This is a joint post by Brad Setser and Mark Sobel, the U.S. Chairman of the Official Monetary and Financial Institutions Forum.
The U.S. Treasury’s Semiannual “Foreign Exchange Report” is the main presentation of the United States’ perspective on economic and financial policies around the world. It is often read solely for its judgment on whether key trading partners have engaged in currency “manipulation”. Yet certain foreign exchange market practices that fall short of “manipulation” can be problematic in their own right and merit scrutiny. Traditionally, analyses focused on the activities of central bank and changes in countries’ formal reserve portfolios. But, given the growth of sovereign wealth funds, government pension funds, and the close relationships between certain countries’ banking systems and their governments, exchange rates can often be influenced significantly not just by central banks, but by other governmental actions and actors.
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Thus, even though most countries are seeking to prevent their currencies from depreciating and thus few countries are at risk of a “manipulation” designation, the report’s analytic underpinnings should be enhanced to capture the full range of practices governments can use to manage exchange rates. Three enhancements to the foreign exchange report are proposed below.
The Treasury’s next Foreign Exchange Report, due in April, is unlikely to attract much attention. In 2022, most of the United States’ trade competitors sold foreign exchange to prop up their currencies and limit imported inflation, even if that meant giving up export edge. The dollar’s strength was the result of the Federal Reserve’s rate hikes, not unfair currency practices. No significant country is at risk of being singled out for engaging in questionable or harmful currency practices, such as excessive and unwarranted intervention to hold their currency down.
The Foreign Exchange Report has evolved over time, with important changes to the report’s methodology and analysis in the last ten years. For example, the implementation of numerical thresholds for analyzing countries against the three criteria set out in the 2015 Trade Enforcement Act focused the report on quantitative assessments of various countries’ foreign exchange policies.*
Moreover, recent work has helped set out clear criteria for evaluating the transparency of the foreign exchange policies of the United States’ main trading partners. Previous reports drew attention to Taiwan’s limited reserve disclosure and the possibility—now confirmed—that Taiwan’s Central Bank had a significant forward book and thus more reserves than it disclosed. Recent reports have also highlighted the very limited scope of China’s currency disclosure and the difficulties separating the activity of the People’s Bank of China (PBOC) from the activity of China’s large state banks.
Further evolution would strengthen the report’s coverage of exchange market developments. Three specific enhancements are now needed to reinforce the report’s analysis and assure that its focus better captures the full range of foreign countries’ currency practices, which have evolved significantly even since the implementation of the revised process specified by the Trade Enforcement Act in 2015.
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One: The country analysis in the Foreign Exchange Report could include, where needed, an assessment of whether countries’ intervention is linked to specific movements in the exchange market. For example, the Treasury should systematically plot estimates of monthly intervention against the daily foreign exchange rate (intervention data typically can only be estimated monthly). This data would help the Treasury to determine whether a country’s intervention is directed at defending at a certain exchange rate level. Evaluation of pricing differentials between the onshore and offshore forward market can also help inform country analysis. An examination of such activity in the market would help avoid an overly mechanical application of the three criteria laid out in the 2015 Trade Enforcement Act, which in theory allow an assessment that is entirely based on economic variables without any examination of market movements.
Two: The Foreign Exchange Report could systematically examine changes in the balance sheets of major state actors in the foreign exchange market other than the central bank. Foreign exchange purchases (and sales) by large state actors—like sovereign investment funds and state banks—have an increasingly recognized impact on the foreign exchange market. Their activity in the market could be undertaken for legitimate financial reasons but also directly to help achieve an exchange rate objective or be a part of a broader policy to maintain large external surpluses and a competitive exchange rate. For example, the Bank of Korea has argued, correctly, that the foreign purchases of Korea’s large National Pension Service contributed to the won’s weakness in the summer of 2022 and undercut the Bank of Korea’s effort to stabilize the won. Japan’s Government Pension Investment Fund (the GPIF) also historically has a large impact on currency markets. Global diversification can be a legitimate goal of a pension fund, but the timing of the GPIF’s moves into foreign assets has, at times, been viewed by market participants as part of a policy effort that aims to move the yen. China is the most important case here: participants in the onshore and offshore foreign exchange market often speak of China’s “invisible” reserves in the state banks. Moves in the net foreign asset position of the state banking system are increasingly viewed as part of China’s exchange rate toolkit.
It goes without saying that the Treasury should also examine large financial flows that may be the byproduct of undisclosed intervention—whether the support the Central Bank of China (Taipei) long provided Taiwan’s life insurers seeking to limit the risk on their foreign bond purchases through the onshore hedging market, or the outflows generated by China’s two large and internationally active policy banks.
Three: The Foreign Exchange Report could routinely compare self-reported intervention against the reported change in the central bank’s balance sheet and balance of payments–based measures of reserve outflows. The Treasury has succeeded in persuading numerous countries to report, on a voluntarily basis, their actual intervention in the foreign exchange market to the Treasury—though the biannual reporting of annual data still limits the broader utility of this data. Korea, Singapore, Taiwan, and Vietnam, for example, all provide this data to the Treasury. In several cases, there are substantial differences between the reported level of intervention and the reported increase (or decrease) in reserves in the balance of payments data. The Treasury could illustrate how the data lines up and highlight how the full extent of intervention is reflected in the balance of payments data and on central bank balance sheets. For example, a significant fraction of Singapore’s intervention shows up as an increase in the government’s reported external deposits, as Singapore’s sovereign wealth fund purchases foreign exchange bought by the Monetary Authority of Singapore for its own investment program. Given the difficulties inferring levels of intervention from the reported change in the size of total foreign exchange reserves—which can be heavily influenced by market moves yet not always marked to market—the Treasury is likely to be ever more reliant on self-reporting. Best practice is always to both trust and to verify.
These three enhancements to the Treasury’s standard analysis would not have changed the Treasury’s judgements about the currency practice of any major U.S. trading partner in 2022—and, while the future is uncertain, would be unlikely to change any judgments in the 2023 foreign exchange reports (which will cover calendar 2022 and the four quarters through the middle of 2023). Most countries that have intervened have done so to prevent their currencies from depreciating more, and thus haven’t acted in ways that would give their exports a competitive edge or impeded necessary adjustments in the global balance of payments.
The Treasury could also usefully clarify that it will not single out any country with a current account deficit—assuming that the current account deficit is well measured and doesn’t stem from unusual accounting of investment flows—for intervention that balances the risks associated with international financial inflows. This would reduce concerns that more careful scrutiny of currency practices will undermine necessary prudential buffers. For example, it would not have been necessary to have included India on the report’s monitoring list even when India crossed the threshold for intervention given its ongoing current account deficit.
These three enhancements, while technical, could be of great importance in strengthening the report’s overall analysis of country currency practices. Over the past few years, it has become clear that a growing number of Asian countries—China in particular—can use tools that go well beyond visible purchases and sales of foreign exchange by the central bank to influence or manage currency movements. The report’s analytic foundation needs to evolve to reflect current realities.
As a first step, the April 2023 Foreign Exchange Report might usefully include an annex on the large state institutions active in the foreign exchange market across Asia and an analysis of their impact on balance of payments flows over the last ten years. In subsequent reports, the analytic country sections could also systematically incorporate analysis of the timing of market intervention and the impact of a broader set of state flows of the balance of payments.
With these enhancements, the U.S. Treasury’s analysis of currency practices and exchange rate management would be substantially strengthened and should provide a basis for similar analytical refinements to the work of the International Monetary Fund.
*The three criteria are current account as a share of GDP, intervention in the foreign exchange market as a share of GDP, and the bilateral balance with the United States.
