Chapter

Chapter 2 Developments in the International Monetary System

Author(s):
International Monetary Fund
Published Date:
September 1985
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The growing importance of international capital movements continued to dominate developments in exchange markets and in world liquidity. In the face of rapid changes in asset preferences caused by actual and expected divergences in economic policies and performance among industrial countries, exchange rates moved sharply at times in 1984 and 1985. In the process, competitive relations among important countries were altered so as to increase, rather than diminish, existing imbalances in trade flows. As a result, protectionist pressures increased, the task of economic policymaking was made more difficult, and a greater burden was placed on international surveillance over these policies. Creditworthy countries continued to have adequate access to cross-border credit and could thus finance their balance of payments and adjust their reserve holdings in accordance with their needs. All the same, world reserves have not increased since the end of 1982, as a decline in the value of gold reserves offset a rise in non-gold reserves. Countries with balance of payments deficits whose lack of creditworthiness limited their access to international capital markets had some difficulty, and faced relatively high costs, in maintaining reserves at levels they considered adequate. These issues will be discussed in this chapter, beginning with exchange rate matters and then proceeding to questions of international liquidity.

Exchange Rates and Surveillance

For the major industrial countries, exchange rate movements during most of the period since the beginning of 1984 tended to increase existing current account imbalances. These movements occurred in spite of the marked tendency toward convergence of inflation rates that has been evident among these countries over the past several years. Despite a partial reversal since February 1985, appreciation of the U.S. dollar over the last five years has caused a loss of international competitiveness by the United States, and the U.S. current account balance has gone increasingly into deficit. In contrast, during 1984 Japan and, to a much lesser degree, the Federal Republic of Germany increased their already substantial current account surpluses.

The recent evolution of exchange rates and external payments positions among major industrial countries has given rise to substantial concern about strains on the international monetary system, leading to renewed interest in discussions regarding possible improvement in its functioning. These concerns relate to a number of features, including a pattern of real exchange rates for the major currencies that may not be conducive to an orderly evolution of trade and payments positions, debt-servicing difficulties in developing countries, and increased pressures for protectionism in industrial countries. This part of the chapter discusses these issues and their implications for Fund surveillance.

EXCHANGE RATE ISSUES IN INDUSTRIAL COUNTRIES

The appreciation of the U.S. dollar relative to other major currencies, which had been a feature of the international monetary scene since the third quarter of 1980, continued during 1984 and the first two months of 1985. Indeed, the dollar experienced a sharp upward movement during the month of February 1985 that brought its effective exchange rate to a level 50 percent higher than its average over the decade 1974 to 1983, and more than 20 percent above its level at the end of 1983. During February, the dollar rose briefly above 3.45 deutsche mark and 260 Japanese yen. The sharp appreciation in February was reversed in March, and in the subsequent four months nominal exchange rates of the dollar declined further, to below 2.9 deutsche mark and 240 yen, bringing them back to levels prevailing during July and August of 1984.

Movements in competitiveness were often in directions opposite to those needed to re-establish a stable pattern of current account positions among the major industrial countries. Normalized unit labor costs in U.S. manufacturing rose by 11 percent relative to the dollar value of labor costs in other industrial countries from the, fourth quarter of 1983 to the fourth quarter of 1984. Over this same period, the U.S. current account deficit, including official transfers, widened from $40 billion in 1983 to about $100 billion in 1984. The counterpart of these developments for the United States was exchange rate depreciation and increased current account surpluses for several major industrial countries. The deutsche mark depreciated by 13 percent against the U.S. dollar during 1984, while the current account surplus of the Federal Republic of Germany increased from $4 billion in 1983 to $6 billion in 1984. Similarly, despite favorable movements in prices and costs in Japan relative to the United States, the Japanese yen was 7 percent lower against the U.S. dollar at the end of 1984 than a year earlier; Japan’s current account surplus increased from $21 billion in 1983 to $35 billion in 1984. When scaled by output, the current account imbalance of Japan is comparable in magnitude to that of the United States, though in the opposite direction: both are close to 3 percent of gross domestic product (GDP).

FACTORS INFLUENCING FLOATING EXCHANGE RATES

A number of separate factors may have contributed to the exchange rate movements that occurred in 1984 and the first half of 1985. First, the continued attractiveness of acquiring claims on the United States has been enhanced by the vigor of the U.S. economy, especially relative to that of the European economies. Direct investment flows to the United States increased and, with the sharp decline in new bank lending to developing countries, the United States also experienced substantial net banking inflows. Both of these developments acted to strengthen the U.S. dollar. In contrast, most European countries exhibited only moderate economic growth during 1984, and confidence may also have been adversely affected by industrial disputes in the United Kingdom and the Federal Republic of Germany.

Second, the stance of monetary policy in major industrial countries has had a determining effect on movements in nominal exchange rates and in real exchange rates, that is, exchange rates adjusted for differences in rates of change of prices and costs among countries. A policy based on control of the monetary aggregates by the authorities in the United States has meant that, when economic activity has expanded at a rapid pace, as was the case during the first half of 1984, U.S. domestic interest rates adjusted for inflation have tended to rise relative to rates abroad, contributing to some strengthening of the dollar in real terms. Conversely, the slower pace of economic activity since mid-1984 has led to a steady decline of real interest rates in the United States. Furthermore, the evident success of U.S. Federal Reserve policy in containing inflationary pressures has helped to make dollar assets attractive as a store of value. While other industrial countries also have had marked success in reducing rates of inflation—inflation rates in the Federal Republic of Germany, the Netherlands, and Japan are currently lower than those in the United States—interest rates in those countries have not generally matched U.S. interest rates. Interest differentials have therefore frequently favored investment in assets denominated in U.S. dollars. However, since August 1984, interest rate spreads in favor of the dollar have declined substantially.

Third, fiscal policy settings in major countries have continued to be quite divergent, and discretionary shifts in fiscal policy accentuated that divergence in 1984. When government fiscal deficits, defined broadly to include the position of both central and local governments, are adjusted to remove purely cyclical movements owing to the functioning of automatic stabilizers, such as benefits to the unemployed, it is apparent that fiscal policy in France, the Federal Republic of Germany, and Japan has become more restrictive, while that in the United States has become more expansionary. Large U.S. federal deficits, while stimulating economic activity both domestically and in other countries, have added to the already substantial demand for credit to finance private investment spending in the United States; and relatively high real interest rates have helped to bring about a large and growing transfer of savings from the rest of the world.

These factors have exercised a strong influence on exchange rates, particularly through their effects on capital movements. Removal of restrictions on financial transactions as well as financial innovations have promoted integration of international capital markets. As a result, asset market transactions have become increasingly important, relative to trade, in influencing exchange rate movements.

In recent years, major industrial countries have taken measures that facilitate shifts in asset holdings, both by making it easier to acquire claims on foreign residents and by allowing nationals to take positions in foreign currencies. Among these measures have been a series of changes since 1980 that have liberalized capital flows into and out of Japan. These measures have allowed portfolio diversification by large Japanese institutional investors and, to a lesser extent, have favored the increased international use of yen-denominated instruments. During 1984 several countries, led by the United States, abolished the withholding of taxes on interest paid to foreign holders of bonds, thus furthering the integration of international capital markets. The arbitraging of expected rates of return on assets denominated in different currencies has also been facilitated by the development of new financial instruments, such as interest rate swaps, currency swaps, and note issuance facilities. Finally, domestic financial deregulation and innovation may tend to promote integration of world asset markets by expanding the range of instruments yielding competitive rates of return available to both domestic and foreign investors. In the United States, for instance, abandonment of ceilings on interest rates on bank deposits and the introduction of money market accounts have provided attractive alternatives to marketable securities. In some other industrial countries, for instance Australia and New Zealand, increasing competition and regulatory changes have lowered barriers separating financial institutions, with the result that interest rates came to be more strongly influenced by market forces. Some domestic financial liberalization has also taken place in Japan.

Innovations in financial markets have to some extent been the result of technological advances that have lowered transaction costs, making movement of funds and automatic transfer of balances into interest-bearing accounts less costly. Information about foreign financial markets is being made more widely available via computerized information services. Some innovations have no doubt been spurred by the period of very high nominal interest rates in the early 1980s. Furthermore, in several major countries there has been a change in philosophy concerning the proper role of government that has favored moves toward less regulation in a number of fields, including financial matters.

EXCHANGE RATES AND FINANCIAL INTEGRATION

The international integration of financial asset markets has several implications for interpreting recent events and for considering the functioning of the international monetary system. First, international capital mobility, by giving a country access to foreign saving, allows it more flexibility in its macroeconomic policies; recent experience of major industrial countries suggests that the associated current account deficits and surpluses can persist for extended periods of time. Second, exchange rates may at times respond suddenly to changes in expected returns and perceptions of risk associated with assets denominated in different currencies. Finally, the importance of financial asset markets in the determination of exchange rates has implications for the conduct of domestic monetary and fiscal policies. These issues are further considered below.

Since widespread floating began in 1973, but particularly during the 1980s, financial integration has been associated with substantial and persistent deviations of real exchange rates from levels that would be consistent with sustainable current account positions. The real effective exchange rate of the U.S. dollar at the end of 1984 was some 35 percent above its average over the period 1974 through 1983, and its appreciation from the beginning of 1980 amounted to more than 50 percent (Chart 12). The United States has had current account deficits for the last two years totaling some $140 billion and is likely to have annual deficits exceeding $100 billion for the next few years. Since the beginning of 1981 Japan has persistently run current account surpluses, totaling some $70 billion over the past four years. The Federal Republic of Germany was in a position of current account surplus from 1973 to the end of 1978; a series of substantial deficits in the period 1979—81 has been followed by small but growing current account surpluses.

Chart 12.Three Major Industrial Countries: Payments Balances on Current Account, Including Official Transfers, as Percent of GNP, and Real Effective Exchange Rates, 1973—841

1 Real effective exchange rates are measured by relative normalized unit labor costs.

As a result of recent current account deficits, the United States has moved from a large net creditor position vis-à-vis the rest of the world, estimated by the U.S. Department of Commerce to have been $150 billion at the end of 1982, to a net debtor position. Prospective current account developments imply that it will soon be a substantial net debtor, although the data are subject to considerable measurement problems. Japan’s net asset position vis-à-vis nonresidents of Japan was $25 billion at the end of 1982, as estimated by the Ministry of Finance, and current account surpluses and valuation adjustments in 1983 and 1984 have added some $49 billion to that figure. These current account surpluses had as their main counterpart substantial long-term capital outflows, taking the form both of acquisition of foreign securities by large institutional investors in Japan and foreign loans by Japanese financial institutions and, to a much lesser extent, of direct investment abroad by Japanese companies. Continuing current account surpluses in coming years would reinforce Japan’s position as a large net creditor.

Another implication of the importance of asset transactions in the determination of exchange rates is that, like other asset prices, exchange rates may exhibit a high degree of volatility. This volatility has been evident over the past year, as on numerous occasions day-to-day movements of the U.S. dollar against currencies of the European Monetary System (EMS) have been very large. On September 21, 1984, the range of movement of the dollar-deutsche mark rate in the course of the day even attained 4 percent. An investor considering the purchase of foreign currency must take into account any eventualities that may affect the value of the currency in the future. For instance, volatility in the value of the pound sterling against other major currencies during 1984 stemmed in part from rapid changes in prospects in world oil markets.

To some extent, volatility of exchange rates may simply reflect rapid adjustment to new information, and the increasing integration of world financial markets favors that process by allowing positions in different currencies to be taken quickly and cheaply. On the other hand, as with other asset prices, it is possible that investors may on occasion ignore fundamental determinants and concentrate on their perceptions of other investors’ preferences, leading to “speculative bubbles.” Sudden shifts in sentiment are possible in such a situation as investors realize that the bubble will eventually burst, and exchange rates may appreciate or depreciate substantially as a result.

The degree of risk that investors perceive to be associated with an asset is also important, and changes in the perception of the underlying risks can bring about sharp exchange rate changes. In recent years, substantial movements both into and out of dollar assets have been motivated by risk considerations. The United States has benefited from a safe-haven demand for dollar assets by investors in both industrial and developing countries, but there have also been occasions when concern about the solvency of financial institutions in the United States has led to sudden exchange rate changes. The announcement of loan losses by the Continental Illinois Bank in May 1984 triggered downward pressures on the dollar, and the failure of several dealers in government securities and the troubles of non-federally-insured savings and loan associations are certainly part of the explanation for the depreciation of the dollar in March of this year.

In recent years, day-to-day movements in the U.S. dollar exchange rates of other major currencies, except the Canadian dollar, have on numerous occasions approached, and sometimes exceeded, 1 percent (Chart 13). Contrary to the expectations of some observers, there has been little tendency for the variability of exchange rates to decrease through time, despite the experience of more than a decade with the widespread floating of exchange rates and a substantial convergence of inflation rates. Industrial countries have made considerable progress in dampening inflation, and the reduction in the rate of price increase has been greatest in the countries that initially had relatively high inflation. As a result, nominal interest rate differentials have also generally declined. However, because of the speculative element in exchange rate determination, underlying determinants may not entirely explain exchange rate movements. For instance, exchange rate variability may not correspond closely to the variability of interest rate differentials (Chart 14).

Chart 13.Exchange Rates for Six Major Currencies: Daily Percentage Changes Against the U.S. Dollar, January 1, 1981-April 29, 1985

Chart 14.Five Major Industrial Countries: Variability of Interest Rate Differentials and Bilateral Exchange Rates, 1981-84

1The variability of interest rate differentials is measured as the standard deviation of the daily series of day-to-day 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 day-to-day percentage changes in the currency of the first country expressed m terms of the currency of the second.

During 1984 and early in 1985, on several occasions the central banks of major industrial countries intervened substantially, either alone or in a concerted effort, in order to limit exchange rate variability. On one occasion in May 1984, the dollar was subject to sharp downward pressure and the U.S. authorities intervened to calm disorderly exchange market conditions. In the summer of 1984, and early in 1985, the Bank of Canada intervened substantially to moderate the depreciation of the Canadian dollar against the U.S. currency. At times, in September and October of 1984 and early in 1985, there was concerted intervention by the Deutsche Bundesbank and other central banks during episodes of persistent strength of the dollar. Intervention seems to have had the

desired effect in these latter cases of halting a series of sharp moves in the same direction in currency values—in this case in the direction of U.S. dollar appreciation. Nevertheless, the size of day-to-day movements in the days following a period of substantial intervention remained high and, although the dollar broadly declined late in September 1984, it attained new peaks later in the year and early in 1985.

More generally, the integration of international capital markets and its effect on the functioning of the international monetary system has implications for the conduct of monetary and fiscal policies. Although recent experience suggests that sterilized exchange market intervention (i.e., intervention transactions that are not allowed to affect the money supply) seems to have some effect in calming disorderly markets, the effectiveness of this policy measure is limited. A durable official influence over exchange rates can result only from the use of policy tools that change underlying macroeconomic conditions.

As has been discussed above, monetary and fiscal policies can have persistent effects on real exchange rates. For instance, appreciation of real exchange rates may result from a sustained anti-inflationary monetary policy; fiscal expansion may lead to an appreciation when it is accompanied by strong business investment and is not accommodated through central bank credit, particularly if there is a high degree of capital mobility. A combination of these two factors, as recently experienced in the United States, is thus especially likely to impart a tendency toward exchange rate appreciation. Appreciation may help to achieve anti-inflationary objectives by lowering the prices of imported goods, but it worsens the competitive position of industries producing traded goods.

