Chapter

Chapter 2 Developments in the International Monetary System

Author(s):
International Monetary Fund
Published Date:
September 1982
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Two aspects of the international monetary system are examined in this chapter. The first part of the chapter deals with exchange rate arrangements and exchange market policies of members and concludes with a section on the Fund’s recent experience with surveillance over members’ exchange rate policies. The second part of the chapter, concerned with international liquidity and reserves, describes recent developments in the level, composition, and distribution of international reserves, as well as the role of international credit markets in balance of payments financing. The chapter ends with a review of the provision of conditional and unconditional liquidity by the Fund.

Exchange Rates and Surveillance

Movements in effective exchange rates of industrial countries during 1981 and the early part of 1982 chiefly reflected large changes vis-à-vis the U.S. dollar, but movements in other bilateral rates (for example, between the EMS currencies on the one hand and the Japanese yen and pound sterling on the other) were also quite substantial.1 As these changes were often unrelated, or even opposite, to concurrent differences in inflation rates, they altered competitive positions among industrial countries and affected both domestic price levels and the management of domestic demand. There was also considerable exchange rate volatility, with frequent day-today changes in exchange rates in excess of 1 per cent and quarter-to-quarter changes in excess of 5 per cent. This tendency toward longer swings in exchange rates lasting as long as two or three years, accompanied by considerable shorter-term volatility, has been observed since the beginning of widespread floating in March 1973.

Even with the advantage of hindsight, it is not an easy task to identify the primary factors that have been responsible for these movements in exchange rates and to assess the extent to which the movements may have been justified by changes in underlying economic and financial conditions. Recent Annual Reports have discussed the roles that differential movements in inflation rates, interest rates, and current account positions play in producing changes in exchange rates, but, as pointed out in Chapter 1, the broad swings in exchange rates cannot be explained completely by reference to these factors. The difficulty of identifying and measuring the relative contributions of various factors to exchange rate movements has added to the complexity of policy formulation in industrial countries.

Developing countries have also been adversely affected by the variability of exchange rates. In particular, swings in exchange rates among industrial countries have increased the difficulty of devising and implementing satisfactory exchange rate policies in developing countries. A further problem that is relevant to some developing countries—as indeed also to some industrial countries—is the tendency to delay exchange rate changes that are needed to offset differences in inflation rates and other factors having persistent effects on the balance of payments.

The problems faced by industrial and developing countries are discussed separately in the following two sections, although many of the issues in this part of the chapter are relevant to both groups. The analysis takes into account the wide diversity that exists in the economic conditions of countries within each group.

Industrial Countries

After assessing the cost of exchange rate volatility and longer-run exchange rate swings, the following analysis considers the role that various economic policies might play in the search for less exchange rate variability among industrial countries.

Costs of Exchange Rate Variability

The continued tendency for the exchange rates of major currencies to be volatile is illustrated in Chart 14, which depicts daily changes in the ten bilateral exchange rates between the French franc, the Japanese yen, the deutsche mark, the pound sterling, and the U.S. dollar. The bilateral exchange rates shown in the chart have a similar pattern of movement; the day-to-day changes were rather large during the first three or four years of the floating rate period and became quite large again recently. For most of these bilateral exchange rates, the average daily changes have been larger during 1981 than during any year of the past decade but have declined moderately during the first half of 1982. This day-to-day variability was particularly high for exchange rates vis-à-vis the U.S. dollar and the Japanese yen. The evidence with respect to changes in exchange rates from quarter to quarter is similar; volatility from quarter to quarter has been particularly high over the past year and a half, especially for U.S. dollar and yen exchange rates.

Chart 14.Short-Run Variability in Bilateral Exchange Rates for Five Major Currencies, April 2, 1973-June 30, 1982

(Daily percentage changes)

Evaluation of the cost of exchange rate volatility is a difficult and controversial exercise. Much of the discussion of volatility has focused on the potential implications for the profitability of international trade. In particular, exchange rate volatility is likely to increase the riskiness of uncovered foreign currency transactions and may raise the cost of obtaining forward cover.

When exchange rates are relatively variable in the short run, the differences between forward exchange rates and future spot rates tend to be amplified, as is shown in Chart 15. In other words, the forward exchange rate for a particular date becomes less accurate as a predictor of the actual spot rate on that date. All of the European currencies presented in the chart experienced greater day-to-day fluctuations in exchange rates vis-à-vis the U.S. dollar during 1981 than during either of the preceding two years, although the fluctuations in the Swiss franc were not unusually large in relation to the experience of 1978. In the forward exchange markets for the European currencies, the failure of 3-month forward exchange rates to predict spot rates at the maturity of the forward contract was also greater in 1981 than in any of the three preceding years. In contrast, exchange rate variability was roughly constant for the Canadian dollar and the Japanese yen—though relatively larger for the yen than for the Canadian dollar—while the prediction errors in those forward markets were steady or declining.

Chart 15.Indicators of Risk in Exchange Markets, 1978-81

(In per cent)

1Exchange rate variability is measured as the standard deviation of daily percentage changes in the spot exchange rate, expressed in U.S. dollars per currency unit.

2Errors in forward markets are measured as the standard deviation of daily percentage differences between the three-month forward exchange rate and the spot exchange rate three months later.

Differences between forward exchange rates and the subsequently observed spot rates for corresponding dates are important because they indicate the degree of risk present in the exchange market. Higher risk leads participants in international trade to increase the proportion of their trade contracts that is to be hedged. By itself, this effect increases the cost of entering into foreign trade. In addition, the cost of hedging a given contract in the forward exchange market may also increase as a result of the increase in risk. This view is supported by developments in the cost of hedging in the New York market as measured by the bid-offered spreads for the 3-month and 12-month forward exchange rates of seven major industrial countries against the U.S. dollar for the period from the beginning of 1974 to the end of 1981 (Chart 16). For most European countries and Japan, bid-offered spreads declined from the high level of 1974 to a low point late in the 1970s. Thereafter they rose sharply, and for 1981 they were again as high as in 1974, and some were even higher. This suggests that the cost of undertaking hedging transactions in the forward market, which declined in the mid-1970s, has again risen sharply since 1979.

Chart 16.Spreads Between Buying and Selling Rates in Forward Exchange Markets, 1974-811

(In per cent)

1Average daily rates (U.S. dollars per currency unit in the New York foreign exchange market).

A widespread increase in exchange market risks or in the cost of foreign exchange transactions generally is by itself a cause for concern. It has been difficult, however, to assess the effect of changes in these costs on the volume of international trade. Econometric studies, including some by the Fund staff, that have attempted to measure the direct and indirect effects of exchange rate volatility on international trade have yielded inconclusive results. The evidence from surveys, on the other hand, indicates an effect that is distinct, though probably not large. Whether the most recent episode of volatility has been sufficiently important to generate larger effects is a subject of ongoing study.

The longer-term variability of exchange rates raises a quite different set of issues, related to the extent to which movements in nominal exchange rates reflect shifts in underlying economic conditions. All of the major currencies have experienced very substantial longer-term movements throughout the period of floating rates (Chart 17). Some of these movements have later been reversed. Real exchange rates, that is, exchange rates adjusted for changes in relative costs and prices, also have been highly variable (Chart 18) and have, moreover, at times moved in the opposite direction from that which would have been required to stabilize or adjust current account balances. While the precise measurement of real exchange rates depends on the choice of cost or price deflator, it is clear that their movements have on occasion created substantial problems in the real sectors of the industrial economies, making international adjustment more complicated.

Chart 17.Selected Industrial Countries: Exchange Rates, April 1, 1973-June 30, 19821

(In U.S. cents per currency unit).

1Daily Noon quotations in New York.

Chart 18.Major Industrial Countries: Effective Exchange Rates and International Cost Competitiveness, First Quarter 1973–First Quarter 19821

(Index, average for period shown = 100)

1The indices of effective exchange rates are based on the Fund’s multilateral exchange rate model. The indices of relative costs are calculated by adjusting the indices of relative normalized unit labor costs in manufacturing for exchange rate changes. For a definition of normalized unit labor costs, see Chapter 1, page 25, footnote 3 to Table 9.

The lack of a close correspondence between changes in local currency production costs and movements in nominal exchange rates can be illustrated by the evolution of real effective exchange rates of the large industrial countries in recent years—notably, the real appreciation of the pound sterling during 1979 and 1980 and of the U.S. dollar during 1980 and 1981, as well as the real depreciation of the Japanese yen during 1979 and of the deutsche mark during 1980 and 1981. When changes in real exchange rates reflect temporary disturbances in financial asset markets, rather than major changes in international comparative advantage, they tend to be reversed before long. Such swings in real exchange rates may lead to unnecessary movements of labor and capital in and out of sectors producing tradable goods. Although little direct evidence is currently available on the costs of such swings in resource allocation, it seems likely that they have contributed to uncertainty about the profitability of various industries and may thereby have inhibited fixed capital formation, particularly in countries with a large foreign trade sector. In addition, because goods and labor markets are far from being perfectly efficient, such swings can contribute to wasteful investment and to unemployment.

Smooth and prompt adjustment of exchange rates is an essential element in the prevention of large balance of payments imbalances. As the relative cyclical positions of the industrial countries and other factors influencing foreign trade flows underwent major changes during the past two years, pressures arose on those countries’ current account balances, as discussed in Chapter 1. An appreciation of real exchange rates for incipient surplus countries and a real depreciation for incipient deficit countries could have contributed to maintaining viable current account positions. In fact, however, the changes in exchange rates were often dominated by developments in financial markets and did not correspond to the need for current account adjustment. As a result, unsustainable current account imbalances could build up and then exert strong pressure on exchange rates. Once exchange rates start to move in response to large current account imbalances, they often enlarge these imbalances initially because they improve the terms of trade of surplus countries and worsen the terms of trade of deficit countries, while the volumes of foreign trade flows respond slowly to changes in price competitiveness, in part owing to the difficulty of identifying the underlying direction of exchange rate movements when exchange rates are highly volatile. This J-curve effect may, in turn, lead to further and excessive exchange rate changes, as has at times been observed in the 1970s.

Another cost associated with swings in real exchange rates is that they tend to complicate the operation of demand management policies. Regardless of whether the authorities have a specific objective for the exchange rate, the effects of exchange rate movements on the domestic economy—including terms of trade effects and changes in real interest rates associated with capital flows—cannot be ignored. The authorities may have to choose between allowing their own interest rates to fluctuate along with those in other countries—maintaining stable interest rate differentials in order to reduce the variability of exchange rates—and keeping domestic interest rates stable while allowing the exchange rate to fluctuate. As discussed in last year’s Annual Report, the relationship between changes in interest rate differentials and changes in exchange rates is far from simple. In a number of industrial countries, interest rate differentials and exchange rate changes were more variable on average during 1980 and 1981 than during the preceding two years; there is, however, no close correspondence between year-to-year changes in the variability of these two elements (Chart 19).

Chart 19.Variability of Differentials Between Domestic and U.S. Interest Rates and of Exchange Rates Vis-à-Vis the U.S. Dollar, 1978-81

(In per cent)

Sources: International Monetary Fund, Treasurer’s Department, and Board of Governors, U.S. Federal Reserve System.

1The variability of the interest rate differential is measured as the standard deviation of the daily series of three-month changes in the interest rate differential on assets of three months’ maturity.

2Exchange rate variability is measured as the standard deviation of the daily series of three-month percentage changes in the exchange rate vis-à-vis the U.S. dollar.

Policies that Influence Exchange Rates

Although the desirability of a reduction in the variability of exchange rates is not in doubt, there is much controversy as to how to achieve this goal. From a longer-run standpoint, it is widely accepted that, in order to have less variability in real exchange rates, it is necessary to achieve more stable underlying domestic economic and financial conditions, particularly a reduction in and convergence of actual and expected inflation rates. The increased importance attached to the reduction of domestic inflation and inflationary expectations in major industrial countries during the past two or three years, and the relative success that some of these countries have already achieved in that endeavor, is thus welcome from an international as well as from a domestic point of view. Nonetheless, the divergence of inflation rates remains quite large (Table 12); success in the struggle against inflation has come slowly and at different rates in different countries, and it has been accompanied by different effects on interest rates. Partly for this reason, the pursuit of anti-inflationary policies in industrial countries has so far been associated with more, rather than less, medium-term variability of exchange rates.

Table 12.Major Industrial Countries: Inflation Rates, 1977-81(Change from fourth quarter of previous year, in per cent)
19771978197919801981
GNP deflators
United States6.18.58.09.88.9
Canada6.16.711.99.811.1
France9.110.010.110.910.5 1
Germany, Federal Republic of4.03.54.05.14.6
Italy15.913.717.319.815.01
Japan5.44.01.74.32.3
United Kingdom13.010.918.617.310.8
Mean8.58.210.211.09.0
Standard deviation4.43.76.35.84.3
Normalized unit labor costs in manufacturing
United States6.46.87.710.47.1
Canada6.13.67.17.49.1
France6.38.79.19.59.9
Germany, Federal Republic of5.22.83.04.31.6
Italy13.89.912.317.716.3
Japan3.1-3.0-0.71.3-0.1
United Kingdom7.712.416.718.98.5
Mean7.05.97.99.97.5
Standard deviation3.45.25.76.55.5
Sources: International Monetary Fund, International Financial Statistics; United Kingdom, Central Statistical Office, Economic Trends.

