International_Economics_Tenth_Edition (1)

16.1 The Bank for International Settlements, founded in 1930, facilitates international policy coordination through its monthly meetings of central bank officials. Set your browser to this URL:

http://www.bis.org

16.2 The Organisation for Economic Cooperation and Development (DECO) is a Paris-based organization of 29 countries. Its goal is to develop compatible, wideranging policies that boost prosperity. Visit

its Web page by setting your browser to this URL:

http://www.oecd.org

16.3 The National Bureau of Economic Research (NBER) provides online data and summaries of research studies relating to international finance, trade, and investment at its Web site. Set your browser to this URL:

http://www.nber.org

Although individuals desirecash balancesprimarilyto fill the gap betweenmonetary receipts and payments, this desire is influenced by a number of other factors. The need for cash balances may become more acute if the absolute dollar volume of transactions increases, becauselarger imbalances may result between receipts and payments. Conversely, to the extent that individuals can finance their transactions on credit, they require less cash in hand.

Just as an individual desires to hold cash balances, national governments have a need for international reserves. The chief purpose of international reserves is to enable nations to finance disequilibrium in their balance-of-payments positions. When a nation finds its monetary receipts falling short of its monetary payments, the deficit is settled with international reserves. Eventually, the deficit must be eliminated, because central banks tend to have limited stocks of reserves.

From a policy perspective, the advantage of international reserves is that they enable nations to sustain temporary balance-of-payments deficits until acceptable adjustment measures can operate to correct the disequilibrium. Holdings of international reserves facilitate effective policy formation because corrective adjustment measures need not be implemented prematurely. Should a deficit nation possess abundant stocks of reserve balances, however, it may be able to resist unpopular adjustment measures, making eventual adjustments even more troublesome.

Demand for International Reserves

When a nation's international monetary payments exceed its international monetary receipts, some means of settlement is required to finance its payments deficit. Settlement ultimately consists of transfers of international reserves among nations. Both the magnitude and the longevity of a balance- of-payments deficit that can be sustained in the absence of equilibrating adjustments are limited by a nation's stock of international reserves.

On a global basis, the demand for international reserves depends on two related factors: (1) the monetary value of international transactions and

(2) the disequilibrium that can arise in balance-of- payments positions. The demand for international reserves is also contingent on such things as the speed and strength of the balance-of-payments adjustment mechanism and the overall institutional framework of the world economy.

Exchange-Rate Flexibility

One determinant of the demand for international reserves is the degree of exchange-rate flexibility of the international monetary system. This is because exchange-rate flexibility in part underlies the efficiency of the balance-of-payments adjustment process.

Figure 17.1 on page 492 representsthe exchangemarket position of the United States in trade with Great Britain. Starting at equilibrium point E, suppose that an increase in imports increases the U.S. demand for pounds from Do to D 1. The prevailing exchange-rate system will determine the quantity of international reserves needed to bridge the gap between the number of pounds demanded and the number supplied.

If exchange rates are fixed or pegged by the monetary authorities, international reserves play a crucial role in the exchange-rate stabilization process. In Figure 17.1, suppose the exchange rate is pegged at $2 per pound. Given a rise in the demand for pounds from Do to Db the United States would face an excess demand for pounds equal to £100 at the pegged rate. If the U.S. dollar is not to depreciate beyond the pegged rate, the monetary authorities-that is, the Federal Reserve-must enter the market to supply pounds, in exchange for dollars, in the amount necessary to eliminate the disequilibrium. In the figure, the pegged rate of $2 per pound can be maintained if the monetary authorities supply £100 on the market. Coupled with the existing supply schedule So, the added supply will result in a new supply schedule at 51' Market equilibrium is restored at the pegged rate.

Rather than operating under a rigidly pegged system, suppose a nation makes an agreement to foster some automatic adjustments by allowing market rates to float within a narrow band around the official exchange rate. This limited exchangerate flexibility would be aimed at correcting minor

payments imbalances, whereas large and persistent disequilibrium would require other adjustment measures.