The international integration of markets for both financial instruments and goods implies that policy changes in one country may have substantial effects on neighboring countries, and one channel for such effects is exchange rate movements. Contrary to expectations, floating exchange rates among the currencies of major industrial countries have not in practice granted governments an extra degree of autonomy to pursue their own policy objectives. Instead, the experience of industrial countries over the past decade has emphasized their interdependence. Consequently, particular attention has been given to ways of strengthening Fund surveillance to achieve a greater degree of international compatibility and convergence of economic conditions and policies in a medium-term framework.

Exchange rate volatility may result from uncertainty about the stance of policy at home and abroad, given the integration of international asset markets. It is therefore important for members to reduce this uncertainty as much as possible by avoiding sudden shifts in announced policy measures and in the implementation of those policies.

THE EMS AND SMALLER INDUSTRIAL ECONOMIES

The EMS has been successful in achieving considerable stability among the exchange rates of the currencies of participants in the exchange rate mechanism. Exchange rate movements among these currencies have generally been smaller than those among other major currencies. Although realignments of central parities have been necessary at times, they have taken place less frequently in recent years than previously. A realignment occurred in July 1985, the first since March 1983; in contrast, there were seven realignments between the formation of the EMS in March 1979 and March 1983. The strength of the U.S. dollar has probably helped in recent years to prevent pressures on central parities from developing. Among the EMS currencies, the deutsche mark provides the principal investment alternative to assets denominated in U.S. dollars, in part because the Federal Republic of Germany (like the Netherlands) imposes virtually no restrictions on capital movements. Strong demand for dollar assets has therefore tended to reduce the demand for deutsche mark assets and has thus attenuated upward pressures on the deutsche mark relative to other EMS currencies.

A more important factor supporting the relative stability of the EMS in recent years has been the introduction of restrictive monetary and fiscal policies in the countries with higher inflation rates. Since 1983, the French Government has taken vigorous measures to restrain domestic expenditures, leading to a fall in the rate of inflation and an improvement of the trade balance. In Belgium, a reduction of the large government deficit has been a precondition both for re-establishing internal equilibrium and for easing pressures on the franc, and some progress has been made in that direction. In Italy, moves to limit the government deficit, together with a reduction in the degree of automatic indexation of wages, have led to a marked deceleration of inflation. However, the rate of inflation is still higher than in other major EMS countries. This inflation differential, and a deteriorating external position, made necessary the realignment within the EMS in July 1985, which involved a downward shift in the central rate of the lira against other member currencies of about 8 percent.

Several other industrial countries have recently reduced restrictions on capital movements and promoted integration with international financial markets. Where a particular country has followed the practice of pegging its currency either to another currency or to a basket of currencies, liberalization may bring out the problem of reconciling domestic monetary targets and a fixed exchange rate. There may therefore be pressures on the authorities to float the exchange rate.

Australia and New Zealand have recently moved to floating exchange rates during a period of major domestic financial innovation and deregulation. Since 1980, measures have been taken in Australia to remove lending guidelines and controls on interest rates, and the Australian dollar moved from an administered to a market float starting in December 1983. Since the change in government in July 1984, New Zealand has taken a series of liberalization measures relating to domestic financial arrangements and external payments. Wide-ranging moves in the direction of deregulation highlighted the difficulty in reconciling domestic monetary goals with a pegged exchange rate, and, for this reason, among others, on March 4, 1985, the New Zealand dollar was allowed to float.

Finland, Norway, and Sweden have continued to peg their exchange rates to trade-weighted baskets of currencies and to subordinate monetary policies, to a greater or lesser extent, to exchange rate objectives.

During 1984, interest rates in Sweden were kept somewhat above levels prevailing abroad in order to limit capital outflows. In Norway, despite moves since 1980 toward liberalization of the banking system, interest rates are still tightly controlled. Finland has significantly liberalized the domestic financial system, but has retained exchange controls.

IMPLICATIONS FOR EXCHANGE RATE POLICIES

Concern about exchange rate volatility and persistent shifts in competitiveness among both major and other industrial countries that seem to result from the importance of asset market transactions in exchange rate determination has led to discussion of ways to limit exchange rate movements. The success of the EMS is sometimes cited as a model for a return to a system of adjustable pegs for major currencies. Though it is true that the intervention mechanisms have served to limit exchange rate fluctuations within the EMS, it is also the case that the countries of the EMS are very closely linked by trade and, as members of the European Community, share some supranational institutions. As discussed above, member countries of the EMS have been willing to coordinate policies in such a way that divergences in inflation and payments imbalances are reduced.

Some observers have suggested that countries should restrict capital movements to insulate themselves from financial developments abroad, for instance, by imposing an interest equalization tax. As a result, it is argued, speculative forces would have less play, and exchange rates would diverge less from those consistent with a normal level of competitiveness. Restrictions on capital flows would, however, be contrary to the secular trend in favor of liberalization, which stems from concern to promote economic efficiency. It would in any case be difficult to restrict international capital flows in the face of a wide range of competitively priced instruments associated with domestic financial deregulation. Furthermore, restrictions on capital mobility would reduce countries’ access to foreign savings and prevent some profitable investment opportunities from being exploited.

Unfortunately, asset market deregulation does not seem to have been accompanied, in recent years, by any decline in the incidence of trade barriers. On the contrary, there has been a revival of protectionist sentiment. Liberalization of capital movements, if not accompanied by appropriate policies for internal and external balance, may result in large real exchange rate changes that bring forth demands for protection of industries producing traded goods. It is therefore important in choosing economic policies that their international consequences be taken into account, in order to avoid disruption to the international trading system, from which all countries benefit.

EXCHANGE RATE POLICIES IN DEVELOPING COUNTRIES

For many developing countries, exchange rate policies in recent years were an essential element of adjustment in the face of unsustainable current account deficits and external indebtedness, as well as high and rising rates of inflation. The need to improve the current account was made more urgent by the increased difficulty of attracting foreign loans and the limited supply of direct foreign investment capital. The difficulty of attracting capital to developing countries was aggravated by high interest rates in international financial markets, a safe haven for loanable funds in a few industrial countries, an adverse investment climate including uncertainty about profit prospects in many of the developing countries, and a perception among some suppliers of funds of severe restrictions on foreign direct investment in some of the developing countries. In light of these constraints on capital inflows and the heavy burden of debt service payments foreseen for the medium term, exchange rate policies during the period 1982—84 reflected a need for reducing current account deficits from the historically high levels of 1981 and 1982.

RECENT EXCHANGE RATE EXPERIENCE

The discussion of exchange rate policies in this section focuses on developments in real effective exchange rates, which can serve as an indicator of changes in external price competitiveness. Changes in the real effective exchange rate ensue from a combination of changes in the nominal effective exchange rate, domestic price developments, and price movements in trading-partner countries.1 The real effective exchange rate thus reflects the effects of economic policies both in a particular country and in its trading partners, as well as other developments. This rate is, therefore, not entirely under the control of the authorities and should be thought of as an intermediate target variable rather than a direct instrument of economic policy.

For some developing countries, the movements in real effective exchange rates in 1984 reflected the policy intentions of the authorities, acting in response to the need for external adjustment. For other countries, these exchange rate movements resulted from policies taken mainlv for domestic reasons, usually to reduce inflation and foster real output growth. In still other countries, they were the outcome of pegging arrangements in conjunction with the reluctance of the authorities to move the nominal rate in line with the difference between domestic and foreign inflation; thus, movements of exchange rates among the major currencies often played a role in determining the real effective exchange rates of the developing countries concerned.

The real effective exchange rates of about 45 percent of the 104 developing countries for which data are available depreciated in 1984; the remaining exchange rates appreciated. Of the total number of countries in the sample, 13 percent had a real depreciation of over 10 percent and about 17 percent a real appreciation of over 10 percent. Taking all the 104 developing countries together, the unweighted average real effective exchange rate remained approximately constant. A similar constancy of real effective exchange rates of the developing countries can be observed over the period 1982—84 as a whole.

For about 70 percent of the developing countries, the change in the real effective exchange rate during 1984 was less than 10 percent. A relatively large depreciation (at least 10 percent) was often associated with undertaking a comprehensive adjustment program which was sometimes supported by the use of Fund resources (Ghana, Uganda, and Zaïre). For some countries, depreciation was part of the continuing adjustment effort made necessary by high current account deficits in relation to exports of goods and services (Paraguay, Uganda, and Zambia) or high ratios of external debt and debt service to export earnings (Chile, Zambia, and Zaïre). For other countries, the real effective depreciation reflected, to some extent, the low rate of inflation relative to that of trading partners (China and Togo).

A relatively large appreciation of the real effective exchange rate (at least 10 percent) resulted from a variety of factors. For some countries it reflected a lag of nominal exchange rate adjustments behind bursts of domestic inflation (Bolivia and Guyana). Permitting the real exchange rate to appreciate substantially was also an indication that the authorities preferred other measures to adjust their current account balances, including the tightening of exchange and trade restrictions (Nigeria and Trinidad and Tobago). In some countries, the authorities delayed exchange rate adjustment because they were concerned, inter alia, with the effect of nominal exchange rate depreciation on inflation and income distribution (Egypt, Nigeria, and Tanzania); this was so, even where beneficial effects on external adjustment may have been expected. It may be noted that in a few countries the real appreciation in 1984 partially offset the depreciation of 1982-83, but still did not prevent substantial depreciation over the whole period 1982—84 (Cyprus, Malawi, and Mexico).

Differences among the exchange rate policies of individual developing countries can be explained in part by the structure of their foreign trade. Expectations regarding the effectiveness of a change in the exchange rate in influencing exports differ with respect to commodity groups. Most developing countries exporting primarily fuel products did not feel an acute need for exchange rate change in the face of declining export earnings. Foreign exchange earnings are not perceptibly influenced by the nominal exchange rate, the latter being important principally for determining the domestic currency counterpart (which has budgetary significance) and for influencing the non-fuel sector. Imports of raw materials and capital goods have varied mainly with public sector investment; at the same time, with the cushion of accumulated international reserves, there has not been pressure to reduce the importation of consumer goods. But among fuel exporters with a strong potential for non-fuel exports, whose supply is apt to be influenced by relative prices, active use of the exchange rate has been felt desirable, especially when accumulated foreign reserves were small in relation to imports and to debt service obligations. Among the latter group of fuel exporters, some (Indonesia, Mexico, and Venezuela) permitted their real effective exchange rates to depreciate substantially (15—28 percent) during 1982—84. Taken as a whole, however, the real effective exchange rate of fuel exporters appreciated during 1984 by a weighted average of 8½ percent (4¾ percent on an unweighted basis), as many of these countries continued to maintain relatively fixed nominal exchange rates with the U.S. dollar; this brought the cumulative appreciation of the weighted-average exchange rate over the period 1982-84 to 10 percent (11¾ percent, if unweighted).

For developing countries exporting mainly manufactured products, changes in the real effective exchange rate can have important effects on overall competitiveness. Since wages are an important part of production cost, variations in the foreign currency equivalent of domestic wage rates greatly affect profitability in the export and import-substituting manufacturing sectors relative to that in sectors producing nontraded goods, especially when prices of exports and import substitutes are set in international commodity markets without the individual country involved having a perceptible influence. In that case, a decline in the nominal exchange rate is often necessary to offset the effect of an excessive rise in wage rates on competitiveness in the export and import-competing sectors. The willingness of countries exporting manufactures to make active use of exchange rate policies is based not only on the perceived effects of such policies on domestic supply but is also related to the relatively high income elasticities of demand for their products in international markets. In 1984, countries exporting mainly manufactures experienced a real exchange rate depreciation of 5% percent (weighted average); seven of the ten countries in this relatively small group allowed their real effective exchange rates to depreciate.

The authorities in countries exporting primary products are traditionally less optimistic about the role of exchange rates in their export performance and see other factors as playing much more crucial roles in determining the volume of their exports. Among such other factors are international commodity agreements (e.g., for coffee, sugar, tin); regulated domestic producer prices (as in many sub-Saharan African countries where there are state marketing boards); economic conditions and agricultural protectionism in the industrial countries; and the level and efficiency of domestic investment in export industries and in infrastructure. While there is some basis for this view, it can sometimes be exaggerated because the exchange rate imposes constraints on the use of other instruments for influencing domestic supply. For instance, in the absence of adjustment of nominal exchange rates, the authorities are often reluctant, for budgetary reasons, to raise regulated domestic producer prices for export crops so as to keep pace with domestic inflation or to induce an expansion in production. Similarly, the efficiency of investment in export industries can be seriously compromised if foreign inputs are underpriced relative to domestic inputs as a result of an overvalued domestic currency. Moreover, in countries that are exporters of mineral products, wages are important in production cost, and movements in the exchange rate play an important role in profitability, output, and investment in the mineral subsector. Finally, many exporters of primary products have rapidly expanding manufacturing export sectors. For such countries, the role of the exchange rate is no less important than for countries now classified as exporters of manufactures. In any event, during the period 1982-84 countries exporting mainly primary products permitted their real effective exchange rates to depreciate less than did countries exporting mainly manufactures (see Chart 15) despite the greater relative deterioration of the current account ratio of primary product exporters during 1978-81. In 1984, exporters of primary products showed a depreciation of the weighted-average real effective exchange rate of only ¾ of 1 percent; fewer than half (45 percent) of the primary product exporters (57 countries in the sample) showed real effective exchange rate depreciation.

Chart 15.Developing Countries: Real Effective Exchange Rates by Predominant Export, 1977-841

(Indices, 1977 = 100)

1 These indices measure the evolution of a country’s prices relative to those of its trading partners, adjusted for exchange rate changes. Prices are measured by the average annual consumer price index, with indices of partner countries averaged by using import weights, and exchange rates are measured by an import-weighted index of average annual exchange rates. Group indices are GDP-weighted averages of country indices. For classification of countries in groups shown here, see Appendix IX.

The group of countries for which services and remittances constitute relatively important sources of foreign exchange earnings was about evenly divided between those with depreciating and appreciating real effective exchange rates in 1984; but, overall, the group experienced significant appreciation (by a weighted average of 6¾ percent).

There have been wide differences in the exchange rate experience of the developing countries in different regions in recent years, which to some extent mirror differences found among country groups classified by structure of foreign trade (Chart 16). For instance, exporters of manufactures are found chiefly in Asia and Europe; the bulk of the African countries are primary product exporters; 10 of the 16 Middle Eastern countries in the sample (of 104 countries) are fuel exporters. Since 1981, the real effective exchange rates of developing countries in Asia, Europe, and the Western Hemisphere have on average tended to depreciate, while those of Africa and the Middle East have appreciated. In 1984, the weighted average of real effective exchange rate indices in Africa and the Middle East rose by 5¾ and 10 percent, respectively, while the rates in Asia and Europe on average depreciated in real effective terms by 3½ and 6 percent, respectively; those in the Western Hemisphere showed a real effective appreciation of 1¼ percent in 1984.

