The U.S. Treasury released its semi-annual exchange rate report on Friday, and as signaled by President Trump it did not cite China (or any other country) as an exchange manipulator. There had been earlier speculation, and some concern, that Treasury would substantially rewrite the criteria to meet the President’s pre-election pledge, but the report plays it straight down the middle. No country meets all three existing criteria for manipulation of their exchange rate for competitive gain, though six countries—China, Germany, South Korea, Taiwan, Japan, and Switzerland—are placed on a watch list. At the same time, one can read in the report’s analysis a toughening of exchange rate policy, at least prospectively, in its calls for an ambitious set of reforms in the monitored countries, and its commitment to “aggressively and vigilantly monitoring and combating unfair currency practices”. On balance, the report reaffirms that, while trade and not exchange rates is likely to be the primary battleground for U.S. economic relations in the future, exchange rates remain a flash point.
Flagrant 1 and flagrant 2 fouls
As noted in the report, and discussed at length by Brad Setser, Treasury has a two-tiered approach for assessing the exchange rate policies of our major trading partners. The Omnibus Trade and Competitiveness Act of 1988 set the standard for determining currency manipulation, but the remedies under that law have long been seen as ineffective. The Trade Facilitation and Trade Enforcement Act of 2015 provided new weapons to go after countries seeking an unfair advantage, and for that law Treasury has measured countries by three criteria: (1) a significant bilateral trade surplus with the United States (at least $20 billion); (2) a material current account surplus (at least 3 percent of GDP); and (3) persistent, one-sided intervention to weaken one’s currency (repeated net purchases of foreign currency of at least 2 percent of an economy’s GDP over a 12 month period. The table below, from the Treasury report, shows that no country violates (shown in red) all three criteria.
Here there is little change from past reports. While China arguably met this test from 2005 to 2012, and perhaps later, since the middle of 2015 the country has spent large amounts of international reserves to resist a rapid and disruptive depreciation. So the Treasury report rightly resists calling that manipulation, and instead calls on China to “demonstrate that its lack of intervention to resist appreciation over the last three years represents a durable policy shift by letting the RMB rise with market forces once appreciation pressures resume.”
Where there does seem to be a toughening is in how it discusses countries on the watch list. This includes China (which now meets only one of the three criteria but is included because of the size of its bilateral surplus with the United States) and five countries that met two of the three criteria at least once in the last two reports. Here, in addition to strengthened language on the commitment to remedy these imbalances, many of the policies that the Treasury would like to see addressed—such as market access policies in China, labor market reforms in Japan, and stronger demand growth in Germany—are unlikely to resolve by the next report.
Coupled with the ongoing review of trade policies now underway, and underscored by Commerce Secretary Ross’ sharp response to legitimate concerns from the IMF about the risk of rising protectionism—trade rather than exchange rates is likely to be the primary battleground for the United States going forward. Further, some toughening of language could pay off--after all, the report is part of a signalling effort that aims to achieve better results in trade than have been the case over the last decade. But the report leaves me with three concerns for the future:
- In the near term, the weaker environment for global capital inflows, which has contributed to downward pressure on currencies of emerging markets, has lessened the incentive for intervention. Indeed, the report sees much of the improvement in the metrics for the countries on the watch list as an opportunistic response to events. When conditions change, currency policies are likely to return to the fore.
- We may be asking for more from our trading partners than can be achieved, either on macroeconomic or other policies (such as linking the decision not citing China to help on North Korea), creating high risk of disappointment in the future.
- Currency strength for other reasons, such as a faster than expected tightening of financial conditions by the Federal Reserve, could exacerbate protectionist pressures and put pressure on the Trump administration to take action to talk down the dollar or otherwise go after countries for their exchange rate policies. This political risk cycle should be a significant concern for markets.
All this suggests that currency policy will remain front and center in the months and years ahead.