Referring to Figure 17.1, assume that the U.S. official exchange rate is $2 per pound, but with a band of permissible exchange-rate t1uctuations whose upper limit is set at $2.25 per pound. Given a rise in the U.S. demand for pounds, the value of the dollar will begin to decline. Once the exchange rate depreciates to $2.25 per pound, domestic monetary authorities will need to supply £40 on the market to defend the band's outer limit. This will have the effect of shifting the market supply schedule from So to S2' Under a system of limited exchange-rate flexibility, then, movements in the exchange rate serve to reduce the

payments disequilibrium. Smaller amounts of international reserves are required for exchangerate stabilization purposes under this system than if exchange rates are rigidly fixed.

A fundamental purpose of international reserves is to facilitate government intervention in exchange markets to stabilize currency values. The more active a government's stabilization activities, the greater is the need for reserves. Most exchangerate standards today involve some stabilization operations and require international reserves. However, if exchange rates were allowed to float freely without government interference, theoretically there would be no need for reserves. This is because a floating rate would serve to eliminate an incipient payments imbalance, negating the need

for stabilization operations. Referring again to Figure 17.1, suppose the exchange market is initially in equilibrium at a rate of $2 per pound. Given an increase in the demand for foreign exchange from Do to Db the home currency would begin to depreciate. It would continue to weaken until it reached an exchange value of $2.50 per pound, at which point market equilibrium would be restored. The need for international reserves would thus be nonexistent under freely floating rates.

Other Determinants

The lesson of the previous section is that changes in the degree of exchange-rate flexibility are inversely related to changes in the quantity of international reserves demanded. In other words, a monetary system characterized by more rapid and flexible exchange-rate adj ustments requires smaller reserves, and vice versa.

In addition to the degree of exchange-rate flexibility, several other factors underlie the demand for international reserves, including (1) automatic adjustment mechanisms that respond to payments disequilibrium, (2) economic policies used to bring about payments equilibrium, and (3) the international coordination of economic policies.

Our earlier analysis has shown that adjustment mechanisms involving prices, interest rates, incomes, and monetary flows automatically tend to correct balance-of-payments disequilibrium. A payments deficit or surplus initiates changes in each of these variables. The more efficient each of these adjustment mechanisms is, the smaller and more short-lived market imbalances will be and the fewer reserves will be needed. The demand for international reserves therefore tends to be smaller with speedier and more complete automatic adjustment mechanisms.

The demand for international reserves is also influenced by the choice and effectiveness of government policies adopted to correct payments imbalances. Unlike automatic adjustment mechanisms, which rely on the free market to identify industries and labor groups that must bear the adjustment burden, the use of government policies involves political decisions. All else being equal, the greater a nation's propensity to apply commercial policies (including tariffs, quotas, and

subsidies) to key sectors, the less will be its need for international reserves. This assumes, of course, that the policies are effective in reducing payments disequilibrium. Because of uncertainties about the nature and timing of payments disturbances, however, nations are often slow to initiate such trade policies and find themselves requiring international reserves to weather periods of payments disequilibrium.

The international coordination of economic policies is another determinant of the demand for international reserves. A primary goal of economic cooperation among finance ministers is to reduce the frequency and extent of payments imbalances and hence the demand for international reserves. Since the end of World War II, nations have moved toward the harmonization of national economic objectives by establishing programs through such organizations as the IMF Fund and the Organisation for Economic Cooperation and Development. Another example of international economic organization has been the European Union, whose goal is to achieve a common macroeconomic policy and full monetary union. By reducing the intensity of disturbances to payments balance, such policy coordination reduces the need for international reserves.

Other factors influence the demand for international reserves. The quantity demanded is positively related to the level of world prices and income. One would expect rising price levels to inflate the market value of international transactions and, therefore, to increase the potential demand for reserves. The need for reserves would also tend to rise with the level of global income and trade activity.