Chart 16.Developing Countries: Real Effective Exchange Rates by Region, 1977-841

(Indices, 1977 = 100)

1These indices measure the evolution of a country’s prices relative to those of its trading partners, adjusted for exchange rate changes. Prices are measured by the average annual consumer price index, with indices of partner countries averaged by using import weights, and exchange rates are measured by an import-weighted index of average annual exchange rates. Group indices are GDP-weighted averages of country indices. For classification of countries in groups shown here, see Appendix IX.

EXCHANGE ARRANGEMENTS

The exchange rate regimes chosen by the developing countries have affected the way in which exchange rate fluctuations among major currencies have impinged upon their economies. In fact, movements in real effective exchange rates have differed markedly among countries according to the type of exchange arrangement. The nominal exchange rates of currencies that are pegged, especially those pegged to a single currency, have not, for the most part, been

adjusted enough to offset the influence of the effective depreciation or appreciation of the currencies or composite to which they are pegged. Hence, between 1979 and 1984 the currencies pegged to the U.S. dollar appreciated substantially in real effective terms (Chart 17). The currencies pegged to the SDR have also tended to appreciate significantly in real effective terms during this period, except for 1981.

Since 1973, when the major currencies began to float against each other, developing countries have paid increasingly close attention to the choice of their exchange rate regime. The evolution of exchange arrangements over the past six to ten years has been affected mainly by the desire for more frequent adjustment of nominal effective exchange rates or for greater control over the evolution of the real effective exchange rate. Over the last five to six years the evolution has been away from single-currency pegs toward flexible arrangements and, somewhat less so,

Chart 17.Developing Countries: Real Effective Exchange Rates by Exchange Arrangements, 1980-841

(Change from preceding year, in percent)

1Percentage changes for groups are unweighted averages of percentage changes in country indices. The indices measure the evolution of a country’s prices relative to those of its trading partners, adjusted for exchange rate changes. Prices are measured by the average annual consumer price index, with indices of partner countries averaged by using import weights, and exchange rates are measured by an import-weighted index of average annual exchange rates. Changes from each year to the following year are calculated for a constant sample of countries that observed the exchange arrangement in question in both years. For classification of countries, see Appendix IX.

toward pegging to currency composites, especially those reflecting individual countries’ trade weights (Table 11). Consistently with this desire for increased flexibility, the nominal effective exchange rate has depreciated markedly for currencies with flexible arrangements (Chart 18). The need for flexibility has been felt especially by countries with relatively high inflation rates, which have generally maintained exchange arrangements that permit frequent adjustment of nominal rates. In 1984, among 29 high-inflation countries2 only 5 were pegged to a single currency, compared with 28 for 50 medium-inflation countries and 18 for 46 low-inflation countries. In contrast, 20 of the high-inflation countries had flexible arrangements compared with 10 for medium-inflation and 9 for low-inflation countries.

Chart 18.Developing Countries: Nominal Effective Exchange Rates by Exchange Arrangements, 1980-841

(Change from preceding year, in percent)

1The nominal effective exchange rate of a country is an import-weighted index of average annual exchange rates of the trading partner currencies in units of the domestic currencies. Changes in group nominal exchange rates are unweighted averages of changes in country indices. Changes from each year to the following year are calculated for a constant sample of countries that observed the exchange arrangement in question in both years. For classification of countries, see Appendix IX.

Table 11.Developing Countries: Exchange Rate Arrangements, End of June 1979-851(Number of countries)
1979198019811982198319841985
Pegged to a single currency61585656545149
U.S. dollar41403838363331
French franc14141413131314
Other currency6445554
Pegged to composite27323234353540
SDR13151415141112
Other composite14171819212428
Flexible arrangements29283235363938
Adjusted according to
A set of indicators4344566
Other225252831313332
Total117118120125125125127

Based on mid-year classifications; excludes Democratic Kampuchea, for which no current information is available. For classification of countries, see Appendix IX.

This category comprises the following categories used in Table 12: “Flexibility limited vis-à-vis single currency,” “Managed floating,” and “Independently floating.”

Based on mid-year classifications; excludes Democratic Kampuchea, for which no current information is available. For classification of countries, see Appendix IX.

This category comprises the following categories used in Table 12: “Flexibility limited vis-à-vis single currency,” “Managed floating,” and “Independently floating.”

Table 12Exchange Arrangements as of June 30, 19851
Flexibility Limited vis-à-vis a SingleMore Flexible
Pegged toCurrency or Group of CurrenciesAdjusted
Single currencyCurrency compositeCooperativeAccording to aManagedIndependently
U.S. dollarFrench francOtherSDROtherSingle currency2arrangementsset of indicatorsfloatingfloating
Antigua andBeninBhutan (IndianBurmaAlgeria3Afghanistan3Belgium3Brazil4ArgentinaAustralia
BarbudaBurkina Fasorupee)BurundiAustriaBahrain4DenmarkChile3,4Costa Rica3Canada
Bahamas3CameroonThe GambiaGuinea3Bangladesh3Qatar4FranceColombiaEcuador3Dominican
BarbadosCentral African(poundIran, IslamicBotswanaSaudi Arabia5Germany,Peru3El Salvador3Republic
BelizeRepublicsterling)Republic ofCape VerdeUnited ArabFederalJamaica
BoliviaJordanChinaEmirates5Republic ofGreece
ChadLesotho (SouthIrelandPortugalGuineaBissauJapan
DjiboutiComorosAfrican rand)Italy6Somalia3,7IcelandLebanon
DominicaCongoSwaziland (SouthKenya8CyprusIndia9New Zealand
Egypt3EquatorialAfrican rand)RwandaFijiLuxembourg3Philippines
EthiopiaGuineaSào Tomé andFinland8NetherlandsIndonesiaSouth Africa
GhanaGabonPrincipeGuyanaIsrael
GrenadaIvory CoastSeychellesHungaryKoreaUganda
Guatemala3Sierra Leone3KuwaitMexico3United Kingdom
MaliMoroccoUnited States
HaitiNigerVanuatuMadagascarNigeriaUruguay
Honduras3SenegalViet NamMalawiPakistanZaïre
IraqTogoMalaysiaSpain
Lao People’sMaldivesSri Lanka
DemocraticMaltaTurkey
Republic3MauritaniaWestern Samoa
LiberiaMauritiusYugoslavia
Libyan ArabMozambique3
JamahiriyaNepal
Nicaragua3Norway
OmanPapua New Guinea
Romania
Panama
Paraguay3Singapore
St. Christopher andSolomon Islands
NevisSweden
St. LuciaTanzania
St. Vincent and theThailand
Grenadines
Tunisia
Sudan3Zambia
SurinameZimbabwe
Syrian Arab
Republic3
Trinidad and
Tobago
Venezuela3
Yemen Arab
Republic
Yemen, People’s
Democratic
Republic

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. The arrangement shown is that maintained in the major market.

Member maintains a system of advance announcement of exchange rates.

Exchange rates are determined on the basis of a fixed relationship to the SDR, within margins of up to ±7.25 percent. However, because of the maintenance of a relatively stable relationship with the U.S. dollar, these margins are not always observed.

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

The exchange rate is maintained within overall margins of ±7.5 percent about the fixed shilling/SDR relationship; the exchange rate is re-evaluated when indicative margins of ±2.25 percent are exceeded.

The exchange rate is maintained within margins of ±2.25 percent.

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

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. The arrangement shown is that maintained in the major market.

Member maintains a system of advance announcement of exchange rates.

Exchange rates are determined on the basis of a fixed relationship to the SDR, within margins of up to ±7.25 percent. However, because of the maintenance of a relatively stable relationship with the U.S. dollar, these margins are not always observed.

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

The exchange rate is maintained within overall margins of ±7.5 percent about the fixed shilling/SDR relationship; the exchange rate is re-evaluated when indicative margins of ±2.25 percent are exceeded.

The exchange rate is maintained within margins of ±2.25 percent.

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

The decision to permit greater flexibility of exchange rates was, in some countries, taken after a prolonged period of generally rigid pegging with only minor and infrequent adjustments of the nominal rate, despite high and rising domestic inflation (Ghana, Uganda, and Zaïre). For these countries, the exchange rates became seriously overvalued and sizable parallel markets developed outside of the official exchange systems. While it was clear, in each case, that the required adjustment of the rate would have to be large, it was not obvious what the correct level of the rate should be. Hence, it was decided to allow market forces to play a role in the determination of the rate. At the same time, there was a fear of substantial overshooting, given the narrowness of the exchange markets in these countries and the virtual absence of foreign assets of the monetary authority to be assigned to exchange market intervention. The concern with overshooting was increased by the fear of its adverse distributional effects on certain income groups. For these reasons, a modified floating system, usually involving multiple rates, was generally preferred to one of free floating for finding the new “equilibrium” rate. The two (or more) rates were generally unified at the free market rate once effective policies of demand management were put in place.

ROLE OF EXCHANGE RATE IN EXTERNAL ADJUSTMENT

The basic aim of external adjustment is to bring the current account balance to a level that is deemed sustainable over the medium term. For most developing countries, external adjustment over the period 1982—84 required improving the current account balance in relation to exports of goods and services (the current account ratio). A number of countries used direct controls and exchange restrictions to curtail imports of goods and services. The latter policies, especially when they are combined with domestic price controls, can limit the appreciation of the real effective exchange rate, and the deterioration of the current account, while failing to address the financial disequilibrium and the structural distortions of which weak current account performance is a symptom. To the extent, however, that current account improvements were brought about by adjustment policies rather than by trade and payments restrictions, the current account ratio can be taken as an indicator of the effectiveness of these policies.

Of 104 developing countries for which the requisite data are available, 36 experienced a worsening and 68 an improvement in the current account ratio between 1981 and 1984. Of the 36 countries whose current account ratio deteriorated, 25 experienced appreciation of their real effective exchange rates. Twenty-four of the 36 countries experienced a worsening in their fiscal balances (in relation to GDP) while, in all, 31 showed either an appreciation of the exchange rate or worsened fiscal balance, or both. This demonstrates the importance of the association between current account performance, the real effective rate, and the fiscal balance. But it should be underscored that other factors also had significant direct effects on the current account balance that did not operate through the real effective exchange rate or the fiscal balance. Among these were external factors such as worsening terms of trade or fall in foreign demand for exports. Also important were domestic factors such as faulty domestic producer pricing policies, disturbances and disruptions to normal productive activities, and unfavorable weather for agricultural export crops.

The importance of other factors in current account performance can be seen from the fact that 36 of 61 countries whose real effective exchange rate appreciated between 1981 and 1984 experienced an improvement in their current account ratios between the two dates, and among 35 countries with real effective exchange rate appreciation of at least 10 percent, 17 countries (including Bolivia, the Congo, Egypt, Haiti, the Libyan Arab Jamahiriya, Malaysia, Nigeria, and Sierra Leone) improved their current account ratios. Various factors appear to have contributed to such favorable current account developments in the face of real effective exchange appreciation, including increased exchange and trade restrictions in a number of these countries, as well as substantial improvements in fiscal balances and increased efficiency in the supply of exports in some of them.

Of the 68 countries (in the sample of 104 developing countries) that improved their current account balances in relation to exports between 1981 and 1984, 32 experienced real effective exchange rate depreciation during this period. Forty-five countries of the 68 improved their fiscal balances (in relation to GDP) and, in all, 54 countries had either a depreciation of the real effective exchange rate or improved fiscal balance or both.

Between 1981 and 1984, there were 43 countries with depreciating real effective exchange rates. For 32 of these countries, the current account ratio improved between the two dates. There were, therefore, 11 countries that realized deteriorating current account ratios despite real effective exchange rate depreciation. The reasons for this varied among countries. For some countries the authorities were reluctant to take measures to realize a real effective exchange rate depreciation large enough to counteract other factors, especially those emanating from the international economy, that were having an unfavorable impact on the current account. In some of these countries the authorities may not have felt a strong need for adjustment, owing to such factors as a reasonably strong foreign reserve position, the availability of capital inflows from abroad, and the expectation of an early reversal of the adverse developments that had caused the current account deterioration in the first place. In a few countries the real effective exchange rate depreciated sharply only in 1984, after appreciating in 1982 and 1983, while other adjustment measures had also been inadequate; given the lag between exchange rate changes and their effect on the current account, the real depreciation appears to have come too late in these countries to prevent the worsening of the current account ratio over the whole period.

In recent years, the need for adjustment has been particularly acute among the major borrowers. These countries, like some others, have diversified economies that respond in a fairly elastic way to relative prices. In these circumstances, more active use of the exchange rate for external adjustment was generally considered appropriate. From 1981 to 1984, the unweighted average of the real effective exchange rates of these countries dropped markedly—on average by over 13 percent (Chart 19). For other market borrowers and for official borrowers, real effective exchange rates appreciated after 1981. For the official borrowers (excluding China and India), the appreciation accumulated to 4½ percent during the period 1982-84. For the other market borrowers, the real effective exchange rate appreciated by somewhat less than 4 percent in 1984, thereby just wiping out depreciations in 1982 and 1983. Between 1981 and 1984 the current account ratio improved for 6 of the 7 major borrowers, compared with 19 of the 26 other market borrowers and 24 of the 42 official borrowers, in the sample of 104 countries; 29 countries in the sample were not classified as borrowers.

Chart 19.Developing Countries: Real Effective Exchange Rates by Financial Criteria, 1977-841

(Indices, 1977 = 100)

1The indices measure the evolution of a country’s prices relative to those of its trading partners, adjusted for exchange rate changes. Prices are measured by the average annual consumer price index, with indices of partner countries averaged by using import weights, and exchange rates are measured by an import-weighted index of average annual exchange rates. Group indices are unweighted averages of country indices. For classification of countries in groups shown here, see Appendix IX.

SURVEILLANCE

As exchange rate developments in recent years show, discordance in policy strategies and performance among countries can lead to misalignment in the pattern of exchange rates. Through the exercise of surveillance over its members’ policies, the Fund aims at reducing such discordance in a manner that is consonant with the achievement of sustained non-inflationary growth. The Fund also encourages members that manage their exchange rates to follow a flexible exchange rate policy consistent with the need for balance of payments adjustment. These surveillance activities are conducted according to the prin ciples and procedures for surveillance set forth in the document entitled “Surveillance over Exchange Rate Policies.”3

In its annual review of the general implementation of surveillance over members’ exchange rate policies conducted in March 1985, the Executive Board once again emphasized the great importance that it attaches to the surveillance function of the Fund.4 Much of the discussion was focused on the effectiveness of surveillance in the current international economic environment. The Board noted the important role that surveillance had played in bringing key policy issues to the attention of the relevant authorities and keeping them under active discussion. In many instances, policy decisions in member countries clearly had taken account of the views expressed by the international community through the Fund’s surveillance process. More generally, however, the Board stressed that there remained substantial divergences between the policies actually pursued by some member countries and those advocated by the Fund membership collectively. It also stressed that, while the Fund should continuously endeavor to sharpen its analysis and to improve its procedures, the basic problem was neither analytical nor procedural; rather, it had to do with a lack of determination in implementing policy strategies that were framed in the light of their international compatibility.

