The Viability of the Special Drawing Rights as an International Reserve Asset

The Special Drawing Right (SDR) is an unconditional claim to the hard-currency reserves of other International Monetary Fund (IMF) members and certain other prescribed holders. After the large IMF allocations of August-September 2009, SDRs still account for only 2 percent of lower-income country reserves and less than 4 percent of global reserves.

At present the SDR mechanism functions largely as a reserve-pooling arrangement, useful in re-allocating global liquidity from countries with ample liquidity to those with higher needs. But the mechanism does not create new liquidity, in the form of higher supplies of high-powered reserve currencies, as might be needed during a global crisis. The SDR’s value is linked to that of a basket of the four principal reserve currencies, so as to stabilize the value of IMF members’ claims on the reserve pool. But the SDR is not itself a currency that can be bought and sold in private markets. In light of the small scale and conditionality of the international liquidity safety net, including IMF resources, many lower-income countries have chosen self-insurance through accumulation of substantial international reserves, mostly U.S. dollars and euros. The resulting insurance system has numerous drawbacks, however, some at the country level, some systemic. At the country level, reserve holders may earn low returns on their balances of the “privileged” reserve currencies. At the system level, official shifts between reserve currencies could destabilize exchange markets. And there are other potential problems.

If countries held more SDRs and fewer reserve currencies, these problems might be mitigated. The main proposal for large scale replacement of currency reserves with SDRs is through a substitution account, under which countries deposit currency reserves with the IMF in return for SDRs. This scheme, however, merely transfers any financial burden to the IMF, which itself could earn low returns on its currency balances and would bear the risk of exchange rate changes. How can IMF members share the cost? Plans for a substitution account foundered on this rock in 1979-1980; the scale of the problem is even greater now. As has been true in the euro zone, absence of a centralized fiscal power hobbles the provision of public goods that might enhance systemic financial stability. (Of course, individual counties are free now to choose reserve portfolios that reproduce the SDR basket, though most hold a higher weight of U.S. dollars.)

If SDRs can be created only through the allocation process and not through substitution, then under current arrangements, the extent to which they can replace currency reserves is self-limiting. Roughly speaking, because SDRs are merely claims on hard-currency reserves and cannot be used in private markets, their emission has no further value once the value of outstanding SDR claims is sufficient to purchase the outstanding stock of gross currency reserves.

The situation would be different if SDR claims could be presented directly to central banks in return for their own currencies, as some have suggested, because this change would make the outside supply of reserve currencies elastic in a crisis. Such a system would reproduce the stabilizing properties of the network of central bank swap facilities set up during the recent global financial crisis, but it would be predictable rather than ad hoc and all countries, not just a select few, would have access. An equivalent mechanism could be set up without reference to the SDR at all, simply by instituting lines of credit from central banks and administered by the IMF. The IMF could extend the facilities directly to national central banks meeting specified standards of supervisory diligence and independence from political interference. Such credit lines would complement expanded flexible IMF loan facilities for sovereigns. Likewise, even the current SDR-based reserve-pooling arrangements could be accomplished, perhaps in a more flexible and need-based way, by explicit reserve pooling. An advantage of this approach is that countries would not need to offset the currency risk taken on through SDR transactions with opposite, possibly costly, forward-market transactions. The costs of these could become significant were SDRs to become more important as a reserve category.

Denominating more global reserves in SDR would affect exchange rate volatility among the main reserve currencies primarily to the extent that it reduced potential official demand shifts among those currencies. Were more countries to peg to the SDR as a result, however, their effective nominal (and probably real) exchange rate volatility would fall. Adding China’s yuan to the SDR basket, given its current policy of heavy management against the U.S. dollar, would effectively increase the dollar’s weight in the SDR basket. Since the yuan is not an international reserve currency, the rationale for tying the SDR’s value to the yuan at the present time is unclear. An enhanced international liquidity safety net, whether based on the SDR or on some system of credit lines centered on the IMF, would enhance the IMF’s power and thus calls for complementary reforms in governance structure. These should be aimed at increasing the voice of emerging and developing countries, in line with their growing weight in the world economy. An enhanced safety net also could worsen moral hazard on the part of market participants or governments, so the IMF’s macroeconomic and financial surveillance powers would likewise have to be upgraded. That change would greatly add to the need for reformed governance.