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On the Adequacy of Australia’s International Reserves
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Vol. 01 No. 01, March 170
ON THE ADEQUACY OF AUSTRALIA'S INTERNATIONAL RESERVES
In recent years, especially since the sterling devaluation of November 1967, divergent opinions have been expressed on whether or not Australia's balance of payments is in "equilibrium". I A related question, and one which has not received much attention(at least not in the academic literature) I concerns the adequacy of Australia's overseas reserves. Adequate for what? Should the monetary authorities aim at a particular level of reserves dudng a given period? What criteria should gltide such decisions?
It is the purpose of this paper to assess what economic meaning can be attached to the concept of reserve adequacy in the light of recent Australian experience. The data used covers a period (1954 to 1969) in which the Australian balance of payments has shown a marked capacity for fluctuation. Moreover, during this period many pessimistic forecasts have been made about the long term trend of the Australian balance of payments. It seems that a re-action to what Corden has called "balance of payments pessimism" has at last set in 2 but there is little evidence to suggest that this re-action springs from an awareness.by economists that an assessment of reserve needs cannot be gauged by a mere analysis of past data. A country's need for reserves will change as the structure of the economy changes. Balance of payments "pessimism" - or l1optimism" based on observed trends in reserves and other economic magnitudes may be misleading - for reasons which will be discussed shortly. However, it is logical IDld useful to start by observing trends which have, in fact, taken place in relevant magnitudes over the period. It will then bc a matter of demonstrating that certain modifications to the raw data may be necessary before one can arrive at a final opinion on reserve adequacy. The data on reserves, imports and the money supply, which it is customary to use for assessing the adequacy of reserves, is set out in rabies 1 and 2. The reasons for focussing on money is that theoretical developments in the balance of payments attach considerable importa.nce to changes in money. Thus it has been argued that balance of payments deficits (or surpluses) are essentially monetary phenomena - in short, that a balance of payments deficit I. See, for example, J.O.N. Perkins, "Australia and the 1967 Devaluation of Sterling", Economic Record. March 1968, especially pp. 6·7 and appendix; also W.M. Carden, "A Survey of Australian Economic Policy", AmericQIl ECOllomic Review. Vol. LVIII,
No.3, Pari 2 (supplement) June 1968, pp. 101-3. 2. ibid.
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cannot persist without credit creation (and preswnably, a surplus cannot persist without a contraction of credit 3). If this notion is correct it impl ies that deficits persist because the monetary authorities t.:'1.ke offsetting action (expand the money supply) and do not allow the deflationary effects of the deficit to work themselves out in the domestic economy(e. g. through higher interest rates). This means, in turn, that a deficit will reduce international reserves (R) without reducing the money supply (M) (i. e. that the ratio RIM will fall). On this basis therefore it can be argued that changes in the RIM ratio provide a fairly good index of a COWltry'S balance of payments position and of reserve adequacy. In other words, assuming a fixed exchange rate, no intensification of controls and no structural changes. an increase in the ratio would appear to signal a favourable trend in the reserve position (that reserves were becoming more adequate or less inadequate) while adecrease in the ratio would suggest a deterioration in the reserve position (reserves were becoming more inadequate or less adequate) .
But is it realistic to assess the adequacy of reserves by merely observing past changes in these ratios? This has to be approached cautiously. Changes in the structure of the economy and in the ability and willingness to use internal policies to adjust for balance of payments disequilibria will more than likely influence a judgment on whether or not existing reserves are adequate. For example, a reluctance to allow interest rates to vary with cyclical changes in income would clearly raise the minimum level of reserves considered to be adequate. The concept of reserve adequacy must, therefore, be forward looking in some degree: the main question is whether existing reserves are adequate in the light of expected changes in the Australian economy (including the anticipated polic¥ responses to these changes) and changes in conditions overseas. In Section III we look at the motives for holding reserves. What factors exert the most important influence on Australia' s need for reserves? How must the crude statistical measures be modified to take account of them? Before proceeding with this analysis it is necessary to establish what elements comprise Australia l s overseas reserves. Reserve Bank statistics show a division between gold and holdings of sterling, dollars and other foreign exchange. Australia l s gold 3. H.G. Johnson "Towards a General Theory of the Balance of Payments". Reprinted in 1968
Readings ill Jllfcmot;onaf Economics, Caves R.E. & Johnson H.G. eds.• A.E.A.,
pp.374·388. 4. There is no attempt in this paper "to condense the different factors that influence the amount of international reserves a country should hold into a single index': H.R. Heller, "Optimal International Reserves", Economic Journal, Vol. LXXVI, June 1966 p. 296. It is felt that there is not great merit from a policy viewpoint in pursuing the search for the elusive one objective number which could be used to assess a country's external liquidity position.
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Vol. 01 No. 01, March 170
TABLE I INTERNATIONAL RESERVES AND THE MONEY SUPPLY SA million End of
Reserves
June
M1
(a)
1954
Percent
(b)
M2 (c)
(d)
1,126
3,600
3,129
5,600
31.3
36.0
20.1
1955
850
3,641
3,159
5,766
23.3
26.9
14.7
1956
700
3,557
3,090
5,816
19.7
22.7
12.0
1957
1,120
3,771
3,239
6,208
29.7
34.6
18.0
1958
1,039
3,777
3,179
6,354
27.5
32.7
16.4
1959
1,029
3,918
3,274
6,676
26.3
31.4
15.4
1960
1,066
4,167
3,521
7,192
25.6
30.3
14.8
1961
1,076
4,163
3,293
7,302
25.8
32.7
14.7
1962
1,162
4,418
3,379
7,846
26.3
34.4
14.8
1963
1,313
4,611
3,464
8,518
28.5
37.9
15.4
1964
1,763
5,112
3,732
9,556
34.5
47.2
18.4
1965
1,468
5,479
3,791
10,337
26.8
38.7
14.2
1966
1,527
5,714
3,816
10,938
26.7
40.0
14.0
1967
1,377
6,100
4,074
11,824
22.6
33.8
11.6
1968
1,346
6,605
4,414
12,805
20.4
30.5
10.5
1969
1,514
7,292
4,750
13,974
20.8
31.9
10.8
(a)
M
RIM
comprises gold, holdings of US dollars, sterling and other foreign exchange, and gold tranche position with 1M F:
(b)
deposits of public (current and fixed) with all cheque-paying banks plus notes and coin in hands of public.
(e)
current account deposits of public with cheque paying banks plus notes and coin in hands of public.
(d)
deposits of public (current and fIxed) with all cheque-paying banks, deposits with all savings banks and notes and coin in hands of public.
Source:
Reserve Bank of Australia, Statis/ical Blllleti", Financial SlIpplemem. September 1969, pp. 38·39 and 84-85.
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Vol. 01 No. 01, March 170
TABLE 2 INTERNATIONAL RESERVES AND IMPORTS End of June
Reserves ($A m) (a)
Imports
1954
1.126
1.323
85.1
1955
850
1.642
51.8
1956
700
1.597
43.8
1957
1.120
1.381
81.1
1958
1.039
1.521
68.3
1959
1.029
1.554
66.2
1960
1.066
1.814
58.8
1961
1.076
2,056
52.3
1962
1,162
1,701
68.3
1963
1,313
2,065
63.6
1964
1.763
2,237
78.8
1965
1,468
2,739
53.6
1966
1,527
2,822
54.1
1967
1,377
2,837
48.5
1968
1,346
3,159
42.6
1969
1,514
3,195
47.4
(SA m) (b)
Rfl Ratio (Per cent)
(a)
see table 1.
(b)
for preceding financial year. Recorded imports adjusted in respect of coverage and valuation for balance of payments purposes.
Source:
For reserves (sec table 1). For imports. Commonwealth Statistician. Balonce of Payments, 1961/62 10 1965/66 and first half of 1966/67; and Reserve Bank Statistical Bulletin, August 1969.
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these and super gold tranc he positi ons with the IMF are added to nd dema on ble figure s on the groun ds that these amou nts are availa the in es to meet balan ce of paym ents needs , and furthe r that chang and gold and super gold tranc he positi ons involv e corre spond ing e includ To gs. holdin nge oppos ite chang es in gold and foreig n excha overthe of re one witho ut the other would prese nt a misle ading pictu credi t all trend of Austr alia's overs eas reser ves. Austr alia's ngs tranc he positi on with the Fund is exclu ded, howe ver, since drawi to s tment adjus policy al intern in the credi t tranc he would requi re resto re balan ce of paym ents equil ibrium . 5 II.
