Using SDRs to finance development

In this second article, Soren Ambrose and Bhumika Muchhala explain what SDRs are and how they work.

WHILE analysts of the prospects for a new global reserve system acknowledge a variety of options - including reviving the gold standard, or implementing Keynes' proposal, at the time of the Bretton Woods agreements, for a global currency issued by a global central bank (the 'bancor') - most of the proposals identify the Special Drawing Right (SDR) as the most convenient existing vehicle for creating a new system.

How do SDRs work?

SDRs have existed for 40 years, but have long been absent from development debates. They were created in 1969, when the 'Bretton Woods' system of currency values - under which most currencies were valued in US dollars, and the dollar in turn held a steady value to an ounce of gold - still prevailed. Their creation by the International Monetary Fund (IMF) board was sparked by a shortage of both dollars and gold. But by 1973, the creaking Bretton Woods system collapsed when the US abandoned its commitment to dollar-gold convertibility, and currencies began to float freely. No longer a crucial supplement to the Bretton Woods system, SDRs faded into obscurity, though they continued to make up a small portion of countries' reserve holdings.

However, in 2009 the IMF completed a general allocation of SDRs for the first time in 28 years. The G20 group of major world economies had called for the $250 billion allocation at its London summit in April 2009 in a bid to inject liquidity into the troubled global economy. After formal approval by the IMF board, the SDRs were allocated on 28 August. In another move urged by the G20 in April, an additional $33 billion in SDRs was allocated on 9 September and distributed to countries which joined the IMF since the last allocation in 1981. (Although this special allocation had the effect of giving a boost to many crisis-ridden Eastern European countries, it was not purely a response to the crisis. It represented the culmination of a proposal for a special allocation approved by the IMF in 1997 but delayed by the US Congress until 2009.)

Only two distributions, in 1970-72 and 1979-81, had taken place before 2009; the total value of SDRs before 2009 was about $47 billion (at today's rates). The two recent allocations, then, increased the amount of SDRs by more than a factor of six.

Once SDRs are allocated to a country, they are listed as reserves, and are under the management of the country's central bank. While maintained in that state, they cost nothing, and bolster a country's savings, thereby increasing its creditworthiness and perceived economic stability. With greater reserves, a country can generally borrow more and on better terms, or free up existing hard currency reserves. SDRs, whose value is based on a basket of four major currencies (a carefully proportioned mix of the US dollar, the euro, the Japanese yen, and the UK pound sterling), can also be converted into cash through a system of swaps managed by the IMF. Countries pay fluctuating interest charges on converted SDRs until they are replenished. The countries providing the hard currency in the conversions get additional SDRs, on which they earn interest.

Governments are otherwise free to use the cash realised from SDR conversions however they like: to stimulate a stagnant economy, boost spending for social programmes, or substitute for investments that may have dried up. Even though SDRs are issued by the IMF, which is notorious for the pro-cyclical 'structural adjustment' conditions it has imposed on borrowers since the early 1980s, they are not subject to its conditions. The IMF manages the system, but has no say in how SDRs are used.

Last June, at the United Nations Conference on the World Financial and Economic Crisis and Its Impact on Development, the G77-plus-China group of developing countries united behind a call for a significant expansion of SDR allocations. However, the conference's final statement, approved by unanimous consent, did not reflect their position. The outcome document did, however, call for a 'review [of] the allocation of special drawing rights for development purposes'. Although the US and Canadian governments formally went along, they immediately issued 'explanations', saying that SDRs should only be seen as a source of added liquidity. Depending on how countries deploy them in the months to come, there may be some debate about the appropriate use of SDRs, even in the absence of any formal mechanisms for outsiders to influence their use.

New special allocations of SDRs

Civil society organisations have called for additional SDR allocations - either at regular intervals, or automatically in times of crisis - which would be apportioned on the basis of need rather than quota. Such need could be gauged, in part, by the gap in resources available to countries to meet their goals for healthcare, housing, education, and food security. It could also be determined by more specific macroeconomic factors such as shortfalls in a country's foreign exchange reserve levels, out of which import payments and foreign debt servicing are made. As already noted, creating SDRs costs nothing. The only material basis for objections is the risk of inflation. This risk has been generally discounted for the allocation during the recent crisis because there is consensus on the need for more global liquidity.

