Submitted to the Financing Growth Task Force of the B20, Istanbul, 9 February 2015
Ousmène Jacques Mandeng, Senior Fellow, Reinventing Bretton Woods Committee
The present note offers a proposal for consideration by the G20 to support a significant enlargement of the IMF SDR basket. The proposal is seen to constitute an important addition to the B20 Australia recommendation of achieving greater recognition of emerging markets economies. The SDR also represents an integral part for strengthening the international financial architecture. The measure is in addition considered an important element towards meeting the objectives of the delayed IMF governance reform. The IMF is due to undertake a review of the SDR basket during 2015 to be concluded towards end-2015.
The SDR basket is important for the business community on at least a combination of three counts: i) helping proliferation of currencies as vehicle and settlement currencies in international transactions, ii) fostering development of underlying local credit and capital markets to establish more diversified funding and credit opportunities in particular for corporations and especially medium sized enterprises, iii) reducing dependence on international liquidity by advancing local and regional liquidity pools mitigating the need to hold foreign exchange positions in the main currencies and strengthening the capacity of the international economy to conduct orderly external adjustments.
The nature of the SDR implies that the SDR basket is viewed primarily as a signalling device. SDRs are issued by the IMF and held by central banks as part of their international reserves. The relationship between SDRs and its impact on the business community rests largely on the assumption that central banks’ holdings of an enlarged SDR basket would serve as catalyst to support international currency diversification. A broader SDR basket would indicate a broadening of currencies held by central banks thus giving confidence to commercial banks, other financial institutions and commercial entities to diversify their currency holdings and laying the foundations for a more diversified international monetary system.
The proposal envisages enlarging the SDR basket from the current 4 currencies comprising the dollar, euro, sterling, yen to a broader set of up to 16 currencies including in addition the Australian dollar, Brazilian real, Canadian dollar, Chinese renminbi, Indian rupee, Indonesian rupiah, Korean won, Mexican peso, Russian rouble, Saudi riyal, South African rand and Turkish lira. The enlargement would return the SDR to its original conception as a broad currency basket and shift emphasis towards the role of SDRs in strengthening international monetary stability.
Special Drawing Rights
The SDR is a reserve asset held by central banks of IMF member countries. It gives the right to call unconditionally on national currencies. The SDR was created in 1969 and the first SDRs were allocated in 1970.1 SDRs can only be issued through allocations by the IMF requiring support of 85 percent of the IMF member countries. There had been three general allocations, of which by far the biggest one in August 2009 of SDR161 billion, and one special allocation. The IMF has made cumulative SDR allocations of SDR204billion (USD289 billion; EUR253 billion). The SDR is not a market-based asset and its value and interest rates are not determined by market forces.
The SDR was originally valued in gold. In 1974 with the collapse of the Bretton Woods system it was redefined in terms of a weighted basket of currencies. The currency basket contained 16 currencies at the outset and was subsequently reduced to 5 currencies in 1981 largely on the premise that several of the 16 currencies were not used widely in international financial markets. The 5-currency basket was reduced to 4 currencies with the introduction of the euro (Table).2
The SDR basket inclusion guidelines rest principally on the share of a country’s exports of goods and services and use of the currency in international transactions. In 2000, an IMF decision formalised the practice of including only currencies in the SDR basket that are freely usable.3 Other principles guiding SDR valuation comprise that the currency weight should reflect their relative importance in the world’s trading and financial systems and that any revision in the valuation method should only occur as a result of major changes in the roles of currencies in the world economy.4
SDR allocations give every participant a costless asset where the recipient obtains an SDR funded by an SDR allocation. The holder thus receives interest on its SDR holdings and pays interest on its cumulative allocation. The two interest rates (SDR interest rate) are the same and the net interest received is zero. Net interest is received/paid only if a recipient holds more/less SDRs than its cumulative allocation. On central bank balance sheets SDR holdings appear as an asset and the cumulative SDR allocation as a liability.
The provision of freely usable currencies against SDRs is an obligation of SDR holders. The obligation to exchange SDRs is limited to twice the country's cumulative SDR allocation. Countries using their SDRs hold fewer SDRs than they had been allocated. Countries holding more SDRs than their cumulative allocation are creditors to the SDR system. SDRs are normally exchanged between countries on a voluntary basis but the IMF can designate certain countries to receive SDRs. Sizeable SDR exchanges would imply that there would be large net creditors and large net debtors to the system.
