Chapter

Chapter 2 Developments in the International Monetary System

Author(s):
International Monetary Fund
Published Date:
September 1983
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The economic and financial difficulties faced by many governments and the banking community over the past year have focused attention on the role that might be played by the international monetary system in fostering a more orderly world economic environment. This chapter deals with developments in two principal features of that system. First, the exchange rate arrangements and exchange rate policies of members are reviewed, and this examination is followed by an account of the Fund’s surveillance over these policies. The second topic, international liquidity, records the circumstances leading to changes in official reserve holdings and in the availability of private credit extended across national borders, and discusses the role of the Fund in providing conditional and unconditional liquidity to its members.

Exchange Rates and Surveillance

The exchange rate system remained subject to considerable stress during 1982 and the first half of 1983. In the industrial world, the exchange rates of the major currencies continued to be subject to pronounced swings; the most significant movements were the renewed appreciation of the U.S. dollar and the further depreciation of the Japanese yen through October 1982, both of which were only partly reversed by subsequent developments. There were also recurring periods of tension within the European Monetary System (EMS), leading to two realignments of central rates in 1982 and one in the first quarter of 1983. Finally, the currencies of a number of smaller industrial countries underwent sizable devaluations, some of which were viewed by trading partners as being possibly too large.

In the developing world, the stress was related mainly to the worsening external positions of many countries and the emerging risk of a serious financial crisis. As discussed in Chapter 1, the prolongation of the world recession, high interest rates, and the insufficient adaptation of domestic policies in a number of developing countries induced commercial banks to reassess the creditworthiness of developing countries in general, and of the heaviest borrowers among them in particular. The result was a marked reduction of new loan commitments in the second half of 1982, and, in some cases, a reluctance on the part of the banks to “roll over” or refinance maturing loans. In the event, the development of a crisis of confidence, which would have had major consequences for the whole network of international trade and payments, was checked, thanks to prompt action by the international community. However, as a result of a severe shortage of foreign exchange reflecting a sudden reduction in the growth of bank lending, most of the heaviest borrowers experienced both dislocations in production and abrupt exchange rate depreciations. These countries have now initiated substantial longer-term adjustments, but the return to more normal economic conditions will require considerable effort and may be slow.

In these difficult circumstances, the Fund has continued to stress its surveillance activities. In the major industrial countries, it has encouraged the implementation of policies that would help restore and maintain stable domestic economic and financial conditions. This in turn would facilitate the convergence of economic conditions across countries, and a smoother evolution of the pattern of exchange rates. It is also important that every major industrial country, in the process of selecting a specific policy mix for achieving adjustment, have concern for its effects on the rest of the world. In the many smaller industrial countries and developing countries that have large external imbalances, the Fund has encouraged the implementation of strong domestic and external policies of adjustment. At the same time, it has stressed that orderly adjustment required a reversal of recent protectionist tendencies, in both industrial and developing countries, and also a further increase in the exposure of banks in a number of developing countries, albeit on a moderate scale.

The following two sections discuss the working of the exchange rate system, first in the industrial countries and then in the developing countries. The third section reviews the Fund’s recent experience with surveillance over the exchange rate policies of its members.

Industrial Countries

The substantial variability that continued to characterize the exchange rates of the major industrial countries during 1982 and the first half of 1983, as well as the levels reached by some of these exchange rates, is a source of considerable concern. As discussed in previous Annual Reports (mainly in the Report for 1982, pages 42 and 45), economic agents can protect themselves from the month-to-month or quarter-to-quarter variability at moderate cost, but they have more difficulty in protecting themselves from exchange rate swings that last several years. Such swings can involve costs in terms of resource misallocation and impediments to the conduct of demand management policies in both industrial and developing countries. Furthermore, there is always the risk that exchange rate swings may strengthen protectionist tendencies and help to create an environment in which some countries are tempted to undertake competitive devaluations or induce excessive depreciations of their currencies in order to export part of their unemployment.

Even with the benefit of hindsight, it is difficult to identify the specific sources of exchange rate variability. A major reason for this difficulty is that, in open economies with diversified financial markets, the behavior of the foreign exchange price of the currency is similar to the behavior of the price of any other financial asset, that is, it fluctuates as a result of many unanticipated events. The degree to which an event had been anticipated by market participants and the importance they had attached to it are factors that are often impossible to gauge. It is mainly for this reason that attempts to find a close relationship between short-run exchange rate movements and concurrent movements in other economic variables, such as interest rate differentials or current account balances, are usually unsuccessful. Actual short-run changes in interest rate differentials or current account balances are unsatisfactory proxies for both the unanticipated changes in these variables and their effects on expectations concerning future developments. Over longer periods, however, it is possible to some extent to associate broad exchange rate swings with major economic and financial developments that have gradually affected the expectations of private market participants. Although such an analysis cannot establish firm and precise causal relationships, it can contribute to an understanding of the sources of longer swings in exchange rates.

Most of the following analysis constitutes a review of the working of the exchange rate system during the past four years, which were characterized in particular by the pursuit of anti-inflationary policies. The focus is on the major factors that can be associated with the pronounced exchange rate swings experienced during this period. An attempt is then made to draw some of the policy implications.

Factors Behind Exchange Rate Swings

The most significant exchange rate swings of the past four years have been among those major currencies (or currency groups) that are floating independently (Chart 15). Exchange rates among the major EMS countries that maintain common margins of fluctuation have been less affected (Chart 16).

Chart 15.Bilateral Nominal and Real Exchange Rates Subject to Floating, First Quarter 1973–Second Quarter 1983

(Indices, average for period shown = 100)

1 Calculated on the basis of relative GNP deflators.

Chart 16.Selected Nominal and Real Exchange Rates Within the EMS, First Quarter 1973–Second Quarter 1983

(Indices, average for period shown = 100)

1 Calculated on the basis of relative GNP deflators.

For the United States, Japan, and the Federal Republic of Germany, the exchange rate swings of the past four years can in part be attributed to differences in the speed of adjustment of wage and price inflation to reduced rates of monetary growth. In all three countries, there was a progressive shift toward more restrictive monetary policies during 1979 and the early part of 1980, as the authorities became concerned about renewed inflationary pressures in the wake of the oil price increase (Table 11). However, the initial reaction of domestic costs and prices differed considerably among the three countries. As measured by movements in the GNP deflator, the rate of inflation increased significantly in the United States, while it stayed almost constant in the Federal Republic of Germany and declined in Japan. This marked difference in inflationary developments occurred mainly because the initial conditions were different. Inflation was already high and rising in the United States on the eve of the 1979–80 oil price increase, and, as indicated by various surveys, inflationary expectations remained strong. In contrast, the rate of increase in the price level was low and stable in Japan and in the Federal Republic of Germany, and inflationary expectations had gradually abated. In addition, Japanese and German labor unions, aware of the new inflationary risk, settled for moderate nominal wage increases.

Table 11.Major Industrial Countries: Changes in Stocks of Money (Ml), 1976–82(Percentage changes from year-end to year-end)
1976–781979198019811982
Nominal changes
Canada7.23.610.41.43.8
United States7.67.47.35.08.5
Japan11.43.0–2.010.05.7
France10.212.27.014.610.6
Germany, Fed. Rep. of9.83.94.2–0.86.8
Italy22.423.513.410.017.0
United Kingdom15.88.67.38.110.6
Real changes1
Canada–7.40.1–8.7–5.9
United States1.1–0.7–2.6–3.53.9
Japan5.61.4–5.87.84.5
France0.51.5–4.31.3
Germany, Fed. Rep. of5.7–5.31.8
Italy4.55.0–5.6–7.3–0.2
United Kingdom3.4–8.2–8.6–1.13.6
Sources: National estimates.

Changes in deflated values approximated through use of GNP/GDP deflators for fourth quarters of successive years.

Sources: National estimates.

Changes in deflated values approximated through use of GNP/GDP deflators for fourth quarters of successive years.

As a result of the difference in inflationary developments, real interest rates—that is, the difference between nominal interest rates and estimates of expected rates of inflation—diverged considerably in the three countries; in particular, real interest rates rose more strongly in the United States, where inflation was accelerating in the face of declining monetary growth, than in the two other countries (Chart 17).1 In the United States, real short-term interest rates increased from about zero in 1978 to an average of about 8 per cent during 1981 and the first half of 1982. In Japan and the Federal Republic of Germany, the increase was less marked, from about 2 per cent in Japan and about 1 per cent in the Federal Republic of Germany in 1978 to an average of 5–6 per cent in both countries during 1981 and the first half of 1982.

Chart 17.Four Major Industrial Countries: Nominal and Real Interest Rates, January 1978–June 1983

(In per cent per annum)

1 Nominal interest rates are deflated by changes in the deflator of private domestic demand averaged over the previous quarter, the current quarter, and the next quarter to obtain real interest rates.

This change in relative monetary conditions was an important factor contributing to the strength of the U.S. dollar vis-à-vis the yen and the deutsche mark from 1981 to the first half of 1982. The tendency toward higher nominal and real interest rates in the United States attracted foreign financial investments, causing the U.S. dollar to appreciate to a point at which interest rate differentials were offset by the expected rates of subsequent depreciation. This appreciation of the dollar resulted initially in an improvement in the U.S. terms of trade. At the same time, higher nominal and real interest rates contributed to a particularly marked decline in economic activity and in imports. The consequent improvement in the current account position helped to bring about a further exchange rate appreciation. While such effects can be expected to be temporary because the loss of competitiveness will in the longer run lead to a worsening of the current account, past experience would suggest that they can persist for a substantial period of time.

In addition to the difference in monetary conditions, several other factors may have played a role in the large net appreciation of the U.S. dollar vis-à-vis the yen and the deutsche mark, notably in real terms, between the third quarter of 1979 and the middle of 1982. In particular, since Japan and the Federal Republic of Germany are relatively more dependent on imported oil than the United States, the sharp increase in the price of oil in 1979–80 had a more substantial impact, proportionally, on their balance of payments than on that of the United States. Moreover, the weakness of the U.S. dollar in 1977–78 had led to a strong U.S. competitive position, which, with a lag, favored the improvement of the U.S. current account during 1979–80. There was an opposite situation in Japan and in the Federal Republic of Germany; strong appreciation of the yen and the deutsche mark in 1977–78 had led to weak competitive positions, which favored negative current account changes during 1979–80. In addition, it may be noted that the extent of the depreciation of the yen during the latter half of 1979 was probably also related to a perception in the market that, in its prolonged previous appreciation, the yen had substantially overshot its sustainable value.

It is more difficult to explain the continued strength of the U.S. dollar during the second half of 1982 and the first half of 1983. Monetary conditions, as reflected in short-term real interest rates, probably remained more restrictive in the United States than in the two other countries, but the difference was being rapidly eroded as the U.S. inflation rate declined sharply, bringing about a decline in the growth of transactions demand for money, while the rate of U.S. monetary expansion rose. Such a reduction of the earlier divergences in monetary conditions tended to weaken the dollar and to strengthen the yen and the deutsche mark. Furthermore, there were two other factors acting in the same direction. The relative U.S. current account position worsened markedly in the second half of 1982 and is expected to worsen further in 1983 as the major changes in relative competitive positions induced by the exchange rate changes of 1980–82 continue to be felt. The decline in the real price of oil in late 1982 and early 1983 should have had an effect opposite in direction to that of the price rise of 1979–80. In fact, there was a period of marked depreciation of the U.S. dollar vis-à-vis the deutsche mark and, more particularly, the yen in November-December 1982. However, the period of dollar depreciation was short-lived and was followed by a phase of new strength vis-à-vis the deutsche mark and stability, at a relatively high value, vis-à-vis the yen.

One of the factors that can be associated with the persistent strength of the U.S. dollar during the second half of 1982 and the first half of 1983 is the marked change of expectations with respect to the evolution of the U.S. fiscal deficit during the mid-1980s. The emerging expectations of a large and persistent deficit may have led economic agents to revise their expectations of future U.S. interest rates upward. This would help explain why U.S. interest rates, in particular for longer maturities, have remained high despite the sharp decline in U.S. inflation. Real interest rate differentials on long-term financial assets were probably more favorable to U.S. assets in 1982 and the first half of 1983 than at any time during the previous three years.

In sum, the change of expectations with respect to the U.S. fiscal deficit may have played the same role during 1982 and the first half of 1983 as the change in expectations with respect to U.S. monetary conditions during the previous two and a half years. Nevertheless, it must be recognized that the magnitude of the net real appreciation of the U.S. dollar vis-à-vis the yen and the deutsche mark over the past four years—about 30 per cent vis-à-vis the yen and 40 per cent vis-à-vis the deutsche mark—is difficult to explain in terms of a succession of overshooting effects, or in terms of the longer-run implications of a fiscal deficit for the structure of the balance of payments. The major shift in the United States from a rate of inflation of about 8 per cent in the period 1978–79 to a rate of only 3 to 4 per cent in the early months of 1983 may also have contributed to the appreciation of the U.S. dollar. If economic agents prefer holding their financial assets in “strong” currencies, that is, the currencies of countries with low inflation rates, the recent success of the United States in restoring greater price stability will have enhanced the attractiveness of U.S. dollar assets. Last but not least, as discussed in Chapter 1, the U.S. dollar may in recent years have benefited from capital inflows induced by unsettled economic and political conditions abroad, as well as a favorable political climate for private investment in the United States.

For the United Kingdom, the exchange rate strength of the past four years also seems to be associated with the adjustment to reduced rates of monetary growth, although it is difficult to disentangle this effect from the effect of rising oil production and changes in the price of oil. The initial response of the rate of inflation to the tightening of monetary policy in 1979–80 was even more disappointing in the United Kingdom than in the United States. The rate of inflation rose from 11 per cent in 1978 to 19 per cent in 1980, largely because of sharp increases in wage rates following the breakdown of the incomes policy, the readjustment of public sector salaries, and the shift from income taxes to indirect taxes. The result was a severe monetary squeeze, which, together with favorable oil developments, pushed the pound sterling sharply upward. As the inflation rate began to decline in the course of 1981 and economic agents ceased to adjust their expectations of U.K. interest rates upward, the pound sterling began to decline from the high peak reached in the first quarter of 1981. However, the decline stopped late in 1981 and began again only one year later, when oil prices appeared likely to weaken markedly. Even after that second phase of the decline, the real effective exchange rate of the pound sterling was still about 30 per cent higher than in 1978, the year before the tightening of monetary policy.

Over the past four years, the exchange rates among the major EMS countries that maintain common margins of fluctuation were more stable in real terms than the rates among the major floating currencies (or currency groups). During this period, there were seven currency realignments, but most realignments were relatively small and tended to offset the effects of differences in inflation rates. The major exceptions were the realignments of February 1982 and March 1983, which led to a substantial decline in the exchange rates of the Belgian franc and the French franc vis-à-vis the deutsche mark and the Netherlands guilder. The relative stability of real exchange rates in the EMS was achieved with little or no convergence of inflation rates; on the whole, the inflation differentials were as large in 1982 and early 1983 as in the last years of the 1970s.

An important factor explaining the ability of the EMS countries to stabilize real exchange rates among their currencies is the somewhat more limited role of private financial transactions in the determination of these exchange rates. Except for the Federal Republic of Germany, the EMS countries have financial markets that are less diversified and less open to the outside than those of the United States, Japan, and the United Kingdom. At times, private capital flows may occur on a large scale, in particular through changes in the leads and lags for payments of trade transactions, but the type of persistent exchange rate overshooting that is caused by portfolio reallocation is less of a problem.

In addition, the EMS countries have accepted the existence of a common constraint on their financial policies, at least to some extent. In Belgium and Denmark, the exchange rate constraint induced a stronger domestic adjustment effort involving both a suspension of wage indexation and a shift toward a more restrictive budgetary policy. In France, the authorities had to end their isolated attempt to shift toward a more expansionary stance of financial policies, in part because of the resulting pressures on the exchange rate. More generally, interest rate policies have been used to foster exchange rate stability in the period between two currency realignments, mainly in countries with weak currencies, even though this has resulted in fluctuating interest rates (Chart 18).

