This Appendix provides definitions of variables and sources of the data used. Countries in the sample are listed in Appendix II.
Twenty-four countries were subdivided into a small industrial country group (major reserve-currency countries were excluded for reasons given in the text), a set of non-debt-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 because it faced credit rationing.
All aggregates were measured in U.S. dollars. In addition to the reasons quoted in the text for using dollar figures, the primary source of data was 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 looked at nominal rather than real reserve demand.
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 a reserve that is truly “of last resort,” to be sold only 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; if valued at current market prices, the holdings 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 capital gains whenever the price rose, the price increase does not reflect a higher value of reserves.
This variable was defined as individual country spreads over the six-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 Treasury bill 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, whereas almost all syndicated loans are quoted over six-month LIBOR. As a practical matter, the three-month Treasury bill rates move closely with the six-month rates.) The syndicated loan rates chosen were average rates for loans to a given country in each quarter between 1978 and 1986, weighted according to the share in total loans to that country in that quarter. Syndicated borrowing spreads over six-monthly LIBOR were from the Bank of England, and the six-month LIBOR and the three-month Treasury bill rates were from Data Resources, Inc.
Probability of Deficits (VARB)
The literature has found that the variability of reserves (denoted VARB) over 14 past periods is a consistently significant determinant of reserve holdings for all economies. It was therefore assumed that reserve variability, measured over this time frame and detrended to exclude persistence, could be used to proxy p(D), the probability distribution of a future payments imbalance. Thus, the probability of deficits arising and of using reserves became
The definition for reserve variability was that used by most authors:
for country i and time t, where aT is the result of a regression to estimate the trend in R:
The Marginal Propensity to Import (MPM)
The marginal propensity to import was proxied here by the average propensity to import—that is, by imports as a ratio of GDP or GNP. Both these aggregates were taken from the Fund’s IFS.
Scale Variable (Imp)
The scale of imports was proxied here by the IFS dollar value of imports.
APPENDIX II Sample Countries
The country groups used in this study were as follows:
|Nondebt Developing Countries and Territories|
|Korea, Rep. of||Thailand|
|Debt Developing Countries|
|Nondebt Developing Countries and Territories|
|Korea, Rep. of||Thailand|
|Debt Developing Countries|
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Mrs. Landell-Mills is a Senior Economist in the Special Issues Unit of the Exchange and Trade Relations Department and was Assistant Division Chief of the Editorial Division, External Relations Department, at the time this paper was written. She holds graduate degrees from Cambridge University and George Washington University, This paper is based on the author’s Ph.D. dissertation.
The author is grateful for comments from Robert Dunn, Sebastian Edwards, Oli Havrylyshyn, Mike Loewy, and colleagues in the Fund.
Studies specifically asking whether reserve demand shifted after 1973 (Frenkel (1983), Frenkel and Hakkio (1980), and Frenkel (1978)) have consistently shown that there was no significant shift. Lizondo and Mathieson (1985), in a Fund 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 1983)) noted the need to include some proxy for forgone earnings in reserve demand equations; others attempted to proxy it but found it not significant—Ken en and Yudin (1965) and Kelly (1970) tried per capita income, whereas 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 have 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, p. 2) found that: “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, p. 169) also found that the available evidence suggests that the level of fees moves in line with spreads, so that the spread is a reasonable indicator of the price of the loan.
The Fund’s Annual Report shows that about 60 percent of total official placements was 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 of global foreign exchange reserves, which shows that between 1978 and 1981 industrial countries held, on average, 82 percent of their reserves in dollars, whereas 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, whereas loan volume exerted a significant but negative impact.
Fund studies on reserves have also used the U.S. Treasury bill rate to proxy earnings on invested reserves. Edwards (1985a) used LIBOR to proxy these returns.
The impact of scale is emphasized in all the literature; a Fund study by Lizondo and Mathieson (1985) 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 exogenous 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 (1970, p. 50) states that “basically reserves are useful because of what they are, not because of the way they grow.”
Williamson (1973, p. 17), quotes examples of underreporting (by the capital-surplus exporters) and overreporting (by Mexico, Brazil, and the Philippines).
A Fund study on reserves noted 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. The difference in the returns on these two instruments is not large.