A related point discussed by the Executive Board during the 1985 review concerned the evenhandedness of surveillance, which was considered essential for its effectiveness. While Directors noted the view that the Fund was much stricter in its surveillance over the policies of developing countries that were in deficit than over those of other countries, they ascribed it largely to an insufficient distinction between the function of surveillance and other functions of the Fund, such as the implementation of conditionality and the Fund’s jurisdiction over exchange restrictions. These other functions do imply special responsibilities for the Fund. For example, the Fund has the responsibility to see that its resources are used in support of effective adjustment, and member countries that seek the Fund’s financial support have therefore to arrange their policies so as to qualify for such support according to the criteria used by the Fund. It is thus inevitable that the Fund has a stronger direct influence on the policies of countries that undertake Fund-supported adjustment programs than on the policies of other countries. This asymmetry can, however, be greatly attenuated by strengthening the effectiveness of surveillance over the policies of all member countries. Because of the strong effects of developments in major industrial countries on the rest of the world, more effective surveillance for those countries would improve the international monetary system as a whole.

In the course of the review, the Board considered various possible avenues for improving the effectiveness of surveillance. The Interim Committee, too, discussed these matters at its meeting in April 1985. In its conclusions, the Committee urged that steps be taken to strengthen surveillance over the policies of all Fund members. It also urged that consideration be given, within the context of the policy of uniform treatment of members, to means of increasing the effectiveness of surveillance over the policies of those industrial and developing countries that have a significant effect on the functioning of the world economy.

Through its Article IV consultations, bilateral meetings, and the participation of the Managing Director in international meetings, the Fund has communicated its views to the authorities concerned and highlighted the unfavorable effects of existing policy weaknesses on the international community. In addition, the Fund has taken a strong public stance in this context, especially through its publications and the speeches of the Managing Director. In particular, the Fund has stressed that the unfavorable consequences of policy weaknesses in major industrial countries are felt with severity by developing countries. While developing countries should continue their adjustment efforts, the major industrial countries need to improve their policies and thereby contribute to the global adjustment process.

THE SUBSTANCE OF SURVEILLANCE

An assessment of the effectiveness of surveillance, of possible areas of weakness, and of feasible improvements must be based on an analysis of the factors and policies that have led to the emergence and persistence of the severe problems that plague the world economy. Such analysis has been a major aspect of each annual review of Fund surveillance since the first review in 1979, as well as of each Board discussion of the world economic outlook since that time. The main conclusions reached during these reviews and discussions have been presented in previous Annual Reports. Nonetheless, at this time of renewed search for ways of improving the effectiveness of surveillance, it is useful to pull together these various conclusions and reassess them in the light of recent developments.

It is clear from the above discussion of the factors behind the pronounced movements in exchange rates among major industrial countries that these movements cannot be viewed as prima facie evidence of a lack of effectiveness of surveillance. In particular, some of these exchange rate movements may be the normal consequence of economic developments and policies—magnified perhaps by increased integration of national financial markets, which per se is a welcome evolution—rather than the result of faulty economic policies or of capricious behavior of private market participants. Changes in perceptions of a currency as a “safe haven” and in prospects for returns on investments in particular currencies may also cause substantial movements in exchange rates. Reactions to new developments take place rapidly in financial markets so that, with the rising volume of financial transactions, exchange rates tend to be volatile. Even more important, since reactions to price changes in markets for goods and labor, which are important determinants of long-run exchange rate trends, are much less rapid than those in financial markets, exchange rates at times deviate for lengthy periods and in substantial degree from their long-run trend values. The task of surveillance begins when there are reasons to believe that unwelcome economic developments, including exchange rate changes, are the result of inappropriate policies. In this context, the Fund has for some time stressed the need for each country to follow a policy strategy that is both stable and balanced. It should be stable because frequent changes in policies will inevitably lead to frequent changes in the exchange rate. Moreover, in the absence of predictable policies, views regarding the longer-run trend value of the exchange rate may be so weakly held that the rate may become subject to self-sustaining speculative effects. From a domestic standpoint, frequent changes in policies may destabilize output and prices, and may ultimately hinder rational decision making by private economic agents. The policy strategy should, moreover, be balanced because a lack of harmonious coordination of various policy instruments results in economic tensions that are apt to manifest themselves in a waste of domestic resources and in external imbalances. In any case, an unbalanced combination of policies is unlikely to be stable, because the pressure for a change in policies is bound to grow as their unfavorable effects become more obvious.

In principle, the desirability of a policy strategy that is stable and balanced is not contested. The problem is that in practice the authorities often find it difficult to pursue such a strategy. For instance, removal of rigidities in markets for goods and labor is often unpopular, if only because the benefits and costs resulting from the removal may fall unevenly on social groups of different political strength. Again, the reduction of fiscal deficits, which generally entails unpopular measures, requires difficult budgetary decisions—whether to raise taxes or to lower government spending, and which components of these revenues or expenditures to alter. Such questions clearly go beyond the realm of economic efficiency and have important political dimensions.

Furthermore, it is often difficult to know what the appropriate policy measures are. For instance, a number of observers have focused attention on the effects of shifts in international currency preferences on exchange rates. It can be argued that the monetary authorities should accommodate these shifts when they are unrelated to the fundamental determinants of exchange rates rather than accept large temporary exchange rate movements that would disturb resource allocation in the markets for goods and labor. At the limit, a stable monetary strategy could be interpreted as one that allows the monetary aggregates to change in order to reflect shifts in external demand for the currency. In practice, however, it is not always clear whether an exchange rate movement is the consequence of a shift in currency preferences or of more fundamental developments. Moreover, even when such a shift can be identified, a policy of accommodation may not be without danger: for example, an expansion of the monetary aggregates undertaken to meet a rise in foreign demand may be misinterpreted by domestic residents and lead to a rise in inflationary expectations. It could thus be inappropriate for national authorities to attempt systematic accommodation of international currency shifts. At the same time, the exchange rate movements, apart from signaling shifts in external demand for a currency, may at times also provide a presumptive indication that previously undetected domestic developments, possibly resulting from structural changes in the financial system, warrant a reassessment of the monetary targets.

Foreign exchange market intervention, although sometimes itself a source of volatility, may at times play a useful role in dampening, or even stopping, speculative exchange rate movements, especially if the intervention is decisive, concerted among the major countries, and properly timed. For example, the concerted intervention by a number of major industrial countries in February 1985 seems to have been instrumental in arresting the rise of the U.S. dollar. However, as stated in the report of the working group on exchange market intervention,5 there is much evidence that sterilized intervention does not generally have a lasting effect. Ultimately, any serious attempt to achieve greater exchange rate stability has to rest on the implementation of more appropriate and internationally compatible economic policies.

In this context, it is noteworthy that the countries participating in the exchange rate arrangements of the EMS have been largely successful in stabilizing exchange rates among their currencies. This success has been achieved mainly through a convergence of their domestic policies and performance, with the countries suffering from relatively high inflation making a major adjustment effort in order to reduce their inflation rates to the level prevailing in the relatively low-inflation countries. Nonetheless, there is little doubt that the commitment of the authorities to the defense of the central rates and the agreed intervention mechanisms have contributed to the success of the system. While the EMS system could not easily be extended or reproduced elsewhere, its success under the circumstances in which it operates may offer encouragement to those searching for greater stability of exchange rates in the world economy.

Timely adjustment is as important for developing countries as for developed countries. Delay in taking appropriate measures results in unnecessary loss of foreign reserves, in a worsening of the structure of the country’s debt, and often in large accumulation of external arrears. Stop-gap borrowing is normally possible only on rather unfavorable terms with respect to both interest payments and repayment periods. Postponing adjustment also aggravates distortions in the structure of domestic production caused by inefficient pricing and the use of direct controls. In addition, an unwelcome consequence of the continuation of inappropriate policies is often a decline in private capital inflows and in domestic investment. When the delayed adjustment is finally undertaken, it may have to be large and rapid, and therefore more costly to output and employment in the short term and less beneficial over the medium term than if more timely and resolute policies had been put in place.

Achievement of timely adjustment in developing countries depends very much on the appropriate combination and phasing of the various policy instruments used in the adjustment program. Adjustment problems typically arise in circumstances in which a country has come to use more resources than are available within its own borders. The need to curtail public and private demand for goods and services is therefore usually the centerpiece of an adjustment program. Demand-management policies must, of course, reflect the particular social and political, as well as economic, circumstances of the country. Moreover, they should be used in such a way as to avoid or minimize any adverse influence on the overall supply of goods and services, for instance, through a negative impact on the level and efficiency of private investment, lest they undo the effect of any supply-enhancing policies contained in the program. In turn, policies to increase domestic output should be, as far as possible, designed so as to avoid raising overall domestic demand in order not to conflict with the aims of the demand-management policies included in the policy package. To the extent that these tasks—constraining demand and augmenting production—are to be accomplished simultaneously through a rearrangement of market incentives, a shift of relative prices will often be required.

In the short run, an adjustment of the exchange rate, when needed, can improve the allocation of scarce foreign exchange resources in the economy. In the longer run, the effects of exchange rate adjustment on relative prices can improve the allocation of economic resources in general in line with the true scarcity value of foreign resources. When nominal wages are inflexible and cannot easily be lowered, exchange depreciation supported by restrictive monetary policies can reduce the budgetary contraction required to achieve a given improvement in the current account balance. In this way, exchange rate adjustment can contribute to a more favorable situation with respect to output growth and employment than could have been reached if the same external adjustment had been attained through larger budgetary contraction with an unchanged exchange rate.

The choice of adjustment policies must be guided by the effectiveness of different measures in improving the current account balance and promoting long-term capital inflows. Since various measures affect these elements of external adjustment at different speed and in different degree, the size and timing of the required adjustment plays a role in determining the optimal combination of policies at any given time. Indeed, an important reason for timely adjustment is that it permits a much broader range of instruments to be applied, compared with a situation in which the adjustment need has become a matter of emergency. Timely adjustment can, in consequence, permit a better policy design, fostering a more even growth of economic welfare over time, than could be achieved if adjustments were initially delayed.

Flexible management of exchange rate policy can increase the effectiveness and efficiency of other supply policies, including producer pricing policies and the structure of government investment. As stressed before in this Report, the exchange rate often imposes constraints on the efficient use of certain other supply policy instruments. For example, producer prices can affect the domestic supply of export crops; needed increases in these prices are often resisted unless the nominal exchange rate is allowed to depreciate at the same time, because at a given exchange rate the profitability of marketing boards would tend to be impaired, at least in the short term. The relative use of domestic and foreign inputs also tends to be distorted when the exchange rate is kept at an inappropriate level.

Flexibility of the nominal exchange rate is of particular relevance when the external disequilibrium to be corrected has been caused mainly by domestic financial developments. This tends to be true, for example, in countries with substantial inflation, where fiscal disequilibrium and rapid domestic credit expansion result in serious pressure on the balance of payments. In the absence of continuous revision of the nominal exchange rate, the real effective exchange rate in such countries soon becomes inappropriate and harmful to economic development prospects.

Adjustments in the real exchange rate can be especially effective in correcting payments imbalances for countries that are producing exportables with relatively high supply elasticities or countries that are in the process of promoting export diversification and a shift toward the supply of goods benefiting from longer-run favorable demand prospects in the world market. Whether disturbances requiring external adjustment come from international or domestic factors, adjustment of the real exchange rate recognizes the changed economic opportunities confronting the country. The ability to alter the real effective exchange rate in such circumstances is a crucial element in adjustment.

The implication is that the typical developing country should aim at keeping its real effective exchange rate at a level that facilitates attainment of its potential output growth and a sustainable current account balance. The nominal exchange rate should then be changed as frequently as needed to maintain the desired real effective rate, taking into account the circumstances of the country, particularly its ability to use monetary and fiscal instruments to keep domestic prices in check. The choice of exchange arrangements should be made with a view to providing the needed exchange rate flexibility.

External adjustment by the developing countries needs to be supported by an adequate flow of appropriate financial resources. Beyond exercising surveillance over the policies of these member countries, the Fund has continued to encourage commercial banks to provide financing in support of Fund-assisted adjustment programs. In particular, the Fund has welcomed recent examples of multiyear debt rescheduling arrangements for countries that have already achieved solid progress in their adjustment efforts. The Fund has also stressed the primary need, particularly for the low-income developing countries, for an increase in the volume of foreign aid and its effective utilization. This is especially true for sub-Saharan African countries that are severely affected by the current drought. Many low-income developing countries face debt-servicing problems even though much of their debt is owed to official creditors. The Fund has often assisted in the process of official debt rescheduling within the framework of the Paris Club in support of adjustment programs involving the use of Fund resources. So far, most of these reschedulings have been made one year at a time. The Paris Club has, however, recently started to conduct multiyear reschedulings, in close cooperation with the Fund, when debtor countries have a proven record and continuing prospects of sound adjustment.

Ultimately, an open multilateral trading system remains the most important requirement for a gradual improvement of the international economic situation. Although there have recently been some favorable developments in this respect, the overall trend toward protectionism can hardly be considered as having been checked, let alone reversed. The Fund is extremely concerned with this evolution and has focused in its recent work on the issue of protectionism and how it relates to problems in the areas of fiscal policy and structural adjustment. It has also highlighted the importance of this issue in all its surveillance activities and has continued its close collaboration with the Contracting Parties to the General Agreement on Tariffs and Trade.

PROCEDURES

The basic vehicle for the Fund’s surveillance continues to be the Article IV consultation. In recent years, the Fund has been successful in its efforts to ensure that consultations with all members are held regularly. Article IV consultations normally take place annually but there could be a longer interval—up to two years—for some members, and shorter cycles may be requested in some circumstances. The annual cycle is, however, required for countries whose developments have a substantial effect on other members, for countries with Fund-supported programs, and for countries for which there are questions about balance of payments viability. At the time of the 1985 review of surveillance, the Executive Board stated that at least the 25 Fund members with the largest quotas should be regarded as countries whose developments have a substantial effect on other members. In the new system of advance specification of consultation cycles instituted in 1983, the length of the consultation cycle or the date for the next consultation is specified at the conclusion of each consultation. As a result of the new system, the consultation frequency has risen sharply in the past two years, with 80 percent of the membership covered both in 1983 and in 1984. At the end of 1984, there were only 4 members without consultation for two years or more, compared with 6 at the end of 1983 and 19 at the end of 1982.

The analytical content of Article IV reports has been considerably broadened and adapted to the requirements of surveillance in recent years. In particular, international economic linkages and issues related to trade and protectionism have been increasingly emphasized. Moreover, Article IV consultations have stressed the need to discuss with member countries the medium-term implications of their policies. Since 1983, consultation reports for almost all countries in which external indebtedness is a significant issue have included a description of the medium-term external debt outlook. More recently, the medium-term analysis has been expanded to include the sensitivity of the debt projections to alternative assumptions and to examine the evolution of important components of the balance of payments. Even for countries in which external indebtedness is not a major issue, including many industrial countries, the need to analyze the internal coherence and chance of success of the whole medium-term policy strategy of the authorities has led to the introduction of medium-term scenarios in consultation reports.

Another major surveillance issue is the need for structural adjustment. This need has, of course, always been recognized in the Fund’s work with developing countries. There is, however, a new emphasis on these issues in industrial countries. This emphasis reflects mainly the earlier experience with inflation at times of economic slack and, most recently, the persistence of fiscal deficits and unemployment in many industrial countries. These latter problems are often intimately related through the effects of low economic activity on tax receipts and on government financial support for ailing industries and unemployed workers.

