International Liquidity: Meaning, Need and Features | Central Bank

In this article we will discuss about:- 1. Meaning of International Liquidity 2. Need and Problem of International Liquidity 3. Features 4. Measures to Solve the Problem 5. IMF and International Liquidity.

Meaning of International Liquidity:

International liquidity is defined as the aggregate stock of internally 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 to adjustment measures. Shortage of liquidity hampers the expansion of global trade and its surplus leads to global inflationary pressures.

International liquidity is generally used as a synonym for international reserves. Such reserves include a country’s official gold stock holdings, its convertible foreign currencies, SDRs, and its net reserve 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.

In the literature on international liquidity distinction is made between owned and borrowed reserves, and between conditional and unconditional reserves. Foreign exchange surplus, after meeting all current and capital account obligations of the country with the rest of the world, are “owned” reserves.

Similarly, the official gold stock of a country constitutes its owned reserves. Capital imports in the form of borrowings from abroad and direct investments by foreign countries constitute borrowed reserves. Both owned and borrowed reserves are the source of international liquidity.

Unconditional international liquidity consists of a country’s official gold stock, holdings of its foreign currencies and SDRs, its net position in the IMF, and private holding of international assets. In all such cases, liquidity assets are available to the country without any conditions or restrictions on their use. But in the case of borrowed reserves, the lender country may impose conditions or restrictions on the use of liquid assets by the borrowing country.

Many international financial institutions provide funds on conditional basis for specific projects and on specified repayment provisions. All these are cases of conditional liquidity. This is done to avoid the misuse of liquidity by the borrowing country.

Need and Problem of International Liquidity:

The (need or) problem of international liquidity arises because the demand for international liquidity is rising more than its supply, thereby implying shortage of international liquidity.

The principal causes for the shortage of international liquidity are the following:

1. BOP Deficits:

There have been increasing BOP deficits of the majority of countries in the world. In particular, after the opening of LDCs to world markets, these countries have been facing persistent BOP deficits. Too much dependence on exports has exposed these economies to international fluctuations in the demand for and prices of their products.

They have become unstable due to international cyclical instability. On the other hand, their import requirements have been on the increase in order to develop. As a result, they are faced with foreign exchange constraints. This has necessitated larger inflow of aid and foreign investment.

Consequently, debt serving and interest on debt have risen and payments of dividends, profits and royalties on private direct foreign investment have grown, thereby leading to decline in the net inflow of foreign capital. All these have led to further shortage of foreign exchange reserves.

2. High Tariff Barriers:

The exports of LDCs to developed countries have not been increasing, thereby adversely affecting their export earnings. One of the reasons for the non-expansion of their exports has been high tariff barriers imposed by the developed countries on their exports, especially by their regional groups like the EEC.

At the same time, the LDCs are trying to cut down their essential imports from the developed countries by means of exchange controls, high tariffs, import quotas and similar protectionist devices in order to conserve foreign exchange. This has adversely affected their development process.

3. Attitude of Developed Countries:

The majority of developed countries have surplus in their balance of payments. They are creditors of LDCs and do not take any interest in getting rid of their surplus so as to increase international liquidity.

4. Unequal Distribution of International Reserves:

The distribution of international reserves is biased and favours the developed countries. It is primarily based on their quotas in the IMF. Whenever the IMF quotas are revised, the larger share goes to the developed countries. It is the developing countries whose need for international liquidity is far greater which suffer from its shortage.

Features of International Liquidity:

The main features of international reserves or international liquidity have been:

1. Gold reserves of the countries of the world increased from $ 33.9 billion in 1951 to SDR 224.1 billion in 1997.

2. Marked increase in the share of foreign exchange reserves from $13.7 billion in 1951 to SDR 1078.2 billion in 1997.

3. Increase in reserve position in the IMF from $ 1.7 billion in 1951 to SDR 36.2 billion in 1997.

4. Emergence of SDRs since 1972 which increased from SDR 8.7 billion to SDR 18.7 billion in 1997.

Thus the total international reserves comprising the above four items increased from $ 49.3 billion to SDR 1357.2 billion in 1997.

No doubt, international reserves have been on the increase but they have not been rising as much as the increase in the volume and value of world trade. More so in the case of LDCs whose needs are greater and more urgent than that of developed countries.

Measures to Solve the Problem of International Liquidity:

The following measures have been suggested to solve the problem of international liquidity:

1. Promoting Export Expansion:

Developing countries should reduce BOP deficit by promoting export expansion. The choice lies in concentrating the expansion of primary or secondary products or both. The expansion of secondary products requires import substitution for export expansion. These policies will earn them foreign exchange.

2. Limiting Exports:

They should ban non-essential consumer goods, and limit imports of specific goods by selective tariffs, physical quotas, etc. This policy will enable them to conserve foreign exchange.

3. Changing Official Exchange Rate:

A developing country can change its official exchange rate by devaluing its currency so that its export prices are lowered and import prices are increased. This will help in earning foreign exchange.

4. Restrictive Monetary-Fiscal Policies:

By following restrictive monetary and fiscal policies, a developing country can reduce domestic demand for products which will lower import prices, reduce inflationary pressures and BOP deficit.

