International Liquidity: Concept, Problem and Importance

Read this article to learn about the concept, problem and importance of international liquidity.

Concept of International Liquidity:

The late Per Jacobsson said, “By liquidity, I understand the supply of credit in national currencies as needed to finance and provide the means of payment for trade and production.”

International liquidity consists essentially in the resources available to national monetary authorities to finance potential balance of payments deficit…it may consist in the possession of assets like gold, foreign exchange and in the ability to borrow internationally.

Thus, in its international setting, liquidity includes all those assets including SDRs which are generally acceptable without loss of value for settling international debts.

It may include the following:

Gold stocks with the Central Banks and with the IMF; foreign exchange reserves of countries ; drawing rights of member countries with IMF; credit arrangements between countries ; country’s capacity to borrow in the money markets of another country ; accumulation facilities (these arise when a foreign country accepts payments of debts in debtor’s currency like Sterling balances accumulated during World War II ; Euro-Dollars SDRs etc.

Corresponding to domestic liquidity which is a function of income, rate of interest and aggregate value of assets; we may spell out international liquidity of a country in the following function:

LI = LI (Exps, i diff, Gm, $, £—sterling, IME dr It, Deffd payts, sht-term, Credits Sarr). where, LI stands for international liquidity (LI to the right is a functional notation); i diff = interest differential Gm = monetary gold; Exps = export surplus; dr It = drawing limit; Deffd payts = deferred payments arrangements with foreign countries; Sht term = Short term ; Credit Sarr = Credit arrangements or Swars.

The IMF distinguishes between unconditional liquidity and conditional liquidity. The former consists of gold, foreign exchange reserves and credit facilities (gold reserve tranche position in the Fund) which member countries could use automatically—without any questions being asked concerning balance of payments outlook and monetary policies. Conditional liquidity implies credit facilities which are not automatic, i.e., which can be used only if the potential lender (for example, the IMF) has received assurance concerning the monetary and BOP outlook of the borrowing country or its ability to repay credit in time.

Problem:

There is no agreement amongst the economists about the true nature of the problem of international liquidity. Some economists feel that the problem is quantitative—that is, inadequacy of the means of international payments. Others feel that the problem is qualitative in nature and pertains to the form and composition of international reserves for liquidity purposes.

There are others who present the problem of international liquidity in a different way—the claim that the problem is more of confidence, which arises due to lack of adjustment on account of fixed exchange rates (as had been the case under Bretton Woods System till 1976).

They feel that had there been greater adjustment in the exchange values of the currencies according to the conditions prevailing in the market or had there been flexible exchange rates helping quick adjustments, there would have been no problem of international liquidity.

So the problem according to them, is one of adjustment. It may be true that a part of the problem of international liquidity (that is, providing the means of international payments) may be that of confidence and adjustment but mainly the problem is of inadequacy of reserves to cope with the expanding requirements of international trade. It has been found that the growth in the liquidity has not kept pace with the growth in the world trade.

During the 1970s through 1980s, the world trade almost doubled in a decade or so but the world reserves increased by hardly 25 per cent to 30 per cent in a decade and even this increase was unevenly distributed not only amongst developed countries but also between developed and underdeveloped countries, thereby causing a serious shortage of international liquidity.

The average annual increase in world trade in past decade 1970-80 was about 8 to 10 per cent while the annual average percentage change in reserves was hardly 3V2 per cent between 1970-80. The ratio of reserves to imports which is generally taken as an approximate indicator of the adequacy of reserves, has markedly declined thereby suggesting the inadequacy of not only the present volume but also the rate of growth of international reserves.

International monetary system Or arrangements, based on gold or gold exchange standard or dollar and sterling as international reserves, could no longer inspire confidence and provide for increased quantum of international liquidity on account of expanding world trade.

Apart from this, most baffling has been the problem as to the form, the new international reserve asset should take. Opinions differed in the past amongst leading countries as to the true nature and form of the new international reserve asset.

