Under the par value system of exchange rates, countries held reserves mainly to finance imbalances in their overall balances of payments that arose at given exchange rates. Par value changes were employed for correcting fundamental disequilibria. Under the present system of managed floating, countries have the choice between allowing the exchange rate to respond to market forces and intervening in the market. While it is tautologically true that under a pure fixed exchange rate regime overall payments disequilibria will be reflected in changes in reserves, and that under a freely flexible exchange rate regime there will be no need for reserves, it is not possible to state a priori whether there will be a reduction in reserve use, given a movement toward more flexible exchange rates.

Abstract

Under the par value system of exchange rates, countries held reserves mainly to finance imbalances in their overall balances of payments that arose at given exchange rates. Par value changes were employed for correcting fundamental disequilibria. Under the present system of managed floating, countries have the choice between allowing the exchange rate to respond to market forces and intervening in the market. While it is tautologically true that under a pure fixed exchange rate regime overall payments disequilibria will be reflected in changes in reserves, and that under a freely flexible exchange rate regime there will be no need for reserves, it is not possible to state a priori whether there will be a reduction in reserve use, given a movement toward more flexible exchange rates.

Under the par value system of exchange rates, countries held reserves mainly to finance imbalances in their overall balances of payments that arose at given exchange rates. Par value changes were employed for correcting fundamental disequilibria. Under the present system of managed floating, countries have the choice between allowing the exchange rate to respond to market forces and intervening in the market. While it is tautologically true that under a pure fixed exchange rate regime overall payments disequilibria will be reflected in changes in reserves, and that under a freely flexible exchange rate regime there will be no need for reserves, it is not possible to state a priori whether there will be a reduction in reserve use, given a movement toward more flexible exchange rates.

Several interrelated reasons explain this counterintuitive assertion. Williamson (1974) argues that if an exchange rate parity provides a credible estimate of the equilibrium exchange rate the abandonment of the parity may lead to increased reserve use. This result can come about as follows: If the parity provides a correct focus for stabilizing speculation, a move toward more flexible exchange rates (with no declared parity but with the authorities attempting to minimize deviations from a perceived equilibrium exchange rate) could result in additional scope for destabilizing speculation, based on extrapolative expectations. In resisting such fluctuations, the authorities may expend more reserves than under a par value system with an appropriate parity.

The view that there is necessarily a trade-off between exchange rate changes and reserve changes rests on the assumption that the behavior of the foreign exchange market is independent of the exchange rate regime and that the market is stable.1 If the foreign exchange market is unstable in the short run to medium run, it is possible to observe a simultaneous increase in exchange rate variability and reserve use (Williamson, 1975). Finally, reserve use might not decline given a move toward more flexible rates, since, in a world where the rules of the game are so unsure, it would not be surprising if accommodating private capital flows were slow to occur (Makin, 1974).

This paper examines for 14 industrial countries their reserve use during a period of relatively fixed exchange rates, and it compares those figures with their reserve use during a period of managed floating. Monthly reserve figures as published in the International Monetary Fund’s International Financial Statistics (IFS) 2 were obtained from January 1968 to June 1975. The period of a fixed exchange rate system is taken to be January 1968 to December 1972 and the period of a managed floating exchange rate system as March 1973 to June 1975.3

There are two general approaches to the study of what has happened to reserve use: global and country. A global approach would examine world reserves to see how “use” had changed. While this approach is helpful for some purposes, for example, in assessing the adequacy of world liquidity, it would not reveal what had happened to the individual country’s reserve use. In this paper, interest is focused on an individual country’s reserve use. For each country that is considered, various measures of reserve use have been computed for the two periods and compared. Conclusions concerning changes in reserve use are then presented for individual countries. Since there is no standardized definition of reserve use that can be readily obtained from published data, several measures of reserve use have been calculated. If different measures of reserve use yield conflicting results, this underscores the difficulty in analyzing this question, while if consistent results are obtained from a majority of the measures, there will be a degree of confidence in drawing conclusions. The various measures of reserve use are defined and the results obtained are given later. The first definition corresponds to that of Williamson (1975), the differences being (1) the procedure for deflating reserves and (2) the time units in which the data are measured. Regarding the first difference, the procedure that is used here is preferred, since it allows the results of this paper to feed back into an ongoing study of objective indicators. The second difference relates to whether the data should be analyzed on a monthly or annual basis. Williamson examines both, but since the number of annual observations is small, this paper looks only at monthly data.

