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The Cost of a Foreign Exchange Standard or of the Use of a Foreign Currency as the Circulating Medium

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1957
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ALTHOUGH THE NUMBER is diminishing, various independent countries and colonial areas still have no monetary authority with discretionary power over currency circulation, but use either a foreign currency or a foreign exchange standard, i.e., a local currency with a mandatory 100 per cent foreign exchange cover. The characteristics and some of the possible advantages and disadvantages of these “automatic” currency systems are briefly described in this paper. However, the paper deals primarily with the economic cost of employing foreign assets as the circulating medium or as a mandatory cover for the currency. This cost is genuine, but in assessing its magnitude, account should be taken of the fact that countries having independent currency systems must also maintain foreign exchange reserves. The net cost of the automatic systems, therefore, relates only to the extra amount of foreign assets that is immobilized; in most instances, this net cost appears to be small.

Nature and Operation of Automatic Currency Systems

The term “automatic” as used in this paper describes a monetary system in which there is no monetary authority with discretionary power to issue and retire currency. In such a system, the domestic circulation of notes and coin is subject to the same automatic forces as under a gold coin or gold certificate standard, i.e., the currency in circulation is primarily a resultant of movements in the balance of payments. Two basic types of automatic system are now in operation. One type is that which employs a foreign currency as the circulating medium, e.g., the U.S. dollar in Panama and Liberia. Panama has no national currency of any significance,1 and the U.S. dollar, which enjoys full legal tender privileges, is used for local purposes. Liberia employs the U.S. dollar as legal tender, predominantly in the form of silver dollars and subsidiary coins. The second type is that which involves a 100 per cent mandatory foreign exchange cover for a locally issued currency, e.g., the sterling exchange standard system (or currency board system) which exists in various British colonial areas.2 Jordan, an independent country since 1946, also operates under a sterling exchange standard; the Jordanian Currency Board was established in 1949 with its head office in London.

Under the sterling exchange standard, a currency board is empowered to issue a local currency, but the board is denied any discretionary power to direct or to manage the currency issue. Local currency is issued and redeemed by the board in exchange for sterling at a fixed rate. This is done only in response to the initiative of the second party to the transaction, usually a commercial bank; hence, this function of the board can be characterized as that of a money-changer. For this service the board charges a commission, usually ¼ to ½ per cent, which is applicable to transactions in either direction, i.e., it is applied equally to exchanges of either sterling or local currency.3

The most important difference between the Panamanian type of currency system and the (sterling) exchange standard system is that under the latter the authorities acquire foreign exchange and are able to invest in sterling securities and earn the prevailing rate of return;4 such interest earnings are entirely foregone under the Panamanian system.

There are undoubtedly important advantages in maintaining automatic currency systems in some areas. In certain small dependent territories, the difficulty of setting up and managing an independent monetary system is avoided through this arrangement. Use of a widely acceptable currency is an important advantage in tourist and border trade in Panama, and perhaps elsewhere; and the exchange stability of the local currency under the currency board system is, of course, advantageous for international trade and investment.

The limitations that an automatic currency system imposes on the governmental authorities may be considered either an advantage or a disadvantage. On the one hand, the lack of discretionary power to expand the currency issue restricts the capacity of the government to finance its expenditures in an inflationary way. The expedients of printing money or of borrowing from a bank of issue are not available, and, in the absence of a central bank, possibilities of borrowing from commercial banks are likely to be limited. Even if the government finds it possible to finance a relatively large deficit by borrowing from local commercial banks, the inflationary consequences are limited since the increase in the domestic money supply will tend to be checked, automatically, by balance of payments forces, i.e., through increased imports or other debit items, which will result nearly concurrently in a net outflow of currency (or a reduced net inflow of currency). Since inflationary tendencies resulting in part from government deficits are a chronic problem in many underdeveloped countries, an automatic currency system is regarded by many observers as a useful safeguard. A similar argument, of course, can be advanced in favor of the gold standard.

