Special Drawing Rights: A Fantasy Built upon Foundations of Sand

| About: Market Vectors (CNY)
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I have had a very interesting contribution to my blog regarding IMF Special Drawing Rights (SDRs) in a comment, with the commentator also sending some additional information by email. The point made by the commentator is that it appears that there is the development of quantitative easing (printing money) at the world level through the issuance of SDRs. As such, I thought I would examine SDRs more closely, which has proved to be a somewhat challenging task.

This is the explanation of SDRs from the IMF website:

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation taking effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs will increase from SDR 21.4 billion to SDR 204.1 billion (currently equivalent to about $317 billion).

The SDR is based on a basket of currencies including the £GB, $US, Japanese Yen and Euro, but is also potentially a claim upon the currency of any IMF member. The status as a reserve asset "derives from the commitments of members to hold, accept, and honor obligations denominated in SDR." In other words, it is a form of money. Perhaps the most interesting aspect of the SDR is the following (from the IMF):

The IMF has the authority under its Articles of Agreement to create unconditional liquidity through "general allocations" of SDRs to participants in its SDR Department (currently, all members of the IMF) in proportion to their quotas in the IMF.

What this means is that the IMF has no limit on the amount of money that it is able to create, and that is the creation of money in addition to the central banks of the basket currencies. The IMF is able to create money at will. To give a sense of the value of the SDRs, the exchange rate for SDRs is $US 0.634, £GB 1.048 as of 10 September (figures will change as the page is updated), and the SDRs also pay interest according to a calculation based upon the bond yields of the currency basket members (currently 0.26%):

SDR allocations provide each member with a costless asset. If a member’s SDR holdings rise above its allocation (for example, if it purchases SDRs from another member), it earns interest on the excess; on the other hand, if it holds fewer SDRs than allocated, it pays interest on the shortfall at the official SDR interest rate.

However, SDRs are unusual in that they can only be held and traded by governments and 'prescribed holders' such as the BIS. What we seem to have here is a currency which can be issued at will, with no restraints, and which can then be used by governments to pay their debts to each other. It is therefore interesting to note that the IMF has just completed a record allocation of SDRs to the tune of $US 250 billion:

The Board of Governors of the International Monetary Fund (IMF) has approved on August 7, 2009 a general allocation of Special Drawing Rights (SDRs) equivalent to US$250 billion to provide liquidity to the global economic system by supplementing Fund’s member countries’ foreign exchange reserves.

In order to support the finance of the IMF and SDRs, the following countries have chipped in:

• As of end-July 2009, three bilateral borrowing agreements, designed to temporarily bolster the Fund's capacity to provide timely and effective balance of payments support to member countries during the current crisis, are effective: Japan ($100 billion), Norway ($4.5 billion), and Canada ($10 billion).

• In addition, European Union members have pledged loans worth €75 billion ($100 billion). Switzerland has pledged about $10 billion. China, Brazil and Russia have indicated their willingness to invest in notes issued by the IMF.

• In sum, substantial progress toward the G-20 goal of $250 billion in immediate resource additions has already been made and the Fund is continuing to work with members to supplement its resources.

In broader terms, this is the IMF description of the source of the organisation's financing:

The IMF's resources come mainly from the quotas that countries deposit when they join the IMF. Quotas broadly reflect the size of each member's economy: the larger a country's economy in terms of output, and the larger and more variable its trade, the larger its quota tends to be. For example, the United States, the world's largest economy, has the largest quota in the IMF. Quotas are reviewed periodically and can be increased when deemed necessary by the Board of Governors.

Countries deposit 25 percent of their quota subscriptions in Special Drawing Rights or major currencies, such as U.S. dollars or Japanese yen. The IMF can call on the remainder, payable in the member's own currency, to be made available for lending as needed.

Perhaps the most interesting point here is that many of the countries that are the major contributors to the IMF are countries with large and growing government debt, with the US as an obvious example. As such, there is a situation in which, for example, the US is funding lending despite having a high level of net debt. The money that they are lending is borrowed money. The creditor is a debtor, and the real creditors are therefore the lender of the money to the US, with China as one of the major lenders. This from Forbes:

He [Liu Guagxi, director general of the Capital Account Management unit of its forex reserve body -- the State Administration of Foreign Exchange (SAFE)] said Beijing was encouraging overseas direct investments and the yuan would be growingly recognized as a global currency.

'Renminbi (yuan) will be more and more widely recognised worldwide and more and more in use in trades and capital transactions. This is irreversible,' he said.

China wants the yuan to be added to the basket of currencies that make up the International Monetary Fund's Special Drawing Right (SDR) virtual currency.

