Crashing the SDR

If China is serious about elevating the SDR to reserve currency status, it should take steps to create a liquid market in SDR claims. It could issue its own SDR denominated bonds.

But skeptics question whether the SDR could ever replace the dollar as the world s leading reserve currency, for the simple reason that the SDR is not a currency.

Back in the 1970 s, there was some limited issuance of SDR denominated liabilities by commercial banks and SDR denominated bonds by corporations.

In order to make the SDR the principal reserve asset via the allocation route, close to 3 trillion in SDRs would need to be created, an unrealistic proposition.

Such a solution is readily available in the form of Special Drawing Rights (SDR).

This means that the SDR is not an attractive unit for official reserves.

The establishment of SDRs was accompanied by a commitment, included in the IMF Articles of Agreement, to making the special drawing right the principal reserve asset in the international monetary system (Article VIII, Section 7 and Article XXII).

One way to make the SDR the major reserve currency relatively soon would be to create and allocate a massive amount of new SDRs to the IMF s members.

This is what was hoped for when SDRs were created in the 1960 s, and this process must be completed by transforming the SDRs into such a global currency.

But there is a more realistic way for the SDR s importance to grow.

For example, alternative systems of SDR allocation, with a greater proportion of SDRs given to countries actually demanding the reserves (mainly developing countries), might contribute to global growth and stability.

But the process for issuing SDRs is cumbersome, and there are no private markets in which they can be traded.

This defence is not available where damages of less than 1131 SDR are sought.

The US ought not to shy away from wider use of IMF Special Drawing Rights. Because SDRs are denominated in several national currencies, no single currency would enjoy an unfair advantage.

Transforming the SDR into a true international currency would require surmounting other obstacles.

The overdraft facility could again be financed with counter cyclical issues of SDRs.

The Fund could stand ready to buy and sell SDR claims to all comers, private as well as official, at narrow bid ask spreads competitive with those for dollars.

The SDR would offer little protection if the dollar and euro lost value over time.

The SDR was introduced 40 years ago to supplement what was then seen as an inadequate level of global reserves, and was subsequently enshrined in the IMF s amended Articles of Agreement as the future principal reserve asset.

But skeptics question whether the SDR could ever replace the dollar as the world s leading reserve currency, for the simple reason that the SDR is not a currency. It is a composite accounting unit in which the IMF issues credits to its members.

Ideally, additional issuance of SDRs would be accompanied by further measures to increase their effectiveness. For example, countries unused SDRs could be held as deposits by the IMF, which the Fund could then use to finance its lending programs.

The US ought not to shy away from wider use of IMF Special Drawing Rights.

Of course, an earlier attempt was made to create a commercial market in SDR denominated claims.

They should be the major source of IMF financing as well, replacing quota subscriptions or lending to the Fund by member countries (potentially making the IMF a purely SDR based institution, as proposed decades ago by the late IMF economist Jacques Polak).

Following the creation of SDRs in 1969, IMF members committed to make them the principle reserve asset in the international monetary system, as stated in the Articles of Agreement. But the peculiar way in which SDRs were adopted limited their usefulness.

The political reasons for including the renminbi in the SDR are all too clear.

Because SDRs are denominated in several national currencies, no single currency would enjoy an unfair advantage.

All they have to do is vote for the creation of SDR and then pass on the benefits to less developed countries.

Back in 1980, the IMF came close to adopting a so called SDR Substitution Account.

This approach undoubtedly has major shortcomings. Indeed, the key advantage of the IMF s SDR department that it is a quasi universal and government driven system whereby currencies are exchanged with reliable collateral (the SDR) would be lost.

SDRs are highly complicated and difficult to grasp, but they boil down to the international creation of money.

Of course, China should not rule out the possibility of adjusting the composition of its foreign exchange reserves to mimic the composition of the SDR.

Recognition of this fundamental problem was the reason why the IMF s Special Drawing Rights (SDRs) were created in the 1960 s.

Doing so would build on the enlightened suggestion made at the G 20 s London meeting in April 2009 to issue SDRs equivalent to 250 billion, which was then quickly implemented.

In the case of the IMF, the financing for such liquidity could be counter cyclical issues of SDRs.

We are also prepared to consider the impact of issuing special drawing rights with a view to eliminating the instability and financial imbalances that are overwhelming the developing world.

It will be called the School in the Cloud.

Commercialize the SDR

The discussions surrounding the enlargement of the SDR basket (by including the renminbi) and coordination of bilateral swap arrangements should be understood from this perspective.

The reason is obvious on a moment s reflection the combined share of the dollar and euro approaches 80 of the basket of currencies that comprise the SDR.

The idea was that by issuing SDRs, the IMF would provide catch up economies seeking to accumulate reserves with an alternative to piling up dollars.

These technical difficulties stood in the way of previous attempts to put the SDRs to practical use, but they do not apply to the proposed green fund.

In principle, the IMF could be allowed to print money (it already has its own accounting unit, the so called Special Drawing Rights).

The problem is that SDRs are used neither to settle cross border transactions nor as a unit in which to denominate international bonds.