Chapter

Chapter 2: Developments in the International Monetary System

Author(s):
International Monetary Fund
Published Date:
September 1981
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The behavior of exchange rates during 1980 and the first half of 1981 reflected the fundamental problems of the international economy during this period. Continued divergences among rates of inflation and growth of real output in the industrial countries, as well as sizable changes in current account positions, contributed to sustained movements in exchange rates during the 18-month period ended in mid-1981. Viewed from a medium-term perspective of two to three years, exchange rates of industrial countries have generally moved in the direction suggested by the evolution of current account imbalances. During the period under review in this Report, however, short-run fluctuations in interest rate differentials between major industrial countries were much larger than in previous years and were associated with high short-run variability of bilateral exchange rates. The non-oil developing countries, which faced an especially difficult economic environment, had an important stake in maintaining exchange arrangements that would moderate the effects on them of exchange rate fluctuations among major currencies and in pursuing national exchange rate policies that would avoid a further weakening in current account positions already impaired by external circumstances. For oil exporting countries, too, exchange rate developments had an important role to play by affecting the competitiveness and profitability of the non-oil sector and hence the success of efforts to diversify production and exports. These topics of exchange rate behavior and international adjustment, as well as the important role of the Fund in surveillance over members’ exchange rate policies, are treated in the first part of this chapter.

Recent developments in the international monetary system have had a substantial impact on the volume, distribution, and composition of international liquidity. The level and pattern of international reserves have been affected especially by the recycling of net current account earnings of oil exporting countries, largely through international capital markets, as well as by exchange market intervention, increased holdings of European Currency Units (ECUs), SDR allocations, and increases in reserve positions in the Fund. The recent and prospective future growth of international liquidity, supplied by financial markets as well as by the Fund, raises issues with regard to the adequacy of international reserves, the role of the SDR in the international monetary system, and the Fund’s contribution in providing conditional liquidity and supplementing the global supply of reserve assets. These matters are discussed in the second part of this chapter.

Exchange Rate Arrangements and Policies

Recent developments in the exchange rate system, discussed in the following section, were marked by large exchange rate changes related both to differences among the internal monetary developments in several major countries and to large shifts in current account balances. This part of the chapter also discusses, against this background, the efforts of the developing countries to adapt their exchange arrangements and policies to the rapid, and mostly unfavorable, changes in their external environment that have been taking place. In assessing these developments, Fund surveillance over exchange rate policies of members must take into account not only the need for achieving external balance but also the political and economic desirability of meeting domestic objectives.

Exchange Rate Experience of Industrial Countries

Analysis of the evolution of exchange rates among the industrial countries is complicated by the interdependence among changes in exchange rates, monetary and other policies undertaken by those countries, and other factors affecting their current account positions. While most countries in the world, including most of the smaller industrial countries, peg their currencies to one of the major currencies or to baskets that include these currencies, the rates among the major currencies themselves—except for rates between currencies of participants in EMS intervention arrangements—are subject to wide variation and are determined principally by financial policies and current account developments in the countries concerned. Monetary policies and current account positions have both a direct impact on the demand for, and supply of, the domestic currency in the foreign exchange market and an indirect effect brought about by altering the expectations of investors with regard to future exchange rates and thereby inducing portfolio shifts among assets denominated in different currencies. Exchange rate movements, in turn, have a major impact on current account developments, which tend, however, to be more heavily influenced in the short run by cyclical changes in real income. The following sections describe salient aspects of these interdependent processes.

Exchange Rate Developments 1

The year 1980 and the first half of 1981 witnessed unusually large changes in the effective exchange rates for currencies of certain industrial countries (Chart 8) and some even larger changes in certain bilateral rates. The Japanese yen showed the largest effective appreciation, rising by 22 per cent from December 1979 to June 1981. The effective exchange value of the U.S. dollar appreciated rapidly in the last quarter of 1980 and the early months of 1981, reaching in June a level 16 per cent higher than its level in December 1979. At the other extreme, the currencies of participants in the European Monetary System (EMS) and Switzerland depreciated sharply, and the currencies of most other industrial countries also depreciated. The deutsche mark, for example, depreciated by 13 per cent on an effective basis, by 27 per cent against the dollar, and by 32 per cent against the yen.

In contrast to these large changes in exchange rates between certain major currencies, nominal rates among EMS participants were stable. This stability resulted partly from the fairly heavy official intervention in exchange markets that was required at times to maintain margins and partly from interest rate policies designed for this purpose. The similarity of current account developments among EMS participants also contributed to maintaining stable exchange rates. There has been only one currency realignment since the end of 1979—the lowering of the central rate of the Italian lira vis-à-vis the ECU by 6 per cent in March 1981. There remained, however, considerable differences among EMS participants’ rates of inflation, which in 1980 ranged from 5.5 per cent for the Federal Republic of Germany to 21 per cent for Italy.2

Those exchange rates that registered wide swings from year to year, as discussed earlier, also showed substantial short-run variability in 1980 and the first half of 1981. There were, however, noticeable differences between the evolution of the variability of import-weighted effective exchange rates and that of U.S. dollar exchange rates (Table 13).3 The variability of effective exchange rates for most industrial countries—and notably for the smaller industrial countries—was lower or only slightly higher in 1980 than in 1979 and was lower than in any other year since 1973. In contrast, the variability of dollar exchange rates increased substantially in 1980 compared with 1979, returning to or exceeding levels prevailing during the earlier years of floating rates.

Table 13.Average Monthly Variability of Effective Exchange Rates and U.S. Dollar Exchange Rates, January 1974-December 19801
Effective Exchange Rate2Dollar Exchange Rate
1974-771978197919801974-77197819791980
Industrial countries1.281.440.961.031.892.271.372.18
Canada1.031.401.210.780.981.141.181.04
France1.341.610.640.891.982.221.402.59
Germany, Federal Republic of1.221.330.640.962.112.631.472.72
Italy1.600.730.681.152.111.641.262.58
Japan1.483.132.033.341.623.732.233.76
United Kingdom1.231.612.160.961.802.332.632.10
United States0.620.940.601.18
Other industrial countries1.411.510.940.952.262.641.442.41
Developing countries31.411.661.471.451.321.491.331.51
Pegged to U.S. dollar1.051.551.511.240.490.530.800.00
Pegged to SDR1.661.992.581.971.522.582.602.24
Pegged to French franc0.660.700.370.461.992.221.412.58
Other developing countries1.871.961.521.811.721.761.422.20

Variability is defined here as the standard deviation of monthly percentage changes in effective exchange rates and in U.S. dollar exchange rates over each period. Figures for groups of countries are simple averages of those for the countries in each group.

Monthly import-weighted effective exchange rates are used in these calculations. Weights are based on 1977 imports as reported in International Monetary Fund, Direction of Trade (various issues).

Countries are classified according to their exchange arrangements on January 31, 1981.

Variability is defined here as the standard deviation of monthly percentage changes in effective exchange rates and in U.S. dollar exchange rates over each period. Figures for groups of countries are simple averages of those for the countries in each group.

Monthly import-weighted effective exchange rates are used in these calculations. Weights are based on 1977 imports as reported in International Monetary Fund, Direction of Trade (various issues).

Countries are classified according to their exchange arrangements on January 31, 1981.

Exchange Rates and Interest Rates

The sharp changes in U.S. short-term interest rates over the past year and a half have resulted in large variations in interest rate differentials between the United States and other major industrial countries. These movements have been associated with fluctuations in U.S. dollar exchange rates taking place over the same period. Attention has been attracted, in particular, by the sharp appreciation of the U.S. dollar at times of relatively large interest differentials in favor of the United States, for instance in February and March 1980 and again in the last quarter of that year and the first half of 1981. There exists, however, a range of views on the relationship between exchange rates and interest rates. Salient aspects of this relationship are discussed in this section.

An analysis of the recent interaction between interest rates and exchange rates must start with the observation that changes in both of these variables depend upon such factors as the growth in supply of and the demand for money and other financial assets in different economies and the expectations of the market with regard to rates of inflation in different countries. Broadly speaking, both interest rates and exchange rates depend on domestic monetary and fiscal policies, and divergences among countries in the policies they are following therefore result both in divergences among their interest rates and in exchange rate movements.

When financial markets are internationally integrated, differences between interest rates in two countries ordinarily reflect differences between their expected rates of inflation. In addition, interest arbitrage brings about the equality of the interest rate differential with the forward discount on the currency of the country with the higher rate of inflation, indicating also that its currency is expected by the market to depreciate at a rate equal to the difference between the expected rates of inflation. Because of the impact of these expectations on the evolution of spot exchange rates, there will be a tendency for spot rates to move at the expected rate of depreciation. This tendency is not disturbed by changes in nominal interest differentials that merely reflect changes in expected inflation rates, since such interest rate changes do not create new inducements for international capital movements.

Interest rates also change, however, in response to factors other than altered expectations with respect to inflation. Such movements in real interest rates change expected yields of assets denominated in different currencies and may thus, by inducing an inflow of capital, lead to an initial appreciation of the currency of the country whose relative interest rate has risen. This appreciation will continue until the yield incentive is eliminated. Once these initial changes in exchange rates have occurred, exchange rates can again be expected to move in line with expected relative rates of inflation, at any rate in the absence of unanticipated disturbances.

Because of the influences on interest rates and exchange rates described above, the observed movements of interest rates and exchange rates can be either in the same or opposite directions. The interpretation of the experience of recent years is complicated by this dual relationship and by the fact that exchange rates are subject to a number of other factors, such as sharp shifts in current account balances and announcements of important changes in economic policies, which may have more important effects than do interest rate differentials. Thus, there are some clearly observable relationships for certain periods—for instance, for the Federal Republic of Germany in 1978 and 1979 (Chart 13)—when a stable interest rate differential is associated with a steady exchange rate movement in the direction and of the magnitude to be expected if both rates mainly reflected expected rates of inflation. There are, however, other times, notably during 1980 for the six major industrial countries shown in Chart 13, when the large changes of interest rate differentials that took place appear to reflect chiefly changes in real interest rates and therefore produce exchange rate changes in the opposite direction; changes in real interest rates since 1978 are shown in Chart 14. At yet other times—for instance, for Japan in 1978 and 1979—large fluctuations in exchange rates, in the face of stable interest rate differentials, suggest that exchange rate developments were dominated by factors other than those relating to interest rates.

Chart 13.Six Industrial Countries: Interest Rate Differentials and Exchange Rates, January 1976-June 19811

Source: International Monetary Fund, International Financial Statistics.

1 The interest rate differential is the excess of the short-term domestic interest rate (the call money rate for France, the Federal Republic of Germany, Italy, and Japan, and the treasury bill rate for Canada and the United Kingdom) over the U.S. federal funds rate. Exchange rates are monthly averages of daily rates in U.S. dollars per unit of local currency and are expressed as an index, with the average daily rate over the entire period being equal to 100.

Chart 14.Seven Industrial Countries: Real Short-Term U.S. Interest Rate and Differentials Between U.S. and Domestic Rates,1 January 1976-June 1981

(In per cent per annum)

1 The real interest rates are calculated by deflating the nominal interest rates used in Chart 13 by a measure of the expected rate of inflation. This measure is the average rate of change of the price deflator for private domestic demand in the quarter containing the month for which the calculation is made and the following two quarters. Fund staff projections of this deflator are used for the second, third, and fourth quarters of 1981. The real interest rate differential is the excess of the country’s real interest rate over the U.S. real interest rate.

The general rise in nominal and real interest rates in the industrial countries has in part reflected reductions in the growth of monetary aggregates resulting from the efforts of these countries to restrain inflation. In 1980, the major industrial countries succeeded, with some important exceptions, in lowering growth rates for narrow money, as well as for more broadly defined monetary aggregates, compared with 1979. (See Table 14 for data and definitions.) The unusually great variability of interest rate differentials between the United States and other industrial countries can be attributed in part to the problems encountered by the United States in gradually reducing monetary expansion to targeted growth rates. These problems were manifested by sharp changes in domestic demand for money and credit in the United States during 1980 and the first half of 1981, stemming from the temporary imposition of selective credit controls and large shifts in economic activity, which resulted in substantial movements in interest rates.

Table 14.Seven Industrial Countries: Monetary Growth Rates, 1974-80

(Change from end of previous year, in per cent)

Narrow Money1Broad Money1
1974-7721978197919801974-772197819791980
United Kingdom15.516.49.13.910.314.612.518.2
Germany, Federal Republic of10.014.02.04.19.110.24.84.6
France11.611.111.86.415.112.213.98.3
Italy15.726.623.712.920.823.019.411.7
Canada7.97.01.410.716.916.917.69.7
Japan10.813.43.0-2.012.613.18.46.8
United States5.57.36.04.08.410.27.210.9
Source: International Monetary Fund, International Financial Statistics (various issues).

Narrow money is defined as the sum of currency outside banks and private sector demand deposits. Broad money consists of the sum of narrow money and quasi-money comprising the time deposits, savings deposits, and foreign currency deposits of residents.

Annual average rates.

Source: International Monetary Fund, International Financial Statistics (various issues).

Narrow money is defined as the sum of currency outside banks and private sector demand deposits. Broad money consists of the sum of narrow money and quasi-money comprising the time deposits, savings deposits, and foreign currency deposits of residents.

Annual average rates.

Although changes in interest differentials tended to move together with daily and weekly movements in U.S. dollar exchange rates throughout most of the period, other influences, such as current account developments, reduced the correlation between exchange rates and interest differentials over longer intervals (Chart 13). For example, by the beginning of the second quarter of 1981 interest rate differentials in favor of the U.S. dollar vis-à-vis most other major currencies had narrowed, but the dollar continued to appreciate (Chart 8). Moreover, although the EMS currencies and the Canadian dollar seemed to be sensitive to interest rate differentials, other major currencies, such as the Japanese yen and the pound sterling, appreciated against the U.S. dollar in 1980.

As already noted, the type of relationship observed between interest rate differentials and changes in U.S. dollar exchange rates during 1980 is not apparent for earlier years or for the early months of 1981 (Chart 13). In 1980, time periods in which interest rate differentials favored U.S. dollar-denominated financial assets generally coincided with appreciation of the U.S. dollar. It is worth noting that in some instances the magnitude of this appreciation suggested a volatile reaction of the market’s expectations with regard to future dollar exchange rates. For example, while the average interest differential in favor of assets denominated in U.S. dollars compared with assets denominated in deutsche mark over the four quarters ended in March 1981 was about 4 per cent, the U.S. dollar actually appreciated by 8 per cent per annum against the deutsche mark over this period. There is thus no straightforward, mechanical relationship between the magnitudes of interest rate differentials and those of exchange rate changes.

There is, however, a clear indication that an increase in the size of short-run changes in interest rate differentials has in general been accompanied by an increase in the variability of exchange rates, although this seems to have been less true for Canada and the United Kingdom than for other major industrial countries (Chart 15). For Canada, the variability of both rates was much lower, and changed less from year to year, than for the other countries shown in Chart 15. In the fourth quarter of 1978, and again in 1980 and 1981, sharp changes in interest differentials, owing largely to developments in the United States, coincided with sharp month-to-month changes in exchange rates, ranging from 2 to 4 percentage points for the currencies shown. Similar developments also took place in the smaller industrial countries.

Chart 15.Six Industrial Countries: Variability of Differentials Between Domestic and U.S. Interest Rates and of Changes in U.S. Dollar Exchange Rates, 1976-801

(In per cent)

Source: Board of Governors, U.S. Federal Reserve System.

1 For each year, variability is measured as the standard deviation of daily interest rate differentials and of percentage changes in exchange rates from the corresponding date of the previous month. The interest rate differential is the excess of the U.S. federal funds rate over the three-month local interbank lending rate, except for Canada and Japan, for which the local rates are the three-month finance company rate and the two-month money market rate, respectively.

Just as greater volatility of interest differentials between assets denominated in U.S. dollars and in other currencies in 1980 has been associated with the variability of U.S. dollar exchange rates, closer correspondence of interest rate policies among EMS participants, as well as intervention policies, have contributed to offsetting both external and internal influences that would otherwise have disturbed the stability of exchange rates among the currencies of these countries. Although considerable differences in interest rates had been observed throughout the 1970s among the countries now participating in the EMS—perhaps reflecting persistent differentials in actual or anticipated inflation rates—establishment of the EMS in March 1979 coincided with a marked reduction in these differentials, and this reduction, together with the subsequent maintenance of stable differentials, might be expected to reduce short-term strains in exchange rates among the participating countries.

