Ousmène Mandeng: Revive the IMF SDR Substitution Fund

2016-05-11 IMI

Ousmène Mandeng: Head of Research and Development New Sparta Asset Management. Introduction The inclusion of the renminbi into the IMF Special Drawing Right (SDR) basket was an important but mostly symbolic step. The relevance of the renminbi inclusion will come with the proliferation of the SDR. This will rest largely on the amount of SDRs outstanding. While the IMF is unlikely to offer greater SDR allocations amid resistance from key IMF member countries, China should embark on promoting the SDR through an SDR substitution fund.It would likely define the actual future of the SDR and help inserting the renminbi into the international monetary system. History of SDR The SDR emerged amid perceived impending shortages of international reserves possibly disrupting or constraining orderly payments and settlement of international transactions. Concerns about the adequate supply of reserves are immediately related to the purpose and origins of the IMF itself. John Maynard Keynes stated as part of the objects of his 1942 proposal of an international clearing union: “We need a quantum of international currency, which is neither determined in an unpredictable and irrelevant manner as, for example, by the technical progress of the gold industry, nor subject to large variations depending on the gold reserve policies of individual countries; […].” The SDR was based on a dual concern about inadequate reserve supply and undue dependence on countries issuing reserve assets. The SDR was conceived during the 1960s amid mounting concerns about adequate international liquidity. Proposals to create international liquidity as per the Bernstein Plan through the Reserve Settlement Account or the Triffin Plan were still received with considerable hesitance. Triffin famously insisted that international liquidity should not be dependent on the balance of payments of the U.S. or the U.K. From 1964, the IMF became increasingly concerned about the slowing pace of reserve accumulation.At the time, any rise in international reserve was mostly due to increased holdings of foreign exchange mainly dollarsandit was feared that the accretion of dollar international liquidity will soon dry up leading eventually to a significant weakening of the structure of international liquidity.In 1965, the IMF included as part of its work programme the need for additional reserves.In 1967, the IMF began deliberations in earnest about a reserve facility based on drawing rights in the Fund. In 1968, the IMF Executive Board issued a report recommending modifications of the Articles of Agreement of the IMF to establish a facility for special drawing rights. On 1 January 1970, the first SDR allocation was made. In 1978, the second amendment of the IMF Articles of Agreement came into effect and provided for the SDR to become”the principal reserve asset in the international monetary system.” In 1972, at the IMF Annual Meetings, then U.S. Treasury Secretary George Shultz offered the international community a bold plan to reform the international monetary system and end the special role of the dollar as a reserve currency. The U.S. proposal came after a complete disruption of the then existing monetary order and as key countries growing mistrust in the U.S. administration’s willingness to make necessary economic policy adjustments to ensure the stability of the dollar. Shultz presented the outlines of a plan including: Substituting the dollar for the SDR to become the formal numeraire of the system, offering an exchange of existing reserve assets (dollars) into other reserve assets, eliminating the role of gold, transferring sovereignty to international institutions to manage the system. The idea of a substitution account to exchange foreign exchange for SDRs had emerged. It rested largely on the desire to substitute existing reserve assets and bring forward the amount of SDRs outstanding.In 1972-74, the Committee of Twenty analysed the possibility of a substitution account based on a compulsory exchange of foreign exchange assets for SDRs.In 1975, the IMF debated a substitution account for gold to allow IMF member countries to obtain SDRs in exchange of gold. In 1979 after different iterations, the IMF reconsidered a substitution account to exchange dollars for SDRs. The idea attracted considerable interest and consisted of an account administered by the IMF that accepts deposits on a voluntary basis of eligible dollar-denominated securities in exchange for an equivalent amount of SDR-denominated claims. Considerations assumed that for such account to obtain broad participation, the costs and benefits should be fairly shared among all parties concerned and it should contain adequate provisions for liquidity, rate of interest and preservation of capital value. The account was seen to contribute significantly to promote the SDR as the principal reserve asset. Its proposal aimed to maintain stable the balance between assets and liabilities affected by differences in the interest rates between dollar and SDR-denominated claims and the exchange rate of the dollar against the SDR. A proposal was submitted to set aside IMF gold to support the operation of the account while the U.S. and other participants would share any residual profit or loss of the account. The SDR’s favourable momentum though was short-lived.Conditions for reserve supply changed andsupport for the SDR declined precipitously. SDR allocations remained few and the substitution account ideas were abandoned in 1980. The idea failed largely amid disagreement about the distribution of the risks and