance on income and transfers. Trade balances are heavily affected by cyclical forces – the growth of one economy's income relative to that of its major trading partners. Indeed, a principal cause of the widening of the U.S. current account deficit in recent years has been the strong cyclical performance of the U.S. economy relative to many other major industrial economies. Trade may also be affected by a number of factors that influence costs and prices in one economy relative to its trading partners – for example, exchange rate movements, growth in productivity, and relative monetary conditions. Given the large US current account deficit, it is natural that the counterpart to the deficit is to be found in large surpluses in other countries of the world.

The current account balance is, by accounting definition, equal to the gap between saving and investment in a country.[6] Saving is equal to public and private saving and is thus affected by fiscal policy and individual saving decisions. Investment is determined by business decisions, which depend on productivity, interest rates, and the relative attractiveness and risk-adjusted returns of economies.

A current account deficit must be financed from abroad, by foreigners acquiring more assets in the deficit country than the deficit country is acquiring abroad. Alternatively stated, a current account deficit is mirrored in capital and financial account inflows (including changes in foreign exchange reserves). Thus, exchange rate determination is strongly affected by global capital flows. Strong inflows of capital into the United States in recent years have been attracted by sound U.S. economic performance, the attractiveness of the U.S. investment climate, and the depth and liquidity of U.S. financial markets. When global tensions arise, there can also be "safe haven" demand for such currencies as the U.S. dollar.

As a share of GDP, current account balances vary widely (see table). The globalization of financial markets has given investors greater freedom in placing their assets and has supported greater dispersion of the size of current account balances and net foreign asset positions.[7]

Different Exchange Rate Regimes
There is considerable diversity in the exchange rate regime choices of countries, ranging from flexible exchange rate systems with little or no intervention to currency unions and full dollarization. Until the early 1970s, the international economy had generally operated with pegged exchange rates – as under the pre-WWII gold standard and the post-WWII Bretton Woods system. Even after the collapse of the Bretton Woods system, European economies continued to maintain relatively fixed exchange rate arrangements among themselves, culminating in the creation of the euro. The IMF Articles of Agreement (Article IV) provide that members have the right to determine their own exchange rate arrangements.[8]

Many countries have continued to choose a form of pegged exchange rate regime, particularly countries which are small and open; trade significantly with a country to whom their currency is pegged; have limited financial sector development; lack a significant capacity to implement an independent monetary policy and instead use the exchange rate as a nominal anchor; or believe that exchange-rate based stabilization is an attractive method to address high inflation. Strong exchange rate pegs, such as currency board arrangements and outright dollarization, have also been used by a number of countries in recent years. A country's macroeconomic policies should be consistent with whatever exchange rate regime is chosen.

Conclusion
The determination of foreign exchange rates is a complex process that involves countless economic decisions, both at the national and global levels. Although there are many plausible reasons that authorities might seek to influence an economy's exchange rate, there is a legitimate concern that some countries might succeed in manipulating an exchange rate to prevent effective balance of payments adjustments or to achieve an unfair competitive advantage in international trade. The assessment of whether an economy is manipulating the rate of exchange in terms of Section 5304 requires a comprehensive review of significant international economic developments to determine if a country is able to manipulate the rate of exchange for those purposes and succeeds in creating an unfair competitive advantage or preventing effective balance of payments adjustments.

Treasury has broadly used the approach outlined above since it began assessing foreign exchange policy under Section 5304. Treasury has stated, in the past, that it considered certain economies to be manipulating their exchange rates in terms of that Section. It continues to carry out these assessments vigorously and will report to Congress on any economy that it considers to be manipulating its exchange rate in terms of Section 5304 and on the negotiations required with such an economy under that Section. Treasury must continuously monitor country economic developments and global financial markets in every corner of the world on a real-time basis to render its assessments.

[1] See "Surveillance over Exchange Rate Policies," Decision No. 5392-(77/63), 4/29/1977, as amended (also included as Attachment III).

[2] The discrepancy between estimates of China's global trade surplus based on Chinese and partner country statistics was analyzed in the 301 petition submitted by the Fair Currency alliance in April 2004. The global discrepancy is currently being analyzed by Treasury, and also by John Schindler and Dustin Beckett at the Federal Reserve ("How Big is China's Trade Surplus," unpublished draft, 2005). Studies of the US-China bilateral trade balance have been conducted by Fung and Lao (K.C. Fung, Lawrence J. Lau, "New Estimates of the United States - China Bilateral Trade Balances," Institute for International Studies, Stanford University, April 1999) and by Voon and Kueh (J.P. Voon and Y.Y. Kueh, "Country of Origin, China's Value-Added Exports, and Sino-U.S. Trade Balance Reconciliation," paper presented to the Third Sino-American Relations Conference, Hong Kong, November 15-16 1999).

[3] Examples include purchasing power parity, the monetary approach, and the portfolio balance approach, as well as numerous formal macroeconomic models.

[4] IMF, Surveillance over Exchange Rate Policies, April 29, 1977.

[5] Article VIII, Section 2(a) of the IMF Articles of Agreement states: "Subject to the provisions of Article VII, Section 3(b) and Article XIV, Section 2, no member shall, without the approval of the Fund, impose restrictions on the making of payments and transfers for current international transactions." The IMF does not have authority over the capital account.

[6] In the first half of 2004, the US current account deficit was $594 billion (seasonally adjusted, on a national income accounts basis). This deficit equaled the gap between $2,246 billion in investment and $1,652 billion in saving. That is, U.S. domestic investment was $594 billion more than domestic saving with net foreign investment making up the difference.

[7] See, for example, "Financial Globalization and Exchange Rates," Philip Lane and Gian Maria Milesi-Ferrretti, IMF Working Paper, January 2005.

[8] See also "Exchange Rate Regimes in an Increasingly Integrated World Economy;" Occasional Paper 193; Michael Mussa, Paul Masson, et al., International Monetary Fund, 2000.