Exchange Rates

The prospects for moving from a three month truce to a more durable ceasefire and eventual resolution of the current trade conflict with China have become a central focus of global markets. The issues that need to be sorted out are too complex to be addressed in full in ninety days, but it is certainly possible that enough progress could be made in the next ninety days to allow both sides to decide to continue the negotiations.   I personally hope that the administration’s focus on structural issues will go beyond the structural issues that have impeded investment in China by U.S. firms. Letting more U.S. firms invest in China on their own terms—and not just on China’s terms (through a JV, often with tech transfer)—is important. But it won’t do much to expand the number of manufacturing jobs supported by exports to China—doing that requires making it possible for U.S. firms to export to China, not just for U.S. firms to produce in China to sell in China. Finding a deal that tears down the barriers to selling more American made capital goods, which are often bought by state firms whose management is appointed by the party, is in some ways harder than finding a solution to concerns about IPR theft, or even tech transfer (which would be structurally addressed by lifting the JV requirements).   Concretely I suspect that this means seeking commitments from China to offset the trade impact of its (non-negotiable, I assume) industrial policy in civil aviation on U.S. exports, and making sure that China is open to imports of things like U.S. made medical equipment. Autos, I fear, are now a lost cause.* U.S. exports of manufactures to China haven’t been growing since 2012—and over a long-time horizon, they have grown more slowly than China’s economy.** I also assume that an informal part of the current “pause” is a “pause” in Chinese depreciation, even as China's own economy slows. A weaker yuan wouldn’t create a conducive atmosphere for negotiations. And, well, I think the yuan is still something that China effectively manages.   By managing the flows that are allowed to keep the market in equilibrium. By sending signals about the price that the Chinese government wants to see in the market. The counter-cyclical factor in the daily fix being the most obvious. And by buying or selling foreign currency as needed—or instructing the state banks to do so on its behalf. The only real question is whether China is ultimately managing against the dollar (and thus intent on defending seven to the dollar) or managing against a basket. Or managing against the dollar at some times and the basket at others, depending on its needs of the moment. For now, I think the facts still fit best with “management against a basket”—with the yuan allowed to float in a narrow band around an undeclared central point vs. the basket (see the chart above), but with active intervention (see the swings in the settlement data below) as needed at the edges of the band. But it is striking that many active in the FX market believe that China ultimately is still targeting the dollar-yuan (dominant currency pricing and all, and, well, seven still seems to be an important number) rather than the basket. The settlement data for October and the rise in headline reserves in November suggest that the amount of actual intervention needed to keep the yuan inside the basket has been pretty modest recently. Surprisingly modest in fact, as in the past downward moves in the yuan have triggered large-scale outflows. So modest that some think that there is a bit of hidden intervention (state banks borrowing dollars through the swaps market e.g. swapping yuan for dollars and then selling the dollars and buying yuan spot to support the yuan). See Mike Bird of the Wall Street Journal in late October. I though haven’t (yet) found a smoking gun that clearly points to more intervention then net sales of $50b in settlement data since July. And more generally, I am struck by the fact that the flow of foreign exchange in and out of China, while regulated heavily, now seems to be fairly close to balance. The current account for one is far closer to balance than it has historically been. That reflects some one off factors—China’s willingness to allow large scale outward tourism (and to look the other way if this leads to some backdoor financial outflows), the 2018 rise in oil prices, the 2018 rise in memory chip prices, higher iron ore imports after supply side reforms shut down some low quality, polluting Chinese production. But for now the measured current account is close to balance, and the goods surplus basically covers the services deficit from tourism and "hot" outflows. I am not as convinced as the market that China’s current account will swing into deficit next year—at least so long as the trade truce remains in place. Falling oil and semiconductor prices are almost certain to slow the growth in China's imports next year. Note that the overall trade surplus (and the surplus with the United States) rose amid weak trade in November.  And the financial account also looks relatively balanced— I think that reflects three or four things: “Hot” outflows through errors and omissions are pretty close to the “basic balance” (the sum of the current account plus net FDI flows). This took a bit of work—China had to crack down on the currency speculation embedded in the FDI outflows from the Anbangs and HNAs and Wanda’s of the world. But China did that in early 2017, and that led to a structural improvement in the basic balance of around $100b a year. The controlled opening of China’s financial account to portfolio flows has attracted a real inflow—$150b in bond inflows in the last four quarters of data. The state banks have been able to borrow abroad to finance their lending abroad. So far—and the data here is still patchy—the yuan’s move this summer doesn’t look to have led to a large reversal in bank flows. My guess is that’s because the nature of the bank flows has shifted. Back in 2015, the inflows were funding carry trades (Chinese firms wanted to borrow in dollars, because they could then sell the dollars and hold higher yielding yuan assets). The more recent inflows look to have financed the dollar lending of the state banks. Though they may also have funded some leveraged firms squeezed out of the yuan funding markets by the deleveraging campaign.   