The role of SDRs in the global financial system

In this third and final article, Soren Ambrose and Bhumika Muchhala explain how SDRs can be part of global financial reforms, specifically in repairing the current distorted and inefficient global reserve system.

JUST as Special Drawing Rights (SDRs) were originally created to address a shortcoming of the Bretton Woods system, so they are attractive again because they can help patch some of the manifest failures of the reigning financial system. But that system has been failing developing countries for a long time, and allocations of SDRs cannot substitute for the fundamental reforms required to create a financial system that is just and sound for the entire world. But SDRs can be a part of those reforms, specifically the repair of the distorted and inefficient global reserve system.

A number of proposals have been made for how the global reserve system can be refashioned so as to avoid the seemingly inevitable distortions resulting from reliance on one dominant world currency (the US dollar). These distortions include the essential freezing of massive amounts of dollars - potential development resources - as countries like China 'self-insure' against future crises by building up their reserves. This self-protection has resulted in a massive accumulation of US dollar reserves, amounting to $3.7 trillion across all developing countries in 2007 (Commission of Experts, 2009). These reserves are in essence a transfer of resources, at very low interest rates, from developing countries to the industrial countries, especially the US, which issue the reserve currencies. While the chief source of emergency finance available to developing countries during times of crises is the International Monetary Fund (IMF), many prefer low-return investments to the imposed, and often harmful, conditions of IMF loans.

Most of the proposals for reform of the global reserve system focus on the creation of a new dedicated international currency for reserves, to avert the distortions created by reliance on national currencies. The June UN Conference on the World Financial and Economic Crisis and Its Impact on Development took a potentially important step by 'acknowledging' the calls for such reform. The outcome document includes the following:

'The crisis has intensified calls by some States for reform of the current global reserve system to overcome its insufficiencies. We acknowledge the calls by many States for further study of the feasibility and advisability of a more efficient reserve system, including the possible function of SDRs in any such system and the complementary roles that could be played by various regional arrangements.'

This is a concrete indication of momentum towards addressing the shortcomings of the current reserve system. It could be used as a starting point for pushing relevant discussions in international fora.

Indeed, the idea is now being discussed more broadly. Bloomberg reported in June that John Lipsky, the number-two official at the IMF, told a conference in St. Petersburg, Russia that 'there are many, many attractions in the long run' to the introduction of a new global reserve currency. He emphasised that 'this is not a quick, short or easy decision', and indeed that it would be 'quite revolutionary' (Nicholson, 2009). In November 2009, the IMF published a 'staff position note' - not an official IMF position - on the prospects for reform of the global monetary system. The paper lays out the various options, and acknowledges the sound rationale for exploring them. But while it does not come to a firm conclusion, it suggests that significant change would require so much political will that it may never happen, and so energy should be focused on improving the current arrangement (Mateos y Lago et al., 2009).

The People's Bank of China, which holds the world's largest quantity of US dollar reserves at $2.1 trillion (as of June 2009), has been perhaps the most visible proponent of serious reform, saying that 'to avoid the shortcomings of sovereign credit currencies acting as reserve currencies, we need to create an ... international reserve currency that can maintain the long-term stability of its value' (Dow Jones/WSJ, 2009). The density of China's dollar-denominated reserves makes it vulnerable to the foreign exchange risks of the US dollar; at the same time China is a key contributor to the reduced level of demand, because its static reserves keep global demand lower than it would be if those funds were in play in the global economy.

Like most others making the proposals, the Chinese central bank governor, Zhou Xiaochuan, has identified the SDR as the most likely vehicle for a global reserve currency (Kim & Yong, 2009; BBC, 2009; Dow Jones/WSJ, 2009). The idea of a global reserve currency also attracted support at the recent summit meeting of the 'BRIC' countries (Brazil, Russia, India, China), where the idea was broached and pushed by the Russian government, though no joint position was announced (Xu, 2009; Russia Today, 2009).

