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Demand for international liquidity : the developing countries. Otchere, Danny Kit 1968

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THE DEMAND FOR INTERNATIONAL LIQUIDITY: THE DEVELOPING COUNTRIES by DANNY KIT OTCHERE B.Sc. (Econ.) University of Ghana, 1966 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF ARTS i n the Department of Economics We accept t h i s thesis as conforming to the required standard THE'UNIVERSITY OF BRITISH COLUMBIA May '196 8 In presenting t h i s thesis i n p a r t i a l f u l f i l m e n t of the requirements for an advanced degree at the University of B r i t i s h Columbia, I agree that the Library s h a l l make i t f r e e l y available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the Head of my Department or by his representatives. I t i s understood that copying or publication of t h i s thesis for f i n a n c i a l gain s h a l l not be allowed without my written permission. Department of Economies The University of B r i t i s h Columbia Vancouver 8, Canada Date May, 1968 i ABSTRACT The f o l l o w i n g a n a l y s i s i s ah a t t e m p t t o a p p l y some o f t h e c o n c e p t s o f c u r r e n t m o n e t a r y t h e o r y t o t h e q u e s t i o n o f demand f o r i n t e r n a t i o n a l l i q u i d i t y . The e s s a y i s , however, l i m i t e d t o t h e l i q u i d i t y and d e v e l o p m e n t p r o b l e m s o f d e v e l o p i n g c o u n t r i e s . A v a i l a b l e s t a t i s t i c a l e v i d e n c e f o r t h e p e r i o d between 1951 and 1964 i n d i c a t e s t h a t t h e d e v e l o p i n g c o u n t r i e s , e x c l u d i n g t h e m a j o r o i l - p r o d u c i n g c o u n t r i e s , have e x p e r i e n c e d a c o n t i n u e d d e c l i n e i n t h e i r r a t i o s o f r e s e r v e s t o i m p o r t s -a common measure o f t h e " a dequacy" o f i n t e r n a t i o n a l r e s e r v e s . T h i s t r e n d , i t has b e e n s u g g e s t e d , seems t o i m p l y . t h a t t h e d e v e l o p i n g c o u n t r i e s have b e e n f a c i n g a l i q u i d i t y c r i s i s o f t h e i r own, q u i t e a p a r t f r o m t h e more w i d e l y d i s c u s s e d p r o b l e m o f t h e i n a d e q u a c y o f i n t e r n a t i o n a l l i q u i d i t y i n t h e w o r l d c o n t e x t . V a r i o u s e x p l a n a t i o n s f o r t h i s l i q u i d i t y c r i s i s have b e e n o f f e r e d , a l l o f w h i c h seem t o f a l l i n t o one o f t h r e e c a t e g o r i e s : v i z . , what may be t e r m e d as a) t h e " p r o f l i g a c y " h y p o t h e s i s , b) t h e " s t a g e o f g r o w i n g p a i n s " h y p o t h e s i s , and c) t h e " p r i m i t i v e " r a t i o n a l c h o i c e h y p o t h e s i s . N o t a l l e c o n o m i s t s a g r e e on w h i c h h y p o t h e s e s a r e i m p o r t a n t ; n e i t h e r a r e t h e y s u r e o f t h e e x a c t r e l a t i o n between them. I n o u r ; a n a l y s i s , t h e f i r s t h y p o t h e s i s i s r e j e c t e d f o r n o t d o i n g f u l l j u s t i c e t o t h e a n a l y s i s o f t h e p r o b l e m s i n v o l v e d ; on t h e o t h e r hand, t h e o t h e r two a r e a c c e p t e d as s u g g e s t i v e b u t i n c o m p l e t e s i n c e t h e y a r e n o t bound t o g e t h e r i n t o any c o n s i s t e n t t h e o r y . I t i s t h e p u r p o s e . o f t h i s e s s a y t o d e v e l o p a c o n s i s t e n t t h e o r e t i c a l s t r u c t u r e b a s e d on t h e a l t e r n a t i v e h y p o t h e s i s t h a t : "as a m a t t e r o f c i r c u m s t a n t i a l p o l i c y " , i t m i g h t be r a t i o n a l c h o i c e on t h e p a r t o f a d e v e l o p i n g economy t o u t i l i z e some o f i t s a c c u m u l a t e d s t o c k o f r e s e r v e s t o f i n a n c e d e v e l o p m e n t e x p e n d i t u r e s . Our a n a l y s i s s t a r t s f r o m t h e p r o p o s i t i o n t h a t a m o n e t a r y a u t h o r i t y ( d e v e l o p i n g c o u n t r y ) c a n c h o o s e a l e v e l o f r e s e r v e s i t w i l l h o l d . As a r e s u l t , i f t h e d r a w i n g down o r a c c u m u l a t i o n o f r e s e r v e s i s a d e l i b e r a t e a c t i o n on i t s p a r t , t h e n i n p r i n c i p l e , a demand f u n c t i o n f o r r e s e r v e s c a n be s p e c i f i e d . O f c o u r s e , t h e " p r i m i t i v e " r a t i o n a l c h o i c e m o d e l s u g g e s t s t h i s b u t o u r m a i n c o n t r i b u t i o n l i e s i n t h e e x t e n s i o n o f t h e i r framework by a p p l y i n g t h a t b r a n c h o f m o n e t a r y t h e o r y known as t h e t h e o r y o f p o r t f o l i o s e l e c t i o n . I n t h i s way, we a r e a b l e t o b a s e t h e w h o l e a n a l y s i s o f t h e demand f o r r e s e r v e s on t h e t h e o r y o f t h e p r e c a u t i o n a r y demand f o r money i n a w o r l d o f u n c e r t a i n t y . Our b a s i c a p p r o a c h , therefore, d i f f e r s from that of the more common analyses which are based on a flow approach of the transaction demand for money, e.g., the quantity theory of money. Indeed, the application of the p o r t f o l i o theory offers the i n t e r e s t i n g paradoxical r e s u l t that the developing countries have a low precautionary demand for reserves even though th e i r reserve needs seem to be great. I t i s further found that by maintaining low reserve l e v e l s , these countries choose a risky p o r t f o l i o ; but that such a choice might be a r a t i o n a l economic behaviour because there i s a simultaneous expectation that, other things being equal, drawing down reserves to finance investment i n c a p i t a l formation may lead to future increases i n per capita consumption. No attempt i s made to subject our alternative hypo-thesis to any testing. That presently w i l l l i e outside the scope of thi s essay. From a po l i c y standpoint, however, the alternative hypothesis suggests that the quantity of reserves demanded at a p a r t i c u l a r moment of time can a f f e c t the terms on which some developing countries w i l l invest i n c a p i t a l formation (that i s , finance development expenditures), although i t i s not only th i s variable that can do so. Secondly, i t demonstrates that, given the growth problems of developing countries, i t might pay i f the monetary authorities u t i l i z e some of the country's accumulated stock of reserves to finance development expenditures i v F i n a l l y , we c o n c l u d e t h a t t h e c o s t s o f d e v e l o p m e n t i n d e v e l o p i n g c o u n t r i e s c a n be m i n i m i z e d i f more l i b e r a l m easures were e f f e c t e d t o p r o v i d e f o r a l a r g e r i n f l o w o f c a p i t a l a i d t o t h e s e c o u n t r i e s b o t h f r o m d e v e l o p e d c o u n t r i e s and o t h e r i n t e r -n a t i o n a l i n s t i t u t i o n s c o n c e r n e d w i t h d e v e l o p m e n t a i d . The same n o t i o n a p p l i e s t o t h e p o l i c i e s u n d e r l y i n g t h e s e c o u n t r i e s ' d r a w i n g s i n t h e c r e d i t t r a n c h e s a t t h e I n t e r n a t i o n a l M o n e t a r y Fund. v i TABLE OF CONTENTS Page ABSTRACT i ACKNOWLEDGEMENTS V TABLE OF CONTENTS * v i LIST OF TABLES : v i i i LIST OF FIGURES i x CHAPTER I INTRODUCTION ; . . . 1 1.1 The Concept of International L i q u i d i t y ... 2 I.1A Unconditional vs. Conditional L i q u i d i t y . 3 1.2 International L i q u i d i t y Position of the Developing Countries 7 I.2A Group Differences 8 1. 3 COMMON HYPOTHESES 13 I.3A The "Profligacy" Hypothesis ............. 13 I.3B The "Stage of Growing Pains" Hypothesis . 14 I.3C The "Primitive" Rational Choice Hypo-thesis ; 16 I. 3D An Alternative Hypothesis 18 II THE DEMAND FOR INTERNATIONAL LIQUIDITY 21 II . The Existi n g Literature 21 II . 1 The Level of Imports Approach 21 II . 1A The Transactions Aspect 22 II. IB The Precautionary Aspect 23 II.1C The Optimal Level Aspect 26 II.ID Empirical Findings on the "Level of Imports" Approach 27 II. 2 The Money Supply Approach 30 II.2A Some Empirical Findings of the Money Supply Approach ; . 31 v i i II.3 Application of the Keynesian L i q u i d i t y Preference Theory ........ 32 II. 4 Conclusion i . . . . . 33 II. 5 THE THEORETICAL FRAMEWORK 35 II. 5A The P o r t f o l i o Approach 36 11.6 The Application of the P o r t f o l i o Approach 40 II . 6A Assumptions 40 II.6B A Developing Country's Demand for L i q u i d i t y . . . ; 42 B i . The Cost of Reserve Accumulation 42 B i i . The Rate of Return on Ca p i t a l Formation ; 44 B i i i . The Risk of Inadequate Reserves . . . i i . 46 Biv. The Cost of Manipulating the Level of Imports 49 Bv. Conclusions 56 11.7 USE OF THE INTERNATIONAL MONETARY FUND 58 II.7A P o l i c i e s governing the Use . of Fund Resources 60 Ai . . The Credit Tranches 62 II.7B Transactions with Developing Countries • 64 11.8 Some Modifications of the Analysis ... 68 III INTERNATIONAL MONETARY REFORM 71 III..1 K i l l i n g Two Birds with one Stone. 72 i . The Stamp Plan 73 i i . The Scitovsky Plan 74 i i i . UNCTAD Experts' Proposal 76 III.2A Alternative Plans 79 i . The Credit F a c i l i t i e s Approach 80 i i . The Bernstein. Plan - 82 i i i . The Special Drawing Right Proposal ... 85 i i i a D i s t r i b u t i o n of the New Reserves 86 i i i b Implications for the Developing Countries 87 II I . 3 Conclusion 89 IV SUMMARY AND CONCLUSIONS .* 92 IV. 1 Summary 92 IV. 2 Implications for Poli c y 95 IV. 3 CONCLUSION 98 BIBLIOGRAPHY 101 APPENDIX 108 v i i i LIST OF TABLES Page I COUNTRIES1 RESERVES AS A PERCENTAGE OF IMPORTS (1951 - 1964) 9 II COUNTRIES' OFFICIAL RESERVES 59 i x LIST OF FIGURES FIGURE Page I. . P o r t f o l i o Choice by the Wealth holder 39 II. Comparison of Risk Levels of Developed and Developing Countries ... i 52 I I I . P o r t f o l i o Choice by the Developing Country ; 54 V ACKNOWLEDGEMENTS I wish to express many sincere thanks to Dr. Ronald A. Shearer for supervizing t h i s thesis and for his combined i n t e r e s t and advice and guidance through-out the course of thi s study. Also, I am deeply thankful to the other members of the Economics Department and friends whose valuable suggestions and encouragement have been a source of much in s p i r a t i o n to me. F i n a l l y , I wish to express my gratitude to Freda Eldridge for proofreading the manuscript, and to the University of Ghana for t h e i r f i n a n c i a l assistance which made possible my two-year programme at The University of B r i t i s h Columbia. CHAPTER I INTRODUCTION In the l a s t decade, monetary authorities and i n t e r -national i n s t i t u t i o n s have been increasingly concerned about the inadequacy of international l i q u i d i t y i n r e l a t i o n to growing world trade and payments. In one sense, the in t e r e s t of the developing countries"'" i n any reform of the international monetary system i s e s s e n t i a l l y the same as that of a l l other countries. But t h i s i s because any impairment i n the world economy generally affects both the developed and the developing countries a l i k e , although i n varying degrees. However, besides t h i s general i n t e r e s t i n the global problem of international l i q u i d i t y , many economists suggest that the developing nations are experiencing a l i q u i d i t y c r i s i s of t h e i r own as evidenced by a continued decline i n t h e i r i n ternational l i q u i d i t y p o s i t ion. In t h i s way, not only have the developing countries a stake i n the improvement of the international "'"Developing countries are here defined as including a l l of L a t i n America, a l l of Asia except Japan, and a l l of A f r i c a except the Union of South A f r i c a . This i s an arbit r a r y c l a s s i f i c a t i o n since some countries i n thi s group have higher levels of per capita-income than a few countries i n Europe. Note that the qual i f y i n g word, "developing", i s used to imply that these countries are i n a process of growth and development. 2 monetary machinery, but also they must be concerned with t h e i r own position v i s - a - v i s the rest of the world. 1.1: The Concept of International L i q u i d i t y In domestic monetary theory, the term, " l i q u i d i t y " , i s often used to describe the usefulness of a given asset i n meeting l i a b i l i t i e s ; that i s , i t s degree of 'moneyness'. By analogy, i t . i s argued that we should be able to define a class of i n t e r n a t i o n a l l y l i q u i d assets, i . e . , assets which are 2 p a r t i c u l a r l y useful i n meeting international contingencies. The i n t e r n a t i o n a l l i q u i d i t y position of a nation would then depend on i t s holdings of i n t e r n a t i o n a l l y l i q u i d assets. Thus, the "Group of Thirty-Two Economists" defined i t as the command of a country 1s monetary authorities over l i q u i d assets l i k e foreign exchange for use i n intervening i n the foreign exchange 3 market to support the value of i t s currency. This seems to provide a s o l i d basis for empirical work. Unfortunately, however, the international l i q u i d i t y p o s ition of a country i s very d i f f i c u l t to quantify. Internationally l i q u i d assets may take various forms, and these forms may be imperfect substitutes for each other. Moreover, i f we are Compare for example, H.W. Arndt, "The Concept of L i q u i d i t y i n International Monetary Theory", Review of  Economic Studies, Vol. XV, No. 1, (1947-1948) pp.20 - 26. 3 Report on the Deliberations of an International Study Group of Thirty-Two Economists, International Monetary  Arrangements: The Problem of Choice, International Finance Section, Princeton University, 1964, pp.28 - 30. 3 going to include a l l assets which are p o t e n t i a l l y available for intervention i n the foreign exchange market, we must include intangible l i n e s of c r e d i t , p a r t i c u l a r l y lines of c r e d i t among monetary authorities and with international i n s t i t u t i o n s . As a r e s u l t , i t i s not clear that the international l i q u i d i t y p o s i t i o n of even a single country can be unambiguously measured. Indeed, some economists have taken the extreme 4 pos i t i o n that " l i q u i d i t y i s a state of mind". I.1A: Unconditional vs Conditional L i q u i d i t y In principle,.the term, " i n t e r n a t i o n a l . l i q u i d i t y " may be used to cover a country's o f f i c i a l holdings of i n t e r n a t i o n a l l y l i q u i d assets including i t s a b i l i t y to borrow such assets i n t e r n a t i o n a l l y . Typical items entering into the concept are holdings of gold and convertible foreign exchange, claims on international i n s t i t u t i o n s , and entitlements to borrow from international i n s t i t u t i o n s , foreign governments or from 5 . . private sources abroad. For quantitative purposes, i n t e r -national l i q u i d i t y i s often c l a s s i f i e d into "unconditional" and "conditional" l i q u i d i t y . Kenen, P.B. and E.B. Yudin, "The Demand for International Reserves", Review of Economics and S t a t i s t i c s , Vol. 47, No. 3, August, 1965, p.242. 5 For a f u l l e r discussion on the d e f i n i t i o n of the concept, see B.J. Cohen, "A Note on the D e f i n i t i o n of International L i q u i d i t y " , Economia Internazionale, Vol. 17, 1964, pp.491 -501. Cohen feels that the concept should be used appropriately (?) to r e f e r to l i q u i d i t y i n the world context. See also, C.R. Whittlesey, " L i q u i d i t y , International L i q u i d i t y , and the Dollar Problem", Weltwirtschaftliches Archiv, Vol. 93, 1964, pp.242 - 249 4 Unconditional l i q u i d i t y exists i n the form of l i q u i d assets unconditionally at the disposal of a country holding them. Clearly, gold and convertible foreign exchange owned by a country give i t "unconditional" l i q u i d i t y just as part of i t s drawing rights - the gold tranche - at the International 6 Monetary Fund may also be considered as unconditional. On the other hand, conditional l i q u i d i t y , consists i n the p o t e n t i a l access to reserves, an access which i s subject to observance of ce r t a i n conditions as to the use to be made of the funds or as to the general p o l i c i e s to be pursued by the r e c i p i e n t . The International Monetary Fund i s the largest single provider of conditional l i q u i d i t y i n the form of drawing rights under members' quotas. Conditional l i q u i d i t y at the Fund i s manifested c h i e f l y i n the c r e d i t tranches i n which requests for transactions a r e . l i k e l y to be favourably received only when the drawings or stand-by arrangements are intended to support a sound program aimed at establishing or maintaining an enduring s t a b i l i t y of the member's currency at a r e a l i s t i c rate of exchange.• In t h i s way, c r e d i t tranche policy i s d i f f e r e n t from that of the gold tranche since i n the l a t t e r drawings are somewhat automatic when they are made to combat a temporary balance of payments d e f i c i t . A d e tailed discussion on the d i s t i n c t i o n between conditional and unconditional l i q u i d i t y can be found i n J.M. Fleming, "International L i q u i d i t y : Ends and Means", I.M.F. Staff Papers, Vol. 8, 1960/61, pp. 447 - 449. 5 In addition, such i n s t i t u t i o n s as the Bank for Inter-national Settlements and a network of i n t e r - c e n t r a l bank "swap" arrangements provide ad hoc credits as substitutes for reserves. However, i t should be noted that these ad hoc arrangements 7 mainly cater to the needs of the developed countries. Generally, conditional and unconditional l i q u i d i t y cannot just be added up; countries cannot regard them as perfect substitutes. Moreover, except for that held under the International Monetary Fund agreement, conditional l i q u i d i t y cannot be subjected to exact quantitative measurement.^a I t appears to take the form of ad hoc agreements among central banks as needed. These arrangements are not o f f i c i a l l y established as l i n e s of c r e d i t ; and even i f they were, there are no data published on. them. As Machlup noted, the s t a t i s t i c a l measurement of conditional l i q u i d i t y presents problems because: "Measurement of outside-financing f a c i l i t i e s are not always meaningful. Both the l i q u i d i t y of assets (other than the p e r f e c t l y l i q u i d assets counted as monetary reserves) and the a v a i l a b i l i t y of c r e d i t See, A.N. McLeod, Contentious Thoughts on International  L i q u i d i t y , Central Bank of Tobago, (Trinidad, 1967), pp.2 - 9. For example, between 1962 and 1963, there was a substantial growth of mutual c r e d i t arrangements on b i l a t e r a l basis between the United States and various i n d u s t r i a l countries while less formal arrangements were devised for the United Kingdom i n 1961 and again i n 1963. 7a It must be noted that even i n the c r e d i t tranches at the Fund, members may not want to treat l i n e s of credits i n the d i f f e r e n t tranches as perfect substitutes for each other. 6 for any one country depend on the simultaneous demand for l i q u i d funds by others".8 In fact, when we consider only the developing countries, the problem of the s t a t i s t i c a l measurement of conditional l i q u i d i t y becomes r e l a t i v e l y simple. They have no other s i g n i f i c a n t source of conditional l i q u i d i t y except that obtainable at the International Monetary Fund. Consequently, i t i s possible to conceive that t h i s aspect of l i q u i d i t y can be s t a t i s t i c a l l y measured and included i n the international reserve figures of the developing countries. In general, however, member countries of the Fund, including the developing ones, do not regard t h i s type of l i q u i d i t y as quite equal to fr e e l y available reserves, l i k e the drawing rights i n the gold tranche; they therefore do not include conditional l i q u i d i t y i n t h e i r international reserves figures. The convention has been to consider only i n t e r n a t i o n a l l y l i q u i d assets which are held unconditionally - including drawing rights i n the gold tranche - by a country. Although this conventional measurement of i n t e r n a t i o n a l l i q u i d i t y w i l l be followed i n th i s essay,.we s h a l l l a t e r on examine the Fund's a c t i v i t i e s with the developing countries to f i n d out the extent to which the Fund's provision of conditional l i q u i d i t y benefits these countries. The Fund's provision of conditional l i q u i d i t y to these countries has great relevance to our subsequent analysis. F. Machlup, The Need for Monetary Reserves, Reprints i n International Finance, Princeton University Press: Princeton University, October, 1966, No. 5, p . l . 