International Liquidity: Meaning, Composition, Problem,

Solution and Debt Crisis

Meaning of International Liquidity.

International liquidity refers to the availability of internationally acceptable means
of payment. It comprises all types of generally acceptable assets available to the
countries for financing the deficits in their international balance of payments. In
common language, international liquidity means international reserves.
International reserves have been defined to include official holdings of gold,
foreign exchange, SDRs, reserve position in the IMF. Private holdings of foreign
assets are not included in international liquidity. Walter defines international
liquidity as “the sum total of the international reserves of all nations participating
in the world monetary system”. The world’s need for international liquidity
depends upon- (a) the volume of international commercial and financial
transactions, and (b) the imbalances that characterize these transactions. Given
the volume of world trade and payments, the greater the collective payments
imbalances of the participating countries, the more pronounced will be the
overall need for international liquidity.

Composition of International Liquidity:

Under the present international monetary system, the main components of
international liquidity are as follows:
a) IMF trench positions which represent the drawing potential of the members.
b) Special drawing rights (SDRs) which have been first introduced in 1970 by
the IMF as a new international reserve asset.
c) Dollar reserves of countries other than the U.S.A.
d) Sterling reserves of countries other than the U.S.A.

1
 e) Gold reserves of the national monetary authorities (i.e., central banks) with
the IMF.

Table-1 gives an idea of the composition of and recent trends in the international
reserves. Over the years, the total world reserves have increase from SDR 106 in
1970 to SDR 753 (i.e., 610 %); gold has increased from SDR 40 to SDR 310 (i.e., 675
%) and the world reserves (excluding gold) have increased from SDR 56 to SDR
443 (i.e., 691 %). Foreign exchange reserves have gone up from SDR 45 in 1970 to
SDR 389 (i.e., 764 %) an Fund related assets have risen from SDR 11 in 1970 to SDR
54 in 1987 (i.e., 391%). In 1987, gold accounted for less than half (i.e., 41%) of the
total world reserves. The proportion of foreign exchange in the total world
resources (excluding gold) was 88%; the proportion of reserve position in the IMF
was 8%; and the proportion of Special Drawing Rights (SDRs) was 4% In general,
the behaviour of world reserves (excluding gold) tends to be parallel to the
proportion of foreign exchange reserves. The proportion of foreign exchange
component in the total world reserves (excluding gold) has moved from 80% in
1970 to 87% in 1973, 91% in 1980 and 88% in 1987.

Problems of International Liquidity:

The problem of international liquidity is concerned with the imbalances in the
demand for and supply of international liquidity. International liquidity shortage
(i.e., the demand exceeding the supply) leads to recession in the world economy.

2
On the contrary, international liquidity surplus (i.e., supply exceeding demand)
tends to have inflationary impact on the international economy.

Solution to the problem of international liquidity relates to the attempt to ensure

that there exists neither a liquidity shortage nor a liquidity surplus. The supply of
and demand for international liquidity must be balanced so that the
contractionary or expansionary pressures do not disturb the world economy. The
International liquidity should play a neutral role of lubricating international trade
and the payments mechanism without generating destructive forces of its own.
In short, the international liquidity problem refers to the problem of nature and
availability of means of international payments. In the present world situation, the
liquidity problem has two aspects- quantitative and qualitative. The quantitative
aspect relates to the problem of adequacy of international liquidity. The
qualitative aspect relates to the nature and composition of international reserves.

Quantitative Aspect of the Problem:

International liquidity problem is the problem of inadequacy of international
reserves. Reserves are said to be inadequate when their availability is insufficient
to ensure the smooth functioning of the international monetary system and to
meet the expanding world trade. During 1950s, there was no liquidity problem in
general because the availability of reserves was on the whole sufficient to meet
its demand. But, the liquidity problem became serious since 1960. Shortage of
reserves has been increasingly felt everywhere.