The net result is that, gulp, as long as all of the conditions above hold, the “structural” need for China to intervene heavily has fallen.     The current account plus net FDI flows*** covers the leakage from Chinese capital flight (in errors and omissions). And the gap between those two numbers is still a good predictor of "true" intervention.**** And it will remain a good proxy for the intervention need so long as the formal, measured, and largely regulated part of the financial account basically balances. Inflows through regulated channels (the bond inflows) and through offshore borrowing by regulated entities (the state banks) has roughly matched the outflow associated with the build of foreign assets by the state banks. The banks have been buying bonds offshore and building up some potential ammunition if they are called on to intervene, and they also have been supporting the belt and road. Which means, at the end of the day, that the flows in China’s foreign exchange market seem to be in rough balance at the current exchange rate—and that as a result it doesn’t take a ton of effort (or intervention) for China to keep the yuan where it wants the yuan. So what matters for the market (for now) is less the flows and more the politics. And so long as the negotiations with the United States are ongoing, I suspect (or perhaps just hope) that the politics will push the Chinese to keep the yuan from testing new lows.   * BMW is the largest exporter of cars and SUVs from the United States to China. And China recently let it obtain majority control of its JV as a sweetener to get it to raise its Chinese production. Mercedes now wants a bigger stake in its JV as well. (For high margin cars and SUVs, the JV requirement effectively acts as a tax, one that encouraged imports rather than Chinese production). Plus, Keith Bradsher's reporting suggests that the U.S. auto companies have no economic incentive not to use their existing Chinese supply chain to supply the Chinese market. In fact, at current exchange rates, I suspect they increasingly have an incentive to use their Chinese supply chains to meet global demand. ** In my view, the current Chinese economic policy that most directly threatens a large number of American jobs is China’s desire to build its own civil aviation industry. Something close to a quarter of Boeing’s narrow body output is now exported to China. Civil aviation accounts for $130b of U.S. exports, or well over 10 percent of the United States' total manufactured exports. Yet so long as subsidies for domestic Chinese production and “buy China” preferences in civil aviation aren't on the negotiating table, the future of America’s most important source of manufactured exports to China depends either on a bet that China’s civil aviation sector won’t produce a viable competitor any time soon, or on a bet that the Chinese plane will be so dependent on a U.S. aeronautics supply chain that there won’t be a major net loss of jobs. Despite some new JVs. *** The FDI inflow here is mostly imputed as it reflects reinvested earnings, which is also a debit on the current account, so in some sense it is a “fake flow”—but no matter, think of the goods surplus funding the tourism outflow and errors and omissions. **** My broad measure tries to pick up the growth in the foreign assets of CIC and the state banks as well as the increase in the PBOC's formal reserves. It is based on four lines in balance of payments which I believe are dominated by state institutions.

China could widen the trading band around its currency in response to Trump's tariffs, but that wouldn't give it full policy autonomy. It would still need to defend the new edge of any trading band.

China still manages its currency. That’s hardly a shocking statement, I know. But I don’t fully subscribe to the view that China’s depreciation in the summer was simply a market move, given the dollar's broad strength.   If China’s currency appreciates, that means that China’s authorities decided to allow the appreciation—and not enter the market to block “market” pressure to appreciate. And if China’s currency depreciates, that means that China’s authorities decided to allow the depreciation, and not enter the market to block “market” pressure to depreciate. The key isn’t the market pressure, at least not on its own. It is the decision by Chinese authorities to allow the market pressure to push the currency to a new level.   That’s why—as the Economist's Buttonwood notes this week—there is real information value in the price of the yuan. "When the yuan moves, it carries rare news— about currency demand, about China and by extension about the world economy." And that’s also why there is information in the scale of China’s intervention in the foreign exchange market. If China is resisting market presure, in either direction, it should show up somewhere on the state's balance sheet. Those proxies for China's true intervention are currently telling two stories: China is still using intervention—though on a more modest scale than in the past—to help define the yuan’s trading range (against the basket I assume). China's intervention is currently being done in a less transparent way than in the past, as it is largely coming through the state banks rather than the PBOC.   The most straightforward way to assess China’s intervention is to look for changes in the value of the foreign exchange reserves the People’s Bank of China (PBOC) reports on its balance sheet. Those reserves are reported at historical purchase cost. The change in the reserves thus provides a measure of intervention. And the PBOC’s balance sheet (the changes in the PBOC's balance sheet are the yellow line on the graph) has been absolutely flat this year.   Too flat in a way.   It isn’t clear, for example, what is happening to the interest income that China receives on its massive stock of reserves. It doesn’t seem to be entering into the PBOC’s balance sheet in any obvious way these days. You would think the PBOC’s balance sheet would be growing by something like $50 billion a year just based on the interest on its reserve stocks.