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International Currencies and Endogenous Enforcement

Author(s):
Roohi Prem
Published Date:
March 1997
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I. Introduction

Over the past three to four decades, the world economy has witnessed a key development: the trend toward emergence of greater symmetry in relative size and economic importance among the “big three”, that is, the United States, Germany, and Japan. These shifts have been accompanied by another trend that is no less notable: shifts in the relative importance of their currencies in the world economy. As Chart 1 shows, by several indicators, the deutsche mark (DM) and the yen have been emerging as major international currencies, challenging the long-held hegemony of the U.S. dollar.

Chart 1.Selected Indicators of International Currency Use

Note:

The currencies are abbreviated as follows: US$ for U.S. Dollar, DM for Deutsche Mark, Pound for British Pound, F Fr for French Franc, S Fr for Swiss Franc, N F1 for Netherlands Guilder, A$ for Australian Dollar, and C$ for Canadian Dollar.

The changing landscape of the world economy has inspired a great deal of speculation as to what the future world economic system, and the future international monetary system would look like. One vision of the future entails a “tripolar” world, with the Western Hemisphere, Europe, and the Asia and Pacific region as the three main global zones of economic activity, and the U.S. dollar, the duetsche mark (or a unified European currency), and the yen as the system’s three key currencies, each currency dominating its own individual sphere of influence. 2/ Skeptics, however, point to the potential obstacles that underlie European unification and the formation of a single European currency, or the limited extent of Japanese integration with Asia. This debate notwithstanding, observed shifts in the pattern of global influence have sparked renewed interest, both theoretical and empirical, in the topic of international currencies.

Key currencies, or perhaps more generally, international currencies, perform the important role of international money. 3/ By acting as a medium of exchange, unit of account, and/or store of value beyond the borders of the nation that issues it, an international money provides world liquidity and facilitates smooth functioning of the international payments mechanism. More importantly, an international currency entails, by virtue of that status, a certain degree of power and privilege for the issuer nation. When its domestic currency is held by foreigners, the foreigners in effect extend credit to the issuer nation. Moreover, this credit is “near free” in the sense that as long as these assets (foreign balances denominated in the home currency) are not withdrawn, the issuing country can use these funds almost free of charge (Grubel 1964). 4/ The issuer can obtain a kind of a free command over real resources and can use them to enlarge its investment at home or abroad, or consume them (Cohen 1971, Grubel 1964, Tavlas 1991). To put it differently, the privilege lies in the relaxation of the issuer’s balance of payments constraint. Additionally, a key currency country has the ability to wield global influence, because its currency is used as international money. Its policies can have profound implications for the world economy, from creation of a deflationary or inflationary impact (liquidity crises), to disruption of trade, finance, and systemic stability. It matters therefore, currencies of which countries are awarded international status by the international community, and why. 5/

The determinants of the international role of a currency are the subject of investigation in this paper. Specifically, what enables the national currency of a country to serve as international money in the world economy? The answer to this question is critical in shaping our understanding and interpretation of past, present, and future trends in the evolution of international currencies. The standard literature to date on the subject has identified a variety of factors, in the form of country and currency characteristics, that determine a national currency’s international comparative advantage. These determinants (hereafter, “standard” determinants) are inflation variability, exchange rate variability, inflation rate, exchange rate, financial openness, world export share, depth and breadth of the financial market, and net foreign asset position. The levels and variability of inflation and exchange rates relate to monetary performance of the issuing country, and along with financial openness, are broadly referred to in this paper as “currency stability criteria”.

The thrust of this paper’s critique of the standard approach to international currencies relates to the role of currency stability criteria as determinants of internationalization. Implicit in this approach is a view of agents who base their future expectations about the transaction costs associated with a currency, and thereby, decisions about holding and use of that currency, on the available evidence regarding currency stability (monetary performance and financial openness). 6/ In effect, they presume that future currency stability will mirror the past performance of the currency. Although at first glance it would seem that such a presumption is consistent with rational expectations formation, the paper argues that in fact this cannot be the case. The central argument in this paper is that there are certain incentive incompatibilities in the relationship between a key currency issuer and foreign holders of its currency, and when such incentive incompatibilities are recognized, the premise that a history of good performance (currency stability) is a reliable indicator of future performance is rendered naive. Indeed, once the issuer’s currency is held as international money in sizable amounts, the issuer has an incentive ex post to deviate from its previously established path of stability. That the issuer will not be tempted to do so cannot be guaranteed ex ante; actions of the issuer are not exogenously enforceable. It follows that in such a situation, the mere evidence of stability in the past cannot be taken as a reasonable indicator of future stability prospects.

The paper thus introduces an element of novelty into the standard literature on international currencies, by advocating a theoretical framework that makes explicit these incentive incompatibilities and the potential for strategic acts of opportunism on the part of the issuer. The analysis in this paper is an attempt to situate the issue of determinants of international currency status within a growing body of literature on exchange relations called the enforcement literature. This literature has shown that when contracts, implicit or explicit are exogenously (third-party) unenforceable, endogenous enforcement must regulate the exchange -- parties to the exchange themselves must adopt or institute certain enforcement activities such as surveillance and sanctioning mechanisms that alleviate the incentive incompatibility and elicit desired levels of the attribute in question. The paper explores these endogenous enforcement strategies in the context of the international money issuer. It identifies four observable characteristics of the issuer nation as “enforcement” determinants of the currency’s international role: stock of foreign direct investment assets abroad, multinational rent earnings from abroad, central bank independence, and military strength. These characteristics embody information about the extent to which the issuer is committed against imprudence. They reflect the credibility of the issuer’s promise of stability and signal what future prospects for currency stability might be expected.

If agents are rational and aware of the underlying incentive incompatibilities, then, when forming future expectations about the transaction costs associated with the currency and assessing its desirability, they should invoke, in addition to the observed historical record of monetary performance and financial openness, consideration of these enforcement determinants. The enforcement approach to international currencies is thus consistent with a broader concept of rational expectations, whereby expectations about future currency stability are informed by the record of past stability, as well as by considerations of the likelihood that the issuer might engage in strategic opportunism in the future.

The paper estimates empirically a model of the determinants of international currency status, whereby standard determinants along with enforcement determinants constitute the complete set of factors that influence the international role of a currency. This analysis is a significant contribution to the literature in that it represents the first empirical effort to test the theory of determination of currency internationalization. The model is estimated using time-series cross-sectional analysis for three data sets as samples, and two different measures of the international role of a currency. The empirical results indicate that the enforcement determinants are strongly significant and robust in explaining international currency share. None of the standard determinants related to monetary performance has any explanatory power. The performance of the rest of the standard determinants can be characterized as mixed. The empirical findings demonstrate the validity of the endogenous enforcement approach as a theoretical framework for analyzing the issue of determinants of international currency status. In particular, they support the proposition that the enforcement determinants are better indicators of a currency’s international role than the standard criteria commonly associated with currency stability.

The remainder of this paper is organized as follows. Section II presents the theoretical rationale underlying the standard determinants, and critiques the role of currency stability criteria in this approach. Section III introduces the endogenous enforcement perspective and identifies the so-called enforcement determinants. Section IV estimates the model empirically, and discusses results. Section V draws implications and concludes the paper.,

II. Theoretical Considerations: The Standard Approach to International Currencies

1. Standard determinants

Determinants of the international role of a currency have been well documented in the literature, so their discussion will be kept brief. 7/ All together, these constitute a set of country and currency characteristics that relate to one of three general categories: (1) monetary performance, (2) trade patterns, and (3) financial market comparative advantage and international financial intermediation. Inflation and exchange rate levels, and inflation and exchange rate variability are the determinants relating to monetary performance of the issuing country. Share of world exports is a determinant relating to trade patterns of the issuing country. Financial market depth and breadth, financial openness, and net foreign asset position are the determinants relating to financial market comparative advantage and international financial market intermediation. The theoretical rationale underlying each of these factors is discussed next.

The basic framework of analysis is one where agents are assumed to use and hold those particular international currencies that offer relatively low costs of information (transaction) associated with their use. Currencies that are relatively stable in external and internal value, as well as offer relative certainty with respect to financial openness, that is, a low risk of exchange or capital controls, imply a low degree of uncertainty associated with their use, and thus, low transaction costs. The price of an international currency plays an important role in disseminating information, and instability of value distorts the ability to embody and provide sufficient information to transactors, making it necessary for them to undertake costly investigation. Likewise, excessive regulations on financial transactions raise transaction costs by impairing quick movements in and out of foreign currency assets, thereby increasing the risk factor and uncertainty associated with international use of a currency. They also increase transaction costs by restricting foreign access to domestic financial markets and reducing foreign opportunities to hold claims denominated in the currency, and by restricting domestic financial institutions from being competitive offshore. High inflation rates distort movements in relative prices through which market information is transmitted, and create uncertainty. A weak exchange rate implies an eroded or diminished purchasing power over other currencies and increases the costs associated with a currency.

Besides the above-mentioned currency stability criteria, another important indicator of the transaction costs associated with a currency is the extent of the currency’s use in world trade and payments. Currencies of countries that are predominant in world trade and payments, that is, countries with large shares of world exports, offer large markets in those currencies. The existence of a large market in a currency implies greater familiarity with the currency, and lower uncertainty and search costs.

The depth and breadth of the financial market is another factor relating to transaction costs. The breadth of a financial market refers to a large assortment of financial instruments traded, while the depth refers to the existence of well-developed securities markets. Financial markets that have breadth and depth offer the most capital certainty for their currencies. In other words, from the point of view of a risk-averse investor, the risk of capital loss on the sale of an asset is smaller in a broad and deep market than in a thinner market. There are two main reasons: first, an economic agent acting alone is less likely to have an influence on asset prices in a market that is deep and broad, and second, an exogenous disturbance is likely to induce greater price variations in a market that lacks depth and breadth. Thus, broad and deep markets tend to be resilient, and by offering the advantage of capital certainty for assets denominated in that currency, they lower overall transaction costs of that currency. They also lower costs by offering international holders a stable and diverse supply of assets.