The SDR is calculated as the sum of the weights of the four currencies valued in dollars on the basis of daily exchange rates. The SDR interest rate is calculated weekly and based on the weighted average of short-term instruments of the SDR basket constituent currencies.
The SDR is a purely official asset, it is not a currency and does not constitute a liability of the IMF. SDRs can only be held by IMF member countries and a few additional so-called prescribed holders including the BIS and ECB. The IMF receives SDRs in settlement of charges and to some extent repayment of credit and pays interest on creditor positions and credit in SDRs.5 The SDR also serves as a unit of account of the IMF’s operations.
The SDR basket is reviewed every five years or earlier if circumstances warrant an earlier review. Changes to the composition of the SDR basket require a 70 percent majority at the IMF Executive Board.
The SDR has played to date a very narrow role. The SDR was intended to provide an alternative to the dollar and gold at a time when there was considerable concern about inadequate central bank reserve growth to accommodate increasing international liquidity needs thereby hampering the orderly expansion of international trade and finance.6 The IMF Articles of Agreement prescribe that the SDR is to become the principal reserve asset.7 The underlying idea was that international liquidity should not be dependent on the possibility to accumulate international reserves. The SDR issuance history has been plagued by a rift between advanced economies arguing mostly against more issuance on the basis of international liquidity adequacy and mostly emerging markets that favoured issuance on the basis of the SDR’s ability to improve the quality of the international monetary system.8 There was considerable controversy about reducing the number of currencies to 5 from the 16-currency basket amid opposing views as to the role of the SDR.
SDR and the international financial architecture
The international financial architecture comprises broadly a framework and set of measures defining conditions for international financial transactions and resolution of financial crises. The SDR forms part of a subset of the international financial architecture, the international monetary system. The system constitutes the rules and regulations guiding international liquidity management to support orderly exchange markets and is considered vital for a balanced expansion of international trade and finance. The main actors of the system are central banks and the IMF. The four currencies or their equivalents that make the SDR basket today—the dollar, euro, yen and sterling—represented in 1950 100 percent of central banks’ foreign exchange reserves, a proxy for addressing international liquidity needs, and in 2014 93 percent in 2013 (Figure). The international economy has yet to address the international monetary consequences of globalisation.
The international monetary system has not changed materially since the establishment of the IMF in 1945. It has long been seen with concern that the system continues to rely on a narrow set of national currencies to manage international liquidity and as such is subject to the vicitudes of the national policies of the main currency issuing countries. The Federal Reserve is a national entity and has no mandate to accommodate international liquidity needs despite the fact that the dollar is also the main international currency.
The SDR can constitute a framework for advancing greater diversification in the international monetary system. A broader SDR basket would offer a more diversified currency exposure to central banks that may encourage central banks to hold outright a larger number of different currencies giving confidence to commercial banks, other financial institutions and commercial entities to diversify their currency holdings and laying the foundations for a more broader-based international monetary system.
The shortcomings of the international monetary system have for a long time been associated with the so-called Triffin dilemma. The Triffin dilemma was formulated out of concern for gold shortages under the Bretton Woods system but is assumed to be equally valid under a fiat standard. Triffin stressed the “vulnerability of a world monetary system whose operation becomes increasingly dependent on one or a few national currencies as major components of international monetary reserves.”9 Triffin implied that international liquidity depends on the supply of liquidity from key currency countries and asserted that a key currency country cannot increase issuance of reserve assets without facing a deteriorating liabilities ratio that will eventually undermine confidence in the reserve assets (Triffin dilemma). The adoption of a multiple-currency system would allow in essence mitigating the risks from using few currencies and hence reduce idiosyncratic risk in the system.
SDR and IMF governance
The SDR constitutes a framework for shared responsibilities in the functioning of the IMF. The relationship between the SDR and IMF governance is based on the notion that the SDR basket signals the importance of currencies and commitment to the IMF. Currency inclusion may therefore be used as a proxy for an exclusive or inclusive approach to mutuality and participation at the IMF and in the international monetary system.