Some econo mists have made a distin ction betwe en the ves. level of reser ves (rese rve stoCk) and the rate of growt h of reser enwill The point of the distin ction is that a 'high' reser ve stock ce of hance the abilit y of a count ry to meet curre nt and future balan for (say ves reser in ase paym ents defic its while a high rate of incre in its defic large of the past four years ) will decre ase the likeli hood more could the imme diate future (and if the defic its do occur they ing readi ly be financ ed). 6 This distin ction is not made in the follow Austin acy adequ ve l'eser of analy sis, partly becau se the conce pt able ralia has been relate d to what is regar ded as being a desir loses ction minim um level of reser ves and partly becau se the distin d to much of its signjf icanc e once chang es in reser ves are relate y. chang es in other magn itudes - such as impo rts and the mone y suppl The latter (ratio ) appro ach seem s best suited to our purpo se. Graph 1 shows chang es in the RIM ratio for the perio d mone y 1954 to 196n on the basis of three altern ative meas ures of the y y suppl y. It is evide nt that whate ver defini tion of the mone suppl
is we adopt , the overa ll trend patte rn and the degre e of fluctu ation JVM the in ments move of n very nearl y the same . An exam inatio ce ratio siuce 1954, as shown in Graph 11. enabl es us to identi fy balan an (i) of paym ents fluctu ations in terms of five distin ct perio ds: veadver se move ment betwe en 1954 and 1956; (ii) a decis ive impro (iv) 1961; to 1957 from ment ment in 1956/ 7; (iii) an adver se move le a favou rable trend betwe en 1961 and 1964; and (v) an unfav ourab what with move ment from 1964 to 1969. These obser vatio ns tally of the is comm only believ ed to have been the chang ing fortun es Austr alian balan ce of paym ents over the last 15 years . In Graph /I the reser ve/im port ratio (R/l) is plotte d very along side the R/M ratio. Here we find that there has been a reserves since 5. Tables showing changes in the composition or Australia's international 1954 arc included in an appendix. Reserves", Essays ill 6. See J .M. Fleming, "Towards Assessing the Need ror International 5. p. 1967, ry Ill/ema tional Finance. Princeton, No. 58, Februa
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Economic Analysis and Policy
Vol. 01 No. 01, March 170
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Economic Analysis and Policy
Vol. 01 No. 01, March 170
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Economic Analysis and Policy
Vol. 01 No. 01, March 170
close correlation between movements in these ratios. 7 The value of imports and the volume of money have shown broadly parallel movements for most of the period. As the monetary authorities expand credit imports rise (both ratios fall) and as the monetary authorities contract credit (or slow down the expansion) imports fall (both ratios rise). By incorporating money as well as reserves and imports in our equation we are able to establish, as a first approximation, the relevance to the question of reserve adequacy of the response of monetary policy to changes in the balance of payments. In this sense the adequacy of reserves (A ) is a function R of the reserve/import ratio which is, in turn, a function of the reserve/money supply ratio:
III.
To assess the need for reserves in total we have to ask why reserves are held in the first place and how changes in economic conditions (at home and abroad) and changes in domestic policies will affect these needs. It can be argued, and with some justification, that a country facing the prospect of wide fluctuations in export earnings and capital inflow (and with imports geared to the rate of growth) will require larger reserves than the average. Australia would seem to fit neatly into that category. The demand for reserves will in some measure reflect the need to take aCcow1t oCa succession of unfavourable events; and as long as this attitude is matched by an equal awareness of the possibility of a succession of favourable events there can be no quibble. A country, like Australia, greatly dependent on foreign trade, will certainly need to give priority to the possibility of wide swings in exports anel other major components of the balance of payments.
A second fWlction of reserves, and one which is probably now more important, is to facilitate payments adjustment to structural and chronic imbalance. 8 Reserves give the monetary authorities a breathing space so that the nature of the imbalance can be 7. There were, however, three years when the ratios showed divergent trends. In 1960/61 imports rose (partly under the innuence of the lifting of restrictions and partly in Jagged response to the peak level of economic activity) at a time when the monetary authorities were intent upon credit restraint; in 1961·63 the relatively depressed state of the economy meant that imports did not rise even though M rose by lllore than 16% - further evidence, perhaps, that monetary policy cannot be relied upon to provide a quick stimulus in a recession. 8. T. Scilovsky, Money alld file Balance of Paymell/s, Rand McNally 1969, p. 171.
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Vol. 01 No. 01, March 170
diagnosed and appropriate policies implemented, But we can take this a step further. The basic reason for holding reserves is to enable a country at some future time to finance a balance of payments deficit without recourse to deflationary measures in the domestic economy (1.U1less, of course, the deficit was caused by an inflationary policy in the first place). Whether reserves are in fact considered adequate at any time therefore depends on what the future is expected to hold. The Treasury has put this point succinctly: II it is well that we should look beneath the movement in reserves t~ 'the deeper trend in the balance of payments. It is not so much whether reserves fall in anyone year that matters bu t whellzer the forces contributing to that fall are likely to contil/ue." 9 (my italics). But little of any moment can be said about reserve adequacy or the need for reserves without specifying the policy on exchange rates. If exchange rates were free to move in sympathy with market forces the need to hold reserves would Virtually disappear because amovement in the exchange rate would then perform the same function (equate supply and demand for foreign exchange) as reserves perform under a regime of fairly rigid exchange rates. The follOWing analysis therefore assumes at the outset the absence of an equilibrating mechanism via adjustment of exchange rates; it also assumes no intensification of restrictions on trade and payments. With these two assuIDlltions out in the open it is clear that the burden of adjusting for balance of payments disequilibria falls squarely on domestic monetary and fiscal policies; and it is the anticipated response of these policies to future external disequilibria which will have an important bearing on the level of reserves which the monetary authorities should aim at now, The fewer the equilibrating forces and the slower their action the larger must be the external reserves. 10 Holding reserves involves an opportunity cost in terms of larger outlays on consmnption and investment which could otherwise have occurred. II It is therefore evident that once an assessment has been made of reserve needs (With allowance [or a 1 safety margin' to cover unforeseen developments) the appropriate poUcy will be to ensure that reserves are not permitted to be appreciably 9. The Commonwealth Treasury, nlc Australiall r.eollomy, 1967, White Paper, p. I J. 10.
The concept of adequate external reserves is discussed by T. Scitovsky in economic 171eoryand Western Europeon Integratioll (Allen & Unwin) 1958, pp. 101·2.
I I. There is, however, a slight offset in terms of income earned all Australia's holdings of sterling and dollar securities. The interest earned on these securities is believed to have increased appreciably in recent years with the sharp upward movement in New York and London money market rates. A lucid discussion of the nature of the costs involved in holding reserves is found in Hel1er,toc.cit., pp. 297·300. TC f '" rR, where TCf is the opportunity cost of holding reserves, r the differential between the social rate of return on capital and the return, if any, on reserves, and R is actual reserves.
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Vol. 01 No. 01, March 170
in excess of n level which will satisfy those needs. Policy should thus be directed to ensure that the actual level of reserves (R) is equated as nearly as possible with reserve needs (N ). Thus, in R equilibrium R
If R
. . • • . • .
=
. (2)
>
N there is a cost over and above what is necessary to incur. R The opportunity cost then becomes a real cost in terms of the use of resources (imports) which could increase economic welfare. In short, resources which could safely be released to promote welfare are being held idle. If R < N the economy is exposed to undue risk R of instability in the sense that a succession of unfavourable developments will impose strains on the economy, the adverse effects of which (in terms of economic welfare) more than offset the additional benefits to be derived now from a higher level of imports. But N is not static. When NR changes, ideas on what R constitutes an adequate level of reserves (A ) must also change. R We have noted earlier the common practice of regarding An as beingfWlctionally related to both HIland RIM. It now becomes clear that if N changes significantly (and needs are geared to present R trends and future prospects) recent changes in R/I and RIM may no longer serve as sure guides to
An. An will depend not only on nil
and RIM (as magnitudes which can be observed) but also on a changing index of reserve need (which is not something which can be observed and statistically recorded).
Thus we could say that:
N ) • . • • (3) R IfN is estimated to rise, An will also have to rise, mld vice versa. R =
[ (R/I,
HIM,
But how do we estimate N ? Needs are not easily R quantifiable but a starting point is to identify certain phenomena which are plainly relevant to reserve needs. Functional relationship (4) is an attempt to movc in this direction (rather than in the opposite direction of attempting to formulate a single criterion of reserve adequacy). 12 The point is
12. The most commonly used indicator of reserve :ldequacy is the R/I r:ltio. However, Heller has formulated a measure of rcserve :ldequacy 011 the basis of three variables payments imbalanccs, thc propensity to import and the opportunity cost of holding rcserves. Ibid. pp. 304-5
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Vol. 01 No. 01, March 170
that you cannot assess reserve adequacy (A ) merely by observing R changes in the RIM or R/I ratio. It is also necessary to assess reserve needs which is, of course, quite a difficult task. What follows may, however, stimulate further research into an area largely neglected (in Australia) but nevertheless seemingly of some importance.
where need for reserves. autonomous change in imports and invisible payments.