7 1.2; International L i q u i d i t y Position of the Developing Countries From what has been said above, i t w i l l be assumed i n the rest of thi s essay that reserve holdings of the developing countries consist of owned reserves - gold and convertible 9 foreign exchange - and th e i r net I.M.F. positions. Hence, suppose we take as a f i r s t approximation (but even with some reservations), the common measure of the l e v e l of i n t e rnational l i q u i d i t y i n any country as the l e v e l of holdings of gold and foreign exchange reserves plus reserve position i n the Fund r e l a t i v e to the l e v e l of imports, a s t r i k i n g contrast between the experience of the developed and the developing countries i n recent years i s evident. For example, i n 19 51, reserves as percentage of imports for a l l developing countries combined was 67%; but, by 19 64, t h i s r a t i o had declined to 46%. By contrast, the Group of Ten (excluding I.M.F. positions represent claims that countries have on the Fund as a counterpart either to t h e i r gold subscriptions or to the amounts of th e i r currencies drawn by other countries. Here,, we refer exclusively to access to drawing rights i n the gold tranches. Reserve po s i t i o n at the Fund varies from country to country since i n the f i r s t place member quotas d i f f e r ; secondly, the gold tranche at any time depends on how i t i s affected by the Fund transactions i n the member's currency. When a country normally joins the Fund, i t pays 25% of i t s quota i n gold and 75% i n i t s own. currency. The Fund 1s i n i t i a l holding of that currency i s then 75% of quota and the country's gold tranche position i s 25% of the quota. "^H.G. Johnson brings out the p r a c t i c a l l i m i t a t i o n s of this measure i n his a r t i c l e , "International L i q u i d i t y : Problems and Plans", Malayan Economic Review, Vol. VII, No. 1, A p r i l , 1962, pp. 4 - 5 . See also, F. Machlup, Plans for Reform of the International Monetary System, International Finance Section, No. 3, Princeton University, 1964, pp. 15 - 18. 8 the United States) had the r a t i o of t h e i r reserves to imports r i s e from 27% i n 1951 to 38% i n 1964. (See Table I ) . I.2A: Group Differences Such aggregate r a t i o s , however, tend to understate the problem. For, not only did the r a t i o of reserves to imports decline i n these countries but the absolute l e v e l of reserves declined as well, although very s l i g h t l y . Moreover, the very fact that these figures are averages conceals the important observation that for some large groups of developing countries, the decline i n t h e i r i n t ernational l i q u i d i t y p o sition has been even more severe. On the other hand, others experienced an increase i n reserves. As can be seen from Table I, the six major o i l -producing countries had t h e i r reserves as a percentage of imports grow from 60% i n 1951 to 67% i n 1964. One-fourth of the gross reserves of a l l developing countries combined i s concentrated in. these countries, which, however, form a small part of the t o t a l population of a l l developing countries. S i m i l a r l y , the r a t i o for some f i v e countries i n the Far East rose from 53% i n 1951 to 62% i n 1964. 1 1 The t o t a l reserves of these two groups of countries together, equivalent to about $4*5 b i l l i o n , amounted at the end of 1966 to some two-fifths of the t o t a l reserves of the developing countries as a whole. These countries are: Vietnam, Korea, China, Malaysia, and Thailand. 9 TABLE I COUNTRIES RESERVES AS A PERCENTAGE OF IMPORTS (1951 - 1964) (Gold and Foreign Exchange Holdings plus reserve position i n the I.M.F. at the end of the year, related to imports during the year) Countries Reserves as percentage of imports*; 1951 •52 •53 '54 '55 •56 '57 '58 •59 '60 •61 '62 •63 •64 MAJOR OIL EXPORTERS 60 64 67 55 64 80 75 64 52 49 50 51 76 67 Iran 81 112 111 84 69 67 59 44 37 30 30 42 47 30 Iraq 80 75 94 114 108 111 77 94 91 66 53 53 92 60 Kuwait 30 34 34 34 34 Libya 56 67 51 58 47 51 59 Saudi Arabia 69 79 92 87 161 172 Venezuela 50 52 53 47 51 76 78 66 46 51 53 53 78 72 COUNTRIES WITH INITIAL HIGH RESERVES 75 65 96 88 86 73 46 43 44 38 32 26 26 22 Argentina 35 36 67 54 39 34 22 10 28 42 26 8 28 14 B r a z i l 26 26 46 30 38 50 32 34 27 24 32 26 21 29 Ceylon 67 46 34 58 69 69 54 49 34 25 25 24 24 12 Ghana 209 204 198 258 216 194 160 190 137 107 48 63 35 38 India 108 106 154 144 133 85 42 39 41 29 29 22 24 19 Pakistan 98 41 79 78 103 76 59 54 86 48 43 38 35 24 Sudan 19 8 105 122 122 109 148 62 52 80 91 . 64 57 35 26 U.A.R. 143 114 136 152 117 94 85 64 47 40 29 30 24 23 10 TABLE I (continued) Countries Reserves as percentage of imports 1951 '52 •53 • 54 '55 '56 •57 '58 •59 '60 '61 '62 •63 •64 OTHER DEVELOP-ING COUNTRIES 49 52 52 47 44 44 38 41 53 .47 45 44 44 42 B o l i v i a 35 27 32 16 9 1 7 9 11 10 10 4 10 23 Chile 18 20 20 16 23 23 12 15 31 20 12 13 13 15 Columbia 33 40 37 38 20 20 30 40 52 34 27 18 21 21 Costa Rica 16 24 26 21 24 14 13 21 15 12 6 12 13 14 Dominican Rep. 36 31 29 39 32 32 35 32 31 26 11 14 23 19 Ecuador 52 64 53 33 31 31 36 36 44 35 36 44 40 31 E l Salvador 70 65 61 52 42 37 37 37 38 27 22 21 29 28 Honduras 40 35 37 41 32 27 20 13 17 18 17 16 13 20 Guatemala 51 58 53 47 53 51 51 33 33 39 41 35 34 30 Jamaica • • • • • • 38 39 33 29 29 40 37 32 36 33 40 34 Mexico 36 35 31 26 50 48 41 35 45 37 36 37 44 39 Nicaragua 25 32 33 21 20 10 14 10 18 17 19 19 29 28 Panama 66 62 63 58 48 48 25 44 35 27 18 18 18 8 Peru 24 22 19 26 19 19 9 8 19 28 84 22 24 28 Uruguay 86 135 .191 122 103 102 77 186 109 56 101 92 112 96 Jordan 59 50 50 61 . 47 60 52 48 40 38 44 45 51 55 Lebanon 31 31 39 44 40 38 40 51 48 44 48 58 53 59 Syria 14 22 35 28 27 35 37 24 28 21 16 18 16 17 11 TABLE I (continued) Countries Reserves as percentage of imports 1 9 5 1 ' 5 2 ' 5 3 •54 ' 5 5 •56 ' 5 7 ' 5 8 ' 5 9 •60 ' 6 1 ' 6 2 ' 6 3 ' 6 4 Burma 111 115 119 61 53 61 31 58 63 50 55 76 80 79 China 56 39 43 28 43 54 63 54 53 39 42 38 63 69 Korea 19 39 32 44 -28 26 26 39 48 46 66 40 24 32 Malaysia 66 78 80 99 : .97 92 85 93 117 112 118 114 111 109 P h i l l i p i n e s 46 51 49 39 26 28 10 15 16 19 8 11 16 14 Thailand 133 115 93 91 90 87 79 79 75 82 94 96 94 99 Vietnam • * • » • • 48 61 48 69 76 90 69 58 61 47 Ethiopia 64 45 50 Morocco ,32 ,',43 50 41 40 25 12 Nigeria 99 74 59 56 43 36 Tunisia o 3 1 56 45 35 29 28 13 GRAND TOTAL 67 69 74 73 66 62 57 62 58 55 54 51 50 46 Memorandum Item The Ten (excluding the U.S.) 27 30 36 40 37 34 30 .42 40 43 45 43 40 38 Source: Banca Nazionale Del Lavoro Quarterly Review, June, 1 9 6 7 , pp. 176 - 177 (modified) 12 S i g n i f i c a n t l y enough, these two groups accounted for less than one-fourth of the t o t a l imports of a l l developing countries combined i n the same year. When we exclude the major oil-producing countries, the r a t i o of reserves to imports for a l l other countries (although including the f i v e i n the Far East) f e l l from 64% i n 1951 to 39% i n 1964. In t h i s group, the countries with i n i t i a l high l e v e l of reserves at the beginning of the period experienced a d r a s t i c f a l l i n t h e i r reserve holdings, while for a l l others, the decline was very moderate. In the former group, i . e . , the group with i n i t i a l high reserve l e v e l s , the r a t i o f e l l from 75% i n 1951 to 22% i n 1964; and i n the l a t t e r group the decline i n the r a t i o of reserves to imports was from 49% i n 1951 to 42% i n 1964. The above s t a t i s t i c a l evidence indicates that reserve levels of most developing countries have f a l l e n i n recent years. Thus, i f the problem of inadequacy of international l i q u i d i t y i s serious for the developed countries which seem to have more access to reserve substitutes through private and b i l a t e r a l c r e d i t arrangements among themselves, "then that for the developing countries appears to be even more serious. These l a t t e r countries have less access to c r e d i t f a c i l i t i e s and for thi s reason, other things equal, i t might be argued that they should hold large reserves. They suffer as much as, i f not more than, other countries from fluctuations i n t h e i r 13 balance of payments. This i s p a r t i c u l a r l y true of those developing countries whose exports are concentrated on a few products which are subject to very serious price fluctuations and seasonal variations. For these countries, reserve needs would seem to be greater than those of the developed countries. I f we accept the above argument as v a l i d , the es s e n t i a l paradoxical s i t u a t i o n relates to the fact that the reserve holdings of many such developing countries have been reduced i n recent years, as indicated by the above s t a t i s t i c a l evidence. Some economists have attempted to put forth explanations to foster an understanding of the phenomena underlying the decline i n reserve lev e l s of the developing countries. I t i s to these explanations that we now turn, 1.3: COMMON HYPOTHESES 1.3A: The "Profligacy" Hypothesis The f i r s t of these explanations i s what we s h a l l term 12 as the "profligacy" hypothesis. I t seems to be implied that the developing countries are "Young and inexperienced" but, being eager to improve the l i v i n g standards of t h e i r peoples, they run down th e i r reserves unwisely. They undertake overly • -P. Streeten, "International Monetary Reform and the Less Developed Countries", Banca Nazionale- Del Lavoro, Quarterly  Review . (Rome, June, 1967), p. 163. Streeten seems to imply that such a hypothesis e x i s t s . 14 ambitious programs for economic development but are unable to economize on the use of t h e i r scarce foreign exchange resources. Hence, the inference that since they cannot manage the i r monetary a f f a i r s and thus t h e i r balance of payments, a decline i n t h e i r reserve holdings must be sought i n th e i r " i r r a t i o n a l " economic behaviour. Other economists, however, f e e l that the "profligacy" argument i s u n j u s t i f i e d since i t f a i l s to take into consideration the many "teething" troubles - economic, p o l i t i c a l and s o c i a l -faced by the developing countries i n th e i r e f f o r t s to improve the l i v i n g standards of t h e i r peoples. They therefore maintain that any explanation for the l i q u i d i t y c r i s i s i n these countries should be sought from the development process i t s e l f . I.3B: The "Stage of Growing Pains" Hypothesis Impl i c i t i n t h i s l i n e of argument i s a model which may be described as follows: The developing countries are agrarian economies. They export one or a few primary products i n a world where a fixed exchange rate i s the only i n t e r n a t i o n a l l y acceptable p o l i c y . They undertake programs for rapid economic development v i a i n d u s t r i a l i z a t i o n but domestic c a p i t a l formation and consumption have high marginal import requirements. Although they have a high income e l a s t i c i t y of demand for imports, they face an i n e l a s t i c demand with respect to income and price for t h e i r exports. Thus, over time, the terms of 15 trade have turned against them. I t i s f i n a l l y argued that with a r e s t r i c t i o n , due to an imperfect c a p i t a l market, i n autonomous c a p i t a l inflows, the reserve holdings of these countries have accordingly been reduced. Under the assumptions of thi s model, two important implications are worth noting. F i r s t , a decline i n reserve holdings i s an inevi t a b l e phenomenon consequent upon the development process i t s e l f . Over time, the developing countries would tend to be i n chronic balance of payments d e f i c i t s ; t h e i r demand for foreign currencies would tend to be greater than the foreign demand for t h e i r own currencies at the fixed exchange rate. And of course, under the assumption of a fixed exchange rate, there would tend to be more currency or import r e s t r i c t i o n s i n the developing than i n the developed countries i f that rate i s to be maintained. Secondly, reserve levels would tend to be reduced more i n those developing countries which are bent on more rapid economic development and which therefore require more c a p i t a l goods imports ( i t i s thus assumed that the developing countries do not produce c a p i t a l goods l o c a l l y ) than 14 i n those countries which are bent on less rapid development. In t h i s li g h t , . Streeten has argued that i n those developing cf. R. Prebisch, "Commercial P o l i c y . i n the Under-developed Countries", American Economic Review, and H. Singer, "The D i s t r i b u t i o n of Gains between Investing and Borrowing Countries", American Economic Review, May, 1950. See also, Sidney Weintraub, The Foreign Exchange Gap of the Developing  Countries,. Essays i n International Finance, No. 48, Princeton University, September, 1965. 14 . The oil-producing countries are an exception to the eff e c t s of t h i s model since they face a r e l a t i v e l y high income e l a s t i c i t y of demand for t h e i r exports. 16 countries where the r a t i o of reserves to imports has f a l l e n , the decline has not been due to profligacy on the part of the monetary authorities but "rather an i n a b i l i t y to raise reserves i n the face of growing import requirements" for 15 development. Thus, basic to Streeten's position i s the assertion that the decline i n reserve holdings i s associated with r i s i n g imports and non-trade payments. A s i m i l a r hypothesis, though d i f f e r e n t i n many respects, strongly asserts that the developing countries cannot hold reserves because they have a great propensity to spend them 16 for development purposes. In t h i s way, i f reserve holdings have f a l l e n , i t might be a r a t i o n a l economic decision on the part of the monetary authorities of these countries. This i s the "primitive" r a t i o n a l choice hypothesis. I.3C: The "Primitive" Rational Choice Hypothesis The g i s t of t h i s hypothesis i s that i n the process of growth, i t may become necessary to weigh opportunities for more p r o f i t a b l e uses against the arguments for accumulating reserves. This i s because holding reserves represents claims on r e a l resources which might otherwise be used to increase consumption or development i n general. Developing countries 15 P. Streeten, op. c i t . , p.163 "*"^ The International Monetary Fund agrees with t h i s view. See, I.M.F. Annual Report, 1965, p.181. 17 want to improve th e i r l i v i n g standards and they cannot afford to invest r e a l resources i n t h i s way. This hypothesis i s therefore cast i n terms of cost-benefit analysis since i t presumes that reserve management i n these countries should be viewed on the basis of how the benefits and costs of holding reserves compare with those of other assets. The argument i s best represented by views given by both Bernstein and Wallich. To Bernstein, "The i n a b i l i t y of the underdeveloped countries to accumulate reserves does not arise from a world shortage of monetary reserves. I t i s a r e f l e c t i o n of the fact that holding reserves i s a form of investment and that the underdeveloped countries cannot afford to invest r e a l resources i n monetary reserves at a time when they are desper-ately short of c a p i t a l for development".1? Wallich makes an even stronger assertion that:" "There are a great many countries that are i n foreign exchange s t r a i t s but that havei no true demand for l i q u i d i t y . That i s the case with many developing countries. Demand for l i q u i d i t y means to want ready international cash that the country does not spend except i n emergency, and i t recon-s t i t u t e s immediately thereafter. The developing countries are i n such need of resources that any additional reserves given them would be used to ease a l i t t l e the t i g h t exchange controls under which most of them operate. In that way, the reserves would be spent on imports and they would not be reconstituted. In any meaningful sense, therefore, the developing countries have, for the most part, no u n s a t i s f i e d demand for l i q u i d i t y " . -*-8 E.M. Bernstein, "Underdeveloped Countries and Monetary Reserves", Guidelines for International Monetary Reform, Hearings, 89th Congress (Washington) 1st session, July 27 - 29, 1965, J o i n t Economic Committee, U.S. Congress, Part 2, p.271. 18 H.C. Wallich, "Testimony", Guidelines for International  Monetary Reform (as above), Part 1, p.70. 18 As they stand, the above arguments are highly suggestive i n the sense that the decline i n reserve holdings might have involved a deliberate choice on the part of the monetary authorities of the developing countries. However, plausible as the explanations might be, they are a l l subject to a basic shortcoming; that i s , they are not based on any coherent t h e o r e t i c a l structure. As such they tend to be oversimplified. I t i s possible therefore to show that p a r t i c u l a r l y the "stage of growing pains" and the "primitive" r a t i o n a l choice hypotheses are complementary; and that, i n an alternative analysis, the "profligacy" hypothesis i s not v a l i d . I.3D: An Alternative Hypothesis We postulate that, i n general, accumulation or drawing down of reserves i s a p o l i c y decision which ought to be placed i n the context of other p o l i c y decision variables, e.g., the p o l i c y to accelerate economic development. In the developing countries where c a p i t a l i s scarce but there i s an urgent need to improve the l i v i n g standards of the people, accumulation or holding of reserves obviously involves a high s o c i a l cost. The s o c i a l opportunity cost of holding reserves can be measured by the foregone return on increasing c a p i t a l formation or consumption which may be determined by a p a r t i c u l a r country's marginal rate of time preference. Hence, i t can be argued that the problem of the decline i n reserve holdings of developing 19 c o u n t r i e s i s a r e f l e c t i o n not of p r o f l i g a c y but of r a t i o n a l economic behaviour. I t i s a p o l i c y . d e c i s i o n based on the assumption t h a t at l e a s t the s o c i a l r e t urns from u t i l i z i n g p a r t of accumulated stock of reserves f o r development purposes are greater than those from holding t h a t amount of reserves. On the b a s i s of the above reasoning, we develop the a l t e r n a t i v e hypothesis t h a t : given the growth problems of the developing c o u n t r i e s , i t might be a r a t i o n a l economic d e c i s i o n on the p a r t of the monetary a u t h o r i t i e s to u t i l i z e some of t h e i r accumulated stock of reserves to finance development expenditures. Of course, the "stage of growing p a i n s " and the " p r i m i t i v e " r a t i o n a l choice models tend to suggest t h i s but our main c o n t r i b u t i o n w i l l l i e . i n the attempt to work out a theory of demand f o r i n t e r n a t i o n a l l i q u i d i t y on the p a r t of the developing c o u n t r i e s , which i s c o n s i s t e n t w i t h the hypo-t h e s i s . Our a n a l y s i s w i l l , i n essence, be an a p p l i c a t i o n of a curre n t theory of demand f o r money - the " p o r t f o l i o approach" - to the i n t e r n a t i o n a l payments sphere and we s h a l l attempt to show how t h i s theory can o f f e r f u r t h e r i n s i g h t s i n t o our understanding of the problem at hand. Thus, our approach conforms to the trend i n curren t s t u d i e s on demand f o r i n t e r n a t i o n a l reserves which are based on other aspects of monetary theory, e.g., the q u a n t i t y theory of money. 20 In Chapter II the exis t i n g l i t e r a t u r e on demand for inter n a t i o n a l l i q u i d i t y w i l l be b r i e f l y surveyed. A theory of demand for inte r n a t i o n a l l i q u i d i t y on. the part of the developing countries w i l l then be worked out on the basis of the p o r t f o l i o approach to demand for money. The use of the f i n a n c i a l resources of the International Monetary Fund by these countries i s also examined to f i n d out how i t helps our main analysis. Chapter III examines the implications of some proposals for a reform of the international monetary system for the developing countries i n the context of the conclusions reached i n Chapter I I . In the concluding Chapter IV suggested p o l i c y measures are considered, based on our analysis of demand for l i q u i d i t y . We then summarize and conclude that what i s urgently required i n the developing countries i s not additional reserves per se; rather there i s need for a system to e f f e c t a large increase of c a p i t a l aid and other development resources from the developed countries, other international i n s t i t u t i o n s concerned with development, and probably even from the International Monetary Fund. This might be one way to assure harmony i n the world economic system. 