In summary, central banks need international reserves to cover possible or expected excess payments to other nations at some future time. The quantity of international reserves demanded is directly related to the size and duration of these payment gaps. If a nation with a payments deficit is willing and able to initiate quick actions to increase receipts or decrease payments, the amount of reserves needed will be relatively small. Conversely, the demand for reserves will be relatively large if nations initiate no actions to correct payments imbalances or adopt policies that prolong such disequilibrium.

494 International Banking: Reserves, Debt, and Risk

Supply of International

Reserves

The analysis so far has emphasized the demand for international reserves. But what about the supply of international reserves?

The total supply of international reserves consists of two distinct categories: owned reserves and borrowed reserves. Reserve assets such as gold, acceptable foreign currencies, and SDRs are generally considered to be directly owned by the holding nations. But if nations with payments deficits find their stocks of owned reserves falling to unacceptably low levels, they may be able to borrow international reserves as a cushioning device. Lenders may be foreign nations with excess reserves, foreign financial institutions, or international agencies such as the IMF.

I Foreign Currencies

International reserves are a means of payment used in financing foreign transactions. One such asset is holdings of national currencies (foreign exchange). As seen in Table 17.1, the largest share of international reserves today consists of holdings of national currencies.

Over the course of the 1800s-1900s, two national currencies in particular have gained promi-

International Reserves, 2003, All Countries

(in Billions of SDRs')

nence as means of financing international transactions. These currencies, the U.S. dollar and the British pound, have been considered reserve currencies (or key currencies), because trading nations have rraditionally been willing to hold them as international reserve assets. Since World War II, the U.S. dollar has been the dominant reserve currency. Other reserve currencies are the Japanese yen and a few other currencies that are acceptable in payment for international transactions.

The role of the pound as a reserve currency is largely due to circumstances of the late 1800s and early 1900s. Not only did Britain at that time play a dominant role in world trade, but the efficiency of London as an international money market was also widely recognized. This was the golden age of the gold standard, and the pound was freely convertible into gold. Traders and investors felt confident financing their transactions with pounds. With the demise of the gold standard and the onset of the Great Depression during the 1930s, Britain's commercial and financial status began to deteriorate, and the pound lost some of its international luster. Today, the pound still serves as an important international reserve asset, but it is no longer the most prestigious reserve currency.

The emergence of the U.S. dollar as a reserve currency stems from a different set of circumstances. Emerging from World War II, the U.S. economy was not only unharmed but actually stronger. Because of the vast inflows of gold into the United States during the 1930s and 1940s, the dollar was in a better position than the pound to assume the role of a reserve currency.

The mechanism that supplied the world with dollar balances was the balance-of-payments deficits of the United States. These deficits stemmed largely from u.s. foreign aid granted to Europe immediately after World War II, as well as from the flow of private investment funds abroad from u.s. residents. The early 1950s were characterized as a dollar-shortage era, when the massive development programs of the European nations resulted in an excess demand for the dollars used to finance such efforts. As the United States began to run modest payments deficits during the early 1950s, the dollar outflow was appreciated by the recipient nations.

By the late 1950s, the U.S. payments deficits had become larger. As foreign nations began to accumulate larger dollar balances than they were accustomed to, the dollar-shortage era gave way to a dollar glut. Throughout the 1960s, the United States continued to provide reserves to the world through its payments deficits. However, the persistently weak position of the U.S. balance of payments increasingly led foreigners to question the soundness of the dollar as a reserve currency. By 1970, the amount of dollar liabilities in the hands of foreigners was several times as large as U.S. reserve assets. Lack of confidence in the soundness of the dollar inspired several European nations to exercise their rights to demand that the u.s. Treasury convert their dollar holdings into gold, which in turn led the United States to suspend its gold convertibility pledge to the rest of the world in 1971.

Using the dollar as a reserve currency meant that the supply of international reserves varied with the payments position of the United States. During the 1960s, this situation gave rise to the socalled liquidity problem. To preserve confidence in the dollar as a reserve currency, the United States had to strengthen its payments position by eliminating its deficits. But correction of the U.S. deficits would mean elimination of additional dollars as a source of reserves for the international monetary system. The creation in 1970 of SDRs as reserve assets and their subsequent allocations have been intended as a solution for this problem.