A final factor relating to transaction costs is the net foreign asset position of the currency issuer. 8/ It has been argued that a key currency nation is, in effect, a world banker or an international financial intermediary. 9/ When foreigners hold short-term claims denominated in its currency, for investment or transaction purposes, they supply short-term liquid capital (on net) in the currency of that country. The ability of the issuer to attract short-term liquid capital or liquid deposits denominated in its own currency enables it to play the role of a world banker, supplying long-term capital in the form of loans and investments denominated in its own currency to the rest of the world. Net debtor or net creditor status signals the financial health of the intermediary. A net debtor position, for example, jeopardizes the functioning of the world banker, and by signaling solvency risk, it creates uncertainty and raises transaction costs associated with the currency.

In sum, the various factors highlighted above are indicators of the transaction costs associated with a currency’s international use. Potential international holders, assumed to be seeking to minimize their transaction costs (both present and future expected) of holding and using international currencies, thus consider these factors in assessing the desirability of a currency.

2. The role of currency stability criteria

As the previous section indicated, the importance of currency stability has been duly recognized in the existing literature. It is argued (correctly) that national currencies possess international comparative advantage in the form of low costs of information if they have a protracted record of stability in the sense of a low degree of inflation and exchange rate variability, and a consistent record of a high degree of financial openness. Furthermore, it is implied that costs -- not just present but future expected as well -- to international money holders and users will rise if the value of a currency, internal or external, fluctuates considerably, or if financial restrictions such as exchange controls are imposed. It follows that if a currency in international use begins to display unsatisfactory performance in the sense of poor stability, its international attractiveness and therefore its international use will be undermined.

A careful evaluation of this argument shows that it appears to rely on a key premise -- that the actual observed evidence with respect to currency stability is a reasonable indicator of the currency’s future stability. Implicit is a view of agents who base their future expectations about the transaction costs associated with a currency, and thereby decisions about holding and use of that currency, on the available evidence regarding monetary performance and financial openness. It would seem that reliance on a history of good performance (currency stability) in the past as a reasonable indicator for the future conforms to a rational expectations formation process. The paper takes issue with this point. It notes that there exist potential incentive incompatibilities (agency problems) in the relationship between the issuer of international money and foreign holders of its currency, which the standard approach to international currencies fails to account for. Once these incentive incompatibilities are explicitly recognized, it is no longer rational to rely solely on the observed record of past stability.

Briefly, the underlying incentive incompatibility is this. The foreigner holds some amount of the issuer’s currency, expecting the issuer to maintain stability, that is, to uphold the real value of his holdings through good monetary performance, as well as to maintain financial openness. However, the issuer can at best offer only an exogenously unenforceable promise to do so. Indeed, once its currency is held as international money in sizable amounts, the issuer has an incentive ex post to renege on the implied contract, in other words, to deviate from its past record of stability. A strategy of unanticipated inflation, for example, enables a country with an international currency to inflate away an arbitrarily large portion of the real purchasing power represented by its nominal debt (Tavlas 1991), resulting in large-scale wealth transfers from holders to the issuer. Foreigners are not protected against such opportunism or imprudence on the part of the issuer, because they can only hedge against the anticipated component of inflation. Likewise, policy surprises such as financial regulations and exchange and capital controls that restrict financial openness can also mean substantial opportunistic gains for the issuer in the form of increased flexibility in pursuing domestic macroeconomic objectives, but they impose considerable costs on the foreign holders by limiting their freedom and flexibility in moving their funds. 10/ If such policies are surprises and therefore not foreseeable, there is little foreign holders can do, ex ante, or ex post, to hedge against these losses. 11/

If the underlying model is assumed to be one where all agents are rational and understand the incentive incompatibility, then they also understand that in such a situation, a promise is only a promise. That the issuer might renege cannot be precluded ex ante; so the observed evidence on monetary performance and financial openness is at best an imperfect indicator of future performance. Thus, enforcement concerns are paramount. In the absence of exogenous enforcement, how then is prudent (non-opportunistic) performance on the part of the currency issuer ensured?

In recent years, an entire body of literature 12/ has emerged that makes explicit the distinction between the class of economic exchanges that involve comprehensive exogenous enforcement of contracts (implicit and explicit), and the class of economic transactions that does not. 13/ This literature (enforcement literature) holds that in situations not amenable to exogenous enforcement, endogenous enforcement is operative. Endogenous enforcement is said to occur when parties to the exchange themselves adopt or institute certain enforcement activities such as surveillance and sanctioning mechanisms that regulate the exchange and elicit desired levels of the attributes in question. These endogenous enforcement mechanisms may constitute a combination of penalties and incentives that reduce the incentive incompatibilities and thereby endogenously enforce the exchange relation.

Collateralization is a widely known endogenous enforcement mechanism in this literature. It is said to ensue when both parties somehow come to share a stake in satisfactory performance by the potentially belligerent party. 14/ When agents are ensured that their exchange partners have too great a stake in the satisfactory outcome of a transaction to fail to live up to its explicit or implied conditions, the relationship is endogenously enforced. Collateralization, as an endogenous enforcement mechanism in problems of agency, is in fact a derivative of a broader concept called pre-commitment. 15/ In many social and economic situations, threats and/or promises are invoked by one party or the other. But a threat or promise must be credible in order to have its intended effect. Pre-commitment is a technique for lending credibility to both threats and promises. Schelling (1956, 1960), who pioneered the work on pre-commitment, notes that the essence of such a class of tactics as pre-commitment lies in some voluntary but irreversible sacrifice of freedom of choice. There are several ways to pre-commit, that is, to tie one’s hands towards or against a particular action. Pledging one’s reputation, hostage-offering, undertaking specific costly social investments, and volunteering of strategic information are but a few of the many specific acts of commitment. 16/ More generally, these are acts that generate a stake in prudent performance by making the belligerent party vulnerable either in terms of punitive sanctions initiated by the disgruntled party, or in terms of some self-imposed institutional constraints that render imprudence costly. The next section explores various pre-commitment strategies in the context of the relationship between the international currency issuer and foreign holders of its currency.

III. Endogenous Enforcement in the Case of Key Currencies

Applying the logic laid out above, an international currency issuer may be understood as appropriately collateralized if it demonstrates a stake in prudent performance. This may be achieved in two ways: via relative exposure to foreign retaliation in the form of punitive sanctions, and/or via relative exposure to internal rigidities and resistance to imprudent behavior. The former may be interpreted somewhat loosely, as the “external tying of hands”, and the latter as the “internal tying of hands”. It is important to acknowledge that this is only a crude distinction, because strictly speaking, even the external forces (foreign sanctions) that may tie the issuer’s hands against opportunism might ultimately bind the issuer via an internal channel, that is, by impacting adversely on some key interest group within the key currency nation. Nevertheless, the distinction is useful for two reasons. First, it helps to point out that the international community can, by initiating external sanctions, play a role in enforcing prudent performance on the part of the issuer. Second, it helps to underscore the point that even if foreign punitive retaliation might not be forthcoming (for example, if foreigners lack the ability or the willingness to impose sanctions), internal rigidities within the issuer nation could, on their own, enforce prudent behavior. Howsoever its hands may be tied, ultimately the important point from an enforcement perspective is for the issuer to demonstrate a stake in maintaining prudence. Such an international currency issuer is collateralized, committed, and credible.

Drawing on the accumulated literature on enforcement and pre-commitment, several factors in the form of issuer nation characteristics can be identified as potential commitment devices. These are discussed next.

1. Enforcement determinants

One characteristic of the issuer nation that helps to generate collateralization is the physical presence abroad of a large stock of foreign direct investment assets. Taking a cue from the institution of hostages (see Section II), we conjecture that this stock serves the important function of a hostage. The hostage, by exposing the issuer nation to potential costs in the form of foreign retaliation (hostage/asset appropriation), ties the issuer’s hands against imprudent actions. 17/ An international currency issuer with a larger stock of such exposed assets is, in effect, more heavily collateralized (compared with one with a smaller stock) since it has a larger stake in maintaining satisfactory performance.

Another characteristic of the issuer nation that reduces the incentive incompatibility between the parties is the accrual of sizable economic rents to the key currency nation’s multinationals from their trading and financial activities abroad. This represents another dimension of exposure -- in the event that the issuer nation’s performance is deemed unsatisfactory, foreigners could take aim at this exposed target by imposing trade and financial sanctions that would restrict the multinationals’ access to valuable foreign markets and associated opportunities. Since their economic futures are tightly linked with an open international economy, such rent-earning multinationals could serve as an effective hedge against imprudent policy actions on the part of their government. 18/

Still another feature can be identified by recognizing the importance of an exposed, that is, a pledged reputation, as a commitment strategy. Besides the seizure of foreign direct investment assets as hostages, and the imposition of trade and financial sanctions on multinationals, foreign retaliation can take another potentially potent form -- censure of the issuer nation. 19/ But loss of prestige is a deterrent only if the issuer is appropriately collateralized, that is, demonstrates a strong interest in preserving its reputation. It follows, therefore, that a heavily collateralized issuer must be a nation that has significantly “invested” in its reputation, for example, by assuming an international leadership position in issues of world peace, conflict, and security. In general, it would seem that military strength is a prerequisite for effective international leadership. The exercise of military power -- in the form of military threats as well as military favors and defense umbrellas -- is indeed part and parcel of successful international political diplomacy. Military strength can thus impart to a key currency nation, a vital resource necessary for it to assert international dominance and earn international stature. At the same time, it ties the issuer’s hands against imprudence by exposing it to potential retaliation in the form of adverse reputation effects. 20/

The broad characteristics discussed above are features of the key currency nation that reflect the extent of its exposure to external sanctions, that is, sanctions potentially initiated by foreigners. Additional characteristics may be identified by focusing internally, that is, by exploring within the key currency nation potential domestic rigidities that serve to constrain its actions. These rigidities would deter opportunism even if foreign sanctions were absent. In effect, they act as internal sanctions.