=
the marginal propensity to import.
=
autonomous change in exports and invisible receipts. 13
Cp
~
net foreign capital inflow (portfolio type investment).
CD
=
net foreign capital inflow (direct investment).
ill
/!.X
G p
u
A
~
=
speed of response of monetary/fiscal policy to external disequilibria. demand for reserves to satisfy a margin to cover unIoreseen developments.
The need (and hence the demand) for reserves (now and in the immediate future) is therefore regarded as being dependent on the behaviour of six variables in the system: (i) X ; (ii) fA; A ratio; 14 (v) G p ; and (vi) a residual (iii) m; (iv) the Cp/C D factor U. IS 13. For the purpose of this exercise all exports are assumed to be autonomous. I am indebted to Mr. M. Weisser for drawing my attention to this point. Autonomous changes are defined as changes (in exports and imports) which are umelated to changes in domestic income. 14. No specific allowance has been made for official borrowing overseas which is of some importance to Australia. Confidence in continued large borrowings (net of repayments) in this category would, txlwever, reduce the need to hold reserves and could therefore be included under CD. 15. This factor 'U' is probably of considerable importance in practice. Countries have different allitudes to risk bUI some allowance has 10 be made for lhe fact thal the future incidence and magnitude of balance of payments disequilibria are uncertain. This is related to the earlier reference to Australia as 3 country which faces wide fluctuations in exports and capital inflow. See supra p.46 and H.G. Grubel, The Ifltemationol Monetary System, Penguin 1969, pp. 72-3. If Cp and CD cannot be estimated, some allowance for them would need to be made in the residual item ·U'.
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The larger is m (the marginal propensity to import) the less the need for reserves since any change in income is associated with a fairly large change in the demand for imports. Thus, if exports fall and a country has a balance of payments deficit income tends to fall (or rises at a slower rate) through the familiar multiplier mechanism and the resultant fall in imports lessens the need for reserves. 16 The slight downturn in the Australian economy in 1966 (associated with the drought) affords a good illustration of the importanceo( m to the question of reserve adequacy. Between 1965 and 1966 the slower rate of growth of the economy was associated with a sharp drop in imports (the value of imports fell by about 4 per cent, as against a rise averaging 14 per cent p. a. in the three preceding years. Another good example is provided by the rather severe recession which occurred in West Germany during 1967 and which led to a sharp fall in the demand for imports (the economic slowdown produced a fall of DM 2.7 billion - or 4 per cent - in the value of imports, compared with a rise averaging 12 per cent p. a. in the three preceding years).!7 But the value of m fluctuates considerably from year to year. It cannot be assumed constant. 18 16. The ratio marginal propensity to import/average propensity to import
(V equals the
income elasticity of demand for imports which measures the sensitivity of imports to
,
changes in income. The value of (~ for Auslralia is about 1.4 if we average out over a 5 year period (about lhe same as for Canada. Germany, USA and UK). IMF,Iflternational
,
Fillollciol Statistics. The imparlance of ~ for balance of paymenls adjustment was discussed by P.W. Paish in "Banking Policy and the Balance of International Payments", Ecol/omica, November 1936 and reprinted in Readings in the 71leory of International Trade. AEA (Allen & Unwin) 1950, pp. 35·55. For estimating reserve need-s it seems that III
,
is more relev'lIIt Ihan ~ since for balance of paymcnts adjustment purposes our main
interest is in the absolute changc in imports (61) which is associated with a given changc in income (6V). 17. Calculations based on data from 1M P Internatiollal Finallcial Statistics. 18. In the last 6 years III has rangcd in vaJue from between .12 and .27 for Australja,.I0 and .28 for Canada and .08 and .30 for West Germany. Averagcd over the last 6 - 7 years the values are: Australia (.20); Canada (.22); West Germany (.19); Japan (.09); USA (.05) and UK (.23). See ibid. It is recognized, of course, lhat inler-country comparisons are difficult for a variety of reasons. For one thing it is nOI strictJy corrcel to use IFS dala (or any other data of total imports) for calculaling the marginaJ propcnsities to import because a part of IOlal imports (I A) is of an autonomous nature (not induced by past or current changcs in domestic income). The autonomous component has been importanl in Australia during recent years, as evidenced by large defence purchases and government ordcrs for aircraft on behalf of Qalltas and the domestic airlines. Comparisons betwcen countries arc also made difficult by the incidencc of import surcharges and exchange rate adjustments (e.g. Uniled Kingdom). Allowance for these items could no doubt bc attempted. However. the only point at issue hctc is that whcn an estimate is made of the future valuc of Tn the averaging out of past values may not be a vcry accurate guide.
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e It is some times sugge sted that the preca ution ary motiv
be is the domin ant influe nce in the dema nd for reser ves. This may onrelati oing true but what must be recog nized , and what the foreg nts ship explic itly recog nises , is that there are certa in devel opme s at in the balan ce of paym ents (base d on inform ation about trend acy; accur nable reaso with ated home and abroa d) which can be estim nce and the way in which these devel opme nts are expec ted to influe of s mean the and vario us segm ents of the balan ce of paym ents l ationa adjus tment will large ly deter mine the volum e of intern there reser ves which the mone tary autho rities desir e to hold (and ded as by condi tion the notion of what level of reser ves is regar in the lies r facto al residu the of being adequ ate). The signif icanc e the in ations fluctu fact that there are certa in event s which cause rtimpo the Thus balan ce of paym ents which carmo t be predi cted. ravulne ance of the residu al item turns largel y on the degre e of rbbility of the econo my and balan ce of paym ents to exter nal distu tural ances . As indica ted in Sectio n N (see infra, pp. 52·55 ) struc some ed reduc have my and other chang es in the Austr alian econo what the impor tance of this residu al item. One probl em is that we canno t specif y what the relev ant we do time horiz on for estim ating these chang es will be (altho ugh ed in know that the Treas ury, for its own purpo ses, has indulg once some long range forec asting ). Howe ver, the equat ion shows at R/I) or (RIM acy adequ ve why the custo mary meas ures of reser This ves. reser of may not afford an accur ate guide to the adequ acy ion is true at both the nation al and intern ationa l level. The equat can gives impli cit recog nition to the possi bility that count ries ves. achie ve a certa in ecollo my(o r diseco nomy '.) in the use of reser mean will nse respo er quick A The key varia ble is there fore G p ' ves; that count ries can get by with a lower absol ute level of reser ry ' s cowlt a that s, paribu is ceter a slowe r respo nse will indica te, fixed a ing assum s, mean need for reser ves has incre ased (whic h rly excha nge rate, that a given absol ute level of reser ves, if forme adequ ate, is no longe r so). No respo nsible ~overnment would openl y sancti on a asset s policy of resou rce wasta ge I by holdin g exces sive overs eas most as mone tary reser ves. Yet such wasta ge may occur , and in ) latter the likely (more ance count ries thl'ough the inabil ity or reluct to action tary mone and of the autho rities to take appro priate fiscal r the corre ct for a balan ce of paym ents defici t. Hence the slowe ves reser speed of respo nse of these polici es (G p ) the large r the neede d to cushio n balan ce of paym ents defici ts.
es can afford this 19. The point has been made, however, that relatively affluent countri a fairly long over average the all luxury and hence may tend to hold excessive reserves period. See Grubel,op. cit., p. 72.
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The equation also recognises the possibility, and this seems particularly relevant to Australia, that part of the increase in exports, imports and invisibles will occur quite independently of changes in domestic income; if X is expected to rise (e. g. A higher exports associated with new mineral discoveries and/or increasesin overseas demand) or I is expected to rise (e. g. larger A invisible payments geared to past foreign investments in Australia and/or imports of defence equipment and civil aircraft) then it is clear that the need for reserves will be less in the first instance abstracting from other influences - and larger in the second (the two could balance out) . Changes in world economic conditions may, of course, affect values placed on lA' XA, CplC n and 0P' The foregoing approach has the virtue that itis forwardlooking and enables us to interpret the meaning of changes in the conventional ratios from the standpoint of reserve adequacy. The variables in the equation are, with the exception of ro, essentially of independent status. 20 IV.