On the other hand, an automatic currency system may be considered disadvantageous because it prevents the authorities from applying effective monetary measures to reduce the severity of swings in the business cycle. Again, the system is subject to the same forces as the gold standard. A balance of payments surplus introduces additional currency into circulation, and a payments deficit drains away currency. Since currency serves not only as hand-to-hand money but also as commercial bank reserves, the change in deposits and in total money supply is likely to be greater than a balance of payments surplus or deficit. As the authorities cannot take compensatory action of a monetary character, an automatic currency economy is, to this extent, more responsive than other economies to the forces of inflation and deflation arising from the balance of payments position. The automatic relationship between the money supply and the balance of payments may render the monetary system incapable of expansion and contraction in response to seasonal financial demands. And the system may be unable to expand with economic growth except through the accumulation of export surpluses. Cyclical fluctuations may, of course, be damped to some extent through the use of the foreign exchange reserves of private banks (or through foreign loans). Also, governments may be able to apply a limited type of countercyclical fiscal policy, e.g., during an export boom, by budgeting for government surpluses and accumulating foreign exchange holdings through the levy of export duties or through the operations of a marketing board, and by drawing down government-held balances during a depression. However, the authorities of an automatic currency economy are powerless to take effective countercyclical monetary measures.5

Another possible disadvantage of the automatic currency system is that the absence of a central bank acting as a lender of last resort may require the banking system to hold larger cash reserves (inclusive of central bank reserves) than would be needed under a discretionary system, and may expose individual banks to the risk of insolvency.6 This may induce a conservative policy on the part of the banks and prevent them from playing as active a role in the financing of investment as would be possible under a different monetary system.

Economic Costs of Automatic Currency Systems

Under an automatic currency system, as under the gold standard, the economy must bear a real cost for obtaining its currency. The gross cost is represented by a cumulative export surplus (or, more precisely, the cumulative total of net credit entries in the balance of payments).7 Under the currency board system an offset against this cost is the interest earned on the foreign securities which form the currency cover. But in a poor and underdeveloped area, the return on this mandatory external investment (capital export) may be considerably less than the value to the community of additional imports.

In estimating the real cost of an automatic currency system, the capacity of the economy to absorb the additional resources which the release of the excess foreign exchange could provide has been questioned by some observers. This reservation applies chiefly to the use of accumulated foreign assets for capital goods imports, for which there is a limit to the rate of efficient absorption; the underdeveloped areas, however, could easily use more imported consumer goods. Even as regards capital goods, any limit on absorptive capacity is likely to become more remote with the progress of development. It has also been argued that, in the British colonies, government projects are not impeded by the requirement that sterling assets be used as currency cover since colonies needing sterling can borrow in London.8 This argument, however, appears to overstate the ease of borrowing, especially under conditions of monetary stringency in London,9 and it neglects the interest cost.

To obtain some idea of the difference between the cost of employing an automatic currency system and the cost of employing a discretionary monetary system, data on central banks’ total holdings of foreign assets may be compared with their total currency issues. To the extent that the observed ratios of foreign assets to currency issues in countries with discretionary systems are less than 100 per cent, these countries have been able to use external receipts which would have been immobilized under an automatic system.10 It should be noted that central banks ordinarily hold the whole of the official foreign reserves of the country, and that some of the reserves are commonly held not only as currency cover but also as cover for various deposit liabilities. In some countries, minimum holdings of foreign reserves against both currency and deposit liabilities are specified by law. On the other hand, the foreign asset reserves held by currency boards, under a 100 per cent exchange standard, in most cases probably constitute the greater part, if not the whole, of official foreign exchange reserves of the country or colony.11 The legal requirement of a one-to-one correspondence between foreign assets and the currency issue under the currency board system should not obscure the fact that these assets also serve as international reserves. The requirement means that the accumulation or decumulation of foreign reserves involves exactly equal increases or decreases in the domestic currency issue (and also, perhaps, changes in deposit money). Under a discretionary system, the accumulation or decumulation of foreign reserves also tends to increase or decrease the money supply, but the monetary effects can be wholly or partly counteracted by central banking operations.

