Chapter

Chapter 2: Developments in the International Monetary System

Author(s):
International Monetary Fund
Published Date:
September 1979
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This chapter reviews a number of recent developments in the international monetary system in a longer-term perspective. The marked variability in exchange rates among the larger industrial countries within the last two years has generated some criticism of floating exchange rates. It is certainly widely recognized that given the underlying economic and financial conditions prevailing in recent years a substantial degree of exchange rate flexibility has been and remains essential, and that exchange rate changes have made a significant contribution to international adjustment. At the same time, the experience of recent years has provided a reminder that there are limits to what can be accomplished by changes in exchange rates. In particular, attention has been drawn to the substantial lags in current account adjustments to exchange rate changes and to the extent to which such adjustments to rate changes can be slowed down or even nullified by the absence of supporting domestic measures. Moreover, the behavior of exchange markets has at times been characterized by “overshooting” with consequential reversals of exchange rate movements. Recent experience with floating rates has thus led a number of countries to the view that more management of exchange rates is required. It has also reinforced the conclusion, embodied in the new Article IV, that in the absence of orderly underlying economic and financial conditions in member countries it will not be possible to achieve a stable system of exchange rates.

The second part of the chapter deals with international liquidity. In the face of continued large payments imbalances in 1978, management of foreign exchange rates resulted in official intervention in exchange markets—for some countries quite heavy at times—and in continued expansion of official foreign exchange reserves, albeit at a much less rapid rate than in the preceding year. This development was also fostered through an ample supply of international credit provided by commercial banks. To the authorities of some members, this supply appeared so abundant as to arouse interest in possible methods for its control. To obviate undue expansion of private credit while responding to world liquidity requirements, members’ access to conditional liquidity was augmented in 1978 through a rise in Fund quotas by one third, as well as by an extension of the Fund’s credit facilities, and it is to be further enlarged in the near future by a quota increase amounting to one half of present quotas. Steps were also taken to enhance the role of special drawing rights in the international monetary system. These include the resumption of SDR allocations, changes in the characteristics and uses of SDRs, and the consideration of a substitution account administered by the Fund that would accept deposits of reserve currency balances in exchange for claims denominated in SDRs.

The Exchange Rate System

A description has been given in Chapter 1 of the frequent and sharp changes in exchange rates that have taken place over the last two years. Reference has also been made to the measures adopted by industrialized countries to strengthen intervention in exchange markets and to pay increased attention to external adjustment requirements in the formulation of domestic economic policies. In addition, it has been pointed out in Chapter 1 that, in spite of the significant changes that have occurred in exchange rates and relative prices, current account imbalances have been slow to adjust.

These developments, coming as they do after several years of widespread floating, have raised a number of issues that will be considered here, beginning with some of the consequences of exchange rate variability, followed by an analysis of why the adjustment mechanism has tended to be sluggish. The recent efforts of the industrialized countries to moderate exchange rate movements are described briefly, and the potential implications of these efforts reviewed. This is followed by a discussion of the exchange rate problems of less developed countries. Many of these countries have not escaped the consequences of exchange rate instability among the largest industrial countries, and some have had problems in reaching and maintaining appropriate exchange rate levels. The Fund has a responsibility for helping to deal with these problems of the exchange rate system through its surveillance over the exchange rate and related policies of members, and the first half of the chapter concludes with some observations on the opportunity this provides for cooperative action within the international community.

The Variability of Exchange Rates

Prior to the adoption of widespread floating, there was disagreement on the likely degree of instability of flexible exchange rates. Many of the earlier episodes of floating rates had been characterized by frequent and sharp changes in rates, but it could be argued that this was to be expected, since countries had generally used flexible rates only during times of economic instability. It was often suggested that under more settled conditions flexible rates could be expected to be relatively stable. More recent analysis has suggested that exchange markets tend to behave in some respects like other financial markets and thus may exhibit a fair degree of variability even when underlying conditions are less disturbed than at present. While this analysis is suggestive, the fact that there has been a background of relatively unstable economic and financial conditions during the six years of generalized floating makes it difficult to draw firm conclusions on what might happen in a more stable international environment.

In discussing exchange rate movements, it is helpful to distinguish among three types of variability: short-run fluctuations of a day-to-day, week-to-week, month-to-month variety; intermediate-term fluctuations over periods extending from one or two quarters to one or two years; and long-term shifts in exchange rates that persist. The three types of variability are illustrated in Charts 14 and 15 and Table 10. Chart 14 shows the daily changes of leading currencies against the U.S. dollar. It is evident that for the Federal Republic of Germany, Japan, Switzerland, and, to a lesser extent, France the years of floating break up into three periods: the first, one of considerable fluctuations; the second, a period of relative calm in 1976 and early 1977; and the third, the last two years of significant changes with greater stability in the first half of 1979. For Italy and the United Kingdom there was an additional period of larger fluctuations in 1976. For Canada the bilateral daily rates with the U.S. dollar were relatively more stable than for other countries, although also with some tendency for Canadian exchange rate variability to increase in recent years. One of the problems with a chart of this kind is that it shows only fluctuations of the U.S. dollar against individual currencies. For many purposes, however, the bilateral rates that are most frequently quoted are not the only bilateral rates that matter. Further, the changes shown in Chart 14 combine all three types of variability.

Chart 14.Short-Run Variability of Exchange Rates in Terms of U.S. Dollars, April 2, 1973-June 30, 1979

(Daily percentage changes)1

1 A negative change indicates a depreciation of the local currency.

Chart 15.Indices of Effective Exchange Rates, December 1972-June 1979

(Monthly average of daily spot rates. First quarter 1973 = 100)1

1 The weights for calculating effective exchange rates are derived from the Fund’s multilateral exchange rate model.

Table 10.Average Monthly Variability of Effective Exchange Rates for Eight Currencies, 1973–78 and First Half 19791(In per cent)
197719781979
Currency1973197419751976First

Half
Second

Half
First

Half
Second

Half
First

Half
U.S. dollar2.461.901.370.470.231.141.132.130.66
Pound sterling1.680.770.952.410.970.942.450.581.29
Deutsche mark3.071.751.200.980.341.301.321.730.64
French franc1.772.121.501.210.230.622.140.990.63
Japanese yen2.581.931.010.991.181.922.833.921.41
Italian lira2.301.100.393.680.560.970.740.700.42
Canadian dollar0.770.820.971.421.191.191.601.611.78
Swiss franc2.502.091.350.901.211.163.014.540.69

For each period, variability is measured by the standard deviation of monthly percentage changes in effective exchange rates. Monthly values of effective exchange rates are calculated by combining monthly averages of daily exchange rates vis-à-vis the currencies of partner countries with weights derived from the Fund’s multilateral exchange rate model.

For each period, variability is measured by the standard deviation of monthly percentage changes in effective exchange rates. Monthly values of effective exchange rates are calculated by combining monthly averages of daily exchange rates vis-à-vis the currencies of partner countries with weights derived from the Fund’s multilateral exchange rate model.

It is useful, therefore, to supplement Chart 14 with Table 10, which shows the variability of monthly divergences of effective exchange rates adjusted for the average change over each annual or semiannual period. Roughly the same pattern as in the chart showing daily fluctuations can be seen for sterling, the deutsche mark, the French franc, the yen, the lira, and the Swiss franc. Not surprisingly, the U.S. dollar mirrors the pattern of a number of the other major currencies, although it does not reflect the fluctuations of the pound sterling and Italian lira in 1976. Using effective exchange rates, the variability of the Canadian dollar is rather different, with small fluctuations in the early years, rising gradually to significant levels in 1976–78.

Chart 15 illustrates both intermediate-term fluctuations and long-term structural shifts in the pattern of effective exchange rates. Intermediate-term fluctuations in effective rates appear for the United States as a mirror image of opposite fluctuations in the Federal Republic of Germany and, to some extent, Switzerland. There are also less marked fluctuations in the exchange rates of the United Kingdom, France, and Canada in the early years. In the case of Japan, there are some minor fluctuations at the beginning of the period with a striking intermediate-term fluctuation in 1978–79.

While the size of recent intermediate-term fluctuations can be partly explained by current differences in trends in the growth of money and in prices and costs, differences in current account positions and in circumstances and policies as reflected in levels of capacity utilization appear to have been more important short-run factors. (Representative measures of these indicators are shown in Table 11.) For example, measures of prices, such as the GNP deflator or data on broad money or broad money per unit of output, do not suggest that large exchange rate changes would have occurred. Narrower measures of prices, such as wholesale prices of manufactures, reveal sharper differences, but in part they may reflect the pressure to adjust the prices of internationally traded goods to a common level in response to exchange rate changes. Manufacturing unit labor costs in major countries are less immediately affected by exchange rates and also show sharper international differences than the GNP deflators. The same was broadly true of the rates of productivity growth (as measured by output per man-hour in manufacturing). The striking contrasts in current account positions and significant differences in levels of capacity utilization, reflecting the sharper recovery of the U.S. economy from the 1974–75 recession than that of Japan and the Federal Republic of Germany, contributed to expectations of future exchange rate changes that led to shifts among currencies by asset holders during this period.

Table 11.Variables Related to Exchange Rate Changes, 1975–78(Percentage change over preceding period unless otherwise indicated)
1975197619771978
Exchange rates
Deutsche mark/U.S. dollar−4.92.3−7.8−13.5
Japanese yen/U.S. dollar1.8−0.1−9.5−21.6
Broad money1
Germany, Federal Republic of (M3)7.510.09.410.1
Japan (M2)13.314.611.411.7
United States (M2)7.79.910.78.3
Broad money per unit of output
Germany, Federal Republic of9.64.76.66.5
Japan11.77.65.75.8
United States9.14.05.54.1
GNP deflator
Germany, Federal Republic of6.73.23.83.9
Japan8.55.65.54.7
United States9.65.25.97.4
Wholesale prices of manufactures
Germany, Federal Republic of4.73.92.61.3
Japan1.64.81.4−1.7
United States11.04.66.27.5
Unit labor costs in manufacturing
Germany, Federal Republic of8.8−1.72.44.0
Japan21.80.14.5−1.7
United States6.63.86.26.7
Output per man-hour in manufacturing
Germany, Federal Republic of3.88.15.32.7
Japan−3.98.05.18.7
United States4.74.42.42.7
Index of relative cyclical position2
Germany, Federal Republic of101102103102
Japan88909193
United States100103106111
Balance on current account—including official transfers
(in billions of U.S. dollars)
Germany, Federal Republic of3.63.54.38.9
Japan−0.73.710.917.5
United States18.54.3−14.113.9
Sources: Data reported to the International Monetary Fund and Fund staff estimates.

See Chart 4 for a comparison between broad money and M1 for these countries.

This index shows the ratio between actual and potential output in the manufacturing sector, relative to an export-weighted average of such ratios for the 13 other industrial countries; this average is equal to 100. In general, the degree of capacity utilization is very difficult to measure accurately, especially during a period such as that of the past few years, when marked changes in both cyclical influences and structural factors of various types have been occurring simultaneously.

Sources: Data reported to the International Monetary Fund and Fund staff estimates.

See Chart 4 for a comparison between broad money and M1 for these countries.

This index shows the ratio between actual and potential output in the manufacturing sector, relative to an export-weighted average of such ratios for the 13 other industrial countries; this average is equal to 100. In general, the degree of capacity utilization is very difficult to measure accurately, especially during a period such as that of the past few years, when marked changes in both cyclical influences and structural factors of various types have been occurring simultaneously.

There has always been concern that the variability of exchange rates that might exist under a flexible rate system would have detrimental effects on international trade and foreign investment. Existing statistical studies have not detected a significant decline in the growth of international trade that can be related to exchange rate fluctuations, although there has not been time to observe the effects of the instability of the last two years. Statistical analysis of foreign investment similarly fails to reveal any noticeable decline in response to exchange rate variability. The surveys that are available on the reaction of businessmen in industrial countries to exchange rate uncertainty also suggest that in general they have adjusted their behavior to take account of exchange rate uncertainty rather than having reduced their international transactions.