Within this framework it becomes much easier to evaluate the significance of changes in R/M or R/I. A rise or fall in these ratios may, or may not, indicate that reserves are more or less adequate than previously because, in interpreting the significance of movements in R/M and R/I, it is necessary to allow for the possibility of simultaneous changes in the need (or reserves. Since 1964 both ratios have fallen steadily. This would indicate that reserves have become less adequate (i. e. that the balance of payments position has steadily deteriorated) only if the need for reserves in that period has remained unchanged or has not fallen as much. It is a matter of judgment, upon weighing the various factors in the equation, whether reserve needs did, in fact, remain fairly constant during this period. ThiS model (or assessing re.serve needs has value when app.1ied to the peri
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Vol. 01 No. 01, March 170
in this connection is the improvement in Australia's competitive position in world markets. Such improvement would indicate a fall in the IA/X ratio. In the period 1960-65 Australia's average rate A of inflation was greater than the United States' but less than the United Kingdom's and substantially less than Japan's?:1 Since 1965 Australia's consumer price index has risen at an average rate of about 3%per year, compared with West Germany 1 s1.8%, USA's 4.2%, UK's 4. 7%, and Japan's 5. 3%. 22 These are countries with whom Australia has important trading links. The response of government policy to external disequilibria (G p ) has improved in this period: this is especially true of monetary policy when we compare recent performances with the inherent lack of flexibility evident during the 1958-60 episode and also between 1954-56. There is now a greater willingness to use a flexible interest rate policy to secure external balance in conjWlction with the use of fiscal policy to promote full employm.ent and a rapid growth rate. 23 A rise in Gp has therefore reduced the need for reserves. Amost difficult item to assess is Cp/C . 24 There has, n of course, been a vast inflow of overseas capital in the period 1964-69. Such rate of inflow greatly exceeded expectations, but in more recent years this item has been geared more closely to the portfolio investment component: C p has risen faster than Cn' This trend constitutes a less stable element in the Australian
21. See J.O. Adelunle, "Rales of Innation in Industrial, Other Developed and Less Developed Countries, 1949·65", IMF Sla!! Paperf, Vol. XV No.3, November 1968, pp.536·7. 22. These calculations are based on dala in IMF, Illternational Financial Slarislics, Vol. XXII, No.8, August 1969, p.31. 23. The assignment of particular instrumcnts of policy to specific objectives has been advocatcd by several economists. See R.J\. Mundell, "The Appropriate use of Monetary and Fiscal Policy undcr Fixed Exchange Rates"', IMF, Slaff Papers, March 1962, and reprinled in IlIfeTllaliOllal Economics, Macmillan. 1968, pp. 233-239. 24. The distinction bel ween Cp and Co is quite arbitrary. The Commonwealth Slalistician rcgards invcstment as dircct (a) when investment is made through a branch of an overseas company, or (b) whcn there is ownership of 25% of more of a company's ordinary shares (or voting stock) by one company or a group of companics incorporated in one overseas country. or ownership of 50% or more of a company's ordinary shares (or voting stock) by individuals Or companies in one overseas country. C.B.C.S. A,,"ual Bullelill o!Ol'erseas II/vestmelll, 1966-67, p. 49.
54
Economic Analysis and Policy
Vol. 01 No. 01, March 170
balance of payments which would increase the need for reserves. 25 Also, the interdependence between I and CD must be allowed for in assessing present and future reserve needs. Any anticipated increase in CD would have to be related to I (which includes profit remittances abroad). One might offset the other. But Cp has no such close association with I; C p might fall without any resulting fall in 1. The recent steep rise in C p would therefore be a factor tendi.ng to increase the need to hold reserves. The conclusion is that the RIM and nil rati.os can be a useful guide to the question of reserve adequacy; at the same time it is felt that, in assessing reserve needs, more emphasis should be given to the immediate past, the present and the future - rather than the more distant past. 26 The variables which are relevant to this task are not easily quantifiable, but this is not a valid reason for pretending that they do not exist. The use of more flexible monetary policies, the recent improvement in the competitive position, the very favourable prospects for a range of exports and the widening of the industrial base - these developments would all suggest that the needs for reserves is now less than it was 5 - 10 years ago. Put another way, it means that Australia can now afford to risk a higher rate of importing - allow the R/I ratio to fall - without regarding the fall as a sign that the balance of payments position has deteriorated. Against this is the inherent uncertainty of future developments (the precautionary motive for holding reserves) and the greater element of instability injected into the balance of payments via the recent sharp rise in foreign portfolio and institutional investment coupled with the rising interest - dividend bill to service past investments [rom abroad. Which of these [orees predominate is a matter of judgment by the monetary authorities. It seems legitimate to argue that any further fall in the R/I or HIM ratios (the ratios rose slightly in 1968-69) would be, primajacie, a cause for concern. However, in order to arrive at a final judgment on reserve adequacy we would have to consider the range of factors which enter 25. C p includcs institutional lcnding which is repayable OVer a shorl period whereas provision is not normally made for repayment of direct investments. A significomt part of earnings on direct investments are also held back in Australia for future expansion. See l.a.N. Perkins, Australia ill rhe World Ecol/omy, Sun Uook,Melbourne, 1968, p. 34. 26. For a country like Australia, with its strong impulse to growth and propensity for structural change, the "random walk" theory seems to be of little relevance to the question of reserve adequacy. This theory posits, as an important elemen[ in the demand for international reserves, the average absolute changes in reserves in thc reccnt past.
55
Economic Analysis and Policy
Vol. 01 No. 01, March 170
into lA' X , C, G p and U. There is little to be said in favour of A rwming away from this approach because of a belief that it cannot form the basis of a simple model of economic behaviour. The issues at stake are highly complex and any analysis to be of value as an aid to policy must start with due recognition of the degree of complexity involved. Rule-of-thumb measures of reserve adequacy (e. g. that reserves should be able to purchase 5 or 6 months imports) are no substitute for a thorough-going assessment of reserve needs based on the foregoing considerations.
The UniVel"sity of New England
J. S. H. Hunter
Economic Analysis and Policy
56
Vol. 01 No. 01, March 170
AI'PENDIX 1. COMPOSITION OF AUSTRALIA'S INTERNATIONAL RESERVES
(SA m) End of
Gold
US Dollars
Sterling
June
Other Foreign
IMFGold
Exchange (.)
Tranche
Total
1954
114.1
27.6
983.3
1.4
1955
124.7
38.1
678.9
-0.2
8.0
849.5
1956
146.4
40.8
502.1
2.4
8.0
699.7
1957
103.5
51.2
957.7
8.0
1120.4
1958
131.5
51.4
847.8
8.0
1038.7
1959
120.3
61.5
826.4
0.5
20.0
1028.7
1960
133.0
83.2
784.7
0.2
65.0
1066.1
1961
138.3
60.1
880.4
-2.5
1962
158.3
66.2
870.5
1.0
66.0
1162.0
1963
178.5
108.2
935.0
2.1
89.0
1312.8
1964
194.6
128.0
1347.6
3.4
89.0
1762.6
1965
205.0
153.5
996.1
1.3
112.0
1467.9
1966
198.2
194.0
980.2
2.4
152.0
1526.8
1967
204.4
250.6
742.7
1.3
178.0
1377.0
1968
229.9
222.0
633.2
11.5
249.0
1345.6
1969
230.5
4DO.3
645.3
34.3
204.0
1514.4
(3)
1126.4
1076.3
negative figure denotes excess of liabilities over assets. The recent increase in olher foreign exchange holdings is believed 10 consist mainly of holdings of
Deutsche Mark.
Sol/ret!:
Reserve Bank of Australia. StQtistical Bulletin, FiIlQl/eml Supplement. September 1969.
Economic Analysis and Policy
57
Vol. 01 No. 01, March 170
2. COMPOSITION OF AUSTRALIA'S INTERNATIONAL RESERVES (Per cent of Each Hem to Total)
Elld
or
Gold
US Dollars
Sterling
June
Olher Foreign
IMF Gold
Exchange
Tranche
1954
10.1
2.5
87.3
1955
14.7
4.5
79.9
1956
20.9
5.8
7 I. 7
1957
9.2
4.6
~5.5
0.7
195~
12.7
4.9
81.6
0.8
1959
I 1.7
6.0
~0.3
1960
12.5
7.8
73.6
1961
12.8
5.5
81.7
1962
13.6
5.7
74.9
0.1
5.7
1963
13.6
8.2
71.2
0.2
6.8
1964
11.0
7.3
76.5
0.1
5.1
1965
14.0
10.5
67.8
0.1
7.6
1966
13.0
12.7
64.2
0.1
10.0
1967
14.8
18.2
53.9
0.2
12.9
1968
17.1
16.5
47.1
0.8
18.5
1969
15.2
26.4
42.6
2.3
13.5
Source:
Sec Table I.
0.1 0.9 0.5
0.1
1.I
1.9 6.1
39
Vol. 01 No. 01, March 170
ON THE ADEQUACY OF AUSTRALIA'S INTERNATIONAL RESERVES
In recent years, especially since the sterling devaluation of November 1967, divergent opinions have been expressed on whether or not Australia's balance of payments is in "equilibrium". I A related question, and one which has not received much attention(at least not in the academic literature) I concerns the adequacy of Australia's overseas reserves. Adequate for what? Should the monetary authorities aim at a particular level of reserves dudng a given period? What criteria should gltide such decisions?