21 CHAPTER II THE - DEMAND FOR INTERNATIONAL LIQUIDITY II : THE EXISTING LITERATURE Before we proceed to develop a theory to explain the. decline i n the reserve holdings of the developing countries, i t i s necessary to survey b r i e f l y the existing l i t e r a t u r e on demand for international reserves with a view to providing the background to this study. In previous studies dealing with the subject, two main approaches can be discerned, namely: the " l e v e l of imports" approach and the "money supply" approach. Not a l l studies f i t comfortably into either category, of course. II.1: The,Level of Imports approach The central feature of studies f a l l i n g i n th i s category i s that they relate the demand for international reserves to the l e v e l of imports. Thus for example, we find the research s t a f f of the International Monetary Fund estimating that the i n d u s t r i a l countries should hold the reserve-import r a t i o i n the range of t h i r t y or forty to f i f t y percent, with the implication that t h i s i s a desirable target. International Monetary Fund, Staff Papers, "Inter-national L i q u i d i t y and Reserves" (August, 1958, I.M.F.), pp. 48 - 49. 22 This i s a view independently supported by T r i f f i n as well. We may d i s t i n g u i s h between three aspects of t h i s approach: the transactions aspect, the precautionary aspect and the optimal l e v e l aspect. II.1A: The transactions aspect In t h i s category, the approach i s based on the . application of the quantity theory of money to the i n t e r -national payments sphere, with the l e v e l of imports taking, the place of transactions and international l i q u i d i t y taking the place of the money supply. I t i s assumed that v e l o c i t y and the price l e v e l cannot change enough to o f f s e t any decrease i n or the decline i n the growth of international reserves. Consequently, i t i s argued that "world reserves ought to grow roughly i n accord with the increase i n the 3 volume of world trade, measured as a t o t a l of world imports" i f the inadequacy of world monetary reserves i s not to lead to the curtailment of international trade. Like the c l a s s i c a l demand for money analysis, the assumption of a constant v e l o c i t y of world reserves i n the above approach implies that there i s unit e l a s t i c i t y of RY T r i f f i n , Gold and the Dollar C r i s i s , Yale University Press, 1 9 6 1 , p . 4 5 . He emphasizes the 4 0 % l e v e l and suggests a 2 0 % absolute minimum l e v e l of reserves to hold. R. Ward, International Finance, Prentice-Hall Inc., Englewood C l i f f s , N.J., 1 9 6 5 , p . 1 8 5 . 23 demand for reserves with respect to the l e v e l of imports.. For, i f i t were possible by an alternative assumption that v e l o c i t y of world reserves could vary widely, any given l e v e l of international reserves could be adequate. Veloci t y would merely adjust so that any given l e v e l of reserves would be matched by the necessary l e v e l of imports. Yet, as i n c l a s s i c a l monetary theory, t h i s adaptability of v o l o c i t y i s ruled out for " i n s t i t u t i o n a l reasons". Thus, i n one i n t e r -pretation, the theory of the demand for reserves based on th i s approach i s concerned with the "transactions" demand. It i s not necessary, however, to rule out a precautionary motive for holding reserves. An example of a study along 4 these lines i s the pioneering work done by Nurkse. I I . IB: The precautionary ..aspect Nurkse started by asserting that international reserves should be' held as a buffer to meet fluctuations i n countries' balance of payments. I n i t i a l l y , he assumed that the t o t a l demand for.world reserves could be determined by the possible size and.duration of the d e f i c i t s i n the balance of payments of countries combined. Next, he argued that t o t a l demand for world l i q u i d i t y was p a r t l y determined by the degree R. Nurkse, International Currency.Experience: Lessons  of the Inter-War Period, League of Nations, 1944, pp. 80 - 91. See also, W.M. Scammell, International Monetary Policy , 2nd e d i t i o n , Macmillan & Co., 1962, pp.75 - 82. 24 to which business cycles i n separate countries were synchronized with each other. Synchronization of c y c l i c a l movements, he suggested, would require a smaller volume of reserves, (with less f l e x i b i l i t y ) i n order to f u l f i l the buffer function, the implication being a constant e l a s t i c i t y of demand for imports and exports. In t h i s way, i f for.example, a l l economies expanded and contracted simultaneously and approximately at the same rate, international payments and receipts i n i n d i v i d u a l countries would be moving i n the same d i r e c t i o n . In the l i g h t of the above argument, he deduced that since i t was possible, however, for non-synchronization to create an international payments gap of intermediate magnitude, there was need to expand reserves i f this occurred and to reduce them i f the contrary case took place. In t h i s way, he concluded that the magnitude of the.non-synchronization, uncertainties and errors of diagnosis i n p o l i c y prescriptions might determine the t o t a l demand for international reserves. In addition, Nurkse suggested that long term c a p i t a l movements create a need for reserves i n that these c a p i t a l flows are c y c l i c a l l y unstable so that a borrowing country, to smooth out i t s importing capacity, must always set reserves aside to meet t h i s need. The obvious implication for a developing country which i s subject to large variances i n i t s export receipts and which faces a r e s t r i c t i o n , due to an imperfect c a p i t a l market, i n 25 autonomous c a p i t a l inflows might be that the monetary authorities would have to maintain a large volume of reserves. This i s necessary i f balance i s to be maintained i n i t s international payments and receipts. However, does a developing country r e a l l y hold large reserves as a f u l l precautionary measure against such emergencies as suggested by Nurkse? This i s a p r i n c i p a l question to which we s h a l l address ourselves l a t e r on i n our main analysis. Meanwhile, other studies indicated that Nurkse's demand analysis was inadequate. I t was maintained that the amplitude and duration of the c y c l i c a l swings i n the balance of payments caused by domestic business cycles have been altered i n the post war period. Moreover, international reserves function not only as a buffer but also as balances to e f f e c t an e q u i l i b r i a t i n g adjustment necessitated by s t r u c t u r a l payments imbalances. Anything that required that more reserves should be held to perform the l a t t e r function was a matter that involved some subjective reckoning of reserve "adequacy" on the part of monetary aut h o r i t i e s . In fact, to say that the demand for reserves depends on the,level of imports does not t e l l us what the optimum r a t i o of reserves to imports i s for a p a r t i c u l a r country. The choice of t h i s optimum l e v e l involved a value judgement which varied from country to country. Thus, the emphasis was s h i f t e d from concern with the global l e v e l to concern with the l e v e l of 26 reserves i n i n d i v i d u a l countries. Some work i n this d i r e c t i o n 5 was done by J.M. Fleming. II.1C: The Optimal Level aspect Following Scitovsky's idea that global reserves could be adequate i f countries behaved symmetrically towards payments surpluses and d e f i c i t s , ^ Fleming suggested that monetary authorities could manage the l e v e l of imports to achieve an optimal l e v e l of reserves to hold. This was to be done with the recognition that reserve increments are subject to diminishing marginal u t i l i t y since i t i s possible to have growing c r e d i t ease generate i n f l a t i o n . No doubt, basic to Fleming's position i s the. hypothesis that the economic gain from incremental reserves becomes progressively smaller and f i n a l l y negative. In his own words, he maintained that: "Generally speaking, there i s a diminishing and utlimately negative m a r g i n a l . u t i l i t y of reserve increases; i t i s this that ensures the existence at any time of an optimal l e v e l (of reserves to h o l d ) " 7 I t i s important to note that, on the basis of Fleming's 5 J.M. Fleming, "International L i q u i d i t y : Ends and Means", op. c i t . , pp.440 - 449. See also his a r t i c l e , "The Fund and International L i q u i d i t y " , I.M.F. Staff Papers, Vol. 11, 1964, pp.180 - 195. ^T. Scitovsky, Economic Theory and Western European  Integration, 1958, pp.101 - 109. 7 J.M. Fleming, op. c i t . , p.441. 27 analysis, monetary authorities of i n d i v i d u a l countries can choose the l e v e l of reserves they may want to hold. Hence, a demand function for reserves can, i n p r i n c i p l e , be s p e c i f i e d . Although the above model i s developed from the point of view of the developed countries, i t can be argued that i t i s applicable to the developing countries as well. In the l a t t e r countries where the e s s e n t i a l aim of national policy i s economic growth, the costs of excessive reserve accumulation can be viewed i n terms of the effects on the growth rate of g the economy. Under these circumstances, the Fleming model w i l l be basic to our main analysis. II.ID: Empirical Findings on the 'Level of Imports' approach Machlup has c r i t i c i z e d the l e v e l of imports approach 9 to demand for international reserves. A f t e r analyzing the available data on reserve holdings of 14 i n d u s t r i a l countries, and r e l a t i n g these holdings to a number of theories which seek to explain the need for reserves, he found that there i s no consistent pattern of behaviour among monetary authorities of such countries. Indeed, he has maintained that there are s t r i c t l y no empirical grounds to conclude that there i s a systematic r e l a t i o n s h i p even between o f f i c i a l reserve cf. T. Balogh, "International Reserves and L i q u i d i t y " , Economic Journal, June, 1960, pp.363 - 364. F. Machlup, The Need for Monetary Reserves, op. c i t . , pp. 1 0 - 1 5 . 28 holdings and i ) imports, i i ) past d e f i c i t s , i i i ) v ariations i n foreign trade, iv) imports and c a p i t a l flows, v) domestic money supply, and vi) current l i a b i l i t i e s - a l l of which may also be thought of to r e f l e c t needs. He shows that very u n r e a l i s t i c assumptions w i l l be needed to find out the exact re l a t i o n s h i p between o f f i c i a l reserves and those variables. Emphasizing the contingency function of holding reserves -besides the transactions aspect,. - he showed, however, that reserves could, other things being equal, be related more to past d e f i c i t s than the other variables. He distinguished between the demand and the need for reserves and proposed that i n his view the need for reserves by a country could be estimated on the basis of past experience. Although Machlup's model takes account of the pre-cautionary as well as the transactions demand for reserves, i t f a i l e d to analyze further one aspect of reserves - as a means of holding wealth and not necessarily as a means of payment. Indeed, t h i s aspect of reserves i s not emphasized i n the l i t e r a t u r e ( i . e . , no emphasis i s put on whether a country should hold i t s wealth i n reserve accumulation or i n some other alternative r e a l asset). Another theory which Machlup c r i t i c i z e d as based on untenable assumptions - the theory that li n k s the size of imports with the p r o b a b i l i t y d i s t r i b u t i o n of d e f i c i t s i n the balance of payments and the function of o f f i c i a l reserves to 29 finance such d e f i c i t s - has received empirical v e r i f i c a t i o n from Kenen and Yudin. 1^ From the hypothesis that countries hold.reserves to cope with disturbances i n t h e i r balance of payments, they s p e c i f i e d that a country's demand for reserves depends on expectations as to size and duration of the disturbances i n the balance of payments. Hence, the derived demand function i s cast i n terms of three parameters: the 2 anticipated mean disturbance, e, the variance, a , and the duration of the disturbance, p. On the basis of these parameters, a demand function of the form, R i t = ' & 0 " + B 2 p l + ^ 3 a e i i s derived, where measures the i t h country's o f f i c i a l reserves at the s t a r t of the month. The regression equation was then used to appraise the d i s t r i b u t i o n of reserves for the countries covered. The s t a t i s t i c a l significance of the demand function, however, indicated that only the variance 2 term, a i s e s s e n t i a l , for i t showed that o f f i c i a l reserves are i n fact related to the variance of past (expected future) disturbances. I t i s to be noted that the above empirical studies dealt mainly with the i n d u s t r i a l c o u n t r i e s , 1 1 a flaw 1 0Kenen, P.B. and E.B. Yudin, "The Demand for Inter-national Reserves", op. c i t . , pp.242 - 250. 1 1These countries are: Austria, belgium, Canada, Denmark, Finland, Germany, I t a l y , Japan, Netherlands, New Zealand, Norway, Sweden, Switzerland and the United Kingdom (1957 - 1962). In Machlup's study c i t e d above, France, the United States, Ireland, and A u s t r a l i a are included, but Norway, New Zealand are excluded (1961 - 1965). 30 manifested also i n the money supply approach to demand for inter n a t i o n a l reserves. II.2: The Money.Supply approach The rel a t i o n s h i p between demand for reserves and the money supply i s i m p l i c i t i n the works of Johnson and Scitovsky. Making use of the r e a l balance e f f e c t as a mechanism that li n k s i n d i v i d u a l countries' economic systems into the.world economic system (under appropriate circumstances)> t h e i r models indicate that the l e v e l of reserves appropriate for a given country depends on the manner i n which the monetary authorities manage the domestic money supply i n response to.an external d e f i c i t . To Johnson, a country should hold reserves s u f f i c i e n t to allow any foreign imbalances to correct themselves through the drawing down of domestic.real balances. On the other hand, . Scitovsky has argued that the sum of domestic cash balances tends to overstate the a b i l i t y of a country to run an external d e f i c i t ; i n t h i s way, the minimum l e v e l of reserves postulated should correspond to the p a r t i c u l a r country's a b i l i t y to overspend externally by drawing down i t s cash balances. In other words, these arguments are suggesting that reserve management should be so made as to keep i n step with the. domestic money supply i n a manner dictated by the propensities of the p a r t i c u l a r country to import and to spend domestically. H.G. Johnson, International Trade and Economic Growth, Cambridge, Mass., Harvard University - Press, 1961, pp. 156 - 158, and T. Scitovsky, Economic Theory and Western European Inte- gration, op. c i t . , pp. 101 - 109. 31 II.2A: Some Empirical Findings of the Money Supply approach Maintaining that the concept of the money supply i s not unambiguous and even i f t h i s d i f f i c u l t y were overcome, . the r a t i o of o f f i c i a l reserves to the money supply varied from country to.country, Machlup, i n his study of 14 i n d u s t r i a l countries, found that there was no systematic re l a t i o n s h i p between the variables. He asserted: "The enormous differences among countries compel re j e c t i o n of any theory that would assert a needed or most desired r a t i o of foreign reserves to the quantity of domestic money supply,, unless the theory included some.parameter that would f i t the r a t i o to p a r t i c u l a r circumstances".13 However, i n a very recent a r t i c l e , a contrary r e s u l t was obtained by Courchene and Youssef i n an empirical 14 study on demand for international reserves. Their model attempted to determine the explanatory power of the variables, 'the l e v e l of imports', the 'money supply 1 and the long term i n t e r e s t rate, (long term government bond ra t e s ) . Their study on 9 i n d u s t r i a l countries indicated that there i s a stable demand function for reserves with the money supply and the long term i n t e r e s t rate as the necessary explanatory variables. The authors' regression equations, however, f a i l e d F. Machlup, The Need for Monetary Reserves, op. c i t . p.20. 14 T.J. Courchene and G.M. Youssef, "The Demand for International Reserves", Journal of P o l i t i c a l Economy, Vol. 75 August, 1967, part 1, no. 4, pp.404 - 406. The countries cover i n the study are: Switzerland, I t a l y , Germany, Sweden, Belgium Japan, Denmark, Netherlands and A u s t r a l i a . 32 to indicate the l e v e l of imports approach as s t a t i s t i c a l l y s i g n i f i c a n t - a not surprising r e s u l t owing to the assumptions employed. At t h i s point, i t might be stressed that most of the studies c i t e d above are done from the point of view of the developed rather than the developing countries. S i m i l a r l y , the empirical studies a l l use i n t e r e s t rate and other relevant data obtained from t h e . i n d u s t r i a l countries. This bias, probably a r i s i n g from the charge of i n s u f f i c i e n t data i n the developing countries themselves, i s p a r t i a l l y o f f s e t i n a work done by two Indian economists. Their study on the demand for international reserves deals exclusively with the developing countries. I I . 3: Application of the Keynesian -Liquidity Preference" Theory Courchene's and Youssef's work was based on the finding that both the transactions and precautionary demand for reserves might be i n t e r e s t e l a s t i c ; however, the study made by the two Indian economists takes into account the speculative aspect as well. Indeed, the l a t t e r work i s an application of a s i m p l i f i e d version of Keynesian monetary economics to the i n t e r n a t i o n a l payments sphere. They derive a demand function for gross reserves, G = f(m, i , ) , with l e v e l C.N. V a k i l and M. Doodha, India and International  Monetary Reform, Vora and Co. (Bombay, 1962) , pp. 1 - 43. 33 of imports, m, and the short term i n t e r e s t rate, i , as the necessary independent variables. Their analysis i s a r e s u l t of t h e i r c r i t i c i s m of T r i f f i n ' s approach to the same problem of demand for l i q u i d i t y which considers only the transactions aspect based on the demand function, D r = f ( g , n,) where g, the rate of growth i n world economies, and n, the r a t i o of gross reserves to imports, are a l l assumed to be necessary explanatory variables."*"^ The main contribution of the authors' study l i e s i n the.inclusion of the speculative demand.as a function of the i n t e r e s t rate and the application of the whole analysis to the l i q u i d i t y problems of India and other developing countries. Indeed, on the basis of the i r theory, they emphasize the need to l i b e r a l i z e the terms of borrowing by the developing countries, from both the developed countries and other i n t e r n a t i o n a l organizations. II.4: Conclusion From our b r i e f survey of the existing l i t e r a t u r e , i t may be concluded that there i s a gradual recognition that demand for international l i q u i d i t y can be treated as demand for a l i q u i d asset, just l i k e money. The f u l l implications of t h i s have, however, not been explored. 'Moreover,.there seems to be a controversy over the relevant explanatory variables that ought to be included i n the demand function T r i f f i n , R., Gold and the Dollar C r i s i s , op. c i t . , pp. 40 - 65. 