* The activity over the spring and summer has showed up only in the settlement data (the black line in the graph)—a data set that aggregates the activities of the state banks and the PBOC. The easiest interpretation of a gap between the “settlement” data and the PBOC balance sheet is that the gap reflects the activities of the state banks (before 2015, China published a useful data series on the foreign exchange position of the banking system—but, alas, that data series disappeared after the August 2015 depreciation. I still miss it…) And it looks like the state banks bought $20 billion of foreign exchange in both April and May. That in effect set a cap on how far the Chinese would allow the yuan to appreciate. The state banks then sold some dollars forward in July, and also sold about $10 billion in foreign exchange in August. That—along with other signals from the Chinese authorities (the counter-cyclical factor, the increase in the reserve ratio on forwards, a rising premium in the offshore forward market that raised the cost of shorting the yuan) helped end the depreciation of June and July. The yuan now looks to be effectively managed against a basket, with an (undeclared) band between say 92 and 98 on the CFETS basket. That at least is what I would infer from China's pattern of intervention over the last 18 months. There is one other point that is worth making: while China still intervenes to manage its currency, the amount of intervention that has been required to keep the yuan within the authorities’ band has been pretty modest recently. By Chinese standards, $10-20 billion a month is nothing… That reflects the fall in China’s current account surplus. The surplus in manufactures remains large, to be sure (as the IIF's Robin Brooks has emphasized). But higher commodity prices have reduced (for real) the overall goods surplus. And more tourism and changes in the way tourism spending abroad is estimated have dramatically increased China’s tourism deficit.** There isn’t a massive gap between export proceeds and imports (so long as the tourism “imports” are all real).   And over the last year, the financial account has generally been close to balance. Cracking down on Anbang and HNA led to a big fall in outward FDI. Sizable inflows into Chinese government bonds have helped to balance ongoing private outflows (which show up in the errors and omissions line). And the banks, in aggregate, are now borrowing abroad to fund much of their lending abroad. They no longer are generating a net outflow. That makes China’s decision about how to manage the yuan as the United States escalates its tariffs—with a potentially giant increase in January—all the more interesting. A weaker yuan is the obvious way to offset a negative export shock, and it is an easy way to try to counter the Trump administration’s actions—especially once China is in a position where it cannot match Trump’s tariffs dollar for dollar.    But letting the yuan go through the bottom edge of the range that the PBOC has—more or less—established over the past two and a half years might upset expectations. There was a sense over the summer that China would likely step in to limit depreciation at the 91 or 92 market (on the CFETS basket) and at around 6.9 to the dollar. That helped keep the broader market calm.   If the yuan were to fall through those barriers, there isn’t an obvious limit to how far it could fall. Global markets might get nervous. Finally, letting the yuan weaken would put a lot of pressure on other emerging market currencies. China doesn’t have a lot of foreign currency debt, at least not relative to the size of China’s economy (the banks are borrowing abroad to lend abroad, so they are hedged; some property firms though aren’t and could be in trouble). But some other emerging markets do have a problem with foreign currency debt and wouldn’t welcome a Chinese decision that puts further pressure on their currencies.    And, well, letting the yuan weaken in response to U.S. tariffs helps China export more to Europe and Japan—and they might not put all the blame for a new China exchange rate shock on the United States. Makes for an interesting choice.   Even though China doesn't meet two of the three criteria that the U.S. Treasury has set out to evaluate when exchange rate management crosses the line and becomes manipulation,*** the way China manages its currency still matters for the United States—and for the world.   *It would be great if the interest income was sold for CNY and remitted back to the budget—that’s what I think countries with large reserves should do. Yet the balance of payments data has shown $20-30 billion in reserve growth a quarter ($110b, or almost a percentage point of GDP, in the last four quarters of data), and the most obvious explanation for the difference with the PBOC’s balance sheet is that interest income isn’t entering into the PBOC’s ticker. That then raises the question of how interest income does enter into the balance sheet…     **I was looking back to see if China’s current account surplus exceeded 3 percent of GDP in 2014 and 2015. That's the U.S. Treasury's threshold for assessing manipulation these days. It now doesn’t. But it did back at the time. The $100 billion jump in China’s tourism imports in 2014 (from methodological changes in the compilation of the balance of payments data) came at a very convenient time. ***There is a conceptual difficulty with Treasury’s criteria that is worth noting. The criteria were developed to capture countries that blocked appreciation through heavy intervention—a coherent, clear definition of manipulation that hasn’t been consistently applied in the past. They won’t capture a country that in effect manages its currency down—as the process of carrying out a managed depreciation burns through reserves. Think of it this way: if China let its currency depreciate to 90 vs. the basket (or 7 vs. the dollar), Chinese residents might start to expect that China wanted further weakness, and move funds out of the yuan. Controlling the depreciation, once it gets started, can require selling a lot of reserves—and the 2015 definition of manipulation is entirely focused on reserve purchases. I suspect that this would prompt the Trump administration to dust off the 1988 definition of manipulation (weakening a currency to gain a competitive advantage in trade). But that too has problems, as China could respond to concerns that it is guiding its currency down by just letting the yuan float down…the reality now, I think, is that it is in the United States’ interest for China to continue to manage its currency for a while longer.