Chart 18.Selected Members of the EMS: Nominal and Real Interest Rates, January 1978–June 1983

(In per cent per annum)

1 Nominal interest rates are deflated by changes in the deflator of private domestic demand averaged over the previous quarter, the current quarter, and the next quarter to obtain real interest rates.

However, the willingness to accept the existence of a common constraint has stopped short of adopting policies that would have ensured a convergence to low inflation rates in all EMS countries. It is impossible to assess what would have happened in the absence of the EMS exchange rate arrangements, but so far their disciplinary effect has not been as large as expected, and the EMS has not yet achieved its intended goal of fostering the emergence of a “zone of greater monetary stability” in Europe. In fact, the cumulative changes in nominal exchange rates that have taken place over the past four years have been larger than those during the previous four years. Furthermore, the frequency of realignments has been such that without some convergence of inflation rates in the near future and a reduction in the frequency of realignments, the system may begin to assume the character of a crawling peg.

Some Policy Implications

The above review of exchange rate developments over the past four years suggests that there are particular factors that generate exchange rate swings during a transitional period from high to low inflation rates. The main one is that the speed of adjustment of the inflation rate to the rate of monetary growth tends to differ among countries because of differences in the strength of inflationary expectations, the flexibility of the goods and labor markets, and the behavior of economic agents. To reduce these differences so as to achieve greater exchange rate stability is a difficult task. Nevertheless, there is much that the authorities of the countries with persistent inflationary tendencies can do to facilitate adjustment. By following an adequately restrictive monetary policy, supported by a fiscal policy consistent with the maintenance of low rates of monetary growth in the future, the authorities can foster the reduction of inflationary expectations. Moreover, they can influence these expectations by making it clear that they will not accommodate wage and price increases through monetary expansion, despite temporary adverse consequences for the level of employment. By reducing rigidities in the goods and labor markets, the authorities can also speed up the actual decline in the rate of inflation. For example, they can modify the application of wage indexation schemes to increase the responsiveness of wages (and thus prices) to changes in the level of aggregate demand. Finally, in some countries, the authorities may be able to use some flexible form of incomes policy as an adjunct to an appropriate policy of demand restraint.

While the authorities are not powerless in the face of the exchange rate swings that occur during a transitional period of adjustment, the prospects for restoring greater exchange rate stability are far better once the period of adjustment is over. As discussed in Chapter 1, the period of adjustment that began in 1979 is not complete, but the reductions in inflation rates that have taken place during 1982 and the early months of 1983, in particular in the United States and the United Kingdom, have demonstrated how much has already been achieved. It is not too early, therefore, to focus on issues that relate to the working of the exchange rate system when underlying economic conditions are relatively stable. In this context, both exchange market intervention and new monetary management techniques making use of the exchange rate as an indicator may have to be considered.

National authorities differ in the importance they attach to the role of sterilized intervention, that is, any combination of operations that change the monetary authorities’ net foreign currency assets without changing their total monetary liabilities. These different attitudes largely reflect differences among countries in the size and depth of financial markets, as well as in economic and trade structures. In large countries with deep financial markets, sterilized intervention is viewed as being unlikely to have a significant and lasting effect, in part because of the scope for offsetting private capital flows. On the other hand, in some of the smaller industrial countries that have less highly developed financial markets and, possibly, more control over capital flows, the tendency is to believe that sterilized intervention can play an important role in contributing to exchange rate stability. Even in these countries, however, it is clear that there are risks associated with exchange market intervention, including the risk that a system designed to avoid undue exchange rate movements may tend to postpone needed exchange rate adjustments. This risk is clearest in situations where the authorities are implementing some form of exchange rate pegging, but it may also be present under a regime of managed floating. The difficulty of assessing these risks helps to explain the diversity of views among the authorities in large industrial countries on the appropriateness of intervention.

While there is general agreement that official intervention should be undertaken to counter disorderly market conditions, the definition of such conditions is not easy. The U.S. authorities have expressed the view that in practice disorderly market conditions are rare and that intervention should be undertaken only under extraordinary circumstances, while other countries take the view that intervention may be required to give depth to markets that are “thin” and susceptible to an undesired degree of volatility, to offset the effects of other market inefficiencies, or to counter destabilizing speculation.

Even more fundamental differences of view surround the question of whether, for a given country, exchange market intervention can be effective in preventing an exchange rate from deviating unduly from the level that the authorities of that country consider reasonable on the basis of underlying economic and financial conditions. The experience of recent years suggests that the effectiveness of intervention in this context depends in part on whether the intervention is coordinated among major countries, and whether these countries are willing to commit themselves publicly to the defense of a certain exchange rate objective and to direct their economic and financial policies (and not merely intervention policy) to this objective. One reason for this may be that intervention per se has little effect on exchange rate expectations unless private market participants have reason to believe that the authorities are willing to continue to intervene in the future, and if necessary to modify their domestic policies, to prevent the exchange rate from moving beyond a certain point, at least over the near term.

Many of the issues concerning the role of intervention were recently reviewed by the working group set up by the seven largest industrial countries at the summit meeting in Versailles in June 1982. In its report, the working group was able to find a substantial area of common ground among the seven countries. In particular, the report indicated that “the Working Group felt that intervention had been an effective tool in the pursuit of certain exchange rate objectives—notably those oriented towards influencing the behaviour of the exchange rate in the short run. Effectiveness was found to have been greater when intervention was unsterilised than when its monetary effects were offset.… There was also broad agreement that sterilised intervention did not generally have a lasting effect, but that intervention in conjunction with domestic policy changes did have a more durable impact. At the same time, it was recognised that attempts to pursue exchange rate objectives which were inconsistent with the fundamentals through intervention alone tended to be counterproductive.” 2

In many respects, monetary management techniques making use of the exchange rate as an indicator may be a more promising approach to greater exchange rate stability than intervention. In recent years, it has been particularly difficult to assess the degree of restrictiveness inherent in a country’s monetary policy stance. On occasion, this has led to the implementation of policy measures that destabilized both the domestic economy and the exchange rate. The development of reliable policy indicators is thus a matter of continuing concern. In particular, it is worth considering to what extent exchange rate stability and the performance of domestic monetary policy can both be enhanced through the use of the exchange rate as a policy indicator.

All of the major industrial countries, and many of the smaller ones as well, have relied heavily during recent years on preannounced monetary targets in the implementation of credible anti-inflation policies. In many circumstances, however, interpretation of monetary growth has been obscured both by short-run fluctuations in the demand for money related to shifts in market expectations and by structural and regulatory changes affecting the banking system. Changes in interest rates have at times provided important additional information, helping to indicate whether monetary growth can be ascribed chiefly to policy-induced increases in supply or to increases in demand. As a first approximation, for example, when rising interest rates coincide with accelerating monetary growth, this might suggest an upward shift in the demand for money balances. The difficulty with this interpretation is that the interest rates in recent years have been strongly affected by inflationary expectations, which may well have been quite volatile and difficult to assess during periods when monetary policy is changing course.

For countries with independently floating or highly flexible exchange rates, changes in exchange rates provide further information that frequently has helped to clarify the picture emerging from monetary growth and changes in interest rates. Because restrictive monetary policies tend to induce exchange rate appreciation in real terms, and conversely for expansionary policies, sustained movements in real exchange rates may provide a helpful supplement to monetary growth and interest rate changes in indicating the thrust of a country’s policy relative to that in other countries. As indicators of policy stance, however, exchange rates alone have serious defects. As the experience of the past decade has clearly demonstrated, exchange rates have been affected by a variety of influences and have not always provided an unambiguous indication of the direction of monetary policy, much less the degree of stimulus or restraint. The usefulness of the exchange rate as an indicator of the relative stance of monetary policy derives primarily from its relationship to other information. Changes in exchange rates can serve only as a supplementary indicator, helping to provide an interpretation of other developments, including changes in monetary growth and interest rates.

Developing Countries

The extent to which developing countries were able to achieve needed adjustment in recent years in the face of a worsening external environment was clearly affected by factors over which they had relatively little control. Conditions in international commodity and credit markets, as well as structural impediments to shifts in the pattern of resource allocation and production, were particularly important in this respect. Nevertheless, their economic policies with regard to exchange rates, demand management, and interest rates also had a significant influence on the wide variations among these countries with regard to the outcome of the adjustment process.

Exchange Rate Experience

The principal factors influencing a developing country’s choice of exchange rate regime, discussed in detail in previous Annual Reports, include the desire to minimize the costs associated with short-term variations in exchange rates among the currencies of major trading partners, expectations concerning the medium-term behavior of the exchange rates of these currencies, and, for countries with more flexible arrangements, the influence of exchange rate considerations on formulation of domestic economic policies. Since 1977, there has been a tendency to move away from single currency pegs, and in particular away from the U.S. dollar, to a currency composite, or to alternative, more flexible, arrangements. (See Table 12.) The group of countries with more flexible arrangements includes a small number of countries that adjust their exchange rates according to a set of indicators related to the relative movements of domestic and foreign prices.

Table 12.Developing Countries: Exchange Rate Arrangements, 1977–83 1(Number of countries)
1977197819791980198119821983
Pegged to a single currency67626158565654
U.S. dollar44414140383836
French franc14141414141313
Other currency9764455
Of which, pound sterling4431111
Pegged to composite26282732323435
SDR12151315141514
Other composite14131417181921
Flexible arrangements17232928323536
Adjusted according to a set of indicators7543445
Other 210182525283131
Total110113117118120125125

Based on mid-year classifications; excludes Democratic Kampuchea, for which no current information is available.

This category comprises the following categories used in Table 13: “Flexibility limited vis-à-vis single currency,” “Other managed floating,” and “Independently floating.”

Based on mid-year classifications; excludes Democratic Kampuchea, for which no current information is available.

This category comprises the following categories used in Table 13: “Flexibility limited vis-à-vis single currency,” “Other managed floating,” and “Independently floating.”

Most countries whose currencies remain pegged to a single currency have been reluctant to adjust the peg in response to movements in exchange rates among major currencies. As a result, the nominal effective exchange rates of these currencies have tended to appreciate or depreciate along with the currency to which they are pegged. For instance, the nominal import-weighted effective exchange rates of currencies pegged to the U.S. dollar appreciated by some 20 per cent on average over the period 1980–82, while the nominal effective exchange rates of currencies pegged to the French franc depreciated by 6 per cent on average over the same period. For many of the latter countries, the effective depreciation was substantially reduced by the large proportion of trade conducted with France or with other countries whose currencies are pegged to the French franc.

A number of countries have been reluctant to adjust nominal exchange rates when rates of inflation are higher than those of their major trading partners. This has tended to reduce the relative profitability of producing internationally tradable goods, thereby encouraging a shift of resources toward the sectors producing nontradable goods. One indicator of such shifts in profitability or competitiveness in the production of tradable goods is the relative movement of domestic and foreign prices adjusted for changes in exchange rates, that is, an index of the “real” effective exchange rate.3 When a country’s rate of inflation, adjusted for movements in nominal exchange rates, remains persistently higher than the inflation rates of its trading partners, there is generally an eventual reallocation of resources away from the tradables sector, which tends over the long run to weaken the external current account. Furthermore, when adverse changes in the terms of trade or other exogenous factors (such as an increased cost of servicing its external debt) have produced a long-term deterioration in the structure of a country’s balance of payments, policies to increase, rather than just maintain, the relative price of tradable goods may be required.

The composition of countries’ exports and economic activity also influence their exchange rate experience. For instance, most major oil exporters had substantial current account surpluses for much of the period 1973–82 and consequently did not undertake exchange rate measures even though their domestic inflation rates were generally higher than those of their major trading partners; as a result, their real effective exchange rates appreciated substantially. (See Chart 19.) This appreciation, which was particularly strong during the period 1980–82 because most of these countries’ currencies also appreciated along with the U.S. dollar, tended to discourage economic diversification by reducing the competitiveness of domestic production of non-oil tradable goods.

Chart 19.Developing Countries: Real Effective Exchange Rates, by Analytical Subgroups of Countries, 1973–82 1

(Indices. 1973 = 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 effective exchange rates. Group indices are unweighted averages of country indices.

2 Within the group of “non-oil developing countries.”

The real exchange rates of the group of non-oil developing countries classified as net oil exporters were also influenced by developments in the world oil market. After a period of depreciation from 1975 to 1979, real exchange rates appreciated significantly through mid-1982 because rates of inflation higher than those of trading partners were not, in general, offset by exchange rate action. Beginning in the second half of 1982, however, devaluations by several of these countries, including Mexico, as part of comprehensive adjustment programs, contributed to a decline in their real effective exchange rates.

By contrast, countries classified as major exporters of manufactures have generally had relatively stable real effective exchange rates since 1973, despite a wide variation in the rates of domestic inflation within the group. The major exception was Argentina, where a sharp real appreciation occurred during the period 1978–80, which was, however, reversed in 1982. The general stability of real exchange rates reflected an active use of exchange rate policies to maintain external competitiveness. Such policies were pursued to take advantage of the substantial diversification of these countries’ economies and the consequent wide opportunities for switching resources to production for foreign markets or for import substitution.

These substitution possibilities, and price and income elasticities of demand for the exports of these economies that are generally higher than those of other non-oil developing countries, contributed to the ability of most major exporters of manufactures to cope with the adjustment problems of the past decade. The high degree of their integration into world trade and the international financial system, however, also caused some of them to be particularly affected by the global recession that began in 1980 and by the subsequent increase in protectionist measures in industrial countries. In response to these adverse developments, various economic strategies were followed within the group. Those countries, including most countries in Asia, that placed greater emphasis on maintenance of an appropriate exchange rate and domestic cost-price structure had, on the whole, greater success in reducing the size of their external imbalances, and their economic growth performance generally matched or exceeded that of countries that pursued policies involving less emphasis on the maintenance of international competitiveness.4

Other net oil importing countries—namely, middle-income primary producers and countries in the low-income group—faced a wide variety of circumstances. In a number of countries, particularly those that already had a relatively important manufacturing sector, the authorities successfully responded to the adverse external environment of the past three years by promoting diversification of exports and import substitutes. A key factor in this diversification was the provision of appropriate price incentives, including stable or declining real exchange rates, which were achieved through relatively moderate rates of domestic inflation (as in India, Ivory Coast, and Thailand) or through flexible exchange rate policies offsetting more rapid rates of inflation (as in Turkey).

Nevertheless, many countries exporting primary products, particularly in the low-income group, experienced an appreciation of their real effective exchange rates, especially after 1979. The largest real appreciations took place in some of the larger African countries, where exchange rate policies were not used with sufficient flexibility to offset relatively high rates of domestic inflation.

The Role of Exchange Rate Policies in External Adjustment

The authorities in many developing (and some industrial) countries are sometimes hesitant to use devaluation as a policy tool to correct an unsustainable external deficit, in part because of concern with its short-term costs and in part because of uncertainties as to its results. The costs are often seen in terms of the political and social repercussions of the effects of a devaluation on the distribution of income, particularly through its impact on consumer prices. The repercussions of these distributional effects may be regarded as costly even when they merely reverse the impact of earlier events and policies that had increased the relative prices of nontradable goods. The potential medium-term benefits of a devaluation are viewed as uncertain both in strength and timing, because the magnitudes and lags of the demand and supply responses to price changes are difficult to predict. Moreover, the trend toward greater protectionism in the industrial countries is seen as a factor reducing the potential impact of devaluation on the volume of a country’s exports.

The effect of a devaluation on the balance of payments depends on the response of domestic supply of and demand for tradable goods to the shift in relative prices and on the impact of the devaluation and accompanying policy measures on the balance of aggregate supply and demand. The former effect will in turn depend in part on the structure of the economy and the nature of its exportables. On the one hand, a country with considerable exports of manufactures may have a relatively high short-run price elasticity of export supply, because existing plant and equipment can be used more intensively and output can be redirected from domestic to foreign markets. One recent notable example of such a redirection of output has been that achieved by Turkey over the period 1979–82.

On the other hand, a country exporting only a small number of commodities that do not compete with other goods in production or consumption may experience a limited short-run supply response to a devaluation. In such a situation, which is typical of most low-income countries, structural adjustment often takes considerable time; it may also require a substantial amount of new investment and, since these countries have limited access to world financial markets, additional concessional financing from abroad. Even for these economies, however, a sizable increase in production costs of a primary product relative to its local currency price tends to discourage its production; it can also divert export receipts from official to parallel markets. There is now ample evidence that maintenance of international competitiveness is a key element in maintaining or increasing export market shares.5 Instances of the latter development over the period 1979–82 are provided by Burma and Kenya, which managed to expand the volume of their exports following declines in their real effective exchange rates.