34 for reserves. Some economists stress the " l e v e l of imports" or the " l e v e l of imports" and the i n t e r e s t rate; others prefer "the money supply" or the "money supply" and the i n t e r e s t rate. In either case, i t i s not even clear whether the short term or the long term.rate has greater explanatory power. F i n a l l y , i t i s evident that very l i t t l e work has been done exclusively on the.demand for reserves by the developing countries. The alternative theory we s h a l l be concerned with below does not attempt to solve or reconcile these problems as they e x i s t i n the l i t e r a t u r e . Rather, we s h a l l examine, as said before, the problem of the precautionary demand for int e r n a t i o n a l l i q u i d i t y mainly on the part of the developing countries from a d i f f e r e n t viewpoint of monetary theory - . the p o r t f o l i o approach to demand for money. This theory w i l l serve as a vehicle for explaining the decline i n reserve holdings of the developing countries. The j u s t i f i c a t i o n for the use of t h i s theory l i e s p a r t l y i n the fact that, l i k e money, inte r n a t i o n a l l i q u i d i t y , considered as a means of holding wealth, may not only be a substitute for other "near reserves" but also for r e a l assets. Moreover, i n the developing countries, where a high price i s put on the holding of reserves that might otherwise be used to purchase the needed c a p i t a l equipment from abroad, i t i s more f r u i t f u l to view t h e i r demand for l i q u i d i t y as influenced by cost and y i e l d considerations rather than primarily as a means of e f f e c t i n g a cer t a i n volume of transactions. The relevance of 35 our approach, therefore, l i e s - i n the fact that the p o r t f o l i o theory involves a choice between various alternatives with y i e l d s and r i s k s i n a world of uncertainty, which, as w i l l be shown below, is. what we need as a basis for our analysis. In the r e s t of t h i s chapter, we s h a l l deal with the p o r t f o l i o approach to the demand for precautionary money balances arid attempt to employ i t to explain the decline i n reserve holdings of the developing countries. II.5: THE THEORETICAL FRAMEWORK We have found from the preceding sections that, i n p r i n c i p l e , i t i s possible to specify a demand function for an optimal l e v e l of reserves a p a r t i c u l a r country may want to hold, even though the empirical l i t e r a t u r e reveals a controversy over which explanatory variables should be included i n this function. Moreover, i t i s evident from the l i t e r a t u r e that i t i s possible to employ, some concepts of monetary theory as a t h e o r e t i c a l basis for demand for international reserves. This i s p a r t i c u l a r l y true i f we r e c a l l the empirical study done by Courchene and Youssef. The basic t h e o r e t i c a l framework within which our analysis w i l l therefore be placed i s provided by Tobin's model of the p o r t f o l i o approach of the demand for money. However, because our present analysis d i f f e r s from previous studies i t may be necessary to explain b r i e f l y what the port-f o l i o theory i s about. 36 II.5A: The P o r t f o l i o Approach Tobin's analysis of the precautionary demand for money i s approached i n terms of asset preferences or port-f o l i o balance. Money i s considered an asset, a means of holding wealth and not necessarily as a means of payment. It i s also considered as one of a spectrum of assets of varying l i q u i d i t y . Hence, the theory i s based on a choice between assets whose y i e l d Is high but for which the r i s k of c a p i t a l loss i s great and those whose y i e l d and r i s k are both low. Such an approach d i f f e r s from Keynes 1 l i q u i d i t y preference theory i n which asset holders are assumed to choose between only money and bonds, a l l of which are further assumed to be i d e n t i c a l as to maturity and r i s k . Under certa i n assumptions including a constant rate of i n t e r e s t and a given price l e v e l , the.portfolio approach assumes that an i n d i v i d u a l investor seeks to maximize the expected value on his p o r t f o l i o , where there are at least two parameters i n his u t i l i t y function, expected y i e l d and r i s k . In other words, the investor i s assumed to have preference for expected y i e l d and an aversion towards r i s k . He i s supposed to be w i l l i n g to assume more r i s k i f expected y i e l d increases enough to o f f s e t greater r i s k and vice versa. Hence, other things being equal, he w i l l choose of the possible combinations of assets more of those whose rate of return i s r e l a t i v e l y higher and fewer of those which have a 37 lower rate of return. Under conditions of uncertainty, he w i l l prefer, of any two p o r t f o l i o s with the same expected, y i e l d , the one with the lower dispersion of y i e l d . Thus, the higher the prospective y i e l d of a p o r t f o l i o , the more he w i l l be induced to accept additional r i s k s on the alternative asset that i s more remunerative. In i t s s i m p l i f i e d form, the theory assumes that the investor has i n his p o r t f o l i o only two assets, A and B. His t o t a l assets are thus equal to T = A + B = 1, where A > 0, and B > 0. I t i s assumed that A (money) i s a r i s k l e s s asset i n the sense that i t s y i e l d has a zero variance, that i s i t s rate of return has a certain value of lAX^ (-)n the other hand, B (bond) a r e a l asset i s r i s k y i n the sense that i t s outcome has a non-zero variance. Its rate of return has a mean value of, AX^' a n <^ a variance, (j^  . Thus the mean value of the rate of return on the whole p o r t f o l i o wi; and by the same token, the standard deviation of the rate of return on the p o r t f o l i o w i l l b e , ^ — IjTfS' I f u ( A,B) i s the u t i l i t y function for the p a r t i c u l a r investor, then he w i l l seek to maximize £ .11 be,^=(A<4+- B/4), subject to his t o t a l wealth constraint. I t i s considered that the p o r t f o l i o has a certain r i s k and the investor regards the t o t a l variance of the expected value of the p o r t f o l i o as an indicator of 38 t h i s r i s k . Figure 1 summarizes the main implications of t h i s argument. OK^ i s an opportunity locus tangent to an indifference curve, 1^. The opportunity locus depicts combinations of assets at the disposal of the wealth holder. Its slope measures the i n t e r e s t rate and the proportions of the r i s k y asset held i n the p o r t f o l i o . Point 0 corresponds to complete s p e c i a l i z a t i o n of the p o r t f o l i o i n the low y i e l d asset, A, while corresponds to complete s p e c i a l i z a t i o n i n the high.yield asset, B. And the same holds true for OK^ and 112* ^ r e P r e s e n t s combinations of equal expected y i e l d , a l l equivalent to a certain return, OB. The investor would be i n d i f f e r e n t between p o r t f o l i o s on t h i s curve. For a given r i s k , {j^ , the. investor always prefers a greater to a smaller expected y i e l d , ^ . Thus, at. P n where the opportunity P " locus, OK^ i s tangent to the indifference curve, 1^, he maximizes expected value on his p o r t f o l i o , subject to his wealth constraint, W. At Pg, he holds OPQ of B and OK^ -OPQ of the r i s k l e s s asset, A. Points above PQ are preferred to those below i t so that at P^ where the investor i s on a higher indifference curve, II , he holds more of B at a higher 17 The best exposition of t h i s approach, which i s here given b r i e f l y , can be found i n d e t a i l i n J . Tobin, "JThe Theory of P o r t f o l i o Selection", reprinted i n F.H. Hahn and :F.. P. R. Brechling editions, The Theory of Interest Rates (Macmillan, 1965), pp.3 - 51. See also his a r t i c l e , " L i q u i d i t y Preference as Behaviour Towards Risk", Review of Economic Studies, Vol. 25 February, 1958, pp.65 - 86. A c l a s s i c a l statement on this approach i s also given by J.R. Hicks, "A Suggestion for the Simplifying - of the Theory of Money", Economics, New Series, Vol. 2, 1935, pp.1 - 19. 39 Expected Y i e l d Figure 1. P o r t f o l i o choice by the wealth holder. 40 r i s k but with the expectation of higher y i e l d as well. Obviously, OP-j^  > OPQ. From the above analysis, i t i s concluded that the precautionary demand for money i s inversely related to a rate of i n t e r e s t which i s assumed to be a convenient measure of the d i f f e r e n t i a l between the secure and random rates of return on assets, A and B respectively. I t i s to be noted that i n t h i s analysis the investor holds money because of uncertainty and an aversion towards r i s k . Indeed, r i s k aversion i s assumed normal behaviour. Our next task i s to demonstrate that the demand for inter n a t i o n a l l i q u i d i t y can be analyzed on the same p r i n c i p l e s as above. That i s , i f international l i q u i d i t y i s considered as international money, then i t s derived demand function should have the same property of the inverse relationship with the rate of i n t e r e s t . To be able to do t h i s , certain assumptions are necessary. II.6: THE APPLICATION OF THE PORTFOLIO APPROACH II.6A: Assumptions Our f i r s t basic assumption i s that a Central Bank (monetary authority) can be regarded generally as a wealth holder or a spending unit. This i s a reasonable assumption to make since as an arm of the government, the monetary authority may be regarded as making choices on the composition 41 of wealth for the society as a whole. I t has the power to carry these,choices into e f f e c t through the government, which may i n s t i t u t e d i r e c t and i n d i r e c t controls. This includes control over the country 1s balance of payments. Thus, i t can manipulate the l e v e l of reserves through the l e v e l of exports and p a r t i c u l a r l y through the l e v e l of imports. Secondly, at any point of time, the monetary authority has the power to allocate to various uses both the income and wealth of the country. We can c l a s s i f y the purposes to which i t w i l l devote these resources as consumption, c a p i t a l formation and international l i q u i d i t y . To further simplify the analysis, we assume that an increase i n c a p i t a l formation leads to a proportionate increase i n domestic consumption i n the long run. Under th i s assumption, both consumption and c a p i t a l formation are treated as one composite " r e a l " asset. F i n a l l y , the monetary authority i s regarded as having a p o r t f o l i o consisting of only l i q u i d (international l i q u i d i t y ) and " r e a l " (capital formation plus consumption) assets. On the basis of these assumptions, we may cast our analysis of the demand for international l i q u i d i t y i n terms of the usual theory of consumer choice. We consider that the demand function w i l l be determined by three major sets of factors: namely, a) the t o t a l resources (wealth) of the country that i s to be held i n various forms, b) the prices and returns on a l l the alternative forms of holding wealth, 42 and c) the tastes and preferences of the monetary authority (Henceforth we s h a l l be using "government", "country" and "monetary authority" interchangeably.) If a) and b) are given, the p o r t f o l i o theory requires that the authority's u t i l i t y function, which, we assume, r e f l e c t s a high c a p i t a l asset preference, be determined by two parameters, r i s k and expected y i e l d . Under these circumstances, how do we specify the demand function for reserves on the part of a developing country? II.6B: A Developing Country's Demand for L i q u i d i t y We assume we are dealing with a " t y p i c a l " developing economy represented, for example, by the model underlying the "stage of growing pains" hypothesis. I t i s a small open economy which i s s t r i v i n g for rapid economic development i n a large and uncertain world. Since domestic savings are low, i t can increase c a p i t a l formation mainly through c a p i t a l goods imports. The monetary authority i s regarded as making r a t i o n a l p o l i c y decisions on the combination of assets i n his p o r t f o l i o such that future per capita consumption (expected yield) can be maximized. In t h i s decision-making process, what are the alternatives open to the country? B . i : The Cost of Reserve Accumulation Current studies emphasize that the advantages of holding reserves stem from the convenience and the security 43 that a wide choice of adjustment techniques o f f e r s . A country chooses to hold reserves because they have a marginal u t i l i t y measured i n terms of the services they provide. That i s , they permit the country to ride out temporary and periodic disturbances i n i t s balance of payments and they afford i t an e f f e c t i v e weapon against speculative attacks on i t s currency. Plausible as these benefits might be, however, reserve accumulation i s not i t s e l f a costless action. Generally, the marginal u t i l i t y obtained from holding reserves declines as t h e i r quantity increases since the hoarding of any reserves i n excess of a country's need represents a r e a l s a c r i f i c e i n terms of consumption or investment foregone. Thus, beyond a c e r t a i n point, the marginal cost of holding reserves begins to exceed the 19 marginal u t i l i t y of holding them. The marginal return on holding reserves depends on the amount involved, the holding Recall Nurkse's argument as outlined i n the review of the l i t e r a t u r e . See also, M.O. Clement, R.L. P f i s t e r , and K.J. Rothwell, Theoretical Issues i n International Economics, J.W. Markham ed-tion, Houghton M i f f l i n Co., Boston, 1967, pp.402 - 403. 19 This point indicates an equilibrium point where the marginal cost i s equal to the marginal u t i l i t y of holding reserves. I t may therefore be designated as the minimum l e v e l of reserves to hold by a country. In p a r t i c u l a r , i t corres-ponds to the l e v e l estimated by the research s t a f f of the IMF for the developed countries. Since these countries, however, have a high marginal propensity to hold reserves, i t can s i m i l a r l y be argued that developing countries which have a low marginal propensity to hold reserves should also maintain reserves lower than th i s minimum l e v e l . 44 period, and the i n t e r e s t rate. But i f we allow only for the in t e r e s t rate that can be earned on reserves, the cost of holding them i s the loss of t h e i r use of r e a l resources given up by accumulating reserves. This cost can be measured by the rate of return on investing the reserves i n r e a l resources which might otherwise a s s i s t to expand output and to stimulate r e a l economic growth. S i m i l a r l y , the cost can be measured by the i n t e r e s t rate on investing the reserves i n less l i q u i d foreign s e c u r i t i e s . For a developing country which i s s t r i v i n g for rapid development, the s o c i a l opportunity cost of holding reserves i s very high since they could be used to purchase the needed foreign goods (capital included) and services. In this way, the choice i n regard to the form i n which the monetary •authority w i l l want to hold the country's wealth l i e s between r e l a t i v e l y unprofitable reserve accumulation and t h e i r investment i n a channel that w i l l y i e l d higher s o c i a l returns for the economy as a whole. B . i i : The Rate of Return on Capital Formation By assumption, the l e v e l of domestic savings i s low, and besides other s t r u c t u r a l problems of growth, there i s acute shortage of c a p i t a l i n the developing economy. Hence, a program for i n d u s t r i a l i z a t i o n would i n i t i a l l y require large c a p i t a l goods imports, or d i r e c t foreign lending and investment. 45 I t i s noticeable, however: " that young nations do not at t r a c t much private c a p i t a l . F a i t h f u l to the p r i n c i p l e of immediate returns, ... the c a p i t a l i s t s are very chary concerning a l l long term investments, when asked to invest i n independent countries. They are often h o s t i l e to the prospective programmes of planning l a i d down by the young new government ... They w i l l i n g l y agree to lend money ... but only on conditions that t h i s money i s used to buy th e i r manufactured products and machines. In other words, that i t serves to keep the fa c t o r i e s of the mother country going".20 In addition, the volume of d i r e c t foreign investment may be limited because of r i s k of p o l i t i c a l i n s t a b i l i t y , fear of na t i o n a l i z a t i o n , and other regulations concerning the earnings that can be taken out of the developing country. Under these circumstances, the expected inflow of c a p i t a l w i l l not be s u f f i c i e n t l y available to cover d e f i c i t s i n the balance of payments of the country. At a minimum, i t i s thi s r e s t r i c t i o n i n the expected inflow of c a p i t a l , coupled with the s c a r c i t y of domestic c a p i t a l i t s e l f , besides some imperfections i n the c a p i t a l market, which bring about an inequality between the world market rate of in t e r e s t and what may be c a l l e d the s o c i a l rate of return on c a p i t a l (or the s o c i a l marginal productivity of c a p i t a l ) , making the l a t t e r higher than the former. This rate i s i m p l i c i t l y the same as the s o c i a l opportunity cost of holding reserves which, as we said before, i s high for a developing country. An additional factor re-pp. 78 Fanon, The Wretched of the Earth (New York, 19 66), 46 in f o r c i n g t h i s higher rate of return on. c a p i t a l might be the desire of the developing country to catch up with the l i v i n g standards of other developed countries, i . e . , a demonstration, e f f e c t . B . i i i : The Risk of Inadequate Reserves By hypothesis, i t might be r a t i o n a l for the country to u t i l i z e some of i t s reserves to finance development expenditures. Hence, faced with a s i t u a t i o n i n which there i s a r e l a t i v e l y low rate of return on reserve accumulation but a r e l a t i v e l y high one on c a p i t a l formation, the monetary authority w i l l seek a rearrangement i n i t s p o r t f o l i o such that there w i l l be a s h i f t from holding more of the l i q u i d asset to holding a larger amount of the " r e a l " asset. That i s , , i t w i l l draw down reserves to finance expenditures on c a p i t a l formation, which, by assumption, can mainly increase through imports of c a p i t a l goods (intermediate production goods included). Other things being equal, i t i s possible to conceive that t h i s process of u t i l i z i n g reserves for c a p i t a l formation might go as far (probably to zero) as placing the developing country i n a s i t u a t i o n where i t w i l l run the r i s k of being unable to pay for the needed imports. This might have the e f f e c t of disrupting the entire development process i t s e l f . In t h i s way, i t i s necessary for the country to hold some reserves as an aversion to this r i s k . Indeed, 47 there are strong arguments to suggest that some reserves should be held. . In a large and uncertain world i n which export terms of trade are exogenously determined for the developing country, export earnings are very unpredictable. Moreover, due to some imperfections i n the world c a p i t a l market and the r i s k associated with foreign investment i n thi s country, adequate c a p i t a l inflows are hard to forecast. Hence, i t i s necessary for t h i s country to hold some reserves as a precautionary measure against short term fluctuations i n i t s balance of payments. There i s another e s s e n t i a l factor rei n f o r c i n g the necessity to hold some own reserves. The International Monetary Fund i s the only source of conditional l i q u i d i t y for t h i s country. Though the cost of being reserve-deficient i s the i n t e r e s t cost of borrowing which i n c i d e n t a l l y i s low at the Fund, the fact that credits are imperfect substitutes for own reserves and they can be made available to the drawing country only after i t has accepted to observe cert a i n conditions (which may i n t e r f e r e with i t s domestic p o l i c i e s of development) makes thi s cost p r a c t i c a l l y high. As Fleming put i t ; "The d i f f i c u l t i e s of u t i l i z i n g conditional l i q u i d i t y at short notice, i t s u n s u i t a b i l i t y as a war chest, the un d e s i r a b i l i t y of accumulating too many repayment obligations, and the reluctance that some countries may f e e l at accepting 22 the conditions under which i t i s made available" - a l l these J.M. Fleming, "International L i q u i d i t y : Ends and Means", op. c i t . , p.448. 48 factors w i l l necessarily set a l i m i t to the country's w i l l i n g -ness to draw down own reserves to zero. In thi s way, the r e s t r i c t e d supply of 'conditional l i q u i d i t y 1 from the Fund would further explain why the developing country may have to hold some own reserves as an aversion to the r i s k of being 23 unable to pay for the needed imports for development. What we have said above merely implies that the developing country should hold some reserves; i t does not t e l l us what l e v e l of reserves the country should maintain. However, by assumption, we know that the monetary authority 24 has control over i t s balance of payments and i t has the power to choose the l e v e l of reserves i t wants to hold, other things equal. In thi s l i g h t , i t i s conceivable that the pressing demand to increase economic development and therefore c a p i t a l formation w i l l force i t to f i x t h i s l e v e l at a low point where a subjective c a l c u l a t i o n of the r i s k i s just compensated by the s o c i a l rate of return on c a p i t a l . Thus, the higher the s o c i a l rate of return on c a p i t a l for-mation r e l a t i v e to the cost of being reserve-deficient, the We s h a l l examine i n some d e t a i l Fund a c t i v i t i e s with the developing countries i n recent years i n a l a t e r section. 