In countries with well-developed financial markets, such adjustments are relatively simple to make in the case of daily, weekly, or monthly fluctuations in rates, which principally affect international transactions that are under way or planned for the near future. Forward markets for covering trade transactions or hedging asset positions have kept the cost of such fluctuations within reasonable limits. Fluctuations over intermediate periods can be more troublesome. As for long-term shifts in exchange rates, these would eventually have to occur under any type of exchange arrangement if domestic economic policy adjustments do not deal with the underlying causes of divergence. Expectations with regard to these shifts could affect trade or investment only if there were considerable uncertainty about the extent to which the shifts would be in line with relative price-cost developments; but such uncertainty is also present when rates are pegged.

There seems little question, however, that the problems encountered by international traders and foreign investors from exchange rate variability, including those arising from the need to meet corporate or externally applied accounting standards on the valuation of foreign assets and liabilities, have turned out to be more complex than many anticipated. These problems have led to the commitment of a good deal of executive time and effort to deal with foreign exchange issues, and many participants in international transactions have found the variability of exchange rates at the least troublesome and, in some cases, a very serious matter. In general there appears to be much more concern over exchange rate variability than over price fluctuations in other financial markets. The reasons for this are not obvious, although it is noteworthy that fluctuations in exchange rates have much broader effects than those resulting from changes in prices and yields in other markets and, therefore, more serious economic and political implications.

It is not easy to judge the extent to which exchange rate instability under the floating system can be attributed to floating per se and how much to instability in underlying economic and financial conditions. While countries continue to accept the need for the adjustment of exchange rates to underlying conditions, the actions of most countries indicate a widespread view that un-managed floating can be a factor in exchange rate instability. These actions include the establishment of the European Monetary System and the more active intervention in exchange markets by the United States and Canada.

Exchange Rates and the Adjustment Mechanism

The 1977 Annual Report pointed out that exchange rate changes had made only a limited contribution to eliminating persistent current account imbalances, and the 1978 Report indicated that the effects of exchange rate changes on a number of persistent current account surpluses and deficits were still not evident. It is suggested in Chapter 1 that in the period from early 1978 to mid-1979 there was some evidence that such imbalances were in the process of being reduced. It remains true, however, that given the time horizons within which policymakers must frequently work, the lags in the response of trade balances to exchange rate changes has affected the way in which the flexible rate system is viewed.

There are several reasons why the response of current account balances to exchange rate changes has been particularly sluggish in the recent period. In the first place, exchange rate changes will have significant consequences only to the extent that their effects on relative costs and prices are not offset by domestic wage and price changes. Such offsetting wage-price movements tend to be larger in more open economies, where import prices are a major component of the cost of living, and the response of wages and prices can be a source of serious difficulty where inflationary expectations are deeply entrenched. If wage increases are indexed to changes in the consumer price index, or wage bargaining is quickly affected by actual and anticipated price increases arising from depreciation, the ratio of domestic to foreign costs will change by much less than the exchange rate.

While offsetting effects on domestic wages and prices reduce the impact of exchange rate changes on relative national cost levels, it is clear from the evidence presented in Chapter 1 that substantial changes have taken place in relative costs and prices in recent years. As earlier experience would suggest, however, trade flows have reacted with a significant lag to relative price changes. This was to be expected, since in the period following a change in exchange rates and relative prices most trade is based on previously concluded contracts, and a considerable time is required before it is possible to take advantage of cheaper sources of supply or for newly competitive producers to capture additional export markets. Such changes in trade flows often require substantial search time and information costs, and may entail the establishment of new or adapted plant and equipment, new distribution systems, and the adjustment of products to tastes in new markets. Conversely, recent experience has shown the extent to which exporters in countries with sharply appreciating currencies have been able to benefit inter alia from their existing reputations for reliability, timely delivery, service, and high-quality goods and have been able to hold on to significant market shares in spite of a worsening competitive position.

There are other reasons why trade flows respond sluggishly to exchange rate changes even when resulting adjustments in relative costs are maintained. Nontariff barriers to trade can have an important effect on the response of trade flows to changes in relative prices, if new opportunities for sales encounter strong resistance. Another factor that may have some significance is that enterprises in countries with a past history of overvaluation have undertaken substantial direct investment in countries with lower cost levels. The fact that they have an investment in foreign facilities may discourage corporations from either exporting to countries serviced by their subsidiaries or curtailing imports from their own foreign production facilities.

The above reasons may help to explain why estimates, based on the Fund’s world trade model, show that for 14 industrial countries import and export price elasticities for manufactured imports and exports are each below unity for a period of up to one year. Over the longer run, the elasticities are higher, indicating that a sustained change in relative prices will lead to substantial positive effects in both volume and value terms. Nevertheless, the typical effect of a currency depreciation is an initial worsening of the current account followed by an improvement after a lag generally exceeding one year.

A major additional factor accounting for the slowness of current account adjustments has been the demand-management policies being followed by surplus and deficit countries. Exchange rate-induced changes in relative prices will shift demand from output in appreciating countries to that in depreciating countries, but if fiscal and monetary policies being followed in the deficit countries are relatively more expansionary than policies in the surplus countries, this will tend to offset such shifts.

If a surplus in the current account is the counterpart of a sustainable capital flow, it may not require correction, just as a deficit can persist if offset by sustainable foreign borrowing. There remains the question of why in fact capital flows have not responded to a similar extent to the same forces that have led to current account surpluses and deficits.

If, for example, the amount that residents wish to save is high relative to the level of domestic investment, then both adjustments through financial markets and monetary policy ought to lead to relatively low real interest rates. The opposite should be the case in countries where the amount that residents want to save is low relative to investment opportunities, with market adjustments and monetary policy leading to relatively high real interest rates. This in turn ought to affect capital flows and help to maintain overall external balance. This tendency would be further strengthened by portfolio adjustments as investors exploit existing interest rate differentials. Although nominal interest rates in deficit countries have exceeded those in surplus countries, in a period as turbulent as this one with major changes in exchange rate expectations, it is not surprising that long-run tendencies have sometimes been swamped by short-run forces.

With regard to direct investment, international disparities in interest rates may well be a less important factor than relative costs. Investment tends to flow to countries with depreciating currencies as long as domestic wages and other costs are not fully adjusted to exchange rate changes. The response of direct investment to this incentive, however, is subject to a considerable lag and may be hampered by several factors, including a lack of institutions geared to foreign investment, government restrictions on foreign ownership, and the pressure exercised by those concerned with the export of employment opportunities.

Prospects for Greater Exchange Rate Stability

Given the disappointment with both the variability of floating rates and their contribution to adjustment, it is not surprising that there has been discussion of means of achieving greater exchange rate stability. Two major initiatives were taken by industrial countries during the past year to reduce unwanted exchange rate changes. One of these was the set of measures adopted by the United States on November 1, 1978. As part of a comprehensive economic program, the United States announced that it would—in cooperation with the authorities of the Federal Republic of Germany, Japan, and Switzerland—intervene in exchange markets in a forceful and coordinated manner to correct movements of the dollar exchange rate that were felt to have exceeded any decline related to fundamental factors. The measures were designed to offset negative market psychology that in the judgment of the authorities was not justified by the underlying economic situation. The steps taken were not aimed at establishing fixed exchange rates or target zones for rates. Rather, they represented a move to restore order in exchange markets so that rates could respond more readily to economic fundamentals.

The second initiative was the creation by the European Community (EC) of the European Monetary System (EMS), which was officially put into effect by the participating European countries1 on March 13, 1979. The aim of the agreement is to foster “closer monetary cooperation leading to a zone of monetary stability in Europe.” The agreement consists principally in an intervention requirement on the part of each participant to limit exchange rate fluctuations, in the creation of the ECU (European Currency Unit, a basket of all nine EC currencies) as the center of the system, and in the enlargement of credit facilities already established in the EC as well as in connection with the former European common margins arrangement (the so-called snake). The intervention mechanism requires that countries intervene to prevent movements greater than 2.25 per cent around parity in bilateral rates between participants.2 There exists also a presumption that a participating country will take action when the value of its currency in terms of the ECU diverges from its central rate by more than a uniform percentage, the precise percentage for each country being adjusted to take account of the weight of its currency in the basket. Unlimited very short-term credit for intervention purposes continues in the same form as in the “snake” arrangement, except that such credit can be extended for a somewhat longer period than before. An initial supply of ECUs has been issued by the European Monetary Cooperation Fund against deposits of 20 per cent of both the gold and the dollar reserves of participating countries; these ECUs are to be used for the settlement of such intervention debts in accordance with agreed rules. The existing short-term and medium-term facilities of the EC have been substantially enlarged, and credit under the short-term facility can also be granted over longer periods. It is envisaged that ultimately all the credit facilities under the EMS will be consolidated in a European Monetary Fund.

In addition to contributing to increased integration within the EC area, the principal objective of the EMS is to promote internal financial stability. Participating countries in the earlier European common margins arrangement—particularly those with small, open economies—have argued that the exchange rate stability gained through that arrangement has assisted their domestic economic policies and strengthened their foreign sectors. The economies of those countries that previously allowed their rates to float but are now joining the arrangement have in the past followed a different path from those of the “snake” countries in response to differing circumstances and policies. Thus, the task of stabilizing rates will require a concentrated effort toward policy coordination. It is expected by the participants that the greater exchange rate stability gained by more concerted intervention policies will facilitate the task of harmonizing financial policies.

These recent initiatives raise the question of what would be the requirements for a system in which exchange rate fluctuations were reduced and the rate changes that did occur were more consistently in line, with long-term underlying trends. As indicated in the introduction of this chapter, the answer to this question embodied in the new Article IV is that such a system requires orderly underlying economic and financial conditions in member countries. Such conditions imply, inter alia, a closer approximation to reasonable price stability in member countries, and a strong commitment by member governments to avoid future departures from price stability. In an environment of this kind expectations could be stabilizing rather than destabilizing. The world is clearly still a long way from a system of this kind, but the wider recognition that inflation not only leads to instability but also over the longer run adversely affects growth and employment opportunities constitutes an important first step on the road to a more stable international monetary system.

Special Problems of Less Developed Countries and Their Exchange Rate Policies

The early years of floating exchange rates in the industrial countries were particularly difficult ones for most less developed primary producing countries. Major contributing factors were the rise in oil prices, slower growth and slack demand conditions in the industrial countries, an overall deterioration in the external terms of trade in some cases, and lags in adjusting domestic financial policies to the new external circumstances. Both the introduction of floating exchange rates for the currencies of the industrial countries and the pressing needs of the external adjustment process faced less developed countries with new and complex choices with regard to the exchange arrangements best suited to their particular needs and to the role of the exchange rate for their own currency in achieving required external and internal adjustments. The choices made in a number of cases had substantial influence on the ability of these countries to cope with both external and domestic disturbances.

Exchange Arrangements

In choosing an exchange rate regime, the less developed countries can be broadly described as falling into two groups. The first group consists of those members that have continued the practice of pegging to a major currency—usually, but by no means always, the traditional intervention currency. For those members continuing long-standing fixity of exchange rates between their currencies and a principal currency used for international transactions, several reasons were relevant. One of these was convenience for those engaged in foreign trade, particularly where the bulk of contracts was denominated in the principal currency or where there was a high degree of geographic concentration of trade. Another was encouragement of confidence in the home currency and in domestic policies, in order, inter alia, to foster domestic investment from both resident and foreign sources. Finally, related closely to the previous reason, there was the desire to use a fixed exchange rate as a stable element around which domestic policies could be planned and implemented. For countries that are members of the West African and Central African currency unions, the policy of pegging to the French franc followed from continued participation in their respective groups. Another important consideration in some cases may also have been that the particular peg chosen was expected to result in a desired change in the effective exchange rate.