Jacques Polak, the long-time research director at the IMF, has, with P.B. Clark, argued that the only appropriate gauge for determining how SDRs are allocated is 'the benefit of permitting low-income countries to acquire and hold reserves at a much lower interest rate than they would have to pay in the market, and a reduced dependence of the system on borrowed reserves that are liable to be recalled when they are most needed.' (Polak & Clark, 2006)

Targeted allocations - to just the low-income countries (LICs), for example - would probably require an amendment to the IMF's Articles of Agreement, which can be a lengthy process, as the US Congress's 12-year delay on the recent special allocation illustrates. By contrast, the process that started with the G20 calling for the $250 billion SDR allocation in April took only four and a half months to result in an allocation. With this precedent and the heightened political will demonstrated by the G20, a special allocation could happen in a timely fashion.

Reversible, or temporary, SDRs

The different circumstances and needs of LICs and emerging economies as well as concerns about the potential inflationary impact of additional, more frequent, or larger SDR issues could be taken into account with different kinds of allocations. As Yilmaz Akyz, former director of UNCTAD's Division on Globalisation and Development Strategies, argues, additional standard SDRs could be distributed to low-income countries while middle-income countries get larger amounts of 'reversible', or temporary, SDRs. If converted, these SDRs would be replenished once the crisis ends. Whether converted to cash or maintained as reserves, the temporary SDRs would expire at an established time after the impacts of the crisis subside. Indeed, the proposal made by the G77-plus-China at the recent UN Conference called for $100 billion worth of SDRs to be allocated by the IMF to low-income countries at no cost to them, while another $800 billion in temporary SDRs would be issued to middle-income countries. This could enable countries to pursue a quick, counter-cyclical 'quantitative easing' - stimulating the economy by lowering interest rates to near zero - at the global level at low cost, which is exactly what many individual rich countries have done.

Temporary SDRs for better-off developing countries would respond to concerns about any potential inflationary impact that might be associated with broad and regular issues of SDRs. Countries which are able to use SDRs for their external financing needs would be more likely to be able to avoid conventional, condition-laden IMF loans, and would reduce the IMF's possible need for new funds from their wealthier shareholders. Finally, as Akyz points out, large SDR allocations could allow emerging economies with surpluses, such as China, to diversify their reserve holdings and reduce both their dependence on the US dollar and their vulnerability to its fluctuations in value.

Proposals for SDR transfers

To address the imbalance in the recent general allocation - which was done according to the quotas which determine voting power at the IMF and are based on the economic size of member countries - there have been calls for creating a system that allows for, and encourages, the transfer of SDRs from wealthy countries to those which need them. One problem is that the interest charges for the SDRs would remain with the donor country to which they were originally allocated - a serious disincentive to altruism. There were hopes that the IMF would address this issue in the guidelines for the new allocation, but when the SDRs were issued in July they stated only that 'no proposal for the voluntary redistribution of SDRs has ever been put into effect' because it 'has a real cost to the provider' (IMF, 2009). The exploration of other options by which the interest costs to the provider could be financed has not been addressed by the IMF.

In practice, the recipient countries could agree to reimburse the contributing countries for transferred SDRs. The charge would be the same fee they pay for converting SDRs from their own allocations, and would be offset by the interest they would earn for holding SDRs above their own allocation (or, if they previously converted some SDRs, by the reduction in the charges corresponding to the increased levels of SDRs). Added costs would emerge when the recipient country converts its transferred SDRs into cash: at that point it would cease receiving credit for additional SDRs in its account, meaning it would have to pay more to the IMF even as it continued to pay the contributing country's fees. But this would still be equivalent to the costs a country would incur for converting SDRs from within its own allocation. There is thus little cause to object to transfers or to recipient countries making use of those transfers as they see fit.