Third quarter 1981 over third quarter 1980 growth rate.

Sources: International Monetary Fund, International Financial Statistics; United Kingdom, Central Statistical Office, Economic Trends.

Third quarter 1981 over third quarter 1980 growth rate.

Much of the discussion of this transitional problem has focused on monetary policies, which have borne the major burden in recent efforts to reduce inflation. Most of the larger industrial countries have reduced the growth rates for both narrow and broad money stocks below those experienced, on average, in earlier years (Table 13). Given the presence of long lags in the effect of changes in monetary policy on prices and nominal income, real interest rates have moved up considerably. Obviously, the impact of monetary restraint on interest rates has not been uniform across countries, and real interest rate differentials have tended to result in exchange rate movements.

Table 13.Major Industrial Countries: Monetary Growth Rates, 1975-81(Change from end of previous year, in per cent)
Narrow Money1Broad Money1
1975-7821979198019811975-7821979198019813
United Kingdom16.39.13.99.112.012.518.517.9
Germany, Federal Republic of9.73.23.9-1.59.45.24.63.7
France9.911.86.416.013.013.98.311.2
Italy22.323.712.99.822.119.412.210.4
Canada6.21.410.1-2.816.717.79.519.9
Japan11.33.0-2.010.012.68.46.810.7
United States7.48.05.35.08.68.07.66.5
Source: International Monetary Fund, International Financial Statistics.

Narrow money is defined as the sum of currency outside banks and private sector demand deposits. Broad money consists of the sum of narrow money and quasi-money comprising the time deposits, savings deposits, and foreign currency deposits of residents.

Annual average rates.

The figures for growth of broad money during 1981 are distorted for a number of countries. The high growth rate in Canada reflected the introduction of a new bank reporting system and the entry of new banks in line with recent changes in banking legislation. The low growth rates in Italy and the United States reflected disintermediation into treasury bills and money market mutual funds, respectively.

Source: International Monetary Fund, International Financial Statistics.

Narrow money is defined as the sum of currency outside banks and private sector demand deposits. Broad money consists of the sum of narrow money and quasi-money comprising the time deposits, savings deposits, and foreign currency deposits of residents.

Annual average rates.

The figures for growth of broad money during 1981 are distorted for a number of countries. The high growth rate in Canada reflected the introduction of a new bank reporting system and the entry of new banks in line with recent changes in banking legislation. The low growth rates in Italy and the United States reflected disintermediation into treasury bills and money market mutual funds, respectively.

In certain circumstances, fiscal policy may have an important effect on exchange rates. When a restrictive monetary stance is accompanied by an expansionary fiscal stance and by the expectation that this mix of policies will persist over the next few years, private market participants may reasonably come to expect that real interest rates are likely to remain high for an extended period. This effect may be particularly pronounced in countries with low private saving rates, where fiscal deficits may absorb a substantial proportion of the total flow of net domestic saving. In general, the expectation of persistent high real interest rates is accompanied by the expectation that economic growth will be low, so that the current balance will be strong and the rate of inflation will decline. Under present conditions of responsive international capital markets, these factors tend, in turn, to contribute to an appreciation of the exchange rate in both nominal and real terms. In contrast, a large fiscal deficit that is accompanied by a lax monetary stance, or by the expectation that it will soon lead to a lax monetary stance, may tend to contribute to depreciation of the exchange rate in nominal and real terms as private market participants come to expect a rise in the inflation rate and a weakening of the current account balance. Nevertheless, the link between the fiscal deficit and the exchange rate is a complex one, and the tendency of an expansionary fiscal policy, combined with monetary restraint, to lead to an appreciation of the real exchange rate has not always been evident.

These considerations suggest that, on balance, the stability of exchange rates could be enhanced by a more balanced and coordinated mix of monetary and fiscal policies in industrial countries. This need for adjusting the mix of policies was recognized in the joint communique released at the end of the seven-nation economic summit held at Versailles in June 1982. The communique stressed that the nations concerned would, as a matter of urgency, pursue prudent monetary policies and achieve greater control of budgetary deficits, while working toward a constructive and orderly evolution of the international monetary system by a closer cooperation in pursuing medium-term economic and monetary objectives.

In this context, it should also be recognized that various other policies may serve as important complements to changes in the monetary-fiscal mix. For example, as noted in Chapter 1, the adoption of some flexible form of incomes policy could serve in some countries as an adjunct to appropriate monetary and fiscal policies; to the extent that an incomes policy helped to smooth internal adjustment, it would also moderate the pressure on real exchange rates. In addition, structural rigidities in wage bargaining and price-setting mechanisms tend to limit the extent to which countries with pegged exchange rates can use exchange rate adjustment measures to restore international competitiveness, and may make national authorities more reluctant to adopt such measures. In these instances, successful efforts to reduce the degree of structural rigidity in goods and factor markets would serve to enhance the efficacy of exchange rate adjustments. In countries with more flexible exchange rates, the elimination of structural rigidities might help to reduce the degree of variability in the exchange market, since exchange rate variability is partly a consequence of relatively slow adjustment in the prices of both final goods and factors of production. Modification in the application of wage indexation schemes could be particularly helpful in this regard.

More generally, achievement of better medium-term stability and credibility of national economic policies would improve the international adjustment process in at least two ways. First, the existence of stabilizing capital flows that offset temporary movements in current account balances is essential for the proper functioning of the international monetary system, but capital flows cannot be expected to play a stabilizing role unless market participants have an informed view on the likely evolution of policies for at least a few quarters ahead. Second, only stable and credible policies can lead to the winding down of inflationary expectations that is a prerequisite for the reduction of inflation.

The emphasis in the conduct of monetary policy that is given to the achievement of preannounced monetary growth targets relative to other policy objectives may be associated with greater variability in exchange rates over periods of several months. A number of countries appear to have experienced significant shifts in the demand for money in recent years as a consequence of technological and regulatory developments. One such problem that may be particularly serious in its implications for exchange rate stability is the effect of currency substitution on the demand for money. In countries where residents are free to substitute assets denominated in foreign currencies for domestic money holdings, shifts in expectations about exchange rates or relative interest rates can affect the normal relationship between monetary aggregates and domestic nominal demand.

In some countries, the authorities could improve national economic performance by monitoring the effects of monetary policy on exchange rates, as well as on the money stock and domestic interest rates. However, there are dangers that must be avoided. First, a sustained monetary expansion for the purpose of resisting a sharp appreciation of the exchange rate could worsen inflationary expectations, threatening the stability of nominal wage demands. Perseverance in monetary restraint is a prerequisite for success in the fight against inflation in the longer run, although some consideration of the exchange rate may help the authorities to determine the appropriate degree of restraint in the short run. Another potential danger associated with domestic policy measures aimed at influencing exchange rates is that they may amplify the external effects of a major policy shift in one of the large industrial countries, as other countries seeking to avoid large exchange rate changes decide to shift their policies in the same direction. Such a “bandwagon” effect can be helpful when all countries are faced with similar external and domestic economic conditions, but it can be harmful when conditions differ. In sum, since all indicators contain elements of uncertainty and ambiguity, countries should seek to monitor the exchange rate as one among several indicators of monetary policy while ensuring that the broader goal of domestic monetary and economic stability is attained.

At present, national authorities differ substantially in their views as to the weight that should be placed on the exchange rate as a target or indicator for the conduct of domestic policies. These differences of view result in part from differences in circumstances. Many smaller countries with fairly open economies tend to view a stable exchange rate vis-à-vis the currency of a major country with a low inflation rate as a useful guide and anchor for the conduct of domestic policies. Some larger countries tend to place less weight on the exchange rate in implementing their economic policies, since the feedback from exchange rate changes to domestic prices is less pronounced than in smaller countries.

Developing Countries

Since 1979, the non-oil developing countries have faced an especially unfavorable external environment. Chapter 1 has already outlined the serious adjustment problems resulting from sluggish growth and trade protection in the industrial countries, high real interest rates, and adverse developments in the terms of trade. An additional feature of the international economy that has caused problems for developing countries has been the substantial variability of exchange rates among the major currencies. The following sections will discuss the extent to which exchange rate policies can be used, in conjunction with other measures, to deal with these problems.

Choice of Exchange Rate Regime

Fluctuations in exchange rates between the currencies of industrial countries can produce various difficulties for developing countries. Short-term variability in these rates can increase uncertainty and risk for importers and exporters, particularly when forward exchange facilities are inadequate. Longer-term fluctuations in these rates may generate uncertainty about the profitability of investment in traded goods sectors. Moreover, to the extent that a shift in exchange rates leads to a reallocation of resources, such a reallocation may be wasteful if the initial change in rates is subsequently reversed. Fluctuations in the domestic currency value of imports and exports can also cause difficulties for the management of government finances, for instance, because taxes on international trade are important sources of government revenue in many developing countries. Governments and other borrowing agencies have also been affected by the impact of exchange rate movements on the management and servicing of external debt. In addition, the monetary authorities can encounter problems in managing their foreign exchange reserves and intervention operations.

A country’s choice of exchange rate regime determines the way in which exchange rate fluctuations among major currencies impinge upon its economy. Unless a country’s export and import prices are all fixed in terms of a single foreign currency, pegging its own currency to a single currency implies that fluctuations in exchange rates will inevitably lead to variations in at least some import or export prices. For example, an oil importing country pegging its currency to the U.S. dollar may thereby avoid changes in the domestic currency price of oil imports, because oil prices are fixed in terms of the U.S. dollar, but exchange rate changes abroad may alter the domestic currency value of non-oil components of its foreign trade.

The difficulties experienced as a result of exchange rate fluctuations among major currencies have prompted considerable interest in exchange rate regimes that would shelter the economies of developing countries as much as possible from the effects of currency fluctuations. A number of countries have chosen to peg to a composite of currencies rather than to retain their traditional single currency pegs. Some countries appear to have chosen their currency baskets on broad considerations relating to the pattern and structure of their external trade and payments. Others have elected to peg to the SDR as a convenient way of approximating the importance of various major currencies in international transactions. Such pegs can help to reduce the impact of currency fluctuations on effective exchange rate indices, but the extent to which this is possible will depend on the similarity of the weights in the basket to which the currency is pegged and the weights used for the effective exchange rate index in question. In constructing effective exchange rate indices, attention may be focused on several economic variables as alternative targets, such as import prices, export competitiveness, or the trade balance; for each target variable a separate effective exchange rate index can be calculated. A currency basket that will work well in stabilizing a particular effective exchange rate index may work poorly with respect to others. Hence, a developing country cannot by its own choice of exchange rate regime completely avoid being affected by exchange rate variability among major currencies.

Developing countries are paying considerable attention to the choice of exchange regime, as indicated by the 55 changes in regime that have been notified to the Fund by these countries during the six years ended June 30, 1982. Table 14 shows the exchange regimes to which developing countries have adhered during this period.

Table 14.Developing Countries: Exchange Rate Arrangements, 1976-821(Number of countries)
1976197719781979198019811982
Pegged to single currency67676261585656
U.S. dollar46444141403838
French franc13141414141413
Other currency8976445
Of which, pound sterling3443111
Pegged to composite25262827323234
SDR11121513151415
Other composite14141314171819
Flexible arrangements15172329283235
Adjusted according to a set of indicators6754344
Other29101825252831
Total107110113117118120125

Based on mid-year classifications; excludes Democratic Kampuchea, for which no current information is available.

This category comprises the following categories used in Table 15: “Flexibility limited vis-à-vis single currency,” “Other managed floating,” and “Floating independently.”

Based on mid-year classifications; excludes Democratic Kampuchea, for which no current information is available.

This category comprises the following categories used in Table 15: “Flexibility limited vis-à-vis single currency,” “Other managed floating,” and “Floating independently.”

Within the group of countries maintaining pegged arrangements, there has been a tendency away from single currency pegs toward adopting as a peg the SDR or some other currency composite. Many countries continue, however, to peg their currencies to a single currency. For countries with a large part of their international transactions conducted with a single major country or with countries that also peg their currencies to the currency of that major country, the additional degree of insulation against exchange rate fluctuations that could be provided by pegging to a suitable currency composite may be small and could be outweighed by the advantages of having the domestic currency fixed in terms of a major convertible currency. Decisions to retain a single currency peg may also be influenced by institutional or historical considerations. For example, the various benefits of membership in a currency union may be seen by its members as outweighing possible difficulties arising from a single currency peg and the inability to make discrete exchange rate adjustments on a unilateral basis. Such considerations lie behind the stability in the number of countries pegging their currencies to the French franc. On the other hand, there has been a movement away from pegging to the U.S. dollar, reflecting the high variability of exchange rates between the U.S. dollar and the currencies of other industrial countries, as well as the lesser importance, on average, of ties among countries that peg their currencies to the U.S. dollar compared with the group linked by the French franc.

While the choice of exchange rate regime has for many developing countries been motivated by the desire to reduce the domestic impact of exchange rate fluctuations, for a number of countries this choice has also been influenced by the desire to maintain appropriate exchange rates over longer periods. One example of this is the group of countries adjusting exchange rates for their currencies according to a set of indicators of relative movements in domestic and foreign prices. While developing countries maintaining more flexible arrangements are still in a minority, Table 14 illustrates a growing movement toward such arrangements and away from single currency pegs.