As of June 30, 1979, however, while 60 less developed members pegged their currencies to another currency, 50 had chosen some other type of exchange arrangement.3 Of these, 13 pegged their currencies to the SDR and 13 to other composite currency baskets, while 3 adjusted the rates for their currencies according to a set of indicators and 21 maintained other exchange arrangements (Table 12).4 Many members in this latter category are ones that, as a consequence of broadly diversified trade patterns, found that, with rate fluctuations among the major currencies, pegging to a single currency resulted in disruptive fluctuations in the prices of a large portion of their exports or imports. They thus sought to minimize such fluctuations by frequent adjustments in their exchange rates.

Table 12.Exchange Arrangements of Fund Members as of June 30, 1979
Type of Exchange

Arrangement
Industrial

Countries
More Developed

Primary Producing

Countries
Oil Exporting

Countries
Non-Oil

Developing

Countries1
Total
Currency pegged to
U.S. dollar143641
French franc1414
Pound sterling33
Other currencies33
SDR1313
Other composite3221118
Exchange rate adjusted to a set of indicators134
Cooperative exchange arrangements718
Exchange rates otherwise determined11961541
Total141312981371

This figure does not include Democratic Kampuchea, for which no information is available.

This figure does not include Democratic Kampuchea, for which no information is available.

The variability of exchange rates, shown in Table 13,5 has increased substantially for most developed and less developed countries between the last years of the par value system and the years since 1973. While such variability results both from changes in the rate between the home currency and the intervention currency and from changes between the intervention currency and third currencies, it can be seen from Table 13 that the latter type of change has accounted for much of the variability, especially during the floating period. The increase in variability between the two periods was especially marked for those countries pegged to the SDR or those not classified elsewhere in Table 13. This is not surprising, as one would expect that floating rates among the major currencies would result in larger variations in effective exchange rates for those countries whose trade is widely diversified geographically. Hence, these would be the countries that would benefit from pegging their currencies to a composite of currencies or from engaging in some form of managed floating, and one may suppose that the variability of exchange rates would have been even greater for these countries had they been pegged to another currency. For countries pegging their currencies to the U.S. dollar or the French franc, the low degree of variability is apparently related to the high geographic concentration of their trade, which is in turn an important factor in the decision of these members to remain pegged to a single currency.

Table 13.Average Monthly Variability of Effective Exchange Rates, January 1967-December 19781(In per cent)
Jan. 1967-

Mar. 1973
Apr. 1973-

Dec. 1978
Developed countries1.1271.680
Industrial0.8751.320
Other1.5672.311
Less developed countries21.7052.411
Exchange rate
Pegged to the U.S. dollar1.522(1.422) 31.778(0.563)
Pegged to the French franc0.493(0.001)40.612(—)
Pegged to the SDR1.4174.602(1.965)
Countries not classified above2.2853.180

The exchange rates used in these calculations are monthly import-weighted effective exchange rates. Variability is defined as the standard deviation of the monthly percentage changes in the exchange rate about the average monthly percentage change.

Countries are classified according to their exchange arrangements as of June 30, 1979.

The figures in parentheses indicate that part of variability that was due to changes in the rates of these currencies against the U.S. dollar, the French franc, or the SDR, respectively. For other countries, and for SDR peggers during the period 1967–73, calculations of this sort would not be meaningful.

In 1967 the Mali franc was depreciated by 50 per cent relative to the CFA franc.

The exchange rates used in these calculations are monthly import-weighted effective exchange rates. Variability is defined as the standard deviation of the monthly percentage changes in the exchange rate about the average monthly percentage change.

Countries are classified according to their exchange arrangements as of June 30, 1979.

The figures in parentheses indicate that part of variability that was due to changes in the rates of these currencies against the U.S. dollar, the French franc, or the SDR, respectively. For other countries, and for SDR peggers during the period 1967–73, calculations of this sort would not be meaningful.

In 1967 the Mali franc was depreciated by 50 per cent relative to the CFA franc.

Exchange rate variability has been a matter of concern to less developed countries for several reasons. It has contributed to greater unpredictability of import prices and export receipts in both the short run and the intermediate term, which in turn has made it more difficult for both the public and private sectors to plan their activities, manage their finances, and choose between import suppliers. Moreover, the greater unpredictability of exchange rates in the intermediate term has complicated the task faced by many less developed countries in the management of both their foreign reserves and their external debt. In addition, those members not pegging their currency to another one have had to make frequent decisions on the level at which to maintain the exchange rate.

Another significant problem has been the increased short-term exchange risk faced by exporters and importers. While in industrialized countries the risk is reduced by means of forward markets, such markets typically do not exist or are inadequate in less developed countries. In some countries, an attempt has been made to provide at least exporters, and occasionally also importers, with forward exchange facilities through the central bank. Such arrangements may involve exchange risk for the central bank, especially if forward cover is being provided to importers and a future depreciation of the local currency is expected, or if a special forward rate is offered to exporters in order to stimulate exports. Where the balance of payments position of a member is weak, the authorities have often prohibited forward transactions. Where the latter are permitted, the authorities have sometimes preferred to encourage establishment of forward exchange facilities in the private market, including links with forward markets in established financial centers. For many countries, however, such a development would require further improvements in local banking expertise, telecommunication facilities, and correspondent relationships with foreign banks.

Exchange Rate Policies

With regard to policies determining the extent and frequency of changes in exchange rate levels, the first fact to be noted is that the present environment of various types of regime has presented less developed countries with a much greater range of choice of such policies than existed under the par value system. Previously, for the typical less developed country, changes in par value were infrequent, normally preceded by a long period of more rapid rates of domestic price increases than those abroad, a worsening balance of payments, and increasing resort to exchange and trade restrictions. Under present circumstances, a depreciation of the domestic currency can be regarded as much less unusual than was hitherto the case.

There are, to be sure, reasons why the authorities in some countries have continued to be reluctant to carry out the exchange rate adjustments called for by a persistent balance of payments deficit. In many instances, these are related to the short-run effects of changes in the rate and in some particulars are similar to the experience of the industrialized countries with exchange rate flexibility. On the one hand, because of short-run price inelasticity of exports and imports, the effects on the balance of payments are not soon apparent; on the other hand, there is an immediate impact on domestic prices. Moreover, unless the depreciation is accompanied by the appropriate supporting policies, the desired change in relative prices will not be achieved; in some circumstances such policies lead to a temporary decline in aggregate real expenditure and are therefore difficult to carry out. Further effects of a depreciation that may create difficulties for the authorities are the initial impact on income distribution, which is often in favor of profit recipients relative to wage earners, and the fiscal burden of increasing the size of external debt in domestic currency. Less commonly, where an appreciation of the domestic currency is called for, the required change is often resisted on the grounds of damage to the sectors producing exports and import substitutes.

Considerations such as the foregoing have led to the tendency already alluded to for the authorities of many countries to postpone needed adjustments in the value of their currencies. Experience has shown that the long-run costs of such postponement often outweigh any short-run benefits. This is particularly true in cases where price levels have already moved far out of line with those abroad without any corresponding exchange rate movements. This not only has a direct consequence of distorting relative prices and resource allocation but also gives rise to exchange and trade restrictions, price controls, and special fiscal measures that are created to improve the balance of payments in lieu of an exchange rate change. The overall result of this course of action can be a slowing of economic growth and, if anything, a worsening in the underlying current account position. While the ultimate effects on domestic consumption may be postponed through foreign financing, the delayed adjustment when it is made will be more disruptive than would have been more timely action.

An exchange rate policy that maintains an appropriate relationship between domestic and external price levels has a noticeable influence on the current account over the medium term if adequate supporting policies are pursued. A number of non-oil less developed countries have been able to improve their current account position over the floating rate period as a whole, notwithstanding the oil price increase, unfavorable trends in prices for their exports, and other external developments. Some of these countries (including Burma, India, Kenya, Sri Lanka, and Thailand) experienced an effective depreciation of their currencies in real terms6 over the ten years 1968–77. To be sure, current account improvement reflects not only exchange rate action but also demand-management policies and other measures affecting the relative price incentives of production for export or domestic sales, as well as changes in external demand and the terms of trade. Nevertheless, those countries whose improved current accounts were based on relatively rapid rates of export expansion have placed noticeable emphasis in their policies on maintaining appropriate price incentives in favor of export growth. In contrast, a number of other less developed countries have customarily stressed import substitution, which tends to introduce a bias against production for export relative to domestic sales. In some of these countries with an improved current account performance but rather weak export growth, import substitution policies and recessionary conditions were responsible for limiting the growth of imports.

It is noteworthy that, while the majority of less developed countries have continued to be reluctant about making adjustments in their exchange rates, a number of these countries in recent years have followed a policy of permitting considerable flexibility of exchange rates between their currencies and the major intervention currency. These countries include those that engage in managed floating, or adjust their rates frequently according to a set of indicators, or are pegged to a composite of currencies. For some of these, countries, where inflation rates are substantially higher than those abroad, severe disruptions for the export and import sectors quickly arise unless frequent exchange rate adjustments are made. For certain other countries, which have maintained moderate inflation rates, a flexible use of exchange rate policy has been encouraged by other factors, such as relatively sophisticated financial markets. The choice of exchange rate policy has also been affected by the structure of the external sector and its size relative to GNP. Many countries with flexible exchange rate policies have relatively diversified economies and a sizable share of manufactured goods in their exports, so that both the demand for imports and the supply of exports tend to be sensitive to changes in the real exchange rate. Indeed, many of these countries have achieved substantial increases in the volume of their exports in recent years, without which the burden of external adjustment would have been rendered much more difficult. In a number of cases, this has been facilitated by sound domestic policies.

Among the less developed countries that had pegged their rates, a number in recent years have had to rely on formal devaluations of their exchange rates along with restrictive demand-management measures to achieve needed adjustments in their external accounts (for example, Burma, Ghana, Tanzania, Zaïre, and Zambia). In a number of instances the exchange rate adjustments were linked directly to the need to provide adequate price incentives to export producers. In countries where the initiation of the adjustment effort was delayed and domestic cost-price relationships had seriously deteriorated, the needed adjustments in the exchange rate were understandably large. Such action was often combined with measures to reduce or eliminate exchange controls, quantitative restrictions, and taxes on and subsidies to foreign trade that had been introduced during previous balance of payments difficulties. The need to retain the price incentives created by these measures could typically be met only by large changes in the rate.

The attitudes of less developed countries toward the role of the exchange rate vary considerably, reflecting, inter alia, the size and structure of the external sector and the strength of domestic inflationary pressures relative to those abroad. In part, perhaps, this also results from differences in the extent to which the free-market price mechanism or direct controls have been the preferred means for determining resource allocation and promoting economic growth. In varying degrees, most less developed countries have relied upon exchange and trade controls to regulate foreign trade and payments and to encourage preferred patterns of industrial expansion and income distribution. It appears, however, that for many less developed countries relatively limited reliance on restrictive exchange and trade controls, together with a flexible use of exchange rates, has facilitated the adaptation of their economies to unfavorable external developments and has helped both to promote the growth of exports and to raise levels of output and employment.

In summary, while floating exchange rates have resulted in some unavoidable problems for less developed countries, they have also provided more opportunity to follow flexible exchange rate policies that could improve the prospects for exports and economic growth. A number of less developed countries have taken advantage of this opportunity and have benefited from such a flexible approach. It should be remembered, however, that suitable financial policies are essential for strengthening the external position, and that the choice of a member’s exchange arrangement must necessarily be conditioned to its particular circumstances.

Surveillance

It is clear from what has been said earlier that for the time being, and probably for some years to come, members will continue to exercise their freedom to follow the exchange rate regime of their choice. It is equally clear, however, that the freedom to choose an exchange rate regime does not confer on a member the freedom to maintain any exchange rate it chooses without corresponding obligations to the international community. The present method of ensuring the fulfillment of those obligations is through Fund surveillance over exchange rate policies. While the Fund has always had an interest in, and views about, the exchange rate policies of its members, the new principles and procedures for implementing formal surveillance have been in effect only since April 1978. Nevertheless, some preliminary comments can be made arising out of this brief experience. These include observations on the scope of surveillance, the other corrective forces that support surveillance, and the need to take into account reserve and external debt positions in applying surveillance.