It is apparent that China has recognised that, in reality, a large proportion of the funding of the IMF is actually rooted in Chinese credit. In addition to the US contribution being rooted in borrowed money from China, China is also lending money directly to the IMF with the purchase of SDRs.

An IMF official, speaking on condition they not be named, said the board initially considered limiting the bond sales to $150 billion, based on the level of interest from member states. Board members decided against such a cap because IMF needs will evolve over time, the official said.

China’s government has said it will buy $50 billion in notes. Russia and Brazil last month said they would each buy $10 billion of bonds from the IMF. India has also indicated it would contribute to an IMF bond program. The four nations make up the so-called BRICs.

“This is a victory for the BRICs, particularly China,” said Claudio Loser, the former director of the IMF’s Western Hemisphere department. “Because they will be investing in the fund they will have, directly or indirectly, some say in the governance of the fund that goes beyond their quota.”

The more that the idea of SDRs is examined, the more curious the whole scheme becomes. On the one hand there is an organisation which has no economy of its own, issuing a currency that is rooted in the economies of debtor countries. It then disburses created currency over and above its own holdings of assets, including to the countries that are funding the organisation. This is the IMF on access to financing:

Access to financing. The amount of financing a member can obtain from the IMF (its access limit) is based on its quota. Currently, under Stand-By and Extended Arrangements, a member can borrow up to 100 percent of its quota annually and 300 percent cumulatively. However, access may be higher in exceptional circumstances.

....but the financing of the IMF does not actually come from the countries that are providing the quota, but instead coming from countries like China, who are lending the funds to countries like the US to provide the quota.

Quite simply the SDR is a currency, a form of money, that is rooted in the lending of the major creditor economies such as China. As such, the idea that the currency is rooted in a basket of currencies from debtor countries is, to say the least puzzling. It is no wonder that China is seeking to have the basket include the RMB, as the RMB is the real funder of a large proportion of the SDRs.

In effect, what a country like the US can do, is borrow money from China, lend the same money into IMF funding, and as a result can multiply access to even greater credit. Furthermore, the more money the US lends, the greater the control that the US has in the disbursement of money, as voting rights are tied to the amount of funding that is provided. One of my recent posts was published in Seeking Alpha, and the post discussed the rise of the RMB as a world reserve currency. I pointed out at the time that China's support for SDRs was a red herring, and that China was seeking to replace the $US with the RMB as the world reserve currency. There were several comments that were critical of the post, suggesting that the RMB as the next world currency were a fantasy.

When we actually look at the funding of the SDRs and the IMF, it becomes apparent that one of the China is one of (if not the most) important underlying creditor. Despite this, up to now, their influence in the IMF is disproportionately small. The idea that they might genuinely support SDRs as a new international reserve currency under current arrangements is therefore highly improbable. As I have suggested in previous posts, the SDR is simply a stalking horse for the replacement of the $US with the RMB.

China, in purchasing the SDRs is simply making explicit the reality that the RMB is now the most important currency in the world system, as it is the primary currency of international credit. Whilst China will, in the short term, seek to support the SDR system, they will only continue as a creditor in the long term if Chinese influence in the IMF becomes more proportional to their real role as a major creditor. To a lesser extent, the same might be said of the other underlying lenders, but I have concentrated on China as the major creditor to the US, and therefore the major creditor to the IMF.

In the meantime, the IMF is enacting a policy of quantitative easing (money printing) in which they are issuing currency which is based in economies that are already themselves undertaking quantitative easing. This IMF printed money is being issued internationally, and represents further calls on the output of the countries that constitute the basket of currencies. The problem arises is that countries like the UK and US are currently incapable of supporting their own level of consumption with their output, so it is not clear how such issuance might actually be underwritten without a further underwriting by creditor countries. In other words, the SDRs are entirely contingent for their value on the willingness of countries like China to continue to support countries like the UK or US with credit.

What we are actually seeing in the issuance of SDRs is an illusion. There is, in reality, very little that might support them going forward, at least as long as their value resides in currencies that are being debased by their own central banks, as well as by the issuance of the SDRs themselves. Quite simply, they present the same problems as the fiat currencies in which they are based, and simply serve to add to the problems of those currencies. Alongside this, we can see that the whole system remains beholden primarily to the ongoing support of China, both directly and indirectly.

As a conclusion to this post, I will admit that I find the whole issue of SDRs to be inherently confusing (not something I like to admit), and that my analysis of this issue is therefore open to question. My reading for the post included a wide variety of sources, such as an IMF Working Paper (e.g. 'International Liquidity and the Role of SDR in the International Monetary system', 2002, Clark and Polak). Despite such reading, I find myself struggling to see the SDRs as anything but a fantasy whose value is built upon foundations of sand. I therefore welcome other interpretations, analysis, or explanation and critiques.