The following are the reasons for the inadequacy of international reserves:
i. Inadequate Growth of Reserves. Although the total volume of reserves
has been increasing since World War II, the rate of growth has been
slower than the expansion of world trade. During 1960s, the world
economy faced a situation when international liquidity was inadequate

3
 to maintain the total volume of trade. World’s reserves declined as a
percentage of imports for all groups of countries from 67% in 1951 to 55%
in 1960 and further to 32% in 1970.

ii. Uneven Expansion of Reserves. The growth of international reserves has

been uneven among the countries. Some developed countries have
registered a growth rate of 15% or more per annum, while many
developing have a growth rate of less than 1 %.

iii. No Conscious Policy. There has been no conscious policy of relating

reserve growth to the expansion of international trade. The growth of
liquidity has been of a somewhat haphazard nature. It has tended to
depend upon uncertain factors, such as gold mining developments, the
sale of gold from U.S.S.R. and the willingness of people in various
countries to hold their international reserves in dollars.

iv. Slow Growth of Gold. Gold reserves increased at a very low rate. Table-
2 shows that the increase in the gold reserves rise only from 33.9 billion
dollars in 1951 to 39.3 billion dollars in 1971; their proportion in the total
reserves declined from 68.8% to 30.2% during 1951-71. In fact, gold
reserves were limited by the physical amount of the metal in existence.
There was some possibility of increasing gold reserves by new mining or
by bringing some stock of gold out of private hoards, but this too was a
limited possibility, especially when the price of gold was held fixed at a
very low level in an inflationary world. Again the value of gold could
have been increased by general devaluation (i.e. by an increase in the
price of gold). But, this was opposed by most of the officials.

4
v. No Solution by Rising IMF Quotas. The international liquidity can be
improved by increasing reserve trench positions. The trench positions
can be increased by raising IMF quotas and this was done a number of
times. But, this measure cannot by itself increase the world’s total
reserves. Whenever a quota increase boosts a nation’s trench position,
its subscription payment reduces its stock of other reserve assets by an
equal amount.

vi. Liquidity Problem of Developing Countries. The liquidity problem is much

more serious for the developing countries because of the following
reasons:

 While the developed countries need international reserves mainly

to tide over a short-term balance of payments deficit, the
developing countries require foreign resources both to cover the
temporary fluctuations in their annual exchange earnings as well
as to meet long-term needs of economic development.

 The developing countries are chronically capital deficient and

technologically backward countries and need huge amounts of
funds for importing goods and technology.

 These countries mostly export cheaper primary goods and import

costly capital goods. The foreign demand for primary goods has
been declining and their terms of trade have been deteriorating.

 Recent recession in the developed countries has led these

countries to adopt protectionist policies, which have further

5
 affected adversely the export earnings of the developing
countries.

 All these factors have resulted in heavy balance of payment

deficits in the developing countries and these deficits are growing
continuously.

 The developing countries face serious debt-repayment problem

and the rich countries as well the international financial
institutions, like the. IMF, the world Bank, the I.D.A, etc. do not
provide sufficient assistance to help these countries come out of
their present difficulties relating to debt- repayment crisis and
adverse balance of payments.

Qualitative Aspect of the Problem (Or the Confidence Problem):

The qualitative aspect of the liquidity problem is concerned with the use of reserve
currencies. The U.S. dollar and the pound sterling are the principal or key
currencies. However, since World War II, dollar has been widely accepted as the
major international currency for carrying out international trade and investment
transactions. In the composition of international liquidity, gold and reserve
currencies play a dominant role. But, since gold reserves cannot be increased
much, the growing requirements of international liquidity are to be met by
increasing the reserve currency holdings. Now the process of increasing the
reserve currency (dollar) holdings means creating balance of payment deficits in
the reserve currency centre country (America), if the other countries tend to
accumulate the reserve currency. This leads to the confidence problem. The
confidence problem is primary concerned with the inherent defect in the reserve
currency system and is related to the value of a reserve currency as an asset.

6
This problem arises from the need for increased reserves of the reserve currency
and can be understood with the help of the following propositions:

(a) Dollar is as good as gold because the U.S. is ready to exchange dollar for gold
at a fixed price on demand,
(b) Other countries need increasing stocks of reserves which can be supplied only
by creating the U.S. payments deficits,
(c) If this process continues for a long time, the other countries would have more
dollars than the gold reserves owned by the U.S.
(d) All the dollars then could not possibly be exchanged for gold and the U. S.
would be viewed as a chronic deficit country.
(e) The dollar would eventually cease to be attractive.

