November 2015

16 November 2015

SDR valuation review decision

The SDR valuation review is now scheduled to be completed on 30 November and as expected is to provide for inclusion of the renminbi. On 13 November, the IMF issued a press release indicating that the Managing Director supports inclusion of the renminbi in the SDR basket. The addition of the renminbi would be the first time the SDR basket will see a net increase in the number of currencies and may signal new momentum around the IMF’s reserve asset. However, the review also reveals the contentiousness of the SDR valuation framework.

The inclusion of the renminbi has been in doubt amid the criteria guiding currency inclusion in the SDR basket. Inclusion rests on an export criterion and a freely usable criterion. China easily passes the first. The second is problematic and had held up renminbi inclusion in the past. The IMF staff assessment that the renminbi now meets the freely usable criterion must remain controversial amid prima facie evidence that access to the renminbi remains restricted and that capital controls are still relatively comprehensive.

The export criterion is also problematic given that denomination rather than export value should matter for a reserve asset. This has led to a seemingly disproportionate weight of sterling and yen relative to the dollar in the SDR basket compared with the weight of sterling and yen in central banks’ foreign exchange reserves, e.g. the ratio of sterling to dollar has always been about 1/3 in the SDR basket. The ratio of sterling-denominated reserves to dollar denominated reserves fell from 1/6 in 1970 to 1/14 today.

Consideration for changing the criteria would have been more appropriate to offer a new inclusive platform to promote greater emerging markets currency proliferation generally. It seems difficult to argue that the Mexican peso, Korean won or Australian dollar exhibit fewer reservable criteria than the renminbi. The renminbi inclusion may therefore raise suspicion that inclusion has been unduly politically motivated. It risks reducing transparency and verifiability of the SDR valuation process. This serves as a reminder that the SDR basket selection criteria are arbitrary and outdated and that changing the criteria would have been the better approach.

With equivalent US$280 billion of SDRs outstanding against about US$11,000 billion in central banks’ foreign exchange reserves, it is unlikely SDRs will be able to play a meaningful role. While theoretically, the IMF could decide to increase SDR allocations, given the needed majorities at the Board, this seems improbable any time soon. However, the signalling effect from inclusion could be important.

The renminbi inclusion may lead to a revival of interest in the SDR. Support for the SDR actually faded away quickly shortly after its introduction in 1969 as circumstances that originally promoted the idea of SDRs changed. More recently the large issuance in August 2009 of US$250 billion brought some interest back. In 2009, the Chinese authorities floated the idea of repositioning the SDRs, together with the Russian authorities. In April 2015 with China’s IMFC Statement for the IMF Spring Meetings it became clear that China wanted the renminbi to be included in the SDR basket.

Box. SDRs

The SDR is an international reserve asset that offers its holders unconditional foreign exchange liquidity. The SDR is a costless asset on which the holder neither earns nor pays interest on a net basis. It is not a currency nor a liability of the IMF. The SDR is basically an internal money and can almost only be used for transactions within the IMF. It also serves as a unit of account for IMF transactions.

Holders of the SDRs are IMF member countries and their fiscal agents normally the central banks. SDRs can be freely exchanged, typically by voluntary transactions by agreement though the possibility of so-called transactions by designation exist, at a value determined by the value of the SDR basket for foreign exchange among IMF members. Some countries hold more SDRs than they were allocated, being net creditors to the SDR system, while other countries using their SDRs hold less SDRs than their allocations, and are net debtors to the system.

The valuation of the SDR is based on the value of the SDR basket. The basket is currently made of four currencies, the dollar, euro, sterling and yen and the value of the basket is the weighted average of the bilateral exchange rates vis-à-vis the dollar. The SDR value is passive and not subject to market forces nor does it exert pressure on markets (except possibly through hedging as some central banks chose to hedged their net SDR exposure). The value of the SDR also does not reflect supply and demand of SDRs. The SDR pays an interest rate that is normally the weighted 3-month Treasury bill or equivalent rate of the underlying currencies (the rate has been fixed at 0.05 percent since October 2014).

The currency weight are based on the relative share of each currency in reserve holdings (40 percent) and the value of exports of goods and services (60 percent). On that basis, according to the IMF and using today’s data, the currency weights would be 45, 36, 10 and 9 for the dollar, euro, sterling and yen, respectively. The renminbi would attract a weight of 14 to 16 percent according to IMF estimates implying probably a significant reduction in the weight sterling and yen.

UBS European Conference 2015—Main impressions

The UBS European Conference 10-11 November, one of the leading investor conferences in London, was notable for its topics and absence thereof. Given the nature of the conference, there were plenty of sessions on macroeconomic and financial topics, sessions on growth and innovation, on Europe with one session on the U.K.’s membership in the European Union, one on emerging markets and two on China. There were no sessions on climate change, international security or on immigration.

The most interesting remarks (though not necessarily remarks I agree with) were:

ECB debt buying and fiscal space: The ECB at its current asset purchasing pace will hold as much as one third of Eurozone government debt by September 2017 (compared with about 35 percent for the Bank of England and the Bank of Japan and 20 percent for the Federal Reserve of benchmark government securities). One commentator argued that this increases considerably fiscal space implying that “governments have no excuse not to do more” fiscal stimulus. The ECB government debt purchases will de facto suspend the debt as government debt service will be netted against profit transfers from the ECB to governments. He recommended for the ECB to “do whatever it takes” to absorb government debt.

