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International Trade and Finance

Notes generate a trade suplus, or raise interest rates to draw in foreign capital. Higher economic openness
could make such adjustments easier, thereby reducing the demand for reserves, but might also make
an economy more vulnerable to foreign trade shocks, thereby raising desired reserve holdings.
On the other hand, the main cost of holding reserves is their interest cost. A central bank that switches
from domestic bonds to foreign reserves loses the interest on the domestic bonds and instead earns
the interest on dollars. If markets harbor any fears that the domestic currency could be revalued, then
domestic bonds will offer a higher interest rate than foreign reserves, implying that it is costly to
switch the central bank’s portfolio toward reserves. In addition, reserves may offer lower interest
simply because of their higher liquidity.
It was argued in the 1960s that countries with more flexible exchange rates would find it easier to
generate an export surplus if reserves ran low—they could allow their currencies to depreciate, perhaps
avoiding the recession that might Percent per year
otherwise be needed to create a trade
balance surplus. When industrial 25
countries moved to floating exchange
rates in the early 1970s, many 20
economists therefore expected that the Developing countries
demand for international reserves
would drop sharply. 15
Figure 1 shows, however, that nothing
of the sort happened. For industrial
countries, the growth rate of 10 All countries
international reserves has declined only
slightly since the 1960s. Industrial- 5
country reserves have persistently Industrial countries
grown at roughly the same pace as
nominal industrial-country income. For 0
developing countries, the growth rate of 1962-1972 1972-1982 1982-1992 1992-2002 2002-2006
reserves has, if anything, risen (though Figure 17.1: Growth Rates of International Reserves
the recent sharp upsurge is to some Annualized growth rates of international reserves did not
degree a reflection of huge reserve decline sharply after the early 1970s. Recently, developing
purchases by China). Accelerating countries have added large sums to their reserve holdings.
reserve growth has taken place despite
the adoption of more flexible exchange Source : Economic Report of the President, 2007.
rates by many developing countries.
One explanation for this development, which we will discuss further in later chapters, is that the
growth of global capital markets has vastly increased the potential variability of financial flows across
national borders, and especially across the borders of crisis prone developing countries. The sharp
decline in developing-country reserve growth in the 1982-1992 period, shown in the figure, reflects
an international debt crisis during the years 1982-1989. In that crisis, foreign lending sources dried
up and developing countries were forced to draw on their reserves. The episode illustrates well why
developing countries have added so eagerly to their reserve holdings. Even a developing country
with a floating exchange rate might need to pay off foreign creditors and domestic residents with
dollars to avoid a financial crisis and a currency collapse.
Nothing about this explanation contradicts earlier theories. The demand for international reserves
still reflects the variability in the balance of payments. The rapid globalization of financial markets in
recent years has, however, caused a big increase in potential variability and in the potential risks that
variability poses.
17.2 Fixed Exchange Rates

In a system of fixed exchange rates, the exchange rate is fixed at an official predetermined rate. The
central bank acts as a market maker and steps in to fill any imbalance between demand and supply.

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