24 See appendix on Chapter I I , Section II.6, pp. 10 8-109. 49 more l i k e l y i t i s that an increase i n the range of d i s t r i -bution of expected foreign exchange flows (through either export earnings or c a p i t a l inflows) w i l l , encourage the country to take a large r i s k of. holding a low l e v e l of reserves. To function with t h i s low l e v e l of reserves, the monetary authority would manipulate the l e v e l of imports through the 25 use of import and foreign exchange controls. B.iv: The Cost of Manipulating the Level of Imports The use of import controls, obviously, has implied economic and r e a l costs for the country. Nevertheless, on our proposition that the po l i c y i s a deliberate one based on the chosen development strategy, we can further postulate that t h i s country i s prepared to bear these costs. We learn from the analysis that c a p i t a l formation can increase i n this country mainly through imports of c a p i t a l goods. This means that, to e f f e c t the increase, the use of the controls should a l t e r the composition of imports i n such a way that there w i l l be a "capital-goods-import" bias. Thus, at any moment of time, more c a p i t a l goods can be obtained but only at the expense of less imports of consumer goods. I f the domestic supply of consumer goods i s inadequate (which might be the case i n a developing country at an i n i t i a l stage of i n d u s t r i a l i z a t i o n ) , 25 The use of such controls i s of the discretionary kind which, i t i s claimed, does not "correct" or "remove" a d e f i c i t , but "suppress" i t . See, for example, F. Machlup, Real Adjustment, Compensatory Corrections.,, and -Foreign  Financing of Imbalances i n International.Payments, Reprints i n International Finance, No. 2 (Princeton University, September, 1965), es p e c i a l l y pp.192 - 193. 50 i t i s possible that the procedure w i l l have the e f f e c t of slowing down the tempo of development i n the country. The reason for thi s may be expressed succintly i n another way: to the developing country, a p o l i c y to increase c a p i t a l formation (in t h i s case, through increase i n c a p i t a l goods imports) may be said to have a "production" e f f e c t . That i s , the stimulus given by the i n i t i a l increase i n investment i n the economy which i s expected to r e s u l t i n greater increase i n national income than before. An increase i n the share of investment, however, implies a reduction i n current con-sumption (brought about by the use of d i r e c t and i n d i r e c t controls) which may have an adverse e f f e c t on the.productivity of labour and, consequently, on the expected increase i n national income. This i s the "consumption" e f f e c t , the strength of which i s determined at any moment of time by the adverse impact on productivity and the shortage of consumption goods. Since, t h i s shortage may r e s u l t i n disincentives to work, i t may a f f e c t the o v e r a l l process of growth i n the economy. In t h i s way, i t i s clear that, although the net increase i n national income depends on the r e l a t i v e strength of the two e f f e c t s , development v i a t h i s p o l i c y involves a great amount of r i s k . At t h i s point, l e t us, for comparative purposes, consider the requirements of the International Monetary Fund 51 concerning the minimum l e v e l below which reserves cannot be run down. We assume that for various levels of reserves, a p a r t i c u l a r country faces varying degrees of r i s k . Thus, i n Figure I I , m a Y be termed as the "standard r i s k l e v e l " which attaches to the minimum l e v e l of reserves, X^ which i s to be maintained by i n d u s t r i a l countries i n the view of the IMF so as to achieve external balance without much disturbance to the domestic economy. R^, on the other hand, i s the actual "e f f e c t i v e r i s k l e v e l " taken by some developing countries by maintaining a lower"reserve l e v e l , but viewed by them.as conforming to the objectives of t h e i r i n t e r n a l development p o l i c i e s . Obviously, X^ > X^ and < R-^ . In Figure I I , SS i s a r i s k curve. I t i s convex to the o r i g i n because there i s diminishing marginal r i s k as the quantity of reserves increases. Thus, the lower the r a t i o of reserves to imports, the greater i s the r i s k or the magnitude of import r e s t r i c t i o n s and exchange controls that w i l l be imposed i n a p a r t i c u l a r country, and vice versa. The p o l i t i c a l and other arguments of whether the developing countries would be defying i n t e r n a t i o n a l monetary conduct w i l l not be considered here since they f a l l outside the scope of t h i s exercise. The important point we must note i s that the r e l a t i v e l y high r i s k , R 1 w i l l be taken by the developing country but behind t h i s deliberate choice of p o l i c y i s the expectation that, i n the long run, the benefits accruing from increase i n c a p i t a l formation w i l l far Figure II. Comparison of Risk Levels of Developed and Developing Countries 53 compensate for the short.run costs involved. Hence, we can e s t a b l i s h that such a developing country has chosen a r i s k y p o r t f o l i o . That i s , the monetary authority has chosen a combination of assets i n i t s p o r t f o l i o where there are more of the. " r e a l " asset and fewer of the l i q u i d asset. The main argument of t h i s analysis can now be summarized i n Figure I I I . The l i n e CT or CK depicts com-binations of the two assets at the disposal of the monetary authority. A A q and B B q are indifference curves representing the preferences of the authority at d i f f e r e n t levels of r i s k . I t i s assumed that i t has preferences between expected increase i n per capita consumption occasioned by increase i n c a p i t a l formation and r i s k of inadequate reserve l e v e l . "Current discussion on economic development i s usually dominated by a s t a t i c or a very short term view. Investment has been regarded as a deduction from income, which i t w i l l be very d i f f i c u l t to ra i s e since per capita incomes i n the poor countries are so low. The other, and more p o s i t i v e , role of investment as an instrument of r a i s i n g income i s sometimes l o s t sight of. Investment merely appears as a cost, as a burden, bearing an inverse c o r r e l a t i o n with consumption. Only i n a long term view does investment assume i t s r e a l r o l e as the major factor i n r a i s i n g output. Hence, i t s c o r r e l a t i o n with consumption becomes d i r e c t rather than inverse. The greater the investment, and the larger the output, the higher the consumption". See, Surrendra J . Patel, Journal of Modern African Studies, "Economic Transition i n A f r i c a " , Vol. 2, no. 3, Cambridge University Press, 1964, p.346. 54 Figure I I I . P o r t f o l i o Choice by the Developing Country 55 Their shape r e f l e c t s the assumption of r i s k aversion - a diminishing marginal rate of substitution of reserve accumulation for c a p i t a l formation as the l a t t e r increases at the expense of the former. The curves r i s e for th i s r i s k -averting authority. As i t takes more r i s k , i t must be compensated by a higher expected increase i n per capita consumption. Given the structure of the economy, the instruments available, and the preferences of the authority ( r e f l e c t i n g the preferences of society), the tangency point, P, indicates that the country i s on a higher indifference curve, A A q , with both higher expected increase i n per capita consumption, OA, and higher r i s k , OG. On curve, B B q , the equilibrium point i s S with both lower expected increase i n consumption, OB, and lower r i s k , OF. Thus, the closer the tangency point i s to the v e r t i c a l axis, the less reserves w i l l be u t i l i z e d to finance development expenditures, and vice versa. Our analysis w i l l apply to countries on the I-curve A A Q . By comparison, the curve B B q can be taken as t y p i c a l of the oil-producing countries. I t i s clear that i n the former s i t u a t i o n , investment i n c a p i t a l formation has taken place at the-expense of reserve accumulation - a choice of ris k y p o r t f o l i o that goes along with i t an expectation of higher increases i n per capita^ consumption i n the long run. 56 Since a low l e v e l of reserves goes with a high expectation of high return on per capita consumption, and by assumption, on c a p i t a l formation, we can state that demand for international l i q u i d i t y i s inversely related to an in t e r e s t rate which may be a convenient measure of the d i f f e r e n t i a l between the rate of return on c a p i t a l formation and that on holding reserves. The higher this i n t e r e s t rate, the smaller w i l l be the demand for reserves (and vice versa). On the basis of our analysis, i t can be seen that a developing country (as defined) has a low precautionary demand for international l i q u i d i t y . B.v: Conclusions Two consequences follow from the above analysis. F i r s t , the determination of a country's own demand for a stock of.reserves implies an idea of some psychological reckoning based on non-economic as well as economic po l i c y considerations and shaped i n part by the subjective values of the monetary authority i n the p a r t i c u l a r country. As McLeod put i t : "The equilibrium l e v e l of i n d i v i d u a l ... holdings of owned reserves i s ultimately determined by the. holders i n the l i g h t of t h e i r assessment of a l l exi s t i n g circumstances. In any case, i t i s ce r t a i n l y not determined by what some other i n d i v i d u a l or body, however expert, may think i t should be". 2 7 A.N. McLeod, "Contentious Thoughts on International L i q u i d i t y " , op. c i t . , p.14 57 Thus, granting the existence of such value judgements and -preferences of monetary au t h o r i t i e s , a country may not demand a s p e c i f i c stock of reserves - considered as i n t e r n a t i o n a l l y acceptable - but rather any amount of reserves f a l l i n g within a range that i s considered adequate. Secondly, the average amount of reserves held by a p a r t i c u l a r country w i l l be a resultant of economic e q u i l i b r i -ating processes and not a datum as assumed by some economists who employ the transactions approach. Consequently, i n our analysis the ultimate demand function for int e r n a t i o n a l l i q u i d i t y i s D r = f(R,W), where R = the.rate of i n t e r e s t , and W = the wealth of the economy. I t does not contain as a variable the volume of transactions. I t contains rather those basic technical and cost conditions that a f f e c t reserve management. The demand equation i t s e l f r e f l e c t s a wealth constraint and a substitution e f f e c t on the demand for i n t e r -national l i q u i d i t y . The function, therefore, mirrors the general view that demand for inte r n a t i o n a l l i q u i d i t y can be considered part of a general theory of p o r t f o l i o selection or asset preferences. F i n a l l y , i t might, be noted as a s i d e l i g h t that at the same time the developing country determines i t s demand for reserves, i t may also contemplate on the composition of th i s demand. That i s , the proportions i n which i t might wish 58 to hold.gold and convertible foreign currencies. This deter-mination also involves some cost balancing and value judgments. The.cost of holding gold i s the s a c r i f i c e of i n t e r e s t that could be earned on foreign exchange assets, i . e . , foreign s e c u r i t i e s . The cost of holding reserve currencies, on the other hand, i s the r i s k of devaluation (exchange risk) or i n c o n v e r t i b i l i t y . Given the implications of our main analysis, i t can be stated that a developing country cannot afford to invest i n excessive gold accumulation. Hence, i t s r a t i o of gold ~to reserve currencies w i l l be low as compared to that of 2 8 a developed country. Table II shows countries' o f f i c i a l reserves (1960-1966). I t i s evident from i t that for the developing countries- reserve positions at the Fund are low while t h e i r holdings of other i n t e r n a t i o n a l l y l i q u i d assets are small r e l a t i v e to those of the developed countries. For example, t o t a l gold holdings of a l l developing countries tend to be about 20% of the t o t a l for both the United States and United Kingdom. II.7: USE OF THE INTERNATIONAL MONETARY FUND In the above analysis, we have defined international l i q u i d i t y as the developing country's holdings of gold and foreign exchange reserves plus i t s I;M.F. po s i t i o n . I.M.F. position was further defined as the country's drawing rights i n the gold tranche, which i s equivalent to i t s owned reserves. 2 8 c f . P.B. Kenen, Reserve Asset Preferences of Central  Banks and the S t a b i l i t y of the Gold Exchange Standard, Princeton Studies i n International Finance, no. 10, 1963, pp. 15 - 18. TABLE I I . COUNTRIES' O F F I C I A L RESERVES, 1960-66 ( I n m i l l i o n s o f U.S. d o l l a r s ) Tota l Totals , E n d o f 1966 Reserves Net Changes in Reserves' • as Pcr-Rcservc c e n t r e • Foreign position of 1960 1961 1962 1963 1964 1965 1966 G o l d exchange in I M F Tota* I m p o r t s » Industrial Countr ies United States - 2 , 1 4 5 - 6 0 6 - 1 , 5 3 3 - 3 7 7 - 1 7 1 -- 1 , 2 2 2 - 5 6 9 13,235 1,321 326 14.881 53.7 United K i n g d o m 918 - 4 0 1 - 1 0 - 1 6 1 - 8 3 1 688 96 1,940 1,159 , — 3,100 18.6 Tota l reserve centers - 1 , 2 2 7 - 1 . 0 0 7 - 1 , 5 4 3 - 5 3 8 - 1 , 0 0 2 - 5 3 4 - 4 7 3 15,175 2,480 326 17,981 4 0 . 5 France 536 1,093 684 859 816 619 390 5,238 507 988 6,733 56.9 G e r m a n y 2,242 131 - 2 0 7 694 232 - 4 5 3 599 4,292 2.479 1,257 8,023 4 4 . 5 Italy 4 195 548 269 - 4 4 9 205 976 111 2,414 1.612 835 4 , 9 1 ! 57.3 Be lg ium-Luxembourg and Netherlands 622 402. - 7 2 343 499 179 48 3,261 733 7S3 4,777 31 .4 Switzerland 261 434 113 203 46 124 80 2,841 483 . — 3,324 84.3 Other Industrial Europe 1 54 328 276 369 502 33 131 1,030 2,077 377 3,484 2 8 . 3 Tota l Industrial Europe 3,910 2 ,940 1,060 2,020 2,300 1,480 1,370 19,075 7,895 4,289 31,260 . 4 4 . 7 Canada - 4 0 287 271 56 278 146 - 3 3 4 1,046 1,199 448 2,693 2 7 . 0 Japan 502 - 2 8 3 356 36 - 3 9 133 - 3 3 329 1,469 321 2,119 2 2 . 3 Tota l industrial countries 3,140 1,940 145 1,570 1,540 1,225 530 35,625 13,040 5,335 54,055 4 0 . 4 Other Developed Countries Other European countries 8 369 322 312 279 521 - 1 7 8 - 7 9 1,788 1,602 245 3,635 32 .9 Austral ia, New Zealand, South A f r i c a - 5 8 8 504 328 573 25 - 5 6 8 243 861 1,367 220 2,448 33.7 Tota l other developed countries - 2 2 0 825 640. 855 545 - 7 4 5 165 2,650 2,970 ~ ~ 4 6 5 6,OSS 33.3 Less Developed Countr ies 64 .9 M idd le East oil p roducers 7 - 4 9 55 42 409 30 248 260 439 1.312 77 1,825 Other M i d d l e East 40 43 234 95 86 183 - 7 354 965 29 1,343 4 5 . 0 F a r East B 154 " 39 67 207 171 249 495 228 2,376 84 2.6S7 54 .9 Other As ia - 1 3 5 - 3 0 2 - 1 0 2 68 - 2 1 5 37 - 3 1 422 658 17 1,098 19.4 Lat in Amer ica , N o r t h • - 1 5 4 - 8 3 29 374 145 16 - 3 7 554 1.032 156 1,741 3 7 . 6 Other Lat in Amer ica 69 - 1 6 6 - 4 9 3 107 - 1 4 417 - 8 1 429 97.1 37 1,388 2 3 . 8 Af r ica 1 0 39 - 3 1 2 - 5 - 2 7 6 - 8 1 67 33 68 987 S3 1,139 2 3 . 5 To ta l less developed countries - 3 0 - 7 2 5 - 1 9 5 935 125 1,235 680 2,630 8.250 481 11,360 28.1 G r a n d Tota l 2 ,895 2,035 595 3,360 2,210 1,710 1,380 40,905 24.260 6,331 71,495 37.3 Source: International Monetary F u n d , Internationa! Financial Statistics. 1 Excluding Soviet countries and Ma in land Ch ina . Totals may not add because of rounding and because some area totals include unpublished data. * Including reserve position in the F u n d . N o sign indicates increase; minus sign indicates decrease. 1 Reserves at end of 1966 as percentage of imports c.i.f. during the year, 4 Including swap claims and nonmarketable U .S . Government securities. » Austria, Denmark , Norway, Sweden. 6 F in land, Greece, Iceland, Ireland, Portugal, Spain, Turkey, Yugoslavia , 7 Iran, Iraq, Kuwait . L ibya, Saudi A r a b i a . 8 Republic of Ch ina , Korea , Malays ia , Philippines, Thai land, V i c t - N a m . • Central America, Dominican Republic, Jamaica, Mex ico , Panama, Venezuela. 1 0 Excluding Libya and the United A r a b Republ ic . » Percentages for country groups are based on the imports for countries to which reserve statistics refer; the percentage for the total relates, however, to the total imports of all less developed countries and, primarily because dependent territories have no separate monetary reserves, this percentage lies below the weighted average of the subgroups listed. • . 60 The d e f i n i t i o n therefore tended to ignore another aspect of l i q u i d i t y - conditional l i q u i d i t y at the Fund. This i s access to drawing rights i n the c r e d i t tranches, which are considered p e r f e c t l y l i q u i d assets, though imperfect substitutes for own reserves. In this section, we intend to elaborate on our o r i g i n a l contention (p.47) that p o l i c i e s governing access to these l i n e s of c r e d i t tend to support the argument that the developing country should hold some reserves. For, i f the country had s u f f i c i e n t assured access to lines of c r e d i t at the Fund, i t i s conceivable i n view of our analysis that i t would further draw down i t s own reserves to finance develop-ment expenditures. The very p o l i c i e s governing drawings i n the c r e d i t tranches indicate that the willingness of the country to follow t h i s course of action w i l l be limited. II.7A: P o l i c i e s Governing the Use of Fund Resources Generally, when a country joins the Fund, i t pays 25% of i t s quota i n gold and 75% of i t i n i t s own currency. On the basis of these quota subscriptions, the country obtains unrestricted access to a certa i n amount of the Fund's holdings of foreign currencies (gold tranche, 25%) and conditional rights to larger amounts i n the cr e d i t tranches (75%). A t y p i c a l developing country has a percentage quota of about between 1 - 5% of t o t a l members' quota i n the Fund. Besides t h i s r e l a t i v e l y small quota, Fund c r e d i t can be made available 61 to a l l members only i n such circumstances that these countries have.satisfied the Fund of th e i r intention and capacity to restore-external balance and a s s i s t i n achieving other 29 objectives of the Fund. F i r s t and foremost, when a member draws on the Fund, i t indicates as a matter of general policy i t s intention to repurchase the Fund's holdings of i t s currency acquired i n the transaction not l a t e r than three to f i v e years after the drawing, unless these holdings are otherwise reduced. A drawing from the Fund provides the drawing country with a l i q u i d asset, an international money of some form, i n exchange for a short term l i a b i l i t y i n terms of the repurchase o b l i -gation. A member cannot reduce the Fund's holdings of i t s currency below 75% of i t s quota and cannot use also a currency i n repayment which w i l l raise the Fund's holdings of that currency above 75% of the p a r t i c u l a r country's quota. These p o l i c i e s are es e e n t i a l l y meant to preserve the l i q u i d i t y of the Fund during transactions. Thus, we should be more interested i n discussing the p o l i c i e s governing drawings i n the tranches, p a r t i c u l a r l y those i n the c r e d i t tranches. For i n the gold tranche drawings are automatic i n that member countries can count on the receipt of an overwhelming benefit of the doubt i n regard to drawings which w i l l raise the Fund's L.B. Yeager examines these objectives; see his International Monetary Relations, Harper and Row (New York, 1966), pp.347 - 358. See also, C. Gutt, International Monetary Fund  and i t s Functions, The Academy of P o l i t i c a l Science, Columbia University, 1947, pp.53 - 56. 