The size and speed of supply responses are not, however, solely structural characteristics of an economy, but are greatly influenced by domestic pricing and demand management policies. The links between exchange rate policy and decisions on production and investment are stronger, the greater is the flexibility of the domestic price structure and the more economic agents, including those in the public sector, are allowed to react to price incentives. Appropriate demand management policies, by convincing producers that the increase in profitability in the tradable goods sector is not a temporary development, serve, inter alia, to reduce inflationary expectations and to encourage necessary long-term resource shifts. If the sources of internal inflation are not eliminated, the shift in the cost-price structure in favor of the tradable goods sector will soon be eroded, requiring further exchange rate action.

A number of countries, including Argentina, Brazil, and Israel, have resorted to continuous depreciation of the exchange rate (a “crawling peg”) in the face of rapid domestic inflation. Such an approach is clearly preferable to maintaining an unchanged exchange rate, under which severe distortions would soon develop in a situation of rapid inflation. A crawling peg may also be less vulnerable to speculative capital flows than a regime of infrequent changes in the exchange rate. An outcome preferable to any of these alternatives, however, would be a reduction of inflationary pressures. While the use of continuous depreciation might be thought to allow a country to adopt an inflation target without regard to external developments, inflationary expectations soon become entrenched and large segments of the economy seek to protect themselves through various forms of indexation. The resulting increased rigidity of relative prices makes it more difficult to reduce inflationary pressures, or to adjust to external shocks, without substantial adverse impact on the level of economic activity.

It has been observed that a group of developing countries exporting similar products faces a low price elasticity of demand for these exports and that, therefore, a simultaneous attempt to increase export supply by exchange rate depreciation by each country in the group would only lead to a deterioration of the terms of trade of all the countries. The importance of this consideration, however, varies substantially among different groups of developing countries, since the price elasticity of demand depends on the nature of the product exported. Although exports of mining and agricultural products without close substitutes in industrial countries generally face inelastic demand, a number of primary commodity exports compete with identical or related goods produced in the industrial world, so that the price elasticity of demand for these goods is not negligible in the medium term, provided that the industrial countries allow greater access to their markets. In addition, there is substantial empirical evidence that industrial countries’ imports of manufactures from developing countries are quite price sensitive, and in recent years they constituted the most rapidly growing component of industrial countries’ imports from developing countries as a whole. The benefits of this expansion, however, accrued mainly to the major exporters of manufactures and to other middle-income oil importing countries with significant manufacturing sectors. The low-income group of countries (excluding India and China) have only limited exports of manufactures, accounting for some 11 per cent of total exports on average in recent years. A greater diversification of their export base, notwithstanding the potential price effects associated with it, will be required over the medium term if the burden of overall adjustment is not to be forced onto the import side of their accounts. A reversal of recent trends toward more protectionist trade policies in the industrial countries would also have a major influence on developing countries’ export prospects; this issue is discussed in greater detail in a later section of this chapter.

The potential benefits of a more appropriate structure of costs and prices are not, however, limited to exports. An exchange rate action can bring substantial benefits on the import side. In particular, in countries where an overvalued currency and a domestic price structure that discriminates against agricultural production have led to large food imports, exchange rate devaluation combined with a shift toward more market-related prices can result in a substantial short-term increase in domestic output of food crops. In recent years a number of countries, including Malawi, Somalia, and Sri Lanka, have achieved significant production responses in domestic agriculture following a shift in the internal terms of trade toward agriculture.

The adjustment problems of centrally planned economies bear special mention. Many of these countries experienced growing external difficulties in 1981 and 1982, particularly on their convertible currency accounts, and, in response, many adopted adjustment programs. Although administrative cutbacks in imports were the dominant feature of most of these adjustment efforts, a number of countries, including Hungary and Romania, did adopt policies involving further movement of relative prices in domestic markets toward those prevailing in world markets, combined with a greater role for financial incentives and decision making at the level of individual economic units. In some countries, particularly Hungary, these policies were supported by more active use of the exchange rate to promote exports and reduce import dependence. As in market economies, the effectiveness of exchange rate and other price corrections in improving the external balance depends on the support provided by measures to restrain domestic expenditure. In addition, recent experience suggests that adoption of market-oriented measures to promote external and structural adjustment may be best supported by further decentralization of economic decision making, accompanied by a greater accountability of enterprises for the financial outcome of their actions.

Exchange Rates and Interest Rate Policy

An exchange rate action often needs to be supported by a shift toward more appropriate interest rate policies, which have a major impact on both resource allocation and demand management. In many developing countries nominal interest rates are held by administrative means at a level below that which would equate the underlying supply and demand for funds, and are frequently held well below current rates of inflation. Although the importance of interest rate policy varies with the institutional framework of a country and the degree of sophistication of its financial markets, interest rates that are not competitive with international rates or with returns on alternative domestic assets generally contribute to lower rates of investment and economic growth, because domestic financial savings are discouraged in favor of the accumulation of stocks of goods or of foreign financial assets. In the past two years, a number of countries, including Jamaica, Thailand, and Turkey, have achieved substantial increases in rates of domestic financial savings following a shift toward positive real interest rates as a result of some combination of higher nominal interest rates and lower inflation.

If interest rates are kept too low, countries typically resort to administrative measures for the selective allocation of credit. Such allocation tends to be influenced heavily by social or political considerations rather than by the productivity of the resulting investment. At the same time, low interest rates in combination with an overvalued currency, which lowers the local currency price of imported capital equipment, can result in the adoption of production techniques that are overly capital intensive and adversely affect employment opportunities. Negative real interest rates also exert a destabilizing influence on demand management: the reduced willingness to hold domestic financial assets exacerbates the inflationary consequences of an expansionary monetary policy. Moreover, the increase in the demand for foreign assets occasioned by such circumstances is difficult to prevent, even in countries with strict capital controls, especially when the currency is overvalued.

Experience suggests, especially for countries with relatively developed domestic financial institutions, that more appropriate interest rates, together with realistic exchange rate policies, can help foster efficient use of resources, which contributes to the required external adjustment while helping to restore a satisfactory rate of economic growth. They can also have a direct impact on the external accounts by encouraging net capital inflows to supplement domestic savings. Recent developments in a number of Latin American countries, in particular, show that expectations regarding future exchange rate movements are also crucial in this regard; if destabilizing short-term capital flows are to be avoided, it is important that a move toward more market-related interest rates be accompanied by exchange rates that are consistent with underlying economic forces.

Protectionism and Developing Countries’ Adjustment Policies

In many developing countries, the authorities’ initial response to a weakening external position has often been to introduce or intensify restrictions on imports and, less frequently, to adopt various indirect incentives for selected exports. The generally difficult balance of payments situation of non-oil developing countries in 1982 led many of them to intensify import restrictions, particularly in the form of quantitative controls. Restrictions on invisible transactions were also intensified by many countries. Similarly, emerging balance of payments difficulties led to the introduction or intensification of import restrictions in some oil exporting countries during the course of the year. Only a limited number of developing countries, including Bangladesh, Haiti, India, Jamaica, Morocco, Pakistan, Tunisia, Turkey, and Uganda, achieved some liberalization of their import regimes. Most of these liberalizations took place within the framework of adjustment programs supported by use of Fund resources. The use of selective export incentives also increased in 1982, as a number of developing countries, particularly in Latin America, sought to promote their exports through new fiscal incentives or preferential financing facilities.6

A policy of import controls and selective export incentives generally entails a high cost in terms of economic efficiency. To be sure, the “infant industry” argument may justify some controls and incentives, provided their levels are not excessive and provided they are only imposed temporarily. Nevertheless, if high import tariffs and export subsidies are maintained indefinitely, and if the differences in tariff or subsidy rates between closely related goods are large, the resulting distortion of relative prices leads to an inefficient structure of production and investment and eventually to a lower rate of economic growth than could have been achieved otherwise. In some cases, an increasingly severe foreign exchange constraint leads to even more stringent direct import controls and a resulting sharp decline in output because of dislocation caused by shortages of imported inputs and spare parts. A number of African economies, among others, have experienced such difficulties during the past two years. Such countries are less able to adjust to the impact of external shocks than countries that have followed outward-looking growth strategies.

Moreover, developing countries are an increasingly important market for the exports of members of this group. In recent years about 30 per cent of all exports from non-oil developing countries have gone to other developing countries (including the major oil exporters). Consequently, increased protection within the group of developing countries has a direct impact on the export prospects and adjustment possibilities of the developing countries themselves.

The dampening effect on production of inappropriate relative prices and import shortages caused by excessive trade protection can be reversed by an exchange rate depreciation combined with a liberalization of import restrictions. It is important, however, that these measures be taken in a timely manner, because the longer the economic distortions prevail, the more difficult will be the adjustment process, as patterns of investment and resource allocation adapt to the distorted price structure and vested interests become entrenched.

Both the long-term prospects for export expansion and the ability of developing countries to expand their exports as part of a process of medium-term adjustment depend crucially on expanding the absorptive capacity of the industrial countries, which account for over 60 per cent of all exports from non-oil developing countries. Therefore, the spread of protectionist measures in most industrial countries during the past two years has substantial adverse effects on adjustment possibilities and the longer-term development potential in developing countries. Protectionism generally stems from a desire to limit the loss of employment and reduction in real incomes in specific industrial sectors, rather than from overall balance of payments problems. Consequently, new protectionist measures are concerned mainly with specific commodities, particularly certain manufactures and processed agricultural products, and frequently involve a recourse to non-tariff barriers, including quantitative restrictions and voluntary export restraints that may be imposed in a discriminatory (country-specific) manner.

One protectionist measure of particular importance to developing countries is the extension until July 1986 of the Multi-Fibre Arrangement, which regulates developing countries’ exports of textiles and clothing to the industrial countries. The protocol extending the arrangement contains understandings that may further restrict trade by allowing for stricter terms of access to markets to be applied to “dominant” suppliers than to other developing countries. This new provision, which will affect primarily Asian developing countries in the group of major exporters of manufactures, is directed at countries that have already demonstrated a significant comparative advantage in the production of textiles and clothing. Other recently introduced measures include the imposition by various industrial countries of quantitative restrictions on imports of steel and steel products, automobiles, footwear, electronic consumer goods, and other manufactured products. Even though some of these measures affect primarily trade among industrial countries, they represent a progressive extension of restrictions to sectors in which developing countries, principally the major exporters of manufactures, have an actual or potential comparative advantage.

Since most of the new protectionist measures involve quantitative restrictions, they will tend to hinder developing countries from undertaking adjustment by means of exchange rate policies designed to expand the volume of exports. Such restrictions have had only a limited direct impact on the exports of countries without substantial manufacturing production. Nevertheless, the general trend toward greater protectionism in manufactures tends to discourage new export-oriented investment in these sectors and so hinders efforts to achieve a greater diversification of the export base of developing countries.

The existing highly restrictive structure of agricultural protection in most industrial countries has a direct impact on the export potential and adjustment possibilities of a broad range of developing countries. Although a few additional restrictions on agricultural trade have been introduced (including limitations on imports of sugar into the United States, cereal substitutes into the European Community, and meat into the North American market), the structure of this protection has remained largely unchanged in the past two years. However, the level of subsidization and protection of domestic production under arrangements for price equalization has increased markedly as a result of depressed commodity prices. Such an insulation of domestic producers and consumers from changes in supply and demand in international markets shifts the burden of adjustment onto other countries, including many developing countries, by reducing the demand in those markets for the output of lower-cost producers.

To a considerable extent, the pace of adjustment of developing countries will be determined by the speed at which industrial countries are able to adjust to larger and more diversified flows of imports by resisting pressures for new protectionist measures and by dismantling existing restrictions. This is of special importance for the heavily indebted developing countries, which require open foreign markets if they are to generate sufficient export earnings to meet their external debt-servicing requirements. A case for reducing protectionism in the industrial countries will also be easier to make to the extent that developing countries refrain from subsidizing production of export goods, which tends to induce retaliatory measures. Moreover, developing country markets are of growing importance to the industrial countries, so that there are many opportunities for mutually beneficial trade liberalization, which would only increase the stability of the trading system as a whole.

Adjustment and the External Debt of Non-Oil Developing Countries

The current account developments and financing patterns of recent years have led to substantial changes in the level and composition of the external debt of non-oil developing countries, as discussed in Chapter 1. The size of this debt and the related debt-servicing payments have a significant influence on the adjustment process in the countries concerned, in terms of both the policy choices facing national authorities and their continued access to world financial markets. In particular, both the original external borrowing and the ensuing debt-servicing payments will have an important influence on exchange rate policy.

In countries with poorly developed financial markets, an increase in external borrowing to finance domestic expenditure—provided that it is not all devoted to the acquisition of traded goods (such as imported capital equipment)—will lead to an initial improvement in the balance of payments, a rise in the price of nontraded goods relative to the price of traded goods, and a consequent tendency for the real effective exchange rate to appreciate. If the growing size of the country’s external debt eventually necessitates a cutback in new external borrowing, the balance of payments will deteriorate, and restoration of external balance may require both an exchange rate depreciation and a reduction of domestic expenditure relative to income.

For some developing countries with relatively well-developed financial markets, especially those in Latin America, the initial improvement in the balance of payments resulting from increased borrowing has tended to be offset by an outflow of private capital. Such outflows have arisen in part because residents have increased the proportion of foreign assets in their portfolios in expectation that the exchange rate would have to depreciate in the long run in order to generate the trade surplus needed to service the larger stock of foreign debt. This tendency has not appeared in those countries, for instance in Asia, where such borrowing has been perceived as financing investment in export-oriented industries, thereby improving future current account prospects.

The ability of non-oil developing countries to cope with their debt-servicing burdens depends not only on future levels of world demand and interest rates and on the pursuit of appropriate macroeconomic policies in the borrowing countries but also on the uses made of the resources generated by the external borrowing. If the additional resources made available by external borrowing are used for sufficiently productive investment in the traded goods sector, they will generate future real resources that will permit servicing of the debt without affecting future consumption, as well as directly produce foreign exchange earnings to meet debt-servicing obligations. A poor choice of investment projects, however, perhaps caused by reliance on an inappropriate domestic price structure, may mean that future returns from the investments will be insufficient to cover debt service, which will then be partly at the expense of future consumption. Moreover, in many developing countries much of the recent borrowing has been used to finance investment in infrastructure, most of whose output is nontraded. Consequently, even if the investments themselves have a high rate of return, an increase in the relative price of traded goods may be required to generate foreign exchange to meet debt-servicing payments. There is also often a serious imbalance between the maturity structure of the investments and the debt, which increases the countries’ vulnerability to the emergence of possibly temporary, but nevertheless serious, debt-servicing problems. This imbalance is especially prevalent in some Latin American countries that have relied excessively on short-term loans from the international banking system.

Borrowing to maintain consumption in the face of temporary declines in income, owing to adverse movements in the terms of trade or internal shocks, might be justified in some instances, especially if there are large costs associated with adjusting to a lower consumption level. Nevertheless, as in the case of borrowing to finance low-return investments, the resulting debt-servicing payments will then be at the expense of future consumption. Such payments will make future adjustment all the more difficult, especially if the factors adversely affecting income prove to be not easily reversed. Under such circumstances, an exchange rate depreciation may well be required as part of the package of expenditure-reducing and expenditure-switching measures to bring about the reduction in domestic consumption and to generate the trade surplus required to meet the debt-servicing payments.