The need for strong measures to counteract inflation through control of monetary aggregates is widely acknowledged. The high real interest rates sometimes resulting from these measures may, while they last, dampen economic activity and investment. Further costs may arise from fluctuations in interest rates and exchange rates, chiefly because of induced changes in patterns of international trade and investment that may be inconsistent with longer-run values of these rates. While such distortions may often be small because of the long lags between movements of exchange rates or interest rates and decisions regarding production and investment, they may be sizable in countries in which domestic prices and wages respond rapidly, especially in an upward direction, to movements in the exchange rate.

Exchange Market Intervention

The principal purpose of official intervention in exchange markets is to reduce short-run exchange rate fluctuations, or “smooth” medium-term movements in exchange rates, through the purchase of foreign exchange when the home currency tends to appreciate and the sale of foreign exchange when the home currency tends to depreciate. Such intervention tends to lower the money supply in countries whose currencies are depreciating while raising it in countries with appreciating currencies. These changes in money supply, if permitted to occur, would contribute to the adjustment of the underlying imbalance being financed by the intervention. When these induced changes in money supply conflict with national monetary targets, however, it may be decided to “sterilize” the intervention by taking offsetting domestic monetary measures, even at the cost of weakening international adjustment through monetary effects.

For most countries, direct official intervention in foreign exchange markets is not made public. For this reason, the magnitude of intervention can generally be assessed only through an examination of changes in gross reserves. As discussed in previous Annual Reports, this measure of intervention has several limitations: it does not take into account official compensatory borrowing in foreign currencies or swap transactions, and monthly data may hide information on intervention that is reversed within a month. It is possible that a more adequate measure of intervention would produce a closer relationship between changes in reserves and in exchange rates, such as that shown in Chart 16 for Japan.

Chart 16.Eight Industrial Countries: Monthly Changes in Official Reserves Relative to Exports and in Exchange Rates, January 1978-June 1981

(In per cent)

1 Changes in reserves are defined here as the total of changes in foreign exchange holdings, reserve positions in the Fund, and holdings of SDRs, minus changes in the use of Fund credit and cumulative SDR allocations. In calculating these changes, foreign exchange holdings are valued in U.S. dollars and are corrected for valuation changes, and all changes in SDR-denominated reserve components are converted into U.S. dollars at average monthly exchange rates. The figures for 1979-81 have been adjusted by excluding the value of ECUs issued against gold holdings of EMS members. For each country, the change in reserves is expressed as a percentage of average monthly exports for the period 1978-79.

2 The exchange rate at the end of each month is measured in U.S. dollars per unit of domestic currency for all countries except the United States, for which the effective exchange rate derived from the Fund’s multilateral exchange rate model is used.

3 The left scale for Switzerland is different from that used for the other countries because of the exceptionally large magnitudes of reserve changes relative to exports.

Day-to-day changes in official intervention often offset each other over time. At times, however, there are extended episodes of intervention in one direction that reveal an attempt to counteract, or slow the pace of, exchange rate changes. For example, during the period from August 1980 through January 1981, when the U.S. dollar was generally appreciating against other currencies, U.S. foreign exchange reserves rose from US$5.4 billion to US$10.7 billion. Since February, the magnitude of U.S. intervention has been greatly reduced, and in May the U.S. authorities announced a policy of intervening only when necessary to counter disorderly market conditions. During 1980, when the deutsche mark depreciated by 7 per cent (on a MERM-weighted basis), the net external assets of the Bundesbank—which include net borrowings of foreign exchange and thus provide a more comprehensive measure of intervention than the use of foreign exchange reserves alone—fell by DM 16.5 billion. Of this amount, a fall of DM 12.5 billion was associated with intervention in the deutsche mark/U.S. dollar market; a decline of nearly DM 8 billion consisted of net intervention to maintain agreed margins for exchange rates among participating currencies in the EMS; and an increase of about DM 4 billion reflected conversions of foreign-held bonds denominated in deutsche mark and net swaps with domestic banks. Japan’s foreign exchange reserves rose by slightly over US$5 billion during 1980, as the yen appreciated by 18 per cent on a MERM-weighted basis. By contrast, the effective appreciation of sterling by 11 per cent in 1980 was accompanied by only a slight increase in foreign exchange reserves of the United Kingdom; an additional moderating influence was provided by early repayment of official debt. While in 1980 the French franc depreciated somewhat in terms of its effective exchange rate, it was often relatively strong against the deutsche mark within the EMS and large purchases of deutsche mark contributed to a net increase in France’s foreign exchange reserves by some US$9 billion.

Intervention in official exchange markets by industrial countries is normally accompanied by sterilization operations. As a result of such sterilization, intervention has the net effect of changing the currency denomination of nonmonetary official debt in the hands of the private sector but not the money supply of the country in which the intervention is taking place or that of the country supplying the intervention currency. Thus, an intervention purchase of U.S. dollars by the authorities in the Federal Republic of Germany need not directly affect monetary aggregates in either that country or the United States if the additional U.S. dollar holdings of the German authorities are invested by them in U.S. dollar-denominated government securities purchased in the U.S. market and if the impact of the intervention on the German money supply is offset by a sale of securities denominated in deutsche mark in the German market.

A more direct method of intervening without affecting the domestic monetary base makes use of official compensatory borrowing by offering bonds denominated in foreign currencies in the private market. This technique, which has been used in several industrial countries, has the effect of diminishing the supply of domestic currency assets in private portfolios and thereby reducing pressure against that currency in the foreign exchange market. At the same time, the currency composition of official debt held by the private sector is changed in a single operation without either affecting the monetary base of the intervention country or involving exchange market transactions by the monetary authorities. By contrast, swaps of spot and forward exchange between the monetary authorities and the private sector have a temporary effect on the money supply and have indeed been used as a means of controlling the domestic monetary base.

Fully sterilized exchange market intervention—that is, intervention that alters only the relative supplies of securities denominated in different currencies without affecting the domestic money supply—has on occasion accommodated short-run changes in the demand for assets denominated in different currencies that were generated by changes in interest rates believed by the market to be temporary. The usefulness and the limitations of official intervention in foreign exchange markets are discussed below in the context of the Fund’s surveillance over the exchange rate policies of members.

Exchange Rates and Current Account Positions

Previous Annual Reports have emphasized the contribution that exchange rate changes can make toward reducing existing current account imbalances while at the same time pointing out the factors that can delay and offset this contribution. During the past two years, there have been rather dramatic changes in current account balances, particularly among the three largest industrial countries. Both cyclical movements in income and prior movements of countries’ exchange rates have contributed to these shifts in current account balances. An equally notable development, however, has been the effect that current account imbalances themselves have had on exchange rate movements. Indeed, experience suggests that lines of influence run in both directions, with current account imbalances being affected by past movements of exchange rates and in turn affecting current movements.

Current account positions (excluding official transfers) for the seven major industrial countries during 1980 can be put into perspective by comparison with the situation in 1978 (Table 15). At that time, the U.S. current account was in deficit by roughly US$10 billion, while the Federal Republic of Germany and Japan had a combined current account surplus of more than US$30 billion. Just two years later, the U.S. current account was in surplus by US$10 billion while the other two countries had shifted to a joint deficit of almost US$19 billion. Over the same period, the current accounts of France and Italy went from surpluses to deficits, the current account deficit of Canada was reduced sharply, and the United Kingdom’s current account surplus more than doubled.4 While changes in the nominal value of net oil imports and other structural changes were an important element in current account developments during this period (Table 15, row 1, memorandum item), the exchange rate played a role in the adjustment process in each of the seven major industrial countries. The size of this role, however, was conditioned by a number of factors that bear careful examination.

Table 15.Seven Major Industrial Countries: Current Account Balances, Nominal and Real Exchange Rates, and Relative Cyclical Positions, 1978-80
United

States
Fed. Rep.

of Germany
JapanItalyFranceUnited

Kingdom
Canada
(In billions of U.S. dollars)
(1) Current account balance1
1978-9.513.316.87.75.24.8-4.1
19796.8-0.3-8.06.12.81.5-4.4
198010.0-9.0-9.5-9.4-6.110.2-2.0
Memorandum item
Net oil imports2
197840.714.725.58.711.73.81.0
197958.0.24.437.812.116.71.60.4
198076.131.757.621.427.8-0.62.0
(In per cent)
(2) Change in nominal effective
exchange rate3
1978-80-4.05.6-12.5-6.91.017.3-4.0
1976-80-14.020.115.5-22.0-6.810.2-20.1
(3) Change in real effective exchange rate4
1978-802.1-1.2-26.92.76.244.1-4.2
1976-80-8.06.2-15.51.02.151.4-21.1
(4) Change in relative cyclical positions5
1978-80-5.04.39.66.3-2.2-8.00.3
Sources: International Monetary Fund, World Economic Outlook and Fund staff estimates.

Current account balance excluding official transfers.

Comprise crude oil and petroleum products.

These effective exchange rates are based on the weights used by the Fund for international cost and price comparisons; these weights differ somewhat from those derived from the multilateral exchange rate model, which are used to calculate the effective exchange rates published in International Financial Statistics and shown elsewhere in this Report. Positive (negative) entry indicates appreciation (depreciation).

Change in ratio of own to competitors’ indices for unit labor cost, adjusted for changes in nominal effective exchange rate; the weights used for this calculation are those referred to in footnote 3. Positive (negative) entry indicates worsening (improving) competitive position.

Change in ratio of own to competitors’ resource utilization in manufacturing, where resource utilization is defined as ratio of actual output in manufacturing sector to staff estimates of potential output in that sector. Positive (negative) entry indicates increase (decrease) in resource utilization relative to that of competitors.

Sources: International Monetary Fund, World Economic Outlook and Fund staff estimates.

Current account balance excluding official transfers.

Comprise crude oil and petroleum products.

These effective exchange rates are based on the weights used by the Fund for international cost and price comparisons; these weights differ somewhat from those derived from the multilateral exchange rate model, which are used to calculate the effective exchange rates published in International Financial Statistics and shown elsewhere in this Report. Positive (negative) entry indicates appreciation (depreciation).

Change in ratio of own to competitors’ indices for unit labor cost, adjusted for changes in nominal effective exchange rate; the weights used for this calculation are those referred to in footnote 3. Positive (negative) entry indicates worsening (improving) competitive position.

Change in ratio of own to competitors’ resource utilization in manufacturing, where resource utilization is defined as ratio of actual output in manufacturing sector to staff estimates of potential output in that sector. Positive (negative) entry indicates increase (decrease) in resource utilization relative to that of competitors.

The first such factor is the behavior of product and factor prices in a country relative to movements in those prices in competitor countries. To take this factor into account, the influence of exchange rates on trade flows should be assessed in terms of changes in real (rather than nominal) exchange rates, that is, exchange rates adjusted for relative movements in prices or labor costs.

The contrast between nominal and real changes in effective exchange rates is shown in rows 2 and 3 of Table 15, with the change in relative unit labor costs being employed as the price-cost index by which the nominal rate is corrected. For example, movements in real effective exchange rates from 1976 to 1980 were appreciably smaller than changes in nominal rates for both the United States and the Federal Republic of Germany, so that price changes offset much of the change in competitiveness initiated by a change in the nominal exchange rate. There was also a marked contrast between the behavior of nominal and real exchange rates for the Japanese yen over the same period. Labor cost behavior in Italy was sufficiently inflationary relative to that in competitor countries to eliminate the improvement in competitiveness initially resulting from a 10 per cent depreciation of the lira. In the United Kingdom, the increase in relative labor costs combined with relative exchange rate movements during this period to produce a large decline in that country’s competitive position.

Another major factor affecting the influence of exchange rates on the current account is the period required for the full response to changes in the prices of traded goods to take effect. On the basis of results of empirical studies, two conclusions may be drawn. One is that, over periods of two to three years, the demand for exports and imports is fairly price elastic in most industrial countries, although the full effect of changes in exchange rates takes even longer to be worked out; the supply response is especially slow when economies are operating close to full capacity. The second conclusion is that the price elasticities of demand are much smaller over the span of a year than over the longer run. This evidence suggests that the equilibrating effect of exchange rate changes on the current account will take place only gradually and will usually not be apparent from a comparison of contemporaneous exchange rate changes and current account positions. In fact, as noted in previous Annual Reports, the tendency in most countries for import prices to change more rapidly in terms of local currency than do export prices, coupled with a slow response in the volume of imports and exports, often produces a short-term worsening (improvement) of the trade balance in response to an exchange rate depreciation (appreciation)—the so-called J-curve effect. The lagged response of the trade balance to exchange rate changes may in turn contribute to exchange rate adjustments that are so large as to bring about, over time, an overcorrection of the initial current account imbalance.

Thus, conclusions about the effect of exchange rate changes on current account positions must take into account the timing of the response. Specifically, it may be noted that the improvement in the U.S. current account balance from 1978 to 1980 was accompanied by a real appreciation of the dollar of 2 per cent over the same period but appears associated with a real depreciation of 8 per cent for 1976-80. Similar marked differences are also evident for the Federal Republic of Germany, Japan, and Canada, again suggesting that changes in the current account are better explained by movements in real exchange rates over a longer past period than by current or recent changes in nominal exchange rates.

Yet a further important influence affecting the impact of exchange rate movements on current accounts is the evolution of cyclical changes in real income in the countries concerned. Again, it is worthwhile to note a broad conclusion of empirical work, namely, that the sum of income elasticities of the demand for imports and exports is, for periods of less than a year, anywhere from two to four times larger than the sum of the relative price elasticities. In recent years, countries’ trade and current account balances have therefore tended to be dominated in the short run by their cyclical real income positions compared with those of other countries, except in a few instances when proportionate changes in real effective exchange rates were relatively large. As a result, trade and current account balances generally improve in countries whose real income is cyclically relatively low.5 When a country’s cyclical real income position strengthens relative to that of other countries, its current account may well deteriorate even though its nominal, or even its real, exchange rate may simultaneously depreciate.

An examination of changes in relative cyclical positions6 between 1978 and 1980 for each of the seven major industrial countries shows that the large positive change in the U.S. current account balance from 1978 to 1980 was accompanied by a reduction in its relative cyclical position, while the deterioration in both the German and Japanese current accounts was associated with a relative strengthening in cyclical real income (Table 15, row 4). The improvement in the relative cyclical position of Italy was a major factor in that country’s deteriorating current account balance, and the fall in the relative cyclical position of the United Kingdom contributed significantly to its current account surplus in 1980. In Canada and France, cyclical developments in real income were slight in comparison with partner countries and hence exerted less influence on the current account.

The impact of exchange rate movements on the current account is also affected by the commodity composition of a country’s foreign trade. Changes in relative prices have been shown to exert a greater influence on the volume of exports and imports of manufactured goods than on those of primary commodities. The independent effect of changes in real exchange rates on the balance of manufacturing trade will, therefore, tend to be more pronounced than the effect on the current account balance as a whole. Clearly, when changes in prices of major primary products, such as oil, are very large relative to exchange rate changes, and when such commodities are relatively important in a country’s foreign trade, the link between observed changes in exchange rate and current account balances will be further modified, as has undoubtedly been true since 1978.

The experience of industrial countries over the last few years thus suggests that exchange rate changes do work to correct—perhaps even reverse—current account imbalances. At the same time, current account imbalances are strongly influenced by relative cyclical movements in economic activity and themselves affect exchange rates, either directly by changing the proportion of foreign to domestic assets in portfolios in the process of financing the imbalances, or via expectations about future exchange rates. In the first instance, exchange rates will move to the extent that asset holders attempt to maintain the portfolio composition existing prior to an increase in the current account imbalance. In countries with unrestricted capital movements, this direct role of current account imbalances in the determination of exchange rates is likely to be minor compared with its role via expectations, because of the small magnitude of these imbalances relative to that of internationally transferable assets. The foreign exchange market can be regarded as operating like an asset market, with the exchange rate being the price that brings the demand for assets denominated in different currencies into balance with their supply. The demand for such assets depends in turn upon the expected rates of return, which are determined in part by expected changes in exchange rates. Since the stocks of internationally mobile assets in industrial countries are always much larger than asset flows deriving from current income, attempts to change international portfolios have a potentially much larger impact on the foreign exchange market than do changes in current account balances.

Viewed in this perspective, expectations about future exchange rates become a major determinant of present exchange rates. The factors presumed to affect expectations about future exchange rates are numerous and wide ranging—e.g., inflation differentials, monetary and fiscal policies, interest rates, relative competitive positions, trade and current account balances, and political uncertainties. One popular view influencing these expectations is that countries cannot indefinitely sustain large accumulations of current account imbalances in either direction. Thus, where future macroeconomic policies are not expected to be adequate for reducing existing current account imbalances, there is a strong presumption that real exchange rates will eventually play a role in restoring balance. In this way, current account surpluses or deficits can give rise to expectations with respect to appreciation or depreciation of the exchange rate in the future, and hence to anticipatory movements in the present exchange rate as well. More precisely, inasmuch as the current rate already reflects all publicly available information, unexpected current account imbalances (so-called current account “surprises”) will give rise to present exchange rate changes, as market participants re-evaluate their predictions about future exchange rates. For example, an unexpected change in the price of a major traded commodity will affect exchange rates because of expectations regarding the different effects of the price change on the current account balances of various countries.

