If you had to select the major topic in the currency arena for 2009 and beyond, the growing desire of certain central banks to embrace the International Monetary Fund’s Special Drawing Rights facility would not be the worst choice you could make. As the year has developed, the push of the BRIC countries in advocating the use of Special Drawing Rights has started to raise serious questions as to the US dollar’s role as the reserve currency of choice across the world. But are these SDRs a viable replacement? Indeed, let’s take a look at what they are in the first place.
Special Drawing Rights – A Brief History
Special Drawing Rights were an attempt to alleviate concerns arising from the fixed currency regime devised at Bretton Woods in the 1960’s. Noted economist Robert Triffin raised doubts as to the sustainability of the project. He argued that a system based purely on USD and gold reserves had an inherent dichotomy that an increase in liquidity demand from global central banks could only be met by an increase in the supply of the U.S. dollar, as gold was a finite resource.
If a push for global growth were predicated on an increase in the stock of U.S. dollars, an undesirable feedback loop would lead to an erosion of confidence in the dollar and bring the entire regime into question. In an attempt to circumvent this issue, the International Monetary Fund (IMF) created the oddly named Special Drawing Right, a kind of synthetic reserve asset based on the dollar price of gold.
By 1972, SDRs accounted for just under 10% of non-gold global reserve assets. By 1973 however, the Bretton Woods system had broken apart and a new era of floating exchange rates emerged, making the USD based SDR seem rather redundant. Moves were made to re-price the SDR with a basket of currencies, initially 16 and subsequently the G5 currencies as were seen at that time (USD, GBP, JPY, DEM and FRF). After the advent of the European single currency, this basket of 5 became 4 with the EUR replacing the Deutschemark and French Franc.
The IMF still uses SDRs as their basic accounting unit even though the stock of SDRs has not increased since 1972. In 1997, the SDR stock was to be doubled (an additional SDR 21.7 billion) but this expansion had not occurred by the end of 2008 as the United States had an effective veto on the proposal.
So, Why Are SDRs back in the headlines?
Given the effect of inflation and monetary expansion seen in the quarter of a century since the creation of the last SDR, the stock of SDR assets is now a paltry one-half of one percent of the world’s non-gold reserves. Over the course of this year, and in response to the dramatic financial contagion that has engulfed global finance since 2007, the BRIC countries (Brazil, Russia, India and China) led primarily by Russia and China, have been increasingly vocal in their calls for some form of new reserve asset for the world’s central banks.
The SDR facility, already in existence for nearly 30 years seemed a readymade alternative to the dollar. Talk of ending the USD’s pre-eminence stretches back much further than recent history, but the emergence of the BRIC economies, coupled with financial turmoil has pushed the agenda ahead at a rapid pace in recent months.
The tacit acknowledgement of China’s call for an increased SDR facility by U.S. Treasury Secretary Tim Geithner earlier this year was an important step for the plan, which gained increasing traction at the G20 meeting in London in April. At the meeting, the IMF looked the big winners with over a trillion dollars allocated to them and an increase in the SDR facility of $250 billion.
Much has been written about the USD reserve story being a battle between East and West. China has been notable in its reduction of purchases of U.S. securities over recent months and though it is easy to argue this is due to concerns about current U.S. economic policy, it must be remembered that it probably has more to do with simple trade flows. The U.S. consumer, the driver of growth in the first part of the third millennium, has been stopped in its tracks. If China is getting fewer dollars from the sale of manufactured goods, it stands to reason they have fewer U.S. dollars to plough back into the U.S. securities market.
Additionally, the Chinese are undertaking an internal stimulus plan, which also sees the need to bring money home. At present, a desertion of the dollar is not in the interests of the BRIC economies. After all, China along with Japan, continue to top the list of overseas holders of U.S. dollar securities. A U.S. dollar collapse is not in their interest. The undercurrents of concern however, are plain to see. China has opened Forex swap lines with many trading partners and is looking to transact business between themselves and Brazil in either yuan or reals – effectively bypassing any reliance on the dollar for bi-lateral trade. Whether the scope of these non-USD trade flows increases between BRIC nature is open to debate, but I think it more likely than not.
This is an excerpt from July 2009 issue of Forex Journal.