There is evidence that, at least among the major borrowers, the increase in external indebtedness over the past decade has been associated with a higher rate of investment and has not been used primarily to finance consumption at the expense of a lower rate of domestic savings. In this regard, it may be noted that for 14 of a group of 20 non-oil developing countries, including most of the largest international borrowers, the ratio of saving to GNP increased from 1968–72 to 1974–77 and rose further in 1978–81; during the latter period, the saving rates of all but 2 of the 20 countries were equal to or higher than those they had in the period 1968–72.7

In the final analysis, the viability of any level of external debt depends to a large extent on the perceptions by foreign lenders of a country’s creditworthiness. The marked slowdown in bank lending in the second half of 1982, which, although broadly based, affected particularly Latin American and East European countries, was a major cause of the adjustment of current account balances that took place during the year and that is expected to be carried further in 1983. It is important, however, that increased concern over the outstanding indebtedness of some of the major borrowing countries not result in a further sudden sharp fall in net bank lending, since this could only exacerbate already serious short-term liquidity problems and impede an orderly process of adjustment. The implementation of sound adjustment programs by the countries concerned plays a major role in restoring confidence to international capital markets by convincing creditors that realistic policies are in place to ensure effective utilization of available foreign savings.

Even with effective adjustment policies, however, the external payments situation for many developing countries will remain difficult in the near future. The resolution of debt-servicing difficulties will take time and will depend on renewed growth of economic activity in the industrial countries and of world trade, on measures to promote exports from developing countries, on adequate growth of official development assistance, and on further progress in reducing the high fiscal deficits and inflationary expectations throughout the world economy that are contributing to high interest rates.

Surveillance Over Exchange Rate Policies

Under the Articles of Agreement, the Fund is charged with overseeing the international monetary system in order to ensure its effective operation. Article IV, Section 3(b) provides that “the Fund shall exercise firm surveillance over the exchange rate policies of members, and shall adopt specific principles for the guidance of all members with respect to those policies.” These principles, which were enunciated in an Executive Board decision adopted in 1977,8 were reviewed in 1980 and 1982 and will be reviewed again not later than April 1, 1984.

The principles of surveillance emphasize that the Fund is concerned with the policies of all member countries regardless of the exchange rate arrangements to which they adhere. In general, Fund surveillance focuses on the examination of the overall economic situation of a member country in order to assess the appropriateness of its policies with respect both to the sustainability of its external position and to the effects on other member countries. The existence of a problem and the need for discussion with a member may be signaled by one or more conditions, including exchange rate movements that appear to be unrelated to underlying economic and financial conditions, protracted large-scale exchange market intervention in one direction, unsustainable levels of official or quasi-official borrowing or lending, changes in the use of restrictions on, or incentives for, current or capital transactions, or the pursuit of domestic financial policies that provide abnormal encouragement or discouragement to capital flows.

Issues in the Implementation of Surveillance

As in other recent years, the existence of large and sustained movements in exchange rates among the currencies of industrial countries was a central issue in the implementation of Fund surveillance during 1982 and the first half of 1983. In addition, the emergence of severe debt-servicing problems in a number of developing countries led the Fund to consider the appropriateness of their exchange rate and other adjustment policies even more closely than in the past. Furthermore, the increasing tendency toward protectionism in trade relations and restrictions on financial transactions lent special significance to surveillance over the policies of both developing and industrial countries.

The problems associated with exchange rate variability among the industrial countries remained a major source of concern for the Fund. Particularly worrisome in this context were the pronounced swings in exchange rates among the major currencies. As discussed above, the adjustment from a high to a low inflation rate may itself be a temporary source of these exchange rate swings, but, ultimately, there is no doubt that the achievement of stable underlying economic and financial conditions is a prerequisite for a stable and well-functioning exchange rate system. For this reason, as well as for domestic purposes, the Fund has continued to urge countries to persevere with anti-inflationary policies now in place and to strengthen them whenever necessary.

In addition, the Fund has urged countries to adopt a set of policies that takes adequate account of interactions with economic policies and conditions in other countries. Two problems have been given particular attention. First, as described earlier in this chapter, differences among the major countries in the relative emphasis given to monetary and fiscal restraint may have contributed to the substantial changes that have taken place in real exchange rates. Some differences in the policy mix are naturally to be expected, reflecting economic conditions and social choices of the countries concerned; nonetheless, it is important for countries to take into account the effects of their policy choices on other countries. Second, the effects of anti-inflationary policies on exchange rates have been aggravated by a slow rate of economic adjustment, especially in labor markets. Accordingly, the Fund, taking into account the conditions prevailing in individual countries, has frequently suggested the implementation of supporting measures such as incomes policies or policies designed to reduce structural rigidities in the economy.

A different kind of exchange rate problem has arisen from the lack of convergence of economic conditions among countries attempting to maintain stable nominal exchange rates. Many countries peg their currency either to a single currency or to a currency composite, and other countries participate in a cooperative arrangement. In practice, these countries choose the extent to which it is desirable to adapt their domestic policies to those of the countries to which their exchange rates are pegged, and they occasionally adjust their exchange rates to compensate for the effects of whatever differences remain in economic conditions. These adjustments, however, are especially difficult to implement successfully when a country’s underlying policies and economic conditions differ fundamentally from those in countries to whose currencies its exchange rate is pegged. Markets may come to expect recurrent adjustments in one direction, resulting in speculative pressures that necessitate frequent adjustments or the imposition of controls on the flow of capital. The Fund accordingly has stressed the importance of overall convergence of underlying economic conditions as a necessary requirement for the smooth functioning of such exchange rate arrangements.

The Fund must also consider whether members may have used exchange rate policies to gain a competitive advantage. Any depreciation of a country’s real exchange rate will at least temporarily improve that country’s competitive position. A surveillance issue arises only if a particular devaluation appears to lead to an unwarranted change in competitiveness, namely, one that seems excessive in view of the loss of competitiveness experienced in the past and the size of the current and prospective external imbalances. However, the difficulty of determining appropriate exchange rate adjustments has been particularly acute during the past few years, as the smaller industrial countries have responded to the policies of monetary restraint adopted by the major industrial countries. In these circumstances, with the volume of world trade declining, countries that needed to adjust their balance of payments have had to try to increase their share of total trade. In general, therefore, many of the smaller industrial countries have had to bring about a depreciation of their exchange rates in both nominal and real terms.

There are a number of possibly adverse consequences of currency devaluations that the Fund has urged countries to keep in mind. Most important, devaluations may shift a large part of the adjustment burden onto other small countries that are close trading partners of the devaluing country. It is thus essential to ensure that devaluations not be so large as to raise the possibility of an unwarranted change in competitiveness. In addition, devaluation may weaken a country’s own domestic stability by adding to inflationary pressures. These pressures have been especially acute where wages are adjusted automatically for variations in consumer prices, even when they result from variations in prices of imported goods.

The second major surveillance issue faced by the Fund during this period was related to the need for adjustment on the part of developing countries with external debt problems. In this context, the Fund has stressed the need to maintain appropriate exchange rates. As noted earlier in this chapter, there is considerable evidence that those developing countries that have tended to avoid overvaluation of their exchange rates have adjusted better to the harsher external environment of recent years than many other developing countries. In contrast, the trade and growth performance of those countries whose real exchange rates have tended to appreciate has deteriorated relatively more than average. There are, of course, many reasons for this difference in performance, but the difference in growth strategies and in exchange rate policies seem to be an important reason.

The Fund has also stressed that improvement in economic performance requires the implementation of domestic financial policies that provide appropriate support for exchange rate adjustments. Monetary restraint is essential in countries experiencing high rates of inflation, and the general tendency toward increasing fiscal deficits over a number of years—in industrial as well as developing countries—needs to be reversed. In many countries, current account deficits have been in part the result of large structural fiscal deficits that have absorbed a disproportionate share of domestic saving. The fiscal deficits thus have contributed both directly and indirectly to the growth of external debt, which in turn has brought about a debt-servicing burden that has further perpetuated the current account deficits.

Given the extent of the adjustment problems of developing countries, the Fund has encouraged the commercial banks to provide adequate financing in support of Fund-assisted adjustment programs, since abrupt cutbacks in the flow of net bank lending (such as took place in the latter half of 1982) make it more difficult for the non-oil developing countries to maintain an appropriate balance between financing and adjustment. This difficulty is especially serious for the net oil exporters and the major exporters of manufactures, the two subgroups of the non-oil developing countries that rely most heavily on private financing. The Fund has also urged industrial countries to open their domestic markets more fully to both agricultural and industrial exports of developing countries.

The growth of protectionism is of course of concern to the Fund not only in relation to the adjustment problems of developing countries but also in relation to its general surveillance responsibilities. Over the past several years, many industrial and developing countries have introduced various kinds of trade barriers. The proliferation of these measures, including unilateral quotas, bilateral arrangements, and “voluntary restraint” by exporters, directly affects the global allocation of resources, the effectiveness of exchange rate adjustments, and the efficiency of the open multilateral trading system. In the broadest sense, trade restrictions are major impediments to the process of global adjustment because they obstruct the exchange of goods on the basis of comparative costs and retard needed structural change in the domestic economies of countries imposing them. Because of the severe external constraints facing many of the developing countries, the possibility of achieving significant reductions in trade restrictions will depend to a large extent on the leadership provided by the industrial countries. In this connection, the undertaking of the General Agreement on Tariffs and Trade (GATT) at its ministerial meeting in November 1982 “to resist protectionist pressures in the formulation and implementation of national trade policy and in proposing legislation” and “to avoid measures which would limit or distort international trade” is to be welcomed. The ministers also agreed upon a detailed work program to be pursued under GATT auspices, one aim of which will be to “ensure the effective implementation of GATT rules and provisions and specifically those concerning the developing countries, thereby furthering the dynamic role of developing countries in international trade.” 9

It now remains to translate these intentions into concrete policy actions so as to resume progress toward an open multilateral trading environment, which is in the interest of both developed and developing countries. To this end, the Fund has intensified its collaboration with the GATT and has placed increased emphasis on these issues in all of its surveillance activities.

Procedures for Implementing Surveillance

The difficult world economic environment and the strains within the international financial system have heightened the need for the effective implementation of surveillance. The Fund, in its most recent review of the implementation of surveillance, took steps accordingly to further adapt established surveillance procedures to improve their effectiveness. Important goals in these efforts are to ensure a uniform treatment of member countries and to encourage exchange rate policies that are consistent with a medium-term global adjustment strategy.

Article IV consultations remain the principal vehicle for the exercise of Fund surveillance over the exchange rate policies of member countries. The discussion and analysis of economic developments in connection with Article IV consultations provide a basis for the Fund’s assessment of members’ policies from the perspective both of individual members and of the functioning of the international economy. Because of this central role, it is essential that Article IV consultations be held regularly and that their analytical content be comprehensive. In principle, consultations are to take place annually, but in practice it has not proven possible to adhere to a strict annual cycle for all members. In recognition of a need to achieve a higher degree of frequency of consultations, there has been some adaptation of procedures this year. For most members—including in particular those whose policies have a substantial impact on other economies, those that have Fund-supported programs, and those for which there are substantial doubts about the medium-term viability of the balance of payments situation—there will be stricter adherence to an annual consultation cycle. At the conclusion of each consultation, a date by which the Executive Board discussion of the next consultation is expected to be concluded will be set. For members on an annual cycle, the interval between consultations will be limited to 12 months, with a grace period of 3 months beyond the specified date. For other members, an interval greater than 12 months may be proposed, but in no case will it exceed two years. The Executive Board will be notified through periodic reports of any delays in the consultation schedule.

The analytical content of Article IV consultations is continuously adapted to ensure comprehensiveness and relevance. The 1983 review stressed the need for a more expanded coverage of trade policy and for a forward-looking analysis of external debt management consistent with the global economic analysis provided in the World Economic Outlook exercise. In the context of Article IV consultations, more comprehensive analysis of the effects of trade measures on domestic adjustment and the exchange rate, as well as on the country’s trading partners, will provide a basis for discussion between the Fund and the member country.

Intensified efforts are being made to improve the coverage of external debt developments and policies in Article IV consultation reports, and, to the extent possible, to provide a forward-looking analysis of a country’s debt-servicing prospects. This analysis is not to be confined to countries using Fund resources but is to be employed as a normal procedure for members engaged in significant external borrowing operations. Essential to this effort is the development by the Fund’s Bureau of Statistics (in cooperation with the Bank for International Settlements) of a broad data base covering international banking and external debt. Further, under the aegis of the Central Banking Department’s technical assistance program, member countries will be provided with more technical assistance in the field of external debt. These activities will enable the staff to provide a more comprehensive analysis of external debt management in the context of Article IV consultations and to inform the Board, at an early stage, of potential payments difficulties faced by individual member countries.

The established procedures for surveillance provide that notifications of changes in members’ exchange arrangements be communicated to the Fund within three days. Of the notifications communicated to the Executive Board in 1982, some 80 per cent were in conformity with the three-day standard. Significant changes in a member country’s arrangements are normally followed promptly by a staff assessment of the change. In addition, the staff prepares a quarterly paper for the Executive Board, summarizing developments in members’ exchange arrangements during the previous quarter.

Changes in exchange rates or exchange rate policies are also the subject of informal discussions between the Fund and the authorities of individual countries. Moreover, the policies of the major industrial countries are discussed during special staff visits as well as by the Executive Board in the context of the World Economic Outlook exercise. Past decisions on surveillance procedures prescribe two other types of discussion that are more formal. First, paragraph V of the Procedures for Surveillance agreed in 1977 requires the Managing Director, when he considers that a member’s exchange rate policies might not be in accord with the exchange rate principles, to raise the matter informally and confidentially with the member and to inform the Executive Board of his conclusions. Second, the supplemental procedure adopted by the Executive Board in January 1979 authorizes the Managing Director to initiate informal and confidential discussions with a member if he considers that a modification in the member’s exchange arrangements or exchange rate policies, or the behavior of the exchange rate of its currency, might be important or might have important effects on other members. If, after prior discussion with the member, he considers that the matter is important, he may initiate and conduct an ad hoc consultation. In 1982, following a preliminary discussion in the Executive Board of the devaluation by Sweden, a special consultation was held between the staff and the Swedish authorities. A comprehensive report on the devaluation was then discussed by the Executive Board.

Following the March 1983 review of surveillance procedures, the Executive Board decided to initiate, on an experimental basis, a system whereby the Executive Board will be notified regularly of all sizable changes in real effective exchange rates. This decision was taken in recognition of the importance of changes in real exchange rates in the adjustment process and the need for the Fund to apply surveillance with respect to exchange rate changes uniformly to all members, irrespective of their exchange arrangements. This procedure will be in addition to existing procedures for notification of changes in member countries’ nominal exchange rates. Moreover, it is planned to issue periodic staff reports to the Executive Board containing a review of changes in real effective exchange rates over the most recent period, highlighting changes that are particularly large.

Complementing the surveillance procedures applied to individual countries are the comprehensive analyses of the world economy and the exchange rate system provided in the World Economic Outlook. In this context, the staff analysis focuses on a global medium-term approach to domestic and external adjustment problems. Particular attention is given to the implications for global adjustment of the policies and developments in the major industrial countries. Special studies of current issues are included as a regular feature of the World Economic Outlook.

In addition to regular staff reports on recent developments in international capital markets, trade policy, and exchange and trade restrictions, the staff prepared a number of Executive Board papers on topics related to surveillance. Among these were papers dealing with exchange rate policies in developing countries, issues concerning the Fund’s approach to centrally planned economies, the effects of the energy situation on oil exporting countries, interest rate policies of developing countries, and external debt-servicing problems.

Exchange Arrangements of Member Countries

The trend toward the adoption of more flexible exchange arrangements, as noted in last year’s Annual Report, continued in 1982 and the first half of 1983. During 1982, six countries changed their exchange arrangements to or from pegged arrangements, of which five moved in the direction of greater flexibility. The other member reverted to a single currency peg in conjunction with a sizable devaluation and an effort to unify its multiple exchange markets. Two other countries that had previously limited the flexibility of their exchange rate in terms of a single currency undertook instead to manage their exchange rate on a flexible basis; a third ceased management altogether and now allows its exchange rate to float independently. Five other countries did diminish the flexibility of their exchange arrangement slightly, but two of these did so within the context of a simplification of their multiple exchange markets. In the first half of 1983, two countries changed their exchange arrangements in the direction of greater flexibility and another two changed their pegs from the U.S. dollar and the SDR to composite currency pegs reflecting their patterns of trade. Of the two countries that undertook to manage their exchange rates with greater flexibility, one moved from a single currency peg, while the other moved from an arrangement under which the flexibility of its exchange rate was limited in terms of a single currency.