It is the purpose of this paper to assess what economic meaning can be attached to the concept of reserve adequacy in the light of recent Australian experience. The data used covers a period (1954 to 1969) in which the Australian balance of payments has shown a marked capacity for fluctuation. Moreover, during this period many pessimistic forecasts have been made about the long term trend of the Australian balance of payments. It seems that a re-action to what Corden has called "balance of payments pessimism" has at last set in 2 but there is little evidence to suggest that this re-action springs from an awareness.by economists that an assessment of reserve needs cannot be gauged by a mere analysis of past data. A country's need for reserves will change as the structure of the economy changes. Balance of payments "pessimism" - or l1optimism" based on observed trends in reserves and other economic magnitudes may be misleading - for reasons which will be discussed shortly. However, it is logical IDld useful to start by observing trends which have, in fact, taken place in relevant magnitudes over the period. It will then bc a matter of demonstrating that certain modifications to the raw data may be necessary before one can arrive at a final opinion on reserve adequacy. The data on reserves, imports and the money supply, which it is customary to use for assessing the adequacy of reserves, is set out in rabies 1 and 2. The reasons for focussing on money is that theoretical developments in the balance of payments attach considerable importa.nce to changes in money. Thus it has been argued that balance of payments deficits (or surpluses) are essentially monetary phenomena - in short, that a balance of payments deficit I. See, for example, J.O.N. Perkins, "Australia and the 1967 Devaluation of Sterling", Economic Record. March 1968, especially pp. 6·7 and appendix; also W.M. Carden, "A Survey of Australian Economic Policy", AmericQIl ECOllomic Review. Vol. LVIII,
No.3, Pari 2 (supplement) June 1968, pp. 101-3. 2. ibid.
40
Economic Analysis and Policy
Vol. 01 No. 01, March 170
cannot persist without credit creation (and preswnably, a surplus cannot persist without a contraction of credit 3). If this notion is correct it impl ies that deficits persist because the monetary authorities t.:'1.ke offsetting action (expand the money supply) and do not allow the deflationary effects of the deficit to work themselves out in the domestic economy(e. g. through higher interest rates). This means, in turn, that a deficit will reduce international reserves (R) without reducing the money supply (M) (i. e. that the ratio RIM will fall). On this basis therefore it can be argued that changes in the RIM ratio provide a fairly good index of a COWltry'S balance of payments position and of reserve adequacy. In other words, assuming a fixed exchange rate, no intensification of controls and no structural changes. an increase in the ratio would appear to signal a favourable trend in the reserve position (that reserves were becoming more adequate or less inadequate) while adecrease in the ratio would suggest a deterioration in the reserve position (reserves were becoming more inadequate or less adequate) .
But is it realistic to assess the adequacy of reserves by merely observing past changes in these ratios? This has to be approached cautiously. Changes in the structure of the economy and in the ability and willingness to use internal policies to adjust for balance of payments disequilibria will more than likely influence a judgment on whether or not existing reserves are adequate. For example, a reluctance to allow interest rates to vary with cyclical changes in income would clearly raise the minimum level of reserves considered to be adequate. The concept of reserve adequacy must, therefore, be forward looking in some degree: the main question is whether existing reserves are adequate in the light of expected changes in the Australian economy (including the anticipated polic¥ responses to these changes) and changes in conditions overseas. In Section III we look at the motives for holding reserves. What factors exert the most important influence on Australia' s need for reserves? How must the crude statistical measures be modified to take account of them? Before proceeding with this analysis it is necessary to establish what elements comprise Australia l s overseas reserves. Reserve Bank statistics show a division between gold and holdings of sterling, dollars and other foreign exchange. Australia l s gold 3. H.G. Johnson "Towards a General Theory of the Balance of Payments". Reprinted in 1968
Readings ill Jllfcmot;onaf Economics, Caves R.E. & Johnson H.G. eds.• A.E.A.,
pp.374·388. 4. There is no attempt in this paper "to condense the different factors that influence the amount of international reserves a country should hold into a single index': H.R. Heller, "Optimal International Reserves", Economic Journal, Vol. LXXVI, June 1966 p. 296. It is felt that there is not great merit from a policy viewpoint in pursuing the search for the elusive one objective number which could be used to assess a country's external liquidity position.
Economic Analysis and Policy
41
Vol. 01 No. 01, March 170
TABLE I INTERNATIONAL RESERVES AND THE MONEY SUPPLY SA million End of
Reserves
June
M1
(a)
1954
Percent
(b)
M2 (c)
(d)
1,126
3,600
3,129
5,600
31.3
36.0
20.1
1955
850
3,641
3,159
5,766
23.3
26.9
14.7
1956
700
3,557
3,090
5,816
19.7
22.7
12.0
1957
1,120
3,771
3,239
6,208
29.7
34.6
18.0
1958
1,039
3,777
3,179
6,354
27.5
32.7
16.4
1959
1,029
3,918
3,274
6,676
26.3
31.4
15.4
1960
1,066
4,167
3,521
7,192
25.6
30.3
14.8
1961
1,076
4,163
3,293
7,302
25.8
32.7
14.7
1962
1,162
4,418
3,379
7,846
26.3
34.4
14.8
1963
1,313
4,611
3,464
8,518
28.5
37.9
15.4
1964
1,763
5,112
3,732
9,556
34.5
47.2
18.4
1965
1,468
5,479
3,791
10,337
26.8
38.7
14.2
1966
1,527
5,714
3,816
10,938
26.7
40.0
14.0
1967
1,377
6,100
4,074
11,824
22.6
33.8
11.6
1968
1,346
6,605
4,414
12,805
20.4
30.5
10.5
1969
1,514
7,292
4,750
13,974
20.8
31.9
10.8
(a)
M
RIM
comprises gold, holdings of US dollars, sterling and other foreign exchange, and gold tranche position with 1M F:
(b)
deposits of public (current and fixed) with all cheque-paying banks plus notes and coin in hands of public.
(e)
current account deposits of public with cheque paying banks plus notes and coin in hands of public.
(d)
deposits of public (current and fIxed) with all cheque-paying banks, deposits with all savings banks and notes and coin in hands of public.
Source:
Reserve Bank of Australia, Statis/ical Blllleti", Financial SlIpplemem. September 1969, pp. 38·39 and 84-85.
Economic Analysis and Policy
42
Vol. 01 No. 01, March 170
TABLE 2 INTERNATIONAL RESERVES AND IMPORTS End of June
Reserves ($A m) (a)
Imports
1954
1.126
1.323
85.1
1955
850
1.642
51.8
1956
700
1.597
43.8
1957
1.120
1.381
81.1
1958
1.039
1.521
68.3
1959
1.029
1.554
66.2
1960
1.066
1.814
58.8
1961
1.076
2,056
52.3
1962
1,162
1,701
68.3
1963
1,313
2,065
63.6
1964
1.763
2,237
78.8
1965
1,468
2,739
53.6
1966
1,527
2,822
54.1
1967
1,377
2,837
48.5
1968
1,346
3,159
42.6
1969
1,514
3,195
47.4
(SA m) (b)
Rfl Ratio (Per cent)
(a)
see table 1.
(b)
for preceding financial year. Recorded imports adjusted in respect of coverage and valuation for balance of payments purposes.
Source:
For reserves (sec table 1). For imports. Commonwealth Statistician. Balonce of Payments, 1961/62 10 1965/66 and first half of 1966/67; and Reserve Bank Statistical Bulletin, August 1969.
43
Economic Analysis and Policy
Vol. 01 No. 01, March 170
these and super gold tranc he positi ons with the IMF are added to nd dema on ble figure s on the groun ds that these amou nts are availa the in es to meet balan ce of paym ents needs , and furthe r that chang and gold and super gold tranc he positi ons involv e corre spond ing e includ To gs. holdin nge oppos ite chang es in gold and foreig n excha overthe of re one witho ut the other would prese nt a misle ading pictu credi t all trend of Austr alia's overs eas reser ves. Austr alia's ngs tranc he positi on with the Fund is exclu ded, howe ver, since drawi to s tment adjus policy al intern in the credi t tranc he would requi re resto re balan ce of paym ents equil ibrium . 5 II.
