The SDRs (special drawing rights) were born with big ambitions. Created in 1969 by the IMF to support the Bretton Woods fixed exchange system the initial expectations were that it would become a major component of global reserves, while gold and reserve currencies were regarded to have only a minor incremental role in official reserves.
Notwithstanding the initial intentions, until now the SDR has had only a limited use as a reserve asset and its main function has been to serve as the unit of account of the IMF and some other international organizations. Volumes speak for themselves: at the beginning of 2009 the cumulative allocations of SDRs amounted to only 21.4 billion1.
There are many reasons that can explain why the initial expectations on the SDR were not fulfilled. In the first place, the rationale behind its creation (mainly the possibility and fears of liquidity shortage) soon disappeared with the end of the Bretton Woods fixed exchange system and the shift to floating rates. Also the minimal amount of SDRs allocated and the limitations on its scope and use are to be blamed. The SDR is not a currency, as the IMF itself remarks: “The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members in a managed market; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions”. Then, the SDR circulates only in the official circuit: it can be held by governments, central banks, the IMF and a narrowly defined group of other “official holders”. But it cannot be used in the other transactions in which central banks and governments engage. Furthermore, the SDR is not a market-based asset: it has always been administratively controlled by the IMF in every respect, from its valuation and yield to who may hold it and what it may be used for. Also the efforts to promote the SDR use in private markets have been largely ineffective. A limited market in private SDRs emerged in the mid 1970s when some banks began to accept time deposits in SDRs and some companies began issuing long-term debt securities in SDRs but these attempts did not prove to be successful. They did not gain the scale needed for a new market to open and be attractive and, above all, could not face and overcome successfully US dollar supremacy.
A sudden change of course for the SDR occurred when, in March 2009, the Governor of the People’s Bank of China, Zhou Xiaochuan, underlined the presence of the Triffin dilemma and put forward a proposal with a number of actions to promote the use of the SDR as a supra-sovereign reserve currency stating that, even if until now SDR’s role has been restrained by limitations “it serves as the light in the tunnel for the reform of the international monetary system”. In his proposal he also underlined the need for an enlargement of the SDR basket of currencies and suggested that part of the IMF member countries’ reserve be entrusted to the centralised management of the IMF through the establishment of an open-ended SDR denominated Fund which would allow subscription and redemption in the existing reserve currencies by various investors.
The decisions taken at the G20 Summit held shortly afterwards in April 2009 in London were supportive of a strengthening of the IMF and of its resources and allowed as well for an increase of the total SDRs stock. In particular, the commitments taken by the G-20 included the implementation of two allocations of roughly $283 billion SDRs, which allowed the outstanding stock to increase nearly ten-fold to about $316 billion2.
The relationship between China and the US represents an emblematic example of what is usually referred to as global imbalances. On the one side there is China which registered a number of consistent and repeated surpluses with a simultaneous building up of foreign exchange reserves: China’s reserves stood at $2.13 trillion in June 2009. A good portion of these reserves has been invested in US Treasury bonds considered as a “safe haven”3. On the other side there is the US whose recent economic history has been characterised by persistent current account deficits and growing foreign debt. External debt, in particular, has experienced a frightening growth in the past quarter century and it has changed in nature (from US investment in the rest of the world to financing of domestic demand)4. This means that developing countries were, and still are, transferring reserves to the industrialised countries, mainly the US, that issue the reserve currencies, lending to them at very low interest rates, and, in effect, making it possible for them to live beyond their means. This situation cannot continue as it is. On the one hand, the Chinese authorities are worried about the value of their investments denominated in US dollars, for possible further and future value losses but, at the same time, do not have alternatives presenting the same liquidity as US bonds. On the other hand, the US, being an indebted country, is ceding some power and needs to change course. The “exorbitant privilege” the US enjoyed is presenting its bill: it may be convenient for it as well to move forward5. From the Obama administration arrive signs that the US will not continue to be the world's consumer and importer of last resort. As recently argued6, there is a recognition that US influence can be compromised if it is dependent on foreign investors to bail out its financial sector (as in the early part of this crisis) or to finance its fiscal profligacy (as China and other surplus countries have been doing for a long time).