At the end of June 1983, the currencies of 54 members were pegged to a single currency (36 to the U.S. dollar, 13 to the French franc, 2 to the South African rand, and 1 each to the Indian rupee, the pound sterling, and the Spanish peseta). Fourteen currencies were pegged to the SDR and 25 to other currency composites. In all, therefore, 93 members had currencies classified under the “Pegged” category. Seventeen members maintained exchange arrangements classified in the category headed “Flexibility Limited.” Within this group, 9 currencies were in the subclassification “Single Currency” (all vis-à-vis the U.S. dollar) as a result of having their exchange rates fluctuate within the equivalent of margins of 2¼ per cent or less against an identifiable single currency of another member; the other 8 currencies, as shown in Table 13, were those of countries maintaining cooperative arrangements with the EMS. Thirty-five members maintained exchange arrangements in the “More Flexible” category; of these, 5 adjusted their exchange rates according to a set of indicators, 22 had managed floating rates, and the currencies of 8 members floated independently.

Table 13.Exchange Rate Arrangements, June 30,1983 1
PeggedFlexibility Limited Vis-à-Vis a Single Currency or Group of CurrenciesMore Flexible
Adjusted according to a set of indicatorsOther managed floatingIndependently floating
U.S. dollarFrench francOther currencySDROther compositeSingle currency 2Cooperative arrangements
Antigua andBeninBhutanBurmaAlgeria 3AfghanistanBelgium 3BrazilArgentinaCanada
BarbudaCameroon(IndianGuinea 3AustriaBahrain 4DenmarkChile 3AustraliaIsrael
Bahamas 3Centralrupee)Guinea-Bangladesh 3, 5GhanaFranceColombiaCostaJapan
BarbadosAfricanEquatorialBissauBotswanaGuyanaGermany, FederalPeru 3Rica3Lebanon
BelizeRepublicGuineaIran,Cape VerdeMaldivesRepublic ofPortugalEcuador3South
Bolivia(Spanish peseta)Islamic Republic ofIrelandGreeceAfrica
BurundiChadThe GambiaJordanChina 3Qatar 4Italy 6IcelandUnited
DjiboutiComoros(poundKenyaCyprusSaudiLuxembourg 3India 7Kingdom
DominicaCongosterling)MalawiFijiArabia 4NetherlandsIndonesiaUnited
DominicanGabonLesothoSão Tomé andFinland 8ThailandKoreaStates
Republic 3Ivory Coast(SouthPrincipeHungary 3United ArabMexico 3Uruguay
Egypt 3African rand)SeychellesEmirates 4
El Salvador 3MaliSwazilandSomalia 9KuwaitMorocco
EthiopiaNiger(SouthVanuatuMadagascarNew Zealand
GrenadaSenegalAfricanViet NamMalaysiaNigeria
GuatemalaTogorand)Zaїre 3MaltaPakistan
HaitiUpper VoltaZambia 10MauritaniaPhilippines
HondurasMauritiusSierra
IraqNepalLeone 3
Jamaica 3NorwaySpain
Lao People’sPapua NewSri Lanka
DemocraticGuineaTurkey
RepublicSingaporeUganda 3
Liberia
Libyan ArabSolomon IslandsWestern
JamahiriyaSwedenSamoa
Nicaragua 3TanzaniaYugoslavia
OmanTunisia
PanamaZimbabwe
Paraguay
Romania
Rwanda
St. Lucia
St. Vincent
Sudan 3
Suriname
Syrian Arab
Republic 3
Trinidad and
Tobago
Venezuela 3
Yemen Arab
Republic
Yemen, People’s
Democratic
Republic of

No current information is available to Democratic Kampuchea. All members whose currencies are pegged to a single currency do so at present within zero fluctuation margins. Members whose currencies are pegged to the SDR or “Other composite” maintain their exchange rates within zero or very narrow margins, seldom exceeding ± 1 per cent about the peg. Within the “Flexibility Limited” category the “Single currency” subcategory lists those members that are observed to maintain an exchange arrangement such that their exchange rate fluctuates with a variability equivalent to 2¼ per cent margins with respect to another member’s currency. The subclassification, “Cooperative arrangements,” lists the countries participating in the European Monetary System (EMS). With the exception of Italy, which maintains margins of 6 per cent, these countries maintain 2¼ per cent margins with respect to their cross rates based on the central rates expressed in terms of the European currency unit (ECU). Members with exchange arrangements listed under the “More Flexible” category are divided on the basis of the extent to which the authorities intervene in the setting of exchange rates. In some instances the exchange rate is allowed to move continuously over time; if the authorities intervene at all they do so only to influence, but not to neutralize, the speed of exchange rate movement. That exchange arrangement is classified as “Independently floating.” Alternatively, the exchange rate may be set for a short interval, usually one day to one week, and the authorities stand ready to buy and sell foreign exchange at the specified rate (the “managed floating” group).

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.

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

Changes in the exchange rate vis-à-vis the U.S. dollar generally occur when the effective exchange rate, as calculated on the basis of the weighted currency basket, deviates by more than ± 1 per cent from the pegged level.

Margins of ± 6 per cent 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 margins of 5 per cent on either side of a weighted composite of the currencies of the main trading partners.

The fluctuation band of the Bank of Finland’s currency index is currently about 4.5 per cent (equivalent to margins of ± 2.25 per cent).

The exchange rate is maintained within margins of ± 2.25 per cent.

The exchange rate is maintained within margins of ± 2.5 per cent in terms of the fixed relationship between the kwacha and the SDR.

No current information is available to Democratic Kampuchea. All members whose currencies are pegged to a single currency do so at present within zero fluctuation margins. Members whose currencies are pegged to the SDR or “Other composite” maintain their exchange rates within zero or very narrow margins, seldom exceeding ± 1 per cent about the peg. Within the “Flexibility Limited” category the “Single currency” subcategory lists those members that are observed to maintain an exchange arrangement such that their exchange rate fluctuates with a variability equivalent to 2¼ per cent margins with respect to another member’s currency. The subclassification, “Cooperative arrangements,” lists the countries participating in the European Monetary System (EMS). With the exception of Italy, which maintains margins of 6 per cent, these countries maintain 2¼ per cent margins with respect to their cross rates based on the central rates expressed in terms of the European currency unit (ECU). Members with exchange arrangements listed under the “More Flexible” category are divided on the basis of the extent to which the authorities intervene in the setting of exchange rates. In some instances the exchange rate is allowed to move continuously over time; if the authorities intervene at all they do so only to influence, but not to neutralize, the speed of exchange rate movement. That exchange arrangement is classified as “Independently floating.” Alternatively, the exchange rate may be set for a short interval, usually one day to one week, and the authorities stand ready to buy and sell foreign exchange at the specified rate (the “managed floating” group).

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.

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

Changes in the exchange rate vis-à-vis the U.S. dollar generally occur when the effective exchange rate, as calculated on the basis of the weighted currency basket, deviates by more than ± 1 per cent from the pegged level.

Margins of ± 6 per cent 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 margins of 5 per cent on either side of a weighted composite of the currencies of the main trading partners.

The fluctuation band of the Bank of Finland’s currency index is currently about 4.5 per cent (equivalent to margins of ± 2.25 per cent).

The exchange rate is maintained within margins of ± 2.25 per cent.

The exchange rate is maintained within margins of ± 2.5 per cent in terms of the fixed relationship between the kwacha and the SDR.

International Liquidity and Reserves

International reserves, which are defined to include official holdings of gold, foreign exchange, SDRs, and reserve positions in the Fund, were strongly affected by developments in the world economy in 1982. For the first time in more than two decades, the foreign exchange component declined, from SDR 305 billion at the end of 1981 to SDR 295 billion at the end of 1982. Both international reserves and international liquidity, which also takes into account the capacity to borrow from abroad, were affected by developments in exchange rates and exchange arrangements, adjustments in general macroeconomic policies, and the emergence of disturbances in financial markets associated with debt-servicing problems of some developing countries. To limit the adverse impact of these disturbances on the international monetary system, important initiatives were taken by the Fund, which played an active role in promoting adjustment in countries suffering from serious international payments problems. In addition, agreements were recently reached to increase substantially the resources available to the Fund from quota subscriptions and the General Arrangements to Borrow.

The remainder of this chapter examines recent developments regarding international reserves and liquidity. First, the changing composition, distribution, and sources of international reserves are reviewed. This review is followed by a description of the size, composition, and yield of the foreign exchange component of reserves. The role of private international capital markets is then dealt with in terms of their provision of international liquidity and their impact on the adjustment process. Next, the adequacy of reserves and international liquidity is considered. The chapter concludes with a discussion of the measures that the Fund has undertaken to provide liquidity and promote international financial adjustment.

Recent Evolution of Official Reserve Assets

Non-Gold Reserves

In 1982, international reserves, excluding gold, fell by about 1 per cent to SDR 338 billion (Table 14). This was the first annual decline in nominal non-gold reserves since 1959, and it represents a substantial turnaround from the average annual rate of growth of these reserves of 16 per cent in the period from 1974 to 1980 or even from the 5 per cent growth in 1981.

Table 14.Official Holdings of Reserve Assets, End of Selected Years 1973–82 and End of March 1983 1(In billions of SDRs)
1973197719781979198019811982March 1983
All countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund6.218.114.811.816.821.325.529.4
Special drawing rights8.88.18.112.511.816.417.717.5
Subtotal, Fund-related assets15.026.222.924.328.637.743.246.9
Foreign exchange102.7203.6223.92249.7296.8304.8294.6293.3
Total reserves excluding gold117.7229.8246.92274.0325.4342.5337.8340.2
Gold 3
Quantity (millions of ounces)1,0221,0291,0379444952952947947
Value at London market price95.0139.8179.9367.1440.2325.0392.2364.1
Industrial countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund4.912.29.67.710.713.517.120.7
Special drawing rights7.16.76.49.38.911.914.114.1
Subtotal, Fund-related assets12.018.916.017.119.625.431.234.8
Foreign exchange65.7100.0127.2136.1164.3159.7153.2155.1
Total reserves excluding gold77.7118.9143.1153.2183.9185.2184.4190.0
Gold 3
Quantity (millions of ounces)8748818847894788788787787
Value at London market price81.3119.6153.4306.7364.2269.1326.0302.6
Oil exporting countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund0.35.44.43.04.15.86.77.4
Special drawing rights0.30.40.51.01.21.82.12.0
Subtotal, Fund-related assets0.65.84.94.05.37.68.89.4
Foreign exchange10.255.240.1251.066.972.466.860.5
Total reserves excluding gold10.861.045.0255.072.280.075.669.9
Gold 3
Quantity (millions of ounces)3434363740424242
Value at London market price3.14.86.314.218.514.217.416.2
Non-oil developing countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund0.90.50.91.02.12.01.71.3
Special drawing rights1.41.11.22.11.72.71.61.4
Subtotal, Fund-related assets2.41.62.13.23.84.73.32.7
Foreign exchange26.848.456.662.665.572.774.677.7
Total reserves excluding gold29.249.958.765.869.277.377.880.3
Gold 3
Quantity (millions of ounces)114114117118124122118118
Value at London market price10.615.520.246.257.541.849.745.4
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. Figures for 1973 include official French claims on the European Monetary Cooperation Fund.

Beginning with April 1978, Saudi Arabian holdings of foreign exchange exclude the cover against a note issue, which amounted to SDR 4.3 billion at the end of March 1978.

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.

The decrease recorded in the quantity of countries’ official gold holdings from the end of 1978 to the end of 1979 reflects mainly the deposit by the members of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The European currency units issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

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. Figures for 1973 include official French claims on the European Monetary Cooperation Fund.

Beginning with April 1978, Saudi Arabian holdings of foreign exchange exclude the cover against a note issue, which amounted to SDR 4.3 billion at the end of March 1978.

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.

The decrease recorded in the quantity of countries’ official gold holdings from the end of 1978 to the end of 1979 reflects mainly the deposit by the members of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The European currency units issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

The decline in non-gold reserves in 1982 was the result of a fall of more than 3 per cent in the foreign exchange component of reserve holdings, which was only partially offset by the increase in Fund-related reserve assets—SDRs and reserve positions in the Fund. In general, the behavior of total international reserves, excluding gold, tends to parallel that of the foreign exchange component, which accounts for more than 85 per cent of the total. Nevertheless, beginning in 1980 this relationship has become less close as a result of divergent movements in foreign exchange holdings and Fund-related reserve assets.

In both the industrial countries and the oil exporting countries non-gold reserves declined in 1982 (Table 14). The decline was especially pronounced for the oil exporting countries, whose holdings fell by SDR 4.4 billion, or 6 per cent. The reduction in the holdings of industrial countries amounted to less than SDR 1 billion and was approximately offset by the small increase in the reserve holdings of non-oil developing countries. In this last group, the non-gold reserves of the low-income countries increased by 1 per cent in 1982, but those of the middle-income primary producing countries fell by 10 per cent.

At the end of 1982, the industrial countries held 55 per cent of total non-gold reserves, the oil exporting countries 22 per cent, and the non-oil developing countries 23 per cent (Chart 20). At the end of 1973, in comparison, 66 per cent of total reserves were held by industrial countries, 9 per cent by oil exporting countries, and 25 per cent by non-oil developing countries. These changes demonstrate the extent of the redistribution of reserves from the industrial countries to the oil exporting countries that has taken place in the intervening period. The redistribution reflects primarily shifts in the current account of the balance of payments, largely in response to changes in the value of oil trade.

Chart 20.Non-Gold Reserves, December 1973 and December 1982

(In billions of SDRs)

Foreign Exchange Reserves

Official holdings of foreign exchange declined by SDR 10 billion in 1982 to SDR 295 billion at the end of the year. For both the industrial and the non-oil developing countries, the steepest decline occurred in the first quarter of 1982, and the industrial countries showed a further, smaller, drop in the second quarter. Thereafter, some reconstitution of foreign exchange reserves occurred, resulting in a small net gain over the year for the non-oil developing countries. In contrast, the foreign exchange reserves of the oil exporting countries declined steadily during the year. Although the declines in the foreign exchange reserves of the industrial and the oil exporting countries were similar in absolute magnitude, at about SDR 6 billion, the proportionate erosion was greater for the oil exporting countries. The increase of about SDR 2 billion in the foreign exchange reserves of the non-oil developing countries reflected divergent regional developments: Western Hemisphere countries registered sharp declines in their holdings, and European and African countries also showed losses. However, the Asian countries on the whole maintained their holdings of foreign exchange reserves, and China had a large increase. For the Middle Eastern countries there was also an increase in holdings, though of smaller proportions.

The decline in the foreign exchange holdings of industrial countries in 1982, as in 1981, reflected in part the intervention undertaken to smooth exchange market fluctuations and to support currencies in the face of a strong U.S. dollar. The leading industrial countries, with the exception of the Federal Republic of Germany and the United States, experienced fairly pronounced reductions in foreign exchange reserves. The holdings of many of the smaller industrial countries also declined.

Since U.S. dollar-denominated assets constitute a large proportion of total foreign exchange reserves, changes in the SDR/dollar rate can exert a significant influence on the SDR value of these holdings. Following a 9 per cent appreciation of the U.S. dollar relative to the SDR in 1981, the U.S. dollar appreciated by a further 5 per cent during 1982. This appreciation increased the SDR value of a given volume of U.S. dollar reserves in the same proportion. If foreign exchange reserves are measured in terms of the U.S. dollar, the decline in 1982 is thus steeper—about $30 billion, or 8 per cent, to $325 billion at the end of the year.

Holdings of Fund-Related Reserve Assets

Fund-related reserve assets consisting of both reserve positions in the Fund and SDRs grew by almost 15 per cent in 1982 to reach SDR 43 billion at the end of the year (see Table 14). The growth of Fund-related reserve assets relative to foreign exchange holdings has raised the share of the former in total non-gold reserves almost to the proportion observed at the end of 1973 (13 per cent). Since no allocation of SDRs was made in 1982, the increase in countries’ holdings of SDRs resulted mainly from the net use of the Fund’s holdings in the extension of credit to members. There was some decline in the Fund’s holdings of SDRs, from a peak of SDR 5.5 billion at the end of 1980 to SDR 3.7 billion at the end of 1982. This development was in accordance with the Fund’s policy during this period of using its SDR holdings along with its currency resources to finance its lending policy. Reserve positions in the Fund increased by SDR 4 billion during 1982 to SDR 26 billion. As in 1981, most of the increase in these reserve positions accrued to the United States and Saudi Arabia. The reserve position of the United States rose by SDR 3.1 billion, reflecting the larger use of U.S. dollars in Fund operations, while that of Saudi Arabia rose by SDR 1.3 billion as a result of that country’s increased lending to the Fund.