For each country analyzed in this study, percentage changes in monthly reserves were computed. Since world reserves have been growing over time, this in itself will result in an observed “use” of reserves. Therefore, to correct for this trend effect, percentage changes in world reserves 4 were calculated and subtracted from the corresponding country figures. All these data are measured in U. S. dollars, which leaves them open to the criticism of valuation effects.5 They are also vulnerable to the criticism that published reserve figures are sometimes a misleading guide to true reserve changes.6 The first definition of reserve use employed in this paper is the average of the absolute values of the monthly percentage changes in a country’s reserves corrected for the change in world reserves. That is, for a country, i, reserve use, Ui, is given by

Ui=(Σt=1T|RtiRt1iRt1iRtwRt1wRt1w|/T)×100

These calculated values of reserve use for the two exchange rate regimes are given in Table 1. The figures indicate that nine countries have had a reduction in their reserve use under the present exchange rate regime, with the Federal Republic of Germany indicated as having the largest reduction (3.23 percentage points). The countries considered to be the “freest” floaters, Canada, the Federal Republic of Germany (vis-à-vis currencies outside the snake), and the United States, are all indicated as having reduced (gross) reserve use in the floating period.

Table 1.

Industrial Countries: Average of Absolute Values of the Monthly Percentage Changes in Reserves

(In per cent)

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The remaining five countries appear to have increased their reserve use in the floating period, with Italy having the largest indicated increase (4.95 percentage points).7 The changes in calculated reserve use are, in general, not large, thus making it difficult to draw any strong conclusions concerning reserve use between the two regimes.

A second method of measuring reserve use is defined as the variability of reserves. This is obtained by calculating the standard deviation of the percentage changes in a country’s monthly reserves corrected for the change in world reserves about the mean value of these country figures for each period. That is, for a country, i,

R^ti=RtiRt1iRt1iRtwRt1wRt1i

and reserve use, U^i, is defined as

U^i=(Σt(R^tiR^¯i)2T1)1/2×100

This measure of reserve use gives greater weight to larger deviations of percentage reserve changes from the mean change.8

The results of these calculations are given for each period in Table 2. These figures indicate that under this measure ten countries have had a decrease in their reserve use under managed floating, the United Kingdom being the added country. Again, the Federal Republic of Germany appears to have had the largest reduction (5.37 percentage points). Of the remaining four countries, Italy again appears to have had the largest increase in reserve use (7.84 percentage points).

Table 2.

Industrial Countries: Standard Deviation of Percentage Changes in Monthly Reserves About the Mean Value

(In percent)

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The changes in reserve use calculated from this second definition are again neither large nor totally convincing in supporting the hypothesis that reserve use might decrease, given more flexible exchange rates.

Thus, an alternative procedure was employed to see to what extent reserve changes were used to cover payments imbalances. Under a system of fixed exchange rates, a country could not induce short-term capital flows through exchange rate changes, while under a system of flexible exchange rates, changes in exchange rates would be expected to induce or prevent short-term capital flows. Accepting that argument, it would be expected that, on average, reserve changes relative to the basic balance to be financed would be larger under a fixed rate system than under a floating rate system. (These calculations should be viewed with a degree of caution, since the distinction between autonomous and accommodating transactions in the balance of payments is not precise and may not correspond with the distinction between short-term capital flows and other transactions.)

For all countries examined,9 the ratio of the average absolute quarterly change in reserves to the average absolute quarterly basic balance was calculated. The period of fixed exchange rates was taken as January 1969-December 1972 and the period of managed floating rates as April 1973-April 1975 except where noted otherwise. These figures are given in Table 3. Eight countries have a lower average ratio in the floating period than in the fixed period, indicating that reserves for them may be playing a lesser role in financing disequilibria under floating exchange rates.

Table 3.

Industrial Countries: Ratio of the Average Change in Reserves to the Average Basic Balance (in Absolute Terms)

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April 1973-March 1975 only.

January 1970-December 1972 only.

Of the five countries that appear to have increased reserve use in the floating period, three are small countries belonging to the snake arrangement, while the figures for Austria are similar and do not seem to indicate any significant change in reserve use between the two periods.