The commitment literature has shown that in some situations, the potentially belligerent party can earn credibility by investing in certain social institutions that restrain its behavior. Independent central banks are precisely such institutions. An independent central bank represents a structural impediment to unanticipated inflation. Typically, it is the fiscal arm of the government that is faced with the temptation of engaging in short-term wealth transfers through unanticipated inflation. Therefore, an institutional structure that severs federal government control over monetary policy and concentrates it within an independent body with an explicitly stated mandate for price stability can be an extremely effective commitment device. 21/

It might seem, on the surface at least, that the deterrent effect of independent central banks emanates from the mere mechanical separation of monetary and fiscal authority in an economy. However, the role played by central bank independence in generating collateralization can only be understood well if one delves into the sources of independent central bank preferences. Several researchers in the political-economy tradition have suggested that the independent central bank preferences for price stability and financial openness are in fact a reflection of the preferences of the central bank’s primary political constituency: the domestic (typically also multinational) financial sector. 22/ The financial community values domestic price stability in the interest of protecting the real value of its assets denominated in the domestic currency. Likewise, this sector maximizes its gains in a steady policy environment of unregulated financial activities at home and abroad. From the point of view of international money holders, therefore, the existence of an independent central bank signals a low propensity or predisposition to imprudence (unanticipated inflation and/or arbitrary financial regulation). Additionally, if an independent central bank commands a strong international reputation (as does the Bundesbank), fear of adverse reputation effects from abroad may serve as a deterrent to deviation from the banks’ publicized preferences and mandates.

Besides an independent central bank, other social institutions internal to a key currency nation are also significant in that they have the capacity to restrain its behavior. For example, a well-established stable democratic political system and a well-developed and efficient legal infrastructure ensure sufficient domestic restraint and minimize the possibility of abrupt radical changes in policies.

In sum, several broad characteristics of the issuer nation have been identified as potential commitment devices: large stock of foreign direct investment assets situated abroad, accrual of sizable economic rents to multinationals from their trading and financial activities abroad, high international profile, independence of the central bank, a well-established stable democratic political system, a well-developed legal infrastructure, and military strength. For purposes of empirical analysis, these features are narrowed down to four specific quantifiable indicators, called“enforcement”determinants of the international role of a currency: stock of foreign direct investment assets abroad, multinational rent earnings from abroad, central bank independence, and military strength.

The enforcement determinants reflect the extent to which the issuer is collateralized against imprudence, or in other words, the extent to which the incentive incompatibilities are alleviated. Rational agents, who are assumed to be aware of the incentive incompatibilities, therefore invoke -- in addition to the observed historical record of monetary performance and financial openness (currency stability) -- consideration of enforcement determinants, when forming future expectations about the transaction costs associated with the currency and assessing its desirability. Moreover, the enforcement determinants are expected to embody greater and more meaningful information content about future currency stability prospects than what is contained in the mere statistical record of past performance. This so, because they are derived from an in-depth consideration of the issuer’s incentives and constraints in reneging on the implied contract.

IV. Empirical Analysis

1. An econometric model of the determinants of currency internationalization

This section estimates empirically a model of the determinants of the international role of a currency. Standard determinants (Section II), in conjunction with enforcement determinants (Section III), constitute all the factors that influence international holders’ decisions to hold and use various international currencies. Estimation of the model reveals the magnitude and direction of the separate effects of various determinants on currency internationalization. In particular, it enables an explicit comparison between the standard determinants and the enforcement determinants in terms of relative explanatory power.

The specification of the international role of a currency, as well as of its determinants, in the form of econometric variables was necessarily informed by several considerations, both theoretical and practical. Owing to limitations of space, discussion of data issues and variable selection is confined to Appendix I. Table 1 summarizes the definitions (measures) of all the independent variables, their expected signs, and data sources. Two different definitions (measures) of the international role of a currency were used -- the currency’s share in international bond issues, and its share in world official foreign exchange reserves. Note that one definition -- currency composition of foreign exchange reserves -- relates to the currency’s official role and is a stock-based measure, while the other -- currency composition of international bond issues -- is a flow measure and reflects the private aspect of a currency’s international role. Admittedly, each series captures a different (disaggregated) aspect of a currency’s international role, and perhaps ideally different (sub)sets of determinants should explain these different aspects of a currency’s international role; however, it is important to keep in mind that for the purposes of this econometric study, the sense in which we use these two alternative definitions is ultimately only to serve as potential indicators (proxies) of the overall international role of the currency.

Table 1.Independent Variables: Measures and Sources
VariableMeasure(s) and Expected Sign(s)Source(s)
Standard
INFLInflation rateRatio of percent change in annual consumer price index to the average percent change for all countries in the sample.-IMF, International Financial Statistics Yearbook.
INFLVInflation variabilityRatio of standard deviation of quarterly percent changes in consumer price index to the average standard deviation for all countries in the sample.-IMF, International Financial Statistics.
EXRExchange rate(1) Bilateral market rate: Domestic currency price of US$ (Exception: US$/SDR for the US).

-

-
IMF, International Financial Statistics Yearbook.
(2) Effective (MERM) exchange rate index.-IMF, International Financial Statistics Yearbook.
EXRVExchange rate variability(1) Ratio of standard deviation of quarterly percent changes in exchange rate to the average standard deviation for all countries in the sample.

-IMF, International Financial Statistics.
(2) Ratio of standard deviation of quarterly percent changes in effective exchange rate index to the average for all countries in the sample.-IMF, International Financial Statistics.
EXPSHExport shareRatio of exports to world exports.+IMF, International Financial Statistics Yearbook.
KKICapital controls indexSum of restrictions in 5 categories: restrictions on payments for current transactions, restrictions on payments for capital transactions, import surcharges, advance import deposits, and surrender requirement for export proceeds.-IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.
FINSHFinancial market shareRatio of international bond issues to total world issues of international bonds.+OECD, Financial Statistics.
NFARNet foreign assets relative to GNPRatio of net foreign asset position as a share of GNP to the average of net foreign asset to GNP for all countries in the sample.+Individual country official sources.
Enforcement
CBIICentral bank independence index(1) Annual turnover rate of central bank governor.-Cukierman, Webb and Neyapti (1992).
(2) Central bank legal independence aggregate index.+Cukierman, Webb and Neyapti (1992).
(3) Epstein-Schor central bank independence index.+Epstein and Schor (1992).
FDISHForeign direct investment stock shareRatio of stock of foreign direct investment assets abroad to world stock.+Individual country official sources; IMF, Balance of Payments Statistics Yearbook; Dunning and Cantwell (1987).
NFISHNet factor income shareRatio of net factor income earnings to total net factor income of all countries in the sample.+OECD, National Accounts: Main Aggregates.
MILSHMilitary expenditure shareRatio of military expenditure to world military expenditure.+SIPRI, World Armaments and Disarmaments: SIPRI Yearbook; U.S. Arms Control and Disarmament Agency, World Military Expenditures and Arms Transfers.

As Table 2 shows, the availability of data for the two series varied over time and across countries; the sample size varied accordingly in each case. The data were sorted into three samples.

Table 2.Dependent Variable: Measures and Sources
MeasureSample(s)Source(s)
Currency share in world international bond issues.SAMPLE1

1964–90, 6 countries

US, UK, Germany, Japan, France, Netherlands.
OECD, Financial Statistics.
SAMPLE2

1973–90, 9 countries

US, UK, Germany, Switzerland, Japan, France, Netherlands, Australia, Canada.
Currency share in world official foreign exchange reserves.SAMPLE3

1973–90, 9 countries

US, UK, Germany, Switzerland, Japan, France, Netherlands, Australia, Canada.
IMF, Annual Report.

The model was specified as a pooled time-series cross-sectional equation. 23/ The equation was estimated for each of the three samples, using Generalized Least Squares (GLS). 24/

t= 1,…, T

i= 1,…, N

where

CURSHi, t = Share of currency i at time t, relative to world

INFLi, t = Inflation rate of country i at time t, relative to the average for N countries

INFLVi, t = Inflation variability of country i at time t, relative to the average for N countries

EXRi, t = Exchange rate of country i at time t

EXRVi, t = Exchange rate variability of country i at time t, relative to the average for N countries

EXPSHi, t = Export share of country i at time t, relative to world

KKIi, t = Capital controls index for country i at time t

FINSHi, t = Financial market share of country i at time t, relative to world

NFARi, t = Net foreign assets as a share of GNP for country i at time t, relative to the average for N countries

CBIIi, t = Central bank independence index for country i at time t

FDISHi, t = Foreign direct investment assets stock share of country i at time t, relative to world

NFISHi, t = Net factor income share of country i at time, relative to N countries

MILSHi, t = Military expenditure share of country i at time t, relative to world

β’s are parameters to be estimated, and u is the stochastic error term. Note that T and N vary by data set.

2. Estimation results

Results for SAMPLE1 are discussed first. Table 3 presents GLS estimates for equation (1). As the table shows, the variables Milsh, Fdish, Cbii, and Expsh exhibited strong t-ratios. None of the monetary performance variables Infl, Inflv, Exr, and Exrv performed well as explanatory variables. Finsh, Nfar, and Kki were not statistically significant, while Nfish was significant in only one instance. These results are indicative of the strong performance of the enforcement variables, individually, as explanatory variables. To test their joint significance, the enforcement variables were next restricted to zero, and equation (1) was re-estimated. At the 5 percent level of significance, an F-test comparing the restricted equation with any of the versions of equation (1) presented in Table 3 rejected the joint hypothesis that the true coefficients for the enforcement variables were all zero. 25/

Table 3.GLS Estimatesa: SAMPLE1 (1964–90, Six Countries, Dependent Variable: Currency Share in International Bond Issues), Equation (1)
Explanatory VariableIIIIII
Infl-0.698

(-0.762)
-0.471

(-0.519)
-0.394

(-0.451)
Inflv0.366

(0.963)
0.384

(1.012)
0.321

(0.878)
Exr0.001

(0.254)
0.006

(1.000)
0.007*

(1.379)
Exrv0.074

(0.282)
0.107

(0.405)
0.104

(0.419)
Expsh1.136**

(2.769)
1.076**

(2.897)
0.840**

(2.333)
Kki0.127

(0.310)
0.127

(0.334)
0.289

(0.791)
Finsh0.052

(1.024)
0.050

(0.998)
0.058

(1.220)
Nfar0.306

(0.281)
0.618

(0.539)
0.704

(0.624)
Cbii-15.336**

(-1.944)
4.418

(0.691)
4.714**

(2.585)
Fdish0.368**

(2.990)
0.325**

(2.554)
0.263**

(1.995)
Nfish0.081

(0.985)
0.049

(0.614)
0.098*

(1.305)
Milsh1.115**

(4.122)
1.333**

(5.027)
1.265**

(4.984)
Intercept-6.965**

(-2.073)
-12.201**

(-3.281)
-15.043**

(-4.109)
Buse R20.7790.7290.746
Buse Raw-Moment R20.8030.7580.773
Error sum of squares73.50374.20573.032
F-statistic46.82235.86539.127
Number of observations162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less aCorrections for both autocorrelation and heteroscedasticity.I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less aCorrections for both autocorrelation and heteroscedasticity.I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.