Non-oil developing countries reduced their holdings of Fund-related assets by SDR 1.4 billion during 1982. The bulk of the decline occurred in SDR holdings (SDR 1.1 billion), partly as a consequence of their use in repurchase transactions with the Fund and partly because of the exchange of large amounts of SDRs for currencies, notably by Argentina, Brazil, and Mexico. Although the oil exporting countries increased their holdings of Fund-related assets by SDR 1.2 billion, the biggest increase, by SDR 5.8 billion, occurred in the holdings of the industrial countries. Reserve positions in the Fund of the industrial countries rose by 27 per cent, to SDR 17 billion, at the end of 1982, reflecting the higher use of the currencies of these countries during 1982 in connection with the extension of Fund credit to other countries. Over the same period, SDR holdings of the industrial countries increased by 18 per cent, to SDR 14 billion.

Gold

The physical stock of gold held as part of official reserves did not change much in 1982 and remained at about 1 billion ounces. The distribution between different country groups of the gold stock also remained stable. There was, however, some use of gold as a collateral for official borrowings by some countries. The decline in gold prices that had occurred in 1981 was partly reversed in 1982, especially in the latter half of the year. During 1982, the market value of gold expressed in SDRs rose by 21 per cent. When gold holdings are valued at market prices, their share in total reserve portfolios rose from 49 per cent in 1981 to 54 per cent in 1982.

Developments in First Quarter of 1983

Compared with the stock held at the end of 1982, total non-gold reserves of all countries increased by about SDR 2 billion at the end of the first quarter of 1983 (see Table 14). While the amount held by the non-oil developing countries grew by a similar amount, there was a sharp decline of almost SDR 6 billion (7 per cent) in the holdings of the oil exporting countries, which matched a gain in the non-gold reserves held by the industrial countries. Total holdings of Fund-related reserve assets grew substantially by about SDR 4 billion, mostly as a consequence of the increase in the reserve positions in the Fund held by industrial countries. Total foreign exchange reserves declined, and there was some shift in holdings from the oil exporting countries to the industrial countries. Among the non-oil developing countries, the decline during 1982 in the foreign exchange reserves held by the Western Hemisphere countries was halted, while the other regions managed to generally maintain or increase their holdings.

Some Characteristics of Foreign Exchange Reserves

This section reviews certain characteristics of the foreign exchange component of international reserves and its recent evolution, taking account of the price and quantity changes affecting its SDR value. The currency composition of foreign exchange holdings is examined, and the sources of supply for foreign exchange reserves are, discussed. In addition, the cumulative returns, taking into account both interest earnings and exchange rate movements, on SDRs and major currencies are compared.

Currency Composition and Sources

The tendency toward diversification of reserve currency holdings, which had been observed in the period following the breakdown of the Bretton Woods par value system, began to show a reversal in 1981, a development that continued in 1982. A principal reason for diversifying reserve portfolios is to reduce the perceived risk of capital losses that might arise as a result of significant exchange rate movements. However, the use of the U.S. dollar as an intervention currency, the depth and range of U.S. dollar-denominated financial markets, and, in recent years, the high returns on dollar assets have reduced incentives for diversification of official reserve holdings.

From the end of 1977 to the end of 1980, the share of the U.S. dollar in total identified official holdings of foreign exchange declined from 79 per cent to 69 per cent (see Tables 15 and 16). Since 1980, however, the share of the U.S. dollar has increased; it rose to 71 per cent at the end of 1982. In these calculations, the SDR value of European currency units (ECUs) issued against U.S. dollars is counted as part of total U.S. dollar holdings, and the SDR value of ECUs issued against gold is not counted as part of foreign exchange holdings. However, when ECUs, which in 1982 amounted to 14 per cent of total identified foreign exchange holdings, are treated separately, the share of the dollar declines to 60 per cent of these holdings (see Table 16).

Table 15.Currency Composition of Official Holdings of Foreign Exchange, End of 1977–End of 1982 1(In millions of SDRs)
197719781979198019811982
U.S. dollar
Change in holdings29,59211,665–15,21810,9097,281–7,525
Quantity change36,09622,277–13,85425,913–7,895–16,095
Effect of price change–6,504–10,612–1,3644,99615,1768,570
Year-end value150,393162,058146,840157,749165,030157,505
Pound sterling
Change in holdings521239392,768–1,273–353
Quantity change–1521566572,199–392250
Effect of price change204–33282569–881–603
Year-end value3,0623,1854,1246,8925,6195,266
Deutsche mark
Change in holdings4,9665,2993,5158,857–2,369–3,668
Quantity change3,9294,0272,55911,528–753–3,625
Effect of price change1,0371,272956–2,671–1,616–43
Year-end value15,61020,90924,42433,28130,91227,244
French franc
Change in holdings51525137943–196–90
Quantity change496–66861,189266194
Effect of price change199151–246–462–284
Year-end value1,8281,8531,9902,9332,7372,647
Swiss franc
Change in holdings1,593–7741,8582,624–244–914
Quantity change1,029–1,2581,7663,084–682–538
Effect of price change56448492–460438–376
Year-end value3,7012,9274,7857,4097,1656,251
Netherlands guilder
Change in holdings51299419652157–430
Quantity change27222385806266–405
Effect of price change247734–154–109–25
Year-end value8221,1211,5402,1922,3491,919
Japanese yen
Change in holdings1,0793,1298502,2351,124–360
Quantity change8472,7942,1497911,018–208
Effect of price change232335–1,2991,444106–152
Year-end value2,2195,3486,1988,4339,5579,197
European currency units
Change in holdings32,53115,109–4,277–5,399
Quantity change 327,765–2,105–1,229–1,906
Effect of price change4,76617,214–3,048–3,493
Year-end value32,53147,64043,36337,964
Sum of the above
Change in holdings37,84819,76625,03144,097203–18,739
Quantity change42,27228,15221,51323,405–9,401–22,333
Effect of price change–4,424–8,3863,51820,6929,6043,594
Year-end value177,635197,401222,432266,529266,732247,993
Total official holdings 4
Change in holdings41,91920,28925,83246,9698,029–10,092
Year-end value203,606223,911249,743296,712304,741294,649
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 then yields the SDR value of the quarterly price change for each currency. All changes are summed over consecutive quarters to yield cumulative changes over the years (or other periods) 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 then yields the SDR value of the quarterly price change for each currency. All changes are summed over consecutive quarters to yield cumulative changes over the years (or other periods) 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.

Table 16.Share of National Currencies in Total Identified Official Holdings of Foreign Exchange, End of Selected Years 1973–82 1(In per cent)
19731976197719781979198019811982Memorandum:

1982

Including

ECUs 2
All countries
U.S. dollar76.179.779.476.973.768.771.171.460.0
Pound sterling5.62.01.61.51.92.92.22.22.0
Deutsche mark7.17.08.29.911.513.812.311.610.4
French franc1.10.91.00.90.91.21.11.11.0
Swiss franc1.41.42.01.42.23.12.92.72.4
Netherlands guilder0.50.50.40.50.70.90.90.80.7
Japanese yen0.10.81.22.52.93.53.83.93.5
Unspecified currencies8.17.86.26.36.05.95.66.320.0
100.0100.0100.0100.0100.0100.0100.0100.0100.0
Industrial countries
U.S. dollar86.387.089.186.283.577.978.977.256.6
Pound sterling3.70.70.50.50.60.60.70.70.6
Deutsche mark2.93.84.06.67.512.411.210.88.8
French franc0.1
Swiss franc0.80.90.70.41.31.51.51.61.4
Netherlands guilder0.30.30.20.30.40.50.60.50.4
Japanese yen0.40.31.62.02.83.23.93.2
Unspecified currencies6.07.05.14.44.54.24.05.229.1
100.0100.0100.0100.0100.0100.0100.0100.0100.0
Developing countries3
U.S. dollar55.072.868.762.762.558.962.864.764.7
Pound sterling9.53.22.83.03.45.33.94.04.0
Deutsche mark15.910.112.915.016.015.313.612.512.5
French franc3.31.62.02.12.02.52.22.42.4
Swiss franc2.61.93.42.93.34.84.33.83.8
Netherlands guilder0.90.70.70.91.11.31.31.21.2
Japanese yen0.21.12.14.04.04.34.54.04.0
Unspecified currencies12.68.67.49.37.87.67.37.57.5
100.0100.0100.0100.0100.0100.0100.0100.0100.0
Sources: Various Fund publications and Fund staff estimates.

The detail in each of the columns may not add to 100 because of rounding. 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.

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, amounting to 14.4 per cent for the total and 24.8 per cent for the industrial countries, respectively, has been added to that of unspecified currencies.

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

Sources: Various Fund publications and Fund staff estimates.

The detail in each of the columns may not add to 100 because of rounding. 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.

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, amounting to 14.4 per cent for the total and 24.8 per cent for the industrial countries, respectively, has been added to that of unspecified currencies.

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

ECUs are issued by the European Monetary Cooperation Fund to the central banks of the members in exchange for the transfer of 20 per cent of the gold holdings and 20 per cent of the gross U.S. dollar holdings of these institutions. These swaps are renewed every three months, and changes in 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. In 1982, holdings of ECUs dropped by over SDR 5 billion (12 per cent) largely as the result of a decline in the value of the gold component, which in turn reflected a lagged response to the fall in gold prices during the first half of 1982.10 While the aggregate amount of the U.S. dollar component also declined, the appreciation of the dollar relative to the SDR helped to moderate the fall in the value of holdings.

To explain developments in the currency composition of foreign exchange holdings, it is useful to distinguish between price and quantity changes affecting the SDR value of official holdings of foreign exchange (see Table 15). The amount of U.S. dollar holdings declined for the second year in a row, the drop in 1982 being particularly marked. However, the continued appreciation of the U.S. dollar against other major currencies served to increase the SDR value of U.S. dollar reserves. Nonetheless, the effects of the U.S. dollar appreciation were not sufficient in 1982 to prevent an absolute decline in official U.S. dollar holdings expressed in terms of SDRs. The drop in the SDR value of other foreign exchange holdings reflected a decline in the amount held, as well as a depreciation relative to the SDR of nearly all of the other currencies specified in Table 16. Since official holdings of other currencies declined to a greater extent than U.S. dollar holdings, the share of the U.S. dollar in foreign exchange reserves increased. In part, the relative position of the U.S. dollar improved because of the high yields that could be earned on U.S. dollar assets in 1981 and 1982.

When measured in terms of U.S. dollars, the decline in identified foreign exchange holdings amounted to about $37 billion in 1982. This reflects a contraction of $25 billion in the amount of foreign exchange held and a negative price effect of $12 billion as a consequence of the depreciation of the other major reserve currencies ($7 billion) and of the ECU ($5 billion) relative to the dollar.

During the 1970s, a number of other currencies were affected by this diversification of official portfolios. The relative share of the pound sterling declined significantly from 1973 to 1979, although some reversal in the trend occurred when the pound appreciated, especially in 1980. The share of the deutsche mark in foreign exchange reserves increased by more than 50 per cent from 1973 to 1982, to about 12 per cent at the end of that period, and holdings of Japanese yen grew from a negligible amount to about 4 per cent (see Table 16). While the use of the deutsche mark for intervention, especially within the European Monetary System, has increased, the U.S. dollar still remains the principal intervention instrument. The other reserve currencies thus appear to be held primarily as working balances to facilitate transactions, as hedges against exchange losses, and as investments.

In addition to official portfolio preferences and the effects of foreign exchange intervention practices, the factors determining the supplies of the various currencies have also affected the evolution of the multiple reserve currency system. When the U.S. current account of the balance of payments was in substantial deficit during 1977–78, the volume of dollar holdings rose sharply, even though the share of the U.S. dollar in total foreign exchange holdings declined as a result of the depreciation of the U.S. dollar relative to the SDR. The reversal in the U.S. current account position in 1980–81 reduced the supply of dollars, but, as noted earlier, the share of the dollar in foreign exchange holdings increased, in part because of the sharp appreciation of that currency relative to the SDR. Broadly similar developments at times also characterized the fluctuations in the share of the deutsche mark in official foreign exchange holdings. The emergence of current account deficits in the Federal Republic of Germany in 1979–80 was associated with a marked increase in the quantity of deutsche mark held as reserves in 1980. Despite some depreciation in the deutsche mark/SDR rate in 1980, the share of the deutsche mark in total foreign exchange holdings rose sharply, from 11.5 per cent in 1979 to 13.8 per cent in 1980.

Attitudes of the national authorities regarding the international use of their currencies also affect the currency composition of reserves. The decision to issue external liabilities denominated in the national currency, which may be held in the reserves of other countries, is sometimes regarded as conferring a balance of payments advantage. This advantage needs to be weighed, however, against the risk of diminished control over domestic monetary developments. Few countries whose currencies are potential reserve assets are content to have their currencies held to any large extent in the foreign exchange holdings of other countries.

The degree of currency diversification differs significantly among major country groups. The larger industrial countries tend to concentrate their reserve holdings in U.S. dollars, although in recent years there has been some diversification even in this group. In contrast, the smaller industrial countries generally exhibit more currency diversification. The most pronounced differences in currency diversification, however, are those between the industrial countries and the developing countries, for which the portfolio or investment aspects of reserve holdings have become important because of the relatively attractive yields that have been offered in international capital markets. Although the ratio of U.S. dollar assets to total foreign exchange holdings has increased to nearly two thirds for developing countries, it remains substantially below the ratio of four fifths observed for industrial countries (see Table 16). While the developing countries have reduced the share of their foreign exchange reserves held in sterling since 1973, that share is still higher than the corresponding share of the industrial countries. Holdings of French franc assets, which are not a significant proportion of industrial countries’ reserves, account for over 2 per cent of the foreign exchange reserves of the developing countries. The share of the deutsche mark has increased sharply for industrial countries, especially after the creation of the European Monetary System, but the proportion of this currency in the official portfolios of developing countries has declined in recent years. The share of the yen has, however, increased sharply, for both industrial and developing countries.

The drop in reported total official holdings of foreign exchange in 1982 took the form of a decline in holdings of U.S. dollars, of other currencies, and of ECUs (see Table 17). The fall in reported official claims on residents of the United States amounted to about 5 per cent in 1982 and was similar to the decline estimated for deposits in the Eurodollar markets. However, there is a sizable discrepancy between external liabilities to foreign official institutions as reported by U.S. sources, which show an increase of about 7 per cent, and claims on residents of the United States taken from reported reserve holdings, not all of which is explained by the issuance of ECUs (see footnote 2 in Table 17). According to the reported holdings, about one third of U.S. dollar-denominated official foreign exchange holdings is held in the Eurodollar markets. The share of other Eurocurrency deposits in the total of claims denominated in these currencies is closer to one half but showed a significant decline in 1982.

Table 17.Sources of Official Holdings of Foreign Exchange Reserves, End of Year 1975–82 1(In billions of SDRs)
19751976197719781979198019811982
U.S. liabilities to foreign official institutions6979104120109123139149
Items not included in reported U.S. dollar holdings 2–6–8–10–7–13–22–35–50
Official claims on residents of the United States6371941139610110499
Official claims on residents of other countries denominated in the debtor’s own currency1417192730413938
Subtotal7788113140126142143137
Identified official holdings of Eurocurrencies
Eurodollars3947544749546057
Other currencies1213192125343330
Subtotal5160736874889387
European currency units33484338
Residual31114181617192633
Total official holdings of foreign exchange139162204224250297305295
Sources: International Monetary Fund, International Financial Statistics; U.S. Treasury Department, Bulletin; and Fund staff estimates.

