Does the SDR Have Any Relevance in the New Financial Paradigm?

Board of governors of IMF

There has been considerable speculation as to what the revised SDR basket will mean and that we will see the launch of the gold backed Chinese yuan on 1st October to coincide with the launch of the new SDR basket, which will include the Chinese yuan for the first time. There has also been suggestions that we will see the end of the Federal Reserve Note (FRN), as the worlds reserve currency, at the end of this month. We will examine what the SDR is and why this author considers all this speculation to be baseless, at this time.

However, we need to be explicitly clear that we do envisage the introduction of the gold backed yuan, at some point, because we are aware that there was a plan to launch it in March only for Washington to regard that as a declaration of war and therefore Beijing backed away from that idea. In addition there is no doubt we are seeing the death of the FRN as the world’s reserve currency, as we have discussed countless times.

So what is the SDR?

The SDR was created by the IMF in 1969 as a supplementary international reserve asset, with respect to what was the Bretton Woods fixed exchange rate system backed by gold. Ironically the role of the SDR largely became irrelevant when the Bretton Woods agreement was scrapped and major currencies moved to what is termed  “floating exchange rate mechanisms,” leading to the accumulation of foreign reserves, which we see today.

The exception to this was in response to the 2008 financial crisis, when the IMF issued 182.6 billion SDRs which it claimed played “a critical role in providing liquidity to the global economic system and supplementing member countries’ official reserves amid the global financial crisis.” It should be noted that whilst the SDR is a basket of currencies it is NOT A CURRENCY nor a claim on the IMF. It is actually a potential claim on the freely usable currencies of IMF members. It is possible for holders of SDRs to obtain currencies in exchange for their SDRs in two ways:

  1. Voluntary exchanges between members
  2. IMF designating “stronger members” to purchase SDRs from “weaker members”

The allocation of SDRs is based on a perceived long-term global need to supplement existing reserves and has been implemented on three previous occasions:

  • 1970 – 1972: SDR 9.3 billion
  • 1979 – 1981 SDR 12.1 billion
  • 28th August 2009: 161.2 billion

A special one-time allocation of SDR 21.5 billion became effective on 10th August 2009, which was the “Fourth Amendment to the Articles of Agreement.” This amendment enabled all members of the IMF to participate in the SDR mechanism on an equitable basis, given that over 20% of global nations had not joined the IMF prior to 1981 and did not receive an allocation until this fourth amendment was adopted. Therefore there are currently a total of SDR 204.1 billion which, at current exchange rates, equates to approximately $280 billion dollars.

The respective weights for the SDR basket are illustrated below and compare the percentages assigned in the 2010 review and the 2015 review, which will be implemented on 1st October 2016. Interestingly, we can see that the US Dollar weighting essentially remains the same, with the Euro showing the largest reduction to accommodate the Chinese yuan in the new basket.

 

Weighting in Percentage Terms

2010

 

2016

 
US Dollar

41.9

41.73

Euro

37.4

30.93

Chinese Renminbi

N/A

10.92

Japanese Yen

9.4

8.33

Pound Sterling

11.3

8.09

For over 20 years SDR transactions have operated through voluntary trading agreements, which now totals 32 with over fifty percentage such arrangements implemented since the 2009 SDR allocation revisions. It should be noted that IMF members usually buy SDRs to discharge obligations to the IMF and they may choose to sell SDRs to adjust the composition of their currency reserves. Should there ever be an occasion that there is insufficient capacity under the voluntary trading arrangement the IMF can “designate stronger nations” to buy SDRs from “weaker nations.”

Editorial Comment:

Given the composition of the SDR, one has to ask oneself: how exactly does the introduction of the yuan, at an 11% weighting, make any difference given the US Dollar remains the largest component? If the dollar collapses what then happens to the SDR? Currently the capacity of SDRs seems woefully inadequate to handle any future stresses in the global financial system and the idea that “stronger nations” can effectively be forced to buy SDRs seems incredulous to this author.

There is no evidence to suggest that a gold backed yuan will be launched on 1st October but I would acknowledge that anything is possible. The fact that would coincide with the launch of the new SDR basket is an irrelevance anyway as one does not depend on the other. I am not expecting to see anything fundamentally change with regards to the SDR operation and mechanism after 1st October and I do not see the inclusion of the yuan at that weighting as having any real significance, especially given the total allocation that is currently in circulation.

We are seeing too many square pegs being hammered into round holes with regards to dates and what is going to happen. I have even heard suggestions that the Iraqi dinar would be included in the SDR and that secretly the yuan is already included in the SDR basket, both of which are simply not the case. I would expect next week to pass off without any significant incident, relating to the yuan’s inclusion in the SDR basket. The eventual launch of a gold backed yuan will be the seismic event, not the launch of a newly-weighted SDR which has been, in any case, under-utilised and largely an irrelevance since its inception.

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