Some econo mists have made a distin ction betwe en the ves. level of reser ves (rese rve stoCk) and the rate of growt h of reser enwill The point of the distin ction is that a 'high' reser ve stock ce of hance the abilit y of a count ry to meet curre nt and future balan for (say ves reser in ase paym ents defic its while a high rate of incre in its defic large of the past four years ) will decre ase the likeli hood more could the imme diate future (and if the defic its do occur they ing readi ly be financ ed). 6 This distin ction is not made in the follow Austin acy adequ ve l'eser of analy sis, partly becau se the conce pt able ralia has been relate d to what is regar ded as being a desir loses ction minim um level of reser ves and partly becau se the distin d to much of its signjf icanc e once chang es in reser ves are relate y. chang es in other magn itudes - such as impo rts and the mone y suppl The latter (ratio ) appro ach seem s best suited to our purpo se. Graph 1 shows chang es in the RIM ratio for the perio d mone y 1954 to 196n on the basis of three altern ative meas ures of the y y suppl y. It is evide nt that whate ver defini tion of the mone suppl
is we adopt , the overa ll trend patte rn and the degre e of fluctu ation JVM the in ments move of n very nearl y the same . An exam inatio ce ratio siuce 1954, as shown in Graph 11. enabl es us to identi fy balan an (i) of paym ents fluctu ations in terms of five distin ct perio ds: veadver se move ment betwe en 1954 and 1956; (ii) a decis ive impro (iv) 1961; to 1957 from ment ment in 1956/ 7; (iii) an adver se move le a favou rable trend betwe en 1961 and 1964; and (v) an unfav ourab what with move ment from 1964 to 1969. These obser vatio ns tally of the is comm only believ ed to have been the chang ing fortun es Austr alian balan ce of paym ents over the last 15 years . In Graph /I the reser ve/im port ratio (R/l) is plotte d very along side the R/M ratio. Here we find that there has been a reserves since 5. Tables showing changes in the composition or Australia's international 1954 arc included in an appendix. Reserves", Essays ill 6. See J .M. Fleming, "Towards Assessing the Need ror International 5. p. 1967, ry Ill/ema tional Finance. Princeton, No. 58, Februa
44
Economic Analysis and Policy
Vol. 01 No. 01, March 170
.......:;;.
•
•
• • • • •
•
•
•
45
Economic Analysis and Policy
Vol. 01 No. 01, March 170
•
•
.,,
• •"
• •z ,
" o o z
•
• .•,
••
., o
••
,•'.
46
Economic Analysis and Policy
Vol. 01 No. 01, March 170
close correlation between movements in these ratios. 7 The value of imports and the volume of money have shown broadly parallel movements for most of the period. As the monetary authorities expand credit imports rise (both ratios fall) and as the monetary authorities contract credit (or slow down the expansion) imports fall (both ratios rise). By incorporating money as well as reserves and imports in our equation we are able to establish, as a first approximation, the relevance to the question of reserve adequacy of the response of monetary policy to changes in the balance of payments. In this sense the adequacy of reserves (A ) is a function R of the reserve/import ratio which is, in turn, a function of the reserve/money supply ratio:
III.
To assess the need for reserves in total we have to ask why reserves are held in the first place and how changes in economic conditions (at home and abroad) and changes in domestic policies will affect these needs. It can be argued, and with some justification, that a country facing the prospect of wide fluctuations in export earnings and capital inflow (and with imports geared to the rate of growth) will require larger reserves than the average. Australia would seem to fit neatly into that category. The demand for reserves will in some measure reflect the need to take aCcow1t oCa succession of unfavourable events; and as long as this attitude is matched by an equal awareness of the possibility of a succession of favourable events there can be no quibble. A country, like Australia, greatly dependent on foreign trade, will certainly need to give priority to the possibility of wide swings in exports anel other major components of the balance of payments.
A second fWlction of reserves, and one which is probably now more important, is to facilitate payments adjustment to structural and chronic imbalance. 8 Reserves give the monetary authorities a breathing space so that the nature of the imbalance can be 7. There were, however, three years when the ratios showed divergent trends. In 1960/61 imports rose (partly under the innuence of the lifting of restrictions and partly in Jagged response to the peak level of economic activity) at a time when the monetary authorities were intent upon credit restraint; in 1961·63 the relatively depressed state of the economy meant that imports did not rise even though M rose by lllore than 16% - further evidence, perhaps, that monetary policy cannot be relied upon to provide a quick stimulus in a recession. 8. T. Scilovsky, Money alld file Balance of Paymell/s, Rand McNally 1969, p. 171.
Economic Analysis and Policy
47
Vol. 01 No. 01, March 170
diagnosed and appropriate policies implemented, But we can take this a step further. The basic reason for holding reserves is to enable a country at some future time to finance a balance of payments deficit without recourse to deflationary measures in the domestic economy (1.U1less, of course, the deficit was caused by an inflationary policy in the first place). Whether reserves are in fact considered adequate at any time therefore depends on what the future is expected to hold. The Treasury has put this point succinctly: II it is well that we should look beneath the movement in reserves t~ 'the deeper trend in the balance of payments. It is not so much whether reserves fall in anyone year that matters bu t whellzer the forces contributing to that fall are likely to contil/ue." 9 (my italics). But little of any moment can be said about reserve adequacy or the need for reserves without specifying the policy on exchange rates. If exchange rates were free to move in sympathy with market forces the need to hold reserves would Virtually disappear because amovement in the exchange rate would then perform the same function (equate supply and demand for foreign exchange) as reserves perform under a regime of fairly rigid exchange rates. The follOWing analysis therefore assumes at the outset the absence of an equilibrating mechanism via adjustment of exchange rates; it also assumes no intensification of restrictions on trade and payments. With these two assuIDlltions out in the open it is clear that the burden of adjusting for balance of payments disequilibria falls squarely on domestic monetary and fiscal policies; and it is the anticipated response of these policies to future external disequilibria which will have an important bearing on the level of reserves which the monetary authorities should aim at now, The fewer the equilibrating forces and the slower their action the larger must be the external reserves. 10 Holding reserves involves an opportunity cost in terms of larger outlays on consmnption and investment which could otherwise have occurred. II It is therefore evident that once an assessment has been made of reserve needs (With allowance [or a 1 safety margin' to cover unforeseen developments) the appropriate poUcy will be to ensure that reserves are not permitted to be appreciably 9. The Commonwealth Treasury, nlc Australiall r.eollomy, 1967, White Paper, p. I J. 10.
The concept of adequate external reserves is discussed by T. Scitovsky in economic 171eoryand Western Europeon Integratioll (Allen & Unwin) 1958, pp. 101·2.
I I. There is, however, a slight offset in terms of income earned all Australia's holdings of sterling and dollar securities. The interest earned on these securities is believed to have increased appreciably in recent years with the sharp upward movement in New York and London money market rates. A lucid discussion of the nature of the costs involved in holding reserves is found in Hel1er,toc.cit., pp. 297·300. TC f '" rR, where TCf is the opportunity cost of holding reserves, r the differential between the social rate of return on capital and the return, if any, on reserves, and R is actual reserves.
Economic Analysis and Policy
48
Vol. 01 No. 01, March 170
in excess of n level which will satisfy those needs. Policy should thus be directed to ensure that the actual level of reserves (R) is equated as nearly as possible with reserve needs (N ). Thus, in R equilibrium R
If R
. . • • . • .
=
. (2)
>
N there is a cost over and above what is necessary to incur. R The opportunity cost then becomes a real cost in terms of the use of resources (imports) which could increase economic welfare. In short, resources which could safely be released to promote welfare are being held idle. If R < N the economy is exposed to undue risk R of instability in the sense that a succession of unfavourable developments will impose strains on the economy, the adverse effects of which (in terms of economic welfare) more than offset the additional benefits to be derived now from a higher level of imports. But N is not static. When NR changes, ideas on what R constitutes an adequate level of reserves (A ) must also change. R We have noted earlier the common practice of regarding An as beingfWlctionally related to both HIland RIM. It now becomes clear that if N changes significantly (and needs are geared to present R trends and future prospects) recent changes in R/I and RIM may no longer serve as sure guides to
An. An will depend not only on nil
and RIM (as magnitudes which can be observed) but also on a changing index of reserve need (which is not something which can be observed and statistically recorded).
Thus we could say that:
N ) • . • • (3) R IfN is estimated to rise, An will also have to rise, mld vice versa. R =
[ (R/I,
HIM,
But how do we estimate N ? Needs are not easily R quantifiable but a starting point is to identify certain phenomena which are plainly relevant to reserve needs. Functional relationship (4) is an attempt to movc in this direction (rather than in the opposite direction of attempting to formulate a single criterion of reserve adequacy). 12 The point is
12. The most commonly used indicator of reserve :ldequacy is the R/I r:ltio. However, Heller has formulated a measure of rcserve :ldequacy 011 the basis of three variables payments imbalanccs, thc propensity to import and the opportunity cost of holding rcserves. Ibid. pp. 304-5
Economic Analysis and Policy
49
Vol. 01 No. 01, March 170
that you cannot assess reserve adequacy (A ) merely by observing R changes in the RIM or R/I ratio. It is also necessary to assess reserve needs which is, of course, quite a difficult task. What follows may, however, stimulate further research into an area largely neglected (in Australia) but nevertheless seemingly of some importance.
where need for reserves. autonomous change in imports and invisible payments.