I Gold

The historical importance of gold as an international reserve asset should not be underemphasized. At one time, gold served as the key monetary asset of the international payments mechanism; it also constituted the basis of the money supplies of many nations.

As an international money, gold fulfilled several important functions. Under the historic gold standard, gold served directly as an international means of payments. It also provided a unit of account against which commodity prices as well as the parities of national currencies were quoted. Although

gold holdings do not yield interest income, gold has generally served as a viable store of value despite inflation, wars, and revolutions. Perhaps the greatest advantage of gold as a monetary asset is its overall acceptability, especially when compared with other forms of international monies.

Today, the role of gold as an international reserve asset has declined. Over the past 30 years, gold has fallen from nearly 70 percent to less than 3 percent of world reserves. Private individuals rarely use gold as a medium of payment and virtually never as a unit of account. Nor do central banks currently use gold as an official unit of account for stating the parities of national currencies. The monetary role of gold is currently recognized by only a few nations, mostly in the Middle East. In most nations outside the United States, private residents have long been able to buy and sell gold as they would any other commodity. On December 31,1974, the U.S. government revoked a 41-year ban on u.s. citizens' ownership of gold. The monetary role of gold today is only that of a glittering ghost haunting efforts to reform the international monetary system.

International Gold Standard

Under the international gold standard, whose golden age was about 1880 to 1914, the values of most national currencies were anchored in gold. Gold coins circulated within these countries as well as across national boundaries as generally accepted means of payment. Monetary authorities were concerned about maintaining the public's confidence in the paper currencies that supplemented gold's role as money. To maintain the integrity of paper currencies, governments agreed to convert them into gold at a fixed rate. This requirement was supposed to prevent monetary authorities from producing excessive amounts of paper money. The so-called discipline of the gold standard was achieved by having the money supply bear a fixed relation to the monetary stock of gold. Given the cost of producing gold relative to the cost of other commodities, a monetary price of gold could be established to produce growth in monetary gold-and thus in the money supply-at a rate that corresponded to the growth in real national output.

496 International Banking: Reserves, Debt, and Risk

Over the course of the gold standard's era, the importance of gold began to decline, whereas both paper money and demand deposits showed marked increases. From 1815 to 1913, gold as a share of the aggregate money supply of the United States, France, and Britain fell from about 33 percent to 10 percent. At the same time, the proportion of bank deposits skyrocketed from a modest 6 percent to about 68 percent. By 1913, paper monies plus demand deposits accounted for approximately 90 percent of the U.S. money supply.

After World War I, popular sentiment favored a return to the discipline of the gold standard, in part because of the inflation that gripped many economies during the war years. The United States was the first to return to the gold standard, followed by several European nations. Efforts to restore the prewar gold standard, however, ended in complete collapse during the 1930s. In response to the economic strains of the Great Depression, nations one by one announced that they could no longer maintain the gold standard.

In the United States, the Great Depression brought an important modification of the gold standard. In 1934, the Gold Reserve Act gave the U.S. government title to all monetary gold and required citizens to turn in their private holdings to the U.S. Treasury. This was done to end the pressure on U.S. commercial banks to convert their liabilities into gold. The U.S. dollar was also devalued in 1934, when the official price of gold was raised from $20.67 to $35 per ounce. The dollar devaluation was not specifically aimed at defending the U.S. trade balance. The rationale was that a rise in the domestic price of gold would encourage gold production, adding to the money supply and the level of economic activity. The Great Depression would be solved! In retrospect, the devaluation may have had some minor economic effects, but there is no indication that it did anything to lift the economy out of its depressed condition.

Gold Exchange Standard

Emerging from the discussions among the world powers during World War II was a new international monetary organization, the International Monetary Fund (IMF). A main objective of the

IMF was to reestablish a system of fixed exchange rates, with gold serving as the primary reserve asset. Gold became an international unit of account when member nations officially agreed to state the par values of their currencies in terms of gold or, alternatively, the gold content of the U.S. dollar.

