IMF And China Accelerate Creation Of New Global Reserve Currency

| About: iShares China (FXI)

By Valentin Schmid

Click to enlarge

International Monetary Fund Managing Director Christine Lagarde speaks at the 40th anniversary of the IMFC meeting at the IMF Headquarters in Washington, April 20, 2013. (Stephen Jaffe/IMF via Getty Images)

For most people, SDR sounds like an odd disease. And yet, it could be the world's next reserve currency, at least if China and the International Monetary Fund (IMF) get their way.

The so-called Special Drawing Rights (SDR) are an IMF construct of actual currencies, right now the euro, yen, dollar, and pound. It made news last year when the Chinese renminbi was also admitted, although it won't formally be part of the basket until October 1st of this year.

IMF members have it and can trade it with each other for actual currencies, which indebted nations like Greece and the Sudan frequently do. The average Joe or the average company on the street can't hold the instrument right now, let alone spend it.

But that's precisely what the global monetary elite wants in the not too distant future, and it will use China as a Guinea pig. Before the meeting of G20 central bankers and finance ministers in Chengdu, China, from July 22-23, some academics started pushing the idea of an extended use of the SDR (currently worth $1.39)

"Establishing the SDR as the leading global reserve currency would have far-reaching benefits"

Jose Antonio Ocampo, a professor at Columbia University, wrote in a post on Project Syndicate on July 8.

"Beyond the push to use SDRs more actively in IMF programs, governments could issue SDR-denominated bonds. Moreover, private banks could increase their use of this monetary unit, just as some European banks used the so-called European Currency Unit, helping to pave the way for the euro," he continues.

IMF Is at It as Well

On cue, the IMF itself published a paper on "whether a broader role for the SDR could contribute to [the international monetary system's] smooth functioning," and even released a video on July 8 to explain the convoluted nature of the instrument (see above).

It echoes Ocampo's idea of private corporations issuing bonds in SDR and banks making loans in SDR, or a special version of it called M-SDR, presumably standing for "market" based instruments like bonds.

The IMF experimented with these M-SDRs in the 1970s and 1980s when banks had SDR 5-7 billion in deposits and companies had issued SDR 563 million in bonds. A paltry amount, but the concept worked in practice.

"M-SDRs emerged in the 1970s and early 1980s before the market faded, but there has been renewed interest recently," writes the IMF, although it is unclear whether there really exists interest outside the IMF's imagination and some government-controlled entities, like supra-national development organizations.

History of M-SDR use. (IMF)

So after the G20 meeting on July 25, the deputy director of the People's Bank of China's (PBOC) International Office Zhou Juan immediately countered the concern about a lack of market demand. He said an international development organization like the Asian Infrastructure and Investment Bank (AIIB) could issue SDR bonds in China as late as August, according to Chinese newspaper Caixin.

Zhu echoed both Ocampo and the IMF and said that "SDR-denominated bonds should be appealing to official investors at their preliminary stage because they can provide diversified investment products and reduce exchange rate and interest rate risks."

China has openly called for the SDR to replace the U.S. Dollar as the world's reserve currency. "China has been pushing for the SDR to become more widely used for some time, as a way to challenge the dominance of the dollar without pushing the renminbi as a direct competitor," Julian Evans-Pritchard, a China economist at Capital Economics in Singapore, told Reuters.

The IMF did an analysis and concluded financial instruments denominated in SDR would lower volatility and risk compared to holding assets in individual currencies and save costs, just as Zhu said as well. "M-SDRs could, therefore, be attractive to investors and issuers by offering a prepackaged diversification option," the fund writes.

A Solution for China's Capital Outflows?

China insider David Marsh, the founder of finance think tank OMFIF (Official Monetary and Financial Institutions Forum) wrote on Marketwatch in late April about another benefit of launching the M-SDR in China, although he did talk about a wider range of applications rather than just the issuance by the development institution.

Beijing's SDR capital market initiative will allow domestic Chinese investors to subscribe to domestic bond issues with a significant foreign currency component, a means of helping dampen capital outflows that have gained prominence in the last 18 months as a result of progressive capital liberalization.

In other words: If Chinese investors can buy bonds or other debt instruments in SDR in China, they could circumvent the capital controls and hold a diversified portfolio of euros, dollars, yen, and pounds with a small amount of renminbi mixed in. And they don't have to go out of their way smuggling gold across the border to Hong Kong or buying up Italian soccer clubs.

China lost $676 billion in capital in 2015 alone and foreign currency reserves are nearing the critical level of $2.7 trillion (now $3.2 trillion), the minimum the IMF thinks the country needs to run the economy.

So it's safe to say the IMF had the same issue in mind when it wrote its paper, whose authors we don't know. In mid-July, it stated:

In China, there may be untapped demand among domestic investors for exposure to reserve currencies as capital controls are gradually lifted. From this perspective, M-SDRs issued in the onshore market could potentially reduce demand for foreign currency and reduce capital outflows by allowing domestic market participants to diversify their foreign exchange risk.

Of course, China, the IMF, and global academics will find a host of problems implementing their plan, including no existing market clearing mechanism and liquidity issues or simply a lack of demand for a superfluous product that nobody knows or understands.

Superfluous because institutions from central banks to sovereign wealth funds already run their own diversified currency portfolios and don't need the IMF to tell them which weight is appropriate for their own needs.

There is no demand for the product because it has been around for more than 40 years and it hasn't been adopted by private players. The only people who are calling for it are government officials and academics and the only vehicle for early adoptions are Chinese state banks or state-controlled international institutions that can't make a decision on their own.

But practical problems like these have never deterred the IMF or China and we will see more about the feasibility of the plan as the year progresses.