The SDR solution

Posted by on 5 May 2011

 

There is universal agreement that the international monetary system (IMS) needs reform. All of us understand the benefits of avoiding the Triffin Dilemma by reforming the international financial system. The present system, dominated by reserves holdings of US dollars, places an unsustainable burden of creating reserves on the US. While the US enjoys the "exorbitant privilege" of issuing a reserve currency in the short run, it hallows the productive capacity of the economy in the long run. . Recently Joe Stiglitz has proposed a solution in the FT The best alternative to a new global currency (

http://www.ft.com/cms/s/0/c2215510-5bc4-11e0-b8e7-00144feab49a.html#axzz1LDaAseCM ). He suggests that SDRs’ role be expanded through new issues and by increasing their use in IMF lending. In essence the proposal is to move to a world where reserve needs are met by IMF credits known as Special Drawing Rights (SDR) allocations rather that by building precautionary reserves. The proposal can be to be thought as a process in which member countries swap their USD reserves for SDRs. The assets on the balance sheet of IMF will be composed of the current members’ currencies, and the liabilities of the IMF will be the SDR. All exchange rates would be priced in SDR and it will be used as unit of account and exchange. This approach makes the IMF the Central Bank of the World. http://www.project-syndicate.org/commentary/ocampo8/English ). The proposal warrants careful examination due to the authoritative experts supporting it. Surprisingly the proposal has not elicited a careful analysis from International Financial Institutions such as the IMF. An analysis of the proposal suggests that it is not well thought out. It reflects an incomplete understanding of finance, the SDR, the Fund, and the IMS.http://www.project-syndicate.org/commentary/eichengreen29/English) argues that the problem is that SDRs are not a currency that can be used to settle cross-border transactions or as a unit of value in which to denominate international bonds. That means that there are no private markets for SDRs, and it is not evident that it feasible to create such markets.

Stiglitz was later joined by 17 prominent economists and policy makers that endorse the proposal to transform the SDR into an international currency to rival the dollar in their recent not so modest Project Syndicate article A Modest Proposal for the G-20 (

Barry Eichngreen in The Bear of Bretton Woods (

Another consideration is that currencies are far more than a medium of exchange. Acquisition of a reserve currency reflects trust and confidence in a particular society. It is a vote of confidence in the country’s stability and social norms such as liberty, peace and justice. In other words, domestic currencies that serve as reserve currencies are backed by a set a "values"- accountable and responsible domestic policy making institutions. Further a reserve currency has to be freely convertible, have a stable wealth storage value and provide an attractive environment for commerce due to trust in the rule of law. If all those favorable conditions apply domestic currencies represent a call on the domestic wealth, resources and industriousness of a nation. It is not possible for the IMF to pool currencies that do not have those properties and create an accepted medium of exchange.

We need to understand what the proposal is. Is it substitution for existing reserves (such as China’s $3 trillion largely in US$) or preempting prospective reserve accumulation by allocating additional SDR? If its a "substitution for reserves" account to accommodate China’s desire to limit its exposure to the US$, we need to know who is going to bear the exchange risk? In short, the proposal is flawed if there are no limits/controls on subsequent reserves accumulation and does not even facilitate diversification unless the collective membership of the IMF is ready to cover the foreign exchange risk on behalf of China transparently. One doubts such largess by the IMF’s membership. Allocating additional SDR in large amounts is another possibility. We should note is that according to the IMF, global FX reserves were about $9 trillion last year and they are growing at the rate of more than $1 trillion per year. Does the proposal envision that IMF could or should issue an equivalent amount -$1 trillion per year - of SDRs to accommodate the need for precautionary reserves? For that we need to recall that the IMF injected 250 billion dollars into member nations' foreign exchange reserves to boost liquidity amid the global economic crisis "to provide liquidity to the global economic system by supplementing fund's member countries' foreign exchange reserves." At the time the IMF explained that some members may choose to sell part or all of their allocations to other members in exchange for hard currency -- for example, to meet balance of payments needs -- while other members may choose to buy more SDRs as a means of reallocating their foreign exchange reserves.

While a onetime $250 billion SDR allocation done with a slight of hand by international financial bureaucrats through accounting entries might be justified in exceptional times, $1 trillion per year of SDRs becomes an enormous transfer of financial resources that is not different from any other entitlement. It cannot and should not become a norm of massive regular entitlements managed by benevolent international bureaucrats to countries that end up benefitting from hundreds of billions of disposable reserves.

This leads to the question as to who will determine the pace and exchange rate at which the new (more inclusive) SDRs will be issued by the IMF. Such a system can undermine market discipline through diffused decision making and collective burden sharing. For example, the European experiment with the European Central Bank (that lacks collective fiscal support) is not going well, Similarly, the emissions of bonds by the European Financial Stability Facility (EFSF) - aiming at preserving financial stability in Europe - would be backed by guarantees given by the euro area member states and critics point out that it can turn into an opaque loss transfer mechanism. In this context, there is a risk that mutual financial institutions- such as the IMF and The World Bank –run as clubs might not end up being exceedingly disciplined in the issuance of SDRs. Is the IMF going to become the undisciplined Central Bank of the World that will issue SDRs with abandon undermining the domestic financial stability of member countries? Does the proposal socializes the fiscal and trade problems of member countries, that become the collective problems of the IMF members? Alternatively, the decision making process on issuing SDRs at the IMF could end up being extremely complicated, fraught with politics and therefore exceedingly slow in responding to a crisis. It might end up being far from the rapid decision making of a central bank and therefore useless in a crisis.

While the title of Joe Stiglitz column in Project Syndicate is - I Dissent: Unconventional Economic Wisdom- one ends up concluding that this time the dissent is going too far. One is left with the conclusion that it is not a coincidence that the proposal was issued at a meeting in Beijing organized by Columbia University’s Initiative for Policy Dialogue and China’s Central University of Finance and Economics. It is understandable why the Chinese authorities want to establish the SDR as a reserve currency. Their self interested view is that the Fund should open a facility -- the substitution account -- in which countries could swap their dollar reserves for SDR reserves -- presumably at a fixed exchange rate. This would enable countries to diversify out of dollars without turning the dollar exchange rate against themselves due to market impact. There aren’t obvious reasons as to why the countries affected by China’s mercantilist policies should support the proposal when China is running large surpluses and accumulates enormous reserves.

In conclusion, it is not a serious proposal, but rather a distraction from looking for solutions to a flawed international financial monetary system in desperate need of mending.