Vietnam appears to be taking a page out of China's post-WTO playbook by intervening to keep its currency weak and its exports strong.

China's currency is getting awfully close to some key levels, levels where in the past China has resisted further depreciation. The signals China sends from here on will be critical.

This one is for my currency trading friends...

A deep dive into the details of China's balance of payments over the last few quarters of data. During the dollar's depreciation in 2017 and the first quarter of 2018, it looks like China was adding to its official assets once again—though the growth largely came from the state banks.

Emerging markets have come under a bit of pressure recently, with the combination of the dollar’s rise and higher U.S. ten year rates serving as the trigger. The Governor of the Reserve Bank of India has—rather remarkably—even called on the U.S. Federal Reserve to slow the pace of its quantitative tightening to give emerging economies a bit of a break. (He could have equally called on the Administration to change its fiscal policy so as to reduce issuance, but the Fed is presumably a softer target.) Yet the pressure on emerging economies hasn’t been uniform (the exchange rate moves in the chart are through Wednesday, June 13th; they don't reflect Thursday's selloff). That really shouldn’t be a surprise. Emerging economies are more different than they are the same. With the help of Benjamin Della Rocca, a research analyst at the Council on Foreign Relations, I split emerging economies into three main groupings: Oil importing economies with current account deficits Oil importing economies with significant current account surpluses (a group consisting of emerging Asian economies) And oil-exporting economies It turns out that splitting Russia out from the oil exporting economies makes for a better picture. The initial Rusal sanctions were actually quite significant (at least before Rusal got a bit of a reprieve).   And, well, Mexico is a bit of a conundrum, as it exports (a bit) of crude but turns into a net importer if you add in product and natural gas.     But there is clearly a divide between oil importers with surpluses (basically, most of East Asia) and oil importers with deficits. The emerging economies facing the most pressure, not surprisingly, are those with growing current account deficts and large external funding needs, notably Turkey and Argentina. In emerging-market land, at least, trade deficits still matter. In fact, those that have experienced the most depreciation tend to share the following vulnerabilities: A current account deficit A high level of liability dollarization (whether in the government’s liabilities, or the corporate sector) Limited reserves Net oil imports Relatively little trade exposure to the U.S., leaving little to gain from a stimulusinduced spike in U.S. demand Doubts about their commitments to deliver their inflation targets, and thus the credibility of their monetary policy frameworks. It is all a relatively familiar list. Though to be fair, Brazil has faced heavy depreciation pressure recently even though it has brought its current account down significantly since 2014.*  Part of the real’s depreciation is a function of the fact that Brazil and Argentina compete in a host of markets, and Brazil must allow some depreciation to keep pace with Argentina. Part of it may be a function of market dynamics too, as investors pull out of funds with emerging market exposure, amplifying down moves. And of course, part of it comes from increasingly pessimistic expectations for Brazil’s ongoing economic recovery—driven by uncertainty ahead the coming presidential elections together with a quite high level of domestic debt. And for Mexico, well, elections are just around the corner and uncertainty about the future of NAFTA can’t be helping… * Brazil also benefits from having much higher reserves than either Turkey or Argentina.  Its reserves are sufficient to cover the foreign currency debt of its government as well as its large state banks and firms in full.  This has given the central bank the capacity to sell local currency swaps to help domestic firms (and no doubt foreign investors holding domestic currency denominated bonds) hedge in times of stress.  But Brazil's reserve position is a topic best left for another time.

