What Might Be in Treasury's October 2019 Foreign Exchange Report?

The rumored inclusion of currency in the "harvest" truce announced last Friday (the "phase 1" deal supposedly under negotiation with China), together with the designation of China as a manipulator in a press release back in August has taken some of the drama out of the October 15 (give or take) foreign exchange report. Indeed it now seems likely that the report will be delayed until the negotiations with China are complete.

That in a sense is a shame, as the truly interesting question now is whether designation of China back in August* (even if it is reversed) heralds a broader changes in the Trump Administration's foreign exchange policy. I am interested, in particular, in whether the Administration plans to moves more away from the “three criteria” set out in the 2015 Trade Enforcement Act.

The administration is required by law to assess countries against those three criteria, so the report cannot ignore them. But the three criteria could be relegated to say an annex, with greater emphasis placed on qualitative judgments about countries policies.

That is, in fact, how President Trump generally talks of manipulation. He frequently refers to European “manipulation” when the euro depreciates (especially after an ECB policy decision)—though recently his emphasis has been on how the Fed is letting the United States down by not following suit. And he does so without ever linking his claim of manipulation to any ECB action in the foreign exchange market (as there isn’t any).

So one possible report would use the August designation of China to pivot away from the three criteria toward a broader definition of manipulation that focuses on any action by a surplus country that gives its exports a competitive advantage. That might lead to more focus on Europe—and for that matter, more focus on Vietnam, as Vietnam is “winning” the trade war on many counts (its surplus with the United States is soaring) and it is fairly clearly resisting pressure on its currency to appreciate.

Another possible report would, more or less, graft the designation of China under the 1988 trade law to the now standard assessment of most countries against the three criteria set out in the Trade Enforcement Act. The Treasury recently expanded the report’s coverage, so the “standard” treatment isn’t especially standard for some countries.

But barring a change in the criteria, it would generate a relatively predictable outcome.

And if the Treasury doesn’t change the criteria, I don’t think anyone (other than China) will get dinged as a manipulator.

The two most interesting cases are Thailand and Vietnam. Thailand will likely only meet one of the Treasury’s three criteria—its current account surplus is over 2 percent of GDP, yet it looks to have barely avoided crossing the (arbitrary) trip wire on the bilateral balance (its goods surplus with the United States will be $19 billion and change in the 12 months through June) and it won’t meet the intervention criteria over the last four quarters of data (reserve growth was around 1 percent of GDP, and the Treasury will net out estimated interest income).

But, well, Thailand is getting off largely because the Treasury "looks back" twelve months, and Thailand is getting credit for the reserves it sold last year. If the Treasury leaves Thailand off its watch list, it is doing Thailand a disservice, as Thailand has been intervening pretty heavily in the third quarter to limit the baht’s appreciation and its bilateral surplus with the U.S. could easily top $20 billion. It clearly is at risk of meeting all three criteria in the next foreign exchange report.

Vietnam is another interesting case. It clearly runs a large bilateral surplus with the United States, so it won’t get off the hook there. But its overall current account surplus has come down, and looks to be under two percent of GDP (I think ING is using old data). That legitimately should take it off the list. And like Thailand, it is getting credit—under the Treasury’s formula—for the reserves it sold in late 2018 even though it has been adding significantly to its reserves this year.

What about other countries?

I suspect Malaysia will also get more scrutiny because of the combination of its bilateral surplus with the United States and its growing current account surplus, which now is above two percent of GDP. It though won’t be named if the Treasury sticks to a formulaic application of the three criteria, as its intervention has been modest.

Korea also looks to be home free—its bilateral surplus has come down thanks to soaring imports of U.S. oil and LNG, but it will still just exceed $20 billion. But it hasn’t been overtly intervening—weak global trade and weak chip prices have legitimately pushed the Korean won down. Though I do think the Treasury should start asking new hard questions about the role the National Pension Service’s diversification into foreign assets is playing in supporting the won’s weakness.

Japan falls in the similar boat—a large bilateral surplus with the United States, and an overall current account surplus, but in Japan's case no overt intervention (though its government pension fund is buying a lot of foreign assets). 

Plus, Korea and Japan have also done (rather modest) trade deals that have put them on Trump’s good side.

The Swiss might be in trouble—they too have a large overall surplus and a large bilateral surplus (pharmaceuticals and tax driven). But they only recently restarted intervention and their reserve growth in the four quarters through q2 2019 doesn't, judging from the balance of payments, cross the Treasury threshold. They also never really have been on Trump’s radar.

But the biggest problem with the Treasury's current criteria is that the emphasis on the bilateral balance will give some countries that don't deserve it a free pass. The $20 billion bilateral surplus threshold is arbitrary and, well, it lets countries that produce high end parts that are exported elsewhere for final assembly entirely off the hook.

Singapore runs a massive current account surplus, and it has been intervening pretty heavily—but it runs a bilateral deficit with the United States (importing more from the United States—especially fuel oil—than it exports directly to the United States). It more or less admitted it has more reserves than it needs when it transferred $33 billion (S$45 billion) from its reserves to its sovereign wealth fund back in the spring. Its heavy intervention to sustain a large current account surplus (while running a fairly tight fiscal policy) meets the text book definition of manipulation.** 

And then there is Taiwan.

Until its bilateral surplus with the U.S. tops $20 billion, Taiwan won’t get the attention its actual activity in the foreign exchange market clearly deserves. Concentrated Ambiguity and I tried to change that but, well, Treasury isn’t likely to move without a bit of public pressure, and Treasury’s decision to ignore the evidence that Taiwan’s intervenes heavily to sustain the massive undervaluation of Taiwan’s dollar isn’t really on the political radar.

* Back in August, the designation of China as a manipulator relied on the 1988 Omnibus Trade Act, as China doesn’t meet the formal criteria for designation under the 2015 Trade Enforcement Act. And no actual sanctions flow from this designation. The argument was that China manages its exchange rate (fair enough) and the August depreciation was done with the intent of giving China a competitive advantage (a fairly loose standard).

** The only case for letting Singapore off is that it is a city state, and thus it makes sense for Singapore to target the exchange rate rather than domestic variables when setting its monetary policy. And low levels of inflation don't suggest a strong need for appreciation of the Singapore dollar. That said, Singapore and the world would be better off with an appreciated exchange rate, less intervention and an expansionary fiscal policy. After twenty plus years of a roughly twenty percent of GDP external surplus that has largely gone into the buildup of the government's external assets, Singapore is in no way fiscally constrained. And if the 1988 Trade Act can be used against China, it could also be used against others who don't meet all three of the 2015 criteria.