Appendix I: The Data
Sample countries. 24 countries (see Appendix II), subdivided into a small industrial country group (major currency countries are excluded for reasons given in the text), a set of nondebt problem countries, and a set of debt problem countries. The difference between the last two groups was whether the country had entered into a rescheduling arrangement during the period. The debt problem group was dropped for 1982-86 since it faced credit rationing.
Data. All aggregates are measured in U.S. dollars. In addition to the reasons quoted in the text for using dollar figures, the primary source of data is the Fund’s International Financial Statistics (IFS), which reports reserve and trade statistics in dollar terms. It is, therefore, sensible to use data converted into dollars by a consistent methodology at the same time, since this should minimize distortions from the effects of converting different exchange rates. Following Frenkel (1978), this study looks at nominal rather than real reserve demand.
Reserves. The IFS definition of total reserves of the monetary authorities minus gold (line 11.d in the monthly publication) was used. Gold was excluded for two reasons; first, there is some question whether central banks consider gold to be as liquid as, say, foreign currency holdings. Apart from the fact that large sales might depress the market price, central banks seem to regard gold as reserves that are truly “of last resort” which are only to be sold in extremis. The second reason for excluding gold holdings is that if they are valued at the official price, the value will be vastly underestimated, but if valued at current market prices, they will be overvalued. The price of gold has varied quite a bit over the period considered, and unless one considers that a country was ready to realize the capital gain whenever the price rose, the price increase does not reflect a higher value of reserves.
Net Rate. Individual country spreads over the 6-month LIBOR on syndicated loans to the sample countries, denominated in U.S. dollars, plus the six-month LIBOR rate, and less the three-month U.S. Treasury bill rate. (Ideally the term structure of the interest rates should be matched. The three-month TB rate was chosen because the shorter-maturity assets were thought to correspond to authorities’ needs for liquid assets more closely than the longer-term maturities, while almost all syndicated loans are quoted over six-monthly LIBOR. As a practical matter, the three-monthly TB rates move closely with the six-monthly rates.) The loan rates chosen are average rates for loans to a given country in each quarter between 1978 and 1986, weighted according to its share in total loans to that country in that quarter. Syndicated borrowing spreads over six-monthly LIBOR are from the Bank of England and the 6-monthly LIBOR and the three-month Treasury bill rate are from Data Resources Inc.
Probability of Deficits (VARB). The literature has found that the variability of reserves over fourteen past periods is a consistently significant determinant of reserve holdings for all types of economy. We therefore assume that reserve variability (denoted VARB), measured over this time frame and detrended to exclude persistence, can be used to proxy p(D), or the probability distribution of a future imbalance. Thus, the probability of deficits arising and of using reserves becomes:
log R = log VARB - log m - log r.
The definition for reserve variability is that used by most authors:
for country i and time t, where âT is the result of a regression to estimate the trend in R;
Rt = a0 + aTt + εT over t = T-14, …, T
The marginal propensity to import (MPM), is proxied here by the average propensity to import—that is, by imports as a ratio of GDP. Both these aggregates are taken from the Fund’s IFS.
Scale Variable (Imp). The dollar value of imports, from the Fund’s IFS.
Appendix II: Sample Countries
Nondebt Developing Countries and Territories:
Taiwan Province of China
Debt Developing Countries:
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The author is grateful for comments from Sebastian Edwards, Mike Loewy, Harish Mendis, Bahram Nowzad, Liliana Rojas-Suarez, and Peter Wickham, among others.
Studies specifically asking whether reserve demand shifted after 1973 (Frenkel (1984), Frenkel and Hakkio (1980), and Frenkel (1978)) consistently show that there was no significant shift. Lizondo and Mathieson (1985), in a study that updated earlier work, found some instability in equilibrium formulations of the equation but not in disequilibrium formulations.
Several authors (Heller (1966) and Frenkel (1978 and 1984)) noted the need to include some proxy for forgone earnings in reserve demand equations; others attempted to proxy it but found it not significant—Kenen and Yudin (1965) and Kelly (1970) tried per capita income, Courchene and Youssef (1967) used the domestic interest rate, while Hippie (1974) used the inverse of the gross marginal capital output ratio. Frenkel, and Jovanovic (1981) took (with payments fluctuations) the government bond yield or discount rate and found it had the right sign and was significant. Other authors dropped the opportunity cost variable.
On the basis of an analysis of front-end fees and LIBOR spreads for 183 Eurocurrency credits arranged in 1981-83, Mills and Terrell (1984) found (see p. 2): “A close statistical relationship exists between the level of fees and the level of spreads. This relationship indicates that fees are utilized to raise the level of total compensation to banks in a very consistent manner.” Johnston (1982), also found “What evidence is available tends to suggest that the level of fees moves in line with spreads….The spread is therefore a reasonable indicator of the price of the loan” (p.169).
The Fund’s Annual Report shows that about 60 percent of total official placements were denominated in dollars over the sample period. This is confirmed by the survey by the Group of Thirty (1982) of reserve management by central banks holding more than half global foreign exchange reserves, which shows that between 1978 and 1981 industrial countries held, on average, 82 percent of their reserves in dollars, while developing countries held an average of 60 percent.
Between 1978 and 1984, an annual average of 72 percent of the external assets of BIS reporting banks were denominated in dollars. Between 1984 and 1986, this share fell, but was still, on average, 69 percent of the total.
This concept of opportunity cost assumes that the monetary authorities have priorities that are independent of those of the government; whether these can be acted upon is another question.
In a test that estimated spreads during the 1970s as a function of domestic interest rates in the major currency countries, the banks’ source of funds, and two variables reflecting specific Euromarket conditions, Johnston (1982) found that the domestic interest rates had the strongest and most significant effect on spreads, while loan volume exerted a significant but negative impact.
Fund studies on reserves have also used the Treasury bill rate to proxy earnings on invested reserves. Edwards (1985) used LIBOR to proxy these returns.
See Rothschild and Stiglitz (1970), pp. 225-43.
The impact of scale is emphasized in all the literature; a Fund study by Lizondo and Mathieson has a convenient presentation of the results of several equations over an extended time period. Frenkel (1978), pp. 130-34, shows that using small-country assumptions there is a positive link between openness defined as the average propensity to import and reserve holdings. The assumptions in question are that the price of imports is given (so that any exogoenous change occurs in export prices), and that the income elasticity of money demand is greater than or equal to unity. Frenkel maintains that empirical work on money demand shows that this assumption is well founded.
Niehans, in International Monetary Fund (1970), p. 50: “Basically reserves are useful because of what they are, not because of the way they grow.”
Williamson (1984), p. 17, quotes examples of underreporting (by the capital-surplus exporters) and overreporting (by Mexico, Brazil, and the Philippines).
Kapur (1977) states that the banks’ political assessment of countries has a 20 percent weight in creditworthiness analysis, while a review of the published quantitative indicators used by banks showed that 3 out of 56 indicators contained reserves. Moreover, a review of four econometric studies of creditworthiness analysis (Edwards (1983 and 1985), Feder and Just (1977), and Feder and Ross (1977)), showed that each study used four indicators, of which reserves formed part of one ratio.
A Fund study on reserves notes that in any case the net cost of reserve holding for reserve center countries would not be large, since the opportunity cost would be the rate of interest on their public sector money market obligations net of returns from comparable domestic assets. As the difference in the returns on these two instruments is not large, costs would be minimal.