Since April 1978, one formal modification of the Fund’s surveillance function has been made that bears mention. In January 1979, a supplementary surveillance procedure was introduced, under which the Managing Director must initiate an informal and confidential discussion with the member whenever he considers that a modification in the member’s exchange arrangements or exchange rate policies or the behavior of the exchange rate for its currency may be important or may have important effects on other members. If, after this prior discussion, the Managing Director considers the matter to be of importance, he must either conduct an ad hoc consultation with the member and report to the Executive Board, or informally advise the Executive Directors on the consultation as promptly as circumstances permit. This supplementary procedure permits the Fund to look into exchange market developments without any presumption that the member in question has not complied with its obligations.

While this decision reflects an extension of possible methods for carrying out the Fund’s surveillance function, there have also been developments in the application of surveillance. Thus the Fund is increasingly using the authority it has under Article IV with respect to both the exchange rate policies of members and related economic policies that can affect the exchange rate. Under this Article the Fund is entrusted with the task of overseeing the compliance of members with their obligations under Section 1 of Article IV, which refers to the pursuit of domestic economic policies that will promote a stable system of exchange rates.

The use by the Fund of its wider authority, which extends beyond exchange rate policies and domestic policies directly related to “balance of payments purposes,” has resulted from successive discussions within the Fund on the world economic structure and outlook. In these discussions it has become increasingly apparent that, particularly in the case of countries with well-developed financial markets, a close relationship exists between domestic economic policies and external developments even if the domestic policies are not directly related to “balance of payments purposes.” Moreover, given the lags in the response of trade flows to exchange rate and relative price changes, countries can be directly affected over the short run by domestic developments in other countries even if their trade is carried out across floating rates. The experience of the last two years has demonstrated the fact that domestic economic policies in the largest industrial countries can affect levels of economic activity elsewhere and can lead to changes in the structure, and short-term variability, of exchange rates that are widely regarded as disruptive to the system as a whole. Such developments are of concern to the international community, and there has been a good deal of support for periodic Fund consideration of the general economic policies of member countries.

While surveillance is a significant factor in encouraging the adjustment of inappropriate exchange rates, it is important to recognize the corrective forces that existed and that continue to exist quite independent of the Fund’s new authority over exchange rate policies. Thus, countries with undervalued currencies encounter a number of difficulties, frequently including the need to contend with the monetary effects of rapid reserve accumulation, and the resulting requirement to weigh the benefits of investment in reserve assets against alternative uses of these resources. In contrast, countries with overvalued currencies tend to rely on restrictions, excessive borrowing, or underutilization of capacity, and all of these have their costs. The latter countries usually find it necessary at some stage to come to the Fund for assistance, and an adjustment of the exchange rate is often part of the program for which the Fund gives support.

Although corrective forces will in most cases lead to a solution after a sufficiently long interval, there are two disadvantages to relying on these forces alone, or in postponing adjustment until a critical situation has been allowed to develop. The first is that such forces bear unevenly on countries, with those with undervalued currencies being able to resist pressures for change much more effectively than those at the other end of the spectrum. The second weakness is that, in both cases, adjustment can be postponed to the point where the changes are disruptive both for the country concerned and, in varying degree, for the system as a whole.

In implementing surveillance it is essential that the Fund avoid a static mechanical approach. Thus, while the general rule is that an appropriate exchange rate is one that results in a balancing of sustainable net capital flows with the underlying value of net transactions on current account, some departure from this path may be desirable in order to promote restoration of a member’s reserve position. The April 1977 decision, “Surveillance over Exchange Rate Policies,” provides that “the Fund’s appraisal of a member’s exchange rate policies shall be based on an evaluation of the developments in the member’s balance of payments against the background of its reserve position and its external indebtedness.”

Under an approach that takes into account reserve and external debt positions, countries that have a history of a weak balance of payments with low net reserves would not be discouraged from maintaining a value for their currencies that would permit them to repay debt and to accumulate reserves. Alternatively, countries with substantial reserves and high borrowing capacity might be encouraged to allow their currencies to appreciate to, or remain at, a level that would lead to little increase, or even a decrease, in their reserves, thus giving other countries room to adjust. In short, judgments about the suitability of a particular structure of exchange rates cannot be made only in terms of the present and the future, but need to take into account what has happened in the past. The Fund may thus contribute to the long-term stability of the system by encouraging countries in a relatively strong position to refrain from intervening excessively to prevent an appreciation of their currencies or to intervene to prevent a depreciation. In other cases, and these are likely to be greater in number, the Fund can act as a catalyst in stimulating members in a relatively weak position to adopt appropriate domestic policies and, where necessary, to carry out devaluations in order to achieve the competitive position they require to reconstitute their net reserves. In applying this broad approach to surveillance, as in all its surveillance activities, the Fund will continue (in the words of Article IV, Section 3(b)) to “pay due regard to the circumstances of members” and to take into account the responsibility of members under the decision on surveillance over exchange rate policies “to counter disorderly conditions” in exchange markets.

A final comment can be made on the role of surveillance over exchange rate policies under various exchange rate regimes. While “firm” surveillance arose as part of the new Article IV and is sometimes associated with floating exchange rates, the need for authority of this kind emerged from the experience with the par value system. In the present mixed system, surveillance applies equally to those members that peg and to those that float, and, under any exchange regime, it can play an important role in preventing the emergence and retention of an inappropriate structure of exchange rates.

International Liquidity

Developments in international liquidity are intimately linked with countries’ exchange rate policies and with the course of events affecting currency markets. Reserves can be used for official intervention in exchange markets in order to reduce the amplitude of short-term fluctuations in a country’s exchange rate. The scope for exchange rate stabilization through intervention thus depends, inter alia, on the state of international liquidity or, more precisely, on the volume of international reserves and the cost at which individual countries can obtain and use them. The global stock of foreign exchange reserves is, in turn, influenced by developments in exchange markets, which may at times lead the authorities of many countries to intervene in the same direction, thereby increasing or reducing aggregate holdings of the principal reserve currency. This twofold relation between exchange market conditions and international liquidity enters into any analysis of historical reserve developments or of the adequacy of reserves. The following treatment of these topics begins with a review of reserve developments in 1978 and a historical survey of the rate of growth of reserves and its variability in the era of floating exchange rates, continues with a consideration of the adequacy of reserves, and concludes with a discussion of the composition of official foreign exchange reserves and the role of the SDR. Recent developments in international liquidity other than reserve movements and the role of the Fund in the provision of conditional and unconditional liquidity are dealt with in connection with the last two of these three topics.

Recent Developments in International Reserves

Reserve Changes in 1978

As reported in the Fund’s International Financial Statistics, the value of official holdings of foreign exchange, expressed in SDRs, increased by about 10 per cent during 1978, from SDR 200 billion at the beginning of the year to SDR 221 billion at the end (Table 14). This rise reflected not only foreign exchange transactions conducted by monetary authorities, including the acquisition and use of currency balances through official borrowing abroad and repayment of foreign liabilities, but also alterations in the value of currency holdings resulting from changes in valuation and statistical coverage.7 The increase attributable to transactions alone was SDR 34 billion (17 per cent) in 1978. compared with a corresponding rise of SDR 45 billion (28 per cent) in 1977. As in past years, the contribution of transactions in other reserve assets to the growth of total reserves was small during 1978. Countries’ aggregate holdings of SDRs remained approximately unchanged. Reserve positions in the Fund declined by somewhat more than SDR 3 billion. Of this total, a reduction of SDR 0.5 billion came about through sales of gold by the Fund; the remainder was the counterpart of a net decline in the use of Fund credit. The volume of gold held in official reserves increased by about 0.7 per cent, as the distribution to members of a portion of the Fund’s gold exceeded net sales to the market from official holdings. As the London market price of gold in terms of SDRs increased by 28 per cent, the value of official gold holdings expressed at that price increased by SDR 39 billion, or 29 per cent.

Table 14.Official Holdings of Reserve Assets, End of Years 1971–78 and End of May 19791(In billions of SDRs)
19711972197319741975197619771978May

1979
Reserves excluding gold
Fund-related assets
Reserve positions in the Fund6.46.36.28.812.617.718.114.813.1
Special drawing rights5.98.78.88.98.88.78.18.112.2
Subtotal, Fund-related assets12.315.015.017.721.426.426.222.925.3
Foreign exchange75.095.9101.8126.3136.9159.8200.1220.82231.8
Total reserves excluding gold87.2110.9116.8144.0158.3186.2226.3243.82257.1
Gold
Quantity (millions of ounces)31,0261,0171,0171,0161,0151,0101,0121,0199314
Value (i) at SDR 35 per fine ounce35.935.635.635.635.535.335.435.732.6
(ii) at London market price41.260.894.7154.8121.6117.1137.4176.7201.4
Source: International Financial Statistics.

“Fund-related assets” comprise reserve positions in the Fund and SDR holdings of all Fund members. 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 except Romania, for which data are not published. 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 decrease recorded in the quantity of countries’ official gold holdings from the end of 1978 to the end of May 1979 reflects mainly the deposit by the eight countries participating in the exchange rate and intervention mechanism of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The ECUs issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

Source: International Financial Statistics.

“Fund-related assets” comprise reserve positions in the Fund and SDR holdings of all Fund members. 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 except Romania, for which data are not published. 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 decrease recorded in the quantity of countries’ official gold holdings from the end of 1978 to the end of May 1979 reflects mainly the deposit by the eight countries participating in the exchange rate and intervention mechanism of the European Monetary System of 20 per cent of their gold holdings with the European Monetary Cooperation Fund. The ECUs issued in return for these deposits are shown as part of the countries’ official foreign exchange holdings.

The growth of foreign exchange holdings during the first five months of 1979 came to SDR 11 billion, reflecting both transactions and valuation changes, for which separate estimates are not available. The increase in holdings of the eight countries participating in the exchange rate and intervention mechanism of the European Monetary System (EMS), which came into force on March 13, 1979, amounted to SDR 13 billion, mostly reflecting the issuance of ECUs in return for deposits of gold.8 Some other industrial countries also showed large changes in their foreign exchange reserves, notably Japan and Switzerland with decreases of SDR 6.3 billion and SDR 2.3 billion, respectively, and the United States with an increase of SDR 2.2 billion. The changes in Fund-related reserves were much smaller, although members’ holdings of SDRs rose by SDR 4.1 billion, mainly as the result of the allocation of SDR 4 billion on January 1, 1979, and reserve positions in the Fund were reduced by SDR 1.7 billion, largely through net repurchases. The volume of gold recorded in countries’ reserves declined by almost 9 per cent, chiefly because of the above-mentioned deposits of gold by EMS participants.

For industrial countries as a group, holdings of reserves excluding gold increased by SDR 21 billion in 1978—a rise of 19 per cent, compared with 31 per cent in 1977. Almost the entire amount of the increase in 1978 could be accounted for by changes in the holdings of the Federal Republic of Germany, Japan, and Switzerland, and nearly two thirds of it occurred during the last quarter of that year, when these countries intervened heavily with the objective of stabilizing conditions in the currency markets. During the same quarter, the United States reduced its holdings of Fund-related assets and engaged in borrowing abroad to acquire foreign currency balances for exchange market intervention undertaken in cooperation with these three countries. This acquisition marked the first sizable increase in U.S. holdings of foreign exchange assets in many years.

The group of countries to record the largest proportionate rise in reserves excluding gold during 1978 was that of the more developed primary producing countries, whose holdings increased by SDR 4.1 billion, or by fully 30 per cent. The reserves of these countries had reached a high point in 1973 and thereafter had experienced two years of substantial decline followed by two years of virtual stagnation. The recovery in 1978 brought their holdings back to a value slightly above that reached five years earlier.

Non-oil developing countries as a group continued to add to their reserves during 1978. For all regions taken together, the increase in reserves excluding gold was 20 per cent. The experience of individual geographic areas, however, was very uneven. Non-oil developing countries in the Western Hemisphere added almost 35 per cent to their holdings, whereas those in Africa recorded no advance at all. The remaining areas fell between these extremes, with non-oil developing countries in Asia and in the Middle East showing additions of about 11 and 19 per cent, respectively.