62 holdings of a p a r t i c u l a r member's currency to not. more than i t s quota. A . i : The Credit Tranches Generally, drawings i n the f i r s t c r e d i t tranche - i . e . , currency holdings (0 - 25%) above a member's quota - may be favourably allowed i f the member j u s t i f i e s the need for the. request. Beyond th i s tranche, drawings are s t r i c t l y conditional and they can be permitted given the need and the substantial j u s t i f i c a t i o n . Sometimes drawings within the quota l i m i t of 25% within a 12 month period may not provide a member with the amount of assistance i t may need to meet i t s problems. In such cases, the Fund might employ the use of waivers. Some p o l i c i e s governing drawings beyond the gold tranche are also designed to deal with standby arrangements. Standby arrangements are often negotiated on s p e c i f i c understandings regarding the use of the resources available. Usually the granting of such an arrangement i s accompanied by a l e t t e r of intent which contains precise declarations of po l i c y to be followed by the drawing member, including measures such as those concerning the extension of bank c r e d i t to the government or the private sector and concerning public finance. Indeed, the most common purpose for which Fund assistance i s given to a developing country i s i n support of s t a b i l i z a t i o n programs designed to eliminate i n f l a t i o n and 63 reduce reliance on r e s t r i c t i o n s both on trade and payments. Large amounts of resources are always available i n the cr e d i t tranches but the use that a country can make of standby r i g h t s , for example, i s conditioned by the Fund's rules regarding drawings i n t h i s area. The obligation of a member drawing under the f a c i l i t y to consult the Fund p r i o r to adopting any practice or p o l i c y increases i n d i r e c t l y the power of the Fund to dictate national p o l i c i e s which i t has on occasion done, i n terms of the type of s t a b i l i z a t i o n program designed for the p a r t i c u l a r country. The reason i s that most developing countries have a b e l i e f i n cheap money po l i c y and i n f l a t i o n as instruments to a s s i s t and advance i n d u s t r i a l i z a t i o n . Moreover, they tend not to be interested i n the achievement of external balance for i t s own sake; that i s , they consider i t a po l i c y constraint rather than a po l i c y objective. These pol i c y objectives of the developing countries tend to c o n f l i c t with those of the.Fund. Sometimes, some standbys may include conditions intended to discourage excessive debt burden and the acceptance of an 31 unduly large amount of suppliers' c r e d i t s . cf. Per Jacobsson, International Monetary Problems: 1957 ~ 1963, I.M.F. 1964, Washington, D.C, pp.148, - 152. 31 See, for example, P. L i e f t i n c k , External Debt and  Debt-Bearing Capacity of Developing Countries, Essays i n International Finance, Princeton University, March, 1966, no. 51, e s p e c i a l l y pp.4 - 11. 64 The Fund does not agree to refinance debts d i r e c t l y but i t may pa r t i c i p a t e i n a debt renegotiation with the countries or agencies concerned. I t offers f i n a n c i a l assistance only when this may lead to a successful imple-mentation of a s t a b i l i z a t i o n program. The Fund has provided th i s type of assistance on an informal basis as part of the negotiations i n regard to the outstanding debts of Turkey i n 1958/59, B r a z i l i n 1961 and 1964, Argentina i n 1962 and 1965, L i b e r i a i n 1963Indonesia i n 1963, and Chile i n 1965. I t i s true to some extent that a general b e l i e f i n the a b i l i t y of countries to maintain viable exchange rates has been engendered by the existence of these arrangements. These arrangements are, however, more b e n e f i c i a l to the developed - countries than to the developing countries since i n the l a t t e r i n t e r n a l p o l i c i e s of development tend to c o n f l i c t with what the Fund w i l l want the drawing countries to do. A developing country, for instance, which i s engaged i n intensive use of import r e s t r i c t i o n s and i s not contem-plati n g on accepting the p o l i c i e s of the Fund can v i r t u a l l y not count on receiving assistance from the Fund - a matter that tends to indicate that such a country should hold some minimum of own reserves. II.7B: TRANSACTIONS. WITH DEVELOPING COUNTRIES Indeed, available evidence indicates that i f Fund 65 p o l i c i e s on drawings were l i b e r a l i z e d , developing countries would r e l y heavily on supplemental reserves from the Fund. Before 1957 a large part of Fund transactions with members was concentrated i n the developed countries which needed much f i n a n c i a l assistance to tide them over i n the post-war reconstruction period. At that time, only a few developing countries such as Turkey, India, and some L a t i n American countries drew on the Fund. Their t o t a l drawings, however, formed a.small percentage of the - t o t a l net drawings by a l l members, the magnitude of which was influenced largely by 32 drawings of the United Kingdom. After 1957 the number- of drawings by the developing countries began to grow. Their membership i n the Fund has increased as well, and so also have t h e i r a c t i v i t i e s with 33 the Fund, which have expanded very considerably. For example, between 1958 and 1959 only gross drawings by various groups of countries amounted to $3,400 m i l l i o n . Of t h i s amount, about 60% was drawn by the OEEC and other countries including A u s t r a l i a , South A f r i c a , Japan, etc., while 40% went to the developing countries (this compares with less than 20% before 1957). Of t h i s 40%, the L a t i n American countries accounted for 22% and other Asian and A f r i c a n countries accounted for the.remaining 18%. Indeed, 32 Evidence for net drawings by the developing countries before 1957 i s summarized i n Brian Tew, International Monetary  Fund: Its Present Role and Future Prospects, Essays i n Inter-national Finance (March, 1961), no. 36, pp.4 - 5.. 33 Of the 107 members of the Fund about 80 of them are developing countries. 66 the best evidence of increased use of Fund resources by these countries i s indicated by the number of standbys arranged and the d i r e c t drawings made by these countries. Between 1957 and 1965, the Fund approved 137 new or renewed standby arrangements: 17 were for the developed countries and 120 for the developing countries. S i m i l a r l y , there were 55 d i r e c t drawings: 19 by the developed countries and 36 by the develop-ing countries. Since the Fund began operations i n 1947, i t has provided $2,860 m i l l i o n i n various currencies to t h i r t y -six developing countries, about 47% of the t o t a l purchases made to members by the end of 1965. At the end of January of that year, t h i r t y of these countries accounted for nearly 50% of the $2,6 b i l l i o n of net drawings s t i l l outstanding at the Fund. The charge has often been made that, despite i t s measures l i k e increased Fund quotas and the Compensatory Export Financing f a c i l i t y , the provision of resources by the Fund to these countries i s inadequate. Its very p o l i c i e s have the e f f e c t of producing t h i s r e s u l t . For example, i t i s maintained that the Fund i s an organization whose resources are intended to be drawn on pre c i s e l y for short term imbalances i n trade. Unfortunately, when i t s constitution was drawn, regard was had only for the problems of the i n d u s t r i a l countries so that the panaceas that may be e f f e c t i v e when applied to malfunctioning i n d u s t r i a l countries 67 are often t o t a l l y without relevance for the developing countries. I t i s , so to speak, a " r i c h man's club" that stresses the achievement of external balance by a l l member countries. On the basis of the goals of t h e i r development strategies, however, developing countries are not merely interested i n the achievement of t h i s objective for i t s own sake. Hence, i t becomes evidently possible that the Fund's provision of c r e d i t to these countries w i l l be p r a c t i c a l l y limited, making i t possible for them to use import controls, even as part of t h e i r monetary p o l i c i e s . However, plausible as these arguments might b e r our analysis tends to demonstrate that measures that tend to provide more conditional l i q u i d i t y to the developing countries w i l l have a simultaneous impact of inducing them to draw down th e i r own reserves to finance development expenditures. Indeed, i f such measures should produce any change i n the i r present development expenditure behaviour-; there would have to be a large amount of reserves made available to help to ease a l i t t l e the t i g h t exchange controls under which most of them operate. The reason i s that what the developing countries need i s not additional reserves per se, but additional c a p i t a l aid. These arguments provide the basis of our examination of the implications of some proposals for international monetary reform for the developing countries, which w i l l be our purpose i n Chapter I I I . 68 II.8: SOME MODIFICATIONS OF THE ANALYSIS Before we proceed any further, some modifications of the analysis c a l l for examination. We must note that, although the p o r t f o l i o theory tends to demonstrate that there has been increase i n c a p i t a l formation at the expense of accumulation of reserves, we cannot a p r i o r i conclude that t h i s process has d e f i n i t e l y led to increase i n the rate of growth of the developing countries. Increase i n c a p i t a l formation would a f f e c t the l e v e l of income but not necessarily the growth rate unless some basic s t r u c t u r a l changes i n the economy occur. In the short run, t h i s i s p a r t i c u l a r l y what i s l i k e l y to happen.. But i n the long run, i t i s possible to assume that, other things being equal, t h i s rate would be affected p o s i t i v e l y since domestic savings and export c a p a b i l i t i e s might have r i s e n to the point where foreign c a p i t a l might become r e l a t i v e l y , un-necessary for the growth rate to be sustained. This condition w i l l , be met as the increase i n incomes creates a permanent and growing margin of savings that w i l l i t s e l f generate enough domestic c a p i t a l to support the investment-growth process. The extent to which th i s process can go on depends on the absorptive capacity of the p a r t i c u l a r economy. Generally, increase i n income depends on the productivity of the added c a p i t a l and t h i s productivity can be gauged by increases i n wages, p r o f i t s including i n t e r e s t , depreciation and cost-price-raising-taxes, which r e s u l t from a r i s e i n investments. The 69 better the r a t i o between the amount of additional c a p i t a l invested and these proceeds (the gross added value), the greater the r i s e i n incomes brought about by the imported c a p i t a l . The productivity of the added c a p i t a l also varies with the absorptive capacity of the economy and the factors which influence that capacity, for example, the s k i l l s of the population, also determine to a large extent the c a p i t a l -return r a t i o . I f investment projects are so chosen that they remove the bottlenecks that stand i n the way of rapid increases i n productivity of e x i s t i n g economic a c t i v i t i e s , rather than c a p i t a l consuming and extravagent new projects with long gestation periods, the necessary growth rate w i l l be achieved to minimize the foreign exchange constraint. This whole complex process' i n which additional c a p i t a l i s accumulated and i n which an i n i t i a l increase i n incomes can, by savings and investment, lead to a greater increase i n incomes, i s the pivot around which the process of economic growth revolves. Other.things equal, i t i s the percentage of the increase i n incomes that i s saved which indicates the rate of growth of the economy. Such a process, however, varies from country to country, depending on the structure of the economy and therr.ate of population growth. As a matter of empirical i n t e r e s t , Baldwin has shown that i n aggregative terms, the economic performance of the. developing countries i n recent years has been very encouraging. 70 For example, between 1957/5 8 and 1963/64, t h e i r gross national product grew at a 4*7% annual rate. However, since the annual rate of population growth was 2*4% i n the same period, per capita income rose by only 2*3% i n the developing countries as compared with the 3*1% i n the developed countries i n the same . period. R.E. Baldwin, Economic Development, and Growth, John Wiley & Sons, Inc., (New York, 1966), es p e c i a l l y p.116, and table I.1, p.4. 71 CHAPTER III INTERNATIONAL MONETARY REFORM AND DEVELOPING COUNTRIES In the preceding chapter we attempted to show that the r e l a t i v e l y high rate of return on c a p i t a l has led some developing countries to draw down on t h e i r i n t e r n a t i o n a l l y l i q u i d assets to finance development expenditures. We explained that the strength of the "demonstration e f f e c t " , i n addition to other factors, has made the s o c i a l opportunity cost of holding reserves very high. This i n turn has made i t d i f f i c u l t for the developing countries to invest r e a l resources i n the accumulation of reserves. In the l i g h t of these conclusions, i t can be argued that any reform of the in t e r n a t i o n a l monetary system which provides them with additional reserves, but does not increase the inflow of c a p i t a l , w i l l further induce them to pursue t h e i r present p o l i c y of u t i l i z i n g reserves for develop-ment purposes. With th i s proposition i n mind, we s h a l l examine some of the plans for a reform of the international monetary machinery, which have d i r e c t relevance to the developing countries. From the l i t e r a t u r e on the plans for international 72 monetary reform, we can c l a s s i f y the plans into two categories according to purpose: a) plans which seek a simultaneous solution of the problem of the inadequacy of l i q u i d i t y i n the world context and the problem of increasing development finance to the developing countries, and b) those which intend to create additional reserves i n the system to the "benefit" of both the developed.and the developing c o u n t r i e s . 1 I I I . l : "KILLING TWO BIRDS WITH ONE STONE" The proposals i n t h i s category have as th e i r basic aim the simultaneous solution of the general l i q u i d i t y problem and the development 'problem' of the developing countries. E s s e n t i a l l y , they emphasize that there should be a " l i n k " between monetary reform and provision of the development finance to the developing countries. I t i s stressed that monetary reform should go hand i n hand with, and should f a c i l i t a t e , the adoption of trade and aid p o l i c i e s that would contribute to the removal of the s t r u c t u r a l problems that i n h i b i t growth i n these countries. In t h i s way i t can be argued that such proposals w i l l be considered "good" by the developing countries since the e f f e c t w i l l be to increase the "'"The reader who i s interested i n the. general plans for reform may consult, R.G. Hawkins, Compendium of Plans for  International Monetary.Reform, The B u l l e t i n , C.J. Devine In s t i t u t e of Finance (New York University, December, 1965) No. 37 - 38. See also, F. Machlup, Plans for Reform of the Inter-national Monetary System, Reprints i n International Finance (Princeton University, March, 1964) rev. ed. No. 3, and Streeten, "International Monetary Reform and the Less Developed Countries", op. c i t . , pp.157 - 178. 73 flow of c a p i t a l , which i s at present i n great demand by them. i : THE STAMP PLAN One such proposal for l i n k i n g the creation of additional l i q u i d i t y and the provision of additional c a p i t a l aid to the 2 developing countries was suggested by Maxwell Stamp i n 1962. The g i s t of th i s Plan consisted i n the issuing of international c e r t i f i c a t e s - international money - created by the International Monetary Fund or some other agency concerned with aid or the need for additional reserves. These c e r t i f i c a t e s were to be d i s t r i -buted to the developing countries which would then use them to purchase goods for development purposes from the advanced countries that expressed th e i r willingness to accept them. As i t stood, the scheme was plausible i n terms of the objective i t was designed to achieve. For example, i t was suggested that the implementation of the scheme would have the e f f e c t of counterbalancing the tendency of a l l developed countries to seek an export surplus. Moreover, "the i n j e c t i o n of the new purchasing power into the pockets of the under-developed countries could mean that fewer advanced countries would run d e f i c i t s , and, therefore, the probable c a l l s on the Fund to 3 cover ordinary balance of payments cr i s e s would be lessened". i b i d , pp. 60 - 68. i b i d , p. 64 74 Two doubts were, however, raised against the scheme. The f i r s t r e lated to the central issue of whether any given developing country could control i t s own c a p i t a l contribution i f the newly created asset i s accepted. Secondly, some doubts were cast on the d e s i r a b i l i t y of the scheme since fear was expressed that the new asset would not be accepted by a l l countries. Scitovsky's Plan was an attempt to overcome the problem of a c c e p t a b i l i t y by s h i f t i n g the i n i t i a t i v e of reserve creation to d e f i c i t countries i n need of reserves, and which, therefore, would be ready to surrender r e a l resources for aid. In a sense, th i s implied that d e f i c i t advanced countries would be providing the largest part of the development aid to the developing countries. i i : THE SCITOVSKY PLAN This Plan proposed that the d e f i c i t countries would make a budgetary appropriation for grants-in-aid to the developing countries while handing over these grants to a reformed I.M.F. (preferably, T r i f f i n ' s X.I.M.F.^) i n the form of t h e i r national currencies or government debts. The I.M.F. would then issue an international currency backed by the d e f i c i t country's currency or debt. This would then be made T. Scitovsky, Requirements of an International Reserve  System, Essays i n International Finance, No. 49, Princeton University, 1965, e s p e c i a l l y pp.10 - 13. 5 R. T r i f f i n , Gold and the Dollar C r i s i s , op. c i t . , pp. 105 - 115. See also: R.G. Hawkins, Compendium of Plans for  International Monetary Reform, pp.14 - 37. 75 available to the developing countries through an intermediary of an International Development Association for the purpose of financing development imports from the o r i g i n a l d e f i c i t country. In other words, the developing countries would be receiving t i e d grants since the scheme r e s t r i c t s them to spend the money only i n the d e f i c i t countries against whose currencies or debts i t was issued. Meanwhile, the d e f i c i t countries would be receiving additional external reserves i n exchange for the goods exported to the developing countries. This arrangement i s thus designed to cater to the development needs of the developing countries, while providing increases i n world reserves. In a very recent a r t i c l e Scitovsky has revised his scheme and proposed that to avoid undesirable consequences for any group of countries- the newly created reserves should be equal to the value of the products to be transferred to the developing countries.^ F i n a l l y , he showed that, under his scheme, the l e v e l of world unemployment w i l l decrease, in t e r n a t i o n a l l i q u i d i t y w i l l increase and the developing countries w i l l be receiving unrequited f i n a n c i a l assistance. This arrangement, despite i t s s a l i e n t aspects, has met with vehement c r i t i c i s m e s p e c i a l l y from Professor Lee, who has argued that i n cases where the m u l t i p l i e r e f f e c t of the whole T. Scitovsky, "A New Approach to International L i q u i d i t y " , American Economic Review, December, 1966, Vol. 56, pp. 1212 - 1219. transfer of resources i s not equal to unity (as Scitovsky's model assumes), " i t i s l i k e l y that the d e f i c i t country w i l l continuously be i n d e f i c i t , while the creation of new reserves w i l l always be short of the d e f i c i t i n the balance of payments" I t i s cle a r , however, that, l i k e the Stamp Plan, the Scitovsky Plan was intended to augment the f i n a n c i a l resources needed to finance economic development i n the developing countries, v i a an inte r n a t i o n a l monetary reform. This basic purpose was the objective of an alternative proposal made by the Experts of the United Nations Committee for Trade and Development (UNCTAD). . i i i : UNCTAD EXPERTS' PROPOSAL The Experts emphasized the importance of the " l i n k " from a d i f f e r e n t viewpoint. They argued that the developing countries should have a share i n any unconditional l i q u i d i t y that was to be created as a r e s u l t of any inte r n a t i o n a l monetary reform. The creation of such additional l i q u i d i t y was, however, to be linked to the provision of additional 8 development resources to these countries. In a sense, the additional l i q u i d i t y was to be created through the I.M.F.'s C.H. Lee, "A New Approach to International L i q u i d i t y : Comment", American Economic Review, September, 1967, Vol. 57, No. 4, pp.919 - 920. o U^N.C.T.A.D. Experts Report, International Monetary  Issues and the Developing Countries, U.N. Publication, November 1965. 