A key implication of the feedback of current account imbalances on exchange rates is that periods of especially large imbalances are also apt to be periods of relatively large exchange rate changes, particularly if the size of these imbalances is unexpected. Accordingly, although current account balances are only one of many factors affecting exchange rates, countries with current account surpluses that are large relative to normal capital flows tend to have appreciating currencies more often than do countries with deficits or with moderate current account surpluses, and the currencies of countries with correspondingly large deficits tend to depreciate.

Although the interest of the authorities in exchange rate developments is often directed at their impact on the current account, their effect on international capital flows can also be significant. Unlike the current account, however, the capital account responds not so much to the existing level of the exchange rate as to expected future changes in the rate. This is true for both short-term and long-term financial capital. Direct investment is motivated principally by a number of additional considerations based on a long time horizon, such as the anticipated future relationship between exchange rates and relative prices. Nevertheless, the present level of spot exchange rates can have some immediate effects on such capital movements. For instance, the depreciation of a country’s currency, by improving the profitability and competitiveness of its export industries, can induce foreign direct investment in those industries. Short-term capital, too, responds to expectations of future changes in exchange rates, which can be affected by current exchange rate movements. For example, if such capital has previously fled the country in anticipation of a depreciation, the depreciation, when it occurs, may prompt a reflow of funds under the assumption that further depreciation is unlikely. Again, to the extent that international investors wish to hold a fixed proportion of their assets in domestic currency instruments, a depreciation, by lowering the proportion of domestic to foreign currency assets, can lead to an increased demand for domestic assets so as to restore the original asset proportions.

Exchange Rate Experience of Developing Countries

The last two years have been particularly difficult for most non-oil developing countries. The adjustment problems of these countries have been aggravated by subnormal expansion of export volumes resulting from the slow growth experienced in the industrial countries, and by a general weakening of their terms of trade due in part to increases in oil prices. At the same time, these countries had to contend with a marked rise in interest rates and substantial fluctuations in exchange rates among major currencies. The following sections review the impact of these developments on the economies of developing countries and discuss the use of exchange rate policies for dealing with their adjustment problems.

Impact of Interest Rate and Exchange Rate Developments in the Industrial Countries

Impact of Higher Interest Rates

To finance their large current account deficits, a number of non-oil developing countries have relied extensively on external borrowing from private sources; this has not been true, however, for many low-income countries. The upward movement in interest rates has affected service payments not only on newly contracted debt but also on outstanding medium-term and long-term debt that is subject to floating interest rates. While the importance of such debt differs considerably from country to country, there has been over the last decade a shift by many middle-income non-oil developing countries away from multilateral and bilateral official sources of financing toward commercial sources, particularly financial institutions. Because such financing is frequently subject to floating interest rates, interest payments on total debt outstanding from these sources responds quite quickly to changes in interest rates. The six-month London interbank offered rate (LIBOR) on dollar deposits—the key rate for many developing countries—rose from an average of 9.2 per cent in 1978 to 12.2 per cent in 1979 and to 14 per cent in 1980. In addition, higher interest rates in international capital markets eventually affect the cost of borrowing from official institutions that raise a part of their resources in the market or at market-related rates. This factor is of particular importance to many low-income developing countries, which have made, or have been able to make, only limited use of the private capital markets and have thus relied primarily on official institutions for financing.

Together with the rapid expansion of outstanding external debt, the rise in interest rates has substantially increased the interest service payments made by the non-oil developing countries.7 For the group as a whole, investment income payments, consisting primarily of interest on external debt, rose from an estimated US$27 billion in 1978 to US$50 billion in 1980 and had a major adverse impact on the combined current account deficit. A rise in nominal interest rates shortens the real amortization period, compared with the one originally contracted, and increases the perceived country risk through the negative effect on the current account balance just mentioned. To the extent that the rise in nominal interest rates reflects increased inflation rates, these adverse effects are somewhat mitigated by the gradual reduction over time in the real value of the outstanding debt. Increases in real interest rates, however, are more likely to have a net adverse impact, especially if they occur at a time of decelerating rates of inflation.

An additional complicating element has been the variability of interest rates. The six-month LIBOR on dollar deposits rose from 14 per cent in December 1979 to 19 per cent in March 1980, then fell back to below 10 per cent in June and July 1980 before rising to 17 to 18 per cent late in 1980 and continuing at 15 to 18 per cent during the first half of 1981. Such fluctuations affect not only foreign exchange and budgetary management, because of the repercussions on current net interest payments, but have also complicated the task of calculating the balance between the return to, and the cost of, future borrowing.

In financing their current account deficits in 1980, a number of non-oil developing countries reduced their rate of reserve accumulation and increased their reliance on short-term borrowing from nonofficial sources. While this weakening of their external financial positions has affected the ability of some countries to roll over maturing loans and to attract additional current account financing from private sources, such difficulties have arisen only occasionally, and the growth in debt service in most developing countries has not exceeded servicing capacity. Nevertheless, the positive real interest rates on external borrowing that had clearly emerged by 1980—in contrast to the situation in the mid-1970s—have provided an added inducement for non-oil developing countries to carry out effective adjustment programs rather than to rely on borrowing for the financing of payments imbalances.

The task of sustaining investment has been made more difficult by the high rates of interest in industrial countries. On the one hand, in those developing countries that are relatively free from restrictions on capital movements, rising interest rates abroad have encouraged capital outflows and resulted in upward pressure on domestic interest rates, thus tending to discourage borrowing for investment from both local and external sources. On the other hand, the higher domestic interest rates have failed to stimulate domestic savings appreciably, partly because real interest rates remained negative in many developing countries. In addition, for most non-oil developing countries, the higher costs of external financing, owing to higher interest rates abroad, reduced their ability to import capital goods and intermediate products, thus further dampening domestic investment.

The rise in interest rates in industrial countries also had a number of adverse effects on oil exporting countries, even those with substantial current account surpluses and large holdings of foreign assets. In several of the capital surplus countries with open economies and virtually unrestricted capital movements, private capital outflows increased substantially in response to the widening of interest rate differentials in favor of Eurocurrency investments. As the market’s demand for funds to finance these capital outflows increased, bank credit to the private sector expanded rapidly and strained local banking systems in these countries. The reluctance of the authorities, owing to economic and social considerations, to raise domestic interest rates restricted the ability of central banks to contain capital outflows. The increase in capital outflows during the period under review limited the availability of funds for domestic investment purposes and restricted the rate of growth of absorptive capacity in several of these economies. In some cases, the authorities allowed a marginal increase in the domestic interest rates or permitted their currencies to appreciate in an attempt to reduce the attractiveness of foreign currency investments. Both measures, however, were adopted with some reluctance, out of concern for adversely affecting domestic investment and diversification efforts through an increase in local costs.

Effects of Exchange Rate Fluctuations

Many developing countries continue to align their currencies to one of the major currencies (Table 16), and the stability of exchange rates for their currencies thus tends to depend chiefly on the stability of rates among the major currencies. Other countries are able to reduce the overall variability of their exchange rates by pegging to a basket of currencies.

Table 16.Exchange Arrangements of Fund Members, June 30, 1981
Developing Countries
Non-oil developing countries
Type of ExchangeIndustrialOil exportingNet oilMajor exportersOther develop-
ArrangementCountriescountriesexportersof manufacturesing countriesTotal
Currency pegged to
U.S. dollar443038
French franc21214
Other currencies44
SDR11314
Other composite42211322
Adjusted according to a set of
indicators1214
Cooperative exchange arrangements88
Other85361436
Total2012129871401

Excluding Democratic Kampuchea, for which no current information is available.

Excluding Democratic Kampuchea, for which no current information is available.

The variability of bilateral rates vis-à-vis the U.S. dollar increased from 1979 to 1980 for the currencies of developing countries other than those pegged to the U.S. dollar or the SDR (Table 13), while the variability of effective exchange rates was relatively low. Short-term variations in the bilateral exchange rates between major currencies can impose significant costs on the developing countries. With contracts typically denominated in foreign currencies, such fluctuations can, for example, increase short-term uncertainty and risk for importers and exporters if, as is true for many of these countries, adequate forward exchange facilities are not available. Official agencies, such as the central government and the monetary authorities, whose activities involve inflows and outflows of foreign exchange can also incur similar costs.

Apart from increasing short-run uncertainties, large fluctuations in exchange rates among major currencies affect other key variables in the economies of the developing countries. Changes in exchange rates among the currencies of industrial countries have recently been considerably larger than movements in relative prices, leading to variations in the relative export prices of the industrial countries and thus in the import prices faced by individual developing countries, which typically have well-established and persistent patterns of imports. For example, the prices of imported plant, equipment, and intermediate goods tend to be fixed in terms of the exporter’s currency, and exchange rate fluctuations are thus translated into changes in the costs faced by the importing sectors with respect to goods imported from countries to whose currencies the local currency is not pegged. This in turn affects the domestic price level, real incomes, and the internal terms of trade in the importing country.

Since countries are often more sensitive to fluctuations in certain bilateral exchange rates than in others, the extent to which developing countries incur costs associated with fluctuations of exchange rates among major currencies can be influenced by the choice of an exchange rate regime. It should also be noted that the incidence of the various types of cost will vary with the choice of exchange rate regime; a policy of minimizing the impact of fluctuations in exchange rates on domestic prices will not necessarily minimize, for example, the impact on domestic incomes or on the trade balance. For this reason, it is unlikely that the choice of an exchange rate regime by member countries has been dominated by the desire to achieve stability with respect to any one objective. Moreover, although the incidence of costs associated with exchange rate fluctuations may be expected to influence the choice of exchange arrangement by member countries, there are other broader considerations that have influenced this choice, such as the importance of historical links between certain countries, the expected medium-term behavior of major currencies, and the role of the exchange rate in setting the framework of domestic economic policies. The diversity of these considerations, and the varying circumstances in which developing countries find themselves, explain the variety of exchange arrangements that have in fact been adopted by these countries (Table 16).8

Exchange Rates and Current Account Positions

When exchange rates, internal prices, or foreign prices are expected to maintain themselves at levels at which they would induce an unsustainable current account deficit or undesired internal repercussions, policies to achieve adjustment must be set in train. Most developing countries cannot influence the foreign currency prices for imports and exports, so that exchange rate and other policies cannot affect the external terms of trade for these countries. These policies can, however, influence relative prices between traded and non-traded goods. A country that pegs to an external standard but pursues policies leading to higher rates of inflation than its trading partners experiences a reduction in competitiveness (or relative domestic profitability) in the sectors producing import substitutes and exports. To the extent that this reduction persists, it may over time induce a reallocation of resources away from these sectors. These considerations apply both to the non-oil developing countries and to the oil exporting countries but, because of their differing circumstances, merit separate discussion for each group.

Non-Oil Developing Countries

In some non-oil developing countries, there has been a continuing reluctance to adjust nominal exchange rates to changing economic circumstances. With inflation in a number of these countries recently running at rates higher than in their major trading partners, the difficulty of reducing their current account deficits has been increased by shifts in relative prices unfavorable to the sectors producing exports and substitutes for imports. To gain perspective on the adjustment problems currently faced by the non-oil developing countries, it is useful to review briefly the adjustment experience during the period after the first round of oil price increases in 1973-74.

The experience and policy responses of non-oil developing countries during that period varied considerably. Key structural differences among countries with regard to dependence on imported oil, the pattern of trade and output, and the types of social and political institutions were clearly important in determining the extent and speed of adjustment. Countries with the capability of exporting manufactures were in a better position than other non-oil developing countries to improve their external position by redirecting existing output toward net exports, and were generally more successful than other non-oil developing countries in achieving reasonably high rates of real growth.9 Many of these countries, however, also faced the need to change the sectoral pattern of output by redeploying factors of production into their traded goods sectors, and in a number of countries—for example, Brazil, Korea, Portugal, and Uruguay—the oil price increase prompted the authorities either to undertake structural reforms and a reorientation of development strategy toward export-oriented manufacturing or to intensify existing efforts in these directions. The implementation of such growth strategies enabled these countries to attract relatively large flows of external savings, thereby reducing the need to finance the required investment in their traded-goods sectors through reductions in domestic consumption. The emphasis on structural change often required, apart from the implementation of consistent demand management policies, active use of supporting policies to assist the transfer of resources to the traded-goods sector. Changes in the composition of public investment, the use of tax and other policies for the encouragement of investment in the industries producing traded goods, and modification of pricing policies played important roles. Moreover, some exporters of manufactures with relatively high inflation rates changed their nominal exchange rates frequently in order to maintain competitiveness and to prevent appreciation of their real effective exchange rates.

For middle-income primary producers and countries in the low-income group, the potential to adopt similar strategies for growth and adjustment was more limited. Nevertheless, the authorities in a number of predominantly primary producing countries were successful in promoting diversification by providing incentives and support to sectors producing manufactures, including processed primary products, for export and for import substitution. Some of the middle-income primary producers were able to increase their medium-term borrowing abroad on commercial terms to finance investment and ease the process of adjustment; their access to external capital markets afforded them the opportunity to pursue policies for promoting the required investment without abrupt changes in the pattern of domestic saving and consumption. Countries in the low-income group, which have particularly low savings rates and faced impediments to borrowing in international capital markets, depended for these reasons to a much larger extent on official sources of financing. Many of these countries were less successful in avoiding a reduction in economic growth and in maintaining investment and imports. Postponement of the required structural adjustment left these countries especially vulnerable to the impact of further external shocks.

The vulnerability of many non-oil developing countries to the most recent oil price increases reinforces the need for available financing to be used in ways that improve the prospects for real growth and promise the attainment of sustainable external positions. Lower real exchange rates in a number of these countries would enhance their efforts at raising their capacity for supplying exports and thus to alleviate their adjustment problems.

One of the key elements in adjustment by the non-oil developing countries will necessarily be the growth in external markets for their exports. In this respect, the present environment may be less favorable than that prevailing after the oil price increases of 1973-74. The current recession in the industrial countries, although less severe than that in 1974-75, is widely expected to be followed by a less rapid recovery; even in the absence of further shocks, the growth performance of these countries is unlikely to improve much, if at all, over that experienced in the recent past. Moreover, existing protectionist measures in some industrial countries, and any additional measures that might be taken if the recent upsurge in protectionist sentiment continues, endanger the access of developing countries to export markets, particularly those for manufactures. It must be added, however, that the exploitation of such opportunities would do little to improve the prospects of low-income countries lacking the possibility of early diversification of their production structure.

Export growth in the developing countries has in recent years become somewhat less dependent on growth in the industrial countries, and, since 1973, exports to other developing countries have grown as a proportion of total exports of non-oil developing countries. This experience suggests that the further growth of such trade could over time assist export-oriented development strategies, improve resource allocation, and thereby provide an impetus to the growth of output in these countries. To this end, trade liberalization among developing countries, especially those exporting manufactures and other middle-income countries, may play a useful role. Here again, though, the potential gains derived from such arrangements by low-income primary producing countries are far more limited.

Exchange rate policies in the non-oil developing countries also have an impact on their external capital flows. Capital movements undertaken by residents are strongly influenced by exchange rate expectations. For instance, if the local currency is regarded as overvalued and thus due for an eventual depreciation, capital flight will occur, while the devaluation of the local currency, if considered adequate to correct the previous overvaluation and especially if combined with the liberalization of exchange controls, will tend to induce a reflow of funds. The effect of exchange rate changes on direct foreign investment, however, is less marked than the impact on financial flows, since direct investment is typically motivated less by short-run exchange rate developments than by long-run considerations, such as expected market developments and the long-run relation between exchange rates and prices. In general, countries that have shown a tendency to maintain overvalued exchange rates, accompanied by the exchange and trade controls required to maintain such rates, have been less successful in attracting foreign investment than countries with a record of adjusting exchange rates promptly when the need to do so arises.

Oil Exporting Countries

Some of the oil exporting countries again face large surpluses as a result of decisions to maintain high rates of oil production in excess of those required to provide for their immediate development needs. For excessive current account surpluses arising from other causes, the process of adjustment would typically call for increased expenditures and appreciation in real exchange rates. This was broadly what occurred in these oil exporting countries in the mid-1970s. While their large current account surpluses were reduced as consumption and investment expenditures increased, these adjustments also brought about relatively high rates of domestic inflation and difficulties in the implementation of balanced development policies. These outcomes have brought into focus the special adjustment problems of oil exporting countries and the difficulties of defining the appropriate role of the exchange rate and other policy instruments in the situation of these countries.