This is precisely what happened to the U.S. dollar. During 1950s, the persistent U.S.
deficits were generally welcome. The U.S. gold stock was huge enough to meet
the other countries’ demand for seeking dollars for gold. The European countries
faced a dollar shortage; they needed dollar reserves; and not gold. Thus, there
was little problem of international liquidity. But, the situation changed during
1960s. The dollar shortage with the European countries was over, the U.S. deficits
not only continued but increased, considerably. Thus, the American gold stock
fell short of the dollar holdings of other countries. In other words, America could
not exchange all the dollars; for gold, even if it wanted to do so. This created the
confidence problem for dollars as a reserve currency.

Thus, under the present monetary system, we are faced with an international
liquidity dilemma. An increase in the liquidity reserves requires the U.S.’s willingness
to insure deficits in its balance of payments. But, continued U.S. deficits will
disincline the other countries to keep their international reserves in the form of
dollars. They will start converting their dollars into gold. There will be dollar crises

7
and it will lose its popularity. If, in order to avoid these crises, America attempts to
reduce its balance of payments deficits, the world’s liquidity reserves will fall. Thus
the problem of international liquidity is closely linked with America’s balance of
payments problem. The qualitative aspect of the international problem or the
confidence problem of the reserve currency (i.e., dollar) is clearly shown in Table-
2. Whereas in 1951, 69% of the world’s reserves consisted of gold and about 9% of
U.S dollars, by 1971, the proportion of gold fell to 30% and that of U.S. dollars went
up to 39%.

This expansion of dollar holdings came into being only as a result of large scale
U.S. payments deficits. Increasing dollar reserves outside the U.S. and decreasing
gold reserves in U.S. made the convertibility of dollars into gold less and less
credible and shook confidence in the dollars as a reserve currency.

Proposals to Solve Liquidity Problem:

There is general agreement on the nature of international liquidity problem, and
need to increase international reserves. Many proposals have been made to
solve the problem.
I. Triffin Plan:
Prof. R. Triffin, in his book, Gold and Dollar Crisis (1960), recommended the
transformation of the IMF into a World Central Bank holding member countries’

8
deposits in the form of a new international currency named the ‘bancor’, and
extending credit to them. The Triffin Plan aims at the internationalisation of world
monetary reserves and institutionalisation of international lending.

The main features of the Triffin Plan are:

 The IMF would act as a true international central bank.
 A new international money (bancor) would be introduced and the IMF
would have powers to create new international reserves by advancing
loans in the form of created deposits.
 The balance of key currencies (dollar and sterling) would be transferred to
the IMF and would be converted into bancor accounts.
 The bancor accounts would be part and parcel of the total monetary
reserves of the depositing countries, who undertake to accept bancor
balances in the settlement of international debts.
 Bancor balances in excess of a given minimum would be converted into
gold.
 The IMF would also engage in open market operations through purchase
and sale of securities in the financial market.
The Triffin Plan was not acceptable to many monetary authorities and member
countries who mainly regarded it as ‘a blue-print for international inflation.’

II. Stamp Plan:

Maxwell Stamp, in 1960, proposed a plan for creating additional international
liquidity, and at the same time putting it in to the hands of the developing
countries who needed it most. The stamp Plan originally envisaged that the IMF
should issue gold certificates upto about 3000 billion dollars. These certificates
would be provided to developing countries through some lending agency.
Members of the IMF would accept these certificates when tendered by the Fund
or by a central bank of a member country in exchange for national currencies.

9
The developing countries could purchase capital goods from the developed
countries and pay for them in local currencies exchanged for gold certificates.
If the developed countries were in surplus, they could add these certificates to
their reserves; if they were in deficit, they could use these certificates to meet the
deficit. In this way, these certificates would find their way to the countries with
overall surplus of reserves, and these surplus reserves would have been
automatically lent to the rest of the world.

III. Angell Plan:

Prof. Angell agrees with Triffin’s diagnosis of the international liquidity problem, but
does not accept his prescription completely. Like Triffin, he wants the IMF to
introduce a new money, but there should be no convertibility of money into gold.
He is of the view that gold is the root cause of all trouble in the present system,
and thus wants its elimination from the world monetary order.

IV. Bernstein’s Plan:

Bernstein, an official of the IMF, was in favour of a much more liberal Fund policy
and recommended the integration of the Fund reserves with its members ‘working
reserves. The main features of the Bernstein’s plan are as follows:
 A member’s maximum drawing rights should be regarded as a part of its
reserves, and these can be used by the member automatically when the
need arises.
 The IMF can issue debentures which the industrially advanced member
countries should buy to an agreed limit.
 The members are to be allowed to borrow in excess of their quotas and
access to the Fund should be made automatic.
 There should be continuous review, and gradual increase in the quotas of
the members from time to time.

