International Economics
By Robert J. Carbaugh
9th Edition
Chapter 18:
International Banking: Reserves, Debt and Risk
Carbaugh, Chap. 18
Nature of international reserves
Reserves of foreign currency and other suitable assets are used to finance payments imbalances
Reserves allow a nation to take more time to correct BOP disequilibrium (but may also delay needed action)
Demand for reserves depends on the monetary value of international transactions and the size of payments imbalances
International reserves
Carbaugh, Chap. 18
Demand for international reserves
Main factor in demand for reserves is the nature of the adjustment mechanisms to correct BOP imbalances
Exchange rate flexibility is a crucial element of the adjustment process
Key use for reserves is to intervene in currency markets to defend an exchange rate
The more a nation is willing to let its currency float, the less it will need sizable reserves
International reserves
Carbaugh, Chap. 18
Demand for international reserves
Other factors affecting demand for reserves:
Automatic adjustment mechanisms that respond to payments imbalances
Economic policies used to correct payments imbalances
International coordination of economic policies
Level of world prices and income
International reserves
Carbaugh, Chap. 18
Demand for reserves and exchange rate flexibility
International reserves
Carbaugh, Chap. 18
Supply of international reserves
International reserves may be owned by nations or may be borrowed if reserves on hand prove insufficient
Owned reserves:
Reserve currencies (US dollar, Japanese yen, etc,)
Gold - once central, now rarely used
Special drawing rights
Borrowed reserves can come from the IMF and other official arrangements, or can be borrowed from major commercial banks
International reserves
Carbaugh, Chap. 18
Gold as a reserve asset
Gold was originally used as currency, but it began to be replaced by paper money and bank deposits
Post-World War I inflation prompted many nations to return to a gold standard, where all currency in circulation was backed by gold
Gold standard collapsed during the Great Depression, to be replaced by a gold exchange standard after World War II
International reserves
Carbaugh, Chap. 18
Gold as a reserve asset (cont’d)
The US dollar was set to be convertible to gold at a fixed rate, and the dollar became a key reserve asset
Stresses from persistent US payments deficits brought an end to the gold exchange standard by 1973, and in 1975 gold was removed as an international reserve asset
International reserves
Carbaugh, Chap. 18
Special Drawing Rights (SDRs)
Because a gold standard limits the amount of currency available to the supplies of gold on hand, the IMF created the SDR to increase international liquidity
SDRs represent rights to draw foreign currencies from the IMF to use for settlement purposes; they are allocated to IMF members proportionally
SDRs are pegged to a basket of key international currencies, and are useful because they are not tied to any one currency
International reserves
Carbaugh, Chap. 18
Facilities for borrowing reserves
IMF drawings - members may purchase foreign currency with their own currency, with limits and sometimes conditions
General Arrangements to Borrow - major industrial nations agreed to make further reserves available to the IMF if needed
Swap arrangements - major industrial nations agree to swap currencies with each other; can be done more quickly and less visibly than Fund drawings
International reserves
Carbaugh, Chap. 18
Facilities for borrowing reserves (cont’d)
Special financing facilities - to compensate mostly developing countries which face hardships which are transient or beyond their control: Compensatory Financing Facility, Oil Facility, Buffer Stock Facility
Commercial bank lending
International reserves
Carbaugh, Chap. 18
International lending risk
Credit risk - potential for financial default
Country risk - whether government policies will help or hinder the servicing of the loan
Currency risk - whether devaluations or exchange controls will interfere with the repayment of the loan
International lending
Carbaugh, Chap. 18
International debt problems
Many developing nations borrowed heavily on easier terms in the 1970s because major banks were flush with deposits from oil producing states
In the 1980s, rising interest rates caused payments on the variable rate international loans to increase, and the ability of many of these major debtor nations to service their loans came into question
International lending
Carbaugh, Chap. 18
International debt problems (cont’d)
Most loans were denominated in dollars, meaning that these nations had to run current account surpluses to earn foreign exchange with which to make loan payments - just as the industrial nations went into a recession
Measures used to gauge debt burden: debt-to-export ratio; debt service/export ratio
International lending
Carbaugh, Chap. 18
Options for debt-service problems
Nations can stop making payments - but there are severe consequences
Service debt at any cost - but may be politically impossible
Reschedule the debt - stretch out repayment schedule (but pay more overall)
Obtain emergency loans from the IMF - but conditionality may be hard to stomach
International lending
Carbaugh, Chap. 18
Reducing bank exposure to developing-country debt
Loan sales in secondary market
Debt buybacks or debt-for-debt swaps
Debt-for-equity swaps
Debt reduction and forgiveness
International lending
Carbaugh, Chap. 18
Eurocurrency markets
Deposits in dollars and other major currencies in banks outside the US
Main advantage over US deposits is interest rate differential
Eurocurrency market facilitates financing of trade and investment, but there are concerns that some of the banks in this market do not face the same regulations as do large banks in the industrial nations
International lending
Carbaugh, Chap. 18