These adjustment problems typically differ from those of other developing countries because of certain special characteristics of the oil exporting countries. The accrual of oil revenues directly to governments makes the process of external adjustment through monetary channels less automatic than in other countries, and also affords the governments a leading role in directing the pattern of domestic consumption and of foreign and domestic investment. In many of the oil exporting countries, the ability to promote adjustment through rapid absorption is constrained by shortages of certain factors of production; in particular, countries with indigenous populations that are small relative to their oil resources face the high social and economic costs of importing skilled and unskilled labor required for infrastructural and industrial development.

More fundamentally, the oil exporting countries are highly dependent, in terms of both export earnings and national income, on the exploitation of an exhaustible natural resource. The strategic problem confronting the oil exporting countries is to decide on the optimal rate of exploiting their known oil reserves so as to secure for their societies the greatest possible benefits of present and future consumption. The basic options are to conserve oil underground and exchange it for consumption goods at a later time; to produce oil and exchange it for current consumption goods; and to invest current oil revenues in real or financial assets so as to command a stream of consumption benefits in the future. The determination of the optimal rate of oil extraction and the choice among alternative uses of oil revenues are highly complex decisions, depending on such factors as the overall world demand for oil, the size of petroleum reserves, current and expected oil prices, the preference between current and future consumption, the expected real rates of return on financial and real assets, and the structural characteristics of the economies concerned. From the point of view of safeguarding future income and consumption, investment in real domestic non-oil assets has the advantage of enabling the oil exporting countries not only to transfer income from the present to the future but also to provide the avenue through which the productive base of the economy can be broadened and its dependence on oil reduced; as discussed above, implementation of investment programs has been complicated by the high interest rates prevailing in the industrial countries. Those oil exporting countries that will in the foreseeable future require alternative sources of foreign exchange earnings must seek development and diversification of their non-oil export sectors, and it is with regard to this objective that real exchange rates play an important role.

In oil exporting countries, as in other countries, the importance of the exchange rate stems from its role in influencing the relative price of traded goods and non-traded goods, the competitiveness of the sectors producing exports and import substitutes, and the relative profitability of investment in those sectors. While the leading role of governments in directing expenditure patterns and investment decisions in some oil exporting countries may weaken the influence of relative prices, the market nevertheless often plays a significant role in price and interest rate determination. Moreover, even in countries in which that role may be small, measures of relative scarcities are important signals to take into account when determining government policies affecting resource allocation. Relatively high real exchange rates, which would in general be appropriate for countries with substantial current account surpluses, could impede the achievement of certain development objectives in oil exporting countries, including the diversification of exports.

Like most developing countries, the oil exporting countries have generally chosen to peg their currencies at fixed nominal exchange rates to a major foreign currency or a basket of currencies. Movements in real effective exchange rates therefore depend primarily on the rate of domestic inflation relative to that of their major trading partners. In these circumstances, the effectiveness of a policy of export diversification depends not only on exchange rates but also on the monetary and fiscal policies pursued. Relative price advantages originally conferred by a given nominal exchange rate can quickly be eroded if attempts are made to expand output beyond the capacity of the economy. In these circumstances, moveover, the attempt to maintain a favorable competitive position for the non-oil external sector, or even to promote diversification, through exchange rate depreciation would jeopardize domestic price stability and would thus tend to undermine the objective sought.

Surveillance over Exchange Rate Policies

Exchange rate developments during 1980 and the first half of 1981 have highlighted the importance of the Fund’s obligation to exercise firm surveillance over its members’ exchange rate policies. The important role of surveillance has also been stressed by a number of Governors at the 1980 Annual Meetings, who stated that the Fund should exercise its surveillance in a forceful manner with full attention given to the need for policies aimed at strengthening underlying conditions and stabilizing exchange rates, in particular in the larger industrial countries, as well as for international cooperation and a multilateral approach to the problems of adjustment and financing. The focus of this section is on recent exchange rate developments and the key aspects of surveillance that they evoke. Certain procedural questions as well as a number of recent changes in exchange rate arrangements adopted by the Fund’s members are also considered. A more general review of the principles and procedures of surveillance can be found in last year’s Annual Report.

Key Aspects of Surveillance

The appropriateness of the exchange rate policy of a country can be assessed only in the context of its overall economic strategy. The Fund’s surveillance over exchange rate policies, therefore, involves assessments, case by case, of the economic policies of countries in an attempt to ascertain whether these policies are consistent with the countries’ broad obligations under Article IV and the three principles for the guidance of members’ exchange rate policies adopted by the Fund in April 1977, which state:

A. A member shall avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members.

B. A member should intervene in the exchange market if necessary to counter disorderly conditions which may be characterized inter alia by disruptive short-term movements in the exchange value of its currency.

C. Members should take into account in their intervention policies the interests of other members, including those of the countries in whose currencies they intervene.10

In this context, recent exchange rate developments have brought into focus two aspects of surveillance, namely, the relation between exchange rates and demand management policies, and the role of exchange rates in the adjustment process. With respect to the first of these issues, the experience of the past year and a half provides ample evidence that exchange rates can be affected not only by deliberate manipulation using monetary and other policy instruments but also by policies that are being pursued primarily for domestic purposes. If the country in question is one of the major industrial countries, the exchange rate consequences of domestic policies may be a source of concern for the rest of the world. The Fund must, therefore, at times assess whether the need to achieve certain domestic objectives justifies the use of policies whose effects on exchange rates may be judged to be adverse from the point of view of other countries, or whether it would be possible to use alternative policy mixes that may be as effective for domestic purposes and have more acceptable exchange rate implications. As regards the role of exchange rates in the adjustment process, it must be acknowledged that this role, from the standpoint of an individual country, cannot be divorced from the choice of strategy for fighting inflation or from an analysis of the effectiveness of alternative means available to the country for influencing the allocation of its resources. At the same time, however, the objective of effective balance of payments adjustment must not be neglected, whether the country is small or large, and the Fund consequently has to assess the appropriateness of the overall policy design. These two questions are discussed below.

Demand Management Policies and Exchange Rates

Issues relating to the connection between demand management and exchange rate policies came to the fore in 1980 and the first half of 1981 in the context of the generally high, and also variable, interest rates in the United States. The Fund has stressed for some time that the first priority of economic policy at the present time must be to counter inflationary pressures, and in that context it is crucial that the authorities be seen to maintain a firm strategy of reducing their monetary growth rates over time. Thus, the Fund can only welcome the policy stance of the U.S. monetary authorities that aims at keeping the growth of the monetary aggregates within progressively reduced target ranges, implying considerable restraint on the growth of nominal gross national product (GNP). As discussed above, such a policy has resulted in U.S. interest rates that were high not only in nominal terms but also in real terms. This has tended, inter alia, to dampen the level of economic activity in the United States and to strengthen the U.S. current account. Both the interest rate and the current balance effects have tended to increase the external value of the U.S. dollar. This in turn has contributed to the pressure on a number of other countries, especially industrial countries, to boost their interest rates in order to limit the depreciation of their exchange rates and the resulting increase in the local currency prices of tradable goods in their markets. It is difficult to assess how harmful this move toward high nominal and real interest rates has been in those industrial countries that, while suffering from recessionary tendencies, were faced by rising inflation rates, but it is clear that many of the national authorities concerned considered that they had been constrained to adopt interest rate policies and credit market measures that were more restrictive than needed from a purely domestic standpoint given the appropriately cautious nature of their fiscal policies.

The strong impact that monetary policies may have on exchange rates provides a further reason for the need, discussed in Chapter 1, to use a more broadly based policy approach to counter the forces of inflation. A more appropriate mix of fiscal and monetary policies, in particular, can play an important role in easing pressures in money and capital markets and in reducing real interest rates. Supply policies that enhance competitive mechanisms in markets for goods and labor, such as reductions in import controls or duties and the easing of government regulations, as well as flexible forms of incomes policy, can also play similar roles.

To the extent that such policy measures succeed in reducing the appreciation of the real exchange rate typically accompanying a shift toward a more vigorous anti-inflationary monetary policy, they would also limit the help that the country is getting in its fight against inflation from the moderating influence of the exchange rate appreciation on the local currency prices of tradable goods and, possibly, from gains in the terms of trade. For a country to seek an appreciation of its real exchange rate on this ground, however, would be a misguided decision, since an appreciation of the real exchange rate will soon worsen the foreign trade performance of the country, while the high real interest rates would add to unemployment and weaken investment. A more important factor limiting the use of fiscal and incomes policies as well as supply measures for offsetting the exchange rate effects of a restrictive monetary policy is the existence of social and political constraints on the use of these policies.

In view of these constraints, considerable interest attaches to the question of the extent to which intervention in the foreign exchange markets and the use of official compensatory borrowing can in present circumstances play a role in moderating the real exchange rate effects of short-term divergences in monetary policies of countries with floating currencies. There are different views on this issue. On one side, internationally coordinated intervention in the past is seen to have exercised a stabilizing influence on exchange rates. In March 1980, for example, the Japanese authorities announced that the United States would intervene, together with Japan, to support the yen, in close consultation with the Federal Republic of Germany and Switzerland. This announcement and the subsequent intervention, in conjunction with a number of other measures, seem to have had a certain stabilizing effect on exchange markets. Another view puts more weight on the limits to the effectiveness of intervention in a world in which national capital markets have become closely integrated. In particular, if the divergence in monetary policies is sustained for some time and the authorities are unwilling to accept the monetary effects of their intervention, it is unlikely that intervention alone can be successful in offsetting the effect of this divergence on exchange rates. Moreover, exchange market pressures perceived by the authorities as resulting from abnormal real interest rate differentials may sometimes also reflect underlying balance of payments disequilibria; intervention guided by such perceptions may have a destabilizing effect on exchange rates by delaying balance of payments adjustment. Despite these differences of view, there is broad agreement that the injunction concerning intervention to counter disorderly market conditions contained in the second exchange rate principle quoted above should not be interpreted too narrowly, that intervention is not an effective alternative to the use of a more broadly based policy approach to counter the forces of inflation, and that it should not be used to delay balance of payments adjustment needed in the light of underlying conditions.

This being said, the magnitude of the effect of divergences in monetary policies on real exchange rates during 1980 and the first half of 1981 should not be exaggerated. The main problem during that period was that the pressures on exchange rates arising from the restrictive monetary policy in the United States were added, for the EMS countries, to the pressures that resulted from their large current account deficits. The large changes in real exchange rates between the United States and the EMS countries over the past 18 months can thus not be viewed as being caused solely by divergences in monetary policies, and attempts to moderate these changes should not be limited to the reduction of such divergences. For Japan, an initially weak current account position gave rise to similar problems in the early part of 1980, but during the rest of 1980 and so far in 1981 a much-improved current account position as well as a generally better underlying position allowed the yen to strengthen considerably despite the maintenance of relatively low interest rates in Japan.

Another aspect of the relationship between demand management and exchange rate policies is its bearing on the short-run stability of interest rates and exchange rates. A policy of maintaining stable rates of growth of the monetary aggregates over the short run may have advantages in terms of stabilizing the expectations of private market participants. At the same time, it cannot be assumed that the demand for money will necessarily grow at a steady rate all the time. Faced by an inflexible supply, shifts in money demand may tend to result in significant fluctuations in real interest rates and exchange rates. For example, the analysis presented earlier in this Report stressed the importance of short-run changes in U.S. economic activity as a factor behind the large fluctuations in U.S. interest rates over the past 18 months. There is thus at times a difficult choice to be made between short-term stability of the monetary aggregates and short-term stability of real interest rates and exchange rates—two obviously desirable targets. Here again intervention may at times play a useful role in limiting short-term movements in exchange rates, but when interest rate fluctuations are as large as they have been in the recent experience of the United States it may not be possible to avoid exchange rate adjustments.

Role of Exchange Rates in the Adjustment Process

The issue concerning the role of the exchange rate in the adjustment process also raises difficult problems from the standpoint of the Fund’s surveillance over exchange rate policies. Both the advantages and disadvantages of exchange rate flexibility in this context have come to be appreciated more fully in recent years, but a considerable margin for differences of view remains. Two things are clear, however. First, as long as a country has major chronic inflationary problems, there is no realistic alternative to continuous or frequent adjustments of its exchange rate. Second, when an improvement of a country’s external position is needed, certain conditions must be met if, starting from a position of external disequilibrium, a change in the exchange rate is to result in a smooth and lasting adjustment. These conditions include the absence or gradual reduction of: (i) the widespread indexation of nominal wages on a price index that includes import prices, (ii) excess demand conditions owing to expansionary monetary or fiscal policies, (iii) official price regulations and practices that prevent the most crucial domestic prices for tradable goods from reflecting world market prices, and (iv) regulations or rigidities that substantially impair the reallocation of available productive resources. Social goals may have to be sacrificed, at least temporarily, to meet these conditions, but the removal of regulations and rigidities can also at times be useful from a social viewpoint.

These conditions are important not only for a smooth adjustment through exchange rate flexibility but also for the success of any other kind of adjustment policy. Indexation of nominal wages on the consumer price index, for example, is likely to lead to increased adjustment problems during a period of worsening terms of trade, no matter what the exchange rate policy of the authorities may be. If such a form of indexation is combined with a flexible exchange rate policy, the outcome may be inflation if the authorities follow an accommodating monetary policy and unemployment if they do not. With a fixed exchange rate, the result will tend to be a persistent balance of payments deficit and, if the country is a small open economy, unemployment as well. Thus, the Fund has continuously stressed the importance of eliminating, or at least reducing, rigid forms of wage indexation (in particular, when import prices are not excluded), excess demand conditions, price regulations, and other regulations or rigidities hindering the optimal allocation of resources, no matter what exchange rate regime is chosen by the country.

Once the conditions for adjustment have been secured or restored, the issue of the role of the exchange rate must be assessed in a pragmatic way on the basis of the particular conditions prevailing in the country concerned and the policy strategy of its authorities. A country with an unsustainable external deficit that is not simply the reflection of excess demand conditions will often be faced with the need to restore adequate incentives for investment and production in the tradable goods sector. This can be done by reducing the rate of growth in nominal production costs per unit of output substantially below those observed in trading partner countries, or by letting the exchange rate depreciate and then preventing nominal production costs from increasing at a rate that offsets the gains in competitiveness resulting from the exchange rate depreciation. Neither alternative is easy to carry out. Both will require an overall adjustment program aimed at reducing the rate of growth of nominal domestic demand, while allowing for enhanced investment in the sector producing tradable goods. As regards the first alternative, it may be difficult enough in practice to bring the rate of inflation back into line with the average prevailing in competitor countries; to reduce it even further so as to avoid the need for a devaluation may be a formidable task. The alternative of depreciation, while not painless, may thus in many cases be the only feasible solution if investment and production incentives in the sector producing tradable goods have to be improved.

As discussed above, the role of the exchange rate can be particularly important for an individual primary producing country that has a serious external adjustment problem. A single country is normally faced with a highly price-elastic foreign demand for its output, so that the volume of its exports can be seriously affected by a lack of cost competitiveness. Although the country normally has little influence over world market prices for its exports, the quantities of goods that it will export at these prices will decline if their local currency equivalent makes production unprofitable.

Account must, however, be taken of difficulties in the implementation of exchange rate policies that are particularly important for developing countries and may require that exchange rate action be combined with supportive measures. These difficulties are of several types.

(i) The process of changing resource allocation is often costly and requires a substantial amount of time because of the low mobility of resources in the short run. This makes it particularly important to avoid delays in necessary exchange rate realignments and to secure adequate medium-term financing in order to ensure an orderly adjustment process. Financing at concessionary rates is needed, at least for the low-income developing countries.

(ii) A change in the exchange rate needs to be supported by other measures aimed at improving resource allocation. There is often a tight interdependence between the exchange rate policy of the authorities and the pricing policies of marketing boards, which have a major impact on producers’ attitudes. Thus, producer prices in domestic currency normally have to be increased when an exchange rate depreciation occurs, and, conversely, a depreciation is frequently felt to be the only means of raising producer prices without unduly increasing the deficit of marketing boards. Import taxation and export subsidies may also have to be modified. Further, many of the investment decisions are made in the public sector, and it is important that these decisions reflect economic returns.

(iii) Changes in exchange rates have effects on the distribution of real incomes that may create social and political difficulties for the authorities. While it is difficult to generalize on this question, a devaluation will tend to increase the real incomes of entrepreneurs and workers in export sectors and sectors competing with imports and decrease the real incomes of certain other social groups, such as those urban higher-income groups that have a relatively high propensity to consume imported goods and those farmers that do not produce for export and need imported fertilizers and other inputs. Moreover, changes in exchange rates may sometimes impair a country’s fiscal position by increasing fiscal expenditures more than tax revenues. Supportive fiscal measures may thus be required.

