Part I: Parsifal Scheduling

CHAPTER 18 INTERNATIONAL BANKING: RESERVES, DEBT, AND RISK

CHAPTER OVERVIEW

This chapter conducts a survey of the international banking system. The chapter begins by discussing how international reserves allow nations to bridge the gap between monetary receipts and payments. Deficit nations can use international reserves to buy time in order to postpone adjustment measures. The chapter then discusses the major determinants of the demand for international reserves: (1) the monetary value of international transactions and (2) the size and duration of balance-of-payments disequilibria. The need for international reserves tends to become less pronounced with floating exchange rates than with fixed exchange rates. The more efficient the international adjustment mechanism and the greater the extent of international policy coordination, the smaller the need for international reserves. The supply of international reserves consists of owned reserves and borrowed reserves. Among the major sources of reserves are foreign currencies, monetary gold stocks, special drawing rights, drawing positions at the International Monetary Fund, swap arrangements, and the General Arrangements to Borrow. When making loans, a bank faces credit risk, country risk, and currency risk. A bank can reduce its exposure to developing-nation debt through outright loan sales in the secondary market, debt buybacks, debt-for- debt swaps, and debt/equity swaps. A nation experiencing debt-servicing difficulties may cease repayments on its debt, service its debt at all costs, or reschedule its debt. Debt rescheduling has been widely used by borrowing nations in recent years. After completing the chapter, students should be able to:

 Explain how international reserves allow nations to cope with balance-of-payments disequilibria.  Identify the determinants of the demand for international reserves.  Identify the major sources of international reserves.  Describe the risks that bankers face when making loans to international borrowers.  Discuss the options available to nations which experience debt-servicing difficulties.  Discuss the role of the International Monetary Fund in the world financial system.

60 61 Instructor’s Manual for International Economics, 8e

BRIEF ANSWERS TO STUDY QUESTIONS

1. Similar to a householder’s desire for cash balances, nations require international reserves to bridge the gap between monetary receipts and payments. Deficit nations require international reserves to finance their payments disequilibriums. 2. A country’s demand for international reserves depends on the monetary value of international transactions as well as the size and duration of payments disequilibriums.

3. Owned reserves include monetary gold stocks, foreign currencies, and special drawing rights. Borrowed reserves include IMF drawings, swap arrangements, compensatory export financing, oil facility, and buffer stock facility.

4. Foreign currencies constitute the most important component of the world’s international reserves while special drawing rights constitute the least important component.

5. A reserve currency, such as the U.S. dollar or British pound, is a currency that trading nations are willing to hold along with other international reserve assets, such as gold.

6. Since 1975 gold has been demonetized. Today, gold is considered a commodity by the International Monetary Fund.

7. One drawback of a pure gold standard is that gold stocks might not grow as rapidly as international trade. A gold-exchange standard attempts to economize on gold as an international reserve by including key currencies (i.e., the U.S. dollar) as an international reserve.

8. Special drawing rights are unconditional rights to draw currencies of other countries. They were created by the IMF to supplement the other forms of international reserve assets. The SDR’s value is determined by the basket valuation technique.

9. See Question 3.

10. The international debt problem of the 1980s referred to the inability of some developing countries to pay back loans to Western commercial banks. The debt problem was intensified by factors including world recession, high interest rates, and the appreciation of the U.S. dollar.

11. A Eurocurrency is a deposit, denominated and payable in dollars and other foreign currencies, in banks outside the United States. Dollar deposits located in banks outside the United States are known as Eurodollars.

12. When making international loans, bankers face the following risks: (a) credit risk, (b) country risk, and (c) currency risk.

13. A country’s debt-to-export ratio is the ratio of external debt to exports of goods and services. Changes in this ratio indicate whether a country’s debt burden is rising or falling relative to its ability to pay. The debt service ratio refers to the scheduled interest and principal payments as a percent of export earnings. Chapter 18: International Banking: Reserves, Debt, and Risk 62

14. A country facing debt servicing problems has several options: (a) cease repayment on its debt, (b) service the debt at all cost, or (c) reschedule the debt.

15. Banks can reduce their exposure to developing country debt via several methods: (a) outright loan sales, (b) debt buybacks, (c) debt-for-debt swaps, or (d) debt/equity swaps.

16. Debt equity swaps involve commercial banks selling their foreign loans to the foreign government for foreign currency which is then used to finance an equity investment in the foreign country. The equity investment is assumed to be a safer investment than the original loans made to the foreign borrower.

SUGGESTIONS FOR FURTHER READINGS

Anunobi, F. The Implications of Conditionality: The International Monetary Fund and Africa. Washington, D.C.: University Press of America, 1992. Broze, J. The International Origins of the Federal Reserve System. Ithaca, NY: Cornell University Press, 1997. Clayton, J. The Global Debt Bomb. Armonk, NY: M.E. Sharpe, Inc., 1999. Danaher, K., ed. Fifty Years is Enough: The Case Against the World Bank and the International Monetary Fund. Boston, MA: South End Press, 1994. Eichengreen, B. The New International Financial Architecture. Washington, D.C.: Institute for International Economics, 1999. Goldstein, M. and C. Reinhart. Leading Indicators of Financial Crises in the Emerging Economies. Washington, D.C.: Institute for International Economics, 1999. Gregorio, J. An Independent and Accountable IMF. Washington, D.C.: Brookings Institution Press, 2000. Griesgraber, J., ed. The World Bank. East Haven, CT: Pluto Press, 1996. Gup, B., ed. International Banking Crises. Westport, CT: Quorum Books, 1999. Harper, R. Inside the IMF. New York: Academic Press, 1998. Herman, B. and K. Sharma. International Finance and Developing Countries in the Year of Crisis. Washington, D.C.: Brookings Institution Press, 1998. Hill, C. Safeguarding Prosperity in a Global Financial System. Washington, D.C.: Institute for International Economics, 1999. Hill, H. The Indonesian Economy in Crisis. New York: St. Martin’s, 1999. Kessler, T. Global Capital and National Policies: Reforming Mexico’s Financial System. Westport, CT: Praeger Publishers, 1999. Khan, S. Do World Bank and IMF Policies Work? New York: St. Martin’s, 1999. Larrain, F., ed. Capital Flows, Capital Controls, and Currency Crises: Latin America in the 1990s. Ann Arbor, MI: The University of Michigan Press, 1999. McKinnon, R. and K. Ohno. Dollar and Yen. Cambridge, MA: MIT Press, 1997. McQuillan, ed. The International Monetary Fund: Financial Medic to the World? Stanford, CA: Hoover Institution, 1999. Temperton, P., ed. The Euro. New York: John Wiley, 1998.