Among the innovations in the content of staff reports made in 1984, two can be singled out. The first was the inclusion in most staff reports on developing countries of material describing the country’s relations with the World Bank, in many cases including the Bank’s assessment of the investment or development program and other policy issues studied by the Bank. The second was a review of recent developments and policies against the background of the conclusions of the previous consultation. In particular, care was taken to explore whether the country had implemented the Executive Board’s recommendations and whether further developments supported the case for these recommendations.

The continuous efforts by the Fund to adapt its surveillance procedures has also led to a new procedure, usually referred to as enhanced surveillance. This procedure is still evolving and has been adopted for only a few countries in the context of multiyear rescheduling arrangements. In those cases in which it has been adopted, the country concerned has taken the initiative of requesting the Fund to monitor its policies through more frequent Article IV consultations. The new procedure has facilitated negotiation of multiyear rescheduling arrangements for several members, which have been aimed at helping members make the transition to normal access to bank lending. While enhanced surveillance can support banks’ risk assessment, it is in no way a substitute for independent economic evaluations by commercial banks, which retain full responsibility for their credit decisions based on their own assessments.

Fund participation in multilateral meetings with governments and with other international organizations remains another major channel for Fund surveillance. The Managing Director has participated in meetings between the finance ministers of the five major industrial countries, which provide an important opportunity for discussion of world economic developments and international policy coordination. The Group of Ten has also played an important role over the past year in serving as a forum for discussion of new approaches to surveillance. The report of the deputies of the Group of Ten on the functioning of the international monetary system, which was released in June 1985, contains findings with respect to strengthening surveillance, as well as the functioning of floating exchange rates, the management of international liquidity, and the role of the Fund. The Group of Twenty-Four is reviewing issues relating to the conduct of surveillance, especially those concerned with the relations between industrial and developing countries. The Interim Committee will give preliminary consideration to these matters at its next meeting in October 1985.

Fund surveillance activities rest on a large amount of supporting work. In particular, the Fund continuously monitors its members’ exchange rates and exchange rate policies. Since 1983, the Executive Board has been notified regularly of all sizable changes in real effective exchange rates. Information notices generally include appraisals of the exchange rate developments reported. So far, information notices have not led to Board discussions, though they have often served to sharpen the focus of discussion of exchange rate policy when a Board meeting concluding an Article IV consultation or discussing the use of Fund resources was scheduled shortly after the issuance of an information notice.These new monitoring procedures supplement the existing system, implemented in 1977, according to which any change in a member’s exchange arrangements must be communicated to the Fund within three days.

Even more importantly, the Fund’s surveillance activities benefit from the comprehensive analyses of the world economy provided in the world economic outlook exercise. Besides serving as the focus of the Fund’s consideration of questions of international policy interactions and economic linkages, the papers prepared for this exercise provide short-term forecasts and a medium-term perspective that serve as reference points for the Fund’s work on issues involving individual countries. In 1984 and the first half of 1985, a major topic of the discussion on the world economic outlook was the medium-term prospects for growth in industrial countries and the likely consequences for developing countries. The aim of the analysis was to delineate the adjustment policies that are needed in each group of countries.

RECENT CHANGES IN REPORTED EXCHANGE ARRANGEMENTS

The trend toward the adoption of more flexible exchange arrangements continued in 1984 and the first half of 1985. A major new development in this period has been the adoption of independently floating exchange rates by a number of developing countries. Another feature of the movement toward increased flexibility of exchange arrangements has been the shift away from arrangements of “limited flexibility”—quasi-pegs to a single currency, which in all instances was the U.S. dollar—toward pegging to currency composites, including the SDR. Of the 15 members that changed their exchange arrangements in 1984 and the first half of 1985, 6 adopted arrangements of independent floating. El Salvador, which had maintained its currency pegged to the U.S. dollar, was reclassified as operating managed floating arrangements. Peru moved from a managed float to an arrangement under which the currency is adjusted according to a set of indicators. Guyana, Maldives, and Thailand, which had previously maintained their currencies with limited flexibility against the U.S. dollar, and Malawi, whose currency had been pegged to the SDR, adopted as pegs currency composites tailored to reflect the relative importance of their trading partners. Sierra Leone changed its pegging arrangement from the U.S. dollar to the SDR, while Equatorial Guinea changed its currency from the Spanish peseta to the French franc. In addition, 2 new members informed the Fund of their exchange arrangements: St. Christopher and Nevis has been classified within the group of countries whose currencies are pegged to the U.S. dollar and Mozambique within the group of countries whose currencies are pegged to a currency composite other than the SDR. As a result of these changes, the number of Fund members with “more flexible” exchange arrangements increased from 38 at the end of 1983 to 40 at the end of June 1985, and members whose arrangements are labeled as “independently floating” increased from 8 to 14 over this 18-month period. One industrial country (New Zealand) and 5 developing countries (the Dominican Republic, Jamaica, the Philippines, Uganda, and Zaïre) formally adopted floating rate arrangements in unitary exchange markets. The number of countries with currencies pegged to a single foreign currency decreased from 51 to 50, while the number of those pegging to a composite of currencies increased from 39 to 44. Arrangements in the “limited flexibility” category declined from 17 to 13.

From the inception of the present classification system in December 1981 to June 1985, the proportion of Fund members with “more flexible” arrangements, including members maintaining a cooperative arrangement under the EMS, has risen from 28 percent to 33 percent, while that of members with single-currency pegs (including arrangements under which there is limited flexibility vis-à-vis a single currency) declined from 47 percent to 37 percent. The proportion of members pegging to currency composites increased from 25 percent to 30 percent in this period (with the proportion of arrangements classified within the “other currency composite” subcategory increasing from 16 percent to 22 percent).6

At the end of June 1985, 50 member currencies were pegged to a single currency, 12 to the SDR, and 32 to other currency composites; 40 members maintained exchange arrangements in the “more flexible” category; and 13 members maintained arrangements of limited flexibility (Table 12).

International Liquidity, Reserves, and Financial Markets

During 1983 and 1984, reserve movements were strongly affected by the efforts of many countries to rebuild their reserve holdings following the losses of foreign exchange reserves in 1982. For many developing countries, this reserve accumulation has occurred during a period of sharply reduced access to international financial markets. The expansion of reserve holdings entailed changes in the types of assets held as reserves, in the currency composition of foreign exchange holdings, and in the sources of reserve growth.

This section examines a number of recent developments in international liquidity and reserves. First, there is consideration of the changes in international monetary arrangements that may have made the stock of international reserves more a reflection of the economic policies and reserve preferences of individual countries than an exogenous constraint on countries’ policies. Second, there is a review of the recent evolution of holdings of official reserve assets. Third, the currency composition and distribution of international reserves and liquidity are examined. Fourth, the sources of reserve growth are reviewed, with special emphasis on the role of private international financial markets in the provision of international liquidity and the financing of the adjustment process, and on the importance of current account imbalances as sources of reserves. Finally, there is a discussion of the adequacy of international reserves and the role of the Fund in the provision of international liquidity through conditional credit and SDR allocation.

THE ROLE OF RESERVES IN THE INTERNATIONAL MONETARY SYSTEM

The role of reserves in the international monetary system has gradually evolved in response to a number of developments fostering the perception that reserves are no longer determined primarily by forces or policies external to the operations of the monetary system but rather reflect the economic policies and reserve preferences of individual countries, including those of reserve currency countries. Under the gold standard, the relatively fixed stock of gold and the commitment of many countries to making their currencies convertible into gold imposed a constraint on the issuance of domestic money and thereby on the levels of prices and economic activity in individual countries. In contrast, the link between the stock of gold on the one hand and prices and output on the other hand was less direct under the gold exchange standard, in part owing to the more active use of credit arrangements as a source of reserves and restrictions on gold convertibility. Since countries could increase their reserve holdings by acquiring claims on reserve-currency countries, an important component of total reserves could respond to the policies of countries. Nonetheless, the possibility of gold conversion at times influenced the policies of even the reserve-currency countries.

The current multicurrency reserve system represents the cumulation of an evolutionary trend in which the importance of the level of reserves as a constraint upon policy has progressively declined for countries having access to international financial markets and, in particular, for the reserve-currency countries. The suspension of convertibility of the U.S. dollar and the collapse of the system of fixed exchange rates were further—and definitive—steps in that evolution because the collective demand for reserves no longer reflected the need to meet conversion and intervention obligations. Of course, these developments did not imply that national authorities no longer wished to hold gold and other reserve assets.

With the weakening of the reserve constraint, countries sought other ways to guide their economic performance, individually and collectively. In the major industrial countries, for example, the post-1971 system relied heavily on targets for monetary and credit aggregates. Such control techniques did not, of course, appear de novo; they were increasingly experimented with as the system evolved toward the climactic events of the early 1970s. Moreover, the widespread adoption of floating in no way implied that a country’s policy choices had no effects beyond its own borders. On the contrary, experience since 1971 reinforces the view that countries have common interests in setting their economic policies; these interests manifest themselves in a number of ways, for instance, in growing support for international surveillance over these policies.

Under the current system, the total stock of reserves can to some extent adjust to changes in the demand. This supply response is not constrained by forces outside the international monetary system even though supplies of specific reserve assets may be fixed. Countries with access to international capital markets have often found borrowing from private financial institutions an efficient means of obtaining additional foreign exchange reserves. An individual country can acquire reserves at a net cost equal to the rate at which it can borrow (inclusive of the risk premium) less the deposit rate paid on reserves (or the yield on securities).7 However, a significant number of developing countries do not have access to the international credit markets and such countries can acquire reserve additions only through a surplus in their current accounts or through intergovernmental borrowing.

The supply of foreign exchange reserves for countries with access to credit markets is not necessarily tied to the structure of current account balances of any group of countries (including the reserve-currency countries). The counterpart of a given country’s current account deficit is the accumulation of domestic assets by foreign entities or the sale of foreign assets by domestic residents. This exchange of assets could be undertaken either by the private sector (which would not directly lead to reserve accumulation) or by the authorities (which can reflect intervention activity in the foreign exchange market and can thereby result in reserve accumulation).

For countries that do not have access to international capital markets, the process of reserve acquisition is different from that described above. These countries often face a high real cost of accumulating reserves associated with the adjustments of domestic macroeconomic and exchange rate policies needed to achieve a balance of payments surplus. For these countries, reserve holdings can at times correspond to minimal working balances.

The remainder of this chapter examines a number of recent aspects of the continuing evolution of the multicurrency reserve system. In addition to a discussion of movements in holdings of reserves, there is also consideration of the changes in the composition of foreign exchange reserves, the sources of reserve growth, including current account balances and international financial markets, and the adequacy of reserves and international liquidity.

RECENT EVOLUTION OF OFFICIAL RESERVE ASSETS

In 1984, total international reserves measured in terms of the SDR declined by about 1 percent, as a fall in the market value of official holdings of gold was almost completely offset by an increase in holdings of non-gold reserves. The growth of non-gold reserves reflected larger holdings of both Fund-related reserve assets and foreign exchange reserves by both of the major country groups, industrial countries and developing countries. The fall in the value of official holdings of gold reflected both a small reduction in the quantity of official gold holdings and a 14 percent decline in the market price of gold in terms of the SDR. Out of the SDR 701 billion of total reserves at the end of 1984, two thirds was held by industrial countries and one third by developing countries.

NON-GOLD RESERVES

Non-gold reserves increased by 12 percent in 1984, to SDR 403 billion at the end of the year (Table 13). Following a 1 percent decline in non-gold reserves in 1982, these reserves have grown at an annual rate of 11 percent in the period 1983-84, slightly less than than the annual growth rate of 13 percent in the period 1973-81.

The expansion of non-gold reserves by SDR 42 billion in 1984 reflected an increase of SDR 4.5 billion (8 percent) in the holdings of Fund-related reserve assets and an increase of SDR 38 billion (12 percent) in foreign exchange reserves. Both major country groups increased their holdings of non-gold reserves in 1984: industrial countries by SDR 20 billion (10 percent), and developing countries by SDR 23 billion (14 percent).

FOREIGN EXCHANGE RESERVES

Foreign exchange reserves increased by 12 percent (SDR 38 billion) in 1984 to SDR 345 billion at the end of the year (Table 13). Although this expansion of foreign exchange reserves was somewhat slower than the average rate of growth for the period 1973-81 (14 percent), it represented a further acceleration in the growth of foreign exchange reserves following a decline of 3 percent in 1982 and an increase of 8 percent in 1983. While total holdings of foreign exchange reserves grew by SDR 38 billion, the industrial countries accounted for nearly half of this increase as their holdings rose by SDR 16 billion. Among the countries in this group, Spain experienced the largest increase in foreign exchange reserves (SDR 5.0 billion), following an exchange rate depreciation and implementation of restrictive demand-management policies. Other industrial countries with significant accumulations of foreign exchange reserves were Norway (SDR 3.2 billion) and Japan (SDR 3.3 billion).

Table 13.Official Holdings of Reserve Assets, End of Selected Years 1979-84 and End of March 19851(In billions of SDRs)
March
1979198019811982198319841985
All countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund11.816.821.325.539.141.640.9
SDRs12.511.816.417.714.416.516.7
Subtotal, Fund-related assets24.228.637.743.253.558.057.6
Foreign exchange249.7292.9292.7284.2307.0345.0328.8
Total reserves excluding gold274.0321.6330.4327.4360.6403.1386.5
Gold2
Quantity (millions of ounces)944.4953.0953.3948.7947.4946.3947.3
Value at London market price367.1440.5325.5392.9345.2297.6314.6
Industrial countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund7.710.713.517.125.627.226.6
SDRs9.38.911.914.111.513.413.9
Subtotal, Fund-related assets17.119.625.531.137.140.640.5
Foreign exchange136.1164.7159.6153.2167.5183.9176.3
Total reserves excluding gold153.2184.3185.1184.4204.6224.5216.8
Gold2
Quantity (millions of ounces)789.1787.9787.6787.3786.6786.0786.3
Value at London market price306.7364.2269.0326.1286.6247.2261.2
Developing countries3
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund4.06.17.88.413.614.314.3
SDRs3.22.94.53.72.93.12.8
Subtotal, Fund-related assets7.29.012.312.116.517.417.2
Foreign exchange113.6128.2133.1131.0139.5161.1152.5
Total reserves excluding gold120.8137.2145.3143.1155.9178.5169.7
Gold2
Quantity (millions of ounces)155.4165.1165.6161.4160.8160.3161.1
Value at London market price60.476.356.666.858.650.453.5
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. For classification of countries in groups shown here, see Appendix IX.

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.

In previous Annual Reports, data on the reserve holdings of oil exporting and non-oil developing countries were reported separately. The corresponding figures for 1983 and 1984 are as follows:

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. For classification of countries in groups shown here, see Appendix IX.

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.