Given that, in the first round of estimation above, neither the inflation- nor the exchange rate-based variables proved statistically significant, in subsequent stages of the empirical analysis, estimation was restricted to two alternative versions of equation (1). In these versions, the inflation-based and the exchange rate-based variables were omitted in turn so as to reduce the number of explanatory variables, increase the degrees of freedom, and make the results somewhat more tractable. 26/

t = 1,…, T

i = 1,…, N

α’s and λ’s are parameters to be estimated, and u is the stochastic error term.

Tables 5 and 6 present for SAMPLE1 the results of GLS estimation for equations (2) and (3), respectively. As the tables indicate, regression results for (2) and (3) were very similar to those of (1) estimated earlier. Moreover, there did not appear to be much difference in the outcomes of the inflation and the exchange rate versions. By and large, Milsh, Fdish, Cbii, and Expsh were significant in both equations. Similarly, Kki and Nfar were not statistically significant in either equation. In both equations, the performance of Finsh and Nfish was poor. Infl and Inflv did not perform well in equation (2): Exr and Exrv performed poorly in equation (3).

Table 4.GLS Estimatesa: SAMPLEI (1964–90, Six Countries, Dependent Variable: Currency Share in International Bond Issues), Equation (1) with Exchange Rate Regime Dummy
Explanatory VariableIIIIII
Infl-0.673

(-0.722)
-0.415

(-0.451)
-0.409

(-0.460)
Inflv0.372

(0.979)
0.378

(0.992)
0.332

(0.908)
Exr0.002

(0.330)
0.010*

(1.578)
0.008*

(1.576)
Exrv0.067

(0.249)
0.121

(0.451)
0.098

(0.381)
Expsh1.053**

(2.564)
0.900**

(2.338)
0.689**

(1.882)
Kki0.202

(0.468)
0.286

(0.708)
0.403

(1.028)
Finsh0.050

(0.993)
0.056

(1.108)
0.057

(1.190)
Nfar0.474

(0.419)
0.795

(0.680)
1.018

(0.871)
Cbii-16.094**

(-2.025)
11.671*

(1.484)
5.280**

(2.837)
Fdish0.339**

(2.632)
0.276**

(2.099)
0.225**

(1.658)
Nfish0.102

(1.215)
0.076

(0.938)
0.121*

(1.591)
Milsh1.127**

(4.138)
1.356**

(5.108)
1.292**

(5.039)
Dummyb0.585

(0.533)
1.808*

(1.378)
1.025

(0.952)
Intercept-6.885**

(-2.001)
-15.054**

(-3.519)
-15.896**

(-4.091)
Buse R20.7790.7350.751
Buse Raw-Moment R20.8040.7640.779
Error sum of squares67.89467.05466.475
F-statistic43.44834.29637.223
Number of observations162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Exchange Rate Regime Dummy: 1 if ≥ 1972, 0 otherwise.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Exchange Rate Regime Dummy: 1 if ≥ 1972, 0 otherwise.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Table 5.GLS Estimatesa: SAMPLE1 (1964–90, Six Countries, Dependent Variable: Currency Share in International Bond Issues), Equation (2)
Explanatory VariableIIIIII
Infl-0.711

(-0.785)
-0.759

(-0.860)
-0.671

(-0.777)
Inflv0.354

(0.959)
0.374

(1.037)
0.341

(0.973)
Expsh1.186**

(2.986)
1.330**

(3.432)
1.055**

(2.732)
Kki0.147

(0.362)
0.037

(0.094)
0.223

(0.582)
Finsh0.048

(0.962)
0.039

(0.786)
0.050

(1.037)
Nfar0.262

(0.253)
0.255

(0.233)
0.082

(0.080)
Cbii-15.322**

(-1.927)
1.100

(0.183)
4.004**

(2.219)
Fdish0.373**

(2.993)
0.380**

(2.916)
0.330**

(2.482)
Nfish0.081

(0.984)
0.035

(0.418)
0.064

(0.779)
Milsh1.085**

(4.128)
1.198**

(4.270)
1.162**

(4.334)
Intercept-6.851**

(-2.079)
-11.202**

(-3.219)
-13.637**

(-3.953)
Buse R20.7750.7150.729
Buse Raw-Moment R20.8010.7450.757
Error sum of squares84.12385.54384.135
F-statistic55.27740.07042.804
Number of observations162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Table 6.GLS Estimatesa: SAMBLE1 (1964–90, Six Countries, Dependent Variable: Currency Share in International Bond Issues), Equation (3)
Explanatory VariableIIIIII
Exr0.003

(0.613)
0.006

(1.190)
0.008**

(1.724)
Exrv0.063

(0.253)
0.093

(0.372)
0.096

(0.406)
Expsh1.120**

(2.713)
1.098**

(3.025)
0.864**

(2.502)
Kki-0.059

(-0.151)
-0.003

(-0.008)
0.177

(0.525)
Finsh0.058

(1.165)
0.054

(1.094)
0.064*

(1.380)
Nfar0.406

(0.384)
0.498

(0.465)
0.648

(0.608)
Cbii-13.383**

(-1.669)
2.676

(0.429)
4.574**

(2.471)
Fdish0.340**

(2.808)
0.333**

(2.749)
0.245**

(1.910)
Nfish0.088

(1.105)
0.049

(0.654)
0.101*

(1.427)
Milsh1.143**

(4.289)
1.309**

(5.081)
1.276**

(5.200)
Intercept-7.731**

(-2.516)
-11.879**

(-3.612)
-15.116**

(-4.492)
Buse R20.7600.7070.726
Buse Raw-Moment R20.7870.7380.756
Error sum of squares87.50289.22089.133
F-statistic50.63038.60842.423
Number of observations162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.

Equations (2) and (3) were also estimated for two of the remaining samples in turn. The results are summarized in Tables 7 and 8 (SAMPLE2), and Tables 9 and 10 (SAMPLE3).

Table 7.GLS Estimatesa: SAMPLE2 (1973–90, Nine Countries, Dependent Variable: Currency Share in International Bond Issues), Equation (2)
Explanatory VariableIIIIII
Infl-0.907

(-1.850)
-0.580

(-1.277)
-0.602*

(-1.356)
Inflv-0.142

(-0.596)
-0.010

(-0.044)
-0.014

(-0.064)
Expsh0.005

(0.016)
0.495*

(1.592)
0.493**

(1.663)
Kki-1.218**

(-3.048)
-0.825**

(-2.072)
-1.171**

(-2.903)
Finsh0.172**

(3.691)
0.193**

(4.282)
0.175**

(3.860)
Nfar-1.039*

(-1.314)
-1.070*

(-1.449)
-1.553**

(-2.223)
Cbii-9.428*

(-1.495)
13.600**

(3.070)
2.719**

(3.072)
Fdish0.330

(2.934)
0.331**

(3.223)
0.293**

(3.005)
Nfish0.041

(1.051)
0.011

(0.320)
-0.027

(-0.804)
Milsh1.230**

(4.263)
1.186**

(4.582)
1.362**

(5.291)
Intercept2.094

(0.943)
-7.720**

(-2.419)
-6.100**

(-2.209)
Buse R20.6030.6240.614
Buse Raw-Moment R20.6410.6720.627
Error sum of squares50.14555.25753.270
F-statistic24.48728.06723.112
Number of observations162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Table 8.GLS Estimatesa: SAMPLE2 (1973–90, Nine Countries, Dependent Variable: Currency Share in International Bond Issues), Equation (3)
Regressions with Exrε and ExrvεRegressions with Exrεε and Exrvεε
Explanatory VariableIIIIIIIIIIII
Exr-0.007*

(-1.299)
-0.002

(-0.298)
-0.008

(-1.207)
-0.005

(-0.373)
-0.016

(-1.231)
-0.017*

(-1.562)
Exrv0.112

(0.348)
0.383*

(1.293)
0.426*

(1.479)
0.123

(0.703)
0.148

(0.731)
0.137

(0.815)
Expsh0.379

(1.172)
0.511*

(1.591)
0.463*

(1.486)
0.342

(1.023)
0.149

(0.587)
0.369

(1.279)
Kki-1.135**

(-2.886)
-0.992**

(-2.379)
-1.320**

(-3.198)
-1.187**

(-2.947)
-0.805**

(-1.948)
-1.173**

(-2.750)
Finsh0.156**

(3.253)
0.175**

(3.788)
0.157**

(3.377)
0.142**

(3.062)
0.215**

(4.640)
0.171**

(3.682)
Nfar-0.494

(-0.601)
-0.841

(-1.182)
-0.923*

(-1.607)
-1.204*

(-1.596)
-2.492**

(-3.243)
-1.473**

(-2.072)
Cbii-10.721**

(-2.091)
13.149**

(2.957)
2.037**

(2.426)
-10.389**

(-1.668)
13.642**

(3.072)
1.872**

(2.329)
Fdish0.401**

(3.619)
0.316**

(3.041)
0.299**

(3.022)
0.457**

(3.864)
0.347**

(3.355)
0.383**

(3.806)
Nfish0.053*

(1.476)
0.013

(0.384)
-0.020

(-0.638)
0.037

(0.934)
0.040

(1.074)
-0.003

(-0.073)
Milsh0.941**

(3.532)
1.185**

(4.332)
1.293**

(4.878)
0.931**

(3.030)
1.098**

(4.336)
1.145**

(4.163)
Intercept-1.304

(-0.625)
-8.472**

(-2.903)
-5.862**

(-2.407)
0.037

(0.015)
-3.234

(-1.083)
-2.998

(-1.110)
Buse R20.6260.6200.6070.5650.6320.597
Buse Raw-Moment R20.6810.6680.6250.6270.6740.610
Error sum of squares51.46254.71152.68054.08356.48153.637
F-statistic29.33627.59822.90723.08828.41521.422
Number of observations162162162162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Market Exchange Rate-based measures.