The only group of countries to show a decline in reserves for 1978 was that of the major oil exporting countries. Part of the recorded reduction of SDR 16 billion in reserves excluding gold resulted from the reclassification by Saudi Arabia of a portion of its foreign exchange holdings (Table 14, footnote 2). Even when allowance is made for this change in coverage, however, the decrease from the end of 1977 to the end of 1978 was 19 per cent.

Within each group, developments in individual countries differed substantially (Table 15). Each of the three industrial countries mentioned above as major reserve gainers in 1978 saw its reserves excluding gold rise by more than SDR 5 billion; four other industrial countries and three non-oil primary producing countries each added more than SDR 1 billion to their holdings. Three major oil exporting countries and one industrial country experienced declines exceeding SDR 1 billion. Saudi Arabia had a decrease of SDR 5.6 billion in its adjusted reserves. The United Kingdom, which had added nearly SDR 14 billion to its reserves during 1977, saw its holdings go down by more than SDR 4 billion in 1978.

Table 15.Countries with Changes of SDR 1 Billion or More in Official Reserves Excluding Gold During 19781(In billions of SDRs)
Change During
Indicated Period
1978Fourth

Quarter

1978
Large increase in calendar year 1978
Germany, Fed. Rep. of8.66.5
Japan6.52.6
Switzerland5.24.4
France2.30.5
Italy1.80.4
Austria1.10.5
Denmark1.10.1
Seven industrial countries26.615.0
Spain2.80.2
Brazil3.21.3
Argentina1.2−0.4
Three primary producing countries7.21.1
Subtotal, countries with
large increases33.816.1
Large decrease in calendar year 1978
United Kingdom−4.3−0.7
Saudi Arabia−5.62−1.1
Nigeria−2.00.3
Venezuela−1.8−0.1
Three primary producing countries−9.42−0.9
Subtotal, countries with
large decreases−13.72−1.6
All other countries (net)1.71.4
Total, all countries21.8215.9

During the first five months of 1979, many of the countries covered in this table again recorded changes of SDR 1 billion or more in their reserves excluding gold. The data for these countries are as follows (in billions of SDRs): Of the countries with large increases in 1978, France (4.9), Italy (5.9), Denmark (1.2), and Argentina (1.6) showed further increases, while the Federal Republic of Germany (−1.5), Japan (−6.5), Switzerland (−2.4), and Austria (−1.2) snowed decreases; of the countries with large decreases in 1978, Saudi Arabia (−1.5) showed a further decrease and the United Kingdom (1.3) an increase. Three other countries also had large increases in January-May 1979: the United States (3.2), the Netherlands (2.1), and Belgium (1.2). For the Federal Republic of Germany, France, Italy, Denmark, the Netherlands, and Belgium, holdings of reserves excluding gold were increased during this period by the issuance to them of ECUs in return for deposits of gold.

The change shown for Saudi Arabia is that in adjusted foreign exchange reserves, in which the effect of the change in reporting coverage is left out of account. (See Table 14, footnote 2). Other subtotals and totals containing Saudi Arabia’s holdings are correspondingly adjusted.

During the first five months of 1979, many of the countries covered in this table again recorded changes of SDR 1 billion or more in their reserves excluding gold. The data for these countries are as follows (in billions of SDRs): Of the countries with large increases in 1978, France (4.9), Italy (5.9), Denmark (1.2), and Argentina (1.6) showed further increases, while the Federal Republic of Germany (−1.5), Japan (−6.5), Switzerland (−2.4), and Austria (−1.2) snowed decreases; of the countries with large decreases in 1978, Saudi Arabia (−1.5) showed a further decrease and the United Kingdom (1.3) an increase. Three other countries also had large increases in January-May 1979: the United States (3.2), the Netherlands (2.1), and Belgium (1.2). For the Federal Republic of Germany, France, Italy, Denmark, the Netherlands, and Belgium, holdings of reserves excluding gold were increased during this period by the issuance to them of ECUs in return for deposits of gold.

The change shown for Saudi Arabia is that in adjusted foreign exchange reserves, in which the effect of the change in reporting coverage is left out of account. (See Table 14, footnote 2). Other subtotals and totals containing Saudi Arabia’s holdings are correspondingly adjusted.

Medium-Term Reserve Developments

Two striking features of reserve developments in the 1970s are the high average rate of growth of nominal reserves and the substantial year-to-year variation in reserve growth. These features will be discussed in turn.

In the decades of the 1950s and 1960s world reserves grew much less rapidly than in the 1970s. For instance, from 1951 to 1969, world reserves including gold rose on average by less than 3 per cent per annum, and the foreign exchange component grew by 5 per cent per annum. The average annual increase in gold holdings, the dominant component of reserves throughout this period, was less than 1 per cent. The proportionate rise in reserve positions in the Fund was quite large, 8 per cent per annum, but the absolute amount of this element of reserve growth was only SDR 5 billion over this period of 18 years. During the first three years of the 1970s, which can be regarded as a transition period straddling the collapse of the Bretton Woods par value system in 1971, reserve growth accelerated sharply. From the end of 1969 to the end of 1972, the average annual rate of increase in foreign currency holdings in terms of SDRs was 43 per cent, and as a result foreign exchange had become the dominant reserve component at the end of this three-year period.

In the six years of widespread floating that has characterized the international monetary system since the early months of 1973, the average annual rate of growth of foreign exchange reserves, measured in SDRs, has been 15 per cent. Although substantially below the explosive increase during the transition period 1970–72, this is still a high rate of growth in historical comparison. It may be noted in this context, however, that the average annual rate of increase in the value of world imports measured in SDRs over the six-year period 1972–78 was 18 per cent. While changes from year to year in official foreign currency holdings are determined by a variety of factors, some of which are discussed below, the accumulation of these holdings over longer periods corresponds to the secular trend in the demand for reserves, which is related to the long-term increase in the value of international settlements. From 1951 to 1969, for instance, official foreign exchange holdings rose at an annual rate (5.1 per cent) that was somewhat below the rate of increase in world imports (6.6 per cent).

The change in holdings of Fund-related reserve assets is influenced largely by developments affecting their supply. In the absence of an SDR allocation, countries’ holdings of SDRs failed to grow from the end of 1972 to the end of 1978—and in fact marginally declined during the last two years of this period—but they increased at the beginning of 1979, when allocations were resumed at the rate of SDR 4 billion per annum. Reserve positions in the Fund come about chiefly as a result of the net use of Fund credit. They are closely related to the size of quotas and various credit facilities made available by the Fund, as well as to members’ decisions on the use of these facilities. While these positions have greatly increased in recent years—they nearly tripled from the end of 1973 to the end of 1977—they are subject to considerable variation. For instance, as pointed out earlier, they fell by almost one fifth in the course of 1978. If the SDR allocation at the beginning of 1979 is added to the end-1978 data, Fund-related assets as a proportion of total reserves excluding gold declined from about 13 per cent in 1972 and 1973 to 11 per cent at the beginning of 1979. The volume of official gold holdings was nearly constant at slightly more than one billion troy ounces (31,600 tons) during the period under review. The value of these holdings at market prices fluctuated sharply, with year-end peaks of SDR 155 billion in 1974 and SDR 177 billion in 1978 and a year-end low point between these peaks of SDR 117 billion in 1976.

The second notable feature of recent reserve developments mentioned at the beginning of this section is the high variability of the yearly rate of change of reserves, especially of foreign exchange holdings. The sources of variability in the rates of change of reserve components other than foreign exchange holdings have been touched on above. The following analysis deals only with variation in the rate of change in official foreign exchange holdings, which ranged from 6 per cent in 1973 to 25 per cent in 1977. Since about four fifths of foreign exchange reserves are denominated in U.S. dollars, the question arises whether the valuation effect of movements in the exchange rate between the SDR and the U.S. dollar could have significantly contributed to the variability of foreign exchange reserves measured in SDRs. This does not appear to be the case, however. The variation in annual growth rates of foreign exchange holdings expressed in U.S. dollars was even larger (between 3½ and 31 per cent) than that calculated from the same data expressed in SDRs (Table 16).

Table 16.Annual Rates of Growth of Official Foreign Exchange Holdings Expressed in SDRs and in U.S. Dollars, and Rate of Appreciation of the U.S. Dollar Against the SDR, 1973–78(In per cent)
Year-EndRate of Growth of ForeignAppreciation (+) or
toExchange Holdings Expressed inDepreciation (-) of
Year-EndSDRsU.S. dollarsU.S. Dollar Against SDR
1972–735.817.5-10.0
1973–7424.426.3-1.5
1974–758.43.74.6
1975–7616.815.90.8
1976–7725.230.9-4.4
1977–7812.5 120.6 1-6.8

Percentage changes are calculated on the basis of foreign exchange holdings at the end of 1978 adjusted as described in Table 15, footnote 2.

Percentage changes are calculated on the basis of foreign exchange holdings at the end of 1978 adjusted as described in Table 15, footnote 2.

As mentioned earlier, the rate of change of foreign exchange reserves is related to changing tendencies in exchange market intervention in response to movements of exchange rates. For instance, at times when the U.S. dollar declines against other currencies in general—as measured, say, by movements in the exchange rate between the SDR and the U.S. dollar—there is a tendency for official U.S. dollar holdings to be increased through purchases in the exchange markets designed to reduce the rate of appreciation of other currencies against the U.S. dollar. The opposite occurs when the U.S. dollar appreciates against other currencies. Monthly percentage changes in the U.S. dollar value of official foreign exchange holdings have, with considerable regularity, moved counter to the corresponding percentage changes in the SDR/dollar rate, especially during the most recent four years of the entire period examined (Chart 16, top panel). Statistical estimates for the period from April 1973 to February 1979 indicate that, on average, the monthly percentage change in foreign exchange reserves was about three fourths of the percentage change (in the opposite direction) in the SDR value of the U.S. dollar, a relationship significantly stronger than could be accounted for by valuation effects alone. This relation, which explains about two fifths of the total variation in monthly percentage changes of foreign exchange reserves, has been sufficiently pronounced to have resulted in a clear association between the level of the SDR/dollar exchange rate and the U.S. dollar value of foreign exchange reserves (which, in the bottom panel of Chart 16, is expressed in terms of percentage deviations from its secular trend).

Chart 16.Official Foreign Currency Reserves of All Countries and Exchange Rate of the U.S. Dollar, April 1973–February 1979

1 For the period prior to June 1974, the U.S. dollar exchange rate is calculated using the SDR currency basket announced on June 13, 1974.

The relation just described should be even more clearly observable if changes in U.S. dollar holdings alone were considered, instead of changes in the dollar value of all foreign exchange holdings. While monthly U.S. dollar holdings for all countries are not available, quarterly changes in official U.S. dollar reserves of five industrial countries with large holdings of U.S. dollars (the Federal Republic of Germany, France, Japan, Switzerland, and the United Kingdom) show a similar countermovement to the weighted average of their exchange rates against the U.S. dollar (Chart 17). Although the relation is obscured by other factors in the early part of the period, particularly in 1974, it is very pronounced from the beginning of 1975 onward. According to estimates based on 15 observations from the second quarter of 1975 to the fourth quarter of 1978, the dollar holdings of the five countries taken as a group have tended to change more than in proportion to (almost one and one half times) the percentage change in the combined exchange rate of the currencies of these countries, and more than one half of the total variation in the rate of change of their U.S. dollar holdings is accounted for by this relation.

Chart 17.Five Industrial Countries: Quarterly Changes in Official Holdings of U.S. Dollars and in Weighted Average Exchange Rate Index, Second Quarter 1973–Fourth Quarter 19781

1 The five countries are France, the Federal Republic of Germany, Japan, Switzerland, and the United Kingdom. The exchange rate index is constructed as a weighted geometric mean of the dollar exchange rates of the five countries, with weights equal to countries’ shares in the group’s average exports of goods and services, 1972–76.