Korea has indicated that it will, very gradually, start to disclose a bit more about its direct activities in the foreign exchange market. The Korean announcement presumably was meant to front-run its currency side agreement with the United States. Optics and all—better to raise your standard of disclosure unilaterally and then lock in your new standard in a trade deal than the reverse. The problem is…Korea’s actual disclosure commitment is underwhelming. If this is all the U.S. is getting out of the side agreement, it is a bad deal. It sets too low a bar globally, and fails to materially increase the amount of information available to assess Korea’s actions in the market. Many emerging markets disclose their purchases and sales (separately) monthly, with a month lag. India for example (see the RBI monthly data here [table 4] and here). That should be the basic standard for any country that wants a top tier trade agreement with the U.S. Remember, the agreement is about disclosure only—it isn’t a binding commitment not intervene. What has Korea agreed to? A lot less. For the next year or so, it will disclose its net intervention semi-annually, with a quarterly lag. That means data on Korea’s purchases next January this won’t be available until the end of September, and January’s purchases will be aggregated with the purchases and sales of the next five months—blurring any signal.* Korea will start to disclose quarterly with a quarter lag at the end of 2019. But that’s still a long lag. Intervention in January 2020 wouldn’t be disclosed until the end of June 2020. Moreover, quarterly disclosure of net purchases doesn’t provide much information beyond what is already disclosed in the balance of payments (BoP). The BoP shows quarterly reserve growth, which combines intervention and interest income, with a quarter lag. Now is it true that quarterly intervention with a quarter lag was the standard in the TPP side agreement. But the Trump Administration has claimed that TPP was a bad deal, and they would do a better deal. They don’t seem to have gotten that out of Korea. And currency intervention should have been a real focus in the negotiations with Korea. There is no doubt Korea intervenes, at times heavily. And I am confident that the absence of any currency discipline in the original KORUS has had a real impact. Korea, in part through intervention, has kept the won weaker than it was prior to the global crisis. And the won’s weakness in turn helped raise Korea’s auto exports, and thus contributed to the increase in the bilateral deficit that followed KORUS. To be sure, Korea’s German style fiscal policy has also contributed to Korea’s overall surplus. But that isn’t something that realistically can be addressed in a trade deal. Moreover, the failure to get a higher standard than TPP undercuts the Trump administration’s argument for bilateral deals. A big, multi-country deal can in theory be held up by a few reluctant countries. Singapore, for example, has made no secret of its opposition to a high standard for the disclosure of foreign exchange intervention (see end note 4 in the currency chapter of the draft TPP agreement; I assume exceptions to quarterly disclosure didn’t arise by accident). Singapore also discloses comparatively little about the activities of the GIC. And a bilateral deal in theory also could address country-specific currency issues—like the activities of Korea’s large government pension fund. A reminder: Korea’s government-run pension fund is building up massive assets, placing a growing share of those assets abroad and reducing its hedge ratio (it is now at zero, or close to it). This at times has looked a bit like stealth intervention. And it certainly has an impact on Korea’s external balance—structural, unhedged outflows of well over a percentage point of Korea’s GDP have helped Korea to maintain a sizeable current account surplus with less overt intervention. And I worry that the pension fund’s balance sheet will in the future provide Korea with an easy way to skirt the new disclosure standard—particularly if Korea would be at risk of disclosing a level of intervention that might raise concerns about manipulation. Suppose the Bank of Korea bought a bit too much foreign exchange in the first two months of a quarter. The Korean government could encourage the pension fund to buy a couple of billion more in foreign assets in the third month of the quarter, and meet that demand through the sale of foreign exchange from the intervention account. Voila, less disclosed intervention. Remember, sales don’t need to be disclosed separately. A bilateral deal in theory could have included commitments disclose the pension service’s foreign assets, and its net foreign currency position vis-à-vis the won (e.g. its hedges, if any). It thus could have set a standard not just for disclosure of direct intervention, but also for disclosure by sovereign wealth and pension funds. The side agreement on currency with Korea consequently looks to be to be a missed opportunity for sensible tightening of disclosure standards, on an issue that really matters for the trade balance.     Now for some super technical points. The intervention data should not precisely match the reserves data. When Korea buys foreign exchange, it sometimes then swaps the foreign exchange with the domestic banks for won. This lowers the net amount of foreign exchange the central bank ends up directly holding, while creating a future obligation to buy back the dollars swapped for won. This shows up in the central bank’s reported forward book. Total intervention thus may exceed the change in reserves in the balance of payments. However, it can be inferred from the combined increase in reserves and forwards—and Korea currently releases both its forwards monthly and its balance of payments data monthly. As a result its intervention can be inferred from these monthly numbers—quarterly data with a quarter lag will add very little. The buildup of government assets abroad—non-reserve government assets that is—now accounts for a significant share of the net outflow associated with Korea’s current account surplus. And with higher oil prices set to lower Korea’s surplus further, that share will grow. As a chart of the net international investment position shows, the rise in the foreign assets by the National Pension Service now accounts for the bulk of the rise in the total foreign assets of the government of Korea. On a flow basis, outflows from insurers are now more important than the pension outflow—however the insurers, unlike the NPS, supposedly hedge. 3. The increased scrutiny of Korea’s management of the won that has come with the negotiation of the currency chapter—and the risk Korea could be named in the foreign exchange report—has had some positive effects. It didn’t keep Korea from intervening pretty massively to block won appreciation in January at around the 1060 mark (and I suspect Korea has bought at a few other times in the first quarter as well). But it does seem to have encouraged the Koreans to take advantage of dollar rallies to sell won and thus hold their net purchases down. In 2015 and 2016 the Koreans didn’t tend to sell dollars unless the won was approaching 1200 (an extremely weak level). In the past few months they have been selling on occasion at around 1100 (or at least not rolling over some maturing swaps and thus delivering dollars to the market). The won’s trading band has been pretty tight. I just think the block at 1060 should disappear.   */ as I understand it, Korea won’t ever disclose its intervention this January—the first disclosed data will be for the second half of 2018.