(iv) It should be stressed that developing countries cannot expand their exports, especially their emerging exports of agriculturally based products and manufactures, if importing countries, in particular the industrial countries, use protective measures directed against the importation of these products. New restrictive measures should be avoided, and, often, existing protective barriers will have to be lowered if the adjustment process of developing countries is to be successful.

In centrally planned economies, where imports, capital movements, investment, and prices are controlled, the influence of the overall domestic price level on the foreign trade performance is weakened and the market mechanism is playing a less significant role. The exchange rate need not be relied upon to produce balance of payments adjustment. As in the case of other economies, however, exchange rate and price policies may be significant in promoting efficiency and proper allocation of resources.

While the characteristics of major oil exporting countries differentiate them from other countries in regard to the working of the external adjustment process and the role of the exchange rate, the structure of costs and prices in these countries also plays a significant role in the allocation of resources and, therefore, calls for attention to issues of exchange rate policy. In particular, the desirability of encouraging economic diversification by promoting the production of non-oil traded goods argues against permitting exchange rate developments that undercut domestic competitiveness.

The importance of exchange rate policy in the design of an adjustment program has led a number of developing countries to include exchange rate adjustments in economic programs supported by resources from the Fund. Mindful of the political and social problems involved, the Fund itself in connection with such arrangements has refrained from insisting on change in the exchange rate except where it was clear that such a change was needed. The approach whereby a stand-by arrangement remains in effect after a certain period (generally, six months) only if the national authorities and the Fund reach agreement on the issue of the exchange rate following the completion of a joint exchange rate study has on occasion been used to ensure better-informed decisions.

In some recent instances, the authorities in certain developing countries have recognized the need for an exchange rate adjustment but have been reluctant to implement it for fear of particular consequences that are regarded as undesirable for social, political, or economic reasons. In these situations, a search has been made for alternatives to an exchange rate adjustment in the form of a simultaneous application of export subsidies and import surcharges. In practice, however, this approach has drawbacks. Since it is ordinarily the intention to avoid full equivalence to an exchange rate adjustment, the subsidies and surcharges usually cover only selected exports and imports. They result thus in a multiplicity of effective exchange rates and, if maintained over protracted periods, entail potentially serious distortions in the structure of prices and costs. The existence of such schemes not only tends to discourage efficiency on the part of particular producers and industries but also gives rise to pressures for measures to create additional incentives, so that over time the system of trade restrictions tends to become more complex and to entail increasing administrative costs, inefficiencies, and room for abuse. In addition, such schemes have frequently led to a worsening of the budgetary position.

It is often preferable for the required measures to include a one-step adjustment in a unitary exchange rate. In circumstances where this option is excluded from consideration for political or other reasons, three alternative approaches are possible. One approach that has been followed is to adjust the unitary exchange rate in smaller steps until the appropriate exchange rate has been reached. Another approach has involved the adoption of a dual exchange rate system, taking the form of a floating rate or of a fixed uniform rate of subsidies and surcharges for certain current account items. The third, and least preferable, option has been to introduce different rates for the export subsidy and the import surcharge, or a variety of rates within the export or import group. Because of the complexity, significant unfavorable impact on resource allocation, and administrative cost of the second and third of these solutions, the Fund has continued to discourage members from using them except temporarily, when no other approach seemed feasible.11

Review of Procedures for Surveillance

In the review of the implementation of the Fund’s surveillance over members’ exchange rate policies completed by the Executive Board in June 1980, it was concluded that the strengthening of Fund surveillance should be accomplished through effective implementation of existing procedures, which were considered to be sufficiently flexible for this purpose. In the review of April 1981, the conclusion with respect to the adequacy of these procedures was reiterated and stress was laid on the need to give adequate attention in the implementation of existing procedurese to longer-run considerations in the assessment of members’ exchange rate policies, including the prospective evolution of external indebtedness. Accordingly, no changes in procedures have been introduced, and the description of the procedures given in the 1980 Annual Report remains valid. These procedures have, nevertheless, continued to evolve with respect to the role of the World Economic Outlook exercise, the supplemental consultation procedure, and the annual Article IV consultation missions.

The World Economic Outlook discussions provide an essential background to the Fund’s surveillance activities in individual member countries. These discussions are the principal means by which the Executive Board reviews, at frequent and regular intervals, broad developments in exchange rates and the working of the international adjustment process as a whole. They ensure that each member’s external position is assessed in the context of the global need for adjustment, and that its adjustment process is viewed as an integral part of what must be a multilateral process. Recent World Economic Outlook exercises have also been used to analyze global adjustment needs in a medium-term framework extending through the mid-1980s. This was done by developing various “scenarios” that focus mainly on medium-term prospects for the external positions and growth rates of various analytical subgroups of non-oil developing countries. Such an analysis is particularly appropriate at the present time given the magnitude and structural nature of the adjustment problems now facing the world economy.

In the course of the review of June 1980, it was also agreed that the Fund should make more active use of supplemental surveillance consultations with members.12 The importance of discretion and caution in initiating such consultations was emphasized. Supplemental consultations provide a mechanism for timely contact with members and enable the Fund to analyze important developments during the interval between regular Article IV consultations, without the presumption that the member concerned has not complied with its obligations under Article IV. Difficulties may indeed arise in initiating such consultations because of the formality associated with any consultation and the need for discretion and caution. During 1980 and the first half of 1981, the Managing Director took up issues of interest in informal discussions with Executive Directors and with members. Moreover, the staff has had close contacts with the authorities of a number of countries with respect to their exchange rate developments, in addition to the regular Article IV consultation discussions; in one case, the staff contact took the form of a special mission. This informal, low-key approach has proved useful in implementing the intent of the decision cited above. The Managing Director will continue to assess the need for supplemental surveillance consultations and to evolve these procedures with a view to strengthening their effectiveness, taking into account the nature of developments and the requirements of caution and confidentiality.

The consultations under Article IV comprehend the regular consultations to be conducted under Articles VIII and XIV, which are, in principle, to be held annually. The Executive Board decided that these annual consultations would be conducted in accordance with the procedures already adopted for the consultations that had been held before under Articles VIII and XIV, adapted and extended to meet the requirements of surveillance under Article IV.13 The Executive Board has also stressed that such consultations should lead to reports including frank analyses by the Fund staff of the exchange rate policies of all members. A total of 94 consultations under Article IV were initiated in 1980, and 90 consultations were completed; of the latter number, 26 were in respect of consultations initiated in 1979. The average interval between consultations with members was approximately 18 months over the past two years. Consultations with approximately one third of the Fund members, including those of major importance in the international adjustment process, continued on a roughly annual cycle, while the average interval between consultations with other members was approximately 21 months. In 27 of the 61 instances in the last two years in which the interval between consultations has exceeded 18 months, the Executive Board reviewed members’ economic situations and prospects on the occasion of requests for use of Fund resources or reviews of existing programs.

Changes in Exchange Arrangements

Since the Second Amendment to the Articles of Agreement entered into force, all countries are required to notify the Fund promptly of changes in their exchange arrangements. From the end of June 1980 to the end of June 1981, five members notified the Fund of changes in their exchange arrangements. These changes, as well as the exchange rate arrangements that countries adhered to on June 30, 1981, are indicated in Table 17.

Table 17.Exchange Rate Arrangements, June 30, 19811
Pegged toAdjusted According to a Set of IndicatorsCooperative Exchange ArrangementsOther
U.S. dollarFrench

franc
Other

currency
SDROther

composite
BahamasBeninEquatorialBurmaAlgeriaBrazilBelgiumAfghanistan
BarbadosCameroonGuineaGuineaAustriaColombiaDenmarkArgentina
BurundiCentral(Spanish peseta)GuineaBangladeshPeru2FranceAustralia
ChileAfricanThe GambiaBissauBotswanaPortugalGermanyBahrain
DjiboutiRepublic(pound sterling)IranCape VerdeFed. Rep. ofBolivia
Ireland
DominicaChadLesothoJordanChina, People’sItalyCanada
Dominican RepublicComoros(South African rand)KenyaRepublic ofLuxembourgCosta Rica2
EcuadorCongoSwazilandMalawiCyprusNetherlandsGhana
EgyptGabon(South African rand)MauritiusFijiGreece
El SalvadorIvory CoastSâo Tomé andFinlandGuyana2
PrincipeKuwait
EthiopiaMadagascarSeychellesMalaysiaIceland
GrenadaMaliSierra LeoneMaltaIndia
GuatemalaNigerViet NamMauritaniaIndonesia
HaitiSenegalZaïreNorwayIsrael
HondurasTogoZambiaPapua New GuineaJapan
IraqUpper VoltaSingaporeKorea
JamaicaSolomon IslandsLebanon
Lao People’s DemocraticSwedenMaldives
RepublicTanzaniaMexico
LiberiaMorocco2
Libyan Arab Jamahiriya
NepalThailandNew Zealand
NicaraguaTunisiaNigeria
OmanZimbabwePhilippines
PakistanQatar
PanamaSaudi Arabia
ParaguaySouth Africa
RomaniaSpain
RwandaSri Lanka
SomaliaTurkey
St. LuciaUganda2
St. Vincent andUnited Arab
the GrenadinesEmirates
SudanUnited Kingdom
SurinameUnited States
Syrian Arab RepublicUruguay
Trinidad and TobagoWestern Samoa
VenezuelaYugoslavia
Yemen Arab Republic
Yemen, People’s Democratic
Republic of

No current information on the exchange rate system of Democratic Kampuchea is available.

Costa Rica, Guyana, Morocco, Peru, and Uganda changed their exchange rate arrangements during the year ended June 30, 1981. The currencies of Costa Rica and Guyana were previously pegged on the U.S. dollar. The currencies of Uganda and Morocco were pegged on the SDR and on another currency composite, respectively. Peru was previously classified in the “other” category.

No current information on the exchange rate system of Democratic Kampuchea is available.

Costa Rica, Guyana, Morocco, Peru, and Uganda changed their exchange rate arrangements during the year ended June 30, 1981. The currencies of Costa Rica and Guyana were previously pegged on the U.S. dollar. The currencies of Uganda and Morocco were pegged on the SDR and on another currency composite, respectively. Peru was previously classified in the “other” category.

International Liquidity and Reserves

In recent years, international liquidity and official reserve holdings have continued to be influenced by changes in the international monetary system. The global stock of reserves has been affected by the exchange arrangements adopted by member countries and their economic policies, by the manner in which the net current account earnings of the oil exporting countries were recycled, as well as by the allocation of SDRs, increases in Fund quotas, and the continued expansion of holdings of ECUs. The SDR value of various reserve components has also been influenced by movements in exchange rates and the price of gold.

This part of the chapter describes the recent changes in the level and composition of international reserves. Following an examination of the behavior of the overall stock of international reserves, changes in reserves are separated into those produced by transactions and those that resulted from variation in the SDR prices of the various reserve components. There is next an analysis of the sources of growth in conditional and unconditional liquidity as provided by the Fund and international financial markets. The role of the Eurocurrency markets is further examined in terms of their contribution to the recycling of the net earnings on current account of the oil exporting countries during the periods 1973-74 and 1979-80. The final sections review the adequacy of international reserves and the role of the Fund in the international monetary system.

Recent Developments in International Reserves

During 1980, the growth of total reserves excluding gold accelerated to 19 per cent—an increase of SDR 51 billion—in comparison with annual growth rates of 11 per cent in 1979 and 8 per cent in 1978 (Table 18). Holdings of foreign exchange and Fund-related assets—SDRs and reserve positions in the Fund—grew at comparable rates in 1980, 19 per cent and 18 per cent, respectively. This contrasts with the years 1978-79, when foreign exchange holdings grew much more rapidly than Fund-related assets. As in 1979, a significant proportion of the increase in foreign exchange reserves was accounted for by larger holdings of ECUs. The increase in total foreign exchange reserves of SDR 47 billion in 1980 was composed of a rise in holdings of foreign currencies of SDR 32 billion and an increase in ECUs of SDR 15 billion. As will be discussed below, the higher SDR value of ECUs primarily reflected valuation adjustments associated with a higher ECU price of gold. Holdings of Fund-related assets grew by SDR 4 billion in 1980, compared with an increase of only SDR 1 billion in 1979. This more rapid growth reflected in part increased borrowing from the Fund by members. SDR holdings at the end of 1980 were depressed by payment in SDRs of 25 per cent of the quota increase that went into effect in November. As a result of this SDR payment, the Fund’s General Resources Account became the largest SDR holder, with holdings of SDR 5.6 billion at the end of 1980. Despite the SDR allocation and the heavier use of Fund resources in recent years, the share of Fund-related assets in total reserves excluding gold at the end of 1980 was lower (9 per cent) than it had been at the end of 1973 (13 per cent).

Table 18.Official Holdings of Reserve Assets, End of Selected Years 1973-80 and End of May 19811

(In billions of SDRs)

1973197519761977197819791980May 1981
All countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund6.212.617.718.114.811.816.817.9
Special drawing rights8.88.88.78.18.112.511.816.3
Subtotal, Fund-related assets15.021.426.426.222.924.328.634.2
Foreign exchange101.5137.4160.3200.3221.22246.2293.3309.8
Total reserves excluding gold116.5158.8186.7226.5244.22270.5321.9344.0
Gold3
Quantity (millions of ounces)1,0181,0181,0131,0151,0229304938939
Value at London market price94.7121.9117.5137.8177.3361.5433.5384.7
Industrial countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund4.97.711.812.29.67.710.711.6
Special drawing rights7.17.27.26.76.49.38.912.0
Subtotal, Fund-related assets12.014.919.018.916.017.119.623.7
Foreign exchange65.768.773.7100.0127.2135.9164.2167.0
Total reserves excluding gold77.783.792.7118.9143.1153.0183.8190.6
Gold3
Quantity (millions of ounces)8748728728818847894788788
Value at London market price81.3104.5101.2119.6153.4306.7364.2322.6
Oil exporting countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund0.34.35.45.44.43.04.14.4
Special drawing rights0.30.30.30.40.51.01.21.9
Subtotal, Fund-related assets0.64.65.85.84.94.05.36.3
Foreign exchange10.242.449.155.240.1251.067.179.7
Total reserves excluding gold10.847.154.961.045.0255.072.486.0
Gold3
Quantity (millions of ounces)3435373436374041
Value at London market price3.14.24.34.76.314.218.516.9
Non-oil developing countries
Total reserves excluding gold
Fund-related assets
Reserve positions in the Fund0.90.60.50.50.91.02.11.9
Special drawing rights1.41.21.11.11.22.11.72.4
Subtotal, Fund-related assets2.41.81.61.62.13.23.84.4
Foreign exchange24.825.336.344.052.958.260.260.8
Total reserves excluding gold27.227.137.845.655.061.364.065.1
Gold3
Quantity (millions of ounces)1091081019899102107107
Value at London market price10.113.011.813.317.239.749.543.9
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 the Netherlands Antilles, Switzerland, and Fund members for which data are available. 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 the 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 nine member countries of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The European Currency Units (ECUs) 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 the Netherlands Antilles, Switzerland, and Fund members for which data are available. 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 the 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 nine member countries of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The European Currency Units (ECUs) issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

All three major country groups experienced increases in their holdings of total reserves excluding gold in 1980. For the industrial countries, holdings of non-gold reserves grew at approximately the same rate (20 per cent) as the average for all countries. The major oil exporters increased their holdings by 32 per cent, while those of the non-oil developing countries increased much more slowly, by 4 per cent. For the latter group of countries, this was a much slower rate than in 1979 (11 per cent) or 1978 (21 per cent). The sharp reduction in the growth of the reserves of non-oil developing countries as a group accompanied the weakening of their external payments positions resulting from such causes as cyclical factors affecting export receipts, higher import costs, and increased debt service. The development of non-gold reserves was even more unfavorable for some subgroups of developing countries: those of the low-income countries declined by 5 per cent and those of the group of major exporters of manufactures fell by 10 per cent in the course of 1980.

Holdings of ECUs have continued to expand, reflecting primarily the revaluations of gold deposits with the European Monetary Cooperation Fund. This agency values the gold deposited by member countries at the lower of: (1) the average market price over the preceding six months, or (2) the average market price on the penultimate working day preceding the swap period for which the ECU price of gold holdings is to be established.14 According to this formula, the price of gold used by the EMS, which had risen from ECU 165 per ounce at the time of the first swap period on March 13, 1979 to ECU 211 at the end of 1979, continued to increase, reaching ECU 425 at the end of 1980 and approximately the same value at mid-1981. During 1979, the resulting revaluation of the deposited gold stock, which remained unchanged at approximately 85 million ounces after July 1979, equaled almost SDR 5 billion. The impact of this revaluation (net of the effect on any change in physical gold holdings) was even larger in 1980, when the rise in the ECU price of gold resulted in an increase of SDR 17.5 billion in foreign exchange reserves.