costs involved. The 1970 SDR allocation was part of first general allocation in 1970-72 of SDR9.3 billion and the second general allocation in 1979-81 was of SDR 12.1 billion. For almost 30 years, no further SDR allocations were made. In 2009, amid some renewed interest, a third general allocation of SDR162.2 billion was distributed together with a special one-time allocation of SDR21.5 billion. There are SDR204.1 billion outstanding today. The limited interest for SDRs rests in large part in the SDR’s features and failure to adopt the substitution accounts. The SDR is a reserve asset issued by the IMF and used almost exclusively in transactions with the IMF. It is de facto a credit line allowing countries to exchange SDRs for foreign exchange. It is neither a currency nor a liability of the IMF. The SDR is for all practical purposes a pure form of internal money. Its valuation does not depend on market movements nor does it seemingly affect the market. As such the SDR value offers little indication about net demand for international liquidity. The SDR are held predominantly by central banks in their accounts in the IMF. The SDR is also a unit of account and all transactions of the IMF are accounted for in SDRs.Attempts to give rise to private sector use of SDRs were largely unsuccessful. The SDR valuation is a weighted average of the exchange rates of the SDR basket currencies relative to the dollar. The currencies included in the SDR basket are the dollar, euro, sterling and yen and from October 2016 the renminbi. The weights are based on the share of each currency in world exports of goods and services and international reserves. The addition of the renminbi to the SDR basket represents some innovation—the SDR was made previously of many currencies—but does not address the fundamental limitations inherent in the SDR (Table). The most limited feature of the SDR seems to be the small amount outstanding. The equivalent US$280 billion of SDRs pales against the US$11,400 billion in central bank foreign exchange reserves. Future prospects The reluctance to issue more SDRs has been based in large part on an assessment by the IMF that there is insufficient demand for additional reserve assets and subsequent opposition by key IMF member countries. General SDR allocations are performed on a needs basis, that is, whether there is a long-term global need to supplement existing reserve assets. Decisions on general allocations are normally taken for successive basic periods of up to five years. In 2001, in conclusion for the eighth basic period, one IMF Alternate Director stressed that “we cannot support the finding of a ‘long-term global need.’ The current slowdown of the world economy can be attributed to many factors—the lack of availability of SDRs is surely not one of them. [O]n a global scale, the system has been capable of generating the reserves it needs.” The view has been representative for the dominant attitude at the IMF Executive Board. In 2011, for the tenth basic period, the IMF Acting Managing Director concluded that there is no broad support for an SDR allocation. The views expressed by some IMF Executive Directors that SDR allocations should also respond to mounting undue concentrations in reserve holdings and to serve to promote the SDR as a reserve asset have remained unheeded. An SDR substitution account is considered to remain the most promising approach to promoting the SDR. The mechanism of such account remains relatively simple if and only if considerations of risk and cost sharing are discarded. The aim would be to use a substitution account to issue SDRs in large amounts to offer adequate liquidity and establish a private market for SDRs. Participation should be strictly voluntary and participants attracted by the properties of the SDR-denominated securities issued by the account. The proposition rests largely on the implicit diversification benefits of holding liquid SDR-denominated securities that have been significantly enhanced with the adoption of the renminbi in the SDR basket.The renminbiwould itself directly benefit by gaining access to a broad international investor base.Participants could include central banks but also private sector investors. One of the key lessons of previous attempts at a substitution account is that participants have to be willing to hold SDR risk. China should give consideration to sponsor launching a substitution account. This could be done by seeding an SDR substitution fund. The fund would hold as assets, eligible securities deposited by participants in the fund andparticipants would receive SDR-denominated notes in exchange.The SDRs would be freely tradable with third parties and the price be strictly market determined as a function of the net asset value of the account, that is, the advantage of poolingdifferent reserve assets. The value of the SDRs would thus be the difference between the value of the deposited assets and the liquidity premium of the SDRs and the transaction costs of diversification. The SDR could trade at a discount or premium to the net asset value of the fund. The SDR will remain mostly symbolic if SDRs outstanding remain small. The IMF is unlikely to support significant additional SDR allocations. China should therefore give consideration to initiating andlaunching an SDR substitution fund possibly as part of its G20 Presidency agenda.As in the past, a substitution fund will likely determine interest in and the future of the SDR. It will thus decide on the actual relevance of the renminbi SDR basket inclusion.

DOWNLOAD

Ousmène Mandeng: Revive the IMF SDR Substitution Fund

related articles

tags