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The Role of International Reserves and Foreign Debt in the External Adjustment Process

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The Role of International Reserves and Foreign Debt in the External Adjustment Process The Role of International Reserves and Foreign Debt in the External Adjustment Process SEBASTIAN EDWARDS* 1. INTRODUCTION During the 1970s the developing countries underwent serious current account deficits in their balance of payments, which led, inter alia, to major increases in their foreign debt. Whereas in 1970 the public and publicly guaranteed debt of the low-income countries (excluding the People's Republic of China and India) amounted to 16.5 percent of their gross national product (GNP), in 1980 it had risen to 31.5 percent of GNP. On the other hand, the ratio of foreign public and publicly guaranteed debt of the middle-income countries increased from 11.8 percent of GNP in 1970 to 17.4 percent of GNP in 1980.1 More recently, some developing countries—Mexico, Brazil, Costa Rica, and Argentina, for instance—have faced serious problems in servicing their foreign debt. The analysis of the determinants of the current account of the balance of payments, and its relation to macroeconomic adjustment, has lately made significant progress. Particular emphasis has been given to the intertemporal nature of the current account, and the distinction has been made between temporary and permanent shocks.2 It has been postulated, for instance, that whereas the most appropriate policy to face temporary shock is to increase the level of foreign debt (or reduce the level of international reserves), reduction of the level of internal absorption is the optimum policy in response to a permanent shock.3 Despite renewed interest in analyzing the macroeconomic adjustment process in an open economy, most of the papers, theoretical as well as empirical, emphasize the use of a particular tool to achieve such adjustment. Thus, for instance, while certain authors have made a detailed analysis of the *I am indebted to Sergio Malaga and Juan Guillermo Espinosa for their valuable comments. (The original version of this paper was written in Spanish.) 1See World Bank, World Development Report, 1982. 2See, for example, Sachs (1981), (1982). 3See Sachs (1981), Obstfeld (1982) and Svensson and Razin (1983). 143 ©International Monetary Fund. Not for Redistribution 144 SEBASTIAN EDWARDS use of foreign debt as an instrument for adjustment, others have focused on the use of reserves, and a third group has examined in detail the role of the exchange rate and its relation to the current account.4 Exceptions to this rule are Eaton and Gersovitz (1980), who have analyzed the joint determination of international reserves and foreign debt; Edwards (1983 a), who has explicitly considered the use of the exchange rate as an adjustment tool in the analysis of demand for international reserves; and Frenkel and Aizenman (1982), who have theoretically examined the joint determination of the optimum degree of float for a currency and the level of reserves the country wishes to maintain. The purpose of this paper is to analyze in some detail the role of international reserves and external debt in the process of macroeconomic adjustment in developing countries, with particular emphasis on Latin American countries. The discussion explicitly recognizes that both reserves and debt are alternative instruments that countries may use to achieve external balance.5 In addition, it is recognized that foreign debt plays a twofold role in the economic process. First, in the short run, changes in the external debt make it possible to cope with temporary external disequilibria. Second, foreign debt plays a long-run role connected with financing gross domestic investment. In fact, insofar as the current account deficit—which is equal to external savings—is partly or totally financed by new (net) foreign borrowing, the foreign debt will be playing a major long-term role in the development and economic growth process. It is precisely this twofold role played by foreign debt that requires developing countries to find ways to manage it carefully. In this context it is important, for example, to make the needs for external resources to finance gross investment compatible with the uses of debt for short-term purposes. Appropriate planning of the evolution of external liabilities and assets of the monetary system will prevent imbalances that may turn out very costly in the long run.6 In this paper various problems connected with the role of international reserves and foreign debt in the external adjustment process are empirically analyzed. Section 2 contains a general discussion of the subject, emphasizing the fact that most of the economic literature dealing with demand for international reserves has failed to consider explicitly the role played by debt (or exchange rate variations) in the external adjustment process. This section also presents a discussion—and a word of caution—on the use of dynamic optimization models to determine the optimum degree of debt for a country. Section 3, in turn, presents new empirical evidence on the determinants of 4See, for example, Dornbusch and Fischer (1980) and Rodriguez (1980). 5It is further recognized, theoretically, that adjustments in the exchange rate play a similar role. In the empirical analysis the inclusion of such adjustments did not affect the results, hence they are not presented in this paper. 6See Loser (1977). ©International Monetary Fund. Not for Redistribution INTERNATIONAL RESERVES AND FOREIGN DEBT 145 demand for international reserves in the developing countries, using data for 1975-80. This section also presents results obtained when reserves and debt are considered to be alternative instruments for achieving external equilib- rium. The main conclusions reached in this section are that: (a) the demand for reserves in the developing countries has been a stable function in the past few years, although from a legal standpoint the international monetary system has been characterized by a dirty float;7 (b) demand for reserves in the developing countries displays diseconomies of scale showing that, as a result of economic growth, such countries' need for international liquidity will grow more than proportionately in the next few years; (c) reserves and foreign debt are substitutes, in the sense that both have been used by these countries as alternative ways to finance their external adjustment processes. Section 4 of the paper examines a critical issue for macroeconomic management of reserves and foreign debt. The section discusses in what way the levels of debt and reserves, among other variables, affect the level of country risk perceived by the international financial community. The importance of this discussion lies in the fact that should a relation exist between these variables and the probability of default perceived by the international financial community, countries may manage these variables in such a way that the degree of risk of default perceived is kept at relatively low levels. This in turn will lead to more favorable terms for obtaining foreign funds and continuing maintenance of such loans. The results presented in this section, based on data from over 700 public and publicly guaranteed loans granted in the period 1976-80 in the Eurocurrency market, show that the higher the debt/output ratio the higher the perceived probability of default. It was further found that a higher international liquidity ratio will result in a lower perceived country risk. In Section 5 an empirical analysis on the relation between the dynamic adjustment of international reserves and monetary market equilibrium is presented. This analysis shows that international reserve movements over time arise essentially from two factors: (a) discrepancies between desired reserves and reserves actually maintained; and (b) imbalances in the monetary market. These results—which basically correspond to the analysis presented in the monetary approach to the balance of payments—point out that situations of excess supply of money will tend to result in international reserves dropping below desired levels. The above findings, in the light of results obtained from analysis of country risk determinants, have obvious implications in terms of economic policy. Insofar as a country wishes to 7Of course while the currencies of industrial countries have tended to float (dirtily), developing countries have adhered to the most diverse exchange arrangements. See the introduction in any recent issue of the International Monetary Fund publication International Financial Statistics (IFS) for a list of such agreements. ©International Monetary Fund. Not for Redistribution 146 SEBASTIAN EDWARDS maintain an acceptable (conservative) degree of perceived country risk, it must be particularly careful in the way it handles its monetary policy. Section 6 of the paper contains some considerations on the case of the Latin American countries, with emphasis on the importance of designing a coherent exchange rate policy to deal with macroeconomic adjustment problems. Finally, some concluding remarks are offered in Section 7. 2. INTERNATIONAL RESERVES AND FOREIGN DEBT IN THE MACROECONOMIC ADJUSTMENT PROCESS There is an extensive literature, empirical as well as theoretical, on the role of international reserves in the external adjustment process, which has been reviewed, among others, by Clower and Lipsey (1968), Gruebel (1971), Williamson (1973), and Bird (1978). Generally speaking, most of the studies on the subject assume that countries maintain reserves both for financing international transactions and for facing unforeseen international payment difficulties. Hippie (1974), for instance,
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