by Jan Nieuwenhuijs, Voima Gold:
There’s no way IMF’s Special Drawing Rights, a poorly designed synthetic reserve asset, will replace the U.S. dollar as the world reserve currency.
After several years of monetary madness—artificially lowering interest rates to the extent all asset prices are distorted—the world is slowly waking up to the fact that printing money by central banks is a one-way street. Once central banks enter this trajectory (and they have), they can’t reverse. Markets have become addicted to cheap money, and central banks feel compelled to print more when the economy, or stock market, weakens. The Federal Reserve, the issuer of the U.S. dollar, is trapped too. Possibly, a paradigm shift in the international monetary system will transpire during the coming economic downturn, and the dollar will lose its status as the world reserve currency.
Some analysts proclaim the next world reserve currency is standing ready to replace the dollar. This would be the Special Drawing Right (SDR), issued by the International Monetary Fund (IMF). According to my analysis, though, the SDR isn’t capable of being the world reserve currency. It will never be much more than a unit of account.
If you ask a random financial expert what an SDR is, he or she is likely to say, “It’s a currency issued by the IMF, comprising a basket of the world’s most important currencies.” Based on this definition, some analyst forecast the SDR will replace the dollar. But, from examining the anatomy of the SDR, it appears it’s not a currency and there is no free market to exchange them. Which is problematic.
The SDR is a “supplementary international reserve asset” that was created by the International Monetary Fund in 1969. At first, it was defined as 0.888671 grams of gold. By denominating it in a fixed weight of gold, some thought SDRs were backed by gold. Alas, SDRs were created out of thin air and then given a gold exchange rate, but they could not be redeemed for gold (page 212).
In 1974, after the collapse of Bretton Woods, the SDR’s value was redefined based on a basket of currencies. But, again, the SDR was not backed by these currencies. Rather, the SDR’s valuation was, and is, based on the weights given to the currencies in the basket.
On the IMF website, we can read an illuminating definition of the SDR:
The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.
The SDR is not a currency, because it can’t be used by individuals; it’s not a medium of exchange. The word “potential” in the definition of the SDR is crucial. It reveals that any monetary authority holding SDRs, might be able to convert them into “freely usable currencies of IMF members”, or it might not. How come? In the IMF Financial Operations 2018 we can read:
there is no market for the SDR itself in which excess supply or demand pressure can be eliminated by adjustments in the price, or value, of the SDR.
The SDR is a “potential claim” on freely usable currencies, because there is no market for the SDR, and it’s not a liability of the IMF. The result is that possibly SDRs can be exchanged for actual currencies (below is explained how), but there is no guarantee.
How the SDR can function as the backbone of the international monetary system (IMS) if there is not a (highly liquid) market for it? The answer is, it can’t.
From this short introduction, we see that the SDR is essentially a unit of account. In the remainder of this article, we will delve into the anatomy of the SDR, how it’s traded and the likelihood of replacing the U.S. dollar.
What Is an SDR?
The SDR is a supplementary international reserve asset. SDRs can’t be held by private entities or individuals, but only by IMF member countries, and, currently, fifteen organizations approved by the IMF as “prescribed holders” (page 91). Let’s start with a brief introduction of the IMF’s governing structure, as a backdrop to understand how SDRs are created and used. We’ll start with the IMF’s General Department.
The IMF’s resources are mainly held in its General Resources Account, which is managed by the General Department. Each IMF member country is required to transfer financial resources to the IMF based on its “quota”, set according to a member’s relative economic position in the world economy. The General Resources Account is a pool of currencies and reserve assets, mostly built from members’ paid capital subscriptions derived from quotas (page 13).
For lending operations (for which the Fund is mostly known for), the IMF does offer SDRs as an alternative to “usable currencies” from its General Resources Account, but in practice, the majority of loans and repayments are made in usable currencies (page 92). (“Freely usable currencies”, according to the IMF are currencies “widely used to make payments for international transactions, and [are] widely traded in the principal exchange markets.”)
Quotas are also tied to an IMF member’s voting power, and they determine the share of SDR allocations. When SDR’s are created by the IMF, out of thin air, they are allocated among all 189 IMF members according to the quotas. The IMF can’t allocate SDRs to itself or to prescribed holders (page 89).
Once newly created SDRs are collected, two entries arise on an IMF member’s balance sheet: “SDR holdings” on the asset side, and “SDR allocations” on the liability side.
Members receive the SDR interest rate on SDR holdings and pay the SDR interest rate on SDR allocations. SDR interest rate transfer system is a zero-sum game. Those having less SDR holdings than allocations pay interest to those with more SDR holdings than allocations. The IMF’s SDR Department, the center of the SDR apparatus, manages all interest rate flows.