7(7 issue of "Fund Units". That i s , the I.M.F. was to lend the International Bank for Reconstruction and Development or i t s a f f i l i a t e s , part or a l l of the usable counterpart currencies deposited by member countries against the issue of Fund units i n exchange for I.B.R.D. bonds. Each developed country was then to compete for the additional orders made available by the World Bank investment i n order to re t a i n the f u l l addition to i t s reserves represented by the i n i t i a l d i s t r i b u t i o n of Fund Units. I t was suggested that i f the i n i t i a l d i s t r i b u t i o n of the additional orders diverged from that of the newly created Fund Units, then a new r e d i s t r i b u t i o n of the Fund units had to take place. The developed countries which might have gained from th i s r e d i s t r i b u t i o n would then have done so by giving up resources to f u l f i l the development orders coming from the developing countries. The greater the extent to which one developed country made r e a l resources available through the procedure, the greater w i l l be the extent to which i t w i l l also be able to share i n the ultimate d i s t r i b u t i o n of the newly created reserves. In thi s way, the process intended to make available additional reserves to the developed countries while at the same time providing the needed c a p i t a l aid to the 78 developing countries. I t i s evident from the foregoing that the implementation of any of the above proposals w i l l have one obvious advantage as our analysis indicated: namely, since the developing countrie are not interested i n holding reserves per se, an increase i n c a p i t a l aid to them w i l l , other things being equal, have the e f f e c t of reducing the r i s k of t h e i r development " p o r t f o l i o s " , thus making i t r e l a t i v e l y possible for them to hold larger reserve lev e l s as well. Unfortunately, the leading i n d u s t r i a l countries object to any prospective l i n k i n g of the problems of international l i q u i d i t y and economic development. The Group of Ten, for example, stated thus: "the provision of c a p i t a l to the developing countries i s a problem quite d i s t i n c t from the creation of reserves and should be achieved by other techniques" It i s to be noted that the new asset was supposed to be created according to the needs (somehow estimated) of the world economy and not according to the needs of the developing countries. A proportion of these newly created assets- or the currencies furnished as backing for them, was to be put at the disposal of the I.B.R.D. and the size and timing of this provision would be designed to meet the needs of development po l i c y - a matter the success of which depended on the e f f e c t i v e planning techniques of the I.B.R.D. "*"^ The Group of Ten, Report of the Study Group on the  Creation of Reserve Assets, Report to the Deputies of the Group of Ten, May 31, 1965, pp. 69 - 70. 7L9 I t i s maintained that the system involved a long term movement of r e a l resources from the more to the less developed nations. Thus, i f any of the proposals which try to package the problem of l i q u i d i t y and development were put into operation, the developing countries w i l l be gaining without incurring any r e a l costs - that i s , they would be paying nothing for something."''''' III.2A: ALTERNATIVE PLANS Besides the proposals which aimed at meeting the c a p i t a l imports needs of the developing countries, the Bernstein Plan and the Credit F a c i l i t i e s Approach intended to meet the reserve needs of these countries. Like the recent S.D.R. Proposal, which w i l l be discussed below, these Plans sought to provide additional l i q u i d i t y to the developing countries. As we stressed before, the opportunity cost of holding reserves i s high for these countries. Hence, i t i s obvious that the implementation of any of these alternative Plans w i l l not tend to a l t e r the development expenditure behaviour of these countries, Benjamin Cohen has, on the contrary, noted that the developing countries r e a l l y pay something for nothing because of the s t r i k i n g l y inequitable d i s t r i b u t i o n of adjustment costs, part of which i s often transferred to them from the developing countries. Hence, he has argued that there i s a strong case for l i n k i n g the problem of l i q u i d i t y and economic development i n any i n t e r n a t i o n a l monetary reform. In p a r t i c u l a r , he has proposed that a good deal of assistance could be provided to the developing nations by d i s t r i b u t i n g to them the largest part of any newly created reserves (irrespective of how) as a consequence of a world monetary reform. See, B.J. Cohen, Adjustment Costs and the D i s t r i b u t i o n of Reserves, Princeton Studies i n International Finance, No. 18 (Princeton University, 1966), e s p e c i a l l y pp.31 - 35. since they w i l l tend to spend any additional reserves given them for development purposes. In any case, l e t us see how these Plans intended to provide additional l i q u i d i t y to these countries. We s h a l l examine i n order, The Credit F a c i l i t i e s Approach, the Bernstein Plan, and f i n a l l y , the S.D.R. Proposal. i : THE CREDIT FACILITIES APPROACH This approach, intending to favour countries with low reserves (the developing countries included), aimed at carrying out one function of reserves - to enable a country to finance d e f i c i t s i n i t s balance of payments without reducing the foreign exchange value of i t s currency - while simultaneously providing the stimulus for countries to take measures to reduce d e f i c i t s 12 i n due course. Under t h i s scheme, drawing righ t s at the Fund would be made "unconditional". A borrowing country w i l l have the d i s c r e t i o n to choose whether to exercise i t s r i g h t or not as the circumstances permit; the lending i n s t i t u t i o n , the I.M.F. w i l l have no d i s c r e t i o n i n t h i s matter. The F a c i l i t y w i l l be usable e n t i r e l y upon the d i s c r e t i o n of the country that owns the new reserves. The drawings (loans) w i l l be repayable only after f i v e or more years so that an owner may spend them without worrying about his a b i l i t y to replenish them during the next few years after a drawing i s made. F. Machlup, "Credit F a c i l i t i e s or Reserve Allotments?", Bance Nazionale Del Lavoro, Quarterly Review, Rome, June, 1967, pp.135 - 156. 8'1 In addition, the scheme proposed that the unconditional drawing rights could be transferred into overdraft f a c i l i t i e s so that instead of a country drawing from a pool of foreign currencies held by the I.M.F., the country would now have the r i g h t to overdraw a deposit account carried with the Fund and denominated i n Fund Reserve Units. The d i s t r i b u t i o n of the newly created reserves would then be based i n such a way that, while new funds would be created by way of loans to countries i n d e f i c i t , countries i n surplus positions would be forced to earn new reserves by supplying r e a l resources to the d e f i c i t countries. The obligation to repay the loan i n due course, however, ensured that the transfers of resources would be temporary. Although t h i s approach seems to be the least d i s c r i m i -natory as compared to others l i k e the Bernstein Plan, since most countries would have the d i s c r e t i o n to use th e i r rights 13 at w i l l , i t has been termed "adventitious" and "haphazard". I t i s maintained that countries i n low reserves and those suffering from payments d e f i c i t s would be the ones which would make large drawings. Hence, reserve increases might be large i n some years and probably zero i n others when some countries have surplus reserve l e v e l s . Moreover, although the scheme might bestow benefits on countries i n d e f i c i t s , (especially the developing ones), i t i s considered less favourable than a 3 i b i d , p.152 8 3 deliberate creation of reserves because i t s t i l l implies a movement of r e a l resources from one part of the world to another, a c r i t i c i s m to which the other proposals discussed above were subject. i i : THE BERNSTEIN PLAN This Blan may be considered as ensuring additional reserves to the developing countries while at the same time making i t possible for them i n d i r e c t l y to receive c a p i t a l 14 aid from the advanced countries. The aim of this Plan was to e f f e c t a system whereby a large number of i n d u s t r i a l countries which hold about 86 per cent of world monetary gold outside the communist bloc w i l l provide increases i n int e r n a t i o n a l reserves i n some form. The currencies of eleven major countries - United Kingdom, United States, Canada, Japan, France, Sweden, Switzerland, Germany, I t a l y , the Netherlands, and Belgium - were to be pooled at the International Monetary Fund. Against t h i s pool of currencies, the Fund w i l l issue an equal amount of composite reserve units (CRU). Members would acquire CRU by depositing i n the Fund agreed amounts of t h e i r own currencies receiving i n exchange deposit credits denominated E.M. Bernstein, "A P r a c t i c a l Proposal for International Monetary Reserves", Model, Roland & Co., Quarterly Review, Fourth Quarter, 1963. See also, S. Posthuma, "The International Monetary System", Banca Nazionale Del Lavoro Quarterly Review, No. 66 (September, 1963), pp.239 - 261. Posthuma's ideas were-i n a sense the forerunner of the Bernstein Plan. The complexities of t h i s Plan are pointed out i n R. T r i f f i n , "The Bizarre Proposals of Dr. Bernstein for International Monetary Reform", Kyklos, Vol. 17, 1964, pp.328 - 343. i n CRU, equivalent to the U.S. d o l l a r i n value. The CRU would then be used i n combination with gold to s e t t l e i n t e r n a t i o n a l payments imbalances, with p a r t i c i p a t i n g countries agreeing to hold CRU up to a stated proportion of th e i r holdings i n gold. In t h i s way, the new system was intended to develop into a new monetary standard, the Composite Gold Standard, i n which.gold and reserve units w i l l serve as international monies. Since the benefits of the Composite gold standard were to accrue largely to the developed countries, Bernstein suggested the establishment of a complementary program which would cater to the needs of the developing countries. He argued that as these l a t t e r countries cannot hold large reserves of th e i r own because they cannot afford to invest r e a l resources i n thi s form, i t was es s e n t i a l they had an assured access to the Inter-national Monetary Fund as a main source of conditional l i q u i d i t y . To him: "No change i n the international monetary system that would provide for a regular growth of reserves even on a generous scale could induce the underdeveloped countries to accumulate reserves. I f th e i r reserve needs are to be met, i t w i l l have to be from a common reserve to which they have access when they face balance of payments d i f f i c u l t i e s " . 1 5 Hence, he argued that i t might be desirable to make the f i r s t c r e d i t tranche available to them on the same unconditional basis as the gold tranche. In addition, the pol i c y on E.M. Bernstein, "Underdeveloped Countries and Monetary Reform", op. c i t . , p.271. 84 Compensatory Financing of export fluctuations i n i t i a t e d i n 1963 was to be l i b e r a l i z e d by making the maximum amount of such cr e d i t s 50% of quota and by placing the compensatory cred i t s e n t i r e l y outside the present quota-tranche system. If these changes were effected, the scheme would have brought the developing countries benefits i n both d i r e c t and i n d i r e c t ways: d i r e c t l y , because they would then have an assured access to adequate f i n a n c i a l resources from the Fund i n case of need - an access which i s presently conditional because of the p o l i c i e s governing drawings i n the c r e d i t tranches. They would have also benefited i n d i r e c t l y because, other things being equal, other developed countries might have received additional reserves to be s u f f i c i e n t l y l i q u i d to afford more c a p i t a l and f i n a n c i a l aid to them. Although such were the expected benefits of the Bernstein Plan i n the case of the developing^countries, the whole scheme has been considered by many as discriminatory and p o l i t i c a l l y inexpedient, given the way i n which the new 16 reserves were to be di s t r i b u t e d to a l l countries. The recent i n t e r n a t i o n a l monetary reform - the Special Drawing Rights (SDR) Proposal - seeks to overcome th i s problem.by providing additional reserves to a l l countries on "non-R. T r i f f i n , for example, discusses some of the flaws i n the Plan i n his a r t i c l e , "The Bizarre Proposals of Dr. Bernstein for International Monetary Reform", op. c i t . , pp. 328 - 343. 85 discriminatory" basis. The examination of this proposal i s the purpose of the next section. i i i : THE "SPECIAL DRAWING RIGHT" PROPOSAL The recent reform i s a kind of contingency plan for supplementing the supply of inte r n a t i o n a l reserves by means of member countries' access to Special Drawing Rights at the International Monetary Fund. New reserves of unconditional character were to be created under th i s f a c i l i t y , i n the sense that a member " w i l l be able to use the SDR ... whenever i t has 17 a balance of payments need to do so". On the basis of inte r n a t i o n a l conventions, participants would be obliged to accept the new reserve asset; either to hold i t or to use i t to s e t t l e i n t ernational payments. The resources of the new scheme were therefore to consist i n the obligation on the part of the participants t° accept drawing right s i n exchange for an equal amount of convertible currency. When a member draws on the New General Account at the Fund, i t would normally ask the Fund against which other participant i t should exercise the drawing r i g h t . When thi s i s granted, the drawing country w i l l acquire currencies i n the form of convertible foreign exchange to be delivered by countries (country) drawn upon, either d i r e c t l y or through the i n t e r -mediary of the Fund. J.J . Polak, "The New Special F a c i l i t y i n the IMF", The Banker, November, 1967, p.966. See also, on the new f a c i l i t y , "Outline of a F a c i l i t y based on SDR i n the Fund", International F i n a n c i a l News Survey, Supplement, Vol. XIX, no. 36, September, 1967 86 In the framework of the above s t i p u l a t i o n s , a member i s also .obliged to reconstitute. That i s to say, over a f i v e year period a member's average use of the new f a c i l i t y i s not to exceed 70% of i t s average cumulative a l l o c a t i o n . In other words, i n the f i v e year period a country's average holdings of the new reserves should at least be 30% of i t s average a l l o c a t i o n over the same period. I f the holdings f a l l below thi s minimum l e v e l , the p a r t i c u l a r country w i l l then be obliged to reconstitute. However, t h i s procedure d i f f e r s from the repurchase rules of the present Fund i n that the reconstitution idea i n the new f a c i l i t y derives from the "guidance of other countries drawings". For instance, i f other countries do not want to draw, reconstitution may not be necessary even though a country's average holdings might remain below the required minimum l e v e l . Moreover, i t i s stipulated that the long term need for reserve increases w i l l be based on a quinquennial review of the e x i s t i n g quantity of reserves within a period. Having touched on the main features of the new f a c i l i t y , we can now turn to the most important issue of the d i s t r i b u t i o n of the new reserves. i i i a : D i s t r i b u t i o n of the New Reserves On the question of d i s t r i b u t i o n , i t i s maintained that a l l o c a t i o n of new reserves w i l l be made to a l l member countries independently of t h e i r payments positions on the basis 87 of the existing quotas i n the Fund. This means that the d i s t r i b u t i o n of the new reserves w i l l have very important repercussions for the developing nations. The United States and the United Kingdom respectively have quotas of 26*6% and 12*6% of t o t a l member quotas i n the Fund, while most developing countries have each quotas either below or a l i t t l e above 1%. As a whole, the developing countries account for 27% of t o t a l member quotas ( i . e . almost equal to that of U.S.) while t h e i r share i n t o t a l of world reserves i s less than 17%. The former figure, however, i s influenced more by some groups of countries such as the oil-producing countries which have already r e l a t i v e l y large reserves and other L a t i n American countries with inadequate reserves. Thus, i n terms of i n d i v i d u a l countries' share i n the d i s t r i b u t i o n , the i n i t i a l d i s t r i b u t i o n w i l l tend to be more advantageous to those countries which have larger quotas than others with small quotas i n the Fund. In t h i s way, i t i s easy to see that a large part of the new reserves would go to the developed countries. Are there, however, any long run or short run benefits of the reform for the developing countries? i i i b : Implications for the Developing Countries A l l countries p a r t i c i p a t i n g i n the d i s t r i b u t i o n of the new reserves w i l l experience varying consequences from the creation of the new reserves. The effects of increased reserves 88 on the p o l i c i e s of a l l countries, as a r e s u l t of easier l i q u i d i t y conditions,. w i l l induce some countries to pursue p o l i c i e s that w i l l increase t h e i r import demand.or export supply. Developing countries, however, face i n e l a s t i c demand for t h e i r exports while they have an e l a s t i c one for the imports of other countries. Thus, i t i s possible to argue that the bulk of the new reserves w i l l sooner or l a t e r gravitate to countries such as the i n d u s t r i a l countries and some primary producers which have a high propensity to hold reserves. On the other hand, one possible e f f e c t may be to argue that i n the long run, some benefits w i l l accrue to the developing countries as a r e s u l t of t h e i r a c q u i s i t i o n of additional reserves or the p o s s i b i l i t y of larger access to c a p i t a l aid from other developed countries which might be w i l l i n g to do so. The outcome of the l a t t e r process i s , however, unpredictable es p e c i a l l y when some i n d u s t r i a l countries, under the stress of severe balance of payments d i f f i c u l t i e s might s c r u t i n i z e t h e i r budgetary expenditures and have f i n a n c i a l aid subjected to 18 severe economies. In t h i s case, the developing nations w i l l receive li m i t e d benefits from the scheme. Of course,there w i l l be some short run benefits from additions to th e i r reserve l e v e l s , but these w i l l have to be large enough otherwise a complete over-haul of import r e s t r i c t i o n s and exchange, controls w i l l not be 18 cf . A.K. Solomon, "New Arrangements to Supplement World Reserves and th e i r Implications for the Developing Countries", International F i n a n c i a l News Survey, Supplement, I.M.F., Vol. XIX, No. 49, 1967, pp.413 - 420. 89 possible. Indeed, our analysis of demand for international l i q u i d i t y by the developing countries indicated that they have a low precautionary demand for reserves. We explained that the opportunity cost of holding reserves i s high for them since the reserves could as well be used to finance development expenditures. On the presumption that such factors influencing our conclusions have not changed, i t i s l i k e l y that once the additional reserves are given them, the developing countries w i l l spend them on development purposes. The e s s e n t i a l fact i s that, what the developing countries need i s not additional reserves per se; they need additional c a p i t a l aid for develop-ment purposes. And i n the event that the l a t t e r i s not f o r t h -coming, i t i s conceivable that once the i n i t i a l high levels are reestablished, they w i l l tend to spend the additional . . 