The proposal of the People’s Bank of China Governor about the use of SDR as a supra-sovereign reserve currency was followed by a number of different reactions. The Chinese point of view is backed by other countries, in particular by the other BRIC countries (Brazil, Russia and India). On the contrary, the US – through the words of Timothy Geithner (Treasury Secretary) and Ben Bernanke (Chairman of the Fed) – have rejected the idea but, considering the amount of Chinese central reserves, accounted to include at least some US dollar 1 trillion, the US cannot discard as not important the remarks coming from China.
Apart from official reactions, in general, a debate on a possible new role for the SDR aroused after Governor Zhou comments7. The debate focused on a number of questions: is the Chinese proposal feasible? What has to be done to effectively use the SDR as a supra-national reserve currency? Which problems remain to be solved?
1. The composition of the basket of the SDR
The SDR basket now comprises only four currencies: the US dollar, the euro, the Japanese yen and the pound sterling8. The weights of the four currencies are revised every five years on the basis of the value of the exports of goods and services and the amount of reserves denominated in the respective currencies held by other members of the IMF. To ensure that the currencies included in the SDR valuation basket are among the most widely used in international transactions they need to be “freely usable”9. The next review of the basket is due in late 2010: that could be the right opportunity to revise the basket to better reflect the changes in the world economy, together with the increasing role played by some countries. In fact, a number of countries, whose currencies are now excluded from the basket, have auspicated an enlargement of the number of currencies in the basket. The Governor of the People’s Bank of China in particular has declared his support for an enlargement of the basket “to include currencies of all major economies, and GDP may also be included as a weight”. A number of issues need to be addressed and agreed upon in view of the next review:
- how many currencies should be included in the new basket? The trade off is between the need to enrich its current composition providing more diversification on the one hand against the risk of getting back to a too crowded basket, which could be difficult to replicate. In this regard, the presence of regional currencies in the SDR basket would help in the review with the trade-off between not too crowded and not sufficiently representative;
- which criteria are to be followed to select the currencies and their amount in the basket? As previously mentioned the use of the GDP has already been put forward. Perhaps the weight of the different currencies in the basket could be fixed in the Agreements in function of a valuation of each currency based on “economic fundamentals which also include elements which are not today counted as economic, such as human development, ecological sustainability, the concentration/diffusion of assets and incomes, the demographic composition of the population and their tendencies”10.
- do commodities, such as gold, need to be included in the basket as some have suggested?
- is the five year review timing now in place appropriate? Does it match the stability required from the SDR to become a reserve currency?
2. Reform of the IMF
After years of neglect, the IMF has recently received international support for a revived activity. In line with this idea various suggestions have been put forward in order to strengthen its activities. Also to support the market of the SDRs, a reform of the IMF is needed. This reform would involve the activities to be carried out by the IMF, the funds at its disposal (currently inadequate), governance both in terms of governing bodies and majorities required for its activities to be carried out and of quotas and representation.
3. Change and increase in SDR allocations
Until now SDR allocations have been rare and the required 85% voting power majority has given some countries an effective veto power. The decisions taken at the April 2009 G20 Summit show that a general consensus about the need to push forward on this issue has been reached but, apart from individual actions, other reforms are needed. In this respect the Commission of experts of the President of the UN General Assembly (also known as the Stiglitz Commission) puts forward some proposals, regarding the opportunity to: 1) make SDR issues automatic and regular, 2) adjust total issues in a counter-cyclical way; 3) allocate SDRs with criteria based on need and not merely on quotas. The IMF should also be able to provide additional liquidity in case of shortage11.