The strange case of Taiwan and its life insurance industry.

The U.S. Treasury Department’s next foreign exchange report is due on April 15—so it should come out soon, maybe even tonight. Normally the section on China attracts all the attention. But right now there isn’t any reason to focus the foreign exchange report on China. China has neither been buying or selling large quantities of foreign exchange in the market—and, well, the yuan did appreciate a bit in 2017. China no doubt still manages its currency but it isn’t obviously managing its currency in a way that is adverse to U.S. economic interests. And China’s loose macroeconomic settings have kept its current account surplus down even though China’s industrial policy seeks to displace imports with domestic production. I worry about what may happen if China tightens excessively before it stops saving excessively—but that isn’t an immediate concern. The real Asian interveners right now are China’s neighbors—Korea, Taiwan, Thailand, and Singapore. All bought foreign exchange on net in 2017, and all also run sizeable current account surpluses. Korea’s surplus is well above 5 percent of its GDP; Taiwan, Thailand, and Singapore all run surpluses of over 10 percent of their GDP. Combined these four countries run a current account surplus of close to $250 billion—bigger, in dollar terms, than either China or Japan. And they all have plenty of fiscal policy space: they could rely more on domestic demand and less on exports. Singapore isn’t going to be in the report—it is intervening rather massively (also see Gagnon), but it gets an unwarranted free pass as a result of its bilateral trade deficit with the United States (a deficit that likely reflects some tax arbitrage, as firms import into Singapore to re-export). So I will be most interested in what the Treasury has to say about Korea, Taiwan, and Thailand. Thailand is the most interesting case. It hasn’t been traditionally covered in the report as it wasn’t considered a major trading partner. But in 2017 it met all three of the criteria that the Treasury has set out to determine if a country is manipulating: a bilateral surplus of more than $20 billion, a current account surplus of more than 3 percent of GDP, and intervention in excess of 2 percent of GDP. Thailand’s bilateral surplus just topped $20 billion, but it easily meets the other two criteria with a current account surplus of 11 percent of its GDP and intervention of 8 percent of GDP. I personally think the Treasury should go ahead and name Thailand and give the Bennet Amendment process a test. There is more than a bit of flexibility in the determination of who counts as a major trading partner. And there is a more intermediate option—the Treasury could indicate that it plans to expand the report’s coverage in October and indicate that if Thailand doesn’t change its policies, it would likely meet all three of the Bennet amendment criteria. It would be rather disappointing if the Treasury simply sticks to its current list of major trading partners (and leave Thailand out entirely). The changes introduced to a designation under the Bennet amendment were designed to make designation (technically, designation for enhanced analysis) a live option. The actual sanctions are quite mild (arguably too mild) and only come into play after a year of negotiation. And the available sanctions on the Bennet list stop well short of any new tariffs. In some ways, Thailand is easy. It hasn’t tried to hide its activities in the foreign exchange market and a strict by the books application of the criteria set out in 2015 would lead to the conclusion that Thailand should be named. It has let its currency, the baht, appreciate over the last year (most currencies have strengthened against the dollar) but the scale of both its intervention and its current account surplus stands out. Korea and Taiwan are harder. Both have long been subject to scrutiny in the foreign exchange report. And both have become adept at adopting domestic policies that encourage large capital outflows and thus reduce the need for headline intervention. Korea channels a significant fraction of the buildup of funds in its social security fund (the national pension service) into foreign assets. And Taiwan has allowed its life insurers to buy a ton of foreign assets—loosening limits on foreign exchange exposure in the process (a new note by Citi's Daniel Sorid and Michelle Yang estimates that the life insurers have added $300 billion to their foreign assets in the last five years, bringing their total foreign portfolio up to $480 billion/65 percent of total assets). As a result of these “structural” outflows from regulated institutions, both Korea or Taiwan have been able to keep their intervention, using the Treasury's methodology, under the 2 percent of GDP threshold in recent years. Taiwan, though, is close and it has never disclosed its activities in the forward market, so there is a possibility that it actually violates the intervention criteria.