Table 1 shows for 20 countries the central bank holdings of total foreign assets expressed as a percentage of gross12 currency liabilities. The findings give a rough indication of the amount of resources that might be released through the adoption of a discretionary system in similarly situated countries now having automatic currency systems.13 The countries selected are relatively underdeveloped countries for which the necessary data were easily obtainable from the Fund publication, International Financial Statistics. The countries are arranged in ascending order of the proportion of central bank holdings of foreign assets to the national currency liability (determined on the basis of the average of end-of-year ratios over the period covered by the available data—i.e., for most countries an eight-year period beginning 1948).

Table 1.Central Bank Holdings of Foreign Assets as Per Cent of Gross Currency Liability, Various Countries, 1948–55 1(Data as of end of period)
CountryAverage

of End-of

-Year Data
19481949195019511952195319541955
IIIIIIIVIIIIIIIVIIIIIIIV
Group I
Brazil377161443028272831272520191716161615
Bolivia38564255723021634737262014104113
Costa Rica422624194057819178617973495076968261
Colombia464243414548616059526169586238404033
Turkey495764625443494842434245403938363029
Nicaragua523128286285114154128691021279246659211169
Mexico6017438260566353486744303952707899100
Median46
Group II
Philippines699174817270737574686872615854555643
India728476767370706872716970706763606260
Pakistan27415295828344424344414440404140415858
Dominican Republic848875831009188888576971001008678767672
Guatemala8795909590108111837390766968891089698
Thailand948910510910910899979585787371701111158381
Ecuador95100911109411412010394979386818389757976
Median84
Group III
Honduras110518513914912811913713512110811911010697109117102
El Salvador1111191331311201081521591411061391421169913314912292
Cuba112118122102104118120112118122118104111118123111
Venezuela119123131119111115107123127120117135126111115133131117
Ceylon1241081091541601039276796795125124139149160156154
Burma1391011211501822211631891901911301351089467585355
Median116

Based on data from International Financial Statistics (Washington). Except for India and Pakistan, the data for foreign assets are the domestic currency valuations entered in the balance sheets of central banks, as published in IFS. For India and Pakistan, the central bank rupee valuations of gold do not correspond to the rupee valuations of foreign exchange; therefore, the foreign assets data used are the IFS data on foreign assets expressed in U.S. dollars, converted to rupees at par. Gross currency liabilities include currency held by the banking system.

See text footnote 14.

Based on data from International Financial Statistics (Washington). Except for India and Pakistan, the data for foreign assets are the domestic currency valuations entered in the balance sheets of central banks, as published in IFS. For India and Pakistan, the central bank rupee valuations of gold do not correspond to the rupee valuations of foreign exchange; therefore, the foreign assets data used are the IFS data on foreign assets expressed in U.S. dollars, converted to rupees at par. Gross currency liabilities include currency held by the banking system.

See text footnote 14.

The countries are divided into three groups. The first contains countries which, during the period under observation, have not maintained as a general practice a high proportion of foreign assets relative to currency. For each country in this group, the proportion averaged a maximum of 60 per cent during the period covered; the proportion has fluctuated widely, however, and in recent years the ratios for Costa Rica and Nicaragua have increased significantly. Also, the ratio for Mexico shows a phenomenal increase in 1955: by the end of 1955, foreign asset holdings slightly exceeded the currency liability, whereas the average of assets to currency during the preceding seven years amounted to only 54 per cent.