Effective Exchange Rate-based measures.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Market Exchange Rate-based measures.

Effective Exchange Rate-based measures.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Table 9.GLS Estimatesa: SAMPLE3 (1973–90, Nine Countries, Dependent Variable: Currency Share in Official Foreign Exchange Reserves), Equation (2)
Explanatory VariableIIIIII
Infl-0.148

(-0.557)
0.158

(0.718)
-0.109

(-0.376)
Inflv-0.095

(-0.705)
-0.075

(-0.725)
-0.047

(-0.337)
Expsh-0.065

(-0.679)
0.065

(0.511)
0.012

(0.105)
Kki-0.641**

(-2.852)
-0.172

(-0.895)
-0.920**

(-3.770)
Finsh-0.044**

(-1.765)
-0.008

(-0.466)
-0.014

(-0.599)
Nfar0.055

(0.130)
-0.639*

(-1.557)
-0.617

(-0.987)
Cbii10.442**

(3.967)
14.180**

(6.884)
0.687*

(1.444)
Fdish0.195**

(3.556)
0.170**

(3.717)
0.179**

(3.216)
Nfish0.067**

(3.641)
0.081**

(4.581)
0.095**

(4.853)
Milsh1.813**

(13.011)
1.631**

(11.138)
1.598**

(10.453)
Intercept-1.803**

(-1.771)
-7.016**

(-5.275)
-0.949

(-0.835)
Buse R20.8840.8080.825
Buse Raw-Moment R20.9000.8230.848
Error sum of squares45.05448.69648.691
F-statistic123.25163.91776.523
Number of observations162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Table 10.GLS Estimatesa: SAMPLE3 (1973–90, Nine Countries, Dependent Variable: Currency Share in Official Foreign Exchange Reserves), Equation (3)
Regressions with Exrε and ExrvεRegressions with Exrεε and Exrv εε
Explanatory VariableIIIIIIIIIIII
Exr0.005**

(1.881)
0.020**

(5.075)
0.009

(3.575)
-0.035**

(-4.870)
-0.032**

(-4.680)
-0.031**

(-4.611)
Exrv-0.212

(-1.274)
-0.083

(-0.681)
-0.229*

(-1.466)
0.019

(0.205)
0.030

(0.341)
0.051

(0.543)
Expsh0.078

(0.543)
-0.011

(-0.097)
0.232**

(1.698)
-0.080

(-0.743)
0.172*

(1.322)
0.181*

(1.456)
Kki-0.755**

(-3.655)
-0.048

(-0.252)
-0.667**

(-3.544)
-0.928**

(-4.156)
-0.219

(-1.115)
-0.889**

(-4.206)
Finsh-0.044**

(-1.924)
-0.006

(-0.332)
-0.012

(-0.538)
-0.011

(-0.486)
0.010

(0.584)
0.009

(0.428)
Nfar0.047

(0.118)
-0.579*

(-1.522)
-0.835**

(-1.956)
0.035

(0.091)
-0.568*

(-1.485)
-0.587

(-1.197)
Cbii6.085**

(2.757)
15.082**

(7.232)
2.225**

(4.840)
9.613**

(4.068)
12.672**

(6.341)
1.250**

(2.629)
Fdish0.327**

(5.897)
0.218**

(4.507)
0.347**

(6.711)
0.341**

(6.349)
0.237**

(5.211)
0.305**

(6.005)
Nfish0.057**

(3.528)
0.071**

(4.379)
0.050**

(3.124)
0.080**

(4.489)
0.082**

(4.737)
0.087**

(4.796)
Milsh1.620**

(12.022)
1.697**

(12.289)
1.455**

(10.826)
1.462**

(11.391)
1.441**

(10.740)
1.322**

(10.067)
Intercept-2.885**

(-3.259)
-7.391**

(-6.563)
-5.418**

(-5.111)
0.816

(0.706)
-3.711**

(-2.530)
-0.433

(-0.299)
Buse R20.8900.8380.8590.8800.8100.830
Buse Raw-Moment R20.9010.8510.8750.8950.8300.854
Error sum of squares47.63548.48051.67548.36950.20652.623
F-statistic125.18378.67596.181116.35267.19380.068
Number of observations162162162162162162
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Market Exchange Rate-based measures.

Effective Exchange Rate-based measures.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Market Exchange Rate-based measures.

Effective Exchange Rate-based measures.

I Cbii measured as Annual Turnover Rate of Central Bank Governor.II Cbii measured as Central Bank Legal Independence Index.III Cbii measured as Epstein-Schor Central Bank Independence Index.

3. Summary of main findings and final regressions

The main findings from the empirical analysis may be summarized as follows. Overall, the results were fairly stable across the three samples estimated in this study, thus indicating that the two different measures that served as alternative specifications of the international role of a currency are fairly close substitutes and could be treated as such in future empirical research as well.

The most striking finding of the econometric analysis was that all but one of the enforcement variables corresponding to the enforcement determinants proved to be strongly significant and robust in explaining international currency share, with signs as expected. Three enforcement variables -- Milsh, Fdish, and Cbii -- repeated their strong performance as explanatory variables consistently across all three samples. The fourth enforcement variable, Nfish, achieved significance in all SAMPLE3 regressions, and occasionally in the SAMPLE1 regressions. Of the three measures of central bank independence Cbii, the legal aggregate index, and the Epstein-Schor index worked fairly well, while the turnover rate measure occasionally proved problematic (sign contrary to expectations) in SAMPLE3 regressions.

The strong and consistent performance of the enforcement determinants as explanatory variables was, however, not echoed by the set of variables corresponding to the standard determinants. In particular, monetary performance-related variables -- Infl, Inflv, Exr, and Exrv -- generally did not achieve explanatory power. Occasionally, Exr attained significance with the appropriate sign, but only when the effective exchange rate index-based measure was used. To test whether multicollinearity might have been responsible for the low t-ratios, we ran auxiliary regressions with Infl, Inflv, Exr, and Exrv each as the dependent variable regressed on the rest of the independent variables in the model. The regressions revealed little evidence that multicollinearity was a contributing factor in the poor performance of these variables. Additionally, in light of the fact that central bank independence, Cbii, proved to be strongly significant while none of the standard monetary performance variables did, we checked pairwise correlation coefficients between Cbii and each of variables Infl, Inflv, Exr, and Exrv. These coefficients were weak in every sample, confirming that pairwise collinearity was not responsible for the low t-ratios. 27/

As to the other explanatory variables corresponding to the standard determinants -- Expsh, Finsh, Kki, and Nfar -- their performance can be characterized as mixed at best. Expsh was consistently significant in all the 1964–90 regressions, but its performance weakened somewhat in the 1973–90 regressions. Finsh attained significance in the 1973–90 regressions (only SAMPLE2), but was not statistically significant otherwise. Kki was significant in SAMPLE2 regressions, and occasionally so in SAMPLE3. Nfar was not significant in the 1964–90 regressions, but when it did attain significance (for example, in a number of instances in the 1973–90 regressions), its sign was contrary to expectations.

These mixed results are not easily comprehended. It is not clear, for example, whether the significance of a particular variable in some time periods as opposed to others was simply a spurious outcome, or alternatively, indicative of a structural time-shift in the model itself, affecting the relevance of that variable as a regressor. Moreover, explanatory variables such as Nfish, Finsh, and Kki at best only imperfectly gauge and capture the three underlying determinants of multinational rent earnings from abroad, financial market depth and breadth, and financial openness, respectively (see Appendix I). Their performance as explanatory variables should therefore be interpreted with caution. It is possible that perhaps better designed variables might have resulted in better performance. Finally, the unexpected outcome registered by Nfar raises interesting questions. Contrary to the standard logic that a higher net debtor status should diminish international confidence in a currency and lower its international status, the empirical results indicated that, ceteris paribus, a net debtor position is associated with a larger currency share. This result warrants a re-examination of the traditional theoretical relationship between net foreign asset position and international currency share. While a full investigation of this issue is beyond the scope of this paper, one preliminary thought relates to the possibility of reverse causation, that is, the international role of a currency might in fact be a cause of deterioration in the net foreign asset position.

We conclude this section by presenting some final regressions. For each of the three samples, one final “best” equation was estimated whereby all the independent variables that were not significant in previous rounds for that sample were eliminated. Table 11 shows the estimated coefficients, along with elasticities for the independent variables, calculated at mean values. The elasticity figures indicate the relative strength (magnitude) of the impact of the various explanatory variables on the international role of a currency.

Table 11.GLS Estimatesa: All SAMPLES, Final Regressions
SAMPLEISAMPLE2SAMPLE3
Explanatory VariableCoeff.Elas.bCoeff.Elas.bCoeff.Elas.b
Expsh1.464**

(4.082)
0.7590.424*

(1.539)
0.244
Kki-0.861**

(-2.085)
-0.042
Finsh0.163**

(3.643)
0.104
Nfar-1.218**

(-2.182)
0.117
Cbii3.132**

(1.806)
0.3421.818**

(2.469)
0.2720.678**

(1.521)
0.101
Fdish0.418**

(3.260)
0.3930.238**

(2.402)
0.2680.119**

(2.647)
0.133
Nfish0.023**

(2.147)
0.024
Milsh1.090**

(4.263)
0.4771.425**

(5.178)
0.6180.710**

(4.837)
0.306
Intercept-15.292**

(-6.716)
-4.587**

(-2.165)
-0.868*

(-1.412)
Buse Raw-Moment R20.6250.5620.284
Error sum of squares128.5480.51372.892
F-statistic52.24724.70812.463
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Elasticity at mean values of dependent and independent variables.

Cbii measured as Epstein-Schor Central Bank Independence Index in all regressions.SAMPLEI: 1964–90, 6 Countries, Dependent Variable is Currency Share in International Bond Issues.SAMPLE2: 1973–90, 9 Countries, Dependent Variable is Currency Share in International Bond Issues.SAMPLE3: 1973–90, 9 Countries, Dependent Variable is Currency Share in Official Foreign Exchange Reserves.
Note:t-statistics in parentheses, *significant at the 10 percent level, **significant at the 5 percent level or less.