Exchange Rates and Adjustment Policies

The achievement of balance of payments adjustment in response to the internal and external developments described in Chapter 1 raises broad policy issues. Countries can respond to a marked deterioration in their external position through some combination of financing their current account imbalances by external borrowing, adjusting demand management policies, and adopting measures to achieve structural adjustment. The necessity of reducing current account imbalances to sustainable levels and the desirability of maintaining adequate growth rates require close coordination of these policies, particularly as there are practical limits on the extent to which developing countries can obtain foreign financing.

The ability of a developing country to carry out adjustment is determined by a number of factors, some of which are related to the existing economic structure of the country and some to the external economic environment that it faces. But the nature of the policies adopted has proved to be the crucial factor. In the attempt to maintain expenditures on development, many countries that have followed expansionary policies have failed to foster a relative price structure that would encourage the sectors producing traded goods. An important indicator in this regard is the relative movement of domestic and foreign prices adjusted for exchange rates, that is, an index of the “real” effective exchange rate. Such an index is subject to a number of methodological and data problems, and may fail to account properly for price and cost developments of particular commodities; nevertheless, an upward movement in this index tends in general to signify a declining margin between the price that producers of traded goods receive for their output and the domestic costs they face, thereby encouraging them to switch their resources toward producing nontraded goods, whose relative profitability has increased.

The evolution of real effective exchange rates in recent years shows a range of experience among developing countries. The unweighted average of country indices may be taken as an indicator for various analytical and geographic country groups (Chart 20). There was no distinct trend in these indices for the analytical groups over the period from 1973 to 1977, except for an upward movement in the index for the major oil exporters. Over the past two to three years, however, the indices for all these groups have, on average, risen. Differences are more pronounced among regional groups of non-oil developing countries, and the increase in the indices for countries in Africa and the Middle East is particularly noticeable.

Chart 20.Developing Countries: Relative Prices, Adjusted for Exchange Rates, 1973-811

(Index, 1973=100)

1 This index is an approximate measure of the evolution of a country’s prices relative to those of its trading partners, adjusted for exchange rate changes. Prices are measured by the consumer price index, with indices of partner countries averaged by using import weights, and exchange rates are measured by an import-weighted index of effective exchange rates. Group indices are unweighted averages of country indices.

2 Within the group of “non-oil developing countries.”

For a number of countries in these groups, there has been a reluctance to change nominal exchange rates in the face of differences in inflation performance at home and abroad. In part, this reluctance stems from the difficulties in evaluating the need for exchange rate action when world market conditions for traded goods are changing and are often uncertain. In addition, owing to low short-run price elasticities of supply and demand, beneficial effects may only come about over the medium term. Such potential benefits may be heavily discounted in relation to certain immediate costs, such as the impact of devaluation on consumer prices, particularly when these costs are likely to engender important political and social repercussions. In view of these obstacles, the authorities may attempt to change relative prices through administrative controls. Postponement of appropriate measures, however, can result in an even more difficult adjustment at a later stage.

The experience of the 1970s has shown that a number of countries adopting outwardly oriented policies have been able to achieve adjustment without prolonged impairment of their growth performance. The concept of outwardly oriented policies implies a set of measures that produce a price structure favoring production that would compete in external markets. Maintaining an appropriate real exchange rate is a crucial ingredient of such a policy approach. The concept encompasses, however, a wider range of measures. The structure of administered prices—especially those paid to agricultural producers—as well as taxes and subsidies on foreign trade, are often in need of adjustment. Overvalued currencies can also give undue encouragement to certain capital-intensive industries and production techniques, above and beyond the stimulus to the importation of capital goods provided by low tariffs and other measures specifically designed to assist infant industries. Resulting inefficiencies show up in the form of increased costs in other sectors of the economy.

Exchange rate action usually needs to be supported by major adjustments in financial policies. Attention must be focused not only on the familiar problem of maintaining an appropriate level of aggregate demand but also on the effects of interest rate policies on resource allocation and on the balance of payments. For many countries, regulation of interest rates is considered necessary because of the limited development of their financial systems. Often, nominal interest rates are held at low levels. This policy is pursued for various reasons, including the desire to assist certain sectors of the economy and to avoid increasing interest costs in the government budget. But these ceilings can, in turn, have adverse effects on resource allocation, especially when they result in negative real interest rates. For example, negative real interest rates tend to channel savings away from financial intermediaries and hence from funds available for investment, and into “inflation hedges.” They also directly affect the external position by encouraging private capital outflows; even in countries with strict capital controls, significant scope for such outflows may exist through smuggling and false invoicing of trade transactions. Another effect of both the controls themselves and the consequences just mentioned is that they tend to impede the development of domestic financial institutions. Indeed, appropriate interest rate policies should be supplemented by steps to encourage the further development of financial markets.

The developing countries that, in general, have fared the best in coping with the adjustment problems of the past decade have been the major exporters of manufactures. The markets for their exports were more buoyant than those for the exports of other developing countries, and the price sensitivity of demand for their products was also greater. Because of the nature of their exports, they were in a much stronger position to take advantage of the rapidly growing demand for imports in the oil exporting countries. These major exporters of manufactures, as a group, have had relatively stable real effective exchange rates since 1973. In most of these countries, exchange rate policies have been supplemented by other measures to encourage these exports. Their experience has by no means been uniform, however, and the more outwardly oriented of these countries have on the whole been more successful in adjusting. Nevertheless, the adverse external developments of the past three years have slowed economic growth in these countries.

The adjustment problems of the primary producing countries since 1973 have been especially difficult. An upswing in world demand and increased access to export markets in industrial countries would be the developments most likely to lead to a rapid improvement in their balance of payments. In the absence of these developments, however, the balance of payments of these countries cannot improve without suitable price incentives. There is now a substantial body of evidence suggesting that relative prices have an important influence in the medium and long run on the supply of primary products; in a number of primary producing countries, the supply of exports has actually declined because producer prices have not been maintained at appropriate levels. Nevertheless, adjustment of the balance of payments of these countries is often not easy to achieve at the outset because price elasticities of demand for and supply of their export goods are generally quite low in the short run, and attempts by exporters of a particular primary product to increase export volumes rapidly could have the immediate effect of a decline in export revenues. Recourse to financing is thus often necessary to bridge the period over which adjustment is to be effected.

The balance of payments impact of inadequate incentives to produce relates not only to export commodities. Frequently, an overvalued currency, in conjunction with low tariffs on food imports (particularly wheat and rice) relative to other imports, has left many countries with a price structure that discriminates against production of food for the domestic market and ultimately leads to large food imports. Appropriate price incentives can, therefore, lead to improvements in the balance of trade even when it is difficult to increase export revenues.

Within the primary producing group, a wide variety of circumstances and experiences can be observed. By adopting outwardly oriented policies, a number of middle-income primary producers have been quite successful in diversifying their economies and adjusting to the adverse external environment. On the other hand, a number of low-income countries, especially in Africa, appear to have had increasing difficulties in the 1970s, in part because of their failure to maintain an appropriate structure of relative prices. The appreciation in the real exchange rates of many African countries is especially disquieting. The low-income countries, in particular, face serious challenges in the coming years, and the structural adjustment policies needed may take considerable time to bear fruit. Yet, they are essential for longer-term economic development. In the short run, additional concessional financing from abroad will be needed to support these adjustment policies. In addition, more buoyant economic conditions and less restrictive trade policies in the industrial world can make significant contributions to the prospects of these economies. Indeed, this last comment applies to all developing countries.

The adjustment problems faced by the oil exporting countries during most of the past decade have differed from those discussed above because of the special characteristics of these countries. The nature of these adjustment problems has been dealt with in detail in previous Annual Reports. In these countries, there has been the desire to develop and diversify their economies in view of the eventual depletion of their oil wealth. Overambitious development plans can, however, strain domestic resources and give rise to inflationary pressures. These pressures lay behind marked real exchange rate appreciations in these countries in the 1970s. While real appreciation would normally be seen as an appropriate response to a strong balance of payments position in these countries, it could impede the objective of developing a competitive sector producing non-oil traded goods. The importance of the non-oil sector has been vividly demonstrated by recent developments in the world oil markets. While the weakening of this market has required a reconsideration of development plans in many oil exporting countries, some have found themselves in a relatively favorable position to cope with these difficulties because of satisfactory performance in the non-oil production sector.

The adjustment problems of centrally planned economies bear special mention. Clearly, the institutional features of these economies significantly limit the role that exchange rates play in external adjustment. Management of domestic aggregate demand consistent with balance of payments adjustment is typically accomplished by altering the real targets of the plan, while specific balance of payments objectives are pursued through direct controls on the underlying economic transactions (imports, exports, and capital movements). However, the authorities in some centrally planned economies have permitted a larger role for financial incentives and flexible domestic prices in microeconomic decision making. In some of these countries, currency depreciation and a narrowing of the range of multiple exchange rates have been parts of overall policy packages aimed at adjusting the structure of prices to be consistent with fostering an expansion of exports. Pursuit of such strategies requires that the exchange and trade systems permit direct access and greater exposure of firms to international markets, and that the structure of domestic prices give sufficient incentive for the production of traded goods. To the extent that the authorities in these countries continue to relax direct controls over external transactions, exchange rates and exchange arrangements may assume a more important role.

Surveillance Over Exchange Rate Policies of Member Countries

In the broadest sense, the purpose of the Fund’s surveillance over exchange rates is to evaluate the appropriateness of the policies of individual members and to encourage the adoption of policies that enhance the functioning of the exchange rate system, taking account of the recent developments and general issues discussed above. Fund surveillance thus involves the crucial, but difficult, task of integrating the individual country aspect of surveillance—namely, the consultation discussions held with individual member countries—with the multilateral or global aspect of surveillance, which involves the operation of the system as a whole. The 1977 document “Surveillance over Exchange Rate Policies,”2 which describes the principles and procedures of surveillance, explicitly acknowledges the difficulties of this task by noting that these principles “are not necessarily comprehensive and are subject to reconsideration in the light of experience.” Thus, the Executive Board is required to review this document at intervals of two years—in addition to the required annual review of the implementation of the Fund’s surveillance over members’ exchange rate policies. Such a general review was completed by the Executive Board in the early months of 1982.

In its review of the 1977 document, the Executive Board concluded that the principles, as they stand, place the judgments to be exercised in regard to surveillance in an appropriately broad context and give adequate guidance for surveillance. Accordingly, in light of the experience to date, the Board agreed that these principles are not in need of revision or reformulation at the present time.

As regards the annual review of the implementation of surveillance, the Board endorsed the Managing Director’s efforts to strengthen surveillance by the Fund, but it was recognized that full cooperation of members is essential if this function is to be made more effective. In this context, cooperation between members should take place on three distinct levels. First, it is important to reach a common view or understanding on the analytical framework within which exchange rate issues and requirements can be discussed. The Fund has been working toward this goal, but more needs to be done to improve the understanding of the interrelationships between balance of payments deficits, budgetary policies, interest rates, and exchange rates. The second level of cooperation is the agreement by members to discuss with the Fund, and within the Fund, the aspects of individual policy choices that have, or can have, an adverse impact on other countries. Third, it is important for members to cooperate by taking into account, in their national decision-making processes, the views expressed and conclusions reached by the Board. Such cooperation is the essence of surveillance.

Issues in Implementing Surveillance

In implementing surveillance, the Fund has continued to be guided by the view that widespread restoration of stable domestic economic and financial conditions is a sine qua non for a more stable exchange rate system. This view has led the Fund to emphasize the need for the broad policy approach against inflation that is discussed in Chapter 1. In the short run, this approach cannot be expected to result in stable exchange rates because the reduction of monetary growth rates over time—one of the crucial components of the approach—often tends to be accompanied in the initial phase by interest rates that are high and variable in nominal and real terms. Nevertheless, once inflation is under control and the credibility of the anti-inflationary stance of the authorities is established, interest rates can be expected to decline and become less variable, thus contributing to a reduction in the variability of exchange rates.

Many practical issues have arisen in regard to the application of this broad policy approach to the situation in specific countries. One major issue concerns the mix of policies in domestic economic and financial management. As already noted earlier in this chapter, this policy mix affects the behavior of the exchange rate in the market. If the emphasis in controlling inflation is placed more on interest rates and monetary policy than on public expenditures and taxation, the exchange rate may tend to appreciate more, in the short run, than if the reverse emphasis were applied. Beyond this basic agreement on the effect of the mix of policies, there are differences of view on the feasibility of identifying an appropriate exchange rate other than a market-determined rate and on the desirability of altering the policy mix primarily to influence the exchange rate.

It is evident that each member will wish to choose the mix of policies that it believes to be most appropriate to its circumstances. But the principles of surveillance also imply that the interests of other members should be taken into account. For example, a country that relies too heavily on monetary policy in controlling inflation, especially if it is a large financial center, can create problems for other countries that are reluctant to permit changes in their exchange rates by limiting the scope for domestic policies that would be more appropriate to their own circumstances. Conversely, an excessively depreciated exchange rate resulting from an unbalanced policy mix, or for any other reasons, can lead to defensive measures elsewhere.

Another important issue that has attracted increased attention recently is that of the appropriate scale and incidence of intervention to counteract disorderly conditions in the exchange markets. Clearly, it is important for members to show strong purpose in preventing, to the extent possible, disorderly exchange market conditions while avoiding excessive intervention that could be destabilizing. It is difficult, however, to reach a consensus, except in relatively clear-cut cases, on what specific market developments should trigger official intervention, or on the extent to which this intervention should be coordinated among monetary authorities in different countries.