For the second group of countries, the average proportion of foreign assets to national currency has ranged from 69 per cent to 95 per cent. Most of the countries in this group, unlike those in the first group, appear to have maintained a relatively stable relation between their foreign asset holdings and their domestic currency liabilities. Some of the variation in the Pakistan data can be attributed to valuation phenomena. In 1949, the Pakistan rupee was not devalued with sterling and the Indian rupee; therefore, in terms of Pakistan rupees, holdings of sterling and Indian rupees declined to the extent of the devaluation of these currencies. In August 1955, however, the Pakistan rupee was devalued and restored to the pre-1949 relationship with sterling and the Indian rupee; this devaluation immediately raised the Pakistan rupee valuation of total holdings of gold and foreign exchange. Hence, the foreign asset-currency ratio for Pakistan declined as a result of the 1949 devaluation of sterling and the Indian rupee, and increased as a result of the 1955 devaluation of the Pakistan rupee.14 One of the countries in the second group, the Philippines, operated under a dollar exchange standard until the establishment of the Central Bank of the Philippines on January 1, 1949. The data indicate that Philippine foreign assets have recently been allowed to decline to less than 60 per cent of the currency circulation.

The third group includes countries which do not seem to have made much use of their ability to issue a currency without foreign asset coverage. Two of them, Ceylon and Burma, maintained a currency board monetary system until recent years. Although a central bank was established in Ceylon in August 1950, the practice of maintaining a high foreign asset reserve relative to the national currency has continued, except for a period in 1953 and 1954. In Burma, where the assets and liabilities of the currency board were transferred to the Union Bank in July 1952, the foreign asset coverage has been below 100 per cent since the last quarter of 1954.15 Cuba, which established a central bank in 1950, has continued its policy of maintaining a large foreign asset reserve relative to the domestic currency liability.

The quarterly figures in Table 1 appear to indicate that several countries do, in fact, take advantage of the flexibility of their discretionary monetary systems to meet the changing financial needs of their economies by allowing the foreign asset coverage of the currency to vary in accordance with changing seasonal and financial demands. As has been noted above, the automatic relationship between the money supply and the balance of payments, maintained in an automatic system, may render the economy incapable of meeting changing demands for finance in response to seasonal fluctuations.

In order to ascertain whether differences between countries in the ratios of foreign asset holdings to currency issue are attributable in part to differences in the relative importance of currency and deposit money, figures on the relations of currency to total money supply and of foreign assets to money supply are presented in Table 2. The countries are arrayed in the same order as in Table 1. In Table 2 gross currency circulation as defined in Table 1—i.e., including currency held by the banking system—is related to money supply as defined in International Financial Statistics—i.e., currency exclusive of bank holdings plus demand deposits exclusive of government and interbank deposits. Although there are variations in the composition of the money supply of the 20 countries, the use of total money supply rather than gross currency issue would not have greatly affected the findings of Table 1; all the countries of group I and most of the countries in the other two groups would fall in the same group on either basis of comparison.

Table 2.Currency as Per Cent of Money Supply, and Central Bank Holdings of Foreign Assets as Per Cent of (1) Currency and (2) Money Supply, Various Countries1(Averages of end-of-year data, 1948–55)
Currency2 as Per

Cent of Money

Supply3

(1)
Foreign Assets

as Per Cent

of Currency2

(2)
Foreign Assets

as Per Cent of

Money Supply

(Col.1 ×

Col. 2 ÷ 100)

(3)
Group I
Brazil383714
Bolivia593822
Costa Rica564224
Colombia484622
Turkey474923
Nicaragua545228
Mexico536032
Median5346234
Group II
Philippines6356943
India697250
Pakistan677450
Dominican Republic558446
Guatemala7158762
Thailand839478
Ecuador569553
Median6784504
Group III
Honduras5011055
El Salvador6111168
Cuba53611259
Venezuela5911970
Ceylon4912461
Burma6813995
Median56116644

Based on data from International Financial Statistics (Washington).

Data refer to gross currency circulation, i.e., inclusive of currency held by the banking system.

Data refer to net money supply as defined in IFS, i.e., currency outside the banking system plus deposit money which is, by definition, net of government and interbank deposits.