Corrections for both autocorrelation and heteroscedasticity.

Elasticity at mean values of dependent and independent variables.

Cbii measured as Epstein-Schor Central Bank Independence Index in all regressions.SAMPLEI: 1964–90, 6 Countries, Dependent Variable is Currency Share in International Bond Issues.SAMPLE2: 1973–90, 9 Countries, Dependent Variable is Currency Share in International Bond Issues.SAMPLE3: 1973–90, 9 Countries, Dependent Variable is Currency Share in Official Foreign Exchange Reserves.

V. Conclusions and Implications

The empirical investigation of the determinants of currency internationalization indicated that with one exception (multinational rent earnings from abroad), all the enforcement determinants -- stock of foreign direct investment assets abroad, central bank independence, and military strength -- were strongly significant and robust in explaining international currency shares. All the standard determinants related to monetary performance -- inflation, inflation variability, exchange rate, and exchange rate variability -- failed to attain explanatory power, while the performance of the rest of the standard determinants -- financial openness, world export share, financial market depth and breadth, and net foreign asset position -- was mixed at best. With the usual word of caution about the limitations of any econometric endeavor, the empirical results from this research permit the following interpretation.

The strong empirical performance of the enforcement determinants demonstrates the validity of the endogenous enforcement approach as a theoretical framework for analyzing key currencies. Indeed, the empirical results lend support to the theoretical proposition (introduced in Section III) that the enforcement determinants are better indicators of a currency’s international role than the standard currency stability criteria of monetary performance and financial openness, the reasoning being that they embody greater and more meaningful information content about the propensity of a country to exhibit currency stability than what is contained in the mere statistical record relating to stability. With the exception of financial openness, none of the other standard determinants commonly understood as indicators of a currency’s stability prospects had any explanatory power whatsoever.

Endogenous enforcement as a theoretical framework for analyzing the issue of determinants of international currency status, as well as the empirical findings from the estimation of the model of determinants, carries important implications and raises several issues for future research. One implication relates to the possibility of substitution between the standard determinants and the enforcement determinants. Using a familiar tool from microeconomics, the production function, one can visualize a highly stylized scenario: key currency status as the “output”, and the two sets of determinants as two hypothetical inputs, a “standard” input, and an “enforcement” input (Chart 2). Points on the isoquant, or more appropriately the “iso-key currency share curve”, indicate various combinations of the two inputs necessary to achieve a fixed level of international currency share, and movements along the curve indicate potential trade-offs between the two inputs necessary to maintain the currency share constant. Our empirical estimates of the coefficients in fact allow for the calculation of elasticity of substitution at mean values of the inputs, taking two specific inputs at a time. For example, the ratio of the estimated coefficients for Fdish, an enforcement input (0.418), and Expsh, a standard input (1.464), yields an elasticity of substitution at 0.286 (Table 11). This implies that, ceteris paribus, at mean values of Fdish and Expsh, a 1 percent reduction in Expsh must be matched by a 0.286 percent increase in Fdish, for the international share of the currency to remain constant.

Chart 2.The Key Currency Model as a Production Function

Any potential for substitution between the standard determinants and the enforcement determinants would have a far-reaching implication -- that key currency nations have more autonomy than is traditionally believed to be the case. Conventional wisdom is that key currency nations are bound by their inflation performance; the restraint on monetary policy constitutes a constraint on national autonomy. However, if the relative strength of one or more enforcement determinants could compensate for the weakness in monetary performance, a key currency nation would no longer face the monetary-policy constraint to the extent envisaged.

Another implication of this paper relates to our understanding of trends in the evolution of international currencies in the world economy. The post-Bretton Woods period has witnessed several interesting shifts in the relative importance of international currencies, ranging from virtual dominance of the dollar in the 1970s, to the emergence of the duetsche mark and the yen as major challengers to the dollar’s hegemony in the 1990s. Typical attempts to analyze these trends have concentrated entirely on movements in the standard determinants. The paper contributes to such analyses by suggesting that these trends cannot be explained by standard determinants in isolation; shifts in the distribution of enforcement capabilities among potential key currency-issuing nations play a fundamental and critical role in determining these trends.

With respect to the future and the evolution of the international roles of the U.S. dollar, the duetsche mark, and the yen, popular predictions often paint a picture of an evolving tripolar world where “no dominant trend toward any [currency] will develop” (Bryant 1990, p.33). Purportedly, these forecasts of relative currency shares are based on expected levels of the usual fundamentals defined by standard theory. We would beg to differ from such tripolar predictions (no hegemony) in terms of a crucial qualification. Only if the trend toward convergence of enforcement capabilities among the big three continues in the future, might the tripolar system evolve in the form envisioned. Huge disparities among the United States, Germany, and Japan in their enforcement determinants, for example, could drive a wedge between their international currency shares and potentially steer the future course of evolution away from the tri-currency system. Analysis of trends in the enforcement environment in the world economy and their impact on currency internationalization thus promises to be an important avenue for future research.

Finally, this paper is an exercise in situating the topic of international currencies within new, emerging insights in the discipline of economics, as represented by the enforcement approach to exchange relations. Mainstream economics has long taken for granted the problem of agency and enforcement as a solved political problem. This paper is an attempt to address this oversight in the international money literature.

APPENDIX I Data Issues and Variable Selection

The development of an empirical counterpart to our (theoretical) model of the determinants of currency internationalization involves specification of the relevant entities in terms of econometric variables. This exercise is informed by several considerations, theoretical and practical (data availability), relating to the devising of appropriate econometric variables to represent both the international role of a currency, and the various theoretical determinants of this role. In some cases, the specification process is relatively straightforward; for others, however, lack of a suitable precedent in the previous literature on international currencies implies the need for subjective discretion and judgment. We first discuss econometric specification in variable form for the currency’s international role, followed by specification of variables for its determinants.

I. Dependent Variable

The international role of a currency, or its relative currency share, is the entity to be explained. However, the international role of a currency is by definition a multi-dimensional concept. It embodies the three functions of medium of exchange, unit of account, and store of value, manifested at both the private and the official levels. This multidimensionality immediately raises concerns about how to represent it in the form of a single variable. One might conceive of a potential aggregate index: however, this raises difficult but legitimate questions, such as how to devise an appropriate weighting scheme that allots different weights to the various functions of a currency, and assigns different weights to the official versus the private aspect, and so on. Additional complications relate to the fact that not all of the various aspects of a currency’s international role can even be quantified. The approach taken in this study, therefore, is to make no attempt at aggregation. Rather, we choose to proxy the theoretical aggregate (the international role of a currency) in terms of several alternative definitions of the dependent variable that are based on disaggregated aspects of international currency role. To the extent that these disaggregated aspects are chosen such that they closely mirror overall trends in the currency’s international role, this should be a reasonable approximation. The selection of these various definitions (and measures) of the dependent variable is mainly guided by data availability.

In general, data are quite limited. Very few of the above-mentioned (disaggregated) aspects of a currency’s international role afford systematic and consistent data series over an extended period of time. In addition, the number of countries with currencies serving as international money -- that is, those with a significant (non-trivial) share in the international economy -- is rather small. In this study, we select two different definitions and measures of the international role of a currency -- a currency’s share in international bond issues, and its share in official foreign exchange reserves -- based on the observation that they were the only ones that yielded somewhat reasonably sized data series over time and across countries. Table 2 (see text) summarizes these definitions, the range of data availability, and data sources. 28/ Note that one definition, currency composition of official foreign exchange reserves, relates to a currency’s official role, and is a stock-based measure, while the other, currency composition of international bond issues, essentially reflects the private aspect of a currency’s international role, and is a flow measure. Thus these two definitions capture a broad range of the various dimensions of a currency’s international role. Admittedly, each series captures a different (disaggregated) aspect of a currency’s international role, and perhaps ideally, different (sub)sets of determinants should explain these different aspects of the currency’s international role, but it is important to keep in mind that for the purposes of this econometric study, the sense in which we use these alternative definitions is ultimately only to serve as potential indicators (proxies) of the overall international role of the currency.

As Table 2 shows, the availability of data for the two currency share series varies over time and across countries, and the sample sizes differ accordingly.

II. Independent Variables

We first describe the process of econometric specification of variables corresponding to the standard determinants in our model, followed by the enforcement determinants. Descriptive statistics for each variable in each of the three samples are provided in Appendix II.

1. Independent variables corresponding to the standard determinants

Although there are no previous econometric studies that test the theory of determination of a currency’s international role, there exist some descriptive empirical studies 29/ that explain emerging trends in relative currency shares of the dollar, the duetsche mark, and the yen, in terms of the set of standard determinants. For some of the standard determinants, the empirical representations invoked in these studies readily suggest suitable candidates for econometric variables in our empirical model. However, for other standard determinants, as discussed below, the specification process is less straightforward.

Inflation is represented by the inflation variable INFL, defined and measured in relative terms as the percentage change in the annual consumer price index, divided by the average for all the countries included in the sample. Inflation variability is similarly defined in relative terms. It is represented by the inflation variability variable INFLV, which is the standard deviation of quarterly percentage changes in the consumer price index divided by the average standard deviation for all the countries included in the sample. Exchange rate is represented by the exchange rate variable EXR. There are two different ways in which this variable can be defined and measured 30/, as the bilateral market exchange rate expressing the price of the currency in terms of the U.S. dollar, and as the weighted or effective MERM exchange rate index (based on the Multilateral Exchange Rate Model). Since the correlation between these two measures is found to be a surprisingly weak -0.206, 31/ both are retained as alternative measures of the exchange rate. Exchange rate variability is represented by the exchange rate variability variable EXRV. Corresponding to the two different definitions (and measures) of the exchange rate variable, there are two definitions (and measures) of exchange rate variability. The first one is constructed by taking the ratio of the standard deviation of quarterly percentage changes in the bilateral market exchange rate to the average standard deviation for all the countries included in the sample. Likewise, the second one is based on the standard deviation of quarterly percentage changes in the effective exchange rate index. 32/ Once again, the weak correlation (0.102) 33/ between these two measures does not provide a clear case for dismissal of any one of the two.