The interest charge countries pay on converted SDRs is based on the interest rates on short-term debt for its chosen currency. At the moment, with the driving down of interest rates in response to the financial crisis, the rate is very low - less than 0.5%. However, as the interest rates of the four currencies that comprise SDRs begin to increase with perceived recovery in industrialised countries, the composite interest rate of the SDR will also increase. In fact, the SDR interest rate can vary a great deal, and has been as high as 9%. The interest charges continue until the country replenishes its SDR account by re-converting hard currency.

There are reports of African countries accumulating unmanageable debts in the early 1980s after converting SDRs in advance of the sudden rise in interest rates spurred by the US Federal Reserve. At least for LICs, then, the costs for converting SDRs, including transferred SDRs, should be eliminated or subsidised through the use of other IMF resources (such as the sale of some of the IMF's massive gold stocks). Not only would this make SDRs more attractive for poorer countries, but it would also reduce richer countries' reluctance to transfer their SDRs. If it should prove impossible to mitigate these costs, some mechanism for making the costs predictable, or smoothing them over time, should be introduced.

Another factor discouraging transfers is that some potential donor countries, including the US and the UK, have accounting rules which count SDRs as assets - even though they are acquired at no cost. Thus their transfer would have to be accepted as a loss or balanced by other assets. But it should be a relatively simple matter for governments to change the budgetary status of SDRs.

In August 2009, the IMF floated a proposal that wealthy countries transfer their idle SDR allocation, not to countries in need, but rather to the IMF itself, which would then loan the resources to low-income countries. At the IMF/World Bank annual meetings in October, the British and French governments announced that they would do so (though because the IMF cannot itself hold SDRs, the governments converted them to hard currency first). This was an unfortunate move, as it will almost certainly discourage any other wealthy country from instead offering direct transfers. The loans to LICs that will result will be concessional, but they will also be attached to the IMF's characteristic fiscal and monetary conditions, which are, even at this time of global crisis, pro-cyclical and contractionary as they require public spending cuts and tight monetary policy. When the SDR proceeds are transferred to the IMF instead of directly to LICs, they are converted from unconditioned, cheap resources (or free, if maintained as reserves) to conditioned, debt-creating loans. This method allows donor governments to be seen as generous even as they increase the power of the IMF over low-income country economies.

But as the European Climate Foundation points out, there is a positive effect of the move by the UK and France: it sets a timely precedent for transfers of wealthy countries' SDRs, and for 'de facto using SDR-generated resources for development funding'.

At the Copenhagen climate conference in December 2009, philanthropist George Soros built on this precedent by proposing the transfer of the remaining SDRs issued to developed countries in the most recent allocation. He suggested that the proceeds could create a $100 billion 'fast-start green fund' for climate finance that could be a partial answer to demands by developing countries. The costs of conversion of the SDRs to hard currency could be guaranteed by the IMF's enormous gold stocks, says Soros, with the expectation that loans made by the fund would most likely be repaid with sufficient interest to cover those costs. This proposal would require US Congressional approval for the use of the gold stocks - hardly an easy hurdle. Otherwise, while its proposed funding of loans, rather than grants, is unlikely to satisfy developing countries' demands for climate restitution, it is a method for mobilising the wasted resources held by wealthy countries in the form of SDRs for a vital purpose.     

The above is an edited extract from the paper 'Fruits of the Crisis: Leveraging the Financial & Economic Crisis of 2008-2009 to Secure New Resources for Development and Reform the Global Reserve System' (January 2010).

References

IMF (2009). 'Proposal for a General Allocation of SDRs'

Polak, J.J. and P.B. Clark (2006). 'Reducing the Costs of Holding Reserves: A New Perspective on Special Drawing Rights', in I. Kaul and P. Conceicao (eds.), The New Public Finance: Responding to Global Challenges, Oxford University Press.

*Third World Resurgence No. 234, February 2010, pp 23-25