Median is derived directly from figures in column (3).

Average of end-of-year data beginning 1949.

Average of end-of-year data beginning 1950.

Based on data from International Financial Statistics (Washington).

Data refer to gross currency circulation, i.e., inclusive of currency held by the banking system.

Data refer to net money supply as defined in IFS, i.e., currency outside the banking system plus deposit money which is, by definition, net of government and interbank deposits.

Median is derived directly from figures in column (3).

Average of end-of-year data beginning 1949.

Average of end-of-year data beginning 1950.

The statistics in both Table 1 and Table 2 indicate the amount of foreign assets relative to currency that has been held by the monetary authorities of the countries under observation without regard to the adequacy of these holdings. The question of the amount of foreign assets that is required in connection with a discretionary system, however, raises the question of the adequacy of monetary reserves. Although a general discussion of reserve adequacy is outside the scope of this paper,16 some attention must be given to the subject.

One criterion of reserve adequacy is the extent to which countries have been able to maintain the foreign exchange value of their currency without resort to exchange restrictions. By this standard it appears that most of the countries in group I have had inadequate reserves. Mexico is the only one that does not maintain restrictions under Article XIV of the International Monetary Fund Agreement.

Restrictions appear to be least severe in Costa Rica and Nicaragua, for which the ratio of foreign assets to currency has increased significantly in recent years. Neither country applies quantitative restrictions on imports. In July 1955, Nicaragua eliminated the exchange surcharges which had constituted its principal restrictions. Mexico, although it maintains no exchange restrictions, has been forced to devalue its currency on various occasions during the postwar period.

Of the second group of countries, only Guatemala and the Dominican Republic apply no restrictions to foreign payments. India and Pakistan are members of the sterling area, and both countries have exchange systems that restrict imports. In India, there has been a relaxation of restrictions in recent years. In Pakistan, restrictions were intensified in late 1952 and in 1953 and remained rather severe in 1954 and 1955. Thailand and Ecuador have maintained multiple exchange rate systems and other restrictions, but their exchange systems appear to have been less restrictive than those of many other countries, especially some of those in group I. Although Ecuador and Thailand impose some restrictions on imports, the value of imports to which restrictions apply is small in comparison with the total value of imports of both countries. In Ecuador, import restrictions consist only of a prohibited list; in Thailand, restrictions are applied to a list of specified goods which are either prohibited or subject to import licensing. Since January 1, 1956, Thailand has conducted all exchange transactions at a single fluctuating free market rate. In general, the countries in the second group appear to have maintained relatively sound currencies and to have encountered less serious payments problems than most of those in the first group.

The four Latin American countries in the third group (that with the highest ratios of foreign assets to currency issue) impose no restrictions on foreign payments. Ceylon and Burma belong to the sterling area, and their restrictions apply mainly to transactions with the dollar area.

Another measure of reserve adequacy is the relationship of foreign assets to imports. Central bank holdings of foreign assets as a percentage of imports are given in Table 3 for the same countries covered by Tables 1 and 2. Generally, the countries in group I have reserves that, by this standard, are considerably less adequate than are the reserves of most countries in groups II and III. In groups II and III, however, there are considerable differences among countries.

Table 3.Central Bank Holdings of Foreign Assets as Per Cent of Imports, Various Countries, 1948–551(Data as of end of period)
Average,

1948–55
19481949195019511952195319541955
Group I
Brazil427067642728461716
Bolivia232423252383136178
Costa Rica1512961220221820
Colombia282842282529273016
Turkey505659695434404342
Nicaragua2241316122937372221
Mexico341229523131392848
Median32
Group II
Philippines2536839865155544328
India134131173106102148142131
Pakistan108129121498598163
Dominican Republic2373933334337
Guatemala5154524957514552
Thailand697667787778615164
Ecuador2585052905974613837
Median58
Group III
Honduras232811314437414636
El Salvador677191846863605142
Cuba287817772989399
Venezuela2514653565052524753
Ceylon394650484324153845
Burma97611351291101151175850
Median59

Based on data from International Financial Statistics (Washington). Imports are valued c.i.f. unless otherwise indicated; they are totals for calendar years, except those for Burma, which refer to years ended September 30. Data on foreign assets used in calculations refer to end of calendar year (see Table 1, footnote 1, and text footnote 14).