In previous Annual Reports, data on the reserve holdings of oil exporting and non-oil developing countries were reported separately. The corresponding figures for 1983 and 1984 are as follows:

Oil ExportingNon-Oil Developing
CountriesCountries
1983198419831984
Total reserves(In billions of SDRs)
Fund-related assets
Reserve positions in the Fund11.312.62.31.7
SDRs1.51.71.41.4
Subtotal, Fund-related assets12.814.33.63.1
Foreign exchange52.953.686.6107.5
Total reserves excluding gold65.767.990.3110.6
Gold
Quantity {in millions of ounces)43.844.0117.0116.3
Value at London market prices16.013.842.636.6

Developing countries’ holdings of foreign exchange reserves increased by SDR 22 billion in 1984, after declining in 1982 and increasing by a modest amount in 1983. This relatively large expansion in foreign exchange reserves (15 percent) was associated with improvements in their current account positions and continued, though often quite limited, access to international financial markets. The experiences of the various regions in the group, however, were not uniform. Western Hemisphere countries, which reduced their current account deficit from SDR 11.7 billion in 1983 to SDR 5.5 billion in 1984, received net capital inflows that permitted an accumulation of foreign exchange reserves of SDR 14 billion in 1984. Within this region, the largest individual accumulations took place in Brazil (SDR 7.6 billion), Mexico (SDR 3.8 billion), and Venezuela (SDR 1.8 billion). Similarly, Asian countries reduced their aggregate current account deficits from SDR 15 billion in 1983 to SDR 7.7 billion in 1984, and increased their holdings of foreign exchange reserves by SDR 10 billion in 1984. Singapore experienced the largest individual accumulation (SDR 1.7 billion) within this region, followed by Indonesia (SDR 1.3 billion). In contrast, Middle Eastern countries, despite a decline in their current account deficit from SDR 20 billion in 1983 to SDR 16 billion in 1984, reduced their holdings of foreign exchange reserves by SDR 4.2 billion in 1984. Changes in holdings of foreign exchange reserves in the other regions were significantly smaller. European countries increased their holdings of foreign exchange reserves by SDR 1.5 billion in 1984, while the foreign exchange reserves of African countries remained virtually unchanged from 1983 to 1984.

The share of industrial countries in total foreign exchange reserves has declined substantially during the past decade, from 64 percent to 53 percent, while the share of developing countries thus increased from 36 percent to 47 percent. This redistribution of foreign exchange reserves did not occur at a uniform pace throughout the decade. The share of developing countries in total foreign exchange reserves rose substantially during the first years of this period, partly as a result of increases in the current account surpluses in the oil exporting countries, to reach 54 percent at the end of 1976. This process was reversed in the next two years, and the share of developing countries in total foreign exchange reserves reached 43 percent at the end of 1978. Since then, changes in the distribution of foreign exchange reserves have been more modest.

HOLDINGS OF FUND-RELATED RESERVE ASSETS

In 1984, Fund-related reserve assets increased by 8 percent to SDR 58 billion at the end of the year, reflecting expansions of holdings of both reserve positions in the Fund and SDRs (Table 13). Reserve positions in the Fund grew by SDR 2.5 billion, maintaining the upward trend evident since 1980. Holdings of SDRs increased by SDR 2.1 billion in 1984, in contrast to a decline of SDR 3.3 billion in 1983. This decline was largely associated with the increase in quotas under the Eighth General Review of Quotas. Since member countries in the aggregate paid 22 percent of the 1983 quota increase in SDRs, their holdings of SDRs declined, with an accompanying increase in their reserve positions in the Fund. These SDR payments, made in December 1983, amounted to SDR 6.0 billion. In 1984, payments for quota increases were relatively minor, with only SDR 0.2 billion paid in SDRs. Since the cumulative total stock of SDRs has remained constant since the last allocation in 1981, the expansion in SDR holdings of member countries (SDR 2.1 billion) in 1984 was reflected in a roughly corresponding decline of Fund holdings of SDRs.

In 1984, holdings of Fund-related reserve assets increased for both industrial and developing countries. Industrial countries increased their holdings by SDR 3.5 billion, with the United States experiencing the largest individual accumulation, of SDR 1.9 billion. Developing countries increased their holdings by SDR 0.9 billion. This expansion largely reflected an increase in Saudi Arabia’s reserve position in the Fund resulting from additional Fund borrowing from that country. As a result of these changes, industrial countries held 70 percent of total Fund-related reserve assets at the end of 1984, while developing countries held the remaining 30 percent.

GOLD

Gold valued at current market prices (in terms of the SDR) declined by 14 percent in 1984, reflecting a small reduction in the physical amount of official holdings of gold accompanied by a fall in its market price. The physical stock of gold reserves has remained fairly constant since 1972, with the exception of a 9 percent decline in 1979. The reduction in 1979 was largely the result of members of the EMS depositing 20 percent of their gold holdings with the European Monetary Cooperation Fund (EMCF) in exchange for European Currency Units (ECUs). Since 1979, changes in physical holdings have been small, and at the end of 1984 such holdings were nearly equal to those at the end of 1979. The distribution of gold holdings between both major country groups has also remained virtually constant. Of a total physical stock of gold reserves of 946 million ounces at the end of 1984, industrial countries held 83 percent and developing countries 17 percent.

The market price of gold has shown large changes during the last 12 years, ranging from an equivalent of SDR 90 an ounce at one point in August 1976 to one of SDR 639 an ounce at one point in January 1980. During 1984, a decline in the market price of gold (from SDR 364 an ounce to SDR 315 an ounce) reduced official gold holdings valued at current market prices to SDR 298 billion. As a result of the decline in gold prices during the last two years, as well as the accumulation of non-gold reserves, the share of gold in total reserves declined from 55 percent at the end of 1982 to 42 percent at year-end 1984.

DEVELOPMENTS IN FIRST QUARTER OF 1985

In a reversal of the growth experienced in 1984, non-gold reserves fell by SDR 17 billion in the first quarter of 1985. This decline was due almost entirely to a reduction in foreign exchange reserves (SDR 16 billion). The small decline in Fund-related reserve assets (SDR 0.5 billion) reflected a fall in reserve positions in the Fund (SDR 0.7 billion) that was only partially offset by an increase in SDR holdings (SDR 0.2 billion). Both major country groups reduced their holdings of non-gold reserves, industrial countries by SDR 7.7 billion and developing countries by SDR 10 billion.

The market price of gold measured in terms of the SDR increased by 6 percent in the first quarter of 1985. The resulting increase in official gold holdings valued at current market prices (SDR 17 billion) offset almost exactly the decline in non-gold reserves. As a result, total international reserves (including gold valued at market prices) remained virtually unchanged in the first quarter of 1985.

CURRENCY COMPOSITION AND PLACEMENT OF FOREIGN EXCHANGE RESERVES

This section examines the currency composition of foreign exchange reserves, the effects of market transactions and exchange rate movements on official holdings of major currencies, and the placement of foreign exchange reserves.

CURRENCY COMPOSITION OF RESERVES

During the last decade, there has been a continuing diversification of the currency composition of foreign exchange reserves. While that composition had remained relatively stable during the period 1975–77, the attempts of authorities to reduce the risk of significant capital losses due to a depreciation of the U.S. dollar led to some diversification of foreign exchange reserves in the years 1977—80. The share of the U.S. dollar in total foreign exchange reserves declined from 78 percent in 1977 to 67 percent in 1980 (Table 14). This diversification away from the U.S. dollar was partly reversed in the early 1980s, when the sharp appreciation of the U.S. dollar and high real interest rates on U.S. dollar assets increased the attractiveness of U.S. dollar instruments. As a result, the share of U.S. dollars in foreign exchange reserves rose to 69 percent by end-1983. In 1984, however, the share of the U.S. dollar in foreign exchange reserves declined to 65 percent, as monetary authorities shifted the composition of their portfolio toward the deutsche mark, the Japanese yen, and, to a lesser extent, the pound sterling. In the calculation of these shares, the SDR value of ECUs issued against gold is not counted as part of foreign exchange reserves, but the SDR value of ECUs issued against U.S. dollars is counted as part of the holdings of U.S. dollars. The overall picture regarding trend changes in the currency composition of foreign exchange reserves is similar if ECUs, which were introduced in 1979 and accounted for 11 percent of total foreign exchange reserves at the end of 1984, are treated separately. Under this alternative treatment of ECUs, the share of the U.S. dollar declined from 77 percent in 1977 to 55 percent in 1980; it then increased to 58 percent in 1981 and stayed at that level through 1983, before declining to 57 percent in 1984.

Table 14.Share of National Currencies in Total Identified Official Holdings of Foreign Exchange, End of Selected Years 1977-841(In percent)
Memorandum:

ECUs Treated

Separately2
197719781979198019811982198319841984
All countries
U.S. dollar78.075.672.966.869.868.768.565.157.0
Pound sterling1.81.72.03.02.12.42.62.92.6
Deutsche mark9.110.912.515.012.912.311.212.011.0
French franc1.21.21.31.71.41.31.11.11.0
Swiss franc2.22.12.53.22.72.72.32.01.9
Netherlands guilder0.80.91.01.31.11.10.80.80.7
Japanese yen2.43.33.64.44.14.54.75.24.8
Unspecified currencies4.44.34.24.65.87.08.711.021.1
Industrial countries
U.S. dollar89.086.283.577.678.777.077.673.657.0
Pound sterling0.90.70.80.80.70.80.91.61.4
Deutsche mark5.47.99.714.413.012.513.115.212.9
French franc0.30.40.60.50.50.40.30.40.4
Swiss franc0.81.21.51.81.81.81.51.41.2
Netherlands guilder0.60.50.60.70.80.70.50.70.6
Japanese yen1.82.32.63.53.74.55.26.35.3
Unspecified currencies1.20.80.60.60.72.30.90.821.3
Developing countries3
U.S. dollar67.261.762.356.261.160.659.757.057.0
Pound sterling2.73.03.25.03.54.04.34.14.1
Deutsche mark12.614.815.215.712.812.19.48.88.8
French franc2.12.22.12.92.32.11.81.71.7
Swiss franc3.73.43.54.63.63.63.12.62.6
Netherlands guilder1.11.41.51.91.41.51.20.90.9
Japanese yen3.04.64.55.24.54.64.34.14.1
Unspecified currencies7.69.07.88.510.811.416.220.820.8
Sources: Various Fund publications and Fund staff estimates.

Starting with 1979, the SDR value of European currency 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. For classification of countries in groups shown here, see Appendix IX.

This column is for comparison and indicates the currency composition of reserves when holdings of ECUs are treated as a separate reserve asset, unlike the earlier columns starting with 1979 as is explained in the preceding footnote. The share of ECUs in total foreign exchange holdings was 11.0 percent for all countries and 20.6 percent for the industrial countries.

The calculations here rely to a greater extent on Fund staff estimates than do those provided for the group of industrial countries.

Sources: Various Fund publications and Fund staff estimates.

Starting with 1979, the SDR value of European currency 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. For classification of countries in groups shown here, see Appendix IX.

This column is for comparison and indicates the currency composition of reserves when holdings of ECUs are treated as a separate reserve asset, unlike the earlier columns starting with 1979 as is explained in the preceding footnote. The share of ECUs in total foreign exchange holdings was 11.0 percent for all countries and 20.6 percent for the industrial countries.

The calculations here rely to a greater extent on Fund staff estimates than do those provided for the group of industrial countries.

The changes in the SDR value of foreign exchange reserves can also be decomposed into price and quantity changes for each of the major currencies (including ECUs) and for the total of the identified foreign exchange reserves (Table 15). In 1984, total identified foreign exchange reserves increased by SDR 27 billion as a result of a positive quantity change of SDR 24 billion and a positive price change of SDR 3.3 billion. This overall change in the SDR value of foreign exchange reserves encompassed increases in the quantity of each major currency with the exception of the ECU, and negative price changes for all the currencies with the exception of the U.S. dollar. The change in holdings (resulting from the combination of price and quantity changes) was positive for all the national currencies. The currencies with the largest expansions were the U.S. dollar (SDR 18 billion), the deutsche mark (SDR 7.1 billion), and the Japanese yen (SDR 3.4 billion). Holdings of pounds sterling increased by SDR 2.0 billion, while holdings of the French franc, Swiss franc, and Netherlands guilder increased by smaller amounts. The relatively small overall price change reflected the offsetting effects of an increase in the SDR price of the U.S. dollar and declines in the SDR prices of the other currencies. While price changes accounted for nearly two thirds (SDR 12 billion) of the increase in the holdings of U.S. dollars, the declining SDR values of the other currencies reduced holdings of those currencies by SDR 8.9 billion.

Table 15.Currency Composition of Official Holdings of Foreign Exchange, End of 1979-End of 19841(In millions of SDRs)
197919801981198219831984
U.S. dollar
Change in holdings−14,0575,8899,113−4,53012,65518,169
Quantity change—12,5912642−6,516−13,2883,8485,999
Price change−1,4665,24715,6298,7588,80712,170
Year-end value155,410161,299170,412165,882178,536196,705
Pound sterling
Change in holdings7542,921−1,8476268781,960
Quantity change4302,311−9661,2891,2303,362
Price change324610−881−663−352−1,403
Year-end value4,5517,4725,6256,2507,1299,088
Deutsche mark
Change in holdings3,9149,770−4,123−2,266−8277,083
Quantity change2,84012,795−2,288−2,2621,6739,977
Price change1,074−3,025−1,836−3−2,500−2,895
Year-end value28,27238,04333,91931,65430,82637,909
French franc
Change in holdings4351,265−656−372−315388
Quantity change3561,588−35−5161618
Price change79−323−622−367−476−230
Year-end value3,0274,2923,6363,2642,9493,337
Swiss franc
Change in holdings1,0002,357−1,032−187−50317
Quantity change9162,881−1,470162−271681
Price change84−524439−350−231−664
Year-end value5,7608,1177,0856,8986,3956,412
Netherlands guilder
Change in holdings374959−387−64−533179
Quantity change3251,193−219−41−276374
Price change49−234−168−23−257−195
Year-end value2,3573,3162,9282,8642,3312,510
Japanese yen
Change in holdings7142,901−1107521,3573,401
Quantity change2,4081,021−2428565693,597
Price change−1,6941,880132−104789−196
Year-end value8,10011,00110,89011,64213,00016,401
European currency unit
Change in holdings32,70614,952−4,727−5,0074,074−4,071
Quantity change327,295−1,545−2,143−1,460−297−774
Price change5,41116,497−2,584−3,5474,371−3,297
Year-end value32,70647,65842,93137,92541,99937,928
Sum of the above
Change in holdings25,84041,015−3,770−11,04916,78727,126
Quantity change21,97920,886−13,879−14,7506,63623,835
Price change3,86120,12910,1083,70110,1513,291
Year-end value240,183281,197277,427266,378283,165310,290
Total official holdings4
Change in holdings25,66343,190−321−8,34822,77237,989
Year-end value249,731292,921292,600284,252307,024345,012
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 and cumulating these differences yields the effect of price changes over the years shown.

Reflects mainly 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 and cumulating these differences yields the effect of price changes over the years shown.

Reflects mainly 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.