*    And this is a case where methodology matters. The Treasury deducts estimated interest income from estimated reserve growth, which helps Taiwan a lot given Taiwan's enormous stock of reserves. A simple estimate that takes reported reserve flows in the balance of payments and adds in the reported change in the forwards book puts Korea over the threshold in 2013 and 2014 (before the Bennet criteria were articulated) and would put Taiwan just over 2 percent of GDP.** A by the books application of the Bennet criteria thus would let both Korea and Taiwan off. Treasury could say that neither meets all three criteria and more or less be done with it—perhaps adding that both the won and the new Taiwan dollar appreciated against the U.S. dollar in 2017.  Treasury will of course laud Korea for agreeing to more disclosure in the renegotiated KORUS and ding Taiwan for failing to disclose its forward book or any of the other details that should be disclosed if it voluntarily committed to live up to the IMF’s standard for reserve disclosure. Calling for transparency around intervention is squarely within the Treasury’s comfort zone. But in this case going strictly by the book would ignore what I think is the real issue. Both Korea and Taiwan are currently intervening to cap the appreciation of their currencies—Korea at 1050 to 1060 won to the U.S. dollar, and Taiwan at around 29 new Taiwan dollars to the U.S. dollar. To be fair, both have shifted the intervention range up a bit in 2018—in early and mid-2017 Korea intervened at around 1100 (it shifted a bit in late 2017), and Taiwan at around 30. But 1050 and 29 are still relatively weak levels for both currencies—given the size of each countries’ surplus** there is ample scope for further appreciation. I consequently will be watching to see if the Treasury signals that it objects to the level where Korea and Taiwan are intervening even if the amount of intervention falls short of the formal criteria. Korea's intervention in November, December, and January was actually relatively heavy (the won weakened a bit in February, allowing Korea to sell some of its January purchases, but it looks likely that Korea intervened again to block appreciation through 1050 in late March/early April). And I am curious if the Treasury will show any sign that it is looking closely at shadow intervention—asking, for example, Korea to disclose the net foreign exchange position (including hedges) of its national pension service, and Taiwan to report not just the central bank’s forward book but also the aggregate foreign exchange position of its regulated insurers. There are also signs that Taiwan’s state banks may have been buying more foreign exchange than in the past. But there I am not holding my breath, I don’t really expect any changes.  Looming in the background is another issue. Without large-scale intervention, foreign demand for Treasuries may be a bit weaker than it has been in the past (see my magnus opus on how the U.S. finances its current account deficit). Deutsche Bank has highlighted this possibility in some of its recent research. They are in my view, more or less right to note that foreign demand for Treasuries historically has been a by-product of intervention, and often, the result of intervention well in excess of the current 2 percent of GDP threshold. But I am not sure that the Trump Administration is willing to declare that it wants to toss aside the Bennet criteria in order to encourage countries to maintain undervalued currencies so as to raise demand for Treasuries and thus facilitate foreign funding of the fiscal deficit.   *Taiwan though benefits from the bilateral balance criteria, as it exports its chips (semiconductors) to China, and thus the reported bilateral balance understates its "value-added" bilateral surplus. Taiwan's current account surplus rose in 2017 and is now bigger in dollar terms than Korea's surplus. ** The Setser/Frank estimates for reserve growth in the tables differ from the Treasury numbers in two ways: Cole Frank and I used the balance of payments data to estimate reserve growth, while the Treasury uses valuation-adjusted change in headline reserves, and I didn't deduct out estimated interest income. The Treasury believes that only actual purchases in the foreign exchange market should count, and tries to strip out interest income. For countries that already have too many reserves, I think the country should normally sell the interest income received on foreign bonds for domestic currency to cover payments on sterilization instruments and profit remittances back to the Finance Ministry. This matters for a country like Taiwan, which has about 80 percent of GDP in reserve assets. Interest income is likely over a percent of GDP, and will rise over time if U.S. rates continue to increase. I also included for reference changes in the government's holdings of portfolio debt. These purchases have often appeared in the balance of payments at times when Korea is intervening in the market: they look to be to be a form of shadow intervention.  

The Trump Administration should be giving Korea a hard time for its return to foreign exchange market intervention in January 2018.