Fixing the global reserve system... and the IMF too

The economists Yilmaz Akyuz and Jose Antonio Ocampo advocate using SDRs in a much more expansive way than they currently are, by making the IMF, which issues them, use SDRs exclusively. That is, all of its funding would be supplied and maintained as SDRs, and all its lending operations would be conducted in SDRs. This would pave the way for the IMF to take on the role of the world's de facto central bank.

As Ocampo points out, this would complete 'the transition launched in the 1960s with the creation of SDRs, fulfilling the objective then included in the IMF Articles of Agreement of "making the special drawing right the principal reserve asset in the international monetary system" (Article VIII, Section 7 and Article XXII)' (Ocampo, 2009).

Clearly such a development is not going to be brought about by the very slow pace of SDR allocations: the ones just completed in 2009 are only the third and fourth in history, and SDRs still constitute a small percentage of total world reserves. Ocampo estimates they now make up less than 5% of the world's non-dollar reserves.

If the IMF were to become entirely SDR-based, SDRs would replace quotas and the emergency borrowing mechanisms (the General and New Arrangements to Borrow) as the single source of funding for the IMF. Countries with surplus reserves would be allowed - indeed, encouraged - to convert their reserves to SDRs. This would allow countries like China to decrease the percentage of their reserve holdings in dollars, thereby creating a healthier distribution of risks. A 'substitution mechanism' based on proposals within the IMF to deal with earlier instances of dollar weakness could be devised. Under it, according to Akyz, 'the IMF would issue interest-bearing certificates denominated in SDRs against dollar reserves handed over by central banks at the market exchange rate, and invest these reserves in interest-bearing United States treasury bills and bonds. The operation would not affect the total volume of international reserves but its composition - thus no "inflation" fears. Countries can use these certificates to settle international payments or to acquire reserve currencies. The substitution would result in a withdrawal of a large stock of dollar reserves from the market and put them into IMF coffers. It would eliminate the risk of monetary turmoil that could result from a potential widespread unloading of dollar reserves by central banks.' (Akyz, 2009)

Ocampo would accept the continuing use of the current quota system to determine SDR allocations and voting power within the institution, but Akyz holds that with an SDR-based IMF, 'the present practice of allocations [of SDRs] to countries according to their quotas would be discontinued.' Allocations could be done on the basis of formulas gauging the relative importance or size of economies, relative proportions of national income devoted to building foreign exchange reserves, and the need for greater reserve backing in some countries. They could also be used as a counter-cyclical tool at times of turmoil or crisis. This, says Akyz, 'would help counter deflationary forces in the world economy and provide an offset to fluctuations in private balance-of-payments financing'. The UN's Trade and Development Report (2009) also highlights that one of the advantages of using SDRs in such a counter-cyclical manner is that it would, in principle, facilitate the task of preventing excessive currency depreciations for countries in crisis.

The Stiglitz Commission, which advised the June UN conference and helped draw attention to the deficiencies of the global reserve system, also suggests that the IMF take charge of the system and that SDRs be used as the global reserve currency. But it suggests that if there are objections to the IMF playing this role, a 'Global Reserve Bank' could be created. It foresees the global currency (probably SDRs) being allocated annually to countries based on their weight in the global economy, their needs, or a combination, and also suggests varying the total amounts issued to respond counter-cyclically to global economic trends. The Commission maintains that such an arrangement 'should be designed to regulate the creation of global liquidity and maintain global macroeconomic stability' and make problems 'related to the creation of excess liquidity by the reserve currency country less likely to occur'. It adds that the system should 'be designed to put pressure on countries to reduce their surpluses and to thus reduce their contribution to the insufficiency of global aggregate demand' (Commission of Experts, 2009).

Such pressure could be applied through the allocations: 'Countries that maintain excessive surpluses could lose all or part of their quota allocations if they are not utilised in a timely manner to increase global demand.' (Commission of Experts, 2009)

The Commission also suggests that the system could be phased in gradually, with only countries that immediately see the benefit of converting their reserves to SDRs doing so, thus providing an example that other countries, including the US, will want to emulate. Once a critical mass of countries is committed to the system, revised approaches to allocating SDRs could be implemented.