The SDR value of ECUs outstanding was also affected during 1980 by the fact that the ECU depreciated against the U.S. dollar to an even greater extent than against the SDR. The dollar appreciation would by itself have caused more ECUs to be issued against dollar deposits in the EMS. However, sales of U.S. dollars by members of the EMS in an attempt to slow the dollar appreciation were sufficient to bring about a decline in dollar deposits in the European Monetary Cooperation Fund and, thereby, a reduction of SDR 2.6 billion in ECUs issued against dollars. On balance, the increase in ECUs from SDR 32.5 billion at the end of 1979 to SDR 47.5 billion at the end of 1980 reflected the fact that the increase in the SDR value of ECUs issued against gold (SDR 17.6 billion)15 far outweighed the decline in the SDR value of ECUs issued against dollars (SDR 2.6 billion).

During the first five months of 1981, total non-gold reserves continued to expand at nearly the same annual rate as in 1980. Holdings of SDRs at the end of May 1981 reflected the SDR allocation at the beginning of the year. When combined with the change in reserve positions in the Fund, this resulted in an increase of 20 per cent in the holdings of Fund-related assets during the first five months of 1981, which accounted for approximately one fourth of the growth in total non-gold reserves of SDR 22 billion. Foreign exchange reserves grew by SDR 17 billion.

This pattern of more rapid growth of Fund-related assets than of foreign exchange reserves during the first part of 1981 was observed in all major country groups. The oil exporting countries experienced a uniform expansion of Fund-related assets (up 19 per cent) and foreign exchange reserves (up 19 per cent) during the first five months of the year. While the holdings of Fund-related assets of the non-oil developing countries increased by 16 per cent during this period, their foreign exchange reserves expanded hardly at all. The industrial countries increased their holdings of Fund-related assets and foreign exchange reserves by 21 per cent and 2 per cent, respectively.

The position of gold in the reserve portfolios of countries is difficult to gauge, since various methods of valuing gold holdings are in use. As already discussed, for example, the European Monetary Cooperation Fund values its gold deposits on the basis of the lower of the average market price over the preceding six months or the market price just prior to its swap periods. Since other authorities have used quite different valuation policies (some of which are not publicly announced), the total of official gold reserves as valued by holders is not available. In this Report, official gold holdings are for expository purposes valued at the market price of gold in London at the specified dates.

The physical stock of gold in official reserves has remained almost unchanged at about 1 billion ounces during the past decade, except for a decline by about 9 per cent in 1979 as a result of the deposit of gold in the European Monetary Cooperation Fund. The market value of gold (in SDRs), however, increased 12-fold from the end of 1970 to the end of 1980. While the market value of gold reserves was somewhat smaller than that of non-gold reserves in 1973, it was some-what larger in mid-1981. The rate of increase in the value of gold reserves has been uneven because of the variable rate of change in the price of gold. For example, the SDR price of gold doubled between the end of March 1973 and the end of 1974, declined by one fourth during the following two years, and quadrupled between the end of 1976 and the end of 1980. The recent growth in the market value of gold reserves was reversed by a sharp reduction (by 11 per cent) in the value of this reserve component during the first five months of 1981, reflecting a decline in the market price.

The importance of gold reserves relative to non-gold reserves varies among country groups. At the end of May 1981, the market value of gold reserves was 169 per cent of that of non-gold reserves for the industrial countries, 67 per cent for the non-oil developing countries, and 20 per cent for the oil exporting countries.

Foreign Exchange Reserves

The growth of the foreign exchange component of reserves reflected the effects of foreign exchange transactions of monetary authorities and changes in the SDR prices of currencies and the ECU. This section reviews the relative importance of these price and quantity changes, and then compares the size of the cumulative interest-adjusted foreign exchange gains or losses on different types of foreign exchange holdings.

Currency Composition

The currency composition of the increase in foreign exchange reserves in 1980 provides some evidence that the currency diversification of foreign exchange holdings noted in last year’s Annual Report has continued (Table 19). While holdings of U.S. dollars increased by SDR 11 billion, the principal non-dollar currencies held in official reserves—the deutsche mark, the Swiss franc, the Japanese yen, the pound sterling, the French franc, and the Netherlands guilder—grew by SDR 19 billion. This change in the composition of reserve holdings was not as large as that in 1979, when U.S. dollar holdings declined by SDR 15 billion and holdings of the principal non-dollar currencies increased by SDR 9 billion. The increase in the U.S. dollar component in 1980 reflected both an appreciation of the dollar relative to the SDR, by 3 per cent, and an increase in the quantity of dollars held.

Table 19.Quantity and Price Changes Affecting the SDR Value of Official Holdings of Foreign Exchange, by Currency and in Total, End of First Quarter 1973-End of 19801

(In millions of SDRs)

1973:I to
197619771978197919801980:IV
U.S. dollar
Starting value105,657122,822152,232162,045146,94565,607
Quantity change16,48636,02720,433-13,73725,548101,648
Price change679-6,618-10,620-1,3634,981-9,782
Total change17,16629,4099,813-15,10010,52991,866
Pound sterling
Starting value5,0523,0123,2593,2024,1204,602
Quantity change-1,29532-346222,1643,008
Price change-745216-23296586-740
Total change-2,040248-579172,7492,268
Deutsche mark
Starting value8,20810,39114,86919,70522,9495,190
Quantity change1,1623,5083,6362,34011,78524,970
Price change1,0219701,199904-2,5322,041
Total change2,1834,4784,8353,2449,25327,011
French franc
Starting value1,6261,4211,4641,9532,095909
Quantity change-6627402901,0342,197
Price change-139168753-232-209
Total change-205434891428021,989
Swiss franc
Starting value2,0782,2613,9144,1486,3861,075
Quantity change211,103-3112,1533,5087,089
Price change16254954586-5721,158
Total change1831,6532342,2382,9368,247
Netherlands guilder
Starting value7457688241,0171,396287
Quantity change-51321193508511,733
Price change73247429-14284
Total change23561933797081,818
Japanese yen
Starting value6971,0032,0863,7145,7670
Quantity change2698721,2703,0331,2397,373
Price change36211358-9801,4191,052
Total change3061,0831,6272,0532,6598,425
ECU
Starting value032,5090
Quantity change327,943-2,84025,103
Price change4,56617,86122,427
Total change32,50915,02147,530
Sum of above
Starting value124,063141,678178,648195,784222,16777,670
Quantity change16,52641,60125,51522,79423,289173,121
Price change1,087-4,632-8,3803,59121,36916,031
Total change17,61636,97017,13426,38244,657189,154
Total official holdings4
Starting value137,401160,348200,306221,211246,23998,344
Total change22,94739,95820,90525,02847,025194,920
Ending value160,348200,306221,211246,239293,264293,264
Source: Fund staff estimates.

The currency composition of foreign exchange is based on the IMF 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 several quarters to yield cumulative changes over the periods shown.

For details for the period 1973-75, see Annual Report, 1980, Table 15, page 62.

Reflects largely 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 IMF 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 several quarters to yield cumulative changes over the periods shown.

For details for the period 1973-75, see Annual Report, 1980, Table 15, page 62.

Reflects largely 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.

A direct comparison of the changes in 1980 with those in 1979 is, however, made difficult by the effects of the establishment of the EMS. The largest part of the decline in holdings of U.S. dollars in 1979 was the result of deposits of U.S. dollars (equivalent to SDR 13 billion) by EMS member countries in the European Monetary Cooperation Fund against an equivalent amount of ECUs issued to the depositors. These ECUs, as well as those issued against gold deposits, are counted as part of foreign exchange reserves, while the U.S. dollars and the gold deposited with the European Monetary Cooperation Fund are not counted as part of countries’ reserves. As discussed earlier, there were no corresponding large-scale deposits of dollars or gold in the European Monetary Cooperation Fund during 1980, and most of the increase in ECU holdings in the last year has resulted from the revaluation of gold deposits. While almost three fourths of the increase of SDR 26 billion in identified foreign exchange reserves in 1979 stemmed from ECUs issued against gold, this share dropped to only two fifths of the increase of SDR 45 billion in 1980. If ECUs issued against U.S. dollars were counted as dollars and ECUs issued against gold were excluded from foreign exchange reserves, there would have been only a small decline (SDR 2 billion) in official holdings of U.S. dollars and an increase (SDR 7 billion) in total identified foreign exchange reserves in 1979. In contrast, there would have been increases in both dollar holdings (SDR 8 billion) and total foreign exchange reserves (SDR 27 billion) in 1980. Thus, although both adjusted and unadjusted figures show that holdings of non-dollar foreign exchange reserve assets increased relative to dollar reserve assets in both 1979 and 1980, the currency diversification of official reserve assets took place at a slower rate than suggested by the unadjusted figures.

The SDR value of official holdings of foreign exchange has been altered by changes in the quantity and the SDR price of each component currency (Table 19). The depreciation of the U.S. dollar relative to the SDR during the years 1977-79 reduced the SDR value of U.S. dollar holdings by SDR 19 billion, which offset almost half the increase of SDR 43 billion in the volume of U.S. dollar reserves. The appreciation of the U.S. dollar relative to the SDR in 1980 implied that almost one half of the increase in total U.S. dollar holdings was accounted for by price changes.

While exchange rate movements have often been important in explaining year-to-year changes in the SDR values of individual currency components, quantity changes have dominated over the period between the end of March 1973 and the end of 1980. Over the entire period, the increase of SDR 92 billion in holdings of U.S. dollars consisted of a rise of SDR 102 billion in the quantity of dollars and an offset of SDR 10 billion attributable to a depreciation of the U.S. dollar relative to the SDR.

For the other national currencies, price changes contributed at most 14 per cent (for the Swiss franc) to the total increase in official holdings of these assets during the period 1973-80. For the ECU, however, price effects explained almost 50 per cent of the total increase in ECU holdings over a period of less than two years. As discussed earlier, this reflected primarily the effects of the revaluation of gold deposits in the European Monetary Cooperation Fund.

The increase in total holdings of separately identified national currencies (excluding ECUs) of SDR 142 billion between the end of March 1973 and year-end 1980 was the result of an increase of SDR 148 billion in the volume offset by a decline of SDR 6 billion in the SDR value of currency holdings. When ECU holdings are included, the decline in the SDR value of foreign exchange reserves owing to exchange rate movements was more than offset by an increase of SDR 22 billion in ECUs induced by the rise in the market price of gold, so that exchange rate and other price changes actually increased the value of reserve holdings by SDR 16 billion.

The differing rates of growth of holdings of individual currencies and ECUs imply that the currency composition of foreign exchange reserves continued to change (Table 20). The share of the U.S. dollar in the SDR value of foreign exchange reserves identified by currency continued its decline from a peak of 87 per cent in 1976 to 59 per cent by the end of 1980. The 1979 and 1980 shares for the U.S. dollar were affected by the substitution of ECUs for U.S. dollars in the reserves of the members of the EMS, as already described. If ECUs issued against U.S. dollars were added to dollar holdings and ECUs issued against gold were eliminated from total foreign exchange reserves, then the share of U.S. dollars in total foreign exchange reserves identified by currency would have been 79 per cent at the end of 1979 and 73 per cent at the end of 1980.

Table 20.Share of National Currencies in SDR Value of Total Official Holdings of Foreign Exchange, End of Selected Quarters, 1973-801

(In per cent)

1979:IV1980:IV
ExcludingExcluding
1973:I1975:IV1976:IV1977:IV1978:IV1979 Iv1980:IVECU2ECU2,3
U.S. dollar84.585.286.785.282.866.1459.0578.973.1
Pound sterling5.94.12.11.81.61.92.62.03.0
Deutsche mark6.76.67.38.310.110.312.111.314.0
French franc1.21.31.00.81.00.91.11.01.3
Swiss franc1.41.71.62.22.12.93.53.24.1
Netherlands guilder0.40.60.50.50.50.60.80.70.9
Japanese yen0.60.71.21.92.63.22.83.7
ECU14.6417.85
Total100.0100.0100.0100.0100.0100.0100.0100.0100.0
Sources: Various Fund publications and Fund staff estimates.

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

In this alternative calculation, the SDR value of European Currency Units (ECUs) issued against U.S. dollars (SDR 12,784 million at the end of 1979 and SDR 10,176 million at the end of 1980) is added to the SDR value of U.S. dollars, but the SDR value of ECUs issued against gold (SDR 19,725 million at the end of 1979 and SDR 37,354 million at the end of 1980) is excluded from the total distributed here.

The five-currency basket SDR has weights of 42 per cent for the U.S. dollar, 19 per cent for the deutsche mark, and 13 per cent for each of the pound sterling, the French franc, and the Japanese yen.

The share of U.S. dollars would rise by 5.8 percentage points and that of the ECU would fall by the same amount if ECUs issued against U.S. dollars were treated as U.S. dollars in foreign exchange reserves.

The share of U.S. dollars would rise by 3.8 percentage points and that of the ECU would fall by the same amount if ECUs issued against U.S. dollars were treated as U.S. dollars in foreign exchange reserves.

Sources: Various Fund publications and Fund staff estimates.

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

In this alternative calculation, the SDR value of European Currency Units (ECUs) issued against U.S. dollars (SDR 12,784 million at the end of 1979 and SDR 10,176 million at the end of 1980) is added to the SDR value of U.S. dollars, but the SDR value of ECUs issued against gold (SDR 19,725 million at the end of 1979 and SDR 37,354 million at the end of 1980) is excluded from the total distributed here.

The five-currency basket SDR has weights of 42 per cent for the U.S. dollar, 19 per cent for the deutsche mark, and 13 per cent for each of the pound sterling, the French franc, and the Japanese yen.

The share of U.S. dollars would rise by 5.8 percentage points and that of the ECU would fall by the same amount if ECUs issued against U.S. dollars were treated as U.S. dollars in foreign exchange reserves.

The share of U.S. dollars would rise by 3.8 percentage points and that of the ECU would fall by the same amount if ECUs issued against U.S. dollars were treated as U.S. dollars in foreign exchange reserves.

The recent change in the U.S. dollar share in foreign exchange reserves was influenced by a number of factors, including official intervention policies and changes in the SDR values of individual currencies. Official exchange market interventions designed to slow the appreciation of the U.S. dollar against other currencies have often resulted in sales of dollars from official holdings, which have reduced the share of the dollar in official reserves. Exchange rate changes have also affected total foreign exchange reserves measured in SDRs, as well as the share of individual currencies in foreign exchange reserves, because the composition of these holdings differs from that of the SDR itself. In 1980, the rise in the SDR prices of the U.S. dollar, sterling, and the yen not only added more to the SDR value of foreign exchange reserves than was subtracted by the fall in the SDR prices of the deutsche mark and the French franc (thereby increasing the SDR value of foreign exchange reserves) but also influenced the shares of the individual currencies.

The shares of the non-dollar national currencies in total identified foreign exchange reserves continued the trends evident in earlier years, except for the pound sterling. Holdings of the deutsche mark, the Swiss franc, and the Japanese yen increased as a proportion of total reserves. While the shares of the French franc and the Netherlands guilder rose marginally, the pound sterling reversed the trend toward a declining share evident through 1978 and increased its proportion. This latter development reflected both an increase in the volume of sterling held and the effect of an appreciation of the pound sterling relative to the SDR. The greater proportion for the Japanese yen in 1980 also reflected an appreciation of the yen relative to the SDR.

Rates of Return on Major Currencies

One important element influencing the diversification of reserve holdings has been the relation between rates of return (including both interest income and exchange gain or loss) earned on foreign exchange holdings denominated in various currencies. From the second quarter of 1973, the first full quarter after the transition to floating among the major currencies, to the first quarter of 1981, there has been remarkably little net movement in the SDR value of the U.S. dollar. At the end of this period, that value was a mere 3 per cent below the starting value of SDR 0.83 per dollar. As the SDR value of the U.S. dollar was approximately the same at the end of the second quarter of 1973 and at the end of the first quarter of 1981, there would have been little difference in the value of currency holdings in terms of the dollar or of the SDR. The SDR values of the pound sterling and the French franc were, however, 11 per cent below their starting levels. Conversely, the SDR values of the deutsche mark and the Japanese yen were more than 25 per cent higher in the first quarter of 1981 than in the second quarter of 1973.