ECB policy action: The ECB was too concerned about inflation for too long and has consequently always been “behind the curve” was stressed by one commentator. Inflation targeting to work has to be symmetric and a central banks needs to address inflation under-shooting as much as over-shooting. “Had the ECB moved earlier together with the Fed, the euro would have depreciated to parity with the dollar and the Eurozone would be in a much better world.” The Federal Reserve “has always been ahead of the curve.”

Effect of quantitative easing (QE) and helicopter money: The limited effect of QE was highlighted by several commentators. There was consensus that QE impacts the yield curve but that the effect is very small. One commentator stressed that QE is not helicopter money as the proper definition of helicopter money implies “giving money to the public”. This has not occurred with QE as the money continues to remain with the banks. Another commentator added that QE may be counterproductive in the Eurozone as the transmission channels in the U.S. via the housing market and external debt through lower interest rates are not as relevant in the Eurozone.

Emerging markets debt: “Then we had the problem of European banks and now we have the emerging markets corporate debt problem.” Although emerging markets have accumulated lots of foreign exchange reserves, the missing explicit link between reserves in the hand of central banks and emerging markets corporates implies that foreign exchange pressure may not be handled smoothly.

Eurozone debt restructuring and fiscal space: One commentator stressed that when a government is considered to exhibit credit risk, its debt will be unduly subject to pro-cyclical market movements. Governments with credit risk therefore will “see safe haven flows moving away from them” compiling fiscal and adding balance of payments pressures. Governments need to have fiscal space to be able to conduct fiscal stabilisation policy. The commentator recommended for Eurozone countries to split their government debt into senior and junior tranches to create the fiscal space needed where the senior tranche would act to attract safe have flows. He warned that the current limited fiscal space may prove fatal in the event of another cyclical downturn.

Exchange rates and transmission mechanism: The exchange rate is probably the most potent policy transmission channel for advanced economies central banks at the moment.

International trade agreements: “Bilateral and multilateral international trade agreement like the Transatlantic Trade and Investment Partnership (TTIP) will substitute the World Trade Organisation (WTO).”

Renminbi in SDR basket: The renminbi inclusion into the basket and renminbi internationalisation is meant to “bring forward domestic reforms” in China. However, renminbi internationalisation should not be a policy objective but rather an outcome.

UBS on the spot electronic survey of conference audience:

Percent of respondents:

80%, renminbi will devalue further.
72%, renminbi will be selected for inclusion in the IMF SDR basket.
67%, China will grow 5-6 percent over the medium term.
65%, fiscal policy should be deployed more aggressively.
63%, monetary policy is still potent.
53%, China will undertake serious reforms in the short term.
38%, in central bank foreign exchange reserves renminbi will displace both dollar and euro holdings.
24%, China will grow 6-7 percent over the medium term.

G20 Summit Antalya

The G20 Communiqué of 16 November was bland affirming that the G20 finds it difficult to reach consensus on critical economic policy, energy and international security measures. Turkey’s G20 Presidency wanted to focus on implementation and rather quickly it was seen as merely a prelude to the Chinese G20 Presidency. Accordingly, nothing special was contemplated or achieved. This seems like a missed opportunity. Turkey would have been in the credible position to guide concrete actions to confront a sluggish EU as an EU peripheral country and the largest EU refugees crises by virtue of being at the centre of it. The former would have offered valuable insight into the geography of economic crises and the second tackling the refugee crisis as an international and not a bilateral effort. Neither featured among Turkey's G20 Presidency priorities.

The G20 Presidencies have been mixed at best. Some have been rather inconsequential. The risk is that the G20 loses its residual momentum and be relegated completely to a mere talking shop or downgraded to something worse. China’s G20 Presidency will be critical to lift the group. It has to demonstrate that the G20 matters for policy coordination and to tackle agenda items that are truly global in nature. This should mean a greatly streamlined agenda. The proliferation of different groups around the G20 undermines focus and the division of labour between the different existing institutions within the U.N. or otherwise.

The production of concrete deliverables is always difficult given the relative short period of the G20 presidencies. However, this is why prioritisation matters. Identification of feasible deliverables is essential for a successful presidency and itself reflection of proper economic policy assessment and judgement. The G20 needs to show it can take executive decisions. That is why it was elevated to heads of government level in the first place.

The Antalya Communiqué offers no concrete deliverables. The broad commitment that "growth is inclusive, job-rich and benefits all segments of our societies" illustrates that the G20 finds it difficult to identify a common denominator for action. The Communiqué seems a mere compilation of boilerplate past commitments and neither conveys a sense of actual targets, verifiability or next steps.

One interesting hint is reaffirmation of the “agreement that the heads and senior leadership of all international financial institutions should be appointed through an open, transparent and merit-based process.” With Ms Christine Lagarde’s mandate ending in June 2016, this may signal a desire for change at the top of the IMF.

The commitments around energy seem neglected. As only point 22 of the Communiqué, energy appears to be not much of a G20 priority. It should be as in poor countries adequate energy supply will define economic progress and social stability. Turkey organised the first G20 energy minister meeting which, while adding to the proliferation of G20’s tasks, has contributed to signalling forcefully that energy is a global matter and requires global solutions. With climate change, as point 24 of the Communiqué, the G20 priorities seem misaligned with immediate required policy actions on that front.

The refugee crisis would have been a perfect opportunity to pledge strong support and offer concrete resources. As point 25 out of 26 of the Communiqué it seems to confirm that policy interests are too heterogeneous and that there is no consensus of what needs to be done among the G20 to allow for meaningful actions at the global level.

The G20 issued a separate statement on the fight against terrorism. The commitments remain very general only and do not include any timetable for actions. Another hint that the topic and what to do remains divisive among the G20.