The post-World War II international monetary system as formulated by the fund nations was n0111inally a gold exchange standard. The idea was to economize on monetary gold stocks as international reserves, because they could not expand as fast as international trade was growing. This required the United States, which emerged from the war with a dominant economy in terms of productive capacity and national wealth, to assume the role of world banker. The dollar was to become the chief reserve currency of the international monetary system. The coexistence of both dollars and gold as international reserve assets led to this system's being dubbed the dollar-gold system.

As a world banker, the United States assumed responsibility for buying and selling gold at a fixed price to foreign official holders of dollars. The dollar was the only currency that was made convertible into gold; other national currencies were pegged to the dollar. The dollar was therefore regarded as a reserve currency that was as good as gold because it was thought that the dollar would retain its value relative to other currencies and remain convertible into gold.

As long as the monetary gold stocks of the United States were large relative to outstanding dollar liabilities abroad, confidence in the dollar as a viable reserve currency remained intact. Immediately following World War II, the U.S. monetary gold stocks peaked at $24 billion, about two-thirds of the world total. But as time passed, the amount of foreign dollar holdings rose significantly because of the U.S. payments deficits, whereas the U.S. monetary gold stock dwindled as some of the dollars were turned back to the U.S. Treasury for gold. By 1965, the total supply of foreign-held dollars exceeded the U.S. stock of monetary gold. With the United States unable to redeem all outstanding dollars for gold at $35 per ounce, its ability as a world banker to deliver on demand was questioned.

These circumstances led to speculation that the United States might attempt to solve its goldshortage problem by devaluing the dollar. By increasing the official price of gold, a dollar devaluation would lead to a rise in the value of U.S. monetary gold stocks. To prevent speculative profits from any rise in the official price of gold, the United States along with several other nations in 1968 established a two-tier gold system. This consisted of an official tier, in which central banks could buy and sell gold for monetary purposes at the official price of $35 per ounce, and a private market, where gold as a commodity could be traded at the free-market price. By separating the official gold market from the private gold market, the two-tier system was a step toward the complete demonetization of gold.

Demonetization of Gold

The formation of the two-tier gold system was a remedy that could only delay the inevitable collapse of the gold exchange standard. By 1971, the U.S. stock of monetary gold had declined to $11 billion, only a fraction of U.S. dollar liabilities to foreign central banks. The U.S. balance-of-payments position was also deteriorating. In August 1971, U.S. President Richard Nixon announced that the United States was suspending its commitment to buy and sell gold at $35 per ounce. The closing of the gold window to foreign official holders brought an end to the gold exchange standard, and the last functional link between the dollar and monetary gold was severed.

It took several years for the world's monetary authorities to formalize the demonetization of gold as an international reserve asset. On january 1, 1975, the official price of gold was abolished as the unit of account for the international monetary system. National monetary authorities could enter into gold transactions at market-determined prices, and the use of gold was terminated by the IMF. It was agreed that one-sixth of the fund's gold would be auctioned at prevailing prices and the profits distributed to the less-developed nations.

As for the United States, the 41-year ban on gold ownership for U.S. residents was ended on

january 1, 1975. Within a few weeks, the U.S. Treasury was auctioning a portion of its gold on the commodity markets. These actions were a signal by the United States that it would treat gold in the same way it treats any other commodity.

I Special Drawing Rights

The liquidity and confidence problems of the gold exchange standard that resulted from reliance on the dollar and gold as international monies led in 1970 to the creation by the IMF of a new reserve asset, termed special drawing rights (SDRs). The objective was to introduce into the payments mechanism a new reserve asset, in addition to the dollar and gold, that could be transferred among participating nations in settlement of payments deficits. With the IMF managing the stock of SDRs, world reserves would presumably grow in line with world commerce.

SDRs are unconditional rights to draw currencies of other nations. When the fund creates a certain number of SDRs, they are allocated to the member nations in proportion to the relative size of their fund quotas. Nations can then draw on their SDR balances in financing their payments deficits. The key point is that certain surplus nations are designated by the fund to trade their currencies for an equivalent amount in SDRs to deficit nations in need of foreignexchange reserves. Nations whose currencies are acquired as foreign exchange are not required to accept more than three times their initial SDR allotments.