In some instances, volatile exchange market behavior has been related largely to developments in monetary and fiscal policies. In such conditions, experience suggests that intervention cannot be expected to play a significant role in dampening exchange rate fluctuations, and the Fund has focused more on an examination of the adequacy of underlying policies. While official intervention cannot, by itself, be expected to correct for the effect of these fundamental conditions, it may at times be used in the short run to support a change in underlying domestic policies that would otherwise take longer to be reflected in the exchange markets. Intervention can then be employed to signal the policy change to the exchange markets.

Recent experience has also cast doubt on the once general view that the “thrust of policies” could be judged on the basis of a relatively small number of indicators, such as cyclically adjusted fiscal deficits, interest rates, and exchange rates. In conditions of relatively high and variable interest rates and considerable volatility of exchange rates, the problem of identifying the broad thrust of a country’s economic policy becomes much more complicated. Private market participants may be slow to perceive and interpret clearly the counterinflationary implications of policies, and the authorities must endeavor to achieve improved communication of their objectives and methods to market participants.

While issues relating to the variability of floating exchange rates have been a focal point in the implementation of surveillance over the policies of major industrial countries, the principal issues for smaller economies have centered around the appropriateness of a pegged exchange rate adhered to despite fundamental changes in underlying economic conditions. In these circumstances, the Fund has emphasized the importance of adopting an appropriate exchange rate policy in due time before economic distortions arising from currency overvaluation, particularly those resulting from controls adopted for payments reasons, become embedded in the economic structure.

Procedures for Implementing Surveillance

Surveillance is implemented by the Fund through a variety of channels, including discussions of members’ positions and policies by the Executive Board on the occasion of Article IV consultations, reviews of the World Economic Outlook by the Executive Board and the Interim Committee, and consultations with members by the Managing Director and the staff. In addition, papers on exchange rates and balance of payments adjustment issues, as well as reports on trade restrictions and multiple currency practices, are prepared by the staff for the information of the Executive Board. As a result, there are each year a number of occasions on which the Executive Board has the opportunity to deal with issues related to surveillance.

In accordance with the Second Amendment to the Articles of Agreement, which entered into force on April 1, 1978, regular Article IV consultations with members have become the principal vehicle for the exercise of Fund surveillance over the exchange rate policies of members. Because of their frequency and regularity, Article IV consultations are a particularly appropriate instrument for the prompt identification of balance of payments problems and can help in promoting early adjustment, which requires less strenuous corrective measures and increases the chances of success.

Recognition of the importance of Article IV consultations to the adjustment process has led the Executive Board to enhance the comprehensiveness of these consultations. A recent Executive Board decision on use of the Fund’s general resources in stand-by arrangements states that “Article IV consultations are among the occasions on which the Fund would be able to discuss with members adjustment programs, including corrective measures, that would enable the Fund to approve a stand-by arrangement.” 3 In this decision, the Executive Board explicitly provided for the possibility that Article IV consultations would encompass discussions on the desirability of adjustment supported by stand-by arrangements.

It is important to recognize that the role of Article IV consultations has not been confined to the bilateral relationships between members and the Fund. Consultations, and especially the reports resulting from them, play an important role in the Fund’s relations with other international organizations, such as the General Agreement on Tariffs and Trade, the International Bank for Reconstruction and Development, and the Organization for Economic Cooperation and Development. For members, too, consultation reports can be useful in the conduct of their external relations.

The effectiveness of the Fund’s surveillance depends importantly on the regularity of consultations with members. Specific exchange rate policies cannot be judged except in the context of an overall appraisal of the progress of a country’s economic and financial situation, which can only be developed within the consultation framework. Moreover, regular and frequent Article IV consultations may tend to reduce the need for special consultations related to surveillance over exchange rate policies. The Fund’s goal has been to attempt to cover three fourths of the membership within any 12-month period, while maintaining an annual consultation cycle with major countries and with countries that have Fund-supported programs. However, difficulties have arisen in fully achieving this target. The total number of consultations per year has declined since 1978-79, while membership has increased, and there has been an increase in the number of members that have not held consultations with the Fund for 18 months or longer.

A consultation cycle of 15 months or less has, however, been maintained for more than 40 countries, including most of the major industrial countries. For members with Fund-supported programs, a high percentage of consultations has been combined with, or has preceded, discussions on the use of Fund resources. In its review of the implementation of surveillance, the Executive Board stressed the need for efforts to maintain adequate frequency of the Fund’s consultations with member countries.

The World Economic Outlook discussions by the Executive Board and the Interim Committee provide an opportunity to achieve convergence of views on the appropriate general orientation of members’ policies. These discussions are thus a second important instrument of the collective exercise of multilateral surveillance undertaken by the Fund. It provides an opportunity to improve the understanding of the international interactions of national policy measures, with the primary role of the Fund being the clear identification of major policy issues.

During 1981, the World Economic Outlook discussions continued to provide a comprehensive framework for the analysis of broad developments in exchange rates, and thus to furnish an essential background for surveillance over the exchange rate policies of members. Staff analyses of the World Economic Outlook were discussed in depth by the Executive Board in May and September of 1981 and in April of 1982; on each occasion, a further review was conducted shortly afterward by the Interim Committee. These discussions allowed the Executive Board and the Interim Committee to assess developments in specific exchange rates in the larger context of global economic and financial trends and the working of the international adjustment process as a whole. In addition, they provided an opportunity to study in practical terms the effects of the economic policies of industrial countries on one another and on the rest of the world.

Exchange Arrangements of Member Countries

Under the Second Amendment to the Articles of Agreement, each member country is obligated to notify the Fund of the exchange arrangements of its choice. Members’ cooperation in providing this information promptly is crucial for the implementation of surveillance. In the period July 1975 to December 1981, the exchange arrangements of Fund members were classified under four broad headings, as follows: (1) currencies pegged to a single currency or to a composite of currencies (including the SDR); (2) exchange rates adjusted according to a set of indicators; (3) cooperative arrangements; and (4) other arrangements. During this period, exchange arrangements in general tended to become more heterogeneous, one result of which was that the residual category “Other” grew from 15 members in July 1975 (out of a total membership of 126) to 37 members in December 1981 (out of a total membership of 143). As such a large undefined residual category was unsatisfactory for classification purposes, a revised and amplified method of classification was adopted to reflect the extent and form of flexibility that these arrangements permit. (See Table 15.)

Table 15.Exchange Rate Arrangements, June 30, 1982 1
Pegged toLimited Flexibility vis-à-visMore Flexibility
Adjusted according to a set of indicatorsOther managed floatingFloating independently
U.S. dollarFrench francOther currencySDROther compositeSingle currency2Cooperative arrangements
Antigua and BarbudaBeninBhutanBurmaAlgeria3Bahrain 4Belgium3BrazilAfghanistanArgentina
Bahamas3Cameroon(Indian rupee) EquatorialGuineaAustriaGhanaDenmarkColombiaAustraliaCanada
BarbadosCentralGuinea-BissauBangladesh5GuyanaFrancePeru3Bolivia3Costa
BelizeAfricanGuineaIranBotswanaIndonesiaGermany,PortugalChileRica3,6
BurundiRepublic(Spanish peseta)JordanCape VerdeMaldivesFederalIcelandGreece
Republic ofIsrael
DjiboutiChadThe GambiaKenyaChina, People’sPhilippinesIrelandIndia7Japan
DominicaComoros(pound sterling) LesothoMalawiRepublic of3Qatar4Italy8KoreaLebanon
Dominican Republic3CongoMauritiusCyprusSaudi ArabiaLuxembourg3MexicoSouth Africa
Ecuador3Gabon(South African rand)Sao Tome andFijiThailandNetherlandsMoroccoUnited
Egypt3Ivory CoastPrincipeFinland9United ArabNew ZealandKingdom
SeychellesHungary3Emirates4United
States
El Salvador3MaliSwazilandSierra LeoneKuwaitNigeria
EthiopiaNiger(South African rand)VanuatuMadagascarPakistan6
GrenadaSenegalViet NamMalaysiaSpain
GuatemalaTogoZaire3MaltaSri Lanka
HaitiUpper VoltaZambia 10MauritaniaTurkey
HondurasNorwayUganda
IraqPapua NewUruguay 11
Jamaica3GuineaWestern
Lao People’s Demo-SingaporeSamoa
cratic RepublicSolomon IslandsYugoslavia
LiberiaSweden
Libyan ArabTanzania
JamahiriyaTunisia
Nepal3,12Zimbabwe
Nicaragua3
Oman
Panama
Paraguay 3
Romania
Rwanda
St. Lucia
St. Vincent and
the Grenadines
Somalia 3
Sudan3
Suriname
Syrian Arab Republic3
Trinidad and Tobago
Venezuela
Yemen Arab Republic
Yemen, People’s
Democratic
Republic of

No current information is available relating to Democratic Kampuchea.

All exchange rates have shown limited flexibility vis-à-vis the U.S. dollar.

Member maintains dual exchange markets involving multiple exchange arrangements. Except in one case, the arrangement shown is that maintained in the major market.

Exchange rates are determined on the basis of a fixed relationship to the SDR, within margins of up to ± 7.25 per cent.

Changes in the exchange rate vis-à-vis the pound sterling generally occur when the effective exchange rate, as calculated on the basis of the weighted currency basket, deviates by more than ± 1 per cent from the pegged level.

Member has recently changed its form of exchange arrangements; classification in terms of the extent of flexibility of its implementation of these is preliminary.

The exchange rate is maintained within margins of 5 per cent on either side of a weighted composite of the currencies of the main trading partners.

Margins of ± 6 per cent are maintained with respect to the currencies of other countries participating in the exchange rate mechanism of the European Monetary System.

The fluctuation band of the Bank of Finland’s currency index is currently about 6 per cent (equivalent to margins of ± 3 per cent).

The exchange rate is maintained within margins of ± 2.5 per cent in terms of the fixed relationship between the kwacha and the SDR.

Member maintains a system of advance announcement of exchange rates.

A fixed rate for the Nepalese rupee is also maintained vis-à-vis the Indian rupee.

No current information is available relating to Democratic Kampuchea.

All exchange rates have shown limited flexibility vis-à-vis the U.S. dollar.

Member maintains dual exchange markets involving multiple exchange arrangements. Except in one case, the arrangement shown is that maintained in the major market.

Exchange rates are determined on the basis of a fixed relationship to the SDR, within margins of up to ± 7.25 per cent.

Changes in the exchange rate vis-à-vis the pound sterling generally occur when the effective exchange rate, as calculated on the basis of the weighted currency basket, deviates by more than ± 1 per cent from the pegged level.

Member has recently changed its form of exchange arrangements; classification in terms of the extent of flexibility of its implementation of these is preliminary.

The exchange rate is maintained within margins of 5 per cent on either side of a weighted composite of the currencies of the main trading partners.

Margins of ± 6 per cent are maintained with respect to the currencies of other countries participating in the exchange rate mechanism of the European Monetary System.

The fluctuation band of the Bank of Finland’s currency index is currently about 6 per cent (equivalent to margins of ± 3 per cent).

The exchange rate is maintained within margins of ± 2.5 per cent in terms of the fixed relationship between the kwacha and the SDR.

Member maintains a system of advance announcement of exchange rates.

A fixed rate for the Nepalese rupee is also maintained vis-à-vis the Indian rupee.

It is noteworthy that, between 1975 and 1981, the portion of the Fund membership that maintained pegged exchange arrangements declined from about 78 per cent to 65 per cent. The proportion of world trade accounted for by Fund members maintaining pegged arrangements declined from 26 per cent to 18 per cent; this was due entirely to a shift away from single currency pegs. The number of countries maintaining composite currency pegs increased markedly, from 20 per cent to 36 per cent, although in trade-weighted terms the proportion remained roughly unchanged. Although the number of countries pegging to the SDR doubled from 1975 to 1981, the percentage of Fund members’ trade that this group accounted for declined to less than one third of its 1975 level.

Preferences with respect to single currency pegs have also changed considerably. In trade-weighted terms, the proportion of countries pegging their currencies to the U.S. dollar declined by about one half from mid-1975 to the end of 1981. In part, this movement may have reflected the greater volatility of the U.S. dollar vis-à-vis currencies of other major industrial countries.

International Liquidity and Reserves

International reserves are conventionally defined as official holdings of gold, foreign exchange, and Fund-related assets. Apart from gold, these reserves are made up of currencies suitable for intervention in the foreign exchange market and for direct payment of foreign obligations and of financial assets that can be converted into such currencies on short notice at a generally moderate risk of loss.

A broader concept of international liquidity includes, in addition to the holdings of international reserves, the capacity of borrowing from foreign sources. The concept of international liquidity is much less precise than that of international reserves, because the capacity to borrow abroad is in part determined by the terms on which a country is willing or able to borrow, including cost, maturity, and other conditions related to the loans.

Developments in official reserve holdings and in international liquidity are affected by the structure of the international monetary system, including the exchange arrangements adopted, by macroeconomic policies, and by the responses of monetary authorities to the emergence of payments imbalances. Credit market conditions and interest rates also bear on the broader concept of international liquidity by affecting the borrowing possibilities of countries.