Imports f.o.b.

Based on data from International Financial Statistics (Washington). Imports are valued c.i.f. unless otherwise indicated; they are totals for calendar years, except those for Burma, which refer to years ended September 30. Data on foreign assets used in calculations refer to end of calendar year (see Table 1, footnote 1, and text footnote 14).

Imports f.o.b.

If holdings of foreign assets are to be adequate for financing foreign transactions, they must normally be maintained at some appropriate (though not invariable) relationship to the value of total imports. Therefore, the greater the value of imports, the greater the required holdings of foreign reserves are likely to be. Hence, in countries where imports are large relative to national income and to the money supply, foreign assets also may be expected to be large relative to these factors. In general, the countries which hold the largest foreign assets relative to currency appear also to have comparatively high ratios of imports to national income. Table 4 shows that, with the exception of El Salvador, all the countries in group III have an average propensity to import of 20 per cent or more. In no country in group I and in only two in group II is there such a high propensity to import. The high propensity may at least partly explain why the countries in group III have found it necessary to hold large amounts of foreign assets relative to currency. Among the countries in groups I and II the pattern is less clear, although the median ratio of imports to national income is somewhat higher in group II than in group I. The ratios, of course, reflect the influence of restrictions as well as fundamental economic characteristics.

Table 4.Imports as Per Cent of National Income, Various Countries, 1948–54 1
Average, 1948–541948194919501951195219531954
Group I
Brazil121412101513713
Bolivia
Costa Rica
Colombia1616111316151819
Turkey111112101113109
Nicaragua1212
Mexico1311121315131415
Median12
Group II
Philippines1520211114131213
India7868856
Pakistan9810116
Dominican Republic2020232018
Guatemala1516161516141415
Thailand21172120232220
Ecuador131012121218
Median15
Group III
Honduras222223192227212192
El Salvador1516314
Cuba3132303233312928
Venezuela293128322728
Ceylon3538363035393630
Burma2019131621232124
Median26

Based on data from International Financial Statistics (Washington); United Nations, Monthly Bulletin of Statistics (New York); and United Nations, Statistics of National Income and Expenditure (Statistical Papers, Series H, No. 8, New York, September 1955).

Beginning with 1953, figures used as national income component of ratio represent gross national product at market prices.

Very crude estimate of national income.

Based on data from International Financial Statistics (Washington); United Nations, Monthly Bulletin of Statistics (New York); and United Nations, Statistics of National Income and Expenditure (Statistical Papers, Series H, No. 8, New York, September 1955).

Beginning with 1953, figures used as national income component of ratio represent gross national product at market prices.

Very crude estimate of national income.

In determining the amount of foreign assets that might be released by transition from an automatic currency system to a discretionary system, therefore, a country’s propensity to import must be regarded as important. Even after the adoption of a discretionary currency system, countries with a high propensity to import which now operate under an automatic currency system might find it impossible to release any of their holdings of foreign assets now immobilized as currency cover.

Other criteria of reserve adequacy include the size of the nonmerchandise component of foreign payments, the seasonal pattern of external transactions, the stage of development of banking and other financial institutions, and other characteristics peculiar to individual countries, such as exclusive dependence on a single export crop.