Financial openness, as a determinant of the international role of a currency, is not easily captured by any single econometric variable. In its true spirit, financial openness is a complex and multidimensional institutional feature. Descriptive literature on international currency use refers to several aspects, ranging from restrictions on capital movements (inflows and outflows), domestic banking regulations relating to transactions with residents and nonresidents, regulations on participation of domestic financial institutions in international financial markets and on participation of foreign financial institutions in the domestic financial market, trade financing restrictions, and regulations relating to short-term (treasury bill and commercial paper) markets or to primary and secondary bond markets. 34/ Clearly, to condense these diverse features relating to financial openness into one variable is next to impossible, so that econometric specification of financial openness inevitably involves focusing on a limited and narrow aspect of the financial regulatory environment. Data considerations, particularly the need to have a homogenous measure of financial openness over time and across countries, lead us to the choice of a capital controls variable KKI, as a proxy for financial openness of the issuing country. Following Epstein and Schor (1992), this variable is defined and measured in terms of a capital controls index. The IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions lists for each country the existence or nonexistence of restrictions in various categories of transactions. The capital controls index is constructed as the sum of restrictions in five categories: restrictions on payments for current transactions, restrictions on payments for capital transactions, import surcharges, advance import deposits, and surrender requirement for export proceeds. The value of the index ranges from 0 to 5, with 0 signifying the lowest level of capital controls (high financial openness) and 5 signifying the highest level of capital controls (low financial openness).

World export share is represented by the export share variable EXPSH, defined and measured as the ratio of a country’s exports to total world exports. Net foreign asset position (net debtor or net creditor status) is defined in relative terms and represented by the variable NFAR, as net foreign assets/GNP divided by the average net foreign asset/GNP ratio for all the countries included in the sample. In order to avoid problems such as infinite observations, all net foreign asset/GNP ratios are first scaled onto a common positive scale by treating the most negative net foreign asset/GNP observation in the sample as a zero.

The econometric specification of financial market depth and breadth raises issues similar to those encountered in the case of financial openness. It is most problematic to find a single variable that serves as a unique barometer of the depth and breadth of the financial market in the issuer nation. Indeed, descriptive studies point to a multitude of institutional and structural features relating to financial market comparative advantage: however, none of these studies offers any method of quantification of relative comparative advantage in the sense of depth and breadth. We therefore venture into uncharted terrain as we attempt to develop some sort of indicator of a country’s relative financial market depth and breadth. We conjecture that one way to capture relative financial market depth and breadth might be in terms of the relative share of the country’s financial market in world capital transactions. In other words, a country’s share in international financial activity, FINSH, may serve as an appropriate variable under the assumption that it is ultimately reflective of the internal characteristics (depth and breadth) of the financial market relative to others. A question then arises as to how this variable might be measured, that is, which particular aspect of international financial market activity should be focused on. We collected data for five different aspects of international financial activity, each lending itself as a potential measure of the variable (country’s share in international financial activity). These five series were ratio of international bond issues to total world issues, ratio of foreign bond issues to total world issues, ratio of deposit money banks’ foreign assets to world total, ratio of deposit money banks’ foreign liabilities to world total, and ratio of international medium and long term bank loans to world total. The correlations 35/ among these measures varied considerably. The strongest correlation coefficient of 0.974 was observed between the third and the fourth measure, followed by the correlation coefficient of 0.605 between the first and the second. The rest of the correlation coefficients ranged from -0.030 to 0.452. Although data were compiled for five different measures of the variable FINSH, ultimately only one, the ratio of international bond issues to total world issues, is used in the estimations in this empirical study. 36/ Our main concern in restricting this choice set is to keep the scope of the empirical project within manageable proportions.

2. Independent variables corresponding to the enforcement determinants

Central bank independence is represented by the variable CBII, and defined and measured in terms of three alternative indices of central bank independence developed in the central bank independence literature. The first two indices, developed in Cukierman, Webb, and Neyapti (1992) are annual turnover rate of central bank governor, and the aggregate legal central bank independence index. A high level of turnover signals low central bank independence. The values of the aggregate legal central bank independence index range from 0 to 1, with 0 signifying the lowest level of central bank independence and 1 signifying the highest level of central bank independence. The third index is the Epstein-Schor index (Epstein and Schor 1992), with values ranging from 0 to 3, signifying respectively the lowest and the highest levels of central bank independence. Of these three measures, the strongest correlation coefficient 37/ of 0.749 is observed between the second and the third, and the weakest -0.192 between the first and the third. The remaining coefficient is -0.336.

Stock of foreign direct investment assets abroad is represented by the foreign direct investment stock share variable FDISH, defined and measured as the ratio of a country’s stock (gross) of foreign direct investment assets abroad to the total world stock. In devising an appropriate econometric variable for multinational rent earnings from abroad, the lack of comprehensive and consistent data over time and across countries regarding multinational activity proves to be a major constraint. As a result, we focused on the particular data series that were available and that might reasonably serve as potential proxies for the relative size of rents earned abroad by a country’s multinationals. Two alternative definitions (and measures) of the econometric variable were identified: gross factor income earnings (excluding labor income) from abroad as a ratio of total gross factor income earnings from abroad for the sample, and net factor income earnings (excluding labor income) as a ratio of total net factor income earnings for the sample. 1/ Although the correlation between these two measures was quite strong, indicating potential substitutability between them, the gross measure had higher correlations with some of the other explanatory variables (such as EXPSH, FDISH, and MILSH) than did the net measure. The potential for multicollinearity problems led us to reject the gross definition and to define the independent variable as net factor income share NFISH, that is, ratio of net factor income earnings to sample total.

Finally, military strength is represented by the military expenditure share variable MILSH, defined and measured as the ratio of the country’s military expenditure to total world military expenditure. Military power admittedly has several additional dimensions, ranging from nuclear capabilities to arms trade to the size of the armed forces. Nevertheless, theoretical as well as data considerations do seem to suggest that world military expenditure share is a reasonable indicator of a nation’s military strength.

To conclude our discussion of the econometric specification of the determinants of currency internationalization, Table 1 (see text) summarizes the definitions (measures) of all the independent variables, their expected signs, and data sources. Whenever possible, both measures of exchange rate and exchange rate variability are used in the estimation process, as are all three measures of central bank independence. The main reason for including alternate measures of the same variable is that by and large, correlations among these alternate measures prove to be weak, so that on an a priori basis, there is no way to judge which would be a better measure.

APPENDIX II
Table II.1.Descriptive Statistics: SAMPLE1 (1964–90, Six Countries, Dependent Variable: Currency Share in International Bond Issues)
VariableMeanVarianceMinimumMaximum
Independent
Infl1.0000.243-0.3902.430
Inflv0.9880.5140.0503.490
Exrε46.34110632.0000.360360.000
Exrvε0.9980.4990.0005.340
Expsh7.91011.0993.57016.190
Kki0.8271.3990.0004.000
Finsh7.97777.3020.00054.200
Nfar1.0000.267-8.4532.400
CbiiI0.1420.0050.0000.300
CbiiII0.3940.0280.1800.690
CbiiIII1.6670.4751.0003.000
Fdish14.359351.3900.36077.530
Nfish16.667975.020-5.34097.200
Milsh6.674101.3200.42037.520
Dependent
Currency Share in World International Bond Issues15.259588.0600.00090.640
Correlation Coefficients Matrix
Dep. Var. CbiiIIInfl CbiiIIIInflv FdishExr NfishεExrv MilshεExpshKkiFinshNfarCbiiI
Dep. Var.1.000
Infl-0.1161.000
Inflv-0.2650.4171.000
Exrε-0.248-0.0220.2741.000
Exrvε-0.3950.0520.1080.0341.000
Expsh0.792-0.314-0.311-0.113-0.2881.000
Kki-0.4030.3720.1550.2940.210-0.4061.000
Finsh0.5680.022-0.0160.032-0.2200.441-0.1551.000
Nfar-0.150-0.281-0.134-0.3250.056-0.333-0.268-0.1621.000
CbiiI-0.110-0.035-0.0340.3240.0600.0740.2630.169-0.3471.000
CbiiII0.382

1.000
-0.393-0.390-0.544-0.1030.536-0.442-0.1510.135-0.474
CbiiIII0.394

0.942
-0.333

1.000
-0.255-0.418-0.1040.617-0.490-0.094-0.043-0.424
Fdish0.863

0.182
0.079

0.186
-0.137

1.000
-0.262-0.3350.584-0.3120.517-0.1240.000
Nfish0.926

0.244
-0.074

0.229
-0.247

0.941
-0.223

1.000
-0.3780.721-0.3290.595-0.1380.044
Milsh0.938

0.251
0.008

0.249
-0.265

0.891
-0.240

0.955
-0.411

1.000
0.737-0.3110.591-0.213-0.039

Bilateral Market Exchange Rate-based measures.

Cbii measured as Annual Turnover Rate of Central Bank Governor.

Cbii measured as Central Bank Legal Independence Index.

Cbii measured as Epstein-Schor Central Bank Independence Index.

Bilateral Market Exchange Rate-based measures.

Cbii measured as Annual Turnover Rate of Central Bank Governor.

Cbii measured as Central Bank Legal Independence Index.

Cbii measured as Epstein-Schor Central Bank Independence Index.