This evidence suggests that intervention transactions in response to exchange rate movements have been large enough to offset the valuation effects of changes in the SDR/dollar rate on foreign exchange reserves measured in SDRs but not so large as to account for the observed substantial changes in the SDR value of these holdings. The high variability in the rate of growth of these reserves cannot, therefore, be explained on the basis of these factors alone.

As Table 16 indicates, 1974 and 1977 stand out as years in which the growth of official foreign exchange holdings was particularly high, and it is reasonable to look for special factors that may have been at work. In each of these two years, a large proportion of the overall increase was concentrated in a small number of countries. In 1974, the sharp rise in the prices of certain primary commodities, particularly petroleum, led to large current account surpluses on the part of some of the countries that are major exporters of these commodities and to corresponding deficits in the rest of the world. The financing of these current account deficits involved the transfer of foreign exchange balances from private holders in the deficit countries to official entities in the surplus countries and thus gave rise to an increase in the global total of official foreign exchange reserves. Indeed, the rise in the holdings of the major oil exporting countries in 1974 accounted for the entire global increase of SDR 25 billion (24 per cent).

In 1977, several factors appear to have combined to produce the unusually large reserve increase, including the sharp deterioration in the U.S. current account balance, the persistent current surpluses of several industrial countries, and, not least, the volatility of private capital movements. During the year, central monetary institutions acquired a total of SDR 45 billion of foreign currency reserves as a result of intervention in the exchange markets—as distinct from changes in holdings reflecting valuation effects (Table 17). Of this amount, more than SDR 40 billion consisted of assets denominated in U.S. dollars, which were the counterpart of net sales of dollars by private transactors throughout the world in exchange both for goods and services and for assets denominated in other currencies. While the global increase in official foreign exchange holdings cannot be ascribed to particular entries in the balance of payments accounts of individual countries, there is little doubt that the sharp increase in the U.S. current account deficit in 1977, together with the policies of surplus countries with respect to exchange market intervention, contributed to the rapid growth of reserves in that year. The amount of that deficit (SDR 11 billion, including official transfers) was, however, little more than one fourth of the accumulation of U.S. dollar holdings by central monetary institutions. Almost one half of this accumulation corresponds to the U.S. deficit on capital account, which is also related to the growth in global dollar holdings, but with an uncertain causal nexus: it is not clear to what extent it may be cause, and to what extent consequence, of the growth in these holdings. The equivalent of SDR 10 billion of the increase in official U.S. dollar holdings in 1977 took the form of (identified) official Eurodollar placements, which bear no direct relation to the U.S. balance of payments.

Table 17.Composition of the Change in Official Holdings of Foreign Exchange Reserves, 1971–78(In billions of SDRs)
19711972197319741975197619771978
Official claims on countries
United States27.410.04.78.54.311.330.324.6
Other countries1.61.31.83.60.31.23.2
Subtotal29.011.36.512.14.311.631.527.8
Identified official holdings
of Eurocurrencies
Eurodollars0.96.43.713.84.67.410.40.3
Other currencies0.72.12.00.11.7-0.23.82.2
Subtotal1.68.55.713.96.37.214.22.5
Residual13.41.12.1-1.0-3.63.0-0.53.4
Total change in official foreign
exchange reserves arising from
transactions34.020.914.325.07.021.845.233.7
Valuation change-4.4-8.4-0.53.61.1-4.9-8.7
Total29.620.95.924.510.622.940.325.0
Source: Statistical Annex, Table 19.

Includes identified official claims on the International Bank for Reconstruction and Development, the International Development Association, and the European Monetary Cooperation Fund, and the statistical discrepancy. See also Statistical Annex, Table 20, footnote 3.

Source: Statistical Annex, Table 19.

Includes identified official claims on the International Bank for Reconstruction and Development, the International Development Association, and the European Monetary Cooperation Fund, and the statistical discrepancy. See also Statistical Annex, Table 20, footnote 3.

As already mentioned, it is not possible, on the basis of data currently available, to determine with any degree of certainty whether a substantial portion of the accumulation of dollar reserves in 1977 resulted from shifts in private portfolios. Private capital movements, and associated intercurrency shifts in asset portfolios, depend on expectations with respect to exchange rates and interest rates, which in turn are affected by various underlying economic phenomena, including the balance of payments performance of the countries issuing the currencies in question. These expectations are, at times, subject to cumulative reinforcement that tends to destabilize exchange markets. On these occasions, large official intervention purchases of reserve currencies may result in large increases in global foreign exchange reserves. It is significant that the gain in dollar reserves was not widely dispersed across countries in 1977, as might have been expected if it had arisen mainly as a consequence of large net foreign expenditures by U.S. residents. Instead, the increase in official U.S. dollar holdings in that year was concentrated in the United Kingdom, which experienced unusually large capital inflows, and a few other industrial countries. In this connection it may be noted that, although the U.S. deficit on current and capital account was almost as large in 1978 as it had been in 1977, the lower level of exchange market intervention by other countries—SDR 34 billion in 1978 compared with SDR 45 billion in 1977—and the associated larger valuation effect combined to produce a much smaller increase in the SDR value of global foreign exchange holdings in the latter year.

The Adequacy of International Reserves

The preceding discussion of the growth of global reserves in recent years furnishes a convenient starting point for analysis of the adequacy of international reserves. As interpreted in recent Annual Reports, the concept of reserve adequacy is a broad one, involving not only the balance between the global supply of and demand for reserves but also considerations about the state of the private international credit markets and the availability of conditional liquidity. These considerations have to do with the degree to which the supplies of various reserve assets, and the availability of reserves in general, respond to changes in demand for reserves by individual countries and by all countries together. These questions are taken up in the remainder of this section.

Developments in International Credit Markets

The decade of the 1970s has witnessed very rapid growth in the provision of credit by the international capital markets. It is widely recognized that private banking institutions contributed greatly to the smooth functioning of the world trade and payments system in the years 1974–76 by recycling the funds deposited by oil exporting countries and they can be expected to continue to play a major role in international financial intermediation in the future. Two questions have been raised, however, with respect to certain consequences of the increased reliance on private credit markets. The first is the question of whether growth of the Euromarkets induces an expansion of the global reserve stock beyond the level warranted by countries’ long-run reserve needs. The second question is concerned with the extent to which the private international capital markets may contribute to an overexpansion of liquidity by extending credit to countries for longer periods and on easier terms than would be desirable from the standpoint of ensuring timely and adequate adjustment of payments imbalances. These questions have given rise to a renewed debate over the merits of some form of control over the international financial system.

The first question is rooted in the observation that creditworthy countries generally can, if they wish, increase their official reserves by borrowing in the Eurocurrency market and redepositing the loan proceeds in that market, often at a small cost in terms of the difference between their borrowing and lending rates. This does not mean, however, that the growth of international credit markets has caused an expansion of global reserves. In the first place, countries can satisfy their demand for international reserves not only by official (or officially induced) borrowing abroad but also in other ways, for instance, by pursuing macroeconomic policies designed to achieve an overall surplus in the current and private capital accounts. Moreover, although the attractiveness of obtaining reserves by borrowing abroad rises whenever the spread between Eurocurrency borrowing and lending rates narrows, the acquisition of borrowed reserves always entails a net cost and would not be pushed beyond countries’ longer-term reserve needs.

The composition of changes in foreign exchange reserves as between direct claims on reserve currency countries and Eurocurrency holdings cannot furnish reliable evidence on the question at issue, since official foreign exchange holdings may be deposited in Eurobanks even if they did not originate in Eurocurrency loans and, vice versa, proceeds of Euromarket loans may be used to acquire direct claims on reserve centers. In the five-year period 1972–76, the rise in foreign exchange reserves resulting from transactions was nearly evenly divided between direct claims (SDR 46 billion) and identified Eurocurrency deposits (SDR 42 billion), and this division was roughly maintained year by year (Table 17). In the last two years, 1977 and 1978, the increase in direct claims (SDR 59 billion) by far exceeded that in Eurocurrency holdings (SDR 17 billion). This may indicate that large U.S. deficits on current and long-term capital account resulted in substantial additions to direct claims on the United States in these years and that the country distribution of these increments favored retention of these direct claims rather than depositing them in the Eurocurrency markets. This factor may, in particular, account for the small rise in identified official holdings of Eurocurrencies (SDR 2.5 billion) in 1978, the smallest increase since 1971. Of the rise of SDR 34 billion (excluding valuation changes) in foreign exchange reserves in 1978, SDR 25 billion was in the form of direct official claims on the United States. This reflects the fact that during 1978 the overwhelming proportion of the increase in reserves was concentrated among members of the Group of Ten, which have generally refrained since 1971 from redepositing reserve accruals in the Eurocurrency markets. Furthermore, oil exporting countries, some of which hold a substantial portion of their official reserves in Eurocurrency assets, experienced a large decline in reserves in 1978. To summarize, the available data provide no concrete evidence of a systematic causal relationship running from Euromarket growth to growth in international reserves.

The answer to the second question—that of the role of the international capital markets in the adjustment process—is less clear cut. Credit conditions in the private capital markets may be unduly expansionary even if there is no evidence that debtor countries are adding to their holdings of international reserves. Indeed, continuous short-term official foreign borrowing by a country to finance a payments deficit is often regarded as prima facie evidence of inadequate adjustment policies. The international banking system was extremely effective in providing the credit needed to stretch out the period available for adjustment after the increase in oil prices early in 1974. It may not have been equally effective in limiting credit to countries that failed to take timely and adequate adjustment measures. In recent market conditions of ample liquidity and low profit margins, some banks may have been willing to extend credits to countries in which they consider their exposure to be small, in an attempt to earn somewhat higher interest rates, thereby reducing the need of these countries for recourse to conditional credit from the Fund. In these circumstances, some countries may at times receive financing in amounts and on terms that are not sustainable and that tend to delay adjustment. Unchecked expansion of private international credit could thus detract from the smooth functioning of the balance of payments adjustment process.

These and other considerations have stimulated the resurgence of official interest in the regulation of international banking. Two principal aspects of current discussions should be distinguished. The first involves the desirability and feasibility of measures to control the overall growth of Euromarket aggregates. The monetary authorities in certain countries feel that consideration should be given to coordinated action aimed at controlling the growth of the Euromarket. The recent renewal of the 1971 agreement by which central banks of the Group of Ten refrain from depositing reserve accruals in the market is a step in this direction, although it is widely recognized that the effectiveness of this measure in restraining the overall growth of Eurodeposits is quite limited. A more ambitious proposal is the call for reserve requirements against Eurocurrency deposits. While the advocates of this proposal acknowledge that its implementation would be difficult, they feel that reserve requirements would both reduce the competitive advantage of offshore lending relative to lending from domestic offices and enhance international control over the aggregate stock of Eurocurrency deposits. Other monetary authorities, however, feel that, provided the major industrial countries maintain control over domestic monetary aggregates, additional controls over the Eurocurrency markets are unnecessary.

The second aspect of international banking control is that of supervision for prudential purposes, and in this area there is considerably more agreement about the need for further progress. In particular, it has been proposed in a number of industrial countries that the regulatory agencies take a consolidated balance sheet approach to measuring the level and extent of risk involved in lending to individual countries, i.e., that loans made by foreign branches and subsidiaries of each bank should be considered together with any loans from home offices. At present, most member countries do not collect the necessary data for this type of supervision, the United States being an exception. However, a number of other countries are undertaking to establish such reporting procedures for their banks, and in a few countries considerable progress has been made in that regard. The regulatory agencies in the United States have recently announced a new joint supervisory approach aimed at achieving greater uniformity in the evaluation of risk in banks’ foreign portfolios.

