Friday, August 28, 2009

International Liquidity, and Efforts Made by the IMF to Solve this Problem

International Liquidity is defined as the aggregate stock of internationally acceptable assets held by the central bank to settle a deficit in a country’s balance of payments. In other words international liquidity provides a measure of a country’s ability to finance its deficit in balance of payments without resorting International Liquidity.

International liquidity is generally used as a synonym for international reserves. Such reserves include a country’s official gold stock holding of its convertible foreign currencies and its net position in the IMF. Economists like Heller and Mckinnon use a broader definition of international liquidity to include international borrowings, commercial credit operations and the international financial structure in a country’s reserves. This definition implies international availability of liquidity and the possibility of obtaining credit from financial institutions operating in international financial markets. Thus in the broader sense international liquidity includes private as well as official holdings of international liquidity assets.

IMF and International Liquidity:

There was no problem of international liquidity prior 1960. This was because under the Bretton Woods Agreement the exchange rates of countries were fixed in terms of gold or the US dollar at $35 per ounce of gold. Member countries were forbidden to impose restrictions on payments and trade except for transitional period. They were allowed to hold their monetary reserves partly as gold and partly in dollars and sterling. These reserves were meant to incur temporary deficits by member countries while keeping their exchange rates stable. The IMF insisted on expenditure reducing policies and devaluation to correct deficit in balance of payments. Therefore apart from adhoc loans made by the IMF, the growth in liquidity needed to finance the expansion of world trade had to be found in the expansion of gold and the supply of dollar and the sterling. But the physical supply of gold is virtually limited to the output of the mines in South Africa and Soviet Union. Since the dollar acted as a medium of exchange, a unit of account and a store of value of the IMF system, every country wanted to increase its reserves of dollar which led to the dollar holdings a greater extent than needed.

Consequently the US gold stock continued to decline and the US balance of payments continued to deteriorate. Robert Triffin warned in 1959 that the demand for world liquidity was growing faster than supply because the incremental supply of gold was increasing little. Since the dollar was convertible into gold, the supply of the US dollars would be inadequate in relation to the liquidity needs of the countries. This might introduce trade barriers by countries in order to have balance of payments surpluses and build up reserves thus according to Triffin a growing liquidity shortage would generate strong contractionary forces that would threaten the expansion of the world economy and lead to world recession of the 1931 type.

A crisis of confidence had already erupted. The pound had been devalued in November 1967. There was no control over the world gold market with the appearance of a separate price in the open market On 15 August 1970 the United States suspended conversion of dollars into gold and refused to intervene in the foreign exchange markets to maintain exchange rate stability. The ‘Group of Ten’ industrial countries met at the Smithsonian Institute in Washington in December 1971 and agreed to realignment of major currencies by devaluing dollar by 10 percent and revaluing their currencies. The Smithsonian agreement broke down following the US dollar devaluation of February 1973 again and in March 1973 a number of countries had floating exchange rates and EEC countries had a “Joint Float” of their currencies. The Jamaica Agreement of January 1976 formalised the regime of floating exchange rates. By the Second Amendment of the IMF Charter in 1978, the member countries are not expected to maintain and establish par values with gold or dollar. The fund has no control over the exchange rate adjustment policies of the member countries. But it exercise “surveillance” over the exchange rate policies of the members. The system of flexible exchange has tended to reduce the need for more reserves.

In early 1970’s IMF introduced for creation and issue of Special Drawing Rights (SDRs) as unconditional reserve assets to influence the level of world reserves and to solve the problem of international liquidity. There is SDR 146 billion in the Fund’s General Account. The Fund also creates SDRs and allocates them to members in proportion to quotas. For this purpose the Fund has established the Special Drawing Account. Thus SDRs are new form of international monetary reserves which have been created to free the international monetary system from its exclusive dependence on the US dollar and fluctuations in gold prices. As the international monetary asset SDRs are held in the international reserves of central banks and governments to finance and improve international liquidity so as to correct fundamental disequilibrium in the balance of payments of Fund members.

The Fund’s scheme has been criticised for favouring rich nations. It in an inadequate scheme which had tended to make unfair distribution of international liquidity. The allocation of SDR’s to participating countries is proportional to their quotas in this sense the allocation of SDRs to developing countries is too low as compared to their needs. Low allocation of SDRs reduces the borrowing capacity of such countries.

Moreover SDR scheme does not link the creation of international reserves in the form of SDRs with the need for development finance on the part of developing countries. The need for liquidity on the part of developing countries is great “because of their higher costs of adjustment, limited access to private banking and capital markets, greater variability of exchange earnings and higher opportunity cost of holding foreign exchange reserves” Under the circumstances there is need to create more SDRs with fair distribution so that more unconditional liquidity is made available for the greater needs of developing countries.

Unfortunately due to the rigid attitude of the United States and some other developed countries, the Fund has not been able to resume allocation of SDRs from January 1982, despite the repeated pleas of the developing countries over these years. So the Fund has failed in its objectives increasing international liquidity through SDRs. Consequently faced with a recession an inadequate flow of concessional aid and falling prices of commodities and raw materials, developing countries have been facing severe balance of payments and debt problems.

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