Official foreign exchange reserves of Fund members (except for China, for which data are not available) 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 (mainly China, Hungary, Iraq, Israel, Qatar, and Romania). 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 (except for China, for which data are not available) 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 (mainly China, Hungary, Iraq, Israel, Qatar, and Romania). Includes identified official claims on the International Bank for Reconstruction and Development, on the International Development Association, and the statistical discrepancy.

Rates of Return on Major Currencies

In a multiple reserve currency system, considerations of risk and return are among the most important factors determining the allocation of reserve portfolios among short-term investments denominated in different currencies. In principle, monetary authorities might wish to select reserve portfolios that generate adequate returns for given acceptable levels of risk. Crucial criteria in selecting investments are the expectations concerning yields and relative exchange rate movements. Such expectations cannot, of course, be observed, but some inferences about them can be drawn on the basis of observed yields and exchange rate movements.

The cumulative returns on amounts invested at the beginning of the second quarter of 1973 in the money market instruments denominated in the five major currencies that currently comprise the SDR basket are shown in Chart 21.11 The rates of return on the different assets have at times diverged considerably. An investment of one SDR at the SDR-weighted composite interest rate in the second quarter of 1973 would have grown to SDR 2.409 by the end of the first quarter of 1983, less than the SDR 2.578 that would have been obtained had the investment been placed in U.S. Treasury bills, but more than the SDR 2.023 that would have been realized on a French franc investment. Yields on investments in yen and deutsche mark assets would also have earned more than the SDR standard, while assets denominated in pounds sterling would have earned less. The pattern of cumulative returns relative to the SDR standard differed from period to period. In the period up to the end of 1978, the cumulative return on U.S. Treasury bills amounted to about 87 per cent of the return on the SDR standard investment and to only 65 per cent of the yield on an investment denominated in yen. The relative fluctuations in such returns are a source of uncertainty regarding the profits to be obtained from concentrating reserves in any one currency. An incentive is thus provided to diversify the portfolio and to consider investments in currency composites of which the SDR constitutes one example.

Chart 21.Growth of Investments in Specified National Currencies and SDRs, Second Quarter 1973–First Quarter 1983 1

(In SDRs)

1 Cumulative values (in SDRs) of investments in the SDR and in short-term assets denominated in each of the five major currencies of which the SDR is composed, each investment amounting to SDR 1.00 at the beginning of the second quarter of 1973. For this calculation, the SDR was assumed, throughout the period shown, to have had the present currency composition (i.e., the five-currency basket that became effective on January 1, 1981) and to have earned interest at the full combined (weighted average) market rate of interest on the five national assets.

The relative movements in the cumulative returns on investments denominated in different currencies are broadly similar to the observed shifts in the share of national currencies in identified official holdings of foreign exchange (see Table 16). The relatively low return on U.S. Treasury bills in the period to the first quarter of 1981 and the higher yields since that time, correlates with an initial decline and subsequent upswing in the share of U.S. dollar assets in official foreign exchange holdings. As was noted earlier, such movements tend to reflect the reserve-holding behavior of the smaller industrial and developing countries more than that of the major industrial countries.

International Financial Markets, External Debt, and the Adjustment Process

Since private financial markets have come to play an important role in the financing of payments imbalances, the disturbances experienced in these markets during 1981 and 1982 had an important impact on the international adjustment process. In particular, these financial shocks entailed sharp, adverse changes in the availability and, to a lesser extent, the cost of international credit for many developing countries. To limit the extent of these problems and to avoid too harsh and abrupt balance of payments adjustment, international institutions and the governments of several major countries have employed a series of innovative measures designed to help maintain the availability of international credit and reserves. While the disturbances in financial markets in 1981–82 have generally been associated with difficulties in specific banking institutions or countries, the sharp changes in financial flows and interest rates also reflected more general developments, in particular, the major structural changes in international financial markets that occurred during the 1970s and the short-term cyclical developments of the early 1980s. The rest of this section on the role of private financial markets examines how these structural and cyclical factors contributed to the emergence of disturbances of the financial system in 1982 and what these developments imply about the near-term outlook for the international adjustment process.

The Changing Character of International Financial Markets During 1973–82

In the 1970s, international financial markets underwent a series of structural and institutional changes that brought about closer linkages between individual national financial markets and enlarged the role of private financial institutions in the financing of current account deficits of non-oil developing countries. From 1975 to 1982, international bank lending and bond issues grew at an average rate of about 23 per cent per annum. These capital flows reflected the growing integration of capital markets among the largest industrial countries as well as the need to finance expanding trade flows and government budget deficits.

A major stimulus to international bank lending was the need to recycle the current account surpluses of the major oil exporting countries during the mid-1970s. One indicator of the importance of private international banking flows in this recycling process is the ratio, for the non-oil developing countries, of the sum of long-term net borrowing from private financial institutions and “other net short-term borrowing” 12 to the sum of the current account deficits and reserve accumulations.13 During 1974 and 1975, for example, the recycling role of banks expanded, and this private lending ratio rose from 45 per cent in 1973 to 52 per cent in 1975. Thereafter, the relative importance of bank lending declined, with the ratio falling to 36 per cent in 1977, until the renewed rise of current account imbalances at the end of the decade lifted the ratio to another peak at 57 per cent in 1980. Since then, the private lending ratio has receded, and, as debt-servicing problems began to have an impact on the banks’ willingness to lend to certain countries, it has dropped sharply to 31 per cent in 1982.

While the non-oil developing countries were also able to obtain funds from a number of official and other non-bank private sources, the importance of private bank lending is evident in the proportion of total external debt represented by liabilities to banks. The total outstanding debt of non-oil developing countries rose from $161 billion in 1974 to $279 billion in 1977 and to $612 billion by the end of 1982. During the 1977–81 period, the proportion of total debt accounted for by debts to banks rose from 43 per cent at the end of 1977 to 55 per cent at the end of 1981.

Although international borrowing on this substantial scale was undertaken largely in response to external developments, it also reflected a tendency in a number of countries toward an excess of investment and government deficits over domestic saving. Private international capital flows, therefore, funded not only adjustments to external disturbances but also expenditure programs and longer-term investment activities, even though many of the loans were of short-term or medium-term maturity. In particular, short-term maturities created the possibility that the required amortization and interest payments on the debt could at times differ considerably from the earnings on the corresponding investments. The likelihood of such a divergence taking place actually increased over the 1970s as a result of changes in maturity, risk, and return of the financial instruments used in the transfer process.

During the period 1975–80, greater variability of inflation, interest rates, and exchange rates accompanied the generally increasing trend in inflation in some of the countries with major financial markets. In addition, rising nominal interest rates imposed large capital losses on holders of fixed-rate bonds. Substantial changes in exchange rates also created the potential for large swings in the value (measured in domestic currency) of financial instruments denominated in foreign currency. In view of this experience, lenders sought protection from risks linked to variation in exchange rates and interest rates both by purchasing instruments of shorter maturity and by showing a preference for instruments that placed a greater share of these risks on the borrower. These preferences were reflected in the development of such instruments as floating rate notes, interest rate swaps, and deferred payment bonds.

Financial Disturbances of 1982

These changes in the characteristics of financial instruments increased the sensitivity of yields and flows in international financial markets to the cyclical effects generated by increases in the real price of oil, higher levels of nominal and real interest rates, a shift toward less expansionary financial policies in the major industrial countries, and a sharp increase in the financing requirements of many of the major debtor countries during the late 1970s and early 1980s. The disturbances in the financial system that emerged during 1982 thus both reflected and contributed to the declining level of economic activity in the world economy.

Economic developments had a significant impact on the debt-servicing capacity and balance of payments positions of some of the developing countries, especially those with large external debts bearing floating interest rates. During 1981 and 1982, interest rates rose to record high levels, which sharply increased the cost of servicing external debts. The exports of developing countries were also adversely affected by the decline in economic activity, which was accompanied by a sharp fall in the prices of primary commodities, stagnation in world trade, and protectionist measures adopted in some industrial countries. The combination of these external developments and, in some countries, the presence of large-scale investment programs and government deficits soon created the need for either significantly higher levels of external borrowing or stringent adjustment programs, or some combination of these two policies. In part influenced by the expectation of an early recovery from the world recession, some countries significantly increased their international borrowing.

While developments in the real sector increased the financing requirements of a number of countries, disturbances in the financial markets in the last months of 1981 and in 1982 contributed to a serious reduction in the availability of international credit, a redistribution of credit among the groups of industrial, oil exporting, and non-oil developing countries, and the maintenance of high real interest rates. Although international bank lending continued to expand in 1982, the net flows of such credits declined from $165 billion in 1981 to $95 billion in 1982 (Table 18). During the first half of 1982, international bank lending increased at roughly the same rate as in the first half of 1981; but the growth of bank lending, especially to developing countries, dropped off severely in the second half of the year. Total net bank lending to the non-oil developing countries, which had reached about $50 billion in 1980 and 1981, declined to $25 billion in 1982, with only $6 billion occurring in the last six months of the year. This decline can be ascribed to the reduced willingness of banks to lend to certain developing countries. International bank lending to industrial countries also fell, from $99 billion in 1981 to $57 billion in 1982; and the centrally planned economies actually reduced their outstanding bank debt by $4 billion in 1982.

Table 18.External Lending and Deposit Taking of Banks in the BIS Reporting Area, 1978–82 1(In billions of U.S. dollars)
First QuarterSecond QuarterThird QuarterFourth Quarter
197819791980198119821982
Destination of lending 2901251601659520302520
Industrial countries386996995715101913
Oil exporting developing countries1576281331
Non-oil developing countries24404951255146
Centrally planned economies 37655–4–2–1–1
International organizations and unallocated63489144
Sources of funds 2901251601659520302520
Industrial countries686610314110222302624
Oil exporting developing countries337415–19–1–6–3–9
Non-oil developing countries1413895–24–14
Centrally planned economies 32512–3113
International organizations and unallocated347105412–2
Change in net claims 4 on
Industrial countries–303–7–42–45–7–20–7–11
Oil exporting developing countries12–30–35–32729610
Non-oil developing countries102641422071012
Centrally planned economies 35145–61–2–2–3
International organizations and unallocated3–3–24–3322

The data on lending and deposit taking are derived from stock data on banks’ claims and liabilities (net of redepositing among banks in the BIS reporting area) that include valuation changes owing to exchange rate movements Data on adjusted flows are provided by the BIS, but the distribution of those adjusted flows among the major groups of countries according to Fund classifications is a Fund staff estimate.

The BIS reporting area comprises all banks in the Group of Ten countries, Austria, Denmark, Ireland, and Switzerland and the branches of U.S. banks in the Bahamas, Cayman Islands, Hong Kong, Panama, and Singapore.

The distribution of global figures by major groups of borrowers (depositors) was derived from BIS data. For industrial countries, gross claims (liabilities) were reduced by redepositing among banks in the reporting area but increased by claims on (liabilities to) offshore centers. The latter thus were assumed, in the absence of information on the country distribution of onlending from (deposit taking by) offshore centers, to represent lending to (deposit taking from) industrial countries. For the other groups of borrowers and depositors, net claims (liabilities) were equated to gross claims (liabilities).

Excludes Fund member countries.

Lending minus sources of funds.

The data on lending and deposit taking are derived from stock data on banks’ claims and liabilities (net of redepositing among banks in the BIS reporting area) that include valuation changes owing to exchange rate movements Data on adjusted flows are provided by the BIS, but the distribution of those adjusted flows among the major groups of countries according to Fund classifications is a Fund staff estimate.

The BIS reporting area comprises all banks in the Group of Ten countries, Austria, Denmark, Ireland, and Switzerland and the branches of U.S. banks in the Bahamas, Cayman Islands, Hong Kong, Panama, and Singapore.

The distribution of global figures by major groups of borrowers (depositors) was derived from BIS data. For industrial countries, gross claims (liabilities) were reduced by redepositing among banks in the reporting area but increased by claims on (liabilities to) offshore centers. The latter thus were assumed, in the absence of information on the country distribution of onlending from (deposit taking by) offshore centers, to represent lending to (deposit taking from) industrial countries. For the other groups of borrowers and depositors, net claims (liabilities) were equated to gross claims (liabilities).

Excludes Fund member countries.

Lending minus sources of funds.

There was also a shift in the sources of banking funds (Table 18). After increasing their combined deposits in banks by $41 billion in 1980 and by $5 billion in 1981, the oil exporting countries reduced these deposits by $19 billion in 1982 as their current account surplus was eliminated. This reduction in deposit holdings by the oil exporting countries was more than offset by an increase in deposit holdings of the industrial countries.

These changes in deposit placements and lending over the period 1980–82 substantially affected the net claims of banks on various country groups. The industrial countries moved from being a relatively small net source of funds in 1980 ($7 billion) to the largest single source in 1982 ($45 billion). Correspondingly, the oil exporting countries switched from being a large net supplier of funds in 1980 ($35 billion) to being the largest net borrower in 1982 ($27 billion). The annual net borrowings of the non-oil developing countries were reduced from $41 billion to $20 billion between 1980 and 1982, and the centrally planned economies switched from a net borrower position in 1980 and 1981 to a net lender position in 1982, primarily as a result of the repayment to banks of outstanding loans.

The slowing in bank lending during 1982 reflected the impact of a number of disturbances in financial markets in both industrial and developing countries. Throughout the year, the risk of bankruptcies of some of the more heavily indebted corporations created the potential of significant losses on domestic loans for many banks in the industrial countries. Capital markets were also forced to contend with the collapse of a number of financial institutions in industrial and developing countries. During the second half of the year, the debt-servicing problems of countries, such as Mexico and later Brazil, further strained financial markets. In response to this increase in perceived lending risks, loan maturities declined somewhat and the spreads between the London interbank offered rate (LIBOR) and loan rates charged, especially to certain developing countries, increased. While all country groups experienced some increase in the spreads they paid, the adjustments of international financial markets to these disturbances primarily involved sharp reductions in the availability of credit for specific borrowers.

In contrast to international bank lending, international bond issues continued to expand at a high rate in the latter part of 1981 and in 1982. The sum of foreign and Eurobond issues rose by $25 billion (50 per cent) in 1982. Since only the most creditworthy borrowers were able to issue in international bond markets, the expansion of international bond issues was one means by which the flow of international credit was redistributed between borrowers from industrial, oil exporting, and non-oil developing countries. The primary factor in the continued expansion of international bond issues during the year was the general decline in nominal interest rates. Long-term interest rates followed a gradual downward trend, but a sharp decline in short-term interest rates was sufficient to create a positively sloped yield curve in most major financial markets. In part, purchasers were attracted to the bond market by the prospect of high but declining long-term interest rates, and the borrowers’ need for secure longer-term funding brought forth a sustained flow of new issues. As conditions in the market for syndicated loans tightened during the second half of the year, borrowers also shifted increasingly to the bond markets.

This expansion of activity in the bond markets was of little direct benefit to the non-oil developing countries, since bond purchasers were interested primarily in instruments issued by borrowers in industrial countries or by international institutions. Almost all of the growth in net international bond issues between 1980 and 1982 was accounted for by borrowers from industrial countries, whose proceeds rose from $20 billion to $46 billion (Table 19). Issues by developing countries have remained at approximately $3 billion a year throughout the period 1979–82, but even this small figure overstates the position of these countries during the last half of 1982 and the first quarter of 1983. As market participants responded to the financial difficulties of a number of these countries in the second half of 1982, bond issues by developing countries declined markedly. During the first quarter of 1983, they accounted for issues of only $143 million out of total issues of $18 billion.

Table 19.Developments in International Bond Markets, 1978–82(In billions of U.S. dollars)
19781979198019811982
Net bond market lending3033283758
By category of borrower
Industrial countries1922202746
Developing countries43233
Other (including international organizations)78679
Sources: Organization for Economic Cooperation and Development; and Fund staff estimates.
Sources: Organization for Economic Cooperation and Development; and Fund staff estimates.