=
the marginal propensity to import.
=
autonomous change in exports and invisible receipts. 13
Cp
~
net foreign capital inflow (portfolio type investment).
CD
=
net foreign capital inflow (direct investment).
ill
/!.X
G p
u
A
~
=
speed of response of monetary/fiscal policy to external disequilibria. demand for reserves to satisfy a margin to cover unIoreseen developments.
The need (and hence the demand) for reserves (now and in the immediate future) is therefore regarded as being dependent on the behaviour of six variables in the system: (i) X ; (ii) fA; A ratio; 14 (v) G p ; and (vi) a residual (iii) m; (iv) the Cp/C D factor U. IS 13. For the purpose of this exercise all exports are assumed to be autonomous. I am indebted to Mr. M. Weisser for drawing my attention to this point. Autonomous changes are defined as changes (in exports and imports) which are umelated to changes in domestic income. 14. No specific allowance has been made for official borrowing overseas which is of some importance to Australia. Confidence in continued large borrowings (net of repayments) in this category would, txlwever, reduce the need to hold reserves and could therefore be included under CD. 15. This factor 'U' is probably of considerable importance in practice. Countries have different allitudes to risk bUI some allowance has 10 be made for lhe fact thal the future incidence and magnitude of balance of payments disequilibria are uncertain. This is related to the earlier reference to Australia as 3 country which faces wide fluctuations in exports and capital inflow. See supra p.46 and H.G. Grubel, The Ifltemationol Monetary System, Penguin 1969, pp. 72-3. If Cp and CD cannot be estimated, some allowance for them would need to be made in the residual item ·U'.
Economic Analysis and Policy
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Vol. 01 No. 01, March 170
The larger is m (the marginal propensity to import) the less the need for reserves since any change in income is associated with a fairly large change in the demand for imports. Thus, if exports fall and a country has a balance of payments deficit income tends to fall (or rises at a slower rate) through the familiar multiplier mechanism and the resultant fall in imports lessens the need for reserves. 16 The slight downturn in the Australian economy in 1966 (associated with the drought) affords a good illustration of the importanceo( m to the question of reserve adequacy. Between 1965 and 1966 the slower rate of growth of the economy was associated with a sharp drop in imports (the value of imports fell by about 4 per cent, as against a rise averaging 14 per cent p. a. in the three preceding years. Another good example is provided by the rather severe recession which occurred in West Germany during 1967 and which led to a sharp fall in the demand for imports (the economic slowdown produced a fall of DM 2.7 billion - or 4 per cent - in the value of imports, compared with a rise averaging 12 per cent p. a. in the three preceding years).!7 But the value of m fluctuates considerably from year to year. It cannot be assumed constant. 18 16. The ratio marginal propensity to import/average propensity to import
(V equals the
income elasticity of demand for imports which measures the sensitivity of imports to
,
changes in income. The value of (~ for Auslralia is about 1.4 if we average out over a 5 year period (about lhe same as for Canada. Germany, USA and UK). IMF,Iflternational
,
Fillollciol Statistics. The imparlance of ~ for balance of paymenls adjustment was discussed by P.W. Paish in "Banking Policy and the Balance of International Payments", Ecol/omica, November 1936 and reprinted in Readings in the 71leory of International Trade. AEA (Allen & Unwin) 1950, pp. 35·55. For estimating reserve need-s it seems that III
,
is more relev'lIIt Ihan ~ since for balance of paymcnts adjustment purposes our main
interest is in the absolute changc in imports (61) which is associated with a given changc in income (6V). 17. Calculations based on data from 1M P Internatiollal Finallcial Statistics. 18. In the last 6 years III has rangcd in vaJue from between .12 and .27 for Australja,.I0 and .28 for Canada and .08 and .30 for West Germany. Averagcd over the last 6 - 7 years the values are: Australia (.20); Canada (.22); West Germany (.19); Japan (.09); USA (.05) and UK (.23). See ibid. It is recognized, of course, lhat inler-country comparisons are difficult for a variety of reasons. For one thing it is nOI strictJy corrcel to use IFS dala (or any other data of total imports) for calculaling the marginaJ propcnsities to import because a part of IOlal imports (I A) is of an autonomous nature (not induced by past or current changcs in domestic income). The autonomous component has been importanl in Australia during recent years, as evidenced by large defence purchases and government ordcrs for aircraft on behalf of Qalltas and the domestic airlines. Comparisons betwcen countries arc also made difficult by the incidencc of import surcharges and exchange rate adjustments (e.g. Uniled Kingdom). Allowance for these items could no doubt bc attempted. However. the only point at issue hctc is that whcn an estimate is made of the future valuc of Tn the averaging out of past values may not be a vcry accurate guide.
51
Economic Analysis and Policy
Vol. 01 No. 01, March 170
e It is some times sugge sted that the preca ution ary motiv
be is the domin ant influe nce in the dema nd for reser ves. This may onrelati oing true but what must be recog nized , and what the foreg nts ship explic itly recog nises , is that there are certa in devel opme s at in the balan ce of paym ents (base d on inform ation about trend acy; accur nable reaso with ated home and abroa d) which can be estim nce and the way in which these devel opme nts are expec ted to influe of s mean the and vario us segm ents of the balan ce of paym ents l ationa adjus tment will large ly deter mine the volum e of intern there reser ves which the mone tary autho rities desir e to hold (and ded as by condi tion the notion of what level of reser ves is regar in the lies r facto al residu the of being adequ ate). The signif icanc e the in ations fluctu fact that there are certa in event s which cause rtimpo the Thus balan ce of paym ents which carmo t be predi cted. ravulne ance of the residu al item turns largel y on the degre e of rbbility of the econo my and balan ce of paym ents to exter nal distu tural ances . As indica ted in Sectio n N (see infra, pp. 52·55 ) struc some ed reduc have my and other chang es in the Austr alian econo what the impor tance of this residu al item. One probl em is that we canno t specif y what the relev ant we do time horiz on for estim ating these chang es will be (altho ugh ed in know that the Treas ury, for its own purpo ses, has indulg once some long range forec asting ). Howe ver, the equat ion shows at R/I) or (RIM acy adequ ve why the custo mary meas ures of reser This ves. reser of may not afford an accur ate guide to the adequ acy ion is true at both the nation al and intern ationa l level. The equat can gives impli cit recog nition to the possi bility that count ries ves. achie ve a certa in ecollo my(o r diseco nomy '.) in the use of reser mean will nse respo er quick A The key varia ble is there fore G p ' ves; that count ries can get by with a lower absol ute level of reser ry ' s cowlt a that s, paribu is ceter a slowe r respo nse will indica te, fixed a ing assum s, mean need for reser ves has incre ased (whic h rly excha nge rate, that a given absol ute level of reser ves, if forme adequ ate, is no longe r so). No respo nsible ~overnment would openl y sancti on a asset s policy of resou rce wasta ge I by holdin g exces sive overs eas most as mone tary reser ves. Yet such wasta ge may occur , and in ) latter the likely (more ance count ries thl'ough the inabil ity or reluct to action tary mone and of the autho rities to take appro priate fiscal r the corre ct for a balan ce of paym ents defici t. Hence the slowe ves reser speed of respo nse of these polici es (G p ) the large r the neede d to cushio n balan ce of paym ents defici ts.
es can afford this 19. The point has been made, however, that relatively affluent countri a fairly long over average the all luxury and hence may tend to hold excessive reserves period. See Grubel,op. cit., p. 72.
52
Economic Analysis and Policy
Vol. 01 No. 01, March 170
The equation also recognises the possibility, and this seems particularly relevant to Australia, that part of the increase in exports, imports and invisibles will occur quite independently of changes in domestic income; if X is expected to rise (e. g. A higher exports associated with new mineral discoveries and/or increasesin overseas demand) or I is expected to rise (e. g. larger A invisible payments geared to past foreign investments in Australia and/or imports of defence equipment and civil aircraft) then it is clear that the need for reserves will be less in the first instance abstracting from other influences - and larger in the second (the two could balance out) . Changes in world economic conditions may, of course, affect values placed on lA' XA, CplC n and 0P' The foregoing approach has the virtue that itis forwardlooking and enables us to interpret the meaning of changes in the conventional ratios from the standpoint of reserve adequacy. The variables in the equation are, with the exception of ro, essentially of independent status. 20 IV.