The following part of this chapter deals with the recent evolution of the holdings, sources, composition, and distribution of official reserve assets as reported in International Financial Statistics. First, developments in reserve holdings are described and changes are analyzed in terms of quantity and price effects on the SDR value of official holdings. Foreign exchange reserves are then discussed in more detail, particularly their composition and yield. There is, next, an analysis of the sources of growth of Fund-related assets, followed by a brief review of the role of private international capital markets in the provision of international liquidity. The adequacy of international reserves, the changing concepts of international liquidity, and the role of the Fund and of Fund-related assets in providing liquidity are discussed in the final section.

Recent Evolution of Official Reserve Assets

The most striking aspect of the recent evolution of international reserves is their slow rate of growth in 1981 and their decline in the first quarter of 1982. Countries’ holdings of international reserves, excluding gold, were only slightly higher at the end of 1981 than a year earlier. Expressed in terms of SDRs, total non-gold reserves reached SDR 342 billion at the end of 1981, an increase of 6 per cent from the total of SDR 325 billion at the end of 1980 (Table 16). This rate of increase compares with an annual growth rate of 18 per cent in 1980; it was the smallest percentage increase since 1973, being substantially lower than the average annual compounded increase in the intervening seven years (16 per cent between the end of 1974 and the end of 1980).

Table 16.Official Holdings of Reserve Assets, End of Selected Years 1973-81 and End of March 19821(In billions of SDRs)
1973197619771978197919801981March 1982
All countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund6.217.718.114.811.816.821.321.9
Special drawing rights8.88.78.18.112.511.816.416.6
Subtotal, Fund-related assets15.026.426.222.924.328.637.738.5
Foreign exchange102.7161.7203.6223.82249.3296.5304.7293.4
Total reserves excluding gold117.7188.1229.8246.72273.6325.1342.4331.9
Gold3
Quantity (millions of ounces)1,0221,0151,0301,038945 4953952953
Value at London market price95.0117.7140.1179.6366.7440.3324.6271.6
Industrial countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund4.911.812.29.67.710.713.514.0
Special drawing rights7.17.26.76.49.38.911.912.3
Subtotal, Fund-related assets12.019.018.916.017.119.625.426.3
Foreign exchange65.773.7100.0127.2136.1164.3159.7149.5
Total reserves excluding gold77.792.7118.9143.1153.2183.9185.2175.8
Gold3
Quantity (millions of ounces)8748728818847894788788788
Value at London market price81.3101.2119.6153.4306.7364.2269.0226.4
Oil exporting countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund0.35.45.44.43.04.15.86.0
Special drawing rights0.30.30.40.51.01.21.81.9
Subtotal, Fund-related assets0.65.85.84.94.05.37.67.9
Foreign exchange10.249.155.240.1251.066.972.471.4
Total reserves excluding gold10.854.961.045.0255.072.280.079.3
Gold3
Quantity (millions of ounces)3437343637404242
Value at London market price3.14.34.76.314.218.514.212.0
Non-oil developing countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund0.90.50.50.91.02.12.01.8
Special drawing rights1.41.11.11.22.11.72.72.4
Subtotal, Fund-related assets2.41.61.62.13.23.84.74.2
Foreign exchange26.838.948.456.562.265.372.672.5
Total reserves excluding gold29.240.549.958.665.469.077.276.8
Gold3
Quantity (millions of ounces)114106115118119125122123
Value at London market price10.612.215.819.945.857.641.433.2
Source: International Monetary Fund, International Financial Statistics.

“Fund-related assets” comprise reserve positions in the Fund and SDR holdings of all Fund members and Switzerland. Claims by Switzerland on the Fund are included in the line showing reserve positions in the Fund. The entries under “Foreign exchange” and “Gold” comprise official holdings of those Fund members for which data are available and certain other countries or areas, including Switzerland. Figures for 1973 include official French claims on the European Monetary Cooperation Fund.

Beginning with April 1978, Saudi Arabian holdings of foreign exchange exclude the cover against the note issue, which amounted to SDR 4.3 billion at the end of March 1978.

One troy ounce equals 31.103 grams. The market price is the afternoon price fixed in London on the last business day of each period.

The decrease recorded in the quantity of countries’ official gold holdings from the end of 1978 to the end of 1979 reflects mainly the deposit by the nine member countries of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The European Currency Units (ECUs) issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

Source: International Monetary Fund, International Financial Statistics.

“Fund-related assets” comprise reserve positions in the Fund and SDR holdings of all Fund members and Switzerland. Claims by Switzerland on the Fund are included in the line showing reserve positions in the Fund. The entries under “Foreign exchange” and “Gold” comprise official holdings of those Fund members for which data are available and certain other countries or areas, including Switzerland. Figures for 1973 include official French claims on the European Monetary Cooperation Fund.

Beginning with April 1978, Saudi Arabian holdings of foreign exchange exclude the cover against the note issue, which amounted to SDR 4.3 billion at the end of March 1978.

One troy ounce equals 31.103 grams. The market price is the afternoon price fixed in London on the last business day of each period.

The decrease recorded in the quantity of countries’ official gold holdings from the end of 1978 to the end of 1979 reflects mainly the deposit by the nine member countries of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The European Currency Units (ECUs) issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

A second distinctive feature of these developments is the pattern of more rapid growth in Fund-related assets—SDRs and reserve positions in the Fund—than in foreign exchange reserves. While the growth of foreign exchange reserves accounted for most of the rise in non-gold reserves in 1979 and earlier years, holdings of foreign exchange and Fund-related assets grew at similar rates in 1980, 19 per cent and 18 per cent, respectively. This contrasts with the pattern in 1981, when Fund-related assets grew by 32 per cent and foreign exchange holdings by only 3 per cent. More than one half of the increase of SDR 17 billion in non-gold reserves in 1981 took the form of Fund-related assets. Holdings of SDRs rose by SDR 4.6 billion, with most of the increase resulting from the allocation of SDR 4.1 billion in January 1981. Countries’ reserve positions in the Fund rose steadily throughout the year, from SDR 16.8 billion at the end of 1980 to SDR 21.3 billion at the end of 1981, reflecting in the main an extension of conditional Fund credit to members. Most of the increase was accounted for by the United States and Saudi Arabia. The reserve position of the United States rose by SDR 2.1 billion, reflecting the larger use of U.S. dollars in Fund operations. The increase in the reserve position of Saudi Arabia by SDR 1.5 billion accompanied its lending to the Fund under the enlarged access policy and the supplementary financing facility; the increase in its quota was also a contributing factor. Despite the substantial growth of Fund-related assets, their share in total reserve holdings excluding gold was still lower at the end of 1981 (11 per cent) than it had been at the end of 1973 (13 per cent).

Official holdings of foreign exchange amounted to SDR 305 billion at the end of 1981, an increase over significant impact on the SDR value of these holdings. While the SDR value of foreign exchange reserves increased by almost SDR 9 billion in 1981, the U.S. dollar value of these same holdings declined by US$24 billion, from US$378 billion at the end of 1980 to US$354 billion at the end of 1981.

Another departure from the trend observed in previous years is the reduction by SDR 5 billion in ECU holdings of the members of the European Monetary System (Table 17). Under present arrangements, ECUs are allocated by the European Monetary Cooperation Fund to the central banks of its members in exchange for the transfer of 20 per cent of gold and 20 per cent of gross U.S. dollar holdings of these institutions. Since these swaps are reviewed every three months to take into account changes in members’ holdings of gold and dollars as well as changes in gold market prices, the outstanding volume of ECUs fluctuates with the value and volume of these holdings. The fluctuations in 1981 were dominated by changes in the price of gold. The value of ECUs outstanding reached a peak of SDR 49 billion in April 1981 and subsequently fell to SDR 43 billion at the end of the year.

Table 17.Quantity and Price Changes Affecting the SDR Value of Official Holdings of Foreign Exchange, by Currency and in Total, End of First Quarter 1973-End of 19811(In millions of SDRs)
197619771978197919801981End 1973:I to End 1981
U.S. dollar
Starting value104,028120,576150,403162,070147,025156,16374,378
Quantity change15,87136,33222,280-13,68124,188-8,72782,794
Price change677-6,505-10,613-1,3644,95014,9795,243
Total change16,54829,82711,667-15,0459,1386,25288,037
Pound sterling
Starting value5,0553,0103,0623,1954,1356,9326,166
Quantity change-1,265-1521666572,224-3331,323
Price change-780204-33283573-898-1,788
Total change-2,045521339402,797-1,231-465
Deutsche mark
Starting value8,21210,66215,62820,92224,35333,4315,234
Quantity change1,4083,9284,0212,47511,755-36625,753
Price change1,0421,0381,273956-2,677-1,632446
Total change2,4504,9665,2943,4319,078-1,99826,199
French franc
Starting value1,5261,3271,8371,8862,0363,045778
Quantity change-71491-43981,2623372,824
Price change-128199252-253-485-705
Total change-199510491501,009-1482,119
Swiss franc
Starting value2,0362,1083,7012,9274,7537,5491,053
Quantity change-871,029-1,2581,7343,261-8654,432
Price change15956448492-4654511,650
Total change721,593-7741,8262,796-4146,082
Netherlands guilder
Starting value7467718221,1181,5272,279287
Quantity change-48272193759103582,278
Price change73247734-158-115-43
Total change25512964097522432,235
Japanese yen
Starting value6731,0822,2385,3616,2069,290
Quantity change3749412,7862,1461,5301,1469,554
Price change35215337-1,3011,554112956
Total change4091,1563,1238453,0841,25810,510
ECU
Starting value32,70647,658
Quantity change327,212-1,512-2,09823,602
Price change5,49416,464-2,62919,329
Total change32,70614,952-4,72742,931
Sum of the above
Starting value122,276139,536177,691197,479222,741266,34787,896
Quantity change16,18242,59628,17121,01623,618-10,548152,560
Price change1,078-4,441-8,3834,24619,9989,78325,088
Total change17,26038,15519,78825,26243,616-765177,648
Total official holdings4
Starting value138,718161,660203,570223,777249,322296,46998,343
Total change22,94241,91020,20725,54547,1478,252206,378
Ending value161,660203,570223,777249,322296,469304,721304,721
Source: Fund staff estimates.

The currency composition of foreign exchange is based on the Fund’s currency survey and on estimates derived mainly, but not solely, from official national reports. The numbers in this table should be regarded as estimates that are subject to adjustment as more information is received. Quantity changes are derived by multiplying the change in official holdings of each currency from the end of one quarter to the next by the average of the two SDR prices of that currency prevailing at the corresponding dates (except that the average of daily rates is used to obtain the average quarterly SDR price of the U.S. dollar). This procedure converts the change in the quantity of national currencies from own units to SDR units of account. Subtracting the SDR value of the quantity change so derived from the quarterly change in the SDR value of foreign exchange held at the end of two successive quarters then yields the SDR value of the quarterly price change for each currency. All changes are summed over consecutive quarters to yield cumulative changes over the years (or other periods) shown.

Reflects largely deposits of U.S. dollars by members of the European Monetary System (EMS) in the European Monetary Cooperation Fund.

Quantity changes in European Currency Units (ECUs) issued against dollars are evaluated by applying the SDR price of the U.S. dollar on the swap date to the estimated change in dollar holdings. Similarly, quantity changes in ECUs issued against gold are determined by applying the SDR price of the ECU on the swap date to the ECU price of gold used by the EMS and multiplying by the change in the number of ounces.

Include a residual whose currency composition could not be ascertained, as well as holdings of currencies other than those shown.

Source: Fund staff estimates.

The currency composition of foreign exchange is based on the Fund’s currency survey and on estimates derived mainly, but not solely, from official national reports. The numbers in this table should be regarded as estimates that are subject to adjustment as more information is received. Quantity changes are derived by multiplying the change in official holdings of each currency from the end of one quarter to the next by the average of the two SDR prices of that currency prevailing at the corresponding dates (except that the average of daily rates is used to obtain the average quarterly SDR price of the U.S. dollar). This procedure converts the change in the quantity of national currencies from own units to SDR units of account. Subtracting the SDR value of the quantity change so derived from the quarterly change in the SDR value of foreign exchange held at the end of two successive quarters then yields the SDR value of the quarterly price change for each currency. All changes are summed over consecutive quarters to yield cumulative changes over the years (or other periods) shown.

Reflects largely deposits of U.S. dollars by members of the European Monetary System (EMS) in the European Monetary Cooperation Fund.

Quantity changes in European Currency Units (ECUs) issued against dollars are evaluated by applying the SDR price of the U.S. dollar on the swap date to the estimated change in dollar holdings. Similarly, quantity changes in ECUs issued against gold are determined by applying the SDR price of the ECU on the swap date to the ECU price of gold used by the EMS and multiplying by the change in the number of ounces.

Include a residual whose currency composition could not be ascertained, as well as holdings of currencies other than those shown.

