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Does Currency Pressure Work? The Case of Taiwan

by Brad Setser
April 10, 2017

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I confess that I probably am the only person in the world who—setting aside the internal politics of the Trump White House—would be excited to write the Treasury’s foreign currency report this quarter.

Not because of China.

I would say China met the existing 2015 manipulation criteria in the past. I would put the criteria under review (I personally think the bilateral surplus analysis should be complemented with value-added measures,* which would reallocate some of China’s surplus to Japan, Korea, Taiwan, and others).**

But not name China. Not now. As the Financial Times notes: “It is in no one’s interest, including the US, if Beijing suddenly stops intervening to defend the renminbi and a destabilising rush of capital flight and sharp devaluation follows.”

The U.S. would be completely isolated in naming China, the impact of China’s 2016 stimulus seems to have been bigger than the impact of the renminbi’s depreciation (China’s external surplus is falling) and there is plenty of scope to push China on other trade issues.

But the report could still be interesting, as there is a good case that the United States should find ways to keep the heat on Korea and Taiwan up — even if neither likely meets all three of the criteria in the 2015 Trade Enforcement Act, and even if geopolitics probably is a constraint on getting too tough on Korea right now.

It is often argued that countries won’t change their currency policies with a gun pointed to their heads, so explicit threats won’t work. Fair enough: threats do not always work (see the Freedom Caucus, health care).

On the other hand, sometimes countries get a bit locked into a certain set of export-promoting policies, and won’t change unless their feet are held to the proverbial fire.

Korea for example still seems pretty comfortable intervening to keep the won in a band. It seems to have intervened again to limit the won’s appreciation in late March (at around won 1115, the market has subsequently turned). And Korea’s band is set in a way that keeps the won much weaker than it was before the global crisis, allowing foreign demand (via the trade surplus) to help offset the domestic impact of Korea’s weak social safety net, forced pension savings, and tight fiscal policy.

And Taiwan has long been comfortable with a weak New Taiwan dollar maintained in part through intervention and in part through encouraging Taiwanese financial institutions (notably the life insurers) to invest ever larger sums abroad.

The last Treasury foreign exchange report noted that Taiwan met the current account surplus and reserve accumulation criteria of the 2015 trade law. It escaped being dinged because of its small bilateral surplus with the United States.

That report may have gotten Taiwan’s attention (I certainly tried to help the process along too).

Judging from the balance of payments data, Taiwan’s intervention fell off a bit in the fourth quarter.

And Taiwan is reported to have largely kept out of the market in the first quarter of 2017. That is one of the reasons why the New Taiwan dollar appreciated by about 5 percent against the U.S. dollar (and against the yuan—which probably matters more for Taiwan).

As a result, Taiwan’s reported reserve growth over the last four quarters of balance of payments data (calendar 2016) dipped to right around two percent of GDP (The Treasury threshold).

That alone shouldn’t let Taiwan entirely off the hook though. We don’t know how much Taiwan really intervened, because Taiwan doesn’t release data on its forward book (Taiwan has not voluntary adopted the SDDS disclosure standard, which it could do even if it isn’t a member of the IMF). Taiwan claims it doesn’t intervene in the forward market, but, well, the old notion of “trust but verify” would seem to be relevant here.

Now the Treasury calculates reserve growth without explicit reference to the balance of payments data. It adjusts headline reserves for valuation changes, and it nets out estimated interest income. The Treasury’s interest income adjustment—which is debatable, I personally think interest income should be sold for domestic currency, with the proceeds paying the coupon on domestic sterilization instruments and with any excess going into a reserve fund or sent back to the government—should help Taiwan. It should pull Taiwan’s intervention below 2% of GDP in the Treasury’s eye (the details of how you do the calculation turn out to matter).

My gut is thus that Taiwan no longer meets two of the three existing Treasury criteria. So if Treasury sticks strictly to those criteria, Taiwan may have gotten itself off the watch list.

Yet the battle isn’t over. Less intervention has meant that the New Taiwan dollar has appreciated a bit. But its currency is now getting back to its 2013 or 2014 levels (against the dollar). It was risen to the point where Taiwan may well want to resume intervention.

Yet with a current account surplus that is still over 13 percent of GDP, it really should tolerate a bit more appreciation.

There is one other thing, which is a bit more technical.

Taiwan’s life insurers have a ton of foreign assets. And they have added to their foreign asset portfolio at a very impressive clip over the last several years when the New Taiwan dollar was weak and Taiwanese interest rates were low (in part because regulations were relaxed). So long as the government intervened to keep the New Taiwan dollar relative weak, the risk of large foreign exchange losses on their investments was limited. But they stand to take losses in the Taiwan dollar rises (so long as they haven’t already hedged the currency risk). Fair enough. The risk of such losses helps deter large currency mismatches. But at some point the life insurers desire to adjust their hedges might accelerate any currency move…

Or put pressure on Taiwan’s central bank to intervene forward.

Forward disclosure thus is absolutely critical.

Note: I edited this after posting, though the basic content did not change. I actually accidentally posted this when I thought I was saving it as a draft on my way out the door, so it appeared a bit prematurely. My apologies. Notably some important links had not been added.

* The data needed for the value-added adjustment is a real problem, it tends to be available only with long lags
** I might even try to find a way to warn that a country that guides its currency down could meet the 1988 definition manipulation even if it is selling some of its foreign currency reserves to limit the pace of depreciation. A controlled depreciation is hard, and usually requires reserve sales.

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