For eight countries, the ratio of average absolute reserve changes to the average absolute basic balance in the fixed rate period is greater than unity, implying that short-term capital movements “added to” the basic balance that needed to be financed. Except for the Netherlands, the figures for the floating exchange rate period show that this “adding to” of the capital account has been reduced; this may imply that short-term capital flows have become less destabilizing in the floating period.10

Finally, the figures in the second column of Table 3 may be interpreted as indicating the relative freeness of floating by the industrial countries, with the United States being indicated as the freest floater and the small snake countries the least free. These figures should be taken as rough indicators for several reasons. First, they understate the reserve use of countries that have large compensatory borrowings, such as France, Italy, and the United Kingdom. Second, the figure for the Federal Republic of Germany would be even lower if the massive support of the U. S. dollar in early 1973 is excluded. Finally, the increased use indicated for the small snake countries may be due to their being essentially pegged to the deutsche mark at a time when their balances of payments were subjected to large exogenous shocks.

Conclusions

This paper has attempted to estimate the reserve use of 14 industrial countries to see if there has been a change in this use between a period of fixed exchange rates and a period of managed floating exchange rates. The analysis was made on an individual country basis.

Reserve use was calculated in three different ways, recognizing that no standard definition of reserve use exists. It may also be possible to be more confident in drawing conclusions with a larger number of tests. The results of the tests are summarized in Table 4.

Table 4.

Industrial Countries: Summary of Results of Calculating Reserve Use by Three Methods1

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A minus sign is used to show that the test indicated reduced reserve use in the floating period, while a plus sign shows that the test indicated increased reserve use in that period.

Reserve use, U = Σ|R*|/T

Reserve use, U=(Σ(R*R¯*)2T)1/2

Reserve use, U = Σ| reserve change |/Σ| basic balance |

It is possible to make a rather strong statement concerning ten countries: Canada, Denmark, France, the Federal Republic of Germany, Japan, Switzerland, and the United States are indicated as having reduced reserve use in the floating period by all of the tests, while, similarly, Italy, the Netherlands, and Norway are indicated as having increased reserve use in that period. For the remaining countries, the results are mixed, and for any given test, the results are not, in general, strong. The overall tentative conclusion that may be drawn is that, generally, reserve use has declined under this present period of managed floating exchange rates, but not by a large magnitude.

BIBLIOGRAPHY

  • Artus, Jacques R., “Exchange Rate Stability and Managed Floating: The German Experience,” Staff Papers, Vol. 23 (July 1976), pp. 31233.

  • Makin, John H., “Eurocurrencies and the Theory of International Money,” presented at the Conference on Eurocurrencies and the Theory of International Money, Washington, October 1718, 1974.

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  • Williamson, John (1974), “Exchange Rate Flexibility and Reserve Use” (unpublished, International Monetary Fund, August 29, 1974).

  • Williamson, John (1975), “Exchange Rate Flexibility and Reserve Use,” presented at the Conference on Flexible Exchange Rates and Stabilization Policy, Stockholm, August 2627, 1975.

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Ms. Suss, economist in the Special Studies Division of the Research Department, received her doctorate in economics from the University of Pittsburgh. She has been a member of the faculty of the University of Virginia.

1

Stability of the market is defined here as meaning that the curves showing the demand for and supply of foreign exchange have the usual slopes. That is, the demand curve has a negative slope and the supply curve either has a positive slope or cuts the demand curve from above.

2

The data on reserves used refer to gross revenues. These figures do not capture well the net reserve movements of reserve centers and of countries that have large compensatory borrowings. Since it is not possible to obtain data on the timing or volume of compensatory borrowings, gross figures were used.

3

While some countries did have a floating exchange rate during the period 1968-72 (in particular, Canada has had a floating rate since 1970 and the United Kingdom started to float in July 1972), the international monetary system was essentially one of fixed rates. There was also a brief period of generalized floating from August to December 1971.

4

Defined as the reserves of all members of the International Monetary Fund plus Switzerland.

5

The gold component of reserves has been adjusted for effect of the U. S. dollar devaluation in 1971.

6

For example, both Switzerland and Japan have large swap arrangements between the central bank and the commercial banks, which can show up as changes in their gross reserve figures even though there has been no “use” of reserves.

7

Some part of this increase may be related to the large loan extended to Italy by the Federal Republic of Germany.

8

If a country’s reserves grew at a constant rate with respect to world reserves, this measure would have a value of zero, indicating no reserve use.

9

Switzerland was not included because data were not available.

10

Artus (1976) has analyzed this possibility for the Federal Republic of Germany. Short-term capital flows are regarded as being “stabilizing” here if they tend to offset movements in the basic balance.