Alvaro E. Larravide
FOLLOWING the re-establishment of external convertibility of the world’s main currencies since 1958, the dismantling of controls over capital transfers led to an increase in the scope for international movements of private capital in response to small changes in money market conditions. Unencumbered by exchange restrictions, private capital movements took place freely in anticipation of changes in specific exchange rates. At the same time, a steadily mounting volume of transactions developed in response to disparities in interest rates among national capital markets.
External Pressures on Currencies
These external pressures, emanating from a freer system of world payments, posed difficult policy choices to the countries affected by them. On the one hand, the greater freedom and efficiency of the capital markets deriving from this closer interlink age was widely regarded as a contribution to a better working of the international adjustment process. On the other hand, several of the countries affected by capital outflows refused to submit entirely to external pressures in the direction of tighter domestic credit conditions, and responded by instituting a variety of short-run restrictions on capital outflows. The strain felt by the U.S. authorities from this cause, given their commitment to full employment policies, led them to institute an interest equalization tax in 1963, followed by a voluntary credit restraint program two years later and by the imposition of mandatory controls restraining capital outflows early in 1968. This example was followed by several other European countries in the last two years.
Panama’s Adherence to Unrestricted Exchange Dealings
Against this background, the ability of Panama, one of the smallest Latin American republics, to adhere to its lifelong tradition of total absence of exchange restrictions, is particularly remarkable. This is even more so in view of the fact that in the process the country managed to achieve a rate of growth averaging 8 per cent in 1960-68, the highest in Latin America for that period. At the same time, far from losing capital to the pull of foreign capital markets, the private Panamanian banks raised more than $100 million in foreign deposits since 1960 (Chart A), the bulk of them mobilized in the last four years from the highly competitive Eurodollar market. Two thirds of these funds were loaned to nonresidents, but the balance has remained for use in Panama, representing a fairly permanent transfer of resources from overseas money markets into Panama, as illustrated in Chart B.
Behind this spectacular record of economic and financial growth lies one institutional feature which makes Panama unique among the Latin American countries:1 the U.S. dollar is employed as the circulating medium, while the issue of national currency is limited to coins. Superimposed on an open economy with imports representing approximately 40 per cent of gross domestic product (GDP) and with both current and capital transactions free from exchange restrictions, this feature has succeeded in steering the Panamanian economy in the direction of preserving equilibrium between aggregate supply and demand, as in the classic gold standard mechanism.
This feature has a long tradition in the country; in fact, since the achievement of independence at the beginning of this century, Panamanian governments have refrained from exercising discretionary power over currency circulation by printing money.2 The quantity of money in circulation cannot be manipulated by the authorities, except by the use of surpluses previously accumulated or the mobilization of foreign savings. This makes the Panamanian money market unusually responsive to the forces of inflation or deflation arising from the balance of payments, and links it to a close degree with foreign financial markets. Increases or declines in foreign exchange receipts lead automatically to expansions or cuts in the income of Panamanian residents, without the possible intermediation of a rise or a fall in the external value of the currency. This automatic linkage between payment imbalances and self-correcting forces affecting the source of demand pressures—the stock of money and quasi-money—rules out balance of payments difficulties and builds a strong safeguard against inflation into the Panamanian monetary system. Therefore, the policy of the Panamanian authorities of foregoing the creation of a national currency has restored primacy to objectives traditionally fulfilled by the gold standard—monetary stability, a steady exchange rate—but frequently demoted in the last four decades in favor of domestic objectives for employment and economic growth.
A Conflict Settled
The familiar conflict between international and domestic objectives confronting monetary authorities everywhere has, from the outset, been decisively settled in Panama in favor of the former. One corrective measure sometimes employed in other countries facing balance of payments difficulties—changes in the exchange rate—is entirely ruled out in Panama’s adjustment process. The mechanics of this process also obviate the need for exchange restrictions. Both facts have provided for a strong financial environment which has proved to be ideally suited to function in the world monetary environment of our time. The large supply of private liquidity which emerged in that decade in a wide variety of countries, available to profit from disparities in interest rates among money centers, as well as from anticipated changes in exchange rates, did not create in Panama the stresses and strains imposed in many other countries by the growing international mobility of private capital.
PANAMA: SELECTED FOREIGN LIABILITIES OF PRIVATE BANKS
Source: The International Monetary Fund, International Financial Statistics.
FOREIGN ASSETS AND LIABILITIES OF THE BANKING SYSTEM
Source: Office of the Controller General (Panama).
On the contrary, international funds moved massively into Panama, as substantiated in Charts A, B, and D, to the point that private foreign deposits in the banking system at the end of the third quarter of 1969 amounted to $194 million, almost equal to domestic private deposits ($208 million). Such a high proportion of foreign holdings to total deposits highlights the successful role of the Panamanian money market as an international haven of stability combined with favorable banking legislation and taxes low by international standards. Similarly, Panama adapted itself smoothly to the upward leverage of interest rates recently taking place in world markets, through matching rises in local interest rates unencumbered by domestic financial regulations.
In this respect, the Panamanian authorities do not employ monetary instruments commonly used elsewhere. Legal reserve requirements, for example, are never adjusted upward or downward. Deposits by nonresidents are exempted from legal reserve requirements, while reserve requirements for resident sight deposits are 20 per cent and for domestic time deposits 10 per cent. The law requires the legal reserve of commercial banks to be held in highly liquid assets but it does not stipulate where they are to be held.3 Some banks partly meet their requirement with deposits and other assets held abroad, but most banks keep their legal reserves in the form of mutual sight deposits with other banks. The allocation of financial resources is performed by the money market, which, through the price mechanism of interest rates, allocates savings to their most profitable uses. Government decisions in the monetary field are limited to the operations of the two government-owned banks: the Savings Bank and the National Bank; the latter, in the absence of a central bank, functions as the sole depository of national and local government agency funds, as well as agent for the Government in the placement and service of government bonds.