During the period, interest differentials have compensated for part of the actual exchange rate movements and, as a result, have narrowed the differences in the growth of the SDR value of investments in national currencies. Countries that have experienced above-average inflation rates and protracted declines in the SDR value of their currencies, such as the United Kingdom and France, have tended to maintain higher nominal interest rates than countries in the opposite circumstances, such as the Federal Republic of Germany and Japan.

The interest rates referred to are the same as those used in calculating the combined market interest rate on which the SDR interest rate is based.16 The weights used in combining these rates change continuously with changes in the SDR value of the national currency amounts included in the SDR, and interest on official holdings of SDRs has been paid at 100 per cent of the combined market rate only since May 1981. Nevertheless, it is of interest to compare the growth in the SDR value of investments in national currencies with the hypothetical growth of the SDR itself under the assumptions that its currency composition had all along been that which became effective at the beginning of 1981 and that interest had been earned on it at the full combined market rate.

The procedure is as follows: The average interest rates quoted in any quarter yield the interest returns realized during the next quarter in specified currencies. Converting the resulting sums of principal and interest, invested and reinvested with quarterly compounding, from national currency units to SDRs by use of the average quarterly SDR price per unit of national currency shows how the SDR value of one SDR’s worth of national currency originally invested during the second quarter of 1973 would have grown compared with an investment of SDR 1 in the SDR itself (Chart 17).

Chart 17.Growth of Investments in Specified National Currencies and SDRs, Second Quarter 1973-Second Quarter 19811

1 Cumulative value (in SDRs) of investments in the SDR and in short-term assets denominated in the five major currencies of which the SDR is composed, each investment amounting to SDR 1.00 in the second quarter of 1973. The five national assets are described in footnote 16 in the text. 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.

Upon realization in the second quarter of 1981, the SDR value of an investment in SDRs would have increased by 96 per cent, compared with 103 per cent for the pound sterling, 90 per cent for the U.S. dollar, and 86 per cent for the French franc. The SDR values of investments in deutsche mark and Japanese yen would have increased considerably faster, rising by 121 per cent and 137 per cent, respectively. Furthermore, one or the other of these two currencies would have given the highest average rate of return for any period starting with the second quarter of 1973. However, investments in Japanese yen would have been unprofitable relative to the other currencies from 1978 to 1979; more recently, investments in deutsche mark would have performed poorly compared with other currencies.

Fund-Related Assets

Holdings of Fund-related assets rose at a rapid pace in 1980 and the first half of 1981 as a result of SDR allocations and large drawings by members. The share of Fund-related assets in international reserves excluding gold of 10 per cent at the end of May 1981 was well below the share of 13 per cent at the end of March 1973. Allocations of SDRs during the third basic period, which were completed in January 1981, have raised the cumulative amount of SDRs issued from SDR 9.3 billion to SDR 21.4 billion. Relatively large holdings of SDRs by the Fund’s General Resources Account (SDR 5.1 billion at the end of May 1981) resulting from the payment in SDRs of part of the increased quota subscriptions in December 1980 reduced members’ SDR holdings to SDR 16.3 billion at the end of May of this year. The share of these SDR holdings in total reserves excluding gold at the end of May 1981 was less than 5 per cent, which is less than two thirds of the share in 1973. The ratio of allocated SDRs to non-gold reserves in 1981 was also below that in 1973. Reserve positions in the Fund advanced rapidly in 1980 and to date in 1981, as the scale on which the Fund provides balance of payments financing to its members increased. Reserve positions in the Fund as a proportion of total reserves excluding gold equaled 5 per cent in May 1981—the same as the share at the end of 1973.

SDRs are held by member countries, the Fund’s General Resources Account, and certain other prescribed official institutions. As a result of the transfers of SDRs in connection with quota subscriptions, the Fund’s General Resources Account became a major holder of SDRs in 1981, accounting for approximately 25 per cent of outstanding SDRs. There have also been shifts in SDR holdings between the various major country groups. At the end of May 1981, only the oil exporting countries held SDRs in excess of their allocations (128 per cent), while industrial countries held 83 per cent of their allocations and non-oil developing countries’ holdings were 43 per cent of their allocations. These proportions reflect both the payment of 25 per cent of recent quota increases in SDRs and the transfer of allocated SDRs among member countries. The effect of the quota payment can be removed by considering the proportions of the cumulative SDR allocations held at the end of November 1980, immediately before the quota increase became effective. At that time, the industrial countries held SDRs slightly in excess of their allocations (101 per cent), while the SDR holdings of oil exporting countries were 143 per cent of their allocations and those of the non-oil developing countries were only 64 per cent. Even within each of the three country groups, there was considerable variability in the proportions of allocated SDRs held by individual countries. For instance, the Federal Republic of Germany and Japan had holdings equal to 179 per cent and 217 per cent, respectively, of their cumulative allocations of SDRs, while the United States held 77 per cent of its cumulative allocation.17 The SDR holdings of non-oil developing countries in Asia (78 per cent) and the Western Hemisphere (88 per cent) were considerably closer to their allocated amounts than those in Africa (34 per cent), Europe (26 per cent), and the Middle East (23 per cent).

Reserve positions in the Fund have increased sharply from SDR 11.8 billion at the end of 1979 to SDR 17.9 billion at the end of May 1981. Overall reserve positions in the Fund change as the result of such factors as net borrowing by the Fund under various arrangements, drawings by members, and payment of quota subscriptions in assets other than currency. The payment of 25 per cent of the quota increase of November 1980 in the form of SDRs accounted for the major proportion of this latest increase in reserve positions in the Fund. Between the end of 1979 and the end of May 1981, the reserve positions of the industrial countries and oil exporting countries both increased by about 50 per cent, while that of the non-oil developing countries almost doubled.

Sources of Official Reserve Holdings

During the period 1973-80, the primary sources of international reserves excluding gold have been the growth of official claims on countries, acquisition of Eurocurrency deposits,18 the issuance of ECUs, and the increase in Fund-related assets. Although most foreign exchange reserves are represented by official claims on countries denominated in the debtor countries’ currencies, official institutions have continued to hold a significant but declining proportion of their foreign exchange reserves in the Eurocurrency markets (Table 21). At the end of 1975, 33 per cent of foreign exchange reserves was held in the Eurocurrency markets and 60 per cent as official claims on countries, with 7 per cent unidentified. By 1980, only 25 per cent of foreign exchange reserves was held in the Eurocurrency market, whereas 56 per cent was held as official claims on countries and 16 per cent as ECUs. As discussed earlier, the increase in holdings of ECUs in 1979 and 1980 reflected the deposit of both dollars and gold in the European Monetary Cooperation Fund and the revaluation of these deposits as the price of gold and exchange rates changed. If the gold deposits were excluded from foreign exchange reserves and the dollar deposits were added to official claims on the United States, the proportion of foreign exchange reserves in 1980 represented by official claims would rise to 68 per cent and that held in the Eurocurrency markets would be 29 per cent.

Table 21.Sources of Official Holdings of Foreign Exchange Reserves, End of Years 1973 and 1975-801

(In billions of SDRs)

1973197519761977197819791980
Official claims on countries
United States255.468.979.2103.8120.4108.6123.1
Other countries11.914.013.716.618.226.240.3
Subtotal67.382.992.9120.4138.6134.8163.4
Identified official holdings of
Eurocurrencies
Eurodollars18.537.745.353.248.048.753.3
Other currencies5.37.27.612.614.615.320.3
Subtotal23.844.952.965.862.664.073.6
European Currency Units32.447.5
Residual3,410.49.614.514.120.015.08.8
Total official holdings of
foreign exchange101.5137.4160.3200.3221.2246.2293.3
Sources: International Financial Statistics and Fund staff information and estimates.

Official foreign exchange reserves of Fund members (except for the People’s Republic of China, for which data are not available), plus Netherlands Antilles and Switzerland. Beginning in April 1978, Saudi Arabian holdings exclude the foreign exchange cover against the note issue, which amounted to SDR 4.3 billion at the end of March 1978. Data for the end of 1980 are preliminary.

Covers only claims of countries, including those denominated in the claimant’s own currency.

Part of this residual occurs because some member countries do not classify all the foreign exchange claims that they report to the Fund. Includes identified official claims on the International Bank for Reconstruction and Development, on the International Development Association, and the statistical discrepancy.

There are differences between this table and Table 19 owing to different data sources. This table uses U.S. statistics on official claims on the United States to identify such holdings, while Table 19 is based on the survey on the composition of monetary authorities’ gross claims on foreigners conducted by the Fund.

Sources: International Financial Statistics and Fund staff information and estimates.

Official foreign exchange reserves of Fund members (except for the People’s Republic of China, for which data are not available), plus Netherlands Antilles and Switzerland. Beginning in April 1978, Saudi Arabian holdings exclude the foreign exchange cover against the note issue, which amounted to SDR 4.3 billion at the end of March 1978. Data for the end of 1980 are preliminary.

Covers only claims of countries, including those denominated in the claimant’s own currency.

Part of this residual occurs because some member countries do not classify all the foreign exchange claims that they report to the Fund. Includes identified official claims on the International Bank for Reconstruction and Development, on the International Development Association, and the statistical discrepancy.

There are differences between this table and Table 19 owing to different data sources. This table uses U.S. statistics on official claims on the United States to identify such holdings, while Table 19 is based on the survey on the composition of monetary authorities’ gross claims on foreigners conducted by the Fund.

The declining share of Eurocurrency deposits was also accompanied by a redistribution of Eurocurrency holdings between Eurodollars and other Eurocurrencies. In 1975, Eurodollars constituted 27 per cent of foreign exchange reserves, whereas other Eurocurrencies represented 5 per cent of such reserves. By 1980, holdings of Eurodollars were only 18 per cent, while other Eurocurrencies constituted 7 per cent of foreign exchange reserves.19 The decline in the relative share of Eurocurrencies in foreign exchange reserves that has occurred over the period 1975-80 has reflected in part the agreement among members of the Group of Ten during most of the period since 1971 to refrain from redepositing reserve accruals in the Eurocurrency markets, and the fact that the reserves of the oil exporting countries, some of which hold substantial Eurocurrency assets, were relatively stable in the years 1977-79. The sharp rise in the level of Eurocurrency holdings in 1980 was strongly influenced by the much larger current account surpluses and resulting reserve increases of the oil exporting countries.

One recent development in the Eurocurrency markets has been the emergence of SDR-linked certificates of deposits and bonds. In terms of volume, the most significant SDR market is the deposit market, in which banks index the value of deposits to the SDR. The principal depositors appear to be central banks, Middle Eastern governments or agencies, and institutions in the international oil business. The SDR deposit market is a wholesale market with a typical deposit of approximately SDR 10 million, and deposit rates are quoted for periods of between one month and 6 months, and sometimes for 12 months. In addition, some banks occasionally offer forward transactions against the SDR. The first three SDR bond issues occurred in 1975, but by late 1980 only about SDR 200 million of bonds was outstanding. This contrasts with the SDR deposit market, in which a single Eurocurrency bank had deposits in excess of SDR 250 million. In the early months of 1981, however, there were some large syndicated loans and issues of corporate notes denominated in SDRs.

Reported official holdings of foreign exchange reserves may not include all foreign exchange assets that can be mobilized in a short period and do not indicate potential reserve sources. The reported holdings of foreign exchange reserves may understate actual holdings because central banks sometimes place a portion of their reserves in the commercial banking system under repurchase agreement, and these holdings are not included in reported reserves. Some countries also exclude reserves held as cover against the issue of domestic notes and the foreign exchange assets of quasi-official agencies (e.g., national oil companies). Moreover, central banks can increase their actual gross foreign exchange position by borrowing from the Eurocurrency markets or their potential reserve position by arranging for lines of credit that can be drawn upon at some future time. In addition, countries can obtain additional foreign exchange resources by drawing from the Fund. Finally, central banks have arranged for swaps of domestic currency assets with central banks in other countries up to specified limits. Until such time as these swaps are actually used, they would not be counted as part of foreign exchange reserves.

International Liquidity and Adjustment: The Recycling Problem

During 1980, developments in international capital markets were dominated by the recycling of net current account earnings of the oil exporting countries. Despite the many concerns that were expressed early in the year about the difficulties involved in successfully managing the international flow of funds associated with the latest rise in the price of oil, the recycling process has generally worked well. In 1980, the average oil export price rose to US$31 a barrel from US$19 a barrel in 1979 and US$13 a barrel in 1978. As a result of these price changes, the current account surplus of the oil exporting countries increased from an annual average of US$25 billion during the years 1976-78 to US$68 billion in 1979 and to US$112 billion in 1980. At the same time, the current account balance (excluding official transfers) of the industrial countries as a group slipped from an average surplus of US$7 billion in the years 1976-78 to a deficit of US$44 billion in 1980, and the non-oil developing countries increased their current account deficit from an average of US$33 billion in the period 1976-78 to US$82 billion in 1980.20

To finance these current account deficits, countries increased their borrowing and reduced their accumulation of reserve assets. The flow of new external borrowing (net of repayments) of the non-oil developing countries rose by almost two thirds from 1978 to 1980. This increased credit extension was facilitated by the fact that in 1980 approximately 40 per cent of the combined surplus of oil exporting countries was deposited in banks.

To evaluate the magnitude of the recycling problem, it is useful to compare the size of the flows associated with the recycling in the years 1979-80 with that observed in 1973-74. The recent shift in payments imbalances was quite similar to the corresponding change from 1973 to 1974. During both periods, the industrial countries moved from a substantial surplus to a deficit the surplus of the oil exporting countries increased sharply; and the deficit of the non-oil developing countries increased significantly (Table 11). As a result of the oil price increase in 1973, the oil exporting countries experienced a current account surplus of US$68 billion in 1974, compared with an average surplus of US$4 billion in the period 1971-73. The industrial countries moved from an average current account surplus of US$18 billion in the period 1971-73 to a deficit of US$13 billion in 1974, and the non-oil developing countries increased their current account deficit to US$37 billion in 1974 from an average of US$12 billion in the period 1971-73. As part of the process of intermediation between deficit and surplus countries, international bank lending, net of redepositing, rose from an average of US$27 billion in the period 1971-73 to US$50 billion in 1974. This implied more than doubling the net external borrowing of the non-oil developing countries. As a result of this increased borrowing, the ratio of long-term external debt of the non-oil developing countries to exports of goods and services rose from 89 per cent in 1973 to 98 per cent in 1975, and the ratio of this external debt to the gross domestic product (GDP) increased from 17 per cent to 18 per cent.

In a number of respects, the international banking system was better prepared to continue the international financial intermediation process in 1979-80 than during the years 1974-75. The aggregate current account deficit of the non-oil developing countries in 1980 was considerably smaller relative to the recent scale of international banking flows than in 1974. Major banks had also improved their standards for managing international assets and liabilities, and supervisory and regulatory authorities have been paying closer attention to the prudential aspects of international banking. As discussed earlier, bank lending to non-oil developing countries continued to expand during 1979 and 1980. Even though expansion of syndicated loans seems to have slowed, there was considerable growth in the form of unpublicized bank lending. The ratio of long-term external debt of the non-oil developing countries to their exports has not risen but actually declined somewhat from 1979 to 1980,21 and the ratio of this debt to GDP has remained approximately constant between one fourth and one fifth, which is, however, still well above the ratio observed in the years 1973-74. The indebtedness position of these countries appears to have worsened, however, by recent changes in the maturity composition from long-term debt, to which reference was made above, to short-term debt, which is less fully covered in the reported data.

Despite this relatively positive overall picture, there are still some issues of concern for the near term. In the first place, the cost of bank borrowing, as distinct from its availability, may become a serious consideration for a number of countries, especially if high nominal and real interest rates continue to prevail in the industrial countries. The higher level of interest rates is perhaps one of the major differences between the periods 1979-80 and 1973-74. Moreover, political or economic crises may seriously limit the access of some countries to the international capital markets.

During the second half of the 1970s, increasing attention was focused on the prudential aspects of international banking. The authorities were concerned with two objectives: preserving the soundness of banks and maintaining adequate growth of their lending. Relative to total bank assets, bank exposure to the non-oil developing countries is now much higher than it was in 1974. This greater exposure, especially to certain countries, and a decline in the ratio of bank capital to total assets, have been cited as sources of some concern within the banking community. In dealing with the prudential behavior of banks, the regulatory authorities have directed attention to the questions of risk exposure and capital adequacy. The authorities in a number of countries now require the reporting of consolidated balance sheets for domestic banks and their foreign branches and subsidiaries, as well as of consolidated positions vis-à-vis particular countries.