4. Issue of SDR denominated securities
The issue of SDR denominated securities would be a good starting point to increase the appeal of the SDRs. One can make the hypothesis that initially the IMF itself, some Governments and special international financial institutions such as the World Bank could issue SDR denominated securities, which could then be followed by banks and non-financial firms. In fact, in those markets where global imbalances emerged, there is the more impelling and greater need to have debt securities in a supra-sovereign reserve currency. If the positions of the various parties concerned in the issue are considered, this feature could also allow for the achievement of considerable volumes and a possibly adequate level of liquidity. Among the Governments, the US could provide a good example for other countries: if it agrees that a shift towards a more stable and globally balanced international monetary system is desirable it could issue part of its bonds not only in US dollars but also denominated in SDRs. They should encounter a warm welcome from world investors. If recent events have diminished the credibility of the US as a supplier of high-quality financial assets, the possibility to focus its policies on the internal side, and its support for the introduction of a global reserve currency not linked to the US economy would help in re-establishing it and rebalancing the world monetary system. The importance of such a step would constitute a good example to be followed by other countries. However, considering the current US resistance to these proposals, it is unlikely that the US opens the market for SDR-denominated securities. The remarks made by the Governor of the People’s Bank of China are supportive of a market for the SDR denominated assets. It has been suggested that therefore they could issue SDR denominated bonds and encourage other G-20 members to follow their example12. This would be important because it would foster market liquidity for SDR denominated securities, and it would be more important than buying IMF SDR denominated bonds – which they are already doing – since the IMF bonds cannot be traded according to current rules.
The market for SDR denominated securities is institutional. A number of countries want to increase and/or diversify their reserve holdings: such countries have been looking for high quality financial assets to invest into and have, until now, acquired large amounts of US dollar denominated bonds. They share common fears about the value of their investments and it is believed they would be available not only to diversify their investments (which they already can do with euro bonds whose international role has surged but whose market is still fragmented) but to switch to a supra-sovereign global currency. China is already investing in the SDR denominated securities now available. In fall 2009, the IMF and the People’s Bank of China signed an agreement under which the People’s Bank of China would purchase up to SDR 32 billion (around US$50 billion) in IMF notes. The note purchase agreement is the first in the history of the Fund, and follows the endorsement by the Executive Board in July 2009 of the framework for issuing notes to the official sector. Also other countries have expressed this intention: Russia, Brazil and India have indicated their willingness to invest in notes issued by the IMF, US dollar 10 billion respectively. It has been argued13 that pension funds and insurance companies are generally on the demand side for government bonds as they match the maturity of their obligations and they would be interested in SDR denominated bonds as well. However, a problem persists in that SDR denominated bonds would not match the currency denomination of their liabilities.
Apart from being one of the issuers of the SDR bonds, it has been suggested14 that the IMF should also act as market maker to support the market in an initial phase. A deep and liquid market in SDRs requires a critical mass of SDR issuance and a critical mass of trading; aside liquidity it requires also return rates comparable to those of the US dollar debt securities in order to make them attractive. The IMF should stand ready to buy and sell SDR claims to all new comers, private as well as official, at narrow bid/ask spreads competitive with those of the dollar, subsidizing the market in a start-up phase until private market-makers would be able to provide those services at comparable costs. This action by the IMF implies a cost on which the members should agree.
Another issue regarding SDR denominated securities that needs to be addressed is linked to the adoption of a closed or open basket. In short: should the definition of the SDR change through the maturity of the securities in line with the official definition reviewed by the IMF or remain the one valid at the time of the issue notwithstanding the periodic reviews? The experience with the ecu bonds shows that to maintain closed baskets the risk was to have not a single, growing and transparent market but to end up with many sub-markets linked to many different ecus. Therefore, as a general rule all different types of ecu business turned to the open basket formula (the same basket at any given time, even if different from the one adopted at the time of the issue), providing for an automatic and instantaneous following of any official decision to change the ecu. Would it be reasonable to apply the same criteria nowadays for the SDR denominated bonds?
5. The set-up of a clearing system
The experience with the ecu has clearly shown that the setting up of a clearing system is a crucial point. The establishment of a clearing system for the ecu facilitated its use and the growth of the market, proving to be the best way to build up liquidity. The Bank for International Settlements was called to act as clearing house. Similarly, but considering the different nature of the market of SDRs (public rather than private), it can be said that the setting up of a clearing system for central banks investing in SDRs would constitute a step of great importance.