Within this framework it becomes much easier to evaluate the significance of changes in R/M or R/I. A rise or fall in these ratios may, or may not, indicate that reserves are more or less adequate than previously because, in interpreting the significance of movements in R/M and R/I, it is necessary to allow for the possibility of simultaneous changes in the need (or reserves. Since 1964 both ratios have fallen steadily. This would indicate that reserves have become less adequate (i. e. that the balance of payments position has steadily deteriorated) only if the need for reserves in that period has remained unchanged or has not fallen as much. It is a matter of judgment, upon weighing the various factors in the equation, whether reserve needs did, in fact, remain fairly constant during this period. ThiS model (or assessing re.serve needs has value when app.1ied to the peri
53
Economic Analysis and Policy
Vol. 01 No. 01, March 170
in this connection is the improvement in Australia's competitive position in world markets. Such improvement would indicate a fall in the IA/X ratio. In the period 1960-65 Australia's average rate A of inflation was greater than the United States' but less than the United Kingdom's and substantially less than Japan's?:1 Since 1965 Australia's consumer price index has risen at an average rate of about 3%per year, compared with West Germany 1 s1.8%, USA's 4.2%, UK's 4. 7%, and Japan's 5. 3%. 22 These are countries with whom Australia has important trading links. The response of government policy to external disequilibria (G p ) has improved in this period: this is especially true of monetary policy when we compare recent performances with the inherent lack of flexibility evident during the 1958-60 episode and also between 1954-56. There is now a greater willingness to use a flexible interest rate policy to secure external balance in conjWlction with the use of fiscal policy to promote full employm.ent and a rapid growth rate. 23 A rise in Gp has therefore reduced the need for reserves. Amost difficult item to assess is Cp/C . 24 There has, n of course, been a vast inflow of overseas capital in the period 1964-69. Such rate of inflow greatly exceeded expectations, but in more recent years this item has been geared more closely to the portfolio investment component: C p has risen faster than Cn' This trend constitutes a less stable element in the Australian
21. See J.O. Adelunle, "Rales of Innation in Industrial, Other Developed and Less Developed Countries, 1949·65", IMF Sla!! Paperf, Vol. XV No.3, November 1968, pp.536·7. 22. These calculations are based on dala in IMF, Illternational Financial Slarislics, Vol. XXII, No.8, August 1969, p.31. 23. The assignment of particular instrumcnts of policy to specific objectives has been advocatcd by several economists. See R.J\. Mundell, "The Appropriate use of Monetary and Fiscal Policy undcr Fixed Exchange Rates"', IMF, Slaff Papers, March 1962, and reprinled in IlIfeTllaliOllal Economics, Macmillan. 1968, pp. 233-239. 24. The distinction bel ween Cp and Co is quite arbitrary. The Commonwealth Slalistician rcgards invcstment as dircct (a) when investment is made through a branch of an overseas company, or (b) whcn there is ownership of 25% of more of a company's ordinary shares (or voting stock) by one company or a group of companics incorporated in one overseas country. or ownership of 50% or more of a company's ordinary shares (or voting stock) by individuals Or companies in one overseas country. C.B.C.S. A,,"ual Bullelill o!Ol'erseas II/vestmelll, 1966-67, p. 49.
54
Economic Analysis and Policy
Vol. 01 No. 01, March 170
balance of payments which would increase the need for reserves. 25 Also, the interdependence between I and CD must be allowed for in assessing present and future reserve needs. Any anticipated increase in CD would have to be related to I (which includes profit remittances abroad). One might offset the other. But Cp has no such close association with I; C p might fall without any resulting fall in 1. The recent steep rise in C p would therefore be a factor tendi.ng to increase the need to hold reserves. The conclusion is that the RIM and nil rati.os can be a useful guide to the question of reserve adequacy; at the same time it is felt that, in assessing reserve needs, more emphasis should be given to the immediate past, the present and the future - rather than the more distant past. 26 The variables which are relevant to this task are not easily quantifiable, but this is not a valid reason for pretending that they do not exist. The use of more flexible monetary policies, the recent improvement in the competitive position, the very favourable prospects for a range of exports and the widening of the industrial base - these developments would all suggest that the needs for reserves is now less than it was 5 - 10 years ago. Put another way, it means that Australia can now afford to risk a higher rate of importing - allow the R/I ratio to fall - without regarding the fall as a sign that the balance of payments position has deteriorated. Against this is the inherent uncertainty of future developments (the precautionary motive for holding reserves) and the greater element of instability injected into the balance of payments via the recent sharp rise in foreign portfolio and institutional investment coupled with the rising interest - dividend bill to service past investments [rom abroad. Which of these [orees predominate is a matter of judgment by the monetary authorities. It seems legitimate to argue that any further fall in the R/I or HIM ratios (the ratios rose slightly in 1968-69) would be, primajacie, a cause for concern. However, in order to arrive at a final judgment on reserve adequacy we would have to consider the range of factors which enter 25. C p includcs institutional lcnding which is repayable OVer a shorl period whereas provision is not normally made for repayment of direct investments. A significomt part of earnings on direct investments are also held back in Australia for future expansion. See l.a.N. Perkins, Australia ill rhe World Ecol/omy, Sun Uook,Melbourne, 1968, p. 34. 26. For a country like Australia, with its strong impulse to growth and propensity for structural change, the "random walk" theory seems to be of little relevance to the question of reserve adequacy. This theory posits, as an important elemen[ in the demand for international reserves, the average absolute changes in reserves in thc reccnt past.
55
Economic Analysis and Policy
Vol. 01 No. 01, March 170
into lA' X , C, G p and U. There is little to be said in favour of A rwming away from this approach because of a belief that it cannot form the basis of a simple model of economic behaviour. The issues at stake are highly complex and any analysis to be of value as an aid to policy must start with due recognition of the degree of complexity involved. Rule-of-thumb measures of reserve adequacy (e. g. that reserves should be able to purchase 5 or 6 months imports) are no substitute for a thorough-going assessment of reserve needs based on the foregoing considerations.
The UniVel"sity of New England
J. S. H. Hunter
Economic Analysis and Policy
56
Vol. 01 No. 01, March 170
AI'PENDIX 1. COMPOSITION OF AUSTRALIA'S INTERNATIONAL RESERVES
(SA m) End of
Gold
US Dollars
Sterling
June
Other Foreign
IMFGold
Exchange (.)
Tranche
Total
1954
114.1
27.6
983.3
1.4
1955
124.7
38.1
678.9
-0.2
8.0
849.5
1956
146.4
40.8
502.1
2.4
8.0
699.7
1957
103.5
51.2
957.7
8.0
1120.4
1958
131.5
51.4
847.8
8.0
1038.7
1959
120.3
61.5
826.4
0.5
20.0
1028.7
1960
133.0
83.2
784.7
0.2
65.0
1066.1
1961
138.3
60.1
880.4
-2.5
1962
158.3
66.2
870.5
1.0
66.0
1162.0
1963
178.5
108.2
935.0
2.1
89.0
1312.8
1964
194.6
128.0
1347.6
3.4
89.0
1762.6
1965
205.0
153.5
996.1
1.3
112.0
1467.9
1966
198.2
194.0
980.2
2.4
152.0
1526.8
1967
204.4
250.6
742.7
1.3
178.0
1377.0
1968
229.9
222.0
633.2
11.5
249.0
1345.6
1969
230.5
4DO.3
645.3
34.3
204.0
1514.4
(3)
1126.4
1076.3
negative figure denotes excess of liabilities over assets. The recent increase in olher foreign exchange holdings is believed 10 consist mainly of holdings of
Deutsche Mark.
Sol/ret!:
Reserve Bank of Australia. StQtistical Bulletin, FiIlQl/eml Supplement. September 1969.
Economic Analysis and Policy
57
Vol. 01 No. 01, March 170
2. COMPOSITION OF AUSTRALIA'S INTERNATIONAL RESERVES (Per cent of Each Hem to Total)
Elld
or
Gold
US Dollars
Sterling
June
Olher Foreign
IMF Gold
Exchange
Tranche
1954
10.1
2.5
87.3
1955
14.7
4.5
79.9
1956
20.9
5.8
7 I. 7
1957
9.2
4.6
~5.5
0.7
195~
12.7
4.9
81.6
0.8
1959
I 1.7
6.0
~0.3
1960
12.5
7.8
73.6
1961
12.8
5.5
81.7
1962
13.6
5.7
74.9
0.1
5.7
1963
13.6
8.2
71.2
0.2
6.8
1964
11.0
7.3
76.5
0.1
5.1
1965
14.0
10.5
67.8
0.1
7.6
1966
13.0
12.7
64.2
0.1
10.0
1967
14.8
18.2
53.9
0.2
12.9
1968
17.1
16.5
47.1
0.8
18.5
1969
15.2
26.4
42.6
2.3
13.5
Source:
Sec Table I.
0.1 0.9 0.5
0.1
1.I
1.9 6.1