The Adequacy of International Reserves

The adequacy of the level and distribution of any given stock of international reserves can be judged in terms of how well it satisfies the effective demand for international assets to be held in official reserves, both in the aggregate and in individual countries. The demand for reserves reflects such factors as the degree of openness of the economies involved, the variability of payments imbalances, and the cost of holding reserves. With the rapid growth of international financial markets, the supplies of the principal components of international reserves have become increasingly responsive to changes in the demand for reserves. This means that there is unlikely to be a general shortage of reserves. There are still, however, the questions of the net cost at which these reserves are obtained and of their distribution.

One way of examining some of the factors that have influenced the demand for and holding of reserves is to consider the ratio of reserves to imports. Considering, first, developments in the ratio of non-gold reserves to imports, the ratio for all countries combined has fallen from 25 per cent in 1973 to 20 per cent in 1980. This aggregate ratio has encompassed somewhat diverse tendencies among the major country groups. The ratio for the major industrial countries declined even more rapidly, from 23 per cent in 1973 to 16 per cent in 1980. In contrast, the ratio for oil exporting countries increased from 59 per cent to 63 per cent during the corresponding period, although in 1980 this ratio was considerably lower than its peak of about 100 per cent in 1975. For the non-oil developing countries, the ratio of non-gold reserves to imports declined from 30 per cent to 22 per cent.

Another way of putting the magnitude of recent reserve changes in perspective involves expressing reserves in “real terms,” for instance, in terms of purchasing power over exports or imports in 1973. International reserves excluding gold deflated by world export prices (measured in SDRs) increased from an average stock of SDR 204 billion in 1973 to SDR 218 billion in 1980. During the same period, the comparable real reserves of the industrial countries fell from SDR 141 billion to SDR 124 billion, and those of the non-oil developing countries rose slightly, from SDR 44 billion to SDR 46 billion. The reserves of the oil exporters deflated by world export prices increased from SDR 18 billion to SDR 47 billion, reflecting the sharp increase in their current account surpluses. Holdings of real reserves have thus increased significantly only in the oil exporting countries.

This decline in the demand for non-gold reserves relative to imports could in part reflect the fact that the value of official gold holdings has risen sharply since 1973. While the ratio of non-gold reserves to imports declined from 25 per cent to 20 per cent between 1973 and 1980, the ratio of gold reserves (valued at market prices) to imports rose from 17 per cent to 27 per cent. As a result, the ratio of total reserves—non-gold reserves plus gold reserves valued at market prices—to imports rose from 43 per cent to 48 per cent during this period. Since the importance of gold in total reserves varies among countries, the global rise in the market value of reserves including gold relative to the value of imports was not shared by all countries; for instance, the ratio of the market value of total reserves to imports of the non-oil developing countries actually declined from 1973 (40 per cent) to 1980 (37 per cent).

The distribution of reserves, measured relative to imports as a scale factor, is illustrated in Chart 18, where the frequency distributions for the average ratios of reserves excluding gold to imports are presented for the industrial countries, the oil exporting countries, and the non-oil developing countries for the three-year period 1971-73 and for the period from the third quarter of 1979 through the second quarter of 1980. The median value of the distribution of the ratios for individual countries is also reported. As discussed earlier, the group ratios for the industrial countries and the non-oil developing countries have generally been declining since 1973, while that for the oil exporting countries has risen.

Chart 18.Distribution of Ratios of Non-Gold Reserves to Imports1

1 For the most recent 12-month period for which data are available, third quarter of 1979 to second quarter of 1980, the ratios used in this chart are the means of the quarterly ratios of the average stock of reserves to imports (at annual rates). For the historical comparison period, 1971-73, the ratios are the means of the annual ratios for these three years.

2Excludes the United States.

The industrial countries (excluding the United States, whose non-gold reserve holdings are extremely low) have, on average, a lower ratio of reserves to imports than the two other major country groups. The ratios for the industrial countries show, however, considerably less dispersion than those for the oil exporting or the non-oil developing countries and have also become less variable over time. The lower ratios for the industrial countries appear to reflect a relatively low demand for reserves associated with the facts that some of these countries can finance balance of payments deficits by incurring liabilities in their own currencies and that all of them are likely to have good access to the credit facilities of international capital markets.

The ratios of reserves to imports for individual oil exporting countries differed widely both in the years 1971-73 and in the period 1979/80; however, the median ratio for the group as a whole increased sharply between the two time periods. During the period 1971-73, the median ratio of reserves to imports for the oil exporting countries (0.26) was about equal to that for the industrial countries (0.24) and the non-oil developing countries (0.26). During the period 1979/80, in contrast, the median ratio for the oil exporting countries had risen to 0.47, while the ratios for the industrial and non-oil developing countries had fallen to 0.15 and 0.23, respectively.

The ratio of reserves to imports of the non-oil developing countries shows the greatest dispersion, but in the period 1979/80 almost 75 per cent of the reporting countries observed ratios that were no higher than that of the industrial countries as a group. This was so despite the fact that, for the non-oil developing countries, access to capital markets was more constrained than for the industrial countries, reserves contained little gold and thus did not benefit from the rising market value of this reserve component, and the sources of export earnings were far less diversified and less stable. When foreign exchange liabilities of the monetary authorities are taken into account, a number of countries with low reserve ratios also had negative net foreign exchange reserves. There are, however, also a few non-oil developing countries with ratios of reserves to imports that are significantly higher (0.8 and above) than those in the groups of industrial and oil exporting countries.

The preceding analysis suggests that the ample availability of international credit to many countries has generally ensured adequate growth of the overall stock of reserves. Most countries are able to acquire the reserves effectively demanded by them, either through exchange market intervention at exchange rates consistent with external surpluses or through borrowing in international capital markets. In many countries with small non-gold reserves relative to the value of external trade, the effective demand for reserves is, for one reason or another, relatively low. A conspicuous example is the United States, whose ratio of non-gold reserves to imports at the end of 1980 was only 6 per cent but whose need for such reserves was also small. Reliance on floating exchange rates may reduce the demand for reserves relative to trade of a number of countries in comparison with their reserve needs under the par value system in the 1950s and 1960s. On the other hand, the large size and considerable variability of payments imbalances in recent years has no doubt increased the demand for reserves of many countries. A number of oil exporting countries hold large reserves relative to imports not so much because their reserve needs are large but because reserves constitute a temporary investment of their large net current account earnings.

Although reserves can be borrowed, often (but not always) at a relatively small net cost, these credits must be repaid, or at any rate periodically refinanced. Moreover, a number of countries can borrow only at interest rates that contain a high spread over deposit rates, and some have only limited access, or no access, to international capital markets because of their unfavorable economic prospects and the precarious outlook for their balance of payments. Reserves earned through balance of payments surpluses do not have these drawbacks. An adequate evolution of a country’s reserve holdings in the long run is, therefore, closely linked to satisfactory balance of payments adjustment with appropriate allowance for the need for some reserve accumulation, if that need should exceed the country’s share in SDR allocations.

The Role of Fund Liquidity in the International Monetary System

Provision of liquidity, unconditional and conditional, is one of the principal functions of the Fund. Unconditional liquidity is supplied through the allocation of SDRs and, as a by-product of the extension of Fund credit, through the growth of reserve positions in the Fund. Conditional liquidity is made available through the Fund’s various lending programs and facilities. In allocating SDRs, the Fund directly provides reserve assets under rules set out in the Articles of Agreement; this topic is related to the discussion of the preceding section and will, therefore, be taken up first.

Unconditional Liquidity

The characteristics of the SDR have been considerably improved during the last year. Since January 1, 1981, the SDR is based on a new currency basket, containing five major currencies, which is used to determine both the value of the SDR and its interest rate. With effect from May 1, 1981, the SDR interest rate was increased from 80 per cent to 100 per cent of the combined market interest rate (the weighted average of short-term market yields in the five countries whose currencies are in the SDR basket). At that time, the reconstitution requirement on SDR holdings was also eliminated (with effect from April 30, 1981).22 These measures improved the asset quality of the SDR and enhanced the role of the SDR in the international monetary system. As a result, there has been further development of the private market in financial assets denominated in SDRs. The SDR has also been increasingly used by other international institutions, and most recently the International Bank for Reconstruction and Development, the International Development Association, and the Central Bank for West African States have been prescribed as authorized holders of SDRs.

With the final allocation (SDR 4 billion) for the third basic period at the beginning of 1981, there has now been a cumulative allocation of SDR 21.4 billion. The fourth basic period starts at the beginning of 1982. As of June 30, 1981, consensus with respect to SDR allocation in the fourth basic period had not yet been reached, and, as provided in the Articles of Agreement, the Managing Director has made a report to the Board of Governors and to the Executive Board indicating that as of that date he was not in a position to make a proposal regarding allocations during the fourth basic period that has broad support among Fund members. At its meeting in Libreville, Gabon, in May 1981, the Interim Committee urged the Executive Board to continue its deliberations on the subject to enable the Managing Director to submit to the Board of Governors at the earliest possible date a proposal that would command the necessary support among members. In reaching decisions on allocation, the Fund is guided by certain provisions of the Articles of Agreement, which require that there be a long-term global need to supplement existing reserve assets and that SDR allocations be consistent with the objective of avoiding economic stagnation and deflation as well as excess demand and inflation in the world. Moreover, the size of SDR allocations has significance for the objective of making the SDR the principal reserve asset in the international monetary system.

As has been discussed earlier, the rapid growth of non-gold international reserves that has occurred in recent years has primarily taken the form of larger foreign exchange holdings. Accordingly, the share of cumulative SDR allocations in total non-gold reserves declined from 10.5 per cent at the beginning of 1972, just after the last allocation of the first basic period, to 6.6 per cent at the beginning of 1981. Past experience indicates that, with the expansion of international transactions in goods, services, and financial assets, further growth of international reserves is likely to occur. A large part of the total reserve increment will certainly be generated through international financial markets. If a portion of the required reserve increment were, however, to take the form of allocated SDRs, this could satisfy part of the rising demand for reserves without depending on international credit markets; it could also accommodate some tendency toward asset diversification without adding to existing pressures in foreign exchange markets and help to maintain the position of the SDR relative to other reserve assets in the international monetary system. In the present circumstances of the world economy, characterized by sluggish growth and entrenched inflationary pressure, it is of course important that decisions on SDR allocation avoid giving wrong signals to the private sector while aiming at the objectives discussed above.

Conditional Liquidity

Members’ quota subscriptions are the basic source of funds used for the extension of conditional credit by the Fund. A country making use of the Fund’s resources is generally required to undertake an economic program designed to achieve a viable balance of payments position over an appropriate period of time. The criteria for the provision of Fund support are uniform for all members, in the sense that all members in a particular situation are entitled to receive the same treatment, given their needs and their adjustment efforts. The Fund recognizes that to rectify a country’s balance of payments position may, under present circumstances, require structural changes and that these adaptations may take longer than the one to three years normally set for Fund programs. While macroeconomic policies must ensure that the demand for resources is kept in close balance with supply, increased attention has been devoted to the impact of policy measures on the incentives and the capacity to augment supply. To this effect, collaboration with the International Bank for Reconstruction and Development has been intensified. In addition, since payments imbalances are now often large relative to quotas, the Fund has taken steps to enlarge access to its resources. As a general norm, and apart from drawings under certain low-conditionality facilities, members may now use the Fund’s resources up to 150 per cent of their new quotas in any year and up to 450 per cent over three years, with a cumulative limit of 600 per cent of quota.23

To ensure that there are adequate funds available to support members’ adjustment programs, the Fund has periodically increased its quotas and, when necessary, made use of borrowing facilities. Quotas were increased by 50 per cent as a result of the Seventh General Review of Quotas, which became effective in November 1980. In addition to this general quota increase, some members had special increases, chiefly the major oil exporting countries. Most recently, the Saudi Arabian quota in the Fund was doubled to SDR 2.1 billion and the quota of the People’s Republic of China was increased to SDR 1.8 billion. It has been decided that the Eighth General Review will be the occasion to review the criteria by which quotas are calculated and to reflect in the quota structure the evolution in members’ positions in the world economy.

While work has begun on the Eighth General Review, it may be some time before the Fund obtains sufficient additional resources from quota subscriptions. Given the current high rate of use of Fund resources, it is anticipated that the Fund will need to undertake supplementary borrowings of the order of SDR 6-7 billion a year over the next two or three years. In the first half of 1981, the Fund has concluded borrowing arrangements with the Saudi Arabian Monetary Agency, under which the Fund will be able to borrow up to SDR 4 billion in each of the next two years, with the possibility of additional amounts in the third year. In addition, the Fund has made arrangements for short-term financing of about SDR 1.3 billion from central banks of 16 industrial countries. About one half of this amount is available under a borrowing agreement with the Bank for International Settlements and the remainder under direct bilateral arrangements with the 16 central banks.24 These resources will contribute to financing of country programs under the Fund’s policy of giving members enlarged access to its resources. While the Fund is exploring further bilateral borrowing arrangements with members and central banks of members, it may also have recourse to the private capital markets, if indispensable to finance continued expansion of its operations.

1These developments are described in detail in Chapter 1.
2Figures refer to the increase in average consumer prices from 1979 to 1980.
3Import-weighted effective rates were chosen for this comparison rather than the MERM-weighted rates used in Chart 8 because MERM-weighted rates are not available for developing countries.
4Current account developments for these countries, as well as for the smaller industrial countries, are described in Chapter 1.
5In contrast, empirical work does not support the presumption that countries with relatively high trend growth rates of real income will display a tendency toward current account deficit.
6Each country’s cyclical position is defined as the ratio of actual output to estimated “potential output” in the manufacturing sector. A negative entry in row 4 of Table 15 indicates that the country’s resource utilization in manufacturing during the period 1978-80 fell relative to that of its trading partners.
7Further information on recent trends in the external indebtedness of the non-oil developing countries is provided in Chapter 1.
8Members’ exchange rate arrangements on June 30, 1981 and the changes in those arrangements since June 30, 1980 are shown in Table 17.
9The average percentage changes in real output in the period 1975-79 were 3 per cent for the low-income countries (excluding China and India), 4 per cent for India, and 5 per cent for major exporters of manufactures and other net oil importers. (Data for China are not available for years prior to 1977.) The net oil exporters not included in the group of oil exporting countries also achieved relatively high rates of real growth, and include some countries with characteristics similar to the major exporters of manufactures and some more similar to countries in the oil exporting group.
10Executive Board Decision No. 5392-(77/63), adopted April 29, 1977. See Annual Report, 1977, pages 107-109.
11It will be recalled that the Principles of Fund Surveillance over Exchange Rate Policies mention the following as among the developments that might indicate the need for discussion with a member: “2. (iii) (a) the introduction, substantial intensification, or prolonged maintenance, for balance of payments purposes, of restrictions on, or incentives for, current transactions or payments, …” (Executive Board Decision No. 5392-(77/63), adopted April 29, 1977. See Annual Report, 1977, page 108.)
12Executive Board Decision No. 6026-(79/ 13), adopted January 22, 1979. (See Annual Report, 1979, page 136.)
13Executive Board Decision No. 5604-(77/173), adopted December 21, 1977, and Executive Board Decision No. 5695-(78/36), adopted March 20, 1978.
14See Annual Report, 1980, page 60, for a detailed discussion of this valuation technique.
15This reflects the effect of the changes in both gold prices and physical holdings of gold.
16At the start of 1981, these bond-equivalent rates were (a) the market yields for three-month U.S. and U.K. Treasury bills with an initial weight of 42 per cent and 13 per cent, respectively; (b) the three-month interbank deposits rate in the Federal Republic of Germany with a weight of 19 per cent; (c) the three-month interbank money rate against private paper in France with a weight of 13 per cent; and (d) the discount rate on two-month (private) bills in Japan, also with a 13 per cent weight. For the calculation described in the text, this latter rate was estimated prior to October 1980 by making use of the observation that the level of the Japanese call money rate (unconditional), used in the first and second SDR interest rate baskets, was close during the period of overlap to that of the two-month rate currently used before converting that rate from a discount basis to a bond-equivalent basis.
17U.S. holdings of SDRs have been substantially below cumulative allocations ever since November 1978, when the United States reduced its holdings of SDRs from 100 per cent of its cumulative allocation to approximately 50 per cent in order to acquire foreign currency balances for exchange market intervention.
18The term “Eurocurrency deposits” is used to denote deposits denominated in a currency other than the currency of the country in which the bank accepting the deposit is situated.
19If the dollar deposit component of ECUs were redistributed to dollar claims and the gold component were excluded, then Eurodollars would constitute 21 per cent and other Eurocurrencies 8 per cent of foreign exchange reserves at the end of 1980.
20See also Chapter 1.
21This ratio is now lower than at any time since 1974.
24For details, see Chapter 3.

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