Private Capital Flows and the Financing of the International Adjustment Process

The reduction in the rate of growth of international credit had a pronounced effect on the adjustment process. Deteriorating export performance, increased debt-servicing costs associated with high interest rates and greater reliance on short-term maturities, and worsening fiscal positions all contributed in varying degrees to the emergence of debt-servicing problems in a number of major debtor countries. Perceptions of these problems were often triggered by a sharp reduction or reversal in the net inflow of international capital, heightened in some cases by private capital outflows. The rapid decline in the availability of international credit to a number of developing countries created the prospect, in the absence of multilateral official action, of an adjustment process involving severe reductions in output, income, and imports. Given the scope of the repayment problems faced by some of the major debtor countries, a series of special steps were therefore taken in order to ensure a more orderly adjustment process. In August, a special loan facility of nearly $1 billion designed to help maintain short-term liquidity for Mexico was arranged by the U.S. Government. This facility was matched by a loan of the same amount obtained through the Bank for International Settlements (BIS), with the backing of a number of central banks. These “bridging” loans were designed to allow time for a program supported by Fund resources to be developed. In November, following agreement on an appropriate adjustment program, the Fund also asked banks to provide additional medium-term loans of $5 billion (a 7 per cent increase in total bank exposure).

In the second half of 1982, a number of developing countries, especially in Latin America, experienced debt-servicing problems. While the response to these problems varied among countries, the proposed adjustment programs contain a number of common elements, which were also present in the program for Mexico. They included a bridging loan obtained from the BIS but backed by central bank guarantees, the rescheduling of existing loans, and a program supported by Fund resources often accompanied by commitments of commercial banks to new lending. Even with these special measures, however, the continuation of a smooth adjustment process over an extended period is likely to require the provision of significant further amounts of international credit from the private financial markets. To attain the goals of sustainable debt-servicing and viable balance of payments positions for the major debtor countries, continued international cooperation between the various international agencies, private financial institutions, and national governments will be needed.

In the period immediately following the first major increase in the price of oil, private financial institutions played a crucial role in the recycling of the current account surpluses of the oil exporting countries. The availability and flexibility of this source of credit allowed many countries to undertake more gradual and less stringent adjustment measures. Such a transfer of resources was facilitated by the fact that many developing countries began the period 1973–74 with relatively low ratios of outstanding external debt and debt-servicing payments to exports of goods and services. In the late 1970s and early 1980s, the ready availability of private international credit allowed some countries to finance substantial investment and expenditure programs and, at times, to delay adjustment to external and internal developments. The combination of rising interest rates and heavy international borrowing nearly doubled the debt service ratios for many countries. Some countries soon found it difficult to meet their payments for imports, interest charges, and debt amortization through export receipts and new borrowing. Once these repayment difficulties became evident during 1982, the potential for a rapid withdrawal of many private financial institutions from international lending threatened to require abrupt and harsh adjustment measures for a number of large debtor countries. The sharp changes in the availability of private international credit to a number of developing countries that have been witnessed in the past five years thus had an adverse effect on the stability of the international adjustment process.

The Adequacy of International Reserves

An appraisal of the adequacy of international reserves must take into account both the factors affecting the demand for reserves and those determining the supply. The expected size and volatility of payments imbalances are the principal determinants of the demand for international reserves. Of particular importance in this regard are a country’s exchange rate arrangements and the pace of its adjustment to external imbalances. Moreover, the variability of private capital flows and debt service charges experienced in recent years adds to the importance of holding adequate international reserves for the purpose of accommodating temporary payments imbalances and avoiding disruptive adjustment of the domestic economy. The supply of reserves depends primarily on the financial policies of the reserve currency countries, the state of the international capital markets, and, quantitatively to a much more modest extent, on the policies determining the supply of Fund-related reserve assets.

As a first step in assessing the adequacy of reserves, it is useful to consider measures that relate reserve holdings to key determinants of the demand for international reserves.14 The average ratio of non-gold reserves to imports of goods and services, as one measure of the availability of reserves relative to the need for them, fell from 19 per cent in 1973–74 to 17 per cent in 1981–82. If official holdings of gold valued at current market prices are included in reserves, this ratio remains unchanged at about 36 per cent between 1973–74 and 1981–82. These overall ratios, however, conceal significant differences among groups of countries. The ratio of non-gold reserves to imports for the non-oil developing countries declined from 21 per cent in 1973–74 to 15 per cent in 1981–82, and for the oil exporting countries from 96 per cent to 57 per cent. This compares with a more or less unchanged ratio of about 15 per cent for the industrial countries. The ratio of reserves (including gold) to imports of goods and services rose from 37 per cent in 1973–74 to 39 per cent in 1981–82 for the industrial countries, whereas for the non-oil developing countries this ratio declined from 31 per cent to 24 per cent. The oil exporting countries also showed a decline in this ratio from 114 per cent to 68 per cent. Since reserves are held to finance payments imbalances for which the size of imports can only be a proxy, it is also useful to consider the ratio of non-gold reserves to current account deficits. The ratio for all countries that had current account deficits declined moderately from 2.7 in 1973–74 to 2.4 in 1981–82. However, the corresponding ratio for the non-oil developing countries alone fell from 2.1 to 0.9 over the same period.

As indicators of reserve adequacy, the preceding ratios do not reflect the impact of changes in the structure of the international monetary system on the demand for reserves. For example, while a given ratio of reserves to imports can indicate an adequate level of reserves when international capital movements are limited, it may signify inadequate reserves when there are large volatile capital movements. Again, a move from a fixed to a floating exchange rate might, in principle, reduce a country’s need for reserves and could thus alter its evaluation of the adequacy of a given stock of reserves. In practice, however, there has not been a marked decline in reserve holdings, especially by the industrial countries, during the period of widespread floating since 1973. A number of reasons may account for this observation. First, many countries have not adopted floating rates but have continued to peg their exchange rates to one of the major currencies or to baskets of currencies (see Table 13). Second, a number of countries intervene in the foreign exchange markets in order to dampen movements of their exchange rates. Third, the international economy has been subjected to a variety of real shocks and financial disturbances, which have increased the precautionary demand for international reserves.

The demand for international reserves is also influenced by the access many countries have to international financial markets. During the late 1970s and early 1980s, a number of countries often relied on borrowing in the international capital markets as an alternative to owning reserves. This suggests that it might be more appropriate to consider the adequacy, not of reserves alone, but of international liquidity—a broader concept that takes into account the borrowing capacity of countries. Developments during the last six months of 1982 have indicated, however, that a country’s access to international capital markets can change rapidly during periods of financial disturbance. As several countries have recently discovered, reliance on borrowing capacity instead of owned reserves can result in rapid depletion of reserves when access to capital markets is restricted. This applies especially to debtor countries with large short-term external liabilities relative to their reserve holdings. A partial indicator of this vulnerability is the ratio of official non-gold reserves to short-term debt. For the non-oil developing countries, this ratio amounted to more than two in 1973–74 but had dropped to less than one by 1981–82, suggesting that any cessation of short-term capital flows could place the entire amount of reserve holdings in jeopardy.

Some of the key factors influencing the availability of international reserves and liquidity are the monetary policies of the reserve currency countries and the state of their respective balance of payments. While the policies of some of these countries in the 1970s were characterized by rates of money creation substantially higher than those in the 1950s or 1960s, the early 1980s have generally been a period of monetary restraint. In principle, a more restrictive monetary policy in a reserve center will tend to reduce the rate of increase in the supply of the potential reserve media that is generated directly by the reserve center and also through the international capital markets and, hence, the means for financing the acquisition of international reserves by other countries. In addition, such a policy stance can be accompanied during some periods by a rise in the cost of international borrowing.

The observed decline in foreign exchange reserves in 1982 cannot by itself be viewed as an indication of reserve inadequacy, because a decline in holdings may reflect a fall in demand for reserves. In order to come to an assessment of the adequacy of overall liquidity, it would be necessary to separate the influences of demand and supply factors. There are indications that the supply of international reserves was reduced by the move to a balance of payments surplus position on the part of the reserve centers and reduced access of many countries to international capital markets. On the demand side, there are mixed indications: the recent decline in international trade flows points to a reduction in the demand for reserves, while the increased uncertainty with respect to the possibility of obtaining international credit when needed must have tended to increase the demand for owned reserves. The assessment of reserve adequacy is made particularly difficult by the divergence of experiences in different country groups. Despite the decline in the overall level of reserves, the reserve positions of many countries in the industrial group, and for several other countries, including many oil exporting countries, appear satisfactory when assessed in terms of the traditional indicators reviewed above. On the other hand, for the non-oil developing countries and especially for the African and Western Hemisphere groups, there was a pronounced decline in the ratios of reserves to imports and other comparable ratios to levels well below their historical averages. This suggests that any improvement in the foreign exchange earnings of these countries may well be used in part for replenishing their reserves.

Whenever global reserves are adequate, a country can usually increase its reserves through an appropriate mixture of international borrowing and the pursuit of adjustment policies to improve its balance of payments. The difficulties presently being encountered by many countries in expeditiously replenishing their reserve holdings point in the direction of either or both of the following: some lack of global adequacy in the availability of international liquidity or the existence of important impediments, such as those affecting access to international goods and capital markets, to the achievement of a more appropriate distribution of reserves. In many instances, a decisive factor contributing to the difficulties experienced in replenishing reserve holdings has been market skepticism as to the adequacy of policies pursued by the countries concerned. In the last analysis, the adequacy of international liquidity and reserves must be judged in terms of the contribution they can make to sustained and balanced noninflationary growth in the world economy, which requires, inter alia, that pressing balance of payments problems be solved through an appropriate combination of financing and adjustment. In the present difficult environment, official sources of liquidity are likely to play an increasingly important role in supporting countries’ efforts to find solutions to external financial problems.

The Role of the Fund in the Provision of Liquidity

A major function of the Fund is to provide international liquidity in accordance with the purposes of the Fund specified in the Articles of Agreement. Part of the liquidity supplied takes the form of reserve assets that can be used for balance of payments financing (“unconditional liquidity”), while part takes the form of credit to members that is generally subject to conditions (“conditional liquidity”).

Conditional liquidity is provided by the Fund under its various lending facilities. Most of the Fund’s credit extended under these arrangements requires an adjustment program for the member that is intended to promote a sustainable external position. At the end of April 1983, total commitments under conditional forms of lending amounted to SDR 25 billion, of which about two thirds represents undrawn balances. In addition, it is often the case that when the member obtains Fund financing under agreed conditions, its access to international capital markets is enhanced. This catalytic role of the Fund has become more important in the recent period when private lending institutions have been less willing to engage in international lending.

Unconditional liquidity is supplied through the allocations of SDRs and also in the form of reserve positions in the Fund, which are the claims corresponding to the resources that countries have made available to the Fund. Member countries holding SDRs and reserve positions in the Fund can use them to finance balance of payments deficits without having to enter into policy commitments with the Fund. As was noted earlier in this chapter, Fund-related reserve assets held in countries’ reserves amounted to SDR 48 billion at the end of April 1983—14 per cent of total non-gold reserves. Almost two thirds of these assets consisted of reserve positions in the Fund, with the remainder taking the form of SDR holdings. Industrial countries held almost three fourths of these Fund-related reserve assets, oil exporting countries held one fifth, and non-oil developing countries held the remaining one twentieth.

Provision of Liquidity Through Members’ Use of Fund Resources

The Fund makes its resources available to members, under agreed conditions, in support of efforts on their part to overcome balance of payments problems in an orderly way without undue disruption of the flows of international trade and payments. Several facilities are available for extending credit to members for varying periods up to ten years and subject to different degrees of conditionality. For example, the extended Fund facility, which was set up in 1974, is designed to assist members experiencing protracted payments difficulties whose correction requires sustained effort through appropriate policies. In credit arrangements that envisage policy actions to be taken by the member, the use of the Fund’s resources is normally made conditional upon continued policy action in accordance with a program agreed between the member and the Fund. However, no policy adjustment would normally be required when the need for balance of payments financing is of a temporary character resulting solely from circumstances believed to be likely to reverse themselves in the near future, as under the compensatory financing facility designed to meet temporary shortfalls in export earnings.

The limits placed under present policies on a member’s use of the Fund’s credit facilities are defined in terms of the member’s quota in the Fund. For example, to meet a shortfall in export earnings, a member may draw from the Fund up to 100 per cent of its quota. On the other hand, in order to meet a protracted and structural balance of payments problem, a member may, subject to conditions as mentioned above, borrow Fund resources up to 150 per cent of its quota in any year, up to 450 per cent over three years, and, in some circumstances, up to a cumulative limit of 600 per cent of its quota, apart from any amounts borrowed by the member under the compensatory financing and buffer stock facilities.

The number of member countries using Fund resources has increased substantially over the past decade. Ninety-two members had outstanding drawings at the end of 1982 as against 28 members at the end of 1973. While the amount of outstanding Fund credit has shown considerable cyclical variability, it increased from its earlier peak of SDR 13 billion at the end of 1977 by some 80 per cent to SDR 25 billion at the end of June 1983. For the non-oil developing countries as a group, outstanding borrowings from the Fund at the end of June 1983 amounted to more than 30 per cent of the group’s non-gold reserve holdings. The proportion of the outstanding Fund credit subject to high conditionality has increased from 16 per cent at the end of 1976 to 58 per cent at the end of 1982. This evolution has resulted mainly from the need for more active adjustment policies of members using Fund resources in present circumstances and in the light of the continuing requirement for safeguarding the revolving nature of the Fund’s resources. The steps described earlier in this chapter to strengthen and broaden surveillance and to monitor members’ external debt developments could, by providing earlier warning of impending problems, help to reduce the pressure on the Fund’s limited financial resources.

To enable the Fund in the present economic situation to meet approved requests for financial assistance in support of adjustment programs, the Board of Governors has decided to increase quotas from SDR 61 billion to SDR 90 billion. The proposed increase is subject to consent and payment of increased subscriptions by member countries, which are expected to be completed late in 1983. A further increase in the resources available to the Fund will result from the recent decision of the participants in the General Arrangements to Borrow to support a proposed increase in the total of commitments under these Arrangements from SDR 6.4 billion to SDR 17 billion. In the past, the resources available under the Arrangements could be used only to support drawings by the ten participants that are members of the Fund. The participants have now agreed that these resources may be used by the Fund in support of conditional credits to nonparticipating Fund members if the Fund’s other resources should prove inadequate to deal with an exceptional situation associated with balance of payments problems of members of a character or aggregate size that could threaten the stability of the international monetary system. Switzerland, a nonmember of the Fund, will become a full participant in the Arrangements. The Fund, in association with the participants in the General Arrangements to Borrow, has also concluded a borrowing arrangement with Saudi Arabia, in the amount of SDR 1.5 billion, that has similar purposes. In addition, the Fund has supplemented these resources through arrangements to borrow from members and other official sources (see Chapter 3).

SDR Allocation

SDR allocations are made for “basic periods,” which are specified in the Articles to be of five years’ duration unless the Executive Board decides on a different duration. The two decisions on SDR allocation in the past were for three-year periods, 1970–72 and 1979–81. In accordance with the Articles, allocations can be 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 per cent majority of the total voting power. The most recent allocation of SDRs was made on January 1, 1981; this was the last allocation of the third basic period. No allocations have been made in the fourth basic period, which began on January 1, 1982, because the broad support among members required to enable the Managing Director to make a proposal has not yet emerged.

The question of further SDR allocations is currently under review by the Executive Board. At its meeting in Washington, D.C., in February 1983, the Interim Committee considered the question of allocations of SDRs in view of developments since the Annual Meeting in Toronto in September 1982. The Committee’s discussion was held against the backdrop of declining inflation rates in several of the industrial countries, together with concerns that reduced trade flows, generally depressed commodity prices, and, in particular, the external debt problems of several countries might be linked in part to an inadequate supply of international liquidity. The Executive Board was asked to review the latest trends in economic growth, inflation, and international liquidity so that the Managing Director could determine before the next meeting of the Interim Committee (in September 1983) whether a proposal for a new SDR allocation could be made that would command broad support among Fund members.

In decisions on SDR allocation, the Fund is required by its Articles of Agreement to take several elements into account. There must be a long-term global need to supplement existing reserve assets. Also, SDR allocations must promote the attainment of the Fund’s purposes and be consistent with the objective of avoiding economic stagnation and deflation as well as excess demand and inflation in the world. In addition to these requirements, the objective of making the SDR the principal reserve asset in the international monetary system must also be recognized. A report by the Executive Board on the question of SDR allocation will be the subject of discussion at the next meeting of the Interim Committee and at the Annual Meeting of the Board of Governors in September 1983.

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