The need for reserves as indicated by the various criteria bears no uniform relation to the money supply and still less to the currency component of money supply. Nevertheless, it is significant that, of the 20 countries examined, most of those with the more adequate reserves (as indicated by their comparative freedom from stringent restrictions and frequent devaluations) have held foreign assets equal, on the average, to about 70 per cent or more of the currency issue during the period 1948–55. This suggests that automatic currency countries which are similar in essential respects to these countries could expect, by adopting an independent system, safely to reduce their foreign asset holdings by an amount equal to no more than about 30 per cent of the assets now immobilized as currency cover or circulating medium. This figure should be interpreted as an average for a period of years. A somewhat greater reduction in holdings might be safe for automatic currency areas which, compared with the countries studied in this paper, have unusually large currency issues (and corresponding foreign assets) relative to imports. Such a condition would reflect either an unusually low propensity to import or an unusually high ratio of currency to national income.17

The foregoing remarks apply only to foreign assets immobilized as currency cover or used as domestic circulating medium. Foreign assets held by marketing boards or other government agencies, which are large in some British colonies, are not immobilized as currency cover, and the adoption of an independent monetary system would not necessarily affect the rate at which these holdings should be used. The part of privately owned foreign assets which would be most likely to be directly affected would be the holdings of commercial banks. As noted above, establishment of a central bank might permit the banking system as a whole to economize to some extent its holdings of liquid assets (including foreign assets and local currency).

The findings of this paper regarding the need for reserves may be compared with those of other investigators. The authors of a study of British Colonial Africa, for example, indicated that a reserve of 50 per cent of the currency, or perhaps even less, would be “perfectly adequate for the maintenance of convertibility.”18 On the other hand, Dr. Greaves has expressed the contrary view that “to reduce the sterling counterpart funds by anything like 50 per cent would be to take a great risk.…”19 Dr. Greaves indicated further that reserves of two thirds of the present total is probably the minimum amount that can be held with safety; this finding does not differ by much from that of the present study. The special characteristics of the economy should certainly be studied carefully before deciding the requirements of foreign exchange assets in any particular case. If any reduction in foreign asset holdings were considered prudent, it should no doubt be made slowly in order to avoid jeopardizing confidence.

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Mr. Birnbaum, economist in the Finance Division, was educated at Ohio State University and the George Washington University. As a member of the Fund’s Statistics Division, he was formerly responsible for the statistics on government finance published in International Financial Statistics.

Of a total of 3.1 million balboas of coins minted up to the end of 1953, 1.4 million were held by banks (International Financial Statistics, Washington, April 1956, p.172).

For a discussion of the origins and evolution of the sterling exchange standard, and a synposis of U.K. colonial currencies, see H. A. Shannon, “Evolution of the Colonial Sterling Exchange Standard,” Staff Papers, Vol. I (1950–51), pp. 334–54, and “The Modern Colonial Sterling Exchange Standard,” Staff Papers, Vol. II (1951–52), pp. 318–62.

The Memorandum on the Sterling Assets of the British Colonies (Colonial No. 298, London, 1953, p. 3) indicates that the only exception to the rule of a mandatory 100 per cent foreign exchange cover for local currency was Southern Rhodesia, which could invest up to 10 per cent in Southern Rhodesian securities, 7 per cent in Northern Rhodesian securities, and 3 per cent in Nyasaland securities. Up to 1953, the currency authority had made use of this authorization only for the purchase of Southern Rhodesian securities. However, in December 1954 the U.K. Secretary of State for the Colonies stated that he had recently advised the colonial governments that “subject to a review of the individual circumstances of each territory, I would agree in principle to the investment of a small part of the cover for Colonial currencies in locally issued securities. The currencies would still be fully backed and automatically redeemable for sterling. It is not the intention to go beyond this.” (See House of Commons, Weekly Hansard, London, December 15, 1954, “Written Answers to Questions,” column 143.) At the time of writing this paper, no colonial government had been reported as having begun to implement this modification of policy by purchasing local securities. According to the Economist (London, August 11, 1956, p. 508), “there is no means of knowing how far there has yet been a shift from sterling to local currency assets. The movement has probably not gone far.”