Another method of implementing the reformed reserve system would be to assign regional economic formations (e.g. ASEAN, SADC, Mercosur, etc.) to lead the process. Ocampo takes this idea the furthest, suggesting that the IMF be seen as the 'apex of a network of regional reserve funds' and that reliance on the regional formations could be encouraged by making SDR allocations dependent in part on countries' reserve holdings devoted to regional funds.

As an SDR-based institution, the IMF would have the necessary leeway to become a more independent monetary institution. It would, in Akyz's words, 'be translated into a technocratic institution of the kind advocated by Keynes during the original Bretton Woods conference. Its funding would no longer be subjected to arduous and politically charged negotiations dominated by major industrial countries. Nor would it need to borrow from some of its members in order to lend to others. Such an arrangement could thus bring a considerable improvement to the governance of the IMF, allowing it to stay at equal distance to all its members and help to perform policy surveillance even-handedly and effectively. More objective IMF governance could mean an end to the ideological rigidity of the institution and an openness to expansionary, development-oriented policies'. (Akyz, 2009)

Recommendations

* SDRs should be allocated by the IMF regularly, perhaps annually, in times of financial crisis. To do this, the IMF's Articles of Agreement would need to be amended.

* Special, targeted allocations of SDRs should be made on the basis of need rather than quota, or to categories of IMF members, for example to those eligible to borrow from the Extended Credit Facility.

* Wealthy countries should transfer surplus SDRs directly to those with greater need for the resources, and the IMF should facilitate these transfers without itself taking charge of the funds. Such transactions should be conducted transparently.

* The costs of converting SDRs should be eliminated for the most vulnerable developing countries, or subsidised by other IMF funds, such as the profits realised from the sale of IMF gold.

* A second category of SDRs - temporary or reversible - should be created. It could be issued to middle-income countries for temporary finance or reserve use, but they would have to be replenished by a certain date, after which they would expire.

* The use of SDRs for a range of purposes, including for medium- or long-term development, should be asserted and defended.

* Advocates and governments should build on the support expressed for the expanded scope and use of SDRs at the UN Conference on the World Financial and Economic Crisis to push for greater acceptance of their use with individual countries and with the UN.

* The United Nations and other agencies (e.g. the OECD, the IMF, the Financial Stability Forum) should convene formal discussions on the crisis of the global reserve system and work toward consensus on reforms that would eliminate dependence on the US dollar and develop a new global reserve unit not tied to any single country.                                           

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

Akyuz, Yilmaz (2009). 'Policy Response to the Global Financial Crisis:Key Issues for Developing Countries'

BBC (2009). 'China suggests switch from dollar', 24 March

Commission of Experts of the President of the UN General Assembly on Reforms of the International Monetary and Financial System (2009), Report, 21 September

Dow Jones/Wall Street Journal (2009). 'Beijing Formalizes Call for New Reserve Currency', 29 June.

Kim, Kyoungwha and David Yong (2009). 'Dollar's Role Is Safe as IMF Expands Own Currency', Bloomberg, 3 April

Mateos y Lago, Isabelle, Rupa Duttagupta, and Rishi Goyal (2009).'The Debate on the International Monetary System', IMF Staff Position Note, 11 November

Nicholson, Alexander (2009). 'IMF Says New Reserve Currency to Replace Dollar Is Possible', Bloomberg, 6 June

Ocampo, Jos‚ Antonio (2009). 'Special Drawing Rights and the Reform of the Global Reserve System', Intergovernmental  Group of Twenty-Four (G24)

Russia Today (2009). 'Medvedev calls for use of national currencies in trade', 16 June

Xu, Wang (2009). 'BRIC summit may focus on reducing dollar dependence', China Daily, 16 June

*Third World Resurgence No. 234, February 2010, pp 26-28