An Analysis of the Management of the Currency Composition of Reserve Assets and External Liabilities of Developing Countries

Summary Analyses of developing countries’ financial positions have generally focused on the growth and currency composition of their reserve assets. The theory of portfolio selection, however, is clearly relevant to net positions rather than to assets alone. For this reason it is inappropriate to interpret changes in developing countries’ net currency positions as having resulted from independent decisions concerning the currency composition of foreign exchange reserves and external debt. Such a decision-making process would be suboptimal, and we see no reason to ascribe such behavior to the countries studied. In this paper estimates of the currency composition of developing countries’ foreign exchange reserves and external debt are presented and analyzed. Our interpretation of data on net positions suggests very different conclusions concerning the financial policies of developing countries, compared with conclusions based on reserve assets alone. In particular, the share of developing countries’ foreign exchange reserves denominated in US dollars varied over a narrow range in recent years, and changes that occurred can be largely accounted for by fluctuations in dollar exchange rates. This finding, which is consistent with previous work in this area,2 is not maintained when net positions are examined. Net positions showed a substantial shift from 1974 to 1979 as the share of net liabilities denominated in US dollars increased from 25 per cent to nearly 60 per cent. Analysis of net positions of analytical sub-groups of developing countries shows that this large shift toward net dollar liabilities for all developing countries did not result from changes over time in the preferences for dollar positions by the sub-groups studied. For three of the five sub-groups, shares of net positions denominated in US dollars showed even less variation than was the case for shares of foreign exchange reserves denominated in dollars. Rather the shift toward net dollar liabilities resulted from changes in the relative size of financial positions of sub-groups of developing countries that displayed different currency preferences throughout the period 1974 to 1979. Since data on the currency composition of reserve assets are not available for individual developing countries but only for country groups, this finding suggests that great care should be taken in drawing conclusions from aggregate data about a ‘typical’ government’s financial policies or currency preferences. Nevertheless, the fact that preferences vary across sub-groups of countries suggests that changes in the structure of international reserve and debt holdings will continue to exert an important influence on the aggregate net currency positions of developing countries.