26 July 2016
The G20 seems to find it increasingly difficult to reach common ground. The G20 communiqué of Chengdu of 24 July illustrates the blandness of commitments that have become commonplace. However, there is one interesting tangible measure. China is pushing the IMF's Special Drawing Right (SDR) and the G20 is seemingly obliging: "We support examination of the broader use of the SDR, such as […] the potential issuance of SDR-denominated bonds, as a way to enhance resilience."1 There has not been for decades probably more momentum around promoting the SDR. However, concrete options to aid SDR proliferation will remain highly contingent on actual IMF and private sector interests.
The inclusion of the renminibi in the SDR basket effective 1 October 2016 and China's long held interest have undoubtedly caused momentum for the SDR. However, the SDR has had in the past numerous false starts. Since inception in 1969, it has never come close to gaining the importance it was meant to achieve, to become the principal international reserve asset. Diverging views among IMF member countries about the role of the SDR have also not helped (see Historic Perspectives on the SDR). It disappeared into oblivion shortly after it was launched. The short-lived fillip it got with the large general allocation of 2009 had not changed that. With the total of about US$380 billion SDRs outstanding it is simply too small to play a meaningful role in the international monetary system. Its use has remained limited to transactions within the IMF and current provisions prohibit any private sector use. It is not clear whether this will change any time soon.
The IMF has embarked on a series of studies to be delivered by early 2017. An infrastructure around the SDR is being putting in place. The Bank of England is said to start issuing daily quotes for the SDR (the IMF already does it). There is a rumour that China may issue an SDR-denominated bond soon.
The favourable development of the SDR will depend mostly on three factors: i) the IMF increases allocations of SDRs; ii) the IMF implements and receives successful participation in a substitution account; and iii) the private sector launches its own SDR.
The development between the [official] SDR, as issued by the IMF, and any other initiative outside the IMF should be deemed in principle independent of one another. The working assumption would have to be, given the restrictions on the official SDR, that there can be no fungibility between the official and a private sector SDR. This may change of course in the future.
The SDR remains limited to operations within the IMF. SDR allocations can be made only by the IMF and only four general allocations to date have been made. This is due largely to the fact that the IMF membership has found it difficult to supporting any allocation. A majority of 85 percent at the IMF Executive Board is needed to make an allocation and very large allocations require consent by the U.S. Congress (as part of the U.S. membership in the IMF). It is highly unlikely the IMF can agree on further SDR allocations. Changing the provisions of the SDR, e.g. to allow use outside the IMF by non-official entities, would further require changing the Articles of Agreement of the IMF which is also highly improbable in the foreseeable future.
The substitution account has seen several attempts to be implemented. The idea of a substitution rests on swapping claims in conventional reserve assets for SDRs. This remains a critical approach to increasing meaningfully the amount of SDRs outstanding. Disagreements in the past on the absorption of possible losses incurred through an SDR position have prevented implementation of a substitution account. Its success would depend largely on IMF member countries accepting that any possible losses from holding SDRs would have to be internalised by countries themselves and that there cannot be loss absorption by the IMF or any particular country on behalf of others (the U.S. was asked to provide such assurances in the past). Reviving the SDR substitution account is a possibility and desirable.
The private sector launches its own SDRs and there is nothing in principle that prevents it from doing so. This raises a fundamental issue of whether the case for an SDR-denominated asset has been made sufficiently. However, if an SDR champion emerges, and this may be China, by sponsoring large issuance of SDR-denominated market instruments, attitudes may change. Such development would be entirely independent of developments of the official SDR. Nor would a private SDR have to meet all the characteristics of the official SDR. The inclusion of the renminbi in the SDR basket would naturally the private sector to have full access to the underlying renminbi market, something that would have to be in place if the private sector wanted to go ahead with the new SDR basket. China maintains restrictions on the private sector accessing its domestic money and bond markets but this could change of course.
The emergence of China as a main sponsor of the SDR is plausible. Large issuance of SDRs though may be hampered by the fact that this would increase China's foreign currency denominated liabilities which would be undesirable. China could exchange its foreign currency assets for market SDRs , through a private SDR substitution fund (see SDR Substitution Fund) and then trade its SDR-denominated assets in private capital markets to allow the private sector to gain exposure to the SDR while net foreign asset position would not change. China would though not gain from diversifying into SDRs given that the renminbi is its national currency. For China, such engagement would only make sense if its sees in the future a broad use of SDRs as reserve assets.
The replication of the official SDR by the private sector is possible but not necessarily desirable. Earlier private sector issuance in the European Currency Unit (ECU) was made under the assumption that ECU-denominated assets would eventually be fully fungible with euro-denominated assets. In the case of the SDR, the lack of prospect of the official SDR to be accessible by the non-official sector may undermine incentives for pursuing a replication of the official SDR by the private sector at least in the foreseeable future.
The official SDR is also a relatively complicated instrument. The SDR valuation is subject to five-yearly intervals to reset weight and composition of the currency basket. The SDR interest rate is based on short-term money market instruments. Given the very low to negative interest rates in the underlying instruments, the IMF since October 2014 fixed the SDR interest rate at 0.05 percent. Price formation of the SDR is not subject to supply and demand but only to movements in the underlying. All this complicates the private sector replication of the SDR.
The diversification of reserve assets is highly desirable. Brexit has made it more so (see International monetary dimension of Brexit). The SDR could play a useful role in fostering greater diversification. The IMF will determine developments of the official SDR. The private sector may independently opt to develop its own. China as a key sponsor may be an essential catalyst for both. However, the success of the SDR will be desirable if and only if there will be in the future fungibility between official and private SDRs.
1 G20 Finance Ministers and Central Bank Bovernors Communiqué, Chengdu, 24 July 2016