It is rather difficult to determine as to what will constitute the adequate level of international liquidity under the dynamic conditions of expanding world trade and growth in developing economies. It is said that the quantum of international money needed by the world depends on the size of international trade, that is, more trade will require more money to finance it. But, this is not true because trade is not financed normally by reserves.

International reserves finance not the volume of international trade but the balance of payments deficits. The amount or the quantity of international reserves needed, therefore, varies with the size of the swings in the balance of payments.

It may, therefore, be said that in a sense the aggregate needs of international liquidity are in one way related to factors like world trade, capital movements and imbalances in BOP. But their adequacy is also affected by psychological attitudes towards what is minimum or desired levels of natural reserves, by reserve movements and by the use of available credit facilities. Because other influencing factors cannot be quantified growth in imports seems to be the most relevant indicator of the need for reserves.

According to Triffin, “The ratio of gross reserves to annual imports is the first and admittedly rough approach to the appraisal of reserve adequacy”. But it is not easy to determine the correct ratio of gross reserves to annual imports. It will, thus, be seen that the factors which determine the adequacy of international liquidity are, in practice, not precisely measurable.

It is not simply a matter of arithmetical relationship. Broadly speaking, the question of adequacy of liquidity—national or international—is a matter of judgment, depending on the economic circumstances prevailing in a country, on the time and on the purpose for which the reserves are to be used. We may conclude that a country will regard its liquidity or reserves as adequate when, in its opinion, the level of liquidity or reserves are sufficient to meet unforeseen deficits in its balance of payments without adopting restrictive policies affecting economic growth and international trade.

Importance:

The importance of international liquidity lies in providing means by which disequilibrium in the BOP of different countries participating in international trade is settled, As such, it helps in the smooth flow of international trade by facilitating the availability of international means of payment. It make be understood that these means or reserves are used to finance deficits in the BOPs.

These reserve are not used to finance the inflows or outflows of trade. Changes in the balance of payments— temporary deficits and surplus—must be met by transfers of gold, convertible currencies or international borrowing facilities.

All these go to constitute international liquidity. The greater the stock of these items of international liquidity held by any country and by countries in the aggregate, the less will the need for changes in exchange rates.

In a world, in which there are considerable fluctuations in economic activities, accompanied by a growing demand for stability, the importance of international liquidity reserves lies in serving as a buffer, giving each country some leeway for the regulation of its national income and employment and providing it with a means to soften the impact of economic fluctuations arising on account of international trade and transactions.

A greater world holding of international liquidity reserves becomes necessary to maintain stable exchange rates over the whole business cycle than to meet any seasonal or short-run fluctuations. It is in this sense that adequacy or otherwise of foreign liquid reserves is an important determinant of the levels of world trade and economic activity. If there are enough or sufficient international liquid reserves, specially with those countries which are likely to incur deficits—there will be less worry or panic for adjustment.

On the other hand, if there is too little international liquidity in the world, deficit countries will have no or little time to adjust and they will be forced to impose restrictions on trade and capital movements. As a result the world growth in international trade will be hampered and the prices of primary products will fall, turning the terms of trade in an unfavorable manner for developing economies. Easy access to international liquidity reserves makes it possible for the swings in the balance of payments to be financed, otherwise, the world trade may be strangled for want of international liquidity.

It implies not only sufficient quantity but the right composition and distribution of international liquid reserves. In other words, stability of reserves (in monetary system) has to be provided in terms of scale, composition and distribution, scale refers to the supply of liquid funds to the system as a whole ; while distribution applies to the distribution of liquid reserves amongst countries. Composition implies the currency composition of reserve holdings.

Regarding scale the major limitation is its inability to adjust the supply of reserves in a manner which exerts a stabilizing influence on the world economy. Again, the compositional problem inherent in multi-currency reserve system with floating exchange rates has to be looked into. The distributional problems have to be sorted out to the extent to which some countries have easier, less costly, access to international credits or reserves than do other countries in similar circumstances.