Table II.2.Descriptive Statistics: SAMPLE2 (1973–90, Nine Countries, Dependent Variable: Currency Share in International Bond Issues), and SAMPLE3 (1973–90, Nine Countries, Dependent Variable: Currency Share in Official Foreign Exchange Reserves)
VariableMeanVarianceMinimumMaximum
Independent
Infl1.0000.305-0.2503.640
Inflv1.0000.5310.0303.450
Exrε26.4645122.2000.410296.790
Exrεε103.080495.18057.300164.200
Exrvε1.0000.7610.0003.220
Exrvεε1.0000.4820.0805.050
Expsh5.98613.3931.12013.060
Kki0.5120.7610.0003.000
Finsh6.61644.5490.00038.890
Nfar1.0000.3070.0002.540
CbiiI0.1500.0050.0000.300
CbiiII0.4100.0250.1800.690
CbiiIII1.5560.8630.0003.000
Fdish11.699307.0200.00277.530
Nfish11.1111149.800-38.470114.530
Milsh4.50962.8520.20029.580
Dependent
(1) Currency Share in World International Bond Issues10.400377.1900.00083.900
(2) Currency Share in World Off. Foreign Exchange Reserves10.474482.6300.00079.600
Correlation Coefficients Matrix
Dep.Varl1Dep.Var2InflInflvExrεExrεεExrvεExrvεεExpshKki
FinshNfarCbiiICbiiIICbiiIIIFdishNfishMilsh
Dep.Varl1.000
Dep.Var20.9231.000
Infl-0.074-0.0741.000
Inflv-0.149-0.1680.3401.000
Exrε-0.140-0.109-0.1510.1661.000
Exrεε-0.402-0.414-0.0340.059-0.2061.000
Exrvε0.017-0.023-0.1420.1770.315-0.0101.000
Exrvεε0.0610.0540.2190.3000.111-0.0630.1021.000
Expsh0.7080.692-0.272-0.1180.191-0.2820.456-0.0471.000
Kki-0.283-0.2540.3340.084-0.0310.5000.0710.004-0.2401.000
Finsh0.439

1.000
0.3890.0340.1310.2680.0380.1850.0820.445-0.031
Nfar-0.070

-0.217
-0.018

1.000
-0.4850.014-0.050-0.0850.040-0.022-0.132-0.212
CbiiI-0.024

0.233
0.073

-0.005
-0.008

1.000
-0.0250.3520.204-0.0180.1670.0870.201
CbiiII0.262

-0.360
0.229

0.349
-0.356

-0.336
-0.352

1.000
-0.499-0.212-0.288-0.1280.140-0.470
CbiiIII0.270

-0.176
0.266

0.685
-0.516

-0.192
-0.135

0.749
-0.205

1.000
-0.3210.106-0.1370.359-0.491
Fdish0.896

0.451
0.940

-0.042
0.032

0.002
-0.041

0.089
-0.132

0.177
-0.392

1.000
0.0130.0380.602-0.244
Nfish0.876

0.436
0.944

0.203
-0.179

0.128
-0.087

0.186
-0.051

0.345
-0.310

0.897
0.059

1.000
0.0880.656-0.222
Milsh0.918

0.428
0.969

-0.077
0.010

0.036
-0.134

0.134
-0.130

0.194
-0.389

0.925
0.009

0.922
0.076

1.000
0.675-0.171

Bilateral Market Exchange Rate-based measures.

Effective Exchange Rate-based measures.

Cbii measured as Annual Turnover Rate of Central Bank Governor.

Cbii measured as Central Bank Legal Independence Index.

Cbii measured as Epstein-Schor Central Bank Independence Index.

Bilateral Market Exchange Rate-based measures.

Effective Exchange Rate-based measures.

Cbii measured as Annual Turnover Rate of Central Bank Governor.

Cbii measured as Central Bank Legal Independence Index.

Cbii measured as Epstein-Schor Central Bank Independence Index.

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This research was undertaken as part of the author’s doctoral dissertation (May 1995). The author thanks Michael Nowak for comments and suggestions, and Janet Bungay for editorial assistance.

Cohen (1971, pp. 21–22) notes that the notion of key currencies has been used in many different ways in the international monetary literature, sometimes referring to a specific function (international means of payment in trade, or reserve currency role), and sometimes simply as “....a catch-all phrase, a rather crude synonym for international money in general.” Throughout this paper, the terms “key currency” and “international currency” will be used interchangeably.

Typically, these assets are held in the form of securities, and the issuer nation is obliged to pay a nominal interest payment to the holder.

The significance of what we have loosely called privilege and power is also noted by Birnbaum (1968, p. 5). He defines the former in terms of international purchasing power, “....the power of a country to purchase more goods and services from other countries than it sells to them during a specific period....a country’s ability to finance international payments deficits.” The latter “relates to the country’s ability to influence and control the form and issuance of international money.”

Transaction costs include a wide assortment of costs of information, search, uncertainty, enforcement, and negotiation (Tavlas and Ozeki 1992).

The discussion in this section draws upon a vast body of literature, which includes, among others, Bergsten (1975), Bilson (1983), Black (1991), Brunner and Meltzer (1971), Carse and Wood (1979), Chrystal (1977, 1984), Cohen (1971), Despres, Kindleberger and Salant (1966), Grassman (1973, 1976), Kindleberger (1965, 1981), Krugman (1980, 1984), Magee and Rao (1980), McKinnon (1979), Meltzer (1990), Page (1977, 1981), Swoboda (1968, 1969), Tavlas (1991), Tavlas and Ozeki (1991, 1992), and Whitman (1974).

Net foreign asset position is defined in the broad sense, that is, net foreign assets of the central bank (banking system) plus net foreign indebtedness of the private sector.

This scenario may entail, at the very extreme, large-scale appropriations of foreign assets (denominated in the issuer’s currency) or currency reform by the issuer.

One could say that the notion of incentive incompatibilities and the potential for default is not entirely alien to the standard approach. Proponents of the financial intermediary view (see previous section), for example, did seem to be implicitly aware of enforcement issues, as indicated by the importance of the net foreign asset position as a determinant of key currency status. However, the concept of enforcement was never fully exploited and formally incorporated into the analysis.

In these latter types of exchanges, say, between agent A and agent B, there is some aspect of the object of exchange (good or service) that is so complex and/or difficult to monitor that it is contractually unspecifiable, and exogenously unenforceable. If B’s good or service possesses an attribute that is valuable to A but is costly for B to provide, then the fact that the attribute is not fully specifiable in a costlessly enforceable contract implies that a problem of agency exists -- B has the potential to take actions that are harmful or beneficial to A’s interest, but which cannot be precluded or guaranteed by contractual agreement (Bowles and Gintis 1990).

The term “belligerent” should be taken to imply the party with the incentive to renege, that is, engage in opportunism.

It is broader in the sense that it is not necessarily restricted to problems of agency.

Several examples from the literature are illustrative. A union’s threat to strike can be made more credible if it puts its reputation on the line and asserts publicly that it would strike until its demands are met. For kingdoms that lacked trust and good faith, the exchange of hostages was one of several reciprocal acts that maintained peace and deterred mutual destruction. Firms often lend credibility to their promise that layoffs will be governed by seniority by voluntarily encouraging a form of social investment: unionization. A kidnapper’s victim may make credible his promise that he would not reveal the identity of his kidnapper upon release, by volunteering strategic information or even committing a blackmailable act in the presence of his captor.

Strictly speaking, the costs of hostage appropriation are borne by the specific private groups that have ownership of these assets, not the nation at large. It is implicitly assumed here that these private groups have successful representation for their preferences in national policymaking; they have the ability to exert adequate influence on their government so as to deter such policy actions that are likely to provoke external sanctions in the form of asset appropriations.

Once again, this is subject to the assumption that the rent-earning multinational sector possesses the political clout to be able to influence national policy in its favor.

With regard to foreign retaliation in any form, the intended punitive effect would be considerably strengthened in the presence of a concerted international effort by all key currency holders (nations).

Admittedly, this would hold only to the extent that a nation with military power is willing to assume international leadership and cultivate a strong reputation.

As Cukierman, Webb, and Neyapti (1992) point out, the notion of central bank independence does not imply unconditional independence from the federal government, but rather the independence to pursue objectives of price stability even at the cost of other objectives that may be more important to political authorities.

In view of the large number of explanatory variables, cross-sectional estimation was ruled out; as Table 2 shows, for every one of the three samples to be estimated, the number of cross-sectional observations per time observation is too small. Similar degree of freedom constraints also gave rise to questions about the appropriateness of time-series estimation; for every sample, the number of time observations per country is still very small relative to the number of explanatory variables. Moreover, country regressions in any case were not expected to be meaningful, because in general, the variation in data was much more pronounced across cross-sections than over time. Thus, statistically, cross-sectional variation in regressors was expected to explain most of the variation in the dependent variable.

SAMPLE1 was initially taken as a representative case in order to investigate the various econometric issues that typically surround time-series cross-sectional estimation. In this preliminary analysis, equation (1) was first estimated using Ordinary Least Squares. Subsequently, tests confirmed the presence of heteroscedasticity and the inconclusiveness of autocorrelation (both first and second order), thereby suggesting Generalized Least Squares as the more appropriate regression methodology.

In order to account for any structural or qualitative differences between the flexible exchange rate regime (characterizing the period after 1972), and the fixed exchange rate Bretton Woods regime (prior to 1972), equation (1) was re-estimated after including an exchange rate regime intercept dummy (Table 4). The dummy variable was found to be significant in only one instance (at the 10 percent level), implying that for any given set of values for the independent variables, the hypothesis that the expected value of the dependent variable is equal in the two regimes was rejected.

Note that in the standard literature on international currencies, inflation rate and exchange rate are both regarded as essentially representations of the value of a currency, and inflation and exchange rate variability as expressions of the variability of the value of a currency. This implies a certain degree of substitutability; the omission of one set rather than inclusion of both in a single equation may therefore be theoretically justified.

See Appendix Tables II.1 and 11.2 for descriptive statistics.

In addition to OECD publications, other data sources such as the BIS Annual Report were consulted. BIS data, however, were not useful for the purpose of econometric analysis, owing to the lack of regularity, consistency, and comprehensiveness.

See Tavlas and Ozeki (1991, 1992).

Based on the 1973–90 data sample (see Appendix II, Table 11.2).

Tavlas (1991) captures exchange rate variability by taking the standard deviation of monthly percentage changes in the nominal exchange rate. However, we use standard deviations based on quarterly data, primarily to preserve the consistency of our definition of exchange rate variability with our definition of inflation variability (which is based on quarterly data).

Based on the 1973–90 data sample (see Appendix II, Table II.2)s.

Based on the 1973–90 data sample.

Based on preliminary regressions, this measure seemed to yield relatively better results.

Based on the 1973–90 data sample (see Appendix II, Table II.2).

Ideally, one would have liked to use world totals as denominator, but world data are not available.

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