Copyright ©2002, South-Western College Publishing International Economics By Robert J. Carbaugh 8th Edition Chapter 18: International Banking: Reserves, Debt and Risk

Carbaugh, Chap International reserves Nature of international reserves  Reserves of foreign currency and other suitable assets are used to finance payments imbalances  Reserves allow a nation to take more time to correct BOP disequilibrium (but may also delay needed action)  Demand for reserves depends on the monetary value of international transactions and the size of payments imbalances

Carbaugh, Chap International reserves Demand for international reserves  Main factor in demand for reserves is the nature of the adjustment mechanisms to correct BOP imbalances  Exchange rate flexibility is a crucial element of the adjustment process  Key use for reserves is to intervene in currency markets to defend an exchange rate  The more a nation is willing to let its currency float, the less it will need sizable reserves

Carbaugh, Chap International reserves Demand for international reserves  Other factors affecting demand for reserves:  Automatic adjustment mechanisms that respond to payments imbalances  Economic policies used to correct payments imbalances  International coordination of economic policies  Level of world prices and income

Carbaugh, Chap Demand for reserves and exchange rate flexibility International reserves

Carbaugh, Chap International reserves Supply of international reserves  International reserves may be owned by nations or may be borrowed if reserves on hand prove insufficient  Owned reserves:  Reserve currencies (US dollar, German mark, etc,)  Gold - once central, now rarely used  Special drawing rights  Borrowed reserves can come from the IMF and other official arrangements, or can be borrowed from major commercial banks

Carbaugh, Chap International reserves Gold as a reserve asset  Gold was originally used as currency, but it began to be replaced by paper money and bank deposits  Post-World War I inflation prompted many nations to return to a gold standard, where all currency in circulation was backed by gold  Gold standard collapsed during the Great Depression, to be replaced by a gold exchange standard after World War II

Carbaugh, Chap International reserves Gold as a reserve asset (cont’d)  The US dollar was set to be convertible to gold at a fixed rate, and the dollar became a key reserve asset  Stresses from persistent US payments deficits brought an end to the gold exchange standard by 1973, and in 1975 gold was removed as an international reserve asset

Carbaugh, Chap International reserves Special Drawing Rights (SDRs)  Because a gold standard limits the amount of currency available to the supplies of gold on hand, the IMF created the SDR to increase international liquidity  SDRs represent rights to draw foreign currencies from the IMF to use for settlement purposes; they are allocated to IMF members proportionally  SDRs are pegged to a basket of key international currencies, and are useful because they are not tied to any one currency

Carbaugh, Chap International reserves Facilities for borrowing reserves  IMF drawings - members may purchase foreign currency with their own currency, with limits and sometimes conditions  General Arrangements to Borrow - major industrial nations agreed to make further reserves available to the IMF if needed  Swap arrangements - major industrial nations agree to swap currencies with each other; can be done more quickly and less visibly than Fund drawings

Carbaugh, Chap International reserves Facilities for borrowing reserves (cont’d)  Special financing facilities - to compensate mostly developing countries which face hardships which are transient or beyond their control: Compensatory Financing Facility, Oil Facility, Buffer Stock Facility  Commercial bank lending

Carbaugh, Chap International lending International lending risk  Credit risk - potential for financial default  Country risk - whether government policies will help or hinder the servicing of the loan  Currency risk - whether devaluations or exchange controls will interfere with the repayment of the loan

Carbaugh, Chap International lending International debt problems  Many developing nations borrowed heavily on easier terms in the 1970s because major banks were flush with deposits from oil producing states  In the 1980s, rising interest rates caused payments on the variable rate international loans to increase, and the ability of many of these major debtor nations to service their loans came into question

Carbaugh, Chap International lending International debt problems (cont’d)  Most loans were denominated in dollars, meaning that these nations had to run current account surpluses to earn foreign exchange with which to make loan payments - just as the industrial nations went into a recession  Measures used to gauge debt burden: debt-to-export ratio; debt service/export ratio

Carbaugh, Chap International lending Options for debt-service problems  Nations can stop making payments - but there are severe consequences  Service debt at any cost - but may be politically impossible  Reschedule the debt - stretch out repayment schedule (but pay more overall)  Obtain emergency loans from the IMF - but conditionality may be hard to stomach

Carbaugh, Chap International lending Reducing bank exposure to developing- country debt  Loan sales in secondary market  Debt buybacks or debt-for-debt swaps  Debt-for-equity swaps  Debt forgiveness

Carbaugh, Chap International lending Eurocurrency markets  Deposits in dollars and other major currencies in banks outside the US  Main advantage over US deposits is interest rate differential  Eurocurrency market facilitates financing of trade and investment, but there are concerns that some of the banks in this market do not face the same regulations as do large banks in the industrial nations