5. Reduction in BOP Surplus:

The majority of developed countries have BOP surplus which they should reduce by:

(a) Accepting the national currencies of developing countries for payments;

(b) Removal of trade barriers to the products of developing countries; and

(c) Accepting products of developing countries in exchange for their products, as was done by the erstwhile USSR.

6. Expanding International Reserves:

The IMF should expand international reserves by fresh allocation of larger quotas to member countries. In particular, all new issues of SDRs should be distributed to developing countries so that they may pay then to developed countries to solve their foreign exchange problem.

IMF and International Liquidity:

There was no problem of international liquidity prior to 1970. 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 a transitional period. They were allowed to hold their monetary reserves partly 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 ad hoc loans made by the IMF, the growth in liquidity needed to finance the expansion of world trade had to be found 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 sterling. But the physical supply of gold is virtually limited to the output of the mines in South Africa and the 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 dollar holdings to 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 the supply because the incremental supply of gold was increasing little. Since the dollar was convertible into gold, the supply of US dollars would be inadequate in relation to the liquidity needs of 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 a 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 the 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 the realignment of major currencies by devaluing the dollar by 10 per cent 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 the EEC countries had a “joint float” of their currencies.

The Jamaica Agreement of January 1976 formalized 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. The system of flexible exchange rates has tended to reduce the need for more reserves.

Role of the IMF In Increasing World Liquidity:

The IMF is an international monetary institution which is the principal source of supply of world liquidity to its 182 members. Over the years, it has adopted the following measures to increase international liquidity.

SDRs. In early 1970, it introduced a scheme for the 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 are SDR 146 billion in the Fund’s General Account.

The Fund also creates SDRs and allocates them to members in proportion of their quotas. For this purpose, the Fund has established the Special Drawing Account. As the international monetary asset, SDRs are held in the international reserves of central banks and governments to finance improve international liquidity so as to correct fundamental disequilibria in the balance of payments of Fund members. The participants in the SDR scheme receive SDRs under “transactions with designation” and “transactions by agreement” unconditionally. The IMF acts as a clearing house in these transactions. Since 1981 there are 21.4 billion SDRs in the Fund.

Quotas:

The bulk of Fund’s financial resources comes from quota subscriptions of member countries. To meet the global demand for liquidity, it has been increasing quotas of members every four years under the General Review of Quotas. As a result, it increased the member quotas from 7.6 billion in 1947 to SDR 212 billion in 1998.

Selling Gold:

It increases its funds by selling gold to members.

Borrowings:

It borrows from governments, central banks or private institutions of industrialised countries, the Bank for International Settlements, and even from OPEC countries, like Saudi Arabia.

Reserve Tranche:

The Fund has a variety of facilities for lending its resources to member countries. Lending by the Fund is linked to temporary assistance to member in financing disequilibrium in their balance of payments on current account. If a member has less currency with the Fund than its quota, the difference is called gold or reserve tranche.

It can draw up to 25 per cent on its reserve tranche automatically upon representation to the Fund for its balance of payments needs. It is not charged any interest on such drawings, but is required to repay within a period of three to five years.

Credit Tranche:

A member can draw further from balance quota in 4 instalments upon 100 per cent of its quota from credit tranche annually. Drawings from credit tranche are conditional because the members have to satisfy the Fund of adopting a viable programme to ensure financial stability.

To meet the severe balance of payments problems, the Fund has been gradually raising the limit of borrowings by its members over the years under the credit tranche. Now members can draw up to the equivalent of 300 per cent of their new quotas on the total net use of the Fund’s resources. The limits exclude drawings from CCFF, BSAF, SAF, STF and ESAF. The purchases are made under stand-by arrangements rather than directly.

New Credit Facilities:

Since the 1960s, the Fund has created several new credit facilities for its members. Loans from these facilities are separate from tranches and are available for a longer period. These are : BSFF (Buffer Stock Financing Facility), EFF (Extended Fund Facility), SFF (Supplementary Financing Facility), SAF (Structural Adjustment Facility), ESAF (Enhanced Structural Adjustment Facility), CCFF (Compensatory and Contingency Financing Facility), STF (Systematic Transformation Facility), ESAL (Emergency Structural Adjustment Loans) and CCL (Contingency Credit Line).¹ These facilities provide for members annual access to Fund resources up to 150% of their quotas or up to 450% over a three year period.

IDA Replenishments:

Another important source for increasing world liquidity is the IDA Replenishments to the poor developing countries for three years by the developing countries. In recent years, IDA-9 Replenishment gave $ 15.55 billion in 1990, IDA-10 gave $ 18 billion in 1993, and IDA-11 gave 22 billion in 1996 for three years.

Criticisms of IMF:

The various Fund schemes for increasing global liquidity have been criticised for favouring the developed countries. They are inequitable which have tended to mark unfair distribution of international liquidity. For instance, the allocation of SDRs 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, the 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 country is great. Therefore, 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 objective of 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. To solve this problem, there is urgent need for fresh allocation of SDRs which should be distributed only to developing countries.