SDRs pay interest to surplus nations on their net holdings (the amount by which a nation's SDR balance exceeds its allocation as determined by its fund quota). Interest payments come from deficit nations that draw their SDR balances below their original allotments. The SDR interest rate is adjusted periodically in line with the shortterm interest rates in world money markets. It is reviewed quarterly and adjusted on the basis of a formula that takes into account the short-term interest rates of the United States, the United Kingdom, Germany, France, and japan.

498 International Banking: Reserves, Debt, and Risk

When the SDR was initially adopted, it was agreed that its value should be maintained at a fixed tie to the U.S. dollar's par value, which was then expressed in terms of gold. The value of the SDR was originally set at US$1. After several monetary developments, this linkage became unacceptable. With the suspension of u.s. gold convertibility in 1971, it was doubted whether the gold value of the dollar should serve as the official unit of account for international transactions. The United States was making it known that it wished to phase out gold as an international monetary instrument. Furthermore, the dollar's exchange rate against gold fell twice as the result of u.s. devaluations in 1971 and 1973. Finally, under the system of managed floating exchange rates, adopted by the industrialized nations in 1973, it became possible for the SDR's value to fluctuate against other currencies while still bearing a fixed tie to the dollar's value. In view of these problems, in 1974, a new method of SDR valuation was initiated-the basket valuation.

Basket valuation is intended to provide stability for the SDR's value under a system of fluctuating exchange rates, making the SDR more attractive as an international reserve asset. The SDR is called a basket currency because it is based on the value of four currencies: the U.s. dollar, European euro, Japanese yen, and British pound. An appreciation, or increase in value, of anyone currency in the basket in terms of all other currencies will raise the value of the SDR in terms of each of the other currencies. Conversely, a depreciation, or decline in value, of anyone currency will lower the value of the SDR in terms of each other currency. Because the movements of some currencies can be offset or moderated by the movements of other currencies, the value of the SDR in terms of a group of currencies is likely to be relatively stable.

Besides helping nations finance balance-of- payments deficits, SDRs have a number of other uses. Some of the fund's member nations peg their currency values to the SDR. The SDR is the unit of account for IMF transactions and is used as a unit of account for individuals (such as exporters, importers, or investors) who desire protection against the risk of fluctuating exchange rates.

Facilities for

Borrowing Reserves

The discussion so far has considered the different types of owned reserves-national currencies, gold, and SDRs. Various facilities for borrowing reserves have also been implemented for nations with weak balance-of-payments positions. Borrowed reserves do not eliminate the need for owned reserves, but they do add to the flexibility of the international monetary system by increasing the time available for nations to correct payments disequilibrium. Let's examine the major forms of international credit.

IMF Drawings

One of the original purposes of the IMF was to help member nations finance balance-of-payments deficits. The fund has furnished a pool of revolving credit for nations in need of reserves. Temporary loans of foreign currency are made to deficit nations, which are expected to repay them within a stipulated time. The transactions by which the fund makes foreign-currency loans available are called IMF drawings.

Deficit nations do not borrow from the fund. Instead, they purchase with their own currency the foreign currency required to help finance deficits. When the nation's balance-of-payments position improves, it is expected to reverse the transaction and make repayment by repurchasing its currency from the fund. The fund currently allows members to purchase other currencies at their own option up to the first 50 percent of their fund quotas, which are based on the nation's economic size. Special permission must be granted by the fund if a nation is to purchase foreign currencies in excess of this figure. The fund extends such permission once it is convinced that the deficit nation has enacted reasonable measures to restore payments equilibrium.

Since the early 1950s, the fund has also fostered liberal exchange-rate policies by entering into standby arrangements with interested member nations. These agreements guarantee that a member nation may draw specified amounts of foreign currencies from the fund over given time periods. The advantage is that participating nations can