This practice is described by Ida Greaves as an “anachronism” giving rise to frictions in the operation of the banking system (Ida Greaves, Colonial Monetary Conditions, Colonial Research Studies No. 10, London, 1953, pp. 59 and 86).

In general, the currency board authorities are required to accumulate the income from their investments until they amount to 110 per cent of the local currency circulation; net income beyond this point is paid to their governments as a component of the general revenue (Ida Greaves, The Colonial Sterling Balances, Princeton University, Essays in International Finance No. 20, September 1954, p. 11).

For an analysis of the West African currency board system, see United Africa Company Limited, Statistical and Economic Review (London), September 1955, pp. 1–21.

The effect of the absence of a central bank on the credit policies of local branches of foreign-owned banks would, of course, depend on the extent to which local branches have access to the cash resources of the head office. Also, the accessibility of the foreign loan market to locally owned commercial banks might be an important factor in some cases.

See, for example, J. Mars’ discussion of the “sacrifice of exported goods and services” to the extent that the currency circulation of Nigeria increases, in Mining, Commerce, and Finance in Nigeria (London, 1948), p. 190.

See, for example, Frank H.H. King, “Sterling Balances and the Colonial Monetary Systems,” The Economic Journal (London), Vol. LXV (1955), p. 720.

The communiqué issued by the Commonwealth Finance Ministers, after their meeting in Sydney in January 1954, stated that “Commonwealth Governments may now approach the London market after consultation with the U.K. Government.… In view of the many claims upon this market… access has to be limited.… It is also necessary in the general interest for the timing of any such borrowing to be carefully regulated.” Press reports during 1955 indicated difficulties in borrowing on the London market. In November, for example, the underwriters had to take up 86 per cent of their commitments on a £10 million loan floated in London by the Government of the Federation of Rhodesia and Nyasaland.

The fact that currency boards ordinarily accumulate foreign exchange until the holdings amount to 110 per cent of the currency is neglected in the subsequent discussion.

The marketing boards and other government agencies of certain British colonies, however, also hold relatively large foreign exchange reserves.

That is, including currency held by the banking system, since under an automatic system such holdings also immobilize foreign assets.

Theoretically, a comparison of foreign assets held under the automatic and discretionary systems should cover the total official holdings of foreign assets under both systems. However, official reserves held outside central banks (e.g., treasury holdings) have been neglected in the calculations. The amounts involved by the omission of other official holdings probably are relatively small.

Furthermore, beginning with 1952 the data on foreign assets used in the calculations refer to the Issue Department of the State Bank of Pakistan rather than to the total holdings of the Issue and Banking Departments, as in 1948–51. Information on holdings of the Banking Department has not been published for 1952 and later years.

The former Burmese Currency Board was permitted to cover some of its note circulation with Burmese Government securities (International Financial Statistics, Washington, January 1956, p. 217).

See “The Adequacy of Monetary Reserves,” Staff Papers, Vol. III (1953–54), pp. 181–227.

The critical relationships may be illustrated algebraically as follows: Let R = holdings of foreign reserves, M = imports, Y = national income (or some substitute such as gross national product), and C = (gross) currency circulation. This paper has examined statistically for 20 countries the ratios, RC,RM,andMY. If we further introduce the ratio, YC, which can be conceived as a kind of primary money-income expansion factor, we would have the identity, RCRM.MY.YC. For automatic currency economies, RCRM.MY.YC1.

The algebraic relationship may also be examined in terms of the money supply (S) instead of gross currency (C), i.e., RSRM.MY.YS(YS being the income velocity of money). As shown earlier, the use of money supply statistics in place of gross currency data did not invalidate our findings (of course RS<RC;and if RCis reduced to 0.7 then it follows that the ratio RS would be reduced to a still smaller fraction).

W.T. Newlyn and D.C. Rowan, Money and Banking in British Colonial Africa (Oxford, 1954), p. 259.

Ida Greaves, The Colonial Sterling Balances (Princeton University, Essays in International Finance No. 20, September 1954), p. 14.

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