Provision of Conditional Liquidity by the Fund

While the renewed official interest in the supervision of international commercial banking is prompted by the desire to enhance the soundness and resilience of private international financial markets, it is not the primary purpose of the institutions participating in these markets to conduct their operations in a way that will improve the functioning of the international adjustment process. In this regard, the Fund plays a complementary role in the international monetary system: it monitors balance of payments developments, and the mechanism through which it provides conditional liquidity to members is designed to influence the process of payments adjustment through the terms and conditions on which its credits are extended. In particular, the Fund’s assistance to a member is conditional on an explicit understanding that the member will follow macroeconomic policies believed to be appropriate in the light of its situation. Policies that are designed to be of lasting benefit and to treat root causes, not just symptoms, of a country’s balance of payments difficulties may involve short-term costs. In order to enable the Fund to fulfill its function in the adjustment process, members’ access to Fund credit should be large enough to provide justification for accepting these costs. It is important, therefore, to prevent erosion of the real value of the Fund’s resources and to ensure an adequate growth of the potential access of members to its facilities in relation to the rise in the value of international transactions and settlements.

In recent years, the Fund has responded in a number of ways to the need for expansion in members’ access to its resources. In 1978, members’ quotas were augmented from SDR 29 billion to the present total of SDR 39 billion by increases decided under the Sixth General Review of Quotas. In 1976, even before this enlargement had taken effect, the Executive Board had begun the Seventh General Review of Quotas, which was concluded by a Resolution of the Board of Governors, adopted in December 1978, providing for a further increase in quotas by 50 per cent.9 This increase will enlarge the Fund to SDR 59 billion, provided that all members accept the increases proposed for them. These quota increases will become effective for consenting members that have paid their increased subscriptions after members having 75 per cent of total present quotas have accepted their increases.

Augmentation of quotas is not, however, the only means of increasing assistance to member countries. In the years before 1978, when quotas had been stationary for a considerable period—since 1970—the Fund established or enlarged several special facilities aimed at providing additional balance of payments assistance at a given level of quotas. Some of these—the extended Fund facility and the (expanded) compensatory financing and buffer stock facilities, all of which are permanent facilities—have increased members’ access to financial resources without enlarging the total of these resources. For this reason, these facilities cannot be expanded beyond certain limits without putting strain on the liquidity of the Fund. The oil facilities of 1974 and 1975, by contrast, made available resources that the Fund borrowed for this purpose from members in a sufficiently strong balance of payments position, namely, from a number of oil exporting countries and several industrial countries. Although these facilities were thus in a sense “self-financing,” the Fund is committed to repay a lender’s claim if repayment is requested to meet a balance of payments need. This type of facility, too, has thus an effect on the liquidity of the Fund, even though, for a given amount of credit extended, this effect is less pronounced than that which accompanies special facilities financed from the Fund’s regular resources.

In order to be able to provide adequate assistance to members with balance of payments problems that are large relative to their quotas, the Fund decided in August 1977 to establish the supplementary financing facility, which, like the oil facilities, will make available resources borrowed by the Fund from members. This facility entered into force in February 1979, after 13 members (or institutions) had agreed to make available resources amounting to more than SDR 7¾ billion. It is designed to augment the resources available to meet the need of members requiring assistance in larger amounts and for a longer period than would be available under the Fund’s regular tranche policy. The facility will permit the extension, over periods of two to three years, of additional financial assistance to members in conjunction with use of the ordinary resources of the Fund made available under stand-by arrangements in the upper credit tranches or under extended arrangements. These credits will be tied to the adoption of effective programs of adjustment.

Assessment of Reserve Adequacy

The adequacy of international liquidity has been profoundly affected by major changes in the international monetary system in recent years. Most importantly, the large expansion in international banking and the access to such banking funds that many countries now enjoy have gone far toward eliminating the risk of a global deficiency in reserves. International banking has come to play a major role in the financing of payments imbalances, transferring financial resources from surplus to deficit countries in accordance with market incentives. Conditional lending by the Fund, although small in relation to the volume of private international credit, serves an important function by being primarily oriented toward strengthening the balance of payments adjustment process. The growth of its resources and facilities has, over time, permitted the Fund to perform this function on a scale consonant with rising trends in the value of international transactions and settlements.

The Composition of Official Foreign Exchange Reserves and the Role of the SDR

Since the adoption by many Fund members of exchange arrangements permitting greater flexibility of rates, exchange rate movements, particularly among the currencies widely held as part of official reserves, have become a more prominent source of variation in the relative values of international reserve assets. Management of reserve assets has gained importance for monetary authorities and their currency preferences, in addition to those of private holders, constitute a potentially important element in the determination of exchange market developments. Many factors affect authorities’ decisions on the size of their international reserves, the proportion to be held in the form of foreign exchange, and the particular reserve currencies to be included in the portfolio. In addition to concerns about safety, liquidity, and yield, the main considerations have tended to be a country’s exchange arrangements and the structure of its trade and payments.

As a result of the predominant role that the United States has played in international trade and finance, the largest part by far of countries’ foreign exchange reserves has been held in U.S. dollars. Available data on the currency composition of official foreign exchange reserves indicate that the U.S. dollar continues to be the predominant reserve currency. On the basis of reserve statistics for a sample of 76 Fund members, there is evidence of a shift out of sterling, holdings of which were reduced from 8 per cent of the foreign exchange reserves of these countries in 1970 to less than 2 per cent in 1978. The decline in sterling holdings was accompanied by a net increase in holdings of deutsche mark and a small number of other currencies, which did not, however, include the U.S. dollar. Nor has the share of dollar holdings in official foreign exchange reserves declined. Throughout the period since 1970, dollar-denominated assets have remained at roughly four fifths of total official holdings of foreign exchange reserves, despite the valuation effect of significant movements in the exchange rates of other reserve currencies against the dollar.

Although diversification of official foreign exchange reserves does not appear to have been an important cause of exchange rate changes or reserve flows during the past several years, it is conceivable that, in the long run, countries might not wish to hold their reserves so overwhelmingly in a single currency as they have done under the circumstances prevailing in the past. If countries decided, on a substantial scale, to hold other currencies rather than dollars in their reserves, this process of diversification could be disturbing to exchange markets and would lead to a multicurrency reserve practice containing the risk of disruptive short-term switches in the composition of reserves. These considerations suggest the desirability of a larger role for the SDR in members’ reserves. The modalities of Fund action in this regard include allocation of SDRs, enhancement of their attractiveness, and, perhaps, the creation of a substitution account.

The amended Articles of Agreement refer to the objective of “making the special drawing right the principal reserve asset in the international monetary system” (Article VIII, Section 7 and Article XXII). This goal is viewed as a long-term means of reducing the asymmetries and instabilities inherent in a system whose main reserve assets are individual national currencies. In order for the SDR to play a wider role in the system, it must have characteristics that make it an attractive asset to be held, along with currency balances, in members’ official reserves. From this point of view, the most important characteristics of the SDR are its valuation, its interest rate, and the diversity of uses to which it can be put.

In line with these considerations and with obligations under the Articles of Agreement, the Executive Board considered and decided upon a number of measures during 1978 that would enhance the role of the SDR in the international monetary system. These included several decisions designed to expand the use of the SDR, to raise the interest rate, and to halve the obligation to reconstitute SDR holdings after use. (See Chapter 3.)

In December 1978, the Fund decided to resume the allocation of SDRs at a rate of SDR 4 billion per annum for a period of three years commencing at the beginning of 1979. An important consideration in this decision was the objective of making the SDR the principal reserve asset in the system. No allocations of SDRs had taken place since 1972, and with the rapid rise in official holdings of reserve currencies the share of SDRs in international liquidity had progressively declined. Exclusive reliance on the accumulation of reserve currencies to provide for desired increases in reserves would not be compatible with enhancing the role of the SDR. In view of the highly elastic supply of reserves, a substantial portion of any SDR allocation could, in effect, be substituted for increases in official foreign exchange holdings that would occur in the absence of the allocation. The recent decision to allocate SDRs is thus unlikely to lead to a corresponding net increase in reserves. Moreover, one fourth of the subscription payment on the occasion of the quota increase under the Seventh General Review of Quotas is to be paid in SDRs. This payment will temporarily divert about SDR 5 billion, or more than one year’s allocation, from members’ holdings to the Fund, where they will be used in making loans to members.

A further aspect of the general question of reserve composition is currently under discussion. This is the consideration of the possible establishment of a substitution account, to be administered by the Fund, that would accept deposits of foreign exchange from members on a voluntary basis in exchange for an equivalent amount of SDR-denominated claims. The concept of such an account had already come under discussion in the Committee on Reform of the International Monetary System (the Committee of Twenty). The renewed interest in it results from concern with the long-term development of the international monetary system, and with the contribution that such a scheme might make toward promoting the role of the SDR. In this context, a substitution account would permit a change in the composition of members’ reserves unaccompanied by potentially disturbing transactions in foreign exchange markets. While there appears to be broad support among Fund members for consideration of such an account, the problems are complex, and the Fund is now reviewing all aspects of this question.

Statistical Annex
Table 18.Distribution of Reserves, End of Years 1950, 1960, 1970, and 1974–781(In billions of SDRs)
19501960197019741975197619771978
Industrial countries
Austria0.71.82.83.83.83.54.6
Belgium-Luxembourg0.81.52.84.45.04.54.74.5
Canada1.82.04.74.84.55.03.83.5
Denmark0.10.30.50.80.70.81.42.5
France0.82.35.07.210.88.48.410.7
Germany, Federal Republic of0.27.013.626.526.530.032.741.4
Italy0.73.35.45.74.15.79.611.4
Japan0.61.94.811.010.914.319.125.7
Netherlands0.51.93.25.76.16.46.65.8
Norway0.10.30.81.61.91.91.82.2
Sweden0.30.50.81.42.62.13.03.4
Switzerland1.62.35.17.48.911.211.416.6
United Kingdom4.85.12.85.74.73.617.313.1
United States24.319.414.513.113.615.816.015.0
Total, industrial countries36.848.565.897.9104.1113.5139.5160.4
Primary producing countries
More developed countries
Other European countries21.52.35.612.411.111.812.917.1
Australia, New Zealand, South Africa2.01.33.05.04.24.03.02.9
Subtotal, more developed primary
producing countries3.53.68.517.315.315.815.920.0
Less developed countries
Major oil exporting countries31.32.35.038.448.356.162.246.24
Other less developed countries
Other Western Hemisphere52.32.24.59.78.613.116.722.3
Other Middle East61.10.71.63.94.45.06.27.2
Other Asia73.72.75.89.810.715.418.220.2
Other Africa80.50.92.02.42.42.73.13.1
Subtotal, other less
developed countries7.66.613.925.926.136.144.252.8
Subtotal, less developed countries9.399.018.964.374.392.3106.399.04
Total, primary producing countries12.812.627.481.689.7108.1122.3119.04
Total49.661.293.2179.5193.8221.6261.7279.44
Source: International Financial Statistics.

Official reserves of Fund members except Romania, plus the Netherlands Antilles and Switzerland. In addition to the holdings covered in IFS, the figures for 1950 and 1960 include amounts incorporated in published U.K. reserves in 1966 and 1967 from proceeds of liquidation of the U.K. official portfolio of dollar securities. For a number of countries stock reserve figures may differ from those published in national sources because of differences in valuation of gold, which in IFS is valued at SDR 35 per ounce. Totals may not add to figures shown because of rounding and because some totals include unpublished data for component areas.

Finland, Greece, Iceland, Ireland, Malta, Portugal, Spain, Turkey, and Yugoslavia.

Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. See footnote 4.

Beginning with 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.

Argentina, the Bahamas, Barbados, Bolivia, Brazil, Chile, Colombia, Costa Rica, the Dominican Republic, Ecuador, El Salvador, Grenada, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, the Netherlands Antilles, Nicaragua, Panama, Paraguay, Peru, Suriname, Trinidad and Tobago, and Uruguay.

Bahrain, Cyprus, Egypt, Israel, Jordan, Lebanon, the Syrian Arab Republic, the Yemen Arab Republic, and the People’s Democratic Republic of Yemen.

Afghanistan, Bangladesh, Burma, China, Fiji, India, Korea, Lao People’s Democratic Republic, Malaysia, Nepal, Pakistan, Papua New Guinea, the Philippines, Singapore, Sri Lanka, Thailand, Viet Nam, and Western Samoa.

