IMF Special Drawing Rights 101 – the all-you-need-to-know guide

30/05/2015 by

Unless you have been on another planet in the past year, you would have heard of China’s bid for the renminbi (RMB) to be included in the IMF Special Drawing Rights (SDR) basket that is undergoing its five-yearly review later this year. Yet the whole matter has become rather “emotional” that I hope a short piece like this can help to put all the pieces together. Let’s start with a bit of history.

History of the SDR

The SDR was created in 1969 to act as a supplementary “asset” to USD and gold which in turn, were the anchor to the Bretton Woods fixed exchange rate system – a system that came about after World War II to peg all currencies to the USD and gold. But in 1973, the Bretton Woods itself collapsed, with the major currencies going back into free float and so went also the need for any global anchors – USD, gold and the SDR – for fixing exchange rates. The SDR then basically became a unit of accounting between the IMF and member countries. As a medium of exchange, every currency needs an exchange rate – whether it’s the SGD, the Bitcoin or the SDR, although note that the IMF strictly does not call the SDR a currency, as explained below. Prior to the Bretton Woods collapse in 1973, the SDR’s exchange rate was a fixed rate to the USD. After that, it became referenced to a basket of “freely usable” currencies. This basket evolved from 16 currencies in 1973 into 5 currencies (USD, DEM, FFR, GBP and JPY) in 1980 and 4 currencies (USD, EUR, GBP and JPY) in 2000 after the birth of the euro.

The SDR is like a casino chip rather than the Bitcoin

The IMF makes clear that the SDR is neither a currency nor a claim on the IMF. If it isn’t a currency, is the SDR like the Bitcoin? No because firstly, the SDR is not circulated outside of the central banking community, and yet, secondly, unlike Bitcoin, the SDR does have a identifiable institution, the IMF, that has a physical address that acts as an intermediary to which holders of the SDR can go to exchange their SDR for the “freely usable currencies” inside the SDR’s reference basket. Think of the SDR simply as a “chip” that you can buy from the casino using your SGD, USD or whatever currencies, which you can only use inside that same casino and not outside.

How did China appear in the picture?

Post-Lehman crisis in 2008, people were upset with the US and started dumping the USD. People began questioning the value of the USD as a global “reserve currency” that was – and still is – widely used for settling international trade, denominating global financial products, and also being held by virtually all central banks to back the printing of their own currencies. Countries, notably China, asked if there should be more alternative reserve currencies to reduce the hegemony of the USD. This was when people turned again to the IMF to ask if the SDR can be used to replace the USD as a global reserve currency. And the IMF flatly said “no” – it was not about to start printing the SDR and letting it circulate outside of the central banking community, not even if member central banks topped up the IMF’s capital base to support the printing of the SDR. The IMF instead proceeded to evaluate the criteria for broadening its SDR basket with clearly the intention to consider the RMB as a potential candidate. In its staff report, “Criteria for broadening the SDR currency basket“, 23 September 2011, the IMF projected the “size” and “usability” of the RMB in 2015 as surpassing some existing SDR component currencies. This shows that even back in 2011, the RMB was not only being considered as a potential SDR basket component and that the RMB may stand a good chance if it accelerated the pace of market liberalisation from the prior five-year period, 2005-2010.

The emotional twist

Inclusion into the SDR basically elevates the currency to the top of the global financial markets. However, some people thinks little of the SDR basket inclusion, since the SDR is not being circulated outside of the central banking community and is not being used like a reserve currency for denominating trade, services or financial products. That in my view, is a very big misperception. Firstly, note again that the SDR basket composition has not changed since 1980. Surely, a change would be noticeable. Secondly, the above mentioned IMF 2011 report proposed to drop the old rule of keeping the number of basket components to four. In other words, there can be three – not just two – outcomes from the IMF review later this year – a. the RMB is not included in the SDR, b. the RMB is included, and c. the RMB is included but an existing SDR component is taken out. There will be real competition this time. This is why the emotions of some government officials and investors alike are stirred so vigorously by the thought of RMB getting into the SDR basket.

To China, SDR inclusion is a bonus on its agenda to fully open up its capital markets and adopt a free floating currency. Put differently, China will proceed on its agenda, regardless of its SDR inclusion. This determination has already made many global investors – individuals, institutions and central banks – start buying up RMB-denominated assets. Inclusion into the SDR will only endorse this trend and add fuel to the buying. I was asked the question recently – would index providers include China into its global indices such as WGBI if China gets included into the SDR? I think when push comes to shove, index providers will turn to its clients – the global investors – and ask if we want China to be included. And my bet is that the majority would say “yes” because after all, the SDR inclusion is an endorsement on the “freely usability” of the RMB on a “global scale”. What other excuse can we have for not holding the RMB?

Intrinsic value of the RMB as a global reserve currency

There are lots more to be said on this topic – does RMB deserves to be in the SDR? What is the intrinsic value of the RMB if it becomes a global reserve currency? My short answer to Question 1: in 1980, the IMF staff proposed not to include JPY into the SDR but the IMF board voted in favour of it (it requires a 70% majority). In other words, there are political considerations beyond statistics. My short answer to Question 2: China’s reserves can support 3-4x of the stock of RMB printed and circulated. The US’ reserves barely supports 0.5x of USD out there. Extrapolating the RMB into the USD’s position, its intrinsic value can be 3x of where it is today.

***********************

Dear friends,

Charity drive for Operation Hope Foundation’s ‘Raise the Roof’ rebuilding project in Nepal.

Message as follows.

“Currently we are looking at helping affected areas in Gorkha and/or Dhading, which is around the first quake epicentre. We are looking at providing low-cost housing like the Earthbag house and interlocking mudbrick houses which uses natural construction materials like soil/mud and have easy building techniques that would transferable to the villages. We are also looking at home-partnered housing program, where the villagers themselves will be involved in the rebuilding of their own homes, and OHF will mainly be providing the materials, skills, technical know-how, with supervision and follow up on the homes built too.

We are targetting to help rebuild about 100-200 houses for the 100+ families and about 1000 people (including children) affected in one of the village near Dhading. Our current estimation of the Earthbag houses cost around S$500-S$800 per house, so donation of S$10,000 could help rebuild about 12-20 homes.

More information could be found in our website http://ohf.org.sg/rebuilding-lives-restoring-hope-nepal

The writer would like to put 2 paintings up for sale through bids with proceeds going towards the aforementioned charitable cause.