Total reserves excluding gold increased for all three major country groups, although at different rates. While the total for the industrial countries rose by only SDR 1 billion (less than 1 per cent), the major oil exporting countries increased their holdings by SDR 8 billion, an increase over 1980 of 11 per cent. This rate of growth, although substantially higher than the average for all countries, was much lower than in 1980 (31 per cent) and 1979 (22 per cent). For the non-oil developing countries as a group, total non-gold reserve holdings increased by SDR 8.2 billion, which represents an annual rate of growth of 12 per cent, substantially higher than the rate registered during 1980 (5 per cent). The distribution of this increase was very uneven, however. For instance, the non-gold reserves of the low-income countries increased only by some 8 per cent in 1981, and those of the middle-income primary producing countries did not rise at all. Official foreign exchange holdings of industrial countries fell from SDR 164 billion at the end of 1980 to SDR 160 billion at the end of 1981, a decline that is largely accounted for by the reduction of the ECU component of foreign exchange reserves.4 Foreign exchange reserves of the oil exporting countries rose by more than SDR 5 billion, to SDR 72 billion. Non-oil developing countries, too, increased their official holdings of foreign exchange during 1981, by SDR 7 billion, or 11 per cent, although the distribution of the increase among the different countries in this group was uneven. The highest rate of growth in holdings of Fund-related assets was registered by oil exporting countries (43 per cent), followed by industrial countries (30 per cent) and non-oil developing countries (24 per cent).

At the end of 1981, 54 per cent of total non-gold reserves was held by industrial countries, 23 per cent by oil exporting countries, and 23 per cent by non-oil developing countries. This contrasts with the distribution at the end of 1973 (see Chart 21), when 66 per cent of this total was held by industrial countries, 9 per cent by oil exporting countries, and 25 per cent by non-oil developing countries. Most of the redistribution of the previous year of SDR 8.2 billion, or less than 3 per cent. Foreign exchange reserves increased in the first half of 1981, reflecting primarily the expansion in the oil exporting countries’ holdings. The third quarter registered a sharp decline in official foreign exchange holdings, reflecting intervention by industrial countries to support their currencies in the exchange markets, as well as substantial losses of foreign exchange by some oil exporting countries, which in some instances continued in the fourth quarter of the year. The evolution of foreign exchange holdings in 1981 was also influenced by valuation changes. Since a large portion of foreign exchange reserves is denominated in U.S. dollars, fluctuations in the U.S. dollar/SDR rate had a reserves since 1973 appears, therefore, to have been from industrial to oil exporting countries.

Chart 21.Non-Gold Reserves, December 1973 and December 1981

(In billions of SDRs)

During the first three months of 1982, total non-gold reserves fell by SDR 10.5 billion. While the holdings of Fund-related assets increased slightly, foreign exchange reserves fell by more than SDR 11 billion. This decline was mostly accounted for by the industrial countries. The overall level and the composition of non-gold reserves in both oil exporting and non-oil developing countries did not change materially during the first quarter of 1982.

The physical stock of gold comprising official reserves changed very little in 1981, remaining, as during the entire past decade, at about 1 billion ounces. The market value of gold in SDRs, however, declined by more than 26 per cent during 1981, greatly reducing the share of gold in total reserves; that share fell from 57 per cent at the end of 1980 to 45 per cent at the end of March 1982.5

Foreign Exchange Reserves

This section reviews the characteristics of official holdings of foreign exchange and their evolution following the adoption of widespread floating among the currencies of the major industrial countries. Changes in the SDR value of foreign exchange holdings reflect movements in both prices and quantities, which are described in this section in conjunction with the analysis of the currency composition of holdings. The section also includes a discussion of the sources of foreign exchange reserves and a comparison of the cumulative returns on various currencies held in foreign exchange reserves and the SDR, with account being taken of interest earnings as well as exchange rate movements.

Currency Composition

The tendency to diversify foreign exchange holdings among a number of currencies, a characteristic of the evolution of the multiple reserve currency system, appears to have slowed in 1981. The share of the U.S. dollar in the SDR value of foreign exchange reserves identified by currency declined from 78 per cent in 1973 to 62 per cent in 1979 and to 56 per cent in 1980 (Table 18). These developments reflect not only the preferences of holders of U.S. dollars but also their intervention in exchange markets. Although the sharp fall in these shares was affected by the substitution, starting in 1979, of ECUs for U.S. dollars in the reserves of members of the EMS, the decline is also marked (to 74 per cent in 1979 and to 68 per cent in 1980) when ECUs issued against U.S. dollars are added to dollar holdings and ECUs issued against gold are eliminated from total foreign exchange reserves. A reversal of this trend is observed in 1981, when the share of U.S. dollars increased to 58 per cent of identified currencies (to 70 per cent if adjustment for ECUs is made).

Table 18.Share of National Currencies in SDR Value of Total Identified Official Holdings of Foreign Exchange, End of Selected Quarters, 1973-811(In per cent)
1973:11975: IV1976: IV1977: IV1978:IV1979 :IV1980: IV1981: IV1979: IV Excluding ECU 21980: IV Excluding ECU 21981 :IV Excluding ECU 2
All countries
U.S. dollar78.479.479.679.476.962.455.958.473.868.370.6
Pound sterling6.53.92.01.61.51.72.52.01.92.92.3
Deutsche mark5.56.37.08.39.910.411.911.211.513.912.5
French franc0.91.20.91.00.90.91.11.01.01.31.1
Swiss franc1.11.61.42.01.42.02.62.52.33.12.8
Netherlands guilder0.30.60.50.40.50.70.80.90.70.91.0
Japanese yen0.50.71.22.52.63.33.62.93.84.1
ECU13.917.015.4
Unspecified currencies7.36.57.96.26.35.45.05.05.95.85.6
100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Industrial countries
U.S. dollar87.387.386.989.086.262.254.355.983.577.978.9
Pound sterling3.91.10.70.50.50.50.50.50.60.60.6
Deutsche mark2.64.03.84.06.66.39.49.27.512.411.3
French franc0.10.1
Swiss franc0.80.90.90.70.41.11.11.21.31.51.5
Netherlands guilder0.20.30.30.20.30.40.40.50.40.50.7
Japanese yen0.20.40.31.61.72.12.52.02.83.1
ECU24.029.026.9
Unspecified currencies5.36.27.05.14.43.83.23.24.54.23.9
100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Developing countries
U.S. dollar55.270.872.768.662.662.658.161.762.658.161.7
Pound sterling13.46.83.22.83.03.45.34.13.45.34.1
Deutsche mark13.28.810.112.915.016.115.413.816.115.413.8
French franc3.12.41.72.02.22.02.62.32.02.62.3
Swiss franc2.02.31.93.42.93.34.84.33.34.84.3
Netherlands guilder0.60.90.70.70.91.01.31.31.01.31.3
Japanese yen0.20.91.12.24.04.04.95.24.04.95.2
Unspecified currencies12.37.18.67.49.37.57.67.37.57.67.3
100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0100.0
Sources: Various Fund publications and Fund staff estimates.

The detail in each of the columns may not add to 100 because of rounding.

In this alternative calculation, the SDR value of European Currrency Units (ECUs) issued against U.S. dollars is added to the SDR value of U.S. dollars, but the SDR value of ECUs issued against gold is excluded from the total distributed here.

Sources: Various Fund publications and Fund staff estimates.

The detail in each of the columns may not add to 100 because of rounding.

In this alternative calculation, the SDR value of European Currrency Units (ECUs) issued against U.S. dollars is added to the SDR value of U.S. dollars, but the SDR value of ECUs issued against gold is excluded from the total distributed here.

Price and quantity changes explain recent developments in currency composition (Table 17). In 1979, for instance, official dollar holdings declined sharply; at the same time, the share of the U.S. dollar in total foreign exchange reserves valued in SDRs fell even more, owing to the depreciation of the dollar during that year. In 1981, by contrast, the volume of official dollar holdings also fell, but the share of the dollar in total holdings of foreign exchange measured in SDRs increased because of the large appreciation of the dollar during that year.

The decline in the share of the dollar in total foreign exchange reserves during the later years of the 1970s and in 1980 was accompanied by a rise in the shares of several major currencies. The deutsche mark absorbed a large fraction of the growth of official currency holdings through 1980, while the Japanese yen, the Swiss franc, and the pound sterling also played significant roles. The rise in the share of the U.S. dollar in 1981 reflected in part the reduction in both price and quantity of the pound sterling and the deutsche mark, while the holdings of Swiss francs also fell despite the increase in the SDR price of this currency.

The declining share of the U.S. dollar up to 1980 and the recent reversal in that trend reflected a number of developments. One of them was the large increase in the holdings of foreign currencies by the United States during the period of active foreign exchange market intervention that started in November 1978 and was pursued through 1980. Accumulation by the United States of deutsche mark and Swiss francs in 1980 had the effect of covering liabilities in those currencies generated by the issuance in 1979 of the so-called Carter bonds. As those liabilities began to be repaid during 1981, U.S. holdings of foreign exchange started to decline.

Concern over the value of the U.S. dollar in international markets in the latter part of the 1970s also induced currency diversification and a reduction in the share of surplus countries’ reserves held in U.S. dollars. This tendency appears to have been reversed in 1981, when public concern over stability came to be more evenly spread among major currencies and interest rate developments favored holdings of assets denominated in U.S. dollars.

In addition to the preferences of holders and the effects of exchange market intervention, factors affecting the supply of various currencies have also played a major role in the development of the multiple currency system since 1979. The movement of the U.S. current account from a large deficit in 1977-78 to a small surplus in 1979-81 tended to reduce the supply of U.S. dollars to the rest of the world. At the same time, the current account balances of some other reserve centers—especially the Federal Republic of Germany and Japan, and to a lesser extent Switzerland—swung from surplus into deficit. In some instances, these countries borrowed abroad in terms of their own currencies, so that foreign holdings of their currencies increased.

The process of currency diversification has not been the same in industrial and developing countries (Table 18). Industrial countries reduced their holdings of U.S. dollars from 87 per cent at the end of 1975 to 56 per cent at the end of 1981, while increasing their holdings of ECUs, deutsche mark, and Japanese yen. If ECUs, which account for 27 per cent of foreign exchange holdings, are reallocated to gold and U.S. dollars, the shrinkage in the share of dollars in foregin exchange holdings is much smaller—to 79 per cent at the end of 1981. In developing countries, the share of U.S. dollars fell from 71 per cent in 1975 to 61 per cent in 1981, which was, however, still higher than the share of 55 per cent observed in 1973. For both groups, industrial and developing countries, the share of U.S. dollars was lower at the end of 1980 than at any year-end since 1975, but it increased somewhat in 1981.

Table 19.Sources of Official Holdings of Foreign Exchange Reserves, End of Year 1975-811(In billions of SDRs)
1975197619771978197919801981
Official claims on residents of the United States268.979.2103.8120.495.7113.0127.6
Official claims on residents of other countries denominated in the debtor’s own currency12.111.613.717.422.935.933.7
Subtotal81.090.8117.5137.8118.6148.9161.3
Identified official holdings of Eurocurrencies
Eurodollars38.546.153.348.049.355.463.7
Other currencies7.89.416.019.421.928.130.0
Subtotal46.355.669.367.571.183.593.7
European Currency Units32.747.742.9
Residual3,411.415.316.818.526.916.46.8
Total official holdings of foreign exchange138.7161.7203.6223.8249.3296.5304.7
Sources: International Monetary Fund, International Financial Statistics and Fund staff information and estimates.

Official foreign exchange reserves of Fund members (except for the People’s Republic of China, for which data are not available) and certain other countries and areas including Switzerland. Beginning in April 1978, Saudi Arabian holdings exclude the foreign exchange cover against the note issue, which amounted to SDR 4.3 billion at the end of March 1978.

U.S. liabilities to central banks and governments. Adjusted to exclude an estimated amount representing those dollar holdings of EMS member countries against which ECUs have been issued. Include some non-dollar liabilities prior to 1979.

Part of this residual occurs because some member countries do not classify all the foreign exchange claims that they report to the Fund. Includes identified official claims on the International Bank for Reconstruction and Development, on the International Development Association, and the statistical discrepancy.

There are differences between this table and Table 18 owing to different data sources. This tables uses U.S. statistics on official claims on the United States to identify such holdings, while Table 18 is based on the survey on the composition of monetary authorities’ gross claims on foreigners conducted by the Fund.

Sources: International Monetary Fund, International Financial Statistics and Fund staff information and estimates.

Official foreign exchange reserves of Fund members (except for the People’s Republic of China, for which data are not available) and certain other countries and areas including Switzerland. Beginning in April 1978, Saudi Arabian holdings exclude the foreign exchange cover against the note issue, which amounted to SDR 4.3 billion at the end of March 1978.

U.S. liabilities to central banks and governments. Adjusted to exclude an estimated amount representing those dollar holdings of EMS member countries against which ECUs have been issued. Include some non-dollar liabilities prior to 1979.

Part of this residual occurs because some member countries do not classify all the foreign exchange claims that they report to the Fund. Includes identified official claims on the International Bank for Reconstruction and Development, on the International Development Association, and the statistical discrepancy.

There are differences between this table and Table 18 owing to different data sources. This tables uses U.S. statistics on official claims on the United States to identify such holdings, while Table 18 is based on the survey on the composition of monetary authorities’ gross claims on foreigners conducted by the Fund.