Benin, Burundi, Cameroon, the Central African Empire, Chad, Congo, Ethiopia, Gabon, The Gambia, Ghana, Ivory Coast, Kenya, Liberia, Madagascar, Malawi, Mali, Mauritania, Mauritius, Morocco, Niger, Rwanda, Senegal, Sierra Leone, Somalia, Sudan, Swaziland, Tanzania, Togo, Tunisia, Uganda, Upper Volta, Zaïre, and Zambia.

Includes non-oil less developed countries not assigned to one of the geographical areas.

Source: International Financial Statistics.

Official reserves of Fund members except Romania, plus the Netherlands Antilles and Switzerland. In addition to the holdings covered in IFS, the figures for 1950 and 1960 include amounts incorporated in published U.K. reserves in 1966 and 1967 from proceeds of liquidation of the U.K. official portfolio of dollar securities. For a number of countries stock reserve figures may differ from those published in national sources because of differences in valuation of gold, which in IFS is valued at SDR 35 per ounce. Totals may not add to figures shown because of rounding and because some totals include unpublished data for component areas.

Finland, Greece, Iceland, Ireland, Malta, Portugal, Spain, Turkey, and Yugoslavia.

Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. See footnote 4.

Beginning with 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.

Argentina, the Bahamas, Barbados, Bolivia, Brazil, Chile, Colombia, Costa Rica, the Dominican Republic, Ecuador, El Salvador, Grenada, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, the Netherlands Antilles, Nicaragua, Panama, Paraguay, Peru, Suriname, Trinidad and Tobago, and Uruguay.

Bahrain, Cyprus, Egypt, Israel, Jordan, Lebanon, the Syrian Arab Republic, the Yemen Arab Republic, and the People’s Democratic Republic of Yemen.

Afghanistan, Bangladesh, Burma, China, Fiji, India, Korea, Lao People’s Democratic Republic, Malaysia, Nepal, Pakistan, Papua New Guinea, the Philippines, Singapore, Sri Lanka, Thailand, Viet Nam, and Western Samoa.

Benin, Burundi, Cameroon, the Central African Empire, Chad, Congo, Ethiopia, Gabon, The Gambia, Ghana, Ivory Coast, Kenya, Liberia, Madagascar, Malawi, Mali, Mauritania, Mauritius, Morocco, Niger, Rwanda, Senegal, Sierra Leone, Somalia, Sudan, Swaziland, Tanzania, Togo, Tunisia, Uganda, Upper Volta, Zaïre, and Zambia.

Includes non-oil less developed countries not assigned to one of the geographical areas.

Table 19.Composition of Reserve Change, 1970–781(In billions of SDRs)
197019711972197319741975197619771978
Net annual transactions in reserves
Gold
Monetary gold0.3-0.10.2-0.4-0.3-0.3
Gold transactions (acquisitions—) by IMF, BIS, and
European Fund-2.2-1.0-0.50.20.40.5
Countries’ gold reserves-1.9-1.1-0.3-0.1-0.20.10.2
Special Drawing Rights
Allocation of SDRs3.43.03.0
IMF holdings of SDRs (increase—)-0.3-0.2-0.10.10.1-0.1-0.1-0.5
Countries’ SDR holdings3.12.82.80.10.1-0.1-0.1-0.5
Reserve position in the Fund
Use of IMF credit-0.8-1.9-0.3-0.12.73.75.20.5-2.8
IMF gold transactions (inflow +)21.60.40.1-0.1-0.6-0.5
IMF transactions in SDRs (inflow +)0.30.20.1-0.1-0.10.10.10.5
IMF surplus (increase—)-0.1
Reserve position in the Fund1.0-1.3-0.22.73.85.10.4-3.2
Official foreign exchange holdings
Official claims on the United States37.827.410.04.78.54.311.330.324.6
Other official claims4.66.611.09.616.42.710.514.89.2
Official sterling claims on United Kingdom0.51.70.70.32.7-1.1-2.2-0.1-0.3
Official deutsche mark claims on Federal Republic
of Germany0.8-0.40.40.7-0.10.21.41.12.1
Official French franc claims on France0.20.20.30.2-0.2-0.1-0.10.6
Other official claims on other countries denominated
in the debtor’s own currency40.1-0.10.6-0.41.31.00.62.05
Claims on European Monetary Cooperation Fund0.4-0.40.7
Dollar claim of Bundesbank on Bank of Italy1.6-0.40.2-0.3-1.2
Identified official holdings of Eurodollars65.50.96.43.713.84.67.410.40.35
Identified official holdings of other Eurocurrencies40.72.12.00.11.7-0.23.82.25
Identified official claims on IBRD and IDA0.10.10.40.80.7-0.3
Residual7-2.53.41.31.7-1.1-4.32.2-0.32.85
Total official foreign exchange holdings12.434.020.914.325.07.021.845.233.75
Effect of valuation changes on stock of reserves8-4.4-8.4-0.53.61.1-4.9-8.7
Total reserve change14.629.923.55.827.214.327.840.122.05
Sources: International Financial Statistics and Fund staff information and estimates.

The official reserves covered in this table are described in Table 18, footnote 1. Table 20 provides comparable stock data concerning official holdings of foreign exchange. Note, however, that in some years changes in outstanding stocks do not coincide with the estimated transactions values recorded here because of changes in the relationship between the currency of denomination and the SDR. Footnote 1 to Table 20 notes these cases.

Variations in IMF gold investments and gold deposits are excluded because they do not give rise to net creditor positions in the Fund.

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

The underlying stock data were not available prior to 1970; therefore, the value of transactions in these assets is included with the residuals until 1971.

The decrease resulting from the change in coverage of Saudi Arabia’s foreign exchange holdings has been eliminated. See footnote 4 to Table 18.

See Table 20 for more details concerning these Fund staff estimates.

Table 20, footnote 3, provides details.

Countries’ official holdings of foreign exchange are denominated in U.S. dollars or other national currencies. The value of most currencies has changed from time to time in relation to the SDR, the unit in which the figures in these annex tables are expressed. Such changes affect reserve stocks, which are calculated by converting the original currency figures into SDRs at the rates prevailing on each day in question. These valuation changes are shown in this line; the other changes shown in the table (except the grand total below) are thus solely those resulting from international transactions.

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

The official reserves covered in this table are described in Table 18, footnote 1. Table 20 provides comparable stock data concerning official holdings of foreign exchange. Note, however, that in some years changes in outstanding stocks do not coincide with the estimated transactions values recorded here because of changes in the relationship between the currency of denomination and the SDR. Footnote 1 to Table 20 notes these cases.

Variations in IMF gold investments and gold deposits are excluded because they do not give rise to net creditor positions in the Fund.

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

The underlying stock data were not available prior to 1970; therefore, the value of transactions in these assets is included with the residuals until 1971.

The decrease resulting from the change in coverage of Saudi Arabia’s foreign exchange holdings has been eliminated. See footnote 4 to Table 18.

See Table 20 for more details concerning these Fund staff estimates.

Table 20, footnote 3, provides details.

Countries’ official holdings of foreign exchange are denominated in U.S. dollars or other national currencies. The value of most currencies has changed from time to time in relation to the SDR, the unit in which the figures in these annex tables are expressed. Such changes affect reserve stocks, which are calculated by converting the original currency figures into SDRs at the rates prevailing on each day in question. These valuation changes are shown in this line; the other changes shown in the table (except the grand total below) are thus solely those resulting from international transactions.

Table 20.Official Holdings of Foreign Exchange, by Type of Claim, End of Years 1970–781(In billions of SDRs)
197019711972197319741975197619771978
Official claims on United States223.846.756.755.462.768.979.2103.8120.2
Official sterling claims on United Kingdom5.77.38.16.58.36.43.23.32.7
Official deutsche mark claims on Fed. Rep. of Germany1.31.01.42.22.42.54.25.78.3
Official French franc claims on France0.60.81.01.21.11.10.90.81.5
Other official claims on countries denominated in the
debtor’s own currency0.91.00.91.61.52.73.94.76.9
Claims on European Monetary Cooperation Fund0.40.7
Dollar claim of Bundesbank on Bank of Italy1.61.31.51.2
Identified official holdings of Eurocurrencies
Eurodollars
Industrial countries5.13.44.44.76.06.57.910.29.9
Primary producing countries
More developed countries1.61.73.23.43.03.83.74.87.1
Less developed countries3.85.49.210.322.827.734.038.730.8
Western Hemisphere1.01.63.64.05.05.65.97.38.7
Middle East0.61.11.92.312.016.719.120.612.1
Asia1.11.12.02.73.03.55.97.88.2
Africa1.11.61.71.32.82.03.12.91.8
Memorandum item: Major oil exporting countries1.62.83.94.015.620.723.725.814.9
Total identified Eurodollars10.510.416.818.531.838.045.653.647.7
Other Eurocurrencies0.41.13.25.35.87.27.612.214.7
Total identified holdings of Eurocurrencies10.911.620.023.837.645.253.265.862.4
Identified claims on IBRD and IDA0.70.60.60.60.91.82.52.12.0
Residual31.76.17.310.010.27.011.212.416.2
Total official holdings of foreign exchange45.475.095.9101.8126.3136.9159.8200.1220.8
Sources: International Financial Statistics and Fund staff information and estimates.

The official foreign exchange reserves covered in this table are described in Table 18, footnotes 1 and 4. The figures for 1973 include official French claims on the European Monetary Cooperation Fund. This table includes the estimated change in the value of holdings owing to the general realignment of currencies in 1971, the U.S. dollar devaluation in 1973, and the widespread floating of currencies since 1974; see also footnote 8 to Table 19.

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. It also includes asymmetries arising because data on U.S. and U.K. currency liabilities are more comprehensive than data on official foreign exchange as shown in IFS.

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

The official foreign exchange reserves covered in this table are described in Table 18, footnotes 1 and 4. The figures for 1973 include official French claims on the European Monetary Cooperation Fund. This table includes the estimated change in the value of holdings owing to the general realignment of currencies in 1971, the U.S. dollar devaluation in 1973, and the widespread floating of currencies since 1974; see also footnote 8 to Table 19.

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. It also includes asymmetries arising because data on U.S. and U.K. currency liabilities are more comprehensive than data on official foreign exchange as shown in IFS.

1These comprise Belgium, Denmark, France, the Federal Republic of Germany, Ireland, Italy, Luxembourg, and the Netherlands. The United Kingdom is a member of the EMS although it does not participate for the time being in the intervention arrangements.
2Participating countries whose rates were previously floating against other participants’ currencies are permitted to have movements in their bilateral rates of up to 6 per cent around parity. Italy decided to make of this option.
3These figures do not include Democratic Kampuchea.
4The following members had a change in the classification of their exchange arrangements in 1978: Argentina, Bahrain, Chile, Ghana, Guinea-Bissau, Indonesia, Iran, Jamaica, Norway, Papua New Guinea, Peru, Sierra Leone, Thailand, the United Arab Emirates, Viet Nam, and Zaïre. During the first six months of 1979, there were changes in classification for China, Equatorial Guinea, France, India, Ireland, Italy, Jamaica, New Zealand, South Africa, Tanzania, Uruguay, and Western Samoa. These changes include both changes in exchange arrangements and reclassifications of existing arrangements resulting from discussions between the Fund staff and national authorities.
5The measure of variability in Table 13 gives the combined effect of short-run and intermediate-term variability, as defined earlier in this chapter.
6In other words, a depreciation of the effective exchange rate, corrected for the domestic rate of inflation relative to inflation rates in trading-partner countries.
7See Statistical Annex Table 19, especially footnotes 5 and 8.
8For this purpose, the value of gold is calculated on the basis of either the average market price of the six preceding months or the average market price of the penultimate working day, whichever is the lower. The participating countries are listed on page 40, footnote 1.
9Board of Governors Resolution No. 34-2, adopted December 11, 1978 and reproduced in Appendix II.

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