10
V. Devaluation of Dollar:
Some suggested the devaluation of dollar as a measure to solve the world liquidity
problem. The devaluation of dollar would increase the value of gold held by
various governments or private individuals. This would, in turn, encourage the
production of gold.

VI. Raising the Price of Gold:

There was a proposal to raise the official price of gold. As a result, the international
monetary reserves would automatically increase, and the problem of
international liquidity would be solved.

IMF and International Liquidity:

The International Monetary Fund (MF) has been established with an objective of
extending short-term financial assistance to its members to overcome the
balance of payments difficulties as well as emergency situations. It contributes to
the international liquidity in two ways:
(a) By providing conditional liquidity; and
(b) By providing unconditional liquidity.

(a) Conditional Liquidity:

The IMF provides conditional liquidity under its various lending schemes. The credit
provided to the members is generally subject to certain conditions. Most of the
IMF loans require an adjustment programme to be undertaken by the member
country for improving its balance of payments position. Moreover, obtaining funds
from the IMF under agreed conditions increases the member’s access to
international capital market. Important credit facilities provided by the IMF are-
(a) basic credit facility, (b) extended fund facility, (c) compensatory financing
facility, (d) buffer stock facility, (e) supplementary financing facility, (I) trust fund,
(g) structural adjustment facility, etc. In order to make the resources easily and

11
more adequately available, the IMF has been introducing various procedure
changes from time to time.

(b) Unconditional Liquidity:

The supply of unconditional liquidity takes the form of reserve assets that can be
used for balance of payments financing. The IMF provides unconditional liquidity
through the allocation of Special Drawing Rights (SDRs), and also in the form of
reserve positions in the Fund. Member countries can use their holdings of SDRs and
reserve positions in the Fund to finance their balance of payments deficits without
having to enter into policy commitments with the Fund. At the end of March 1987,
the Fund related reserve assets formed 12% of the total non-gold resources.

International Liquidity Problem in Developing Countries:

The liquidity problem is all the more serious and is of different nature in the
developing and less developed countries. These countries experience chronic
deficiency of capital and technology and have to depend largely on the
developed countries for their scarce resources. They require resources- (a) for
covering their short-term balance of payments resources, and (b) for meeting
long-term capital requirements of economic growth. The liquidity problem of the
developing countries has the following peculiar features;

i. Undeveloped Financial Markets:

Domestic financial markets in the developing countries are undeveloped and are
subject to heavy government control. These characteristics have the following
effects:

(a) Lending often takes place at artificially low interest rates fixed by the
government to favour certain industries or sectors of the economy. This means an

12
implicit subsidy to the recipients of the loans and an implicit tax on the banking
system.

(b) Few and not very attractive assets are available to the savers, (c) Government
controls prevent domestic savers from holding foreign assets all these effects
indicate discouragement to domestic saving which is already at the low level
because of low income levels.
2. Heavy Government Expenditures:
Government spending in the developing countries forms a very high percentage
of national income. In order to finance its budget deficits, the government resorts
to the printing of new money (i.e., deficit financing). This results in high rates of
inflation.

3. Exchange Control:
In the developing countries, exchange rates are set by the central bank rather
than determined in the foreign exchange market. Private international borrowing
and lending are strictly restricted. The residents are allowed to purchase foreign
exchange only for certain selected purposes.

4. Primary Exports:
Most of the developing countries mostly rely for their export earnings on a small
number of natural resources or agricultural products. Dependence on such
primary products make these countries vulnerable to shocks in the international
markets because the prices of these goods are highly variable relative to those of
manufactured goods.

5. Dependence of Foreign Borrowing:

Since most, of the developing countries have low saving rates and very high
investment opportunities, they largely rely on capital inflow from abroad to

13
finance their domestic investment. Recently, these countries have borrowed on
a large scale from rich countries and have built up a large debt to the rest of the
world.
6. Forms of Foreign Borrowing:
In different historical periods, the less developed countries have financed their
external deficits through four major channels- (a) bond finance, (b) bank loans,
(c) direct foreign investment, and (d) official lending. (i) Bond finance, i.e.,
collecting of resources by setting bonds to private foreign citizens, was important
in the period upto 1914 and in the interwar years. (ii) Since the early 1970s, the less
developed countries have increasingly borrowed directly from commercial banks
in the financial centres of the developed countries (iii) Direct investment was an
important source of developing country external finance during the 25 years after
World War II. However, the importance of this source has declined recently. (iv)
The developing countries have borrowed from international agencies, like the IMF
and the World Bank, and from the governments of other countries.