RESIDENTS’ PRIVATE DEPOSITS IN THE BANKING SYSTEM
Source: Office of the Controller General (Panama).
Source: The International Monetary Fund, International Financial Statistics.
Notwithstanding this success in the financial field, critical situations have occasionally emerged. Outflows of private capital developing in 1964 and 1968 caused by political disturbances set in motion deflationary pressures. Having given up their financial freedom of maneuver and thus their ability to preserve minimum levels of growth and employment at times of payments pressures, the Panamanian authorities found that their scope for adjustment in such emergencies was limited to the use of foreign credit and surpluses previously accumulated. In the first quarter of 1964 alone, domestic deposits placed in the banking system fell by 12 per cent (Chart C) while foreign deposits declined by 17 per cent (Chart D). In an effort to meet similar deposit withdrawals without contracting substantially its loan portfolio, the National Bank disposed of part of its reserve cash and raised funds abroad to the extent of $5 million. As a result, the domestic credit extended by the banking system rose moderately in 1964, although at a rate substantially below the annual average of previous years. This smaller rate of credit expansion was insufficient to counteract entirely the contractionary effect of the funds pulled out of the country, which was particularly felt in the volume of gross investment, down by 7 per cent in 1964, as compared with an expansion averaging 13.7 per cent per annum in the period 1961-68. Of course, by curtailing domestic demand to manageable levels and by checking possible increases in costs and prices, the capital outflow of 1964 made possible an immediate adjustment in the external accounts of Panama and facilitated the recovery brought about by returning confidence near the end of the year.
The 1964 experience, however, impressed upon the Panamanian authorities the advantage of having a more adequate volume of foreign reserves available for such emergencies: in February 1965, Panama’s quota in the Fund was raised from $0.5 million to $11.25 million, and for the first time a $7.5 million stand-by arrangement was granted by the Fund to Panama in July of the same year.
Another wave of heavy deposit withdrawals developed in March 1968, also due to political events, but this time it affected only the National Bank. The announcement of a second stand-by arrangement granted by the Fund in May 1968, and the immediate drawing of $3 million by the National Bank under this stand-by, contributed to prevent a propagation of the run to the rest of the banking system. The growth of real GDP in 1968, however, was 5.3 per cent, below the 8.5 per cent annual average increase recorded in the three previous years.
The stabilizing role of the automatic linkage between payment imbalances and over-all demand was clearly evident in the brief periods of crisis of 1964 and 1968: in both, the economic contraction sparked by political uncertainties brought immediately a slowdown to the upward trend of imports, which rose at rates markedly below the average of recent years, resulting in consequent and significant decreases in the usual deficit in the current account, thus offsetting destabilizing flows developing in the capital account at the same time.
Manufacture of Heavy Electrical Equipment in Developing Countries
by Ayhan Cilingiroglu
World Bank Staff Occasional Paper No. 9.
This study analyzes the attempt of industrializing countries—Argentina, Brazil, India, Mexico, Pakistan and Spain, particularly—to compete in the field of transformers, generators. Heavy switchgear, motors, etc. The author finds the the dominance of large international firms and the falling real price of such equipment over time have made the task of the new competitors more difficult.
Case studies of costs of equipment in developing countries include calculations of effective protection and domestic resource cost per unit of foreign exchange saved. They also illustrate some practical problems faced by such manufacturers. For example, essential raw materials, in particular, often cost much more than in developed countries even though they are internationally traded. Finally, the author provides some data on relative price trends which suggest that, over time, competitiveness has improved for some products, and that the infant industry argument may have some validity.
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Beneath these short-term fluctuations, however, more basic trends have been clearly discernible in the monetary field over the last few years. Factors such as interest rates in line with those prevailing in free markets abroad, and a high degree of confidence in the currency, have fostered savings habits and promoted strong increases in financial savings. Claims of the private sector against the banking system doubled from 1964—$107.5 million—to December 1969—$220.3 million—as shown in Chart C. In turn, this rapid growth made possible an equivalent expansion in domestic credit which grew from $128.0 million in 1964 to $283.2 million in September 1969. At the same time, the monetary effects of external developments have automatically generated corrections at the source of demand pressures—the total stock of money and quasi-money—and have led to a pattern of relative price stability, with price increases averaging 1 per cent per annum within the last six years.
An appraisal of the Panamanian experience suggests that, instead of being handicapped by a system in which the quantity of money is not a policy variable but is given to them, the Panamanian authorities were able to reconcile an unusual degree of price stability with a record rate of economic growth. The exposure of the country to international private capital movements improved the working of Panama’s adjustment process without affecting the monetary stability of the country. The subordination of domestic objectives such as minimum levels of growth, employment, and income to monetary stability facilitated ultimately the unprecedented economic growth of the country in the last decade.
Other countries without discretionary power over currency circulation are Botswana, Lesotho, Liberia, and Swaziland.
In 1904 Panama concluded a monetary agreement with the United States which in its essential points is still the basis for its monetary system. In this agreement Panama obligated itself to maintain its future domestic currency, the balboa, at par with the U.S. dollar and to make the U.S. dollar legal tender in the country.
The exception to this is the Government Savings Bank which is obligated to hold all its cash reserves on deposit with the National Bank.