In contrast to the expansion in the holdings of national currencies, holdings of ECUs declined by SDR 4.1 billion in 1984. ECUs are issued by the EMCF to the central banks of the members in exchange for the deposit of 20 percent of the gold holdings and 20 percent of the gross U.S. dollar holdings of these institutions. These swaps are renewed every three months, and changes in the members’ holdings of U.S. dollars and gold, as well as in the market price of gold and in the value of the U.S. dollar, affect the amount of ECUs outstanding.8

Quantity and price changes in the SDR value of ECU holdings, therefore, depend on the evolution of its two components, gold and U.S. dollars. In 1984, the decline in the holdings of ECUs resulted from both a negative quantity change and a negative price change. The negative quantity change, SDR 0.8 billion, was due mostly to a decline in the quantity of dollars deposited at the EMCF, since the quantity of gold deposited remained virtually unchanged at 85.7 million ounces during the year. The negative price change, SDR 3.3 billion, was the net result of two opposite effects: an increase in the SDR value of ECUs issued against U.S. dollars (owing to the appreciation of the U.S. dollar with respect to the SDR), and a decline in the SDR value of ECUs issued against gold (owing to the decline in the price of gold in terms of SDRs). Since the ECUs issued against gold constitute a large

fraction of the total amount of ECUs, 77 percent at the end of 1983, the net price change in 1984 was negative.

There are significant differences in the pattern of currency diversification between industrial and developing countries (Table 14). In the period since 1975, reserve portfolios of the industrial countries have been more concentrated than those of the developing countries. Although the share of U.S. dollars in the foreign exchange reserves of the industrial countries declined from 89 percent in 1977 to 74 percent in 1984, it remained considerably above the corresponding share of 57 percent for developing countries in 1984. In addition, the combined shares of the two currencies with the largest shares have remained more stable for the industrial countries. For these countries, the combined shares of the U.S. dollar and the deutsche mark remained within the range of 88 to 94 percent; while for the developing countries, this combined share has been between 66 and 80 percent. Developing countries have also held much larger shares of their foreign exchange reserves in pounds sterling, French francs, Swiss francs, and Netherlands guilders. During 1984, the decline in the share of the U.S. dollar in total foreign exchange reserves for all countries represented a decline in the U.S. dollar share for both groups of countries. In part, the fall in the share of the U.S. dollar in the reserve portfolios of the industrial countries reflected the concerted exchange market intervention undertaken by a number of countries to limit the depreciations of their currencies against the U.S. dollar.

PLACEMENT OF FOREIGN EXCHANGE RESERVES

The growth of foreign exchange reserves in 1984 was accounted for largely by increased official U.S. dollar claims on residents of the United States and increased official holdings of Eurocurrency deposits (Table 16). While foreign exchange reserves grew by SDR 38 billion, official claims on residents of the United States increased by SDR 21 billion, and official holdings of Eurocurrency deposits increased by SDR 14 billion. The growth of Eurocurrency deposits reflected additional holdings of both Eurodollar deposits (SDR 9 billion) and deposits in other currencies (SDR 5 billion). Official claims on residents of other countries denominated in the debtor’s own currency increased by SDR 6 billion, while holdings of ECUs declined by SDR 4 billion.

Table 16.Placement of Official Holdings of Foreign Exchange Reserves, End of Year 1977-841(In billions of SDRs)
19771978197919801981198219831984
Liabilities of residents of the United States to
foreign official institutions104120109123139149163178
Items not included in reported official U.S.
dollar holdings2−10−7−13−22−36−50−52−46
Reported official U.S. dollar claims on resi-
dents of the United States941139610110399111132
Reported official claims on residents of other
countries denominated in the debtor’s own
currency1927304139384046
Subtotal113140126142142137151178
Identified official holdings of Eurocurrencies
Eurodollars5447495458565766
Other currencies1921253432303338
Subtotal73687488908690104
European currency units334843384238
Residual31816171518232425
Total official holdings of foreign exchange
204224250293293284307345
Sources: International Monetary Fund, International Financial Statistics; U.S. Treasury Department, Bulletin; and Fund staff estimates.

Official foreign exchange reserves of Fund members and certain other countries and areas, including Switzerland. Beginning in April 1978, Saudi Arabian holdings exclude the foreign exchange cover against a note issue, which amounted to SDR 4.3 billion at the end of March 1978.

Mainly U.S. dollars deposited with the European Monetary Cooperation Fund in connection with the issuance of European currency units, U.S. obligations to official institutions in countries not reporting to the Fund, and U.S. obligations that are not classified as foreign exchange reserves in the reports provided to the Fund by the holders.

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.

Sources: International Monetary Fund, International Financial Statistics; U.S. Treasury Department, Bulletin; and Fund staff estimates.

Official foreign exchange reserves of Fund members and certain other countries and areas, including Switzerland. Beginning in April 1978, Saudi Arabian holdings exclude the foreign exchange cover against a note issue, which amounted to SDR 4.3 billion at the end of March 1978.

Mainly U.S. dollars deposited with the European Monetary Cooperation Fund in connection with the issuance of European currency units, U.S. obligations to official institutions in countries not reporting to the Fund, and U.S. obligations that are not classified as foreign exchange reserves in the reports provided to the Fund by the holders.

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.

The composition of the holdings of foreign exchange reserves changed somewhat in 1984, after remaining relatively constant during the previous three years. The share of foreign exchange reserves accounted for by official claims on residents of the United States increased to 38 percent, while the share of ECUs declined to 11 per cent. The other components did not change significantly. At the end of 1984, official claims on residents of other countries accounted for 13 percent of foreign exchange reserves, while official Eurocurrency deposits accounted for 30 percent. Official Eurodollar deposits accounted for 63 percent of total official Eurocurrency deposits.

SOURCES OF RESERVE GROWTH

This section considers the roles of private international financial markets and the current account imbalances of reserve-currency countries as sources of international reserves and liquidity. It also examines the role of international capital markets in the current adjustment process.

INTERNATIONAL FINANCIAL MARKETS, THE ADJUSTMENT PROCESS, AND PROVISION OF INTERNATIONAL LIQUIDITY

An important aspect of developments in the international monetary system over the past twenty years has been the greatly increased role of the international financial markets as a source of international liquidity and reserves. The widespread use of private international credit markets by the authorities suggests that international reserves and liquidity are no longer constrained by the structure of current account balances of the reserve-currency countries or by the supply of reserve assets from official sources. International reserves and liquidity have been made available to most countries through the international financial markets on terms reflecting to some degree the borrowing country’s ability and willingness to make the real transfers required to service its debt. In contrast, countries with limited access to the international financial markets could acquire international reserves mainly through net sales of goods and services to nonresidents or through intergovernmental transfers and borrowing.

Since 1982, the flow of funds through international financial markets and the ability of these markets to provide reserves and liquidity have been strongly influenced by the external payments difficulties of a number of developing countries that threaten to curtail the availability of international credit to these countries. The availability of international credit was sustained as a result of a high degree of cooperation between the Fund, international banks, the developing country debtors, and national and other international agencies. This cooperation promoted an orderly balance of payments adjustment process based on a case-by-case approach involving Fund stand-by or extended arrangements, the restructuring of external debt payments, and, for certain countries, the provision of new credits from international banks.

The adjustment efforts of many developing countries and their more limited access to international financial markets resulted in significant changes in their current account positions and their accumulation of international reserves. The financing requirements (current account deficit plus private capital outflows exclusive of principal repayments on foreign debt) of developing countries (except eight fuel exporting countries of the Middle East9) fell from $150 billion in 1981 to $47 billion in 1984. This reduced requirement was largely financed by grants and direct investment flows and by long-term borrowing from official creditors. Hence, these developing countries did not increase their liabilities, net of deposits, to the international financial markets in 1984. Furthermore, their improved financial situation allowed them to increase their foreign exchange reserves by about $21 billion in 1984. This overall experience encompassed divergent behavior for different groups of these countries. In particular, the 34 market borrowers, which account for 70 percent of the developing countries’ total external debt, experienced significantly greater fluctuations in the availability of financing than the remaining 59 official borrowers, which account for 11 percent of the developing countries’ external debt. While market borrowers obtained net private credit of $125 billion in 1981-82, their net borrowing in 1983—84 would have been negative in the absence of $24 billion of concerted lending. Private borrowing of the group of market borrowers experiencing debt service difficulties fell from $59 billion in 1981 to $3 billion in 1984, while those market borrowers that avoided such difficulties experienced a smaller reduction in private lending, from $27 billion to $13 billion. The reduced access of market borrowers to external credit sharply changed the relative importance of the various sources of finance. By 1984, this group’s combined current account deficit was financed entirely by grants and direct investment flows. New external borrowings for this group from private sources was more than matched by an increase in reserves. In contrast, the official borrowers experienced greater stability in their sources of external finance. These countries financed their current account deficits through grants, direct investment, and long-term concessional borrowing from official creditors. The remaining indebted developing countries, whose external borrowing in 1978—82 was more evenly divided among official and commercial creditors, were able to increase their net borrowing from private creditors from $10 billion in 1981-82 to $13 billion in 1983-84.

The limitations on access to international financial markets experienced by market borrowers since the end of 1982 has shown that the availability of international liquidity and borrowed reserves can be subject to abrupt changes. Thus, even though the total reserves of developing countries increased in 1984, the continued limitations on access to private financial markets for some countries may have prevented a corresponding increase in the overall international liquidity available to this group. In part, the rapid accumulation of reserves by these countries reflects attempts to offset the decline in the availability of borrowed reserves through increased holdings of owned reserves.

RECENT DEVELOPMENTS IN THE INTERNATIONAL BANKING AND BOND MARKETS

Since the emergence of external payments difficulties for a number of developing countries in the second half of 1982, net international bank lending to developing countries has continued to decline. This decline in net claims reflects both a decline in bank lending and an increase in deposits held by these countries with international banks (Table 17). The developing countries increased their deposits with the international banking markets by $56 billion and $45 billion during 1983 and 1984, respectively, compared with an increase of $30 billion in 1982. In 1984, this increase in deposits primarily reflected a rise of $21 billion in the holdings of international reserves by all developing countries. Despite the reduction in net bank lending to the developing countries, the overall net lending activity of international banks increased to $174 billion in 1984, well above the $148 billion level of 1983. Lending to industrial countries and offshore banking centers accounted for this increased lending activity.

Table 17.Total Cross-Border Bank Lending and Deposit-Taking, 1982-841(In billions of U.S. dollars; changes in period)
198219831984
Lending to2185148174
Industrial countries12292122
Developing countries3755441
Other transactors4−152
Unidentified borrowers5−11−49
Deposit-taking from6182164188
Industrial countries14493136
Developing countries3305645
Other transactors44103
Unidentified depositors5465
Net flow of funds to (+) and from (-)7
Industrial countries−22−1−14
Developing countries345−1−4
Other transactors4−5−5−1
Unidentified (net)5−15−104
Net errors and omissions81429
Sources: International Monetary Fund, International Financial Statistics (IFS); and Fund staff estimates.

Data on lending and deposit-taking are derived from stock data on the reporting countries’ liabilities and assets after allowing for exchange rate movements. For classification of countries in groups shown here, see Appendix IX.

As measured by differences in the outstanding liabilities of borrowing countries, defined as cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower.

Excluding offshore centers.

Transactors included in IFS measures for the world, to enhance global symmetry, but excluding from IFS measures for “All Countries.” Comprises changes in identified cross-border bank accounts of centrally planned economies (excluding Fund members), and/or international organizations.

Calculated as the differences between the amounts that countries report as their banks’ positions with nonresident nonbanks in their monetary statistics and the amounts that banks in major financial centers report as their positions with nonbanks in each country.

As measured by differences in the outstanding assets of depositing countries, defined as cross-border interbank accounts by residence of lending bank plus international bank deposits by nonbanks by residence of depositor.

Lending to minus deposit-taking from.

Calculated as the difference between global measures of cross-border interbank lending and deposit-taking.

Sources: International Monetary Fund, International Financial Statistics (IFS); and Fund staff estimates.

Data on lending and deposit-taking are derived from stock data on the reporting countries’ liabilities and assets after allowing for exchange rate movements. For classification of countries in groups shown here, see Appendix IX.

As measured by differences in the outstanding liabilities of borrowing countries, defined as cross-border interbank accounts by residence of borrowing bank plus international bank credits to nonbanks by residence of borrower.

Excluding offshore centers.

Transactors included in IFS measures for the world, to enhance global symmetry, but excluding from IFS measures for “All Countries.” Comprises changes in identified cross-border bank accounts of centrally planned economies (excluding Fund members), and/or international organizations.

Calculated as the differences between the amounts that countries report as their banks’ positions with nonresident nonbanks in their monetary statistics and the amounts that banks in major financial centers report as their positions with nonbanks in each country.

As measured by differences in the outstanding assets of depositing countries, defined as cross-border interbank accounts by residence of lending bank plus international bank deposits by nonbanks by residence of depositor.

Lending to minus deposit-taking from.

Calculated as the difference between global measures of cross-border interbank lending and deposit-taking.

The cost of borrowing continued to vary widely by type of borrower. In 1984, the average spread above the London interbank offered rate (LIBOR) paid by borrowers from industrial countries for new commitments decreased from 65 basis points in 1983 to 57 basis points. However, the reported bank lending rates to some extent overstated the true borrowing costs of many borrowers in industrial countries who met their financing needs in international security markets by relying on the use of note issuance facilities10 and the issuance of bonds and floating rate notes11 in the Eurobond markets, both of which offered lower borrowing costs than the conventional bank credit. The average spread on commitments to developing countries decreased from a peak of 170 basis points in 1983 to 144 basis points in 1984. Despite this narrowing of spreads, the average cost of borrowing continued to be high in real terms, reflecting the increase in the level of real interest rates in most major industrial economies. For example, the average real short-term interest rates in the United States rose from 5.8 percent in 1983 to 6.9 percent in 1984, from 2.8 percent to 3.6 percent in the Federal Republic of Germany, from 4.0 percent to 5.2 percent in France, and from 4.6 percent to 6.4 percent in Italy.12

Table 18.International Bond Issues and Placements, 1979-841(In millions of U.S. dollars)
197919801981198219831984
Foreign bonds
Industrial countries13,42111,33914,12916,85418,69318,299
Developing countries1,4317461,2127268931,618
Centrally planned economies243
International organizations5,2595,7145,0307,4617,2697,580
Other154125143158195304
Total foreign bonds20,30817,92420,51425,19927,05027,801
Eurobonds
Industrial countries14,21217,20625,21042,81641,01573,145
Developing countries1,8851,4033,2153,9702,3823,646
Centrally planned economies23055
International organizations2,2201,7102,4863,2806,0744,218
Other34475358263627808
Total Eurobonds18,69120,39431,32450,32950,09881,817
International bonds
Industrial countries27,63328,54539,33959,67059,70891,444
Developing countries3,3162,1494,4274,6963,2755,264
Centrally planned economies27355
International organizations7,4797,4247,51610,74113,34311,798
Other4982005014218221,112
Total international bonds38,99938,31851,83875,52877,148109,618
Source: Organization for Economic Cooperation and Development, Financial Market Trends.

International bonds consist of foreign and Eurocurrency bonds. Foreign bonds are issued by a borrower who is of a nationality different from the country in which the bonds are issued. Such issues are usually underwritten and sold by a group of banks of the market country and are denominated in that country’s currency. In contrast, Eurocurrency bonds are those underwritten and sold in various national markets simultaneously, usually through international syndicates of banks. For classification of countries in groups shown here, see Appendix IX.

Excluding Fund member countries.

Source: Organization for Economic Cooperation and Development, Financial Market Trends.