Differences in the currency composition of foreign exchange reserves among country groups arise from a number of factors. Historical ties account for the higher shares of the French franc and the pound sterling in the holdings of some developing countries, and regional financial and trade agreements explain the much higher share of “unspecified” currencies in the portfolios of these countries. For industrial countries, the elements that appear to bear on their reserve asset preferences are the nature of their exchange arrangements and policy objectives (particularly regarding the extent of foreign exchange market intervention), the distribution of their trade flows among the several key currency countries, the currency composition of government borrowings on foreign capital markets, and to some extent, profit and risk considerations. The authorities of many developing countries may be able to give more weight in choosing the currency composition of their reserves to the ordinary portfolio selection criteria of profit maximization and risk minimization than is possible for the larger industrial countries, whose foreign exchange holdings are so large that the attempt to diversify holdings would tend to upset exchange markets. The currency composition of external payments is, of course, also an important factor affecting the denomination of foreign exchange holdings of these countries. More generally, it can be said that countries—industrial or developing—intervening in U.S. dollars tend to hold, on average, a relatively high proportion of their reserves in that currency in order to reduce transactions costs, even if they peg their currency to a currency basket like the SDR.

Source of Foreign Exchange Reserves

The main sources of growth in official foreign exchange reserves in 1981 were official claims on institutions resident in the United States and deposits in Eurodollar markets (Table 19). Foreign exchange holdings stemming from other sources, namely, identified claims on residents of countries other than the United States and Eurocurrency deposits other than Eurodollars, remained unchanged at SDR 64 billion from the end of 1980 to the end of 1981.6 Creation of ECUs as a source of official reserve holdings was negative in 1981, mainly as a consequence of the reduction in the price of gold.

Approximately one half of foreign exchange reserves are held as official claims on the residents of countries in whose currencies the claims are denominated. This proportion remained approximately unchanged during 1981. Claims on the United States increased by SDR 15 billion in 1981; at the end of the year, they constituted about four fifths of such direct claims. Official Eurocurrency deposits increased by more than SDR 10 billion. As a result, the share of foreign exchange reserves held in the Eurocurrency market rose from 28 per cent at the end of 1980 to 31 per cent at the end of 1981, reversing the trend observed since 1975 toward a reduction in the importance of Eurocurrency deposits as a source of foreign exchange reserves. The rising share of Eurocurrency deposits resulted mainly from an increase in the holdings of Eurodollars of SDR 8 billion, with other Eurocurrencies increasing by only SDR 2 billion. The share of dollar-denominated Euromarket deposits increased from 19 per cent of foreign exchange reserves at the end of 1980 to 21 per cent at the end of 1931, while the share of other Eurocurrencies remained unchanged. This development can be linked to the strong position of the U.S. dollar during 1981.

Rates of Return on Major Currencies

Since portfolio and profitability considerations play an important role in the process of currency diversification, it is useful to compare the rates of return, expressed in a common unit of account, that would have been earned on short-term investments in major currencies and in the SDR. Although portfolio considerations are affected by expected rather than realized rates of return, a review of ex post yields may shed light on some of the factors affecting the decisions of member countries about the currency composition of their reserves.

The SDR rates of return on investments in each of five major currencies are calculated by converting SDR 1 into one of these currencies at the exchange rate prevailing at the time of investment, investing this amount in a short-run instrument denominated in that currency, and converting both principal and interest back into SDRs at the end of the period at the rate then prevailing. The rate of return on a potential SDR-de-nominated investment is the weighted average of the yields on money market investments in the five currencies composing the new SDR basket: the U.S. dollar, deutsche mark, French franc, Japanese yen, and pound sterling.7

International interest parity implies that rates of return on instruments with equal liquidity and default risk should in principle be equalized through a matching expected exchange rate change. When viewed ex post, actual exchange rate movements have indeed compensated for part of the interest differentials, narrowing the disparities in the growth of the SDR value of investments in national currencies. The matching tended to be incomplete, however, at least for the period from the second quarter of 1973 to the end of 1981 (Chart 22).

Chart 22.Growth of Investments in Specified National Currencies and SDRs, Second Quarter 1973-First Quarter 19821

(In SDRs)

1Cumulative value (in SDRs) of investments in the SDR and in short-term assets denominated in the five major currencies of which the SDR is composed, each investment amounting to SDR 1.00 at the beginning of the second quarter of 1973. The five national assets are described in footnote 7 in the text. For this calculation, the SDR was assumed, throughout the period shown, to have had the present currency composition (i.e., the five-currency basket that became effective on January 1, 1981) and to have earned interest at the full combined (weighted average) market rate of interest on the five national assets.

The divergence of rates of return on investments denominated in major currencies, measured in SDRs, is particularly pronounced in the short run, although long-run differences in realized rates of return on specific currencies are also observed. An investor placing SDR 1 worth of dollars in U.S. Treasury bills at the end of the first quarter of 1973 would have, upon realization at the end of 1981, dollars equivalent to SDR 2.109, which is almost identical to the return on an investment in SDRs: at the SDR-weighted composite interest rate, the initial SDR 1 could have grown to SDR 2.101. However, dollar investments ending at any period before 1981, and particularly those ending in the years 1977-80, would have yielded a lower return than SDR investments. The SDR values of investments in deutsche mark or Japanese yen grew faster than the value of an SDR investment, although the return on a yen investment displayed a much larger oscillation. From the end of the first quarter of 1973 to the end of 1981, the SDR value of an investment in yen rose by 143 per cent and that of an investment in deutsche mark by 136 per cent. In addition, one or the other of these two currencies would have given the highest return for any period after the second quarter of 1973. Lower returns than with SDR investments would have been obtained in investments denominated in French francs (which grew by 92 per cent) and in pounds sterling (which grew by 102 per cent). Clearly, these observed rates of return are sensitive to the base period chosen.

The most remarkable feature of developments in this area during 1981 is the rapid increase in the SDR value of the return on U.S. dollar investments owing to both high domestic U.S. interest rates and the appreciation of the dollar compared with the SDR. An investment in U.S. dollars made at the end of 1980 and realized at the end of 1981 would have resulted in a return of 28 per cent in SDR terms, compared with a 14 per cent yield on an SDR investment. The returns on investments in Japanese yen and deutsche mark were 13 per cent and 6 per cent, respectively, while investments in pounds sterling and French francs lost almost 1 per cent when measured in SDR terms.

The trends observed in 1981 continued during the first three months of 1982, with the value of U.S. dollar investments rising faster than investments in other currencies and in SDRs. An investment denominated in U.S. dollars made at the end of 1981 would have yielded a quarterly return of 5.3 per cent if realized and converted into SDRs at the end of March 1982, while an SDR investment would have yielded a quarterly return of 3.1 per cent. An investment in pounds sterling also yielded a higher rate than the SDR (4.1 per cent), while investments in deutsche mark, French francs, and Japanese yen had a return lower than 1 per cent.

During 1981, the full combined (weighted average) market rate of interest on short-term assets in the five countries whose currencies enter the SDR basket reached much higher levels than in any previous year since the transition to floating. This combined rate averaged 14 per cent in 1981, compared with 12 per cent in 1980 and 8 per cent between 1974 and 1979. The high level of yields available in 1981 may have been a potential source of gross reserve expansion by increasing the volume of interest earnings on certain official holdings of non-gold reserves.

Fund-Related Assets and Other SDR-Denominated Claims

The growth of assets denominated in SDRs that are issued or generated by the Fund and held in countries’ official reserves is dealt with in the first part of this section. Developments with respect to SDR-denominated assets issued by private institutions are discussed in the second part.

Official Holdings

In 1981, holdings of Fund-related reserve assets 8 increased their share in total reserves excluding gold for the first time in five years (Table 16). That share at the end of 1981 stood at 11 per cent, compared with the high point of 19 per cent around the end of 1970 and an average of over 12 per cent for the decade 1971-80. In absolute amount, the increase in Fund-related assets during 1981 was over SDR 9 billion, from SDR 28.6 billion at the beginning of the year to SDR 37.7 billion at the end. It thus exceeded by a small amount the rise in the foreign exchange component of reserves.

The total expansion in Fund-related assets in 1981 was almost evenly divided between the two elements, SDRs and reserve positions in the Fund. The increase in countries’ holdings of SDRs, at SDR 4.6 billion, was larger than the final allocation for the third basic period of SDR 4.1 billion, which was made at the beginning of 1981. This difference is attributable to the net decrease in the Fund’s holdings, which had been built up shortly before the end of 1980 through the payment in SDRs of part of members’ subscriptions for quota increases. During 1981, gross drawings in SDRs of nearly SDR 2 billion (compared with drawings in currencies of the equivalent of over SDR 5 billion) and other SDR transfers from the General Resources Account exceeded transfers by participants to the Account, mainly for repurchases and charges. Reserve positions in the Fund went up by SDR 4.5 billion in 1981, of which SDR 2.1 billion was the result of a net increase in medium-term lending to the Fund. The remainder, which reflects the amount of reserve tranche purchases that members could make, is explained by the net use of the Fund’s currency holdings for operations and transactions, the largest single type being the use of currencies for drawings.

The change in the distribution of SDRs by country group in 1981 closely followed the pattern of the allocations at the beginning of the year. For the non-oil developing countries, the increase was slightly less than their allocation. For the oil exporting countries and the industrial group, the increase exceeded the allocation they received, with much of the decrease in the Fund’s holdings being taken up by the latter group in particular. The additions to reserve positions in the Fund were divided entirely between the oil exporting countries and the industrial countries, with the former receiving SDR 1.7 billion and the latter SDR 2.8 billion. For each group, just over SDR 1 billion of the increase took the form of net medium-term lending to the Fund.

Increasing Role of SDR-Denominated Assets in Private Markets

The SDR basket has played an increasing role as a unit of account outside the Fund and as a privately issued currency composite.9 Although the SDR basket is only one possible portfolio of currencies, it is gaining considerable acceptance as a denominator and a unit of contract.

During 1981, following the redefinition of the SDR in terms of five major currencies, the private sector has been showing increasing interest in assets denominated in SDRs. SDR-denominated deposits held with the Bank for International Settlements or in the Euromarket appear together with SDRs proper in the reserve holdings of a number of countries. The interest of private investors in the SDR, as in any currency basket, derives from the reduction in the variability of interest rates and exchange rates compared with assets denominated in individual currencies. As long as the currency composition of the SDR is similar to the portfolio mix preferred by the private sector, SDR-denominated instruments are advantageous in providing convenience and economizing on transactions costs.

Until 1980, only a few banks offered SDR-denominated deposits, 10 but in the first half of 1981 more than 50 banks started to offer time deposits denominated in SDRs. The typical minimum deposit is of US$1 million. Because of the high expected return on U.S. dollar deposits relative to similar assets denominated in other currencies during 1981, the growth of SDR-denominated deposits was slow, but it increased late in the year, and the outstanding balance at the end of 1981 was about SDR 5 billion.11

In June 1980, the first transferable SDR Certificate of Deposit (CD) at a fixed rate of interest was issued, and clear indications of a growing international market for these SDR-denominated instruments have appeared. Immediately following the adoption of the new valuation of the SDR at the beginning of 1981, an international market developed in London aimed at facilitating access to SDR-denominated operations by standardizing instruments and procedures. At almost the same time, an Asian market emerged in Singapore. The total value of CDs issued is SDR 700 million. The market is of a short-term character, with maturities of less than one year and a minimum placement of SDR 1 million. About 20 banks participate. The issues offered in 1981 were all floating rate issues. In the early months of 1982, trading in secondary markets increased.

During 1981, current account deposits in SDRs were established at two banks in Europe, and a system for transferring SDR funds directly without having to use other currencies has begun to develop. This development has opened the possibility of using SDR-denominated deposits as a means of payment for financial and commercial operations and is likely to enhance the role of the SDR in the international financial system.

Although no forward market activity in SDRs took place before 1981, it is now possible to buy and sell SDRs forward against U.S. dollars for periods of up to one year. At least ten banks currently deal in forward SDRs.

Generation of SDR-denominated loans has grown more slowly than SDR-denominated deposits. Borrowings denominated in SDRs consist of Eurobond issues, syndicated credits, and floating rate notes. The total amount outstanding at the end of 1981 was about SDR 2 billion.12 This mismatching between SDR-denominated loans and deposits may hamper, or at least slow down, the development of the private SDR market, because Eurobanks would, no doubt, prefer direct cover of their SDR-denominated liabilities to hedging by currency diversification.

The Adjustment Process and International Capital Markets

One significant trend in the international financial system during the past decade was the increasingly important role of private international capital markets in the financing of payments imbalances. The rapid growth of private international lending has reflected not only an increase in flows between industrial countries but also growing use of these markets by developing countries.

For the largest industrial countries, private capital flows have reflected the growing international integration of capital markets and have been stimulated by attempts to arbitrage yield differentials across countries, the need to finance expanding trade flows between industrial countries, and the financing of government deficits. A few smaller industrial countries have used private capital markets as a continuing source of financing payments deficits. Most of the industrial countries have not, however, relied as consistently as the non-oil developing countries on international credit for the financing of payments imbalances.

In the financing of current account deficits and reserve accumulation of non-oil developing countries, the relative importance of various types of transaction has changed considerably in recent years (Chapter 1, Table 10). Transactions that do not add to net indebtedness (including official transfers) declined from 47 per cent of the total financing requirement in 1973 to 26 per cent in 1981. One of the largest components of these transactions was unrequited transfers to governments of non-oil developing countries. These transfers fell from 25 per cent of the combined current account balance and reserve accumulation in 1973 to only 13 per cent in 1981. While long-term official lending was almost four times as large in 1981 as in 1973, its share in the total financing requirement nonetheless declined from 25 per cent to 20 per cent during this period. In contrast, borrowing by non-oil developing countries from private sources and residual flows, which are primarily unrecorded private capital flows, rose from 26 per cent of total reserve accumulations and current account imbalances in 1973 to 48 per cent in 1981. The share of net direct investment flows to non-oil developing countries in the financing of their aggregate current account deficit remained quite steady at 11-13 per cent from 1974 to 1981, after declining sharply from 20 per cent in 1973 to 13 per cent in 1974.