Until now the US and China seem to be the main actors on the stage. However, Europe has an important role to play on the issue of a reform of the global monetary architecture. The initial reaction from the EU to the Chinese proposal was negative. The European Economic and Monetary Affairs Commissioner, Joaquín Almunia, in response to the Chinese proposal has reaffirmed the US dollar’s role as the world reserve currency, which “will continue to be there for a long period of time.” It is true that a weakening of the US currency, which is an implication of central banks’ shifting away from the US dollar, would be unwelcome to policy makers in the euro-zone, worried about the possibility of stronger pressure on the euro and on their exports. However, taking into consideration these common fears and studying the possible solutions to prevent further pressure on the euro, with the goal of achieving a more stable financial background in mind, Europe should support the Chinese proposal. Its experience with the creation of the common currency and the path followed – from the European unit of account to the ecu and then to the euro – and with the establishment of the European Central Bank constitute valuable items and important contributions to the international debate and to the construction of a supra-national reserve currency. The success of the euro in terms of stability and its affirmation worldwide should constitute a good example and not the reason for being attracted by the temptation of replacing with the euro the US dollar’s role as international reserve currency. To play an important role in this task the EU has to speak with one voice. This would also imply the consolidation of its IMF seats into one (or two, one for the euro-zone countries and the other for other EU countries). Such a move would enhance EU influence and at the same time free up seats for emerging countries, giving more legitimacy to the institution.
Recently the consensus on the need to regulate the creation of global liquidity and to correct the present sources of global imbalances has risen. As said by the Governor of the People’s Bank of China “the creation of an international currency unit, based on the Keynesian proposal, is a bold initiative that requires extraordinary political vision and courage”.
Time is ripe for discussion and decision: the debate has now to focus on concrete solutions.
1 As of 15 January 2010 1 SDR = 1.571 US $.
2 The allocations allowed to take account of the fact that those countries which joined the Fund after 1981 (more than one fifth of current membership) never received an SDR allocation and were aimed at providing liquidity to the global economic system and meeting the long-term global need to supplement IMF members’ existing reserve assets.
3 China does not release the currency composition of its reserves, but the dollar is thought to make up around 65% of the portfolio.
4 A. Iozzo, A. Mosconi, “The foundation of a cooperative global financial system. A new Bretton Woods to confront the crisis of the international role of the US dollar”, in The Federalist Debate, XIX, June 2006, no.2, pp. 6-11.
5 See F. Bergsten, “U.S. policymakers, therefore, must recognize that large external deficits, the dominance of the dollar, and the large capital inflows that necessarily accompany deficits and currency dominance are no longer in the United States' national interest. Washington should welcome initiatives put forward over the past year by China and others to begin a serious discussion of reforming the international monetary system.” “The dollar and the deficits”, in Foreign Affairs, November/December 2009.
6 See F. Bergsten and A. Subramanian, “America cannot resolve global imbalances on its own”, in Financial Times, August 20 2009.
7 See for example the Report of the Commission of experts of the President of the United Nations General Assembly (known as the Stiglitz Commission) on Reforms of the international monetary and financial system, draft version, May 2009.
8 As of 15 January 2010 the weights are as follows: 38% euro, 40% US $, 9% pound sterling and 13% Japanese yen.
9 A currency is freely usable if the IMF Executive Board determines that it is widely used to make payments for international transactions and is widely traded in the principal foreign exchange markets.
10 The suggestion is made by A. Iozzo and A. Mosconi, in their proposal of a world currency unit (wcu). Since the measurement of these values is today still rough and can lead to discussions, a procedure would have to be designed to revise the Agreement to modify the weights. In the future, when reliable and shared measurements are available, the revisions could become automatic. The authors suggest one could think about an evolution from SDRs to the wcu like the one which took place from the European unit of account to the ecu. See A. Iozzo, A. Mosconi, “The foundation of a cooperative global financial system. A new Bretton Woods to confront the crisis of the international role of the US dollar”, in The Federalist Debate, XIX, June 2006, no.2, pp. 6-11.
11 See B. Eichengreen, Commercialize the SDR, Project Syndicate, 2009.
12 B. Eichengreen Commercialize the SDR, Project Syndicate, 2009.
13 B. Eichengreen, “The dollar dilemma”, in Foreign Affairs, September/October 2009.
14 B. Eichengreen, Out of the Box Thoughts about the International Financial Architecture, IMF Working Paper, May 2009.
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