The notion of shared responsibilities in the international monetary system follows proposals put forward in the early 1960s by U.S. undersecretary of finance Robert Roosa in response to concerns about the stability of the system at the time. Roosa suggested that the U.S. should start accumulating currencies of other leading countries to control the supply of dollars for international liquidity requirements. He thought this would allow bringing other currencies into “mutual sharing of some of the responsibilities which the international reserve system must itself carry” and to mitigate possible pressures arising from a loss of confidence in the dollar. Roosa argued that while the other currencies would not be “equally capable of serving the multitude of functions required of a reserve currency,” they could be complements.10 The approach to currency inclusion rests fundamentally on the assumption of currency complementarity rather than substitutability.
The principle of shared responsibilities assumes naturally that other countries would want their currencies to play an international role but above all that it would be optimal for the international economy if they did. China is seen as critical and others like Australia, Brazil, Canada, India, Indonesia, Korea, Mexico, Russia, Saudi Arabia, South Africa and Turkey can play important roles on the basis of regional and other considerations.
SDR basket enlargement—pros and cons
The SDR basket enlargement would require changing the principles underlying the current SDR valuation approach. It rests on replacing the objective of constituting a reserve asset as a substitute for the main international currencies to offering a vehicle and framework for broader currency proliferation as a complement to the main currencies.
The arguments for an SDR basket enlargement rest largely on: i) the SDR could play an important role as catalyst towards greater currency diversification in the international monetary system, ii) international currency diversification is seen as desirable amid establishing more differentiated sources of international liquidity that are more effective in responding to international liquidity demands and promoting development of local credit and capital markets, iii) for central banks, a broader SDR basket may help to increase diversification of reserve holdings and allow gaining exposure to less readily accessible currencies while limiting the impact on total reserve holdings, iv) the current narrow SDR basket does not add value as it is readily replicable in exchange markets at very low transaction costs, v) the SDR has been unsuccessful in assuming a meaningful role as a reserve asset, vi) the limited use of SDRs for almost only internal transactions within the IMF implies that immediate market implications of a broader basket would be minimal if any.
The arguments against enlargement of the SDR basket are likely to be: i) preserving continuity of the basket, ii) the current SDR inclusion criteria prescribe that the constituent currencies need to be freely useable which may exclude several otherwise eligible currencies, iii) the narrow basket allows simple replication and facilitates calculation of the SDR interest rate and ease of use as a unit of account.
The IMF Executive Board is due to review first consideration for the SDR review in May 2015 and to adopt the final review during the last quarter of 2015. To affect the IMF’s decision a proposal should be filed with the G20 ideally by April possibly in combination with a seminar to discuss the proposal.
1 The SDR was agreed in 1967 at the Rio de Janeiro IMF Meetings.
2 See Boughton 2001. Boughton noted a main motivation for reducing the basket to 5 currencies was also due to the fact that the interest rate on the SDR was calculated on the basis of the 5 main currencies.
3 The IMF Executive Board determines what a freely usable currency is. SDR valuation basket—Revised guidelines for calculation of currency amounts, Decision 12281, 11 October 2000, IMF Selected Decisions, 36th issue, Washington, D.C., 31 December 2011.
4 See IMF 2011 and IMF press release no 00/55, IMF completes review of SDR valuation, 12 October 2000.
5 Countries when obtaining credit normally request the IMF to transfers dollars or euros.
6 Issuance of the SDR was in large part motivated by the so-called Triffin dilemma, see e.g. Ousmène Mandeng, “Reserve currencies and solving the new Triffin dilemma,” Central Banking Journal, February 2009.
7 The decision was adopted in 1978 with the second amendment to the IMF Articles of Agreement, Article VIII Section 7: “Each member [country] undertakes to collaborate with the Fund and with other members in order to ensure that the policies of the member with respect to reserve assets shall be consistent with the objectives of promoting better international surveillance of international liquidity and making the special drawing right the principal reserve asset in the international monetary system.”
8 See James Boughton, Silent revolution, the International Monetary Fund 1979-1989, IMF October 2001.
9 Triffin, R. (1961), “Gold and the dollar crisis,” revised edition, Yale University Press, New Haven. Italics as per original.
10 Roosa, R. (1962), “Assuring the free world’s liquidity,” Federal Reserve Bank of Philadelphia, Business Review Supplement, September.