7. Foreign Borrowing in Historical Perspective:

Historically, foreign borrowings of the developing countries have varied in
different periods. From the late 19th century, lending to the developing countries
first boomed, then disappeared during Great Depression and finally reappeared
in-1970s and expanded quickly. Events of 1982 led to sharp contraction of lending
to these countries and an international debt crisis that still threatens the prosperity
of developed and developing nations alike.

8. Capital Flows before 1914:

In the 19th and early 20th centuries, the less developed countries borrowed
heavily from Europe, particularly from Britain. This large scale lending was mainly
the result of (a) London’s leadership of the world economy; (b) Britain’s
commitment to free trade; (c) Britain’s flexibility in accommodating the

14
temporary difficulties of less developed debtors; and (d) profitable foreign
investment opportunities provided by the less developed countries.

9. Capital Flows during 1918-1972:

In the interwar period, most of the loans to the less developed countries originated
in the United States. When the Great Depression began, there was no
internationally recognised authority prepared to ensure a continuing flow of
credit to the less developed countries. As a result, most of these countries
defaulted on other foreign debt Private lending to less developed countries on
the scale of 1920s did not resume until early 1970s.

Classification of Indebted Countries:

The World Bank has identified four categories of developing countries faced with
the external debt problem at present:
(a) 19 severely indebted middle-income countries;
(b) 27 severely indebted low income countries;
(c) 15 moderately indebted middle-income countries; and
(d) 9 moderately indebted low income countries.

This classification is based on four key debt ratios:

(a) Stock of total external debt as a proportion of gross national product;
(b) Stock of total external debt as a proportion of export of goods and services;
(c) Total debt service as a proportion of export of goods and services; and
(d) Total external debt as a proportion of export of goods and services.

Measures to Solve External Debt Problem:

Broadly two types of strategies have been attempted in the recent years for
attacking the debt problem of developing countries- (a) market-based strategy;
and (b) debt strategy for official borrowers.

15
(a) Market-Based Strategy:
The market-based approach is related to the debt problem of commercial
borrowers. It involves the measures like debt buybacks, securitisation, debt equity
swaps and contingent claims. These various measures provide a ‘menu’ of
options from which debtors and creditors could choose. In March 1989, N.F. Brady,
the U.S. Secretary of the Treasury, suggested a plan to deal with the external debt
problem of the developing countries. According to this plan, the debtor nations
should focus their attention on the type of policies which can- (i) encourage new
investment flows, (ii) strengthen domestic savings, and (iii) promote the return of
flight capital. These objectives are to be achieved by the cooperation of the
entire creditor community, i.e., commercial banks, international financial
institutions and creditor governments.

(b) Debt Strategy for Official Borrowers:

This strategy aims at alleviating the debt problem of official debtors. In this regard,
Paris Club creditors have undertaken various concessional operations in the
rescheduling of non-concessional official debt.

Under the Paris Club rescheduling, the creditors may choose from the following
three options:
(i) Partial Write-Offs:
Creditors choosing this option would forgive one-third of the debt service due
during the consolidation period and would reschedule the remainder at market
rates over fourteen years with an eight year grace period on principal payments.
(ii) Longer Repayment Terms:
Creditors would reschedule debt service due during the consolidation period at
market interest rates but with a twenty five year maturity and a grace period of
fourteen years.

16
(iii) Lower Interest Rates:
Creditors would reschedule debt service due during consolidation period at
reduced interest rates either 3.5 percentage points below or one- half of market
rates, whichever gives the smallest reduction over fourteen years with eight years
of grace. Besides these measures, the World Bank also has initiated Special
Programme of Assistance (SPA) for debt distressed low-income African countries
in December 1987. This programme aims at providing substantially increased,
quick disbursing, highly concessional assistance to adjusting countries. Despite the
many initiatives announced during the 1980s to solve the external debt problem,
trends in the flows of real resources to developing countries have been
discouraging. Inadequate flows of international resources are a cause of great
concern to the developing countries interested in pursuing development
activities and seeking a meaningful attack on poverty.

17