The flow of international credit extended to non-oil developing countries took a number of forms, with international bank lending and international bond issues being important channels. Credit extension through these two channels is estimated to have increased from US$58 billion in 1975 to US$191 billion in 1981, with international bank lending accounting for much of this growth. Bond issues grew at a much slower rate and, as a result, declined from 33 per cent of the total of international bank lending and bond issues in 1975 to only 14 per cent in 1980.

Bank lending expanded much more rapidly than bond issuance because it was a highly flexible and generally competitively priced short-term to medium-term source of large-scale credits and, from the point of view of investors, purchases of securities bearing fixed interest rates were not very attractive during a period of generally rising nominal interest rates. The ability of banks to expand or contract their international loan commitments freely had a strong impact on loan terms and maturities. While the average maturity on syndicated loans declined from more than eight years in 1973 to about five years in 1975, owing largely to the Herstatt crisis, the average lengthened to nearly ten years by 1979 before again declining somewhat in 1980-81. The average loan spread over the London interbank offered rate (LIBOR), which rose quite sharply in 1974-75, declined during the second half of the 1970s. A significant number of developing countries had spreads of less than 1 per cent over LIBOR in the last years of the 1970s. In response to the prospect of delayed repayments of debts in some Eastern European and developing countries and the possibility of a significant increase in private sector bankruptcies in the industrial countries, spreads for many developing countries stopped declining in 1980-81, but they remained well below their 1975-76 values. The high interest cost of borrowing abroad that many developing countries have faced since the latter part of the 1970s accordingly reflects chiefly the general increase in interest rates in international capital markets rather than an increase in spreads.

The international bond market became less important as a source of international credit throughout the 1970s. The weakness of this market was evident in a reduction in real volumes of bond issues throughout the period 1975-80, a shortening of average bond maturities, and the development of new financial instruments that transferred part of the risk associated with the variability of interest rates and exchange rates from lenders to borrowers. These changes represented a response to greater uncertainty regarding the future paths of interest rates and inflation. The highly erratic increases in nominal interest rates that took place in the years 1978-81 further reduced the attractiveness of bonds as a portfolio asset by inflicting large capital losses on holders of existing bonds. To guard against a repetition of this experience, bond holders moved into instruments of shorter maturity and began to demand high real returns on longer-term bonds.

The rate at which private financial markets will expand in the future depends on the responses of banks and their regulators to the perceived risks associated with international bank lending—chiefly that loans will cease to be serviced—and to the deterioration of the ratios of bank capital to assets in a number of national banking systems, as well as on future economic and financial developments. Because of high interest rates and some shortening of the external debt maturities, the ratios of debt service to exports for certain non-oil developing countries—for some of them already at a historical high point—are projected to rise further. At a time when perceived risks associated with debt rescheduling and other repayment difficulties have increased, bank capital/asset ratios, which generally declined in the 1970s, have also come under further pressure from falling prices of assets bearing fixed interest and from increasing losses in domestic lending. Continued growth in bank lending to developing countries, particularly those that are already large borrowers, may require a more rapid expansion of bank capital than has been observed in recent years. Banks have found, however, that the real cost of equity capital has recently been relatively high.

These prudential considerations are less likely to be a constraint on the expansion of international bank lending if a favorable environment prevails in the world economy. Adequate rates of growth, low inflation and interest rates, and the maintenance of a liberal trade regime in the industrial countries would all strengthen the external positions of non-oil developing countries that follow prudent policies. Such factors would enhance the perceived creditworthiness of developing countries by reducing the ratios of their indebtedness and their debt service to exports. Moreover, financial institutions would be better able to respond positively to that improvement in creditworthiness because a reduction in loan losses and an improvement in access to capital would reduce their operating costs. Such lower costs would allow these institutions to increase profitability without raising the cost of funds to borrowers.

The Adequacy of International Reserves

The global demand for reserves may be expected to grow in some relationship—not necessarily a proportional one—to world trade and to countries’ payments imbalances. How readily this demand is satisfied at any particular time depends on the responsiveness of the supply of reserve assets. With the rapid development of international financial markets in recent years, the supply of international reserve assets has become quite responsive to changes in the demand for reserves. Indeed, this responsiveness is sufficiently high to allow global reserve holdings to be determined largely by the effective demand for them, even though the access of some countries to private international credit is constrained. This state of global adequacy of reserves should not divert attention, however, from some important questions about the net cost and the distribution of reserves.

The adequacy of reserves, in relation to some measure of the need, can be appraised in a number of ways. In past discussions of the need for reserves, for both individual countries and the entire system, the ratio of reserves to imports and changes in this ratio have been used as indicators.13 An alternative indicator is the ratio of non-gold reserves to current account imbalances, that is, the sum of current account surpluses and deficits added without regard to sign. This ratio declined from an average of 2.0 for 1973-74 to an average of 1.7 for 1979-80, while the average ratio of non-gold reserves to imports fell from 0.24 to 0.22 over the same time span. The apparent decline in the demand for reserves, relative to trade and payments imbalances, may have a number of reasons, including the increasing opportunity cost of holding reserves and the fact that many countries could finance their payments deficits by increasing their indebtedness. The widespread reliance on floating exchange rates and the increase in capital mobility are also likely to have contributed to the reduction in the demand for reserves.

The increasing importance of international financial markets and the improved access of most countries to these markets have reduced the usefulness of relying on indicators like those just discussed to assess the adequacy of international reserves. To the extent that the monetary authorities of countries have access to credit supplied by private financial markets, the liquidity of the system is increased and the need to hold reserves reduced. The ease of access to capital markets is not, of course, the same for all countries. For some of them, particularly those heavily dependent on concessional economic assistance and those facing unfavorable economic prospects, the high cost of borrowing and the low perceived creditworthiness have been obstacles to the use of private capital markets for balance of payments financing. For these countries, the need for owned reserves has not been diminished by the fuller development of international capital markets. More generally, a country’s need for owned reserves is contingent on the availability of credit lines and its capability of enhancing its borrowing capacity at a reasonable cost. The adequacy of international liquidity would appear, therefore, to be a more meaningful concept than the adequacy of international reserves, since the former includes the borrowing potential of countries. Both concepts are elusive, however, and present obstacles to statistical measurement. For that reason, general indications of the functioning of international financial markets and the cost at which countries can have access to them, such as those set forth in the preceding section, are the most important elements in any assessment of the adequacy of international reserves and liquidity.

Provision of Liquidity by the Fund

The Fund provides unconditional and conditional liquidity. Unconditional liquidity is supplied through the allocation of SDRs as well as by the generation of reserve positions in the Fund. These assets can be used by the holder to finance a balance of payments deficit without regard to the circumstances responsible for the deficit and without having to adhere to policy conditions. Conditional liquidity is made available through the extension of Fund credit to members. The conditions attached to this credit vary with the type of facility and, for credit tranche drawings, with the amount of credit given in relation to a member’s quota.

Unconditional Liquidity

Developments in reserve assets supplied by the Fund have already been discussed earlier in this chapter. The year 1981 marked the end of a period of SDR allocation. The last annual allocation of this period, on January 1, 1981, brought the total supply of SDRs to SDR 21.4 billion. The question of a continuation of allocations in 1982 and subsequent years was discussed in 1981 and the first half of 1982 by the Fund’s Executive Board and the Interim Committee. These discussions indicated that, while a large number of members were in favor of a further allocation, the required support for an allocation was still lacking. The Executive Board and the Managing Director will keep the matter under consideration, and the Managing Director will make a proposal for allocation if and when sufficient support is forthcoming.

Reserve positions in the Fund, which are denominated in SDRs, are generated through various Fund transactions and operations, chiefly the use in Fund drawings of the currencies subscribed by members or borrowed from them. Although the Fund can provide unconditional liquidity in the form of SDRs or reserve positions in the Fund, these two assets are not interchangeable, and there are important differences in the manner in which they are generated and in their economic effects.

First, reserve positions in the Fund reflect resources already made available to the Fund, while SDRs do not. Second, the distribution among members of reserve positions is as a matter of course quite uneven in comparison with the distribution of SDR allocations, which are proportional to quotas. Third, reserve positions in the Fund come into existence as a by-product of the extension of credit by the Fund to its members, and their volume is therefore dependent on the amount of such credit extension that is appropriate in the light of the criteria guiding it, whereas SDRs are allocated in response to a global need for supplementing existing reserves.

Conditional Liquidity

One of the main purposes of the Fund, as laid down in the Articles of Agreement, is to make its resources temporarily available to members, under adequate safeguards, in support of efforts to correct maladjustments in their balance of payments. These resources—gold, SDRs, and currencies—are subscribed by members in accordance with quotas assigned to them upon entry into the Fund and reviewed periodically thereafter.

The Fund’s conditional credit extension is based on the principle that its concern should be with both the financing of temporary payments imbalances and the adjustment of unsustainable ones. The objective of the advice and financing extended to members should be to help them achieve a viable external position in the medium run. To achieve this objective, the Fund’s assistance must be conditioned upon the adoption by recipient members of appropriate economic policy programs. Such programs often also enhance members’ access to credit from other sources.

It is generally agreed that the resources available to the Fund should be sufficient for the Fund to play its important role in the adjustment and the financing of balance of payments deficits in accordance with the foregoing considerations. While the Fund has had to supplement the resources obtained through quota subscriptions by borrowing from members, particularly in the circumstances prevailing since the middle of the 1970s, it is generally agreed that its activities should be financed primarily from quota resources. Fund quotas have been reviewed, and generally increased, at intervals of five years. The last general increase in quotas, which was decided in the course of the seventh of these quinquennial reviews, became effective in the last weeks of 1980. Quotas were increased at that time from about SDR 40 billion to SDR 60 billion.14 Work on the Eighth Review of Quotas is now under way; it is to be completed no later than December 1983. This review deals with the size of quotas appropriate for conducting the Fund’s activities in the second half of the present decade. It will also examine the quota shares of members in relation to their positions in the world economy, with a view to adjusting quotas so as to better reflect this relation.

See also Chapter 1, pages 23-27.

See Executive Board Decision No. 5392-(77/63), adopted April 29, 1977, Selected Decisions of the International Monetary Fund and Selected Documents, Ninth Issue (Washington, 1981), page 10.

Executive Board Decision No. 6056-(79/38), adopted March 2, 1979, Selected Decisions of the International Monetary Fund and Selected Documents, Ninth Issue (Washington, 1981), page 19.

Under present arrangements, ECUs have been allocated to the central banks of EMS members against three-month swaps of 20 per cent of the gold holdings of each member. The outstanding volume of ECUs has thus fluctuated with the value of these holdings. When swaps are renewed, at three-month intervals, gold is valued at the lower of two prices: the average price recorded in the preceding six months and the price on the penultimate working day.

The position of gold in reserve portfolios of countries is not easy to assess, as different methods of valuing gold holdings are applied. In this Report, gold holdings, for expository purposes, are valued at the market price in London.

The term “Eurocurrency deposit” denotes deposits denominated in a currency different from the currency of the country in which the bank accepting the deposit is situated.

At the end of 1981, these bond equivalent rates were (a) the market yields for three-month U.S. and U.K. treasury bills with initial weights of 42 per cent and 13 per cent, respectively; (b) the three-month interbank deposits rate in the Federal Republic of Germany with a weight of 19 per cent; (c) the three-month interbank money rate against private paper in France with a weight of 13 per cent; and (d) the discount rate on two-month (private) bills in Japan, also with a weight of 13 per cent. For the calculation described in the text, this latter rate was estimated for periods prior to October 1980 by making use of the observation that the level of the Japanese call money rate (unconditional), used in the first and second SDR interest rate baskets, was close during the period of overlap to the two-month rate currently used (before converting that rate from a discount basis to a bond equivalent basis).

Fund-related reserve assets are comprised of SDRs held by countries and reserve positions in the Fund. The latter consist of reserve tranche positions, that is, the amount of reserve tranche purchases that members could make, and medium-term lending to the Fund. Short-term lending to the Fund under the policy on enlarged access to Fund resources, to the extent that the claims are officially held, is included with official foreign exchange reserves. Short-term lending, none of which occurred before 1981, amounted to SDR 0.1 billion at the end of that year; part of the claims is in the form of notes.

See also Chapter 3, page 92.

The first known deposit facility in SDRs was offered by a London bank in June 1975.

Estimates of the amount vary, but none exceeds a total of SDR 7 billion.

The first SDR-denominated obligation was a bond issued in 1975. There have subsequently been twelve further issues of bonds or notes amounting to a total of SDR 563 million. The first syndicated loan in SDRs was arranged only in 1981, and in the course of that year there have been seven syndicated credits in a total amount of SDR 1.2 billion.

See Annual Report, 1981.

Through entry of new members and special increases, the total of Fund quotas has meanwhile risen to SDR 61 billion (see Chapter 3).

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