Trump’s tax cut has not, to date, unleashed a wave of global demand for U.S. dollar assets. In fact, the dollar weakened as prospects for the tax cut—and associated rise in the U.S. federal budget deficit to over 5 percent of U.S. GDP—increased. And it has depreciated further this year (and even more today). It seems like the best explanation of the dollar’s weakness is the unexpected strength of the entire global economy right now—and in particular the strength of Europe’s recovery. Just as the dollar moved up in 2014 in anticipation of the Fed’s policy normalization, the euro seems to be strengthening on expectations that the ECB might actually need to tighten in 2019. Any exchange rate reflects developments abroad as well as developments at home. Or to make a more technical argument, if the scale of the ECB’s asset purchases was driving a lot of funds out of the European fixed income market and into U.S. bonds, the reduction in the ECB’s pace of buying (which the ECB would no doubt describe as ongoing easing just at a slower pace, as its balance sheet continues to rise) might also have an impact (though the connection between flows and price moves is complex, see Coure's speech at the IMF's research conference). The dollar was certainly on the move even before Secretary Mnuchin's comments today. All this said, I certainly didn’t expect bigger fiscal deficit and a tighter monetary policy as the Fed started to reduce its balance sheet and continues to raise policy raises to combine to lead the dollar to fall. I don’t claim to fully understand the reasons for the dollar’s current weakness. No matter. It has become clear over the past few weeks that most of the world—at least those parts of the world with large current account surpluses—like the dollar more or less where it is, and do not particularly want it to weaken further. They are, as a result, resisting—in various ways—a currency move that would bring the world’s trade into better balance (reminder: U.S. non-petrol exports responded in the way that one would expect given the dollar’s 2014 appreciation, and subsequently have underperformed global growth). Last week, Europe—meaning parts of the ECB—did a bit of soft verbal intervention. Various members of the ECB’s governing council highlighted that a stronger euro would make it harder for the ECB to achieve its inflation target, and thus hinted that further currency moves might lead to a delay in any ECB tightening. Fair enough. But if the Eurozone accepted a stronger currency and offset the drag on both exports and inflation with a more expansionary fiscal stance, it could simultaneously move closer to both external and internal balance. The eurozone now has the tightest fiscal stance—judged by the size of the structural fiscal deficit—of any of the world’s big economies. There is certainly scope for the largest and most export-driven eurozone member-state to offset the impact of a stronger euro with a bit of demand support. Germany's fiscal surplus is heading to over 1.5% of its GDP absent policy changes from a new government. And the reaction in Europe has been mild compared to the reaction in Asia. Almost all the big surplus economies in Asia—with the notable exception of Japan —appear to have intervened to keep their currencies from appreciating against the dollar in the past few weeks. Korea is the most obvious case—it jumped in loudly to keep the won from strengthening too much, and looks to have drawn a new line in the sand around 1060 won to the dollar. But it isn’t alone. China doesn’t seem to want the yuan to be all that much stronger than 6.4 yuan to the dollar—though there isn’t (yet) hard evidence of intervention, and the yuan did move a bit beyond 6.4 today. While Taiwan hasn't defended 30 NTD/USD since late December (to be fair, Taiwan’s central bank maintains the private demand for dollars just happens to surge at about that level), it does seem to have resisted pressure for the Taiwan dollar to strengthen much beyond 29.1 to 29.2 earlier this week (or it just happened that private demand for dollar rose at this level). Thailand—which now runs a current account surplus of around ten percent of its GDP—unquestionably has been intervening, though it seems more to smooth the baht's appreciation than to completely halt it. Thailand releases weekly reserves data, and its combined reserve and forward book jumped by $4 billion in the first two weeks of the year (valuation changes could explain perhaps $1 billion of the change). I will have more on the details of Asia's intervention soon. But before going into individual cases, I wanted to highlight the big picture: A lot of Asian countries with big external surpluses remain ready to step in and keep the dollar from depreciating against their currency. And in the process they block market pressures that might otherwise bring the U.S. trade deficit down. This of course isn’t new. The same thing happened when the dollar floated down against the euro in 2003—Asia initially more or less followed the dollar down, thanks to a surge in intervention. And it happened again when the dollar was under pressure to depreciate in 2009 and 2010 (in part because the ECB kept its monetary policy far too tight back in 2009, 2010, 2011, and 2012, adding to dollar weakness). Basically, when the market wants to fund the U.S., the U.S. historically has accepted the inflow and the stronger dollar—and when the market doesn’t want to fund the U.S., many of the world’s surplus countries have tended to step in and resist the appreciation of their currencies and in the process finance bigger ongoing U.S. trade deficits than the market wanted to fund. And I see some early signs that this process is repeating itself. Basically, the market is now creating pressure to bring the U.S. trade deficit down (which, by implication, means the rise in the U.S. fiscal deficit would need to be funded domestically). But the world's big surplus countries also need to do their part with policies that help rather than hinder global adjustment. Otherwise I worry that the market pressure for trade adjustment will fade —and the pressure for a bigger trade deficit created by the rising U.S. fiscal deficit will come to dominate.*   * I have long believed that the dollar's 2014 rally left the dollar too strong for the tradeables sector of the U.S. economy. U.S. exports have lagged since—and the U.S. trade deficit looks to have taken another leg up in the fourth quarter.