20 reserves for t h i s purpose. III.3: Conclusion It w i l l , therefore, seem from our b r i e f examination of the above proposals which have d i r e c t relevance to the developing 20 Of course, t h i s behaviour w i l l vary between countries. For whether a p a r t i c u l a r country w i l l hold or spend an extra unit of reserves w i l l depend on how i t balances the marginal cost and the marginal u t i l i t y involved. This balancing involves some value judgements on the part of the monetary auth o r i t i e s , which d i f f e r from country to country, depending on the i n s t i t u t i o n a l framework of the.economy. Thus, groups of countries w i l l be behaving d i f f e r e n t l y i n response to the additional reserves gained. And i n t h i s way, i t may not be e n t i r e l y true that a l l the developing countries w i l l spend the additional reserves on development purposes. 90 countries that the developing countries w i l l generally consider a plan "good" i f i t has the e f f e c t of providing them with the necessary development aid. Indeed, our analysis tends to heighten the need for increasing c a p i t a l aid to the developing countries, an issue which has received quite a l o t of stress i n 21 recent years. Hence, other things being equal, the develop-ing countries would have preferred the " l i n k " proposals to others which only seek to give them additional reserves. This i s not to say that the other proposals besides the " l i n k " are not good. Fort example, the new reform, i f implemented, w i l l o f f e r the developing countries temporary r e l i e f from severe strains i n t h e i r payments imbalances. However, the extent to which this can be sustained depends on how well fluctuations in'.-iiexport earnings are s t a b i l i z e d and how regularly c a p i t a l flows into the developing countries. I f none of t h i s occurs, these countries w i l l pursue t h e i r present development expenditure behaviour of u t i l i z i n g reserves to finance develop-ment expenditures. See, for example, B. Belassa, "The C a p i t a l Needs of the Developing Countries", Kyklos, Vol. 17, 1964, pp. 197 - 204. Also, N.T. Wang, New Proposals for the International Finance of  Development (Princeton University, A p r i l , 1968), no. 59, and B.F. Massell, "Exports, C a p i t a l Imports, and Economic Growth", Kyklos, Vol 17, Fasc. 4, 1964, pp.627 - 635. 91 To digress for a moment, we may note the change i n the composition of demand for reserves as a r e s u l t of a reform of the system that offers them additional reserves. Assuming as before that the developing countries do not hold much gold because they cannot afford to invest i n i t , we can argue that they w i l l tend to hold more of the newly created asset than other currencies such as the d o l l a r . The reason for thi s i s that the d o l l a r w i l l s t i l l be more subject to exchange r i s k and high c o n v e r t i b i l i t y r i s k than i t w i l l be i n the case of 22 the new reserve asset. For t h e o r e t i c a l i n t e r e s t i n this matter, see, R.S. A l i b e r , "Gresham's Law, Asset Preferences, and Demand for Inter-national Reserves", Quarterly Journal of Economics, Vol. 81, November, 1967, no. 4, pp.628 - 638. 92 CHAPTER IV SUMMARY AND CONCLUSIONS IV. 1: SUMMARY The p r i n c i p a l issue which we raised at the beginning of t h i s essay relates to the observation that i n recent years the developing nations have been faced with a l i q u i d i t y c r i s i s of t h e i r own, quite apart from the problem of inadequacy of inte r n a t i o n a l l i q u i d i t y i n the world context. That i s , they have been experiencing a decline i n the r a t i o of their^reserves to imports - a common measure of the "adequacy" of international reserves. Our analysis has been.an attempt to provide a coherent t h e o r e t i c a l explanation for th i s l i q u i d i t y c r i s i s . Our method of analysis was based on the application of the p o r t f o l i o approach to demand for money, but i n an environ-ment where economic development i s a goal of national p o l i c y . Unlike the "flow approach" of other recent studies, our analysis postulated that international l i q u i d i t y - a country's holdings of gold and convertible foreign exchange plus i t s I.M.F. posi t i o n - could be considered as a stock of international money, a l i q u i d asset. Placing our analysis i n a cost-benefit framework, we argued that although the s o c i a l rate of return on 93 c a p i t a l was high r e l a t i v e to that on reserves, the country could not hold a l l i t s wealth i n c a p i t a l since i t would then run the r i s k of being unable to pay for the needed imports to increase c a p i t a l formation. In an uncertain world where the country's export earnings are unpredictable and c a p i t a l flows are not completely s e n s i t i v e to the domestic i n t e r e s t rate, i t was necessary for the country to hold some reserves to o f f s e t short-term variations i n i t s balance of payments. In addition, li m i t e d a v a i l a b i l i t y of conditional l i q u i d i t y at the Fund reinforced the necessity for the country to hold some own reserves as an aversion to the r i s k of inadequate reserves. On the proposition that t h i s country could choose the l e v e l of reserves i t w i l l hold, we concluded that the pressing need to increase economic development (capital formation) w i l l force i t to maintain a low. l e v e l of reserves and to use very t i g h t discretionary trade and exchange controls, the r i s k of which po l i c y i t was prepared to bear. This led to our further conclusion that t h i s country has chosen a ri s k y p o r t f o l i o but that t h i s was a r a t i o n a l choice because of the simultaneous expectation that increase i n c a p i t a l formation w i l l lead to expected increases i n per capita consumption. Hence, our f i n a l observation that the country has a low precautionary demand for international, reserves. Indeed, the whole process of adjustment and substitution postulated by the p o r t f o l i o theory involves so many dimensions 94 that simple interpretations are rather dangerous. However, i t does seem plausible that, with the high opportunity cost of holding reserves, the r i s e i n the,social rate of return on c a p i t a l during the period under consideration at least caused a s h i f t of funds from reserve holdings to c a p i t a l formation. This s h i f t must have been large enough to reduce perceptibly the reserve le v e l s of these countries. Next we discussed the possible implications of an in t e r n a t i o n a l monetary reform for the developing.countries i n terms of the conclusions arrived at i n the whole analysis. We emphasized that what these countries need i s not additional reserves per se, but additional c a p i t a l aid for development purposes. Thus, any reform that sought to provide them with additional reserves, and hence reestablish t h e i r i n i t i a l high l e v e l s , w i l l give them a further incentive to use t h e i r reserves to finance development expenditures. The reason i s that the opportunity cost of holding reserves has not f a l l e n (at l e a s t , there i s no available evidence to believe that i t has). This conclusion therefore tends to support the proposition of economists such as Bernstein and Wallich who maintain that the developing countries have a weak tendency to hold reserves but a strong one to spend the reserves for development purposes. The argument of the above analysis was based on the 95 alternative hypothesis that: as a matter of circumstantial p o l i c y , i t might be a r a t i o n a l choice on the part of a develop-ing country to u t i l i z e some of i t s accumulated stock of reserves to finance development expenditures. This proposition was i n p a r t i a l support of other hypotheses such as the "stage of growing pains" hypothesis which sought to provide an explanation of the decline i n reserve lev e l s from the development process i t s e l f , and the "primitive" r a t i o n a l choice hypothesis, which stressed that the developing countries have a weak tendency to hold reserves. IV.2: IMPLICATIONS FOR POLICY, An important p o l i c y implication revealed i n t h i s analysis i s that whether a developing country w i l l accumulate or draw down i t s reserves i s a p o l i c y decision that i t has to place i n the context of other p o l i c y decision variables; e.g., the competing demand to accelerate economic development. If the opportunity cost of holding reserves i s high, the country might, other things being equal, use them to finance develop-ment expenditures. On the other hand, i f the cost i s low, the country might hold large reserves or invest them i n foreign earning assets that w i l l y i e l d i t higher income. I t i s also clear that, other things equal, the higher the l e v e l of a country's reserves, and the better i t s prospects of increasing them i n the future, the more i t w i l l be i n c l i n e d to adopt 96 p o l i c i e s that w i l l worsen i t s balance of payments, the impact of which might be so adverse as to interrupt the development process i n the economy. Our analysis also tends to revive and heighten the old argument of the need for an international p o l i c y to e f f e c t a system whereby more foreign c a p i t a l w i l l flow into the developing c o u n t r i e s . 1 I f we grant that there i s a close p o s i t i v e co-relationship between freedom from exchange controls and inflow of c a p i t a l , then there i s every reason to argue that the developing countries w i l l need a substantial amount of additional c a p i t a l aid which w i l l help bring about l i b e r a l i -zation of r e s t r i c t i o n s on trade and payments. The mechanism by which t h i s r e s u l t i s achieved may be described i n the following way. The increased flow of c a p i t a l into these countries w i l l gradually p u l l down the i n t e r e s t rate making the opportunity cost of holding reserves low and thus encouraging these countries to hold r e l a t i v e l y large reserves 2 and a consequent dismantling of import controls. There i s thus an obvious need for the advanced countries to provide the See, for example, H.B. Chenery. ..and A.M. Strout, "Foreign Assistance and Economic Development", The American. Economic  Review, Vol. LVI, No. 4, part 1, September, 1966, pp.679 - 733. See also Sengupta Argun, "Capital Requirements for Economic Development", Oxford Economic Papers (New Series), Vol. 20, No. 1, March, 1968, pp.38 - 55. 2 I t must be noted that the rate of i n t e r e s t i s r e f l e c t e d i n the behaviour of monetary authorities i n that intensive use of reserves for development purposes was highly correlated with high i n t e r e s t rates. Hence, i t i s also l i k e l y that less intensive use of reserves would correlate with low i n t e r e s t rates. 97 developing nations with long and short term loans on low terms. A l t e r n a t i v e l y , there i s need for the I.M.F. to l i b e r a l i z e i t s conditions underlying drawings i n the c r e d i t tranches. For example, as Bernstein suggested, i t could make drawings under the f i r s t c r e d i t tranche the same as.those,under the gold tranche for these countries. Repurchase rules may be relaxed such that the present period of three to fi v e years i s extended to seven years or a d i f f e r e n t system altogether could be created so that the World Bank or the International Development Association would increase t h e i r provision of f i n a n c i a l assistance to the developing countries, always making sure that the cost of borrowing i s r e l a t i v e l y low. Of course, t h i s way of looking at things tends to indicate the the developing countries should receive p r e f e r e n t i a l treatment as compared to the developed countries. Yet, i t i s clear that unless s u f f i c i e n t funds are provided to these countries enough to meet t h e i r development needs, not on the basis of any market c r i t e r i a but on the basis of a s o c i a l c r i t e r i a that takes into account the facts of inequitable international income d i s t r i -bution and adjustment costs, i t i s l i k e l y that the present development expenditure behaviour of the developing countries w i l l continue for the next two decades. cf. N.T. Wang, op. c i t . , pp.8 - 18. 98 IV.3: CONCLUSION The purpose of t h i s study has been to provide an apparatus f o r t h i n k i n g about the way i n which the r a t i o of reserves to imports of most developing c o u n t r i e s has f a l l e n i n recent years. By the a p p l i c a t i o n of the theory of p o r t -f o l i o s e l e c t i o n , we have s t r e s s e d t h a t the draw down i n reserves might have i n v o l v e d a r a t i o n a l economic d e c i s i o n on the p a r t of the monetary a u t h o r i t i e s of these c o u n t r i e s . The apparatus used f o r t h i s e xplanation had to be simple i f i t was to be very u s e f u l . We th e r e f o r e bought s i m p l i c i t y at the cost of some h e r o i c assumptions. In t h i s way, we have described i n a p u r e l y v e r b a l a n a l y s i s what we th i n k i s the proper t h e o r e t i c a l argument f o r e x p l a i n i n g the present development expenditure behaviour ©f. most developing c o u n t r i e s . The question i s : was the attempted a p p l i c a t i o n of the p o r t f o l i o theory s u c c e s s f u l ? The answer i s not unambiguous. I f one b e l i e v e s that the demand f u n c t i o n f o r i n t e r n a t i o n a l l i q u i d i t y t h a t we have p o s t u l a t e d i s at a l l reasonable, then, i t can be argued t h a t we have gained some understanding of the phenomena underlying the d e c l i n e i n reserve holdings of some developing c o u n t r i e s . I t must be noted t h a t the model used i n t h i s a n a l y s i s i s q u i t e f l e x i b l e i n t h i s regard. For, although the major l i m i t a t i o n of the e x e r c i s e l i e s i n our f a i l u r e to provide a formal t e s t i n g of the hypothesis, i t can be argued tha t i t i s capable of p r e d i c t i n g the behaviour of some developing. 99 countries i n response to additions to t h e i r reserve holdings, i . e . , given a higher i n t e r e s t rate on r e a l c a p i t a l r e l a t i v e to that on reserves. Moreover, i t i s seen that t h i s analytic framework raises i n t e r e s t i n g empirical questions about important issues. For example, i t shows to be totally.erroneous the view that developing countries might have a high demand for reserves. More in t e r e s t i n g than t h i s , however, i s the fact that the model's ambiguity on the time path of the decline or increase i n reserves poses an i n t e r e s t i n g empirical question that would c e r t a i n l y bear investigation since i t raises a new problem i n the context of the important issue of the leads and the lags with>which an expanding economy responds to p o l i c y changes. Thus, the simple model provided i n t h i s essay seems to pass the t e s t for our a n a l y t i c a l framework, inasmuch as i t does seem to t e l l us something that was not very obvious before, and inasmuch a s . i t does rais e i n t e r e s t i n g empirical questions. Of course, i n a study such as the one we have done here, we cannot pretend that we have dealt adequately with t h i s d i f f i c u l t subject, however. The.application of the p o r t f o l i o approach to the i n t e r n a t i o n a l payments sphere, to my knowledge, i s new.. Our analysis i s only an i n i t i a l attempt at t h i s application and i t i s hoped that i t w i l l lead ]to. further research study and analyses on t h i s whole issue of l i q u i d i t y and development 100 problems of developing countries. The ideas we have analyzed have only t h e o r e t i c a l i n t e r e s t , but they attempt at the same time to give empirical content to a l o g i c a l exercise which commands assent. They are properly to be c r i t i c i z e d not on grounds of l o g i c but on grounds of t h e i r empirical v a l i d i t y and relevance. I m p l i c i t l y , or e x p l i c i t l y , they are statements about the way r e a l world i n s t i t u t i o n s of some developing countries work; they therefore f a l l or stand on the question of whether or not the statements have been correct. A construction of an econometric model to test the v a l i d i t y of t h i s approach i s the purpose of a further research study which I intend to do. BIBLIOGRAPHY 101 BIBLIOGRAPHY BOOKS Baldwin, R.E. Economic Development and Growth, John Wiley & Sons, Inc., New York, 1966. Clement, M.O., P f i s t e r , R.L. and Rothwell, K.J. Theoretical  Issues i n International Economics, J.W. Markham edit i o n , Houghton M i f f l i n Co., Boston, 1967, pp. 402 - 403. Duesenberry, J. Saving, Income and the Theory of Consumer Behaviour, Harvard University Press, Cambridge, Mass., 1949. Fanon, F. The Wretched of the Earth, New York, 1966, pp.78 -82. Fell n e r , W.. 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"Credit F a c i l i t i e s or Reserve Allotments", Banca Nazionale Del Lavoro, Quarterly Review, Rome, June 1967, pp.135 - 156. Machlup, F. The Need for Monetary Reserves, Reprints i n Inter-national Finance, no. 5, Princeton, Princeton University Press, October, 19 66. Machlup, F. Real Adjustment, Compensatory Corrections and  Foreign Financing of Imbalances i n International  Payments, Reprints i n International Finance, No. 2, Princeton University, September 1965. Machlup, F. Plans for Reform of the International Monetary System, Reprints i n International Finance, rev. ed. no. 3, Princeton University, March 1964. Massell, B.F. "Exports, C a p i t a l Imports and Economic Growth", Kyklos, Vol. 17, Fas. 4, 1964, pp.627 - 635. McLeod, A.N. Contentious Thoughts on International L i q u i d i t y , -Central Bank of Tobago, Trinidad, February 1967. 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"International Monetary Reform and the Less Developed Countries", Banca Nazionale Del Lavoro, Quarterly Review, Rome, June 1967, pp.157 - 178. Surendra, J.P. ''Export Prospects and Economic Growth: India", Economic Journal,. Vol. XIX, no. 275, September 1959, pp.490 - 506. Tew, Brian, International Monetary Fund: Its.Present Role and  Future Prospects, Essays i n International Finance, no. 36, Princeton University, March 1961. T r i f f i n , R. "The Bizarre Proposals of Dr. Bernstein's Plan for International Monetary Reform", Kyklos, Vol. 17, 1964, pp.328 - 343. U.N.C.T.A.D. Experts Report, International Monetary Issues and  the Developing Countries, U.N. Publication, November 1965. 107 U.N. Economic B u l l e t i n for. Asia and the Far East, 1957. U.N. Survey for Asia and the Far East, 1964. U.N. Economic B u l l e t i n for L a t i n America, 1959. U.N. Economic B u l l e t i n for L a t i n America, 1963-65. Wallich, H.C. "Testimony", Guidelines for International Monetary  Reform, 89th Congress, 1st session, J o i n t Economic Committee, U.S. Congress, Part 1, Washington, July 27-29 , 1965. Wang, N.T. New Proposals for :the ^International Finance of Development, Essays i n International Finance, no. 59, Princeton University, A p r i l 1967. Weintraub, S. The Foreign Exchange Gap of the Developing Countries, Essays i n International Finance, no. 48, Princeton University, 1965. Whittlesey, C.R. " L i q u i d i t y , International L i q u i d i t y , and the Dollar Problem", Weltwirtschaftliches Archiv., Vol. . 93, 1964, pp.242 - 249. APPENDIX 108 APPENDIX TO CHAPTER I I , SECTION II.6B For purposes of understanding the use of the phrase "balance of payments" i n t h i s essay, i t i s necessary to point out that following Mundell, we define i t as the change i n int e r n a t i o n a l reserves under the present exchange rate system."*" Thus, the balance of payments - the change i n reserves over time - i s a flow per unit of time. But items recorded i n the balance of payments represent the accumulated flow over a sp e c i f i e d period of time. The balance of payments of a country over, say, a year i s the i n t e g r a l of the flow of items per unit of time during the year and thus i s a stock. Suppose reserves, R, fluctuate between time t = t and time t = t ^ , according to the equation, R = f ( t ) . Then the balance of payments equation B(t) -± dR/dt E R1 (t) , r e f l e c t s the slope of the equation, R(t); conversely, R(t) r e f l e c t s the i n t e g r a l of B(t) over the past. I f the time from t to t-^ i s one year, for example, then B, the balance of payments over the year, i s B = ' \ B(t) dt R. Mundell, "International Monetary Economics: The balance of Payments", International Encyclopedia of the Social Sciences, INTE to LANG, Vol. 8, Macmillan and Free Press, 1968, pp.1 - 11. 109 where B - R = R , - R . The stock of reserves at given t i t Q periods of time are therefore related to the balance of payments by equations such as: t l % = R t Q + \ B(t) dt. 0 

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