International bonds consist of foreign and Eurocurrency bonds. Foreign bonds are issued by a borrower who is of a nationality different from the country in which the bonds are issued. Such issues are usually underwritten and sold by a group of banks of the market country and are denominated in that country’s currency. In contrast, Eurocurrency bonds are those underwritten and sold in various national markets simultaneously, usually through international syndicates of banks. For classification of countries in groups shown here, see Appendix IX.

Excluding Fund member countries.

At the same time, the position of the developing countries improved as a result of a substantial lengthening of the maturity structure of outstanding bank debt. The average maturities of bank loans for developing countries was extended from seven years in 1983 to eight years and eleven months in 1984. This lengthening of maturities reflected to an important degree the restructuring of debts for the Western Hemisphere countries.

The international bond market continued to expand rapidly during 1984 as borrowing by many high-quality corporate and sovereign borrowers was stimulated by falling interest rates. New gross international bond offerings grew by 42 percent, more than at any time during the past two decades, to reach about $110 billion in 1984 (Table 18). The issue of floating rate notes advanced most rapidly, by 95 percent in 1984, equity-related issues grew by 36 percent, and the issue of straight bonds grew by 18 percent. Most of the new issues were accounted for by industrial country borrowers, whose share of total issues increased from 87 percent in 1983 to 89 percent in 1984. The currency distribution in 1984 remains heavily skewed toward U.S. dollar issues (62 percent of the total).

As the growth in bank lending slowed in the period since 1981, the international bond market gained in relative importance as a source of financing. From 1982 to 1984, international bank lending declined from $185 billion to $174 billion, while international bond lending grew from $76 billion to $110 billion. Developing countries issued $5.3 billion of bonds in 1984, more than at any time since the peak in 1978, but these issues were made by only a few of these countries. The increase in importance of the international bond market is largely the result of innovations in this market that have made the underlying debt instruments more versatile.

DEVELOPMENTS IN DEBT RESCHEDULINGS

The restructuring of bank debt within the context of a Fund-assisted stabilization program has been widely used to alleviate debt service difficulties. During 1983 and 1984, 33 agreements were negotiated, involving 25 countries; a number of further agreements were being negotiated in the first months of 1985. In addition, 23 Fund members obtained 29 official debt reschedulings, mostly through the Paris Club mechanism, compared with 15 countries and 21 debt reschedulings during the period 1975-82. In 1983 and 1984, 32 countries rescheduled a total of $168 billion of their external debt owed to commercial banks and official agencies. The volume of bank debt formally rescheduled, excluding short-term debt rolled over, is estimated at $35 billion in 1983 and $117 billion in 1984, or about 6 percent and 21 percent of the total stock of bank debt of developing countries in 1983 and 1984, respectively. In 1983, 8 countries reached an agreement with banks on concerted lending packages in the context of restructuring agreements, involving lending commitments of $14 billion or 40 percent of new external commitments to developing countries. In 1984, 3 countries reached firm agreements on the concerted lending of $11 billion (40 percent of total new commitments), and 3 additional countries reached agreements in principle on concerted loans of $5 billion. Moreover, the first successful multiyear restructuring agreements were agreed to in principle with Mexico and Venezuela and a preliminary agreement was reached on a multiyear restructuring agreement with Ecuador. Multiyear restructuring agreements are designed to help restore voluntary debtor/creditor relationships for debtor countries that have made substantial progress in their adjustment efforts.

The terms on newly rescheduled debt eased during 1984. The spreads of borrowing rates over LIBOR on rescheduled debt had ranged from 1⅞ to 2½ percentage points in 1982 and 1983, and they fell to 1½ to 2 percentage points in 1984. Rescheduling fees declined as well, in part because of a new rule requiring U.S. banks to amortize most fees over the life of a loan. In addition, maturities and grace periods lengthened. Within the context of the multiyear restructuring agreement with Mexico, banks agreed to lengthen the period of repayment from 8 years to 14 years with margins over LIBOR at ⅞ percentage point during 1985-86, 1⅛ percentage points for 1987—91 and 1¼ percentage points for 1992-98. For the multiyear restructuring agreement with Venezuela, the period of repayment was 12 years at 1⅛ percentage points above LIBOR. Rescheduling fees were waived for both countries.

CURRENT ACCOUNT IMBALANCES AND RESERVE GROWTH

It has been suggested that a current account deficit of a reserve-currency country would lead to an increase in that country’s indebtedness vis-à-vis the monetary authorities in other countries, which would imply a corresponding increase in the reserves of the rest of the world. Such a direct link would have been most likely in an international monetary system with relatively limited private international financial markets. The access of many countries to international financial markets implies, however, that holdings of a particular reserve currency can expand even if the country that issues that currency has a current account surplus. A creditworthy country can readily obtain additional reserves by borrowing in international financial markets and hold these funds as reserve assets at a relatively small net cost equal to the difference between the loan rate and the return earned on reserve assets. Holdings of a particular currency could therefore expand as a result of international financial transactions even if the reserve-currency country has a current account surplus.

Given the current structure of the international monetary system, the nature of the relationships between the current account imbalances of the reserve-currency countries and stocks of reserves denominated in their currencies is basically an empirical issue. During the past decade,13 it has been difficult to find a consistent relationship between the current account imbalances of the major reserve-currency countries and the foreign exchange reserves denominated in their currencies. In Chart 20, this relationship is examined first in terms of linkages between the current account balances of each reserve-currency country and the change in the stock of reserves denominated in that country’s currency, and then in terms of the connection between the cumulative current account balances for each reserve-currency country (starting in 1970) and the stock of reserves.14 A current account deficit is measured as a positive value in Chart 20 since it has been argued that a current account deficit (surplus) would lead to an expansion (contraction) of reserve holdings. The comparison of the current account imbalance and changes in reserve holdings year by year examines the short-run linkages between these variables, whereas the relationship between the cumulative current account balances and the level of reserve holdings considers longer-term linkages. Although for certain countries there is a positive relationship between current account deficits of the reserve-currency countries and increases in reserves denominated in their currencies during portions of the period 1976-84, there was no significant linkage for the period as a whole. The relationships between the cumulative current account balances and the stocks of reserves varies within the period but, once again, there is no consistent evidence of a direct linkage.

Chart 20.Six Industrial Countries: Current Account Imbalances and Reserves, 1975-84

1 A positive value indicates that the country had a current account deficit.

2 Change in holdings of official reserves denominated in the national currency of the country considererd.

3 Sum of the current account balances starting in 1970. A positive value indicates a cumulative current account deficit.

4 Stock of official reserve denominated in the national currency of the country considered.

ADEQUACY OF RESERVES AND THE ROLE OF THE FUND

The recent changes in access to international finance markets for many countries and the movements in reserves described in previous sections have had important effects on the adequacy of international reserves and liquidity. This section considers the factors influencing the adequacy of reserves and the role of the Fund in the provision of liquidity.

ADEQUACY OF INTERNATIONAL RESERVES

An adequate stock of international reserves and liquidity is an important element in attaining a smoothly functioning international monetary system and a continuing expansion of world trade, while avoiding persistent inflation or deflation. An assessment of the adequacy of the existing stock of reserves requires an evaluation of the factors influencing the need for reserves, the terms and conditions under which reserves are supplied, and the sources of supply. The effective demand for reserves is affected by such factors as the levels and variability of trade and capital flows, the speed with which external payments imbalances respond to stabilization programs, the terms and conditions under which reserves can be obtained, and the types of domestic and external shocks that affect a country. Over time, the reserve holdings of all countries together have tended to grow as the value of world trade increased. In the period 1974–84, the ratio of non-gold reserves to imports for all countries had an average value of 21 percent and remained within the range of 20 to 25 percent. For the industrial countries, this ratio has moved in the range of 15 to 19 percent; and for the developing countries, it has fluctuated between 27 and 41 percent. Apart from periods surrounding large exchange rate adjustments or disturbances in financial markets, those reserve ratios have been relatively stable. For example, the average value of the ratio of reserves to imports for all countries of 17 percent in the period 1959—63 is only slightly lower than the average value of 20 percent for the period 1979-84. Although the effective demand for reserves is affected by a number of other factors, trade flows therefore provide an indication of likely movements in this demand.

The adequacy of reserves can also be evaluated by considering the terms and conditions under which individual countries acquire reserves. For countries with access to international credit markets, the terms on which reserves can be acquired and held reflect the net cost of borrowing funds and investing the proceeds in liquid foreign exchange assets. This net carrying cost of reserves can be quite small for countries with good credit ratings, especially relative to the costs of changing other policies in order to generate an overall balance of payments surplus. Borrowing rates differ among countries, since they reflect market evaluations of creditworthiness; the major industrial countries generally have the lowest borrowing costs. Even reserve-currency countries face a cost of acquiring foreign exchange reserves through borrowing, namely, the difference between the cost of servicing their own obligations and the return they obtain from holding assets denominated in foreign currencies.

The terms and conditions on which international reserves can be acquired are also importantly affected by policies of reserve-currency countries. Since most countries have a range of choices as to type of instrument and currency composition in which they hold their foreign exchange reserves, these portfolio decisions are often affected by the return on and stability of the value of different types of reserve assets. Stable economic policies in reserve-currency countries will help stabilize the composition of reserve portfolios.

The adequacy of reserves for countries without access to international financial markets requires further considerations. First, the stock of reserves deemed optimal for these countries is probably greater than that of countries with access to international credit markets. At the same time, the cost of acquiring and holding reserves is related to the necessity of generating net exports of goods and services to the rest of the world or of acquiring additional credits from official or multilateral sources. Such countries face a close linkage between their adjustment policies and their ability to accumulate reserves. The adjustments in absorption and production required to generate payments surpluses imply that the cost of reserve accumulation for these countries is much higher than for countries with access to international capital markets. For this reason, the supply of reserves generated by international agreements takes on special importance. The terms on which such countries acquire reserves, for example, through SDR allocations or government-to-government credit arrangements, may have implications for their adjustment efforts.

THE ROLE OF THE FUND IN THE PROVISION OF LIQUIDITY

The Fund provides reserves and liquidity through the allocation of SDRs and the generation of reserve positions in the Fund. At the end of 1984, Fund-related reserve assets totaled SDR 58 billion, which comprised SDR 16.5 billion of SDRs and SDR 41.6 billion of reserve positions. Reserve positions consist of members’ subscriptions paid in reserve assets, credit extended by the Fund to its members through the sale of other members’ currencies, and the credit extended to the Fund by members under various borrowing arrangements. Fund borrowings from members at the end of 1984 equaled SDR 12.8 billion, with the remainder of members’ reserve positions, amounting to SDR 28.8 billion, accounted for by reserve asset subscriptions and claims arising from the use ol members’ currencies in the extension of Fund credit.

The resources made available to the Fund are used to provide temporary financial support to members undertaking programs of economic adjustment agreed between them and the Fund, with certain specified features of the programs being considered conditions for the continuation of the phased financial support. Access by Fund members to this type of international credit constitutes an extension of international liquidity beyond that provided by reserve holdings and access to private international credit markets. In comparison with these other sources of liquidity, the Fund’s credit is characterized by its conditionally, which gives it an important role among the assets and availabilities that constitute international liquidity.

The role of the SDR and the possibility of a new SDR allocation have been discussed extensively since the last decision to allocate in 1978. SDR allocations are made on the basis of proposals by the Managing Director, concurred in by the Executive Board, and approved by the Board of Governors by an 85 percent majority of the total voting power. The question of further SDR allocations has been kept under continuous review by the Executive Board since the last decision to allocate, but it has not been possible to make a proposal for a new allocation that commands the required support of members with 85 percent of the total voting power in the Fund.

Although most Executive Directors believe that there is a strong case for resuming allocations of SDRs, some other Directors, who hold a substantial share of total voting power, do not. The matter remains under review by the Executive Directors and will be considered by the Interim Committee at its meeting in October. The Fund staff also is currently undertaking a study of the role of the SDR in light of the recent structural changes in the international financial system.

Indices of real effective exchange rates measure the evolution of a country’s prices relative to those of its trading partners, adjusted for exchange rate changes. In this section of the Report, prices are measured by the average annual consumer price index, with indices of partner countries averaged by using import weights, and exchange rates are measured by an import-weighted index of average annual effective exchange rates.

For this grouping, “high-inflation” was defined as an average of 20 percent or more over the period 1979-83; “medium-inflation” as an average of between 10 and 20 percent; and “low-inflation” as an average of less than 10 percent.

Executive Board Decision No. 5392-(77/63), adopted April 29, 1977, Selected Decisions of the International Monetary Fund and Selected Documents, Tenth Issue (Washington, April 30, 1983).

See Executive Board Decision No. 7939-(85/49), adopted March 25, 1985 (reproduced in Appendix II).

Working Group on Exchange Market Intervention, established at the Versailles Summit of the Heads of State and Government, June 4, 5, and 6, 1982, Report of the Working Group on Exchange Market Intervention, March 1983.

Excluding the arrangements for Democratic Kampuchea, for which no information is available.

In addition to the acquisition of reserves through actual borrowing from private markets and intervention in the foreign exchange markets, countries can arrange for lines of credit from either private financial institutions, central banks, or other official institutions.

In calculating the value of the gold holdings of the EMCF in terms of ECUs, the ECU swap price is equal to the lower of two values: the average of the prices recorded daily at the two London fixings during the previous six calendar months and the average price of the two fixings on the penultimate working day of the period.

The Islamic Republic of Iran, Iraq, Kuwait, the Libyan Arab Jamahiriya, Oman, Qatar, Saudi Arabia, and the United Arab Emirates.

The note issuance facility consists of an arrangement whereby an underwriting syndicate commits itself for several years (sometimes as long as ten years) to purchase from an international borrower notes of various maturities up to 12 months with a fixed spread (the cap rate) above a benchmark interest rate. When the borrower activates the facility, notes are sold through bidding by tender or through negotiation to banks that then place the notes with investors. The cost to the borrower of such sales is usually below the “cap rate.” The underwriting banks are required to take up only those notes that cannot be sold below the “cap rate,” although the underwriters may also be among the banks that acquire notes voluntarily.

Floating rate notes are medium-term bonds (five to seven years) whose interest rate is reset at short-term intervals. They have been viewed as a substitute for both fixed rate bonds and syndicated loans. Since 1980 the share of the conventional instruments—straight bonds, syndicated credits, and convertibles—has declined from 85 percent to 58 percent. The greatest decline occurred in the syndicated loan market, whose share fell from 57 percent in 1981-82 to 22 percent of total financing in 1984. Note issuance facilities and floating rate notes have correspondingly increased their share from 6 percent in 1981-82 to 15 percent in 1984 and from 7 percent in 1981-82 to 28 percent in 1984, respectively. Both types of instruments—note issuance facilities and floating rate notes—have been used mainly by borrowers from the industrial countries, but several developing countries, most notably Korea, have begun to explore their use.

Real interest rates are defined as the excess of nominal rates over expected inflation. Expected inflation rates are proxied by a weighted average of the rate of inflation in the current quarter and the next two quarters, with the deflator of private financial domestic demand being used as the price variable.

Consistent data on the currency composition of reserves are available only for the period since 1975.

To the extent that current account imbalances prior to 1970 contributed to the growth of reserve holdings, the estimate of the stock of reserves generated by the cumulative current account balances reported in Chart 20 would be an underestimate. However, this difference would remain constant over time.

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